FINANCIAL ACCOUNTING AND FINANCIAL ANALYSISPGWPM BATCH TWORAGHU IYERAUGUST 2011

As you move higher in management, the language changesTons, kms, people Operating languageRoE, EV, EVA, OPM, FA Turnover ??

Your purpose is the same - to make moneyLanguage of money becomes important

Without money, the best ideas failWright Brothers - aeroplane - without money, they would be unheard and we would be traveling in bullock cartsJames Watt - engine

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

1 Financial accountingAccounting means recording of transactions (financial events)Balance SheetProfit & Loss AccountCash Flow Statement

2 Financial analysisReading the statements and understanding the importIs the company healthyIs the company profitableIs the company making its owners happyWhat is the level of risk

3 Financial decision makingShould I set up this new factoryShould I spend so much on this advertising campaignShould I upgrade my machinesSpend first and wait for returns (takes time)

4 Valuation of companies, projects

5 Financial marketsStock market, derivatives market, commodities market

Finance is a life time journeyIf we build the right awareness, basic understanding and curiosity, then you go ahead and exploreMany non-finance people understand finance better than finance people

Most CEOs understand finance better than CFOsI am v v sure that the decision to make Nanos was Ratan Tata's decision and not Tata Motors CFOs decision

FINANCIAL ACCOUNTING1 Personal Balance Sheet2 Personal P&L3 Basic accounting equation4 Simple example of a new business5 Game - Monopoly

At the end of the game, you will make your own Bal Sheet and P&LBy today evening

6 Corporate Bal Sheet7 Corporate P&L8 Understanding terminology around Corporate Financial Statements

Personal Balance SheetTwo types of numbers in the world

1 Point of time numbers2 Period of time numbers

How many cars do you have?Five carsWhat type of a number is this?Point of time - as of when ? As of today - Aug 14, 2011 - he has five cars

1985 - zero cars2025 - 25 cars

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

1 Point of time numbers2 Period of time numbers

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

What is your salary for Aug 2011?For this answer, your July salary is irrelevantThe Aug salary meter starts from zero on Aug 1

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

Your Personal Balance Sheet as of today - Aug 14, 2011Liabilities - OweSources of FundsWhere the Rupee came fromOwn Capital / Net Worth Own Funds / Accumulated past savings

Opening Balance Profit during the year Closing Balance

Home LoansPersonal LoansGold LoansCar LoansAuto LoansEducation Loans

Loans against Shares

Credit Card duesAll outstanding expenses

Salary ??Education ??Money spent for education ??Wealthy friends ??Wealthy in laws ??Rich dad ??

The most important asset that we have is our "Intellect"The other important asset that we have is our "society - family, friends, relatives, bosses, network, contacts"

Will they appear in our Bal Sheet?Answer - NoWhy?Two challenges:

1 MonetizationI am very intelligentWe all agreeMy intelligence is worth Rs 10 crWe start fighting

2 Transferability (practical ownership)Even if all of us agree that Rangarajan's intellgence is worth Rs 10 cr, can this be transferredin a legally acceptable manner - sale, lease, licence, rent, etc

For accounting, we need a "transaction"Transaction means a financial eventUnless transferability is possible, no event occursRangarajan is very intelligent, but that is not a financial event

Property prices in Mahabalipuram have gone upSo what happens in the Bal Sheet?You have a house in MahabalipuramProperty prices going up is not a "transaction"Nothing happens in the Bal Sheet

SHOW ME THE MONEY

Politicians are required to declare their assetsSo should they declare at their cost (or at current market values)I don’t know

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

Anything that you sell, you will be satisfying both conditions1 You will have to monetize it (bcoz without monetizing, you cant sell)2 A transaction will occur (a transfer will happen)

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

COST VERSUS VALUECost is what you paid, value is what you expect to fetch if the asset is sold off todayAccounting works on COSTCost is a "fact", value is an "opinion"

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

As a result, the Bal Sheet may not reflect current realityIt may be a very old ancient (and for some people - useless) financial statementAccountants have preferred to go by the COST model instead of the VALUE model

Bcoz value is subjective, nobody knows the value, value keeps changing, each expert will come up with his own estimate of value, value is based on something which never happened

What is the loss to the Government due to the 2G Scam?CAG - Rs 1.76 lakh croresJayalalitha - more than Rs 2.00 lakh croresRaja - nothingKapil Sibal - nothing

In the Govt's accounting of 2G licences, the actual amount of money paid by each operator (telecom company) would appear as a transactionIf we got Rs 2,000 cr as licence fees, we will record only Rs 2,000 cr - fact

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

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

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

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

DEPRECIATIONAll assets (other than land) have limited livesIf you bott a car today for Rs 8 lakhs and you estimate is has a ten year life with a salvage value of zero, you should depreciate the car over the ten year period in such a manner that the carrying value of the car in the Bal Sheet becomes zero after ten years

Otherwise, the car will remain at Rs 8 lakhsOne fine day, the car will stop workingThe entire asset will need to be written off on one day (this will become a loss)

You could depreciate the car at Rs 80,000 per annumThis depreciation becomes an expense in the P&L and the carrying value of the car reduces to this extent

Year Op Bal Depn Cl Bal1 800,000 80,000 720,000 2 720,000 80,000 640,000

3 640,000 80,000 560,000 4 560,000 80,000 480,000 5 480,000 80,000 400,000 6 400,000 80,000 320,000 7 320,000 80,000 240,000 8 240,000 80,000 160,000 9 160,000 80,000 80,000

10 80,000 80,000 -

Accountants are very simple people, they don’t understand complicated stuff like inflation, GDP, USD INR, US Debt, S&P rating, etc, etcThey record financial transactionsIf the value of money drops due to passage of time, etc, that is not for the accountant to decipher

A Rs 10 note of 1980 is currently worth how much ?In the Bal Sheet, the Rs 10 will appear at Rs 10 even today

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

The general principle is that we prefer cost over valueWe don’t like valuation, etc, etc

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

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

On rare occasions, we may be forced to take the help of this VALUE animal, but we try to be as far away from the animal as we can

If depreciation is being recognized, why not appreciation?The answer is depreciation is not being recognized in consequence of changes in market value

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

Depreciation does not link up with market valuesDepreciation is a result of "passage of time"

800,000 10 80,000 365

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

How long each asset will last - nobody knowsSo some legal guidelines have been provided - so that corporates don’t come up with very silly estimatesWe do understand that the actual life may not be the same as the estimated lifeAs a result of that, depreciation may be partly correct and partly wrong

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

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

Accounting is a profession largely concerning HISTORYAccountants are historians - financial historiansIn the modern complex world, some elements of future are intricately linked with the pastTo this extent, some estimates are unavoidable - we will use estimates reluctantly and rarely

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

LIABILITIES1 Insurance which does not return anything on maturity (only provides risk protection) ??

2 Family ??3 Any bills payable ??4 House rent ??5 Income tax ??6 Utility bills ?7 Conveyance ?8 School fees ?9 Maintenance?

LIABILITIES VIS-À-VIS EXPENSESWhat is the difference ?

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

What is your expense 36What is your liability 21

An expense is an expense whether paid or notIf humanity understood this properly, credit card companies will go bankrupt

An expense happens when you "incur" the expense, not when you payYou have dinner tonight for Rs 5,000 and you pay thro a credit card at the rate of Rs 500 per month plus interest of 36% plus late payment charges and service tax and etc etc

This payment happens over the next 10 monthsWhen should the expense be recognized?

TodayWhy todayYou ate today

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

1 Expense happens along with payment - simultaneousYou go to the railway station and have chai for Rs 5.00

2 Advances givenPayment happens first, expense is incurred later

3 Stuff bought on credit (say 45 days)Expense happens first, payment happens later

EXPENSE IS EXPENSE WHETHER PAID OR NOT - PRINCIPLE OF ACCRUAL

I am struggling, I have too many liabilitiesI have a son who needs to go to college and a daughter to be marriedHow old are theySon is 2 years old and daughter is 2 months oldI am struggling, I have too many liabilities

Son - I need Rs 45 lakhsDaughter - I need Rs 75 lakhs

How much will appear as Liab in the Bal Sheet todayZeroNo historical liability as yetFuture liab are not liab - they are only tensions - psychological stuff

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

L&T LtdShare Capital / Shareholders Funds Net Worth

Bank Loans

Vendors Payable

Assets are sold for Rs 10,000 crVendors will be paid Rs 500 crLenders will be paid Rs 5,000 crBalance Rs 4,500 cr goes to the shareholders

Reliance Industries is liable to pay Mukesh Ambani

On liquidation, what is the priority of settlement:1 Labour chaps

PF, ESIC2 Official liquidator of the High Court3 Taxes4 Secured lenders (bankers)5 Unsecured lenders and vendors6 Shareholders (Preference and Equity)

YOURPROFIT & LOSS ACCOUNTfor the period April 1, 2011 to Aug 14, 2011ExpensesHouse RentConveyance, TravelFood, ProvisionsElectricity, Water, MaintenanceCell phones, Landline phones, Satellite phones, all PhonesPetrol, Diesel, Kerosene, LPG, LNG

Credit Card ExpensesInterest expense on loans takenDepreciationIncome TaxSalaries paidEntertainment, Medical, Theft, DamagesMany expenses

Net Profit (savings during the period) (taken to Capital in the Bal Sheet)

Insurance Claims will tend to reduce your expenses - Your car got damaged and you spent Rs 25,000This is your expense - but the company gave you Rs 18,000So your net expense is Rs 7,000

You placed a Fixed Deposit (5 year cumulative) with Indian Bank for Rs 10 lakhs on Feb 1, 2011Your financial year end is March, no taxes - special relief for Great Lakes participantsToday is Aug 14, 2011The interest and the principal will come back after 5 years, 10% interestWhat is the Income in the above P&L

Zero ?

INCOME IS INCOME WHETHER RECEIVED OR NOT

There should be reasonable assurance of receiptWe are assuming that Indian Bank will live for 5 years or more and they will be honourable

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

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

TDS on Interest goes by this principle

Investment in National Savings Certificates - Section 80CNo interest ever declared

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

In cricket you can do only three things1 Batting2 Bowling3 Fielding

In financial accounting, there are only four corners:1 Assets2 Liabilities3 Incomes4 Expenses

If you mis-classify through ignorance, that is an errorIf you mis-classify deliberately, that is a fraud

It will change profits, capital

When you go to your banker, you tend to overstateWhen you go the tax dept, you tend to understate

BASIC ACCOUNTING EQUATIONEvery transaction will have two effects - Newton's laws of motion

Assets + Expenses = Liabilities + Incomes

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

Assets Expenses

Washing Machine 25,000 -

You bought washing powder for Rs 25 for this machine and paid in cashThis is a short term item - consumable itemWashing machine is a long term item - not consumed immediately or short term

Cash Bal Washing Exps (25) 25

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

Assets Expenses

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

Pradeep starts a garments business - he has land of Rs 20 lakhs, bank balance of Rs 15 lakhsCompany Name : Pradeep Garments Pvt Ltd (PGPL)

Assets1. Pradeep will bring in capital and HDFC Bank the company will issue shares 1,500,000

2. Pradeep withdraws Rs 20,000 HDFC Bank cash from the bank (20,000)

Cash on hand 20,000

3. He identifies a shop and leases it HDFC Bank for 5 years, rental per month is (100,000) Rs 20,000 and he pays a deposit Shop Deposit of Rs 1 lakh 100,000

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

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

5. He buys some furniture, telephones, Furn, Comp, Tel computers for Rs 2 lakhs and he 200,000 will pay after 15 days

6. He buys 100 shirts at Rs 200 per Inventories shirt and he pays the vendor 20,000 Rs 5,000 on account HDFC Bank

(5,000)

7. PGPL sells 60 shirts at Rs 450 per shirt and collects Rs 20,000 today

7a ) Sales HDFC Bank 20,000 Receivables/ Debtors 7,000

7b ) Cost of Sales Inventories (12,000)

8. PGPL does aggressive marketing HDFC Bank Bal Approached potential customers (50,000) through campaigning and spent Rs 50,000

9. Month end accounting:HDFC Bank Bal

Rent paid (20,000) Salaries payable - Electricity, Telephone (say Rs 2,000) - Depreciation (say Rs 3,000) (3,000)

MONOPOLY GAME1 Monopoly2 Vyapar3 Trade4 Business

One table - 4 to 5 team

You reach Dehradun - Rs 2,300You can buy Dehradun for this priceYou will be given Rs 20,000 cash by your banker - you can treat this is a loanYou pay the cash and get the property document

Anybody else coming to Dehradun will pay you a rent

You can convert Dehradun into a premium property (your wish)Office, Bungalow, Godown

For all unknowns, undefineds, pay Rs 500 to the banker (Jail, Tax, Rest House, Club)

You may run out of moneyYou can mortgage your property cand raise a loanBanker will charge you 10% interest upfront

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

You play around 20 transactions each

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

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

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

As you move higher in management, the language changes

Wright Brothers - aeroplane - without money, they would be unheard and we would be traveling in

It is easy - but any new language takes a little bit of effort and a little bit of time

Accounting means recording of transactions (financial events)

Reading the statements and understanding the import

Should I spend so much on this advertising campaign

Stock market, derivatives market, commodities market

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

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

At the end of the game, you will make your own Bal Sheet and P&L

Understanding terminology around Corporate Financial Statements

Point of time - as of when ? As of today - Aug 14, 2011 - he has five cars

Rs 15 lakhs per annum, per month, Harish Salve - Rs 15 lakhs per day, Rajnikant - Rs 15 lakhs per hour

Balance Sheet Photograph WealthProfit & Loss Video film Income

The P&L starts afresh in every period - starts from zero all over again

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

Your Personal Balance Sheet as of today - Aug 14, 2011Assets - OwnApplication of FundsWhere the Rupee wentHouseLand, Ancestral PropertyCar

33.50 Gold 2.50 Computers, Furniture, Appliances 36.00

SharesCash and Bank BalancesInsuranceFixed DepositsBonds, Mutual Funds, Post Office Deposits

12.00 Loans Given, Advances Given, Deposits Given

2.00

50.00

Will be accounted somewhereNot an assetWill be accounted somewhereNot assetsNot assetsNot assets

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

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

Rangarajan is very intelligent, but that is not a financial event

So should they declare at their cost (or at current market values)

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

Anything that you sell, you will be satisfying both conditionsYou will have to monetize it (bcoz without monetizing, you cant sell)

If you buy a brand, we will show this as an Asset - bcoz it has a cost, it has a transactionIf you develop a brand, it will not appear as an Asset (it may be valuable), there is no cost, there is no

Cost is what you paid, value is what you expect to fetch if the asset is sold off today

If you bott your house for Rs 10 lakhs in 2004 and today it is worth Rs 65 lakhs, your Bal Sheet will

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

Bcoz value is subjective, nobody knows the value, value keeps changing, each expert will come up with his own estimate of value, value is based on something which never happened

All estimates (all values, not costs)All estimates (all values, not costs)All estimates (all values, not costs)All estimates (all values, not costs)

In the Govt's accounting of 2G licences, the actual amount of money paid by each operator (telecom company)

If we got Rs 2,000 cr as licence fees, we will record only Rs 2,000 cr - fact

Warren Buffet says that financial statements are the "starting point" for any financial analysis of deriving

Murugappa Group - wonderful building in Parrys called Parry House - 150 year old

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

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

If you bott a car today for Rs 8 lakhs and you estimate is has a ten year life with a salvage value of zero, you should depreciate the car over the ten year period in such a manner that the carrying value of the

The entire asset will need to be written off on one day (this will become a loss)

This depreciation becomes an expense in the P&L and the carrying value of the car reduces to this extent

10 YearsGiven by Company Law

You can depreciate faster if you wish, but not slower

Accountants are very simple people, they don’t understand complicated stuff like inflation, GDP, USD INR,

If the value of money drops due to passage of time, etc, that is not for the accountant to decipher

Anesh has land, which has got polluted due to chemical effluents etc and the value of the land has dropped

He bott the land for Rs 5 lakhs and the value is irreparably down to Rs 2 lakhs

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

Same car example - the car got caught in an accident after 2 years

The entire Rs 6.40 lakhs will be written off as Expenses on the day of the accident

On rare occasions, we may be forced to take the help of this VALUE animal, but we try to be as far away

The answer is depreciation is not being recognized in consequence of changes in market value

The car that you bott for Rs 8 lakhs today morning is worth how much in the evening?

219 Depreciation per day

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

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

Bank of England constructed its building 250 years ago in London and thought that the building will last

Since the last 150 years, it is appearing in the Bal Sheet at one pound

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

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

Insurance which does not return anything on maturity (only provides risk protection) ??

You are living in a rented house from May 1, 2011 - monthly rent is Rs 9,000

Your financial year ending is March and the agreement is for three years

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

An expense happens when you "incur" the expense, not when you payYou have dinner tonight for Rs 5,000 and you pay thro a credit card at the rate of Rs 500 per month plus interest of 36% plus late payment charges and service tax and etc etc

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

Expense happens along with payment - simultaneousYou go to the railway station and have chai for Rs 5.00

Payment happens first, expense is incurred later

EXPENSE IS EXPENSE WHETHER PAID OR NOT - PRINCIPLE OF ACCRUAL

I have a son who needs to go to college and a daughter to be married

Future liab are not liab - they are only tensions - psychological stuff

My daughter got married yday and the catering bill came to Rs 10 lakhs

2,000.00

5,000.00

500.00 7,500.00

IncomesSalaries, Bonus, IncentiveInterest on Bank Deposits/Loans givenHouse Rent IncomeDividendsCapital Gains on SharesGifts, Inheritances

Scholarship (if more than expense)Tax refundsRoyalty on books / other patents / IPRLotteries, Gambling, Horse Racing, Cock fighting

9.50

2.50

12.00

Insurance Claims will tend to reduce your expenses - Your car got damaged and you spent Rs 25,000This is your expense - but the company gave you Rs 18,000

You placed a Fixed Deposit (5 year cumulative) with Indian Bank for Rs 10 lakhs on Feb 1, 2011Your financial year end is March, no taxes - special relief for Great Lakes participants

The interest and the principal will come back after 5 years, 10% interest

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

simple calculation

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

If you make profits year after year, your Capital / Net Worth will stand enhanced

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

Assets + Expenses = Liabilities + Incomes

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

Liabilities Incomes

Vendor Payable 25,000 -

You bought washing powder for Rs 25 for this machine and paid in cash

Washing machine is a long term item - not consumed immediately or short term

- -

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

Liabilities Incomes

- -

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

Expenses Liabilities IncomesShare Capital Share Capital

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

- - - FCT Vendor PayableShirt Vendor PayableSalaries PayableElec Tel Payable

- - - Total

No transaction, no accounting

These are mere commitments, plansCost of SalesSales PromotionRent

FCT Vendor Salaries - 200,000 - Electricity, Telephones

Depreciation

Shirt Vendor 15,000

- - Net Profit

Sales Revenue 27,000

Receivables/ Debtors - -

Cost of Sales 12,000 - -

Sales Promotion 50,000 - -

20,000 - - 50,000 50,000 - 2,000 2,000 - 3,000 - -

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

Anybody else coming to Dehradun will pay you a rent

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

For all unknowns, undefineds, pay Rs 500 to the banker (Jail, Tax, Rest House, Club)

You can mortgage your property cand raise a loan

You can also sell your property to the other teams - on an auction basis

Each team will have two players - front office (plays the game) and back office (accountant, custodian

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

StaticFlow

50.00

Given by Company Law

You can depreciate faster if you

7,500.00

12.00

Balance Sheet at the end of the 9th transactionShare Capital 1,500,000 Furniture, Comp, TelephonesReserves (accumulated profits) (110,000)

Shop DepositHDFC Bank Balance

FCT Vendor Payable 200,000 Cash on HandShirt Vendor Payable 15,000 InventoriesSalaries Payable 50,000 ReceivablesElec Tel Payable 2,000

1,657,000 Total

Profit & Loss Account for the period during 1st to 9th transactionCost of Sales 12,000 Sales RevenueSales Promotion 50,000

20,000 50,000

Electricity, Telephones 2,000 Depreciation 3,000

(110,000) 27,000

Balance Sheet at the end of the 9th transactionFurniture, Comp, Telephones 197,000

100,000 1,325,000 20,000 8,000 7,000

1,657,000

Profit & Loss Account for the period during 1st to 9th transaction 27,000

27,000

Summary

1 Personal Balance SheetAssets, Liabilities

2 Personal P&LIncomes, Expenses

3 Accounting EquationAssets + Expenses = Liabilities + Incomes

4 Depreciation - assets will reduce in book value with passage of time, because they havelimited livesAt the end of their life, the asset should be brought down to zero (or to salvage value)

5 Cost versus ValueWe prefer Cost in accounting, we don’t understand ValueValue is merely an opinion, opinion keeps changing, value is not a FACT, it has not HAPPENEDCost is a historical fact, evidenced by various documents - bank statement, invoice

6 Principle of AccrualExpense is an Expense whether paid or notUnpaid expenses are liabilitiesIncome is Income whether received or not

Profit & Loss AccountIncomes 100Expenses 103Profit -3

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

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

Expenses 103Profit -3

100

Expenses 103

103

Presentation is the least of our problems, but the source of a lot of unnecessary confusion in the world

I am trading firmI bott 100 units at RsI sold 80 units at Rs

What is my profit or loss?Loss 40Profit 20Profit 25

The problem is that units are not matchingWhat you bott and what you sold are not the sameA comparison of Purchases with Sales will be wrong

We need to compare Sales with COST OF SALES (Cost of Goods Sold)80 units of Sales Revenue should be MATCHED with Cost of 80 units

Sales Revenue 80Cost of Sales/Cost of Goods Sold 80Profit

In America, they call this as COGS

In manufacturing, three levels1 What you bott (raw materials, consumables)2 What you produced (finished goods)3 What you sold (finished goods)

Profit is on what?1 Purchases2 Prodn3 Sales

Only on SALES

Transaction OneI bott 100 units at Rs 3.00 each and paid by cheque

Assets

Inventories300

Bank Bal-300

I sold 80 units at Rs 3.25 each and recd chequeAssets

a) Sales Revenue Bank Bal260

b) Cost of Sales/COGS Inventories-240

You bott Delhi for Rs 7,000I sold Delhi for Rs 7,500

AssetsProperty

7000Bank Bal

-7000

AssetsBank Bal

7500

Property-7000

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

What do you mean by the term "inventories"Your stock in trade - the item that you trade in, you manufacture and you keep selling day in and day out

In the Monopoly game, you can argue that I am a property companyMy business is to buy and sell propertyProperty is my Inventory

You say that I am an individual working in a software companyI bott a house for Rs 20 lakhs and after 5 years, I sold it for Rs 38 lakhsHow should I make my accounts

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

AssetsSame accounting when Property you bott Property 7000

Bank Bal-7000

AssetsSold Property Bank Bal

7500Property

-7000

MONOPOLY GAME BALANCE SHEET

Profit during the year xxxx

Initial Loan

Additional Loans

Payables

MONOPOLY P&LRental ExpensesOther Expenses

Interest Jail Club TaxesCOGS of Properties Gross

Profit xxxx

CORPORATE BALANCE SHEET AND P&LConcepts of Assets, Liab, Incomes, Exps are absolutely the sameMany more terms will emergeLanguage is a major challenge

Share CapitalEquity Share CapitalPreference Share CapitalCapital EmployedCapital GainsWorking Capital

Economics - Capital FormationProductivity of Capital

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

Net Worth = Total Share Capital + Reserves + Revaluation ReservesTotal Debt = Secured Loans + Unsecured LoansTotal Liab = Net Worth + Total Debt

Net Block = Gross Block - Accumulated DepreciationTotal Current Assets = Inventories + Sundry Debtors + Cash and Bank BalancesTotal CA, Loans & Advances = Total Current Assets + Loans & Adv + Fixed DepositsTotal CL & Provisions = Def Credit + Current Liab + ProvisionsNet Current Assets = Total CA, Loans & Adv - Total CL & Provisions

Total Assets = Net Block + Capital WIP + Investments + Net Current Assets + Misc Exp

Various sub totals are useful for analysis (not for totalling)

Sources of FundsShareholders / Owners Money - take high

risk

Lenders Money - some risk

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

Fixed means long termCurrent means short term - Current means quick, fast

SAME BALANCE SHEET IN A DIFFERENT FORMSources of FundsShareholders / Owners Money - take high

risk

Lenders Money - some riskTOTAL LIABILITIESApplication of FundsFixed Assets - long lived assets (> 1 years) These assets are bott for usage, not for resale Slow moving, hardly changing

Investments

Current Assets Assets which are held in the course of day to

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

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

TOTAL ASSETS

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

What is Share Capital?When you subscribe for shares in a company, you get allotted some sharesIf you applied for Coal India Share in the IPO, you got those shares

There are two types of Shares1 Equity Shares2 Preference Shares

Equity Shares is the risk taking instrumentIf the company fails, then the shareholders loses tons of money

Pref Shares get a "preference" over Equity shareholdersIf the company goes into liquidation, then Pref Shares are paid out before Equity shareholdersIt is slightly more safe (less risky) than Equity Shares

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

Dividends are discretionary - there is no complusion by lawI made a profit of Rs 1,000 cr but paid zero dividends - you, as a shareholder, can do nothing

In India, Preference Shares, by law have to be "redeemed" - redeemed means paid back, bott backIf a company issues Pref Shares of face value of Rs 100, the company will declare that they will redeem these Shares after 7 years for Rs 100

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

All the fun is gone - nobody is interestedReturns are stable, redemption price is knownAnything that is known loses attraction

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

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

SHARE APPLICATION MONEYWhen the share issue process is in the pipelineThe company announces an issue of shares on March 25th and people apply for these sharesThe allotment happens on April 11thSo, on March 31st, the funds have come in, but shares have not yet been allottedSo these funds will appear as Share Application Money

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

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

The second source of Reserves is "Share Premium"You are Coal India - the IPO happened at a price of Rs 245 - face value per share is Rs 10They are charging you a premium of Rs 235

Coal India's cash balance will increase by Rs 245Share Capital will increase by Rs 10 (face value)Reserves will increase by Rs 235 (share premium)

Balance SheetEquity Share Capital 10Reserves 235

Having high Reserves means a glorious past

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

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

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

Reserves 35000

All your Reserves are sitting in the Cash box

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

Balance Sheet after 5 years

Reserves 3500000

All your Reserves are sitting in the Cash box

You got marriedWife said - buy me a houseShe saw a house, costing Rs 1 crYou had no choice

New Balance Sheet

Reserves 3,500,000 Home Loan (Debt) 6,500,000

Where are the Reserves? You have Reserves but no CashThe Reserves are in the house (maybe the kitchen was financed from Reserves)

You may sometimes hear the term "Cash Rich Companies"These are companies which have tons of Cash and tons of ReservesIndia Cement has tons of Reserves but not much CashIs it Cash Rich?No

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

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

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

NET WORTHis also called by various names

1 Shareholders Funds2 Owners Funds3 Shareholders Equity4 Owners Equity5 Just Equity (in the US, this is more common)

This represents the funds payable to Shareholders in the event of a LiquidationThe company is liable to pay back its Shareholders this much of moneyThis represents the amount belonging to Shareholders, brought in by Shareholders in the past

Brought in by shareholders directly and indirectly1 Directly means they gave cash to the company and company allotted shares

2 Indirectly means past profitsIf the company made a profit of Rs 100 cr and the company declared a dividend of only Rs 5 cr,the balance Rs 95 cr also belong to the ShareholdersBut the Shareholders have allowed the company to "retain" these earningsIndirectly, they have contributed

DEBT means Borrowings, Loans takenSecured Debt means company has offered some security (collateral)

Mortgage of fixed assetsHypothecation of current assetsMost bank loans, financial institutions are secured

SARFESI Act has substantially strengthened the power of the banking sector in recovering Secured LoansThey can push off the corporate, sell the asset and recover their dues

Unsecured Debt means no security has been offeredPersonal life - Credit Card dues, Personal Loans - horrible loans 30% costIf you have a single paise of these loans, your finances are badly managedFortunately, in the Corporate Sector, having Unsecured Loans is not so bad

Public Deposits are unsecuredYou, as an individual, can earn 9.25% in a SBI FDYou can earn 10.25% in a Tata Steel FDHDFC FD earns you slightly more than SBI FD

Sales Tax Deferral Schemes - provided by the Govts of various StatesYou set up a new factory in Himachal PradeshHimachal Pradesh wants to encourage entrepreneursAny new factory - you can collect Sales Tax on your product from your customersYou are supposed to pay the State Govt next monthBut we will allow you to keep these funds with yourself for 8 yearsYou pay us after 8 years

Such sales taxes collected but not yet paid will appear as Unsecured Loans in the Bal Sheet

If you feel like knowing the break up of Unsecured Loans of India Cement, what can you do?You can go to the India Cements website and you can download the Annual ReportOne year Annual Report will be 50 to 250 pagesThis Annual Report will give you lots and lots of information

APPLICATION OF FUNDS - ASSETS SIDEFixed AssetsGross Block means the original cost of fixed costsAccumulated depreciation means depreciation from date of acquisition of the fixed asset till todayNet Block means Gross Block minus Accumulated Depreciation

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

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

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

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

What is this telling you?B is the older company - most probablyB is also a larger company - most probably

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

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

Capital Work in ProgressFixed assets which are under installation / under constructionFactory is being built, not yet complete

Machine is being installed, not yet readyPipeline is being constructed, not yet operational

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

This Cap WIP will be transferred to Gross BlockFrom that day, depreciation will start

If the amount in CWIP is huge, what does this mean?Huge expansion is happening - may be the fruits will be seen in coming years

Conversely, when a corporate says that our sales will grow 30% per annum for the next 5 years and you don’t find too much in CWIP, what does that mean?They are lying ?

