Professional Documents
Culture Documents
in management, the language changes Tons, kms, people Operating language RoE, EV, EVA, OPM, FA Turnover ?? Your purpose is the same - to make money Language of money becomes important
Without money, the best ideas fail Wright Brothers - aeroplane - without money, they would be unheard and we would be trav bullock carts James Watt - engine It is easy - but any new language takes a little bit of effort and a little bit of time Raw material - time, little commercial sense 1 Financial accounting Accounting means recording of transactions (financial events) Balance Sheet Profit & Loss Account Cash Flow Statement 2 Financial analysis Reading the statements and understanding the import Is the company healthy Is the company profitable Is the company making its owners happy What is the level of risk 3 Financial decision making Should I set up this new factory Should I spend so much on this advertising campaign Should I upgrade my machines Spend first and wait for returns (takes time)
4 Valuation of companies, projects 5 Financial markets Stock market, derivatives market, commodities market
Finance is a life time journey If we build the right awareness, basic understanding and curiosity, then you go ahead and e Many non-finance people understand finance better than finance people
Most CEOs understand finance better than CFOs I am v v sure that the decision to make Nanos was Ratan Tata's decision and not Tata Motor FINANCIAL ACCOUNTING 1 Personal Balance Sheet 2 Personal P&L 3 Basic accounting equation 4 Simple example of a new business 5 Game - Monopoly At the end of the game, you will make your own Bal Sheet and P&L By today evening 6 Corporate Bal Sheet 7 Corporate P&L 8 Understanding terminology around Corporate Financial Statements Personal Balance Sheet Two types of numbers in the world 1 Point of time numbers 2 Period of time numbers How many cars do you have? Five cars What type of a number is this? Point of time - as of when ? As of today - Aug 14, 2011 - he has five cars 1985 - zero cars 2025 - 25 cars
What is your salary? Rs 15 lakhs What type of a number is this? As of today, his salary is Rs 15 lakhs ?? This is a "period of time" number Rs 15 lakhs is a wrong answer, incomplete answer Rs 15 lakhs per annum, per month, Harish Salve - Rs 15 lakhs per day, Rajnikant - Rs 15 lak 1 Point of time numbers 2 Period of time numbers Balance Sheet Profit & Loss
The P&L starts afresh in every period - starts from zero all over again The Bal Sheet continues forever What is your salary for Aug 2011? For this answer, your July salary is irrelevant The Aug salary meter starts from zero on Aug 1 If you bott a house in 2001, will that house belong to you in 2011 also? Yes Your Personal Balance Sheet as of today - Aug 14, 2011 Liabilities - Owe Sources of Funds Where the Rupee came from Own Capital / Net Worth Own Funds / Accumulated past savings Opening Balance Profit during the year Closing Balance Home Loans Personal Loans Gold Loans Car Loans Auto Loans Education Loans 33.50 2.50 36.00
12.00
2.00 50.00
Salary ?? Education ?? Money spent for education ?? Wealthy friends ?? Wealthy in laws ?? Rich dad ??
Will be accounted somewhere Not an asset Will be accounted somewhere Not assets Not assets Not assets
The most important asset that we have is our "Intellect" The other important asset that we have is our "society - family, friends, relatives, bosses, n contacts" Will they appear in our Bal Sheet? Answer - No Why? Two challenges: 1 Monetization I am very intelligent We all agree My intelligence is worth Rs 10 cr We start fighting
2 Transferability (practical ownership) Even if all of us agree that Rangarajan's intellgence is worth Rs 10 cr, can this be in a legally acceptable manner - sale, lease, licence, rent, etc For accounting, we need a "transaction" Transaction means a financial event Unless transferability is possible, no event occurs Rangarajan is very intelligent, but that is not a financial event
Property prices in Mahabalipuram have gone up So what happens in the Bal Sheet? You have a house in Mahabalipuram Property prices going up is not a "transaction" Nothing happens in the Bal Sheet SHOW ME THE MONEY Politicians are required to declare their assets So should they declare at their cost (or at current market values) I dont know In their Balance Sheets, these properties will appear at COST (not market values) Anything that you sell, you will be satisfying both conditions 1 You will have to monetize it (bcoz without monetizing, you cant sell) 2 A transaction will occur (a transfer will happen)
If you buy a brand, we will show this as an Asset - bcoz it has a cost, it has a transaction If you develop a brand, it will not appear as an Asset (it may be valuable), there is no cost, transaction Development costs are not assets, they are "expenses" COST VERSUS VALUE Cost is what you paid, value is what you expect to fetch if the asset is sold off today Accounting works on COST Cost is a "fact", value is an "opinion"
If you bott your house for Rs 10 lakhs in 2004 and today it is worth Rs 65 lakhs, your Bal She show Rs 10 lakhs Even this may have depreciated to Rs 8 lakhs As a result, the Bal Sheet may not reflect current reality It may be a very old ancient (and for some people - useless) financial statement Accountants have preferred to go by the COST model instead of the VALUE model
Bcoz value is subjective, nobody knows the value, value keeps changing, each expert will c his own estimate of value, value is based on something which never happened
What is the loss to the Government due to the 2G Scam? CAG - Rs 1.76 lakh crores Jayalalitha - more than Rs 2.00 lakh crores Raja - nothing Kapil Sibal - nothing
In the Govt's accounting of 2G licences, the actual amount of money paid by each operator would appear as a transaction If we got Rs 2,000 cr as licence fees, we will record only Rs 2,000 cr - fact
Warren Buffet says that financial statements are the "starting point" for any financial analy value (not the end of the exercise) Murugappa Group - wonderful building in Parrys called Parry House - 150 year old Cost may have been Rs 1 lakh Today, depreciated value will be zero Value today - Rs 200 cr
If you take their Balance Sheet, that property appears at zero, but you will "estimate" the p in your wisdom to be Rs 200 cr and value the share price accordingly Accountants are criticized for knowing the cost of everything and the value of nothing
DEPRECIATION All assets (other than land) have limited lives If you bott a car today for Rs 8 lakhs and you estimate is has a ten year life with a salvage v you should depreciate the car over the ten year period in such a manner that the carrying car in the Bal Sheet becomes zero after ten years Otherwise, the car will remain at Rs 8 lakhs One fine day, the car will stop working The entire asset will need to be written off on one day (this will become a loss)
You could depreciate the car at Rs 80,000 per annum This depreciation becomes an expense in the P&L and the carrying value of the car reduces Year 1 2 Op Bal Depn Cl Bal 800,000 80,000 720,000 80,000
720,000 640,000
3 4 5 6 7 8 9 10
Accountants are very simple people, they dont understand complicated stuff like inflation US Debt, S&P rating, etc, etc They record financial transactions If the value of money drops due to passage of time, etc, that is not for the accountant to d 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 l as compared to the cost What should he do now? He bott the land for Rs 5 lakhs and the value is irreparably down to Rs 2 lakhs The general principle is that we prefer cost over value We dont like valuation, etc, etc
But if there is damage to the asset (technically called IMPAIRMENT), then such damage shou Same car example - the car got caught in an accident after 2 years The value of the car is zero The car book value after 2 years may be Rs 6.40 lakhs The entire Rs 6.40 lakhs will be written off as Expenses on the day of the accident
On rare occasions, we may be forced to take the help of this VALUE animal, but we try to b 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 va The car that you bott for Rs 8 lakhs today morning is worth how much in the evening? Rs 7 lakhs So what is the depreciation of day one? If the car had a soul, when would it cry the most? On the first day Is the depreciation Rs 1 lakh? Answer No Depreciation does not link up with market values Depreciation is a result of "passage of time" 800,000 10 80,000 365 219
How long each asset will last - nobody knows So some legal guidelines have been provided - so that corporates dont come up with very s We do understand that the actual life may not be the same as the estimated life As a result of that, depreciation may be partly correct and partly wrong A ten year life of a car may turn out to be 8 or 12 years
Bank of England constructed its building 250 years ago in London and thought that the build for 100 years and depreciated accordingly Since the last 150 years, it is appearing in the Bal Sheet at one pound
Accounting is a profession largely concerning HISTORY Accountants are historians - financial historians In the modern complex world, some elements of future are intricately linked with the past To this extent, some estimates are unavoidable - we will use estimates reluctantly and rare Auditors are people who verify accountants and certify them to be true and fair
LIABILITIES 1 Insurance which does not return anything on maturity (only provides risk protect
2 3 4 5 6 7 8 9
Family ?? Any bills payable ?? House rent ?? Income tax ?? Utility bills ? Conveyance ? School fees ? Maintenance?
LIABILITIES VIS--VIS EXPENSES What is the difference ? You are living in a rented house from May 1, 2011 - monthly rent is Rs 9,000 For simplicity, assume today is Aug 31, 2011 Your financial year ending is March and the agreement is for three years You have paid the landlord Rs 15,000 so far What is your expense What is your liability 36 21
An expense is an expense whether paid or not If humanity understood this properly, credit card companies will go bankrupt
An expense happens when you "incur" the expense, not when you pay You have dinner tonight for Rs 5,000 and you pay thro a credit card at the rate of Rs 500 pe plus interest of 36% plus late payment charges and service tax and etc etc This payment happens over the next 10 months When should the expense be recognized? Today Why today You ate today
Dont confuse or mix up payment with expense - these are very different events - two disti 1 Expense happens along with payment - simultaneous You go to the railway station and have chai for Rs 5.00
2 Advances given Payment happens first, expense is incurred later 3 Stuff bought on credit (say 45 days) Expense happens first, payment happens later EXPENSE IS EXPENSE WHETHER PAID OR NOT - PRINCIPLE OF ACCRUAL I am struggling, I have too many liabilities I have a son who needs to go to college and a daughter to be married How old are they Son is 2 years old and daughter is 2 months old I am struggling, I have too many liabilities Son - I need Rs 45 lakhs Daughter - I need Rs 75 lakhs How much will appear as Liab in the Bal Sheet today Zero No historical liability as yet Future liab are not liab - they are only tensions - psychological stuff My daughter got married yday and the catering bill came to Rs 10 lakhs I have paid only Rs 3 lakhs so far Then, Rs 7 lakhs is a liability in an accounting sense
L&T Ltd Share Capital / Shareholders Funds Net Worth Bank Loans
2,000.00
5,000.00
Vendors Payable
500.00 7,500.00
Assets are sold for Rs 10,000 cr Vendors will be paid Rs 500 cr Lenders will be paid Rs 5,000 cr Balance Rs 4,500 cr goes to the shareholders Reliance Industries is liable to pay Mukesh Ambani
On liquidation, what is the priority of settlement: 1 Labour chaps PF, ESIC 2 Official liquidator of the High Court 3 Taxes 4 Secured lenders (bankers) 5 Unsecured lenders and vendors 6 Shareholders (Preference and Equity)
YOUR PROFIT & LOSS ACCOUNT for the period April 1, 2011 to Aug 14, 2011 Expenses House Rent Conveyance, Travel Food, Provisions Electricity, Water, Maintenance Cell phones, Landline phones, Satellite phones, all Phones Petrol, Diesel, Kerosene, LPG, LNG
Credit Card Expenses Interest expense on loans taken Depreciation Income Tax Salaries paid Entertainment, Medical, Theft, Damages Many expenses
9.50
Net Profit (savings during the period) (taken to Capital in the Bal Sheet)
2.50 12.00
Insurance Claims will tend to reduce your expenses - Your car got damaged and you spent R This is your expense - but the company gave you Rs 18,000 So your net expense is Rs 7,000
You placed a Fixed Deposit (5 year cumulative) with Indian Bank for Rs 10 lakhs on Feb 1, 2 Your financial year end is March, no taxes - special relief for Great Lakes participants Today is Aug 14, 2011 The interest and the principal will come back after 5 years, 10% interest What is the Income in the above P&L Zero ? INCOME IS INCOME WHETHER RECEIVED OR NOT There should be reasonable assurance of receipt We are assuming that Indian Bank will live for 5 years or more and they will be honourable Principal 1,000,000 Interest 10% Annual Interest Period - April 1 to Aug 14 Interest for this period
Income tax goes by this principle and you are supposed to pay tax accordingly Half of humanity is unaware and very few are questioned, so life goes on
TDS on Interest goes by this principle Investment in National Savings Certificates - Section 80C No interest ever declared
If you make profits year after year, your Capital / Net Worth will stand enhanced If you suffer losses, Capital will be eroded In cricket you can do only three things 1 Batting 2 Bowling 3 Fielding In financial accounting, there are only four corners: 1 Assets 2 Liabilities 3 Incomes 4 Expenses If you mis-classify through ignorance, that is an error If you mis-classify deliberately, that is a fraud It will change profits, capital When you go to your banker, you tend to overstate When you go the tax dept, you tend to understate BASIC ACCOUNTING EQUATION Every transaction will have two effects - Newton's laws of motion Assets + Expenses = Liabilities + Incomes
You bought a Washing Machine for Rs 25,000 and you will pay the shop after 7 days (he is y Assets Expenses Liabilities Vendor Payable 25,000
You bought washing powder for Rs 25 for this machine and paid in cash This is a short term item - consumable item Washing machine is a long term item - not consumed immediately or short term Cash Bal Washing Exps (25) 25
You bought a Washing Machine for Rs 25,000 and paid in cash Assets Expenses Liabilities
Pradeep starts a garments business - he has land of Rs 20 lakhs, bank balance of Rs 15 lakhs Company Name : Pradeep Garments Pvt Ltd (PGPL) Assets Expenses HDFC Bank 1,500,000 HDFC Bank (20,000) Cash on hand 20,000 HDFC Bank (100,000) Shop Deposit 100,000
1. Pradeep will bring in capital and the company will issue shares 2. Pradeep withdraws Rs 20,000 cash from the bank
3. He identifies a shop and leases it for 5 years, rental per month is Rs 20,000 and he pays a deposit of Rs 1 lakh
No transaction, no accounting
recruits 10 people at a salary of 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 shirt and he pays the vendor Rs 5,000 on account Inventories 20,000 HDFC Bank (5,000)
7. PGPL sells 60 shirts at Rs 450 per shirt and collects Rs 20,000 today 7a ) Sales
7b ) Cost of Sales
8. PGPL does aggressive marketing Approached potential customers 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 GAME 1 Monopoly 2 Vyapar 3 Trade 4 Business One table - 4 to 5 team You You You You reach Dehradun - Rs 2,300 can buy Dehradun for this price will be given Rs 20,000 cash by your banker - you can treat this is a loan 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, C You may run out of money You can mortgage your property cand raise a loan Banker will charge you 10% interest upfront You can also sell your property to the other teams - on an auction basis Banker will handle the proceedings You play around 20 transactions each
Each team will have two players - front office (plays the game) and back office (accountan of cash balance and historian - record the transactions) Dont make the Bal Sheet and P&L after every entry Make them finally At least one loan taken and one sale of property - recommended
inancial events)
Financial Statements
akhs per day, Rajnikant - Rs 15 lakhs per hour Balance Sheet Profit & Loss Photograph Video film Wealth Income Static Flow
u in 2011 also?
Assets - Own Application of Funds Where the Rupee went House Land, Ancestral Property Car Gold Computers, Furniture, Appliances
Shares Cash and Bank Balances Insurance Fixed Deposits Bonds, Mutual Funds, Post Office Deposits
keeps changing, each expert will come up with which never happened
has a ten year life with a salvage value of zero, in such a manner that the carrying value of the
rporates dont come up with very silly estimates me as the estimated life nd partly wrong
are intricately linked with the past l use estimates reluctantly and rarely
credit card at the rate of Rs 500 per month ice tax and etc etc
LE OF ACCRUAL
e to Rs 10 lakhs
7,500.00
Incomes Salaries, Bonus, Incentive Interest on Bank Deposits/Loans given House Rent Income Dividends Capital Gains on Shares Gifts, Inheritances
Scholarship (if more than expense) Tax refunds Royalty on books / other patents / IPR Lotteries, Gambling, Horse Racing, Cock fighting
12.00
l pay the shop after 7 days (he is your friend) Incomes Vendor Payable -
nd paid in cash
Incomes
FCT Vendor Payable Shirt Vendor Payable Salaries Payable Elec Tel Payable
Total
commitments, plans
Profit & Loss Account for the period duri Cost of Sales Sales Promotion Rent Salaries Electricity, Telephones Depreciation
Sales Promotion -
50,000 2,000 -
Balance Sheet at the end of the 9th transaction 1,500,000 Furniture, Comp, Telephones (110,000)
197,000
Shop Deposit HDFC Bank Balance 200,000 Cash on Hand 15,000 Inventories 50,000 Receivables 2,000 1,657,000 Total
1,657,000
Loss Account for the period during 1st to 9th transaction 12,000 Sales Revenue 50,000 20,000 50,000 2,000 3,000
27,000
(110,000) 27,000
27,000
Summary
1 Personal Balance Sheet Assets, Liabilities 2 Personal P&L Incomes, Expenses 3 Accounting Equation Assets + Expenses = Liabilities + Incomes 4 Depreciation - assets will reduce in book value with passage of time, because the limited lives At the end of their life, the asset should be brought down to zero (or to salvage 5 Cost versus Value We prefer Cost in accounting, we dont understand Value Value is merely an opinion, opinion keeps changing, value is not a FACT, it has n Cost is a historical fact, evidenced by various documents - bank statement, invoi 6 Principle of Accrual Expense is an Expense whether paid or not Unpaid expenses are liabilities Income is Income whether received or not Profit & Loss Account Incomes Expenses Profit
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 Profit 103 Income -3 100
Expenses
Presentation is the least of our problems, but the source of a lot of unnecessary confusion I am trading firm I bott I sold What is my profit or loss? Loss 40 Profit 20 Profit 25 The problem is that units are not matching What you bott and what you sold are not the same A comparison of Purchases with Sales will be wrong We need to compare Sales with COST OF SALES (Cost of Goods Sold) 80 units of Sales Revenue should be MATCHED with Cost of 80 units Sales Revenue Cost of Sales/Cost of Goods Sold Profit In America, they call this as COGS In manufacturing, three levels 1 What you bott (raw materials, consumables) 2 What you produced (finished goods) 3 What you sold (finished goods) Profit is on what? 1 Purchases 2 Prodn 3 Sales Only on SALES Transaction One I bott 100 units at Rs 3.00 each and paid by cheque Assets 80 80 3.25 3.00
Exps
Inventories 300 Bank Bal -300 I sold 80 units at Rs 3.25 each and recd cheque Assets a) Sales Revenue Bank Bal 260 b) Cost of Sales/COGS
Exps 0
You bott Delhi for Rs 7,000 I sold Delhi for Rs 7,500 Assets Property 7000 Bank Bal -7000 0 Exps
Exps 0
This can be done BUT it will the correct method of presentation if your business consists of and selling of properties What do you mean by the term "inventories" Your stock in trade - the item that you trade in, you manufacture and you keep selling day
In the Monopoly game, you can argue that I am a property company My business is to buy and sell property Property is my Inventory You say that I am an individual working in a software company I bott a house for Rs 20 lakhs and after 5 years, I sold it for Rs 38 lakhs How should I make my accounts You are not a property company and therefore property is not your Inventory Assets Property 7000 Bank Bal -7000 0 Exps
Sold Property
Exps
MONOPOLY GAME BALANCE SHEET Profit during the year Initial Loan Additional Loans Cash Balance/Bank Balance Payables Receivables xxxx Properties (you own at the end of Delhi Jaipur Agra Mathura
CORPORATE BALANCE SHEET AND P&L Concepts of Assets, Liab, Incomes, Exps are absolutely the same Many more terms will emerge Language is a major challenge Share Capital Equity Share Capital Preference Share Capital Capital Employed Capital Gains Working Capital Economics - Capital Formation Productivity of Capital REVIEW OF INDIA CEMENTS BALANCE SHEET - 5 YEARS 2007 TO 2011 Net Worth = Total Share Capital + Reserves + Revaluation Reserves Total Debt = Secured Loans + Unsecured Loans Total Liab = Net Worth + Total Debt Net Block = Gross Block - Accumulated Depreciation Total Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances Total CA, Loans & Advances = Total Current Assets + Loans & Adv + Fixed Deposits Total CL & Provisions = Def Credit + Current Liab + Provisions Net Current Assets = Total CA, Loans & Adv - Total CL & Provisions Total Assets = Net Block + Capital WIP + Investments + Net Current Assets + Misc Exp
Various sub totals are useful for analysis (not for totalling) Sources of Funds Shareholders / Owners Application of Funds Fixed Assets - long lived assets (> These assets are bott for usage, Slow moving, hardly changing Investments
Lenders
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)
Current Assets Assets which are held in the cour day running of the business - the soon be converted to Cash Fast moving, changing all the tim Inventories, Sundry Debtors (Rec Customers)
Fixed means long term Current means short term - Current means quick, fast SAME BALANCE SHEET IN A DIFFERENT FORM Sources of Funds Shareholders / Owners Money - take high risk
Lenders Money - some risk TOTAL LIABILITIES Application of Funds Fixed Assets - long lived assets (> 1 years) These assets are bott for usage, not for resale Slow moving, hardly changing Investments Current Assets Assets which are held in the course of day to day running of the business - these assets will
soon be converted to Cash Fast moving, changing all the time Inventories, Sundry Debtors (Receivables from Customers) Less : Current Liabilities Vendors Payable They have supplied us goods and services and we have not yet paid them - very soon we will pay them (< 1 year)
TOTAL ASSETS
In this format, Total Share Capital = Equity Share Capital + Share Application Money + Prefe What is Share Capital? When you subscribe for shares in a company, you get allotted some shares If you applied for Coal India Share in the IPO, you got those shares There are two types of Shares 1 Equity Shares 2 Preference Shares
Equity Shares is the risk taking instrument If the company fails, then the shareholders loses tons of money
Pref Shares get a "preference" over Equity shareholders If the company goes into liquidation, then Pref Shares are paid out before Equity sharehold It is slightly more safe (less risky) than Equity Shares
When the company pays out dividends (dividends are paid out of profits), there too the Pre get a Preference The Pref Shares are paid dividends and then Equity Shares are entitled to dividends
Dividends are discretionary - there is no complusion by law I made a profit of Rs 1,000 cr but paid zero dividends - you, as a shareholder, can do nothin
In India, Preference Shares, by law have to be "redeemed" - redeemed means paid back, bo If a company issues Pref Shares of face value of Rs 100, the company will declare that they these Shares after 7 years for Rs 100 They may also tell you that these Shares will carry a dividend of 8% per annum All the fun is gone - nobody is interested Returns are stable, redemption price is known Anything that is known loses attraction
In equity shares, there is no concept of redemption (company does not pay you back for yo 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 MONEY When the share issue process is in the pipeline The company announces an issue of shares on March 25th and people apply for these shares The allotment happens on April 11th So, on March 31st, the funds have come in, but shares have not yet been allotted So these funds will appear as Share Application Money Once the shares are allotted, the amount will be transferred to Equity Share Capital RESERVES Reserves are primarily "accumulated profits" Profits from the P&L are taken to Bal Sheet In the Bal Sheet, such profits are called as RESERVES If you are a 37 year old company, Reserves will have 37 years of profits The second source of Reserves is "Share Premium" You are Coal India - the IPO happened at a price of Rs 245 - face value per share is Rs 10 They are charging you a premium of Rs 235 Coal India's cash balance will increase by Rs 245 Share Capital will increase by Rs 10 (face value) Reserves will increase by Rs 235 (share premium) Balance Sheet
Having high Reserves does not mean/imply having huge Cash Balance If India Cements Reserves are Rs 3,700 cr and all of us decide to pay them a visit and meet 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 lifestyle Balance Sheet Reserves 35000 Bank Balance
All your Reserves are sitting in the Cash box You worked like this for five years, simple life, did nothing with the cash Balance Sheet after 5 years
Reserves
All your Reserves are sitting in the Cash box You got married Wife said - buy me a house She saw a house, costing Rs 1 cr You had no choice New Balance Sheet Reserves House 3,500,000 Bank Balance
6,500,000
Where are the Reserves? You have Reserves but no Cash The Reserves are in the house (maybe the kitchen was financed from Reserves) You may sometimes hear the term "Cash Rich Companies" These are companies which have tons of Cash and tons of Reserves India Cement has tons of Reserves but not much Cash Is it Cash Rich? No Sometimes, you may have Cash but not much Reserves - can that happen? Yes can happen Your Uncle gave you a loan of Rs 5 cr and so you have Rs 5 cr cash Are you rich? No - you have a rich Uncle India Cement has used all its Reserves in building factories, in its Inventories, in its Sundry REVALUATION RESERVES We will discuss this later (maybe tomorrow) Adjunct area, not an important area Revaluation is rare in India, it is disappearing NET WORTH is also called by various names 1 Shareholders Funds 2 Owners Funds 3 Shareholders Equity 4 Owners Equity 5 Just Equity (in the US, this is more common)
This represents the funds payable to Shareholders in the event of a Liquidation The company is liable to pay back its Shareholders this much of money This represents the amount belonging to Shareholders, brought in by Shareholders in the pa Brought in by shareholders directly and indirectly 1 Directly means they gave cash to the company and company allotted shares 2 Indirectly means past profits
If the company made a profit of Rs 100 cr and the company declared a dividend the balance Rs 95 cr also belong to the Shareholders But the Shareholders have allowed the company to "retain" these earnings Indirectly, they have contributed
DEBT means Borrowings, Loans taken Secured Debt means company has offered some security (collateral) Mortgage of fixed assets Hypothecation of current assets Most bank loans, financial institutions are secured SARFESI Act has substantially strengthened the power of the banking sector in recovering Se They can push off the corporate, sell the asset and recover their dues Unsecured Debt means no security has been offered Personal life - Credit Card dues, Personal Loans - horrible loans 30% cost If you have a single paise of these loans, your finances are badly managed Fortunately, in the Corporate Sector, having Unsecured Loans is not so bad Public Deposits are unsecured You, as an individual, can earn 9.25% in a SBI FD You can earn 10.25% in a Tata Steel FD HDFC FD earns you slightly more than SBI FD
Sales Tax Deferral Schemes - provided by the Govts of various States You set up a new factory in Himachal Pradesh Himachal Pradesh wants to encourage entrepreneurs Any new factory - you can collect Sales Tax on your product from your customers You are supposed to pay the State Govt next month But we will allow you to keep these funds with yourself for 8 years You pay us after 8 years
Such sales taxes collected but not yet paid will appear as Unsecured Loans in the
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 One year Annual Report will be 50 to 250 pages This Annual Report will give you lots and lots of information
APPLICATION OF FUNDS - ASSETS SIDE Fixed Assets Gross Block means the original cost of fixed costs Accumulated depreciation means depreciation from date of acquisition of the fixed asset ti Net Block means Gross Block minus Accumulated Depreciation You bought a car for Rs 8 lakhs and are depreciating it at Rs 75,000 per annum Year Gross Block Less : Accu Depn Net Block 1 8.00 0.75 7.25 2 8.00 1.50 6.50 3 8.00 2.25 5.75 4 8.00 3.00 5.00
Gross Block and Acc Depn are merely for disclosure purposes Only the Net Block goes into the total of the Bal Sheet Year Gross Block Less : Accu Depn Net Block A 500.00 65.00 435.00 B 2,000.00 1,565.00 435.00
What is this telling you? B is the older company - most probably B is also a larger company - most probably In the P&L you will find depreciation. How much will that be? Year Gross Block Less : Accu Depn Net Block P&L Depreciation 1 8.00 0.75 7.25 0.75 2 8.00 1.50 6.50 0.75 3 8.00 2.25 5.75 0.75 4 8.00 3.00 5.00 0.75
Capital Work in Progress Fixed assets which are under installation / under construction Factory is being built, not yet complete Machine is being installed, not yet ready
Pipeline is being constructed, not yet operational The amount in the Bal Sheet reflects the amount spent so far on this project When the asset is ready to be used, what will happen? This Cap WIP will be transferred to Gross Block From that day, depreciation will start If the amount in CWIP is huge, what does this mean? Huge expansion is happening - may be the fruits will be seen in coming years
Conversely, when a corporate says that our sales will grow 30% per annum for the next 5 ye you dont find too much in CWIP, what does that mean? They are lying ?
