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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 04
DISCOUNTED CASH FLOW & EFFECTIVE ANNUAL INTEREST
We shall discuss the following in this hand out.
Discounted Cash Flow
Effective Annual Interest
Bond Valuation - introduction
Discounted Cash Flows:
So far we assumed cash flow of same rupee level over a period of time. Like the way bond interest
occurs ­ cash flow of interest remains at a constant level through to maturity. Often this is not the
case when we move to other areas of valuation. The cash flow at the end of every period is
different from the other and therefore, we need to calculate the present value of each cash flow by
discount factor depending upon the time. For example, an investment opportunity yields cash flow
of Rs. 100 after first year, Rs. 200 and Rs. 300 at the end of second and third year respectively shall
be discounted at 10% rate with first year factor of 0.9090, second year 0.8264 and third year 0.7513.
This means that we can't work out present value here like we did in case of annuities.
Effective Annual Rate ­ EAR
The Effective Annual Rate (EAR) is the interest rate that is annualized using compound interest.
The EAR is the annualized equivalent of interest with shorter compounding periods. It can be
calculated from the following formula:
EAR = [1 + i/n) n - 1
Where n is the number of times (or periods) interest is compounded during the year and i is the
interest rate per period.
Explanation:
The effective annual rate is a value used to compare different interest plans. If two plans were being
compared, the interest plan with the higher effective annual rate would be considered the better
plan. The interest plan with the higher effective annual rate would be the better earning plan.
For every compounding interest plan there is an effective annual rate. This effective annual rate is
an imagined rate of simple interest that would yield the same final value as the compounding plan
over one year.
When interest is compounded more than once in a year, EAR will be greater than the stated or
quoted interest rate.
Bank A pays 15% interest on deposit, compounded monthly.
Bank B pays 15% interest on deposit, compounded quarterly.
Bank C pays 15% interest on deposit, compounded half yearly.
Bank A = 1 + .15/12 12 - 1
=1.16075 ­ 1
= 16.075%
Bank B = 1 + .15/4 4 - 1
=(1.0375) 4 ­ 1
= 1.15865 ­ 1
= 15.865%
Bank C = (1 + .15/2) 2 - 1
= (1.075) 2 - 1
= 1.155625 ­ 1
= 15.5625%
Example:
A bank offers 12% compounded quarterly. If you place 1000 in an account
today, how much you have at the end of two years? What is EAR?
Solution:
EAR = (1 + .12/4)4 ­ 1= 12.55%
= (1.1255)2 X 1000 = 1266.75
OR
Quarterly interest is 12/4 = 3%
15
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Corporate Finance ­FIN 622
VU
=(1.03)8 X 1000 = 1.2667 X 1000 =1266.77
BOND VALUATION:
A bond is a financial instrument or a debt security issued by a company to raise money. It is offered to
general public or to institutions.
Equity & Debt ­ (Bonds)
Equity represents ownership and is a residual claim
Features on Bond
Coupon Interest: stated interest payments per period
Face value: Also Par value. The principal amount
Coupon rate: interest payments stated in annualized term.
Maturity: specified future date on which principal will be repaid.
Yield to Maturity (YTM): Interest rate required in market on a bond.
Current yield= Annual coupon payment(s) divided by bond price.
Discount Bond: A bond which is sold less than the face or par value is discount bond.
Premium Bond: A bond which is sold more than the face or par value is premium bond
16
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk