CHRIST

Deemed to be University

Dr. Raghunandan G,
Assistant Professor,
Department of Commerce

Strategic Financial Management – COH543A

60 Hours/4 Credits

Excellence and Service

 CHRIST
Deemed to be University

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● Pre-class reading to be completed before attending the online session.
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Excellence and Service

 Strategic Financial Management – COH543A
• Unit1: Introduction to SFM
• Unit2: Risk analysis & Classification
• Unit 3: Investment decision and project cash flows
• Unit 4: Capital Budgeting Decisions
• Unit5: Corporate Valuation & Shareholder value creation
• Unit6: Expansion and Financial Re-structuring
• Unit7: Ethical Aspects in SFM
Unit 1: Introduction to SFM

Meaning of SFM - Reasons for managing business financially - 9-s

model for SFM - Value Chain analysis- Strategic Business Units-
Strategic Planning process- Financial goals and strategy- Life –Cycle
costing- Cost Benefit analysis- Activity Based costing
What is meant by Strategy?
• a plan of action designed to achieve a long-term or overall aim.
Strategic Analysis
• Analysing the strength of the business position and understanding
the important external factors that may influence that position.
• Pestle Analysis
• Scenario Analysis
• Five Forces Model
• SWOC Analysis
• Directional Policy Matrix
• Competitor Analysis
Guess Who?
• Prof. Michael Porter
Five Forces Model
• Competition in the Industry - The larger the number of competitors,
the lesser the power of a company.
• Potential of New Entrants Into an Industry - A company's power is
also affected by the force of new entrants into its market. (Ola and
Uber taking over Taxi Service companies)
• Power of Suppliers - The fewer suppliers to an industry, the more a
company would depend on a supplier.
• Power of Customers - The ability that customers have to drive prices
lower or their level of power is one of the five forces.
• Threat of Substitutes - Companies that produce goods or services for
which there are no close substitutes will have more power to
increase prices and lock in favorable terms.
Quiz on Michael Porter’s Five forces Model
1 . According to Porter, which of the following is most
important to achieving a competitive advantage?

a) Serving all customers equally, rather than targeting the most

profitable
b) Outsourcing activities which enhance/refine your competitive
advantage
c) Focusing on becoming the most competitive business within
the sector/market
d) Operating at lower cost, commanding a premium price, or
both
2. Can you identify which of the following forces does
not form part of Porter’s Competitive Position
Analysis?
a) Threat of new entry
b) Risk of losses
c) Buyer power
d) Competitive rivalry
e) Supplier power
3. What is likely to happen if many new
businesses enter a market?
a) Competitive rivalry will intensify
b) Industry capacity will fall
c) Barriers to entry will rise
d) Industry profits will increase
4. A market will usually be more difficult to
enter if there is:
a) Common technology
b) Low brand loyalty
c) Wide access to distribution channels
d) Patented or proprietary know-how
5. Which of these situations is likely to cause high
bargaining power of suppliers?
a) Resource inputs are not essential to product quality
b) Many alternative sources of supply
c) Many customers with low brand loyalty
d) A few large suppliers dominate the market supply
6. What is the main purpose of Porter’s Five
Forces Model?
a) Decide which products to launch
b) Inform investment appraisal decisions
c) Manage product portfolios
d) Analyse competition in a market
Answers
1. Operating at lower cost, commanding a premium price, or
both
2. Risk of losses
3. Competitive rivalry will intensify
4. Patented or proprietary know-how
5. A few large suppliers dominate the market supply
6. Analyse competition in a market
STRATEGIC FINANCIAL MANAGEMENT
• Strategic financial management is basically about the identification of
the possible strategies capable of maximizing an organization's
market value.
• It involves the allocation of scarce capital resources among
competing opportunities.
Why Have a Financial Strategy?
• A well-planned financial strategy can take your
business to the next level and give you a
competitive advantage.
• In the long run, it can increase your profits and
reduce debt.
• You will be able to allocate resources more
effectively and avoid unnecessary expenses.
What is strategy all about?
• Direction: Where the business is trying to get in long/short term
• Market/Scope: Which market should a business compete in and
what kind of activities are involved in such markets
• Advantage: How can business perform better than the competition
in those markets?
• Resources: What resources (skills, assets etc) are required in order to
be able to compete?
• Environment: what external envt factors affect the business ability to
compete?
• Stakeholders: Govt, Investors, Customers.
What is strategy all about?
Strategy for raising capital
• The company manufactures mineral and herbal products. According
to CLSA and HSBC, _______ is the fastest growing FMCG company in
India.
• Patanjali
• https://www.financialexpress.com/market/patanjali-baba-ramdev-
bond-issue-raises-rs-250-crore-in-three-minutes-from-secondary-
markets/1973508/
?utm_campaign=fullarticle&utm_medium=referral&utm_source=insh
orts
9s Model for SFM
• Nine S Model combines the quantitative and qualitative skills of a
strategist.
1.Sanctity
2.Selectivity
3.System
4.Strategic Cost Management
5.Sensitivity
6.Sustainability
7.Superiority
8.Structural Flexibility
9. Soul Searching
• 1. Sanctity refers to the ‘ethical economics’ of business.
• 2. Selectivity (Choose the best) refers to the most appropriate
business choices based on an enterprise's core competence.
• 3. System- (Protocols in the company).
• It refers to the technological, accounting, information and operational
systems of an enterprise.
• 4. Strategic Cost Management- is the micro-level strategic analysis of
various cost-structure and cost implications.
• Activity Based Costing (or Objective Based Costing), Life Cycle Costing etc.
• 5.Sensitivity- It is to know the strategic use of every piece of
information.
• 6. Sustainability- (Going Green) of performance is a matter of long-
term strategic planning.
• http://www.bollant.com/
• https://www.youtube.com/watch?v=hxS5He3KVEM
• 7. Superiority- refers to the position of ‘Leadership’ that an
enterprise must attain in the market. (The strategy that is superior
among all).
• Superior strategy = Different strategy
• “For a strategy to stand a chance of high returns, the decisions taken must be
different from those taken by all competitors”.
• Let’s look at two examples of companies who have competitive
advantage through being different – and more selective.
• Eg. 1 : Southwest Airlines

• Southwest Airlines was the world’s first budget airline. It doesn’t

follow the pack. It avoids large airports and routes that are long or
convoluted. It doesn’t feed you or offer free drinks. It won’t ticket
your bags to through destinations. It offers just one class. It doesn’t
have lounges or other frills.
• It does fly frequently to its chosen cities. It does offer quick,
automated ticketing at the gate. And short check-in times. And very
low fares.
• It gears its investment and operating costs accordingly. It owns a
standardized fleet of planes, initially 737s, lowering maintenance
costs. It doesn’t pay travel agents and requires or encourages direct
payment. It has very high utilization rates – full planes make low
fares.
• It’s different. It’s more profitable. And it has grown fast and become
America’s largest airline.
• You almost certainly know IKEA, the giant furniture and
furnishings retailer. It has large, edge-of-town superstores,
with masses of free parking. Self-service, not the usual
escort of salespeople. Swedish design of low-cost, stylish,
modular and usually flat-pack furniture, all its own brand,
not masses of choice from third party suppliers. Self-
assembly, not manufacturer construction. Instant
availability from adjacent warehouses, not 6-8 week delivery
times. Customers do their own pickup and delivery.
• Yet IKEA offers extra services that most rivals don’t – long
opening hours, crèches, kids’ play areas, cheap and cheerful
restaurants, and free entertainment from clowns and
magicians on holidays.
• All these services are cheap to provide or make a profit for
IKEA. And all of them are geared to their target customer –
young families who want affordable style.
• Like Southwest Airlines, IKEA has pioneered a low-cost system that,
for their target customers, is actually simpler and more convenient
too.
• 8. Structural Flexibility- (Accommodative to change)
• It is the sum total of the qualitative and quantitative adaptability and
adjustability of an organization.
• 9. Soul Searching- It is based on continuous bench marking and
requires a tremendous amount of financial alertness, innovation and
total exposure to new variables and parameters.
• It also refers to establishing new heights of achievement and newer
core-competences.
• The 9 references of SFM ultimately aim for, ‘Wealth Maximization
through the accelerating Effect’.
Strategic Business Unit
• When a company has many products and a diversified portfolio, it
becomes difficult for the top management to manage the products
individually. Hence strategic business units are formed in the
organization.

