Capital Budgeting

Detailed Notes on Capital Budgeting, Techniques used in Capital Budgeting and Risk Analysis in Capital Budgteing

Investment Analysis

CB20

Notes:
There are some limitations in Accounting Basis:
Here cash flows in Accounting are based on Accrual Concept. I.e. accounting is based on earning irrespective of receipt. We can see here that in accounting basis Benefits are Profits after tax which includes Depreciation amount also. Depreciation expenses are those which are not yet occurred, but accounting is done to compensate the reduction in the value of asset over its useful life. Nonetheless we deduct tax on that amount. So in order calculate the Actual Cash Flows after Tax, we should take as per cash basis.

Accounting Basis Cash Basis (Alternate Methods)
Particulars Amount Particulars Amount Particulars Amount
Profit Before Depreciation and Tax XXX Profit Before Depreciation and Tax                                 XXX Profit Before Depreciation and Tax XXX
Less: Depreciation (XXX) Less: Depreciation (XXX) Less: Tax (XXX)
Profit Before Tax XXX Profit Before Tax XXX Profit After Tax XXX
Less: Tax (XXX) Less: Tax (XXX) Add: Tax Savings on Depreciation XXX
Profit After Tax XXX Profit After Tax XXX Cash Flows After Tax XXX
    Add: Depreciation XXX    
    Cash Flows After Tax XXX  
  • PROFITS AFTER TAX – These are the benefits from the Investment. It also includes non-cash items such as Depreciation. Generally this is used in accounting rate of return. Any evaluation done based on PAT may not give accurate results.
  • CASH FLOWS AFTER TAX – these are the benefits from Investment. It does not include any non-cash items. This is used in Payback Period method, Net Present Value Method, Internal Rate of Return method, Profitability Index, Discounting Payback Period method.

Capital Budgeting

  1. Capital Budgeting is Decision Making such as Investment, Dividend or Financing Decisions.
  2. Capital Budgeting is Evaluation of Expenditure Decisions, which involves current outflow of cash and the benefits are incurred in future.
  3. Capital Budgeting is forecasting of expected returns which are likely to be occurred on New Investment Project.
  4. Risk and Uncertainty both refers to a situation with more than one outcomes.
  5. Risk refers to set of Unique Outcomes for a given event, to which we can assign Probabilities.
  6. Uncertainty refers to Outcomes of a given event which are too unsure to be assigned Probabilities.
  7. Standard Deviation as a measure of Risk becomes a difficult proposition in complex situations.

Factors used in Evaluation of Project

  1. Initial Investment: It includes Cost of New Assets Purchased, Investment in Working Capital. It is the cost of New Project. It is Net Cash Outflow at the initial stage of the project.
  2. Life of the Project: The time period during the project generates positive cash flows after tax. It is decided based on Technological Obsolescence, Physical Deterioration and fall in market demand for the product.
  3. Cash Flows after Tax: It includes Sum of Profit after Tax and Depreciation and other amortizations. They are the periodical cash flows generated over the life of the Project.
  4. Terminal Inflows: it includes – Salvage Value of Fixed Assets and Recovery of Working Capital.
  5. Time Value of Money: the Value of Money differs at different points of time. So all the inflows (Periodical and Terminal) are converted into Present value by multiplying with discounting factor.
  6. Discounting Factor: It represents the cut-off rate for capital investment evaluation. Generally we use weighted average cost of capital. (We will discuss this in next few pages). If the cash flows after tax after discounted with the discounting factor is less than the initial investment, the said project should not be selected. It is the present value factor. Generally we take discounting factor as risk free rate of Interest.

Investment Evaluation Process

  1. Identification of Costs and Benefits
  2. Identification of Minimum Rate of Return
  3. Application of Capital Budgeting Techniques to arrive at Decision regarding selection of Project

Capital Budgeting Techniques

CB21

Capital Budgeting Techniques

Traditional Techniques – Non-Discounting Techniques

Accounting Rate of Return – ARR

ARR is Average Yield on Investment. ARR is a relative measure used for Investment Evaluation. The selection process is done by comparing ARR with its Cost of Capital. In this method Profit after Taxes (PAT) as calculated in Accounting Method is used for evaluation.

ARR = (Average PAT pa)/ (Net Initial Investment) X 100

Average PAT pa = (Total PAT during Project Life)/ (Number of Years)

Net Initial Investment = Initial Investment less Salvage Value

Pay Back Period

It is the time duration required for complete recovery of Initial Investment. It the period during which the total cash inflows from the project will become equals to Total cash outflows.

The Project/Investment is said to be Viable if it has the Lower Payback Period, as Initial Investment can be recovered at the earliest.

PROCEDURE FOR COMPUTATION OF PAYBACK PERIOD:

  1. Determine the Initial Investment.
  2. Determine Cash Flows after Tax during the life of the project.
  3. Calculate Payback Period based on CFAT.

Cash Flows after Tax

In case of UNIFORM CFAT per annum In case of DIFFERENTIAL CFAT for various years
Payback Period = (Initial Investment)/(CFAT per annum)

This can also be done in Cumulative Approach, but it is simpler if we use the above formula.

Cumulative Approach

1.       Compute Cumulative CFAT at the end of every year.

2.       Determine the year in which Cumulative CFAT > Initial Investment.

3.       Payback Period = Time at which Cumulative CFAT = Initial Investment.

Accept the project if Payback period is less than the maximum period, else reject the project.

Discounting Techniques

Discounted Payback Period

This is done same as Payback Period, but here we are discounting the Cash Flows after Tax and are considering the change in the value of money over the period of time. (Implies we are considering TIME VALUE OF MONEY).

Step by Step Procedure of COMPUTATION OF Payback Period after discounting CFAT at a predetermined rate:

  1. Determine Cash Outflows – Initial Investment.
  2. Determine Cash Inflows – CFAT
  3. Determine Discounting Factor. And Calculate Present Value Factors for each year over the life of the Project.
  4. Calculate Discounting CFAT = CFAT*Present Value Factors for each year separately.
  5. Calculate Cumulative CFAT at the end of each year over the life of the Project.
  6. Determine the year in which Cumulative Discounted Cash flows exceeds Initial Investment.
  7. Discounted Payback Period is the period in which Cumulative Discounted CFAT = Initial Investment.
  8. Decision – if the Discounted Payback Period is less than the Maximum or Benchmark period – Accept, else reject the said project.

The Process for calculating Discounted Payback Period is same for uniform as well as differential CFAT.

Net Present Value – NPV

It is an Absolute Measure used for Investment Evaluation.

It is Sum of the Present Values of all Future Cash Inflows less Sum of Present Values of Cash Outflows associated with the project.

Here we have to consider CFAT instead of PAT and Terminal Inflows as Cash Inflows.

Cash Outflows include – Initial Investment (Cost of the Project) and Working Capital Investment.

NPV = Discounted Cash Inflows less Discounted Cash Outflows

PROCEDURE FOR COMPUTATION OF NET PRESENT VALUE:

  1. Computation of Cost of Investment – Initial Investment and additional Investment made over the life of the project (after discounting)
  2. Identification of Relevant Cash flows –
    1. Operating Cash flows
    2. Terminal Cash flows
  3. Identification of Cost of Capital – Discounting Rate.
  4. Compute NPV = Discounted Cash Inflows – Discounted Cash Outflows.
  5. Decision – the Project is selected if NPV is positive, else rejected.

 

Notes:

  1. Operating Cash Inflows: these are the inflows that are regularly incurred during the life of the project.
  2. Terminal Cash Inflows: it generally includes salvage value and Residual Working Capital.

Why Discounting is done in NPV? Which is better ARR or PBP or NPV?

Rupee today has more value than the rupee tomorrow. In Payback period and ARR we do not consider this change in the value of Money. This is major limitation of ARR and PBP.

Present Value is not equal to Future Value.

In order to overcome this limitation, we follow NPV method. In this method we take into consideration the change in the value of money. The conversion of Future Values into Present Values is done by discounting. So NPV is more accurate than ARR and PBP.

DECISION MAKING:

CB22.PNG

Profitability Index/Desirability Index/Benefit Cost Ratio – PI

It is a variant of NPV. PI as same parameters as NPV.

NPV = INVESTMENT x (1 – PI)

It is the ratio of Present Value of Operating Cash Inflows to Present Value of Net Investment Cost.

PI = (Present value of operational Cash Inflows)/(Present Value of Net Investment)

PI represents amount obtained at the end of the project life, for every rupee invested in the project. The higher the PI the better the project, since greater return for every rupee invested.

NPV is amount of surplus obtained. PI is what the benefit is for every rupee invested in the project.

NPV does not consider the size disparity and Investment changes in the Project. These Limitations are compensated by PI.

PROCEDURE FOR COMPUTATION OF PROFITABILITY INDEX:

  1. Computation of Cost of Investment – Initial Investment and additional Investment made over the life of the project (after discounting)
  2. Identification of Relevant Cash flows –
    1. Operating Cash flows
    2. Terminal Cash flows
  3. Identification of Cost of Capital – Discounting Rate.
  4. Compute PI = Discounted Cash Inflows ÷ Discounted Cash Outflows.
  5. Decision – the Project is selected if PI is greater than 1, else rejected.

DECISION MAKING:

CB23

Here discounting factor is Weighted Average Cost of Capital.

When NPV > 0, PI will always be greater than 1, as both NPV and PI use same factors.

NPV = A-B and PI = A/B

Where A = Discounted Cash flows after Tax and B = Discounted Cash Outflows.

Which should be preferred – NPV or PI:

NPV gives ranking in absolute terms. PI gives ranking for every rupee invested.

Generally NPV should be preferred since NPV indicates the economic contribution or surplus of the project in absolute terms.

In capital rationing situations, for deciding between mutually exclusive projects, PI is a better evaluation technique.

Internal Rate of Return – IRR

IRR is the rate at which Sum of Discounted Cash inflows is equal to Total Investment. It is the maximum return on Investment.

At IRR, Sum of Discounted Cash Inflows less Sum of Discounted Cash Outflows = 0

As we know, when Sum of Discounted Cash Inflows = Sum of Discounted Cash Outflows, NPV = 0.

And at IRR, Sum of Discounted Cash Inflows = Sum of Discounted Cash Outflows.

So we can conclude that, at IRR, NPV = 0.

IRR is different from Cost of Capital. Differences –

Cost of Capital – Ke[1] Internal Rate of Return – IRR
1.       It is the minimum required on any investment made.

2.       It is related to Financing Aspect – Procurement of Funds.

1.       It is the Maximum Return earned on any Investment.

2.       It is related to Investment Aspect – Utilization or Application of Funds.

The Discount rate i.e. Cost of Capital is assumed to be known in the determination of NPV, while in IRR calculation NPV = 0 and the discount rate which satisfies the condition is determined.

Decision is made by comparing IRR and Cost of Capital.

[1] It is the cost incurred to obtain required capital. It includes Equity Dividend, Preference Dividend, and Interest on debentures and any other cost involved.  Whereas IRR is the maximum return on Investment.

PROCEDURE FOR COMPUTATION OF IRR:

  1. Identify all Cash outflows of the project and the periods in which they are occurred.
  2. Identify all Cash Inflows of the Project and their periods.
  3. Compute NPV at any arbitrary discount rate, say 10%.
  4. Choose another Discount rate in such a way that the desired NPV is Negative, if the other is positive and positive if the other is Negative.
  5. Compute the change in NPV over the two selected discount rates.
  6. On Proportionate basis, compute discount rate at which NPV = 0.

There are several alternatives regarding calculation of IRR, we can discuss them with the help of an example.

Decision Making

CB6

Here Ke = Cost of Capital

Methods for Calculation of IRR under different circumstances:CB7.PNG

IRR AND NPV – WHICH IS SUPERIOR:

At IRR, NPV = 0.

Higher the NPV, higher will be the IRR. However NPV and IRR may give conflicting results in evaluation of different projects.

In that case NPV prevails. NPV is superior to IRR because of the following reasons.

NPV IRR
It represents Surplus from the Project IRR represents a point of No Surplus – No Deficit
Here Cost of Capital is Constant Here NPV is Constant as NPV is taken as Zero. It is a case of Reverse working.
Decision making is easy as a project is selected if NPV > 0 and is rejected if NPV < 0 Here decision making does not depend upon IRR itself. We have to compare IRR with Cost of Capital (Ke) and then decide whether the project is to be selected or not.

i.e. if IRR > Ke – Project is Selected

and if IRR < Ke – Project is rejected

It considers timing difference in cash flows at appropriate discount rate. IRR is greatly affected by volatility in cash flow patterns.
It is presumed that cash flows are reinvested at cut-off rate. It is presumed that cash flows are reinvested at IRR (Maximum return) which is not realistic
It does not have Interpretation problems. That is if cash outflows are at different point of times, then they are just discounted at present value factor. Here there are interpretation problems. Like there may be negative IRRs or multiple IRRs if cash outflows are at different points of time

So all these points helps us understand why NPV is more reliable than IRR.

