FINANCE COMPENDIUM

Macroeconomics

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Introduction to Macroeconomics
Have you ever wondered about those fancy terms you see in the news all the time? You know,
things like inflation, GDP, exchange rates, and all that jazz. Well, turns out, as future business
hotshots, it's kind of important to know what these words mean. Think of them as the code-words of
the business world. This section is like your cheat sheet to understand what those big-shot analysts
are talking about. It's not just a guide; it's your key to understanding the behind-the-scenes stuff that
makes business tick. So, let's dive in and make sense of these mysterious jargons together!

Key Macroeconomic Variables

Gross Domestic Product
The most comprehensive economic indicator is gross domestic product (GDP), which measures the
value of all goods and services produced in a country during a specific period. As such, GDP provides
a basic measure of growth or contraction in an economy, making it a general gauge of economic
health.

Nominal vs Real GDP

Nominal GDP is simply GDP as we have described it under the expenditures approach: the total
value of all goods and services produced by an economy, valued at current market prices.
India’s Nominal GDP in 2023: $3.73 Tn (INR 311.03 Lakh Crore)

Real GDP measures the output of the economy using prices from a base year, removing the effect of
changes in prices so that inflation is not counted as economic growth. Real GDP is calculated relative
to a base year. (Currently the base year is 2011-12)
India’s Real GDP in 2022 = INR 160.06 Lakh Crore
IMF Projected Real GDP Growth rate of India = 6.3%

Calculation of GDP
The values used in calculating GDP are market values of final goods and services—that is, goods and
services that will not be resold or used in the production of other goods and services.

Under the expenditure approach, GDP is calculated by summing the amounts spent on goods and
services produced during the period. Using the expenditure approach, the major components of real
GDP are consumption, investment, government spending, and net exports (exports minus imports).
These components are summarized in the equation:

GDP = C + I + G + (X – M)

where:

C = consumption spending

I = business investment (capital equipment, inventories)

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G = government purchases

X = exports

M = imports

Under the income approach, GDP is calculated by summing the amounts earned by households and
companies during the period, including wage income, interest income, and business profits. Under
the income approach, we have the following equation for GDP, or gross domestic income (GDI):

GDP = national income + capital consumption allowance + statistical discrepancy

Aggregate Demand & Supply

The aggregate demand (AD) curve shows the relationship between the quantity of real output
demanded (which equals real income) and the price level.

The aggregate demand curve slopes downward because higher price levels (holding the money
supply constant) reduce real wealth, increase real interest rates, and make domestically produced
goods more expensive compared to goods produced abroad, all of which reduce the quantity of
domestic output demanded.

The aggregate supply (AS) curve describes the relationship between the price level and the quantity
of real GDP supplied, when all other factors are kept constant. That is, it represents the amount of
output that firms will produce at different price levels.

Inflation
Inflation is the gradual increase in the prices of goods and services over time, reducing the
purchasing power of a currency. Borrowers benefit from inflation because when they repay
borrowed money, it's worth less in real terms than when borrowed. Various indices, such as the
Consumer Price Index (CPI) or Wholesale Price Index (WPI), estimate inflation by tracking the costs
of specific categories of items for groups of people. Each index is constructed with a base year,
comparing price changes over time.
If inflation spirals out of control, it's known as hyperinflation, posing a threat to a country's
monetary system and causing social and political upheaval.
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Disinflation refers to an inflation rate that is decreasing over time but remains greater than zero.

A persistently decreasing price level (i.e., a negative inflation rate) is called deflation. Deflation is
commonly associated with deep recessions. When most prices are decreasing, consumers delay
purchases because they believe they can buy the same goods more cheaply in the future

India’s (average) inflation rate in 2023: 6.5%

India’s (expected) inflation rate in 2024: 5.4%
India’s inflation rate in October 2023: 4.9%

Calculation of Inflation Indices

To calculate a rate of inflation, we need to use a price index as a proxy for the price level. A price
index measures the average price for a defined basket of goods and services. The consumer price
index (CPI) is the best-known indicator of inflation. The CPI basket represents the purchasing
patterns of a typical urban household.

https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home

Unemployment
The Unemployment rate is described as the level of unemployed workers in the aggregate work
force. Workers are viewed as jobless if they as of now don’t work, in spite of the way that they are
capable and willing to do as such. The aggregate work force comprises all employed and jobless
individuals inside an economy. Unemployment can be divided into three categories:

1. Frictional unemployment results from the time lag necessary to match employees who seek
work with employers needing their skills.

2. Structural unemployment is caused by long-run changes in the economy that eliminate

some jobs while generating others for which unemployed workers are not qualified.
Structural unemployment differs from frictional unemployment in that the unemployed
workers do not currently have the skills needed to perform the jobs that are available.

3. Cyclical unemployment is caused by changes in the general level of economic activity.

Cyclical unemployment is positive when the economy is operating at less than full capacity
and can be negative when an expansion leads to employment temporarily over the full
employment level.

India November 2023 Unemployment Rate = 9%

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Currency Exchange
An exchange rate is simply the price or cost of units of one currency in terms of another. In a foreign
currency quotation, we have the price of one currency in units of another currency. These are often
referred to as the base currency and the price currency. In the quotation 1.25 USD/EUR, the USD is
the price currency, and the EUR is the base currency. The price of one euro (base currency) is 1.25
USD (the price currency) so 1.25 is the price of one unit of the base currency in terms of the other.

At a point in time, the nominal exchange rate $1.416/euro suggests that to purchase one euro’s
worth of goods and services in Euroland, the cost in U.S. dollars will be $1.416. As time passes, the
real exchange rate tells us the dollar cost of purchasing that same unit of goods and services based
on the new (current) dollar/euro exchange rate and the relative changes in the price levels of both
countries.

A spot exchange rate is the currency exchange rate for immediate delivery, which for most
currencies means the exchange of currencies takes place two days after the trade.

A forward exchange rate is a currency exchange rate for an exchange to be done in the future.
Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year). A
forward is actually an agreement to exchange a specific amount of one currency for a specific
amount of another on a future date specified in the forward agreement.

The cross rate is the exchange rate between two currencies implied by their exchange rates with a
common third currency. Cross rates are necessary when there is no active FX market in the currency
pair.

₹/$ = ₹83.38/$
₹/€= ₹90.39/€
$/€ = $1.08/€
₹/£ = ₹105.34/£
$/£ = $1.26/£

Forex Reserves
Foreign Exchange Reserve or Forex Reserves is the reserves of different currencies like Japanese Yen,
United States Dollar, pound, Euro etc., control and kept by the financial organization i.e., Reserve
Bank of India and numerous alternative financial authorities as affirmed by the govt. The reason
behind to keep up this sort of reserves is to manage any unexpected financial stuns and crises.

India’s Forex Reserve (currently): $586 billion

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Gold Reserves
Gold is a substitute speculation road for Indian financial specialists. The significance of gold has been
expanded in the present world because of the monetary emergency in the present financial world.
The financial specialists are putting resources into the Gold. Gold is dealt with as an elective
speculation road. It is frequently expressed that gold is the best protecting acquiring power over the
long haul. Gold Reserves: 794.64 MT

Sources of Economic Growth

Economic growth can best be explained by examining five important sources of economic growth:

Labor supply. The labour force is the number of people over the age of 16 who are either working or
available for work but currently unemployed. It is affected by population growth, net immigration,
and the labour force participation rate (described in our topic review of Understanding Business
Cycles). Growth of the labour force is an important source of economic growth.

Human capital. The education and skill level of a country’s labour force can be just as important a
determinant of economic output as the size of the labour force. Because workers who are skilled
and well-educated (possess more human capital) are more productive and better able to take
advantage of advances in technology, investment in human capital leads to greater economic
growth.

Physical capital stock. A high rate of investment increases a country’s stock of physical capital. As
noted earlier, a larger capital stock increases labour productivity and potential GDP. An increased
rate of investment in physical capital can increase economic growth.

Technology. As noted previously, improvements in technology increase productivity and potential

GDP. More rapid improvements in technology lead to greater rates of economic growth.

Natural resources. Raw material inputs, such as oil and land, are necessary to produce economic
output. These resources may be renewable (e.g., forests) or non-renewable (e.g., coal). Countries
with large amounts of productive natural resources can achieve greater rates of economic growth.

Monetary Policy
Monetary policy is implemented using the monetary policy tools of the central bank. The three main
policy tools of central banks are as follows:

1. Policy rate: In India, banks can borrow funds from the RBI if they have temporary shortfalls
in reserves. The rate at which banks can borrow reserves from the RBI is called the repo rate.

2. Reserve requirements: By increasing the reserve requirement (the percentage of deposits

banks are required to retain as reserves), the central bank effectively decreases the funds
that are available for lending and the money supply, which will tend to increase interest
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rates. A decrease in the reserve requirement will increase the funds available for lending and
the money supply, which will tend to decrease interest rates. This tool only works well to
increase the money supply if banks are willing to lend and customers are willing to borrow.

3. Open market operations: Buying and selling of securities by the central bank is referred to
as open market operations. When the central bank buys securities, cash replaces securities
in investor accounts, banks have excess reserves, more funds are available for lending, the
money supply increases, and interest rates decrease. Sales of securities by the central bank
have the opposite effect, reducing cash in investor accounts, excess reserves, funds available
for lending, and the money supply, which will tend to cause interest rates to increase.

Repo Rate (Commercial banks borrow from Central Bank) = 6.5%

Reverse Repo (Central Bank borrows from commercial banks) = 3.35%
Standing Deposit Facility (RBI absorbs excess liquidity (without collateral)) = 6.25%
Marginal Standing Facility (Commercial banks can obtain liquidity overnight from RBI) = 6.75%

SDF Rate = Repo Rate – 0.25%

MSF Rate = Repo Rate + 0.25%

https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752

Fiscal Policy

Fiscal policy refers to a government’s use of spending and taxation to meet macroeconomic goals. A
government budget is said to be balanced when tax revenues equal government expenditures. A
budget surplus occurs when government tax revenues exceed expenditures, and a budget deficit
occurs when government expenditures exceed tax revenues.

Fiscal policy tools include spending tools and revenue tools.

A. Spending Tool

Transfer payments, also known as entitlement programs, redistribute wealth, taxing some and
making payments to others. Examples include Social Security and unemployment insurance benefits.
Transfer payments are not included in GDP computations.
Current spending refers to government purchases of goods and services on an ongoing and routine
basis.

Capital spending refers to government spending on infrastructure, such as roads, schools, bridges,
and hospitals. Capital spending is expected to boost future productivity of the economy.

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B. Revenue Tool

Direct taxes are levied on income or wealth. These include income taxes, taxes on income for
national insurance, wealth taxes, estate taxes, corporate taxes, capital gains taxes, and Social
Security taxes. Some progressive taxes (such as income and wealth taxes) generate revenue for
wealth and income redistributing.

Indirect taxes are levied on goods and services. These include sales taxes, value-added taxes (VATs),
and excise taxes. Indirect taxes can be used to reduce consumption of some goods and services (e.g.,
alcohol, tobacco, gambling).

Factors affecting Forex Rates

1. Current Account Deficit (Imports-Exports) = $9.2Bn (Q1FY24) (1.1% of GDP)
2. Capital Account = Net buying or selling of Indian assets by foreign investors.
3. Forex Reserves = $586 Bn

Factors affecting Forex Rates

1. What is the inflationary situation in India/USA/China?
2. What are the factors causing inflation around the world?
3. What are the factors affecting INR/USD rates?
4. What are the various tools employed by the RBI to manage the exchange rates in the economy?
5. Why are FPIs and FIIs net selling/buying Indian assets?
6. What is the value of India’s GDP and what is the base year of calculation of GDP growth in India?
7. What are the impacts of the Russia – Ukraine war on the Indian economy?
8. What are the impacts of the Israel – Hamas war on the Indian economy?
9. How does the RBI use Repos to control inflation in the country?
10. How is India’s GDP calculated?
11. How does income of NRIs affect the Indian GDP?

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Corporate Finance
FINANCIAL STATEMENTS
Financial statements are written records that convey the business activities and the financial performance of
a company.
Primary financial statements include
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flow
4. Statement of Changes in Equity
5. Notes to Financial Statements

Balance Sheet
Provides an overview of the Assets, Liabilities and Shareholder’s Equity as on a particular date (generally end
of the year). Balance Sheet shows the financial position of the company as at a particular date.
Assets – Liabilities = Equity

a. Assets - These refer to resources or items that the company owns. Assets have future economic
value that can be measured and can be expressed in monetary terms. Examples of a company's
assets include investments, cash, inventory, accounts receivable, land, supplies, equipment,
buildings and vehicles.

b. Liabilities - These refer to the legal financial obligations or debts that companies incur during
business operations. Liabilities can be limited or unlimited. They are settled over time through the
transfer of economic benefits such as money, services or goods. Recorded on the right side of a
company's balance sheet, liabilities include any payable amounts, loans, mortgages, earned
premiums, deferred revenues and accrued expenses.

c. Equity - Equity, also known as shareholder's equity, refers to the amount of money that a
company must return to its shareholders after all of its assets are liquidated and all of its debt is
paid off. Equity is calculated by subtracting a company's total assets to its total liabilities.

Income Statement
Provides a summary of the company’s Revenue, Expenses, Gains or Losses over a particular period. Income
Statement shows the financial performance of the company over a particular period.

a. Revenue - Revenue refers to the income that a company generates from its normal business
operations. It includes deductions and discounts for returned products. Revenue is the gross
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income figure from which costs are subtracted to determine net income.

b. Expenses - Expenses refer to the costs of operations that businesses incur to generate revenue.
Common expenses include employee wages, payments to suppliers, equipment depreciation and
factory leases.

Statement of Cash Flow

Measures how well a company generates cash to fund its operating expenses, pay its debt obligations,
and fund investments.

Statement of Changes in Equity

Records how profits are retained within a company for future growth or distributed to external parties.

Notes to Financial Statements

Captures details relating to the above statements and is used to explain the rationale behind the
numbers flowing into the statements above.

AREAS OF CORPORATE FINANCE

Corporate finance can broadly be divided into the following key areas-
1. Capital Budgeting
2. Capital Structure
3. Financial Statements (Ratio) Analysis

1. CAPITAL BUDGETING
Capital budgeting involves choosing projects that add value to a company. The goal is to maximize the
growth and profitability of the business. As part of capital budgeting, financial analysts go over various
investment alternatives. They conduct a comparative analysis of investments’ present and future value
to interpret their risk-return aspects concerning organizational goals. The key idea is that any project
should have its expected returns more than its hurdle rate.

Hurdle rate
Hurdle Rate = Weighted Average Cost of Capital + Risk Premium
The first element is the company’s cost of capital or fund, which is the Weighted Average Cost of Capital
(WACC). The second element is the risk premium formula, which entirely is dependent on the riskiness
of the project.

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Expected return
Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn)
Where pi= probability of return, Ri= Return

The three most common approaches to project selection are payback period (PB), internal rate of return
(IRR), and net present value (NPV).

Purpose of Capital Budgeting

● Substantial expenditure: Investment decisions are related with the fulfilment of long-term
objectives and the existence of an organization. To invest in a project(s), a substantial capital
investment is required. Based on size of capital and timing of cash flows, sources of finance
are selected. Due to huge capital investments and associated costs, it is therefore necessary
for an entity to make such decisions after a thorough study and planning.
● Long time period: The capital budgeting decision has its effect over a long period of time.
These decisions not only affect the future benefits and costs of the firm but also influence
the rate and direction of growth of the firm
● Irreversibility: Most of the investment decisions are irreversible. Once the decision is
implemented, it is very difficult and reasonably and economically not possible to reverse the
decision. The reason may be upfront payment of the amount, contractual obligations,
technological impossibilities etc.
● Complex decisions: The capital investment decision involves an assessment of future events,
which in fact is difficult to predict. Further, it is quite difficult to estimate in quantitative
terms, all the benefits or the costs relating to a particular investment decision.

Types of Capital Budgeting Decisions

a. Payback Period
It refers to the amount of time it takes to recover the cost of an investment by taking actual future cash
flows. For example, if a capital budgeting project requires an initial cash outlay of $1 million, the PB

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reveals how many years are required for the cash inflows to equate to the one-million-dollar outflow. A
short PB period is preferred as it indicates that the project would "pay for itself" within a smaller time
frame.

ADVANTAGES DISADVANTAGES

• Highly useful when liquidity is a problem, ● The payback period does not account
gives an image of how soon the investment will for the time value of money (TVM). This
start reaping gains can be solved by using the discounted
payback period model
● It ignores the cash flows that occur
towards the end of a project's life, such
as the salvage value. Thus, PB is not a
direct measure of profitability of the
project

b. Discounted Payback Period

A discounted payback period gives the number of years it takes to recover the project’s initial
investment in present value terms, i.e., by discounting future cash flows and recognizing the time value
of money. It should be greater than the Payback Period calculated without discounting. Further, it
should be noted that as the required rate of return increases, the distortion between simple payback
and discounted payback grows.

c. Profitability Index (PI) Method (also known as Desirability Factor/ Present Value Index Method)

In certain cases, we have to compare a number of proposals, each involving different amounts of cash
inflows. The Desirability/ Profitability Index factor helps us in ranking various projects. Mathematically:
The Profitability Index (PI) is calculated as

below:

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ADVANTAGES DISADVANTAGES

It is a relative measure of a project's profitability.• Once a single large project with high NPV is
Thus, It helps with decision-making under capitalselected, the possibility of accepting several small
constraints. When a company has limitedprojects which together may have higher NPV than
resources and can't pursue all potential projects,the single project is excluded.
the profitability index can be used to prioritize• Also, situations may arise where a project with a
which projects to pursue first. lower profitability index selected may generate
cash flows in such a way that another project can
be taken up one or two years later, the total NPV
in such a case being more than the one with a
project with highest Profitability Index.

The Profitability Index approach thus cannot be used indiscriminately but all other types of alternatives
of projects will have to be worked out.

d. Internal Rate of Return (IRR)

The internal rate of return (or expected return on a project) is the discount rate that would result in a
net present value of zero.

The IRR rule is as follows:

IRR > Cost of Capital = Accept Project
IRR < Cost of Capital = Reject Project

IRR can be calculated by equating the NPV as zero-

where:
𝐶𝑡= net cash inflow-outflows during a single period
𝐶0= Total Investment Costs
IRR= Internal Rate of Return
t = Number of time periods

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ADVANTAGES DISADVANTAGES

Works as a benchmark figure for every project Can’t be used to compare projects of different
that can be assessed in reference to the duration as cost of capital isn’t considered
company’s cost of capital
Assumes that all interim cash flows are
IRR is a rate quantity, an indicator of reinvested at the calculated IRR
efficiency, quality & yield of an investment

Comment on IRR: The IRR is the rate at which the project breaks even. The biggest mistake is to use IRR
exclusively. It’s much better to analyse a project using at least one of the other methods — NPV and/or
payback. Using it alone could lead you to make a poor decision about where to invest your company’s
hard-earned dollars, especially when comparing projects that have different durations. Say you have a
one-year project that has an IRR of 20% and a 10-year project with an IRR of 13%. If you were basing
your decision on IRR, you might Favor the 20% IRR project. But that would be a mistake. You’re better
off getting an IRR of 13% for 10 years than 20% for one year if your corporate hurdle rate is 10% during
that period. IRR assumes future cash flows from a project are reinvested at the IRR, not at the
company’s cost of capital, and therefore doesn’t tie as accurately to cost of capital and time value of
money as NPV does. A modified internal rate of return (MIRR), which assumes that positive cash flows
are reinvested at the firm’s cost of capital and the initial outlays are financed at the firm’s financing
cost, more accurately reflects the cost and profitability of a project. Still, it’s a good rule of thumb to
always use IRR in conjunction with NPV so that you’re getting a more complete picture of what your
investment will give back.

e. Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's
cost of capital and that the initial outlays are financed at the firm's financing cost. By contrast, the
traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR
itself. The MIRR, therefore, more accurately reflects the cost and profitability of a project.