• HUL
Strategic Business Unit
• A strategic business unit, popularly known as SBU, is a fully-
functional unit of a business that has its own vision and direction.
• A strategic business unit operates as a separate unit, but it is also an
important part of the company. It reports to the headquarters about
its operational status.
• It operates independently and is focused on a target market.
• It is big enough to have its own support functions such as HR,
training departments etc.
Vice presidents are
appointed to
oversee the
operations of the
newly formed
strategic business
units, and these
executives report
directly to the CEO
There are several advantages of strategic
business units in an organization.
1. Responsibility – One of the first role of strategic business units is to
assign responsibility and more importantly outsource responsibility
to others.
2. Accountability – When handling multiple brands or products, it is
easier if there are separate business units which are accountable
for the success or failure of the business or product.
3. Accountancy – Profit and loss and balance sheets will look more
prettier and more manageable if the statements are prepared
separately for separate strategic business units.
4. Strategy – Companies like Nestle have 4 different strategic units.
One SBU like Maggi deals in Food products, another deals in Dairy
products like Nestle milkmaid, the third SBU deals in Chocolate
products like Kitkat so on and so forth.

Thus, in the above example, it is very simple to change strategy for each
business unit because the strategy for each unit is independent of the other.
5. Independence – The managers of the strategic business units get
more independence to manage their own unit which gives them
the opportunity to be more creative and innovative and empowers
them for making decisions.
6. Funds allocation – The last but not the least advantage of strategic
business units are that funds allocation becomes simpler for the
parent company. Depending on the performance of the SBU, funds
allocation can be done on priority.
• Mahindra Group - By 1994, the Group had become so diverse that it
undertook a fundamental reorganization, dividing into six Strategic
Business Units: Automotive; Farm Equipment; Infrastructure; Trade
and Financial Services; Information Technology; and Automotive
Components (known internally as Systech)
• Bharat Electronics - In the year 2000 BEL reorganised its Bangalore
unit into six Strategic Business Units (SBUs). The RD groups in
Bangalore were also restructured into Specific Core Groups and
Product Development Groups. The same year, BEL shares were listed
in the National Stock Exchange.
• An SBU may be of any size or level but it must have a unique mission,
identifiable vision, an external market and control of its business
functions.
• The idea is to decentralize on the basis of strategy elements.
• A strategic business unit is usually responsible for its own budgeting,
new product decisions, hiring decisions, and price setting.
• An SBU is treated as an internal profit center by corporate
headquarters.
• 'Strategic Business Unit' is a profit center which focuses on product
offering and market segment.
• SBUs typically have a discrete marketing plan, analysis of competition,
and marketing campaign, even though they may be part of a larger
business entity.
An organizational SBU often has the
following characteristics
• It has its own set of customers.
• It should have a clear set of competitors/peers.
• It should have its own strategic planning manager responsible for its
success.
• Its performance must be measurable in terms of profit and loss, i.e. it
must be a true profit center.
The Boston Consulting Group Approach
(BCG):
• Using the classic Boston Consulting Group (BCG) approach, a
company classifies all its SBUs according to the growth-share matrix,
as shown in Figure. On the vertical axis, the market growth rate
provides a measure of market attractiveness.
• On the horizontal axis, relative market share serves as a measure of
company strength in the market. The growth-share matrix defines
four types of SBUs.
• Diversified companies having several SBUs use BCG Matrix.
Companies use the BCG matrix is as a portfolio planning tool.
Stars
Stars are high-growth, high-share
businesses or products. They
often need heavy investments to
finance their rapid growth.
Eventually, their growth will slow
down, and they will turn into
cash cows.
Cash Cows
Cash cows are low-growth,
high-share businesses or
products. These established
and successful SBUs need
less investment to hold
their market share.
Thus, they produce a lot of
the cash that the company
uses to pay its bills and
support other SBUs that
need investment.
Question Marks
Question marks are low-share
business units in high-growth
markets. They require a lot of
cash to hold their share, let alone
increase it.
Management has to think hard
about which question marks it
should try to build into stars and
which should be phased out.
Dogs
Dogs are low-growth, low-
share businesses and
products. They may
generate enough cash to
maintain themselves but do
not promise to be large
sources of cash.
Value Chain Analysis
• Value chain analysis is a process of dividing various activities of the
business in primary and support activities and analyzing them.
• M. Porter introduced the generic value chain model in 1985. Value
chain represents all the internal activities a firm engages in to
produce goods and services.
• VC is formed of primary activities that add value to the final product
directly and support activities that add value indirectly.
A value chain is a business model that describes the full range of activities needed to create a product
or service ultimately leads to profit.
Classification of Value Chain Analysis
A. Primary Activities:
• The functions which are directly concerned with the conversion of input into
output and distribution activities are called primary activities.
1. Inbound Logistics: It includes a range of activities like receiving, storing,
distributing, etc. which make available goods and services for operational
processes.
2. Operations: The activity of transforming input raw material to final product
ready for sale, is termed as operation. Machining, assembling, packaging
are the activities covered under operations.
3. Outbound Logistics: As the name suggests, the activities that help in
collecting, storage and delivering the product to the customer is outbound
logistics.
4. Marketing and Sales: All the activities like advertising, promotion, sales,
marketing research, public relations, etc.
5. Service: Service means service provided to the customer so as to improve
or maintain the value of the product. It includes financing service, after-
sales service and so on.
B. Support Activities: Those activities which assist primary activities in
accomplishment, are support activities.
1. Procurement: This activity serves the organization, by supplying all the
necessary inputs like material, machinery or other consumable items, that
required by the organization for performing primary activities.
2. Technology Development: At present, technology development requires
heavy investment, which takes years for research and development.
However, its benefits can be enjoyed for several years and by a multitude
of users in the organization.
3. Human Resource Management: It encompasses overseeing the selection,
retention, promotion, transfer, appraisal and dismissal of staff.
4. Infrastructure: This is the management system, which provides, its services
to the whole organization and includes planning, finance, information
management, quality control, legal, government affairs, etc.
Value Chain Linkages
• Porter’s Value Chain is a great framework to examine the internal
organization.
• It allows a more structured approach of assessing where in the
organization true value is created and where costs can be reduced in
order to boost the margins.
• It also allows to improve communication between departments.
Strategy at different levels of a Company
• Corporate Level Strategy:
• Business Level Strategy:
• Functional Level Strategy:
Strategic Planning Process
• In today's highly competitive business environment, budget-oriented
planning or forecast-based planning methods are insufficient for a
large corporation to survive and prosper.
• The firm must engage in strategic planning that clearly defines
objectives and assesses both the internal and external situation to
formulate strategy, implement the strategy, evaluate the progress,
and make adjustments as necessary to stay on track.
The Strategic Planning Process
1. Mission & Objectives
2. Environmental Scanning
3. Strategy Formulation
4. Strategy Implementation
5. Evaluation & Control
Mission, Vision and Objectives
• the direction of your organization (Vision)
• what you're going to do and for whom (Mission)
• how to measure it and guide your strategy to get to where you want
to be (Goals)
• Example Vision Statement
• “ABC Dry Cleaners will be the premier professional laundry
of the metropolitan area by providing unmatched customer
service and cleaning services that exceed the competition”.
• Example Mission Statement
• “We exist to help our customers care for
and extend the life of their clothes investment”.
• Example Organizational Goals:
• By 20xx ABC Dry Cleaner will have a customer satisfaction score of 85
• By 20xx ABC Dry Cleaner will have a profit margin of 5%
• By 20xx ABC Dry Cleaner will have a 25% market share
• By 20xx ABC Dry Cleaner will have less than 2% return for poor
quality cleanings
• Guided by the business vision, the firm's leaders can define
measurable financial and strategic objectives.
• Financial objectives involve measures such as sales targets and
earnings growth.
• Strategic objectives are related to the firm's business position, and
may include measures such as market share and reputation.
Environmental Scan
• The environmental scan includes the following components:
• Internal analysis of the firm
• Analysis of the firm's industry (task environment)
• External macroenvironment (PEST analysis)
• The internal analysis can identify the firm's strengths and
weaknesses and the external analysis reveals opportunities and
threats. A profile of the strengths, weaknesses, opportunities, and
threats is generated by means of a SWOT analysis.
• An industry analysis can be performed using a framework developed
by Michael Porter known as Porter's five forces.
Strategy Formulation
• Given the information from the environmental scan, the firm should
match its strengths to the opportunities that it has identified, while
addressing its weaknesses and external threats.
• To attain superior profitability, the firm seeks to develop a
competitive advantage over its rivals. A competitive advantage can
be based on cost or differentiation.
• Michael Porter identified three industry-independent generic
strategies from which the firm can choose.
Strategy Implementation
• The selected strategy is implemented by means of programs, budgets,
and procedures. Implementation involves organization of the firm's
resources and motivation of the staff to achieve objectives.
• The way in which the strategy is implemented can have a significant
impact on whether it will be successful.
• In a large company, those who implement the strategy likely will be
different people from those who formulated it. For this reason, care
must be taken to communicate the strategy and the reasoning
behind it.
• Otherwise, the implementation might not succeed if the strategy is
misunderstood or if lower-level managers resist its implementation
because they do not understand why the particular strategy was
selected.
Evaluation & Control
• The implementation of the strategy must be monitored and
adjustments made as needed.
• Evaluation and control consists of the following steps:
1. Define parameters to be measured
2. Define target values for those parameters
3. Perform measurements
4. Compare measured results to the pre-defined standard
5. Make necessary changes
• Example of organization’s current state:
• Customer Satisfaction scores of 65;
• Profit margin 1%
• 10% of market share
• 10% return on poor quality cleanings
Cost-Benefit Analysis
• A cost benefit analysis (also known as a benefit cost analysis) is a
process by which organizations can analyze decisions, systems or
projects, or determine a value for intangibles.
• The model is built by identifying the benefits of an action as well as
the associated costs, and subtracting the costs from benefits.
• When completed, a cost benefit analysis will yield concrete results
that can be used to develop reasonable conclusions around the
feasibility and/or advisability of a decision or situation.
Why Use Cost Benefit Analysis?
• Organizations rely on cost benefit analysis to support decision
making because it provides an agnostic (in finance referred to as
computing), evidence-based view of the issue being
evaluated—without the influences of opinion, politics, or bias.
• By providing an unclouded view of the consequences of a decision,
cost benefit analysis is an invaluable tool in developing business
strategy, evaluating a new hire, or making resource allocation or
purchase decisions.
There are two main purposes in using CBA:
1. To determine if the project is sound, justifiable and feasible by
figuring out if its benefits outweigh costs.
2. To offer a baseline for comparing projects by determining which
project’s benefits are greater than its costs.
Example:
• A real estate developer considering several different investment
options.
• The assumptions for the investments are that option 1 would build
300 houses, renting 50 of them for 10 years at Rs. 3,000 per year. The
50 rented units would be sold after 10 years for Rs. 60,000.
• Construction costs for option 1 would be Rs. 80,000 per house, which
would sell for Rs. 1,00,000 each. The cost of a sales office would be
Rs. 10,00,000 and the salaries of sales staff would be Rs. 2,00,000
each year. The project would last 2 years, with a financing cost of Rs.
20,00,000 per year.
• The equation is possible, the benefits for option 1 outweigh the costs.