INVESTMENTS Strategic Investments 1 Investments in subsidiaries A company where you own more than 50% L&T has set up a company called L&T IT Ltd, another company called L&T Financ L&T has invested Rs 100 cr in L&T IT Ltd as subscription to share capital So, in the Bal Sheet of L&T, this will appear under Investments I am controlling the subsidiary - the subsidiary will listen to me 2 Investments in associates Associate is a company where we hold 20% to 50% The associate may or may not listen to me - I am not in control I have "significant influence" 3 Investments in joint ventures There is joint control (control shared with another party) All these are long term investments and will generally have some strategic importance They will not be entered into merely because L&T has surplus funds TREASURY INVESTMENTS Treasury means short term I have Rs 25 cr available for the next 4 days What should I do
I can buy a Liquid Mutual Fund which can generate 3.50% return (annualized) Strategic Investments are managed by Board of Directors Treasury is managed by the Finance Dept CURRENT ASSETS Assets which rotate, keep changing - purpose of these Assets is to generate Cash
Inventories in mfg and trading are tangible Raw Mat, WIP, Finished Goods, Packing Materials, Consumables, Stores and Spare Masterbatches In software and service sectors, you will have Unbilled Work Work that is in progress and you have not been able to bill for them Bcoz milestones are not reached as yet Sundry Debtors (also called Receivables, Trade Receivables, Outstandings) Invoices have been raised - product has been delivered, services have been rendered But the customer has not yet paid us - we have the right to collect If these are very high, what does it mean You are in trouble Or your customer is in trouble, which also means you are in trouble You are lazy, slow Your customer is really king Cash and Bank Balances - very simple Loans & Advances under Current Assets means Loans & Advances given by you 1 Staff Loans 2 Advances to Vendors 3 VAT Input Credit 4 Excise Duty Input Credit 5 Disputed taxes paid under protest 6 Any refunds due 7 Deposits for premises, Advance rent paid Deferred Credit Credit given by vendors over a long period of time If you buy a machine from Germany, the vendor may say - pay me after 11 months
Current Liab Your vendors payable, salaries payable, interest payable, expenses payable, electricity pay Provisions You know that some amount is payable but you are not sure of the amount You have estimated the amount
Your power company has overbilled you and you are fighting with them They are demanding Rs 50 lakhs and you think it should be Rs 20 lakhs But that is only your opinion, you also dont know the final amount at which it will be settl
In your Bal Sheet, you have shown a Provision of Rs 20 lakhs - you are not sure of this amou your MANAGEMENT ESTIMATE The moment you start estimating, some element of discretion, politics, manipulation enter Estimate, judgement are very dangerous terms - they can mean anything Rs 50 lakhs will not appear in the Bal Sheet Rs 20 lakhs will appear under Provisions Next year, I pay them Rs 22 lakhs and the matter is over Provision becomes zero Rs 2 lakhs goes into Expense (case of under provisioning) Legal suits, claims, disputed taxes, warranties, retirement benefits - provision examples MISCELLANEOUS EXPENDITURE Will discuss later
CONTINGENT LIABILITY This is not in the Bal Sheet, this is outside the Bal Sheet, this is not forming part of the tota This is only for disclosure Off Bal Sheet item Is not a liability as of today But it can become a liability in the future, if some events occur in a certain manner But such events may or may not occur - we dont know
Your dear friend wants a loan of Rs 20 lakhs He asked you and you said sorry - I am myself in need of a loan He went to a bank Bank wants a guarantor So he comes to you and you reluctantly sign the papers Today evening, in your Bal Sheet, should you show this Rs 20 lakhs as your Liability? No But But - it can become your liability in the future When If he does not pay and the bank comes after you It is not in your Bal Sheet, but you must tell your wife - disclosure Examples Guarantees given Legal suits, claims, disputed taxes Somebody files a suit on you and demands Rs 100 lakhs Your lawyer says the suit can be settled for Rs 5 lakhs Provision in the Bal Sheet of Rs 5 lakhs Contingent Liab off Bal Sheet of Rs 95 lakhs If Cont Liab are too high, analysts can get a little frightened - whether these are Real Liab management has mis-classified INDIA CEMENTS - P&L You sell cement for Rs 220 per bag Add : Excise duty of 16%
16%
What is your Revenue You are a postman for the Govt of India You collect from the customer and pay the Govt - free service that you are rendering for th In the P&L, we will show this as under:
Sales Less : Excise Duty Net Sales Other Income Other Income should mean other than cement (core activities) But in reality, things can get mixed up Sometimes, you may not be sure of how much is real Other and how much is half Other
If Other Income is very high (say more than 20% of Profit Before Tax), then Analysts get wo Bcoz the behaviour of Other Income in future is not known, unpredictable, may not be sust be volatile, may disappear, may be fraudulent, bogus Stock Adjustment When your production is not equal to Sales, profits should be measured only on Sales But costs may be incurred on production Sales Less : COGS What is COGS - Cost of Goods Sold 100
25
Diff between Sales and Production will be the same as Diff between Opening Stock and Clos 20 = 20
Stock Adjustment means diff between Closing Stock and Opening Stock (Prodn and Sales) Sales Revenue - Income - based on Sales Quantity Stock Adjustment (diff between Sales and Prodn) Expense Costs - based on Production Quantity The P&L matches properly
I am trading firm I bott 100 units at Rs I sold 80 units at Rs Real profit is Rs Indian P&L Sales Stock Adjst 20
80 20
3.25 3.00
100
3.00
300.00 20.00
80
3.00
PBDIT - Profit Before Depreciation, Interest and Taxes - UK dictionary EBIDTA - Earnings Before Interest, Depreciation, Taxes and Amortization - US dictionary Both mean the same Amortization is depreciation on intangible assets You depreciate a table and amortize a patent EBIDTA is more popular in the world and in India
3400
Operating Costs Raw Mat, Power, Employees, Mfg, Selling, Admin, Misc EBIDTA Depreciation & Amortization EBIT Interest EBT / PBT Tax PAT / Net Profit Dividends Retained Earnings (goes to Reserves) 500 250
70
The business is responsible for EBIDTA The finance side is responsible for the journey from EBIDTA to PAT Your EBIDTA is very strong But you have tons of Debt Your PAT may not be that strong Your EBIDTA is very mediocre But you are a zero debt company Your PAT may be okay Cash Profit will be 70 + 250 = 320
The term Operating Profit can mean several things to different people In this website format, Operating Profit is computed as EBIDTA excluding Other Income (Co EBIDTA from Core Activities EBIDTA Less : Other Income Core EBIDTA (Operating Profit) 475.63 125.59 350.04
Other companies may define Operating Profit to be the same as EBIDTA So dont go by this one meaning
Some terms are loosely defined Operating Profit, Gross Profit, EBIDTA itself (sometimes it includes Other Income, sometim Other Income) Finance is a social subject - depends on evolution of humanity, behaviour EXTRA ORDINARY ITEMS Personal life Salary - Core Income Interest - Other Income Dowry - Extra Ordinary Income Unusual, Non recurring, Material What is your annual income You say Rs 61 lakhs ? VALUE ADDITION A term used by economists more than finance professionals It means your sale price minus your material costs You buy fabric for Rs 200 and you convert it into a shirt and sell the shirt for Rs 450 You are adding Rs 250 value to the society We dont use this much in Finance Website has calculated it differently We will ignore this for our discussion
GROWTH Everyone - management, shareholders, stock market, employees, vendors, customers are a in growth How much are you growing How fast are you growing How fast is the industry growing Are you faster than them Long term growth is best represented by CAGR CAGR - Compounded Annual Growth Rate (Compounded Average Growth Rate) TO DO: 1 Work out the CAGR for many line items in the P&L and the Bal Sheet
Sometimes, the CAGR may be useless - you need to figure out which ones are me and which are not 2 Some insight into our findings
derstand Value hanging, value is not a FACT, it has not HAPPENED us documents - bank statement, invoice
Loss is plus 3
100 3 103
of Goods Sold)
Only on 2 tons
Liab
Incomes
Liab
Liab
Incomes
Liab
perty company
it for Rs 38 lakhs
Liab
Gross Net
RS 2007 TO 2011
Application of Funds Fixed Assets - long lived assets (> 1 years) These assets are bott for usage, not for resale Slow moving, hardly changing Investments Current Assets Assets which are held in the course of day to day running of the business - these assets will soon be converted to Cash Fast moving, changing all the time Inventories, Sundry Debtors (Receivables from Customers)
1. One below the other 2. Curr Liab appear on the assets side but as a negative Owners Capital, Bank Loans, Fixed Assets, Investments are managed by top management Top Half is managed by Top Management
Bottom half This area of Current Assets and Current Liab is generally
managed by middle management in any company Day to day stuff What to buy, what to produce, how much to produce, when to sell, whom to sell, how many days credit from the vendor, how days credit to the customer
Common variety - comprises 99.999% of Shares in India Rare - hardly 0.001% falls here
med" - redeemed means paid back, bott back 0, the company will declare that they will redeem
ompany does not pay you back for your shares ever) becomes Rs 5,000 in 7 years (may not)
37 years of profits
245
uge Cash Balance s decide to pay them a visit and meet the Cashier tons of cash (Reserves)
eserves gone?
Bank Balance
35000
Bank Balance
3500000
Bank Balance
10,000,000 -
ity (collateral)
oans - horrible loans 30% cost our finances are badly managed g Unsecured Loans is not so bad
ans of India Cement, what can you do? download the Annual Report
Balance Sheet Balance Sheet Balance Sheet P&L is for a period of time (for that one year)
d, another company called L&T Finance Ltd subscription to share capital r under Investments ary will listen to me
- I am not in control
another party)
iscretion, politics, manipulation enters into the picture can mean anything
ofit Before Tax), then Analysts get worried nown, unpredictable, may not be sustainable, may
Controlled by Finance Top Management Policies These people need know Cement
he same as EBIDTA
humanity, behaviour
10 1 50 61
INDIA CEMENTS - BALANCE SHEET Mar '11 Sources Of Funds Equity Share Capital Reserves Revaluation Reserves Networth Secured Loans Unsecured Loans Total Debt Total Liabilities 307.18 3,782.58 4,089.76 1,177.86 1,278.21 2,456.07 6,545.83 307.17 3,221.09 607.56 4,135.82 866.64 1,266.09 2,132.73 6,268.55 282.43 2,683.03 665.93 3,631.39 1,036.25 951.78 1,988.03 5,619.42 Mar '10 Mar '09
Application Of Funds Fixed Assets Gross Block Less: Accum. Depreciation Net Block Capital Work in Progress Investments Current Assets Inventories Sundry Debtors Cash and Bank Balance Loans and Advances Fixed Deposits
Total CA, Loans & Advances Current Liabilities Provisions Total CL & Provisions Net Current Assets Miscellaneous Expenses Total Assets
Mar '08
Mar '07
11.3% 8.2%
30.6%
11.3%
INDIA CEMENTS - PROFIT & LOSS ACCOUNT Mar '11 Mar '10 12 mths 12 mths Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income Expenditure Raw Materials Power & Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Admin Expenses Miscellaneous Expenses Total Expenses EBIDTA Interest PBDT Depreciation Other Written Off Profit Before Tax Extra-ordinary items PBT (Post Extra-ord Items) Tax Reported Net Profit Equity Dividend Corporate Dividend Tax
565.84 1,020.08 265.44 57.38 1,165.91 3,074.65 475.63 141.72 333.91 244.03 89.88 89.88 21.77 68.10 46.08 7.65
540.62 999.85 276.81 47.18 953.30 127.07 2,944.83 920.81 142.64 778.17 233.12 13.74 531.31 531.31 176.98 354.34 61.43 10.20
406.38 891.60 218.74 49.99 769.93 96.50 2,433.14 973.93 112.15 861.78 203.32 10.24 648.22 0.09 648.31 216.13 432.18 54.85 11.23
340.90 690.75 186.61 30.87 664.35 68.50 1,981.98 1,092.96 109.95 983.01 127.92 10.44 844.65 844.65 207.10 637.54 65.89 0.90
CAGR
10.5% 10.9%
260.86 549.00 103.40 25.14 541.66 34.34 1,514.40 754.77 149.80 604.97 102.63 10.38 491.96 491.96 13.13 478.83 30.46 19.65
19.4% -10.9% -1.4% -13.8% 24.2% -34.6% -34.6% 13.5% -38.6% 10.9%
Fixed Assets Long Term Strategic Investments Current Assets Less : Current Liabilities
The rules are different For top management, the skills required are: 1 Vision, Foresight 2 Macro thinking - Globe, India, Tamil Nadu, Cement sector, India Cement 3 Guts 4 Financial wisdom, strategy 5 They need to be contemplative, meditative, slow (not hasty), deep thought 6 More of thinking and less of action - playing chess 7 Implications are long term - if you make a mistake, you will suffer for a long long 8 Need the ability to live with lack of clarity For middle management, the story is entirely different - what skills do you need? 1 Buy buy buy raw material 2 Produce produce produce 3 Sell sell sell 4 Collect collect collect 5 Buy buy buy raw material No vision, no foresight, no macro thinking Most important skill is simple solid hard work Land up there at 900 and work work work
You need good rules to direct the middle management You need good scorecards - to measure how they are performing - week by week India, as a country, great vision - each Planning Commission is a fantastic piece of art Implementation - middle management - is almost non-existent
Pakistan, bad vision Great implementation - each terrorist attack is highly successful - operational excellent 1 Liquidity Middle Mgt
Cash comfort in the short run - can I pay my salaries, vend Will I have to beg, borrow or steal to make these payment If you are uncomfortable, you are facing a liquidity challen How fast am I able to rotate my funds in the short term Rolling of funds Cash comfort in the long run - can I pay my 20 year home In a company, can I pay my long term loans comfortably Insolvent means unable to pay these debts - bankruptcy Profits in relation to Sales - Margins Profits in relation to Investment - Returns
4 Profitability
5 Valuation
LIQUIDITY CURRENT RATIO = Current Assets / Current Liabilities Current Assets are items that will generate cash for you in the short term Curr Liab are items that will take away cash from you in the short term Current Assets will include Loans & Adv Current Liab will include Provisions Current Ratio 1,734.80 494.28 3.51
For every one rupee of Curr Liab, we have the support of Rs 3.51 of Curr Assets In your personal life, lets assume there are no credit cards, debit cards, ATMs Your daily exps are Rs 100 You have cash in your pocket of Rs 351 Are you comfortable? Yes What is the ideal Current Ratio?
Ideal ratios are quite difficult to define in a sociological science like finance Any ideal ratio should be taken with a pinch of salt, should not be blindly applied
Banks will insist on a Current Ratio of at least 1.33:1 in most sectors If your Current Ratio is less than 1.33, then banks will feel quite uncomfortable in lending t your short term requirements Could vary between sectors 1.20 to 1.45 could be a reasonable range
That insistence by the bank on maintaining certain ratios is called as a COVENANT Financial covenants are conditions that the corporate agrees and if the corporate fails, the withdraw their facilities
If the current ratio of a company is say 0.95:1, 0.90:, 0.85:1 - what will you say Liab are high, not enuf Curr Assets, liquidity challenge ?? If I tell you that these companies are Hind Lever, Glaxo, Pfizer - how will you react now? They are not doing well ??
As a supplier to these chaps, will you be frightened by looking at the Curr Ratio? Will you re Will you limit your exposure? They are using suppliers funds as a major source of funds Great idea? Good idea We also should do that Every well managed company should have a Curr Ratio of less than 1.00 Banks are idiots Working Capital = Current Assets - Current Liabilities
Some people argue that negative working capital is a fantastic thing When Curr Liab are more, then Working Capital will be negative and Curr Ratio will be < 1. We should use suppliers funds to run our business We should not invest our own funds too much You are making money on their money - great idea
Negative working capital is dangerous, bad idea You have to return short term liabilities in the short term You cannot convert short term liab to long term liab - if you do that, people will stop deali or will make life difficult for you
The Bal Sheet is wrong There is a line item called "Investments" Investments are of two types - Strategic and Treasury Treasury Investments are really Cash in Hand (temporary cash parked in financial instrumen Current Assets Current Liab Simple Current Ratio Short Term Investments Real Current Assets Real Current Ratio 5,000 5,500 0.91 2,000 7,000 1.27
Some companies have a Curr Ratio of 10:1, 12:1, 15:1 What will you say about these chaps? Not investing in long term stuff ? Money not being utilized properly ? Your daily expense is Rs 100 You keep Rs 50,000 in your pocket every day I ask you why I need for my expenses Am I happy with that answer They are afraid of something? Cant say much ? Waiting for the right opportunity? Maybe inventory is building up? Incompetence? Bad production planning? Bad marketing? They dont have too much of fixed assets? Service industries? These companies are Infosys, Wipro, TCS, etc Huge Current Assets Within Current Assets, it is Cash - huge Cash
Infy - Rs 15,000 cr You ask Infy why do you hold so much Cash - why dont you use it somewhere - is this not in
Infy has two answers: 1 We need money for acquisitions If a good acquisition comes up, typically there are many competitors who also w If we can pay fast, we have a brighter chance of acquiring 2 We are not merely vendors for our customers - we are their lifeline Infy has a customer - RBS RBS runs on Infy systems RBS gets into some trouble in Europe because of global problems RBS does not pay Infy on time So Infy is not able to pay salaries on time So people leave Is that a good idea?