MODIFIED INTERNAL RATE OF RETURN – PROCEDURE:

  1. Determine Cash Inflows and Cash Outflows during the life of the project.
  2. Calculate Terminal cash flows other than the Initial Investment.
    1. Terminal Cash flows = Amount of Cash flow × Re-Investment Factor
    2. Re – Investment Factor = (1+k)n, n = number of years balance remaining
  3. Inflow = Total Terminal Values

Outflow = Initial Investment

  1. We can calculate MIRR as such that, Inflows × PVAF(MIRR%, n years) = Outflows (same as IRR).

Ranking Conflicts

The difference of opinion among NPV, PI, IRR with respect to project selection is called Disparity.

This disparity arises in Mutually Exclusive Investment proposals.

Reasons for Conflict:CB8

COMPARISON OF TWO OR MORE MUTUALLY EXCLUSIVE PROJECTS WITH DIFFERENT PROJECT DURATION:

Equivalent Annual Flows LCM Method Terminal Value
1.       Cash flows are converted into Equivalent Annual Annuity called EAB or EAC

2.       The amounts are then compared and decisions are taken suitably.

3.       In cost comparison – the project with lower cost is selected

4.       In case of benefit comparison – the project with higher benefits are selected.

1.       This involves evaluation of alternatives over an interval equals to Lowest Common Multiple of the lives of alternatives under consideration.

2.       This is similar to Equivalent Annual Cost/ Benefit Method.

Example – if a proposal A has 3 years of life and Proposal B has 5 years of life, LCM period is 15 years. During which period machine A will be replaced 5 times and machine B will be replaced 3 times. Cash flows are extended to this period and computations are made.  The final results would then be on equal platform – equal years.

It involves estimation of Terminal Values for all the alternatives available at the end of certain period

Example – if the project life is 3 years, then the salvage value at the end of the 3rd year should be considered in the evaluation process.

EQUIVALENT ANNUAL FLOWS METHOD:

  1. Calculate Initial Investment of each alternative
  2. Determine project lives
  3. Identify Annuity factor relating to each project
  4. Equivalent Annual Investment (EAI)= (Initial Investment)/(Relevant Annuity Factor)
  5. Calculate CFAT pa or Cash Outflows pa
  6. Equated Annual Benefit = CFAT pa less EAI
  7. Equated Annual Cost = Cash outflows add EAI
  8. Select the project that gives Maximum EAB or Minimum EAC as the case may be.

Application of EAC/EAB:

CB24

Evaluation of Projects

Any project can be evaluated based on Long Term Point of view or Equity funds point of view.

Particulars Long term Funds Point of View Equity Funds point of View
Investment Funds procured from ESH, PSH, Lenders shall be taken as Initial Investment Funds procured from ESH shall be taken as Investment
Discounting Rate Overall Cost of Capital being used Cost of Equity being the discounting factor
Interest on Debt and Debt Repayment Not considered Considered.

Interest on Debt should be deducted from Cash Flows and repayment of Debt shall be considered as Cash Outflow in the year of repayment

Cash Flows Particulars Amount Particulars Amount
EBIT XXX EBIT XXX
Less: Interest NIL Less: Interest XXX
EBT XXX EBT XXX
Less: Tax XXX Less: Tax XXX
EAT XXX EAT XXX
Add: Depreciation XXX Less: Preference Dividend XXX
CFAT XXX Less: Debt Repayment XXX
  Add: Depreciation XXX
CFAT (earnings available to ESH) XXX

In equity funds approach Principal repayment is deducted from Post Tax profit, whereas Interest is deducted from Before Tax Profit.

Project IRR and Equity IRR

Internal Rate Return is defined as the rate of return at which Present Value of Cash flows are equal to present value of outflows, i.e. NPV = 0.

A project can be funded by Equity and/or Debt.

Calculation of the internal rate of return considering only the project cash flows (excluding the financing cash flows) gives us the project IRR. A project IRR is calculated on Free Cash Flows from the Project.

Calculation of the internal rate of return considering the cash flows net of financing gives us the Equity IRR.  An Equity IRR is calculated on Free Cash Flows of Equity. It represents degree of returns of a project to the providers of Equity Capital.

Equity IRR Project IRR
Cost    =           Equity Share Capital

Cash Flows = Revenue

Less:   Cost

Less:   EAI (Instalment)

Cost =           Equity Share Capital

Debt

Cash Flows = Revenue

Less:   Cost

Interpretation of Results: – Equity IRRCB9

CB10

Replacement Analysis

When existing plants are replaced with new machinery, this analysis is made. It is done to make make or buy decisions.

Block consists of –

Several Assets in the block Only Single Asset in the block
Incremental Investment:

Opening WDV

Add: Purchase Cost

Less: Sale value of Old Asset

Incremental Investment:

Opening WDV

Add: Purchase Cost

Less: Sale value of Old Asset

Depreciation Computation:

Depreciation claimed on closing WDV of the block

Depreciation Computation:

Depreciation claimed on closing WDV of the block

Depreciation in the year of Transfer of the Old Asset

Depreciation will be claimed on the closing WDV of the block

Opening WDV = XXX

(+) Purchases = XXX

(-) Sales           = XXX

Closing WDV   = XXX (for Depreciation purpose)

Depreciation in the year of Transfer of the Old Asset

There will be no depreciation in the year of Transfer.

But Short term Capital Gains or Loss will arise.

STCG/STCL:

Sale Value of Assets      XXX

(-) Book Value of Asset XXX

STCG/STCL                       XXX

Replacement analysis – NPVCB11.PNG

Optimum Replacement Cycle

Sometimes a firm may require certain assets essential for Business. It has to replace these assets on regular basis. It is not economical to continue throughout the life of the life of asset. The repairs and maintenance expenses will increase with the life of the asset.

For the purpose of Cost reduction a firm is required to replace these assets before the useful life of the asset.

The timing of replacement depends on Equated Annual Cost.

Steps involved:

  1. Find out replacement option.
  2. Calculate equated annual cost at different replacement cycles.
  3. The Optimum replacement cycle is found at a point at which the equated annual cost is minimum.

Capital Rationing

Allocation of Capital among Several investment proposals.

It is a tool used to overcome Resource Constraints situation. The basic objective of any firm is to maximize the wealth of the shareholders. Capital Rationing is a handy tool to allocate limited funds among various profitable projects.

When the capital required is more than the Capital available, and then Capital Rationing helps to generate effective returns. The reasons for shortage in money may be internal or external. External issues include Securities issued were not subscribed, as this is not in the control of the organisation.  Internal issues includes Self-imposed conditions by management for example, fixed ceilings on projects, company’s fixed debt equity ratio, where a company cannot borrow more than certain fixed amount.

Capital Rationing gives us the Optimum Combination that is best suited for the organisation.CB12

CB13

Options to Abandon

All kinds of Investment Decisions are generally irreversible in Nature. In case Traditional Investment Decisions, there is no option of Termination.

But during the implementations there may be some Strategic alternative available to conclude the project before its useful life.

The point of time at which project should be terminated is the subject matter.

All the abandoned decisions are evaluated under the following Decision Rules:

  1. Based on NPV
  2. Based on Incremental Analysis

Based on Abandonment option, we can restrict the loss.CB14

Utility Theory

The traditional Capital Budgeting techniques fail to consider the Risk Preferences of the Investor.

The Utility Theory helps the Investor by taking the Risk Preferences of each Investment and provides Reasonable Utility from each Investment Proposal.

The Term Utility refers to Satisfaction derived from different Investment Proposals.

These Utilities will vary from Investment to Investment and from Person to Person.

Inflation

There is change in Price Levels as a result of Inflation.

Effects of Inflation:

1.       Cost of investment No Effect
2.       Operational Cash flows Has an effect
3.       Terminal Cash Flows Has an effect
4.       Cost of Capital Has an effect

Project Appraisal under Inflationary Conditions:

  1. Cost Escalation: Make provisions for cost escalations on all heads of cost, keeping in view the rate of inflation during likely period of delay in project implementation.
  2. Cost of Funds: Sources of Finance should be scrutinized carefully with reference to probable revision in the rate of interest.
  3. Adjustment in Projections: adjustments should be made in Cash Flow projections and profitability to take care of the Inflationary pressures affecting future projections.
  4. Re-evaluation of Financial Viability – the Financial Viability should be examined at the revised rates and should be assessed with reference to economic justification of the project.
  5. Choice of Projects: In Inflationary projects, Projects with early payback period should be selected.

APPROACHES:

Adjustment of Cash Flows Adjustment of Cut-Off Rate
Projected Cash flows should be adjusted to an Inflation Index, recognizing Selling Price increases and Cost Increases annually “Acceptance Rate” should be adjusted for Inflation, retaining cash flow projections at current price levels.
  1. Money Cash Flows:

These are the cash flows that are estimated based on Purchasing power of Respective years. These cash flows include the effect of inflation. Money cash flows are also known as Nominal Cash Flows.

Y0 Y1 (Inflation effect)
100 110
  1. Real Cash Flows:

Cash flows that are estimated based on current year purchasing power. They do not include effect of inflation.

Y0 Y1 (No Inflation effect)
100 100
  1. Money Discounted Rate:

The discounting rate adjusted after considering inflation effect.

  1. Real Discount Rate:

The discounting rate not adjusted against the effect of Inflation.

Relationship between MCF and RCF:CB16

MCF x MDR = PV of Discounted Cash Flows

(Or)

MCF x Inflation Rate = RCF

RCF x RDR = Pv of Discounted Cash Flows

Inter Relation:

(1+MDR)=(1+RDR)×(1+IFR)

(MDR) = expected return with Inflation

(RDR) = Due to change in quality

(IFR)  = Due to change in Money Price

Derived Equations:

  1. (RDR) = [(1+MDR)/(1+IFR)]-1
  2. (IFR) = [(1+MDR)/(1+IFR)]-1

The rate of Inflation differs for Inflows and Outflows.

During inflation period, the revenues and expenses will increase in line with the inflation. But Depreciation on assets will be provided on Historical Cost – Not affected by Inflation.

The tax savings on Inflation will remain same, irrespective of effect of Inflation.

Risk Analysis in Capital Budgeting

Risk is generally regarded as a boundary to outcomes.

The term Risk with reference to Capital Budgeting can be defined as the difference between actual cash flows and expected cash flows from the investment.

It is a financial loss that can be sustained as a result of change in environmental conditions.

CB17

RISK ADJUSTING TOOLS:

TRADITIONAL TOOLS MODERN TOOLS
1.       Risk adjusted discount rate

2.       Certainty equivalent factor

3.       Project BEP

4.       Sensitivity analysis

5.       Scenario Analysis

1.       Probability distribution

2.       Standard deviation

3.       Decision trees

4.       Simulation

Traditional Tools

Risk Adjusted Discount Rate – RADR

Expected return changes with risk level for different Investments.

Business is all about taking the risk and earning returns. Higher the risk involved in the business, higher will be the return from the business.

The discount rate used for Investment Evaluation is the expected return from the project.

All projects do not have same risk characteristics, so same discount rate should not be used.

The discount rate should be adjusted against Risk Involved in the project. The adjusted discount rate is known as Risk adjusted discount rate.

Risk Premium Model:

It includes:

  • Risk Free Rate of Return – Minimum rate of return that is expected of any other investment alternative. If a project with risk is going to yield a return lower than risk free return, then the said project should not be undertaken.
  • Risk Premium – additional return expected from a risky investment. It consists of –
    • Firm’s Normal Risk (RN) – this is an adjustment for Firm’s Normal Risk.
    • Project’s Risk (RP) – this is adjustment for differential risk for a project.CB25

LIMITATIONS:

  1. It is difficult to estimate risk premium associated with a project consistently
  2. Risk Adjustment is estimated on ad hoc, unscientific and naïve basis
  3. This method assumes that risk increases with time at a constant rate, which may not be valid.

Certainty Equivalent Factor

Certainty Equivalent approach recognizes risk in Capital budgeting analysis, by adjusting estimated cash flows and employs risk free rate to discount the adjusted cash flows.

Future cash flows are Uncertain Cash flows.

Under this approach all the future expected cash flows are converted into risk less amounts by applying CE factor.CB26

Difference between Certainty Equivalent Approach and Risk Adjusted Discount Rate:

Point Certainty Equivalent Approach Risk Adjusted Discount Rate
Factor Used Here Cash Flows are adjusted Here Discount Rate is adjusted
Time effect Cash flows are adjusted for risk overtime under this method This method assumes that risk increases with time and at Constant Rate
Ease It is difficult to specify series of CEFs It is comparatively easier to adjust Discount Rate
Accuracy This is superior to Risk Adjusted Discount Rate approach, as it can measure risk more accurately Cash flows are more uncertain than the cost of capital. Risk is adjusted only in the Discount Rates, and is not recognised in the Cash Flows

Sensitivity Analysis

NPV is computed based on set of critical factors such as Initial Investment, Selling Price per unit, Volume, Operating Expenses, Discounting Rate, etc.

