Derivatives in Various Markets & Capital Budgeting

8/8/2019 Derivatives in Various Markets & Capital Budgeting

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CAPITAL BUDGETING

PRESENTED BY:

Sagar Thakur C-46

Manas Bendre C-45

Amit Jain C-44

Sourabh Suryawanshi C-35

Ambrish Shah P-32

PRESENTED TO:

Prof. S.Krishnan


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INTRODUCTION TO DERIVATIVES

qThe word derivative comes from the word to derive. It indicatesthat it has no independent value. A derivative is a financial instrumentthat derives its value from an underlying asset.

q This underlying asset can be stocks, bonds, currency, commodities,metals and even intangible, pseudo assets like stock indices.

q Different types of derivatives: Forward , future, swap, option

caps, floor, etc.


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MEANING OF DERIVATIVESECURITY MARKET:

q

Derivative security market are the market in which derivativesecurities trade. It is a financial security ( such as a future ,

forward, option or swap contract) whose payoff is linked to

another.

q Two types of derivative instrument : exchange traded

derivative & OTC derivative.


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DERIVATIVES IN VARIOUSMARKETS

q In Stock Market

q In Commodity market

q In Currency market


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DERIVATIVE INSTRUMENTS

FORWARTDCONTRACT

FUTURECONTRACT

OPTIONSWAP

CONTRACT

PUT CALL


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FORWARD CONT RACT

v Private agreements between 2 parties to transact inthe future at terms agreed to today.

v Forward contract normally traded outside the

stock exchange. They are popular mostly on OTCMARKET.

v Forward contracts require both parties to haveessentially opposite needs, but at the same time forcertain quantity of goods & assets.

v Useful in hedging & speculation.


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FUTURE CONTRACT

Essentially standardized future contracts which are backed by

an organized exchange & follow daily settlement.

Future contract is similar to forward contract but

For financial futures the delivery of an actual asset rarely

occurs and contracts are commonly closed out before maturity,

or settled in cash at maturity.


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DIFFERENCE BETWEEN FORWARD &FUTURE CONTRACT:

vSimilar to forward but features formalized & more standardized:

1) Size of contract: 2) Grade of delivery assets:

3) Delivery date: 4) Delivery location:

v Key difference in future:

1) Standardization 2) Marked to market

3) Secondary trading-liquidity 4) Clearinghouse warrant

performance


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Futures contracts are used by essentially two distinct groupsof economic agents: hedgers and speculators

The overwhelming majority of futures positions are closedout prior to the delivery date, or involve cash settlement forthe case of financial futures.

MAJOR PLAYERS


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HEDGING STRATEGY:

If you are long the underlying the assets ( such thatincrease in asset price increase in the firm value, then youcan enter into forward contract to sell , the asset at forward

price, this can hedge the changes in the asset price.

For example:


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TRADING PROCESS

Buyer Seller

Broker Broker

Clearing House

Purchase Order Sales Order

Transaction

On the floor

Margin Requirement:

20% of the position value


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PROFIT CALCULATION ON AFORWARD CONTRACT:

Profit on a forward contract is related to the differencebetween the price of an underlying assets at theforwards maturity (time = T) and the forward price(initially specified at the onset of the contract at time =0).


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COMMODITY DERIVATIVEMARKET:

Commodity Turnover in $Millions*

Guar seed

4,432.71Gold4,082.15Silver3,869.36

Crude oil3,380.13Chana (chick peas)2,100.15Urad (Black Legume)

624.71


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If $ spot today is Rs.39 & 6 month future is available for 38, anexporter would sell this future for Rs.38 today.

After 3 month if $ spot is 38.25 then people would expect $fall to37.75.

Exporter can buy it & make 25 paise.

FUTURE HEDGING PROCESS:


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STOCK FUTURE INDEX:

The Futures contract allows portfolio managers andspeculators to easily establish various positions in this asset.Since it is difficult and expensive to hold S&P 500 indexthrough the direct purchase of the individual stocks comprising

the index,

This is particularly useful for investors trading SPX (S&P 500index) options, who would like to hedge their position


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OPTIONS

An Options contract confers the right but not the obligation to

buy (call option) or sell (put option) a specified underlying instrument or

asset at a specified price the Strike or Exercised price up until or an

specified future date the Expiry date.