INVESTMENTSStrategic Investments

1 Investments in subsidiariesA company where you own more than 50%L&T has set up a company called L&T IT Ltd, another company called L&T Finance LtdL&T has invested Rs 100 cr in L&T IT Ltd as subscription to share capitalSo, in the Bal Sheet of L&T, this will appear under InvestmentsI am controlling the subsidiary - the subsidiary will listen to me

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

3 Investments in joint venturesThere is joint control (control shared with another party)

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

TREASURY INVESTMENTSTreasury means short termI have Rs 25 cr available for the next 4 days

What should I doI can buy a Liquid Mutual Fund which can generate 3.50% return (annualized)

Strategic Investments are managed by Board of DirectorsTreasury is managed by the Finance Dept

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

Inventories in mfg and trading are tangibleRaw Mat, WIP, Finished Goods, Packing Materials, Consumables, Stores and Spares, Tools, Dies, Masterbatches

In software and service sectors, you will have Unbilled WorkWork that is in progress and you have not been able to bill for themBcoz milestones are not reached as yet

Sundry Debtors (also called Receivables, Trade Receivables, Outstandings)Invoices have been raised - product has been delivered, services have been renderedBut the customer has not yet paid us - we have the right to collectIf these are very high, what does it mean

You are in troubleOr your customer is in trouble, which also means you are in troubleYou are lazy, slowYour customer is really king

Cash and Bank Balances - very simple

Loans & Advances under Current Assets means Loans & Advances given by you1 Staff Loans2 Advances to Vendors3 VAT Input Credit4 Excise Duty Input Credit5 Disputed taxes paid under protest6 Any refunds due7 Deposits for premises, Advance rent paid

Deferred CreditCredit given by vendors over a long period of time

If you buy a machine from Germany, the vendor may say - pay me after 11 months

Current LiabYour vendors payable, salaries payable, interest payable, expenses payable, electricity payable

ProvisionsYou know that some amount is payable but you are not sure of the amountYou have estimated the amount

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

In your Bal Sheet, you have shown a Provision of Rs 20 lakhs - you are not sure of this amount but this is your MANAGEMENT ESTIMATEThe moment you start estimating, some element of discretion, politics, manipulation enters into the picture

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

Rs 50 lakhs will not appear in the Bal SheetRs 20 lakhs will appear under Provisions

Next year, I pay them Rs 22 lakhs and the matter is overProvision becomes zeroRs 2 lakhs goes into Expense (case of under provisioning)

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

MISCELLANEOUS EXPENDITUREWill discuss later

CONTINGENT LIABILITYThis is not in the Bal Sheet, this is outside the Bal Sheet, this is not forming part of the totalThis is only for disclosureOff Bal Sheet item

Is not a liability as of todayBut it can become a liability in the future, if some events occur in a certain mannerBut such events may or may not occur - we don’t know

Your dear friend wants a loan of Rs 20 lakhsHe asked you and you said sorry - I am myself in need of a loanHe went to a bankBank wants a guarantorSo he comes to you and you reluctantly sign the papers

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

But But - it can become your liability in the futureWhenIf he does not pay and the bank comes after you

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

ExamplesGuarantees givenLegal suits, claims, disputed taxes

Somebody files a suit on you and demands Rs 100 lakhsYour lawyer says the suit can be settled for Rs 5 lakhs

Provision in the Bal Sheet of Rs 5 lakhsContingent Liab off Bal Sheet of Rs 95 lakhs

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

INDIA CEMENTS - P&L

You sell cement for Rs 220 per bagAdd : Excise duty of 16%

What is your RevenueYou are a postman for the Govt of IndiaYou collect from the customer and pay the Govt - free service that you are rendering for the nation

In the P&L, we will show this as under:SalesLess : Excise DutyNet Sales

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

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

Stock AdjustmentWhen your production is not equal to Sales, profits should be measured only on SalesBut costs may be incurred on production

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

Opening Stock + Production - Sales = Closing Stock5 100 80 =

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

20 = 20

Stock Adjustment means diff between Closing Stock and Opening Stock (Prodn and Sales)

Sales Revenue - Income - based on Sales QuantityStock Adjustment (diff between Sales and Prodn)

ExpenseCosts - based on Production Quantity

The P&L matches properly

I am trading firmI bott 100 units at Rs 3.00 I sold 80 units at Rs 3.25

Real profit is Rs 20

Indian P&LSales 80 3.25 Stock Adjst 20 3.00

ExpensesCost of purchases 100 3.00

Profit

American PresentationSalesCOGS 80 3.00 Profit

PBDIT - Profit Before Depreciation, Interest and Taxes - UK dictionaryEBIDTA - Earnings Before Interest, Depreciation, Taxes and Amortization - US dictionary

Both mean the sameAmortization is depreciation on intangible assets

You depreciate a table and amortize a patentEBIDTA is more popular in the world and in India

SalesOther Income

Total Income

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

EBIDTADepreciation & AmortizationEBITInterestEBT / PBTTaxPAT / Net ProfitDividendsRetained Earnings (goes to Reserves)

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

Your EBIDTA is very strongBut you have tons of DebtYour PAT may not be that strong

Your EBIDTA is very mediocreBut you are a zero debt companyYour PAT may be okay

Cash Profit will be 70 + 250 = 320

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

EBIDTALess : Other IncomeCore EBIDTA (Operating Profit)

Other companies may define Operating Profit to be the same as EBIDTASo don’t go by this one meaning

Some terms are loosely definedOperating Profit, Gross Profit, EBIDTA itself (sometimes it includes Other Income, sometimes excludes Other Income)Finance is a social subject - depends on evolution of humanity, behaviour

EXTRA ORDINARY ITEMSPersonal lifeSalary - Core IncomeInterest - Other IncomeDowry - Extra Ordinary Income

Unusual, Non recurring, Material

What is your annual incomeYou say Rs 61 lakhs ?

VALUE ADDITIONA term used by economists more than finance professionalsIt means your sale price minus your material costs

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

We don’t use this much in FinanceWebsite has calculated it differentlyWe will ignore this for our discussion

GROWTHEveryone - management, shareholders, stock market, employees, vendors, customers are all interested in growthHow much are you growingHow fast are you growingHow fast is the industry growingAre you faster than them

Long term growth is best represented by CAGRCAGR - Compounded Annual Growth Rate (Compounded Average Growth Rate)

TO DO:

1 Work out the CAGR for many line items in the P&L and the Bal SheetSometimes, the CAGR may be useless - you need to figure out which ones are meaningful and which are not

2 Some insight into our findings

Depreciation - assets will reduce in book value with passage of time, because they have

At the end of their life, the asset should be brought down to zero (or to salvage value)

We prefer Cost in accounting, we don’t understand ValueValue is merely an opinion, opinion keeps changing, value is not a FACT, it has not HAPPENEDCost is a historical fact, evidenced by various documents - bank statement, invoice

Loss is plus 3

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

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

Income 100

100

Income 100Loss 3

103

Presentation is the least of our problems, but the source of a lot of unnecessary confusion in the world

3.00 each 300.00 3.25 each 260.00

40.00 WRONG

We need to compare Sales with COST OF SALES (Cost of Goods Sold)80 units of Sales Revenue should be MATCHED with Cost of 80 units

3.25 260.00 3.00 240.00

20.00

What you bott (raw materials, consumables) 100 tons65 tons2 tons

Only on 2 tons

Exps Liab Incomes

0 0 0

Exps Liab IncomesSales Rev

0 0 260

COGS240 0 0

Exps Liab Incomes

0 0 0

Exps Liab IncomesSales Rev

0 0 7500

COGS7000 0 0

This can be done BUT it will the correct method of presentation if your business consists of buying

Your stock in trade - the item that you trade in, you manufacture and you keep selling day in and day out

In the Monopoly game, you can argue that I am a property company

You say that I am an individual working in a software companyI bott a house for Rs 20 lakhs and after 5 years, I sold it for Rs 38 lakhs

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

Exps Liab Incomes

0 0 0

Exps Liab IncomesCapitalGains

5000 0

Properties (you own at the end of the game) Delhi Jaipur Agra Mathura

Cash Balance/Bank Balance

Receivables

Rental IncomeOther Incomes

Gift LotterySale of Properties GrossAlternatively - Capital Gains on Sale Net

Concepts of Assets, Liab, Incomes, Exps are absolutely the same

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

Net Worth = Total Share Capital + Reserves + Revaluation Reserves

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

Total Assets = Net Block + Capital WIP + Investments + Net Current Assets + Misc Exp

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

Investments

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

1. One below the otherMoney - take high 2. Curr Liab appear on the

assets side but as a negative

Owners Capital, Bank Loans, Fixed Assets, Investments are managed by top managementTop Half is managed by Top Management

Bottom halfThis area of Current Assets and

Current Liab is generally managed by middle management in any company

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

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

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

Common variety - comprises 99.999% of Shares in IndiaRare - hardly 0.001% falls here

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

If the company goes into liquidation, then Pref Shares are paid out before Equity shareholders

When the company pays out dividends (dividends are paid out of profits), there too the Pref Shareholders

The Pref Shares are paid dividends and then Equity Shares are entitled to dividends

Dividends are discretionary - there is no complusion by lawI made a profit of Rs 1,000 cr but paid zero dividends - you, as a shareholder, can do nothing

In India, Preference Shares, by law have to be "redeemed" - redeemed means paid back, bott backIf a company issues Pref Shares of face value of Rs 100, the company will declare that they will redeem

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

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

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

The company announces an issue of shares on March 25th and people apply for these shares

So, on March 31st, the funds have come in, but shares have not yet been allotted

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

If you are a 37 year old company, Reserves will have 37 years of profits

You are Coal India - the IPO happened at a price of Rs 245 - face value per share is Rs 10

Cash Bal 245

Having high Reserves does not mean/imply having huge Cash BalanceIf India Cements Reserves are Rs 3,700 cr and all of us decide to pay them a visit and meet the Cashier and ask him to open the safe, we may expect to find tons of cash (Reserves)

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

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

Bank Balance 35000

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

Bank Balance 3500000

House 10,000,000

Bank Balance -

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

These are companies which have tons of Cash and tons of Reserves

Sometimes, you may have Cash but not much Reserves - can that happen?

Your Uncle gave you a loan of Rs 5 cr and so you have Rs 5 cr cash

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

Just Equity (in the US, this is more common)

This represents the funds payable to Shareholders in the event of a LiquidationThe company is liable to pay back its Shareholders this much of moneyThis represents the amount belonging to Shareholders, brought in by Shareholders in the past

Directly means they gave cash to the company and company allotted shares

If the company made a profit of Rs 100 cr and the company declared a dividend of only Rs 5 cr,the balance Rs 95 cr also belong to the ShareholdersBut the Shareholders have allowed the company to "retain" these earnings

Secured Debt means company has offered some security (collateral)

Most bank loans, financial institutions are securedSARFESI Act has substantially strengthened the power of the banking sector in recovering Secured LoansThey can push off the corporate, sell the asset and recover their dues

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

You, as an individual, can earn 9.25% in a SBI FD

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

Himachal Pradesh wants to encourage entrepreneursAny new factory - you can collect Sales Tax on your product from your customersYou are supposed to pay the State Govt next monthBut we will allow you to keep these funds with yourself for 8 years

Such sales taxes collected but not yet paid will appear as Unsecured Loans in the Bal Sheet

If you feel like knowing the break up of Unsecured Loans of India Cement, what can you do?You can go to the India Cements website and you can download the Annual Report

This Annual Report will give you lots and lots of information

Accumulated depreciation means depreciation from date of acquisition of the fixed asset till todayNet Block means Gross Block minus Accumulated Depreciation

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

4 8.00 3.00 5.00

Gross Block and Acc Depn are merely for disclosure purposes

Bank of England 100.00 99.99 0.01

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

4 8.00 Balance Sheet 3.00 Balance Sheet 5.00 Balance Sheet 0.75 P&L is for a period of time (for that one year)

Fixed assets which are under installation / under construction

The amount in the Bal Sheet reflects the amount spent so far on this project

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

Conversely, when a corporate says that our sales will grow 30% per annum for the next 5 years and

L&T has set up a company called L&T IT Ltd, another company called L&T Finance LtdL&T has invested Rs 100 cr in L&T IT Ltd as subscription to share capitalSo, in the Bal Sheet of L&T, this will appear under InvestmentsI am controlling the subsidiary - the subsidiary will listen to me

Associate is a company where we hold 20% to 50%The associate may or may not listen to me - I am not in control

There is joint control (control shared with another party)

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

I can buy a Liquid Mutual Fund which can generate 3.50% return (annualized)

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

Raw Mat, WIP, Finished Goods, Packing Materials, Consumables, Stores and Spares, Tools, Dies,

In software and service sectors, you will have Unbilled WorkWork that is in progress and you have not been able to bill for them

Sundry Debtors (also called Receivables, Trade Receivables, Outstandings)Invoices have been raised - product has been delivered, services have been renderedBut the customer has not yet paid us - we have the right to collect

Or your customer is in trouble, which also means you are in trouble

Loans & Advances under Current Assets means Loans & Advances given by you

If you buy a machine from Germany, the vendor may say - pay me after 11 months

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

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

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

In your Bal Sheet, you have shown a Provision of Rs 20 lakhs - you are not sure of this amount but this is

The moment you start estimating, some element of discretion, politics, manipulation enters into the picture

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

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

This is not in the Bal Sheet, this is outside the Bal Sheet, this is not forming part of the total

But it can become a liability in the future, if some events occur in a certain manner

He asked you and you said sorry - I am myself in need of a loan

Today evening, in your Bal Sheet, should you show this Rs 20 lakhs as your Liability?

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

If Cont Liab are too high, analysts can get a little frightened - whether these are Real Liab which the

220.00 16% 35.20

255.20

220.00

You collect from the customer and pay the Govt - free service that you are rendering for the nation

255.20 35.20 220.00

Other Income should mean other than cement (core activities)

Sometimes, you may not be sure of how much is real Other and how much is half Other

If Other Income is very high (say more than 20% of Profit Before Tax), then Analysts get worriedBcoz the behaviour of Other Income in future is not known, unpredictable, may not be sustainable, may

When your production is not equal to Sales, profits should be measured only on Sales

Opening Stock + Production - Sales = Closing Stock25

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

Stock Adjustment means diff between Closing Stock and Opening Stock (Prodn and Sales)

Sales Revenue - Income - based on Sales QuantityStock Adjustment (diff between Sales and Prodn)

each 300.00 each 260.00 Profit 40.00 WRONG

260.00 60.00 320.00

300.00

20.00

260.00 240.00 20.00

PBDIT - Profit Before Depreciation, Interest and Taxes - UK dictionaryEBIDTA - Earnings Before Interest, Depreciation, Taxes and Amortization - US dictionary

3400

Controlled by Business peoplePeople who know Cement

500250

Controlled by FinanceTop Management PoliciesThese people need know Cement

70

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

The term Operating Profit can mean several things to different peopleIn this website format, Operating Profit is computed as EBIDTA excluding Other Income (Core EBIDTA)

475.63125.59350.04

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

Operating Profit, Gross Profit, EBIDTA itself (sometimes it includes Other Income, sometimes excludes

Finance is a social subject - depends on evolution of humanity, behaviour

101

5061

A term used by economists more than finance professionals

You buy fabric for Rs 200 and you convert it into a shirt and sell the shirt for Rs 450

Everyone - management, shareholders, stock market, employees, vendors, customers are all interested

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

Work out the CAGR for many line items in the P&L and the Bal SheetSometimes, the CAGR may be useless - you need to figure out which ones are meaningful

Mortgage of Land, Property, FactoriesHypothecation of Inventories, Sundry Debtors

Mortgage of Land, Property, FactoriesHypothecation of Inventories, Sundry Debtors

INDIA CEMENTS - BALANCE SHEET

Mar '11 Mar '10

Sources Of Funds

Equity Share Capital 307.18 307.17 Reserves 3,782.58 3,221.09 Revaluation Reserves - 607.56

Networth 4,089.76 4,135.82

Secured Loans 1,177.86 866.64 Unsecured Loans 1,278.21 1,266.09

Total Debt 2,456.07 2,132.73

Total Liabilities 6,545.83 6,268.55

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

Investments 160.31 313.97

Current AssetsInventories 517.73 468.19 Sundry Debtors 254.40 485.26 Cash and Bank Balance 33.09 2.62 Loans and Advances 2,116.78 1,889.82 Fixed Deposits - 51.19 Total CA, Loans & Advances 2,922.00 2,897.08

Current Liabilities 1,335.08 1,454.10

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

Net Current Assets 1,511.21 1,333.07

Miscellaneous Expenses - -

Total Assets 6,545.83 6,268.54

Mar '09 Mar '08 Mar '07

282.43 281.87 220.37 8.7% 2,683.03 2,314.94 1,166.18 34.2% 665.93 724.30 781.98 -100.0%

3,631.39 3,321.11 2,208.53 16.7%

1,036.25 971.02 1,165.99 0.3% 951.78 840.49 892.77 9.4%

1,988.03 1,811.51 2,058.76 4.5%

5,619.42 5,132.62 4,267.29

5,313.58 4,708.69 3,856.04 11.3% 1,505.33 1,244.24 1,060.21 3,808.25 3,464.45 2,795.83 8.2% 904.04 574.91 142.75

158.97 129.28 55.07 30.6%

390.92 350.64 248.50 20.1% 353.98 311.07 260.21 -0.6% 5.40 7.84 216.15 -37.4% 1,331.88 1,062.06 995.90 20.7% 79.80 417.80 14.04 2,161.98 2,149.41 1,734.80 13.9%

1,342.01 1,143.36 463.82 30.3%

85.37 65.89 30.46 25.6% 1,427.38 1,209.25 494.28 30.0%

734.60 940.16 1,240.52 5.1%

13.55 23.79 33.12

5,619.41 5,132.59 4,267.29 11.3%

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

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

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

Total Expenses 3,074.65 2,944.83 2,433.14

EBIDTA 475.63 920.81 973.93 Interest 141.72 142.64 112.15 PBDT 333.91 778.17 861.78 Depreciation 244.03 233.12 203.32 Other Written Off - 13.74 10.24 Profit Before Tax 89.88 531.31 648.22 Extra-ordinary items - - 0.09 PBT (Post Extra-ord Items) 89.88 531.31 648.31 Tax 21.77 176.98 216.13 Reported Net Profit 68.10 354.34 432.18

Equity Dividend 46.08 61.43 54.85 Corporate Dividend Tax 7.65 10.20 11.23

Mar '08 Mar '07 CAGR12 mths 12 mths

3,554.47 2,610.75 10.5% 510.22 355.54 3,044.25 2,255.21 10.9% 0.37 9.46 30.32 4.50 3,074.94 2,269.17

340.90 260.86 21.4% 690.75 549.00 16.8% 186.61 103.40 26.6% 30.87 25.14 664.35 541.66 68.50 34.34

1,981.98 1,514.40 19.4%

1,092.96 754.77 -10.9% 109.95 149.80 -1.4% 983.01 604.97 -13.8% 127.92 102.63 24.2% 10.44 10.38 844.65 491.96 -34.6% - - 844.65 491.96 -34.6% 207.10 13.13 13.5% 637.54 478.83 -38.6%

65.89 30.46 10.9% 0.90 19.65

FINANCIAL RATIOSBalance SheetShareholders Funds (Net Worth)

Debt

The rules are differentFor top management, the skills required are:

1 Vision, Foresight2 Macro thinking - Globe, India, Tamil Nadu, Cement sector, India Cement3 Guts4 Financial wisdom, strategy5 They need to be contemplative, meditative, slow (not hasty), deep thought6 More of thinking and less of action - playing chess7 Implications are long term - if you make a mistake, you will suffer for a long long time8 Need the ability to live with lack of clarity

For middle management, the story is entirely different - what skills do you need?1 Buy buy buy raw material2 Produce produce produce3 Sell sell sell4 Collect collect collect5 Buy buy buy raw material

No vision, no foresight, no macro thinkingMost important skill is simple solid hard workLand up there at 900 and work work work

You need good rules to direct the middle managementYou need good scorecards - to measure how they are performing - week by week, month by month

India, as a country, great vision - each Planning Commission is a fantastic piece of artImplementation - middle management - is almost non-existent

Pakistan, bad visionGreat implementation - each terrorist attack is highly successful - operational excellent

1 Liquidity Cash comfort in the short run - can I pay my salaries, vendors, power billMiddle Mgt Will I have to beg, borrow or steal to make these payments

If you are uncomfortable, you are facing a liquidity challenge / crisis

2 Efficiency How fast am I able to rotate my funds in the short termMiddle Mgt Rolling of funds

3 Solvency Cash comfort in the long run - can I pay my 20 year home loan comfortablyIn a company, can I pay my long term loans comfortablyInsolvent means unable to pay these debts - bankruptcy

4 Profitability Profits in relation to Sales - MarginsProfits in relation to Investment - Returns

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

LIQUIDITYCURRENT RATIO = Current Assets / Current Liabilities

Current Assets are items that will generate cash for you in the short termCurr Liab are items that will take away cash from you in the short term

Current Assets will include Loans & AdvCurrent Liab will include ProvisionsCurrent Ratio

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

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

What is the ideal Current Ratio?

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

Banks will insist on a Current Ratio of at least 1.33:1 in most sectorsIf your Current Ratio is less than 1.33, then banks will feel quite uncomfortable in lending to you for your short term requirements

Could vary between sectors1.20 to 1.45 could be a reasonable range

That insistence by the bank on maintaining certain ratios is called as a COVENANTFinancial covenants are conditions that the corporate agrees and if the corporate fails, then bankers can withdraw their facilities

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

If I tell you that these companies are Hind Lever, Glaxo, Pfizer - how will you react now?They are not doing well ??

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

They are using suppliers funds as a major source of fundsGreat idea? Good ideaWe also should do thatEvery well managed company should have a Curr Ratio of less than 1.00Banks are idiots

Working Capital = Current Assets - Current Liabilities

Some people argue that negative working capital is a fantastic thingWhen Curr Liab are more, then Working Capital will be negative and Curr Ratio will be < 1.00

We should use suppliers funds to run our businessWe should not invest our own funds too muchYou are making money on their money - great idea

Negative working capital is dangerous, bad ideaYou have to return short term liabilities in the short termYou cannot convert short term liab to long term liab - if you do that, people will stop dealing with youor will make life difficult for you

The Bal Sheet is wrongThere is a line item called "Investments"Investments are of two types - Strategic and TreasuryTreasury Investments are really Cash in Hand (temporary cash parked in financial instruments)

Current Assets 5,000 Current Liab 5,500 Simple Current Ratio 0.91

Short Term Investments 2,000 Real Current Assets 7,000 Real Current Ratio 1.27

Some companies have a Curr Ratio of 10:1, 12:1, 15:1What will you say about these chaps?Not investing in long term stuff ?Money not being utilized properly ?

Your daily expense is Rs 100You keep Rs 50,000 in your pocket every dayI ask you whyI need for my expensesAm I happy with that answer

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

These companies are Infosys, Wipro, TCS, etcHuge Current AssetsWithin Current Assets, it is Cash - huge Cash

Infy - Rs 15,000 crYou ask Infy why do you hold so much Cash - why don’t you use it somewhere - is this not inefficient?

Infy has two answers:1 We need money for acquisitions

If a good acquisition comes up, typically there are many competitors who also want to buyIf we can pay fast, we have a brighter chance of acquiring

2 We are not merely vendors for our customers - we are their lifelineInfy has a customer - RBSRBS runs on Infy systemsRBS gets into some trouble in Europe because of global problemsRBS does not pay Infy on timeSo Infy is not able to pay salaries on timeSo people leaveIs that a good idea?

Infy says that we should have a huge cash balance on hand so that even if our customers don’t pay us,we are able to pay our employees smoothlyCustomers look at our financial strength before awarding contracts to usWe compete with Accenture, IBMIBM Cash Balance - Rs 250,000 crInfy Cash Balance - Rs 15,000 cr

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

LET ME KEEP A PROVISION FOR CONTINGENCIES - THIS IS SIMPLE ENGLISHLET ME MAKE A PROVISION FOR LIABILIITES - THIS IS ACCOUNTING ENGLISH

In your personal life, I recommend that you should keep some cash at home - all the timeWhat will happen when - you don’t knowSuddenly somebody needs to be hospitalized - 2 am in the morningHopsitals don’t entertain - unless you pay cash

This is keeping a provision for adverse possible events - simple EnglishAn Accounting Provision means something is payable to someone - but you don’t know the amount in certain terms - you are fuzzy about the amount

Before jumping to simplistic conclusions, a little bit of reading on the sector, its challenges, its practices will be helpful

BURN RATIOVery useful for start upsIn a start up, revenues are uncertain or may be zero (not yet kicked off)But exps are ongoing

How long can my current cash balance last?

Cash Balance is Rs 500Exps per week are Rs 125I can last only 4

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

India faced this problem in 1991 - year of liberalizationIndia's forex balance was equivalent to 2 weeks of ImportsAt that time, we mortgaged gold and got some dollarsThe IMF insisted that we should open up our economy to foreignorsFDI policy, FII policy - we invited foreignorsStock market opened upInfo tech sector, Call centres - liberalized

Now we are v v v prosperous

All this liberalization was not our visionWe protested and protested, but the IMF compelled us, pushed us into prosperityThe heart of it was the Burn Ratio

1791 to 19911991 to 2011 - we have done better in 20 years

Cash Balance (in weeks) = Cash BalanceExps per week

1,514.40

EFFICIENCY RATIOS

Working Capital Cycle

Cash

36

Rec'bles 138Days

Fin Goods

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

You are running an auto rickshawYou work for 8 hours, but billable time is only 3 hoursBal 5 hours you are waiting

Two people invest Rs 100 in their businessOne rotates this money 3 times Annual Sales are Rs 300One rotates 5 times Annual Sales are Rs 500

TIME IS MONEY

RECEIVABLES (DAYS) : How long are my customers taking to pay meReceivables (Days) = Receivables (Sundry Debtors)

Gross Sales per Day

260.21 = 7.15

Annual Sales 2,610.75 In the P&LDays per annum 365

Sales per day 7.15

INVENTORIES (DAYS) : How long do I take from raw material stage to prodn to selling the produced cement

Inventories (Days) = Inventories =Mfg Cost per Day

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

SOLVENCY RATIOSCash comfort in the long runCan I repay my long term debt comfortablyIn Indian context, we generally club the long term debt and short term debtIn the Indian Bal Sheet, we have something called Loans (Secured + Unsecured)

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

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

In a loan, the bank gives you Rs 10 cr and you repay Rs 10 crIn a limit, the bank tells you that you can draw upto Rs 10 crYou may draw, then deposit cash, again draw, again depositIn US they call this as Revolver

Savings Bank Account min balance is zeroIn a Cash Credit Account, the min balance can be minus Rs 10 cr

Day 1 (1.00)Day 2 3.00 Day 3 (8.00)Day 4 5.00

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

Next year, my business growsSo I ask the bank for a limit of Rs 12 crThird year - Rs 18 cr

29th year - Limit Rs 1,000 cr

When did I repay this loan?

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

Ratios1 Debt Equity Ratio

In your funding, how much is lenders funds and how much is owners fundsDebt is good bcoz it is cheap (cheaper than equity)

You start a new business, you need Rs 50 cr, you have Rs 25 crYou have an option - either you get a loan for Rs 25 cr or you get a partner for Rs 25 cr

Which is betterPartner will demand 50% share of profit, share of ownership, share of office space, share of car, share of foreign trips

Secondly, the interest that you pay the bank is tax deductible (it is an expense in your P&L)However, share of profit that you pay your partner is not an expense (from tax point of view)

First I pay interest Interest is a tax deductible expenseThen I pay income taxThen I pay dividend Dividend is not an expense, it is merely sharing of profits

Which profits? Post tax profits

If I pay the bank 13% interest and my tax rate is 30%, the effective cost of interest is how much?

EBITInterestPBTTax 30%PAT

How much did my PAT fall due to interestHow much interest did I payHow come?I get a tax benefit by claiming interest as an expense30% of the interest is borne by the Govt of India - Govt of India is my partner

You pay 11.5% housing loan interestHome loan interest is tax deductible upto Rs 1.50 lakhs per annumYour tax rate is 30%By paying this interest, you have been able to reduce your tax expense

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

Rate of interest is 11.50%Tax rate (t) 30%1- t 70%Interest x (1-t) 8.05%

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

High debt is high risk - ability to repay ??High debt means - you will do very good if the going is goodConversely, you will do very bad if the going is badRisk means volatility of returns

Debt - - Equity 100.00 100.00 Capital employed 100.00 100.00 Return on Capital 20% 30%PBIT 20.00 30.00

Interest 14% - - PBT 20.00 30.00 Tax 30% 6.00 9.00 PAT 14.00 21.00 Return on Equity 14% 21.0%

Debt 70.00 70.00 Equity 30.00 30.00 Capital employed 100.00 100.00 Return on Capital 20% 30%PBIT 20.00 30.00 Interest 14% 9.80 9.80 PBT 10.20 20.20 Tax 30% 3.06 6.06 PAT 7.14 14.14 Return on Equity 23.8% 47.1%

Debt 99.00 99.00 Equity 1.00 1.00 Capital employed 100.00 100.00 Return on Capital 20% 30%PBIT 20.00 30.00 Interest 14% 13.86 13.86 PBT 6.14 16.14 Tax 30% 1.84 4.84 PAT 4.30 11.30 Return on Equity 429.8% 1129.8%

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

Debt Equity = Debt / EquityDebt means Loans taken (Secured + Unsecured) (taken means amount drawn from the limits)Equity means Net Worth (Capital + Reserves)Generally, we ignore Revaluation Reserves in the computation of Net Worth

How much debt is good?Sector dependentInfra - 5:1 Capital intensive sectors tend to carry more debtPower - 4:1 Asset light sectors will have low debt / zero debtAluminum - 3.5:1Cement - 2.5:1 You cannot compare Infosys with Tata PowerPharma - 1.5:1Software - Zero:1Consulting - Zero:1Call Centers - 1:1

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

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

Colgate make a profit of Rs 1,000 crSterlite also makes a similar profit of Rs 1,000 cr

Colgate can borrow more - steady income, people generally have teeth and generally do brush and will keep brushing for some more centuries - brand is establishedSterlite - copper, zinc, aluminum - prices - change everyday - demand - what will China do

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

Debt Equity Ratio 1.44

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

Interest Coverage Ratio = EBIDTA / InterestEBIDTA 754.77 Interest 149.80 Interest Cover 5.04

If we need to pay the bank one rupee interest, we have Rs 5.04 of support of our earnings

Will the bank be happy?Quite happy

Generally banks look for 3 to 4 times cover

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

Debt Service Coverage Ratio (DSCR) = EBIDTA - TaxInterest + Annual Principal Repayment

EBIDTA 754.77 Tax 13.13

Interest 149.80 Annual Principal RepaymentTotal Debt 2,058.76 Tenor (assumed) 8 257.35

DSCR

For every one rupee that I need to pay the bank (towards interest and principal), I have thesupport of Rs 1.82 of earnings

Banks look for a DSCR of at least 1.60 times (for a great company they may be happy with 1.40 times)

We are looking at repayment capability (not actual repayment)

If you go for a home loan, how much will the bank lend you?1 80% of the cost of the house2 60 months of salary - logic behind this limit is - if you are earning x rupees, how much can

you devote towards EMI

40% of your salary can go towards EMIMore than that will be difficult bcoz you have to also live

EMI / Earnings is 40%DSCR = Earnings / EMI = 2.5 times

The home loan company imposes a DSCR of 2.5 times

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

He picked up 200 sick companies and went back in timeBefore they fell sick, how did the financial ratios look (3 years before, 5 years before)

Apollo - wellness - how well are youYou have a 15% prob of developing xyz illness in the next 10 years

Three types of ratios1 P&L numbers / P&L numbers2 Bal Sheet numbers / Bal Sheet numbers3 P&L number / Bal Sheet number (or vice versa)

He found that the third category was more useful in predictionIn particular, he found the DSCR was excellent in predicting sicknessHe assumed an 8 year tenor of loans for this purpose

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

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

PROFITABILITY RATIOSMargins Profit in relation to SalesReturns Profit in relation to Investment in BusinessWhat does the owner want ? Margins or Returns ?

Returns is the objective of the owner1 High margin high return strategy2 Low margin high return strategy3 High margin low return strategy4 Low margin low return strategy

Low margins may be accompanied by high volumes and faster time cycles

Sometimes low margin may be deliberate strategySometimes, it may be market compulsions - you don’t have a choice

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

Operating Profit Margin = EBIDTA or Core EBIDTANet Sales

754.77 33.5% 2,255.21

Net Profit Margin = PATNet Sales

478.83 21.2% 2,255.21

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

In contrast, sectors with heavy competition will face low marginsCyclical sectors will face cyclical margins

Boom

Recovery

Depression

EBIDTA margins are generated by the "business people"Net Profit margins are generated by business + finance put together

Great EBIDTA, bad NPM - you know whom to blamePoor EBIDTA, poor NPM - bad times, you can blame GodGreat EBIDTA, great NPM - good times, you can praise each otherPoor EBIDTA, great NPM - could be fraud??

RETURNSRoCE = Return on Capital Employed = EBIT

Cap Emp

EBIT - Earnings Before Interest and TaxesCap Emp = Net Worth + Debt (funds deployed by business - including bankers funds and owners funds)

How much is the business generating

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

RoCE 18.71%

RoE = Return on Equity = PATNet Worth

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

RoE 33.57%

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

Reliance is in the business of what?Oil & Gas, Petrochemicals, Refining, etc

Mukesh Ambani is in what business?