FV (Positive cash flows X Cost of Capital) = the future value of positive cash flows at the cost of capital
for the company

PV (Initial outlays X Financing cost) = the present value of negative cash flows at the financing cost of
the company
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n = number of periods

The MIRR addresses some of the deficiencies of IRR e.g., it eliminates multiple IRR rates; it addresses
the reinvestment rate issue and produces results which are consistent with the Net Present Value
method. Further, the MIRR allows project managers to change the assumed rate of reinvested growth
from stage to stage in a project.

f. Net Present Value (NPV)

It is the difference between the present value of cash inflows and present value of cash outflows over a
period of time.
Investors should invest when NPV >0 as the project adds value to the investor

where:
𝐶𝑡=net cash inflow-outflows during a single period
i= discount rate or return that could be earned in alternative investments
t= number of time periods

ADVANTAGES DISADVANTAGES

Allows for easy comparison between options as Estimates of future cash flows & discount rate
long all options are discounted to same point of are difficult to make with 100% accuracy
time
It only considers cash flows of a project.
Discount Rate can be customized to reflect
several factors such as risk in market Opportunity cost is not built into NPV
calculation

Situations where NPV and IRR will reach different conclusions:-

Situation 1: Scale or size disparity

IRR being a relative measure (in %) and NPV an absolute measure (in Rs/ $/ currency), in case of
disparity between scale or size both may give contradicting rankings. For example: a project with high
investment and future cash inflows might give a higher NPV but lower return (i.e. IRR) as compared to a
project with a smaller scale of outflows and inflows.

Situation 2: Time Disparity in Cash Flows

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It might be possible that overall cash flows may be more or less same in the projects but there may be
disparity in their flows i.e. larger part of cash inflows may have occurred in the beginning or end of the
project. In such a situation there may be differences in the ranking of projects as per two methods.

Situation 3: Disparity in life of Proposals (Unequal Lives)

Conflict in ranking may also arise if we are comparing two projects (especially mutually exclusive) having
unequal lives.

For more detailed explanation, kindly refer to the Capital Budgeting section of the Investment Banking
& Valuation segment of the document

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2. CAPITAL STRUCTURE

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations
and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-
capital ratio. The optimal capital structure of a firm is often defined as the proportion of debt and equity
that results in the lowest weighted average cost of capital (WACC) for the firm and maximum value of
the firm.

Cost of Capital
A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known as
the weighted average cost of capital (WACC)

Where:
E = market value of the firm’s equity (market cap) | D = market value of the firm’s debt
V = total value of capital (equity plus debt) | T = tax rate

E/V = percentage of capital that is equity | D/V = percentage of capital that is debt
ke = cost of equity (required rate of return) | kd = cost of debt (yield to maturity on existing debt)

Popular Capital Structure Theories

Net Income Approach

According to this approach, an increase in financial leverage will lead to decline in the weighted average
cost of capital (WACC), while the value of the firm as well as market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a
consequent decline in the value as well as market price of equity shares.

where Ke = Cost of Equity, Kd = Cost of Debt and Kw is Weighted Average Cost of Capital

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Modigliani Miller (MM) Approach

MM model recognised that the value of the firm will increase, or cost of capital will decrease where
corporate taxes exist. As a result, there will be some difference in the earnings of equity and debt-
holders in levered and unlevered firm and value of levered firm will be greater than the value of
unlevered firm by an amount equal to the amount of debt multiplied by corporate tax rate.

MM has developed the following formulae for computation of cost of capital (Ko), cost
of equity (Ke) for the levered firm.

Where,
Keg = Cost of equity in a levered company
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
TB = Present Value of Tax Shields

Where,

Kog = WACC of a levered company

Keu = Cost of equity in an unlevered company
t = Tax rate
L = Debt / ( Debt+Equity)

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3. Financial Statement Analysis through ratios

The trends in the financial statements can be analyzed in three ways as detailed below.

I. Trend Analysis
II. Comparison across companies
III. Benchmarking historical trend with industry

To make the analysis standard across the companies, the trends are expressed in the form of ratios.
Ratio Analysis removes scaling effects and helps compare the companies across the industry

The ratios can be classified into 4 buckets namely:

1. Leverage ratios
2. Liquidity ratios
3. Profitability ratios
4. Activity ratios

Leverage Ratios

Leverage Ratios are used to assess the ability of a company to meet its financial obligations Banks have
regulatory oversight on the level of leverage they can have, as measured by leverage Ratios.

Debt Ratio
Bank’s interest is also affected by the share of capital contributed by them vs equity holders (Riskiness)

Source: Corporate Finance Institute

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Interest Coverage Ratio

The interest coverage ratio is used to measure how well a firm can pay the interest due on outstanding
debt.

A company’s ability to meet its interest obligations is an aspect of its solvency and is thus an important
factor in the return for shareholders.

Debt Service Coverage Ratio (DSCR)

Lenders are interested in debt service coverage to judge the firm’s ability to pay off current interest and
installments.

Earnings available for debt service*

= Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other
amortizations + Interest + other adjustments like loss on sale of Fixed Asset etc.

**Fund from operations (or cash from operations) before interest and taxes also can be considered as
per the requirement.

Capital Gearing Ratio

Capital Gearing Ratio is also calculated to show the proportion of fixed interest (dividend) bearing
capital to funds belonging to equity shareholders i.e. equity funds or net worth. Again, higher ratio may
indicate more risk.

Degree of Operating Leverage, Degree of Financial Leverage and Degree of Combined Leverage

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DOL DFL DCL

Shows level of business risk. Shows level of financial risk. Shows level of total or
combined risk.
It is dependent upon fixed It is dependent upon It is dependent upon fixed
cost. interest and preference cost, interest & preference
dividend dividend.
Measures % change in EBIT Measures % change in EPS Measures % change in EPS
which results from a 1% which results from a 1% which results from a 1%
change in Sales. (= % change in EBIT. (= % change change in Sales. (= %change
change in EBIT/ % change in in EPS/ % change in EBIT) in EPS/ % change in Sales)
Sales)
For example, if DOL is 3 and For example, if DFL is 2 and For example, if DCL is 6 and
there is 8% increase in there is 5% increase in EBIT there is a 8% increase in
output then EBIT will then EPS will increase by sales then EPS will increase
increase by 24% & if there is 10% and if there is a 5% by 48% and if there is a 8%
a 8% decrease in output decrease in EBIT then EPS decrease in sales then EPS
then EBIT will decrease by will decrease by 10%. will decrease by 48%.
24%.
There is a unique DOL for There is a unique DFL for There is a unique DCL for
each level of output. each level of EBIT. each level of sales.

Liquidity Ratios
The ability of a firm to pay its liabilities on time is of critical importance to short-term lenders &
creditors. To measure a company's ability to pay its short-term liabilities with current assets, liquidity
ratios enter the picture. It is impossible for a company to survive without cash flow and the ability to
pay its bills on time. If a company needs to liquidate current assets, it can better understand its short-
term resources by measuring its liquidity ratio.

Current Ratio

It is a liquidity ratio that measures the ability of a company to pay short-term obligations within a year.
Investors and analysts can use it to determine how to maximize a company's current assets to meet
debt obligations.

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Quick Ratio

It measures a company's ability to meet its short-term obligations with its most liquid assets and
measures its short-term liquidity position. In case of an emergency, a company with a higher quick ratio
will be able to generate cash more quickly.

Because inventory and other current assets cannot be converted into cash easily, the quick ratio is more
conservative than the current ratio. When calculating the quick ratio, only assets that can be converted
into cash quickly are taken into account. As opposed to the current ratio, which considers inventory and
prepaid expenses. The inventory in most companies takes time to liquidate, although a few rare
companies are able to liquidate it quickly.

Profitability Ratios
An analysis of profitability ratios determines how profitable a business is based on sales and operations,
balance sheet assets, and shareholders' equity. An organization's profitability ratio reveals how
efficiently it generates profits and value for shareholders. Results with higher ratios are more favorable,
but when compared with similar companies' results, the company's own historical performance, or the
industry average, they provide much more information.

Gross Profit Margin

Gross Profit Margin indicates the performance of a company's sales and production

Operating Margin

Operating Margin helps understand the profitability from the core business operations.

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Cash Operating Margin or EBITDA Margin

EBITDA Margin is used to understand the liquidity position by providing an estimate of the cash profits.

Net Profit Margin

Net Profit Margin aids in understanding the final profit margin from the business

Return on Equity
ROE is a key metric used to understand the value generated by the company for its equity shareholders.
One key tool used in Dupont Analysis which expresses RoE as a function of the firm’s profitability,
efficiency and leverage

DuPont Analysis is widely used to discern the effects of profitability, efficiency and leverage and
understand areas of strength and weakness

Return on Invested Capital

Return on invested capital (ROIC) is the amount of money a company makes that is above the average
cost it pays for its debt and equity capital.

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Return on Capital Employed

ROCE (also known as Return on Invested Capital (RoIC)) is used to assess the overall return on the total
investment irrespective of the mode of financing

Return on Assets
ROA is used to understand the effectiveness with which firms' assets are being used to generate returns

Activity Ratios
An activity ratio broadly describes any type of financial metric that helps investors and research analysts
gauge how efficiently a company uses its assets to generate revenues and cash. Activity ratios may be
utilized to compare two different businesses within the same sector, or they may be used to monitor a
single company's fiscal health over time. These are also commonly referred to as efficiency ratios.

Profitability ratios depict a company's profit generation, while efficiency ratios measure how well a
company utilizes its resources to generate those profits.

Fixed Asset Turnover

Tells how efficiently an organization is managing its fixed assets to tender a sale

Current Asset Turnover

Tells how efficiently an organization is managing its current assets to tender a sale

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Inventory Turnover
Inventory turnover ratio measures how often the inventory balance is sold during an accounting period.

Efficiency Ratio

Cash Conversion Cycle

The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a
company to convert its investments in inventory and other resources into cash flows from sales. This
metric takes into account the time needed to sell its inventory, the time required to collect receivables,
and the time the company is allowed to pay its bills without incurring any penalties. CCC will differ by
industry sector based on the nature of business operations.

𝐶𝐶𝐶 = 𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 + 𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 − 𝐷𝑎𝑦𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash outflow.
Hence, DPO is the only negative figure in the calculation. DIO and DSO are linked to inventory and
accounts receivable, respectively, DPO is linked to accounts payable, which is a liability and thus taken
as negative.

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Corporate Banking
Introduction to Corporate Banking
Corporate banking is a very important division within many large commercial and bulge bracket
banks; this team serves as a critical link between the commercial banking group and the capital
markets/investment banking teams.

Corporate Banking is a division of a bank responsible for putting together loans to corporations,
financial institutions, and governments. Apart from the interest they charge on loans they also earn
fees for customer services they provide, such as checking accounts, financial counselling, loan
servicing, and selling other financial products (such as insurance and mutual funds).

Corporate banking, or “institutional banking”, usually falls under the Investment Banking umbrella of
the bank and is often perceived as a “loss leader” for other investment banking products such as
M&A, bond and equity underwriting.

https://mergersandinquisitions.com/corporate-banking/

Corporate Banking Products

The basic business model of a Corporate Bank is similar to that of a Commercial Bank, which is the
bank’s lending arm to individuals and small businesses: Use customer deposits to make loans and
earn a profit on the spread. The corporate banking division makes loans to corporations, while the
commercial bank division makes loans to people and small businesses.

Commercial banks offer the following products and services, among others, to corporations and
other financial institutions:

● Loans and other credit products

● Treasury and cash management services
● Equipment lending
● Commercial real estate
● Trade finance
● Employer services

i. Revolving Credit Facilities (“Revolver”)

A loan that acts like a credit card for large companies. With a revolver, a certain amount up to some
predefined limit can be drawn and repaid as needed for operating and other activities.

The corporate bank charges fees on the drawn amount (“Utilization fees”) at LIBOR + a spread. In
addition a small “Upfront fee” for putting the loan package together (e.g. 0.3% of the total amount)
and a small “Commitment fee” on undrawn amounts.

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For more info: https://www.wallstreetprep.com/knowledge/corporate-banking-101-revolving-

credit-facilities/

ii. Syndicated Lending

Corporate bankers from different financial institutions join together to offer credit and share in the
risk of financing a corporate borrower using a multilateral credit arrangement called a syndicated
loan.

Corporate banking clients often borrow dollar amounts that are extraordinarily high, given that
these are typically large, publicly traded companies. Some of this credit is issued through the
corporate bond market, but some is debt (like revolvers, CAPEX loans, and commercial real estate
lending) extended directly by financial institutions.

iii. Term Loans

Term Loans are used to fund capital expenditures, general operating activity, M&A, leveraged
buyouts, and recapitalizations. Pricing on term loans is largely the same as the revolver’s utilization
fees: LIBOR + spread. Term loans are more lucrative for the corporate bank because unlike the
revolver the whole amount is drawn and therefore earns strong lending returns.

iv. Bridge Finance

Usually for interim funding for M&A transactions before more permanent capital is raised. Can be
lucrative products.

v. Letters of Credit
A letter from the bank promising payment will be made (i.e., backing from an issuing bank),
effectively replacing the credit risk of the creditor/borrower with that of the bank.

For more info: https://www.wallstreetprep.com/knowledge/corporate-banking-101-term-loans-

bridge-loans-and-letters-of-credit/

Corporate Banking vs Commercial Banking

The underlying business model for commercial banks is pretty similar to the corporate bank but
unlike corporate banking, commercial banking is a standalone business line whose sole focus is
generating income from its lending operations.

For example, while the commercial bank will only lend to a small business if it clears lending returns
of, say, 20%, a corporate bank might accept a paltry 8% lending return if the investment bank views
those returns as acceptable given the potential for future equity capital markets, debt capital
markets, or interest rates derivatives business.

As a result, when screening for whether or not to extend credit, corporate banking deal committees
look at historical investment banking revenues and the potential for longer-term relationships.

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Corporate Banking vs Investment Banking

Corporate banking is sometimes referred to as “investment banking lite”. Similarities exist as the two
divisions often work alongside each other as part of the broader capital markets platform.

However, corporate banking is primarily focused on recurring relationship management via credit
while investment bankers are more focused on idea generation and corporate finance advisory.

Corporate Banking vs Retail Banking

Retail banking is a bank's services that deal directly with consumers, while corporate banking is the
part of the banking industry that serves business or corporate customers.

Retail banking is the face of banking to the public via the many bank branches located in most cities,
mobile apps, and banking websites. Corporate banking, on the other hand, works directly with
businesses of various sizes to provide them loans, credit, savings accounts, and checking accounts
that are specifically designed for companies rather than for individuals.

Corporate Banking ratios

For corporate banking models, analysts will run scenario analysis to see whether the company’s
forecasts are in compliance with the debt covenants, with key covenants being:

Leverage Ratio – Debt / EBITDA must not exceed a certain maximum leverage defined in the
covenants

Minimum Interest Coverage Ratio – EBITDA / interest expense must not fall below a certain
minimum in the covenants

In addition, the models identify whether there is a danger of a breach. They will also be looking at
what debt paydown looks like in each case.

Keywords:

● Covenants
● Cash Sweep
● DSCR
● Pricing Grid
● Amortizing Debt vs Bullet Debt
● Bridge Loan
● Negative Pledge
● Credit Risk, Hedging for the same
● Loan Syndication: https://navi.com/blog/loan-syndication/
● Sources and Use of Funds

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Preparation Checklist:

● Refer Corporate Finance section of the Pocketbook for Basic Ratios, Capital Structure
Theories
● Cost Push Demand Pull Inflation, WPI vs CPI inflation
● Repo Rate
● Bonds, Yields and Spreads, interest rate impact on Bonds
● RBI’s current monetary Policy
● Why Corporate Banking and not Investment Banking/other Finance Roles?
● How do You asses health of a Bank/Corporation?
● Information on basic products from Markets Section: Forwards, Futures, Options
● The Job is relationship based and often interviewers probe by asking situational question

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Investment Banking & Valuation

1. THE TIME VALUE OF MONEY

• Time value of money means that a sum of money is worth more now than the same sum of money in
the future due to its earnings potential in the interim.

• If you hide $1,000 in a mattress for three years, you will lose the additional money it could have
earned over that time if invested. It will have even less buying power when you retrieve it because
inflation would have reduced its value.
• Inflation: Inflation is a rise in prices, which can be translated as the decline of purchasing power over
time.

• As another example, say you have the option of receiving $10,000 now or $10,000 two years from
now. Despite the equal face value, $10,000 today has more value and utility than it will two years
from now due to the opportunity costs associated with the delay.
• Utility: Utility refers to the total satisfaction received from consuming a good or service. Rational
consumers/investors will strive to maximize their utility.
• Opportunity Cost: It is the potential forgone profit from a missed opportunity—the result of choosing
one alternative and forgoing another.

1.1 Understanding Interest Rates

• Nominal Risk-free Rate: The rate of return offered by an investment that carries zero risk. Every
investment asset carries some level of risk, however small, so the risk-free rate is something of a
theoretical concept. In practice, it's considered to be the interest rate paid on short-term government
debt.

• Real Risk-free Rate: The increase in purchasing power of an investor by holding a government security.
Nominal risk-free rate adjusted for inflation gives us the real risk-free rate.

Real risk-free rate = Nominal risk-free rate - Expected Inflation rate

But not every security in the world is risk-free. Hence, the interest rates investors expect also carry
additional risk premiums.
Required Interest rate on a security = Nominal risk-free rate + Default risk premium + Liquidity
premium + Maturity risk premium

• Default Risk: The risk that a borrower will not make the promised payments in a timely manner.
• Liquidity risk: The risk of receiving less than fair value for an investment if it must be sold for cash quickly.

• Maturity risk: The prices of longer-term bonds are more volatile than those of shorter-term bonds. Longer
maturity bonds have more maturity risk than shorter-term bonds and require a maturity risk premium.

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1.2 Basic TVM Formula

Compounding: Compounding is the method used in finding out the future value of the present investment.

Discounting: Discounting is the process of converting the future amount into its Present Value.

• FV = Future value of money

• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
invested for one year at 10% interest. The compounding frequency of this interest rate
₹10
can have a dramatic effect on the future value.
,000 is

• Annual Compounding: FV = ₹10,000 x [1 + (10% / 1)] ^ (1 x 1) = ₹10,500

• Semi-Annual Compounding: FV = ₹10,000 x [1 + (10% / 2)] ^ (2 x 1) = ₹11,025
• Quarterly Compounding: FV = ₹10,000 x [1 + (10% / 4)] ^ (4 x 1) = ₹11,038
• Monthly Compounding: FV = ₹10,000 x [1 + (10% / 12)] ^ (12 x 1) = ₹11,047
• Daily Compounding: FV = ₹10,000 x [1 + (10% / 365)] ^ (365 x 1) = ₹11,052

Annual Compounding

Semi-Annual Compounding

Thus, we see that a higher compounding frequency leads to a higher future value. This is because the intermediate
earnings also compound. Interest earned on interest leads to a higher future value.

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2. CAPITAL BUDGETING
• The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects
where the cash flow to the firm will be received over a period longer than a year.
• Any corporate decisions with an impact on future earnings can be examined using this framework.
• Decisions about whether to buy a new machine, expand business in another geographic area, move the
corporate headquarters to a new location, or replace a delivery truck, to name a few, can be examined using a
capital budgeting analysis.

2.1 Principles of Capital Budgeting

• Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the
capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is
undertaken.

• Don’t include sunk costs in analysis. Sunk costs are costs that cannot be avoided, even if the project is not
undertaken. Because these costs are not affected by the accept/reject decision, they should not be included in
the analysis. An example of a sunk cost is a consulting fee paid to a marketing research firm to estimate
demand for a new product prior to a decision on the project.

• Cash flows are based on opportunity costs. Opportunity costs are cash flows that a firm will lose by
undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that
would be forgone if the project under consideration is undertaken. Opportunity costs should be included in
project costs. For example, when building a plant, even if the firm already owns the land, the cost of the land
should be charged to the project because it could be sold if not used.

• The timing of cash flows is important. Capital budgeting decisions account for the time value of money, which
means that cash flows received earlier are worth more than cash flows to be received later.

• Cash flows are analysed on an after-tax basis. The impact of taxes must be considered when analysing all
capital budgeting projects. Firm value is based on cash flows they get to keep, not those they send to the
government.

• Financing costs are reflected in the project’s required rate of return. Do not consider financing costs specific
to the project when estimating incremental cash flows. The discount rate used in the capital budgeting
analysis takes account of the firm’s cost of capital. Only projects that are expected to return more than the
cost of the capital needed to fund them will increase the value of the firm.

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2.2 Net Present Value (NPV)

• Net present value (NPV) is the sum of the present values of all the expected incremental cash flows if a project
is undertaken.
• The discount rate used is the firm’s cost of capital, adjusted for the risk level of the project.
• For a normal project, with an initial cash outflow followed by a series of expected after-tax cash inflows, the
NPV is the present value of the expected inflows minus the initial cost of the project.

where:
CF0 = initial investment outlay (a negative cash
flow) CFt = after-tax cash flow at time t k = required
rate of return for project

• Alternately, NPV can also be defined as PV (Cash Inflows) – PV (Outflows).

NPV Decision Rule

• A positive NPV indicates that the projected earnings generated by a project or investment exceeds the
anticipated costs, in terms of present value. It is assumed that an investment with a positive NPV will be
profitable.
• An investment with a negative NPV will result in a net loss.
• This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive
NPV values should be considered.

Example

Cost of Capital is 9%. A project under evaluation has the following expected cashflows:

Year 0 (Initial Investment) 1 2 3

Cashflow -100 25 50 75

𝑁𝑃𝑉 = −100 +++= 22.93

As the NPV is positive, the project should be undertaken.

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2.4 NPV vs. IRR

NPV IRR

Advantage NPV is theoretically the best method. It measures profitability as a percentage,

Direct measure of the expected increase in showing the return on each dollar invested.
the value of the firm. The IRR provides information on the margin
of safety that the NPV does not.

Disadvantage It does not include any consideration of the The possibility of producing rankings of
size of the project. For example, an NPV of mutually exclusive projects different from
₹100 is great for a project costing ₹100 but those from NPV analysis.
not so great for a project costing ₹1
million. The possibility that a project has multiple
IRRs (if it has unconventional cashflows) or
no IRR.

Conflicting Project Rankings

1) Consider two projects with an initial investment of ₹1,000 and a required rate of return of 10%. Project X
will generate cash inflows of ₹500 at the end of each of the next five years. Project Y will generate a single cash
flow of ₹4,000 at the end of the fifth year.

Year 0 1 2 3 4 5 NPV IRR

Project X -1000 500 500 500 500 500 895 41%

Project Y -1000 0 0 0 0 4000 1484 32%

Project X has a higher IRR, but Project Y has a higher NPV. Which is the better project?
If Project X is selected, the firm will be worth ₹895 more because the PV of the expected cash flows is ₹895 more
than the initial cost of the project. Project Y, however, is expected to increase the value of the firm by ₹1,484.
Project Y is the better project.

2) Another reason, besides cash flow timing differences, that NPV and IRR may give conflicting project
rankings is differences in project size. Consider two projects, one with an initial outlay of $100,000, and one with
an initial outlay of $1 million. The smaller project may have a higher IRR, but the increase in firm value (NPV) may
be small compared to the increase in firm value (NPV) of the larger project, even though its IRR is lower.

When NPV and IRR give conflicting results, always choose the project with the higher NPV.

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2.4 Payback Period

The payback period (PBP) is the number of years it takes to recover the initial cost of an investment.

Example

Continuing with our same example,

Year 0 (Initial Investment) 1 2 3

Cashflow -100 25 50 75

Cumulative net cashflow -100 -75 -25 +50

𝑢𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐹𝑢𝑙𝑙 𝑦𝑒𝑎𝑟𝑠 𝑢𝑛𝑡𝑖𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 +
𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 2 + = 2.33 𝑦𝑒𝑎𝑟𝑠

Obviously, the shorter a project’s payback period, the better.

Advantage: The main benefit of the payback period is that it is a good measure of project liquidity. Firms with
limited access to additional liquidity often impose a maximum payback period and then use a measure of
profitability, such as NPV or IRR, to evaluate projects that satisfy this maximum payback period constraint.

Disadvantage: The main drawbacks of the payback period are that it does not take into account either the time
value of money or cash flows beyond the payback period, which means terminal or salvage value wouldn’t be
considered. These drawbacks mean that the payback period is useless as a measure of profitability.

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3. COST OF CAPITAL

The capital budgeting process involves discounted cash flow analysis. To conduct such analysis, you must know the
firm’s proper discount rate.

This discount rate is the firm’s weighted average cost of capital (WACC).

The WACC is given by:

where:

i. wd = percentage of debt in the capital structure

ii. wps = percentage of preferred stock in the capital structure
iii. wce = percentage of common stock in the capital structure
iv. kd = The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also
called the before-tax component cost of debt
v. kd(1 − t) = The after-tax cost of debt
vi. kps = The cost of preferred stock.
vii. Kce = The cost of common equity. It is the required rate of return on common stock and is generally difficult to
estimate.

• The interest paid on corporate debt is tax deductible. Because we are interested in the after-tax cost of
capital, we adjust the cost of debt, kd, for the firm’s marginal tax rate, t.
• The WACC, as we have described it, is the cost of financing firm assets. We can view this cost as an
opportunity cost.
• The weights in the calculation of a firm’s WACC are the proportions of each source of capital in a firm’s capital
structure.

How to calculate kp?

The cost of preferred stock (kps) is:

kps = Dps / P

where:
Dps = preferred dividends
P = market price of preferred

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How to calculate k e?

3.1 Capital Asset Pricing Model (CAPM) approach

Where:
Rf = Yields on default risk-free debt such as India’s 10-year Government Bond are usually used. The most appropriate
maturity to choose is one that is close to the useful life of the project.
β= Measure of systematic risk of the firm’s equity securities.

• β =1 exactly as volatile as the market

• β >1 more volatile than the market
• β <1>0 less volatile than the market
• β =0 uncorrelated to the market
• β <0 negatively correlated to the market

E(Rmkt) = Expected rate of return on the market

3.2 The dividend discount model approach

If dividends are expected to grow at a constant rate, g, then the current value of the stock is given by the dividend
growth model:

where:
D1 = next year’s dividend
kce = required rate of return on common equity
g = firm’s expected constant growth rate

Rearranging the terms, you can solve for k ce:

The expected growth rate g can be estimated as follow s:

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𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝑅𝑂𝐸 = (1 − 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒) ∗ 𝑅𝑂𝐸

4. RATIO ANALYSIS
Ratio analysis consists of the calculation of ratios from financial statements. A financial ratio shows the relative
magnitude of selected numerical values taken from those financial statements. The numbers contained in financial
statements need to be put into context so that investors can better understand different aspects of the company’s
operations. Ratio analysis is one method an investor can use to gain that understanding.

Types of Financial Ratios

• Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable
rate of return.
• Liquidity ratios measure the availability of cash to pay current debt obligations.
• Activity ratios (aka efficiency ratios) measure the effectiveness of a firm’s use of resources, or assets.
• Debt (or leverage) ratios measure the firm’s ability to repay long-term debt.
• Market ratios are concerned with shareholder audiences. They measure the cost of issuing stock and the
relationship between return and the value of an investment in company’s shares.

4.1 Profitability Ratios

• Return on Asset

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐴 =

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

The ROA is the product of two common ratios: profit margin and asset turnover. A higher ROA is better, but
there is no metric for a good or bad ROA. ROA depends on the company, the industry, and the economic
environment. ROA is based on the book value of assets, which can be starkly different from the market value
of assets.

• Return on Equity

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 =

𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

ROE is also the product of return on assets (ROA) and financial leverage. ROE shows how well a company uses
investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE
is better.

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• Operating Margin

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

The operating margin shows how much profit a company makes for each dollar in revenue. Since revenues
and expenses are considered ‘operating’ in most companies, this is a good way to measure a company’s
profitability. Although It is a good starting point for analyzing many companies, there are items like interest
and taxes that are not included in operating income. Therefore, the operating margin is an imperfect
measurement a company’s profitability.

• Profit Margin

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

There are two types of profit margin: gross profit margin and net profit margin. Higher profit margin is better
for the company, but there may be strategic decisions made to lower the profit margin or to even have it be
negative.

4.2 Activity/ Efficiency Ratios

• Inventory Turnover

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

365

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑦𝑠 𝑡𝑜 𝑠𝑒𝑙𝑙 𝑡ℎ𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing
effort. Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in
business as the inventory is too low.

• Days Sales Outstanding

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

Generally, higher DSO ratio can indicate a customer base with credit problems and/or a company that is
deficient in its collection activity. A low ratio may indicate the firm's credit policy is too rigorous, which may
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• Fixed Asset Turnover

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦, 𝑃𝑙𝑎𝑛𝑡, 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

It measures how well a company generates sales from its property, plant, and equipment. A higher ratio
implies that management is using its fixed assets more effectively.

4.3 Liquidity Ratios

• Current Ratio

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those
due within one year. It is calculated as the ratio of Current Assets of a company to its Current Liabilities. A
current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly,
if a company has a very high current ratio compared to their peer group, it indicates that management may
not be using their assets efficiently.

• Quick Ratio or Acid test Ratio

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 𝑜𝑟 𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 =

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The acid-test, or quick ratio, compares a company's most short-term assets to its most short-term liabilities to
see if a company has enough cash to pay its immediate liabilities, such as short-term debt.

4.4 Debt Ratios

• Total Debt to Assets

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

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The debt ratio measures the firm's ability to repay long-term debt by indicating the percentage of a
company's assets that are provided via debt. The higher the ratio, the greater risk will be associated with the
firm's operation.

• Interest Coverage Ratio

𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

The interest coverage ratio is used to measure how well a firm can pay the interest due on outstanding debt.
Generally, a higher coverage ratio is better, although the ideal ratio may vary by industry.

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4.5 Market Ratios

• P/E Ratio

𝑃
𝑅𝑎𝑡𝑖𝑜 = (𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)/ (𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)
𝐸

The P/E ratio is a widely used valuation multiple as a guide to the relative values of companies; for example, a
higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is
more expensive than one with a lower P/E ratio.

• P/B Ratio

𝑃 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑅𝑎𝑡𝑖𝑜 =
𝐵 𝐶𝑜𝑚𝑝𝑎𝑛𝑦′𝑠 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

A higher P/B ratio implies that investors expect management to create more value from
a given set of assets, all else equal. Technically, P/B can be calculated either including
or excluding intangible assets and goodwill.

How are the three statements connected?

Net income figure from Income statement gets added to retained r=earnings in Equity.
The same net income figure is the starting point for indirect cash flow statement in the
Cash Flow from Operations.

The changes in Balance sheet line items get reflected in different sections of
cash flow statement and we arrive at net change in cash. This figure gets used
to arrive at ending cash balance in balance sheet.

Changes in Balance sheet assets also reflect changes in income statement in the
form of gains, losses, discontinued operations etc.

For more details how different line items get linked refer following:
https://corporatefinanceinstitute.com/resources/accounting/3-financial-
statements-linked/

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Questions:

• How a $100 increase in depreciation expense affect the three financial

statement?
• Lower operating profit by $100 and net income drop by 60.
• Ending cash increased by $40
• In balance sheet PPE reduce by $100, Overall assets fall by $60
• This gets balanced on the other end by fall in retained earnings by $60.
• A machine of $100 sold off for $80?
• NI decrease by $16
• Cash increase by $84
• PPE reduce $100
• Assets fall by $16 balanced by retained earnings.

Consolidation of Statements

Combined Financial statements of a company and its subsidiaries is presented in consolidatesd statements. For
valuation purposes generally consolidated statements are used unless there is special requirement to analysze
the standalone companies.

Consolidation of Income: Internal transaction i.e revenue for onr and expense for the other is netted off. Since
control is established once we go above 50% holdings we consolidate 100% of revenues and expenses. Non
controlling Interest is subtracted since the parent doesn’t own that part of the income.

Consolidation of Balance Sheet: All line items are combined even though 100% is not owned. Similar control
logic is applicable. In Equity side Non controlling interest appears.

Adjusting entries: Certain transactions can have double accounting. Like parent sold goods to subsidiary and
subsidiary sold to third part. In such cases we can’t record double revenue and thus adjusting entries are used
to eliminate this impact.

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5. ENTERPRISE VALUE & EQUITY VALUE

There are at least two ways you can measure a company’s value:

• “Market Value” – What is the company worth right now according to the stock market, its current owners, or
its current investors?

• Implied or “Intrinsic” Value – What should the company be worth according to your analysis and views?

Why might the Market Value be different from the Implied Value?

Let’s say you’re analysing a company that has $100 in cash flow. Both you and the company’s current owners
believe the appropriate Discount Rate is 10% because similar companies are expected to generate annualized
returns of 10% over the long term. However, you disagree about the expected growth rates. You believe the
company’s cash flow will grow at 4%, but the current owners think it will grow at 5%. As a result, the
company’s value is different for each group:

Implied Value for YOU = $100 / (10% – 4%) = $1,666.

Market Value = $100 / (10% – 5%) = $2,000.

The owners want $2,000 for the company, or they won’t sell it. But you believe that the company is too
expensive and that its intrinsic value is quite a bit lower. As a result, you won’t buy the company at their
asking price of $2,000. That’s the main reason why a company’s Market Value often differs from its Implied
Value: you believe the company’s future growth will be one number, but “the market,” or other investors,
believe something else.

You might also disagree about the Discount Rate or even the company’s Cash Flow. But most valuation
differences boil down to disagreements about future growth rates.

A company might have funded its operations with just Equity, a combination of Debt and Equity, Debt + Equity
+ Preferred Stock, or other combinations of capital.

This question creates the main two measurements of “Company Value”: Equity Value and Enterprise Value.

• Equity Value: The value of everything a company has (Net Assets, or Total Assets – Total Liabilities), but
only to equity investors (common shareholders).

• Enterprise Value: The value of the company’s core business operations (Net Operating Assets, or
Operating Assets – Operating Liabilities), but to all investors (Equity, Debt, Preferred, and possibly others).

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Definitions:

Equity Value: Equity value is found by taking the company’s fully -diluted shares outstanding and multiplying it by a
stock’s current market price.
Debt: They are interest -bearing liabilities and are comprised of short -term and long-term debt. You take the market
value of debt for calculating Enterprise Value.

Preferred Stock: Preferred Stock pays out a fixed dividend, and preferred stockholders also hav e a higher claim to a
company’s assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

Cash and marketable securities: In an acquisition, the buyer would get the cash of the seller, so it effectively pays
less for the company based on how large its cash balance

Non-controlling interest: Non-controlling interest is the portion of a subsidiary not owned by the parent company
(who owns a greater than 50% but less than 100% position in the subsidiary). The Financial statements of this
subsidiary are consolidated in the financial results of the parent company.

Why is Enterprise Value used?

• Enterprise Value is very useful for comparing companies with different capital structures because a change
in capital stru cture will not affect the amount of enterprise value. Hence, it is more commonly used in
valuation techniques.

• In the illustration below you will see an example of enterprise value vs equity value for two companies that
have the same asset value but diffe rent capital structures.

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• As shown above, if two companies have the same enterprise value (asset value, net of cash), they do not
necessarily have the same equity value. Firm #2 financed its assets mostly with debt and, therefore, has a
much smaller equity value.

• While using rela tive valuation method, enterprise value is often used for multiples such as EV/EBITDA,
EV/EBIT or EV/Sales for comparable analysis

How to use EV and Equity value of a company?

Let’s take an example to understand this.

• To calculate a company’s current Equity Value and current Enterprise Value, you start by taking its shares
outstanding and multiplying by its share price.
• For example, if a company has 1 billion shares outstanding, and its current share price is $10.00, its Current
Equity Value is $10 billion
• Then, you subtract its Cash, Investments, and non-core-business Assets, which are worth $1.3 billion + $234
million + $406 million = ~$1.9 billion total.
• Then, you add its Debt and Preferred Stock, which are worth $11.3 million + $879.1 million + $0 = $890.4
million
• So, its Current Enterprise Value is ~$9 billion.

• You now must value the company according to your views of it – in other words, you must calculate its
Implied Enterprise Value and Implied Equity Value.
• So, you project the company’s cash flows, and then you discount them back to their Present Value, using a
variation of this formula:
Free flow cash flow to the firm
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑉𝑎𝑙𝑢𝑒 =
(WACC − Cash flow Growth rate)

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(FCFF and FCFE is explained later in this document)

• Based on your views – the Growth Rate and Discount Rate you’ve used – the company’s Implied
Enterprise Value is $10.5 billion.
• Then, you calculate the company’s Implied Equity Value by adding Cash, Investments, and non-core
business Assets and subtracting Debt and Preferred stock, so its Implied Equity Value = $10.5 billion + $1.9
billion – $890 million = $11.5 billion.
• The company’s Implied Share Price is then $11.5 billion / 1 billion shares, or $11.50 per share
• So, your conclusion might be that the company’s shares SHOULD be worth $11.50 each and that it’s a
good deal to buy them at $10.00 per share.

Please note, this is just one of the methods to calculate the implied/ intrinsic equity value of the company.
Another method to calculate the implied value would be to discount the free flow cash flows to equity
shareholders using the cost of equity as the discounting rate.

EV and Equity value of private companies

• The main difference is that you can’t calculate current Equity Value by using the company’s share price
and shares outstanding because its shares are not publicly traded. So, you have to rely on the valuation at
which the company most recently raised money, the price at which it was acquired, or another external
number to estimate its Current Equity Value.

• As a result, you can’t calculate its current Enterprise Value in a straightforward way. In practice, you often
skip current Equity Value and current Enterprise Value for private companies altogether and just use your
views to estimate the Implied Equity Value and Implied Enterprise Value.

Why do we add minority interest in EV caluculation?

https://corporatefinanceinstitute.com/resources/valuation/minority-interest-in-enterprise-value-calculation/
We use EV multiples for comparison across peers. Now minority interest will be different across companies
but its not relevant to calculation when we want to view multiple’s across peers. So for easing comparison
minority interest is added to compare the firm as a whole.

Business Combination and Intercorporate investments

Refer to to Schweser notes CFA L2 chapter on Intercorporate investments and on
Multinational Operations for detailed understanding. Also can refer to CFA curriculum
books solved examples.

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Investment in Financial Assets

There are 3 ways for investment in financial assets: amortized cost, through profit and loss
(FVPL) and through OCI (FVOCI)
Classification is based on the above tree diagram.

Investment in Associates
20%-50% of voting rights not significant control
Equity Method: Investment is initially recorded at cost of acquired shares. After that
proportionate shares of earning get added. Income to income statement and dividends as
cash to balance sheet.

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6. VALUATION METHODOLOGY
There are different types of valuation methodologies. Popular ones include Absolute/Intrinsic Valuation
(Dividend Discount Model & Discounted Cash Flow Analysis) and Relative Valuation. Let us discuss them in
detail.

Dividend Discount Model

• A method for valuing a firm would be to calculate the value of equity and then add the value of debt.

• To calculate the value of Equity, we need the price of a share. Let us see how it can be calculated.

• We know that price of any project/investment is equal to the discounted cash flows in future years.

• For an equity investor (who does not sell his share) the cash flows from equity investment are the dividends
and thus the value of share is the discounted present value of all the future dividends.

• This is known as dividend discount model.

• Under this model, if DIV1 is the dividend paid out at the end of the first year, r is the discount rate and g is
the growth rate of dividends, then current price i.e. P0 is given by

𝐷𝐼𝑉1
𝑃0 =
r−g
• The dividends grow because the firms do not pay out all the earnings as dividends.

• Some of the earnings are reinvested into the business and earn incremental income leading to growth in
dividends. The ratio of earnings paid out as dividends is called the payout ratio = DIV/EPS (where EPS is the
earning per share).

• Thus, 1 – payout ratio represents the fraction of income reinvested in the business. This is called plowback
rate or retention rate. The retained capital would earn a return equal to the return on equity earned by
the company and thus if the payout ratio stays constant, the income and hence the dividend would grow
at:

𝑔 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 ∗ 𝑅𝑂𝐸

• A major assumption that we have made in the above discussion is that all these ratios remain constant
which is rarely the case in real life scenarios. For stocks with variable growth rates we find dividends for
each year separately and then sum the discounted value to get the price of stock. The process is similar to
that in DCF.

𝑃0

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Where,

Di = Dividend in the ith period

𝑃0 = Expected price of the stock at the start of period

Example: Consider a firm that has an EPS of Rs. 10 and a payout ratio of 0.5. Furthermore, the ROE is 15%, and
discount rate is 10%Then, g = 0.5*0.15 = 0.075; P = Price of share = 10*0.5/(.1-0.075) = Rs. 200

Discounting Cash Flow Method (DCF)

Valuation using Discounted Cash Flow Method is usually more time consuming than other methods.

DCF Method helps estimate the intrinsic value of an asset based on cash flows and their likely certainty. The
Enterprise Value is estimated by discounting expected cash flows using a suitable discount rate

There are two commonly used methods to estimate DCF:

1. Free Cash Flow to Firms

2. Free Cash Flow to Equity

Free Cash Flow to Firms (FCFF)

FCFF, or Free Cash Flow to Firm, is the cash flow available to all funding providers. It is referred to as unlevered
free cash flow. There are 4 ways to compute FCFF:

𝐹𝐶𝐹𝐹 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 (1 − 𝑡) + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 (𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛) −
𝐶𝑎𝑝𝑒𝑥 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐹𝐶𝐹𝐹 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 (1 − 𝑡) − 𝐶𝑎𝑝𝑒𝑥

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 (1 − 𝑡) + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 (𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛) − 𝐶𝑎𝑝𝑒𝑥 −

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇𝐴 (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ∗ 𝑡 − 𝐶𝑎𝑝𝑒𝑥 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Free Cash Flow to Equity (FCFE)

This method is commonly used in Leverage Buyout models and by some financial services firms. FCFE measures
the amount of cash that is available for distribution to equity shareholders.

𝐹𝐶𝐹𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 (𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛) − 𝐶𝑎𝑝𝑒𝑥 −

𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒𝑑 (𝑟𝑒𝑝𝑎𝑖𝑑)

𝐹𝐶𝐹𝐸 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 − 𝐶𝑎𝑝𝑒𝑥 + 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒𝑑 (𝑟𝑒𝑝𝑎𝑖𝑑)

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Note – Interest payments are classified as financing activity in both the ways explained above.

What is more commonly used?

Normally, FCFF is used since it is not affected by non-operating expenses.

Also, the discounting factor (WACC) is not affected by leverage when compared with discounting factor for cash
flows to equity (cost of equity). However, this does not hold true when we take away the constant debt
assumption and we change the capital structure keeping in mind the target debt for each year.

In such case, the WACC ought to change every year. This method is typically not used for sake of simplicity
except in cases of highly volatile leverage of LBOs.

Terminal value – different ways of calculations

There can be two ways to compute Terminal Value as follows:

1. Growing perpetuity

2. Terminal EV multiple

Growing perpetuity method

This method computes the present value of the cash flow assuming the same were to be earned into perpetuity
with a constant terminal growth rate of g.

1+𝑔
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 (𝑛𝑡ℎ 𝑦𝑒𝑎𝑟) = 𝐹𝐶𝐹 (𝑛) ∗
𝑤−𝑔
Hence, a point to note is that FCF of (n+1)th years is divided by (w-g) to get Terminal Value for nth year. ‘w’ is the
discount rate which is usually weighted average cost of capital.

Note – FCF can be replaced with FCFE if we are trying to find equity value. In that case, w will be replaced with
Ke.

Terminal EV multiple (a relative valuation, to that extent)

The last year EBIT/EBITDA can be multiplied by a suitable multiple that reflects fundamentals in the steady state.

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Relative Valuation
• A relative valuation model is a business valuation method that compares a company's value to that of its
competitors or industry peers to assess the firm's financial worth. Relative valuation models are an
alternative to absolute value models, which try to determine a company's intrinsic worth based on its
estimated future free cash flows discounted to their present value, without any reference to another
company or industry average. Like absolute value models, investors may use relative valuation models
when determining whether a company's stock is a good buy.

• Relative valuation is also used in investment banking extensively where the value of the target is
triangulated with the help of industry multiples. The most common multiples are EV/Sales, EV/EBITDA,
P/E, P/B. Advantages

• Relatively easier method. Can be done quickly to find disparity in market valuation of similar companies.

• It is expected to reflect market perceptions and investing moods better than DCF valuation. Such a
multiple analysis helps in taking momentum, value or growth-based strategies and provide a close
indication of how the business is performing in comparison to the peers.

Disadvantages

• Multiple valuation is built on the assumption that market has correctly priced the securities in aggregate
but has made errors in pricing individual securities. So, if an overall basis the market is over/under valued,
the multiple valuation will result in errors.

• In order to create a comparative set of peers, one has to be extra cautious in selecting the right peers
(size, lifecycle, market share) and also take care of the differences in financial years, accounting and
nonoperating items. This makes the process a bit risky.

• It may not work when the investor has long term horizon or when there are limited comparables with
common variables to consider.

Consistency of Ratios
Valuation ratios are broadly of two kinds

1. Enterprise level

2. Equity level

• Equity level ratios can be affected by changes in the capital structure without any change in the enterprise
value. Enterprise level ratios help compare companies with different leverage ratios. Also, enterprise level
ratios are generally less affected by accounting changes/difference as the denominator is higher than that
in case of equity ratios.

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Example: Equity Level – P/E, PEG, P/B

Enterprise Level – EV/EBIT, EV/EBITDA

• What about ratios like EV/Price, EV/Earnings?

The numerator in the ratio is not affected by the capital structure. However, the denominator is affected by
leverage. Hence, these ratios are inconsistent cannot be used to compare two companies with different
leverage levels or even the same company at different points in time.

This principle is applicable even for non- financial ratios. For example, EV/tonne is a popular metric used in
the cement industry. This ratio is consistent as both the numerator (EV) and denominator (capacity) are firm
level metrics and are not affected by the capital structure. However, a Price/tonne or Equity/Sales would be
an inconsistent ratio as price or equity is an equity level metric unlike capacity or sales.

Industry Specific Ratios

Illustrative List:

• Technology (Internet): EV / Unique Visitors, EV / Pageviews

• E-Commerce: EV/Gross Merchandise Value, EV/Revenue

• Cement: EV/Tonne; EV/EBITDA, Capacity utilization

• Airlines: EV/EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Retail Expense)

• Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense),
EV / Daily Production, EV / Proved Reserve Quantities

• Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (FFO = Funds From
Operations, AFFO = Adjusted Funds From Operations)

• Hotel Industry: Average Daily Rate (ADR), Revenue per available room (RevPAR), Occupancy

• Retail Industry: EV/EBITDAR, Revenue per sq feet, revenue per employee

• Banks and NBFCs :ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net
Income / Total Assets), and Price to Book Value and Tangible Book Value rather than Revenue, EBITDA,
and so on.

Rationale for some of the ratios above:

• Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value
drivers rather than revenue or profit.

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• For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize
the expense whereas others rent and therefore have a rental expense.

• For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples;
EBITDAX exists because some companies capitalize (a portion of) their exploration expenses, and some
expense them. You add back the exploration expense to normalize the numbers.

• For REITs, Funds From Operations (FFO) is a common metric that adds back Depreciation and subtracts
gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and
gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of
the cash flow the REIT is generating.

• Banks and NBFCs: Book ratios are considered as operating cashflows can’t be accurately predicted for the
future. Further, the assets and liabilities are generally stated at market value hence, book values are
relevant and can be compared.

Reading Valuation Ratios

How to read ratios and complementary variables to judge whether the company is overvalued:

• PE Ratio : PE Ratio is often read in conjunction with expected growth to judge how stocks are relatively
valued. Favourable stock is one with Low PE Ratio and High expected growth rate in earnings per share.

• P/BV Ratio: P/BV Ratio is often read in conjunction with ROE to judge how stocks are relatively valued.
Favourable stock is one with Low P/BV Ratio and High ROE

• P/S Ratio: P/S Ratio is often read in conjunction with Net Margin to judge how stocks are relatively valued.
Favourable stock is one with Low P/S Ratio and High net profit margin

• EV/EBITDA : EV/EBITDA is often read in conjunction with Reinvestment Rate to judge how stocks are
relatively valued. Favourable stock is one with Low EV/EBITDA and low reinvestment needs

• EV/Capital : EV/Capital is often read in conjunction with Return on Capital to judge how stocks are
relatively valued. Favourable stock is one with Low EV/Capital Stock and high return on capital

• EV/Sales: EV/Sales is often read in conjunction with After-Tax Operating Margin to judge how stocks are
relatively valued. Favourable stock is one with Low EV/Sales and high After- Tax Operating Margin

Ways to compute/read various ratios

• LTM: LTM stands for Last Twelve Months (or TTM = Trailing Twelve Months), is a measure used to evaluate
the company’s performance in the last twelve months. This is with reference to immediately preceding
twelve months. This is a more accurate measure in comparison to values as per financial statements as
these are more recent. LTM is usually used when the company has uniform growth prospects and isn’t
very volatile.

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• NTM: NTM stands for Next Twelve Months. This is normally used to forecast the company’s performance
in the next twelve months. This is normally used when the company’s earnings have cyclical nature,
volatile growth prospects or is technology oriented.

• 1-year forward: A one-year forward ratio typically takes into account the earnings/financial metrics as
projections for the next one year.

Understanding the Drivers of Key Ratios

PE Ratio

For understanding the drivers of P/E ratio, one needs to start from how share price is derived:

𝐷𝑃𝑆 𝑜𝑓 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

𝑃0 =
𝐾𝑒 − 𝑔
This comes from dividend discount method. Now dividing both sides by Earnings per share of year 0 (E 0), we
get

𝑃0 𝐷𝑃𝑆 𝑜𝑓 𝑦𝑒𝑎𝑟 0 ∗ ( 1 + 𝑔)

𝐸0 𝐸𝑃𝑆 𝑜𝑓 𝑦𝑒𝑎𝑟 0 ∗ (𝐾𝑒 − 𝑔)

𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 ∗ ( 1 + 𝑔)
𝑃/𝐸 =
𝐾𝑒 − 𝑔
Therefore, the fundamental drivers of P/E ratio are the payout ratio, expected growth and cost of equity!

EV/EBITDA

Assuming a constant FCFF, Enterprise Value can be written as:

𝐹𝐶𝐹𝐹 𝑜𝑓 𝑦𝑒𝑎𝑟 1
𝐸𝑉 =
𝑊𝐴𝐶𝐶 − 𝑔
Now, the equation can be further modified as follows:

𝐸𝐵𝐼𝑇𝐷𝐴 ∗ (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ∗ (𝑡) − 𝑁𝑒𝑡 𝐶𝑎𝑝𝑒𝑥 − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑊𝐶

𝐸𝑉 =
𝑊𝐴𝐶𝐶 − 𝑔

Dividing both sides by EBITDA

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𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ∗ (𝑡) 𝑁𝑒𝑡 𝐶𝑎𝑝𝑒𝑥 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑊𝐶

𝐸𝑉 (1 − 𝑡 ) + 𝐸𝐵𝐼𝑇𝐷𝐴 − 𝐸𝐵𝐼𝑇𝐷𝐴 − 𝐸𝐵𝐼𝑇𝐷𝐴

=
𝐸𝐵𝐼𝑇𝐷𝐴 𝑊𝐴𝐶𝐶 − 𝑔

From the above equation, the fundamental drivers for EV/EBITDA are the tax rate, expected growth rate, WACC
and the reinvestment rate. More the reinvestment rate, higher the capex and change in working capital.

P/B ratio

For understanding the drivers of P/B ratio, one needs to start from how share price is derived:

𝐷𝑃𝑆 𝑜𝑓 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟

𝑃0 =
𝐾𝑒 − 𝑔
Dividing both sides by Book value (BV) of year 0

𝑃0 𝐷𝑃𝑆 𝑜𝑓 𝑦𝑒𝑎𝑟 0 ∗ ( 1 + 𝑔) 1

= ∗
0 (𝐾𝑒 − 𝑔) 𝐵𝑉 𝑜𝑓 𝑦𝑒𝑎𝑟 0
𝐵𝑉

On the RHS, multiplying and dividing by EPS of year 0

𝑃 𝐷𝑃𝑆 𝑜𝑓 𝑦𝑒𝑎𝑟 0 ∗ ( 1 + 𝑔) 𝐸𝑃𝑆 𝑜𝑓 𝑦𝑒𝑎𝑟 0 (1 + 𝑔)

The above equation can be otherwise stated as:

From the above equation, the fundamental drivers for P/B are the Payout ratio, ROE, expected growth rate and
cost of equity.

Valuation using comparable transactions method

Comparable transaction method involves company valuation using past M&A transactions and is primarily used as
a check to apply a previously determined discount/premium to a company as compared to comparable cos. The
following steps needs to be followed here –

1. Screen for appropriate transactions

a. Recent transactions are preferred more than older ones

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b. Transactions should be from same industry and from a similar country (for example – it is acceptable to take
Indonesia or South Asia as a close proxy for India in telecom or tech industry)

c. Buyer profile also matters a lot – a financial sponsor (e.g. KKR) may pay lesser than a strategic buyer (e.g.
Facebook/Google in case of Reliance JIO)

d. Company size plays a role too – Ideally a similar size company is preferred in this analysis.

2. Filter the transactions with sufficient valuation data

a. Sometimes the screened transactions do not have ready numbers for valuation multiples used in
transactions. To overcome this, analysts are expected to get the hands dirty by calculating those multiples using the
revenues, EBITDA, market capitalization, enterprise value, etc. at the time of that transaction.

b. Sources to look for such numbers in the order of preference: Company materials (annual reports,
presentations, results, announcements, etc.), news articles and databases.

c. If one still doesn’t find a credible number for any multiple (mostly happens in case of enterprise value),
then that transaction will be dropped from the list of analysis.

d. Look out for extreme multiples (too loo or too high – easy to identify from a list) and remove them from
the analysis.

Note: All the multiples are calculated / searched for as on date of the transaction. Hence, one generally looks for
LTM revenue, net debt, & EBITDA.

3. Construct a range of multiples to be used in valuation

a. Have a high, low & average case for the transaction multiples

b. Triangulate the numbers with DFC, relative valuation and come at a conclusion.

Note: It may appear that transactions and relative valuation are same, but it is not completely true. Type of
multiples used can be same in both methods, but transaction valuation captures an additional aspect called
takeover premiums. Takeover premium is the difference between the market price (or estimated value) of a
company and the actual price paid to acquire it, expressed as a percentage. The premium represents the additional
value of owning 100% of a company in a merger or acquisition and is also known as the control premium. The
control premium is the additional benefit an acquirer receives (compared to an individual shareholder) from
having full control over the business. Acquirers typically pay premiums for two main reasons: value of control and
value of synergies.

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Financial Forecasting
Financial forecasting is the process of estimating or predicting how a business will perform in the future. It is
required while performing valuation of a company. • Forecasting Revenue

- Revenue measures the top-line growth and needs to be forecasted based on the drivers of revenue.

A) For instance, when forecasting revenue for the retail industry, we can forecast the expansion rate and
derive income per square meter.

B) When forecasting revenue for the telecommunications industry, we can predict the market size and use
current market share and competitor analysis.

C) When forecasting revenue for any service industries, we can estimate the headcount and use the income
for customer trends.

- Another, quick way (though less detailed and accurate) is to predict future growth based on historical data
and trends.

• Forecasting Margins

- Margins (Gross, Operating, EBITDA, etc.) are usually forecasted as a percentage of revenues.

- A detailed approach to forecasting would incorporate considering factors like cost of input, economies of
scale, and learning curve.

- The above approach can be hard to follow, in case you want to do a less accurate though robust analysis,
you can predict based on historical figures and trend.

• Forecasting Overhead costs (SG&A Expenses)

- Forecasting here is again done as a percentage of revenue.

- Although these costs are fixed in the short term, they become increasingly variable in the long term.

- Therefore, when forecasting over shorter terms (weeks and months), it may be inappropriate to use
Revenues. Rather, a more prudent approach would be to focus operating margin (see point ii above) and
leave SG&A as the balancing figure.

- For example, Forecasted SG&A = Forecasted Gross Margins - Forecasted Operating Margins.

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Summary of forecasting techniques:

Technique Use Math involved Data needed

1. Straight line Constant growth rate Minimum Historical data (ideally 3-5 years)

2. Moving average Repeated forecasts Minimum Historical data (ideally 3-5 years)

3. Simple Compare one independent with one Basic Stats Relevant Observations (check industry
linear dependent variable Knowledge data, ideally over 30)
regression

Special Valuation Situations

When should we not use a DCF in a valuation?

If the company has unstable or unpredictable cash flows (modern technology / internet firms or early startups) or
when debt and net working capital are not normal. Take for example banks and financial services companies –
since they do not re-invest debt and since net working capital is a significant chunk of their Balance Sheets –you
may not use a DCF.

What other valuation methodologies are there?

• Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting
liabilities to determine how much capital, if any, equity investors receive. This is quite useful in bankruptcy
cases.

• Replacement Value – Valuing a company based on the cost of replacing its assets. It is typically not used in
stock valuations.

• LBO Analysis – Determining how much a PE firm could pay for a company to hit the target IRR (which is
close to 25-30% in some cases). This method is useful only in leverage buyout cases.

• Sum of the Parts (SOTP) – Valuing each division/segment of a company separately and adding them
together at the end. Remember to reduce the holding discount which represents the discount on account
of lack of marketability and lack of control. To be used when a company has completely different,
unrelated divisions

• M&A Premiums Analysis – Analysing M&A deals and figuring out the premium that each buyer paid and
using this to establish what a comparable company is worth.

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What are the shortcomings with precedent transactions?

Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market
sentiment all have huge effects. Data on precedent transactions is generally more difficult to find than it is for
public company comparable, especially for acquisitions of small private companies.

Why do you subtract cash in the formula for Enterprise Value?