The Price is called Premium and is paid by buyer of the option to the

seller or writer of the option.


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Options have a buyer and a writer

The option writer receives premium for giving the buyerthe right but not the obligation to sell an asset at a futuredate

Options can be cash settled or settled by physical delivery

Options in India are cash settled


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Put and Call Options

Call Option:

The right to buy a futures contract

Protects against rising price

Put Option:

The right to sell a futures contract

Provides protection against falling prices


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INTRINSIC VALUE

Positive difference between the strike price and theunderlying commodity futures price.

FOR A CALL OPTION strike price below

futures price

FOR A PUT OPTION strike price exceeds

futures price


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Call Option

In-the-Money (ITM)

Strike price < Spot price(current price)

At-the-Money (ATM)

Strike price = Spot price

Out-of-the-Money (OTM)

Strike price >Spot price


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Put Option

In-the-Money (ITM)

Strike price > Spot price

At-the-Money (ATM)

Strike price = Spot price

Out-of-the-Money (OTM)

Strike price < Spot price


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Swaps

Simultaneous purchase and sell between two parties

Spot

Forward

Discount (cheaper)

Premium (costlier)

ap a u ge ng


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ap a u ge ng

Should webuild thisplant?


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Capital Budgeting is the process of evaluating andselecting long term investments that are consistent with

the goal of shareholders wealth maximization

Definition : Capital Budgeting


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CAPITAL INVESTMENT PROCESS

ARR


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SAM Ltd.

Initial Outlay -$250

Year 1 inflow $35

Year 2 inflow $80

Year 3 inflow $130

Year 4 inflow $160

Year 5 inflow $175

Initial Outlay -$50

Year 1 inflow $18

Year 2 inflow $22

Year 3 inflow $25

Year 4 inflow $30

Year 5 inflow $32

ABC Project XYZ Project

P b k P i d


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Payback Period

Management determines maximum acceptable paybackperiod.

== flowscashAnnual/InvestmentInitialPBPayback

The payback period is the amount of time required for thefirm to recover its initial investment.

P b k A l i F SAM L d


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Managements cutoff is 2.75 years.

ABC project: initial outflow of -$250M

But cash inflows over first 3 years is only $245 million.

SAM Ltd. will reject the project (3>2.75).

XYZ project: initial outflow of -$50M

Cash inflows over first 2 years cumulate to $40 million.

Project recovers initial outflow after 2.40 years.

Total inflow in year 3 is $25 million. So, the project generates $10million in year 3 in 0.40 years ($10 million $25 million).

SAM Ltd. will accept the project (2.4


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Computational simplicityEasy to understand

Focus on cash flow

Does not account properly for time value of money.Does not consider cash flow after payback period.Does not lead to value-maximizing decisions.

Strengths & Weakness of the Payback Method

Benefits:

Drawbacks:


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3131

Discounted payback accounts for time value. Apply discount rate to cash flows during payback period.

Still ignores cash flows after payback period.

SAM Ltd. uses an 18% discount rate.

Discounted Payback

Reject

(46.3


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The ratio of the average cash flow received to theamount of funds invested.

Average Rate Of Return (ARR)

ARR uses accounting numbers, not cash flows;no time value of money.

100X

vestmentAverage in

r taxesofits afteAverage prARR =

Average profitsafter taxes

Average annualoperating cash

inflows

Averageannual

depreciation

=


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Year EBIDT PBT PAT Cash Flow1 $65 $60 $30 $35

2 $155 $150 $75 $80

3 $255 $250 $125 $130

4 $315 $310 $155 $160

5 $345 $340 $170 $175

Total $1135 $555 $580

ARR Analysis of ABC Project :

( Depreciation 10% , Tax rate 50 % , All figure

ARR = 111 / 250 X 100 = 44.4 %


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ARR Analysis of XYZ Project :

Year EBIDT PBT PAT Cash Flow1 $35 $34 $17 $18

2 $43 $42 $21 $22

3 $49 $48 $24 $25

4 $59 $58 $29 $30

5 $63 $62 $31 $32

Total $249 $122 $127

ARR = 24.4 / 50 X 100 = 48.8 %

( Depreciation 10% , Tax rate 50 % , All figures are Mio )


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Computational simplicity

Uses readily available accounting information

Profits for the entire life of asset are considered

Does not account properly for time value of money.