Mukesh Ambani is in the business of making money

Making money has two angles:1 Making money from petrochemicals, Oil & Gas, Refining2 Making money from money

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

Mukesh Ambani earns 18% thro Engineering efforts and 15% thro Financial skills, thus earning 33% total

PERSONAL EXAMPLEYou buy a second house for Rs 50 lakhsYou let it out on rent and earn 8 lakhsAfter 2 years, you sell the house 70 lakhs

What is your rate of return Earnings

Rent 8Capital Gain 20

28

Rate of Return 56% in two years time

The same house, you bott using a loan of 40Your own equity 10You paid interest per annum of 11%Two years interest 8.80

Your earningsRent 8.00 Capital Gains 20.00 Less : Interest (8.80)

19.20

Rate of Return 192%

Solvency1 Debt Equity2 Interest Cover3 Debt Service Cover4 Debt / EBIDTA

Profitability1 OPM2 NPM3 RoCE4 RoE

Fixed Assets Top Management

Long Term Strategic Investments

Current Assets Middle ManagementLess : Current Liabilities

Macro thinking - Globe, India, Tamil Nadu, Cement sector, India Cement

They need to be contemplative, meditative, slow (not hasty), deep thoughtMore of thinking and less of action - playing chessImplications are long term - if you make a mistake, you will suffer for a long long time

For middle management, the story is entirely different - what skills do you need?

You need good rules to direct the middle managementYou need good scorecards - to measure how they are performing - week by week, month by month

India, as a country, great vision - each Planning Commission is a fantastic piece of artImplementation - middle management - is almost non-existent

Great implementation - each terrorist attack is highly successful - operational excellent

Cash comfort in the short run - can I pay my salaries, vendors, power billWill I have to beg, borrow or steal to make these paymentsIf you are uncomfortable, you are facing a liquidity challenge / crisis

How fast am I able to rotate my funds in the short term

Cash comfort in the long run - can I pay my 20 year home loan comfortablyIn a company, can I pay my long term loans comfortablyInsolvent means unable to pay these debts - bankruptcy

Profits in relation to Sales - MarginsProfits in relation to Investment - Returns

Stock market ratios - EPS, PE, Dividend yield, Book Value, PBV

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

1,734.80 494.28 3.51 : 1

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

In your personal life, lets assume there are no credit cards, debit cards, ATMs

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

Banks will insist on a Current Ratio of at least 1.33:1 in most sectorsIf your Current Ratio is less than 1.33, then banks will feel quite uncomfortable in lending to you for

That insistence by the bank on maintaining certain ratios is called as a COVENANTFinancial covenants are conditions that the corporate agrees and if the corporate fails, then bankers can

If the current ratio of a company is say 0.95:1, 0.90:, 0.85:1 - what will you say

If I tell you that these companies are Hind Lever, Glaxo, Pfizer - how will you react now?

As a supplier to these chaps, will you be frightened by looking at the Curr Ratio? Will you refuse to supply?

Every well managed company should have a Curr Ratio of less than 1.00

Working Capital = Current Assets - Current Liabilities

Some people argue that negative working capital is a fantastic thingWhen Curr Liab are more, then Working Capital will be negative and Curr Ratio will be < 1.00

You cannot convert short term liab to long term liab - if you do that, people will stop dealing with you

Treasury Investments are really Cash in Hand (temporary cash parked in financial instruments)

They are afraid of something? Cant say much ? Waiting for the right opportunity?

They don’t have too much of fixed assets? Service industries?

You ask Infy why do you hold so much Cash - why don’t you use it somewhere - is this not inefficient?

If a good acquisition comes up, typically there are many competitors who also want to buyIf we can pay fast, we have a brighter chance of acquiring

We are not merely vendors for our customers - we are their lifeline

RBS gets into some trouble in Europe because of global problems

Infy says that we should have a huge cash balance on hand so that even if our customers don’t pay us,

Customers look at our financial strength before awarding contracts to us

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

LET ME KEEP A PROVISION FOR CONTINGENCIES - THIS IS SIMPLE ENGLISHLET ME MAKE A PROVISION FOR LIABILIITES - THIS IS ACCOUNTING ENGLISH

In your personal life, I recommend that you should keep some cash at home - all the time

Suddenly somebody needs to be hospitalized - 2 am in the morning

This is keeping a provision for adverse possible events - simple EnglishAn Accounting Provision means something is payable to someone - but you don’t know the amount in certain

Before jumping to simplistic conclusions, a little bit of reading on the sector, its challenges, its practices

In a start up, revenues are uncertain or may be zero (not yet kicked off)

weeks

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

India's forex balance was equivalent to 2 weeks of Imports

The IMF insisted that we should open up our economy to foreignors

We protested and protested, but the IMF compelled us, pushed us into prosperity

216.15 = 7.42 weeks 29.12

52

Raw Mat

102WIP

We want to know how fast you are in this Cash to Cash Cycle

Annual Sales are Rs 300 Margin of 7%, Profit is Rs 21Annual Sales are Rs 500 Margin of 7%, Profit is Rs 35

RECEIVABLES (DAYS) : How long are my customers taking to pay meReceivables (Sundry Debtors)

36 days

INVENTORIES (DAYS) : How long do I take from raw material stage to prodn to selling the produced cement

248.50 102 Days 2.43

103.4 50% assume mfg is this much

In Indian context, we generally club the long term debt and short term debtIn the Indian Bal Sheet, we have something called Loans (Secured + Unsecured)

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

Working capital facilities from the bank are generally renewed every year

In a loan, the bank gives you Rs 10 cr and you repay Rs 10 crIn a limit, the bank tells you that you can draw upto Rs 10 crYou may draw, then deposit cash, again draw, again deposit

In a Cash Credit Account, the min balance can be minus Rs 10 cr

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

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

In your funding, how much is lenders funds and how much is owners fundsDebt is good bcoz it is cheap (cheaper than equity)

You start a new business, you need Rs 50 cr, you have Rs 25 crYou have an option - either you get a loan for Rs 25 cr or you get a partner for Rs 25 cr

Partner will demand 50% share of profit, share of ownership, share of office space, share of car,

Secondly, the interest that you pay the bank is tax deductible (it is an expense in your P&L)However, share of profit that you pay your partner is not an expense (from tax point of view)

Interest is a tax deductible expense

Dividend is not an expense, it is merely sharing of profitsWhich profits? Post tax profits

If I pay the bank 13% interest and my tax rate is 30%, the effective cost of interest is how much?

500 50060 0

440 500132 150308 350

4260

I get a tax benefit by claiming interest as an expense30% of the interest is borne by the Govt of India - Govt of India is my partner

11.50% 90000Home loan interest is tax deductible upto Rs 1.50 lakhs per annum

30% 27000By paying this interest, you have been able to reduce your tax expense 3.45%

8.05% 63000

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

So, the next thought could be why not borrow and borrow and borrow more

High debt means - you will do very good if the going is goodConversely, you will do very bad if the going is bad

- 100.00 100.00

5% 5.00

- 5.00 1.50 3.50

3.5% Too safe

70.00 30.00 100.00

5% 5.00 9.80 (4.80) (1.44) (3.36)

-11.2% High Risk

99.00 1.00 100.00

5% 5.00 13.86 (8.86) (2.66) (6.20)

-620.2% Reckless Risk

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

Debt means Loans taken (Secured + Unsecured) (taken means amount drawn from the limits)

Generally, we ignore Revaluation Reserves in the computation of Net Worth

Capital intensive sectors tend to carry more debtAsset light sectors will have low debt / zero debt

You cannot compare Infosys with Tata Power

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

If you are a stockbroker earning Rs 1 cr per annum and your friend is a lawyer earning Rs 1 cr

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

Colgate can borrow more - steady income, people generally have teeth and generally do brush and will keep brushing for some more centuries - brand is establishedSterlite - copper, zinc, aluminum - prices - change everyday - demand - what will China do

: 1

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

times

If we need to pay the bank one rupee interest, we have Rs 5.04 of support of our earnings

The next question that arises is - what do we need to pay the bank? Only interest?

EBIDTA - TaxInterest + Annual Principal Repayment

741.64

407.15

1.82 times

For every one rupee that I need to pay the bank (towards interest and principal), I have the

Banks look for a DSCR of at least 1.60 times (for a great company they may be happy with 1.40 times)

We are looking at repayment capability (not actual repayment)

If you go for a home loan, how much will the bank lend you?

60 months of salary - logic behind this limit is - if you are earning x rupees, how much can

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

The home loan company imposes a DSCR of 2.5 times

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

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

Bal Sheet numbers / Bal Sheet numbersP&L number / Bal Sheet number (or vice versa)

He found that the third category was more useful in predictionIn particular, he found the DSCR was excellent in predicting sickness

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

Profit in relation to Investment in Business

FineFineNot interestingGo home

Low margins may be accompanied by high volumes and faster time cycles

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

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

This may be better for India Cement

9.46 745.31 33.0% 2,255.21

Margins are high in service sector, sectors driven by strong brands, technology, patents and IPR protection,

In contrast, sectors with heavy competition will face low margins

Recession

Net Profit margins are generated by business + finance put together

Great EBIDTA, great NPM - good times, you can praise each other

Cap Emp = Net Worth + Debt (funds deployed by business - including bankers funds and owners funds)

exclude Reval Res

Return from the Business

Return for the Owner of the Business

I earn 18.71% on the entire capital employed including funds provided by banks

I, as the owner, earn not only on my funds but also on the bankers funds

Making money from petrochemicals, Oil & Gas, Refining

Why is Finance Dept required in this world? What value do they bring to humanity?

Mukesh Ambani earns 18% thro Engineering efforts and 15% thro Financial skills, thus earning 33% total

Rs 4 lakhs per annum

in two years time ROCE - the house generated 56% return

in two years time

ROE - financial skills generated 136% more

Top Management

Middle Management

1 What do we read from the bookRead Chapters 1, 2 and 3 from the book given to youThat is good enough

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

3 Further reading - what can you readTry and start reading Research Reports on corporates written by brokerage housesIf you understand 50% or more of these Reports, that is a good starting pointWhat you don’t understand - you should network amongst yourselves, other than your GroupGoogle, Facebook, etc

4 What is our assignment, test, exam, homeworkAssignment - will be - to analyze at least two companies from diff sectors - you chooseAuto, Chemicals, Engg, Pumps, Compressors, Trading - Retail, AirlinesGroup of 4 people

5 Test - I don’t knowThe course content will be based on our Excel files

Curr Ratio = Curr Assets/Curr LiabIf I give you the Cur Ratio and the Curr Assets, you should be able to find the Curr Liab

Please note that the book is American style and we are using Indian financialsSo terminology will vary slightly - try and get the broad message and don’t look at nit picking

Try and start reading Research Reports on corporates written by brokerage housesIf you understand 50% or more of these Reports, that is a good starting pointWhat you don’t understand - you should network amongst yourselves, other than your Group

Assignment - will be - to analyze at least two companies from diff sectors - you chooseAuto, Chemicals, Engg, Pumps, Compressors, Trading - Retail, Airlines

If I give you the Cur Ratio and the Curr Assets, you should be able to find the Curr Liab

OCTOBER 2011 EXAMCALCULATORS ALLOWEDLAPTOPS, TEXT BOOK, NOTE BOOKS, NOT ALLOWED60 MINUTES DURATION100 MARKSRAGHU IYER

QUESTION ONEState whether true or false

1 Balance sheet captures point of time numbers2 Accounting equation says : Assets + Expenses = Liabilities + Income3 You bought a house in 1981 for Rs 25,000. Today it is worth Rs 25 lakhs. This house can

appear in your Balance Sheet at Rs 21,000.4 Out of your salary income over the past ten years of hard work, you have built up a

Fixed Deposit of Rs 15 lakhs. This will appear as Capital in your Balance Sheet5 Depreciation is charged in financial accounting because market prices of assets generally

fall after you have bought them6 Your expense for the last six months on a particular line item was Rs 50,000. Of these,

you have paid Rs 35,000 so far. Your liability on this account will be Rs 15,000.7 You bought petrol for your car for Rs 1,400 today. Of this you paid Rs 500 by cash and

Rs 900 through a credit card. Your expense for today is Rs 500.8 You have placed a purchase order for some components for Rs 2 lakhs today. This will

increase your assets and your liabilities in your Balance Sheet of today evening.9 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your Balance

Sheet as of today evening, this amount will appear as a Liability10 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your Balance

Sheet as of today evening, this amount will appear as an Asset

QUESTION TWOIn each of the transactions below, indicate which of the four items will increase / decrease or notbe affected at all:

1 You bought furniture on credit2 You deposited cash into your bank account3 You opened a bank locker and paid

some bank charges4 You appointed a Manager in your company5 You bought inventories and paid cash

6 You paid an advance towards travelling expenses to your sales person

7 You launched an advertising campaign and incurred expenses towards an event, not yet paid for

8 You sold an old machine at book value and got cash

9 Your month is over, but you have not yet paid salaries of this month

10 Your customer paid you a cheque

QUESTION THREE1 Your current assets are Rs 50 crores. Your working capital is Rs 20 crores.

Work out the Current Ratio

2 Inventories comprise 42% of your Current Assets. These are carried onan average for 100 days. Work out the Mfg Cost of the year

3 Receivables comprise 34% of your Current Assets. These are carried onan average for 61 days. Work out the Sales turnover for the year

QUESTION FOUR 19 MarksYour equity is Rs 100 crores and debt is Rs 25 crores. You want to raise moredebt. Your EBIDTA is Rs 30 crores. Interest rates are approx 12.5%.

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

How much incremental debt can this company now take on?

QUESTION FIVE 20 MarksRs cr

Sales 800EBIDTA 125Interest 35Depreciation 10Tax 24

Shareholders Funds 100Debt 30

Work out the OPM, NPM, RoCE and RoE

20 Marks

Accounting equation says : Assets + Expenses = Liabilities + IncomeYou bought a house in 1981 for Rs 25,000. Today it is worth Rs 25 lakhs. This house can

Out of your salary income over the past ten years of hard work, you have built up aFixed Deposit of Rs 15 lakhs. This will appear as Capital in your Balance SheetDepreciation is charged in financial accounting because market prices of assets generally

Your expense for the last six months on a particular line item was Rs 50,000. Of these,you have paid Rs 35,000 so far. Your liability on this account will be Rs 15,000.You bought petrol for your car for Rs 1,400 today. Of this you paid Rs 500 by cash andRs 900 through a credit card. Your expense for today is Rs 500.You have placed a purchase order for some components for Rs 2 lakhs today. This willincrease your assets and your liabilities in your Balance Sheet of today evening.Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your BalanceSheet as of today evening, this amount will appear as a LiabilityYour bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your BalanceSheet as of today evening, this amount will appear as an Asset

20 MarksIn each of the transactions below, indicate which of the four items will increase / decrease or not

Assets Liabilities Incomes Expenses

21 MarksYour current assets are Rs 50 crores. Your working capital is Rs 20 crores.

Inventories comprise 42% of your Current Assets. These are carried onan average for 100 days. Work out the Mfg Cost of the year

Receivables comprise 34% of your Current Assets. These are carried onan average for 61 days. Work out the Sales turnover for the year

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

Bankers are insisting on a max debt equity ratio of 0.6:1 and a minimum

Text Book - Brigham and Houston - Financial Management

Ten Sessions of Two Hours each - Total Twenty Hours1 Valuation Ratios, DuPont Analysis2 Cash Flow Statement3 Compounding and Discounting4 Workshop on Compounding and Discounting5 Payback period, NPV6 IRR, Discounted Payback Period7 Profitability Index, Pros and Cons of Various Methods8 Business Examples and Workshop applying above methods9 Derivation of Cash Flows for evaluating capex proposals

10 Workshop on Cash Flow Derivation

Workshop on Compounding and Discounting

Profitability Index, Pros and Cons of Various MethodsBusiness Examples and Workshop applying above methodsDerivation of Cash Flows for evaluating capex proposals

Financial Ratios1 Liquidity Current Ratio, Burn Ratio2 Solvency Interest Coverage, DSCR, etc3 Efficiency Inventories (Days), Receivable (Days)4 Profitability Margins - Operating, Net, Returns - RoCE, RoE

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

If you as management work well, then you will be rewarded (the company will be rewarded)By who? How ?

By the marketsBy pushing your company valuation upwards

5 Valuation Ratios

STOCK MARKET RELATED STUFF

1 Earnings per Share EPSEPS = Net Profit (PAT) / No of SharesPATEquity Share CapitalFace value per ShareNo of SharesEPS

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

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

The investor community will correlate the price of Rs 75 to the earnings of Rs 2.22 and come upwith their own ideas

If you were Naresh Goyal and you were buying the entire Sahara Airlines, you will NOT BEworried about per Share numbers

Rather you would worried about the total EBIDTA, total PROFIT

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

Forward EPS and Trailing EPS

Trailing EPS means the EPS of the latest four quartersToday's date is Oct 29, 2011What is Trailing EPS ?

If Sept 2011 results are out, then Trailing EPS will beProfits of the period Oct 2010 to Sept 2011 / No of Shares

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

Forward EPS is a for a future periodIt is not known, it is estimated - future is not known

CNBC says Sensex EPS for FY 12 is expected to be Rs 1,185CNBC says Sensex EPS for FY 13 is expected to be Rs 1,301

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

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

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

Forward EPS may refer to any periodFY 12 means what period ? April 2011 to March 2012FY 13 means what period ? April 2012 to March 2013

One year forward means what period?Today, bcoz today is Oct 29, 2011, one year forward will typically mean Oct 2011 to Sept 2012One year forward Sensex EPS is estimated to be Rs 1,243

Europe US is DecemberIndia is March

US - S&P 500 - FY 12 EPS is estimated to be say Rs 103.45What do they mean?They mean Jan 2012 to Dec 2012

You are a cement sector analyst working in KotakLast year India Cement profit was Rs 68 cr (fact)Next year profit as per your estimate is likely to be Rs 125 crProjected PATNo of SharesForward EPS comes to

Various analysts will come up with different Forward EPS estimatesAn average of such estimates is called as CONSENSUS ESTIMATEIf consensus is say Rs 4.03 (India Cement EPS FY 12 forward) and your estimate is far away,then you need to rethink

Analysts EPS Forw1 3.532 1.01 Outlier - he needs to be careful, he should recheck his assumptions3 8.09 Outlier - he needs to be careful, he should recheck his assumptions4 4.055 4.516 3.857 4.23

Consensus 4.18 Simple Average - is generally not done 4.03 More correct average excludes outliers

If you make a loss EPS will be negative, that’s fine

If Trailing EPS is negative and Consensus Forward is positive, those are great turn around casesand you could make big money on the stock market is you identify them in good time

2 PE Ratio or PE Multiple (Price Earnings Multiple)This ratio compares the price per share to the earnings per share

PE Multiple = Price per Share / Earnings per Share

India Cements price per share is say RsTrailing EPS isTrailing PE Mutliple will be

India Cements price per share is say RsForward EPS Consensus isForward PE Multiple will be

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

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

Price per ShareWhich one is more expensive?InfosysWhy?One share of Infy is more expensive than two shares of TCS ??

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

Price per Share

Which one is more expensive?TCS is more expensive ?

In a split what happensYou have one one hundred rupee currency noteThey took it from you and gave you ten ten rupee notes

Price per Share is not an indication of CHEAPNESS or EXPENSIVENESS of a stockMost people go by the price per share, which is a wrong metric

What are these companies earning?If I pay Rs 2,823 for Infosys for one share, what is the support of earnings of that one share which

justifies such a price?

Price per ShareEPS - 1 year forward consensusPE Multiple

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

TCS is more expensive (in this situation)

A lower PE Multiple means a cheaper stockA higher PE Multiple means an expensive stock

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

You want to buy applesRs 60 per kg, Rs 80 per kg, Rs 100 per kg, Rs 120 per kgWhich is the cheapest one?Rs 60 per kg

Always buy Rs 60 applesNever buy Rs 120 apples

A cheap stock may have cheap for the last 30 yearsYou saw it today

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

Post Office or the Bank Fixed DepositI invest RsI earn RsPE Multiple is

PE Multiple of a houseI buy a house for Rs

I earn rent of RsPE Multiple is

If stock market PE multiples become too high (say 25 times), then every investor should keepasking this basic question - why should I not buy Post Office deposits which much cheaper at12.5 timesWarren Buffet says:NEVER FORGET THE POST OFFICE

Expensiveness or cheapness should be measured in relation to the Post OfficeIf Post Office is 12.5 times and stock market is 15 times PE, may be that’s quite okayIf Post Office is 12.5 times and stock market is 35 times PE, may be that’s not okay

Today's PE Multiple on the Sensex is around 12 to 14 times (one year forward)Historically, we have seen a high of 25 timesHistorically we have seen lows of 7 to 8 times also - over the last 30 years

If you and me were rational (which we are not), we would buy at 7 to 8 PE and we would sellat 25 PE

When we say Sensex, we mean India

At 25 PE we will be too excited and experts will be telling us that Sensex from 21000 will soon go to 35000 etc etc - Jan 2008

At 8 PE we will be too exhausted and depressed (most of us would have lost huge amounts by then, no energy left) and experts will be telling us that Sensex will become Nifty - Oct 2008 Sensex went to 7900 (Nifty at that time was 2700)

3 Dividend related ratiosDividend per Share 46.08Dividend % Dividend per Share / Face Value per Share

1.50 Dividend Payout Dividends / PAT

46.08Dividend Yield Dividend per Share / Market Price per Share

1.50

Dividend yield on good companies is only 1 to 3% of their current pricesInvestors don’t buy shares to earn dividends and they do not influence the share purchase decision so much

However, if you are a very old investor (you bought the share in 1991 at very low prices), thendividends can be substantial for you at your old cost

FINANCEHow is Finance different from Financial Accounting / Financial Analysis

Accounting Score keepingGood score keeping does not make you a great cricketer

Analysis Required run rate is xyzNumber of runs scored between midwicket and midon is 72% of the total runs scoredExtension of score keeping skills

Finance Playing the game itself

Finance - future oriented - decision oriented - how to make him liveAccounting - past oriented - post mortem oriented - how did this fellow die

Past is clear, known, no uncertainty - AccountingFuture - vague, uncertain, subjective, you could go wrong

Accounting - right and wrongFinance - no rights and no wrongs - your thought versus mine - your approach versus some one else

What was the EPS of Tata Steel last yearYou have a clear answer

How do I fund the new acquisition of Corus Steel (in Tata Steel)I need Rs 10,000 cr - how do I fund this1,000 ways to fund it - you need to find YOUR WAY

As a finance person, you are a player (manager)As an accounting person, you are an observer

TIME VALUE OF MONEYCompounding and Discounting

Future Value and Present ValueDetermines most long term financial decisions

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

Why does interest exist in the world? What is interest?Compensation for time

Real Interest3%

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

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

Inflation is already factored in when you are dealing with Nominal InterestIn other words, having considered nominal interest, please don’t consider inflation again (double counting)

German FD rates will be 2%Japan FD rates will be 0.50%Botswana FD rates will be 3000%

You friend wants Rs 100He will return interest and principal after 2 yearsHow much will you get after 2 years?Assume you are happy with 10%

When we say 10% what do we mean?

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

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

r (rate of interest) 10%1 + r 110%

Year Value0 100 This method is quicker1 110 You simply multipy by (1+r)2 121

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

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

18990527646

Most of the times, in corporate life, complex formula fail badlyThe more intelligent you are, the more others run away from youThey don’t understand what you are saying

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

This process is called compoundingCompounding means multiplying by (1+r)

Rs 100 is called as the PRESENT VALUERs 121 is called as the FUTURE VALUEMoving from Present Value to Future Value is "compounding"Compounding means multiplying by (1+r)

DISCOUNTINGOpposite of compounding

Your friend wants a loanHe says he can repay you Rs 5 lakhs after 4 yearsHow much can you lend him today (lets assume that you are happy with 10% return)

Year Value4 500,000 3 454,545 2 413,223 1 375,657 0 341,507

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

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

Year Value4 500,000 8.50% 108.50%3 460,829 9.75% 109.75%2 419,890 10.50% 110.50%1 379,991 10.00% 110.00%0 345,446

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

476313 Standard practice in financial framework433012 Present value factor of rupee one373201 r =124000 1+r =

93301373201 Year PV Factor

373206 0 1.0000 1 0.9091 2 0.8264 3 0.7513 4 0.6830 5 0.6209 6 0.5645 7 0.5132 8 0.4665

Present value, DCF value

If I give him Rs 433,012 today and he returns back Rs 2 lakhs each at end of years 5, 6, 7 and 8, I havedealt with him at 10% in this transaction

DENA BANKYou want to introduce a long term scheme for your depositorsThe depositor will pay Rs 1 lakh per annum for 10 yearsYou will pay back Rs 3 lakhs per annum from the end of the 20th year onwardsInterest rate is 8%How long can you pay him Rs 3 lakhs per annum

Year Open Bal CashFlow Interest year begin year begin year end Calculated Manual Calculated

1 - 100,000 8,000 2 108,000 100,000 16,640 3 224,640 100,000 25,971 4 350,611 100,000 36,049 5 486,660 100,000 46,933 6 633,593 100,000 58,687 7 792,280 100,000 71,382 8 963,663 100,000 85,093 9 1,148,756 100,000 99,900

10 1,348,656 100,000 115,892 11 1,564,549 - 125,164 12 1,689,713 - 135,177

13 1,824,890 - 145,991 14 1,970,881 - 157,670 15 2,128,551 - 170,284 16 2,298,835 - 183,907 17 2,482,742 - 198,619 18 2,681,362 - 214,509 19 2,895,871 - 231,670 20 3,127,540 - 250,203 21 3,377,743 (300,000) 246,219 22 3,323,963 (300,000) 241,917 23 3,265,880 (300,000) 237,270 24 3,203,150 (300,000) 232,252 25 3,135,402 (300,000) 226,832 26 3,062,234 (300,000) 220,979 27 2,983,213 (300,000) 214,657 28 2,897,870 (300,000) 207,830 29 2,805,700 (300,000) 200,456 30 2,706,156 (300,000) 192,492 31 2,598,648 (300,000) 183,892 32 2,482,540 (300,000) 174,603 33 2,357,144 (300,000) 164,571 34 2,221,715 (300,000) 153,737 35 2,075,452 (300,000) 142,036 36 1,917,488 (300,000) 129,399 37 1,746,887 (300,000) 115,751 38 1,562,638 (300,000) 101,011 39 1,363,650 (300,000) 85,092 40 1,148,741 (300,000) 67,899 41 916,641 (300,000) 49,331 42 665,972 (300,000) 29,278 43 395,250 (300,000) 7,620 44 102,870 (300,000) (15,770)

1 Time value of money2 Compounding (multiply by 1+r)3 Discounting (divide by 1+r)4 Future value

5 Present value6 Present value factor tables (for one rupee)7 Nominal cash flow8 Discounted cash flow (nominal cash flow x PV factor)

Internal Rate of Return (IRR)You give your friend Rs 5 lakhs today and he returns back Rs 9 lakhs after 3 yearsWhat have you earned (% per annum)?

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

Four variables: Compounding1 FV Determine2 PV Given3 r Given4 n Given

Year CashFlow0 (500,000) 21.64%1 - 2 - How do I know this is right?3 900,000

500,000 608,220 739,864 900,000

"Internal" Rate of ReturnWhat does this "Internal" mean?The rate of return is being computed without referring to any external market or bank or Govt Securitiesor anythingThis rate of return is purely based on your own inflows and outflows of cash without regard to anyexternal factorInternal to your own set of cash flows

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

Year CashFlow

0 (500,000)1 - 2 - 3 200,000 4 200,000 5 200,000 6 200,000 7 200,000 8 200,000 9 200,000

10 200,000

HOME LOAN INDUSTRYEvery EMI that you pay comes straight off the IRRPrincipal amount 2,000,000 Tenor 20 yearsEMI 19,633 Solve for "r" Monthly IRRIRR will help us Annual IRR

Month CashFlow Interest PrincRepaid0 (2,000,000)1 19,633 17,083 2,550 2 19,633 17,062 2,571 3 19,633 17,040 2,593 4 19,633 17,018 2,615 5 19,633 16,995 2,638 6 19,633 16,973 2,660 7 19,633 16,950 2,683 8 19,633 16,927 2,706 9 19,633 16,904 2,729

10 19,633 16,881 2,752 11 19,633 16,857 2,776 12 19,633 16,833 2,800 13 19,633 16,810 2,823 14 19,633 16,785 2,848 15 19,633 16,761 2,872

16 19,633 16,737 2,896 17 19,633 16,712 2,921 18 19,633 16,687 2,946 19 19,633 16,662 2,971 20 19,633 16,636 2,997 21 19,633 16,611 3,022 22 19,633 16,585 3,048 23 19,633 16,559 3,074 24 19,633 16,533 3,100 25 19,633 16,506 3,127 26 19,633 16,479 3,154 27 19,633 16,452 3,181 28 19,633 16,425 3,208 29 19,633 16,398 3,235 30 19,633 16,370 3,263 31 19,633 16,342 3,291 32 19,633 16,314 3,319 33 19,633 16,286 3,347 34 19,633 16,257 3,376 35 19,633 16,229 3,404 36 19,633 16,199 3,434 37 19,633 16,170 3,463 38 19,633 16,141 3,492 39 19,633 16,111 3,522 40 19,633 16,081 3,552 41 19,633 16,050 3,583 42 19,633 16,020 3,613 43 19,633 15,989 3,644 44 19,633 15,958 3,675 45 19,633 15,926 3,707 46 19,633 15,895 3,738 47 19,633 15,863 3,770 48 19,633 15,831 3,802 49 19,633 15,798 3,835 50 19,633 15,765 3,868 51 19,633 15,732 3,901 52 19,633 15,699 3,934 53 19,633 15,665 3,968 54 19,633 15,631 4,002

55 19,633 15,597 4,036 56 19,633 15,563 4,070 57 19,633 15,528 4,105 58 19,633 15,493 4,140 59 19,633 15,458 4,175 60 19,633 15,422 4,211 61 19,633 15,386 4,247 62 19,633 15,350 4,283 63 19,633 15,313 4,320 64 19,633 15,276 4,357 65 19,633 15,239 4,394 66 19,633 15,201 4,432 67 19,633 15,164 4,469 68 19,633 15,125 4,508 69 19,633 15,087 4,546 70 19,633 15,048 4,585 71 19,633 15,009 4,624 72 19,633 14,969 4,664 73 19,633 14,930 4,703 74 19,633 14,889 4,744 75 19,633 14,849 4,784 76 19,633 14,808 4,825 77 19,633 14,767 4,866 78 19,633 14,725 4,908 79 19,633 14,683 4,950 80 19,633 14,641 4,992 81 19,633 14,598 5,035 82 19,633 14,555 5,078 83 19,633 14,512 5,121 84 19,633 14,468 5,165 85 19,633 14,424 5,209 86 19,633 14,380 5,253 87 19,633 14,335 5,298 88 19,633 14,290 5,343 89 19,633 14,244 5,389 90 19,633 14,198 5,435 91 19,633 14,151 5,482 92 19,633 14,105 5,528 93 19,633 14,057 5,576

94 19,633 14,010 5,623 95 19,633 13,962 5,671 96 19,633 13,913 5,720 97 19,633 13,864 5,769 98 19,633 13,815 5,818 99 19,633 13,765 5,868

100 19,633 13,715 5,918 101 19,633 13,665 5,968 102 19,633 13,614 6,019 103 19,633 13,562 6,071 104 19,633 13,511 6,122 105 19,633 13,458 6,175 106 19,633 13,406 6,227 107 19,633 13,352 6,281 108 19,633 13,299 6,334 109 19,633 13,245 6,388 110 19,633 13,190 6,443 111 19,633 13,135 6,498 112 19,633 13,079 6,554 113 19,633 13,023 6,610 114 19,633 12,967 6,666 115 19,633 12,910 6,723 116 19,633 12,853 6,780 117 19,633 12,795 6,838 118 19,633 12,736 6,897 119 19,633 12,677 6,956 120 19,633 12,618 7,015 121 19,633 12,558 7,075 122 19,633 12,498 7,135 123 19,633 12,437 7,196 124 19,633 12,375 7,258 125 19,633 12,313 7,320 126 19,633 12,251 7,382 127 19,633 12,188 7,445 128 19,633 12,124 7,509 129 19,633 12,060 7,573 130 19,633 11,995 7,638 131 19,633 11,930 7,703 132 19,633 11,864 7,769

133 19,633 11,798 7,835 134 19,633 11,731 7,902 135 19,633 11,663 7,970 136 19,633 11,595 8,038 137 19,633 11,527 8,106 138 19,633 11,457 8,176 139 19,633 11,388 8,245 140 19,633 11,317 8,316 141 19,633 11,246 8,387 142 19,633 11,175 8,458 143 19,633 11,102 8,531 144 19,633 11,029 8,604 145 19,633 10,956 8,677 146 19,633 10,882 8,751 147 19,633 10,807 8,826 148 19,633 10,732 8,901 149 19,633 10,656 8,977 150 19,633 10,579 9,054 151 19,633 10,502 9,131 152 19,633 10,424 9,209 153 19,633 10,345 9,288 154 19,633 10,266 9,367 155 19,633 10,186 9,447 156 19,633 10,105 9,528 157 19,633 10,024 9,609 158 19,633 9,941 9,692 159 19,633 9,859 9,774 160 19,633 9,775 9,858 161 19,633 9,691 9,942 162 19,633 9,606 10,027 163 19,633 9,520 10,113 164 19,633 9,434 10,199 165 19,633 9,347 10,286 166 19,633 9,259 10,374 167 19,633 9,170 10,463 168 19,633 9,081 10,552 169 19,633 8,991 10,642 170 19,633 8,900 10,733 171 19,633 8,808 10,825

172 19,633 8,716 10,917 173 19,633 8,623 11,010 174 19,633 8,529 11,104 175 19,633 8,434 11,199 176 19,633 8,338 11,295 177 19,633 8,242 11,391 178 19,633 8,144 11,489 179 19,633 8,046 11,587 180 19,633 7,947 11,686 181 19,633 7,847 11,786 182 19,633 7,747 11,886 183 19,633 7,645 11,988 184 19,633 7,543 12,090 185 19,633 7,439 12,194 186 19,633 7,335 12,298 187 19,633 7,230 12,403 188 19,633 7,124 12,509 189 19,633 7,017 12,616 190 19,633 6,910 12,723 191 19,633 6,801 12,832 192 19,633 6,691 12,942 193 19,633 6,581 13,052 194 19,633 6,469 13,164 195 19,633 6,357 13,276 196 19,633 6,244 13,389 197 19,633 6,129 13,504 198 19,633 6,014 13,619 199 19,633 5,898 13,735 200 19,633 5,780 13,853 201 19,633 5,662 13,971 202 19,633 5,543 14,090 203 19,633 5,422 14,211 204 19,633 5,301 14,332 205 19,633 5,178 14,455 206 19,633 5,055 14,578 207 19,633 4,930 14,703 208 19,633 4,805 14,828 209 19,633 4,678 14,955 210 19,633 4,550 15,083

211 19,633 4,422 15,211 212 19,633 4,292 15,341 213 19,633 4,161 15,472 214 19,633 4,028 15,605 215 19,633 3,895 15,738 216 19,633 3,761 15,872 217 19,633 3,625 16,008 218 19,633 3,488 16,145 219 19,633 3,350 16,283 220 19,633 3,211 16,422 221 19,633 3,071 16,562 222 19,633 2,930 16,703 223 19,633 2,787 16,846 224 19,633 2,643 16,990 225 19,633 2,498 17,135 226 19,633 2,352 17,281 227 19,633 2,204 17,429 228 19,633 2,055 17,578 229 19,633 1,905 17,728 230 19,633 1,754 17,879 231 19,633 1,601 18,032 232 19,633 1,447 18,186 233 19,633 1,291 18,342 234 19,633 1,135 18,498 235 19,633 977 18,656 236 19,633 817 18,816 237 19,633 657 18,976 238 19,633 495 19,138 239 19,633 331 19,302 240 19,633 166 19,467

4,711,920

IRR is an iterative calculationDeterministic calculations 2+7 = 9Probabilistic calculationsWhat will be your sales next year? I don’t knowIf I force you, you may come up with sir, may be Rs 10 cr, may be Rs 15 cr80% prob - Rs 10 cr, 20% prob - Rs 15 cr

Iterative calculationsThe answer is not knownBut we will try and try and try till we succeed

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

FLAT INTEREST RATE EXAMPLEThe real rate of interest that you pay or receive is known only by IRR workingsIf you borrow Rs 5 lakhs from a pathan and he charges you 8% flat interest rate and you repay principalRs 1 lakh per annum for 5 years (year 1 to year 5), what does this flat interest rate meanIt means that you pay interest on Rs 5 lakhs throughout (not on reducing balance but on original loan)

What is the real interest cost to you?

Year CashFlow0 (5.00) 12.38%1 1.40 8% is not 8%, 8% on flat rate basis is 12.38% in reality2 1.40 3 1.40 4 1.40 5 1.40

ZERO PERCENT INTERESTYou go to retail store ABC in T Nagar, ChennaiYou want to buy a LED TVMRP Rs 70,000They are offering zero percent interest instalment facility12 instalments, 3 payable in advance (today)4th to 12th instalment in month 4 to month 122% processing feesIf you were to buy the TV cash down, you get a discount of 4% - in the scheme that discount does not apply

What does zero percent really imply in reality?

There is no inflow for the consumer, so this can be slightly confusing to some people

When you buy the TV, there is simply outflow outflow

Options Buy cash down Use the loan DifferenceMonth - (67,200) (18,900) 48,300 1 - - - 2 - - - 3 - - - 4 - (5,833) (5,833) 5 - (5,833) (5,833) 6 - (5,833) (5,833) 7 - (5,833) (5,833) 8 - (5,833) (5,833) 9 - (5,833) (5,833) 10 - (5,833) (5,833) 11 - (5,833) (5,833) 12 - (5,833) (5,833)

1.05%

INSURANCEEndowment PoliciesAnnual premium 111,000 Sum Assured 2,700,000 Tenor 15

Term PlanYou pay a premium (very low) and if you survive, then you get back nothingAnnual Premium 6,500 Sum Assured 2,700,000 Tenor 15

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

Which plan is better?Endowment versus (Term Plan + PPF)

EndowmentYear CashFlow

0 (111,000) IRR =1 (111,000)2 (111,000)3 (111,000) Endowment is bundling4 (111,000) Bundling of : Insurance Cover and Savings5 (111,000)6 (111,000)7 (111,000)8 (111,000)9 (111,000)

10 (111,000)11 (111,000)12 (111,000)13 (111,000)14 (111,000)15 2,700,000

When I buy the term plan, I will pay annual premium of RsThe balance amount left in my hand is RsThis balance amount will be invested in PPF

Year Open Bal Cash Inflow InterestBeginning

1 - 104,500 8,883 2 113,383 104,500 18,520 3 236,403 104,500 28,977 4 369,879 104,500 40,322 5 514,701 104,500 52,632 6 671,834 104,500 65,988 7 842,322 104,500 80,480 8 1,027,302 104,500 96,203 9 1,228,005 104,500 113,263

10 1,445,768 104,500 131,773 11 1,682,041 104,500 151,856 12 1,938,397 104,500 173,646 13 2,216,543 104,500 197,289

14 2,518,331 104,500 222,941 15 2,845,772 104,500 250,773

Year CashFlow0 (111,000) 7.81%1 (111,000)2 (111,000)3 (111,000)4 (111,000)5 (111,000)6 (111,000)7 (111,000)8 (111,000)9 (111,000)

10 (111,000)11 (111,000)12 (111,000)13 (111,000)14 (111,000)15 3,201,045

1 Don’t go for flat interest rate schemes - the real interest rate is much higher2 Don’t go for zero EMI - pls recheck the IRR3 Don’t go for endowment policies or ULIPs - if you wish to buy insurance, buy Term Plans

Cheapest value for money

In ULIPs, they take Rs 100 from you and carve out Rs 23 towards service charges of various typesWhat gets invested is only Rs 77

2377

30% So long as market has not appreciated by 30% you are under water

How do use these concepts in business lifeMost capex decisions are long termCapex means capital expenditure (new factory, new product launch, new branch, new company acquisition)You invest today and you reap the harvest in futureFuture is long term (at least more than one year)

If I spend Rs 500 cr and I get back Rs 600 cr after 3 years, is that interesting?No - bcoz of time value of money

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

Current Ratio, Burn RatioInterest Coverage, DSCR, etcInventories (Days), Receivable (Days)Margins - Operating, Net, Returns - RoCE, RoE

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

If you as management work well, then you will be rewarded (the company will be rewarded)

Results of those actionsPartly your actions, partly the environment, partly sentiment, etc

68.10 Rs cr 307.18 Rs cr 10.00 Rs 30.72 Cr 2.22 Rs per Share

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

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

The investor community will correlate the price of Rs 75 to the earnings of Rs 2.22 and come up

If you were Naresh Goyal and you were buying the entire Sahara Airlines, you will NOT BE

Rather you would worried about the total EBIDTA, total PROFIT

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

Trailing EPS means the EPS of the latest four quarters

If Sept 2011 results are out, then Trailing EPS will beProfits of the period Oct 2010 to Sept 2011 / No of Shares

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

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

CNBC says Sensex EPS for FY 12 is expected to be Rs 1,185CNBC says Sensex EPS for FY 13 is expected to be Rs 1,301

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

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

Both may be right - one may be Trailing and the other may be Forward

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

Today, bcoz today is Oct 29, 2011, one year forward will typically mean Oct 2011 to Sept 2012One year forward Sensex EPS is estimated to be Rs 1,243

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

Next year profit as per your estimate is likely to be Rs 125 cr 125.00 Rs cr 30.72 You think this will remain constant 4.07 Rs per Share

Various analysts will come up with different Forward EPS estimatesAn average of such estimates is called as CONSENSUS ESTIMATEIf consensus is say Rs 4.03 (India Cement EPS FY 12 forward) and your estimate is far away,

Outlier - he needs to be careful, he should recheck his assumptionsOutlier - he needs to be careful, he should recheck his assumptions

Simple Average - is generally not doneMore correct average excludes outliers

If Trailing EPS is negative and Consensus Forward is positive, those are great turn around casesand you could make big money on the stock market is you identify them in good time

PE Ratio or PE Multiple (Price Earnings Multiple)This ratio compares the price per share to the earnings per share

75.00 Rs per Share 2.22 Rs per Share 33.83 Times (x)

75.00 Rs per Share 4.03 Rs per Share 18.59 Times (x)

For every one rupee that India Cements is likely to earn in the coming year, the market is willing

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

Infosys TCS 2,823.00 1,225.00

One share of Infy is more expensive than two shares of TCS ??

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

Infosys TCS 282.30 1,225.00

They took it from you and gave you ten ten rupee notes

Price per Share is not an indication of CHEAPNESS or EXPENSIVENESS of a stockMost people go by the price per share, which is a wrong metric

If I pay Rs 2,823 for Infosys for one share, what is the support of earnings of that one share which

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

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

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

Rs 60 per kg, Rs 80 per kg, Rs 100 per kg, Rs 120 per kg

A cheap stock may have cheap for the last 30 years

100 Price of the financial instrument8

12.5 times

40 lakhs

2 lakhs20 times

If stock market PE multiples become too high (say 25 times), then every investor should keepasking this basic question - why should I not buy Post Office deposits which much cheaper at

Expensiveness or cheapness should be measured in relation to the Post OfficeIf Post Office is 12.5 times and stock market is 15 times PE, may be that’s quite okayIf Post Office is 12.5 times and stock market is 35 times PE, may be that’s not okay

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

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

If you and me were rational (which we are not), we would buy at 7 to 8 PE and we would sell

At 25 PE we will be too excited and experts will be telling us that Sensex from 21000 will soon

At 8 PE we will be too exhausted and depressed (most of us would have lost huge amounts by then, no energy left) and experts will be telling us that Sensex will become Nifty - Oct 2008 Sensex went to 7900 (Nifty at that time was 2700)

30.72 1.50 Rs per ShareDividend per Share / Face Value per Share

10.00 15%

68.10 68%Dividend per Share / Market Price per Share

75.00 2.00%

Dividend yield on good companies is only 1 to 3% of their current pricesInvestors don’t buy shares to earn dividends and they do not influence the share purchase decision

However, if you are a very old investor (you bought the share in 1991 at very low prices), thendividends can be substantial for you at your old cost

How is Finance different from Financial Accounting / Financial Analysis

Good score keeping does not make you a great cricketerRequired run rate is xyzNumber of runs scored between midwicket and midon is 72% of the total

Extension of score keeping skillsPlaying the game itself

Finance - future oriented - decision oriented - how to make him liveAccounting - past oriented - post mortem oriented - how did this fellow die

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

How do I fund the new acquisition of Corus Steel (in Tata Steel)

If I give you Rs 100 today and you return back Rs 100 after 2 years, that is not fair

The same Rs 100 in a bank would have generated some interest

Nominal Interest10%

Inflation7%

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

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

Inflation is already factored in when you are dealing with Nominal InterestIn other words, having considered nominal interest, please don’t consider inflation again (double counting)

Inflation is 1%Inflation is zero percentInflation is 2500%

121

Conventional terminologiesConventional terminologies

This method is quickerYou simply multipy by (1+r)

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

200

Most of the times, in corporate life, complex formula fail badlyThe more intelligent you are, the more others run away from you

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

How much can you lend him today (lets assume that you are happy with 10% return)

r (rate of interest) 10%1 + r 110%In discounting, we DIVIDE BY 1+r

In discounting, we start with FUTURE VALUE and we derive the PRESENT VALUEWhat is the present value of Rs 5 lakhs receivable after 4 years at a discounting rate of 10%?

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

How do you know what rates will prevail whenRs 5 cr software

Your friend can return to you Rs 2 lakhs per annum at the end of years 5, 6, 7 and 8

Standard practice in financial framework

10%110%

Nominal DiscountedCashFlow Cash Flow

- - If I give you Rs 0.9091 today and you - - return back one rupee after one year, - - then are we dealing at 10% with - - each other 200,000 124,184 200,000 112,895 200,000 102,632 200,000 93,301

433,012

If I give him Rs 433,012 today and he returns back Rs 2 lakhs each at end of years 5, 6, 7 and 8, I have

You want to introduce a long term scheme for your depositors

You will pay back Rs 3 lakhs per annum from the end of the 20th year onwards

8%

Clos Bal year end Calculated 108,000 224,640 350,611 486,660 633,593 792,280 963,663 1,148,756 1,348,656 1,564,549 1,689,713 1,824,890

1,970,881 2,128,551 2,298,835 2,482,742 2,681,362 2,895,871 3,127,540 3,377,743 3,323,963 3,265,880 3,203,150 3,135,402 3,062,234 2,983,213 2,897,870 2,805,700 2,706,156 2,598,648 2,482,540 2,357,144 2,221,715 2,075,452 1,917,488 1,746,887 1,562,638 1,363,650 1,148,741 916,641 665,972 395,250 102,870 (212,901)

Discounted cash flow (nominal cash flow x PV factor)

You give your friend Rs 5 lakhs today and he returns back Rs 9 lakhs after 3 years

Discounting IRRGiven GivenDetermine GivenGiven DetermineGiven Given

How do I know this is right? r = 21.64%1+r= 121.64%

The rate of return is being computed without referring to any external market or bank or Govt Securities

This rate of return is purely based on your own inflows and outflows of cash without regard to any

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

21.39%

0.85% 12 10.25%

PrincBal 2,000,000 1,997,450 1,994,879 1,992,286 1,989,671 1,987,033 1,984,373 1,981,690 1,978,984 1,976,255 1,973,502 1,970,727 1,967,927 1,965,104 1,962,256 1,959,384

1,956,488 1,953,566 1,950,620 1,947,649 1,944,652 1,941,630 1,938,582 1,935,508 1,932,407 1,929,281 1,926,127 1,922,947 1,919,739 1,916,504 1,913,241 1,909,951 1,906,632 1,903,285 1,899,909 1,896,505 1,893,071 1,889,608 1,886,116 1,882,594 1,879,041 1,875,459 1,871,845 1,868,201 1,864,526 1,860,819 1,857,081 1,853,311 1,849,508 1,845,673 1,841,805 1,837,905 1,833,970 1,830,003 1,826,001

1,821,965 1,817,895 1,813,790 1,809,650 1,805,475 1,801,264 1,797,017 1,792,733 1,788,413 1,784,057 1,779,663 1,775,231 1,770,762 1,766,254 1,761,708 1,757,123 1,752,499 1,747,835 1,743,132 1,738,388 1,733,604 1,728,779 1,723,913 1,719,005 1,714,055 1,709,063 1,704,029 1,698,951 1,693,830 1,688,665 1,683,457 1,678,203 1,672,905 1,667,562 1,662,173 1,656,737 1,651,256 1,645,727 1,640,152

1,634,529 1,628,857 1,623,138 1,617,369 1,611,551 1,605,684 1,599,766 1,593,798 1,587,779 1,581,708 1,575,586 1,569,411 1,563,183 1,556,903 1,550,568 1,544,180 1,537,737 1,531,239 1,524,685 1,518,076 1,511,410 1,504,687 1,497,907 1,491,068 1,484,172 1,477,216 1,470,201 1,463,126 1,455,991 1,448,795 1,441,537 1,434,217 1,426,835 1,419,389 1,411,881 1,404,307 1,396,670 1,388,967 1,381,198

1,373,363 1,365,461 1,357,491 1,349,453 1,341,347 1,333,172 1,324,926 1,316,610 1,308,224 1,299,765 1,291,234 1,282,631 1,273,954 1,265,202 1,256,376 1,247,475 1,238,498 1,229,444 1,220,312 1,211,103 1,201,815 1,192,447 1,183,000 1,173,472 1,163,862 1,154,171 1,144,396 1,134,539 1,124,597 1,114,570 1,104,457 1,094,258 1,083,972 1,073,598 1,063,135 1,052,583 1,041,941 1,031,208 1,020,383

1,009,466 998,456 987,351 976,152 964,857 953,466 941,977 930,390 918,704 906,919 895,032 883,045 870,954 858,761 846,463 834,060 821,552 808,936 796,213 783,381 770,439 757,387 744,224 730,948 717,558 704,054 690,435 676,700 662,847 648,876 634,785 620,575 606,242 591,788 577,210 562,507 547,679 532,724 517,641

502,430 487,089 471,616 456,012 440,274 424,401 408,394 392,249 375,966 359,545 342,983 326,280 309,434 292,444 275,309 258,027 240,598 223,021 205,293 187,413 169,381 151,195 132,853 114,355 95,699 76,883 57,907 38,769 19,467 (0)

If I force you, you may come up with sir, may be Rs 10 cr, may be Rs 15 cr

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

8% is not 8%, 8% on flat rate basis is 12.38% in reality

If you were to buy the TV cash down, you get a discount of 4% - in the scheme that discount does not apply

There is no inflow for the consumer, so this can be slightly confusing to some people

MRP 70,000 Discount 4%Cash Down 67,200 Tenor 12 monthsEMI 5,833 Proc Fee 2%

1,400

12 12.63%

You pay a premium (very low) and if you survive, then you get back nothing

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

5.83%

Endowment is bundlingBundling of : Insurance Cover and Savings

6,500 Life Cover 104,500 Savings

8.50%

Cl Bal

113,383 236,403 369,879 514,701 671,834 842,322 1,027,302 1,228,005 1,445,768 1,682,041 1,938,397 2,216,543 2,518,331

2,845,772 3,201,045

Don’t go for flat interest rate schemes - the real interest rate is much higher

Don’t go for endowment policies or ULIPs - if you wish to buy insurance, buy Term Plans

In ULIPs, they take Rs 100 from you and carve out Rs 23 towards service charges of various types

So long as market has not appreciated by 30% you are under water

Capex means capital expenditure (new factory, new product launch, new branch, new company acquisition)

If I spend Rs 500 cr and I get back Rs 600 cr after 3 years, is that interesting?

Actions

These are not comparable

If I give you Rs 0.9091 today and youreturn back one rupee after one year,

108%PV Fact DCF CumuDCF

1.0000 100,000 100,000 0.9259 92,593 192,593 0.8573 85,734 278,326 0.7938 79,383 357,710 0.7350 73,503 431,213 0.6806 68,058 499,271 0.6302 63,017 562,288 0.5835 58,349 620,637 0.5403 54,027 674,664 0.5002 50,025 724,689 0.4632 - 724,689 0.4289 - 724,689

0.3971 - 724,689 0.3677 - 724,689 0.3405 - 724,689 0.3152 - 724,689 0.2919 - 724,689 0.2703 - 724,689 0.2502 - 724,689 0.2317 - 724,689 0.2145 (64,364) 660,324 0.1987 (59,597) 600,728 0.1839 (55,182) 545,545 0.1703 (51,095) 494,451 0.1577 (47,310) 447,141 0.1460 (43,805) 403,336 0.1352 (40,561) 362,775 0.1252 (37,556) 325,219 0.1159 (34,774) 290,445 0.1073 (32,198) 258,247 0.0994 (29,813) 228,434 0.0920 (27,605) 200,829 0.0852 (25,560) 175,269 0.0789 (23,667) 151,602 0.0730 (21,914) 129,688 0.0676 (20,290) 109,398 0.0626 (18,787) 90,611 0.0580 (17,396) 73,215 0.0537 (16,107) 57,108 0.0497 (14,914) 42,194 0.0460 (13,809) 28,385 0.0426 (12,786) 15,598 0.0395 (11,839) 3,759 0.0365 (10,962) (7,203)

Summary of yesterday1 Valuation ratios

EPSForward and Trailing EPSPE MultiplesTells us what is cheap and what is expensive (share price itself does not convey)Dividend ratios - Div per Share, Div %, Div Payout, Div Yield

2 Time value of moneyCompounding - Multiply by 1+rDiscounting - Divide by 1+rNominal cash flowPresent value factorDiscounted cash flowIRRPresent value, future value

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

SEVERAL FINANCIAL CRITERIA1 Payback period2 Net Present Value NPV3 IRR4 Discounted payback period5 Profitability Index (PI) - this is used when you have multiple competing projects

Year Nominal Cumulative Present CashFlow Nom CF Value Factor

0 (100) (100) 1.0000 1 20 (80) 0.8772

2 20 (60) 0.7695 3 30 (30) 0.6750 4 30 - 0.5921 5 30 30 0.5194 6 40 70 0.4556 7 40 110 0.3996 8 40 150 0.3506 9 90 240 0.3075

240.00 NPV

Nominal cash outflows (100)Nominal cash inflows 340 Nominal net cash flow 240

Present value of cash outflows (100.00)Present value of cash inflows 162.43 Net Present Value 62.43

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

Payback periodWithout getting into complicated arithmetic, how many years does it take to get my money backWe ignore interest, we ignore compounding, discountingOur payback is exactly 4 years

If Project A payback is 4 years and Project B is 3 years, which is better?B is better

But the fact may be that after the payback period, A generates huge earnings, while B does not

Drawbacks:1 Interest is ignored2 Cash flows after the payback period are ignored

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

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

If the payback is 7 years, I am simply not interestedMany SME who will reject any project with a payback of over 2 years

Large corporates may typically have hundreds of small projectsI want to buy this new software which will automate several processes and I can save on people costThis software will cost me Rs 2 cr and save wages of Rs 25 lakhs per annum for the next 10 yearsThat is a project

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

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

Within Tata Motors, there are 800 small projects each costing less than Rs 5 crWho approves themExecutive CommitteeThese people will not allow projects beyond 2 year payback, 3 year payback

Tooling Cost payback 1 year - Brakes IndiaCustomer proposals - when calculating RoI, payback is computed - TCS - US customers look at around 1 yearGlass - payback 2 years, 4 year payback products are tough to sell

Conventional glass consumes more electricityHigh performance glass consumes lessBenefit - lower electricity costsCost - incremental cost of this glass

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

Large capital intensive projects will tend to have long paybacks - 7 years, 10 years, 15 yearsFor projects of national importance, such paybacks are commonDelhi Airport - payback may well be 15 yearsKonkan Railway - payback may be 25 yearsReliance Refinery - payback may be 7 years

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

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

Financial ratios work year on year

RoE24% RoE

Project Level 22%Financial parametersCut across several years

2011 2012Company level numbers for one year at a timeCompany is nothing but a collection of projectsAccounting ratios

Project level RoI = Benefits of the Project / Costs of the ProjectThese RoI are very crude workings and most of the time are highly political workings

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

If the NET is a positive number, what does this mean?PV of Inflows is more than PV of Outflows - the idea looks good

If the NET is a negative number, what does this mean?PV of Inflows is less than PV of Outflows - the idea does not look so bright

INTERNAL RATE OF RETURNThe NPV is 62.43 when we are discounting atAt a very simple level, we have assumed that funds will be available atWhat if interest rates start rising and funds are now available atWhat do you think will happen to the NPV?

1 Goes up2 Goes down3 Indifferent

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

If Interest rates go up drastically, say to 45%, what may happen?The project may become unattractive - the NPV may turn negative

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

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

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

If you borrow at 14%, then NPV will be positiveIf you borrow at any rate above 26.08%, the NPV will be negative

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

Many corporates will have a certain minimum IRR which each project should satisfyAny project with an IRR below this threshold will be rejected by management

IRR rate, min rate, threshold rate, hurdle rate

25% IRR - Brakes India - quite a high hurdle - may be difficult to beat20% IRR in competitive segmentsMost Indian corporates look at a min min 15% IRR

I want positive NPV projects - that’s where I make moneyIf my min IRR hurdle is 15% and my pet project is showing an IRR of 22%, what does this meanThis project will show a positive NPV if discounted at 15%

IRR thinking - positive conclusion - 22% > 15%NPV thinking - positive conclusion - NPV will be positive in this project

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

Which one should you use - NPV or IRRAfter the break

DISCOUNTED PAYBACK PERIODThe criticism against the simple payback is that it ignores interestSo the discounted payback overcomes this challenge - it considers interestIt uses the discounted cash flows to compute the payback period and as we know, the discounted cash flowcolumn considers interest

End of year 5 - cumulative DCF is negativeEnd of year 6 - cumulative DCF is positiveDCF in year 6How much do I need to make my Cum DCF zeroHow much fraction of the 6th year

Disc Payback is 5.x yearsDisc Payback is 5.74 years

PROFITABILITY INDEX (PI)This criterion is used when we have limited funds and many competing project ideasYou have only Rs 200 cr and you have 300 ideas which need Rs 700 crYou will have to pick and choose, you cant satisfy everybodySo, which ones to pick? On what criteria?

There can be conflicts between NPV and IRRIn a single project situation there is no conflict

Proj AProject Cost 150NPV Rs cr 100IRR % 19%

So, which one ?The Profitability Index is the answer =

PV of Outflows 150 PV of Inflows 250 Profitability Index 1.67

I don’t have money - so I need to conserve my funds - every rupee is importantIf I invest one rupee in Project A, I am getting back Rs 1.67If I invest one rupee in Project B, I am getting back Rs 1.60

So, I will go for Project A

BUSINESS CAPEX EXERCISEYour company is in infrastructure and is bidding for a road projectThe road will cost Rs 1,000 cr - assume that road building takes one dayIn the first year, the toll revenue will be Rs 100 crThis revenue will increase 10% every yearThe licence to operate the road works for 30 yearsAt the end of 30 years, the company will walk away from the road (road belongs to the Govt)Assume that funds can be brought in at 14%

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

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

GOAL SEEK COMMANDIn the context of IRR, we discussed IRR is that rate of interest which makes the NPV zero

Can we automatically work out the IRR (not using the IRR formula) using the NPV table (without manuallytrying and trying)

INPUT MODELINGA spreadsheet is useful because it can calculateIf a spreadsheet cannot calculate, then it is a word processorMany of us use spreadsheets like word processors

What can be a formula should never be a hard numberHard numbers should be minimal

100 100110 110

RIGHT WRONGOR NOTSO RIGHT ?

100.00 110.00 121.00

MOST RIGHT

Whether a formula should contain a hard number - second question

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

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

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

1 Use minimal hard numbers

2 Keep these hard numbers in clear cells (don’t mix them up with formula)3 Don’t use the same formula again - if you need that number, refer to that cell (instead of

recalculating the number)4 Always remember that your file should be amenable to good WHAT IF analysis

My revenues grow at:

8%9%

10%11%12%

My cost of capital is:

12%13%14%15%16%

How much can you simplify, automate?Test the Goal Seek Command for IRR - NPV

Much faster way of WHAT IF ANALYSISThere is a DATA TABLE function meant for such analysis - very powerful, very easy

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

One Way TableOne input factor is being changed at a timeDis Factor NPV IRR

62.43 26.08%11% 86.94 26.08%12% 78.21 26.08%13% 70.06 26.08%14% 62.43 26.08%15% 55.30 26.08%

16% 48.61 26.08%17% 42.35 26.08%

Two way TablesTwo factors are changing at the same timeWhat will be my NPV in the following 35 situations (7 discounting factors x 5 possible Project Costs)

Dis Factor Project Cost

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

Sensitivity to Revenue GrowthNPV IRR PI

8%9%

10%11%12%

Two Way TablesNPV Sensitivity

12% 13% 14%8%9%

10%11%12%

IRR Sensitivity12% 13% 14%

8%9%

10%11%12%

PI Sensitivity12% 13% 14%

8%9%

10%11%12%

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

Business CaseWe are going to integrate our earlier knowledge of Bal Sheet, P&L with the new knowledge of NPV, IRR

You are putting a new factory, cost of RsYou will produce name platesCost of each name plate is Rs 100Selling price is Rs 150Annual fixed operating costs are Rs 20First year volume of business is 100,000

Volume will increase at 5%

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

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

This business will run for 10At the end of ten year, I will quit the business and sell off the factory, which will fetch only Rs The working capital in the business (at that time) will be released (converted to Cash)

Assume cost of capital is 14%Assume that appropriate depreciation has been provided forIgnore interest, bank loans taken and repaid, income tax

Balance Sheet for each year ProjectionsP&L for each year ProjectionsWe could assume for financial projections that the funds came from owners equity

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

PROJECTED PROFIT & LOSS ACCOUNT

Year 1 2Volume 100,000 105,000 Selling Price 150.00 160.50 Sales Revenue 15,000,000 16,852,500 Variable Cost per Unit 100.00 100.00 Variable Cost Rs 10,000,000 10,500,000 Fixed Costs 2,000,000 2,000,000 EBIDTA 3,000,000 4,352,500 Depreciation 900,000 900,000 EBIT 2,100,000 3,452,500

PROJECTED BALANCE SHEET

Liabilities 0 1 2Sh Capital 11,800,000 11,800,000 11,800,000 Reserves - 2,100,000 5,552,500 Total Liab 11,800,000 13,900,000 17,352,500

AssetsFixed Assets 10,000,000 9,100,000 8,200,000 Work Cap 1,800,000 2,022,300 2,272,054 Excess Cash - 2,777,700 6,880,446 Total Assets 11,800,000 13,900,000 17,352,500

Excess Cash is the balancing number in the Bal Sheet

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZSources of Funds (Inflows)Owners Equit 11,800,000 - - Cash Profits - 3,000,000 4,352,500 Fixed Assets - - - Working Capi - - - Total 11,800,000 3,000,000 4,352,500

Application of Funds (Outflows)Fixed Assets 10,000,000 - - WorkCap 1,800,000 222,300 249,754 Total 11,800,000 222,300 249,754

Surplus - 2,777,700 4,102,746 Open Bal - - 2,777,700 Cl Bal - 2,777,700 6,880,446

Difference in Cash Bal - - - Sum of the difference

Cash Profits = PAT + Depreciation added back

Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EBIDTA, not EBIT

Year 0 1 2Capex FA (10,000,000)

Work Cap (1,800,000) (222,300) (249,754)Cash Profits - 3,000,000 4,352,500 Sale of FARelease of Work CapTotal (11,800,000) 2,777,700 4,102,746

PV Factor 1.000 0.877 0.769 DCF (11,800,000) 2,436,579 3,156,930

NPV 38,806,441

Tells us what is cheap and what is expensive (share price itself does not convey)Dividend ratios - Div per Share, Div %, Div Payout, Div Yield

You are setting up a new project and this project will cost you Rs 100 crFor simplicity, let us assume that the entire spending will happen on day zeroYou will earn Rs 20 cr per annum for the first two years, then Rs 30 cr per annum for the next three years

Profitability Index (PI) - this is used when you have multiple competing projects

Discounted Cumulative 14.00%Cash Flow Disc Cash Flo 114% (100.00) (100.00) 17.54 (82.46) PV Factor = last year PVF / 114%

15.39 (67.07) 20.25 (46.82) 17.76 (29.06) What does 0.5921 mean? 15.58 (13.47) If I give you 0.5921 rupees today 18.22 4.75 and you return me back one rupee 15.99 20.73 after 4 years, then we have 14.02 34.76 transacted with each other at 14% 27.68 62.43 62.43

But this is a useless number, bcoz this does not considertime value of money

This is a useful number bcoz it incorporates time valueof money - even after considering that inflows arrive laterin time, then NPV is still positive - the project looksinteresting

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

Without getting into complicated arithmetic, how many years does it take to get my money back

If Project A payback is 4 years and Project B is 3 years, which is better?