• B/C = 1.0
• Option 2, the construction company could build 200 houses, renting
25 of them for 5 years at Rs. 3,500 per year. The 25 units could be
sold after 5 years for Rs. 70,000.
• Construction costs for option 2 would be Rs. 70,000 per house, and
the rest of the homes would sell for Rs.1,10,000 each. The cost of a
sales office would be Rs. 20,00,000 and sales staff salaries would be
Rs. 1,50,000 each year. The project would last 1 year, with a financing
cost of Rs. 15,00,000 per year.
• The b/c ratio for option 2 would therefore be 21437500/17650000,
or B/C=1.2

• Comparing both options together, it is clear that option 2 has a

higher benefit-to-cost ratio (and costs less to execute) and would
therefore be the most fiscally resourceful option for the developer to
pick.
Lifecycle Costing
• When you run a small business, every little cost counts.
• Making poor purchasing decisions can put an unnecessary financial
burden on your business and lower your company’s bottom line over
time.
• Before you purchase new assets for your business, practice life cycle
costing.
• Knowing the life cycle cost, or whole-life cost, of an asset
impacts business budgeting, product pricing, and decision making.
What is life cycle costing?
• Life cycle costing, or whole-life costing, is the process of estimating
how much money you will spend on an asset over the course of its
useful life.
• Whole-life costing covers an asset’s costs from the time you purchase
it to the time you get rid of it.
Example
• Buying an asset is a cost commitment that extends beyond its price
tag. For example, think of a car.
• The car’s price tag is only part of the car’s overall life cycle cost.
• You also need to consider expenses for car insurance, interest, gas,
oil changes, and any other necessary maintenance to keep the car
running. Not planning for these additional costs can set you back.
To calculate an asset’s life
cycle cost, estimate the
following expenses:

1. Purchase
2. Installation
3. Operating
4. Maintenance
5. Financing (e.g., interest)
6. Depreciation
7. Disposal
• Add up the expenses for each
stage of the life cycle to find your
total.
 Life cycle costing assessment example
• Let’s say you want to buy a new copier for your business.
• Purchase: The purchase price is Rs. 2,500.
• Installation: You spend an additional Rs. 75 for setup and delivery.
• Operating: You need to buy ink cartridges and paper for it, so you
estimate you will spend Rs. 1,000 on these supplies over the course
of its useful life. And, you expect the total electricity the copier will
use to be Rs. 300.
• Maintenance: If the copier breaks, you estimate repairs will total Rs.
450.
• Financing: You purchase the copier with your store credit card, which
has an interest rate of 3.5% per month. You pay off the printer the
next month, meaning you owe Rs. 87.50 in interest (Rs. 2,500 X 3.5%).
• Depreciation: You predict the copier will lose value by Rs. 150 each
year.
• Disposal: You estimate it will cost Rs. 100 to hire an independent
contractor to remove the copier from your business.
• Although the purchase price of the copier is Rs. 2,500, the life cycle
cost of the copier could end up costing your business over Rs. 4,500.

Purpose of the life cycle cost analysis

• 1. Choose between two or more assets
• 2. Determine the asset’s benefits
• 3. Create accurate budgets
Activity-Based Costing
• Pricing products or services is one of the difficult decisions that can
either make or break your business.
• You want to price high enough so you can grow your company with a
decent profit margin, but your prices also need to be competitive to
get customers through the door.
• Many large businesses, particularly in the manufacturing sector, use
activity-based costing to help them accurately price their offerings.
• But, small businesses can also benefit from using this costing method.
• Activity-based costing is a complex subject. Learn the basics of what
activity-based costing is, how to find it, and how it can help your
business.
• The activity-based costing (ABC) system is a method of accounting
you can use to find the total cost of activities necessary to make a
product. The ABC system assigns costs to each activity that goes into
production, such as workers testing a product.
RISK ANALYSIS
 RISK - DEFINITIONS

• In technology and economics, risk is expressed as an expected

value that an event will be accompanied by undesirable
consequences. It is measured by both the probability of the event
and the seriousness of the consequences
• In planning, risk is what can happen that will cause the project to fall
behind schedule or go over cost.
• In management, risk is the possibility that outcomes will be different
from what we expect.
 RISK

• In general, risk can be defined as the probability of the occurrence of

an event resulting in loss/ gain

• Risk may bring in loss or gain

RISK VS UNCERTAINTY
 RISK VS UNCERTAINTY
Risk Uncertainty
Narrow term arises Broader term
due to uncertainty
Quantifiable Not quantifiable
Outcome known Outcome unknown/
uncertain
Risk can be reduced / Cannot be reduced
minimised
Can be controlled Beyond human control
 BASIC CATEGORIES OF RISK
• Pure and Speculative Risk
• Fundamental and Particular Risk
• Enterprise Risk or Business Risk
 TYPES OF PURE RISKS
• Personal risks
• Risk of premature death
• Risk of insufficient income due to retirement
• Risk of poor health
• Risk of unemployment
• Property risks
• Direct loss
• Consequential loss
• Liability risks
• No maximum upper limit for the amount of loss
• A lien can be placed on your income and financial assets to
satisfy a legal judgment
• Legal defense costs can be enormous
 EFFECTS OF PURE RISKS
–ORGANISATION FACES

LOSS OF KEY LOSS OR

EMPLOYEES DAMAGE TO
BODILY FATAL/NON-FATAL PROPERTY
TO EMPLOYEES
LOSS
EVEN
T

LIABILITY LOSSES PECUNIARY LOSSES

 EFFECTS OF SPECULATIVE
RISKS –ORGANISATION FACES
LOSS OF KEY LOSS OF REVENUE
EXPERIENCED DUE TO LOSS
EMPLOYEES OF MARKET SHARE