Infy says that we should have a huge cash balance on hand so that even if our customers do we are able to pay our employees smoothly Customers look at our financial strength before awarding contracts to us We compete with Accenture, IBM IBM Cash Balance - Rs 250,000 cr Infy Cash Balance - Rs 15,000 cr Provisions are Curr Liab, but the amount is not very clear - management estimate LET ME KEEP A PROVISION FOR CONTINGENCIES - THIS IS SIMPLE ENGLISH LET ME MAKE A PROVISION FOR LIABILIITES - THIS IS ACCOUNTING ENGLISH In your personal life, I recommend that you should keep some cash at home - all the time What will happen when - you dont know Suddenly somebody needs to be hospitalized - 2 am in the morning Hopsitals dont entertain - unless you pay cash
This is keeping a provision for adverse possible events - simple English An Accounting Provision means something is payable to someone - but you dont know the a terms - you are fuzzy about the amount
Before jumping to simplistic conclusions, a little bit of reading on the sector, its challenges will be helpful BURN RATIO Very useful for start ups In a start up, revenues are uncertain or may be zero (not yet kicked off) But exps are ongoing How long can my current cash balance last? Cash Balance is Rs Exps per week are Rs I can last only 500 125 4 weeks
Within 4 weeks, I need either Revenue or additional Equity Capital or additional Debt India faced this problem in 1991 - year of liberalization India's forex balance was equivalent to 2 weeks of Imports At that time, we mortgaged gold and got some dollars The IMF insisted that we should open up our economy to foreignors FDI policy, FII policy - we invited foreignors Stock market opened up Info tech sector, Call centres - liberalized Now we are v v v prosperous All this liberalization was not our vision We protested and protested, but the IMF compelled us, pushed us into prosperity The heart of it was the Burn Ratio 1791 to 1991 1991 to 2011 - we have done better in 20 years Cash Balance (in weeks) = Cash Balance Exps per week 1,514.40
52
EFFICIENCY RATIOS
Rec'bles Days
138
Fin Goods
We want to know how fast you are in this Cash to Cash Cycle Why is speed important? You are running an auto rickshaw You work for 8 hours, but billable time is only 3 hours Bal 5 hours you are waiting Two people invest Rs 100 in their business One rotates this money 3 times One rotates 5 times TIME IS MONEY RECEIVABLES (DAYS) : How long are my customers taking to pay me Receivables (Days) = Receivables (Sundry Debtors) Gross Sales per Day 260.21 = 7.15 36
7.15
INVENTORIES (DAYS) : How long do I take from raw material stage to prodn to selling the Inventories (Days) = Inventories Mfg Cost per Day Inventories Mfg Cost for the year Raw Mat Power Employees Other Mfg Costs Total Mfg Cost Days per annum Mfg Cost per Day 248.50 260.86 549.00 51.70 25.14 886.70 365.00 2.43 = 248.50 2.43
103.4
SOLVENCY RATIOS Cash comfort in the long run Can I repay my long term debt comfortably In Indian context, we generally club the long term debt and short term debt In the Indian Bal Sheet, we have something called Loans (Secured + Unsecured) In reality, short term loans may be longer than long term loans How come Working capital facilities from the bank are generally renewed every year Generally these are limits and not loans In a loan, the bank gives you Rs 10 cr and you repay Rs 10 cr In a limit, the bank tells you that you can draw upto Rs 10 cr You may draw, then deposit cash, again draw, again deposit In US they call this as Revolver Savings Bank Account min balance is zero In a Cash Credit Account, the min balance can be minus Rs 10 cr
1 2 3 4
The advantage is that you pay interest only for those days when the balance goes negative Next year, my business grows So I ask the bank for a limit of Rs 12 cr Third year - Rs 18 cr 29th year - Limit Rs 1,000 cr When did I repay this loan? In reality, short term loans may be longer than long term loans Ratios 1 Debt Equity Ratio In your funding, how much is lenders funds and how much is owners funds Debt is good bcoz it is cheap (cheaper than equity)
You start a new business, you need Rs 50 cr, you have Rs 25 cr You have an option - either you get a loan for Rs 25 cr or you get a partner for R
Which is better Partner will demand 50% share of profit, share of ownership, share of office spac share of foreign trips
Secondly, the interest that you pay the bank is tax deductible (it is an expense i However, share of profit that you pay your partner is not an expense (from tax p First I pay interest Then I pay income tax Then I pay dividend Interest is a tax deductible expense
Dividend is not an expense, it is merely sharing Which profits? Post tax profits
If I pay the bank 13% interest and my tax rate is 30%, the effective cost of intere
30%
How much did my PAT fall due to interest 42 How much interest did I pay 60 How come? I get a tax benefit by claiming interest as an expense 30% of the interest is borne by the Govt of India - Govt of India is my partner You pay 11.5% housing loan interest Home loan interest is tax deductible upto Rs 1.50 lakhs per annum Your tax rate is 30% By paying this interest, you have been able to reduce your tax expense
The effective cost of interest is = Rate of Interest x (1-t), where t is the tax rate Rate of interest is Tax rate (t) 1- t Interest x (1-t) 11.50% 30% 70% 8.05%
So, the next thought could be why not borrow and borrow and borrow more Why should you invest your own funds at all Why not have 99% Debt and 1% Equity High debt is high risk - ability to repay ?? High debt means - you will do very good if the going is good Conversely, you will do very bad if the going is bad Risk means volatility of returns Debt Equity Capital employed Return on Capital PBIT 100.00 100.00 20% 20.00 100.00 100.00 30% 30.00 100.00 100.00 5% 5.00
Debt Equity Capital employed Return on Capital PBIT Interest 14% PBT Tax 30% PAT Return on Equity
70.00 30.00 100.00 20% 20.00 9.80 10.20 3.06 7.14 23.8%
70.00 30.00 100.00 30% 30.00 9.80 20.20 6.06 14.14 47.1%
Debt Equity Capital employed Return on Capital PBIT Interest 14% PBT Tax 30% PAT Return on Equity
99.00 1.00 100.00 20% 20.00 13.86 6.14 1.84 4.30 429.8%
99.00 1.00 100.00 30% 30.00 13.86 16.14 4.84 11.30 1129.8%
Debt Equity = Debt / Equity Debt means Loans taken (Secured + Unsecured) (taken means amount drawn from Equity means Net Worth (Capital + Reserves) Generally, we ignore Revaluation Reserves in the computation of Net Worth
How much debt is good? Sector dependent Infra - 5:1 Power - 4:1 Aluminum - 3.5:1 Cement - 2.5:1 Pharma - 1.5:1 Software - Zero:1 Consulting - Zero:1 Call Centers - 1:1
Capital intensive sectors tend to carry more de Asset light sectors will have low debt / zero de 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 ea per annum, you should borrow less than him Colgate make a profit of Rs 1,000 cr Sterlite also makes a similar profit of Rs 1,000 cr
Colgate can borrow more - steady income, people generally have teeth and gene and will keep brushing for some more centuries - brand is established Sterlite - copper, zinc, aluminum - prices - change everyday - demand - what wil Debt Net Worth Less : Reval Res Revised Net Worth Debt Equity Ratio 2,058.76 2,208.53 781.98 1,426.55 1.44 : 1
For every one rupee of own funds, India Cements has borrowed Rs 1.44 Interest Coverage Ratio = EBIDTA / Interest EBIDTA Interest Interest Cover
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 - Tax Interest + Annual Principal Repayment 754.77 13.13 149.80
EBIDTA Tax Interest Annual Principal Repayment Total Debt 2,058.76 Tenor (assumed) 8 DSCR
741.64
257.35
407.15 1.82
For every one rupee that I need to pay the bank (towards interest and principal) support of Rs 1.82 of earnings
Banks look for a DSCR of at least 1.60 times (for a great company they may be happy with 1 We are looking at repayment capability (not actual repayment) If you go for a home loan, how much will the bank lend you? 1 80% of the cost of the house 2 60 months of salary - logic behind this limit is - if you are earning x rupees, how you devote towards EMI 40% of your salary can go towards EMI More than that will be difficult bcoz you have to also live EMI / Earnings is 40% DSCR = Earnings / EMI = 2.5 times
The home loan company imposes a DSCR of 2.5 times DR L C GUPTA'S RESEARCH Can financial ratios help me in predicting sickness? Sickness can lead to corporate failure, bankruptcy, etc Do ratios have predictive ability? If yes, which ones? He picked up 200 sick companies and went back in time Before they fell sick, how did the financial ratios look (3 years before, 5 years before) Apollo - wellness - how well are you You have a 15% prob of developing xyz illness in the next 10 years Three types of ratios 1 P&L numbers / P&L numbers 2 Bal Sheet numbers / Bal Sheet numbers 3 P&L number / Bal Sheet number (or vice versa) He found that the third category was more useful in prediction In particular, he found the DSCR was excellent in predicting sickness He assumed an 8 year tenor of loans for this purpose Debt / EBIDTA Debt EBIDTA Debt / EBIDTA
Crudely speaking, we can say that 2.73 years of EBIDTA can retire all the debt PROFITABILITY RATIOS Margins Profit in relation to Sales Returns Profit in relation to Investment in Business What does the owner want ? Margins or Returns ? Returns is the objective of the owner 1 High margin high return strategy 2 Low margin high return strategy 3 High margin low return strategy 4 Low margin low return strategy
Low margins may be accompanied by high volumes and faster time cycles Sometimes low margin may be deliberate strategy Sometimes, it may be market compulsions - you dont have a choice MARGINS There are many variants of these formula - I am giving you the mainstream formula Operating Profit Margin = EBIDTA or Core EBIDTA Net Sales 754.77 2,255.21 Net Profit Margin = PAT Net Sales 478.83 2,255.21 21.2% 33.5%
Margins are high in service sector, sectors driven by strong brands, technology, patents and sectors with a high entry barrier In contrast, sectors with heavy competition will face low margins Cyclical sectors will face cyclical margins Boom
Recovery
Recession
Depression EBIDTA margins are generated by the "business people" Net Profit margins are generated by business + finance put together
Great EBIDTA, bad NPM - you know whom to blame Poor EBIDTA, poor NPM - bad times, you can blame God Great EBIDTA, great NPM - good times, you can praise each other Poor EBIDTA, great NPM - could be fraud?? RETURNS RoCE = Return on Capital Employed =
EBIT - Earnings Before Interest and Taxes Cap Emp = Net Worth + Debt (funds deployed by business - including bankers fun How much is the business generating EBIDTA Depreciation EBIT Cap Emp 4,267.29 RoCE 754.77 102.63 652.14 3,485.31 exclude Reval Res 18.71% Return from the Business
781.98
I earn 18.71% on the entire capital employed including funds provided by banks But I pay the banks only 11% or 12% or something I, as the owner, earn not only on my funds but also on the bankers funds Reliance is in the business of what? Oil & Gas, Petrochemicals, Refining, etc Mukesh Ambani is in what business?
Mukesh Ambani is in the business of making money Making money has two angles: 1 Making money from petrochemicals, Oil & Gas, Refining 2 Making money from money Why is Finance Dept required in this world? What value do they bring to humanity? The answer is - they convert the 18% RoCE to a 33% RoE
Mukesh Ambani earns 18% thro Engineering efforts and 15% thro Financial skills, thus earnin
PERSONAL EXAMPLE You buy a second house for Rs You let it out on rent and earn After 2 years, you sell the house What is your rate of return Earnings Rent Capital Gain
Rate of Return
The same house, you bott using a loan of Your own equity You paid interest per annum of Two years interest Your earnings Rent Capital Gains Less : Interest
Rate of Return
Solvency 1 2 3 4 Debt Equity Interest Cover Debt Service Cover Debt / EBIDTA
Fixed Assets Long Term Strategic Investments Current Assets Less : Current Liabilities
Top Management
Middle Management
hort run - can I pay my salaries, vendors, power bill rrow or steal to make these payments able, you are facing a liquidity challenge / crisis rotate my funds in the short term
ong run - can I pay my 20 year home loan comfortably ay my long term loans comfortably ble to pay these debts - bankruptcy
Sales - Margins Investment - Returns EPS, PE, Dividend yield, Book Value, PBV
cash for you in the short term h from you in the short term
ios is called as a COVENANT agrees and if the corporate fails, then bankers can
se of global problems
ing contracts to us
- simple English o someone - but you dont know the amount in certain
216.15 = 29.12
7.42 weeks
Raw Mat
102 WIP
aking to pay me
days
k is tax deductible (it is an expense in your P&L) partner is not an expense (from tax point of view)
ndia - Govt of India is my partner 11.50% 30% 3.45% 8.05% 90000 27000 63000
he going is good
Too safe
High Risk
tensive sectors tend to carry more debt t sectors will have low debt / zero debt
people generally have teeth and generally do brush turies - brand is established change everyday - demand - what will China do
times
ve to also live
icting sickness
Not interesting
have a choice
This may be better for India Cement 9.46 745.31 2,255.21 33.0%
e put together
1 What do we read from the book Read Chapters 1, 2 and 3 from the book given to you That is good enough
2 Please note that the book is American style and we are using Indian financials So terminology will vary slightly - try and get the broad message and dont look
3 Further reading - what can you read Try and start reading Research Reports on corporates written by brokerage hou If you understand 50% or more of these Reports, that is a good starting point What you dont understand - you should network amongst yourselves, other tha Google, Facebook, etc
4 What is our assignment, test, exam, homework Assignment - will be - to analyze at least two companies from diff sectors - you Auto, Chemicals, Engg, Pumps, Compressors, Trading - Retail, Airlines Group of 4 people 5 Test - I dont know The course content will be based on our Excel files
Curr Ratio = Curr Assets/Curr Liab If I give you the Cur Ratio and the Curr Assets, you should be able to find the C
ritten by brokerage houses a good starting point st yourselves, other than your Group
OCTOBER 2011 EXAM CALCULATORS ALLOWED LAPTOPS, TEXT BOOK, NOTE BOOKS, NOT ALLOWED 60 MINUTES DURATION 100 MARKS RAGHU IYER
QUESTION ONE State whether true or false 1 Balance sheet captures point of time numbers 2 Accounting equation says : Assets + Expenses = Liabilities + Income 3 You bought a house in 1981 for Rs 25,000. Today it is worth Rs 25 lakhs. This h appear in your Balance Sheet at Rs 21,000. 4 Out of your salary income over the past ten years of hard work, you have built Fixed Deposit of Rs 15 lakhs. This will appear as Capital in your Balance Sheet 5 Depreciation is charged in financial accounting because market prices of asset fall after you have bought them 6 Your expense for the last six months on a particular line item was Rs 50,000. O you have paid Rs 35,000 so far. Your liability on this account will be Rs 15,000 7 You bought petrol for your car for Rs 1,400 today. Of this you paid Rs 500 by c Rs 900 through a credit card. Your expense for today is Rs 500. 8 You have placed a purchase order for some components for Rs 2 lakhs today. T increase your assets and your liabilities in your Balance Sheet of today evening 9 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your Sheet as of today evening, this amount will appear as a Liability 10 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your Sheet as of today evening, this amount will appear as an Asset
QUESTION TWO In each of the transactions below, indicate which of the four items will increase / decrea be affected at all: Assets 1 You bought furniture on credit 2 You deposited cash into your bank account 3 You opened a bank locker and paid
4 5 6 7 8 9 10
some bank charges You appointed a Manager in your company You bought inventories and paid cash You paid an advance towards travelling expenses to your sales person You launched an advertising campaign and incurred expenses towards an event, not yet paid for You sold an old machine at book value and got cash Your month is over, but you have not yet paid salaries of this month Your customer paid you a cheque
QUESTION THREE 1 Your current assets are Rs 50 crores. Your working capital is Rs 20 crores. Work out the Current Ratio 2 Inventories comprise 42% of your Current Assets. These are carried on an average for 100 days. Work out the Mfg Cost of the year 3 Receivables comprise 34% of your Current Assets. These are carried on an average for 61 days. Work out the Sales turnover for the year QUESTION FOUR 19 Marks Your equity is Rs 100 crores and debt is Rs 25 crores. You want to raise more debt. Your EBIDTA is Rs 30 crores. Interest rates are approx 12.5%. Bankers are insisting on a max debt equity ratio of 0.6:1 and a minimum interest cover of 3 times. How much incremental debt can this company now take on? QUESTION FIVE Rs cr Sales EBIDTA 800 125 20 Marks
35 10 24 100 30
20 Marks
rd work, you have built up a in your Balance Sheet market prices of assets generally
e item was Rs 50,000. Of these, count will be Rs 15,000. is you paid Rs 500 by cash and
for Rs 2 lakhs today. This will Sheet of today evening. of Rs 50 lakhs. In your Balance Liability of Rs 50 lakhs. In your Balance
are carried on
raise more
Ten Sessions of Two Hours each - Total Twenty Hours 1 Valuation Ratios, DuPont Analysis 2 Cash Flow Statement 3 Compounding and Discounting 4 Workshop on Compounding and Discounting 5 Payback period, NPV 6 IRR, Discounted Payback Period 7 Profitability Index, Pros and Cons of Various Methods 8 Business Examples and Workshop applying above methods 9 Derivation of Cash Flows for evaluating capex proposals 10 Workshop on Cash Flow Derivation
Current Ratio, Burn Ratio Interest Coverage, DSCR, etc Inventories (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 reward By who? How ? By the markets By pushing your company valuation upwards 5 Valuation Ratios
STOCK MARKET RELATED STUFF 1 Earnings per Share EPS EPS = Net Profit (PAT) / No of Shares PAT Equity Share Capital Face value per Share No of Shares EPS
This is telling you how much the company is earning per Share Per Share numbers are very popular in the stock market (not among managem In the stock market, you buy that one share for say Rs 75 You want to know what the company is earning on MY ONE LITTLE SHARE The most important word it the world is ME, MY, MINE, AHAM The investor community will correlate the price of Rs 75 to the earnings of Rs with their own ideas
If you were Naresh Goyal and you were buying the entire Sahara Airlines, you worried about per Share numbers Rather you would worried about the total EBIDTA, total PROFIT
You should be able to watch CNBC intelligently and understand 50% of what th Forward EPS and Trailing EPS Trailing EPS means the EPS of the latest four quarters Today's date is Oct 29, 2011 What is Trailing EPS ? If Sept 2011 results are out, then Trailing EPS will be Profits of the period Oct 2010 to Sept 2011 / No of Shares If Sept 2011 results are not out, then Trailing EPS will be Profits of the period July 2010 to June 2011 / No of Shares Forward EPS is a for a future period It is not known, it is estimated - future is not known CNBC says Sensex EPS for FY 12 is expected to be Rs 1,185 CNBC says Sensex EPS for FY 13 is expected to be Rs 1,301 Each brokerage house may have its own estimates of Forward EPS Each brokerage house may change its estimates with passage of time In EcoTimes, on page 4, you may read that India Cements EPS is Rs 2.22 In EcoTimes, on page 7, you may read that India Cements EPS is Rs 7.03 Which is right? Both may be right - one may be Trailing and the other may be Forward Forward EPS may refer to any period FY 12 means what period ? April 2011 to March 2012
One year forward means what period? Today, bcoz today is Oct 29, 2011, one year forward will typically mean Oct 2 One year forward Sensex EPS is estimated to be Rs 1,243 Europe US is December India is March US - S&P 500 - FY 12 EPS is estimated to be say Rs 103.45 What do they mean? They mean Jan 2012 to Dec 2012 You are a cement sector analyst working in Kotak Last year India Cement profit was Rs 68 cr (fact) Next year profit as per your estimate is likely to be Rs 125 cr Projected PAT 125.00 No of Shares 30.72 Forward EPS comes to 4.07
Various analysts will come up with different Forward EPS estimates An average of such estimates is called as CONSENSUS ESTIMATE If consensus is say Rs 4.03 (India Cement EPS FY 12 forward) and your estimate then you need to rethink Analysts 1 2 3 4 5 6 7 Consensus EPS Forw 3.53 1.01 8.09 4.05 4.51 3.85 4.23 4.18 4.03
Simple Average - is generally not done More correct average excludes outliers
If Trailing EPS is negative and Consensus Forward is positive, those are great t and you could make big money on the stock market is you identify them in goo
2 PE Ratio or PE Multiple (Price Earnings Multiple) This ratio compares the price per share to the earnings per share PE Multiple = Price per Share / Earnings per Share India Cements price per share is say Rs Trailing EPS is Trailing PE Mutliple will be India Cements price per share is say Rs Forward EPS Consensus is Forward PE Multiple will be
For every one rupee that India Cements is likely to earn in the coming year, th to pay Rs 18.59
Price per Share Which one is more expensive? Infosys Why? One share of Infy is more expensive than two shares of TCS ?? Infy announces a stock split and one share is now split into ten shares Revised prices are Price per Share
Which one is more expensive? TCS is more expensive ? In a split what happens You have one one hundred rupee currency note They took it from you and gave you ten ten rupee notes
Price per Share is not an indication of CHEAPNESS or EXPENSIVENESS of a stock Most people go by the price per share, which is a wrong metric
What are these companies earning? If I pay Rs 2,823 for Infosys for one share, what is the support of earnings of th justifies such a price?