If any one of these factors changes, NPV will also be affected. Sensitivity Analysis measures this change.

SA is a tool to forecast the impact of various factors on the original computed NPV and this approach the Behavioural Change of each Variable will be computed in Advance.

Steps involved:

  1. Compute NPV based on Original Data
  2. Identify Critical Factors that would affect NPV
  3. Compute % change in each variable that leads to NPV as Zero
  4. Identify the most Sensitivity Variable.

 

Scenario Analysis

Meaning –

  1. It is the Analysis of the NPV or IRR of a Project under a Series of Specific Scenarios, based on Macro-Economics, Industry and Firm Specific factors
  2. This Analysis seeks to establish “Worst Case” and “Best Case” scenarios, so that the whole range of possible outcomes can be considered

Steps involved in Scenario Analysis are –

  1. Identify various sources of Uncertainty for the future success of the Project. These are the basic factors around which scenarios will be built
  2. Determine the Scenarios for each factor à Best Case, Average or Most Likely or Worst Case
  3. Estimate the values for each of the variables in the Investment Analysis (Revenue, Growth, Operating Margin, etc) under each scenario
  4. Assign probability of occurrence for each of the scenarios, based on Macro and Micro Factors
  5. Compute NPV and IRR under each Scenario
  6. Arrive at the appropriate decision on the project, based on the NPV under all scenarios, rather just Base Case NPV or Mean NPV

Advantages –

  1. This Analysis brings in the probabilities of changes in key variables
  2. This Analysis helps the Analyst to change more than one variable at a time

Limitations –

  1. There are No clearly delineated scenario in many cases
  2. If there are many important variables to consider, there may give rise to huge number of Scenarios for analysis
  3. There is no clear guiding principle to indicate how the decision maker will use results of Scenario Analysis

Modern Tools

Probability Distribution

  • Probability – the chance of occurrence or non-occurrence of an event is denoted by Probability. If an event is certain to be happen its probability is “1”. In such a case the chance for Non-occurrence is “Zero”. The probability for given event lies between “0-1”.
  • Probability Distribution – An estimate leads to Several Outcomes, the chance of occurrence of each outcome being assigned with probabilities. The series of outcomes and their probabilities is known as Probability Distribution.
  • Expected Value or Mean Value – It is simply Weighted Average of all the Outcomes multiplied by their respective probabilities.

Standard Deviation

The project cash flows are mere estimates. There would be difference between actual Cash flows and expected cash flows. Such difference or variability is known as Risk of the Project.

The Risk of the project can be studied with a statistical tool known as Standard Deviation.

SD is a standardized unit of measure to find out difference in cash flows from the mean value. It is denoted by σ.

Steps involved:

CB27

Higher the Standard Deviation, Higher will be Risk involved in the Project.

Coefficient of Variance or Risk Reward Ratio:

It is used to overcome limitation of Standard Deviation.  It is a relative measure for measuring risk. It is also known as Risk Reward Ratio.

Hiller Model:

Project Cash flows are estimated based on Information available at the time of evaluation.

The cash flows of the project may have some inter relationship.

The Interrelationship of project cash flows will be studied in the following manner:

  • Dependent Cash flows
  • Independent Cash flows

Dependent Cash Flows:

Cash flows of a particular year will have an effect on cash flows from following years. In such a case cash flows will have Perfectly Dependent Correlation.

The raise of NPV is calculated as follows:

  1. Compute Standard Deviation for each year Cash Flows.
  2. Discount the Standard Deviation of Cash Flows with Risk Free Rate of Return (as risk already eliminated)
  3. Standard Deviation of NPV is sum of Discounted Standard Deviation of each year Cash flows
  4. CB29

Independent Cash Flows:

Cash flows are said to be Independent if the Cash Flow of a particular year does not affect cash flows of the following years.

Independent Cash flows are also known as Uncorrected Cash Flows (No Relation)

The risk of NPV with respect to Independent Cash Flows is computed as under: Variance Model

  1. Compute Variance of Cash Flows for all the years.
  2. Double Discount CB30Variance of Cash flows with Risk Free Rate
  3. The sum of Discounted Variance of Cash flows for all the years.
  4. Variance of NPV (Risk of NPV) CB31

CB18

In the absence of information CF are assumed to be Independent in nature.

Normal Distribution Curve and Application of Probability:

  1. Compute the value of Z using the following formula CB33

Where, X = Desired NPV/Desired Value

CB32 = Originally estimated NPV

  1. If in Step 1 value is negative it means that the value of ‘Z’ falls in the left tail of Normal Distribution Curve.
  2. If it (Z) is positive, it means that Z falls on the right tail of the Normal Distribution Curve.
  3. Compute Table Value Corresponding to Z Value
  4. Find out probability for the event
    1. Tail – Right or Left
    2. Requirement </>
    3. Action – Add/Less 0.5 from Z value
      Tail Requirement Action
      Right Tail > Deduct value Z from 0.5
      Right Tail < Add Value of Z to 0.5
      Left Tail > Add 0.5 to value of Z
      Right Tail < Less 0.5 from Value of Z

Joint Probability and Expected NPV:

If the probability distribution of a particular project is not perfectly depended on cash flows of earlier years, the risk of NPV and expected NPV will be computed in the following manner:

Expected NPV:

  1. Identify Investment Alternatives(project outcome)
  2. Compute Joint Probability for each alternative P(XUY)
  3. Compute NPV for each alternative
  4. Expected NPV = the sum of [bxc]

Risk of NPV:

  1. Compute Deviation of NPV (Exp NPV at each alternative – NPV) = CB34
  2. Square the deviation of NPV for each alternative CB35
  3. Multiply Squared Deviations with Joint Probability with each alternative – CB36
  4. The sum of “c” will be variance of NPV for all alternatives – CB37
  5. CB38

Decision Trees

The decision maker has to identify various investment alternatives before making a decision. Sometimes an investment leads to further investment in future periods.

The interconnection between various investments should be carefully studied for better Investment Evaluation.

A decision Tree is a graphical tool used to present complex investment Decisions. It provides complete picture about the future investment in each stage of investment and its consequences and impact in an effective manner

Construction of Decision Tree:

Decision Nodes are denoted by Squares – Rect

Chance Nodes are denoted by Circles – circle

  1. All the Investment alternatives starting from Decision Points. These are represented by Chance Nodes.
  2. Assign Probabilities to each Chance Node
  3. All the Decision Nodes and Chance Nodes should be Serially Numbered.

Evaluation of Decision Tree:

All decision Trees are drawn from Left to Right. But its evaluation starts from right to left.

  1. Expected Monetary Value at Chance Node – EMV:

It is aggregate value of all branches starting from the chance node

  1. Expected Monetary Value at Decision Node:

It is Highest Expected Value of various Chance Nodes starting from Decision Point.

 


 

Simulation

It is a Mathematical Model that represents Decision Making under the conditions of Uncertainty. It involves a series of Prediction over the number of Variables involved in the Decision. It is also based on the concept of Probability.

Simulation is a tool used for Decision Making and it provides Trial and Error approach for Optimum Solution.

Project Planning

Brief Notes on Feasibility Study and Project Report

Feasibility Study

A feasibility study is an analysis of how successfully a project can be completed, accounting for factors that affect it such as economic, technological, legal and scheduling factors. Project managers use feasibility studies to determine potential positive and negative outcomes of a project before investing a considerable amount of time and money into it.

A Feasibility Study is an Evaluation of a Project – How Successfully a project can be completed, what are the factors affecting the Project such as Economical, Technological, Legal and Scheduling Factors. Feasibility studies are done to determine the Positive and Negative outcomes of the project before investing considerable time and money into the project. It is a layout of the business/products/services to be offered and how they will be delivered.

A project will be evaluated based on different criteria. Types of Feasibilities evaluated for a project:

  1. Market Feasibility
  2. Technical Feasibility
  3. Financial Feasibility
  4. Organizational Feasibility

Market Feasibility

Market Feasibility describes the Industry. What the product has to face if introduced to the Market.

In case if a new product is introduced into the market for the first time, the success of the product depends upon the marketing (advertising) of the product. That is it should be conveyed in such a way so that the product becomes familiar to the people.

Market adaption plays a major role in success of the product.

So it is clear that Market Feasibility Study becomes important indicator before launching a new product or existing product in the new market.

For an Existing Product, Market Feasibility consists of –

  1. Demand Estimation
    1. End User Profile – Classification of Customers, Market Segments, etc.
    2. Study of Influencing Factors – Whether Direct or Derived Demand for a Product
    3. Market Potential – Evaluation of Regional, National and Exports Markets etc.
    4. Infrastructure Facilities facilitating or Continuing Demand
    5. Demand Forecasting
  2. Supply Estimation depends on
    1. Past Trends
    2. Projects Undertaken in the Economy
    3. Government Licensing Policy
    4. Availability of required Input
    5. Import Possibility
  3. Identification of Critical Success Factors

Some Examples of Critical Success Factors are – Availability of Raw Materials, Supply, Cost of Power, Transportation Facilities, etc. They are Product and Region Specific

Some CSF are subject to Volatile changes that will have its impact on Net Profitability

  1. Estimation of Demand-Supply Gap

A Multiple Point Forecast gives the most adverse, most likely and most favourable forecast of Demand and Supply

Technical Feasibility

Technical Feasibility describes the details on how a good or Service will be delivered, this includes transportation, business location, technology needed, materials and labor.

It also varies with size and complexity of the project. Commercial viability of the technology is also to be evaluated.

It Includes:

  1. Plant Location – Site Access, Risk involved (whether it is Earthquake prone Zone, drought prone Zone, etc.), etc.
  2. Resources Availability – Raw Material Availability – in Quality and Quantity, Vendor Capabilities, Power availability, Water availability, etc.
  3. Technology – Proposed Technology to be compared with any other alternative Technologies available in the Market, Availability of Labour for the selected Technology, Ease of Absorption, etc.
  4. Plant and Machinery – Installation Aspects – Technical Specifications, Plant Design and Layout, Availability of P&M suppliers in case of Downtime, etc.
  5. Production Aspects – Product Mix, Production Bottlenecks, Process Losses and Possibilities to reduce those Losses, etc.
  6. Control Aspects – Possibilities of Future Manufacturing or Operating Cost Reduction, Technical Obsolescence Possibilities etc.
  7. Back up Plans – Disaster Recovery Plans, Possibility of continuing Operations in case of any Disaster, Safety Standards, etc.

Financial Feasibility

Financial Feasibility is a projection of amount of Funding or Startup Capital Required, sources of capital that can be utilized and the returns that can be expected on the Project Investment.

Market Feasibility Study – Demand and Price Estimates are determined

Technical Feasibility Study – Project Costs along with the operating costs are determined

Financial Feasibility Study – requires detailed financial analysis.

The estimates have to be made from prevailing tax laws point of view and costs involved in various financial alternatives available.

Analysis of –

  1. Projections for Prices of Products, Cost of Resources. The Actual Data of comparable projects are included in the Estimates
  2. Period of Estimation – Determined on the basis of Product Life Cycle
  3. Financing Alternatives are to be considered
  4. Interest and Repayment Schedules, Working Capital Schedules, Depreciation Schedules are to be done
  5. Financial Statements are to be prepared

Organizational Feasibility Study

This includes a definition of corporate and legal structure of business. This includes information about founders and their educational backgrounds and their ability to keep the project alive.

Risk Assessment

A Systematic Process of evaluating the potential risks involved in the proposed project. Evolution of risk is necessary through the adoption of various analysis.

Contents of Project Report

Project Report consists of the following aspects:

  1. Promoters and their qualifications and their experiences.
  2. Market environment should be analyzed and consider whether it is suitable for the said project.
  3. Demand and Supply position of particular type of Product under consideration, competitors share of the market and their marketing strategies. Consumer Preferences.
  4. Working Capital requirements, cost of Plant and Machinery, Labor Cost, Cost of Power, Cost of Land, Development Cost and Operating Cost should be included.
  5. Preliminary Expenses are also to be evaluated to determine the Cost of the Project.
  6. Availability of Raw Materials and reliability on the suppliers and alternate backups in case there is shortage of supply are to be provided.
  7. Technical Know-how, Plant layout, production process, installed and operating capacity of the plant and machinery.
  8. Estimation of Production Costs, Tax Liability, Working Capital Requirements, and Return on Investment are to be evaluated.
  9. SWOT Analysis needed to be done carefully – Study of Strengths, Weakness, Opportunities and Threats of the said Project.
  10. Project Implementation Schedule includes Date of Commencement, Trail Runs, duration of project, time over runs and date of completion of project should be given.

Post Completion Audit

Audit is defined as an Examination of Documents and to verify whether the result is as desired

Post Completion Audit is an attempt at assessing the actual Profile of a given project in terms of results with the intended profile

It is a Part of Internal Audit

When properly carried out, it can help in Continuous Improvement of the Project.