But the fact may be that after the payback period, A generates huge earnings, while B does not

In many sectors, the long term is simply unknown - I simply don’t know

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

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

I want to buy this new software which will automate several processes and I can save on people costThis software will cost me Rs 2 cr and save wages of Rs 25 lakhs per annum for the next 10 years

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

Tata Motors Nano project may well have a payback of ten years

Within Tata Motors, there are 800 small projects each costing less than Rs 5 cr

These people will not allow projects beyond 2 year payback, 3 year payback

Customer proposals - when calculating RoI, payback is computed - TCS - US customers look at around 1 yearGlass - payback 2 years, 4 year payback products are tough to sell

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

Large capital intensive projects will tend to have long paybacks - 7 years, 10 years, 15 yearsFor projects of national importance, such paybacks are common

If you are a middle level manager and you have some bright ideas, then please make sure that such ideas

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

RoE27% RoE

26%

RoE20%

2013 2014 2015 YearsCompany level numbers for one year at a timeCompany is nothing but a collection of projects

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

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

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

when we are discounting at 14%At a very simple level, we have assumed that funds will be available at 14%What if interest rates start rising and funds are now available at 16%

The NPV should fall - the project should become less attractive bcoz the banks will take away more from

If Interest rates go up drastically, say to 45%, what may happen?The project may become unattractive - the NPV may turn negative

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

If you borrow funds at the IRR rate, the project will neither make losses nor profits - you will be indifferent

If your cost of borrowings is less than IRR, then the project is interesting

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

Many corporates will have a certain minimum IRR which each project should satisfyAny project with an IRR below this threshold will be rejected by management

25% IRR - Brakes India - quite a high hurdle - may be difficult to beat

If my min IRR hurdle is 15% and my pet project is showing an IRR of 22%, what does this mean

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

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

The criticism against the simple payback is that it ignores interestSo the discounted payback overcomes this challenge - it considers interestIt uses the discounted cash flows to compute the payback period and as we know, the discounted cash flow

(13.47) 4.75 18.22 13.47 0.74

This criterion is used when we have limited funds and many competing project ideasYou have only Rs 200 cr and you have 300 ideas which need Rs 700 cr

Proj B20012017%

PV of InflowsPV of Outflows

200 Rs cr 320 Rs cr 1.60 times

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

Your company is in infrastructure and is bidding for a road projectThe road will cost Rs 1,000 cr - assume that road building takes one day

At the end of 30 years, the company will walk away from the road (road belongs to the Govt)

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

IRR should not be worked out on the DCF column bcoz the discounting process itself has adjusted cashinflows downwards by 14% and once again on this if you apply IRR (which is another form of discounting),

In the context of IRR, we discussed IRR is that rate of interest which makes the NPV zero

Can we automatically work out the IRR (not using the IRR formula) using the NPV table (without manually

100 is a hard number (unavoidable)Second year should be a formulaSo 100 x 1.1 (or 100 x 110%) is good - formulaBut is it really good?The 1.1 factor or the 110% factor is a hard numberShould a hard number be hard coded onto a formula?Ideally NoThen what should I do?The 10% should sit in a separate cell (hard number)The 110% should be a formula (second cell)

10% 110%

Whether a formula should contain a hard number - second question

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

Keep these hard numbers in clear cells (don’t mix them up with formula)Don’t use the same formula again - if you need that number, refer to that cell (instead of

Always remember that your file should be amenable to good WHAT IF analysis

What happens to my:Situations

Payback 10NPV 10IRR 10Discounted Payback 10PI 10

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

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

What will be my NPV in the following 35 situations (7 discounting factors x 5 possible Project Costs)

(110.00) (120.00) 76.94 66.94 68.21 58.21 60.06 50.06 52.43 42.43 45.30 35.30 38.61 28.61 32.35 22.35

Worst case

Sensitivity to Cost of CapitalNPV IRR

12%13%14%15%16%

25 situations15% 16%

15% 16%

15% 16%

We are reasonably familiar with Payback, NPV, IRR, Discounted Payback and PI

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

1 cr 10,000,000

Variable costs, Direct costs

lakhs 100,000 units

per annum

per annum

Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Vendor Payables,12% of coming year Sales

yearsAt the end of ten year, I will quit the business and sell off the factory, which will fetch only Rs 10The working capital in the business (at that time) will be released (converted to Cash)

Will not affect your Bal Sheet, P&L - only for capex decision

114%

We could assume for financial projections that the funds came from owners equity

3 4 5 6 110,250 115,763 121,551 127,628 171.74 183.76 196.62 210.38 18,933,784 21,272,106 23,899,211 26,850,764 100.00 100.00 100.00 100.00 11,025,000 11,576,250 12,155,063 12,762,816 2,000,000 2,000,000 2,000,000 2,000,000 5,908,784 7,695,856 9,744,149 12,087,948 900,000 900,000 900,000 900,000 5,008,784 6,795,856 8,844,149 11,187,948

3 4 5 6 11,800,000 11,800,000 11,800,000 11,800,000 10,561,284 17,357,140 26,201,288 37,389,237 22,361,284 29,157,140 38,001,288 49,189,237

7,300,000 6,400,000 5,500,000 4,600,000 2,552,653 2,867,905 3,222,092 3,620,020 12,508,631 19,889,234 29,279,197 40,969,217 22,361,284 29,157,140 38,001,288 49,189,237

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ

- - - - 5,908,784 7,695,856 9,744,149 12,087,948 - - - - - - - - 5,908,784 7,695,856 9,744,149 12,087,948

- - - - 280,599 315,253 354,186 397,928 280,599 315,253 354,186 397,928

5,628,185 7,380,603 9,389,962 11,690,020 6,880,446 12,508,631 19,889,234 29,279,197 12,508,631 19,889,234 29,279,197 40,969,217

- - - -

Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EBIDTA, not EBIT

3 4 5 6

(280,599) (315,253) (354,186) (397,928) 5,908,784 7,695,856 9,744,149 12,087,948

5,628,185 7,380,603 9,389,962 11,690,020

0.675 0.592 0.519 0.456 3,798,865 4,369,910 4,876,852 5,325,816

PV Factor = last year PVF / 114%

If I give you 0.5921 rupees todayand you return me back one rupee

transacted with each other at 14%

Payback 7 years

NPV Rs 15 crIRR 31%

Best case

Realistic case

PI

lakhs

7 8 9 10 134,010 140,710 147,746 155,133 225.11 240.87 257.73 275.77 30,166,833 33,892,437 38,078,153 42,780,805 100.00 100.00 100.00 100.00 13,400,956 14,071,004 14,774,554 15,513,282 2,000,000 2,000,000 2,000,000 2,000,000 14,765,877 17,821,433 21,303,598 25,267,523 900,000 900,000 900,000 900,000 13,865,877 16,921,433 20,403,598 24,367,523

7 8 9 10 11,800,000 11,800,000 11,800,000 11,800,000 51,255,113 68,176,546 88,580,144 112,947,667 63,055,113 79,976,546 100,380,144 124,747,667

3,700,000 2,800,000 1,900,000 - 4,067,092 4,569,378 5,133,697 - 55,288,021 72,607,167 93,346,448 124,747,667 63,055,113 79,976,546 100,380,144 124,747,667

- - - - 14,765,877 17,821,433 21,303,598 25,267,523 - - - 1,000,000 - - - 5,133,697 14,765,877 17,821,433 21,303,598 31,401,219

- - - - 447,072 502,286 564,318 - 447,072 502,286 564,318 -

14,318,804 17,319,147 20,739,280 31,401,219 40,969,217 55,288,021 72,607,167 93,346,448 55,288,021 72,607,167 93,346,448 124,747,667

- - - -

7 8 9 10

(447,072) (502,286) (564,318) - 14,765,877 17,821,433 21,303,598 25,267,523

1,000,000 5,133,697

14,318,804 17,319,147 20,739,280 31,401,219

0.400 0.351 0.308 0.270 5,722,329 6,071,384 6,377,493 8,470,284

Growth 1+x5% 105%7% 107%

0% 100%

0% 100%

1,000,000 Asset book value 1,000,000 Sold for the same amount and enhanced cash - No profit no loss on sale

Sold for the same amount and enhanced cash

1 Impact of Interest, Depreciation and Taxes on Capex decisions2 Cost of Capital 3 Risk - Definition, Measurement, Implications

SHOULD WE PREPAY A HOME LOAN OR NOTThere is no answer to the question - at what point in time is advantageous to prepayThe home loan costs you sayYou get a tax benefit of 30%Post tax cost of home loanPPF earns

Why should I prepayAnswer - financially appears to be never prepayPsychologically, some may prefer to prepay - they don’t want tensionIf they have surplus funds, their relatives will take it awayThey don’t trust themselves (on not to spend)

INTERESTWe will recall that in our workings, we have ignored interestFor capex evaluation, we always ignore interestWhy?Is interest not a real cost? How can we ignore interest?

Interest is compensation to the lender for passage of timeIf I borrow at 10 am and return at 1001 am, then possibly most lenders will not charge interestI borrow in 2011 and I return in 2021, hence interest is charged

Discounting is nothing but considering passage of time (time value of money)As we are already discounting cash flows, we should not consider interest - otherwise we will be double counting

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

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

DEPRECIATIONDepreciation is not a cash outflow, it is a mere book entry

So depreciation is ignored in the computation of cash flowsHowever, depreciation becomes important for another purpose, viz taxTax laws allow you depreciation as an expenseSo, if you can claim high depreciation, what will happen?Your tax burden will reduceTax is a cash outflow or a book entry?If tax were a book entry, Planet Earth will become HeavenWe will compute tax after considering depreciation benefitsHowever, the basic depreciation amount itself will be either ignored (if you have not deducted it earlier) oradded back (if you have deducted it earlier)

EBIDTADepreciationEBITInterestPBTTax 30%PAT

Cash flow in the above situationTwo ways of presenting the cash flow - both mean the same thing but start from different pointsEBIDTALess : InterestLess : TaxCash Flow

Presentation TwoPATAdd back DepreciationCash Flow

Presentation ThreeWe just discussed that Interest should be ignored for capex evaluationIf you ignore interest, then we need a number to help us with cash profits

EBIT x (1-t) + DepreciationEBIT

t (tax rate) 30%1 - t 70%EBIT x (1-t)Add DepreciationCash flow for capex decisions

This Rs 120 cr is not the real cash profit of the yearThe real cash profit is Rs 106 cr

In capex evaluation, we are trying to discount cash flowsIf you discount, you should ignore interestThis Rs 120 cr is trying to tell you that if you had not paid any interest, then your cash flow would have beenRs 120 cr

SUMMARY1 We ignore interest bcoz we are discounting cash flows 2 We ignore depreciation bcoz there is no cash flow3 We will consider taxes as an outflow and also consider the impact of depreciation on taxes

P&L - first sessionsSales

Business journey, Sectoral journey

EBIDTA

Finance journeyPAT

Business CaseIn the last Business Case, we will introduce the following:

1 The project cost is funded partly by banks and partly by promotersBanksPromoters

2 Interest rate charged by banks is

3 The bank loan will be repaid equally in the first

4 Tax rate in the country

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

You are putting a new factory, cost of RsYou will produce name platesCost of each name plate is Rs 100Selling price is Rs 150Annual fixed operating costs are Rs 20First year volume of business is 100,000

Volume will increase at 5%Selling prices will increase at 7%Costs will not increase, kept under control

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

This business will run for 10At the end of ten year, I will quit the business and sell off the factory, which will fetch only Rs The working capital in the business (at that time) will be released (converted to Cash)

Assume cost of capital is 14%Assume that appropriate depreciation has been provided forIgnore interest, bank loans taken and repaid, income tax

Balance Sheet for each year ProjectionsP&L for each year ProjectionsWe could assume for financial projections that the funds came from owners equity

Cost of Fixed Assets 10,000,000 Salvage value estimated 1,000,000 Depreciable value 9,000,000 Tenor 10

Depreciation per annum (SLM) 900,000

PROJECTED PROFIT & LOSS ACCOUNT

Year 1 2Volume 100,000 105,000 Selling Price 150.00 160.50 Sales Revenue 15,000,000 16,852,500 Variable Cost per Unit 100.00 100.00 Variable Cost Rs 10,000,000 10,500,000 Fixed Costs 2,000,000 2,000,000 EBIDTA 3,000,000 4,352,500 Depreciation 900,000 900,000 EBIT 2,100,000 3,452,500 Interest 1,062,000 849,600 PBT 1,038,000 2,602,900 Tax 30% 311,400 780,870 PAT 726,600 1,822,030

PROJECTED BALANCE SHEETLiabilities 0 1 2Sh Capital 2,950,000 2,950,000 2,950,000 Reserves - 726,600 2,548,630

Bank Loans 8,850,000 7,080,000 5,310,000 Total Liab 11,800,000 10,756,600 10,808,630

AssetsFixed Asset 10,000,000 9,100,000 8,200,000 Work Cap 1,800,000 2,022,300 2,272,054 Excess Cas - (365,700) 336,576 Total Asset 11,800,000 10,756,600 10,808,630

Excess Cash is the balancing number in the Bal Sheet

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZSources of Funds (Inflows)Owners Equ 2,950,000 - -

Bank Loan 8,850,000 Cash Profit - 1,626,600 2,722,030 Fixed Asset - - - Working Ca - - - Total 11,800,000 1,626,600 2,722,030

Application of Funds (Outflows)Fixed Asset 10,000,000 - - WorkCap 1,800,000 222,300 249,754 Bank Loan - 1,770,000 1,770,000

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

Surplus - (365,700) 702,276 Open Bal - - (365,700)Cl Bal - (365,700) 336,576

Difference in Cash Bal - - - Sum of the difference

Cash Profits = PAT + Depreciation added back

Bank Loan Amortization ScheduleOp Bal 8,850,000 8,850,000 7,080,000 Repay 0 1,770,000 1,770,000 Cl Bal 8,850,000 7,080,000 5,310,000 Tenor 5 yearsInt Rate 12%Interest 1,062,000 849,600

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

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

Sale of FARelease of Work CapTotal (11,800,000) 2,147,700 3,066,996

PV Factor 1.000 0.877 0.769 DCF (11,800,000) 1,883,947 2,359,954

NPV 25,032,192

The reduction in the NPV is attributable to tax costs in this version (as compared to zero tax in the earlierversion)

Cash means cash balance (cash on hand), bank balances, securities which are convertible to cash at shortnotice, cash equivalents (mutual funds, bonds, liquid instruments)

In the accounts, bank balances can go negativeYou pay your vendors on Friday evening - best practiceWhy Friday evening?He will deposit on Saturday and Sunday is a holiday - 3 days you have extracted from the systemIf you have a positive balance, may be it can earn some interest for 3 daysIf you have a negative balance, then you can deposit something on Monday morningA negative bank balance in your books is sometimes called as a Book Overdraft

DEPRECIATION IN YOUR PERSONAL LIFEYour salary income is Rs 15 lakhsYou bott a car for Rs 8 lakhs (life 5 years)Depn per annum is Rs 1.60 lakhsIf depreciation were allowed as an expense for you (unfortunately not the case), what would your taxableincome be?

SalaryLess : DepreciationTaxable Income

This is not allowed as per tax law

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

Business profits before depreciationLess : DepreciationTaxable Income

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

COST OF CAPITALIf your business needs Rs 100, of which the bank is ready to fund Rs 75 and the bank will charge 12% interest,what is your cost of capital?

One thought could be:

75 12% 925 0% 0

100 9% 9

Many new entrepreneurs think this wayBut this is very wrong

Not a penny is free, every penny costs you somethingSome times you pay in a tangible mannerSometimes you don’t pay anything, but there is still a cost attached to itNothing is free

What is the cost of EQUITY? Is it zero?Answer - No it is not zeroHad you not invested in this business venture and done something else with it, what would you have earned?Opportunity cost

Capital

DebtBanks, Fin Inst

COST OF DEBTPrimarily InterestSome bank charges

Stamp duties for executing documentsMortgage deeds

Bank processing charges, guarantees Pre tax cost of debt

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

If your tax rate is sayYour tax benefit on interest is

Your post tax cost of interest is

As a businessman, all interest is tax deductible (on all business loans)As an individual, only home loan interest is tax deductible (other loans are generally not tax deductibleother education)

If you don’t pay any tax, then your cost of debt isHow come you don’t pay tax

1 Loss making company2 SEZ units3 Infrastructure units4 Mauritius

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

What is the cost of equityMany years and many decades passed before humanity could find an answerMost people were looking at the P&L for this cost

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

Don’t look at the P&LLook at the psychology of the investorAsk him - why are you investing in this company's equityWhy not elsewhere

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

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

Bcoz I think that you can generate higher returnsGreed - the basic philosophy of all investing is greed

How much more do you wantSo if you get 9% instead of 8%, are you okay to invest in this company's shares?

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

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

If your long term G Sec yield has been Long term Sensex returns have been

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

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

All this is generic equity (Sensex)

But your company is not the SensexYou company is XYZHow much return should I expect for investing in your company?

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

Then, he said that investors will demand more return from you (as compared to Sensex)HUL HUL

Risk free rate 8.00%Equity risk premium (Sensex 7.50%Relative risk factor 0.85 6.38%Cost of equity for your company 14.37%

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

Your friend comes back from Dubai after 17 yearsHe says I have a great project idea and why don’t you become my partnerWhat ideaSmugglingWhat is your first question?What is the rate of return?

9% Are you interested? NoHe clarifies 9% per monthAre you interested? Which product? Which port? Who will be caught if caught? Will my name appear in documents?

What is the variability in your returns?One year - fantastic 108%Next year - caught - jailThird year - 300%

If the relative risk factor is 3.00, that company or that sector would have enormous variation in earningsyear on yearDLF, Unitech, DB Realty - huge volatility of earnings

If your risk factor is 0.85, your earnings are very steady, maybe growingGovernment employees at personal levelHUL, Nestle, Marico, Colgate

We are DLF

Capital

DebtBanks, Fin Inst

9.10%

How much of my capital is coming from debt and how much from equity (mix)Mix Cost WACC

Debt 40% 9.10% 3.64%Equity 60% 29.38% 17.63%

100% 21.27%

WACC - Weighted Average Cost of Capital

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

This WACC becomes your discounting rate in your capex evaluationAlso called as Hurdle Rate, Threshold Rate, Min IRR Rate, Discounting Rate, WACC - you need as a Manager, to beat this RateOnly then will your NPV be positive and IRR be higher than the WACC

RELATIVE RISK FACTORKnown as "beta" in the stock marketsBeta compares the daily return on your stock vis-à-vis the daily return on the Sensex

Sensex day 17624 Your company share price yday

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

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

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

There are 10,035 problems with the beta, which we can spend time debating - but not much will come outof that discussionMany experts have fought with the CAPM model and have criticized it so much over the last 30 yearsBut none of them have come with an alternative popular modelsThe alternatives are fraught with more controversy

There are 6,000 plus stocks in the countryBut hardly 1,800 of them trade every dayThe top 50 will contribute to 97% of the trading volumes of the countrySo, the share prices of most small stocks are unreliable and so is their "beta"Conceptually, beta assumes a liquid marketAbsence of a liquid market will affect beta accuracy

17624 2.517675 2.517783 2.517501 2.5

No trade

WHAT TO DO IF BETA IS NOT AVAILABLECost of Equity = Risk Free Rate + (Generic Equity Risk Premium x Beta)In many cases, beta is not available

1 Unlisted entity2 Listed but not actively traded

Beta was suggested by Prof William Sharpe as a measure of "risk"He was trying to quantify something that was thought to be very difficult to quantify

If you are not listed, but your competitors, your industry is listed, then you use the industry beta as themeasure of your beta

You are ABC Real Estate Ltd, unlistedBut you have DLF, Sobha Developers and 20 others who are listedIt is quite likely that your risk profile is similar to theirsTheir average beta is your beta

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

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

Sectoral beta becomes your starting point of betaAdjustments to beta for specific factors

1 DebtHigh debt means high risk means high betaIf the industry debt equity is 1:1 and your debt equity is 1.5:1, that meansyou should have a higher beta than industry beta

There is a clear methodology on how beta should be adjusted for debtLevered beta and unlevered beta

2 SizeA smaller company is a riskier entityInfra is hit badlyBut IVRCL is hit more badly than L&TSo if industry beta is 1.31 and your size is one tenth of the size of the averageindustry player, then experts will make your beta 1.81 instead of 1.31

In India, we don’t have scientific adjustments for sizeIn the US, there are agencies which publish beta for various sectors and alsoprovide guidance for size related adjustmentsIbbotsons is a leader in this business of computing beta and empirically suggestingadditions for sizeIbbotsons has been taken over by MorningStar

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

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

RISKRisk is defined as variability of returnIf return is defined as some form of profit (for this limited discussion) and we try and measure profitvariation in relation to variation in sales, that measurement provides some understanding of riskThis is called impact of "leverage"

In engineer, the term "lever" stands for what?For a small amount of effort, the movement is a multiplier impact

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

When can my entire profits be wiped out?

Operating Leverage = % Change in EBIT% Change in Sales

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

Financial Leverage = % Change in PAT% Change in EBIT

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

Total Leverage = % Change in PAT

% Change in Sales

Total Leverage = Operating Leverage x Financial Leverage

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

1 Whether a higher leverage is good or bad2 What makes the leverage high or low

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

A higher fixed cost will necessarily increase leverageHigh fixed cost means high risk - you have to pay for fixed costs whether you make money or notFixed costs (both in personal and business life) is like a stone on your neckHeavier the stone more difficult our life

What is the benefit of outsourcing?I have 5,000 people working for me in CaliforniaNow I transfer them to Bangalore and I pay per hour, per call, per seat, per transaction, per somethingIt that something does not happen (decrease in volume), I wont payWhat have I done?I have converted my fixed costs into a variable cost

Nike has no factoriesWhat is the benefit?No fixed costs

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

Financial LeverageInterest is a fixed costs in most casesInterest depends on whatDepends on how much debt you have in your capital structureHigh debt - means high interest - means high financial fixed costs - means high financial leverage - high risk

- high beta if you are listed

Operating Leverage structuring and Financial Leverage structuring are independent decisions (in simplistictheory)

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

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

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

Overall, we believe that a total levarage of more than 3 is dangerousVery crude benchmark3 times means your entire profits will be wiped out if sales drop by 33%

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

Impact of Interest, Depreciation and Taxes on Capex decisions

There is no answer to the question - at what point in time is advantageous to prepay10.00%

3.00%7.00%8.00% tax free

Psychologically, some may prefer to prepay - they don’t want tensionIf they have surplus funds, their relatives will take it away

We will recall that in our workings, we have ignored interest

Interest is compensation to the lender for passage of timeIf I borrow at 10 am and return at 1001 am, then possibly most lenders will not charge interestI borrow in 2011 and I return in 2021, hence interest is charged

Discounting is nothing but considering passage of time (time value of money)As we are already discounting cash flows, we should not consider interest - otherwise we will be double

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

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

Depreciation is not a cash outflow, it is a mere book entry

So depreciation is ignored in the computation of cash flowsHowever, depreciation becomes important for another purpose, viz tax

If tax were a book entry, Planet Earth will become HeavenWe will compute tax after considering depreciation benefitsHowever, the basic depreciation amount itself will be either ignored (if you have not deducted it earlier) or

Reality HypothesisWith Int W/o Int

150 15050 50

100 10020 080 10024 3056 70

Two ways of presenting the cash flow - both mean the same thing but start from different points150 150-20 0-24 -30 Text Book A page 156106 120

56 7050 50 Text B page 307

106 120

We just discussed that Interest should be ignored for capex evaluationIf you ignore interest, then we need a number to help us with cash profits

100

This method of presentation is more 70 common in capex evaluation models50

120

This Rs 120 cr is trying to tell you that if you had not paid any interest, then your cash flow would have been

We ignore interest bcoz we are discounting cash flows We ignore depreciation bcoz there is no cash flowWe will consider taxes as an outflow and also consider the impact of depreciation on taxes

Business journey, Sectoral journey

Finance journey Depreciation, Interest and Taxes

The project cost is funded partly by banks and partly by promoters75%25%

12%

The bank loan will be repaid equally in the first 5 years

30%

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

1 cr 10,000,000

Variable costs, Direct costs

lakhs 100,000 units

per annumper annum

Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Vendor Payables,12% of coming year Sales

yearsAt the end of ten year, I will quit the business and sell off the factory, which will fetch only Rs 10The working capital in the business (at that time) will be released (converted to Cash)

Will not affect your Bal Sheet, P&L - only for capex decisionAssume that appropriate depreciation has been provided for

114%

We could assume for financial projections that the funds came from owners equity

3 4 5 6 110,250 115,763 121,551 127,628 171.74 183.76 196.62 210.38 18,933,784 21,272,106 23,899,211 26,850,764 100.00 100.00 100.00 100.00 11,025,000 11,576,250 12,155,063 12,762,816 2,000,000 2,000,000 2,000,000 2,000,000 5,908,784 7,695,856 9,744,149 12,087,948 900,000 900,000 900,000 900,000 5,008,784 6,795,856 8,844,149 11,187,948 637,200 424,800 212,400 - 4,371,584 6,371,056 8,631,749 11,187,948 1,311,475 1,911,317 2,589,525 3,356,384 3,060,109 4,459,739 6,042,224 7,831,564

3 4 5 6 2,950,000 2,950,000 2,950,000 2,950,000 5,608,739 10,068,478 16,110,702 23,942,266

3,540,000 1,770,000 - - 12,098,739 14,788,478 19,060,702 26,892,266

7,300,000 6,400,000 5,500,000 4,600,000 2,552,653 2,867,905 3,222,092 3,620,020 2,246,086 5,520,573 10,338,610 18,672,246 12,098,739 14,788,478 19,060,702 26,892,266

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ

- - - -

3,960,109 5,359,739 6,942,224 8,731,564 - - - - - - - - 3,960,109 5,359,739 6,942,224 8,731,564

- - - - 280,599 315,253 354,186 397,928 1,770,000 1,770,000 1,770,000 -

2,050,599 2,085,253 2,124,186 397,928

1,909,510 3,274,487 4,818,038 8,333,635 336,576 2,246,086 5,520,573 10,338,610 2,246,086 5,520,573 10,338,610 18,672,246

- - - -

5,310,000 3,540,000 1,770,000 1,770,000 1,770,000 1,770,000 3,540,000 1,770,000 -

637,200 424,800 212,400

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

3 4 5 6

(280,599) (315,253) (354,186) (397,928) 3,506,149 4,757,099 6,190,904 7,831,564 900,000 900,000 900,000 900,000

4,125,550 5,341,847 6,736,718 8,333,635

0.675 0.592 0.519 0.456 2,784,629 3,162,802 3,498,840 3,796,692

The reduction in the NPV is attributable to tax costs in this version (as compared to zero tax in the earlier

Cash means cash balance (cash on hand), bank balances, securities which are convertible to cash at shortnotice, cash equivalents (mutual funds, bonds, liquid instruments)

He will deposit on Saturday and Sunday is a holiday - 3 days you have extracted from the systemIf you have a positive balance, may be it can earn some interest for 3 daysIf you have a negative balance, then you can deposit something on Monday morningA negative bank balance in your books is sometimes called as a Book Overdraft

If depreciation were allowed as an expense for you (unfortunately not the case), what would your taxable

15.00 1.60 13.40

However, if you are running your business and your profit is say Rs 15 lakhs (before depreciation), Govt says

15.00 1.60 13.40

The businessman is using his car to further his business profits, while the salaried employee would have

If your business needs Rs 100, of which the bank is ready to fund Rs 75 and the bank will charge 12% interest,

Sometimes you don’t pay anything, but there is still a cost attached to it

Had you not invested in this business venture and done something else with it, what would you have earned?

EquityOwners, Shareholders

12.00%

0.50%0.50%

13.00% Before considering tax benefits of interest

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

30%3.90%

9.10% Pre tax Interest x (1-t)

As a businessman, all interest is tax deductible (on all business loans)As an individual, only home loan interest is tax deductible (other loans are generally not tax deductible

13.00%

Cost of equity cannot be seen in the P&L - it is not tangibleWe don’t pay our shareholders anything as an obligation - there is no obligation to payWe may sometimes distribute dividends, but that is not a cost - that is sharing of profits, that is discretionary, no compulsion, it may depend on various factors - even if I make fantastic profits but

Many years and many decades passed before humanity could find an answer

Prof William Sharpe, Stanford University came up with an answer, for which he won the Nobel Prize

First of all, every country has some risk free instruments and any investor can always invest hereIn India, we have the PPF, Post Office Deposits, Govt Securities - risk free

8% 8.50%

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

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

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

India8.00%

15.50%

This tells you that investors are happy with an incremental return of 7.50%

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

How much return should I expect for investing in your company?

Prof William Sharpe said - we should map the risk of your company vis-à-vis that of the Sensex (relative risk)

Then, he said that investors will demand more return from you (as compared to Sensex)DLF DLF Sensex Sensex

8.00% 8.00%7.50% 7.50%

2.85 21.38% 1.00 7.50%29.38% 15.50%

If you invest in the Post Office, you will get 8%, 8%, 8%, 8%, 8%, 8% and your Rs 100 back

He says I have a great project idea and why don’t you become my partner

Which product? Which port? Who will be caught if caught? Will my name appear in documents?