Based on profits and not cash flows

Strengths & Weakness of the ARR Method

Benefits:

Drawbacks:


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Discounting cash flows accounts for the time value ofmoney.

Choosing the appropriate discount rate accounts for

risk.

Net Present Value (NPV)

NPV: The sum of the present values of a projects cashinflows and outflows.

N

N

r

CF

r

CF

r

CF

r

CFCFNPV

)(...

)()()( +++

+

+

+

+

+

+=

11113

3

2

21

0


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Assuming 18% discount rate, NPVs are:

NPV Analysis of SAM Ltd. :

5432 )18.1(175

)18.1(160

)18.1(130

)18.1(80

)18.1(352503.75$ +++++==ABCNPV

ABC project: NPV = $75.3million

5432 )18.1(32

)18.1(30

)18.1(25

)18.1(22

)18.1(18507.25$ +++++==XYZNPV

XYZ project: NPV = $25.7million

Should SAM Ltd. invest in one project or both?


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If Projects ABC and XYZ are mutually exclusive acceptABC because NPVABC > NPVXYZ

If Projects ABC & XYZ are independent accept bothsince NPV > 0.

Accept- Reject Rule


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It recognizes time value of money. It is based on cash flows.

It maximizes shareholders wealth

Difficult to estimate discount rate

Not applicable if projects have unequal life Difference in initial investment

Strengths & Weakness of the NPV Method

Benefits:

Drawbacks:


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It measures the present value of returns per rupeeinvested

PI = Present value of cash inflows

Present value of cash outflows

Also know as Benefit to Cost Ratio ( BCR )

Net benefit cost ratio = BCR 1

Profitability Index ( PI )


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1.5$50 million$75.7 millionXYZ

1.3$250 million$325.3 millionABC

PIInitial OutlayPV of CF (yrs1-

5)

Project

Accept project with PI > 1.0

Reject project with PI < 1.0


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Tells whether an investment increases the firm's value Considers all cash flows of the project

Considers the time value of money Considers the risk of future cash flows (through the cost of

capital)

Requires an estimate of the cost of capital in order to calculatethe profitability index

May not give the correct decision when used to compare

mutually exclusive projects

Strengths & Weakness of the PI Method

Benefits:

Drawbacks:


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It is that rate of return where the present value of cash

inflows are equal to present value of cash outflows.

In other words NPV is 0 at this rate

Internal Rate of Return (IRR)


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Internal Rate of Return

N

N

r

CF

r

CF

r

CF

r

CFCFNPV

)(

....

)()()( +

++

+

+

+

+

+

+==

1111

03

3

2

21

0

IRR: the discount rate that results in a zero NPV for aproject.

The IRR decision rule for an investing project is:

If IRR is greater than the cost of capital, accept the project. If IRR is less than the cost of capital, reject the project.


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IRR Analysis for SAM Ltd.

ABC project: IRR (rabc) = 27.8%

5432 )1(

175

)1(

160

)1(

130

)1(

80

)1(

352500

rrrrr ++

+

+

+

+

+

+

+

+=

XYZ project: IRR (rxyz) = 36.7%

5432 )1(

32

)1(

30

)1(

25

)1(

22

)1(

18500

rrrrr ++

+

+

+

+

+

+

+

+=

SAM Ltd. will accept all projects with at least 18% IRR.


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Considers Time value of Money

Cash flows for the entire life of asset are considered

Does not use the concept of required rate of return

It involves tedious calculations

Assumption of reinvestment is unrealistic

Strengths & Weakness of IRR Method

Benefits:

Drawbacks:

Conclusion:


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Particulars ABC XYZARR 44.4 %

( REJECT )48.8 %( ACCEPT )

NPV $75.3 million ( ACCEPT ) $25.7 million ( REJECT )

PI 1.3( REJECT )

1.5( ACCEPT )

IRR 27.8 %( REJECT )

36.7 %( ACCEPT )

Conclusion:


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International Finance

- Deepak Abhyankar

Financial Markets & Institution

- Mackgraw Hill Publication

q www.financialmarket.com

q www.google.com

Bibliography &Webliography
http://www.financialmarket.com/http://www.financialmarket.com/


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THANK YOU !!!

Derivatives in Various Markets & Capital Budgeting

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