It is performed by Independent Third Parties who have adequate knowledge in different areas

Benefits of PCA –

  1. Identifying Lessons to be learned in Future
  2. Identifying Problems and appropriate Solutions so that corrective action may be taken
  3. Exerting Discipline in the Investment Planning and Control Process

Information required for the Audit comes from three main Sources –

  1. Written Reports and Other Documentations
  2. Various Statistics generated when the Project is underway
  3. Interviews with Project Managers and other Project participants

Post-completion audits play an important role in organisational learning. They also provide a useful basis for control. By investigating each phase of the investment process, using information gleaned from different sources, it is possible to identify what went well and what did not go according to plan. However, post-completion audits can be costly, so many businesses adopt a selective approach to their implementation. There are problems and limitations associated with their use and senior management must be aware of these

Social Cost Benefit Analysis (SCBA)

  1. As we have scarce resources in the society, and as they are used in the projects, Social impact of such projects should be evaluated.
  2. SCBA is an approach for evaluation of merits of a Projects or course of action in a systematic and rigorous way. The objective is to establish the Net Social Benefit of the Project.
  3. This refers to moral responsibility of the Public and Private Sector Enterprises to undertake socially desirable projects. Social Contribution must be kept in view. SCBA sometimes changes the very outlook of a project as it brings elements of study which are unconventional yet very relevant. Every enterprise have moral responsibility to use scarce natural resources in the best interests of the people.
  4. In simpler terms, CBA evaluates Costs “C” and Benefits “B” for the project under consideration and proceed with it if and only if benefits match or exceed costs.
  5. Large Public Sector/Service projects especially in Underdeveloped Countries which would get rejected under simple commercial considerations will find justification if social costs and benefits is considered.

Limitations:

  1. Successful application of SCBA depends upon reasonable accuracy and dependability of underlying forecasts as well as assessment of Intangibles.
  2. Technique does not indicate that, whether the same resources employed in another project would yield better results than this project.
  3. Cost of evaluation by such technique would be enormous for small projects.
  4. SCBA does not consider the costs and benefits which cannot be quantified like, satisfaction, better quality of life, happiness etc.

Lease Financing

What is Lease?

Leasing is a Financial arrangement, under which owner of the asset (Lessor) allows the user of the asset (Lessee) to use the asset for a Specified Period of Time (Lease Term) for periodic Consideration (Lease Rent).

It is a contract where one party purchases the asset and permits its use by another party over a specified period of time. It is an alternative to purchase an asset.

  1. Leases are the legal and binding contracts that set forth the terms of rental agreements in real estate.
  2. If a person wishes to rent an apartment or other residential property, for example, the lease prepared by the landlord describes the monthly rent amount, when it is due each month, what happens if the lessee fails to pay his rent, how much of a security deposit is required, the duration of the lease, whether the lessee is allowed to keep pets on the premises, how many occupants can live in the unit and any other essential information.
  3. The landlord requires the tenant to sign the lease, thereby agreeing to its terms before occupying the property.

Parties involved in Leasing:

Lessor:  He is the real owner of the asset and gives permission to use the asset to another party. As a result of this, Lessor receives Lease Rent, which is taxable in the hands of Lessor.

Lessee: He avails the benefit of usage of Machine, though he is not the real owner of the asset. He pays Lease Rent for the usage of asset.

Classification of Leasing

Financial Lease

Finance Lease is an arrangement to Finance the use of equipment to for major part of its useful life. It is a Loan in disguise, so it is also called as Capital Lease.

It has longer term as it includes major life of the asset. Lessor is only the Legal Owner, all the risks and rewards incident to ownership are passed on to Lessee. Lessee also bears the Risk of Obsolescence (Depreciation).

This agreement cannot be cancelled by either party. Lessor does not bear the cost of repairs, maintenance etc.  He only acts as Financier. The Lease is usually Full Pay out.  Single Lease repays Cost of Asset and Interest.

Variants of Finance Lease:

  1. Lease with Purchase Option – Lessee has the right to purchase the Leased Assets after the expiry of Initial Lease period at an agreed price
  2. Lease with Lessee having Residual Benefits – Lessee has the right to share the sale proceeds of the asset after the expiry of Initial Lease Period and/or to renew the lease agreement at a lower rate.

Operating Lease

If the Lease does not secure for the Lessor the recovery of Capital Outlay plus a return on the funds invested, during the lease term. The Term of Operating Lease is shorter than that of Asset’s Useful Life.

Risk Incident to Ownership wholly belongs to Lessor. Depreciation is borne by Lessor.

The Lease can be cancellable by Lessor.

Lessor bears the Cost of Repairs pertaining to asset as lease is only for shorter period.

The Lease is usually Non Pay out, as lessor expects to lease the asset again and again.

Difference between Operating Lease and Financial Lease

Operating Lease Financial Lease
Lessor allows lessee to use the Asset for a term smaller than the Useful Economic Life of Asset Lessor allows lessee to use the Asset for maximum part of term of Useful life of Asset
Risk incident to Ownership remains  with lessor Lessor is only the Legal Owner

Risk associated with Ownership are transferred to Lessee

All Risks are borne by Lessor All Risks are borne by Lessee
Lease Agreement is Cancellable by Lessor Lease Agreement is Non-Cancellable by either parties
Lessor bears all costs associated with the Asset Lessor only acts as a Financier

He does not bear any Costs

Advantages and Disadvantages in a Lease Proposal to Lessor and Lessee:

Lessor

Lessee

Advantages Advantages
1.       Full Security – As Lessor is the real owner and can take repossession of the asset, his interest is fully secured

2.       Tax Benefits – As Lessor is the owner of the asset, he can also claim Depreciation. (Depreciation for Leased Assets is generally high), as a result Tax Benefit

3.       High Profits – Due to Higher Depreciation rate, there is quicker capital recovery.

4.       Trading on Equity – Lessor have low equity and they run their business on borrowed funds. Thus they carry out their operations with High Financial Leverage, results in High ROE

1.       100% Financing – Lease financing may be available upto 100% of Asset Cost

2.       No Dilution of Ownership

3.       Less Risk – Lessee has the option to opt for a lease proposal with latest technology.

4.       No Loss of Control – there are less documentation process is required in Leasing as compared to Institutional Financing.

5.       Tax Benefits – Benefits may accrue to Lessee based on suitable scheming of Lease Rentals

6.       Small Value Assets – Debt Financing in case of Small Value assets seems impracticable

7.       Eligibility to Borrow: The use of Leased Assets may not affect the borrowing capacity of the Lessee, as Lease Payment may not require normal lines of credit and are payable from income during the Operating period

Disadvantages Disadvantages
1.       High Payout – A Financial Lease may entail a higher pay out obligation, if the equipment is not found useful subsequently, and the Lessee opts for premature termination of the Lease arrangement

2.       Cost – In case of default by Lessee, it might leads to heavy damage to Lessor

1.       Restrictions on Use – Lessor imposes restrictions on use, as he is the owner

2.       No Ownership – as lessee is not the real owner, he is deprived of the residual value of the asset

3.       High Cost – On comparison, Lease Financing has higher interest than that of Term Loans

4.       No Moratorium – Lease Rentals are payable as soon as the leasing agreement is made, so there are cash outflows at the beginning itself. In case of New Projects, it may not be suitable.

5.       Understatement of Lessee’s Assets – Leased Assets do not appear in Lessee’s Balance Sheet. Even though he uses the assets, he cannot claim as the owner of the asset and cannot show in his Balance Sheet

6.       Double Sales Tax – Sales Tax in imposed by different states as a result of Lease Transactions. Here it results in double Taxation. As Lessor already paid Sales Tax at the time of Purchase of Asset.

7.       Default by Lessor – if Lessor bought the asset by taking credit, then on failure to pay any instalments, may results in seizure of the asset by the bank, causing loss to the Lessee.

Difference between Leasing and Hire Purchase

Leasing Hire Purchase
Ownership lies with lessor

Lessee only has the right to use the asset

Lessor is owner till the end of Agreement

Hirer has the option to purchase

Hirer becomes owner after payment of Last Instalment

Depreciation is claimed by Lessor Depreciation is allowed to Hirer
Lease Rentals covers Cost of Usage of Asset Hire Purchase Instalments involves Principal as well as Interest
Lease agreements are done for longer duration and on bigger assets Hire Purchase agreements are done mostly for shorter duration and cheaper assets
For Lessee, Lease Rentals are shown as Expense For Hirer, Only Interest  is shown as Expense
Complete Financing

No Down payments

Partial Financing

There is around 20-30% Down Payment

Evaluation of Lease Proposal

Lease2.PNG

Evaluation of Lease Proposal – Lessor point of view:

In case of Lessor it is an Investment Decision. That is if the Lease Proposal is beneficial then he will lease the asset.

Evaluation of Lease Proposal Using NPV Method:

1.       Computation of Cost of Asset

2.       Identification of Relevant Cash flows –

a.       Operating Cash flows (Lease Rentals)

b.      Terminal Cash flows

3.       Identification of Cost of Capital – Discounting Rate.

4.       Compute NPV = Discounted Cash Inflows – Discounted Cash Outflows.

5.       Decision – the Project is selected if NPV is positive, else rejected.

Evaluation of Lease Proposal Using IRR Method:

1.       Identify all Cash outflows of the project and the periods in which they are occurred.

2.       Identify all Cash Inflows of the Project and their periods.

3.       Compute NPV at any arbitrary discount rate, say 10%.

4.       Choose another Discount rate in such a way that the desired NPV is Negative, if the other is positive and positive if the other is Negative.

5.       Compute the change in NPV over the two selected discount rates.

On Proportionate basis, compute discount rate at which NPV = 0

Bower-Herringer-Williamson Method (BHW):

Here payment streams are divided into two parts – Cash flows associated with Financing and Cash Flows Associated with Tax Savings

Financial aspect : PV of Debt (-) PV of Lease Payments

Tax Aspect : Corporate Tax Benefit between Debt and Leasing alternatives, discounted at an appropriate Cost of Capital

Net Effect :  Net effect of above two aspects is advantage, accept the proposal

Rate of Discount being the Gross Cost of Debt Capital

Problems faced with IRR:

  1. Different Project Lives – IRR cannot be used to choose between alternative Leases which have different lives
  2. Tax Effect – If firms do not pay tax or pay tax at constant rate, then IRR should be calculated from Lease Cash Flows and compared with after tax rate of interest
  3. Inconsistency of Risk – in cases of Lease, the Lease Payments are fairly riskless and Interest rate should reflect this. The salvage value for the asset however is much riskier. Two different discount rates are required for these cash flows. IRR only gives one rate and thus each cash flow is not implicitly discounted to reflect its risk

Multiple Roots (Rate of Returns) – in case of Leasing, the lessee will have immediate cash inflow, a series of cash out flows and a inflow at the end of the period. With changes in cash flow there may be two solutions for IRR

Evaluation of Lease Proposal – Lessee point of View:

Cash Basis:
Particulars Amount
Cost of the Asset

Less:     Present Value of Tax Savings on Depreciation

Present Value of Cash Outflows

XXX

(XXX)

XXX

Borrow and Purchase
  1. Calculate EAI – Equated Annual InstalmentL1

Where,  r is IRR

2. Prepare Loan Amortization Table – Segregation of Interest and Principle components

3. Calculate Depreciation on Asset

4. Tax Savings on Depreciation and Interest

5. Net Cash Outflows – (1) – (4)

6. Calculate Present Value of Cash Outflows

Lease Options
Particulars Amount
Lease Rent

Less:      Tax Savings on Lease Rent

XXX

(XXX)

XXX

XX

XXX

Net Lease Rent

PVAF(r%, n years)

PV of Lease Rentals

An Option with Lower Cash Outflow will be preferred for Financing

Discounting Factor

POST TAX COST OF DEBT WEIGHTED AVERAGE COST OF CAPITAL
Pre-tax Cost of Debt (r %)

Less: Tax (t %)

Post Tax Cost of Debt (r (1-t) %)

1.       If asset is funded by equity, then Discounting Factor will be Cost of Equity

2.       If the asset is funded by combination of Debt and Equity, then Discounting Factor will be WACC.

Notes:

  1. Annual Operating Costs will be incurred whether or not the asset Is purchased or rented. So it is a common cost and is not relevant for present decision.
  2. Lease Rents can be paid at beginning of the year or at the end of the year. In that case while calculating PV Factors, this point is to be noted.

Lease3.PNG

Different Methods of Structuring Lease Rentals

  1. Equal Annual Plan – Lease Rentals are charged equally throughout the period of Lease
  2. Differed Lease Rentals – Lease Rentals are paid after an agreed initial time, generally it is paid as and when funds are generated from the operations of Lease
  3. Stepped up Lease Rentals – Constant rate of increase in the amount of Lease Rentals charged throughout the period of Lease
  4. Balloon Lease Rentals – Initial Lease Rentals are low and are increased as the Cash Flows generated by Lessee are increased.

