dushyant mahadik money, banking, corporate finance and governance area centre for economics and...

DUSHYANT MAHADIKMONEY, BANKING, CORPORATE F INANCE AND

GOVERNANCE AREACENTRE FOR ECONOMICS AND F INANCE

ASCI , TUESDAY, 28 T H FEBRUARY 2012

Financial Aspects of Regulation

BUSINESS DECISION MAKINGNET PRESENT VALUE

COST OF CAPITAL

Agenda

FOUNDATIONS OF MANAGEMENTNON-FINANCIAL CRITERIA

FINANCIAL CRITERIA

Business Decision Making

Foundations of Management

Division of labourCentralization and DecentralizationBusiness PolicyValues and Culture

Criteria for Making Business Decisions

ProfitabilityStrategic FitLong term sustainabilityBest use of available resourcesEmployee First, Customer SecondTriple Bottom LineAdministrative ReasonsLogistic Convenience

Financial Criteria

Break Even AnalysisCost-Benefit AnalysisNet Present Value

Economic Value Added Adjusted Present Value

Payback periodRates of return

Return on Investments Accounting Rate of Return Internal Rate of Return

Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW

Site available to your company on lease is perfectly suited

Entire land mass will get used in the plant and accessories

Your company does not have any cash reserve

Site available to your company on lease is perfectly suited

Entire land mass will get used in the plant and accessories

Your company does not have any cash reserve

Exercise: Limited Power Project

Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW

Each 10 MW plant costs $3 MN

Accessories and other costs are $1 MN

Over next 10 years, the plants are expected to generate revenue of $35 MN and incur cost worth $15 MN

The plant costs $13 MN

Accessories and other costs are $2 MN

Over next 10 years, the plants are expected to generate revenue of $48 MN and incur cost worth $20 MN

Exercise: Limited Power Project

Net Present Value

Discounting the future cash flows

Money today is worth more than having money tomorrow

Ci

Present Value of Ci = -----------------

(1 + r )i

where, r is the discount rate Ci is the net cash flow coming in

during the ith yearMore distant cash flows are more risky, hence

they are discounted more

Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW

Year 0 1 .. 10

Plant -9 .0

Accessories -1 .0

Revenue 3.5 .. 3.5

Operating Cost

-1.5

.. -1.5

Discounted Value @ 4%

-10.0

1.9 .. 1.4

Exercise: Limited Power Projectall figures in million $

Year 0 1 .. 10

Plant -13.0

Accessories -2.0

Revenue 4.8 .. 4.8

Operating Cost

-2.0 .. -2.0

Discounted Value @ 4%

-15.0

2.7 .. 1.9

NPV = $6.22 M > 0

NPV = $7.71 M > 0

What is measured ?

Future cash flows – ignore sunk costOperating cash flowsIncremental cash flows over status quoNon-cash expenses like depreciation,

overheads, etc.Changes in capital (working capital)Include opportunity costExpectations about inflationEffects of tax

Net Present Value

Appreciates time value of moneyOnly cash profits are importantAdditive methodProvides a direct link between management

decision and shareholder valueMutually exclusive projects are handled

betterAble to absorb term structure of interest

rates

Exercise : Illustrating Timing Differences

Project Year 1 Year 2 Year 3 PV @ 10%

A 100 100 100.0 248.69

B 150 100 39.5 248.69

C 50 100 160.5 248.69

Stakeholders may view the projects differently

Differences in time horizonDifferent perception of riskDifferent tolerance for risk

INTRODUCTIONWACCCAPM

Cost of Capital

Cost of Capital

Returns to an operator attract investorsOpportunity Cost of CapitalInvestors may not be attracted for many reasons

Too much debt or too little debt

Management efficiency of the operator

Country/region of the operator

Other risks taken by the operator

Lack of transparency or clarity about future course of action

Discount rate for NPV and Hurdle rate for IRR

Weighted Average Cost of Capital

Returns for the operator should be greater than the operator’s post-tax WACC

WACC =

where, D – value of debt E – value of equity shares t – corporate tax rate (marginal) rD – average rate of interest on debt rE – returns required by the shareholders

ED rED

Ert

ED

D

)1(

Cost of Debt for Tata Power Limited

Refer to hand out given (excerpts of annual report 2010-11)

Schedule C: Secured Loans (Rs 47539 MN)Schedule D: Unsecured Loans (Rs 22354 MN)Schedule 3: Interest Charges (Rs 4489.5 MN)

Cost of debt (weighted average) = 6.42%

Cost of Equity

Cost of EquityDividend discount

models

Capital Asset Pricing Model (CAPM)

Also known as market capitalization rate or required rate of return by equity investors

20

Dividend Discount Models

Walter ModelH ModelMulti-stage Growth ModelGordon Growth Model

DIV1Market Capitalization Rate = -------- + Growth

Rate P0

where, DIV1 = dividend to be paid in next year

P0 = Current share price

21

Growth Rate for Dividend Discount Models

Security AnalystsIndustry ExpertsFundamentals of the company

Revenue from year n+1 will be more than revenues from year n

To the extent to which operating assets are higher

Growth Rate of Profits = Plough Back Ratio x Return on Equity

What is the reinvestment policy of the company ? Plough back = 50% and Return on equity = 12% Growth = 50% x 12% = 6%

Capital Asset Pricing Model

Equity Market Risk PremiumExtra Returns (risk premium) from an

investment are dependant on the underlying risks

Security Market Line

r - rf = (rm - rf)

(beta) is the measure of sensitivity of the investment to market movements

Capital Asset Pricing Model

Assumptions Markets are efficient There is no information asymmetry Transaction costs are negligible, i.e. Borrowing

and lending rates are same There are no taxes

Risk/Return Contribution to a Portfolio Because unique risk is already diversified in a

portfolio

WACC for Tata Power Limited

WACC = 11%

Equity = 16%, 56% of FV

Dividend Discount, 10.0%

12.5 / 1330 + 9%

CAPM 18.9% with b = 0.8

8% + 0.8 * (21%-8%)

Debt = 4.5%, 44% of FV

6.42% x (1-t)

Roadblocks to finding WACC

Unlisted company or part of a conglomerate

Nominal vs Real WACC

Marginal WACC and Average WACC

Measurement of risk

Inefficient capital structure

Back-up Slides

Economic Value Added

Introduced and popularized by Stern Stewart & Company

EVA in year n = cash inflow (or outflow) minus the cost of capital (cost of financing) Also, any additional investment done in the year n is

to be subtractedTotal EVA by taking the project is the sum of

discounted EVA for each year

Adjusted Present Value

NPV is calculated by treating the project as an unlevered firm

That is the value of the project on its ownWhen the project is financed with debt, it

helps the firm save taxes because interest is a tax-deductible expense

The present value of all future tax savings are the financing side effects of the project

Adjusted present value = NPV as unlevered firm + PV of Tax Shields

Dividend Discount Model

Perpetuity formula –Value of perpetuity = periodic payment /

discount rateIf perpetuity is growing –Value of perpetuity = first periodic payment /

(discount rate – growth rate)

So,dividend to be paid in next year

Share Price = ----------------------------------------(required rate) – (growth rate)

Calculation of Beta

2m

imi

Covariance with the market

Variance of the market

References

Data about Tata Power Limited taken from http://www.tatapower.com/investor-relations/pdf/

92Annual-report-2010-11.pdfBeta of major Indian companies

http://www.bseindia.com/about/abindices/betavalues.asp

Further reading on the topic is given in the references section of Chapter III: Management and Analysis of Financial and Other Data http://www.regulationbodyofknowledge.org/

documents/bok/chapter3.pdf