SPECULATIVE
RISKS

INCREASED FIXED LOSS OF CUSTOMERS

CHARGES/ LOSSES /SUPPLIERS
 Types of business risks
• Strategic
• Compliance
• Financial
• Operational
• Reputational
• Political
• Economical
• Human
• Natural
 STRATEGIC RISK
• Exposure to loss resulting from a strategy which turns out to
be defective or inappropriate
• Shifts in consumer preferences, new competitor entering in to
market, emerging technology, M & A integration , industry
changes etc
 COMPLIANCE RISK
• Compliance risk is the possibility that the business will not
comply with laws and regulations in the jurisdictions where it
operates or that the organization will violate a legally binding
contract. Noncompliance can be wilful, or it can result from
being unaware or local legal requirements.
 FINANCIAL RISK
• The possibility that a business will not have adequate liquidity
to meet its ongoing obligations
• It also covers interest rate as well as foreign exchange rate
 OPERATIONAL RISK
It can be defined as “the risk of loss resulting from failed processes, people
and systems, or from external events.” (Office of the Comptroller of
Currency, USA)
- failure of transactions or processes due to poor design
- inadequately trained personnel
- external business disruptions such as a fire.
- risk of fraud
- failure to meet a contractual obligation due to operational reasons.
 REPUTATIONAL RISK
• Loss of a company’s reputation or community standing which
might result from product failures, lawsuits or negative
publicity
TYPES OF RISK
• Systematic Risk
Systematic risk influences a large number of assets. A significant
political event, for example, could affect several of the assets in
your portfolio. It is virtually impossible to protect yourself against
this type of risk.
• Unsystematic Risk
Unsystematic risk is sometimes referred to as "specific risk". This
kind of risk affects a very small number of assets. An example is
news that affects a specific stock such as a sudden strike by
employees.
• Credit or Default Risk - Credit risk is the risk that a company or
individual will be unable to pay the contractual interest or principal on
its debt obligations. This type of risk is of particular concern to
investors who hold bonds in their portfolios. Government bonds,
especially those issued by the federal government, have the least
amount of default risk and the lowest returns, while corporate bonds
tend to have the highest amount of default risk but also higher interest
rates. Bonds with a lower chance of default are considered to be
investment grade.
• Country Risk - Country risk refers to the risk that a country won't be
able to honor its financial commitments. When a country defaults on its
obligations, this can harm the performance of all other financial
instruments in that country as well as other countries it has relations
with. Country risk applies to stocks, bonds, mutual funds, options and
futures that are issued within a particular country. This type of risk is
most often seen in emerging markets or countries that have a severe
deficit.
• Foreign-Exchange Risk - When investing in foreign
countries you must consider the fact that currency
exchange rates can change the price of the asset as
well. Foreign-exchange risk applies to all financial
instruments that are in a currency other than your
domestic currency.

• Political Risk - Political risk represents the financial

risk that a country's government will suddenly change
its policies. This is a major reason why developing
countries lack foreign investment.
• Market Risk - This is the most familiar of all risks. Also
referred to as volatility, market risk is the the day-to-day
fluctuations in a stock's price.
• Market risk applies mainly to stocks and options. As a
whole, stocks tend to perform well during a bull market and
poorly during a bear market - volatility is not so much a
cause but an effect of certain market forces.
• Volatility is a measure of risk because it refers to the
behavior, or "temperament", of your investment rather than
the reason for this behavior.
• Because market movement is the reason why people can
make money from stocks, volatility is essential for returns,
and the more unstable the investment the more chance
there is that it will experience a dramatic change in either
direction.
• Interest Rate Risk
The uncertainty associated with the effects of changes in market
interest rates.  There are two types of interest rate risk identified;
price risk and reinvestment rate risk.  The price risk is sometimes
referred to as maturity risk since the greater the maturity of an
investment, the greater the change in price for a given change in
interest rates. .
 
 
• Price Risk
The uncertainty associated with potential changes in the price of
an asset caused by changes in interest rate levels and rates of
return in the economy. This risk occurs because changes in
interest rates affect changes in discount rates which, in turn, affect
the present value of future cash flows.  The relationship is an
inverse relationship.  If interest rates (and discount rates) rise,
prices fall.  The reverse is also true.  
  Since interest rates directly affect discount rates and present
values of future cash flows represent underlying economic value,
we have the following relationships. 
• Reinvestment Rate Risk
The uncertainty associated with the impact that changing
interest rates have on available rates of return when
reinvesting cash flows received from an earlier investment.  It
is a direct or positive relationship.  
• Liquidity risk
The uncertainty associated with the ability to sell an asset on short
notice without loss of value.  A highly liquid asset can be sold for
fair value on short notice.  This is because there are many
interested buyers and sellers in the market.  An illiquid asset is
hard to sell because there are few interested buyers.  This type of
risk is important in some project investment decisions.
• Inflation Risk (Purchasing Power Risk)
The loss of purchasing power due to the effects of inflation.  When
inflation is present, the currency loses it's value due to the rising
price level in the economy.  The higher the inflation rate, the faster
the money loses its value.
.Financial risk
The uncertainty brought about by the choice of a firm’s financing
methods and reflected in the variability of earnings before taxes
(EBT), a measure of earnings that has been adjusted for and is
influenced by the cost of debt financing.  This risk is often
discussed within the context of the Capital Structure topics.
• Business risk
The uncertainty associated with a business firm's operating
environment and reflected in the variability of earnings before
interest and taxes (EBIT).  Since this earnings measure has not
had financing expenses removed, it reflect the risk associated
with business operations rather than methods of debt
financing. 
• Translation Risks
Uncertainty associated with the translation of foreign currency
denominated accounting statements into the home currency.  This risk is
extensively discussed in Multinational Financial Management courses.
• Transactions Risks
Uncertainty associated with the home currency values of transactions that
may be affected by changes in foreign currency values. This risk is
extensively discussed in the Multinational Financial Management courses.
 
RISK ANALYSIS
• Risk Analysis helps to identify and manage potential problems that
could undermine key business initiatives or projects.
• Risk is made up of two things: the probability of something going
wrong, and the negative consequences that will happen if it does.
• Risk Analysis is carried out by first identifying the possible threats
that are faced, and by then estimating the likelihood that these
threats will materialize.
• Risk Analysis can be quite involved, and it's useful in a variety of
situations. To do an in-depth analysis, detailed information such as
project plans, financial data, security protocols, marketing
forecasts, or other relevant information have to be obtained.
 Example
of risk
managemen
t: A NASA
model
showing
areas at high
risk from
impact for
the
International
 METHODS OF HANDLING RISK
• There are 5 major methods of handling risk:
• avoidance,
• loss control,
• retention,
• noninsurance transfers,
• insurance.
• Risk avoidance
This includes not performing an activity that could carry risk. An
example would be not buying a property or business in order to
not take on the legal liability that comes with it.
Avoidance may seem the answer to all risks, but avoiding risks
also means losing out on the potential gain that accepting
(retaining) the risk may have allowed. Not entering a business to
avoid the risk of loss also avoids the possibility of earning profits.
• Risk reduction
Risk reduction or "optimization" involves reducing the severity of
the loss or the likelihood of the loss from occurring. For example,
sprinklers are designed to put out a fire to reduce the risk of loss
by fire.
Outsourcing could be an example of risk reduction For example, a
company may outsource only its software development, the
manufacturing of hard goods, or customer support needs to
another company, while handling the business management itself.
This way, the company can concentrate more on business
development without having to worry as much about the
manufacturing process, managing the development team, or
finding a physical location for a call centre.
•  Risk sharing
It is sharing with another party the burden of loss or the benefit of
gain, from a risk, and the measures to reduce a risk.
• Risk retention
Involves accepting the loss, or benefit of gain, from a risk when it
occurs. Risk retention is a viable strategy for small risks where the
cost of insuring against the risk would be greater over time than
the total losses sustained. All risks that are not avoided or
transferred are retained by default. This includes risks that are so
large or catastrophic that they either cannot be insured against or
the premiums would be infeasible. War is an example since most
property and risks are not insured against war, so the loss
attributed by war is retained by the insured.
 MEANING OF THREAT
Threat  is an expression of an intention to inflict pain, injury,
evil, or punishment.
OR
 An indication of impending danger or harm.
OR
 One that is regarded as a possible danger; a menace.
 THREATS
• Human - from illness, death, injury, or other loss of a key individual.
• Operational - from disruption to supplies and operations, loss of access
to essential assets, or failures in distribution.
• Reputational - from loss of customer or employee confidence, or damage
to market reputation.
• Procedural - from failures of accountability, internal systems and controls;
or from fraud.
• Project - from going over budget, taking too long on key tasks, or
experiencing issues with product or service quality.
• Financial - from business failure, stock market fluctuations, interest rate
changes, or non- availability of funding.
 ANALYSIS OF RISK
Helps to identify the possible threats a business faces and
then estimates the likelihood that these threats will materialize.