For one rupee of earnings, market is willing to pay Rs 21.63 for Infosys For the same one rupee of earnings of TCS, market is willing to pay Rs 29.70 TCS is more expensive (in this situation) A lower PE Multiple means a cheaper stock A higher PE Multiple means an expensive stock Whether cheaper stock is better stock is a difficult question - no simplistic You want to buy apples Rs 60 per kg, Rs 80 per kg, Rs 100 per kg, Rs 120 per kg Which is the cheapest one? Rs 60 per kg Always buy Rs 60 apples
Never buy Rs 120 apples A cheap stock may have cheap for the last 30 years You saw it today PE of 45 times - Nestle PE of 3 times - Visa Steel Post Office or the Bank Fixed Deposit I invest Rs I earn Rs PE Multiple is PE Multiple of a house I buy a house for Rs I earn rent of Rs PE Multiple is
If stock market PE multiples become too high (say 25 times), then every inves asking this basic question - why should I not buy Post Office deposits which mu 12.5 times Warren Buffet says: NEVER FORGET THE POST OFFICE
Expensiveness or cheapness should be measured in relation to the Post Office If Post Office is 12.5 times and stock market is 15 times PE, may be thats quit If Post Office is 12.5 times and stock market is 35 times PE, may be thats not
Today's PE Multiple on the Sensex is around 12 to 14 times (one year forward) Historically, we have seen a high of 25 times Historically we have seen lows of 7 to 8 times also - over the last 30 years
If you and me were rational (which we are not), we would buy at 7 to 8 PE and at 25 PE
At 25 PE we will be too excited and experts will be telling us that Sensex from go to 35000 etc etc - Jan 2008
At 8 PE we will be too exhausted and depressed (most of us would have lost hu then, no energy left) and experts will be telling us that Sensex will become N Sensex went to 7900 (Nifty at that time was 2700) 3 Dividend related ratios Dividend per Share Dividend % Dividend Payout Dividend Yield
46.08 30.72 Dividend per Share / Face Value per Share 1.50 10.00 Dividends / PAT 46.08 68.10 Dividend per Share / Market Price per Share 1.50 75.00
Dividend yield on good companies is only 1 to 3% of their current prices Investors dont buy shares to earn dividends and they do not influence the sha so much
However, if you are a very old investor (you bought the share in 1991 at very l dividends can be substantial for you at your old cost
FINANCE How is Finance different from Financial Accounting / Financial Analysis Accounting Score keeping Good score keeping does not make you a grea Analysis Required run rate is xyz Number of runs scored between midwicket an runs scored Extension of score keeping skills Finance Playing the game itself
Finance - future oriented - decision oriented - how to make him live Accounting - past oriented - post mortem oriented - how did this fellow die Past is clear, known, no uncertainty - Accounting Future - vague, uncertain, subjective, you could go wrong
Accounting - right and wrong Finance - no rights and no wrongs - your thought versus mine - your approach versus som What was the EPS of Tata Steel last year You have a clear answer How do I fund the new acquisition of Corus Steel (in Tata Steel) I need Rs 10,000 cr - how do I fund this 1,000 ways to fund it - you need to find YOUR WAY As a finance person, you are a player (manager) As an accounting person, you are an observer TIME VALUE OF MONEY Compounding and Discounting Future Value and Present Value Determines most long term financial decisions Time is money If I give you Rs 100 today and you return back Rs 100 after 2 years, that is not fair Why? The same Rs 100 in a bank would have generated some interest That interest I should earn in other opportunities also Why does interest exist in the world? What is interest? Compensation for time Nominal Interest
Real Interest 3%
If Indian Bank offers you 10% interest on Fixed Deposits and inflation in the country is 7%, really earning 3% If you give your friend Rs 100, you would expect at least 10% yield on this loan In economics, economists are quite thrilled to discuss real interest rates In finance, we are more practical and we discuss nominal interest rates
Inflation is already factored in when you are dealing with Nominal Interest In other words, having considered nominal interest, please dont consider inflation again German FD rates will be 2% Japan FD rates will be 0.50% Botswana FD rates will be 3000% You friend wants Rs 100 He will return interest and principal after 2 years How much will you get after 2 years? Assume you are happy with 10% When we say 10% what do we mean? We mean 10% per annum We mean 10% per annum compounded annually Principal Interest in year one End of year one Principal Interest in year two End of year two Principal r (rate of interest) 1+r 100 10 110 11 121 10% 110% Inflation is 1% Inflation is zero percent Inflation is 2500%
10% 10%
Year 0 1 2
Value 100 110 121 This method is quicker You simply multipy by (1+r)
Even more faster - Multiply by {(1+r)^n} (where n stands for number of years) 121 What if my friend returns back the funds after 200 years 18990527646 Most of the times, in corporate life, complex formula fail badly The more intelligent you are, the more others run away from you They dont understand what you are saying It is important to know, but it is more important to express in non-math language This process is called compounding Compounding means multiplying by (1+r) Rs 100 is called as the PRESENT VALUE Rs 121 is called as the FUTURE VALUE Moving from Present Value to Future Value is "compounding" Compounding means multiplying by (1+r) DISCOUNTING Opposite of compounding Your friend wants a loan He says he can repay you Rs 5 lakhs after 4 years How much can you lend him today (lets assume that you are happy with 10% return) Year 4 3 2 1 Value 500,000 454,545 413,223 375,657 r (rate of interest) 1+r In discounting, we DIVIDE BY
341,507
In discounting, we start with FUTURE VALUE and we derive the PRESENT VALUE What is the present value of Rs 5 lakhs receivable after 4 years at a discounting rate of 1 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% a is 8.50% Year 4 3 2 1 0 Value 500,000 460,829 419,890 379,991 345,446 8.50% 9.75% 10.50% 10.00% 108.50% 109.75% 110.50% 110.00%
VARIANT OF THE ABOVE EXAMPLE Your friend can return to you Rs 2 lakhs per annum at the end of years 5, 6, 7 and 8 You are happy to earn 10% per annum How much should you lend him today? 476313 433012 373201 124000 93301 373201 373206 Standard practice in financial framework Present value factor of rupee one r= 10% 1+r = 110% Year 0 1 2 PV Factor 1.0000 0.9091 0.8264 Nominal CashFlow -
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 dealt with him at 10% in this transaction DENA BANK You want to introduce a long term scheme for your depositors The depositor will pay Rs 1 lakh per annum for 10 years You will pay back Rs 3 lakhs per annum from the end of the 20th year onwards Interest rate is 8% How long can you pay him Rs 3 lakhs per annum 8% Year Open Bal year begin Calculated 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 108,000 224,640 350,611 486,660 633,593 792,280 963,663 1,148,756 1,348,656 1,564,549 1,689,713 1,824,890 1,970,881 2,128,551 CashFlow year begin Manual 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 Interest year end Calculated 8,000 16,640 25,971 36,049 46,933 58,687 71,382 85,093 99,900 115,892 125,164 135,177 145,991 157,670 170,284 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
16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44
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
(300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000) (300,000)
183,907 198,619 214,509 231,670 250,203 246,219 241,917 237,270 232,252 226,832 220,979 214,657 207,830 200,456 192,492 183,892 174,603 164,571 153,737 142,036 129,399 115,751 101,011 85,092 67,899 49,331 29,278 7,620 (15,770)
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)
1 2 3 4
Time value of money Compounding (multiply by 1+r) Discounting (divide by 1+r) Future value
5 6 7 8
Present value Present value factor tables (for one rupee) Nominal cash flow Discounted cash flow (nominal cash flow x PV factor)
Internal Rate of Return (IRR) You give your friend Rs 5 lakhs today and he returns back Rs 9 lakhs after 3 years What have you earned (% per annum)? Future Value = Present Value x (1+r) ^ n Four variables: 1 2 3 4 Year 0 1 2 3 CashFlow (500,000) 900,000 FV PV r n Compounding Determine Given Given Given Discounting Given Determine Given Given
"Internal" Rate of Return What does this "Internal" mean? The rate of return is being computed without referring to any external market or bank or or anything This rate of return is purely based on your own inflows and outflows of cash without rega external factor Internal to your own set of cash flows
You give your friend Rs 5 lakhs and he returns back to you Rs 2 lakhs each in years 3 to 10
What are you earning? Year 0 1 2 3 4 5 6 7 8 9 10 CashFlow (500,000) 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000
21.39%
HOME LOAN INDUSTRY Every EMI that you pay comes straight off the IRR Principal amount 2,000,000 Tenor 20 years EMI 19,633 Solve for "r" Monthly IRR IRR will help us Annual IRR Month 0 1 2 3 4 5 6 7 8 9
0.85% 10.25%
CashFlow Interest PrincRepaid PrincBal (2,000,000) 2,000,000 19,633 17,083 2,550 1,997,450 19,633 17,062 2,571 1,994,879 19,633 17,040 2,593 1,992,286 19,633 17,018 2,615 1,989,671 19,633 16,995 2,638 1,987,033 19,633 16,973 2,660 1,984,373 19,633 16,950 2,683 1,981,690 19,633 16,927 2,706 1,978,984 19,633 16,904 2,729 1,976,255
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
16,881 16,857 16,833 16,810 16,785 16,761 16,737 16,712 16,687 16,662 16,636 16,611 16,585 16,559 16,533 16,506 16,479 16,452 16,425 16,398 16,370 16,342 16,314 16,286 16,257 16,229 16,199 16,170 16,141 16,111 16,081 16,050 16,020 15,989 15,958 15,926
2,752 2,776 2,800 2,823 2,848 2,872 2,896 2,921 2,946 2,971 2,997 3,022 3,048 3,074 3,100 3,127 3,154 3,181 3,208 3,235 3,263 3,291 3,319 3,347 3,376 3,404 3,434 3,463 3,492 3,522 3,552 3,583 3,613 3,644 3,675 3,707
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
46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
15,895 15,863 15,831 15,798 15,765 15,732 15,699 15,665 15,631 15,597 15,563 15,528 15,493 15,458 15,422 15,386 15,350 15,313 15,276 15,239 15,201 15,164 15,125 15,087 15,048 15,009 14,969 14,930 14,889 14,849 14,808 14,767 14,725 14,683 14,641 14,598
3,738 3,770 3,802 3,835 3,868 3,901 3,934 3,968 4,002 4,036 4,070 4,105 4,140 4,175 4,211 4,247 4,283 4,320 4,357 4,394 4,432 4,469 4,508 4,546 4,585 4,624 4,664 4,703 4,744 4,784 4,825 4,866 4,908 4,950 4,992 5,035
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
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
14,555 14,512 14,468 14,424 14,380 14,335 14,290 14,244 14,198 14,151 14,105 14,057 14,010 13,962 13,913 13,864 13,815 13,765 13,715 13,665 13,614 13,562 13,511 13,458 13,406 13,352 13,299 13,245 13,190 13,135 13,079 13,023 12,967 12,910 12,853 12,795
5,078 5,121 5,165 5,209 5,253 5,298 5,343 5,389 5,435 5,482 5,528 5,576 5,623 5,671 5,720 5,769 5,818 5,868 5,918 5,968 6,019 6,071 6,122 6,175 6,227 6,281 6,334 6,388 6,443 6,498 6,554 6,610 6,666 6,723 6,780 6,838
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
118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
12,736 12,677 12,618 12,558 12,498 12,437 12,375 12,313 12,251 12,188 12,124 12,060 11,995 11,930 11,864 11,798 11,731 11,663 11,595 11,527 11,457 11,388 11,317 11,246 11,175 11,102 11,029 10,956 10,882 10,807 10,732 10,656 10,579 10,502 10,424 10,345
6,897 6,956 7,015 7,075 7,135 7,196 7,258 7,320 7,382 7,445 7,509 7,573 7,638 7,703 7,769 7,835 7,902 7,970 8,038 8,106 8,176 8,245 8,316 8,387 8,458 8,531 8,604 8,677 8,751 8,826 8,901 8,977 9,054 9,131 9,209 9,288
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
154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
10,266 10,186 10,105 10,024 9,941 9,859 9,775 9,691 9,606 9,520 9,434 9,347 9,259 9,170 9,081 8,991 8,900 8,808 8,716 8,623 8,529 8,434 8,338 8,242 8,144 8,046 7,947 7,847 7,747 7,645 7,543 7,439 7,335 7,230 7,124 7,017
9,367 9,447 9,528 9,609 9,692 9,774 9,858 9,942 10,027 10,113 10,199 10,286 10,374 10,463 10,552 10,642 10,733 10,825 10,917 11,010 11,104 11,199 11,295 11,391 11,489 11,587 11,686 11,786 11,886 11,988 12,090 12,194 12,298 12,403 12,509 12,616
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
190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633
6,910 6,801 6,691 6,581 6,469 6,357 6,244 6,129 6,014 5,898 5,780 5,662 5,543 5,422 5,301 5,178 5,055 4,930 4,805 4,678 4,550 4,422 4,292 4,161 4,028 3,895 3,761 3,625 3,488 3,350 3,211 3,071 2,930 2,787 2,643 2,498
12,723 12,832 12,942 13,052 13,164 13,276 13,389 13,504 13,619 13,735 13,853 13,971 14,090 14,211 14,332 14,455 14,578 14,703 14,828 14,955 15,083 15,211 15,341 15,472 15,605 15,738 15,872 16,008 16,145 16,283 16,422 16,562 16,703 16,846 16,990 17,135
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
226 227 228 229 230 231 232 233 234 235 236 237 238 239 240
19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 19,633 4,711,920
2,352 2,204 2,055 1,905 1,754 1,601 1,447 1,291 1,135 977 817 657 495 331 166
17,281 17,429 17,578 17,728 17,879 18,032 18,186 18,342 18,498 18,656 18,816 18,976 19,138 19,302 19,467
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)
IRR is an iterative calculation Deterministic calculations 2+7 = 9 Probabilistic calculations What will be your sales next year? I dont know If I force you, you may come up with sir, may be Rs 10 cr, may be Rs 15 cr 80% prob - Rs 10 cr, 20% prob - Rs 15 cr Iterative calculations The answer is not known But we will try and try and try till we succeed Excel starts with 10% as the default IRR It tries to check if indeed the IRR is 10% It guesses that the IRR is less than 10% (or more than 10%) If less, it again tries with say 9.75% (illustrating) It tries 32 times (Excel 2007 version) FLAT INTEREST RATE EXAMPLE The real rate of interest that you pay or receive is known only by IRR workings
If you borrow Rs 5 lakhs from a pathan and he charges you 8% flat interest rate and you r Rs 1 lakh per annum for 5 years (year 1 to year 5), what does this flat interest rate mean It means that you pay interest on Rs 5 lakhs throughout (not on reducing balance but on o What is the real interest cost to you? Year 0 1 2 3 4 5 CashFlow (5.00) 1.40 1.40 1.40 1.40 1.40
ZERO PERCENT INTEREST You go to retail store ABC in T Nagar, Chennai You want to buy a LED TV MRP Rs 70,000 They are offering zero percent interest instalment facility 12 instalments, 3 payable in advance (today) 4th to 12th instalment in month 4 to month 12 2% processing fees If you were to buy the TV cash down, you get a discount of 4% - in the scheme that disco 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 Month 1 2 3 4 Buy cash down Use the loan (67,200) (18,900) (5,833) Difference 48,300 (5,833)
5 6 7 8 9 10 11 12
111,000 2,700,000 15
Term Plan You pay a premium (very low) and if you survive, then you get back nothing Annual Premium 6,500 Sum Assured 2,700,000 Tenor 15 Let me assume that the amount of premium saved is invested in PPF earning 8.5% Which plan is better? Endowment versus (Term Plan + PPF) Endowment Year CashFlow 0 (111,000) 1 (111,000) 2 (111,000)
IRR =
5.83%
3 4 5 6 7 8 9 10 11 12 13 14 15
(111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) 2,700,000
When I buy the term plan, I will pay annual premium of Rs The balance amount left in my hand is Rs This balance amount will be invested in PPF Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Open 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 Cash Inflow Interest Cl Bal Beginning 104,500 8,883 113,383 104,500 18,520 236,403 104,500 28,977 369,879 104,500 40,322 514,701 104,500 52,632 671,834 104,500 65,988 842,322 104,500 80,480 1,027,302 104,500 96,203 1,228,005 104,500 113,263 1,445,768 104,500 131,773 1,682,041 104,500 151,856 1,938,397 104,500 173,646 2,216,543 104,500 197,289 2,518,331 104,500 222,941 2,845,772 104,500 250,773 3,201,045
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
CashFlow (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) (111,000) 3,201,045
7.81%
1 Dont go for flat interest rate schemes - the real interest rate is much higher 2 Dont go for zero EMI - pls recheck the IRR 3 Dont go for endowment policies or ULIPs - if you wish to buy insurance, buy T Cheapest value for money
In ULIPs, they take Rs 100 from you and carve out Rs 23 towards service charges of variou What gets invested is only Rs 77 23 77 30% So long as market has not appreciated by 30% you are under water
How do use these concepts in business life Most capex decisions are long term Capex means capital expenditure (new factory, new product launch, new branch, new co You invest today and you reap the harvest in future Future is long term (at least more than one year)
If I spend Rs 500 cr and I get back Rs 600 cr after 3 years, is that interesting? No - bcoz of time value of money What should we discount? What should be the discounting rate? What if the future unfolds differently than what I thought?
Actions
ceivable (Days) Net, Returns - RoCE, RoE to be good or lousy company will be rewarded)
ts of those actions y your actions, partly the environment, partly sentiment, etc
Rs cr Rs cr Rs Cr Rs per Share
al PROFIT
2011 / No of Shares
e 2011 / No of Shares
may be Forward
be careful, he should recheck his assumptions be careful, he should recheck his assumptions
sitive, those are great turn around cases you identify them in good time
s per share
75.00 Rs per Share 2.22 Rs per Share 33.83 Times (x) 75.00 Rs per Share 4.03 Rs per Share 18.59 Times (x)
Infosys TCS 2,823.00 1,225.00 These are not comparable 130.50 41.25 21.63 29.70 20 - 23 27 - 30
imes), then every investor should keep Office deposits which much cheaper at
ation to the Post Office es PE, may be thats quite okay es PE, may be thats not okay
of us would have lost huge amounts by hat Sensex will become Nifty - Oct 2008
eping skills
Inflation 7%
d on this loan
121
ber of years)
200
n-math language
e of interest)
10% 110%
years 5, 6, 7 and 8
Discounted Cash Flow If I give you Rs 0.9091 today and you return back one rupee after one year,
then are we dealing at 10% with each other 124,184 112,895 102,632 93,301 433,012
year onwards
r= 1+r=
21.64% 121.64%
12
e Rs 15 cr
IRR workings
t interest rate and you repay principal flat interest rate mean educing balance but on original loan)
12.63%
ck nothing
under water
interesting?
108% PV Fact DCF 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632 0.4289 0.3971 0.3677 0.3405 100,000 92,593 85,734 79,383 73,503 68,058 63,017 58,349 54,027 50,025 -
CumuDCF 100,000 192,593 278,326 357,710 431,213 499,271 562,288 620,637 674,664 724,689 724,689 724,689 724,689 724,689 724,689
0.3152 0.2919 0.2703 0.2502 0.2317 0.2145 0.1987 0.1839 0.1703 0.1577 0.1460 0.1352 0.1252 0.1159 0.1073 0.0994 0.0920 0.0852 0.0789 0.0730 0.0676 0.0626 0.0580 0.0537 0.0497 0.0460 0.0426 0.0395 0.0365
(64,364) (59,597) (55,182) (51,095) (47,310) (43,805) (40,561) (37,556) (34,774) (32,198) (29,813) (27,605) (25,560) (23,667) (21,914) (20,290) (18,787) (17,396) (16,107) (14,914) (13,809) (12,786) (11,839) (10,962)
724,689 724,689 724,689 724,689 724,689 660,324 600,728 545,545 494,451 447,141 403,336 362,775 325,219 290,445 258,247 228,434 200,829 175,269 151,602 129,688 109,398 90,611 73,215 57,108 42,194 28,385 15,598 3,759 (7,203)
Summary of yesterday 1 Valuation ratios EPS Forward and Trailing EPS PE Multiples Tells us what is cheap and what is expensive (share price itself does not con Dividend ratios - Div per Share, Div %, Div Payout, Div Yield 2 Time value of money Compounding - Multiply by 1+r Discounting - Divide by 1+r Nominal cash flow Present value factor Discounted cash flow IRR Present value, future value
BUSINESS EXAMPLES You are setting up a new project and this project will cost you Rs 100 cr For simplicity, let us assume that the entire spending will happen on day zero You will earn Rs 20 cr per annum for the first two years, then Rs 30 cr per annum for the and then Rs 40 cr per annum for the next four years End of this period, you will sell off the business for Rs 50 cr You can borrow funds at 14% Is this project a good idea?