If the relative risk factor is 3.00, that company or that sector would have enormous variation in earnings

If your risk factor is 0.85, your earnings are very steady, maybe growing

EquityOwners, Shareholders

29.38%

How much of my capital is coming from debt and how much from equity (mix)

I should take up only those projects that will beat the WACC of 21.27%

This WACC becomes your discounting rate in your capex evaluationAlso called as Hurdle Rate, Threshold Rate, Min IRR Rate, Discounting Rate, WACC - you need as a Manager,

Only then will your NPV be positive and IRR be higher than the WACC

Beta compares the daily return on your stock vis-à-vis the daily return on the Sensex

Your company share price yday 203.45

204.651.2

0.59%

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

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

There are 10,035 problems with the beta, which we can spend time debating - but not much will come out

Many experts have fought with the CAPM model and have criticized it so much over the last 30 yearsBut none of them have come with an alternative popular models

The top 50 will contribute to 97% of the trading volumes of the countrySo, the share prices of most small stocks are unreliable and so is their "beta"

Cost of Equity = Risk Free Rate + (Generic Equity Risk Premium x Beta)

Beta was suggested by Prof William Sharpe as a measure of "risk"He was trying to quantify something that was thought to be very difficult to quantify

If you are not listed, but your competitors, your industry is listed, then you use the industry beta as the

But you have DLF, Sobha Developers and 20 others who are listed

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

South India Real Estate is very different from Western India - I will exclude Mumbai based companiesI build residential apartments and therefore will exclude heavy commercial builders

High debt means high risk means high betaIf the industry debt equity is 1:1 and your debt equity is 1.5:1, that meansyou should have a higher beta than industry beta

There is a clear methodology on how beta should be adjusted for debtLevered beta and unlevered beta

A smaller company is a riskier entity

But IVRCL is hit more badly than L&TSo if industry beta is 1.31 and your size is one tenth of the size of the averageindustry player, then experts will make your beta 1.81 instead of 1.31

In India, we don’t have scientific adjustments for sizeIn the US, there are agencies which publish beta for various sectors and alsoprovide guidance for size related adjustmentsIbbotsons is a leader in this business of computing beta and empirically suggesting

Ibbotsons has been taken over by MorningStar

If you are in an industry where there is no other company, all other companies are all unlisted and early

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

If return is defined as some form of profit (for this limited discussion) and we try and measure profitvariation in relation to variation in sales, that measurement provides some understanding of risk

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

Leverage

10.00%

Operating Leverage

19.20%

Financial Leverage

26.67%

19.20% 1.92 times10.00%

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

26.67% 1.39 times19.20%

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

26.67% 2.67 times

10.00%

Total Leverage = Operating Leverage x Financial Leverage 2.67 times

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

Higher leverage means higher risk - in what sense - more volatility of your earnings and if you are a listed

A higher fixed cost will necessarily increase leverageHigh fixed cost means high risk - you have to pay for fixed costs whether you make money or notFixed costs (both in personal and business life) is like a stone on your neck

Now I transfer them to Bangalore and I pay per hour, per call, per seat, per transaction, per somethingIt that something does not happen (decrease in volume), I wont pay

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

Depends on how much debt you have in your capital structureHigh debt - means high interest - means high financial fixed costs - means high financial leverage - high risk

Operating Leverage structuring and Financial Leverage structuring are independent decisions (in simplistic

If you have tons of your own money (equity), you may be able to afford a call center in Chennai more than

If you already are sitting or plan to sit on a high operating leverage, please don’t compound your problems

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

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

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

If your operating leverage is say 2, then how much financial leverage can you afford?

This method of presentation is more common in capex evaluation models

lakhs

7 8 9 10 134,010 140,710 147,746 155,133 225.11 240.87 257.73 275.77 30,166,833 33,892,437 38,078,153 42,780,805 100.00 100.00 100.00 100.00 13,400,956 14,071,004 14,774,554 15,513,282 2,000,000 2,000,000 2,000,000 2,000,000 14,765,877 17,821,433 21,303,598 25,267,523 900,000 900,000 900,000 900,000 13,865,877 16,921,433 20,403,598 24,367,523 - - - - 13,865,877 16,921,433 20,403,598 24,367,523 4,159,763 5,076,430 6,121,080 7,310,257 9,706,114 11,845,003 14,282,519 17,057,266

7 8 9 10 2,950,000 2,950,000 2,950,000 2,950,000 33,648,379 45,493,382 59,775,901 76,833,167

- - - - 36,598,379 48,443,382 62,725,901 79,783,167

3,700,000 2,800,000 1,900,000 - 4,067,092 4,569,378 5,133,697 - 28,831,287 41,074,004 55,692,204 79,783,167 36,598,379 48,443,382 62,725,901 79,783,167

- - - -

10,606,114 12,745,003 15,182,519 17,957,266 - - - 1,000,000 - - - 5,133,697 10,606,114 12,745,003 15,182,519 24,090,962

- - - - 447,072 502,286 564,318 - - - - -

447,072 502,286 564,318 -

10,159,041 12,242,717 14,618,201 24,090,962 18,672,246 28,831,287 41,074,004 55,692,204 28,831,287 41,074,004 55,692,204 79,783,167

- - - -

7 8 9 10

(447,072) (502,286) (564,318) - 9,706,114 11,845,003 14,282,519 17,057,266 900,000 900,000 900,000 900,000

10000005133696.570275

10,159,041 12,242,717 14,618,201 24,090,962

0.400 0.351 0.308 0.270 4,059,932 4,291,795 4,495,213 6,498,388

Growth 1+x5% 105%7% 107%

0% 100%

0% 100%

### Asset book value### Sold for the same amount and enhanced cash

- No profit no loss on sale

Sold for the same amount and enhanced cash

FINANCE - QUESTION PAPER - JAN 2012TIME - ONE HOUR, LAPTOP ALLOWED

Question OneCompany X Ltd figures are as under:Year ending March 31 Mar-11 Dec-11 Mar-12

Rs crProfit After Tax 150 158 175Share Capital 50 60 60Face value per share (Rs) 10 10 10Market price per Share as at Jan 7, 2012 - Rs 304

What is its trailing EPSWhat is its forward EPSWhat is the trailing PEWhat is the forward PE

Question TwoCompany Y relevant figures for the year ended March 31, 2011 are as under:

Rs crProfit After Tax 250Share Capital 100Face value per Share (Rs) 5Market price per Share (Rs) 278

If it declares a dividend of Rs 12 per share, what are the following:Dividend %Dividend PayoutDividend Yield

Question ThreeYour friend has taken a loan of Rs xx from you. He will pay you back Rs 5 lakhsafter 3 years, Rs 2 lakhs after 4 years and Rs 2 lakhs after 5 years. Your rateof interest on this deal is 12%.What is the amount you have lent him today?

Question FourIn your insurance policy, you pay an annual premium of Rs 12,700 for 20 yearsYou get back Rs 4,50,000 after 20 years. What is your rate of return?

Question FiveYou are setting up a new project and this project will cost you Rs 10 crYou will lose Rs 1 cr in year one, earn Rs 2 cr per annum in year two and then Rs 4 cr per annum for the next five yearsEnd of this perid, you will exit the business and realize Rs 3 crYour cost of capital is 15%

Evaluate the project using payback period, NPV and IRRProvide your recommendations on the project

Question Six

Your borrowing rate is 12.50%. You pay tax at 22% on your profits. Risk free rate of interest in the economy is 8.50%. Incremental return on equity demandedby investors is 8%. Your company beta is 1.31.Your debt equity mix is 40:60What is your cost of debtWhat is your cost of equityWhat is the weighted average cost of capital

12 marks

Company Y relevant figures for the year ended March 31, 2011 are as under:

9 Marks

If it declares a dividend of Rs 12 per share, what are the following:

6 marksYour friend has taken a loan of Rs xx from you. He will pay you back Rs 5 lakhsafter 3 years, Rs 2 lakhs after 4 years and Rs 2 lakhs after 5 years. Your rate

6 marksIn your insurance policy, you pay an annual premium of Rs 12,700 for 20 yearsYou get back Rs 4,50,000 after 20 years. What is your rate of return?

15 marksYou are setting up a new project and this project will cost you Rs 10 crYou will lose Rs 1 cr in year one, earn Rs 2 cr per annum in year two and then Rs 4 cr per annum

12 marks

Your borrowing rate is 12.50%. You pay tax at 22% on your profits. Risk free rate of interest in the economy is 8.50%. Incremental return on equity demanded

1 Refresh of WACC2 Refresh of the Cash Flow Statement

1 Incorporation of risk in the capital budgeting processNPV, IRR, Payback

2 Equity versus ProjectIs the project profitable? Is your child doing well?Will the owners be happy? Are you happy about that ?

3 Bonds - what are bonds, how are they valued?4 Very simple options on bonds

5 DuPont Analysis

WACCCapital comes from two sources - Debt and EquityDebt is cheaper (prima facie)WhyHe (the lender) does not demand a share of your profitHe is happy with a fixed return (interest)

In comparison our equity partner is very demandingHe says company earned Rs 1,000 cr - I am 50% partner, so give me Rs 500 crOf course, if the company makes losses, he keeps quiet

The second reason why debt is cheap is that interest is tax deductibleIf I pay interest, it becomes an expense for tax purposesSo I save tax by having such an interest expense

WACC

DebtCost

Average

Cost of Debt

Your interest rate is say 11.00%Your tax rate is say 28%You are profitableTax benefit on interest 3.08%Your post tax cost of debt 7.92%

If on your home loan you are paying 11% interest and your tax slab falls in the 30% range, then your interestcost is not 11%It is only 7.7%

Some people think that the home loan is very expensive and we should repayBcoz they look at 11%They are wrongThey should look at 7.7%

Total Interest is Rs 225000 150000Tax benefit 30% 45000 45000

20%

Your HDFC rate is 11.00%Tax benefit is 2.20%Your post tax cost of debt 8.80%

Cost of debt = Pre tax cost x (1-t) where t is the tax rate

Company is loss makingYour interest rate is say 11.00%Your tax rate is say 28%You are not profitableTax benefit on interest 0.00%Your post tax cost of debt 11.00%

Your company is an SEZ Unit where no tax is applicableYour interest rate is say 11.00%Your tax rate is say 28%You are not profitableTax benefit on interest 0.00%

Your post tax cost of debt 11.00%

Cost of EquityYour shareholders cannot demand anything (like a fixed rate of interest)If you are profitable, they are happy - bcoz the share price will go up - even if you don’t pay them anythingHow will shareholders think about investing in your shares / equity ?Why should a shareholder buy your shares ? What is his expectation from you ?

Thinking is very psychological - half finance, half psychology

What is the risk free interest in the country - he could have invested in those securitiesG Sec 10 year bond 8.52% lets say

But your equity carries tons of risk while that G Sec is risk freeSo what?

He will demand a risk premium from you - he will expect a higher rate of return

Generic Equity Risk Premium - for any investment in a model portfolio (Sensex, Nifty, some benchmark index)

Sensex is made up of 30 leading stocks in the countryNifty is made up of 50 leading stocks in the country

Let us suppose that this risk premium demanded by rational investors today is 8%

Rational investors will demand a total return of 16.52% return for investing in the Sensex / Nifty

If they don’t see a return of 16.52%, they will not be interested in equity

Sensex BSE IndexNifty NSE IndexBoth exchanges compete with each otherOut of the 30 in the Sensex most of the time 27 to 30 will also be part of the Nifty (very high overlap)

In reality, Sensex and Nifty move very very closely with other each otherIf in a month, Nifty appreciates 10.31%, Sensex will appreciate 10.32%

The absolute numbers are very different

Today Sensex is at 16,000 and Nifty is at 5,000

Your company is not the Sensex / NiftyYour company is XYZ company

The investor will ask : what is the risk in your company relative to Sensex

If we denominate Sensex risk as 1.00, then what is your risk?Let us say your risk is seen to be 1.41 (beta)You are more risky than the SensexInvestor will demand a higher return from youHow much higher return?

G Sec + (Equity Risk Premium x Beta)8.52% 8% 1.41

Cost of Equity 19.8%

He will expect a min return of 19.80% on his investment in equity in your company

If some other company beta was 0.81, what does that meanIt is less risky than the Sensex

Humanity needs benchmarks - for any relative discussion a benchmark is essentialIn my SSC I got 81%If the max marks that anyone could have got be assumed to be 100, then what I got is 81What is the benchmark here?100 is the benchmark

We use 100, we use "x", we use 1.00, we use "light years"

My age is 35 yearsWhy yearsConvention understood by humanity

Investing in Sensex means investing in all 30 stocks in the same proportion in which they form the Sensex

Then you would be happy with 16.52% return

WACC

DebtCost

7.92%AverageWeighted

WACC Mix Cost WACCDebt 42% 7.92% 3.33%Equity 58% 19.8% 11.48%

14.81%

If I don’t earn Rs 14.81 on every Rs 100 given to me by society (lenders + shareholders together),then they will punish meThe min return, the IRR, the hurdle rate is 14.81%If I don’t earn even 14.81% over the long run, then I don’t deserve to exist in business (Kingfisher)

World is changing every dayThe WACC may keep changing - dynamic conceptIn reality, we don’t change the hurdle every day - we build in a buffer

So, if the computed WACC is 14.81%, I will ask my units to bear a cost of 16% (buffer is 1.19%)

In my P&L, interest is an expenseDividend that I pay to shareholders is not an expense - not tax deductible - no tax benefits

In your own life, the interest you pay to HDFC is tax deductibleBut the electricity bill is not tax deductible

DuPont AnalysisDuPont is one of those rare entities which has survived more than 100 years in this worldP&G - 180 years, Dun & Bradstreet - 180 years

Financial analysis, costing, financial reporting - these disciplines got their shape in the 1920sAfter the 1st world war, US was in great shape1920s are called as the roaring twenties - huge wealth, sudden wealth, huge inequity in distribution

In India, a cream of the population is enjoying a great timeBulk of the people are still in poverty

DuPont said don’t calculate 100s of financial ratios for the mere purpose of calculationBe clear - what are you going to do with these ratiosIf you have too much info, that is misleading - have focussed information

Richard Collins - Built to Last, Good to Great

Lets look at the best performing companies over the last 30 yearsLets see if we can learn from themHe defined best performing as those which have generated maximum shareholder return over 30 years

Walgreens - pharma retail companyThey focus on one single financial ratio - profit per store

Way back in the 1920s, DuPont did the same thingThey said - focus on one ratio - RoE - Return on EquityThe shareholder invests in you so that you earn for him a high return on his equity

RoE = PAT Net Worth means Share Capital + Reserves (Shareholders Funds)RoNW = Net Worth

RoE = PAT = PAT x SalesNet Worth Sales Cap Emp

Margins Efficiency

Capital Employed = Net Worth + Debt

Sales 100Capital Employed 40 Equity + DebtDebt 15Equity (Net Worth) 25PAT 7

RoE = 7 = 7 x 10025 100 40

Margins Efficiency

28% = 7% x 2.5times

Shareholders are a very demanding communityThey want higher RoE - 28% is good, but they want moreHow do I increase my RoECan I make it 31% - how ? What to do ?

Some ideas will increase margins Will depress efficiency, solvencySome ideas will increase efficiency Will depress marginsSome ideas will increase solvency numberSo these will increase RoE - or will they?

A bright idea - lets increase selling prices which will improve margins, depress efficiency and leave solvency unchanged - lets see what happens

27% = 8% x 2.1times

Not a very bright idea - the RoE is being depressed

Another ideaLet us reduce selling prices, increase volumes, more movement, more efficiency

33% = 6.5% x 3.2times

Fine, lets go ahead

DuPont insight into quality of earningsHow strong are the earningsHow vulnerable

How stable, how volatileIf some tsunami comes along, will you die or survive (compared to others)

RoE Margins Efficiency SolvencyA 30.0% 10% 3.00 1.00 B 30.0% 5% 4.50 1.33 C 30.0% 2% 4.00 3.75 D 30.0% 1% 5.00 6.00 Over ambitious entrepreneurs - over greedy - Alexanders

AKAI, AIWA

How would you rank them ?A Margins are excellent, so they have some strength - great brand, great pricing power, some

technology, some people, locational advantage, Govt policy, vintage, ageA great strength on margins - has it made them a little slow, lazy, complacent ? Appears so

Corporate aristocracy

Solvency - zero debt companyVery conservative in borrowingOld rich

A great idea which can earn 16% return - he will propose we do this for USD 300 mioHis boss will think and think - and allow him to do for USD 30 mio - 30 days

Reliance - same idea USD 300 mioSenior most people - call him in 30 minutesAre you convincedYesSo why not do this for USD 3,000 mio - why USD 300 mio

B What it loses on margins, it makes up on efficiencyQuite low debtBright boy on the horizon - running fast, enthusiastic - stiff competitor for Company A

C Very low margin compared to ANot so efficent as BMaking money on money - by borrowing heavilyMaking money on a business with thin margins is not a reliable source of making money

D Bad product - cant sell without heavy discounts - no strength in the business itselfSuper efficientIs super efficiency good or bad ??Super efficiency to make up for margin deficiency - is highly dangerousSuper efficiency has a tendency to break down

I want my aircraft to run 6 times a dayOther airlines run 4 times a daySo I compromise on maintenance, checking, etc etc

Super efficiency means1 My customer will pay me at 10 am in the morning2 I will deposit high value cheque at 1015 am3 This will be credited in my account at 1130 am (I know the bank)4 I will pay my excise duty at 1145 am5 My consignment will be cleared at 12306 It will reach the customer at 2307 This customer pays on delivery at 2458 I will deposit this cheque at 330 and get credit by 4309 I need to pay wages at 530 today evening

Very dangerousIf one link breaks, then the whole wheel is jammedTransport strikeBank strikeCustoms strike

Olympic runner - winner of the Gold medal 100 meter raceGreat fellow

He wants to go to his office from his houseHe starts running on the road as if it were the OlympicsWhat will happenVery risky

Efficiency is like haemoglobinNormal range 10 to 148 is a problem18 is also a problem

Very high efficiency with borrowed funds is very very high riskCompany is very vulnerable to macro factors and can collapse any moment

Suddenly, India is flooded by Chinese products in this sectorAll companies are forced to reduce their prices affectingmargins by 2%

RoE Margins Efficiency Solvency RoEA 30.0% 10% 3.00 1.00 24.0%B 30.0% 5% 4.50 1.33 18.0%C 30.0% 2% 4.00 3.75 0.0%D 30.0% 1% 5.00 6.00 -30.0%

If money is available easily, that is a major curse (not a blessing)

Outliers - GladwellOne good book a month - must

Key RatiosBanking sector - profit per branch, profit per employeeHotel sector - Average Room Rent (per day)Telecom sector - Average Revenue per User (ARPU)Cement sector - EBIDTA per TonHospital sector - Average Revenue per Bed (per day)Walgreens - profit per storeRetail sector - Gross Margin Return on Inventory (GMROI), Gross Margin per Sq Ft

Bonds - what are bonds, how are they valued?

You are a mfg company and you avail of a loan from SBI of Rs 25 crThis is a private transactions between you and SBIWhen you return the loan you will return to SBI

Alternatively, you could issue bonds of Rs 25 cr to whosoever subscribes to these bondsYou got your Rs 25 cr and it is a loan (debt)

A bond is a debt instrumentBut who is the lender? Not one bank - many entities (banks, financial institutions, retail, other corporates, Govt companies, foreignors, mutual funds, insurance companies)

These bonds will thereafter be traded in the bond marketSo, ICICI Prudential subscribed to Rs 2 cr of your bondsThen they sold these bonds to Reliance Mutual Funds for Rs 2.01 cr after 7 daysReliance is the holder of the bonds

The bonds have a tenor of 7 yearsIn 7 years, they were bott and sold 73 timesAfter 7 years, one market participant will come to you and ask for redemption and you will happily pay him

In bonds, a market develops

Issue Price 100Redemption Price 100Tenor 7 yearsCoupon 8%Payable frequency - once a year

On day one, Tata Power issues bonds of Rs 25 cr (25 lakh bonds of Rs 100 each)Many entities subscribe to these bonds

The coupon is paid to the holder of the bond on the date of the couponIf the bond issue happened on Jan 21, 2012, then the coupon will be paid to the holders on Jan 20, 2013

Bond market has not developedThere is a reasonable G Sec market but the only players are institutionsThe Indian public is quite unaware of this instrument

Mutual funds are major players in the fixed income market

Incorporation of risk in the capital budgeting process

Is your child doing well? RelianceAre you happy about that ? Dhirubhai Ambani

He says company earned Rs 1,000 cr - I am 50% partner, so give me Rs 500 cr

The second reason why debt is cheap is that interest is tax deductible

EquityCost

Reliance Industries Debt Rs 74,000 cr

If on your home loan you are paying 11% interest and your tax slab falls in the 30% range, then your interest

Some people think that the home loan is very expensive and we should repay

750000

Your shareholders cannot demand anything (like a fixed rate of interest)If you are profitable, they are happy - bcoz the share price will go up - even if you don’t pay them anythingHow will shareholders think about investing in your shares / equity ?Why should a shareholder buy your shares ? What is his expectation from you ?

What is the risk free interest in the country - he could have invested in those securities

He will demand a risk premium from you - he will expect a higher rate of return

Generic Equity Risk Premium - for any investment in a model portfolio (Sensex, Nifty, some benchmark index)

Let us suppose that this risk premium demanded by rational investors today is 8%

Rational investors will demand a total return of 16.52% return for investing in the Sensex / Nifty

If they don’t see a return of 16.52%, they will not be interested in equity

Out of the 30 in the Sensex most of the time 27 to 30 will also be part of the Nifty (very high overlap)

In reality, Sensex and Nifty move very very closely with other each otherIf in a month, Nifty appreciates 10.31%, Sensex will appreciate 10.32%

The investor will ask : what is the risk in your company relative to Sensex

He will expect a min return of 19.80% on his investment in equity in your company

Humanity needs benchmarks - for any relative discussion a benchmark is essential

If the max marks that anyone could have got be assumed to be 100, then what I got is 81

Investing in Sensex means investing in all 30 stocks in the same proportion in which they form the Sensex

EquityCost

19.8%

If I don’t earn Rs 14.81 on every Rs 100 given to me by society (lenders + shareholders together),

If I don’t earn even 14.81% over the long run, then I don’t deserve to exist in business (Kingfisher)

In reality, we don’t change the hurdle every day - we build in a buffer

So, if the computed WACC is 14.81%, I will ask my units to bear a cost of 16% (buffer is 1.19%)

Dividend that I pay to shareholders is not an expense - not tax deductible - no tax benefits

DuPont is one of those rare entities which has survived more than 100 years in this world

Financial analysis, costing, financial reporting - these disciplines got their shape in the 1920s

1920s are called as the roaring twenties - huge wealth, sudden wealth, huge inequity in distribution

DuPont said don’t calculate 100s of financial ratios for the mere purpose of calculation

If you have too much info, that is misleading - have focussed information

Lets look at the best performing companies over the last 30 years

He defined best performing as those which have generated maximum shareholder return over 30 years

The shareholder invests in you so that you earn for him a high return on his equity

Net Worth means Share Capital + Reserves (Shareholders Funds)

x Cap EmpNet WorthSolvency

x 4025

Solvency

x 1.6 = 28%times

Will depress efficiency, solvencyWill depress margins

A bright idea - lets increase selling prices which will improve margins, depress efficiency and leave

x 1.6times

Let us reduce selling prices, increase volumes, more movement, more efficiency

x 1.6times

If some tsunami comes along, will you die or survive (compared to others)

Over ambitious entrepreneurs - over greedy - AlexandersAKAI, AIWA

Margins are excellent, so they have some strength - great brand, great pricing power, sometechnology, some people, locational advantage, Govt policy, vintage, ageA great strength on margins - has it made them a little slow, lazy, complacent ? Appears so

A great idea which can earn 16% return - he will propose we do this for USD 300 mioHis boss will think and think - and allow him to do for USD 30 mio - 30 days

So why not do this for USD 3,000 mio - why USD 300 mio

Bright boy on the horizon - running fast, enthusiastic - stiff competitor for Company A

Making money on a business with thin margins is not a reliable source of making money

Bad product - cant sell without heavy discounts - no strength in the business itself

Super efficiency to make up for margin deficiency - is highly dangerous

My customer will pay me at 10 am in the morningI will deposit high value cheque at 1015 amThis will be credited in my account at 1130 am (I know the bank)

I will deposit this cheque at 330 and get credit by 430

Olympic runner - winner of the Gold medal 100 meter race

He starts running on the road as if it were the Olympics

Very high efficiency with borrowed funds is very very high riskCompany is very vulnerable to macro factors and can collapse any moment

Suddenly, India is flooded by Chinese products in this sectorAll companies are forced to reduce their prices affectingmargins by 2%

Margins Efficiency Solvency8% 3.00 1.00 Most safe3% 4.50 1.33 0% 4.00 3.75

-1% 5.00 6.00 Most risky

If money is available easily, that is a major curse (not a blessing)

Retail sector - Gross Margin Return on Inventory (GMROI), Gross Margin per Sq Ft

You are a mfg company and you avail of a loan from SBI of Rs 25 cr

Alternatively, you could issue bonds of Rs 25 cr to whosoever subscribes to these bonds

But who is the lender? Not one bank - many entities (banks, financial institutions, retail, other corporates, Govt companies, foreignors, mutual funds, insurance companies)

Then they sold these bonds to Reliance Mutual Funds for Rs 2.01 cr after 7 days

After 7 years, one market participant will come to you and ask for redemption and you will happily pay him

On day one, Tata Power issues bonds of Rs 25 cr (25 lakh bonds of Rs 100 each)

The coupon is paid to the holder of the bond on the date of the couponIf the bond issue happened on Jan 21, 2012, then the coupon will be paid to the holders on Jan 20, 2013

There is a reasonable G Sec market but the only players are institutions

BONDSTata Power issues bonds of Rs 25 cr

RsIssue Price 100Redemption Price 100Tenor 7 yearsCoupon 8%Payable frequency - once a year

If the bonds are issued on Jan 22, 2012, the interest coupons may be paid on each Jan 21st for the next7 yearsWhosoever holds these bonds on Jan 21st will get full year interest

So, if you bott these bonds on Jan 17, 2014, in all fairness, you should get interest for 4 days but youwill, in fact, get interest for one full year

Dividends are paid on a certain record dateAs of that date, whosever is the owner of those shares gets the dividend

We know that Diwali comes sometime in Oct / NovWe may forecast that this company pays dividends sometime in Sept / OctAn AGM is a must once a year - dividends are declared at the AGM and paid within 42 days

Dividend of Rs 2 on a sharePrice today is Rs 31 (cum-div)On the day after record day, what will happen?Price will be Rs 29 (ex-div)

Why is the term "coupon" used? What is wrong with the term "interest"? Why introduce complexity to the world?

Accrued interest challengeInterest accrues on the bond every day (at the rate of 8% per annum)

0 100.00 1 0.022 2 0.044 If you buy the bond after 52 days, you will pay the seller Rs xx for the bond3 0.066 itself plus Rs 1.140

4 0.088 Suppose for simplicity, the price of the bond itself is Rs 102.00, then you5 0.110 will pay a total of Rs 103.1406 0.132 7 0.153 Clean price8 0.175 Interest accrual9 0.197 Dirty price

10 0.219 11 0.241 If you buy the bond on Jan 17, Tata Power will pay you one year interest12 0.263 on Jan 21 (but you don’t deserve to get one year interest, you deserve13 0.285 only 4 days interest)14 0.307 15 0.329 You will pay the counterparty 361 days interest16 0.351 Tata Power will pay you 365 days intrerest17 0.373 Net net you got 4 days interest18 0.395 19 0.416 20 0.438 21 0.460 22 0.482 23 0.504 24 0.526 25 0.548 26 0.570 27 0.592 28 0.614 29 0.636 30 0.658 31 0.679 32 0.701 33 0.723 34 0.745 35 0.767 36 0.789 37 0.811 38 0.833 39 0.855 40 0.877 41 0.899 42 0.921

43 0.942 44 0.964 45 0.986 46 1.008 47 1.030 48 1.052 49 1.074 50 1.096 51 1.118 52 1.140 53 1.162 54 1.184 55 1.205 56 1.227 57 1.249 58 1.271 59 1.293 60 1.315 61 1.337 62 1.359 63 1.381 64 1.403 65 1.425 66 1.447 67 1.468 68 1.490 69 1.512 70 1.534 71 1.556 72 1.578 73 1.600 74 1.622 75 1.644 76 1.666 77 1.688 78 1.710 79 1.732 80 1.753 81 1.775

82 1.797 83 1.819 84 1.841 85 1.863 86 1.885 87 1.907 88 1.929 89 1.951 90 1.973 91 1.995 92 2.016 93 2.038 94 2.060 95 2.082 96 2.104 97 2.126 98 2.148 99 2.170

100 2.192 101 2.214 102 2.236 103 2.258 104 2.279 105 2.301 106 2.323 107 2.345 108 2.367 109 2.389 110 2.411 111 2.433 112 2.455 113 2.477 114 2.499 115 2.521 116 2.542 117 2.564 118 2.586 119 2.608 120 2.630

121 2.652 122 2.674 123 2.696 124 2.718 125 2.740 126 2.762 127 2.784 128 2.805 129 2.827 130 2.849 131 2.871 132 2.893 133 2.915 134 2.937 135 2.959 136 2.981 137 3.003 138 3.025 139 3.047 140 3.068 141 3.090 142 3.112 143 3.134 144 3.156 145 3.178 146 3.200 147 3.222 148 3.244 149 3.266 150 3.288 151 3.310 152 3.332 153 3.353 154 3.375 155 3.397 156 3.419 157 3.441 158 3.463 159 3.485

160 3.507 161 3.529 162 3.551 163 3.573 164 3.595 165 3.616 166 3.638 167 3.660 168 3.682 169 3.704 170 3.726 171 3.748 172 3.770 173 3.792 174 3.814 175 3.836 176 3.858 177 3.879 178 3.901 179 3.923 180 3.945 181 3.967 182 3.989 183 4.011 184 4.033 185 4.055 186 4.077 187 4.099 188 4.121 189 4.142 190 4.164 191 4.186 192 4.208 193 4.230 194 4.252 195 4.274 196 4.296 197 4.318 198 4.340

199 4.362 200 4.384 201 4.405 202 4.427 203 4.449 204 4.471 205 4.493 206 4.515 207 4.537 208 4.559 209 4.581 210 4.603 211 4.625 212 4.647 213 4.668 214 4.690 215 4.712 216 4.734 217 4.756 218 4.778 219 4.800 220 4.822 221 4.844 222 4.866 223 4.888 224 4.910 225 4.932 226 4.953 227 4.975 228 4.997 229 5.019 230 5.041 231 5.063 232 5.085 233 5.107 234 5.129 235 5.151 236 5.173 237 5.195

238 5.216 239 5.238 240 5.260 241 5.282 242 5.304 243 5.326 244 5.348 245 5.370 246 5.392 247 5.414 248 5.436 249 5.458 250 5.479 251 5.501 252 5.523 253 5.545 254 5.567 255 5.589 256 5.611 257 5.633 258 5.655 259 5.677 260 5.699 261 5.721 262 5.742 263 5.764 264 5.786 265 5.808 266 5.830 267 5.852 268 5.874 269 5.896 270 5.918 271 5.940 272 5.962 273 5.984 274 6.005 275 6.027 276 6.049

277 6.071 278 6.093 279 6.115 280 6.137 281 6.159 282 6.181 283 6.203 284 6.225 285 6.247 286 6.268 287 6.290 288 6.312 289 6.334 290 6.356 291 6.378 292 6.400 293 6.422 294 6.444 295 6.466 296 6.488 297 6.510 298 6.532 299 6.553 300 6.575 301 6.597 302 6.619 303 6.641 304 6.663 305 6.685 306 6.707 307 6.729 308 6.751 309 6.773 310 6.795 311 6.816 312 6.838 313 6.860 314 6.882 315 6.904

316 6.926 317 6.948 318 6.970 319 6.992 320 7.014 321 7.036 322 7.058 323 7.079 324 7.101 325 7.123 326 7.145 327 7.167 328 7.189 329 7.211 330 7.233 331 7.255 332 7.277 333 7.299 334 7.321 335 7.342 336 7.364 337 7.386 338 7.408 339 7.430 340 7.452 341 7.474 342 7.496 343 7.518 344 7.540 345 7.562 346 7.584 347 7.605 348 7.627 349 7.649 350 7.671 351 7.693 352 7.715 353 7.737 354 7.759

355 7.781 356 7.803 357 7.825 358 7.847 359 7.868 360 7.890 361 7.912 362 7.934 363 7.956 364 7.978 365 8.000

How is the bond priced?How are interest rates moving in the economyInterest rates are dynamic - they keep changingInflation, RBI policy on SLR, CRR, Government deficits, tax collections, elections, USD INR rates, etc, etc

Tata Power has issued this bond - 8% coupon, 7 year tenor, Rs 100 face value, redemption valueOn that day of issue, the coupon of 8% was very fair - it has to be fairIf they pay more than fair, they are stupidIf they pay less than fair, nobody will subscribe

Two months later, life has changed, interest rates have movedNow the interest rate in the economy (and for Tata Power) has gone to 8.31%If Tata Power were to issue a bond today, that bond would have to be issued at 8.31%

This bond however has a fixed coupon of 8% (you cant change the terms of the bond)How will the market adjust?The market will adjust by repricing the bond - the price of the bond may no longer be Rs 100Price will move

If the yield in the market nowadays is 8.31% and this bond generates a coupon of Rs 8.00, in crude terms,the price of the bond will be 8 96.27 approx

8.31%

100.000 96.270

8.310 8.000

BOND PRICES ARE INVERSELY CORRELATED TO INTEREST RATES

A more refined bond pricing mechanism will emerge from the following table

Year CashFlow01 82 83 84 85 86 87 108

"One year" has passed and interest rates in the economy have risen toThe cash flows on this bond will be discounted at the current yield

Year CashFlow Disc Fact Pres Val0 1.000 1 8 0.923 7.39 2 8 0.852 6.82 3 8 0.787 6.30 4 8 0.727 5.81 5 8 0.671 5.37 6 108 0.619 66.90

98.58

Interest - generic term denoting what you can earn on a bondCoupon - the rate of interest as per terms of issue of the bondYield to maturity (YTM) - a specific term indicating what you will earn over the life of the bond

A 8% coupon translates into a 8.31% YTM

Bond markets are very complex and software programs costing crores of rupees are used to value bonds and derivatives on bonds

Fine pricing - if the buyer quotes 98.5812, the seller may quote 98.5813Equity market - WABCO TVS - bid - 2412, ask - 2415 - bad pricing

How is your life connected to bondsYou may never buy bonds if deal size is min Rs 100 crAre we wasting our time on this topic ?Many of us might be investing in mutual fundsThere are two types of funds - equity funds and debt fundsDebt funds invest in bond marketsBy investing in debt funds, you are investing in bond markets

The NAV of these funds will move up and down adversely in relation to interest ratesIn the last two years, interest rates have been rising and therefore Debt Fund NAVs have been fallingNow, if you believe that RBI is at the end of its cycle and interest rates will fallDebt Fund NAVs may tend to rise

Which fund to invest?Debt funds or Equity funds - that’s the right choiceIf you decide Equity funds, then within that - you may ask - HDFC or ICICI or Birla Sunlife ??

Which train to catch?Where do you want to go?

Equity funds - high risk, high return - substitute for direct equityInstead of buying Infosys, TCS, SBI shares, you have decided to buy Equity Funds of mutual funds

Debt funds - low risk, low return - substitute for bank fixed depositsInstead of going to Indian Bank and placing a FD, you have chosen Debt oriented mutual funds

FD - 9% Debt Fund - 8 to 10% - better tax benefits

The name of the fund itself, the objectives of the fund will be very clear - whether equity / debt

In an FD, your interest income is taxable at 30% in most casesIn a Debt Fund, your income will be either dividends or capital gains

Rate of tax may vary from 10% to 15%

FD earns 9.00% Debt FundTax 30% 2.70% Tax 10%Post tax 6.30% Post Tax

Open ended has no expiry date - it may remain open for decadesClose ended funds will end on a certain day

FMP - Fixed Maturity Plans - 180 days, 368 days

There are fixed rate bonds (the Tata Power bond above) and there are floating rate bondsIn a floater, you will be paid LIBOR plus 100 basis points (1%)If LIBOR today is 0.65%, you will be paid 1.65%After one year LIBOR goes up to 0.85%, you will be paid 1.85%

What is LIBORLondon Inter Bank Offered RateIt is the rate at which a panel of banks are ready to lend to each other todaySo Bank of America has quoted a rate of 0.65% to Citi for a 1 year USD Loan (today)

This LIBOR changes every dayBanks are usually strong banksIf a bank becomes weak, that bank is pulled out of the panel

SBI will think - LIBOR plus 200 bps is fine Credit spread of 200 bpsTata Power will think - LIBOR plus 250 bps is fineReliance - LIBOR plus 225 bps is fineVisa Steel may be happy with LIBOR plus 700 bps

OPTIONS ON BONDSLakhpati Bond issued by IDBI once upon a timeAnother Lakhpati Bond issued by SIDBI soon thereafter

IDBI said - give us Rs 2,800 and we will give you back Rs 1 lakh after 30 yearsSIDBI said - give us Rs 2,500 and we will give you back Rs 1 lakh after 30 yearsPeople went crazy in the desire to become a Lakhpati

But nobody became a lakhpati and are not going to become eitherWhy?

What is the yield on these bonds?

IDBI Bond 2800 12.66% 113% 30 35.71

On the date of issue, IDBI was quite prepared to be 12.66% per annum for the next 30 yearsWith passage of time, interest rates fell (in the economy)IDBI suddenly felt a little stupid

But they had been smart in the terms of issuueThe terms of issue mentioned that IDBI can call back the bond after 5 years, 10 years, 15 years, 20 years, 25 years if they wanted to - this is a CALL OPTION

They can redeem the bond - they can force you to return the bond and they will pay you a yield of 12.66%

WHAT IS RISKRisk is volatility of returnsReturns can even swing negative (volatility includes loss of principal also)

In any project there will be 5 to 10 key parameters which can make or break the projectThere may be 10,000 parameters - but 10,000 cannot be handled by humanityMost of them may be not materialWisdom is in detecting which are the major ones and focusing on them

In our projections, conduct a sensitivity on those 5 to 10 parametersHow much can they swing

If your sales is based on GDP growth in the economy, how much can GDP growth swingMin 5%Max 10%

What are those factorsHow much can they swing

Volume 10.00 10.50 11.03 11.58 Price p Unit 5.00 5.40 5.83 6.30 Sales Revenue 50.00 56.70 64.30 72.91 Variable Costs p U 3.00 3.21 3.43 3.68 Variable Cost Amt 30.00 33.71 37.87 42.54 Contribution 20.00 23.00 26.43 30.37

Fixed Costs 10.00 10.80 11.66 12.60 Profit 10.00 12.20 14.77 17.77 PV Factor 14%

114%1 0.88 0.77 0.67 0.59

PV of Future Profits 8.77 9.38 9.97 10.52

Total PV 49.70

If I sell this stream of profits today for Rs 49.70, it is the same as working hard for 5 years and earningRs 10 in the first year, Rs 12.20 in the second year and so on

Various assumptions1 First year volume will be 102 Volume will grow at 5%3 First year selling price will be Rs 5 per unit4 Selling price will grow at 8%5 First year VC per unit will be Rs 3 6 These VC will grow at 7%7 First year FC will be Rs 108 They will grow at 8%9 A realistic WACC for this project is 14%

Nobody knows the future and all 9 assumptions could be erroneous, over optimistic ???How wrong is wrong?If I very wrong, what will happen to me? What worst can happen?

What is the best situation? What is the worst situation? How far are these two situations?Sensitivity will help you in weeding out those factors which are not deal breakersIs selling price more important than managing fixed costs?Is volume more important than WACC ?

Selling PV FixedPrice 49.70 Cost 49.70 4.50 28.00 56% 9.00 53.65 4.75 38.85 78% 9.50 51.67 5.00 49.70 100% 10.00 49.70

5.25 60.55 122% 10.50 47.72 5.50 71.40 144% 11.00 45.75

What do you mean by risk free?No variation in returnIn your PPF what is the return? 8%8% in which situation?All situations

Equity versus ProjectProject is funded by two sources - Equity and Debt

If project earns 16% and the WACC is 14%, project is doing pretty well (beating the WACC by 2%)How much will owners make? Owners cost is cost of equityIf cost of equity is say 17%, will owners make 19% ?

If project earns 11% and the WACC is 14%, project is pretty bad (below the WACC by 3%)How much will owners make? Owners cost is cost of equityIf cost of equity is say 17%, will owners make 14% ?

What is the Project IRR and how does it differ from Equity IRR ?If the Project does well, the Owner will do very wellIf the Project does badly, the Owner will do very badly

The Owner's fortunes will swing more than the Project's fortunes

If Commonwealth Games do well, Kalmadi will do very wellIf Commonwealth Games do badly, Kalmadi will do very badly

Year Project Project is funded byCashFlow Proj Cost 100

0 -100 Debt 351 40 Equity 652 403 40 Debt carries interest at4 40 Debt is repaid in equal annual instalments over 4 years

Proj IRR 22% Annual debt repayment

In Project Cash Flows, we ignore interestWe ignore loans availedWe ignore loans repaid

If you want to look at this project through the Owner's eyes (completely new concept), then what arethe cash flows?

Year Project Debt Interest Owner'sCashFlow 12% CashFlow

0 -100 35.00 (65.00)1 40 (8.75) (4.20) 27.05 2 40 (8.75) (3.15) 28.10 3 40 (8.75) (2.10) 29.15 4 40 (8.75) (1.05) 30.20

Proj IRR 22% OwnerIRR 27%

Owner IRR in a good project is higher than Project IRR bcoz Owner makes money in two ways:1 He makes money from the project2 He makes money from money

If I bring in more debt, what will be happen?Owner IRR will shoot up - better and better

Debt 27% If annual cash flows are lower20 24% 22% 27%30 26% 20 Err:504 -20%35 27% 25 Err:504 -6%40 28% 30 Err:504 6%50 30% 35 Err:504 16%60 34% 40 Err:504 27%70 41%80 52%

Rs100105 Premium on Redemption of Rs 5

7 years8%

If the bonds are issued on Jan 22, 2012, the interest coupons may be paid on each Jan 21st for the next

Whosoever holds these bonds on Jan 21st will get full year interest

So, if you bott these bonds on Jan 17, 2014, in all fairness, you should get interest for 4 days but you

As of that date, whosever is the owner of those shares gets the dividend

We may forecast that this company pays dividends sometime in Sept / OctAn AGM is a must once a year - dividends are declared at the AGM and paid within 42 days

Why is the term "coupon" used? What is wrong with the term "interest"? Why introduce complexity to the world?

Interest accrues on the bond every day (at the rate of 8% per annum)

8% 8.00 365

If you buy the bond after 52 days, you will pay the seller Rs xx for the bondtowards accrued interest

Suppose for simplicity, the price of the bond itself is Rs 102.00, then you

102.000 1.140 103.140

If you buy the bond on Jan 17, Tata Power will pay you one year intereston Jan 21 (but you don’t deserve to get one year interest, you deserve

You will pay the counterparty 361 days interestTata Power will pay you 365 days intrerest

Inflation, RBI policy on SLR, CRR, Government deficits, tax collections, elections, USD INR rates, etc, etc

Tata Power has issued this bond - 8% coupon, 7 year tenor, Rs 100 face value, redemption valueOn that day of issue, the coupon of 8% was very fair - it has to be fair

Now the interest rate in the economy (and for Tata Power) has gone to 8.31%If Tata Power were to issue a bond today, that bond would have to be issued at 8.31%

This bond however has a fixed coupon of 8% (you cant change the terms of the bond)

The market will adjust by repricing the bond - the price of the bond may no longer be Rs 100

If the yield in the market nowadays is 8.31% and this bond generates a coupon of Rs 8.00, in crude terms,

BOND PRICES ARE INVERSELY CORRELATED TO INTEREST RATES

A more refined bond pricing mechanism will emerge from the following table

"One year" has passed and interest rates in the economy have risen to 8.31%

r = 8.31%1 + r = 108.31%

8%Yield to maturity (YTM) - a specific term indicating what you will earn over the life of the bond 8.31%

Bond markets are very complex and software programs costing crores of rupees are used to value bonds

Fine pricing - if the buyer quotes 98.5812, the seller may quote 98.5813

The NAV of these funds will move up and down adversely in relation to interest ratesIn the last two years, interest rates have been rising and therefore Debt Fund NAVs have been fallingNow, if you believe that RBI is at the end of its cycle and interest rates will fall

If you decide Equity funds, then within that - you may ask - HDFC or ICICI or Birla Sunlife ??

Instead of buying Infosys, TCS, SBI shares, you have decided to buy Equity Funds of mutual fundsDebt funds - low risk, low return - substitute for bank fixed deposits

Instead of going to Indian Bank and placing a FD, you have chosen Debt oriented mutual funds

The name of the fund itself, the objectives of the fund will be very clear - whether equity / debt

In a Debt Fund, your income will be either dividends or capital gains

8.00%0.80%7.20%

There are fixed rate bonds (the Tata Power bond above) and there are floating rate bonds

It is the rate at which a panel of banks are ready to lend to each other todaySo Bank of America has quoted a rate of 0.65% to Citi for a 1 year USD Loan (today)

Credit spread of 200 bps

IDBI said - give us Rs 2,800 and we will give you back Rs 1 lakh after 30 yearsSIDBI said - give us Rs 2,500 and we will give you back Rs 1 lakh after 30 years

But nobody became a lakhpati and are not going to become either

100,000

On the date of issue, IDBI was quite prepared to be 12.66% per annum for the next 30 years

The terms of issue mentioned that IDBI can call back the bond after 5 years, 10 years, 15 years, 20 years,

They can redeem the bond - they can force you to return the bond and they will pay you a yield of 12.66%

Returns can even swing negative (volatility includes loss of principal also)

In any project there will be 5 to 10 key parameters which can make or break the projectThere may be 10,000 parameters - but 10,000 cannot be handled by humanity

Wisdom is in detecting which are the major ones and focusing on them

In our projections, conduct a sensitivity on those 5 to 10 parameters

If your sales is based on GDP growth in the economy, how much can GDP growth swing

12.16 5% 105% 6.80 8% 108% 82.68 3.93 7% 107% 47.80 34.89

13.60 8% 108% 21.28

0.52 11.05

If I sell this stream of profits today for Rs 49.70, it is the same as working hard for 5 years and earning

Nobody knows the future and all 9 assumptions could be erroneous, over optimistic ???

What is the best situation? What is the worst situation? How far are these two situations?Sensitivity will help you in weeding out those factors which are not deal breakers

Selling PPF Risk FreePrice Return

108% 4.50 8% 100%104% 4.75 8% 100%100% 5.00 8% 100%

96% 5.25 8% 100%92% 5.50 8% 100%

If project earns 16% and the WACC is 14%, project is doing pretty well (beating the WACC by 2%)

If project earns 11% and the WACC is 14%, project is pretty bad (below the WACC by 3%)

What is the Project IRR and how does it differ from Equity IRR ?

The Owner's fortunes will swing more than the Project's fortunes

If Commonwealth Games do well, Kalmadi will do very wellIf Commonwealth Games do badly, Kalmadi will do very badly

Debt carries interest at 12%Debt is repaid in equal annual instalments over 4 years

Annual debt repayment 4 8.75

If you want to look at this project through the Owner's eyes (completely new concept), then what are

LoanBalance 35.00 26.25 17.50 8.75 -

Owner IRR in a good project is higher than Project IRR bcoz Owner makes money in two ways:22%

5% crudely27%

Valuation of Equity1 PBV2 DCF

Enterprise ValueEVAWorking Capital Management

Bonds - we don’t buy for sale - there is no market in India

PBVValue of shares comes from two sources:

1 Assets Few sectors2 Earnings Most sectors

If you have strong assets, the asset value becomes the share value in "some sectors"

You have a company which has only one asset - residential flat

Balance SheetShare Capital 2 Property

The value of the company is Rs 2 cr driven by the asset

You give this flat on rent and you earn Rs 10 lakhs over the next one year

Balance SheetShare Capital 2.00 PropertyReserves 0.10 Cash

Profit & Loss AccountOperating Expenses 0.03 Rental IncomeIncome Tax 0.02 Net Profit (Reserves) 0.10

Value of the company will be Rs 2.10 croresThis value is driven by its assets (property and cash)

At a deeper level, if the value of the flat has increased to say Rs 2.50 cr, then the value of the company should have become Rs 2.60 cr

The assets can either be recognized at book value (Bal Sheet) or at market valueStock markets would recognize market value if the asset can be easily detached and sold and would realize this market value

Suppose you set up an IT company (software)

Balance SheetShare Capital 2.00 Cash

You have good people, but they don’t appear in the Bal Sheet

You earn a profit of Rs 5 cr, sales of Rs 15 cr, expenses of Rs 10 cr

Balance Sheet after one yearBalance SheetShare Capital 2.00 CashReserves 5.00

What do you think will be the "value" of this companyWill you be okay to sell this companny for Rs 7 cr?What is driving that value?

This company earns Rs 5 cr per annum as profitsGive me 10 times earnings as the valueI want a valuation of Rs 50 cr (actual assets are only Rs 7 cr)

ASSET BASED VALUATIONShare Capital (Face Value Rs 10 p share) 40Reserves 160Shareholders Funds (Net Worth) 200

Outside Liabilites 300Total 500

Net Assets means what?1 Assets minus Outside Liabilities

500 300 2002 Net Assets means Shareholders Funds

40 160 200

Book Value per Share = Shareholders Funds per Share (Net Worth per Share)Share Capital 40Face Value per Share 10No of Shares issued 4Shareholders Funds 200Book Value per Share 50

If this company's valuation was indeed driven by assets and the book value of the assets was more or less the market value of the assets, then the share price ought to hover around Rs 50

If the share price was say Rs 20, this might be a great buying opportunityIf the share price was say Rs 200, this might be a great selling opportunity

In the normal course of accounting, the Balance Sheet values of assets are based on "historical cost"In the case of long term assets, this cost is further reduced by "depreciation"

In long term asset heavy industries, the book value may not be very representative of their market valuesMarket values for real estate may be far higher than book valueMarket values for plant and machinery and vehicles may be far lower than book value

BANKING SECTORLiabilitiesShare CapitalReservesNet Worth

Deposits - Fixed, Current, SavingsLoans from Other BanksCurrent Liab - Salary Payable

Book Value per Share = Net Worth per Share = Net Assets per Share

If that Book Value for XYZ Bank is say Rs 95 per share and the market price is say Rs 45 per share - the bank is undervalued signficantly and could be a good buy Rs 395 per share - the bank could be seriously overvalued

Earnings are not very important (assets are more important than earnings)

12 Data for various banks - public, private3 Work out the Book Value per Share on March 31, 2011 - readily available4 Work out the Book Value per Share on December 31, 2011 - not readily available5 Look up the price today6 Work out the PBV - Price / Book Value7 What do you think8 Each person 3/4 banks State Bank of India

Punjab National BankUnion BankCanara BankIndian BankBank of IndiaDena BankUCO BankSyndicate BankCorporation Bank

Bank March BV June Qtr Sept Qtr Dec QtrEPS EPS EPS

HDFCBank 109 5 5 6IndusInd 82 4 4 4Yes Bank 109 6 7 7Axis 463 25 23 22SBI 1023 25 44 51ICICI 478 15 13 11BoB 536 26 29 32BoI 292 13 9 10

www.moneycontrol.com

PNBUnionCanara 405 16 19 19Corporatio 482 27 27 24Indian 184 9 11 12AllahabadAndhraFederalSyndicate 123 6 6 6Dena 104 5 5 6

Pvt banks get higher PBV than public sector banksThe larger banks appear to get a higher PBV

If Indian Bank has assets of one rupee, the market is valuing them at 84 paise (16% discount)Market is of the belief that 16% of the assets will not be realized (will be lost) - bad loans, NPAs

HDFC Bank is not a bankA bank is supposed to borrow funds and lend funds and make the differenceIn London, in the 1980s, they used to say banks are 3-6-3 businessesYou borrow at 3%, you lend at 6%, you go home at 3 pm (play golf with your customers)

A bank is supposed to borrow funds and lend funds and make the differenceThis business is quite tough and competitiveMoney knows no loyalty

If you are a depositor and X bank gives you 7% and Y bank gives you 7.25%, whom do you go to?Y Bank - your family has been with X bank for 73 years

If you having using Colgate toothpaste since birth and Colgate is more expensive than Pepsodent, you are okaywith Colgate

HDFC Bank is not a bankHDFC Bank - a very huge share of profits and revenues come from non-banking activities

Fund based income and Non-fund based incomeFund based income means interest incomeNon-fund based income means

Commission on selling insurance policies to you and me

Commission on mutual fundsCommission on foreign exchangeTreasury activitiesAdvisory to corporates on forex, treasury

More than 40% of their profits come from non-fund initiatives

Which poor Dena Bank and Syndicate Bank have not been able to develop

Are the PBV of smaller PSU Banks too much beaten down?For example, the market is valuing Dena Bank as if 27% of its loans will not be returnedSyndicate Bank - 22% of their loans will not be paid backIndian Bank - 16% will not be paid back

All these banks have already made some provisions for bad loans (as per RBI regulations)Provide means reduce your profits, reduce your reserves, reduce your Book Value

Small Project1 Take 4/5 banks from the above2 Track their max PBV and min PBV over the last 5 years - PBV range

Annual PBV from moneycontrolMax / Min price range for each yearMax / Min PBV range

3 Compare today's PBV with the range and determine where it standsToday's PBV isMax PBVMin PBV

Book ValueBook value represents the net assets and in sectors like banking provides a good benchmark for the priceitself

In other sectors which are driven by "earnings", the book value may act as a floor

Infy price is Rs 2,900Infy book value is lets say Rs 500Rs 2,900 is driven by earnings, but in a real read bad situation if the price falls, then Rs 500 may be a good floor for the price

SAIL - price fell below book value - Rs 80GMR Infra - book value Rs 25 - it went to Rs 17, 18

Earnings as the DriverEarnings are the driver for most sectors (other than Banking, Real Estate)

EPS is say Rs 20 per SharePrice 250 Rs per SharePrice Earnings Multiple PE 12.5 times

If you track the history of the PE over several years, ten years, you will get the max / min of the PEComparing that to today, you will get a sense of expensive or cheapness of the security

Feb 3, 2012 5,326 This number by itself is meaninglessPE 18.97 All the meaning is here in the PE

If the Nifty companies were to earn one rupee, the market is valuing them at Rs 18.97Nifty is an index of India's top 50 companies

Is this 18.97 times too high, too low, around the average?Is the Nifty too expensive, too cheap, just about okay ?

You want to buy a flat in ChennaiYou have a house, you are buying for earning some rental income

Price RentalAnna Nagar 10,000,000 20,000 Mylapore 12,500,000 27,000

Which flat is more expensive?A flat in Anna Nagar costs 500 times monthly rental income, while one at Mylapore costs 463 times monthly incomeAnna Nagar is more expensive

The price does not matter in a financial asset, the PE matters

If Infy price is Rs 2,900 and Satyam price is Rs 72, which is more expensive?Cant say - we need to track the earnings and only then we can commentInfy is earning Rs 110 per share and Satyam is Re 1.05 per share

Infy 2900 110 26.36 Satyam 72 1.05 68.57 Very expensive

Many people immediately conclude that a low PE company is cheap and should be a good buyAnd a high PE is expensive and should be sold offBut that may not be correctHow come ?

Low PE may have been low for 20 years, you saw it todayHigh PE may have been high for 20 yearsSo what does that mean?

Where does the PE come from ?Why is the PE of Co X so high (and consistently high) and Co Y so low (and consistently low)Asian Paints and Berger Paints - Asian Paints PE 32 times, Berger Paints 21 times (today, yday, last year, 1983)

Asian BergerReputationSizeEarnings 100 80Price 1000 800

PE 10 10

Reliance PE more than Cairn EnergyIOC should be more than HPCL, BPCLMarket share ? More market share more PE ?Distribution strength ? More dist strength more PE ?Consistent high RoI ?

The PE is an indicator of "respect"The stock market quantifies everything, including reputation, respect, goodwillThe PE comes the following factors:

1 Consistency of financial performance2 Growth prospects in earnings

PEG Model - was proposed by Peter LynchPeter Lynch was a fund manager in FidelityIn 1977, he managed a fund called Magellan Fund - the size of the funds was USD 20 mio

20 USD Mio50 USD INR

100 Rs crBy 1990, the fund size grew to USD 13 billion

13 USD Bio50 USD INR

65000 Rs cr

He came up with a possible answer to the question - what drives the PEPEG Model : Price Earnings to Growth

The optimium PEG is 1:1If your growth in earnings (EPS) is expected to be 18% per annum, then your PE should be 1818:18 = 1:1If your growth in earnings (EPS) is expected to be 18% per annum, and your PE is 12 times?PEG = 12:18 = 0.67:1What does this mean ?Stock is underpriced, could be a good buy

If your growth in earnings (EPS) is expected to be 18% per annum, and your PE is 22 times?PEG = 22:18 = 1.22:1Stock is overpriced, could be a good sell

Companies and sectors whose earnings are expected to grow rapidly will command a high PE and thosewhich are slow growth will command a low PE

Growth Stocks (High Priced, High PE)Value Stocks (Reasonably Priced, Mid PE, Low PE)

This became a big theme, investing philosophy

What do you mean by size?Who is large? Who is small ?

In the 1980s, if you read Business India, it would give you a listing of the largest Indian corporatesThat list would be based on "assets"More assets, more sizeTop of the list would be : Tatas, Birlas, FERA Companies (MNC), Mahindras, Mafatlals

Late 1980s, early 1990, size came to be defined by Sales TurnoverOil companies started appearing in the list

After mid 1995, when FIIs started investing in the market, size was again redefinedSize was now defined as "Market Cap"Market Cap = Price per Share x No of SharesToday, this definition is valid

If your read Business Today annual issue, you will find Top 500 listed in the order of Market CapSuddenly you find that Infosys and TCS which by asset size or sales turnover are nowhere, are in the top of the list

Market Cap Market CapLarge cap stocks More than Rs 10,00 cr Top 200

Mid cap stocks Rs 5,000 - Rs 10,000 cr Next 300

Small cap stocks Less than Rs 5,000 cr Others

Why should Asian Paints command 32 PEAsian Paints EPS is expected to grow faster than Berger PaintsAsian Paints has done better and has been more consistent than Berger in the past ten years

Asian Paints share is more expensive but deservedly more - need not be a good sellBerger may not be a good buy (inspite of a lower PE)

Don’t look merely at the PE, also look at the PEGIf the PEG is less than 0.70:1, then it could be a great buyIf the PEG is more than 1.30:1, then it could be a good sellThe investment world believes that in reasonably stable industries the PEG works well

Pharma, FMCG, IT - PEG would be reasonably good as an indicator

Guidance Forecast earnings levels provided by management itself (not mandatory)Forward earnings are estimates by analysts - analysts do consider guidance while estimating forward earnings

The PEG has been terribly misused by Indian experts, which we need to knowAny good concept can be misused on TV and we need to be very careful - don’t believe anybodyYou should be very cynical, very pessimistic, very question oriented

Infy in the 1998, 1999, 2000 used to grow at 160% earningsWipro 180%

Infy PE used to be 160 timesWipro 180 times

Experts said this is fairWhy?That is exactly what Peter Lynch has said in the PEG model

PEG 1:1 (180:180, 160:160) - life is fine, world is balancedInfy went to 13,660 in its peakIf you had bott Infy at that time, for the next 8 years you would have been in lossesWhat went wrong?

Global recession ?

Growth of 160%, 180% is not sustainableThis growth was not what Peter Lynch meantHe meant sustainable medium term (say 5 years growth)You grew 160% last year, that is not false, that is true

Infy Turnover In the next 12 years, if Infy were to grow at that rate1998 800 260% Infy would be larger than India2012 516,079,798 Rs cr Is that possible? Doable?

GDP 7,000,000 Rs cr

7373%

Any company PE of more than 50 times - is impossible to sustain

India PE has never crossed 28 times since 1994 (18 years)Whenever it has touched 28 times, markets have crashed If India PE goes to more than 24 times, then be very cautious, be nervous, look at Indian Bank Fixed DepositsAt this time, everyone will be rushing to the stock market

India Today will have on its cover page the BSE Tower BuildingThat means you should get out

History of the PE of any company - PE band - where does it fall nowPE combined with earnings growth prospects

Past and future should be defined based on today (not report date)If you buy the share, when you will buy? Do you have the ability to go back in time (to the report date)?

GSK - Sharekhan Report 2009EPS in the past years 55Max Price in the past relevant years 1457Min Price in the past relevant years 451Max PE 26.49 Min PE 8.20 Average PE 17.35 Current PE

Price Today 2,645 Earnings for the current year 2012 est 101 Current PE 26.19 Compared to history of last two years, it is fairly priced

PEG Model 2011 2012EPS estimate for the future years 86 101Growth in this EPS (CAGR)One year forward PEPEG (One year forward PE / CAGR)

Ideal PEG is 1:1Here the PEG is 1.44:1OverpricedA company with earnings growth of 18% should ideally trade at 18 PEBut this is trading at 26 PESo it is quoting at a premium of 44% over ideal PEG price

1 History PE Band - it is at an average PE - fairly priced2 PEG - I find it overpriced by 44%

L&T JM Report 2010EPS in the past years 53Max Price in the past relevant years 2213Min Price in the past relevant years 1390Max PE 41.75 Min PE 26.23 Average PE 33.99 Current PE Price Today 1,449 Earnings FY 13 71 One year Forward PE 20.41 Compared to history, the PE is reasonable

PEG Model 2013EPS estimate for the future years 71Growth in this EPS (CAGR)One year forward PEPEG (One year forward PE / CAGR)

PEG of 2.87 is quite high (norm is 1:1)

The PEG in this example is quite misleading - a simple formula x/y will always have challenges

If my earnings grow at 2%, will the share be available at 2 PE ?If my earnings grow at 48%, should the share go to 48 PE ?Will not happen and should not happen also

At very low EPS CAGR and very high EPS CAGR, the PEG will get smoothenedL&T will most likely never trade at 7 PE even if earnings grow at 7%

Suppose L&T makes a loss in the next years, so negative CAGR - how will PEG workSo share should be freeIn fact for every share, you should be given an incentive to buy

Book value as per Bal Sheet is Rs 350Very old company lot of Real EstateMarket value of assets will be far higher Say adjusted book value may be Rs 500 or so

If you have strong assets, the asset value becomes the share value in "some sectors"

2

You give this flat on rent and you earn Rs 10 lakhs over the next one year

2.00 0.10

Rental Income 0.15

At a deeper level, if the value of the flat has increased to say Rs 2.50 cr, then the value of the company

The assets can either be recognized at book value (Bal Sheet) or at market valueStock markets would recognize market value if the asset can be easily detached and sold and would realize

2.00

7.00

Assets 500

Total 500

Book Value per Share = Shareholders Funds per Share (Net Worth per Share)Rs crRscrRs crRs (10 + 40)

If this company's valuation was indeed driven by assets and the book value of the assets was more or less the market value of the assets, then the share price ought to hover around Rs 50

If the share price was say Rs 20, this might be a great buying opportunity depressed sentimentIf the share price was say Rs 200, this might be a great selling opportunity exuberance

In the normal course of accounting, the Balance Sheet values of assets are based on "historical cost"In the case of long term assets, this cost is further reduced by "depreciation"

In long term asset heavy industries, the book value may not be very representative of their market values

Market values for plant and machinery and vehicles may be far lower than book value

AssetsLittle bit - offices, furniture, comp

Government Securities

Loans GivenCash on HandDeposits with RBI and Other Banks

Book Value per Share = Net Worth per Share = Net Assets per Share

If that Book Value for XYZ Bank is say Rs 95 per share and the market price is say Rs 45 per share - the bank is undervalued signficantly and could be a good buy

Earnings are not very important (assets are more important than earnings)

Work out the Book Value per Share on March 31, 2011 - readily availableWork out the Book Value per Share on December 31, 2011 - not readily available

State Bank of India HDFC BankPunjab National Bank Axis Bank

ICICI BankCanara Bank Yes Bank

Indus Ind BankBank of India

Syndicate BankCorporation Bank

Dec BV Price PBV

125 525 4.20 Private 94 303 3.22 Private

129 341 2.64 Private 533 1185 2.22 Private

1143 2205 1.93 Public 517 932 1.80 Private 623 795 1.28 Public 324 373 1.15 Public

459 501 1.09 Public 560 477 0.85 Public Good buys ?216 182 0.84 Public Good buys ?