Risk is made up of two things

– the probability of something going wrong, --
and the negative consequences that will happen if it does.
Technical - from advances in technology, or from technical failure.

Natural - from weather, natural disasters, or disease.

Political - from changes in tax, public opinion, government policy, or

foreign influence.

Structural - from dangerous chemicals, poor lighting, falling boxes, or

any situation where staff, products, or technology can be harmed.
 WHEN TO USE RISK ANALYSIS
➔ Planning projects, to help you anticipate and neutralize possible
problems.

➔ Deciding whether or not to move forward with a project.

➔ Improving safety and managing potential risks in the workplace.

➔ Preparing for events such as equipment or technology failure,

theft, staff sickness, or natural disasters.

➔ Planning for changes in your environment, such as new

competitors coming into the market, or changes to government
policy.
 STEPS IN RISK ANALYSIS
1. Identify Threats
2. Estimate Risk
3. Manage Risk
4. Review
 HOW TO IDENTIFY THREATS
• SWOT Analysis – Strength, Weakness, Opportunities &
Threats
• PEST Analysis – Political, Economical, Social, Technological
• Scenario Analysis - Scenarios are stories about the way
the world might turn out if certain trends continue and
if certain conditions are met.
 ESTIMATE RISK
Calculate likelihood of these threats being realized, and
their possible impact.
1. Find out the risk value using the formula
Risk Value = Probability of Event x Cost of Event
Or
2. Use a Risk Impact/Probability Chart
THE RISK IMPACT/PROBABILITY CHART
 RISK IMPACT/PROBABILITY CHART
This chart is based on the principle that a risk has two
primary dimensions:
• Probability
• Impact
 THE CORNERS
OF THE CHART
HAVE THESE
CHARACTERISTI
CS:
Low impact/low probability – Risks
in the bottom left corner are low level
– can be ignored often.
Low impact/high probability – Risks
in the top left corner are of moderate
importance – if these things happen,
the organisation can cope with them
and move on – try to reduce the
likelihood that they'll occur.
High impact/low probability – Risks
in the bottom right corner are of high
importance if they do occur, but
they're very unlikely to happen. Try to
reduce the impact they'll have if they
do occur - contingency plans must be
in place just in case they do.
High impact/high probability –
Risks towards the top right corner are
of critical importance - top priorities,
and the risks that need close attention
 MANAGE RISK
Using existing assets - reusing or redeploying existing equipment,
improving existing methods and systems, changing people's responsibilities,
improving accountability and internal controls, by choosing different
materials, by improving safety procedures or safety gear, or by adding a
layer of security to organization's IT systems etc
Developing a contingency plan – Accept the risk but develop a plan to
minimize the effects of risk if it happens. A good contingency plan will allow
to take action immediately, and with the minimum of project control,
Investing in new resources - This can include insuring the risk –
especially when the risk can threaten the solvency of the organisation.
Develop a procedural prevention plan - the activities that need to take
place every day, week, month, or year to monitor or mitigate the risks
identified. For example, arrange a daily backup of computer files, yearly
testing of building's sprinkler system, or a monthly check on organization's
security system etc.
 REVIEW
Regular reviews - because the costs and impacts of some risks
may change, other risks may become obsolete, and new risks
may appear.

These reviews may involve re-doing Risk Analysis, as well as

testing systems and plans appropriately.
 REFERENCES

http://www.mindtools.com/pages/article/
newTMC_07.htm
 CASE APPLICATION

City Bus corporation provides school bus transportation to private and

public schools in Bangalore. City Bus owns 50 buses that are garaged
in three different areas in Bangalore. The firm faces tough
competition from two larger bus companies that operate in
Bangalore. Public School boards and private schools generally award
contracts to the lowest bidder, but the level of service and overall
performance are also considered.
❖ Briefly describe the steps in the risk management process that should
be followed by the risk manager of City bus
❖ Identify the major threats faced by City Bus

❖ For each of the threat identified, identify a risk management

technique or combination of techniques that could be used to handle
the threat
Calmex Ltd is situated in North India. It specializes in manufacturing overhead
water tanks. The management of Calmex has identified a niche market in certain
Southern cities that need a particular size of water tank, not currently
manufactured by the company. The company is therefore thinking of producing
a new type of overhead water tank. The survey of company’s marketing
department reveals that the company could sell 120000 tanks each year for six
years at a price of ` 1500 each. The company’s current facilities cannot be used
to manufacture the new size tanks. Therefore, it will have to buy a new
machinery. A manufacturer has offered two options to the company. The first
option is that the company could buy four small machines with the capacity of
manufacturing 30000 tanks each at ` 115 million each. The machine operation
and manufacturing cost of each tank will be ` 535. Alternatively, Camex can buy
a larger machine with a capacity of 120000 units per annum for ` 500 million. The
machine operation and manufacturing costs of each tank will be ` 450. The
company has a required rate of return of 12%. Assume that the company does
not pay any taxes.
1. Which option should the company accept? Use the most suitable method of
evaluation to give your recommendation and explicitly state your assumptions.
2. Why do you think that the method chosen by you is the most suitable method in
evaluating the proposed investment? Give the computation of the alternative
methods
TECHNIQUES OF RISK ANALYSIS
1. Sensitivity analysis
2. Scenario analysis
3. Monte Carlo simulation
4. Delphi Method
5. Decision Tree Analysis
6. Utility Theory
 FIVE-PHASE SCENARIO ANALYSIS
PROCESS:
• Define the Problem
• Gather Data
• Separate Certainties from Uncertainties
• Develop Scenarios
• Use the Scenarios in Your Planning
 RISK MANAGEMENT
• Risk management is the identification, assessment, and
prioritization of risks followed by coordinated and economical
application of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events or to maximize
the realization of opportunities.
• Risks can come from uncertainty in financial markets, project
failures (at any phase in design, development, production, or
sustainment life-cycles), legal liabilities, credit risk, accidents,
 calamities and disasters as well as deliberate attack from an
adversary, or events of uncertain or unpredictable root cause.
 IMPACT OF INFLATION ON CAPITAL
BUDGETING DECISIONS
• In today’s complex business environment, making capital
budgeting decisions are among the most important and
multifaceted of all management decisions.
• It represents major commitments of company’s resources and
• have serious consequences on the profitability and financial
stability of a company.
• It is important to evaluate the proposals rationally with respect to
both the economic feasibility of individual projects
Everyone is familiar with the term ‘Inflation’ as rising prices.
This means the same thing as fall in the value of money.
• When analysing Capital Budgeting Decisions with inflation, it is
required to distinguish between expected and unexpected inflation.
• The difference between unexpected and expected inflation is of crucial
importance as the effects of inflation,
especially its redistributive effect, depend on whether it is expected or
not.
• Expected inflation refers to the loss the manager anticipates in buying
power over time whereas
• Unexpected inflation refers to the difference between actual and
expected inflation.
• If rate of inflation is expected, then the manager takeS steps to make
suitable adjustments
in their proposals to avoid the adverse effects which could bring to
them.
• Inflation affects two different features of the capital budgeting decision :
-Projected cash flows
-Discount rate
• Ø  If the projected cash flows are in real term, i.e. the inflation is not included
then the discount rate is considered to be real rate.
• Ø  If the projected cash flows are in nominal  term, i.e. the inflation is included
then the discount rate is considered to be nominal rate.
• Ø  It is very necessary that the payment series and the discount rates should be
specified if it is in nominal value or real value, but not in both values
concurrently.
 METHODS OF HANDLING RISK
• Avoidance
• Not all risks can be avoided
• Not practical
• Loss control
• Loss reduction
• Loss prevention
• Retention
• Active
• Passive
• Non insurance transfers
• Transfer by contracts
• Hedging against price risks
• Incorporation of a business firm
• Insurance
RISK ANALYSIS
 ANALYSIS OF RISK
Helps to identify the possible threats a business faces and
then estimates the likelihood that these threats will materialize.

Risk is made up of two things

– the probability of something going wrong, --
and the negative consequences that will happen if it does.
 WHEN TO USE RISK ANALYSIS
➔ Planning projects, to help you anticipate and neutralize possible
problems.

➔ Deciding whether or not to move forward with a project.

➔ Improving safety and managing potential risks in the workplace.

➔ Preparing for events such as equipment or technology failure,

theft, staff sickness, or natural disasters.

➔ Planning for changes in your environment, such as new

competitors coming into the market, or changes to government
policy.
 STEPS IN RISK ANALYSIS
1. Identify Threats
2. Estimate Risk
3. Manage Risk
4. Review
 THREATS
• Human - from illness, death, injury, or other loss of a key individual.
• Operational - from disruption to supplies and operations, loss of access
to essential assets, or failures in distribution.
• Reputational - from loss of customer or employee confidence, or
damage to market reputation.
• Procedural - from failures of accountability, internal systems and controls;
or from fraud.
• Project - from going over budget, taking too long on key tasks, or
experiencing issues with product or service quality.
• Financial - from business failure, stock market fluctuations, interest rate
changes, or non- availability of funding.
Technical - from advances in technology, or from technical failure.

Natural - from weather, natural disasters, or disease.

Political - from changes in tax, public opinion, government policy, or

foreign influence.

Structural - from dangerous chemicals, poor lighting, falling boxes, or

any situation where staff, products, or technology can be harmed.
 HOW TO IDENTIFY THREATS
• SWOT Analysis – Strength, Weakness, Opprtunities &
Threats
• PEST Analysis – Political, Economical, Social, Technological
• Scenario Analysis - Scenarios are stories about the way
the world might turn out if certain trends continue and
if certain conditions are met.
 FIVE-PHASE SCENARIO ANALYSIS
PROCESS:
• Define the Problem
• Gather Data
• Separate Certainties from Uncertainties
• Develop Scenarios
• Use the Scenarios in Your Planning
 ESTIMATE RISK
Calculate likelihood of these threats being realized, and
their possible impact.
1. Find out the risk value using the formula
Risk Value = Probability of Event x Cost of Event
Or
2. Use a Risk Impact/Probability Chart
THE RISK IMPACT/PROBABILITY CHART
 RISK IMPACT/PROBABILITY CHART
This chart is based on the principle that a risk has two
primary dimensions:
• Probability
• Impact
 THE CORNERS OF THE CHART HAVE THESE
CHARACTERISTICS:
Low impact/low probability – Risks in the bottom left corner are low level –
can be ignored often.
Low impact/high probability – Risks in the top left corner are of moderate
importance – if these things happen,the organisation can cope with them
and move on – try to reduce the likelihood that they'll occur.
High impact/low probability – Risks in the bottom right corner are of high
importance if they do occur, but they're very unlikely to happen. Try to
reduce the impact they'll have if they do occur - contingency plans must be
in place just in case they do.
High impact/high probability – Risks towards the top right corner are of
critical importance - top priorities, and the risks that need close attention
 MANAGE RISK
Using existing assets - reusing or redeploying existing equipment, improving
existing methods and systems, changing people's responsibilities, improving
accountability and internal controls, by choosing different materials, by improving
safety procedures or safety gear, or by adding a layer of security to organization's
IT systems etc
Developing a contingency plan – Accept the risk but develop a plan to
minimize the effects of risk if it happens. A good contingency plan will allow to take
action immediately, and with the minimum of project control,
Investing in new resources - This can include insuring the risk – especially
when the risk can threaten the solvency of the organisation.
Develop a procedural prevention plan - the activities that need to take place
every day, week, month, or year to monitor or mitigate the risks identified. For
example, arrange a daily backup of computer files, yearly testing of building's
sprinkler system, or a monthly check on organization's security system etc.
 REVIEW
Regular reviews - because the costs and impacts of some risks
may change, other risks may become obsolete, and new risks
may appear.

These reviews may involve re-doing Risk Analysis, as well as

testing systems and plans appropriately.
 REFERENCES

http://www.mindtools.com/pages/article/
newTMC_07.htm
 CASE APPLICATION

City Bus corporation provides school bus transportation to private and

public schools in Bangalore. City Bus owns 50 buses that are garaged
in three different areas in Bangalore. The firm faces tough
competition from two larger bus companies that operate in
Bangalore. Public School boards and private schools generally award
contracts to the lowest bidder, but the level of service and overall
performance are also considered.
❖ Briefly describe the steps in the risk management process that should
be followed by the risk manager of City bus
❖ Identify the major threats faced by City Bus

❖ For each of the threat identified, identify a risk management

technique or combination of techniques that could be used to handle
the threat
Calmex Ltd is situated in North India. It specialises in manufacturing overhead
water tanks. The management of Calmex has identified a niche market in certain
Southern cities that need a particular size of water tank, not currently
manufactured by the company. The company is therefore thinking of producing
a new type of overhead water tank. The survey of company’s marketing
department reveals that the company could sell 120000 tanks each year for six
years at a price of ` 1500 each. The company’s current facilities cannot be used
to manufacture the new size tanks. Therefore, it will have to buy a new
machinery. A manufacturer has offered two options to the company. The first
option is that the company could buy four small machines with the capacity of
manufacturing 30000 tanks each at ` 115 million each. The machine operation
and manufacturing cost of each tank will be ` 535. Alternatively, Camex can buy
a larger machine with a capacity of 120000 units per annum for ` 500 million. The
machine operation and manufacturing costs of each tank will be ` 450. The
company has a required rate of return of 12%. Assume that the company does
not pay any taxes.
1. Which option should the company accept? Use the most suitable method of
evaluation to give your recommendation and explicitly state your assumptions.
2. Why do you think that the method chosen by you is the most suitable method in
evaluating the proposed investment? Give the computation of the alternative
methods
TECHNIQUES OF RISK ANALYSIS
1. Sensitivity analysis
2. Scenario analysis
3. Monte Carlo simulation
4. Delphi Method
5. Decision Tree Analysis
6. Utility Theory
Risk can be understood as the potential of loss.

Risk Premium is the compensation, over and above, the

risk-free rate of return that investors require for the
risk contributed by the factor

Return refers to annual rates of return, or the

percentage of return created for each unit (USD) of
original value.

2
 If an investment earns 5 percent, for example, that means that
for every USD100 invested, you would earn USD.5 per year
(because USD.5 = 5% of 100 USD).

 if you buy a share of stock for $100, and it pays no dividend,

and a year later the market price is $105, then your return = [0
+ (105 − 100)] ÷ 100 = 5 ÷ 100 = 5%.

 If the same stock paid a dividend of $2, then your return = [2

+ (105 − 100)] ÷ 100 = 7 ÷ 100 = 7%.

3
1. Risk and return are inextricably related.

2. Higher returns generally can be achieved only by taking

more risk, and vice versa

4
Return

Share
s

Bond
s

Fixed
Dep
osit
s

Risk
Return
1. Periodic Return
2. Arithmetic Mean Return
3. Geometric Mean Return

Risk
1. Standard Deviation
2. Beta
 Total return = Dividend + Capital gain

Rate of return  Dividend yield  Capital gain yield

DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
 Year-to-Year Total Returns on HUL Share
50
40.94
40 36.99

30
21.84
Total Return (%)

20 15.65
12.83
10.81
10 2.93
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-10 -6.73

-20 -16.43

-30 -27.45

-40
Year
 The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
 Formula for the average rate of return is as
follows:
n
1 1
R = [ R1  R 2 
n
 Rn ] 
n
R t
t =1
 Formulae for calculating variance and standard
deviation:

Standard deviation = Variance

1 n
 
2
Variance   
2

n  1 t 1
Rt  R
11
Year-by-
Year
Returns in
India:
1981-2008

12
*Relative to 91-Days T-bills.
 The 28-year average return on the stock market is
higher by about 15 per cent in comparison with the
average return on 91-day T-bills.

 The 28-year average return on the stock market is

higher by about 12 per cent in comparison with the
average return on the long-term government bonds.

 This excess return is a compensation for the higher

risk of the return on the stock market; it is
commonly referred to as risk premium.
  The expected rate of return [E (R)] is the sum of the product
of each outcome (return) and its associated probability:

E (R) = rate of return under scenario 1 x probability of scenario 1 +

rate of return under scenario 2 x probability of scenario 2 +... + rate
of return under scenario n x probability of scenario n
Returns and Probabilities
 The following formula can be used to
calculate the variance of returns:

 2   R1  E  R 2   P1   R2  E  R 2  P2  ...   Rn  E  R 2  Pn

   Ri  E  R 2  Pi
n

i 1

16
 30
0.05
 A risk-averse investor will choose among investments with
the equal rates of return, the investment with lowest standard
deviation and among investments with equal risk she would
prefer the one with higher return.