SEVERAL FINANCIAL CRITERIA 1 Payback period 2 Net Present Value NPV 3 IRR 4 Discounted payback period 5 Profitability Index (PI) - this is used when you have multiple competing proje
Year
Nominal
Cumulative
Present
Discounted
Value Factor Cash Flow 1.0000 (100.00) 0.8772 17.54 0.7695 15.39 0.6750 20.25 0.5921 17.76 0.5194 15.58 0.4556 18.22 0.3996 15.99 0.3506 14.02 0.3075 27.68 NPV 62.43
Nominal cash outflows Nominal cash inflows Nominal net cash flow
(100) 340 240 But this is a useless numbe time value of money
Present value of cash outflows Present value of cash inflows Net Present Value
(100.00) 162.43 62.43 This is a useful number bco of money - even after cons in time, then NPV is still po interesting
If we shift to Planet Jupiter and on Jupiter, there is nothing like INTEREST, then Nominal will be equal to Net Present Value - we will not require any discounting or compounding
Payback period Without getting into complicated arithmetic, how many years does it take to get my mon We ignore interest, we ignore compounding, discounting Our payback is exactly 4 years
But the fact may be that after the payback period, A generates huge earnings, while B do Drawbacks: 1 Interest is ignored 2 Cash flows after the payback period are ignored Merits: In many sectors, the long term is simply unknown - I simply dont know So complex long term projections may be simply false In such cases, I am quite nervous in spending on capex based on very shaky projections I am more convinced that a simple measure like payback is important If the payback is 7 years, I am simply not interested Many SME who will reject any project with a payback of over 2 years
Large corporates may typically have hundreds of small projects I want to buy this new software which will automate several processes and I can save on This software will cost me Rs 2 cr and save wages of Rs 25 lakhs per annum for the next 1 That is a project The large corporate also will look for a quick PAYBACK on its small projects Tata Motors Nano project may well have a payback of ten years This is a large project and who approves it - Ratan Tata himself Within Tata Motors, there are 800 small projects each costing less than Rs 5 cr Who approves them Executive Committee These people will not allow projects beyond 2 year payback, 3 year payback Tooling Cost payback 1 year - Brakes India
Customer proposals - when calculating RoI, payback is computed - TCS - US customers loo Glass - payback 2 years, 4 year payback products are tough to sell Conventional glass consumes more electricity High performance glass consumes less Benefit - lower electricity costs Cost - incremental cost of this glass
Family run company making kids shoes - machines with payback of 3 years get approved q with 10 year payback take time - we may try one machine for testing, but bulk orders a
Large capital intensive projects will tend to have long paybacks - 7 years, 10 years, 15 ye For projects of national importance, such paybacks are common Delhi Airport - payback may well be 15 years Konkan Railway - payback may be 25 years Reliance Refinery - payback may be 7 years
If you are a middle level manager and you have some bright ideas, then please make sure have short paybacks if you want them to be approved
RELATIONSHIP BETWEEN FINANCIAL RATIOS (RoI, RoE, etc) AND CAPEX PARAMETERS ( Financial ratios work year on year RoE 27% RoE 24% RoE Project Level Financial parameters Cut across several years 22%
2011 2012 2013 Company level numbers for one year at a time
Company is nothing but a collection of projects Accounting ratios Project level RoI = Benefits of the Project / Costs of the Project These RoI are very crude workings and most of the time are highly political workings
NET PRESENT VALUE Present value means cash flows of future years discounted to today's value - divide by (1+ The term NET stands of present value of inflows minus present value of outflows If the NET is a positive number, what does this mean? PV of Inflows is more than PV of Outflows - the idea looks good If the NET is a negative number, what does this mean? PV of Inflows is less than PV of Outflows - the idea does not look so bright
INTERNAL RATE OF RETURN The NPV is 62.43 when we are discounting at At a very simple level, we have assumed that funds will be available at What if interest rates start rising and funds are now available at What do you think will happen to the NPV? 1 Goes up 2 Goes down 3 Indifferent
The NPV should fall - the project should become less attractive bcoz the banks will take me, from my business If Interest rates go up drastically, say to 45%, what may happen? The project may become unattractive - the NPV may turn negative
In Chennai, if you are a vegetable vendor, your interest may be 3600% per annum also
He gives you Rs 900 in the morning and collects Rs 1,000 in the evening
The IRR is that rate of interest which makes the NPV zero If you borrow funds at the IRR rate, the project will neither make losses nor profits - you If your cost of borrowings is less than IRR, then the project is interesting IRR in this case will be 26.08% If you borrow at 14%, then NPV will be positive If you borrow at any rate above 26.08%, the NPV will be negative If you borrow at exactly 26.08%, NPV will be zero Many corporates will have a certain minimum IRR which each project should satisfy Any project with an IRR below this threshold will be rejected by management IRR rate, min rate, threshold rate, hurdle rate 25% IRR - Brakes India - quite a high hurdle - may be difficult to beat 20% IRR in competitive segments Most Indian corporates look at a min min 15% IRR
I want positive NPV projects - thats where I make money If my min IRR hurdle is 15% and my pet project is showing an IRR of 22%, what does this m This project will show a positive NPV if discounted at 15% IRR thinking - positive conclusion - 22% > 15% NPV thinking - positive conclusion - NPV will be positive in this project You will never have a conflict where IRR says No and NPV says Yes Which one should you use - NPV or IRR After the break DISCOUNTED PAYBACK PERIOD The criticism against the simple payback is that it ignores interest So the discounted payback overcomes this challenge - it considers interest
It uses the discounted cash flows to compute the payback period and as we know, the dis column considers interest End of year 5 - cumulative DCF is negative End of year 6 - cumulative DCF is positive DCF in year 6 How much do I need to make my Cum DCF zero How much fraction of the 6th year Disc Payback is 5.x years Disc Payback is 5.74 years PROFITABILITY INDEX (PI) This criterion is used when we have limited funds and many competing project ideas You have only Rs 200 cr and you have 300 ideas which need Rs 700 cr You will have to pick and choose, you cant satisfy everybody So, which ones to pick? On what criteria? There can be conflicts between NPV and IRR In a single project situation there is no conflict Proj A Project Cost NPV Rs cr IRR % So, which one ? The Profitability Index is the answer = 150 100 19% Proj B 200 120 17% (13.47) 4.75 18.22 13.47 0.74
I dont have money - so I need to conserve my funds - every rupee is important If I invest one rupee in Project A, I am getting back Rs 1.67
If I invest one rupee in Project B, I am getting back Rs 1.60 So, I will go for Project A
BUSINESS CAPEX EXERCISE Your company is in infrastructure and is bidding for a road project The road will cost Rs 1,000 cr - assume that road building takes one day In the first year, the toll revenue will be Rs 100 cr This revenue will increase 10% every year The licence to operate the road works for 30 years At the end of 30 years, the company will walk away from the road (road belongs to the G Assume that funds can be brought in at 14% Work out the four project evaluation criteria and advise on the feasibility of this project
IRR should not be worked out on the DCF column bcoz the discounting process itself has a inflows downwards by 14% and once again on this if you apply IRR (which is another form then you are double counting
GOAL SEEK COMMAND In the context of IRR, we discussed IRR is that rate of interest which makes the NPV zero Can we automatically work out the IRR (not using the IRR formula) using the NPV table (w trying and trying) INPUT MODELING A spreadsheet is useful because it can calculate If a spreadsheet cannot calculate, then it is a word processor Many of us use spreadsheets like word processors What can be a formula should never be a hard number Hard numbers should be minimal 100 110 RIGHT WRONG 100 110
100 is a hard number (unav Second year should be a fo So 100 x 1.1 (or 100 x 110% But is it really good?
OR NOT SO RIGHT ?
The 1.1 factor or the 110% Should a hard number be h Ideally No Then what should I do? The 10% should sit in a sep The 110% should be a form 10%
Whether a formula should contain a hard number - second question If my toll revenue were to grow at 12% (not 10%), then what? Then what, then what, then what? WHAT IF ANALYSIS Having used a formula once, you should not be required to repeat the formula If you are repeating the same formula again and again, recheck your logic
1 Use minimal hard numbers 2 Keep these hard numbers in clear cells (dont mix them up with formula) 3 Dont use the same formula again - if you need that number, refer to that ce recalculating the number) 4 Always remember that your file should be amenable to good WHAT IF analys
12% My cost of capital is: 12% 13% 14% 15% 16% How much can you simplify, automate? Test the Goal Seek Command for IRR - NPV Much faster way of WHAT IF ANALYSIS There is a DATA TABLE function meant for such analysis - very powerful, very easy For every change of inputs, it re-calculates your desired outputs One Way Table One input factor is being changed at a time Dis Factor NPV IRR 62.43 26.08% 11% 86.94 26.08% 12% 78.21 26.08% 13% 70.06 26.08% 14% 62.43 26.08% 15% 55.30 26.08% 16% 48.61 26.08% 17% 42.35 26.08%
Two way Tables Two factors are changing at the same time What will be my NPV in the following 35 situations (7 discounting factors x 5 possible Pro Dis Factor Project Cost
Sensitivity to Revenue Growth NPV IRR 8% 9% 10% 11% 12% Two Way Tables NPV Sensitivity 12% 8% 9% 10% 11% 12% 13%
PI
14%
15%
11% 12%
We are reasonably familiar with Payback, NPV, IRR, Discounted Payback and PI We are also familiar with Data Tables (1 way and 2 way) We have some idea of good modeling and bad modeling
Business Case We are going to integrate our earlier knowledge of Bal Sheet, P&L with the new knowled You are putting a new factory, cost of Rs You will produce name plates Cost of each name plate is Rs Selling price is Rs Annual fixed operating costs are Rs First year volume of business is Volume will increase at Selling prices will increase at Costs will not increase, kept under control 1
100 Variable costs, Direct costs 150 20 lakhs 100,000 units 5% per annum 7% per annum
Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Ven Expense Payables, Provisions) is estimated to be 12%
This business will run for 10 years At the end of ten year, I will quit the business and sell off the factory, which will fetch o The working capital in the business (at that time) will be released (converted to Cash)
Assume cost of capital is 14% Will not affect your Bal She Assume that appropriate depreciation has been provided for Ignore interest, bank loans taken and repaid, income tax Balance Sheet for each year Projections P&L for each year Projections We could assume for financial projections that the funds came from owners equity Cost of Fixed Assets Salvage value estimated Depreciable value Tenor Depreciation per annum (SLM) PROJECTED PROFIT & LOSS ACCOUNT Year Volume Selling Price Sales Revenue Variable Cost per Unit Variable Cost Rs Fixed Costs EBIDTA Depreciation EBIT 1 100,000 150.00 15,000,000 100.00 10,000,000 2,000,000 3,000,000 900,000 2,100,000 2 105,000 160.50 16,852,500 100.00 10,500,000 2,000,000 4,352,500 900,000 3,452,500 3 110,250 171.74 18,933,784 100.00 11,025,000 2,000,000 5,908,784 900,000 5,008,784 10,000,000 1,000,000 9,000,000 10 900,000
Liabilities Sh Capital Reserves Total Liab Assets Fixed Assets Work Cap Excess Cash Total Assets
0 11,800,000 11,800,000
Excess Cash is the balancing number in the Bal Sheet CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ Sources of Funds (Inflows) Owners Equity 11,800,000 Cash Profits 3,000,000 4,352,500 5,908,784 Fixed Assets sold Working Capital Release Total 11,800,000 3,000,000 4,352,500 5,908,784 Application of Funds (Outflows) Fixed Assets 10,000,000 WorkCap 1,800,000 Total 11,800,000 Surplus Open Bal Cl Bal -
Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EB
Year 0 Capex FA (10,000,000) Work Cap (1,800,000) Cash Profits Sale of FA Release of Work Cap Total (11,800,000) PV Factor DCF NPV 1.000 (11,800,000) 38,806,441
1 (222,300) 3,000,000
2 (249,754) 4,352,500
3 (280,599) 5,908,784
Cumulative
14.00%
Disc Cash Flo (100.00) (82.46) (67.07) (46.82) (29.06) (13.47) 4.75 20.73 34.76 62.43
What does 0.5921 mean? If I give you 0.5921 rupees today and you return me back one rupee after 4 years, then we have transacted with each other at 14%
a useful number bcoz it incorporates time value ney - even after considering that inflows arrive later e, then NPV is still positive - the project looks
EREST, then Nominal Net Cash Flows ting or compounding on Planet Jupiter
y shaky projections
es and I can save on people cost annum for the next 10 years
han Rs 5 cr
years get approved quickly and those ng, but bulk orders are risky
RoE 26%
RoE 20%
2014
2015 Years
at a time
f projects
olitical workings
in this project
Outflows Rs cr Rs cr times
s important
makes the NPV zero sing the NPV table (without manually
a hard number (unavoidable) d year should be a formula 0 x 1.1 (or 100 x 110%) is good - formula it really good?
.1 factor or the 110% factor is a hard number d a hard number be hard coded onto a formula?
what should I do? 0% should sit in a separate cell (hard number) 10% should be a formula (second cell) 110%
he formula
PI
10
(120.00) 66.94 58.21 50.06 42.43 35.30 28.61 22.35 Worst case
Realistic case
Sensitivity to Cost of Capital NPV IRR 12% 13% 14% 15% 16%
PI
25 situations 16%
16%
16%
back and PI
10 lakhs
ot affect your Bal Sheet, P&L - only for capex decision 114%
owners equity
ENDED XYZ 7,695,856 7,695,856 9,744,149 9,744,149 12,087,948 12,087,948 14,765,877 14,765,877 17,821,433 17,821,433
4 (315,253) 7,695,856
5 (354,186) 9,744,149
6 (397,928) 12,087,948
7 (447,072) 14,765,877
8 (502,286) 17,821,433
10 Growth 1+x 155,133 5% 275.77 7% 42,780,805 100.00 0% 15,513,282 2,000,000 0% 25,267,523 900,000 24,367,523
124,747,667 124,747,667
1,000,000 Asset book value 1,000,000 Sold for the same amount and en No profit no loss on sale
21,303,598 21,303,598
9 (564,318) 21,303,598
1 Impact of Interest, Depreciation and Taxes on Capex decisions 2 Cost of Capital 3 Risk - Definition, Measurement, Implications SHOULD WE PREPAY A HOME LOAN OR NOT There is no answer to the question - at what point in time is advantageous to prepay The home loan costs you say 10.00% You get a tax benefit of 30% 3.00% Post tax cost of home loan 7.00% PPF earns 8.00% Why should I prepay Answer - financially appears to be never prepay Psychologically, some may prefer to prepay - they dont want tension If they have surplus funds, their relatives will take it away They dont trust themselves (on not to spend) INTEREST We will recall that in our workings, we have ignored interest For capex evaluation, we always ignore interest Why? Is interest not a real cost? How can we ignore interest?
Interest is compensation to the lender for passage of time If I borrow at 10 am and return at 1001 am, then possibly most lenders will not charge in I borrow in 2011 and I return in 2021, hence interest is charged
Discounting is nothing but considering passage of time (time value of money) As we are already discounting cash flows, we should not consider interest - otherwise we counting
The rate of interest is extremely important but all gets captured in the rate of discountin Cash flows are pre-interest, but discounting takes care of this
DEPRECIATION Depreciation is not a cash outflow, it is a mere book entry So depreciation is ignored in the computation of cash flows However, depreciation becomes important for another purpose, viz tax Tax laws allow you depreciation as an expense So, if you can claim high depreciation, what will happen? Your tax burden will reduce Tax is a cash outflow or a book entry? If tax were a book entry, Planet Earth will become Heaven We will compute tax after considering depreciation benefits However, the basic depreciation amount itself will be either ignored (if you have not ded added back (if you have deducted it earlier) Reality With Int EBIDTA Depreciation EBIT Interest PBT Tax PAT 150 50 100 20 80 24 56
30%
Cash flow in the above situation Two ways of presenting the cash flow - both mean the same thing but start from differen EBIDTA 150 Less : Interest -20 Less : Tax -24 Cash Flow 106 Presentation Two PAT Add back Depreciation Cash Flow
56 50 106
Presentation Three We just discussed that Interest should be ignored for capex evaluation If you ignore interest, then we need a number to help us with cash profits EBIT x (1-t) + Depreciation EBIT t (tax rate) 1-t EBIT x (1-t) Add Depreciation Cash flow for capex decisions This Rs 120 cr is not the real cash profit of the year The real cash profit is Rs 106 cr
In capex evaluation, we are trying to discount cash flows If you discount, you should ignore interest This Rs 120 cr is trying to tell you that if you had not paid any interest, then your cash flo Rs 120 cr
SUMMARY 1 We ignore interest bcoz we are discounting cash flows 2 We ignore depreciation bcoz there is no cash flow 3 We will consider taxes as an outflow and also consider the impact of depreciat
Finance journey
PAT
Business Case In the last Business Case, we will introduce the following: 1 The project cost is funded partly by banks and partly by promoters Banks 75% Promoters 25% 2 Interest rate charged by banks is 3 The bank loan will be repaid equally in the first 4 Tax rate in the country
We are going to integrate our earlier knowledge of Bal Sheet, P&L with the new knowled You are putting a new factory, cost of Rs You will produce name plates Cost of each name plate is Rs Selling price is Rs Annual fixed operating costs are Rs First year volume of business is Volume will increase at Selling prices will increase at Costs will not increase, kept under control 1 100 Variable costs, Direct costs 150 20 lakhs 100,000 units 5% per annum 7% per annum
Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Ven Expense Payables, Provisions) is estimated to be 12%
This business will run for 10 years At the end of ten year, I will quit the business and sell off the factory, which will fetch o The working capital in the business (at that time) will be released (converted to Cash)
Assume cost of capital is 14% Will not affect your Bal Sheet, P Assume that appropriate depreciation has been provided for Ignore interest, bank loans taken and repaid, income tax Balance Sheet for each year Projections P&L for each year Projections We could assume for financial projections that the funds came from owners equity Cost of Fixed Assets Salvage value estimated Depreciable value Tenor Depreciation per annum (SLM) PROJECTED PROFIT & LOSS ACCOUNT Year Volume Selling Price Sales Revenue Variable Cost per Unit Variable Cost Rs Fixed Costs EBIDTA Depreciation EBIT Interest PBT Tax 30% PAT 1 100,000 150.00 15,000,000 100.00 10,000,000 2,000,000 3,000,000 900,000 2,100,000 1,062,000 1,038,000 311,400 726,600 2 105,000 160.50 16,852,500 100.00 10,500,000 2,000,000 4,352,500 900,000 3,452,500 849,600 2,602,900 780,870 1,822,030 3 110,250 171.74 18,933,784 100.00 11,025,000 2,000,000 5,908,784 900,000 5,008,784 637,200 4,371,584 1,311,475 3,060,109 10,000,000 1,000,000 9,000,000 10 900,000
2 2,950,000 2,548,630
3 2,950,000 5,608,739
Bank Loans Total Liab Assets Fixed Assets Work Cap Excess Cash Total Assets
8,850,000 11,800,000
7,080,000 10,756,600
5,310,000 10,808,630
3,540,000 12,098,739
Excess Cash is the balancing number in the Bal Sheet CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ Sources of Funds (Inflows) Owners Equity 2,950,000 Bank Loan 8,850,000 Cash Profits 1,626,600 2,722,030 3,960,109 Fixed Assets sold Working Capital Release Total 11,800,000 1,626,600 2,722,030 3,960,109 Application of Funds (Outflows) Fixed Assets 10,000,000 WorkCap 1,800,000 222,300 Bank Loan Repayment 1,770,000 Total Surplus Open Bal Cl Bal 11,800,000 1,992,300 (365,700) (365,700) -
Bank Loan Amortization Schedule Op Bal 8,850,000 8,850,000 Repay 0 1,770,000 Cl Bal 8,850,000 7,080,000 Tenor 5 years Int Rate 12% Interest 1,062,000
849,600
637,200
Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EB Cash Profit should be : EBIT x (1-t) Plus Depreciation Year Capex FA Work Cap EBITx(1-t) Add : Depn 0 (10,000,000) (1,800,000) 1 (222,300) 1,470,000 900,000 2 (249,754) 2,416,750 900,000 3 (280,599) 3,506,149 900,000
Sale of FA Release of Work Cap Total (11,800,000) PV Factor DCF NPV 1.000 (11,800,000) 25,032,192
The reduction in the NPV is attributable to tax costs in this version (as compared to zero version)
Cash means cash balance (cash on hand), bank balances, securities which are convertible notice, cash equivalents (mutual funds, bonds, liquid instruments)
In the accounts, bank balances can go negative You pay your vendors on Friday evening - best practice Why Friday evening? He will deposit on Saturday and Sunday is a holiday - 3 days you have extracted from the If you have a positive balance, may be it can earn some interest for 3 days If you have a negative balance, then you can deposit something on Monday morning A negative bank balance in your books is sometimes called as a Book Overdraft
DEPRECIATION IN YOUR PERSONAL LIFE Your salary income is Rs 15 lakhs You bott a car for Rs 8 lakhs (life 5 years) Depn per annum is Rs 1.60 lakhs If depreciation were allowed as an expense for you (unfortunately not the case), what w income be? Salary 15.00 Less : Depreciation 1.60 Taxable Income 13.40 This is not allowed as per tax law
However, if you are running your business and your profit is say Rs 15 lakhs (before depre we will allow depn as a tax deductible expense
The businessman is using his car to further his business profits, while the salaried employ earned the same salary even if he had no car COST OF CAPITAL
If your business needs Rs 100, of which the bank is ready to fund Rs 75 and the bank will what is your cost of capital? One thought could be: 75 25 100 12% 0% 9% 9 0 9
Many new entrepreneurs think this way But this is very wrong Not a penny is free, every penny costs you something Some times you pay in a tangible manner Sometimes you dont pay anything, but there is still a cost attached to it Nothing is free
What is the cost of EQUITY? Is it zero? Answer - No it is not zero Had you not invested in this business venture and done something else with it, what wou Opportunity cost
Capital
Debt Banks, Fin Inst COST OF DEBT Primarily Interest Some bank charges Stamp duties for executing documents Mortgage deeds Bank processing charges, guarantees
12.00%
0.50% 0.50%
13.00%
When you charge interest in your P&L as an expense, the profit will reduce So your tax also redcues If your tax rate is say Your tax benefit on interest is Your post tax cost of interest is 30% 3.90% 9.10%
As a businessman, all interest is tax deductible (on all business loans) As an individual, only home loan interest is tax deductible (other loans are generally not other education) If you dont pay any tax, then your cost of debt is How come you dont pay tax 1 Loss making company 2 SEZ units 3 Infrastructure units 4 Mauritius 13.00%
COST OF EQUITY Cost of equity cannot be seen in the P&L - it is not tangible We dont pay our shareholders anything as an obligation - there is no obligation to pay We may sometimes distribute dividends, but that is not a cost - that is sharing of profits, discretionary, no compulsion, it may depend on various factors - even if I make fantasti I need cash for expansion, I may declare zero dividend What is the cost of equity Many years and many decades passed before humanity could find an answer Most people were looking at the P&L for this cost
Prof William Sharpe, Stanford University came up with an answer, for which he won the N CAPM Model - Capital Asset Pricing Model Dont look at the P&L
Look at the psychology of the investor Ask him - why are you investing in this company's equity Why not elsewhere
First of all, every country has some risk free instruments and any investor can always inv In India, we have the PPF, Post Office Deposits, Govt Securities - risk free India current yield on Govt Securities is 8% If I can buy G Securities why should I buy your shares Bcoz I think that you can generate higher returns Greed - the basic philosophy of all investing is greed How much more do you want So if you get 9% instead of 8%, are you okay to invest in this company's shares?
In every country, there will be a long term rate of return from the equity market and a lo of return from the G Sec market (long term here means 25 years, 30 years) Equity market means the index of the country - India - Sensex, Nifty India If your long term G Sec yield has been Long term Sensex returns have been 8.00% 15.50%
This tells you that investors are happy with an incremental return of
Equity is high risk and higher risk requires a higher return to compensate for that higher r All this is generic equity (Sensex) But your company is not the Sensex You company is XYZ How much return should I expect for investing in your company?
Prof William Sharpe said - we should map the risk of your company vis--vis that of the Se Let the Sensex risk be 1.000
Then what is your company risk If that risk is say 1.570 Then, he said that investors will demand more return from you (as compared to Sensex) HUL HUL DLF Risk free rate 8.00% Equity risk premium (Sensex) 7.50% 7.50% Relative risk factor 0.85 6.38% 2.85 Cost of equity for your company 14.38% What is risk? Risk is variability of return If you invest in the Post Office, you will get 8%, 8%, 8%, 8%, 8%, 8% and your Rs 100 back What is the variability in your returns? Zero variability Zero variability means RISK FREE (zero risk)
Your friend comes back from Dubai after 17 years He says I have a great project idea and why dont you become my partner What idea Smuggling What is your first question? What is the rate of return? 9% Are you interested? No He clarifies 9% per month Are you interested? Which product? Which port? Who will be caught if caught? Will my name appear in docum What is the variability in your returns? One year - fantastic 108% Next year - caught - jail Third year 300%
If the relative risk factor is 3.00, that company or that sector would have enormous varia year on year
DLF, Unitech, DB Realty - huge volatility of earnings If your risk factor is 0.85, your earnings are very steady, maybe growing Government employees at personal level HUL, Nestle, Marico, Colgate We are DLF Capital
Debt Banks, Fin Inst 9.10% How much of my capital is coming from debt and how much from equity (mix) Mix Cost WACC Debt 40% 9.10% 3.64% Equity 60% 29.38% 17.63% 100% 21.27% WACC - Weighted Average Cost of Capital I should take up only those projects that will beat the WACC of
This WACC becomes your discounting rate in your capex evaluation Also called as Hurdle Rate, Threshold Rate, Min IRR Rate, Discounting Rate, WACC - you n to beat this Rate Only then will your NPV be positive and IRR be higher than the WACC RELATIVE RISK FACTOR Known as "beta" in the stock markets Beta compares the daily return on your stock vis--vis the daily return on the Sensex Sensex day 17624 Your company share price yday
If you draw up this daily return for the Sensex and your company for the past two years a the line of least squares between them, the slope of that line is called as the "beta" Beta is published by the exchanges and you can have free access
There are 10,035 problems with the beta, which we can spend time debating - but not m of that discussion Many experts have fought with the CAPM model and have criticized it so much over the la But none of them have come with an alternative popular models The alternatives are fraught with more controversy There are 6,000 plus stocks in the country But hardly 1,800 of them trade every day The top 50 will contribute to 97% of the trading volumes of the country So, the share prices of most small stocks are unreliable and so is their "beta" Conceptually, beta assumes a liquid market Absence of a liquid market will affect beta accuracy 17624 17675 17783 17501 No trade WHAT TO DO IF BETA IS NOT AVAILABLE Cost of Equity = Risk Free Rate + (Generic Equity Risk Premium x Beta) In many cases, beta is not available 1 Unlisted entity 2 Listed but not actively traded Beta was suggested by Prof William Sharpe as a measure of "risk" He was trying to quantify something that was thought to be very difficult to quantify 2.5 2.5 2.5 2.5
If you are not listed, but your competitors, your industry is listed, then you use the indus measure of your beta You are ABC Real Estate Ltd, unlisted But you have DLF, Sobha Developers and 20 others who are listed It is quite likely that your risk profile is similar to theirs Their average beta is your beta
Whom should you include in your definition of industry is difficult to answer - controversi
You could say DLF is not like me - DLF is 100 times larger DB Realty is not me - my director is out of jail South India Real Estate is very different from Western India - I will exclude Mumbai based I build residential apartments and therefore will exclude heavy commercial builders
Sectoral beta becomes your starting point of beta Adjustments to beta for specific factors 1 Debt High debt means high risk means high beta If the industry debt equity is 1:1 and your debt equity is 1.5:1 you should have a higher beta than industry beta
There is a clear methodology on how beta should be adjusted Levered beta and unlevered beta
2 Size A smaller company is a riskier entity Infra is hit badly But IVRCL is hit more badly than L&T So if industry beta is 1.31 and your size is one tenth of the siz industry player, then experts will make your beta 1.81 instead
In India, we dont have scientific adjustments for size In the US, there are agencies which publish beta for various se provide guidance for size related adjustments
Ibbotsons is a leader in this business of computing beta and em additions for size Ibbotsons has been taken over by MorningStar
If you are in an industry where there is no other company, all other companies are all un stage entities, then what is your beta Your company is planning to take people to the moon for their summer vacation PE firms start from 40%, 35% as the Cost of Equity in such cases The final number of Cost of Equity is heavily negotiated rather than computed
RISK Risk is defined as variability of return If return is defined as some form of profit (for this limited discussion) and we try and me variation in relation to variation in sales, that measurement provides some understanding This is called impact of "leverage" In engineer, the term "lever" stands for what? For a small amount of effort, the movement is a multiplier impact Original Volume growth Sales Variable Costs Contribution Fixed Costs EBIT Interest PBT Tax PAT 100.00 52.00 48.00 23.00 25.00 7.00 18.00 5.40 12.60 Revised Leverage 10.00% 110.00 10.00% 57.20 52.80 23.00 29.80 19.20% 7.00 22.80 6.84 15.96 26.67%
30%
When can my entire profits be wiped out? Operating Leverage = % Change in EBIT % Change in Sales
A 1% change in Sales will produce a 1.92% change in EBIT Financial Leverage = % Change in PAT % Change in EBIT A 1% change in EBIT will produce a 1.39% change in PAT Total Leverage = % Change in PAT % Change in Sales
Total Leverage = Operating Leverage x Financial Leverage A 1% change in Sales will produce a 2.67% change in PAT
1 Whether a higher leverage is good or bad 2 What makes the leverage high or low
Higher leverage means higher risk - in what sense - more volatility of your earnings and if entity, this will lead to higher "beta" in the marketplace
A higher fixed cost will necessarily increase leverage High fixed cost means high risk - you have to pay for fixed costs whether you make mone Fixed costs (both in personal and business life) is like a stone on your neck Heavier the stone more difficult our life What is the benefit of outsourcing? I have 5,000 people working for me in California Now I transfer them to Bangalore and I pay per hour, per call, per seat, per transaction, It that something does not happen (decrease in volume), I wont pay What have I done? I have converted my fixed costs into a variable cost Nike has no factories What is the benefit?
No fixed costs If you If you If you If you set up a large factory, fixed costs will be high set up a large office, call center types, fixed costs will be high go for latest expensive technologies, fixed costs will be high set up a call center in Chennai compared to Salem, fixed costs will be high
Financial Leverage Interest is a fixed costs in most cases Interest depends on what Depends on how much debt you have in your capital structure High debt - means high interest - means high financial fixed costs - means high financial - high beta if you are listed
Operating Leverage structuring and Financial Leverage structuring are independent decis theory)
If you have tons of your own money (equity), you may be able to afford a call center in C somebody else who has very little of own equity
If you already are sitting or plan to sit on a high operating leverage, please dont compou by adding financial leverage to that entity
If you dont have much of your own funds, then please please reduce your operating leve Overall, we believe that a total levarage of more than 3 is dangerous Very crude benchmark 3 times means your entire profits will be wiped out if sales drop by 33% If your operating leverage is say 2, then how much financial leverage can you afford? 1.5 you are okay
x decisions
dvantageous to prepay
tax free
e, viz tax
hing but start from different points 150 0 -30 Text Book A page 156 120
cash profits
ctoral journey
ly by promoters
10 lakhs
ot affect your Bal Sheet, P&L - only for capex decision 114%
4 115,763 183.76 21,272,106 100.00 11,576,250 2,000,000 7,695,856 900,000 6,795,856 424,800 6,371,056 1,911,317 4,459,739
5 121,551 196.62 23,899,211 100.00 12,155,063 2,000,000 9,744,149 900,000 8,844,149 212,400 8,631,749 2,589,525 6,042,224
6 127,628 210.38 26,850,764 100.00 12,762,816 2,000,000 12,087,948 900,000 11,187,948 11,187,948 3,356,384 7,831,564
7 134,010 225.11 30,166,833 100.00 13,400,956 2,000,000 14,765,877 900,000 13,865,877 13,865,877 4,159,763 9,706,114
8 140,710 240.87 33,892,437 100.00 14,071,004 2,000,000 17,821,433 900,000 16,921,433 16,921,433 5,076,430 11,845,003
4 2,950,000 10,068,478
5 2,950,000 16,110,702
6 2,950,000 23,942,266
7 2,950,000 33,648,379
8 2,950,000 45,493,382
1,770,000 14,788,478
19,060,702
26,892,266
36,598,379
48,443,382
YEAR ENDED XYZ 5,359,739 5,359,739 6,942,224 6,942,224 8,731,564 8,731,564 10,606,114 10,606,114 12,745,003 12,745,003
1,770,000 1,770,000 -
424,800
212,400
ou have extracted from the system st for 3 days ng on Monday morning a Book Overdraft
ached to it
t will reduce
e is no obligation to pay - that is sharing of profits, that is ors - even if I make fantastic profits but
ind an answer
ompany's shares?
7.50%
u (as compared to Sensex) DLF Sensex 8.00% 21.38% 29.38% 7.50% 1.00
my partner
e growing
om equity (mix)
21.27%
ny for the past two years and work out is called as the "beta"
m x Beta)
size is one tenth of the size of the average make your beta 1.81 instead of 1.31
djustments for size h publish beta for various sectors and also djustments
MorningStar
r summer vacation
r than computed
cussion) and we try and measure profit rovides some understanding of risk
Operating Leverage
Financial Leverage
19.20% 10.00%
1.92 times
a 1.92% change in EBIT 26.67% 19.20% 1.39% change in PAT 26.67% 10.00% 2.67 times 1.39 times
2.67 times
op by 33%
9 147,746 257.73 38,078,153 100.00 14,774,554 2,000,000 21,303,598 900,000 20,403,598 20,403,598 6,121,080 14,282,519
10 Growth 1+x 155,133 5% 105% 275.77 7% 107% 42,780,805 100.00 0% 100% 15,513,282 2,000,000 0% 100% 25,267,523 900,000 24,367,523 24,367,523 7,310,257 17,057,266
9 2,950,000 59,775,901
10 2,950,000 76,833,167
62,725,901
79,783,167
79,783,167 79,783,167
####### Asset book value ####### Sold for the same amount and enh No profit no loss on sale
15,182,519 15,182,519
FINANCE - QUESTION PAPER - JAN 2012 TIME - ONE HOUR, LAPTOP ALLOWED Question One Company X Ltd figures are as under: Year ending March 31 Mar-11 Profit After Tax 150 Share Capital 50 Face value per share (Rs) 10 Market price per Share as at Jan 7, 2012 - Rs What is its trailing EPS What is its forward EPS What is the trailing PE What is the forward PE
Dec-11
Question Two Company Y relevant figures for the year ended March 31, 2011 are as under: Rs cr Profit After Tax 250 Share Capital 100 Face value per Share (Rs) 5 Market price per Share (Rs) 278 If it declares a dividend of Rs 12 per share, what are the following: Dividend % Dividend Payout Dividend Yield
Question Three Your friend has taken a loan of Rs xx from you. He will pay you back Rs 5 lakhs after 3 years, Rs 2 lakhs after 4 years and Rs 2 lakhs after 5 years. Your rate
of interest on this deal is 12%. What is the amount you have lent him today?
Question Four In your insurance policy, you pay an annual premium of Rs 12,700 for 20 years You get back Rs 4,50,000 after 20 years. What is your rate of return?
Question Five You are setting up a new project and this project will cost you Rs 10 cr You will lose Rs 1 cr in year one, earn Rs 2 cr per annum in year two and then Rs 4 cr per for the next five years End of this perid, you will exit the business and realize Rs 3 cr Your cost of capital is 15% Evaluate the project using payback period, NPV and IRR Provide your recommendations on the project Question Six
Your borrowing rate is 12.50%. You pay tax at 22% on your profits. Risk free rate of interest in the economy is 8.50%. Incremental return on equity demande by investors is 8%. Your company beta is 1.31. Your debt equity mix is 40:60 What is your cost of debt What is your cost of equity What is the weighted average cost of capital
12 marks
as under: 9 Marks
6 marks
15 marks
12 marks
1 Refresh of WACC 2 Refresh of the Cash Flow Statement 1 Incorporation of risk in the capital budgeting process NPV, IRR, Payback 2 Equity versus Project Is the project profitable? Is your child doing well? Will the owners be happy? Are you happy about that ? 3 Bonds - what are bonds, how are they valued? 4 Very simple options on bonds 5 DuPont Analysis WACC Capital comes from two sources - Debt and Equity Debt is cheaper (prima facie) Why He (the lender) does not demand a share of your profit He is happy with a fixed return (interest) In comparison our equity partner is very demanding He says company earned Rs 1,000 cr - I am 50% partner, so give me Rs 500 cr Of course, if the company makes losses, he keeps quiet The second reason why debt is cheap is that interest is tax deductible If I pay interest, it becomes an expense for tax purposes So I save tax by having such an interest expense WACC
Cost of Debt
Your interest rate is say Your tax rate is say You are profitable Tax benefit on interest Your post tax cost of debt
If on your home loan you are paying 11% interest and your tax slab falls in the 30% range, th cost is not 11% It is only 7.7% Some people think that the home loan is very expensive and we should repay Bcoz they look at 11% They are wrong They should look at 7.7% Total Interest is Rs Tax benefit 225000 45000 20% 11.00% 2.20% 8.80% 150000 45000 75000 0
30%
Your HDFC rate is Tax benefit is Your post tax cost of debt
Cost of debt = Pre tax cost x (1-t) where t is the tax rate
Company is loss making Your interest rate is say Your tax rate is say You are not profitable Tax benefit on interest Your post tax cost of debt
Your company is an SEZ Unit where no tax is applicable Your interest rate is say 11.00% Your tax rate is say 28% You are not profitable Tax benefit on interest 0.00%
11.00%
Cost of Equity Your shareholders cannot demand anything (like a fixed rate of interest) If you are profitable, they are happy - bcoz the share price will go up - even if you dont pa How will shareholders think about investing in your shares / equity ? Why should a shareholder buy your shares ? What is his expectation from you ? Thinking is very psychological - half finance, half psychology What is the risk free interest in the country - he could have invested in those securities G Sec 10 year bond 8.52% lets say But your equity carries tons of risk while that G Sec is risk free So what? He will demand a risk premium from you - he will expect a higher rate of return
Generic Equity Risk Premium - for any investment in a model portfolio (Sensex, Nifty, some Sensex is made up of 30 leading stocks in the country Nifty is made up of 50 leading stocks in the country Let us suppose that this risk premium demanded by rational investors today is 8% Rational investors will demand a total return of 16.52% return for investing in the Sensex / If they dont see a return of 16.52%, they will not be interested in equity
Sensex BSE Index Nifty NSE Index Both exchanges compete with each other Out of the 30 in the Sensex most of the time 27 to 30 will also be part of the Nifty (very hig In reality, Sensex and Nifty move very very closely with other each other If in a month, Nifty appreciates 10.31%, Sensex will appreciate 10.32% The absolute numbers are very different
Your company is not the Sensex / Nifty Your company is XYZ company The investor will ask : what is the risk in your company relative to Sensex If we denominate Sensex risk as 1.00, then what is your risk? Let us say your risk is seen to be 1.41 (beta) You are more risky than the Sensex Investor will demand a higher return from you How much higher return? G Sec + (Equity Risk Premium x Beta) 8.52% 8% 1.41 Cost of Equity 19.8%
He will expect a min return of 19.80% on his investment in equity in your company If some other company beta was 0.81, what does that mean It is less risky than the Sensex
Humanity needs benchmarks - for any relative discussion a benchmark is essential In my SSC I got 81% If the max marks that anyone could have got be assumed to be 100, then what I got is 81 What is the benchmark here? 100 is the benchmark We use 100, we use "x", we use 1.00, we use "light years" My age is 35 years Why years Convention understood by humanity
Investing in Sensex means investing in all 30 stocks in the same proportion in which they fo
WACC
Mix
If I dont earn Rs 14.81 on every Rs 100 given to me by society (lenders + shareholders toge then they will punish me The min return, the IRR, the hurdle rate is 14.81% If I dont earn even 14.81% over the long run, then I dont deserve to exist in business (King World is changing every day The WACC may keep changing - dynamic concept In reality, we dont 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 expense Dividend 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 deductible But the electricity bill is not tax deductible
DuPont Analysis DuPont is one of those rare entities which has survived more than 100 years in this world P&G - 180 years, Dun & Bradstreet - 180 years
Financial analysis, costing, financial reporting - these disciplines got their shape in the 192 After the 1st world war, US was in great shape 1920s are called as the roaring twenties - huge wealth, sudden wealth, huge inequity in dis In India, a cream of the population is enjoying a great time Bulk of the people are still in poverty DuPont said dont calculate 100s of financial ratios for the mere purpose of calculation Be clear - what are you going to do with these ratios If you have too much info, that is misleading - have focussed information Richard Collins - Built to Last, Good to Great
Lets look at the best performing companies over the last 30 years Lets see if we can learn from them He defined best performing as those which have generated maximum shareholder return ov Walgreens - pharma retail company They focus on one single financial ratio - profit per store Way back in the 1920s, DuPont did the same thing They said - focus on one ratio - RoE - Return on Equity The shareholder invests in you so that you earn for him a high return on his equity RoE = RoNW = RoE = PAT Net Worth PAT Net Worth =
Capital Employed = Net Worth + Debt Sales Capital Employed Debt Equity (Net Worth) PAT 100 40 Equity + Debt 15 25 7
RoE =
7 25
7 100 Margins 7%
28%
Shareholders are a very demanding community They want higher RoE - 28% is good, but they want more How do I increase my RoE Can I make it 31% - how ? What to do ? Some ideas will increase margins Some ideas will increase efficiency Some ideas will increase solvency number So these will increase RoE - or will they? Will depress efficiency, solvency Will depress margins
A bright idea - lets increase selling prices which will improve margins, depress efficiency an solvency unchanged - lets see what happens 27% = 8% x times Not a very bright idea - the RoE is being depressed Another idea Let us reduce selling prices, increase volumes, more movement, more efficiency 33% = 6.5% x times Fine, lets go ahead 3.2 x 2.1 x
DuPont insight into quality of earnings How strong are the earnings How vulnerable
How stable, how volatile If some tsunami comes along, will you die or survive (compared to others) RoE A B C D 30.0% 30.0% 30.0% 30.0%
Margins EfficiencySolvency 10% 3.00 1.00 5% 4.50 1.33 2% 4.00 3.75 1% 5.00 6.00 Over ambitious entrepreneurs - over gr AKAI, AIWA
How would you rank them ? A Margins are excellent, so they have some strength - great brand, great pricing po technology, some people, locational advantage, Govt policy, vintage, age A great strength on margins - has it made them a little slow, lazy, complacent ? Corporate aristocracy Solvency - zero debt company Very conservative in borrowing Old rich A great idea which can earn 16% return - he will propose we do this for USD 300 His boss will think and think - and allow him to do for USD 30 mio - 30 days Reliance - same idea USD 300 mio Senior most people - call him in 30 minutes Are you convinced Yes So why not do this for USD 3,000 mio - why USD 300 mio B
What it loses on margins, it makes up on efficiency Quite low debt Bright boy on the horizon - running fast, enthusiastic - stiff competitor for Comp Very low margin compared to A Not so efficent as B Making money on money - by borrowing heavily Making money on a business with thin margins is not a reliable source of making
Bad product - cant sell without heavy discounts - no strength in the business itse Super efficient Is super efficiency good or bad ?? Super efficiency to make up for margin deficiency - is highly dangerous Super efficiency has a tendency to break down I want my aircraft to run 6 times a day Other airlines run 4 times a day So I compromise on maintenance, checking, etc etc Super efficiency means 1 My customer will pay me at 10 am in the morning 2 I will deposit high value cheque at 1015 am 3 This will be credited in my account at 1130 am (I know the bank) 4 I will pay my excise duty at 1145 am 5 My consignment will be cleared at 1230 6 It will reach the customer at 230 7 This customer pays on delivery at 245 8 I will deposit this cheque at 330 and get credit by 430 9 I need to pay wages at 530 today evening Very dangerous If one link breaks, then the whole wheel is jammed Transport strike Bank strike Customs strike Olympic runner - winner of the Gold medal 100 meter race Great fellow He wants to go to his office from his house He starts running on the road as if it were the Olympics What will happen Very risky Efficiency is like haemoglobin Normal range 10 to 14 8 is a problem 18 is also a problem
Very high efficiency with borrowed funds is very very high risk Company is very vulnerable to macro factors and can collapse any moment
Margins EfficiencySolvency 10% 3.00 1.00 5% 4.50 1.33 2% 4.00 3.75 1% 5.00 6.00
Suddenly, India is flooded by Chinese p All companies are forced to reduce the margins by 2% RoE Margins 24.0% 8% 18.0% 3% 0.0% 0% -30.0% -1%
If money is available easily, that is a major curse (not a blessing) Outliers - Gladwell One good book a month - must
Key Ratios Banking sector - profit per branch, profit per employee Hotel sector - Average Room Rent (per day) Telecom sector - Average Revenue per User (ARPU) Cement sector - EBIDTA per Ton Hospital sector - Average Revenue per Bed (per day) Walgreens - profit per store Retail sector - Gross Margin Return on Inventory (GMROI), Gross Margin per Sq Ft
Bonds - what are bonds, how are they valued? You are a mfg company and you avail of a loan from SBI of Rs 25 cr This is a private transactions between you and SBI When you return the loan you will return to SBI Alternatively, you could issue bonds of Rs 25 cr to whosoever subscribes to these bonds You got your Rs 25 cr and it is a loan (debt)
A bond is a debt instrument But who is the lender? Not one bank - many entities (banks, financial institutions, retail, ot Govt companies, foreignors, mutual funds, insurance companies) These bonds will thereafter be traded in the bond market So, ICICI Prudential subscribed to Rs 2 cr of your bonds Then they sold these bonds to Reliance Mutual Funds for Rs 2.01 cr after 7 days Reliance is the holder of the bonds
The bonds have a tenor of 7 years In 7 years, they were bott and sold 73 times After 7 years, one market participant will come to you and ask for redemption and you will In bonds, a market develops Issue Price Redemption Price Tenor Coupon Payable frequency - once a year 100 100 7 years 8%