141 110 0.78 Public Good buys ?120 87 0.73 Public Good buys ?

If Indian Bank has assets of one rupee, the market is valuing them at 84 paise (16% discount)Market is of the belief that 16% of the assets will not be realized (will be lost) - bad loans, NPAs

A bank is supposed to borrow funds and lend funds and make the differenceIn London, in the 1980s, they used to say banks are 3-6-3 businessesYou borrow at 3%, you lend at 6%, you go home at 3 pm (play golf with your customers)

A bank is supposed to borrow funds and lend funds and make the difference

If you are a depositor and X bank gives you 7% and Y bank gives you 7.25%, whom do you go to?

If you having using Colgate toothpaste since birth and Colgate is more expensive than Pepsodent, you are okay

HDFC Bank - a very huge share of profits and revenues come from non-banking activities

Commission on selling insurance policies to you and me

Advisory to corporates on forex, treasury

More than 40% of their profits come from non-fund initiatives

Which poor Dena Bank and Syndicate Bank have not been able to develop

For example, the market is valuing Dena Bank as if 27% of its loans will not be returned

All these banks have already made some provisions for bad loans (as per RBI regulations)Provide means reduce your profits, reduce your reserves, reduce your Book Value

Track their max PBV and min PBV over the last 5 years - PBV range

Compare today's PBV with the range and determine where it stands1.28 ??? What percentile2.01 1000.77 0

Book value represents the net assets and in sectors like banking provides a good benchmark for the price

In other sectors which are driven by "earnings", the book value may act as a floor

Rs 2,900 is driven by earnings, but in a real read bad situation if the price falls, then Rs 500 may be a good

Earnings Upside

Floor - Asset based Book Value

Earnings are the driver for most sectors (other than Banking, Real Estate)

Rs per Share

If you track the history of the PE over several years, ten years, you will get the max / min of the PEComparing that to today, you will get a sense of expensive or cheapness of the security

This number by itself is meaninglessAll the meaning is here in the PE

If the Nifty companies were to earn one rupee, the market is valuing them at Rs 18.97

PE Ratio AnnPE 500 41.67 times 463 38.58 times

A flat in Anna Nagar costs 500 times monthly rental income, while one at Mylapore costs 463 times monthly

If Infy price is Rs 2,900 and Satyam price is Rs 72, which is more expensive?Cant say - we need to track the earnings and only then we can comment

Very expensive

Many people immediately conclude that a low PE company is cheap and should be a good buy

Why is the PE of Co X so high (and consistently high) and Co Y so low (and consistently low)Asian Paints and Berger Paints - Asian Paints PE 32 times, Berger Paints 21 times (today, yday, last year, 1983)

Asian Berger

100 803200 1680

32 21

The stock market quantifies everything, including reputation, respect, goodwill

In 1977, he managed a fund called Magellan Fund - the size of the funds was USD 20 mio

He came up with a possible answer to the question - what drives the PE

If your growth in earnings (EPS) is expected to be 18% per annum, then your PE should be 18

If your growth in earnings (EPS) is expected to be 18% per annum, and your PE is 12 times?

If your growth in earnings (EPS) is expected to be 18% per annum, and your PE is 22 times?

Companies and sectors whose earnings are expected to grow rapidly will command a high PE and those

LargeCap MidCap SmallCapHighest

Lowest

In the 1980s, if you read Business India, it would give you a listing of the largest Indian corporates

Top of the list would be : Tatas, Birlas, FERA Companies (MNC), Mahindras, Mafatlals

After mid 1995, when FIIs started investing in the market, size was again redefined

If your read Business Today annual issue, you will find Top 500 listed in the order of Market CapSuddenly you find that Infosys and TCS which by asset size or sales turnover are nowhere, are in the top of

Market Cap Relative> 0.10% of India Low Risk

0.05% to 0.10% High Risk

Others V High

Asian Paints has done better and has been more consistent than Berger in the past ten years

Asian Paints share is more expensive but deservedly more - need not be a good sell

The investment world believes that in reasonably stable industries the PEG works well

Forecast earnings levels provided by management itself (not mandatory)Forward earnings are estimates by analysts - analysts do consider guidance while estimating forward

The PEG has been terribly misused by Indian experts, which we need to knowAny good concept can be misused on TV and we need to be very careful - don’t believe anybodyYou should be very cynical, very pessimistic, very question oriented

If you had bott Infy at that time, for the next 8 years you would have been in losses

In the next 12 years, if Infy were to grow at that rateInfy would be larger than IndiaIs that possible? Doable?

If India PE goes to more than 24 times, then be very cautious, be nervous, look at Indian Bank Fixed Deposits

History of the PE of any company - PE band - where does it fall now

Past and future should be defined based on today (not report date)If you buy the share, when you will buy? Do you have the ability to go back in time (to the report date)?

2010 2011 200911Gr71 86 25%

2524 27041253 1921

35.55 31.44 17.65 22.34 26.60 26.89

Compared to history of last two years, it is fairly priced

201312018%

26 1.44 times

A company with earnings growth of 18% should ideally trade at 18 PE

2011 2012 200911Gr61 68 13%

2002 1531969 990

32.82 22.51 15.89 14.56 24.35 18.54

Compared to history, the PE is reasonable

2014787%

20 2.87

The PEG in this example is quite misleading - a simple formula x/y will always have challenges

At very low EPS CAGR and very high EPS CAGR, the PEG will get smoothenedL&T will most likely never trade at 7 PE even if earnings grow at 7%

Suppose L&T makes a loss in the next years, so negative CAGR - how will PEG work

1 Equity valuationNext steps

a PBV - Asset based valuationb PE - Earnings based valuationc DCF valuation - mother of all valuations - more complex - used by institutions

NPV, IRR - capex budgetingd Enterprise Value EV

2 Working Capital Management

3 EVA - Economic Value AddedL&T, Murugappa, Godrej, HUL, Coca Cola

4 Bond examples

5 Shares - how does the market behavePersonal investing - what should you do - how can you make money - without risking too much

Summarize yesterday's discussions

AssetsFew sectorsBankingReal EstatePBV

Some banks - PBV Range - 4.20 HDFC Bank to0.73 Dena Bank

Dena Bank is cheap (< 1)HDFC Bank is expensive - non banking work fee based revenue (not fund based)HDFC Bank is not a bank, bank plus plus

PBV < 1 - could be a good opportunity

HDFC Non Banking Revenue - Other Income ? What should it be classified as ? What is Other Income ? Other Income is other than coreWhat is core?If I tell you that core is banking plus treasury plus forex advisory plus wealth management plus insurance

GSK PharmaPE band - averagePE - 26 times, Growth 18% PEG 1.44:1 - slightly expensiveMay not be a great buy

SATYAM CASEShare price fell badlyTill what level it fall ? Rs 55 - two month range

What was the book value at that time?What were contingent claims at that time ?

Class action suit in the USUpaid caseSEC might take action against SatyamIncome tax case - currently on

EXAMPLEYou bott a flat yday - Mylapore for RsRental Income per monthAnnual escalation possible %Your debt component is sayInterest rateOn your equity component, you expect

Assume a five year period is reasonable, what is the expected value of the flat after 5 yearsWhat is the capital appreciation the world expects in 5 years time in MylaporeIgnore income tax

Cost of Capital - WACCDebt 11% 80%Equity 12% 20%WACC

PROJECT IRR LOGICDon’t map the loan availed, loan repaid and interest on loanDont worry about how the project was funded - flat does not know how it was fundedConsider the flat cost as Rs 1.25 cr

Year CashFlow Sale of Flat Total CashFlow Derived number

0 (12,500,000) (12,500,000)1 324,000 324,000 2 356,400 356,400 3 392,040 392,040 4 431,244 431,244

5 474,368 18,821,714 19,296,083

The financial world believes that your flat of Rs 1.25 cr will appreciate to Rs 1.88 cr in 5 years timeThat is why they are happy to accept a rent of Rs 27,000 per month

324,000 12,500,000 18,821,714 12,500,000 5

If capital appreciation appeared to be impossible, rentals would rise in Chennai (or flat prices would fall)

We divorce the two actions - funding and operationsThe funding dept will take care of funding - they will raise debt, equity, whateverThe ops dept will take care of ops - their job is to earn the rentThe flat does not know how it was funded and will generate the same rental income irrespective of how it was funded

EQUITY IRR THINKINGHere you are thinking like Dhirubhai Ambani (not like Reliance)

Year CashFlow Bank Payments Sale of Flat 0 (2,500,000)1 324,000 (1,100,000)2 356,400 (1,100,000)3 392,040 (1,100,000)4 431,244 (1,100,000)5 474,368 (11,100,000) 18,934,758

DCF Valuation of EquityYear 1EBIT 200Tax Rate t 20%EBIT x (1-t) 160Add back Depreciation 35Incremental Working Capital -30Capital Expenditure -15Free Cash Flow to the Firm - FCFF 150

FCFF is your purpose in life Depreciation is not a cash outflow, it is only a book entryWhy are you alive?To generate FCFF

FCFF - what does this meanThis is the amount you can withdraw from the business and give it to the stakeholders

1 You could pay interest to your lenders2 You could repay loans of your lenders3 You could pay dividends to your equityholders4 You could even return to your equityholders - you could buy back shares

If you generate fantastic FCFF, then your valuation in the market will also be fantastic

The value of the company is nothing but the present value of future FCFF (discounted present value)

Year FCFF Sale of firm TotalCash

1 100 1002 150 1503 225 2254 300 3005 500 5000 5500

Value of the Firm

1 Value in the stock market - every day, every momentRetail investors buy 10 shares and 20 shares - PE, PBVInstitutional investors buying 100,000 shares, 1 million shares - FCFF, DCF

Citi has sold a huge stake in HDFC and other large institutions are buyingCiti sold at Rs 657/658

2 Equity placement - private placement of equity

3 Investment by Venture Capital Companies, Private Equity Companies

4 Mergers and Acquisitions

5 Joint Ventures

PROJECT THINKING, CORPORATE THINKINGThe CEO is worried about generating FCFFThis FCFF will be used to pay both debtholders and equityholdersThe discounting is done at WACCWACC includes cost of both debt and equity

If you consider interest as an expense in this thinking, then you are moving to Equity thinking

The machine does not know how it was funded - it works the same way regardless of funding patternThe operational cash flow is not dependent on debt equity mix

LIQUIGAS FALLACYThere was a company Liquigas - they used to work in the following manner:

Year OneBoard Meeting - many new ideas for expansion, new projects100 ideas with varying IRRsBest IRR - 21%, Last IRR - 3%The CEO asks the CFO - what is our cost of capital for this yearFrom where are we raising funds this yearCFO says - we are raising debt and cost of debt is 4%All projects which generate more than 4% IRR are accepted and those with less than 4% IRR are rejected85 new projects sanctionedNew debt is raised and projects are implemented

Year TwoBoard Meeting - many new ideas for expansion, new projects100 ideas with varying IRRsBest IRR - 21%, Last IRR - 3%The CEO asks the CFO - what is our cost of capital for this yearFrom where are we raising funds this yearCFO says - this year we will raise equity because debt is too high nowCost of equity - say 10%All projects with IRR more than 10% are accepted, less than 10% are rejected

Year ThreeBoard Meeting - many new ideas for expansion, new projects

100 ideas with varying IRRsBest IRR - 21%, Last IRR - 3%The CEO asks the CFO - what is our cost of capital for this yearFrom where are we raising funds this yearCFO says - we can raise debt this year - cost 3.8%All projects with IRR more than 3.8% are accepted, less than 3.8% are rejected

Right way of thinkingDon’t correlate funding with projectsHave one common WACC for the company for all yearsWACC in all the three years is say 7.8%

Businessman wants what? You will work for 40 years in your life and you will get one of these1 Profits2 Revenues3 Assets4 Capital5 Returns6 Margins7 Cash, Wealth, Shareholder Wealth, Money8 Reserves

Free Cash Flow is the objective MarginsNot profit CashProfit is a bookish number Revenues

Profit is like CTCCash is like Take Home

ENTERPRISE VALUE - EVIf we were to buy the entire company today, what would it cost us

1 We would buy the entire equityThis would cost us the Market Cap

2 We would become responsible for its debtIf Mukesh Ambani takes over Kingfisher Airlines today and buys all the equity, from tom whomwill SBI call for recovery of its debt?Whom does the income tax dept call for its Satyam tax demands ?Mahindras

3 Whatever cash the company has will become your cash

Balance Sheet - Rs crShare Capital (Face value Rs 5) 100 Reserves 600 Loans 525

1,225 Market price of the share is Rs 71What is its Enterprise Value

1 Market Cap100 5 20

2 Add Debt

3 Less : CashEnterprise Value

Why are Reserves being ignored in this Computation

EBIDTA is lets say

EV/EBIDTA Multiple

For one rupee earning (ebidta), I am required to pay Rs 6.42

Poor man's earnings multiple is the PERich man's earnings multiple is the EV/EBIDTA

SalesOps

EBIDTA

FinancePAT

L&T JM REPORT

Enterprise Value = 9 times Forward EBIDTA

Enterprise Value = Market Cap + Debt - CashDebt - Cash = Net Debt Enterprise Value = Market Cap + Net DebtMarket Cap = Enterprise Value - Net Debt

Sum of the parts valuation (SOTP)EV/EBIDTAPECostMarket CapMultiple RevenueMore complex multiples

Good examples where SOTP is a mustGMRGEReliance - Oil exploration, Refining, Petrochem, RetailKotak - Banking, Securities, Insurance, Investment Banking, Mutual Fund, ReitHDFC - Home Lending, Banking, Insurance, Mutual Fund, Securities, Property VenturesICICISBI - CardsGrasimEssarRaymonds - Textiles, Engg, Automotive, Real EstateMarg - Infra, Real Estate, PortAmalgamations - Tractors, Retail Dealerships, Various other small businesses

M&M - Auto, Leisure, Real Estate, Components, IT, TractorsConglomerates valuation becomes complex

L&T LtdHas invested in L&T Finance, L&T Infotech and L&T X and L&T YL&T holds shares in these other entitiesSo when you buy one share of L&T Ltd you are automatically getting a little bit L&T Finance, L&T InfotechSo the value of L&T should be inclusive of the value of its children

Tata Group should not be treated on parSo when you buy Tata Motors, you don’t get TCS along with it (unless Tata Motors holds a big chunk of TCS shares)

When I buy HDFC, I get a bit of HDFC Bank automatically and HDFC Standard Life automaticallyWhen I buy HDFC Bank, I don’t get HDFC or HDFC Insurance

You will get access to Research ReportsYou need not trade here

INVESTINGIndian equity has done brilliantly over the past 33 yearsSensex 1979 100 Today 2012 18,000

33 17.04% 180

Bank Fixed Deposit 9% 100 1,718

At 9% your Rs 100 would have grown from Rs 100 to Rs 1,718 in 33 yearsAt 17% your Rs 100 would have grown from Rs 100 to Rs 18,000 in 33 years

So where is the catch?

www.motilaloswal.comwww.sharehkhan.comwww.jmfinancial.com

1000 buy

start getting into add, accumulate

600unaware

100

18,000 will go to 5,00,000 or more in the coming three decadesBut the common man will be repeating his behaviour - so he will not become wealthy

A lot of intellect is generally spent in when to buy, when to sell, how to make millionsOnly God knows when to buy and when to sell and he does not disclose

Then there are "experts" who advise you what to doBut they don’t share in losses

All of them in Dec Sensex will go to 14,000 Nifty will go to 4200, 4300 and dollar will go to 59/60January is the weakest in the history of the stock market over the last 12 yearsWhat happened - complete the reverse

In Jan 2008, Sensex went to 22,000 and experts said it will go to 35,000In Oct 2008, Sensex crashed to 7,900 and experts said Sensex will become Nifty (2,500)So experts are pretty useless

So timing the market is not possible - don’t waste your energy in this pursuit

The best way to make money is to invest in SIP - Systematic Investing PlansJust invest Rs 10,000 per month, Rs 5,000 per week, etc Don’t look at the marketDon’t watch CNBCDon’t read EcoTimesDon’t ask people where is the market going to go

You pay a heavy price for a cheery consensus

While SIP might look dull, unintelligent, it is more effective than all intellectual theories about the marketThe quality of your returns is a direct result of the quantum of time you spend in creating the SIPAfter 8 years, you cannot make losses

Which SIP, which mutual fund, which direct equity

Large mutual fund which has strong peopleHDFC Mutual Fund HDFC Top 200, EquityDSP Blackrock TigerFranklin Templeton Blue ChipBirla SunLifePru ICICI

Large diversified mutual fund schemes represent IndiaNifty, Sensex represent IndiaIf India does well, these schemes will do well

EV - COMPUTATIONWhy are Reserves ignored ?Share Capital and Reserves are relevant for book value of the enterpriseWe are not using book value in EV workingWe are using market priceMarket Cap of a company is "Share Price" x "No of Shares"Share price is wherever it is bcoz of what? Bcoz of the Reserves that any company has

PE AND PBV RATIOS - KEEP REDUCING IN ANY RESEARCH REPORT - WHY

Current Market PriceEPS of 5 years 55 71PE 46.3 35.8

Useless UselessWrong WrongNM/NMF NM/NMF

BOND RELATED QUESTIONSQuestion 7-11

14 % coupon - paid semi-annual frequencyFace value USD 1,000Tenor 30 yearsCallable 5 years from nowCallable price is USD 1,050Current price USD 1,353.54Yield curve is flatWhat is the best estimate of nominal interest rate on new bonds

Yield curve is flat - the rate of interest is the same, irrespective of tenorIf I issue new bonds with a tenor of 2 years, the rate of interest is say x%The same rate of interest x% will be valid even if the tenor were to be 3 years, 5 years, 100 years

SolutionYield to Call - if I call the bond in 5 years, what is the effective rate of interest that I will pay

HalfYear CashFlow0 (1,353.54) 3.24%1 70 22 70 6.47% Annual IRR, YTC3 704 705 70 Half of the challenge is not Finance, it is English6 707 708 709 70

10 1120

Question 7-101 Get the coupon rate2 Current yield = Coupon / Current market price

Question 7-13Tenor 20 yearsPar Value USD 1,000

Annual coupon 9%Tenor for you - 5 yearsRequired rate of return for you - 10%After 5 years, YTM is expected to be 8.5% on this bondWhat can you pay for this bond today?

After you sell the bond, it will have a balance tenor of 15 yearsAt that time, when you sell it, it will have a YTM of 8.50% (6th year to 20th year)So with this information, what can you get?You can work out the price of the bond that will prevail at the end of 5 years from today

For the first five years1 Coupons2 End value3 Required rate of return

You can get the price on day one

Question 7-16Heekin USD 140 mio of bonds, average cost is 7.50%Interest expense USD 10.50 mioTimes interest earned (TIE) is 3.2 timesInterest Coverage Ratio is 3.2 times

This info will give you EBIDTATIE cannot fall below 2.5 times

This info will give you the max interest you can ever payOther loan details

You can easily work out which loans, what rate of interest, how much can you borrow

Question 7-17Known - Face value, coupon, tenor, YTMFrom here you can get the purchase priceSell price is givenSo return you can get

WORKING CAPITAL MANAGEMENT

Retail industry has huge working capital, huge inventorySo their focus on this area is very highTheir Receivables are zero

Which product lines are good, bad, excellent, hopelessHow do you determineWhat can you do about the bad and hopeless ones

Product Line Gross ContribnMargins Margins

% %Mens garments 25% 22%Shoes 30% 28%Cosmetics 40% 35%Jewelry 38% 31%

Sales minus Variable Costs = ContributionContribution minus Fixed Costs = Profit

Gross Margin is Sales minus Cost of Goods Sold (in COGS we will include purchase price, taxes on purchase, freight)Gross Margin minus Other Variable Costs (sales commissions, incentives) = Contribution Margin

Sales 100COGSAdmin

SellingDistributionMiscOpex 92 Both fixed and variable (exclude Int, Depn, Inc Tax)Operating Margin 8 EBIDTA

Product Line Gross ContribnMargins Margins

% %Mens garments 25% 22%Shoes 30% 28%Cosmetics 40% 35%Jewelry 38% 31%

Gross Margin Return on Investment/Inventory - GMRoI/IWe want to earn max Gross Margin but on min investment in inventory

1 Gross Margin Return on Inventory2 Contribution Return on Inventory3 Gross Margin Return on Net Inventory (after deducting supplier credit)4 Contribution Return on Net Inventory

What is the Gross Margin / Contribution per square foot of space ?

What is the Gross Margin / Contribution per rupee of salary cost ?

Read the Shoppers Stop Annual Report

1 Concept of Consignment of InventoryVendor comes and places his inventory in your storeYou don’t really buy this inventoryYour investment is zeroIf it sells, then you payIf it does not sell, he will take it back

But generally vendors also need to liveSo they may not give you all inventory on consignment

Asset to Memo ratioJ C Penny - give me 50:50Vendor will say 80:20

2 Store within Store

Economic Value Added - EVA Rs crNet Worth 100Debt 200Capital Employed 300

WACC 14%Min you should earn 42What are you really earningThis earning as : EBIT x (1-t) 51EVA 9

EVA = EBIT x (1-t) minus the Minimum WACCEVA is a Rs cr numberPositive EVA means you are beating the WACC

Stern Stewart & Co - research shows - if your EVA is positive and growing, then Shareholder Wealth is indeed attractiveIf your EVA, then you don’t deserve to live

DCF valuation - mother of all valuations - more complex - used by institutions

Personal investing - what should you do - how can you make money - without risking too much

Valuation

EarningsMost sectors

PE

Right PE - PEG Model - PE should be driven by expected growth in EPSIdeal PEG level 1:1If your EPS is expected to grow at 20%, then your PE may well be 20 timesPE band in history

Nifty PE band - 10 to 28 timesToday Nifty PE - 18 times

Average 18, Std Dev 3.6Below 14, Nifty is very attractiveAbove 22, it may be too expensive

HDFC Non Banking Revenue - Other Income ? What should it be classified as ?

If I tell you that core is banking plus treasury plus forex advisory plus wealth management plus insurance

L&TPE history - was okayPEG was uninterestingGrowth in earnings 7%, PE - 20 timesPEG 2.87 times - which is quite quite high

Growth of 7% appears to be rather mutedCould be over a short period of 2 yearsLong term growth may be much betterHistorically, this company has grown wellMarket will not price at very low PE just because EPS is growing very lowIf growth is 2%, will you get it 2 PE ? NoIf growth is negative, will the share be free ? No

The book value will act as a floor

Earnings upside

Book value floor

Book value Rs 100 lets say

Prob on these contingent claimsOk - these may be Rs 45Share price is rightly Rs 55

12,500,000 27,000

10%80%11%12%

Assume a five year period is reasonable, what is the expected value of the flat after 5 yearsWhat is the capital appreciation the world expects in 5 years time in Mylapore

8.800% 10,000,000 11% 1,100,000 2.400%

11.200%

Don’t map the loan availed, loan repaid and interest on loanDont worry about how the project was funded - flat does not know how it was funded

Total CashFlow

11.19% Goal Seek

12,500,000 324,000 39 times

The financial world believes that your flat of Rs 1.25 cr will appreciate to Rs 1.88 cr in 5 years timeThat is why they are happy to accept a rent of Rs 27,000 per month

2.59% Poor yield on rent8.53% Capital appreciation expected

If capital appreciation appeared to be impossible, rentals would rise in Chennai (or flat prices would fall)

The funding dept will take care of funding - they will raise debt, equity, whateverThe ops dept will take care of ops - their job is to earn the rentThe flat does not know how it was funded and will generate the same rental income irrespective of

Here you are thinking like Dhirubhai Ambani (not like Reliance)

Total CashFlow 12.00% Cost of Equity (2,500,000) (776,000) (743,600) (707,960) (668,756) 8,309,127

2 3 4 5

Depreciation is not a cash outflow, it is only a book entry

This is the amount you can withdraw from the business and give it to the stakeholders

You could even return to your equityholders - you could buy back shares

If you generate fantastic FCFF, then your valuation in the market will also be fantastic

The value of the company is nothing but the present value of future FCFF (discounted present value)

WACC 14% 114%PV Factor DCF 1.000 0.877 87.72 0.769 115.42 0.675 151.87 0.592 177.62 0.519 2,856.53

3,389.16

Value in the stock market - every day, every momentRetail investors buy 10 shares and 20 shares - PE, PBVInstitutional investors buying 100,000 shares, 1 million shares - FCFF, DCF

Citi has sold a huge stake in HDFC and other large institutions are buying

Equity placement - private placement of equity

Investment by Venture Capital Companies, Private Equity Companies

This FCFF will be used to pay both debtholders and equityholders

If you consider interest as an expense in this thinking, then you are moving to Equity thinking

The machine does not know how it was funded - it works the same way regardless of funding patternThe operational cash flow is not dependent on debt equity mix

There was a company Liquigas - they used to work in the following manner:

Board Meeting - many new ideas for expansion, new projects

The CEO asks the CFO - what is our cost of capital for this year

All projects which generate more than 4% IRR are accepted and those with less than 4% IRR are rejected

5% - accepted

Board Meeting - many new ideas for expansion, new projects

The CEO asks the CFO - what is our cost of capital for this year

CFO says - this year we will raise equity because debt is too high now9% - rejected

All projects with IRR more than 10% are accepted, less than 10% are rejected

Board Meeting - many new ideas for expansion, new projects

The CEO asks the CFO - what is our cost of capital for this year

4% - acceptedAll projects with IRR more than 3.8% are accepted, less than 3.8% are rejected

You will work for 40 years in your life and you will get one of these

Cash, Wealth, Shareholder Wealth, Money

8% 9%100 CR 10 CR200 cr 500 CR

If we were to buy the entire company today, what would it cost us

If Mukesh Ambani takes over Kingfisher Airlines today and buys all the equity, from tom whom

Whom does the income tax dept call for its Satyam tax demands ?

Whatever cash the company has will become your cash

Fixed Assets 1,155 Cash 20 Net Current Assets 50

1,225

Rs cr1420 Market value of equity (Capital + Reserves) covers

71 Capital and Reserves here525 We believe that market value

1945 of debt is the same as book value of debt20

1925

300

6.42 times

For one rupee earning (ebidta), I am required to pay Rs 6.42

Cost of one share / Earnings from one shareCost of the company / Earnings from the company

As a small shareholder, you have no controlWhatever PAT the company makes, you accept

As a controlling shareholder, you have tons of controlEspecially in financial issuesGiven an EBIDTA, you can regenerate the PAT

Reliance - Oil exploration, Refining, Petrochem, RetailKotak - Banking, Securities, Insurance, Investment Banking, Mutual Fund, ReitHDFC - Home Lending, Banking, Insurance, Mutual Fund, Securities, Property Ventures

Raymonds - Textiles, Engg, Automotive, Real Estate

Amalgamations - Tractors, Retail Dealerships, Various other small businesses

M&M - Auto, Leisure, Real Estate, Components, IT, Tractors

Has invested in L&T Finance, L&T Infotech and L&T X and L&T Y

So when you buy one share of L&T Ltd you are automatically getting a little bit L&T Finance, L&T InfotechSo the value of L&T should be inclusive of the value of its children

So when you buy Tata Motors, you don’t get TCS along with it (unless Tata Motors holds a big chunk of

When I buy HDFC, I get a bit of HDFC Bank automatically and HDFC Standard Life automaticallyWhen I buy HDFC Bank, I don’t get HDFC or HDFC Insurance

109%

At 9% your Rs 100 would have grown from Rs 100 to Rs 1,718 in 33 yearsAt 17% your Rs 100 would have grown from Rs 100 to Rs 18,000 in 33 years

buy2000

start getting into add, accumulate

add, accumulate 800 panic, run away

panic, run away

18,000 will go to 5,00,000 or more in the coming three decadesBut the common man will be repeating his behaviour - so he will not become wealthy

A lot of intellect is generally spent in when to buy, when to sell, how to make millionsOnly God knows when to buy and when to sell and he does not disclose

All of them in Dec Sensex will go to 14,000 Nifty will go to 4200, 4300 and dollar will go to 59/60January is the weakest in the history of the stock market over the last 12 years

In Jan 2008, Sensex went to 22,000 and experts said it will go to 35,000In Oct 2008, Sensex crashed to 7,900 and experts said Sensex will become Nifty (2,500)

So timing the market is not possible - don’t waste your energy in this pursuit

The best way to make money is to invest in SIP - Systematic Investing Plans

While SIP might look dull, unintelligent, it is more effective than all intellectual theories about the marketThe quality of your returns is a direct result of the quantum of time you spend in creating the SIP

HDFC Top 200, Equity

Share Capital and Reserves are relevant for book value of the enterprise

Market Cap of a company is "Share Price" x "No of Shares"Share price is wherever it is bcoz of what? Bcoz of the Reserves that any company has

PE AND PBV RATIOS - KEEP REDUCING IN ANY RESEARCH REPORT - WHY

254485 101 120

29.9 25.2 21.2 Useless Useful Partly Useful

What is the best estimate of nominal interest rate on new bonds

Yield curve is flat - the rate of interest is the same, irrespective of tenorIf I issue new bonds with a tenor of 2 years, the rate of interest is say x%The same rate of interest x% will be valid even if the tenor were to be 3 years, 5 years, 100 years

Yield to Call - if I call the bond in 5 years, what is the effective rate of interest that I will pay

1000 14% 7% 701050

Annual IRR, YTC

Half of the challenge is not Finance, it is English

After you sell the bond, it will have a balance tenor of 15 yearsAt that time, when you sell it, it will have a YTM of 8.50% (6th year to 20th year)

You can work out the price of the bond that will prevail at the end of 5 years from today

This info will give you EBIDTA

This info will give you the max interest you can ever pay

You can easily work out which loans, what rate of interest, how much can you borrow

Which product lines are good, bad, excellent, hopeless

What can you do about the bad and hopeless ones

Sales Inventory Supplier Gross COGSestimates Credit Marginfor a year

Rs cr Days Days Rs cr Rs cr100 90 30

30 100 45150 60 21

85 180 60

Gross Margin is Sales minus Cost of Goods Sold (in COGS we will include purchase price, taxes on purchase,

Gross Margin minus Other Variable Costs (sales commissions, incentives) = Contribution Margin

Both fixed and variable (exclude Int, Depn, Inc Tax)

Sales Inventory Supplier Gross COGSestimates Credit Marginfor a year

Rs cr Days Days Rs cr Rs cr100 90 60 25.00 75.00

30 100 45 9.00 21.00 150 60 21 60.00 90.00

85 180 60 32.30 52.70

Gross Margin Return on Investment/Inventory - GMRoI/IWe want to earn max Gross Margin but on min investment in inventory

Gross Margin Return on Net Inventory (after deducting supplier credit)

What is the Gross Margin / Contribution per square foot of space ?

What is the Gross Margin / Contribution per rupee of salary cost ?

Vendor comes and places his inventory in your store

So they may not give you all inventory on consignment

Stern Stewart & Co - research shows - if your EVA is positive and growing, then Shareholder Wealth is

Right PE - PEG Model - PE should be driven

If your EPS is expected to grow at 20%, then

Earnings upside

Book value floor

Market value of equity (Capital + Reserves) covers

of debt is the same as book value of debt

COGS Inventory GMROI Gross Mark up GMROIper Day Gross Mgn Cycles Cycles x

Return on per Mark-up365 Inventory annum

Rs cr Rs cr Rs Number % Rs

Inventory GMRoI Cont CRoI Ranking NetInventoryPaid

365 InventoryRs cr % Rs cr % Rs cr 18.49 1.35 22.00 1.19 3 6.16 5.75 1.56 8.40 1.46 2 3.16 14.79 4.06 52.50 3.55 1 9.62 25.99 1.24 26.35 1.01 4 17.33

Net Net GMRONICycle Cycles Gross Mgntime per Return on

annum Net InvnDays Number Rs

GMRoNI CRoNI

% %406% 357%284% 265%624% 546%186% 152%