Cash is considered a non-operating asset and the Equity Value implicitly accounts for it. In an acquisition, the buyer
would take the cash of the seller, so it effectively pays less for the company based on how large its cash balance is
(netting off). Enterprise Value tells us how much we would really have to pay to acquire another company. It is not
always accurate because technically one should be subtracting only excess cash – the amount of cash a company
has above the minimum cash it requires to operate.

What are the two key differences between Enterprise Value/ EBITDA and Price/Earnings Ratio?

Capital Structure: Enterprise Value/EBITDA is independent of the capital structure of the firm as it does not
account for any interest payments, hence leverage of a firm is unaccounted for when we are valuing a firm using
this multiple. Further, the resultant value obtained is Enterprise Value of a firm, which is the sum of Market
Capitalisation and Net Debt (Debt - Cash) of the firm, this value is useful for investors who want a holistic view of
the firm. However, in the case of Price/Earnings, price is reflective of the value of equity shareholding, and
earnings also relate to the earnings attributable to these shareholders after accounting for all debt, interest and
tax payments, therefore it would be affected by the capital structure of a firm (for example more substantial
leverage would lead to lower earnings due to higher interest payments). The price obtained is reflective of the
equity value of a company which is attributable to equity shareholders.

Application:

• P/E Ratio is more broadly applicable than EV/EBITDA for determining under/overvaluation for a retail
investor because the former can be applied to industries/ sectors and entire stock market indices.

• P/E Ratio is not applicable in cases where the earnings of a firm are negative, however, Enterprise
Value/EBITDA can still be used in such cases as long as EBITDA remains positive (except for BFSIs where
debt is used in operations and EBITDA would not reflect an accurate picture)

Approaching a valuation model

To begin a Valuation model, we first need to carry out the industry analysis: Read the following reports to gain
more information about the industry:

• Broker Reports from Bloomberg, etc.

• Industry Reports like IBEF, Consultant’s reports, Industry Association reports, etc.

• News about the industry

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• Govt regulation/ Policy Changes

Once all industry factors are in place, we need to obtain Company specific Info. In order to collect that, we use the
following information:

• Management Discussion & Analysis

• Investor Presentations

• Analyst Call Transcripts

• Historical Financial Data to set the base for the forecasts. Sources: Bloomberg, EIKON etc.

On obtaining the above information, we can proceed with forecasting the key variables in the financial model to
arrive at a suitable valuation.

To cover deep understanding of valuation, have a look at

https://www.youtube.com/playlist?list=PLUkh9m2BorqnKWu0g5ZUps_CbQ-JGtbI9

Basic Checklist:

• Accounting Concepts, Transactions impact on three statements

• Basic ratios

• Valuation methods used for different industry and industry specific ratios

• Prepare two industries: major players, recent developments, current trends (numbers: growth, raw material,
M&A, regulation)

• Valuation multiples across peers

• Recent Regulatory changes in takeover code, IPO etc

• One stock Pitch – News, Justify assumptions, Learn recent numbers of growth, Earning etc

• News Deals: Refer Deals section of Mint, BS etc

• It’s good to keep track of market index movements as well Nifty, Sensex, DJIA, S&P daily and weekly
movement

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Private Equity & Venture Capitalism

PRIVATE EQUITY
What is Private Equity?
Private equity (PE) is ownership or interest in an entity that is not publicly listed or traded. A source of
investment capital, private equity (PE) comes from high-net-worth individuals (HNWI) and firms that
purchase stakes in private companies or acquire control of public companies with plans to take them private
and delist them from stock exchanges.

Most private equity funds invest either in private companies or public companies they intend to take private
(leveraged buyout funds), or in early-stage companies (venture capital funds). Two additional, but smaller,
categories of private equity funds are distressed investment funds and developmental capital funds. A
private equity fund may also charge fees for arranging buyouts, fees for a deal that does not happen, or fees
for handling asset divestitures after a buyout.

The underlying motivation for such commitments is the pursuit of achieving a positive return on investment
(ROI). Partners at private equity (PE) firms raise funds and manage these monies to yield favourable returns
for shareholders, typically with an investment horizon of between four and seven years. The sources of this
increased value are thought to come from the following:
1. The ability to re-engineer the portfolio company and operate it more efficiently.
2. The ability to obtain debt financing on more advantageous terms.
3. Superior alignment of interests between management and private equity ownership.

Types of Private Equity (PE) Firms

1. Passive PE Firms - strict financiers or passive investors wholly dependent on management to grow the
company and generate returns
2. Active PE Firms - provide operational support to management to help build and grow a better company

PE Investment Strategies

1. Leveraged buyouts (LBOs) are the most common type of private equity fund investment. “Leveraged”
refers to the fact that the fund’s purchase of the portfolio company is funded primarily by debt. This may
be bank debt (leveraged debt), high-yield bonds, or mezzanine financing. Mezzanine financing refers to
debt or preferred shares that are subordinate to the high-yield bonds issued and carry warrants or
conversion features that give investors participation in equity value increases.

Two types of LBOs are management buyouts (MBOs), in which the existing management team is
involved in the purchase, and management buy-ins (MBIs), in which an external management team will
replace the existing management team.

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Firms with Stable and Predictable cash flow and a good asset base are attractive LBO candidates because
their cash flow can be used to service and eventually pay down the debt taken on for acquisition.

2. Venture capital (VC) funds invest in companies in the early stages of their development. The investment
often is in the form of equity but can be in convertible preferred shares or convertible debt. While the
risk of start-up companies is often great, returns on successful companies can be very high. This is often
the case when a company has grown to the point where it is sold (at least in part) to the public via an
IPO.

1. The formative stage refers to investments made during a firm’s earliest period and comprises three
distinct phases.
a. Angel investing refers to investments made very early in a firm’s life, often the “idea” stage, and the
investment funds are used for business plans and assessing market potential. The funding source is
usually individuals (“angels”) rather than venture capital funds.
b. The seed stage refers to investments made for product development, marketing, and market
research. This is typically the stage during which venture capital funds make initial investments,
through ordinary or convertible preferred shares.
c. Early stage refers to investments made to fund initial commercial production and sales.
2. Later-stage investment refers to the stage of development where a company already has production
and sales and is operating as a commercial entity. Investment funds provided at this stage are
typically used for expansion of production and/or increasing sales though an expanded marketing
campaign.
3. Mezzanine-stage financing refers to capital provided to prepare the firm for an IPO. The term refers
to the timing of the financing (between private company and public company) rather than the type
of financing.

Private Equity Structure and Fees

Private equity funds are typically structured as limited partnerships. Committed capital is the amount of
capital provided to the fund by investors. The committed capital amount is typically not all invested
immediately but is “drawn down” (invested) as securities are identified and added to the portfolio.
Committed capital is usually drawn down over three to five years, but the drawdown period is at the
discretion of the fund manager. Management fees are typically 1% to 3% of committed capital, rather
than invested capital. Incentive fees for private equity funds are typically 20% of profits, but these fees
are not earned until after the fund has returned investors’ initial capital. It is possible that incentive fees
paid over-time may exceed 20% of the profits realized when all portfolio companies have been liquidated.
This situation arises when returns on portfolio companies are high early and decline later. A clawback
provision requires the manager to return any periodic incentive fees to investors that would result in
investors receiving less than 80% of the profits generated by portfolio investments as a whole.

Private Equity Exit Strategies

The average holding period for companies in private equity portfolios is five years. There are several
primary methods of exiting an investment in a portfolio company:

1. Trade sale: Sell a portfolio company to a competitor or another strategic buyer.

2. IPO: Sell all or some shares of a portfolio company to the public.
3. Recapitalization: The company issues debt to fund a dividend distribution to equity holders (the
fund). This is not an exit, in that the fund still controls the company, but is often a step toward an
exit

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4. Secondary sale: Sell a portfolio

company to another private equity firm
or a group of investors.
5. Write-off/liquidation: Reassess and
adjust to take losses from an
unsuccessful outcome.

Private Equity Company Valuation

Valuation for private equity portfolio companies

is essentially the same as valuing a publicly
traded company, although the discount rate or
multiples used may be different for private
companies.

1. Market/comparables approach:
Market or private transaction values of similar companies may be used to estimate multiples of
EBITDA, net income, or revenue to use in estimating the portfolio company’s value.
2. Discounted cash flow approach: A dividend discount model falls into this category, as does
calculating the present value of free cash flow to the firm or free cash flow to equity.
3. Asset-based approach: Either the liquidation values or fair market values of assets can be used.
Liquidation values will be lower as they are values that could be realized quickly in a situation of
financial distress or termination of company operations. Liabilities are subtracted so only the
equity portion of the firm’s value is being estimated.

Buyouts: DCF is primarily used to value companies. For IRR calculation we calculate exit value from exit
multiple and find total payoff for PE firm. Exit
valueSEQ Figure \*
– Debtholders ARABIC
claim 1 Value.
= Residual ReferIRRLink
is calculated on the PE firms share of residual value and
initial investment.

VC: Process of Venture Capital Financing: 6 Main Steps (yourarticlelibrary.com)

The two fundamental concepts in venture capital investments are pre-money (PRE)
valuation and post-money (POST) valuation.
PRE + INV = POST

Ownership proportion of the venture capital (VC) investor is: f = INV / POST

It is difficult to forecast the cash flows for a VC portfolio company.

Therefore, discounted cash flow analysis (the income approach) is not
usually used as the primary valuation method for VC companies. It is

also difficult to use a relative value or market

approach. This is because a VC company is
often unique, and there may be no
comparable companies to estimate a

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benchmark price multiple from. The venture capital method starts with an estimate of the exit
value—the value of the PE fund’s investment upon exit. To estimate the exit value, the VC investor
typically examines the company’s intellectual property and capital, the potential for the company’s
products, and its intangible assets. Sometimes, a multiple of estimated future revenues is used to
estimate the exit value.

The required rate of return is determined by the return on investment (ROI) multiple. Venture
capital ROI tends to be 10× to 30×, compared with 1× to 2× for buyout transactions.

We calculate post-valuation based on exit value and ROI. Based on this, shares allotted to VC are
found. Then the price paid per share is calculated.

How to Value a Startup Company With No Revenue - MassChallenge

Companies analysed : https://ajuniorvc.com/companies/

Startup concepts: https://ajuniorvc.com/startup-concepts/

Keywords:

Limited Partner vs General Partner Tag-along, Drag-along clauses

Management Fees Co-Investment

Transaction Fees Discount for Lack of Control (DLOC), Discount

for Lack of Marketability (DLOM)
Carried Interest
Unit Economics: What Is Unit Economics in
Ratchet
SaaS? (lightercapital.com)
Vintage
Multiples to measure fund performance: Paid
Keyman Clause in Capital, Distributed to paid in capital,
residual value to paid in capital, total value to
Clawback paid in capital.
Distribution Waterfall

Summer intern roles and expectation at PE firm:

PE firms generally have small teams (10-15 people), and each investment opportunity is looked at by
a group of 2-3 individuals in the team. This implies that work is not very hierarchical, and all
members, from analyst to partners, are expected to generate views on the company being analysed.

A PE analyst would be expected to build financial models with insights based on assumptions
derived from discussion with management & experts, combined with secondary research. These are
then used to develop term sheets (business contracts), and to review portfolio companies (investee
companies) regularly.

A summer intern at a PE firm would be expected to have a good understanding of business,

PowerPoint and Excel skills, along with the basics of accounting and finance. With no fixed teams
within a PE firm, the intern would be expected to work and get along well with all members (from
analysts to partners) of the PE firm.

Work given to a PE intern: Ideally, an intern be working on a live deal along with an individual side
project.

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• Live Deal – Depending on the stage of the deal (preliminary research stage, term sheet
signing, due diligence), the intern would be given parts of the analysis to be taken up
independently. Research stage would involve discussions with management and experts to
gain an understanding of the business and industry and do secondary research (industry
reports, annual reports, comparable company reports). The analysis would have to be
presented to the broader team, which requires making PowerPoint presentations and
building excel models. An analyst may get the opportunity to draft a term sheet and work on
due diligence (getting work done by third party vendors) if a deal is at an evolved stage.

• The intern would be expected to form views on the company and the industry as the
analysis of the investment opportunity progresses.
• Individual Project – The individual project could vary from an industry analysis in a sector in
which the PE team does not have great exposure/prior experience to building an investment
hypothesis on a public/private company.

Summer intern roles and expectation at VC firm:

A summer intern needs basic understanding of finance. The value of start-ups is based on the
earnings that it would generate far ahead into the future, so the conventional valuation models
serve no purpose. The intern is required to have a keen interest in understanding the start-up
ecosystem and business of company and should also be comfortable with a lack of structured data.

Similar to PE firms, VCs have small investment teams (5-15 members). The key responsibilities are:

• Deal Sourcing: This could mean anything from cold calling a list of target companies and
asking them if they would be interested in speaking about potential investment by the firm
to attending networking events. The members of the investment team are expected to
research on latest sub-sector trends and look out for potential investment opportunities.
• Due Diligence: If an investment opportunity is deemed to be promising, it moves into the
due diligence phase. In early-stage venture capital firms, maybe 25 percent of the deals a
firm sees will reach this phase. In this phase, the junior staff will analyze the company's
management, products, competition, addressable market, risk factors, and overall
investment potential.
• Assisting Portfolio Companies: Junior VCs are sometimes expected to provide support for
existing portfolio companies. This can take the form of helping in some capacity with hiring,
business development, strategy, or tactical operations.

Preparation Checklist:

Technical/Industry Knowledge
▪ Detailed understanding of all drivers for an industry and company. Granular understanding of what
moves revenues, costs, and multiples for the chosen industry and how are firms positioned within
the industry
▪ Strong grasp on FRA and Corporate Finance (Damodaran videos:
https://www.youtube.com/playlist?list=PLUkh9m2BorqkKMOj0LkU8JCeDlk4k8P-A)
▪ A structured response to “How to Evaluate an investment opportunity”
▪ What-if scenarios – similar to a consulting case (in shorter form)

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About the Industry

● Different stages and rounds
● Difference between Angel funding, VC Funding and PE funding
● Difference between PE, VC, Asset Reconstruction Companies, etc.
● Deals Page of Mint

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Financial Markets
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INTRODUCTION

There are different functions that the financial markets perform, which includes determination of the prices where
financial markets help in price discovery of various financial instruments, mobilization of the funds, providing an
opportunity to different investors to buy or sell their respective financial instrument at the fair value that is
prevailing in the market, providing the various types of information to traders, and the sharing of the risk, etc.

Some of the important functions of financial markets can be listed as-

Price Determination
Funds Mobilization
Liquidity
Risk sharing
Easy Access
Reduction in transaction costs and provision of the Information
Capital Formation

Market Roles
There are three roles in the financial markets, namely- Trading, Sales, and Structuring. Each of these roles require a
different set of skills and carry different weight of risk with them.

Trading-

1. A trading desk basically does the trade- buy/sell operations and by generating profits for the bank by
holding positions.
2. Traders interact with the market for 2 functions: for covering client transactions and taking positions
based on trading views. In the latter case, the trader takes the risk of the positions on the book, but it
allows them to generate higher revenues for the firm than the regular commission fees from clients. For
client transactions, the flow starts with the buy-side clients reaching out to the Sales desk with their
request which then gets conveyed to the Trading desk by the Sales desk.
3. The role of a trader is to ensure that the buy-side can carry out the transaction at the best possible price.
4. The products traded by the desk include FICC (Fixed Income, Currencies and Commodities), Bullion and
Equities. In FICC, trading desks are structured based on products like FX, Rates, Credit, Exotics, etc. In
Equity, the trading desks are structured based on the trader’s level of involvement in carrying out the
trade. The High-Frequency Trading desk or the Algorithmic Trading desks have a lower level of
involvement in carrying out the trades and hence are called "Low Touch" desks. The volume of trade is
higher on the "Low-touch" desks but the commissions per trade are lower. On the other hand, traders in
the High touch desks have a higher level of involvement in each trade.
5. Strong analytical skills, understanding of market and products and risk-taking ability are some of the skills
required to do well in the role.

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Sales-

1. The role of a sales desk is to earn income by way of bid-ask spread by selling the products offered by the
trading desk to clients.
2. The salesperson directly interacts with the clients through official platforms like Reuters and Bloomberg.
When clients want to trade, they contact the sales desk which passes on the information to the trader
who gives his bid/ask spread. At this point, the salesperson can try to get a better deal for the trader or
quote the price as it is. An important aspect of being part of the sales desk is to understand various
markets, different products and the need of different clients. This knowledge is used to pitch the right
products to the relevant clients at the right time.
3. Strong interpersonal skills along with an understanding of markets, clients and products is needed to
succeed in the role.

Structuring-

1. Structuring desk in the markets division acts as a bridge for the trading desk and the sales desk. Therefore,
a structurer needs to be adept both in client communication and quantitative modelling of a product in a
trade book.
2. The structurer should have a sense of the broad trends in the markets and must design structured
products that will have demand from both institutional and private clients.
3. The work of the structuring desk can be broadly classified in two buckets: a) Synthetic solutions for
specific needs of an institutional clients. e.g.: interest rate swaps, b) Products that can be sold to
individual clients in the open market. e.g. Securities designed on currency forecasts.

TYPES OF SECURITIES – (EQUITY & DEBT)

Equity-
A company has two sources of funding- Equity and Debt. Equity is nothing but the amount of capital that is
invested into the company by its shareholders/owners/investors. Equity can be divided into stocks. Stocks of a
company represent partial ownership of the company.

A shareholder’s liability is limited to the percentage of his ownership or his share in the company.

There are three types of stocks-

1. Common Stock- This is the most general category of stock and represent ownership and the associated
voting rights in the company proportionate to the number of shares that you have. Any claim on the
assets of the company is only residual in the sense that, in case of liquidation, a common stock-holder
would be the last one to get paid. The higher risk is compensated by higher returns in terms of dividends
and potential appreciation in market price.
2. Preferred Stock- A preferred stock is of a nature which is in between that of debt and equity. There might
be some ownership rights and limited voting rights. They have a preference over common stockholders in

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case of liquidation and their dividends are guaranteed.

3. Convertible Preferred Stock- A convertible preferred stock is generally a preferred stock which is
convertible in the sense that it can be exchanged after some period of time (at the discretion of the stock-
holder) into common stock.

Debt-
When a company borrows money to be paid back at a future date with interest (usually from a bank) it is known as
debt financing. It involves borrowing funds from the creditors to meet monetary requirements in return for paying
interest on those funds followed by return of principal. It could be in the form of a secured as well as an unsecured
loan. A firm takes up a loan to either finance a working capital or an acquisition.

Debt financing is the opposite of equity financing, which entails issuing stock to raise money. A firm can sell fixed
income products, such as bonds, bills, or notes to finance itself from debt.
For a common investor, buying a stock means owning a part of equity of the company while buying a bond means
funding a part of company’s debt. A common stockholder earns returns when the price of the share increases while
a bondholder profits from the coupon payments they receive regularly till the maturity of the bond.

For instance, consider a company which takes a bank loan of $500,000 with 10% annual rate of interest for 10
years and principal repayment in the 10th year. The company would get $500,000 to invest in the venture which
needs cash. The bank would gain $50,000 in each of the subsequent 10 years and the principal amount of
$500,000 in the 10th year.

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Important points for equity and debt-

1. The biggest disadvantage of debt financing as opposed to equity financing is that it creates the burden of
loan repayment at all times irrespective of whether the company needs more funding (for startup costs
etc.) or not. With equity financing, companies do not run the risk of having a bad credit rating (which
would make future funding unavailable) if loan repayments are not made on time. Shareholders have the
right to vote in a meeting, they can keep a check on the management and offer significant business
insights and value-additions like supplier networks etc. (depending on who your investors are) that the
management might not always have.
2. The ‘poison pill’ is a warrant or an option that allows holders of the share to get new shares (as a bonus or
for substantial discount) if the management of the company changes hand. This would discourage an
existing shareholder to acquire more shares as he would have to incur the future liability in the form of
potentially significant dilution of his stake. Thus, the acquirer would be discouraged from pursuing a
takeover and would have to negotiate with the incumbent board for diluting the provisions of such
shares.
3. A high debt-equity ratio indicates that the company has been financing its operations by a relatively large
quantity of debt. The exact number which decides whether the debt proportion is excessive or not, varies
across sectors. A high ratio would mean that a large part of the company’s earnings would go towards
servicing the interest on the debt taken. When earnings are not sufficient to meet the interest cost, the
company may get bankrupt leaving potentially nothing for the equity investors.

Startup companies with a potential to grow need a certain amount of investment. Wealthy investors like
to invest their capital in such businesses with a long-term growth perspective. This capital is known as
venture capital and the investors are called venture capitalists

Such investments are risky as they are illiquid but are capable of giving impressive returns if invested in
the right venture. The returns to the venture capitalists depend upon the growth of the company.
Venture capitalists have the power to influence major decisions of the companies they are investing in
as it is their money at stake.

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FIXED INCOME
A fixed-income security is an investment that provides a return in the form of fixed periodic interest
payments and the eventual return of principal at maturity. Unlike variable-income securities, where
payments change based on some underlying measure—such as short-term interest rates—the payments
of a fixed-income security are known in advance.

Bonds are the most common type of fixed-income security, but others include CDs, money markets, and
preferred shares. Not all bonds are created equal. In other words, different bonds have different terms
as well as credit ratings assigned to them based on the financial viability of the issuer. Bonds raised for
risky projects will have higher interest payments.

The U.S. Treasury guarantees government fixed-income securities, making these very low risk, but also
relatively low-return investments. Government fixed income securities are generally considered risk
free.

The value of a fixed income instrument moves conversely with the interest rates. For example, consider
a bond that was bought at par for $500 and which pays a coupon of 7%. Now, if the general level of
interest rates falls (due to deflation or other changes in market conditions), the bond is offering a higher
return at par as compared to market rates. Thus, its price would rise and it would start trading above par
(for example, $520 per bond). The opposite would happen if the general level of interest rates rises.

MONEY MARKET INSTRUMENTS

Money Market Instruments, commonly termed as “paper” are short-term fixed income instruments.
These, unlike their long-term counterpart viz. bonds and equities, typically have a maturity of less than
one year.

A money market is defined as a platform where participants with short term borrowing / lending needs
meet and negotiate. Some examples of “paper” include Treasury Bills (issued by Government),
Commercial Paper (issued by companies), Certificates of Deposit (issued by financial institutions),
Repurchase Agreements (repo and reverse repo facilities by central banks), etc.

STOCK INDICES
A Stock Market Index regularly measures the price performance of a basket of stock from the entire
listed stocks on the exchange. In case of financial markets, an index is a portfolio of securities that
represent a particular market or a portion of a market. Each Index has its own calculation methodology
and usually is expressed in terms of a change from a base value. The base value might be as recent as

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the previous day or many years in the past. Thus, the percentage change is more important than the
actual numeric value. Financial indices are created to measure price movement of stocks, bonds, T-bills
and other type of financial securities. More specifically, a stock index is created to provide market

participants with the capture the overall behavior of equity market and need to represent the return
obtained by typical

information regarding average share price movement in the market. Broad indices are expected to
portfolios in the countryThe Sensex and Nifty-50 are two popular benchmark indices that largely reflect
the performance of Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

Price weighted indices- weigh constituent stocks by its share price. If number of stocks in a company
change (due to stock split lets say), the weight of that stock will change even when there are no real
market factors to cause this. Examples- DJIA, Nikkei 225.

Free float market capitalization weighting- calculates the market capitalization of the company after
taking into consideration only those shares of a company that are actively traded in the open market
and are not held privately. Free float are those shares that are issued by the company which are readily
available and are actively traded in the market. Some of the widely used indices include S&P 500,
NASDAQ Composite, FTSE 100, NIFTY 50, Sensex, and Hang Seng Index.

Significance of Index
A stock index is an indicator of the performance of overall market or a particular sector.
It serves as a benchmark for portfolio performance - Managed portfolios, belonging either to
individuals or mutual funds, use the stock index as a measure for evaluation of their performance.
It is used as an underlying for financial application of derivatives – Various products in OTC and
exchange traded markets are based on indices as underlying asset.

INDEX FUND
These types of funds invest in a specific index with an objective to generate returns equivalent to the
return on index. These funds invest in index stocks in the proportions in which these stocks exist in the
index. For instance, Sensex index fund would get similar returns as that of Sensex index, since Sensex has
30 shares, the fund will also invest in these 30 companies in the proportion in which they exist in the
Sensex.

INDEX DERIVATIVES
Index Derivatives are derivative contracts which have the index as the underlying asset. Index Options and
Index Futures are the most popular derivative contracts worldwide. Index derivatives are useful as a tool to
hedge against the market risk.

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EXCHANGE TRADED FUND

An exchange traded fund (ETF) is a basket of securities that is traded on an exchange, just like a stock.
ETFs offer liquidity anytime through the exchanges. The basket can contain assets such as stocks, bonds
or commodities. Most ETFs track an index, such as a stock index or bond index.

The major differences between ETFs and Mutual Funds are:

ETFs are traded throughout the day on exchanges unlike Mutual Funds which are bought and
sold only from the Fund House at the close NAV of the fund.

Both can track indexes as well, however ETFs tend to be more cost effective (much lower
expense ratio compared to mutual) and more liquid as they trade on exchanges like shares of
stock.

MARGIN
In finance, the margin is the collateral that an investor has to deposit with their broker or exchange to
cover the credit risk the holder poses for the broker or the exchange. An investor can create credit risk if
they borrow cash from the broker to buy financial instruments, borrow financial instruments to sell
them short, or enter into a derivative contract.

Two Major Types of Margins-

Initial Margin is the amount of funds required to initiate a position. It represents the percentage of the
purchase notional value that must be covered by the investor's own money.

Maintenance Margin is the minimum amount that must be maintained at any given time in your
account. In general, the Maintenance margin is less than the Initial Margin.

Marking to Market (MTM)- In futures market, while contracts have maturity of several months, profits
and losses are settled on day-to-day basis – called mark to market (MTM) settlement. The exchange
collects these margins (MTM margins) from the loss-making participants and pays to the gainers on day-
to-day basis.

If the funds in your account drop below the maintenance margin level you may receive a margin call
where you will be required to add more funds immediately to bring the account back up to the initial
margin level.

If you do not or cannot meet the margin call, you may be able to reduce your position in accordance with
the amount of funds remaining in your account.

Your position may be liquidated automatically once it drops below the maintenance margin level.

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Haircut- is defined as the percentage difference between asset’s market value and amount that can be
used as collateral for a loan. Highly liquid assets such as T-Bills will have a lower haircut whereas illiquid
assets will have high haircuts.

CLEARING HOUSE
Financial transactions can take place in an exchange or through an Over the Counter (OTC) market,
which is generally used for non-standardized contracts or products. A clearing firm usually exists in both
the markets to facilitate the process by acting as the counterparty for both the buyer and seller. The
clearing house requires posting of collateral from both counterparties to mitigate its risk. It nets off
multiple trades and it helps the market via providing the information of deals executed using its
services. They also provide the settlement mechanism for trades via which funds & deliverables are
transferred.

LONG / SHORT POSITIONS

Simply put, a long position in a product means that the position holder will benefit if the price of the
product or the underlying product (in case of derivatives) increases and vice versa. The opposite is the
case for the short position holder.

BID / ASK SPREAD

Bid/Ask spread is the amount by which the ask price exceeds the bid price. This is essentially the
difference in price between the highest price that a buyer is willing to pay for an asset and the lowest
price for which a seller is willing to sell it.

The above definition of bid/ask spread is for a marketplace. Bid/Ask spread can also be defined for a
single financial institution, where bid refers to price at which the financial institution (called as market
maker) is ready to buy (or long) an asset and ask is the price at which it is ready to sell (or short) the
asset.

NAKED AND CALENDAR SPREAD

Naked position in the futures market simply means a long or short position in any futures contract
without having any position in the underlying asset. Calendar spread position is a combination of two
positions in futures on the same underlying - long on one maturity contract and short on a different
maturity contract.

OPEN INTEREST AND VOLUME

The open interest is the total number of contracts outstanding (yet to be settled) for an underlying
asset. It is important to understand that the number of long futures as well as number of short futures is
equal to the Open Interest. This is because the total number of long futures will always be equal to the

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total number of short futures. Only one side of contracts is considered while calculating/mentioning
open interest. The level of open interest indicates depth in the market.

HEDGING
Hedging is the practice of limiting/minimizing one’s risks. It can serve as an effective tool to stabilize the
returns one earns on their investments and limit the losses occurring in an unexpected turn of events. It
usually involves some cost or giving up some return in exchange for more safety.

Example-

Airline A is uncertain about the future prices of fuel and wants to hedge its risk. It can get into a contract
of buying fuel at some fixed price on a future date. Such a contract is called a forward contract. Airline A
is thus indifferent to changes in the fuel prices since it has locked in its purchase price.

Hedge Fund B, who doesn’t need fuel, gets into the similar forwards contract where he agrees to buy
fuel at a fixed price on a future date, expecting fuel prices to increase. If the fuel prices actually increase
the hedge fund makes money by buying fuel on the fixed price and selling on the market price.
However, if the fuel prices dip, the hedge fund makes a loss (In a practical situation though, the hedge
fund will square off the contract rather than actually waiting till the maturity date to purchase the oil
physically and then sell it.)

ARBITRAGE
Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit
from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical
or similar financial instruments in different markets or in different forms.

Example-

Consider an investor with £10 million and the following rates: £1 = $1.5 $1 = ¥80 £1 = ¥100 Long Side:
He can buy $15 million from these. With these dollars he can buy ¥1200 million. Short Side: He can sell
¥1200 million to get £12 million. This set of transactions creates an overall risk-free profit of £2 million
purely due to pricing anomalies existing in the market.

Arbitrage is a widely used concept in theoretical finance where various assets are priced assuming the
absence of arbitrage. The assumption made is that the arbitrage opportunity, if any, will last only for an
infinitesimal amount of time in efficient markets. Arbitrage occurs from in-efficiencies in the market and
acts as a corrective measure to restore the efficiency in the system.

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Rally / Sell-Off
These terms are two sides of the same coin. Both imply an unusual change in the trading volumes of a
security. One can be termed as the Bull’s paradise and other Bear’s. Rally and sell-off are the extreme
events; however, their usage is quite common even in the normal day to day movements of the market.

Rally implies a massive surge in the buying activity in a security relative to the selling activity. The number
of buy orders exceeds the number of sell orders, and this excess of demand over supply leads to an
increase in the prices of these securities. A rally is generally triggered by some positive information which
may change performance expectations of the security. For example, Indian stock market rallied by 20% on
the Monday after the formation of a stable government.

A Sell-Off on the other hand implies that the number of sell orders far exceeds the number of buy orders,
and this excessive supply may lead to prices falling down. A sell-off is similarly triggered by negative
information. For example, Satyam stock plummeted by 80% due to the sell-off of Satyam stocks in the
market after the information of internal fraud was made public.

Efficient Market Hypothesis (EMH)

The efficient market hypothesis states that when new information comes into the market, it is immediately
reflected in stock prices and thus neither technical nor fundamental analysis can generate excess returns.
The EMH hypothesizes that stocks trade at their fair market value on exchanges. Proponents of EMH posit
that investors benefit from investing in a low-cost, passive portfolio. Opponents of EMH believe that it is
possible to beat the market and that stocks can deviate from their fair market values.

Fundamental Analysis
Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a
stock. Fundamental analysts’ study everything from the overall economy, industry conditions, competitive
position, company’s quality of management, corporate governance standards, and the financial condition
of company. Earnings, expenses, assets, and liabilities are all important characteristics to fundamental
analysts. Usually a top-down approach (EIC Approach) is followed and analysis begins with economy,
industry and then the company. Financial ratios play a significant role in fundamental analysis. Other
resources are- annual reports, con-calls, any other investor report.

Technical Analysis
Technical analysis is a method of evaluating securities by analyzing the statistics generated by market
activity, such as past prices and volume. Technical analysts do not attempt to measure an instrument’s
intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
The field of technical analysis is based on three assumptions – the market discounts everything (at any
given time, an instrument’s price fully reflects everything that has or could affect the instrument), price
moves in trends, history tends to repeat itself.

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FIXED INCOME CONCEPTS

Coupon rate
Bonds are interest bearing instruments which promise to pay the bearer of the bond a specified
principal on maturity. Coupon bearing bonds pay regular coupons till maturity apart from paying the
principal in the end. The coupon rate is simply the ratio of the interest paid to the face value of the
bond. Hence, a bond paying a coupon rate of 5% on a face value of 1000, pays 50 (or 25 if the payment
is made semi- annually) every time period.

What are covenants?

A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder. Bond
covenants are designed to protect the interests of both parties.

• Negative covenants are restrictions on a bond issuer’s operating decisions, such as prohibiting the
issuer from issuing additional debt or selling the assets pledged as collateral.

• Affirmative covenants are administrative actions the issuer must perform, such as making the interest
and principal payments on time

Types of Bonds
The bonds available for investors come in many different varieties. They can be separated by the rate or
type of interest or coupon payment, by being recalled by the issuer, or because they have other
attributes.

• Zero-Coupon Bonds

One type of commonly issued bonds are zero-coupon bonds which do not pay any coupon in the period
till its maturity, when it pays a promised value of the principal. Naturally these bonds trade at a discount
and the difference in the principal and its price is the interest the bond holder earns for the holding
period. Clean price and the dirty price of a bond are essentially the same.

- Pricing

Assume a zero-coupon paying bond which pays a principal of ‘FV’ at maturity. Assuming time ‘t’ till
maturity, let the discount rate be ‘r’ compounded continuously. The price of the zero-coupon paying
bond is hence: 𝑃 = 𝐹𝑉𝑒−𝑟𝑡. As the equation shows, as the time to maturity decreases, the price of a Zero
should approach its principal value.

- Risks
Most zero-coupon bonds have short maturities due to the high-interest rate risk they carry. This is
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because a slight change in the interest rate can change the price of the bond by a large extent. Since a
Zero-coupon paying bond has no intermediate coupon payments, the investor is also exposed to high
default risk and credit risk as well.

• Convertible Bonds

Convertible bonds are debt instruments with an embedded option that allows bondholders to convert
their debt into stock (equity) at some point, depending on certain conditions like the share price. For
example, imagine a company that needs to borrow $1 million to fund a new project. They could borrow
by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were
some investors willing to buy bonds with an 8% coupon that allowed them to convert the bond into
stock if the stock’s price rose above a certain value, they might prefer to issue those.

The convertible bond may be the best solution for the company because they would have lower interest
payments while the project was in its early stages. If the investors converted their bonds, the other
shareholders would be diluted, but the company would not have to pay any more interest or the
principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can
profit from the upside in the stock if the project is successful. They are taking more risk by accepting a
lower coupon payment, but the potential reward if the bonds are converted could make that trade-off
acceptable.

• Callable Bonds

Callable bonds also have an embedded option, but it is different from what is found in a convertible
bond. A callable bond is one that can be “called” back by the company before it matures. Assume that a
company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If
interest rates decline (or the company’s credit rating improves) in year 5 when the company could
borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and
reissue new bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising
in value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are
not as valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

• Puttable Bond

A puttable bond allows the bondholders to put or sell the bond back to the company before it has
matured. This is valuable for investors who are worried that a bond may fall in value, or if they think
interest rates will rise and they want to get their principal back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower
coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at
a higher value than a bond without a put option but with the same credit rating, maturity, and coupon
rate because it is more valuable to the bondholders.
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Bond pricing
The Yield to maturity of the bond is described as the discount rate which when applied to the cash flows
(as in coupons and principal) originating from the bond, gives its current price. The yield of a bond
trading at par equals is coupon rate. If the bond trades above par, its yield would be below the coupon
rate and vice versa if the bond trades below par.

Assume a 5% coupon bearing bond (annual payments) with a face value of 100. The following table gives
us the yield when the bond trades at par, premium or a discount

The Present value has simply been taken by taking the discounted value of the future value of cash flows
(given in the 2nd column) by the appropriate yield to maturity or discount rate (As we described in the
section pertaining to Time Value of Money and as given in the last row). The price of the coupon bearing

bond maturing after n periods, with r being the yield to maturity and c the coupon payment and FV the
principal, is hence:

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Bond riskiness
Risk in a bond arises from the ability of the bond issuer to pay back the coupons and principal to the
bondholder.

Usually, the government bonds like the long-term G-sec and the short-term maturity Treasury bills are
considered to be risk free and thus provide low returns compared to other type of bonds. The corporate
bond is comparatively riskier owing to the business risk it faces.

Categories of Bonds
There are four primary categories of bonds sold in the markets. However, you may also see foreign
bonds issued by corporations and governments on some platforms.
1. Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for
debt financing in many cases because bond markets offer more favorable terms and lower interest
rates.

2. Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon
income for investors.

3. Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a
year or less to maturity are called “Bills”; bonds issued with 1–10 years to maturity are called “notes”;
and bonds issued with more than 10 years to maturity are called “bonds.” The entire category of bonds
issued by a government treasury is often collectively referred to as "treasuries." Government bonds
issued by national governments may be referred to as sovereign debt.

4. Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie
Mac.

Dirty and clean price

Consider a situation now, where the pricing is done in the time interval between 2 coupon payments.
The interest that has accumulated since the previous coupon payment is called ‘Accrued Interest’. The
bond holder is entitled to receive that interest if he sells it.

The market value of the bond is hence (approximately), the price as calculated from the next coupon
payment date plus the accrued interest. On calculating the price as on the next coupon date, we get the
bond’s ‘Clean Price’. The actual selling price is the bond’s ‘Dirty Price’ which factors in the accrued
interest in between the two coupon paying dates.

𝐷𝑖𝑟𝑡𝑦 𝑃𝑟𝑖𝑐𝑒 = 𝐶𝑙𝑒𝑎𝑛 𝑃𝑟𝑖𝑐𝑒 + Accrued Interest

Dealers usually quote the clean price of the bond when they trade, though the actual cash exchange
happens on the basis of the dirty price. This is because the dirty price keeps changing on a daily basis as
the interest accrues.

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Zero coupon bonds

One type of commonly issued bonds are zero-coupon bonds which do not pay any coupon in the period
till its maturity, when it pays a promised value of the principal. Naturally these bonds trade at a discount
and the difference in the principal and its price is the interest the bond holder earns for the holding
period. Clean price and dirty price of a bond are essentially the same.

Pricing
Assume a zero-coupon paying bond which pays a principal of ‘FV’ at maturity. Assuming time ‘t’ till
maturity, let the discount rate be ‘r’ compounded continuously. The price of the zero-coupon paying
bond is hence: 𝑃 = 𝐹𝑉𝑒−𝑟𝑡. As the equation shows, as the time to maturity decreases, the price of a Zero
should approach its principal value.

Risks
Most zero-coupon bonds have short maturities due to the high-interest rate risk they carry. This is
because, a slight change in the interest rate, can change the price of the bond by a large extent. Since, a
Zero-coupon paying bond has no intermediate coupon payments, the investor is also exposed to high
default risk and credit risk as well.
Modified and Macaulay Duration
Modified Duration is the sensitivity of a bond or any fixed income instrument to the underlying interest
rate. Hence it is the % change in price for a unit change in the underlying discount rate.

Macaulay duration on the other hand is the weighted average maturity of the instrument’s cash flows. It’s
expressed as a unit of time.

Price of bond when coupon is c, principal is P and yield to maturity is r will be-

Macaulay duration would be the weighted time average of these cash flows (divided by the price of the
bond). Hence, the Macaulay duration would be:

As is clear from the above formulae, the Macaulay duration would lie between 0 and the instrument’s
maturity. For Zero coupon bonds, the Macaulay duration would equal the time to maturity for the bond.
Modified duration for the above instrument would be:

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Convexity
Convexity is defined as the 2nd order differential of the price of a fixed income instrument with respect
to the interest rate. It is the measure of how the sensitivity of the instrument i.e. duration changes as
interest rates rise or fall. One can ascertain the nature of convexity by plotting the price of the
instrument vs. the yield to maturity. A bond with higher convexity will see sharper changes in the price
of the instrument for large interest rate movements.

If a position in a bond is duration hedged at a particular point, very small changes in interest rates will
result in no loss or gain to the investor. However, if the convexity of the bond is high, large movements
in the interest rates can affect the profit and loss profile.
Credit Rating
It is an estimate of the credit worthiness of an individual/ organization or a sovereign by a credit rating
agency. The credit rating typically depends on some factors like current ratio, debt level, soundness of
balance sheet etc. All these factors typically decide the default risk of the entity. Also, different debt
issues by the same company might have different ratings.

There is an approximate mapping between the credit spread and the credit rating of an entity. The
spread is defined as the excess interest rate over the sovereign rate at which the borrower country
might take credit (called the risk premium). Some of the more internationally accepted credit rating
agencies (CRAs) are Moody’s, Fitch, Standard & Poor and Dunn & Bradstreet.

A bond with a credit rating of BBB and above by S&P is termed as investment grade bond whereas any
bond with rating below it is a junk bond. A credit rating system of a particular institution is highly
confidential within the institution as that is what that provides them a competitive edge over the others.

What will happen to the price / yield of a bond if its rating is downgraded? Upgraded?
A temporary downgrade or upgrade of an issuer’s rating may not cause any significant changes in
price/yields. However, a series of such events may trigger a response on the price/yield of the bond. For
instance, a series of rating downgrades would cause the investor to infer that the issuer’s ability to repay
the loan is uncertain and will cause the price to go down significantly. Conversely a series of upgrades
would cause the price to go up.
Can you give an example where different debts raised by the same company have different credit
ratings?
Different debts issued by the same company can have different credit ratings. This is because the rating
would depend on the level of seniority of the debt, the type of asset used to secure the debt and the way
in which the bond has been structured. An example of this difference would be the debts raised by Bank of
Maharashtra. Its lower tier 2 bonds have a credit rating (CRISIL) of AA+ while its tier 1 perpetual bonds
have a credit rating of AA.

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CENTRAL BANK POLICY TOOLS & IMPACT

Factors affecting short term rates

Worldwide, short-term interest rates are administered by nations' central banks. In the United States, the
Federal Reserve’s Federal Open Market Committee (FOMC) sets the federal funds rate. Central banks do
not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for
long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the
fed funds rate too low, expectations of future inflation increase, which means long-term interest rates
increase relative to short-term interest rates – the yield curve steepens.

Factors affecting long term rates

Long-term Interest (LTI) Rates affect key interest-rate sensitive sectors of the economy, such as housing,
auto, and investment; interest rates also affect corporate decisions related to pension and asset valuation.
Especially since the beginning of our current financial crisis starting in 2007, it is clear that interest rates
impact the economic recovery. Unfortunately, the lack of accurate information related to future trends of LTI
impairs the ability of organizations to accurately plan for the future. Policymakers, financial analysts, and
organizations need to make specific decisions that are based, in part, on future interest rates trends.
Overnight interest rates, inflation, net capital inflow, budget deficit, and GDP jointly explain, in part, the
behavior of long-term interest rates.
Overnight interest rates - Changes (rise or fall) in the overnight interest rate affect bank leaders’ decisions
regarding borrowing and lending money. For example, a rise in the overnight interest rate discourages bank
officials from borrowing, making the rate at which banks lend money high because demand for money will
exceed the supply for money. On the other hand, falling overnight interest rates motivate bank leaders to be
likely to seek and invest in loans. Therefore, the overnight interest rate works like a regulatory instrument
that controls the manner in which the U.S. economy works.
Expected Inflation - The increase in long-run expectations of inflation leads to higher longterm interest rates
as lenders of capital need a higher return to compensate for the increased inflation levels in the future.
Similarly, decrease in the long-run expectations of inflation lowers the long-term interest rates.
Foreign capital inflow - Long-term interest rates have been impacted by capital inflow into securities
markets. The conundrum surrounding the trend or the pattern of long-term interest rates can be explained
by the impact of capital inflow, which has paramount monetary and numerical impact on long-term interest.
The foreign purchases of government bonds lead to low levels of long-term interest rates. The negative
impact of net inflow on long-term interest rates is an indication that massive capital inflow into a
nation results in excess amount of money circulating in the system, which decreases the actual rate of
loaning out money and motivates investment.
Budget deficit - A deficit is generated once the government's expenditures exceed its revenues. To finance its
operations and increase spending, it borrows money from the private sector and/or from foreign

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governments. Deficit spending can be leveraged by the federal government as a fiscal policy tool to help
stimulate business activity - and hence the economy -- in times of recession. Although increased government
spending can create jobs and spur consumer spending, interest rates are bound to rise as the government
borrows more. Most of the government borrowings are long-term bonds as they are used to finance the

long-term projects and thus the government deficit is associated with an increase in long-term interest rates.
Any effort toward lowering the expected level of future national savings places upward pressure on expected
short-term interest rates and in turn long-term interest rates as well due to the term premium.
GDP - GDP is the most essential economic parameter as it represents a wide range of economic activity
assessment and indicates the pathway of overall aggregate economic activity. In view of this, an increase in
nominal GDP results in an increase in spending. Similarly, this means demand for money also must increase
to meet spending needs. Should the money supply not increase to meet the demand for money, the result
will be higher interest rates, thereby also impacting the longer end of the yield curve.

Policy Rates
Repo Rate-

Repo rate is the rate at which banks borrow from RBI on a short-term basis against a repurchase agreement.
Under this policy, banks are required to provide government securities as collateral and later buy them back
after a pre-defined time.

Reverse Repo Rate-

Reverse Repo Rate is the rate RBI pays to banks in order to keep additional funds with the RBI. Higher the
repo rate, more costly are the funds for banks and hence, higher will be the rate that banks pass on to
customers. A high-rate signals that access to money is expensive for banks; lesser credit will flow into the
system and that helps bring down liquidity in the economy.
Open market operations
Open market operations (OMOs) are the purchase and sale of government securities in the open market are
one of the key tools used by the by a central bank to manage and regulate liquidity on a regular basis. If
central banks want to induce liquidity or more funds into the system, it will buy government securities and if
it wants to curb the amount of money out there, it will sell these to banks.

Reserve Requirements
In the Indian context, the RBI manages the reserve requirements using CRR and SLR.
Cash Reserve Ratio (CRR) is the percentage of a bank’s total deposit that need to be kept as cash with the
RBI in the form of reserves or balances. A high percentage means banks have less to lend, which curbs
liquidity; a low CRR does the opposite.
Statutory Liquidity Ratio (SLR) is the percentage of net demand and time liabilities (NDTL) that the banks are
required to maintain in liquid assets such as cash, gold or RBI approved securities. Banks are allowed to earn
interest on these securities. The lesser the amount of SLR, the more banks have to lend outside. The RBI can
reduce or raise CRR/SLR to tighten or ease liquidity as the situation demands.

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Quantitative Easing
Quantitative easing is an unconventional monetary policy and refers to large-scale asset purchases
conducted by a central bank with newly-created bank reserves. QE increases the money supply in order
to put downward pressure on market interest rates and to expand the economic activity. It also expands
the central bank's balance sheet. It is usually used when inflation is very low or negative, and
conventional expansionary monetary policy has become largely ineffective. QE can help bring the
economy out of recession and help ensure that inflation does not fall below the central bank's inflation
target. One of the risks of QE include inflation overshooting above the target.

Yield curve control

Yield curve control is also sometimes referred to as yield curve targeting or yield curve caps. YCC aims to
control interest rates along some portion of the yield curve. Simply put, YCC imposes interest rate caps on
particular maturities. Because bond prices and yields are inversely related, this also implies a price floor
for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the
central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys
targeted-maturity bonds—increasing the demand and thus the price of those bonds.

Yield curve control is different in one major respect from QE which is that QE deals in quantities of bonds
to be purchased and YCC focuses on prices of bonds.

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DERIVATIVES
Derivatives are used to hedge against risk. Take an example of the investor, Rocky buying an apple farm
in Florida. He is betting on things such as weather conditions in Florida, the prices of oranges etc. He is
confident about his farming skills, but he has no way to forecast the future prices of oranges and
weather conditions in Florida. He wants to do the farming, but without the Derivatives risks involved in
the business. Weather conditions and variability in oranges prices in future are the main cause of risk in
this context. This is where derivatives come into picture.

Derivatives, as the name suggests, are the financial contracts between two counterparties that derive
their value from some underlying asset. The underlying can be a stock, interest rate, bond, commodity,
currency or anything under the sun that can be measured. (In strict sense interest rate is not an asset,
but there are some derivative products such as interest rate swaps which derive their value from
interest rate movement.) For example, trading of weather derivatives is quite common in United States.
The value of the derivative is a function of the value of the underlying.

Derivatives basically fall into two categories - Forwards (includes forwards, futures, swaps, etc.) and
Contingency Claims (includes options).
Applications- Two main applications of derivatives are hedging and speculating. General understanding
is that one who owns the underlying is hedging his risk against unfavorable price movements, whereas
the one who enters into a position (long / short) without holding a position in the underlying is said to
be speculating.

The spot price(s) of any asset class, a commodity such as Gold, Oil etc., or a fixed income instrument
such as a bond or an equity stock, is defined as its current market price. This essentially translates to the
latest traded price. This price is determined by the market demand and supply of the actual asset.

Forward price(f) is a price at which the buyer and seller agree to exchange the asset at some specified
future date. This price is determined by the market expectation of supply and demand during the period
before expiry.

Basis- The difference between the spot price and the futures price is called basis. If the futures price is
greater than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures
price, basis for the asset is positive. During the life of the contract, the basis may become negative or
positive, as there is a movement in the futures price and spot price. Further, whatever the basis is,
positive or negative, it becomes zero at maturity of the futures contract i.e., there should be no
difference between futures price and spot price at the time of maturity / expiry of contract. This
happens because final settlement of futures contracts on last trading day takes place at the closing price
of the underlying asset.
The relationship between the forward (f) and the spot price (s):

here ‘r’ is the risk-free rate and ‘t’ is the time period for the forward contract. This
relationship is only valid for those forward contracts in which it does not cost anything to hold the
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underlying and there are no convenience yields from the underlying (dividend, interest etc.)

Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in
commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till delivery, less the
income earned on the asset during the holding period. For equity derivatives, carrying cost is the interest
paid to finance the purchase less (minus) dividend earned.

Future prices- These can be understood in the similar way. However, we can’t derive any formal
relationship between the future and the spot prices due to the daily settlement of profits and losses. As we
supply/receive cash during the tenure of the contract depending on the movement of underlying price, the
future price will depend on the interest rates in future in addition to the current interest rates.

Contango & Backwardation- The relation between spot and forward-price for commodities can be
described by two states – contango and backwardation. Contango is when the futures price is above the
expected future spot price. Because the futures price must converge on the expected future spot price,
contango implies futures prices are falling over time as new information brings them into line with the
expected future spot price.

Backwardation is when the futures price is below the expected future spot price. This is desirable for
speculators who are net long in their positions: they want the futures price to increase. So, normal
backwardation is when the futures prices are increasing.

Hedge Ratio- Hedging is the art of reducing or eliminating financial risk by entering into a transaction
that will protect against loss through a compensatory price movement. Hedge ratio is a ratio comparing
the value of a position protected via a hedge with the size of the entire position itself. In futures, it is a
ratio comparing the value of the futures contracts purchased or sold to the value of the cash commodity
being hedged. In other words, it is the mechanism for calculating the number of options or other
derivatives, or amount of currency, needed to hedge against the risk of loss in a portfolio of shares or
other derivatives.

Types of Derivatives
Forward contracts-

A forward is a financial contract between two parties in which one party agrees to buy a fixed amount of
the underlying security from the other on a fixed date at some predetermined price. The buyer is said to
hold a long position whereas the seller is holding the short position. The fixed date at which the transfer
is to take place is called the maturity date and the predetermined price is called the strike price. The cash
transaction takes place only at the maturity of the forward.

Now suppose that the merchant is located in New York whereas Rocky is in Florida. It won’t be a viable
option for the investor and the merchant to actually exchange Oranges due to high transportation costs,
etc. So, they might decide on cash settlement instead of actual exchange of Oranges. At expiry the party
holding long position will transfer an amount equal to strike price minus spot price at the expiry date if

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the actual price is less than the strike price and vice versa. This value is called Payoff at expiry.

Using forwards, Rocky has hedged himself against risk associated with price fluctuation in the Oranges
market. But, in the process the forward contract has given birth to another kind of risk – risk of default by
the merchant. Two years is a long time. During the two years period the merchant might get bankrupt or
run away or may simply deny honoring the contract. Such a risk, as discussed below, is called the
counterparty risk.

One solution for this is to deal through a mediator who knows both the parties or through some
mechanism that can ensure that both the parties will honor the contract. Generally, this is done by an
exchange. The exchange plays the role of intermediary for the contracting parties. To reduce the
counterparty risk for the contracting parties, the exchange itself becomes counterparty to the interested
parties. Both the parties deal with the exchange on the other side. Thus, both the parties can rest assured
that the other party (exchange) will honor the contract (Here we are implicitly assuming that a well-
established exchange is more credible than an unknown counterparty).
To ensure that the ‘party’ honors the contract with exchange and does not create additional issues for
the exchange, the exchange asks for daily settlement of the prices (Daily settlement is the mechanism
used by exchange to reduce its own counterparty risk). Such a contract is called a Futures contract.

Essential features of a forward are:

It is a contract between two parties (Bilateral contract).
All terms of the contract like price, quantity and quality of underlying, delivery terms like place,
settlement procedure, etc. are fixed on the day of entering into the contract.
In other words, forwards are bilateral over-the-counter (OTC) transactions where the terms of the
contract, such as price, quantity, quality, time and place are negotiated between two parties to the
contract. Any alteration in the terms of the contract is possible, if both parties agree to it. Corporations,
traders and investing institutions extensively use OTC transactions to meet their specific requirements.
The essential idea of entering into a forward is to fix the price and thereby avoid the price risk.

Futures Contract
A future is a forward contract with daily settlement of price (A future contract is basically a forward
contract with an intermediate exchange for daily settlement of prices). It is a standardized exchange
traded product. The standardization is in terms of size of the lot (the number of underlying in one
contract) and maturity date. Depending on liquidity (or in other words number of interested
counterparties; higher the number easier it is to enter or exit the position), one can enter or exit its
position on a future contract. As it is an exchange-traded product with daily settlement of price, there is
virtually no risk of default from the counterparty.

In order to hold a position in a future contract, individual has to maintain a margin account (a margin
account is explained in detail later) with the broker. Daily settlement of price takes place from the margin
account only. If the amount in the margin account becomes lower than a minimum maintenance level,
investor gets a margin call (or asked to post more money in the margin account by the broker). If he/she
is not able to do so, the position is squared off by the broker. Futures are available on various underlying

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assets such as equity, indices, commodities, etc.

In futures market, the exchange decides all the terms of the contract other than price. Accordingly,
futures contracts have following features:

Contract between two parties through Exchange

Centralized trading platform (i.e., Exchange)
Price discovery through free interaction of buyers and sellers
Margins are payable by both the parties
Quality decided today (standardized)
Quantity decided today (standardized)

Differences between Forwards and Futures- Futures are exchange traded, and thus are virtually risk-free
and standardized. Forwards on the other hand are customizable products traded over the counter and
thus prone to counter party default risk.

The other two types of derivatives are Options and Swaps. We will discuss them in the later section in this
pocketbook.

Forward Rate Agreement (FRA)

Forward Rate Agreements are forward contracts on interest rates, wherein the parties exchange the
contracted interest rate vs. the actual interest rate on a pre-determined notional amount. These
agreements are bespoke in nature and trade over the counter. Unlike Eurodollar future contracts, they
have counterparty and liquidity risks associated with it.

Applications- As FRAs are bespoke contracts, they are often used by companies to hedge their interest
rate risk. Say a company has issued a floating rate note and needs to hedge itself against the risk that
short-term interest rates would rise. In this case it would go short a FRA where it would receive the actual
rates and pay the contracted rates, hence eliminating any interest rate uncertainty.

Options
An option, as the name suggests is a financial instrument that provides the holder an ‘option’. In contrast
to forward, an option contract provides the holder a right but not the obligation to enter into a trade
over the underlying asset.

Options are fundamentally different from forward and futures contracts. An option gives the holder of
the option the right to do something, but the holder does not have to exercise this right. By contrast, in a
forward or futures contract, the two parties have committed themselves to some action. It costs a trader
nothing (except for the margin/ collateral requirements) to enter into a forward or futures contract,
whereas the purchase of an option requires an up-front payment. When charts showing the gain or loss
from options trading are produced, the usual practice is to ignore the time value of money, so that the
profit is the final payoff minus the initial cost.

Two types of options are-

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1. Call option: It is a right to buy the underlying asset at the maturity on a predetermined price

2. Put option: It is a right to sell the underlying asset at the maturity on a predetermined price

Options can be traded in exchanges and also OTC. Options can have stocks, bonds, interest rates,
currencies, and commodities etc. as underlying securities. At the expiry date, if the spot price (price at
which the underlying asset is trading in the spot market) of the underlying is more (less) than the strike
price (price per share for which the underlying security may be purchased by the call option holder or
sold by the put option holder), then the call (put) option buyer would carry on with the transaction
specified, and this is known as 'exercising the option'.
● Seller of the option is called as writer
● Premium is also referred to as price of the option
● American options can be exercised at any time between purchase date and expiration date
● European options can be exercised only on expiration date
● Bermudan options can be exercised only on expiration date
● At expiration, an American option and a European option on same asset with same strike price
are identical

Margin account: The person who holds the ‘option’ makes a payment while buying the contract.
Subsequent to purchasing the option he does not need to maintain a margin account. This stems from
the fact that the holder of ‘option’ has his risk capped at the price of the ‘option’. On the other hand, the
writer has non-capped downside as he might have to pay for the contingency claim. Hence the exchange
makes it mandatory for him to maintain a margin account.

Pay-Off
The pay-off (the money the option holder would receive on expiry date) at maturity of an option is:

1. Call Option: max (0, S-K)

2. Put Option: max (0, K-S)

Where K is the strike price and S is the spot price on expiry date.

Factors affecting option pricing-

As the option contract gives the buyer an ‘option’ but the seller has an obligation, so the seller charges a
price for this, known as price of the option. The price of an option depends on following factors:

a) Strike Price: For Call Option, higher the strike, lower the price of the option and vice versa (reverse
holds true for Put Option)

b) Spot Price: For Call Option, higher the spot higher the price of the option and vice versa (reverse

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holds true for Put Option)

c) Volatility of underlying security: Higher the volatility higher the price for both Call and Put Options

d) Time to Maturity: Higher the time to mature higher the price for both Call and Put Options (only if the
time to maturity goes very high will this relation reverse because the time-value of future cash flow
would reduce; this case can be neglected as there is no liquid markets for these options)

e) Rate of interest: Higher the rate lower the value for both the Options; this comes from the fact that
future cash-flows become less valuable (in terms of NPV) than the current outflow of money.

The value of an option is a sum of its 'intrinsic value' and 'time value'. The 'intrinsic value' is the value,
which the option would fetch if it were to be exercised immediately. Thus, this is the difference between
the strike price and the current spot price of the underlying security.
Moneyness of an option- Options can be classified into three categories,
In-the-money (ITM) option: This option would give the option holder a positive cash flow, if it were
exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. A put
option is said to be ITM when spot price is lower than strike price.
At-the-money (ATM) option: At-the-money option would lead to zero cash flow if it were exercised
immediately. Therefore, for both call and put ATM options, strike price is equal to spot price.
Out-of-the-money (OTM) option: Out-of-the-money option is one with strike price worse than the spot
price for the holder of option. In other words, this option would give the holder a negative cash flow if it
were exercised immediately. A call option is said to be OTM, when spot price is lower than strike price. A
put option is said to be OTM when spot price is higher than strike price.

Put-Call parity
Consider a portfolio consisting of a put option at strike K, maturity = T and a one unit of underlying

security.

At t= T, the value of portfolio is:

if S > K: S + 0 = S (the option is not exercised)

if S < K: S + K-S = K (the option is exercised)

The price of this portfolio at t=0 is S0 + P, where P is price of put option and S0 is spot price of security at
t=0.

Now consider another portfolio consisting of a call option at strike K, maturity= T and purchasing a bond
which pays K at maturity. Payoff at t=T for this portfolio:

if S>K: S-K+K = S (option is exercised)

if S<K: 0+K = K (option is not exercised)

Now the payoff of this portfolio is the same as that of the previous portfolio. So the prices should also be
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equal at t=0. Thus, C + PV(K) = P + S This relation is known as Put- Call Parity.
Naked Option- It is the situation when the call option underwriter does not own the underlying security. In
this case, the underwriter is exposed to unlimited risk. The money that the seller would have to pay in
case of option being exercised would be the difference of spot price and exercise price, and thus this has
no upper cap. Naked Put Option is similar to naked call option, but the only difference being that in this
case the maximum the underwriter may lose is the strike price, as the minimum price of the security
cannot go below zero.

Covered Option-
Covered Call: When the call underwriter owns the underlying security, the call option is said to be covered.
Covered Put: When the put underwriter has short position (has a negative position) in the
underlying security.
The payoff of a covered call is same as that of a naked put and the payoff of a covered put is same as that
of naked call.

Option Greeks
1. Delta

Delta is a measure of the change in an option's price (that is, the premium of an option) resulting from a
change in the underlying security. The value of delta ranges from -1 to 0 for puts and 0 to 1 for calls. Puts
generate negative delta because they have a negative relationship with the underlying security—that is,
put premiums fall when the underlying security rises, and vice versa. Conversely, call options have a
positive relationship with the price of the underlying asset. If the underlying asset's price rises, so does
the call premium, provided there are no changes in other variables such as implied volatility or time
remaining until expiration. If the price of the underlying asset falls, the call premium will also decline,
provided all other things remain constant.

2. Gamma

Gamma measures the rate of changes in delta over time. Since delta values are constantly changing with
the underlying asset's price, gamma is used to measure the rate of change and provide traders with an
idea of what to expect in the future. Gamma values are highest for at-the-money options and lowest for
those deep in- or out-of-the-money. While delta changes based on the underlying asset price, gamma is a
constant that represents the rate of change of delta. This makes gamma useful for determining the
stability of delta, which can be used to determine the likelihood of an option reaching the strike price at
expiration.

3. Theta

Theta measures the rate of time decay in the value of an option or its premium. Time decay represents
the erosion of an option's value or price due to the passage of time. As time passes, the chance of an
option being profitable or in-the-money lessens. Time decay tends to accelerate as the expiration date of
an option draws closer because there's less time left to earn a profit from the trade.

Theta values are always negative for long options and will always have a zero time value at expiration
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since time only moves in one direction, and time runs out when an option expires.

4. Vega

Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the
underlying asset price. While delta measures actual price changes, vega is focused on changes in
expectations for future volatility. Higher volatility makes options more expensive since there’s a greater
likelihood of hitting the strike price at some point. Vega tells us approximately how much an option price
will increase or decrease given an increase or decrease in the level of implied volatility.

5. Rho

Rho measures sensitivity to the interest rate: it is the derivative of the option value with respect to the
risk-free interest rate (for the relevant outstanding term). Except under extreme circumstances, the value
of an option is less sensitive to changes in the risk-free interest rate than to changes in other parameters.
For this reason, rho is the least used of the first-order Greeks.

Delta Hedging
Delta hedging is a type of hedging which involves reducing or eliminating the exposure of a portfolio to
small movements in the price of the underlying security. The delta of an option is the first order partial
derivative of the option price (O) with respect to price of the underlying asset (S). Delta tells us by how
much O will change for a unit increase in S.

Using delta, one can calculate a position in the underlying asset which will hedge the option. Thus, delta
hedging an option involves taking an offsetting position in the underlying security/futures. However, this
position will have to be adjusted dynamically since delta itself changes as S changes. This is because of
the non-linear relation between O and S.

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OPTION STRATEGIES

Spread
A spread strategy involves positions in two or more options of the same type – for example, either two or
more calls or two or more puts.

Bull spread-

A bull spread is created by buying a call option on an underlying with a certain strike price and selling a
call option on the same underlying with a higher strike price, with both options having the same
expiration date. Using call options, because a call price decreases as the strike price increases, the value
of the call sold is lower than the value of the option bought. Thus, a bull spread using call requires an
initial investment.

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Bear Spreads-

An investor who enters into a bear spread is hoping that the stock price will go down. It can be created by
buying a put with one strike price and shorting a put with a lower strike price. A bear spread created
using puts involves initial investment since the put price of the option bought is more than the price of
the option sold. Like bull spreads, bear spreads limit both the upside profit potential and the downside
risk.

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Butterfly Spread-

A butterfly spread involves positions with three different options (with different strike prices). It can be
created by buying a call option with a relatively low strike, K1, buying a call option with a relatively high
strike price, K3, and selling two call options with the same strike price, K2, halfway between K1 and K3.
Generally, K2 is closer to the current stock price. The strategy leads to a profit if the underlying price stays
close to K2, but gives rise to a small loss if there is a significant movement in either direction. Thus, one
enters a butterfly spread if the view on the market is against significant movements on either side.

Combination Strategies
Straddle-

It involves buying a call and a put with the same strike price and the same maturity. If the underlying is
close to the strike price at the time of maturity, then the straddle leads to a loss. However, if there is
large movement ion either side, the strategy leads to handsome payoffs. Thus, a straddle is appropriate
when one has the view that there will be significant movement in the market but is not sure of the
direction of

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the movement. Going long a call and a put to enter into a straddle is called a bottom straddle. A top
straddle is the reverse position – going short both a call and a put.

Strangle-

In a strangle, an investor buys a put and a call (or shorts both a put and a call) with the same expiration
date, but with different strike prices. In the figure below, the call strike price, K2 is higher than the put
strike price, K1. In a strangle, like a straddle, the investor is betting on a huge price movement, but not
sure of the direction in which the move will happen. However, as compared to a straddle, the downside
risk is lower in a strangle. Also, the price movements need to be bigger in a strangle to be able to make
profits.

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Other options
Warrants-

A warrant is an over the counter (OTC) traded instrument gives the holder the right to buy the underlying
security (usually equity) on or before a specific date at a specified price. Warrants are often issued in
conjunction with debt to offer a higher yield to the investor. Warrants are like options in that they give
the holder the right to buy the underlying security at a pre-specified price and time. However, a warrant
is issued and guaranteed by an institution (usually the corporation that issues the debt) while an option is
issued and traded publicly on an exchange.

Embedded Bond Options-

A callable bond gives the issuer the right to buy back the bond at specific dates at a pre-determined
price. Since the callable bond is an option held by the issuer, the issuer usually pays a higher yield as
compared to a non-callable bond.

A puttable bond gives the bond holder the right to sell the bond at a predetermined price at specific
dates. The investor holds the option of selling the bond. Hence, a puttable bond usually earns lower yield
as compared to a non-puttable bond.

SWAPS
A swap is a financial contract to exchange benefits from a series of underlying financial contracts during a
fixed period over the duration of the swap. Swaps can be of various types such as currency swap, interest
rate swaps, commodity swaps, equity swaps etc.

While entering into a swap the counterparties may (e.g. in case of currency) or may not (e.g. in case of
interest rate) exchange the underlying asset (the principal amount). After that for each fixed period, they
exchange the returns on these assets. At maturity they finally exchange back the initial assets (only if the
underlying was exchanged at the inception of Swap).

The two most common types of swaps are:

1. Interest rate Swaps – they can be either of ‘Fixed Vs Floating’ or ‘Floating Vs Floating’

2. Currency Swaps – they can be one of these – ‘Fixed Vs Fixed’, ‘Fixed Vs Floating’ and ‘Floating Vs
Floating’

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Benchmark Rates
A reference rate is an interest rate benchmark used to set other interest rates. Various types of
transactions use different reference rate benchmarks, but the most common is the LIBOR, the prime rate,
and benchmark U.S. Treasury securities. A common reference rate might be LIBOR, which would be used
as a reference in interest rate swaps or an interest rate agreement. In an interest rate swap, the floating
reference rate is exchanged by one party for a fixed interest rate or a set of payments. The reference rate
will determine the floating interest rate portion of the contract.

Interest Rate Swaps

An interest rate swap (IRS) is a contract in which two counterparties agree to exchange interest payments
at some specified intervals on a specified principal amount for a fixed duration of time.

E.g. Counterparty A will receive 3-month LIBOR and pay a rate of 4% (per annum) to counterparty B every
three months based on a notional of $1 million for a total maturity of 1 year. Let us assume this contract
was entered on at 1st of January 2011. The exchange of cash-flows is shown below. (Note that the
following table has been created after the maturity of the swap; we cannot know the future Libor rates
beforehand!) It is important to note that the principal of $1 million is not exchanged between A and B.

However, even if A and B exchanged $1 million at maturity (i.e. 1st Jan 2012), it would not make a
difference to the net exchange of cash-flows because the two payments of $1 million from A and B would
cancel each other. The cash-flow profile will be the same whether A and B exchange the principal or not.
Thus, an IRS can be viewed as an exchange of a fixed-rate for a floating-rate bond.

Currency Swaps
A currency swap (CS) is a contract in which two counterparties agree to exchange both principal and
interest payments in one currency for those in another at specified intervals for a fixed period of time.

A difference between a CS and an IRS is that in a CS, principal is also exchanged, usually at the first and
last payment dates. E.g. On 1st January 2011, counterparty A agrees to receive 5% per annum on
$1million and pay 7% per annum on INR 50 million (based on the existing spot rate of $1 = Rs.50) every
year for a period of two years.

On the day when the A and B enter this contract, they exchange the two notional amounts. However, as
this exchange has been done at the prevailing spot rate of INR 50 per $, effectively the net exchange is
zero. Thus, we can ignore this exchange of cash-flows while trying to value the swap.

Looking at the subsequent cash-flow exchanges, we can see that A has effectively received a $
denominated bond paying 5% per annum on $1 million, and B has received an INR denominated bond
paying 7% per annum on INR50 million.

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SECURITIZATION
Securitization is the financial practice of pooling various types of contractual debt such as residential
mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related
cash flows to third party investors as securities, which may be described as bonds, pass-through
securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest
cash flows collected from the underlying debt and redistributed through the capital structure of the new
financing.

Asset backed Securities

Asset Backed Securities are securities that are backed by specified underlying assets. The underlying
assets are typically illiquid assets, like mortgages, credit card loans, student loans that are securitized to
create tradable securities that have a claim over cash flows from the underlying assets. Securitization is a
process of increasing liquidity of assets and distributing risk, by aggregating a pool of assets and issuing
debt obligations that have a claim over the cash flows from these asset pools.

Mortgage-Backed Securities
Mortgage-backed securities (MBSs), as the name suggests, are debt obligations that have a claim over
cash flows from a pool of mortgages. Securitization of mortgages provides funds to the lenders to issue
new mortgages by selling off the existing mortgages to investors.

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Financial Crisis

The Great Depression

The great depression from 1929-33 has been the worst economic crisis that has ever hit the world. The
intensity of the crisis was exacerbated by the crisis spreading from the financial economy to the real
economy. The crisis started with the stock market crash on October 29, 1929, known as the Black Tuesday
and soon took shape of economic contraction with industrial output falling 46% in USA in the period of
1929-32, unemployment reaching the heights of 25% and widespread deflation with CPI dropping by 27%.

Asian Currency Crisis

Prior to 1997, the South East Asian countries like South Korea, Thailand, Malaysia and Indonesia had
created the “Asian Economic Miracle” with sturdy growth rates of 8-12% for over a decade. These
countries were the hotspots for international capital investments due to high growth rates and foreign
investments friendly economic policies. This growth was stalled by currency depreciation contagion that
rapidly spread through the region and forced the economies and financial markets into a quandary.
The crisis started with Thailand’s financial collapse leading to converting Thai Baht from a US$ fixed peg to
float. The financial collapse triggered a rapid pullout of foreign investments from other Asian economies as
well and nearly all the economies in the region witnessed their currencies plummeting.

Great Financial Crisis

Financial crisis of 2007–08, also called subprime mortgage crisis, severe contraction of liquidity in global
financial markets that originated in the United States as a result of the collapse of the U.S. housing market.
Although the exact causes of the financial crisis are a matter of dispute among economists, there is general
agreement regarding the factors that played a role:

First, the Federal Reserve (Fed), the central bank of the United States, having anticipated a mild recession
that began in 2001, reduced the federal funds rate (the interest rate that banks charge each other for
overnight loans of federal funds—i.e., balances held at a Federal Reserve bank) 11 times between May
2000 and December 2001, from 6.5 percent to 1.75 percent. That significant decrease enabled banks to
extend consumer credit at a lower prime rate (the interest rate that banks charge to their “prime,” or low-
risk, customers, generally three percentage points above the federal funds rate) and encouraged them to
lend even to “subprime,” or high-risk, customers, though at higher interest rates (see subprime lending).
Consumers took advantage of the cheap credit to purchase durable goods such as appliances, automobiles,
and especially houses. The result was the creation in the late 1990s of a “housing bubble” (a rapid increase

in home prices to levels well beyond their fundamental, or intrinsic, value, driven by excessive
speculation).

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Second, owing to changes in banking laws beginning in the 1980s, banks were able to offer to subprime
customers mortgage loans that were structured with balloon payments (unusually large payments that are
due at or near the end of a loan period) or adjustable interest rates (rates that remain fixed at relatively
low levels for an initial period and float, generally with the federal funds rate, thereafter). As long as home
prices continued to increase, subprime borrowers could protect themselves against high mortgage
payments by refinancing, borrowing against the increased value of their homes, or selling their homes
at a profit and paying off their mortgages. In the case of default, banks could repossess the property and
sell it for more than the amount of the original loan. Subprime lending thus represented a lucrative
investment for many banks. Accordingly, many banks aggressively marketed subprime loans to customers
with poor credit or few assets, knowing that those borrowers could not afford to repay the loans and often
misleading them about the risks involved. As a result, the share of subprime mortgages among all home
loans increased from about 2.5 percent to nearly 15 percent per year from the late 1990s to 2004–07.

Third, contributing to the growth of subprime lending was the widespread practice of securitization,
whereby banks bundled together hundreds or even thousands of subprime mortgages and other, less-risky
forms of consumer debt and sold them (or pieces of them) in capital markets as securities (bonds) to other
banks and investors, including hedge funds and pension funds. Bonds consisting primarily of mortgages
became known as mortgage-backed securities, or MBSs, which entitled their purchasers to a share of the
interest and principal payments on the underlying loans. Selling subprime mortgages as MBSs was
considered a good way for banks to increase their liquidity and reduce their exposure to risky loans while
purchasing MBSs was viewed as a good way for banks and investors to diversify their portfolios and earn
money. As home prices continued their meteoric rise through the early 2000s, MBSs became widely
popular, and their prices in capital markets increased accordingly.

Fourth, in 1999 the Depression-era Glass-Steagall Act (1933) was partially repealed, allowing banks,
securities firms, and insurance companies to enter each other’s markets and to merge, resulting in the
formation of banks that were “too big to fail” (i.e., so big that their failure would threaten to undermine
the entire financial system). In addition, in 2004, the Securities and Exchange Commission (SEC) weakened
the net capital requirement (the ratio of capital, or assets, to debt, or liabilities, that banks are required to
maintain as a safeguard against insolvency), which encouraged banks to invest even more money into
MBSs. Although the SEC’s decision resulted in enormous profits for banks, it also exposed their portfolios
to significant risk, because the asset value of MBSs was implicitly premised on the continuation of the
housing bubble.

COVID-19 Crisis
The coronavirus pandemic, which was first detected in China, has infected people in 188 countries. Major
events included a described Russia–Saudi Arabia oil price war after failing to reach an OPEC+ agreement
that resulted in a collapse of crude oil prices and a stock market crash in March 2020.

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Financial Risk - The OECD points out that businesses in many countries have become highly indebted, while
the very low cost of borrowing and accommodative monetary policy have contributed to unprecedented
corporate debt issuance. Consequently, corporate debt stands at very high levels in many G20 countries.
Also, lower-rated credit issued in the form of BBB bonds, non-investment grade bonds, and leveraged
loans have risen to elevated levels, the OECD warns, meaning businesses will have little choice but to
reduce costs and employment to withstand insolvency pressures.

Stock Market - Overall, stock markets declined over 30% by March; implied volatilities of equities and oil
have spiked to crisis levels; and credit spreads on non-investment grade debt have widened sharply as
investors reduce risks.

Oil Prices - The COVID-19 pandemic and related confinement measures caused an unprecedented
contraction in economic activity and a collapse in demand for oil and oil products. The result is one of the
biggest price shocks the energy market experienced since the first oil shock of 1973. Oil prices dipped
below USD 20 (Brent crude) a barrel, losing nearly 70% in value, with storage capacity approaching its
limits. The reduction in the demand for travel and the lack of factory activity due to the outbreak
significantly impacted demand for oil, causing its price to fall.

Bond Markets - As the economic impact of the coronavirus began to be felt, numerous financial news
sources warned of the potential cascade of impacts upon the outstanding $10 trillion in corporate debt.
Between mid-February and early March, investors increased the premium, or additional yield, to hold junk
bonds by four times the premium demanded of higher credit lenders, indicating increased wariness. During
the 2020 stock market crash that began the week of 9 March, bond prices unexpectedly moved in the
same direction as stock prices. Bonds are generally considered safer than stocks, so confident investors will
sell bonds to buy stocks and cautious investors will sell stocks to buy bonds. As big investors sought to sell,
the spread between the prices sellers and buyers wanted has widened. As banks were unable to sell the
bonds they were holding, they also stopped buying bonds. As the number of traders fell, the few trades
remaining wildly swung the bond prices. Market depth in Treasuries, a measure of liquidity, fell to its
lowest level since the 2008 crisis. Also, prices for bond exchange-traded funds began dropping below their
net asset values.

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