Evaluation of Hire Purchase Transactions

  1. Find out the Hire Purchase instalments to be paid
  2. Find out the Interest amounts included in each Instalments. Interest is the difference between Total Consideration paid and Cash Down Price
  1. Calculate Depreciation on Asset
    1. As per Income Tax Act, Hirer is entitles to claim Depreciation on an Asset
  2. Calculate Tax Savings on Interest and Depreciation
  3. Net Cash Flows under Hire Purchase Transaction – (1)-(4)

Sale and Lease Back

Asset is not physically exchanged but is exchanged entirely through Book Entries.

Owner of the Asset sells the asset to a party and that party leases the same asset to the owner who initially sold the asset.

In this transaction, Seller becomes Lessee and Buyer becomes Lessor.

Example – A has a machine. He sells it to B for Selling Price. B in turn Leases it back to A for Lease Rentals.

A – Seller becomes Lessee – he gets Sale Proceeds and pays Lease Rentals

B – Buyer becomes Lessor – Pays Sale Proceeds and gets Lease Rentals.

The main advantage is that the Lessee can satisfy himself completely regarding the quality of the machine.

Sales-Aid Lease

Lessor enters in to a contract with manufacturer, to market the products of manufacturer through his own leasing operations. This is called Sales-Aid Lease.

In this case, Lessor gets commission from manufacturer and also Lease Rentals from Lessee, he gets inflows from two ways.

Leverage Lease

Here, Lessors borrows part of the amount from Lenders (Banks/ Financial Institutions) and purchase the asset and leases it to the Lessee. Here Lender is give Senior Secured Interest on the Asset and assignment of Lease and Lease Payments.

The transaction is routed through Trustee who looks after the interest of the Lessor and the lender. The trustee receives the rentals from Lessee and passes on to the Lender, and any surplus left goes to the Lessor.

Lessor can claim depreciation and tax benefits thereon.

Cross Border Leasing

Lessor and Lessee are situated in different countries.

It is considered as an alternative to Equipment Loans to Foreign Buyers.

In Case of Two Countries CBL – Lessor and Lessee are from different countries

In case of Three Countries CBL – Lessor, Lessee, Manufacturer are from three different countries

In case of Four Countries CBL – Lessee, Lessor, Manufacturer and Fourth Nation providing Debt are from different countries.

Advantages:

  1. Credit availability – Funding for longer period and at fixed rate may not be available at Lessee’s country can be obtained internationally, through CBL.
  2. Assets Choice – Choice of Assets for CBL is different than Domestic Lease, because those assets may find attractive bargain which are internationally mobile, have adequate Residual Value and enjoy undisputed title.
  3. Tax Savings – CBL is widely used to arbitrage the difference in tax laws of different countries, thus leading to tax avoidance and tax shelters
  4. Sale and Lease Back – Original owner of the asset is not subject to taxation in any country, so he need not claim depreciation, CBL involves selling such asset to an investor in such country and long leasing it back to the owner.
  5. Infrastructure – In developing countries, CBL is used as a means of financing infrastructure development
  6. Lower Cost – CBL reduces the overall cost of financing, particularly if Tax Savings are available to the Lessor, are passed through to Lessee as a lower cost of Finance.
  7. Security – Lessor is often able to utilize Non-Recourse Debt to finance a substantial portion of equipment cost.
  8. Accounting Treatment – sometimes, Lessor can utilize very favourable “Leveraged Lease” Financial Accounting treatment
  9. Repossession – In some countries, it is easier for a Lessor to repossess the leased equipment following a Lessee default because the Lessor is an Owner and not a mere Secured Lender.
  10. Defeasing and Currency Management – Appropriate Currency Requirements can be met easily to match the Specific Cash Flow needs of Lessee.

Concept of Breakeven Lease Rental

  1. From Lessee’s perspective
    1. Maximum Lease Rent the Lessee would be willing to pay
    2. If BELR
    3. At BELR, Lessee is indifferent between borrowing and leasing the asset
  2. From Lessor’s perspective:
    1. Minimum Lease Rental accepted by Lessor
    2. If BELR>Actual Lease Rent, the lessor should not accept the Lease proposal
    3. At BELR, net advantage of Leasing from Lessors viewpoint will be Zero

Money Market Operations

MMI

 

Contents

What is Money Market?. 3

Market Participants. 3

Short term Financial Asset. 3

Call Money Market or Inter-Bank Call Money Market. 3

Characteristics of the Money Market. 4

Difference between Capital Market and Money Market. 4

Pre-Conditions for having an Efficient Money Market. 5

Features of an Efficient Money Market. 6

The Features of Money Market in India. 7

  1. Availability of credit instruments: Till 1985-86, the India money market did not had adequate short-term paper instruments. Apart from the call money market, there was only the Treasury bill market. At the same time, there were no specialist dealers and brokers dealing in different segments of the Indian money market and in different kinds of paper instruments. It is only after 1985-86 that RBI started introducing new paper instruments such as 182 days treasury bills, later converted to 364 days treasury bills, certificates of deposits (CDs) and commercial paper (CPs). 7

Rigidities in Indian Money Market. 8

Short Notes on Vaghul Group Report in the context of Indian Money Market. 8

Participants of Money Market in India. 9

Organised Segment. 10

Unorganised Segment. 10

Evolution of Instruments. 10

Call Money/Notice Money. 11

Inter-Bank Term Money. 12

Inter Bank Participation Certificate. 12

Inter Corporate Deposits [ICDs]. 12

Treasury Bills (T-Bills or TBs). 13

Commercial Bills. 14

Bills Discounting. 15

Bills Re-Discounting. 15

Certificate of Deposits. 16

Commercial Paper. 17

Difference between Commercial Paper and Commercial Bill 19

Debt Securitisation. 19

Repo and Reverse Repo Transactions. 21

Illustrations. 22

Amount to be invested in Certificate of Deposits. 22

Commercial Paper – Net Receipt by Issuer. 22

Commercial Paper – Effective Interest Rate. 22

Issue Price of T-Bill 23

Repo and Reverse Repo. 24

Current Price of Bond, Bond Equivalent Yield. 24

 

 

What is Money Market?

A Financial Instrument with High liquidity and very short maturities are traded.

It is used as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year.

Among the most common money market instruments are euro-dollar deposits, negotiable certificates of deposit (CDs), bankers’ acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

Money market transactions are wholesale, meaning that they are for large denominations and take place between financial institutions and companies rather than individuals. Money market funds offer individuals the opportunity to invest smaller amounts in these assets.

Market Participants

Institutions that participate in the money market include banks that lend to one another and to large companies in the eurocurrency and time deposit markets; companies that raise money by selling commercial paper into the market, which can be bought by other companies or funds; and investors who purchase bank CDs as a safe place to park money in the short term.

The U.S. government issues Treasury bills in the money market, and the bills have maturities that range from a few days to one year. Only primary dealers can buy them directly from the government; dealers trade them between themselves and sell retail amounts to individual investors. State, county and municipal governments also issue short term notes.

Commercial paper is a popular borrowing mechanism because it is exempt from SEC registration requirements. It’s attractive to corporate investors because rates are higher than for bank time deposits or Treasury bills, and a range of maturities is available, from overnight to 270 days. However, the risk of default is significantly higher for commercial paper than for bank or government instruments.

Short term Financial Asset

It may be construed as any Financial Asset which can be quickly converted into Money with minimum transaction cost within one year, and are termed as close substitute for money or near money

Call Money Market or Inter-Bank Call Money Market

A Segment of the money market, where Scheduled Commercial Banks lend or borrow on call (i.e. overnight) or at short notice [i.e. for periods up to 14 Days] to manage the day-to-day surpluses and deficits in their cash flows. These day to day surpluses and deficits arise due to the very nature of their operations and the peculiar nature of the portfolios of their assets and liabilities.

 

Characteristics of the Money Market

  1. It is not a single market but a collection of markets for several instruments
  2. It is wholesale market of short term debt instruments
  3. Its principal feature is honour where the creditworthiness of the participants is important.
  4. The main players are: Reserve bank of India (RBI), Discount and Finance House of India (DFHI), mutual funds, banks, corporate investor, non-banking finance companies (NBFCs), state governments, provident funds, and Primary dealers. Securities Trading Corporation of India (STCI), public sector undertaking (PSUs), non-resident Indians and overseas corporate bodies.
  5. It is a need based market wherein the demand and supply of money shape the market.

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Difference between Capital Market and Money Market

 

  Money Market Capital Market
Definition Is a component of the financial markets where short-term borrowing takes place Is a component of financial markets where long-term borrowing takes place
Maturity Period Lasts anywhere from 1 hour to 90 days. Lasts for more than one year and can also include life-time of a company.
Credit Instruments Certificate of deposit, Repurchase agreements, Commercial paper, Eurodollar deposit, Federal funds, Municipal notes, Treasury bills, Money funds, Foreign Exchange Swaps, short-lived mortgage and asset-backed securities. Stocks, Shares, Debentures, bonds, Securities of the Government.
Nature of Credit Instruments Homogenous. A lot of variety causes problems for investors. Heterogeneous. A lot of varieties are required.
Purpose of Loan Short-term credit required for small investments. Long-term credit required to establish business, expand business or purchase fixed assets.
Basic Role Liquidity adjustment Putting capital to work
Institutions Central banks, Commercial banks, Acceptance houses, Nonbank financial institutions, Bill brokers, etc. Stock exchanges, Commercial banks and Nonbank institutions, such as Insurance Companies, Mortgage Banks, Building Societies, etc.
Risk Risk is small Risk is greater
Market Regulation Commercial banks are closely regulated to prevent occurrence of a liquidity crisis. Institutions are regulated to keep them from defrauding customers.
Relation with Central Bank Closely related to the central banks of the country. Indirectly related with central banks and feels fluctuations depending on the policies of central banks.

Pre-Conditions for having an Efficient Money Market

The Development of Money Market into a sophisticated market depends upon the following factors:

  1. Institutions – Institutional Development, relative political stability and a reasonably well developed banking and financial system are required for an effective Money Market
  2. Regulator – Government/Central Bank Intervention is a pre-requisite for proper development of an organised money market, to moderate the liquidity profile. The role of the Central Bank should be strong enough to ensure credibility in the system and supervise the players in the market
  3. Integrity – Unlike Capital Market or Commodity Markets, trading in Money Market are concluded over telephone, followed by written confirmation from the Contracting parties. Hence, integrity is a must. Thus, Banks and other players in the market may have to be licenced and effectively supervised by Regulators
  4. Investment Opportunities – The Market should be able to provide an investment outlet for any temporarily surplus funds that may be available. So, there must be supply of temporarily idle cash that is seeking short-term investment in an earning asset. There must also be a demand for temporarily available cash, either by Banks or Financial Institutions for the purpose of adjusting their liquidity position and finance the carrying of relevant assets in their balance sheets.
  5. Payment Systems – An Efficient payment system for clearing and settlement of transactions, e.g. Electronic Funds Transfer (ETF), Depository System, Delivery versus payment, High value inter-bank payment system, etc. are essential pre-requisites for ensuring a risk free and transparent payment and settlement system
  6. Instruments – The market should have varied instruments with distinctive maturity and risk profiles to meet the varied appetite of the players of the market. Multiple Instruments add strength and depth to the market
  7. Integration – Money Market should be integrated with the rest of the markets in the financial system to ensure perfect equilibrium. The funds should move from one segment of the market to another exploiting the advantages of arbitrage opportunities.

Features of an Efficient Money Market

  1. Part of Financial System – The Financial System of any country is a conglomeration of sub-markets, viz. Money Market, Capital market and Forex Market. The flow of funds in these markets is multi-directional, depending upon liquidity, risk profile, yield pattern, interest rate differential or arbitrage opportunities, regulatory restrictions, etc.
  2. Sub-Markets – A developed money market has the most developed and sensitive sub markets. The money market is a group of various sub-markets, each dealing in loans of various maturities. There will be markets for call loans, the collateral loans, acceptances, foreign exchange, bills of exchange and commercial and treasury bills. If these sub-markets are non-existent or there is a less responsiveness to small changes in the interest and discount rates, it means under no circumstances a money market will be developed. These sub- markets are found in the London Money Market and the New York Money Market.
  3. Area – The activities in the Money Market tend to concentrate in some centre which serves a region or an area, the width of such area may vary considerably. Where more than one market exists in a country, with screen based trading and revolutions in information technology, such markets have rapidly becoming integrated into a National Market. In India, Mumbai is emerging as a National Market for Money Market Instruments
  4. Impersonal – The relationship that characterises a Money Market should be impersonal in character so that competition will be relatively pure.
  5. Price Differentials – In a true Money Market, Price Differentials for assets of similar type [Counter-Party, Maturity and Liquidity] will tend to be eliminated by the interplay of demand and supply. Even for similar types of assets, some differential will no doubt continue to exist at any given point of time which gives scope for arbitrage.
  6. Flexibility – Due to greater flexibility in the Regulatory Framework, there are constant endeavours for introducing new instruments/innovative dealing techniques
  7. Wholesale – Money Market is a wholesale market, and the volume of funds or Financial Assets traded in the market are very large.


 

The Features of Money Market in India

  1. Existence of Unorganized Money Market: The Major defect of the Indian money Market has always been the existence of the indigenous bankers who do not distinguish between short-term and long-term finance. During the last 60 years, there is a whole lot of non-banking financial companies who raise funds from the general public but who are generally outside the control and supervision of RBI
  2. Absence of Integration: An important defect of the Indian money market at one time was the division of the money market into several segments or sections, loosely connected to each other.
  3. Diversity in Money Rates of Interest: Another defect of the Indian money market related to the existence of too many rates of interest – the borrowing rate of the Government, the deposit and lending rates of commercial banks, deposit and lending rates of cooperative banks, etc. The basic reason for the existence of so many rates of interest simultaneously is the immobility of funds from one section of the money market to another.
  4. Seasonal Stringency of Money: A very striking characteristic of the Indian money market was the seasonal monetary stringency and high rates of interest during a part of the year.
  5. Absence of the Bill Market: Another defect of the Indian money market was the absence of a bill market or a discount market for short term bills. A well-organized bill market is necessary for linking up the various credit agencies ultimately and effectively to RBI. No bill market was developed in India due to certain historical accidents—such as the practice of banks keeping a large amount of cash for liquidity purposes, preference of industry and trade for borrowing rather than re-discount in bills, the improper drafting of the bazar hundi, the system of cash credit as the main form of borrowing from banks, the preference of cash transactions in certain lines of activity, the absence of warehousing facilities for storing agriculture produce and the high stamp duty on usance bills.
  6. Highly volatile call money market: Even before 1935, the call money rates used to rise to 7 to 8 per cent during the busy season, while in the slack season they fell to as low as ½ per cent per annum. Despite all the efforts made by RBI to moderate the fluctuations in the call money rates, the latter have continued to be highly volatile. RBI attempts to moderate the fluctuations through supporting the market with additional funds when there is short supply to funds and high call rates and absorbing the additional funds when the call market has large surplus funds. In general, however, RBI has failed to check the high volatility of the call money market in India in certain period.
  7. Absence of a well-organized Banking System: Another major defect of the Indian money market was the absence of a well-organized banking system. Branch banking was extremely slow before bank nationalization in 1969. The extreme sluggishness in the movement of funds and the existence of different interest rates are the result of slow branch banking in the country.
  8. Availability of credit instruments: Till 1985-86, the India money market did not had adequate short-term paper instruments. Apart from the call money market, there was only the Treasury bill market. At the same time, there were no specialist dealers and brokers dealing in different segments of the Indian money market and in different kinds of paper instruments. It is only after 1985-86 that RBI started introducing new paper instruments such as 182 days treasury bills, later converted to 364 days treasury bills, certificates of deposits (CDs) and commercial paper (CPs).

 

Rigidities in Indian Money Market

The Money Market in India is characterized by the following rigidities which are hampering its growth:

  1. Markets not integrated
  2. High Volatility
  3. Interest Rates not properly aligned
  4. Players restricted
  5. Supply based sources influence uses
  6. Lack of many instruments
  7. Players do not alternate between borrowing and lending
  8. Reserve Requirements
  9. Lack of Transparency
  10. Inefficient payment systems
  11. Seasonal Shortage of Funds
  12. Commercial Transactions mainly being in cash
  13. High Stamp Duty limiting the use of Exchange Bills

Short Notes on Vaghul Group Report in the context of Indian Money Market

  • Origin – For an in-depth study and to make recommendations on the steps required to be taken for the development of a healthy and active money market, RBI appointed a Working Group under the Chairmanship of Shri N. Vaghul in September 1986.
  • Terms of Reference –
    • To Examine money market instruments and recommend specific measures for their development
    • To recommend the pattern of money market interest rates and to indicate whether these should be administered or determined by the market
    • To study the feasibility of increasing the participants in the money market
    • To assessee the impact of changes in the cash credit system on the money market and to examine the need for developing specialised institutions such as Discount Houses and
    • To consider any other issue having a bearing on the development of the Money Market
  • Money Market Objectives – As per Vaghul Group, the broad objectives of the Money Market are to provide –
    • An Equilibrating mechanism for evening out short-term surpluses and deficits
    • A focal point for Central Bank intervention for influencing liquidity in the economy
    • Reasonable access to users of short-term money to meet their requirements at a realistic price
  • Strategy – The Vaghul Group adopts a four-pronged strategy –
    • Selective increase in the number of participants to broaden the base of the Money Market
    • Activating the existing instruments and developing new ones so as to have a diversified mix of instruments
    • Orderly movement away from administered interest rates to market determined interest rates, and
    • Creation of an active secondary market through establishing new instruments
  • Other Recommendations –
    • Use of New Money Market Instruments, viz. Commercial Paper, Certificate of Deposits, Factoring Services and Inter-Bank Participation Certificates
    • Creation of New Supporting Institutions, viz. Credit Rating Agencies, Finance House of India (FHI), Discount and Finance House of India (DFHI), etc.

Participants of Money Market in India

MMI3

 

Organised Segment

Features:

  1. There are fairly rigid and complex rules which prevent it from meeting the needs of some borrowers even though funds may be available
  2. There is an overall paucity of loanable funds, mainly because of the rate of interest paid on deposits

Role of Participants:

  1. Participants in the Organised Segment [Banks, NBFC’s and Cooperative Societies] accept deposits from the public and lend them on a short-term basis to industrial and trading organisations. They also extend their activities to rural areas to support agricultural operations
  2. There is also an active Inter-Bank Loan Market as part of the Organised Money Market

Role of RBI:

  1. RBI regulates the Interest rate structure [on Deposits as well as Loans] reserve requirements and sect-oral allocation of credit and
  2. RBI provides support to the Banks by lending them on a short term basis and insuring the deposits made by the public.

Unorganised Segment

Features:

  1. Informal Procedures
  2. Flexible Terms
  3. Attractive Rates of Interest to Depositors
  4. High Rates of Interest to Borrowers
  5. Large size which is difficult to estimate

Role:

The Participants primarily lend to borrowers who are not able to get credit from the Organised Money market. Thus the Unorganised Segment caters to fund needs where the Organised Money Market is notable to serve.

Evolution of Instruments

  • Traditionally, Short-term money market instruments consisted mainly Call Money and Notice Money with limited players, Treasury Bills and Commercial Bills
  • However, new money market instruments were introduced giving a wider choice to short-term holders of money to reap yield on funds even for a day or to earn a little more by parking funds by instruments for a few days more or until such time till they need it for lending at a higher rate
  • Participants in the Money Market use the following Instruments to borrow or lend in the Money Market – Treasury Bills, Government of India Securities [GOI Secs or G-Secs], State Government Securities, Government Guaranteed Bonds, Public Sector Undertakings (PSU) Bonds, Commercial Paper (CP) and Certificates of Deposit (CDs).
  • Banks, which require short-term funds, borrow or sell these securities, and Institutions having surplus funds would lend or buy the securities. Banks experiencing a temporary raise or fall in their deposits and a consequent temporary rise (fall) in their statutory liquidity ratio (SLR) obligations, can borrow (lend) SLR Securities from those experiencing a temporary fall (rise) in their deposits. Banks invest in T-Bills, GOI and State Government Securities, Government Guaranteed Bonds and PSU Bonds to fulfil their SLR obligations.

Call Money/Notice Money

Call money is money loaned by a bank that must be repaid on demand. Unlike a term loan, which has a set maturity and payment schedule, call money does not have to follow a fixed schedule. Brokerages use call money as a short-term source of funding to cover margin accounts or the purchase of securities. The funds can be obtained quickly.

The core of the Indian Money Market Structure is the Inter-Bank Call Money Market which is centralised primarily in Mumbai, but with sub-markets in Delhi, Kolkata, Chennai and Ahmedabad.

Notice Money is for 1 to 14 Days period.

Intervening Holidays and/or Sundays are excluded for this purpose

No Collateral Security is required to cover these transactions

Due to short tenure of transactions, both borrowers and Lenders are required to have Current Accounts with RBI.

Participants:

  • Permitted to Borrow as well as Lend – RBI, Commercial Banks, Cooperative Banks and Primary Dealers
  • Permitted only to Lend –
    • Financial Institutions like LIC, UTI, GIC, IDBI, NABARD, ICICI and Mutual Funds, etc
    • Corporate Entities having bulk lendable resources of minimum Rs. 5 Crores per transaction are permitted to lend in Call Money through all Primary Dealers, provided they do not have any short-term borrowings from Banks.
  • Brokers are not permitted in this market.

Features:

  1. Interest Rate Relationships – Current and expected interest rates on Call Money are the basic rates to which other money markets and to some extent the Government Securities Market are anchored
  2. Market Driver Interest – Interest Rate is market-driven and is highly sensitive to the forces of demand and supply. High inter-day and intra-day variations lead to high degree of exposure to interest rate risk, for the participants in the markets
  3. Seasonal – Generally, the activities in the money market are subjected to fluctuations due to sporadic volatility busy (November to April) and slack (May to October) seasons
  4. Volatility due to mismatch – Mismatches in Assets and Liabilities created by the Banks lead to sporadic volatility in the market. Some Banks over-extend themselves by using Call Money Borrowings to finance the build-up of a large portfolio of GOI Securities, other long term assets and non-food credit

Purposes: Banks borrow in this money market for the following purposes:

  1. To fill the gaps or temporary mismatches in funds
  2. To meet CRR and SLR mandatory requirements stipulated by RBI
  3. To meet sudden demand for funds arising out of large outflows

 

Inter-Bank Term Money

A short-term money market, which allows for large financial institutions, such as banks, mutual funds and corporations to borrow and lend money at interbank rates. The loans in the call money market are very short, usually lasting no longer than a week and are often used to help banks meet reserve requirements.

Period: 90-Day Market

Interest rates are market-driven

Reasons for growth:

  1. Declining spread in lending operations
  2. Volatility in the Call Money Market
  3. Growing desire for Fixed Interest Rates Borrowing by Corporates
  4. Move towards fuller integration between Forex and Money Market
  5. Stringent Guidelines by Regulators or Management of the Institutions
  6. Withdrawal of CRR/SLR on Liabilities of the Banking System

Inter Bank Participation Certificate

With a view to providing an additional instrument for evening out short-term liquidity within the banking system, two types of Inter-Bank Participations (IBPs) were introduced, one on risk sharing basis and the other without risk sharing. These are strictly inter-bank instruments confined to scheduled commercial banks excluding regional rural banks. The IBP with risk sharing can be issued for 91-180 days and only in respect of advances classified under Health Code No. 1 Status. Under the uniform grading system introduced by Reserve Bank for application by banks to measure the health of bank advances portfolio, a borrower account considered satisfactory or assigned Health Code No. 1 is the one in which the conduct of account is satisfactory, the safety of advance is not in doubt, all the terms and conditions are complied with, and all the accounts of the borrower are in order. The IBP risk sharing provides flexibility in the credit portfolio of banks. The rate of interest is left free to be determined between the issuing bank and the participating bank subject to a minimum 14.0 per cent per annum. The aggregate amount of such IBPs under any loan account at the time of issue is not to exceed 40 per cent of the outstanding in the account.

The IBP without risk sharing is a money market instrument with a tenure not exceeding 90 days and the interest rate on such IBPs is left to be determined by the two concerned banks without any ceiling on interest rate.

Inter Corporate Deposits [ICDs]

Meaning:

Inter-company deposit is the deposit made by a company that has surplus funds, to another company for a maximum of 6 months. It is a source of short-term financing.

Types:

  1. Call Deposit: Such a type of deposit is withdrawn by the lender by giving a notice of one day. However, in practice, a lender has to wait for at least 3 days.
  2. Three-month Deposit: As the name suggests, such type of a deposit provides funds for three months to meet up short-term cash inadequacy.
  3. Six-month Deposit: The lending company provides funds to another company for a period of six months.

Features of Inter-corporate Deposits:

  1. It is a popular source of short-term finance.
  2. Procurement procedure is simple.
  3. The rate of interest on such deposits is not fixed. It depends upon the amount involved and the tenure of lending.
  4. It is uncertain source of finance, as deposit can be withdrawn any time—so it is risky also.

Advantages of Inter-company Deposits:

  1. Surplus funds can be effectively utilized by the lender company.
  2. Such deposits are secured in nature.
  3. Inter-corporate deposits can be easily procured.

Disadvantages of Inter-company Deposits:

  1. A company cannot lend more than 10 per cent of its net worth to a single company and cannot lend beyond 30 per cent of its net worth in total.
  2. The market for such source of financing is not structured.