On day one, Tata Power issues bonds of Rs 25 cr (25 lakh bonds of Rs 100 each) Many entities subscribe to these bonds
The coupon is paid to the holder of the bond on the date of the coupon If the bond issue happened on Jan 21, 2012, then the coupon will be paid to the holders on Bond market has not developed There is a reasonable G Sec market but the only players are institutions The Indian public is quite unaware of this instrument Mutual funds are major players in the fixed income market
give me Rs 500 cr
Equity Cost
d we should repay
l investors today is 8%
sted in equity
ative to Sensex
benchmark is essential
d information
1.6 times
ared to others)
h - great brand, great pricing power, some Govt policy, vintage, age a little slow, lazy, complacent ? Appears so
propose we do this for USD 300 mio o for USD 30 mio - 30 days
y - is highly dangerous
et credit by 430
ly, India is flooded by Chinese products in this sector mpanies are forced to reduce their prices affecting Efficiency Solvency 3.00 1.00 Most safe 4.50 1.33 4.00 3.75 5.00 6.00 Most risky
BONDS Tata Power issues bonds of Rs 25 cr Rs Issue Price Redemption Price Tenor Coupon Payable frequency - once a year 100 100 7 years 8% Rs 100 105 7 8%
If the bonds are issued on Jan 22, 2012, the interest coupons may be paid on each Jan 21st 7 years Whosoever holds these bonds on Jan 21st will get full year interest
So, if you bott these bonds on Jan 17, 2014, in all fairness, you should get interest for 4 da will, in fact, get interest for one full year Dividends are paid on a certain record date As of that date, whosever is the owner of those shares gets the dividend We know that Diwali comes sometime in Oct / Nov We may forecast that this company pays dividends sometime in Sept / Oct An AGM is a must once a year - dividends are declared at the AGM and paid within 42 days Dividend of Rs 2 on a share Price today is Rs 31 (cum-div) On the day after record day, what will happen? Price will be Rs 29 (ex-div)
Why is the term "coupon" used? What is wrong with the term "interest"? Why introduce com Accrued interest challenge Interest accrues on the bond every day (at the rate of 8% per annum) 0 1 2 3 100.00 0.022 0.044 0.066 8%
If you buy the bond after 52 days, you will pay the seller Rs itself plus Rs 1.140 towards accrued interest
4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42
0.088 0.110 0.132 0.153 0.175 0.197 0.219 0.241 0.263 0.285 0.307 0.329 0.351 0.373 0.395 0.416 0.438 0.460 0.482 0.504 0.526 0.548 0.570 0.592 0.614 0.636 0.658 0.679 0.701 0.723 0.745 0.767 0.789 0.811 0.833 0.855 0.877 0.899 0.921
Suppose for simplicity, the price of the bond itself is Rs 102 will pay a total of Rs 103.140 Clean price Interest accrual Dirty price 102.000 1.140 103.140
If you buy the bond on Jan 17, Tata Power will pay you one on Jan 21 (but you dont deserve to get one year interest, y only 4 days interest) You will pay the counterparty 361 days interest Tata Power will pay you 365 days intrerest Net net you got 4 days interest
43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81
0.942 0.964 0.986 1.008 1.030 1.052 1.074 1.096 1.118 1.140 1.162 1.184 1.205 1.227 1.249 1.271 1.293 1.315 1.337 1.359 1.381 1.403 1.425 1.447 1.468 1.490 1.512 1.534 1.556 1.578 1.600 1.622 1.644 1.666 1.688 1.710 1.732 1.753 1.775
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120
1.797 1.819 1.841 1.863 1.885 1.907 1.929 1.951 1.973 1.995 2.016 2.038 2.060 2.082 2.104 2.126 2.148 2.170 2.192 2.214 2.236 2.258 2.279 2.301 2.323 2.345 2.367 2.389 2.411 2.433 2.455 2.477 2.499 2.521 2.542 2.564 2.586 2.608 2.630
121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159
2.652 2.674 2.696 2.718 2.740 2.762 2.784 2.805 2.827 2.849 2.871 2.893 2.915 2.937 2.959 2.981 3.003 3.025 3.047 3.068 3.090 3.112 3.134 3.156 3.178 3.200 3.222 3.244 3.266 3.288 3.310 3.332 3.353 3.375 3.397 3.419 3.441 3.463 3.485
160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198
3.507 3.529 3.551 3.573 3.595 3.616 3.638 3.660 3.682 3.704 3.726 3.748 3.770 3.792 3.814 3.836 3.858 3.879 3.901 3.923 3.945 3.967 3.989 4.011 4.033 4.055 4.077 4.099 4.121 4.142 4.164 4.186 4.208 4.230 4.252 4.274 4.296 4.318 4.340
199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237
4.362 4.384 4.405 4.427 4.449 4.471 4.493 4.515 4.537 4.559 4.581 4.603 4.625 4.647 4.668 4.690 4.712 4.734 4.756 4.778 4.800 4.822 4.844 4.866 4.888 4.910 4.932 4.953 4.975 4.997 5.019 5.041 5.063 5.085 5.107 5.129 5.151 5.173 5.195
238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276
5.216 5.238 5.260 5.282 5.304 5.326 5.348 5.370 5.392 5.414 5.436 5.458 5.479 5.501 5.523 5.545 5.567 5.589 5.611 5.633 5.655 5.677 5.699 5.721 5.742 5.764 5.786 5.808 5.830 5.852 5.874 5.896 5.918 5.940 5.962 5.984 6.005 6.027 6.049
277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315
6.071 6.093 6.115 6.137 6.159 6.181 6.203 6.225 6.247 6.268 6.290 6.312 6.334 6.356 6.378 6.400 6.422 6.444 6.466 6.488 6.510 6.532 6.553 6.575 6.597 6.619 6.641 6.663 6.685 6.707 6.729 6.751 6.773 6.795 6.816 6.838 6.860 6.882 6.904
316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354
6.926 6.948 6.970 6.992 7.014 7.036 7.058 7.079 7.101 7.123 7.145 7.167 7.189 7.211 7.233 7.255 7.277 7.299 7.321 7.342 7.364 7.386 7.408 7.430 7.452 7.474 7.496 7.518 7.540 7.562 7.584 7.605 7.627 7.649 7.671 7.693 7.715 7.737 7.759
355 356 357 358 359 360 361 362 363 364 365
7.781 7.803 7.825 7.847 7.868 7.890 7.912 7.934 7.956 7.978 8.000
How is the bond priced? How are interest rates moving in the economy Interest rates are dynamic - they keep changing Inflation, RBI policy on SLR, CRR, Government deficits, tax collections, elections, USD INR r
Tata Power has issued this bond - 8% coupon, 7 year tenor, Rs 100 face value, redemption v On that day of issue, the coupon of 8% was very fair - it has to be fair If they pay more than fair, they are stupid If they pay less than fair, nobody will subscribe Two months later, life has changed, interest rates have moved Now the interest rate in the economy (and for Tata Power) has gone to 8.31% If Tata Power were to issue a bond today, that bond would have to be issued at 8.31%
This bond however has a fixed coupon of 8% (you cant change the terms of the bond) How will the market adjust? The market will adjust by repricing the bond - the price of the bond may no longer be Rs 10 Price will move
If the yield in the market nowadays is 8.31% and this bond generates a coupon of Rs 8.00, i 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 0 1 2 3 4 5 6 7 CashFlow 8 8 8 8 8 8 108
"One year" has passed and interest rates in the economy have risen to The cash flows on this bond will be discounted at the current yield Year 0 1 2 3 4 5 6 CashFlow Disc Fact Pres Val 1.000 8 0.923 7.39 8 0.852 6.82 8 0.787 6.30 8 0.727 5.81 8 0.671 5.37 108 0.619 66.90 98.58 r= 1+r=
Interest - generic term denoting what you can earn on a bond Coupon - the rate of interest as per terms of issue of the bond Yield to maturity (YTM) - a specific term indicating what you will earn over the life of the b A 8% coupon translates into a 8.31% YTM
Bond markets are very complex and software programs costing crores of rupees are used to and derivatives on bonds
Fine pricing - if the buyer quotes 98.5812, the seller may quote 98.5813 Equity market - WABCO TVS - bid - 2412, ask - 2415 - bad pricing How is your life connected to bonds You may never buy bonds if deal size is min Rs 100 cr Are we wasting our time on this topic ? Many of us might be investing in mutual funds There are two types of funds - equity funds and debt funds Debt funds invest in bond markets By investing in debt funds, you are investing in bond markets
The NAV of these funds will move up and down adversely in relation to interest rates In the last two years, interest rates have been rising and therefore Debt Fund NAVs have be Now, if you believe that RBI is at the end of its cycle and interest rates will fall Debt Fund NAVs may tend to rise
Which fund to invest? Debt funds or Equity funds - thats the right choice If 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 equity Instead of buying Infosys, TCS, SBI shares, you have decided to buy Equity Funds Debt funds - low risk, low return - substitute for bank fixed deposits Instead of going to Indian Bank and placing a FD, you have chosen Debt oriented 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 In an FD, your interest income is taxable at 30% in most cases In a Debt Fund, your income will be either dividends or capital gains Rate of tax may vary from 10% to 15% FD earns Tax Post tax 9.00% Debt Fund 2.70% Tax 6.30% Post Tax 8.00% 0.80% 7.20%
30%
10%
Open ended has no expiry date - it may remain open for decades Close ended funds will end on a certain day FMP - Fixed Maturity Plans - 180 days, 368 days
There are fixed rate bonds (the Tata Power bond above) and there are floating rate bonds In a floater, you will be paid LIBOR plus 100 basis points (1%) If LIBOR today is 0.65%, you will be paid 1.65% After one year LIBOR goes up to 0.85%, you will be paid 1.85% What is LIBOR London Inter Bank Offered Rate It is the rate at which a panel of banks are ready to lend to each other today So Bank of America has quoted a rate of 0.65% to Citi for a 1 year USD Loan (today) This LIBOR changes every day Banks are usually strong banks If a bank becomes weak, that bank is pulled out of the panel SBI will think - LIBOR plus 200 bps is fine Tata Power will think - LIBOR plus 250 bps is fine Reliance - LIBOR plus 225 bps is fine Visa Steel may be happy with LIBOR plus 700 bps Credit spread of 200 bps
OPTIONS ON BONDS Lakhpati Bond issued by IDBI once upon a time Another Lakhpati Bond issued by SIDBI soon thereafter IDBI said - give us Rs 2,800 and we will give you back Rs 1 lakh after 30 years SIDBI said - give us Rs 2,500 and we will give you back Rs 1 lakh after 30 years People went crazy in the desire to become a Lakhpati But nobody became a lakhpati and are not going to become either Why? What is the yield on these bonds?
IDBI Bond
2800
12.66%
113%
30
35.71
100,000
On the date of issue, IDBI was quite prepared to be 12.66% per annum for the next 30 years With passage of time, interest rates fell (in the economy) IDBI suddenly felt a little stupid
But they had been smart in the terms of issuue The terms of issue mentioned that IDBI can call back the bond after 5 years, 10 years, 15 y 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
WHAT IS RISK Risk is volatility of returns Returns can even swing negative (volatility includes loss of principal also) In any project there will be 5 to 10 key parameters which can make or break the project There may be 10,000 parameters - but 10,000 cannot be handled by humanity Most of them may be not material Wisdom is in detecting which are the major ones and focusing on them In our projections, conduct a sensitivity on those 5 to 10 parameters How much can they swing If your sales is based on GDP growth in the economy, how much can GDP growth swing Min 5% Max 10% What are those factors How much can they swing Volume Price p Unit Sales Revenue Variable Costs p U Variable Cost Amt Contribution 10.00 5.00 50.00 3.00 30.00 20.00 10.50 5.40 56.70 3.21 33.71 23.00 11.03 5.83 64.30 3.43 37.87 26.43 11.58 6.30 72.91 3.68 42.54 30.37 12.16 6.80 82.68 3.93 47.80 34.89
10.00 10.00
10.80 12.20
11.66 14.77
12.60 17.77
13.60 21.28
0.77 9.38
0.67 9.97
0.59 10.52
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 a Rs 10 in the first year, Rs 12.20 in the second year and so on Various assumptions 1 First year volume will be 10 2 Volume will grow at 5% 3 First year selling price will be Rs 5 per unit 4 Selling price will grow at 8% 5 First year VC per unit will be Rs 3 6 These VC will grow at 7% 7 First year FC will be Rs 10 8 They will grow at 8% 9 A realistic WACC for this project is 14% Nobody knows the future and all 9 assumptions could be erroneous, over optimistic ??? How wrong is wrong? If I very wrong, what will happen to me? What worst can happen?
What is the best situation? What is the worst situation? How far are these two situation Sensitivity will help you in weeding out those factors which are not deal breakers Is selling price more important than managing fixed costs? Is volume more important than WACC ?
5.25 5.50
60.55 71.40
122% 144%
10.50 11.00
47.72 45.75
96% 92%
What do you mean by risk free? No variation in return In your PPF what is the return? 8% 8% in which situation? All situations Equity versus Project Project is funded by two sources - Equity and Debt
If project earns 16% and the WACC is 14%, project is doing pretty well (beating the WACC b How much will owners make? Owners cost is cost of equity If cost of equity is say 17%, will owners make 19% ? If project earns 11% and the WACC is 14%, project is pretty bad (below the WACC by 3%) How much will owners make? Owners cost is cost of equity If cost of equity is say 17%, will owners make 14% ? What is the Project IRR and how does it differ from Equity IRR ? If the Project does well, the Owner will do very well If the Project does badly, the Owner will do very badly The Owner's fortunes will swing more than the Project's fortunes If Commonwealth Games do well, Kalmadi will do very well If Commonwealth Games do badly, Kalmadi will do very badly
Year 0 1 2 3 4
Proj IRR
22%
In Project Cash Flows, we ignore interest We ignore loans availed We ignore loans repaid
If you want to look at this project through the Owner's eyes (completely new concept), the the cash flows?
Project Debt Interest Owner's CashFlow 12% CashFlow -100 35.00 (65.00) 40 (8.75) (4.20) 27.05 40 (8.75) (3.15) 28.10 40 (8.75) (2.10) 29.15 40 (8.75) (1.05) 30.20 22% OwnerIRR 27%
Owner IRR in a good project is higher than Project IRR bcoz Owner makes money in two wa 1 He makes money from the project 22% 2 He makes money from money 5% 27% If I bring in more debt, what will be happen? Owner IRR will shoot up - better and better Debt 20 30 35 40 50 60 70 80 27% 24% 26% 27% 28% 30% 34% 41% 52% If annual cash flows are lower 22% 27% 20 -8% -20% 25 0% -6% 30 8% 6% 35 15% 16% 40 22% 27%
8.00
365
ys, you will pay the seller Rs xx for the bond towards accrued interest
Tata Power will pay you one year interest ve to get one year interest, you deserve
ollowing table
8.31%
8.31% 108.31%
8.31%
ation to interest rates fore Debt Fund NAVs have been falling est rates will fall
5% 8% 7%
8%
108%
Selling PPF Risk Free Price Return 4.50 8% 100% 4.75 8% 100% 5.00 8% 100%
5.25 5.50
8% 8%
100% 100%
8.75
Valuation of Equity 1 PBV 2 DCF Enterprise Value EVA Working Capital Management
Bonds - we dont buy for sale - there is no market in India PBV Value of shares comes from two sources: 1 Assets Few sectors 2 Earnings Most sectors If you have strong assets, the asset value becomes the share value in "some sectors" You have a company which has only one asset - residential flat Balance Sheet Share Capital
2 Property
The value of the company is Rs 2 cr driven by the asset You give this flat on rent and you earn Rs 10 lakhs over the next one year Balance Sheet Share Capital Reserves Profit & Loss Account Operating Expenses
0.02 0.10
Value of the company will be Rs 2.10 crores This value is driven by its assets (property and cash) At a deeper level, if the value of the flat has increased to say Rs 2.50 cr, then the value should have become Rs 2.60 cr
The assets can either be recognized at book value (Bal Sheet) or at market value Stock markets would recognize market value if the asset can be easily detached and sold this market value
2.00 Cash
You have good people, but they dont appear in the Bal Sheet You earn a profit of Rs 5 cr, sales of Rs 15 cr, expenses of Rs 10 cr Balance Sheet after one year Balance Sheet Share Capital Reserves
What do you think will be the "value" of this company Will you be okay to sell this companny for Rs 7 cr? What is driving that value? This company earns Rs 5 cr per annum as profits Give me 10 times earnings as the value I want a valuation of Rs 50 cr (actual assets are only Rs 7 cr)
ASSET BASED VALUATION Share Capital (Face Value Rs 10 p share) Reserves Shareholders Funds (Net Worth) Outside Liabilites Total Net Assets means what? 1 Assets minus Outside Liabilities 500 300 200 2 Net Assets means Shareholders Funds 40 160 200
Book Value per Share = Shareholders Funds per Share (Net Worth per Share) Share Capital 40 Rs cr Face Value per Share 10 Rs No of Shares issued 4 cr Shareholders Funds 200 Rs cr Book Value per Share 50 Rs
If this company's valuation was indeed driven by assets and the book value of the assets w the market value of the assets, then the share price ought to hover around Rs 50 If the share price was say Rs 20, this might be a great buying opportunity If the share price was say Rs 200, this might be a great selling opportunity
In the normal course of accounting, the Balance Sheet values of assets are based on "hist In the case of long term assets, this cost is further reduced by "depreciation"
In long term asset heavy industries, the book value may not be very representative of the Market values for real estate may be far higher than book value Market values for plant and machinery and vehicles may be far lower than book value BANKING SECTOR
Liabilities Share Capital Reserves Net Worth Deposits - Fixed, Current, Savings Loans from Other Banks Current 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) 1 2 3 4 5 6 7 8
www.moneycontrol.com Data for various banks - public, private Work out the Book Value per Share on March 31, 2011 - readily available Work out the Book Value per Share on December 31, 2011 - not readily availab Look up the price today Work out the PBV - Price / Book Value What do you think Each person 3/4 banks State Bank of India Punjab National Bank Union Bank Canara Bank Indian Bank Bank of India Dena Bank UCO Bank Syndicate Bank Corporation Bank
Bank
March BV
June Qtr Sept Qtr EPS EPS 109 82 109 463 1023 478 536 292 5 4 6 25 25 15 26 13 5 4 7 23 44 13 29 9
Dec BV
HDFCBank IndusInd Yes Bank Axis SBI ICICI BoB BoI PNB Union Canara Corporation Indian Allahabad Andhra Federal Syndicate Dena
16 27 9
19 27 11
19 24 12
123 104
6 5
6 5
6 6
141 120
Pvt banks get higher PBV than public sector banks The larger banks appear to get a higher PBV
If Indian Bank has assets of one rupee, the market is valuing them at 84 paise (16% discou Market is of the belief that 16% of the assets will not be realized (will be lost) - bad loans HDFC Bank is not a bank A bank is supposed to borrow funds and lend funds and make the difference In London, in the 1980s, they used to say banks are 3-6-3 businesses You borrow at 3%, you lend at 6%, you go home at 3 pm (play golf with your customers) A bank is supposed to borrow funds and lend funds and make the difference
This business is quite tough and competitive Money knows no loyalty If you are a depositor and X bank gives you 7% and Y bank gives you 7.25%, whom do you Y Bank - your family has been with X bank for 73 years
If you having using Colgate toothpaste since birth and Colgate is more expensive than Pep with Colgate HDFC Bank is not a bank HDFC Bank - a very huge share of profits and revenues come from non-banking activities Fund based income and Non-fund based income Fund based income means interest income Non-fund based income means Commission on selling insurance policies to you and me Commission on mutual funds Commission on foreign exchange Treasury activities Advisory to corporates on forex, treasury More than 40% of their profits come from non-fund initiatives Which poor Dena Bank and Syndicate Bank have not been able to develop Are the PBV of smaller PSU Banks too much beaten down? For example, the market is valuing Dena Bank as if 27% of its loans will not be returned Syndicate Bank - 22% of their loans will not be paid back Indian Bank - 16% will not be paid back All these banks have already made some provisions for bad loans (as per RBI regulations) Provide means reduce your profits, reduce your reserves, reduce your Book Value Small Project 1 Take 4/5 banks from the above 2 Track their max PBV and min PBV over the last 5 years - PBV range Annual PBV from moneycontrol
Max / Min price range for each year Max / Min PBV range 3 Compare today's PBV with the range and determine where Today's PBV is Max PBV Min PBV
Book Value Book value represents the net assets and in sectors like banking provides a good benchma itself In other sectors which are driven by "earnings", the book value may act as a floor
Infy price is Rs 2,900 Infy book value is lets say Rs 500 Rs 2,900 is driven by earnings, but in a real read bad situation if the price falls, then Rs 5 floor for the price SAIL - price fell below book value - Rs 80 GMR Infra - book value Rs 25 - it went to Rs 17, 18
Earnings Upside
Earnings are the driver for most sectors (other than Banking, Real Estate) EPS is say Rs Price Price Earnings Multiple PE 20 per Share 250 Rs per Share 12.5 times
If you track the history of the PE over several years, ten years, you will get the max / mi Comparing that to today, you will get a sense of expensive or cheapness of the security Feb 3, 2012 PE
5,326 This number by itself is meaningless 18.97 All the meaning is here in the PE
If the Nifty companies were to earn one rupee, the market is valuing them at Rs 18.97 Nifty is an index of India's top 50 companies Is this 18.97 times too high, too low, around the average? Is the Nifty too expensive, too cheap, just about okay ?
You want to buy a flat in Chennai You have a house, you are buying for earning some rental income Price Rental PE Ratio 10,000,000 20,000 500 12,500,000 27,000 463
Which flat is more expensive? A flat in Anna Nagar costs 500 times monthly rental income, while one at Mylapore costs income Anna Nagar is more expensive The price does not matter in a financial asset, the PE matters If Infy price is Rs 2,900 and Satyam price is Rs 72, which is more expensive?
Cant say - we need to track the earnings and only then we can comment Infy is earning Rs 110 per share and Satyam is Re 1.05 per share Infy Satyam 2900 72 110 1.05 26.36 68.57 Very expensive
Many people immediately conclude that a low PE company is cheap and should be a good And a high PE is expensive and should be sold off But that may not be correct How come ? Low PE may have been low for 20 years, you saw it today High PE may have been high for 20 years So what does that mean?
Where does the PE come from ? Why is the PE of Co X so high (and consistently high) and Co Y so low (and consistently lo Asian Paints and Berger Paints - Asian Paints PE 32 times, Berger Paints 21 times (today, Asian Reputation Size Earnings Price PE Berger Asian
100 1000 10
80 800 10
100 3200 32
Reliance PE more than Cairn Energy IOC should be more than HPCL, BPCL Market share ? More market share more PE ? Distribution strength ? More dist strength more PE ? Consistent high RoI ? The PE is an indicator of "respect" The stock market quantifies everything, including reputation, respect, goodwill The PE comes the following factors: 1 Consistency of financial performance
2 Growth prospects in earnings PEG Model - was proposed by Peter Lynch Peter Lynch was a fund manager in Fidelity In 1977, he managed a fund called Magellan Fund - the size of the funds was USD 20 mio 20 USD Mio 50 USD INR 100 Rs cr By 1990, the fund size grew to USD 13 billion 13 USD Bio 50 USD INR 65000 Rs cr He came up with a possible answer to the question - what drives the PE PEG Model : Price Earnings to Growth
The optimium PEG is 1:1 If your growth in earnings (EPS) is expected to be 18% per annum, then your P 18:18 = 1:1 If your growth in earnings (EPS) is expected to be 18% per annum, and your PE PEG = 12:18 = 0.67:1 What does this mean ? Stock is underpriced, could be a good buy
If your growth in earnings (EPS) is expected to be 18% per annum, and your PE PEG = 22:18 = 1.22:1 Stock is overpriced, could be a good sell
Companies and sectors whose earnings are expected to grow rapidly will command a high which are slow growth will command a low PE
Growth Stocks (High Priced, High PE) Value Stocks (Reasonably Priced, Mid PE, Low PE)
This became a big theme, investing philosophy What do you mean by size? Who is large? Who is small ?