 A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

 A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not all)
investors are risk-averse.
 The normal probability table, can be used to determine the
area under the normal curve for various standard deviations.

 The distribution tabulated is a normal distribution with mean

zero and standard deviation of 1. Such a distribution is known
as a standard normal distribution.

 Any normal distribution can be standardised and hence the

table of normal probabilities will serve for any normal
distribution. The formula to standardise is:

S= R - E ( R)
s
 An asset has an expected return of 29.32 per cent and the
standard deviation of the possible returns is 13.52 per cent.
 To find the probability that the return of the asset will be zero
or less, we can divide the difference between zero and the
expected value of the return by standard deviation of possible
net present value as follows:
0 - 29.32
 S= 13.52 = – 2.17

 The probability of being less than 2.17 standard deviations

from the expected value, according to the normal probability
distribution table is 0.015. This means that there is 0.015 or
1.5% probability that the return of the asset will be zero or
less.
 Risk, in traditional terms, is viewed as a ‘negative’.
Webster’s dictionary, for instance, defines risk as “exposing to
danger or hazard”.
 The Chinese symbols for risk, reproduced below, give a much
better description of risk
 The first symbol is the symbol for “danger”, while the second
is the symbol for “opportunity”, making risk a mix of danger
and opportunity.
 Systematic Unsystematic
Risk Risk

Interest Rate Inflationary

Market Risk Operational
Risk Risk Business Risk Financial Risk Risk

Demand
Price Risk inflation risk

Reinvestment Cost inflation

Risk risk
 Risk can be understood as the potential of
loss.

It is not exactly same as uncertainty,

which implies the absence of certainty of
the outcome in a particular situation.

24
 BASIS RISK UNCERTAINTY

Meaning The probability of winning Uncertainty implies a

or losing something worthy situation where the
is known as risk. future events are not
known.
Ascertainment It can be measured It cannot be
measured.
Outcome Chances of outcomes are The outcome is
known. unknown.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned
25
1.Risk- Future uncertainties that may lead to variability in the actual
return when compared with the expected return
•The objective of making sound financial decision is not to eliminate
the risk but to measure it and determine whether the risk bearing
would be useful as and when compared with the expected return
2. Return- Final outcome of investment made in purchasing the
securities. It may turn out to be profit or loss depending upon the
market scenario
•The expected return is higher with higher risk associated and vice-
versa
Return

Share
s

Bond
s

Fixed
Dep
osit
s

Risk
 When more and more securities are included in a
portfolio, the risk of individual securities in the
portfolio is reduced.
 This risk totally vanishes when the number of
securities is very large.
 But the risk represented by covariance remains.
 Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

28
 Systematic risk arises on account of the economy-wide
uncertainties and the tendency of individual securities
to move together with changes in the market.

 This part of risk cannot be reduced through

diversification.

 It is also known as market risk.

 Investors are exposed to market risk even when they
hold well-diversified portfolios of securities.

29
30
 Market risk
Tangible – political, economic uncertainty
Intangible events – Market psychology

 Interest Rate Risk

affected by Bond return/price and cost of borrowing of
bond

 Purchasing Power risk

Demand pull inflation
Cost push inflation
 Unsystematic risk arises from the unique uncertainties
of individual securities.
 It is also called unique risk.
 These uncertainties are diversifiable if a large numbers
of securities are combined to form well-diversified
portfolios.
 Uncertainties of individual securities in a portfolio
cancel out each other.
 Unsystematic risk can be totally reduced through
diversification.

32
33
 Business Risk
Internal – R&D, FCs, fluctuation in sales etc
External – Business cycles, political factors

 Financial Risk/Financial Leverage

refers to changes in EBIT and EBT
35
36
 3 factors on Return

1. Risk involved

2. Duration of investment [Time value of money]

3. Expected price levels [Inflation]

 Equity Shares

Preference Shares
Return

Corporate Debentures and Bonds

Treasury Bills

Savings and Fixed deposits

Risk
An asset’s risk can be analyzed in two ways:

on a stand-alone basis, where the asset is

considered in isolation, and

on a portfolio basis, where the asset is held as one

of a number of assets in a portfolio.
 We can use the following equation to calculate the
expected rate of return of individual asset:

 ``
 Suppose you have an opportunity of investing your
wealth either in asset X or asset Y. The possible
outcomes of two assets in different states of economy
are as follows:

Possible Outcomes of tw o Assets, X and Y

Return (% )
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10´ 0.2) + (8´ 0.4) + (5´ 0.2)
+ (- 4´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( Ry ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6´ 0.4) + (15´ 0.2)
+ (20´ 0.1) = 8%
 Risk of individual assets is measured by their variance
or standard deviation.

 We can use variance or standard deviation to measure

the risk of the portfolio of assets as well.

 The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security
should be judged by its contribution to the portfolio
risk.

43
 The portfolio variance or standard deviation depends on the
co-movement of returns on two assets.
 Covariance of returns on two assets measures their co-
movement.
 Three steps are involved in the calculation of covariance
between two assets:

Determining the
Determining the
sum of the product
Determining the deviation of
possible returns of each deviation of
expected returns on from the expected returns of two assets
assets. return for each
asset. and respective
probability.

44
 The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
 It depends on the sign of covariance since standard
deviations are always positive numbers.
 The correlation coefficient always ranges between –1.0
and +1.0.
 A correlation coefficient of +1.0 implies a perfectly
positive correlation while a correlation coefficient of –
1.0 indicates a perfectly negative correlation.
 Deviation from Product of
State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8
The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+ 0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
s x = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+ 0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 + 1.6 + 9.8 + 14.4 = 58.2
s y = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80´ 7.63 44.25

Securities X and Y are negatively correlated.

The correlation coefficient of – 0.746 indicates a high
negative relationship.
 The Committee of Sponsoring Organizations of the
Tread way Commission COSO) is a joint initiative of
the five private sector organizations
 American Accounting Association
 AICPA
 Financial Executives International
 Institute of Management Accountants
 Institute of Internal Auditors
COSO Provides Framework and guidance on
 Enterprise Risk management
 Internal control
 Fraud Deterrence
Risk categories I. STRATEGIC II. OPERATIONAL III. COMPLIANCE IV. FINANCIAL

Risk classes 1. Macroeconomic 5. Innovation 9. Regulatory 13. Treasury

2. Industry / market changes 6. People 10. Litigation 14. Tax

3. M&A / restructuring 7. IT 11. Business Conduct 15. Pensions

4. Reputation 8. Supply Chain 12. Environmental 16. Reporting

Risks 1. Macroeconomic 1. Innovation 1. Regulatory 1. Treasury

2. Economy 2. Business / product portfolio 2. Permits 2. Liquidity risk
3. Political risk 3. Corporate / product branding 3. Sanctions 3. Currency risk
4. Disaster 4. Product quality and liability 4. Interest rate risk
10.0 Litigation 5. Commodity price risk
5. Sales
1. Industry / market changes 6. Services 6. Credit rating risk
2. Market action
3. Capacity expansion 1. Business Conduct 7. Insurance risk
4. New Entrants 1. People 2. ABC, AML, CTF 8. Counter party risk
5. Imports 2. Skilled talent 3. FCD
6. Complementors 3. Labor relations 14.0 Tax
4. Productivity / projects 1. Environmental
1. M&A / restructuring 2. Emissions 15.0 Pensions
2. M&A / JV / divestments 1. IT
3. Restructuring / integration 2. Cybersecurity 1. Reporting
4. Competitor M&A 3. Outsourcing 2. Use of estimates

1. Reputation 3. Loss exposures

2. Health & Safety 1. Supply Chain
3. Sustainable Development 2. Own capacity
3. Sourcing suppliers
4. Corporate Governance
4. Raw materials

5. Energy
6. Procurement
7. Logistics
8. Business interruption

Note: Mergers & Acquisitions (M&A), Anti-Bribery & Corruption (ABC), Anti-Money Laundering (AML), Counter Terrorism Financing (CTF), Fair Competition
Directive (FCD)
 COSO Framework of Enterprise Risk Management

 Enterprise risk management is:

 a process effected by an entity’s board of directors,
management and other personnel, applied in strategy setting and
across the enterprise. Designed to identify potential events that
may affect the entity and manage risks to be within its risk
appetite to provide reasonable assurance regarding the
achievement of entity objectives
 The COSO framework consists of eight interrelated
components:
1. Internal or control environment

2. Objective setting

3. Event identification
4. Risk assessment
5. Risk response

6. Control activities or procedures

7. Information and communication

8. Monitoring
 Asynchronous Activity

The COSO Framework, COSO model, or COSO square, defines the internal control of an
organisation – carried out by management – as a process. A process that identifies events that
could potentially affect the entity is referred to as Enterprise Risk Management (ERM). ERM
includes methods and processes that organisations use to manage risk and seize opportunities
that ensure that the company’s objectives are met.