Treasury Bills (T-Bills or TBs)

A Treasury bill (T-Bill) is a short-term debt obligation backed by the U.S. government with a maturity of less than one year, sold in denominations of $1,000 up to a maximum purchase of $5 million. T-bills have various maturities and are issued at a discount from par. When an investor purchases a T-Bill, the U.S. government writes an IOU; investors do not receive regular payments as with a coupon bond, but a T-Bill pays an interest rate.

The Treasury bill market is the market that deals in treasury bills. These bills are short-term (91-day) liability of the Government of India. In theory, they are issued to meet temporary needs for funds of the government, arising from temporary excess of expenditure over receipts.

In practice, they have become a permanent source of funds, because the amount of treasury bills outstanding has been continually on the increase. Every year more new bills are sold than get retired. Then, almost every year a part of treasury bills held by the RBI are funded, that is, are converted into long-term bonds.

Purchase Process

T-bills can be purchased at auctions held by the government, or investors can purchase T-bills on the secondary market that have been previously issued. T-Bills purchased at auctions are priced through a competitive bidding process, at a discount from the par value. When investors redeem their T-Bills at maturity, they are paid the par value. The difference between the purchase price and par value is interest. For example, an investor purchases a par value $1,000 T-Bill for $950. When this T-Bill matures, the investor is paid $1,000, thereby making $50 on the investment.

Benefits to Investors

There are a number of advantages that T-bills offer to investors. They are considered low-risk investments because they are backed by the credit of the U.S. government. With a minimum investment requirement of just $1,000, and a maximum investment of $5 million, they are accessible by a wide range of investors. In general, interest income from Treasury bonds is exempt from state and local income taxes. They are, however, subject to federal income taxes, and some components of the return may be taxable at sale/maturity. The main downfall of T-bills is that they offer lower returns than many other investments, but these lower returns are due to their low risk. Investments that offer higher returns generally come with more risk.

Advantages of Treasury Bills: Objective of issuing T-Bills is to fulfil the short term money borrowing needs of the government. T-bills have an advantage over the other bills such as:

  1. Zero Risk weightage associated with them. They are issued by the government and sovereign papers have zero risk assigned to them, High liquidity because 91 days and 36 days are short term maturity.
  2. The secondary market of T-Bills is very active so they have a higher degree of tradability.
  3. Treasury Bills are issued only by the central government in India. The State governments do not issue any treasury bills. Interest on the treasury bills is determined by market forces. Treasury bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000

Types of Treasury Bills

Treasury Bills are basically instruments for short term (maturities less than one year) borrowing by the Central Government. Treasury Bills were first issued in India in 1917. At present, the active T-Bills are 91-days T-Bills, 182-day T-Bills and 364-days T-Bills. The 91 day T-Bills are issued on weekly auction basis while 182 day T-Bill auction is held on Wednesday preceding Non-reporting Friday and 364 day T-Bill auction on Wednesday preceding the Reporting Friday. In 1997, the Government had also introduced the 14-day intermediate treasury bills. Auctions of T-Bills are conducted by RBI.

T-Bills are issued on discount to face value, while the holder gets the face value on maturity. The return on T-Bills is the difference between the issue price and face value. Thus, return on T-Bills depends upon auctions. When the liquidity position in the economy is tight, returns are higher and vice versa.

Commercial Bills

The commercial bills are issued by the seller (drawer) on the buyer (drawee) for the value of goods delivered by him. These bills are of 30 days, 60 days or 90 days maturity.

If the seller is in need of funds, he may draw a bill and send it to the buyer for seller is in need of funds, he may draw a bill and send it to the buyer for acceptance. The buyer accepts the bill and promises to make payment on the due date. He may also approach his bank to accept the bill.

The bank charges a commission for the acceptance of the bill and promises to make the payment if the buyer defaults. Once this process in accomplished, the seller can sell it in the market. This way a commercial bill becomes a marketable investment. Usually, the seller will go to the bank for discounting the bill. The bank will pay him after deducting the interest for the remaining period of the bill and service charges from the face value of the bill. The interest rate is called the discount rate on the bills.

The commercial bill market is an important channel for providing short-term finance to business. However, the instrument did not become popular because of two factors:

Cash credit scheme is still the main form of bank lending, and big buyers in the corporate sector are still unwilling to the payment mode of commercial bills.

Bills Discounting

Bill Financing is the core component of meeting the Working Capital needs of Corporates. RBI Guidelines to Banks for Bills Discounting include:

  1. Bills Discounting Facilities should not be provided by any bank outside the consortium arrangement
  2. Bill Discounting Limits should be part of the MPBF/Total Working Capital Limits of the Borrowers based on well-established norms
  3. Bills covering purchase of Raw Material/Inventory for production purpose and sale of goods should be discounted by Banks. Bills for Service Charges, Payment of Duties, Hire-Purchase/Lease Rental Instalments, Sale of Securities and other types of Financial accommodation should not be discounted
  4. Accommodation bills shouldn’t be discounted. The underlining trade transaction should be clearly identified.
  5. Banks should not re-discount the Bills earlier discounted by NBFCs
  6. Banks should be circumspect while discounting bills drawn by Front Companies set up by large industrial groups or other group companies.
  7. Funds accepted by Banks from their Constituents under Portfolio Management Scheme should not be developed for discounting bills

Bills Re-Discounting

Commercial Banks can re-discount with approved institutions the bills which were originally discounted by them, provided that the bills should have arisen out of genuine commercial trade transactions. There is no need for physical transfer of bills, and re-discounting is done through DUPN Mechanism

DUPN: The Rediscounting Institution can rise Derivative Usance Promissory Note. These DUPNs are sold to Investors in convenient lots and maturities [15 Days to 90 Days] on the basis of genuine trade bills, discounted by the Discounting Bank. DUPNs, like Commercial Bills, are exempted from Stamp Duty

Yield on DUPN: DUPN is issued at a discount which is realized at front-end. So, the yield on DUPN is computed as –

MMI4

Where, FV = Face Value of T-Bill; SV = Sale Value; M = Period of Discount, in days.

RBI Guidelines:

  1. The Bank which originally discounts the bills only draw DUPN and continue to hold uneconomical Usance Bills till the date of maturity of DUPN
  2. Matured Bills should be substituted by fresh eligible bills
  3. The transactions underlying the DUPN should be bonafide commercial or trade transactions
  4. The usance of the Bill should not exceed 120 Days and the un-matured period of such bills for drawing DUPN should not exceed 90 Days
  5. Banks should seek re-discounting facility only to the extent of eligible usance bills held by them. Any excess amount obtained by any Bank either due to inadequate cover or by obtaining re-discounting facilities against ineligible bills will be treated as Borrowing, and the Bank will have to maintain CRR/SLR on such borrowings.

Certificate of Deposits

A Certificate of Deposit (CD) is a money market instrument which is issued in a dematerialised form against funds deposited in a bank for a specific period. The Reserve Bank of India (RBI) issues guidelines for Certificate of Deposit from time to time.

Eligibility for Certificate of Deposit:

Certificates of Deposit are issued by scheduled commercial banks and select financial institutions in India as allowed by RBI within a limit. Certificates of Deposits are issued to individuals, companies, corporations and funds among others. Certificates of Deposits can also be issued to Non-Resident Indians but on a non-repatriable basis only. It is important to note that banks and financial institutions cannot provide loans against Certificates of Deposits. Also, banks cannot buy their own Certificates of Deposits prior to the latter’s maturity. However, the aforementioned norms may be relaxed by the RBI for a specific period of time. It is important to note that banks have to maintain the statutory liquidity ratio (SLR) and cash reserve ratio (CRR) on the price of a Certificate of Deposit.

Format of Certificates of Deposit

Banks and financial institutions should issue a Certificate of Deposit in a dematerialised form only. However, investors can seek a certificate in physical form as well as per Depositories Act, 1996. In case an investor seeks a certificate in a physical form, a bank informs the Financial Markets Department, Reserve Bank of India, Mumbai. Also, a Certificate of Deposit entails stamp duty charges as well. Given that Certificates of Deposits are transferable in a physical form, banks should ensure that they are issued on good quality paper. A Certificate of Deposit has to be signed by two or more signatories (authorized).

Minimum size and maturity of a Certificate of Deposit

A certificate of deposit can only be issued for a minimum of Rs.1 lakh by a single issuer and in multiples of Rs.1 lakh. The maturity of a certificate of deposit depends on the investor. For instance, for a certificate of deposit issued by banks, the maturity period is not less than 7 days and not above one year while for financial institutions, a certificate of deposit should not be issued for less than 1 year and not above three years.

Transferability

A certificate of deposit which is not held in an electronic form can be transferred by endorsement and delivery. However, a certificate of deposit held in a demat form is transferred according to guidelines followed by demat securities.

Discount

A certificate of deposit can be issued at a discount on its face value. Furthermore, banks and financial institutions can issue certificates of deposits on a floating rate basis. However, the method of calculating the floating rate should be market-based.

Reporting

Banks’ fortnightly return should include certificates of deposits as per Section 42 of the RBI Act, 1934. Furthermore, banks and financial institutions should also report about certificates of deposits under the Online Returns Filing System (ORFS).

Commercial Paper

It is a Short-term Usance Promissory Note issued by a Company, negotiable by endorsement and delivery, issued at a discount on Face Value, and redeemable at its face value.

Income – The difference between the Initial Investment and the maturity value, constitutes the income of the investor

RBI Guidelines in respect of issue of “Commercial Paper”

Commercial Paper is an unsecured money market instrument issued in the form of a Promissory Note.

Eligibility for issue of CP: Companies, PDs and FIs are permitted to raise short term resources through CP within the umbrella limits.

A company would be eligible to issue CP if it meets the following criteria:

  1. Tangible net worth as per the latest audited balance sheet is not less than Rs. 4 crore;
  2. Has been sanctioned working capital limit by banks or FIs; and
  3. The borrower account of the company is classified as a Standard Asset by the financing bank/ institution.

Issue of CP – Credit enhancement, limits, etc.

  • CP shall be issued as a ‘stand-alone’ product. Further, it would not be obligatory in any manner on the part of the banks and FIs to provide stand-by facility to the issuers of CP.
  • Banks and FIs may, based on their commercial judgment, subject to the prudential norms as applicable to them, with the specific approval of their respective Boards, choose to provide stand-by assistance/ credit, back-stop facility etc. by way of credit enhancement for a CP issue.
  • Non-bank entities (including corporates) may provide unconditional and irrevocable guarantee for credit enhancement for CP issue, provided:
    • The issuer fulfils the eligibility criteria prescribed for issuance of CP;
    • The guarantor has a credit rating at least one notch higher than the issuer given by an approved CRA; and
    • The offer document for CP properly discloses the net worth of the guarantor company, the names of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered by the guarantor company, and the conditions under which the guarantee will be invoked.
  1. The aggregate amount of CP that can be issued by an issuer shall at all times be within the limit as approved by its Board of Directors or the quantum indicated by the CRA for the specified rating, whichever is lower.
  2. Banks and FIs shall have the flexibility to fix working capital limits, duly taking into account the resource pattern of company’s financing, including CP.
  3. An issue of CP by an FI shall be within the overall umbrella limit prescribed in the Master Circular on Resource Raising Norms for FIs, issued by the Reserve Bank of India, Department of Banking Operations and Development, as prescribed/updated from time-to-time.
  4. The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP may be issued on a single date or in parts on different dates provided that in the latter case, each CP shall have the same maturity date.
  5. Every issue of CP, and every renewal of a CP, shall be treated as a fresh issue.

 

Form of the Instrument, mode of issuance and redemption

Form

  1. CP shall be issued in the form of a promissory note (as specified in Schedule I to these Directions) and held in physical form or in a dematerialized form through any of the depositories approved by and registered with SEBI, provided that all RBI regulated entities can deal in and hold CP only in dematerialized form through such depositories.
  2. Fresh investments by all RBI-regulated entities shall be only in dematerialized form.
  3. CP shall be issued in denominations of 5 lakh and multiples thereof. The amount invested by a single investor should not be less than 5 lakh (face value).
  4. CP shall be issued at a discount to face value as may be determined by the issuer.
  5. No issuer shall have the issue of CP underwritten or co-accepted.
  6. Options (call/put) are not permitted on CP.

Tenor

  1. CP shall be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue.
  2. The maturity date of the CP shall not go beyond the date up to which the credit rating of the issuer is valid.

Procedure for Issuance

  1. Every issuer must appoint an IPA for issuance of CP.
  2. The issuer should disclose to the potential investors, its latest financial position as per the standard market practice.
  3. After the exchange of confirmation of the deal between the investor and the issuer, the issuer shall arrange for crediting the CP to the Demat account of the investor with the depository through the IPA.
  4. The issuer shall give to the investor a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order (Schedule II).

Rating Requirement

Eligible issuers shall obtain credit rating for issuance of CP from any one of the SEBI registered CRAs. The minimum credit rating shall be ‘A3’ as per rating symbol and definition prescribed by SEBI. The issuers shall ensure at the time of issuance of the CP that the rating so obtained is current and has not fallen due for review.

