03 Capital Acquisition 09

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Slide no. 1

September 30, 2010

Author: Dilip Thosar

FLAME FSBJune 2010 CF : Corporate FinanceCapital Acquisition

"If you would like to know the value of money, go and try to borrow some." ~BenjaminFranklin

"If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's thebank's problem." ~JP Getty.

"I wish that dear Karl could have spent more time acquiring capital instead of merely writingabout it." ~Jenny Marx

Corporate FinanceCapital Acquisition

FLAMEFSB

Pune

August 2010

In God Alone We TrustEveryone Else Pays Cash

The MatrixLoves Cash « « Do You LoveThe Matrix ?

`

`



Slide no. 2

September 30, 2010



The Financing Decision

Raise Cash to fund operations, procurementand capital purchases

Equity or Debt (Leverage)

Borrowed money cheaper but riskier for company (shareholder) and distributes part of

returns outside of shareholders

Secondary objective: low cost of capital

Primary objective: Maximize shareholders¶

wealth



Slide no. 3

September 30, 2010



Financing : Long Term

Instruments/Mechanisms Equity:

ordinary shares

preference shares

Debt:

Debentures : Convertible/ NCD

Deposits

Bonds

Term loans

Lease financing and hire purchase

BOT


June 2009



Slide no. 4

September 30, 2010



Financing: Short Term

Working Capital Loans Credit Lines

Bill Discounting

Money Market


June 2009



Slide no. 5

September 30, 2010



Capital Instruments

Shares Mutual Funds

Debentures

Fixed Deposits Derivatives: Options, Futures, Forwards

Derivatives: Swaps, Securitized assets

Securities



Slide no. 6

September 30, 2010



Securities Securities

A fungible, negotiable instrument representing financial value Broadly categorized debt (banknotes, bonds and debentures), equity (common stock)

and derivatives (forwards, futures, options, swaps).

Kinds of securities Bonds : Debt

Contractual Obligation to Repay principal and interest

Tradeable instrument that represents a debt owed to the owner by the issuer. Bonds usuallyearn interest periodically and return the principal at maturity.

Terms Coupon Rate - This is the stated rate of interest on the bond. Face Value - This is the principal amount (nominally, the amount that was borrowed and that will be

repaid at maturity Maturity Date - This is the date after which the bond no longer exists. It is also the date on which the

loan is repaid and the last interest payment is made.

Shares : Ownership A share of common stock represents an ownership position in the firm. Apart from rights to

vote on important matters shares usually receive dividends and increase in tradeable value.

Non-contractual returns, Exposure to Residual Loss

Variants and packages of above

Derivatives



Slide no. 7

September 30, 2010



Capital Markets

Market place in which something is bought by buyers when sold

by sellers

Capital Market

Place where capital instruments are traded Types of Capital Markets

Primary : capital created. IPO, Pvt. Placement

Secondary : traded. Exchanges, Kerb, webtrade

Types of securities traded on capital markets

Stock, Commodity, Derivative, Money, Bond, FX, «



Slide no. 8

September 30, 2010



Other Securities and Markets

Derivatives (Futures, Options) Money Markets (inter-corporate)

Bonds

Foreign Exchange Markets (treasury dealers) Commodity Markets

Credit markets (asset securitization)

Mutual Funds and AMCs Bullion Markets



Slide no. 9

September 30, 2010



Capital Market Terms

Investor, Buyer, Seller, Profit from Trade Risk, Reward, risk premium

Leveraged Investments

Insider Information Market drivers:

Technicals, Fundamentals and Sentiment

Bull and Bear markets



Slide no. 10

September 30, 2010



Cost of Capital

Capital provider expects returns To the Corporate raising the capital, this

return (expectation) represents a cost

Cost of Debt Expectation (interest rate) explicitly stated

Tax shield : Interest is tax-deductible

Cost of Equity

Expectation not explicitly stated, has to be

derived

Source of information: share market pricing Author: Dilip Thosar

June 2009



Slide no. 11

September 30, 2010




For BVUDITM, PuneSeptember 2008

Cost Of Debt Financial Leverage: Financing

using Debt With leverage, risk increases, so

do returns

Leveraged Investment :Financing Procurement of an Asset using Debt funds

Leveraged buyout: Borrow onInterest to Buy Shares

The Tax Shield

With increased debt(Leveraging), Cost of Capital lowers

Value of Firm (Cash for Managers) increases

Shareholders¶ wealthincreases



Slide no. 12

September 30, 2010





The Tax Shield Interest is deductible when

computing taxable income Dividend is not a tax-

deductible expense

Tax payable reduces by T *

Interest = T*r B*B Thus Debt reduces theamount of tax due

This saving of cash outflowdue to reduction in tax is

called the tax shield The tax shield reduces

effective cost of debt



Slide no. 13

September 30, 2010



Cost Of Equity

Factors Affecting Expected Return Pure time value of money ± measured by the

risk-free rate

Reward for bearing systematic risk ± measured

by the market risk premium

Amount of systematic risk ± measured by beta


June 2009



Slide no. 14

September 30, 2010




For BVUADITM PuneSeptember 2008

CAPM: Capital Asset Pricing Model E(Ri) = Rf + im * (E(Rm) ± Rf )

Where E(Ri) is the expected return on the capital asset

Rf is the risk-free rate of interest As the arithmetic average of historical risk free rates of return and not the current risk free rate

of return

Rm is the expected return on the market portfolio

im , ³beta coefficient´ is the sensitivity of the asset returns to market returns

im = Cov (Ri, Rm)/Var(Rm) =Cor(Ri, Rm) * ]/m (Rmarket ± Rriskfree) is the market risk premium (the difference between the expected

market rate of return and the risk-free rate of return)

Rate of return computation

Rate of return = (Current Dividend +Increase in share price) /Start Share Price

What does Beta mean or imply? A beta of 1 implies the asset has the same systematic risk as the overall market

A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

A beta = 0 implies the asset is a risk-free asset



Slide no. 15

September 30, 2010





The Security Market Line



Slide no. 16

September 30, 2010





Calculating Beta from historical data im = Cov (Ri, Rm)/Var(Rm), where

Ri is the expected return on the capital asset Rm is the expected return of the market the expected market rate of

return is usually measured by looking at the arithmetic average of thehistorical returns on a market portfolio

i and m are Std.Dev. of returns respectively on security ³i´ and themarket

im = 210.47 / 176.74 = 1.1908

Year Rm Ri Rm-R'm Ri-R'i (Rm-R'm) * (Ri-R'i) (Rm-R'm)^2

0 18.13 21.21 13.29 15.13 201.02454 176.62

-1 16.44 19.81 11.60 13.73 159.2216 134.56

-2 -10.11 -11.01 -14.95 -17.09 255.5553 223.50

-3 -12.37 -15.24 -17.21 -21.32 366.98604 296.18

-4 12.11 15.65 7.27 9.57 69.54482 52.85

4.84 6.08 Average 210.47 176.74

R'm R'i Cov i,m Var m

Microsoft Excel

Worksheet



Slide no. 17

September 30, 2010



Weighted Average Cost Of Capital

Unit Cost Of Equity: r s = r f + *(r m ± r f ) Link with CAPM : E(Ri) = Rf + im * (E(Rm) ± Rf )

Unit Cost Of Debt = (1-T) * r b Pre-tax cost of Debt = Interest rate = r

b

Weighted cost of various debts

r b = (B1r 1 + B2r 2 + B3r 3 + «) / B

WACC : r wacc = (r s*S + (1-T)*r b*B) / (S+B)= (S/S+B)*r s + (B/S+B)*(1-T)*r b

=r s/(1+DE)+ (1-T)*r b/(1+1/DE) Author: Dilip Thosar

June 2009



Slide no. 18

September 30, 2010



Capital Structure Irrelevance

Modigliani and Miller : Capital StructureIrrelevance Principle

In the absence of taxes, bankruptcy costs

and asymmetric information, in an efficient

market where no transaction costs exist and

individuals borrow at the same rate as

corporations, the value of a firm is unaffected

by how that firm is financed Optimal Capital Structure does indeed exist

at a point where debt is 100%



Slide no. 19

September 30, 2010





Optimal Capital Structure

In presence of tax, returns expected onequity increase with leverage

r 0 = ( (1-T)*r b*B + r s*S ) / (B+S)

r s = r 0 + (1-T)*(r 0-r b) * B/S

All-debt seems to be the best structure

Financial Distress and risk of leveraging limits

the debt capacity



Slide no. 20

September 30, 2010





The Financing Pecking Order

1. Use Internal Financing2. Issue safest securities first

Implications

No ³target´ optimal amount of leverage First finance through internal reserves

Then issue debt till ³capacity´

Finally issue more equity

Profitable Firms use less debt

Companies retain Cash Reserves (slack).



Slide no. 21

September 30, 2010




April 2010

Questions?



Slide no. 22

September 30, 2010


FLAME FSBJune 2010

CF : Corporate FinanceCapital Acquisition

Beta, R2, Volatility and Returns

Selected SENSEX Scrips Aug09-Jul10 http://www.bseindia.com/about/abindices/betavalues.asp

r iod

(A

ugust

200

9

-

July

2010)

Scripcode

CompanyBeta

Values

Co-efficient of Determination

(R2)

Avg. DailyVolatility

(%)

Returns (1year) (%)

Weightage (%)in SENSEX as

on 30/07/10

500410 ACC LTD. 0.77 0.27 1.71 -5.66 0.62

500103 BHARAT HEAVY ELECTRICALS LTD. 0.72 0.38 1.36 9.46 3.00

532454 BHARTI AIRTEL LTD. 0.65 0.09 2.53 -25.25 2.93

500087 CIPLA LTD. 0.39 0.08 1.66 18.46 1.22

532868 DLF Ltd. 1.60 0.51 2.60 -23.94 0.92

500180 HDFC BANK LTD 0.70 0.36 1.36 41.87 5.61

500182 HERO HONDA MOTORS LTD 0.76 0.24 1.82 13.07 1.30

500440 HINDALCO INDUSTRIES LTD 1.92 0.57 2.95 59.98 1.54

500696 HINDUSTAN UNILEVER LTD. 0.46 0.11 1.58 -13.77 1.96

500010 HOUSING DEVELOPMENT FIN. CORPN. LTD 0.92 0.47 1.56 17.79 5.59

532174 ICICI BANK LTD. 1.48 0.66 2.12 19.16 7.23

500209 INFOSYS TECHNOLOGIES LTD. 0.75 0.36 1.45 35.13 9.76

507685 WIPRO LTD. 0.80 0.30 1.70 39.73 1.45

SENSEX 1.00 1.16 14.03



Slide no. 23

September 30, 2010


FLAME FSBJune 2010


Numericals A1. Sofa Sogood Ltd. is an all-equity listed and traded

firm with a beta of 0.95. The market risk premium

is 9% and risk-free rate is 5%. What is the

expected rate of return on the equity of this

company?2. The correlation between the returns on Dishwalla

Limited and the BSE Sensex is 0.675. The

variance of the returns on Dishwalla is 0.004225

and the variance of the returns on the BSESensex basket is 0.001467. What is the Beta of

Dishwalla Limited?



Slide no. 24

September 30, 2010


FLAME FSBJune 2010




Slide no. 25

September 30, 2010


FLAME FSBJune 2010


Numericals

03 Capital Acquisition 09

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