In the 1980s, if you read Business India, it would give you a listing of the largest Indian co That list would be based on "assets" More assets, more size Top of the list would be : Tatas, Birlas, FERA Companies (MNC), Mahindras, Mafatlals Late 1980s, early 1990, size came to be defined by Sales Turnover Oil companies started appearing in the list After mid 1995, when FIIs started investing in the market, size was again redefined Size was now defined as "Market Cap" Market Cap = Price per Share x No of Shares Today, this definition is valid
If your read Business Today annual issue, you will find Top 500 listed in the order of Mark Suddenly you find that Infosys and TCS which by asset size or sales turnover are nowhere the list Market Cap Market Cap Large cap stocks More than Rs 10,00 cr Top 200 Mid cap stocks Small cap stocks Rs 5,000 - Rs 10,000 cr Next 300 Less than Rs 5,000 cr Others
Why should Asian Paints command 32 PE Asian Paints EPS is expected to grow faster than Berger Paints Asian Paints has done better and has been more consistent than Berger in the past ten ye
Asian Paints share is more expensive but deservedly more - need not be a good sell Berger may not be a good buy (inspite of a lower PE) Dont look merely at the PE, also look at the PEG If the PEG is less than 0.70:1, then it could be a great buy If the PEG is more than 1.30:1, then it could be a good sell The investment world believes that in reasonably stable industries the PEG works well Pharma, FMCG, IT - PEG would be reasonably good as an indicator
Guidance Forecast earnings levels provided by management itself (not mandatory) Forward earnings are estimates by analysts - analysts do consider guidance while estimat earnings
The PEG has been terribly misused by Indian experts, which we need to know Any good concept can be misused on TV and we need to be very careful - dont believe a You should be very cynical, very pessimistic, very question oriented Infy in the 1998, 1999, 2000 used to grow at 160% earnings Wipro 180% Infy PE used to be 160 times Wipro 180 times Experts said this is fair Why? That is exactly what Peter Lynch has said in the PEG model PEG 1:1 (180:180, 160:160) - life is fine, world is balanced Infy went to 13,660 in its peak If you had bott Infy at that time, for the next 8 years you would have been in losses What went wrong? Global recession ?
Growth of 160%, 180% is not sustainable This growth was not what Peter Lynch meant He meant sustainable medium term (say 5 years growth) You grew 160% last year, that is not false, that is true Infy 1998 2012 GDP Turnover 800 260% 516,079,798 Rs cr 7,000,000 Rs cr 7373% Any company PE of more than 50 times - is impossible to sustain India PE has never crossed 28 times since 1994 (18 years) Whenever it has touched 28 times, markets have crashed If India PE goes to more than 24 times, then be very cautious, be nervous, look at Indian At this time, everyone will be rushing to the stock market India Today will have on its cover page the BSE Tower Building That means you should get out History of the PE of any company - PE band - where does it fall now PE combined with earnings growth prospects
In the next 12 years, if Infy were to Infy would be larger than India Is that possible? Doable?
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 th GSK - Sharekhan Report EPS in the past years Max Price in the past relevant years Min Price in the past relevant years Max PE Min PE Average PE Current PE 2009 55 1457 451 26.49 8.20 17.35 2010 71 2524 1253 35.55 17.65 26.60
Price Today Earnings for the current year 2012 est Current PE PEG Model EPS estimate for the future years Growth in this EPS (CAGR) One year forward PE PEG (One year forward PE / CAGR)
2,645 101 26.19 Compared to history of last two yea 2011 86 2012 101 2013 120 18% 26 1.44
Ideal PEG is 1:1 Here the PEG is 1.44:1 Overpriced A company with earnings growth of 18% should ideally trade at 18 PE But this is trading at 26 PE So it is quoting at a premium of 44% over ideal PEG price 1 History PE Band - it is at an average PE - fairly priced 2 PEG - I find it overpriced by 44% L&T JM Report EPS in the past years Max Price in the past relevant years Min Price in the past relevant years Max PE Min PE Average PE Current PE Price Today Earnings FY 13 One year Forward PE PEG Model EPS estimate for the future years Growth in this EPS (CAGR) One year forward PE 2010 53 2213 1390 41.75 26.23 33.99 2011 61 2002 969 32.82 15.89 24.35
PEG (One year forward PE / CAGR) PEG of 2.87 is quite high (norm is 1:1)
2.87
The PEG in this example is quite misleading - a simple formula x/y will always have chall If my earnings grow at 2%, will the share be available at 2 PE ? If my earnings grow at 48%, should the share go to 48 PE ? Will not happen and should not happen also At very low EPS CAGR and very high EPS CAGR, the PEG will get smoothened L&T will most likely never trade at 7 PE even if earnings grow at 7% Suppose L&T makes a loss in the next years, so negative CAGR - how will PEG work So share should be free In fact for every share, you should be given an incentive to buy
Book value as per Bal Sheet is Rs 350 Very old company lot of Real Estate Market value of assets will be far higher Say adjusted book value may be Rs 500 or so
in "some sectors"
2.00 0.10
0.15
2.00
7.00
500
500
h per Share)
(10 + 40)
k value of the assets was more or less er around Rs 50 depressed sentiment exuberance
overnment Securities
oans Given ash on Hand eposits with RBI and Other Banks
HDFC Bank Axis Bank ICICI Bank Yes Bank Indus Ind Bank
Price
PBV
110 87
0.78 0.73
Public Public
fference
fference
non-banking activities
es to you and me
PBV range
What percentile
act as a floor
arnings Upside
ng them at Rs 18.97
w (and consistently low) ints 21 times (today, yday, last year, 1983) Berger
80 1680 21
ect, goodwill
SmallCap Highest
hindras, Mafatlals
again redefined
d in the order of Market Cap turnover are nowhere, are in the top of Market Cap > 0.10% of India 0.05% to 0.10% Others Relative Low Risk High Risk V High
ot be a good sell
ve been in losses
years, if Infy were to grow at that rate larger than India e? Doable?
go back in time (to the report date)? 2011 86 2704 1921 31.44 22.34 26.89 200911Gr 25%
times
200911Gr 13%
oothened
a b c d
1 Equity valuation Next steps PBV - Asset based valuation PE - Earnings based valuation DCF valuation - mother of all valuations - more complex - used by institutions NPV, IRR - capex budgeting Enterprise Value EV 2 Working Capital Management 3 EVA - Economic Value Added L&T, Murugappa, Godrej, HUL, Coca Cola 4 Bond examples
5 Shares - how does the market behave Personal investing - what should you do - how can you make money - without r Summarize yesterday's discussions Valuation
Assets Few sectors Banking Real Estate PBV Some banks - PBV Range - 4.20 HDFC Bank to 0.73 Dena Bank Dena Bank is cheap (< 1) HDFC Bank is expensive - non banking work fee based revenue (not fund based) HDFC Bank is not a bank, bank plus plus
HDFC Non Banking Revenue - Other Income ? What should it be classified as ? What is Other Income ? Other Income is other than core What is core? If I tell you that core is banking plus treasury plus forex advisory plus wealth managemen GSK Pharma PE band - average PE - 26 times, Growth 18% PEG 1.44:1 - slightly expensive May not be a great buy
SATYAM CASE Share price fell badly Till what level it fall ? Rs 55 - two month range What was the book value at that time? What were contingent claims at that time ? Class action suit in the US Upaid case SEC might take action against Satyam Income tax case - currently on
EXAMPLE You bott a flat yday - Mylapore for Rs Rental Income per month Annual escalation possible % Your debt component is say Interest rate On your equity component, you expect
Assume a five year period is reasonable, what is the expected value of the flat after 5 ye What is the capital appreciation the world expects in 5 years time in Mylapore Ignore income tax Cost of Capital - WACC Debt Equity WACC
11% 12%
80% 20%
PROJECT IRR LOGIC Dont map the loan availed, loan repaid and interest on loan Dont worry about how the project was funded - flat does not know how it was funded
Consider the flat cost as Rs 1.25 cr Year 0 1 2 3 4 5 CashFlow Sale of Flat Total CashFlow Derived number (12,500,000) (12,500,000) 324,000 324,000 356,400 356,400 392,040 392,040 431,244 431,244 474,368 18,821,714 19,296,083
The financial world believes that your flat of Rs 1.25 cr will appreciate to Rs 1.88 cr in 5 That is why they are happy to accept a rent of Rs 27,000 per month 324,000 12,500,000 2.59% 18,821,714 12,500,000 5 8.53%
If capital appreciation appeared to be impossible, rentals would rise in Chennai (or flat p
We divorce the two actions - funding and operations The funding dept will take care of funding - they will raise debt, equity, whatever The ops dept will take care of ops - their job is to earn the rent The flat does not know how it was funded and will generate the same rental income irres how it was funded EQUITY IRR THINKING Here you are thinking like Dhirubhai Ambani (not like Reliance) Year 0 1 2 3 4 5 CashFlow Bank Payments Sale of Flat Total CashFlow (2,500,000) (2,500,000) 324,000 (1,100,000) (776,000) 356,400 (1,100,000) (743,600) 392,040 (1,100,000) (707,960) 431,244 (1,100,000) (668,756) 474,368 (11,100,000) 18,934,758 8,309,127
DCF Valuation of Equity Year EBIT Tax Rate t EBIT x (1-t) Add back Depreciation Incremental Working Capital Capital Expenditure Free Cash Flow to the Firm - FCFF FCFF is your purpose in life Why are you alive? To generate FCFF
FCFF - what does this mean This is the amount you can withdraw from the business and give it to the stakeholders 1 You could pay interest to your lenders 2 You could repay loans of your lenders 3 You could pay dividends to your equityholders 4 You could even return to your equityholders - you could buy back shares If you generate fantastic FCFF, then your valuation in the market will also be fantastic
The value of the company is nothing but the present value of future FCFF (discounted pre
Year 1 2 3 4 5
Sale of firm
1 Value in the stock market - every day, every moment Retail investors buy 10 shares and 20 shares - PE, PBV Institutional investors buying 100,000 shares, 1 million shares - FCFF, DCF Citi has sold a huge stake in HDFC and other large institutions are buying Citi sold at Rs 657/658 2 Equity placement - private placement of equity 3 Investment by Venture Capital Companies, Private Equity Companies 4 Mergers and Acquisitions 5 Joint Ventures PROJECT THINKING, CORPORATE THINKING The CEO is worried about generating FCFF This FCFF will be used to pay both debtholders and equityholders The discounting is done at WACC WACC includes cost of both debt and equity
If you consider interest as an expense in this thinking, then you are moving to Equity thin
The machine does not know how it was funded - it works the same way regardless of fund The operational cash flow is not dependent on debt equity mix LIQUIGAS FALLACY There was a company Liquigas - they used to work in the following manner: Year One Board Meeting - many new ideas for expansion, new projects 100 ideas with varying IRRs Best IRR - 21%, Last IRR - 3% The CEO asks the CFO - what is our cost of capital for this year
From where are we raising funds this year CFO says - we are raising debt and cost of debt is 4% All projects which generate more than 4% IRR are accepted and those with less than 4% IR 85 new projects sanctioned New debt is raised and projects are implemented Year Two Board Meeting - many new ideas for expansion, new projects 100 ideas with varying IRRs Best IRR - 21%, Last IRR - 3% The CEO asks the CFO - what is our cost of capital for this year From where are we raising funds this year CFO says - this year we will raise equity because debt is too high now Cost of equity - say 10% All projects with IRR more than 10% are accepted, less than 10% are rejected Year Three Board Meeting - many new ideas for expansion, new projects 100 ideas with varying IRRs Best IRR - 21%, Last IRR - 3% The CEO asks the CFO - what is our cost of capital for this year From where are we raising funds this year CFO says - we can raise debt this year - cost 3.8% All projects with IRR more than 3.8% are accepted, less than 3.8% are rejected Right way of thinking Dont correlate funding with projects Have one common WACC for the company for all years WACC in all the three years is say 7.8%
2 3 4 5 6 7 8
Revenues Assets Capital Returns Margins Cash, Wealth, Shareholder Wealth, Money Reserves
Free Cash Flow is the objective Not profit Profit is a bookish number Profit is like CTC Cash is like Take Home
8% 100 CR 200 cr
ENTERPRISE VALUE - EV If we were to buy the entire company today, what would it cost us 1 We would buy the entire equity This would cost us the Market Cap 2 We would become responsible for its debt If Mukesh Ambani takes over Kingfisher Airlines today and buys all the equity, will SBI call for recovery of its debt? Whom does the income tax dept call for its Satyam tax demands ? Mahindras 3 Whatever cash the company has will become your cash Balance Sheet - Rs cr Share Capital (Face value Rs 5) Reserves Loans
100 Fixed Assets 600 Cash 525 Net Current Assets 1,225
Market price of the share is Rs What is its Enterprise Value 1 Market Cap 100 2 Add Debt 3 Less : Cash Enterprise Value Why are Reserves being ignored in this Computation EBIDTA is lets say EV/EBIDTA Multiple
71
20
71
For one rupee earning (ebidta), I am required to pay Rs 6.42 Poor man's earnings multiple is the PE Rich man's earnings multiple is the EV/EBIDTA Sales Ops EBIDTA Finance PAT
As a controlling shareholder, you Especially in financial issues Given an EBIDTA, you can regene
Enterprise Value = Market Cap + Debt - Cash Debt - Cash = Net Debt Enterprise Value = Market Cap + Net Debt Market Cap = Enterprise Value - Net Debt Sum of the parts valuation (SOTP) EV/EBIDTA PE Cost Market Cap Multiple Revenue More complex multiples
Good examples where SOTP is a must GMR GE Reliance - Oil exploration, Refining, Petrochem, Retail Kotak - Banking, Securities, Insurance, Investment Banking, Mutual Fund, Reit HDFC - Home Lending, Banking, Insurance, Mutual Fund, Securities, Property V ICICI SBI - Cards Grasim Essar Raymonds - Textiles, Engg, Automotive, Real Estate Marg - Infra, Real Estate, Port Amalgamations - Tractors, Retail Dealerships, Various other small businesses M&M - Auto, Leisure, Real Estate, Components, IT, Tractors Conglomerates valuation becomes complex
L&T Ltd Has invested in L&T Finance, L&T Infotech and L&T X and L&T Y L&T holds shares in these other entities So when you buy one share of L&T Ltd you are automatically getting a little bit L&T Fina So the value of L&T should be inclusive of the value of its children
Tata Group should not be treated on par So when you buy Tata Motors, you dont get TCS along with it (unless Tata Motors holds a TCS shares)
When I buy HDFC, I get a bit of HDFC Bank automatically and HDFC Standard Life automa When I buy HDFC Bank, I dont get HDFC or HDFC Insurance www.motilaloswal.com www.sharehkhan.com www.jmfinancial.com You will get access to Research Reports You need not trade here
INVESTING Indian equity has done brilliantly over the past 33 years Sensex 1979 100 Today 2012 18,000 33 17.04% 180 Bank Fixed Deposit 9% 100 1,718 109%
At 9% your Rs 100 would have grown from Rs 100 to Rs 1,718 in 33 years At 17% your Rs 100 would have grown from Rs 100 to Rs 18,000 in 33 years So where is the catch?
add, accumulate
18,000 will go to 5,00,000 or more in the coming three decades But the common man will be repeating his behaviour - so he will not become wealthy A lot of intellect is generally spent in when to buy, when to sell, how to make millions Only God knows when to buy and when to sell and he does not disclose Then there are "experts" who advise you what to do But they dont share in losses
All of them in Dec Sensex will go to 14,000 Nifty will go to 4200, 4300 and dollar will go t January is the weakest in the history of the stock market over the last 12 years What happened - complete the reverse In Jan 2008, Sensex went to 22,000 and experts said it will go to 35,000 In Oct 2008, Sensex crashed to 7,900 and experts said Sensex will become Nifty (2,500) So experts are pretty useless So timing the market is not possible - dont waste your energy in this pursuit The best way to make money is to invest in SIP - Systematic Investing Plans Just invest Rs 10,000 per month, Rs 5,000 per week, etc Dont look at the market Dont watch CNBC Dont read EcoTimes Dont ask people where is the market going to go You pay a heavy price for a cheery consensus
While SIP might look dull, unintelligent, it is more effective than all intellectual theories The quality of your returns is a direct result of the quantum of time you spend in creatin
After 8 years, you cannot make losses Which SIP, which mutual fund, which direct equity Large mutual fund which has strong people HDFC Mutual Fund HDFC Top 200, Equity DSP Blackrock Tiger Franklin Templeton Blue Chip Birla SunLife Pru ICICI
Large diversified mutual fund schemes represent India Nifty, Sensex represent India If India does well, these schemes will do well EV - COMPUTATION Why are Reserves ignored ? Share Capital and Reserves are relevant for book value of the enterprise We are not using book value in EV working We are using market price Market Cap of a company is "Share Price" x "No of Shares" Share price is wherever it is bcoz of what? Bcoz of the Reserves that any company has PE AND PBV RATIOS - KEEP REDUCING IN ANY RESEARCH REPORT - WHY Current Market Price EPS of 5 years PE Useless Wrong NM/NMF 2544 85 29.9 Useless
71 35.8
BOND RELATED QUESTIONS Question 7-11 14 % coupon - paid semi-annual frequency Face value USD 1,000 Tenor 30 years Callable 5 years from now Callable price is USD 1,050 Current price USD 1,353.54 Yield curve is flat What is the best estimate of nominal interest rate on new bonds
Yield curve is flat - the rate of interest is the same, irrespective of tenor If I issue new bonds with a tenor of 2 years, the rate of interest is say x% The same rate of interest x% will be valid even if the tenor were to be 3 years, 5 years, 1
Solution Yield to Call - if I call the bond in 5 years, what is the effective rate of interest that I wil HalfYear CashFlow 0 (1,353.54) 1 70 2 70 3 70 4 70 5 70 6 70 7 70 8 70 9 70 10 1120
1000 1050
Question 7-10 1 Get the coupon rate 2 Current yield = Coupon / Current market price
Question 7-13 Tenor 20 years Par Value USD 1,000 Annual coupon 9% Tenor for you - 5 years Required rate of return for you - 10% After 5 years, YTM is expected to be 8.5% on this bond What can you pay for this bond today?
After you sell the bond, it will have a balance tenor of 15 years At that time, when you sell it, it will have a YTM of 8.50% (6th year to 20th year) So with this information, what can you get? You can work out the price of the bond that will prevail at the end of 5 years from today For the first five years 1 Coupons 2 End value 3 Required rate of return You can get the price on day one
Question 7-16 Heekin USD 140 mio of bonds, average cost is 7.50% Interest expense USD 10.50 mio Times interest earned (TIE) is 3.2 times Interest Coverage Ratio is 3.2 times This info will give you EBIDTA TIE cannot fall below 2.5 times This info will give you the max interest you can Other loan details You can easily work out which loans, what rate of interest, how much can you Question 7-17 Known - Face value, coupon, tenor, YTM From here you can get the purchase price Sell price is given So return you can get
WORKING CAPITAL MANAGEMENT Retail industry has huge working capital, huge inventory So their focus on this area is very high Their Receivables are zero Which product lines are good, bad, excellent, hopeless How do you determine What can you do about the bad and hopeless ones
Product Line
Gross Margins
Contribn Margins
Sales estimates for a year Rs cr 22% 28% 35% 31% 100 30 150 85
Gross Margin is Sales minus Cost of Goods Sold (in COGS we will include purchase price, t freight) Gross Margin minus Other Variable Costs (sales commissions, incentives) = Contribution M Sales COGS Admin Selling Distribution Misc Opex Operating Margin 100
Product Line
Gross Margins
Contribn Margins
Sales estimates for a year Rs cr 22% 28% 35% 31% 100 30 150 85
Gross Margin Return on Investment/Inventory - GMRoI/I We want to earn max Gross Margin but on min investment in inventory 1 2 3 4 Gross Margin Return on Inventory Contribution Return on Inventory Gross Margin Return on Net Inventory (after deducting supplier credit) Contribution Return on Net Inventory
What is the Gross Margin / Contribution per rupee of salary cost ? Read the Shoppers Stop Annual Report 1 Concept of Consignment of Inventory Vendor comes and places his inventory in your store You dont really buy this inventory Your investment is zero If it sells, then you pay If it does not sell, he will take it back But generally vendors also need to live So they may not give you all inventory on consignment Asset to Memo ratio J C Penny - give me 50:50 Vendor will say 80:20 2 Store within Store
Economic Value Added - EVA Net Worth Debt Capital Employed WACC 14%
Min you should earn What are you really earning This earning as : EBIT x (1-t) EVA EVA = EBIT x (1-t) minus the Minimum WACC EVA is a Rs cr number Positive EVA means you are beating the WACC
42 51 9
Stern Stewart & Co - research shows - if your EVA is positive and growing, then Sharehold indeed attractive If your EVA, then you dont deserve to live
PE Right PE - PEG Model - PE should be driven by expected growth in EPS Ideal PEG level 1:1 If your EPS is expected to grow at 20%, then your PE may well be 20 times PE band in history
Nifty PE band - 10 to 28 times Today Nifty PE - 18 times Average 18, Std Dev 3.6 Below 14, Nifty is very attractive Above 22, it may be too expensive
e classified as ?
ory plus wealth management plus insurance L&T PE history - was okay PEG was uninteresting Growth in earnings 7%, PE - 20 times PEG 2.87 times - which is quite quite high
Growth of 7% appears to be rather muted Could be over a short period of 2 years Long term growth may be much better Historically, this company has grown well Market will not price at very low PE just because EPS is growing very low If growth is 2%, will you get it 2 PE ? No If growth is negative, will the share be free ? No The book value will act as a floor
Earnings upside
Book value Rs 100 lets say Prob on these contingent claims Ok - these may be Rs 45 Share price is rightly Rs 55
10,000,000
11%
1,100,000
12,500,000
324,000
39 times
ppreciate to Rs 1.88 cr in 5 years time Poor yield on rent Capital appreciation expected
CashFlow
future FCFF (discounted present value) WACC DCF 87.72 115.42 151.87 177.62 2,856.53 3,389.16 14% 114%
Equity Companies
owing manner:
9% 10 CR 500 CR
ay and buys all the equity, from tom whom tax demands ?
urrent Assets
1,155 20 50 1,225
Rs cr 1420 Market value of equity (Capital + Reserves) covers Capital and Reserves here 525 We believe that market value 1945 of debt is the same as book value of debt 20 1925
of one share / Earnings from one share of the company / Earnings from the company
mall shareholder, you have no control ever PAT the company makes, you accept
ontrolling shareholder, you have tons of control ially in financial issues an EBIDTA, you can regenerate the PAT
n 33 years 0 in 33 years
getting into
, run away
y in this pursuit
nvesting Plans
han all intellectual theories about the market f time you spend in creating the SIP
enterprise
PORT - WHY
on new bonds
14%
7%
70
u EBIDTA
Inventory
Supplier Credit
Gross Margin
COGS
Inventory
Days 30 45 21 60
Rs cr
Rs cr
Rs cr
Rs cr
Inventory
Supplier Credit
Gross Margin
COGS
Inventory GMRoI
365 Days 90 100 60 180 Days 60 45 21 60 Rs cr 25.00 9.00 60.00 32.30 Rs cr Rs cr % 75.00 18.49 21.00 5.75 90.00 14.79 52.70 25.99 1.35 1.56 4.06 1.24
nventory
Mark up
Cont
CRoI
Ranking
3 2 1 4
Net GMRoNI CRoNI Inventory Paid Inventory Rs cr % % 6.16 406% 357% 3.16 284% 265% 9.62 624% 546% 17.33 186% 152%
eturn on