Difference between Commercial Paper and Commercial Bill

Commercial Bill Commercial Paper
It arises from sale transactions. Generally the bills consists of an Invoice drawn on the Buyer, Documents of Title of Goods, and a Bill of Exchange may be on D/P [Document against Payment] or D/A [Document against Acceptance] terms Commercial Paper is an unsecured and discounted Promissory Note issued to finance the short-term credit needs of Eligible Issuers under RBI Guidelines

 

Banks Finance Commercial Bills through discounting. They are also eligible for re-discounting the same. Both discounting and rediscounting are governed by RBI guidelines Commercial Paper issue is governed by RBI guidelines
Commercial Bill financing is post sale finance.  Commercial Bills are given to the Bank for advancing money against sale of goods There is no sale or trading transactions as such

Debt Securitisation

It is the process of converting mortgage loans together with future receivables into negotiable securities or assignable debt is called ‘securitization’. The Securitization process involves packaging designated pool of mortgages and receivables and selling these packages to the various investors in the form of securities which are collateralized by the underlying assets and their associated income streams.

Securitization is an off-balance sheet financing technique with the objective of mobilising resources at a comparatively lower cost through a wider investor base, by removing loan assets from the balance sheet of the loan originator.

Securitization actually involves conversion of mortgages into securities which are tradable debt instruments. The securities, which are backed by the mortgages, are then freely traded in the market thereby giving rise to a secondary market. In this process, saver’s surpluses are channelized to meet borrower’s deficits. This also facilitates interregional and inter-sectorial flow of funds.

Debt Securitization Process:

The steps involved in Securitization process are the following:

  1. A company that wants to mobilize finance through securitization begins by identifying assets that can be used to raise funds.
  2. These assets typically represent rights to payment at future dates and are usually referred to as ‘receivables’.
  3. The company that owns the receivables is usually called the ‘originator’.
  4. The originator identifies the assets out of its portfolio for Securitization.
  5. The identification of assets will have to be done in a manner so that an optimum mix of homogeneous assets having almost same maturity forms the portfolio.
  6. Assets originated through trade receivables, lease rentals, housing loans, automobile loans, etc. according to their maturity pattern and interest rate risk are formed into a pool.
  7. The aforementioned identified and pooled assets are then transferred to a newly formed another institution called a ‘special purpose vehicle’ usually by way of a trust.
  8. Such trust usually, an investment banker, issues the securities to an investor.
  9. Once the assets are transferred, they are no longer held in the originator’s portfolio.
  10. After acquisition of the assets from originator, the SPV splits the pool into individual shares or securities and reimburse itself by selling these to investors.
  11. The securities, so issued, are known as ‘pay or pass through certificates’.
  12. The securities are normally without recourse to the originator, thus investor can hold only SPV for the principal repayment and interest recovery.
  13. In order to make the issue attractive, the SPV enters into credit enhancement procedures either by obtaining an insurance policy to cover the credit losses or by arranging a credit facility from a third party lender to cover the delayed payments.
  14. To increase marketability of the securitized assets in the form of securities, these may be rated by some reputed credit rating agencies.
  15. Credit rating increases the trading potentials of the certificate, thus its liquidity is enhanced.
  16. A merchant banker or syndicate of merchant bankers will be appointed for underwriting the whole issue.
  17. The securities have to be sold to the investors either by a public issue or by private placement.
  18. The pass through certificates before maturity are tradable in a secondary market to ensure liquidity for the investors.
  19. Once the end investor gets hold of these instruments created out of Securitization, he is to hold it for a specific maturity period which is well defined with all other related terms and conditions.
  20. On maturity, at the end, investors get redemption amount from the issuer along with interest due on the amount.

debt securitization.PNG

Repo and Reverse Repo Transactions

Repo and Reverse Repo:

  1. Repo Agreement refers to the sale of a security with a commitment to re-purchase the same security at a specified price on a specified date
  2. Reverse Repo is a purchase of security with a commitment to sell at a pre-determined price and date

Participants:

  1. Buyer in a Repo is usually a Bank which requires RBI-approved Securities in its investment portfolio, to meet the SLR. The Seller may be another bank/STCI/DFHI
  2. RBI intervenes in the Market when required through its two Subsidiaries, viz. Securities Trading Corporation of India (STCI) and Discount and Finance House of India (DFHI)

Term:

Repos are usually arranged with short-term maturity, i.e. overnight or a few days

Interest:

  1. Computation: Interest for the period of Repo is the difference between Sale Price and Purchase Price
  2. Recognition: Interest should be recognized on a time proportion basis, both in the books of the buyer and seller

Accounting/Recognition of Securities:

  1. Accounting for Repo/Reverse Repo transactions should reflect their legal form, viz. an Outright Purchase and Outright sale
  2. Thus, Securities sold under Repo would not be included in the Investment Account of the Seller, instead these would be included by the Buyer in its Investment Account
  3. The Buyer can consider the Approved Securities acquired under Reverse Repo Transactions for the purpose of SLR during the period of the Repo

 

Bond Valuation

This is the post excerpt.

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Introduction to Bonds

  1. Bonds are Long Term Debt Securities, that are issued by Corporations and Government Entities
  2. Purchasers of Bonds receive Periodic Interest payments, called Coupon Payments, until maturity at which time they receive the Face Value of the Bond and the Last Coupon Payment
  3. Most Bonds pay Interest Semi-Annually
  4. Bond Indenture or Loan Contract specifies the features of the Bond Issue
  5. Companies may issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue. Banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders.
  6. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.

Factors to be considered before buying a Bond:

  • Issuer
  • Interest (Coupon) [Receivable]
  • Maturity Date [The Date when the Company must repay your Principal]

Objectives and Risks:

Corporate bonds offer a slightly higher yield because they carry a higher default risk than government bonds. Corporate bonds are not the greatest for capital appreciation, but they do offer an excellent source of income, especially for retirees. Corporate bonds are also highly useful for tax-deferred retirement savings accounts, which allow you to avoid taxes on the semi-annual interest payments.

The risks associated with corporate bonds depend entirely on the issuing company. Purchasing bonds from well-established and profitable companies is much less risky than purchasing bonds from firms in financial trouble. Bonds from extremely unstable companies are called junk bonds and are very risky because they have a high risk of default.

Strengths:

  1. Many corporate bonds offer a higher rate of return than government bonds for only slightly more risk.
  2. The risk of losing your principal is very low if you only buy bonds in well-established companies with a good track record. This may take a bit of research.

Weaknesses:

  1. Fixed interest payments are taxed at the same rate as income.
  2. Corporate bonds offer little protection against inflation because the interest payments are usually a fixed amount until maturity.

Three Main Uses:

  • Capital Appreciation
  • Income
  • Safe Investment

Terms involved in Bond Valuation

  1. COUPON RATE
    1. It is the Rate at which periodic coupon or interest payments are made
    2. It is expressed as a percentage of the Bond’s Face Value. It also represents the Interest Cost of the Bond, to the Issuer.
  2. COUPON PAYMENTS
    1. Coupon Payments represent the periodic interest payments from the Bond Issuer to the Bond holder
    2. It is expressed as a percentage of the Face Value of the Security given the Coupon Rate
    3. Annual Coupon Payment = Coupon Rate x Face Value of Bond
  3. MATURITY DATE
    1. It represents the date on which the bond matures, i.e. the date on which the Face Value is repaid to the Bond Holder
    2. The Last Coupon Payment is also paid on the Maturity Date
  4. PAR VALUE
    1. Par Value = Face Value of the Bond
  5. CALL DATE
    1. For Bonds which are callable, i.e. Bonds which can be redeemed by the Issuer prior to maturity, the call date represents the date at which the Bond can be called for Redemption
  6. CALL PRICE
    1. Call Money is the amount of money the issuer has to pay to the callable bonds
    2. When a Bond first becomes callable, i.e. on the call date, the Call Price is often set to equal the Face Value Plus one year’s Interest
  7. YEILD TO CALL
    1. The Rate of Return that an Investor would earn, if he bought a Callable Bond at its current Market Price, and held it until the call date given that the Bond was called on the Call Date
  8. REFUNDING
    1. If, when Bonds Mature, the Issuer does not have the Cash on Hand to repay the Bondholders, it can issue a new Bond and use the proceeds either to redeem the older bonds or to exercise a call option. This Process is called Refunding
  9. BOND INDENTURE
    1. It is an Agreement that contains the details about Coupon Payment, Redemption Value and Periodicity of Payment

Fair Value or Intrinsic Value or Equilibrium Value of Bond

  1. To Invest in a bond, the Face Value of Bond should be compared with its “Opportunity Cost”
  2. The Rate at which the Interest of every year are converted into present value is Yield to Maturity (YTM) or Opportunity Cost
  3. FV refers to “Maximum Price” could be offered to Purchase a Bond
  4. Fair Value of a Bond is the Present Value of Future Interest Payments and Redemption Value of a Bond
  5. The Appropriate Discounting Factor being Opportunity Cost (YTM) to an Investor

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Inter Relation between Fair Value of Bond and its Market Price

Relation Indicates Action
FV > MV Under Valuation Buy
FV < MV Over Valuation Sell
FV = MV Correct Price Hold

Inter Relation between YTM and Value of a Bond

Relation Value of Bond
YTM > Coupon Rate Below Par Value (Discount)
YTM < Coupon Rate Above Par Value (Premium)
YTM = Coupon Rate Equal to Par Value

Basic Principles relating to Bond Values – Bond Value Theorems

  1. When Required Rate of Return = Coupon Rate à Bonds Sells at Par Value
  2. When Required Rate of Return > Coupon Rate à Bonds Sells at Discount [Discount declines as Maturity approaches]
  3. When Required Rate of Return < Coupon Rate à Bond Sells at Premium [Premium declines as Maturity approaches]
  4. The Longer the maturity of a Bond, the greater is its price change with a given change in the required rate of return

Return of a Bond

  1. Nominal Yield
  2. Current Yield
  3. Holding Period Return
  4. Yield to Maturity – YTM

Nominal YieldIt is the Coupon Rate. It does not consider External Factors

Current Yield

  1. It is the Yield or Return derived by the Investor on purchase of the Instrument (i.e. Yield Related to Purchase Price).
  2. BV2
  3. YTM considers the Maturity proceeds as well. Current Yield considers only the Coupon Payments, and not the Maturity Payments
  4. If CMP < Maturity Value à YTM will be greater than Current Yield
  5. If CMP > Maturity Value à YTM will be less than Current Yield

Holding Period Return

The total return received from holding an asset or portfolio of assets over a period of time, generally expressed as a percentage. Holding period return/yield is calculated on the basis of total returns from the asset or portfolio – i.e. income plus changes in value. It is particularly useful for comparing returns between investments held for different periods of time.

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Yield to Maturity – YTM

  1. YTM is the Rate of return that an Investor would earn, if the Bond is bought at its Current Market Price, and is held till maturity
  2. YTM is Bond’s Internal Rate of Return, it represents the Discount Rate which equates the Present Value of a Bond’s Future Cash Flows to its Current Market Price
  3. YTM is expressed as an Annual Percentage of the amount of Face Value
  4. YTM is the overall return on the bond if it is held to maturity. YTM is the measure of a Bond’s Rate of Return, that considers both Interest Income and any Capital Gains
  5. YTM reflects all the Interest payments that are available through Maturity, and the Principal that will be repaid, and assumes that all Coupon Payments will be reinvested at the current yield on the bond.
  6. BV4
  7. Coupon Rate is the amount of Annual Return on the Bond
  8. Pro-Rated Discount = Net Capital Appreciation pa; Computed as BV5
  9. Components of Total Income
    1. Coupon Income – Fixed Rate of Return that accrues from the Instrument
    2. Interest on Coupon Rate – Compound Interest earned in the Coupon Income
    3. Capital Gain/Loss – Profit or Loss arising on account of the difference between the price paid for the security and the proceeds received on redemption or maturity

Effective Interest –

It is the actual Interest per annum on the Bond that an Investor earns during his period of holding.

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Value of Perpetual Security

Perpetual Securities are those Securities for which the period of redemption is not specified.

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Duration

  1. Duration of Bond measures how quickly a Bond will repay its true cost
  2. It is the weighted Average Maturity of its Cash Flow Stream, where the weights are proportional to the PV of Cash Flows
  3. It is a Measure of average life of an Investment, i.e. the Measurement of how long it takes for the Price of a Bond or Intrinsic Value (not par value) to be repaid by its internal cash flows

Maturity and Coupon Rate gives a general idea of its Price Sensitivity to Interest Rate Changes. Duration of the Bond can be used to estimate the price Sensitivity more accurately. The Relationship between Factors is –

  • Higher the Interest Rate, Shorter the Duration and vice-versa
  • Higher the Yield to Maturity, the shorter the Duration
  • Higher the Coupon Payments. The shorter the Duration

Computation of Duration

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Volatility

It is the Interest Rate Sensitivity of a Bond, and is related to its Duration.

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