COSO’s ERM is based on the principle that every organisation is primarily active in creating
added value for its stakeholders. The greater the risk of a decision taken, the higher the return.
In a rapidly changing environment, uncertainty often arises, and this offers both risk and
opportunity. ERM enables management to identify, assess and manage these risks. COSO’s
internal control framework is generally presented as a cube, because three dimensions for
control have been merged into the framework.

COSO’s ERM offers organisations:

• The ability to manage risks within their risk appetite philosophy
• Providing maximum value to stakeholders
• Certainty and knowledge about risks
• The ability to prevent business failures and scandals
• A framework to meet the requirements of laws and regulation
COSO Framework
• In 1992, the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) developed a model for evaluating internal
controls.
• This model has been adopted as the generally accepted framework
for internal control and is widely recognized as the definitive
standard against which organizations measure the effectiveness of
their systems of internal control.
• The 5 Components of COSO: C.R.I.M.E.
• The five components of COSO – control environment, risk
assessment, information and communication, monitoring activities,
and existing control activities – are often referred to by the acronym
C.R.I.M.E. To get the most out of your SOC 1 compliance, you need to
understand what each of these components includes.
• Control Environment: How has management put into place policies
and procedures that guide the organization? What kind of tone has
management set in the organization so that everyone knows that
they are supposed to make sure that your controls are operating
effectively and are achieving the results that they expect?
• Risk Assessment: How does your organization assess risk in order to
identify the things that threaten the achievement of their objectives?
• Information and Communication: How does management
communicate to their internal and external users what is expected of
them? How do you make sure that you receive acknowledgement
from those people that they understand what you’re asking them to
do?
• Monitoring Activities: How does management oversee the
functioning of the entire organization? How do you identify when
things aren’t working correctly and correct those deficiencies as
quickly as you possibly can?
• Existing Control Activities: What are the controls that you currently
have in place? Were they in place and operating effectively over a
period of time?
Unit 3: Investment decision and project
cash flows
Long- term Investment decisions- Types of long term investment
decisions- Phases in long term investment decisions- Different
analyses for evaluating an investment proposal- Estimation of project
cash flow - Initial cash flow, Sunk cost, Terminal cash flow (problems
on estimation of cash flow) – Relevant cost analysis (concept)
Financial Management Decisions
• Financial Management is concerned with the acquisition and
utilization of capital funds in meeting the financial needs and overall
objectives of a business enterprise.
• The firm should be able to procure sufficient funds on reasonable
terms and conditions and should exercise proper control in applying
them in order to earn a good rate of return, which in turn allows the
firm to reward the sources of funds reasonably, and leaves the firm
with good surplus to grow further.
• These activities viz. financing, investing and dividend payment are
not sequential they are performed simultaneously and continuously.
Financial Management Decisions – Three
Major Decisions in Financial Management
• 1. Investment Decisions
• The investment decision relates to the selection of assets in which funds will
be invested by a firm. The assets as per their duration of benefits, can be
categorized into two groups: (i) long-term assets which yield a return over a
period of time in future (ii) short-term or current assents which in the normal
course of business are convertible into cash usually with in a year.
a) Capital budgeting: Capital budgeting – the long term investment
decision – is probably the most crucial financial decision of a firm.
It relates to the selection of an asset or investment proposal or
course of action that benefits are likely to be available in future
over the lifetime of the project.
b) Working Capital Management: Working capital management is
concerned with the management of the current assets. As we know,
the short-term survival is a pre-requisite to long-term success.
(The major thrust of working capital management is the trade-off
between profitability and risk (liquidity), which are inversely related to
each other).
• 2. Finance Decisions
• The second major decision involved in financial management is the
financing decision, which is concerned with the financing – mix or
capital structure of leverage. The term capital structure refers to the
combination of debt (fixed interest sources of financing) and equity
capital (variable – dividend securities/source of funds).
• 3. Dividend Policy Decisions
• The third major decision of financial management is relating to
dividend policy. The firm has two alternatives with regard to
management of profits of a firm.
• They can be either distributed to the shareholder in the form of
dividends or they can be retained in the business or even distribute
some portion and retain the remaining.
• The course of action to be followed is a significant element in the
dividend decision.
Short Term Finance decisions
• These decisions involve managing firms day to day fund
requirements. Liquidity decisions in investment in current assets and
firm has to manage profitability and liquidity.
• The investment made in the current assets or short term assets is
termed as Working Capital Management. The working capital
management deals with the management of current assets that are
highly liquid in nature.
• The investment decision in short-term assets is crucial for an
organization as a short term survival is necessary for the long-term
success. Through working capital management, a firm tries to
maintain a trade-off between the profitability and the liquidity.
Long-Term Financing decisions
• Relying purely on short-term funds to meet working capital needs is
not always prudent, especially for industries where the manufacture
of the product itself takes a long time: automobiles, aircraft,
refrigerators, and computers. Such companies need their working
capital to last for a long time, and hence they have to think about
long term financing.
• One of the classifications is as follows,
• Expansion of existing business
• Expansion of new business
• Replacement and moderation
Expansion and Diversification
• A company may add capacity to its existing product lines to expand
existing operation. For example, the Company Y may increase its
plant capacity to manufacture more "X".
• It is an example of related diversification. A firm may expand its
activities in a new business.
• Expansion of a new business requires investment in new products
and a new kind of production activity within the firm.
Replacement and Modernization
• The main objective of modernization and replacement is to improve
operating efficiency and reduce costs.
• Cost savings will reflect in the increased profits, but the firms revenue may
remain unchanged. Assets become outdated and obsolete with
technological changes.
• The firm must decide to replace those assets with new assets that operate
more economically.
• If a Garment company changes from semi automatic washing equipment
to fully automatic washing equipment, it is an example of modernization
and replacement.
Another useful way of classifying
investments is as follows
• Mutually exclusive investment
• Independent investment
• Contingent investment
• Mutually exclusive investment
• Mutually exclusive investments serve the same purpose and compete with
each other. If one investment is undertaken, others will have to be excluded.
• Independent investment
• Independent investments serve different purposes and do not compete with
each other.
• Contingent investment
• Contingent investments are dependent projects; the choice of one
investment necessitates undertaking one or more other investment.
• For example, if a company decides to build a factory in a remote, backward
area, it may have to invest in houses, roads, hospitals, and many more.
• For employees to attract the work force thus, building of factory also requires
investment in facilities for employees.
• The total expenditure will be treated as one single investment.
• Capital Rationing
• Capital rationing is a strategy that firms implement to place limitations on the
cost of new investments. Normally, capital rationing is engaged when a firm
has a low return on investment (ROI) from its current investments due to
high investment costs.
The classification of investment projects
• a) By project size
• Small projects may be approved by departmental managers. More careful
analysis and Board of Directors' approval is needed for large projects of, say,
half a million dollars or more.
• b) By type of benefit to the firm
· an increase in cash flow
· a decrease in risk
· an indirect benefit
• c) By degree of dependence
· mutually exclusive projects (can execute project A or B, but not
both)
· complementary projects: taking project A increases the cash
flow of project B.
· substitute projects: taking project A decreases the cash flow of
project B.
• d) By degree of statistical dependence
· Positive dependence
· Negative dependence
• e) By type of cash flow
· Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
· Non-conventional cash flows: more than one change in the
cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
A Firm’s Cash Flow Generation Process
Estimation of project cash flow
• The capital budgeting process is concerned primarily with the
estimation of the cash flows associated with a project, not just the
project’s contribution to accounting profits.
• Typically, a capital expenditure requires an initial cash outflow,
termed the net investment.
• Thus it is important to measure a project’s performance in terms of
the net (operating) cash flows it is expected to generate over a
number of future years.
Principles of Cash Flow Estimation
• Figure shows the estimated cash flows for a particular project. After
an initial net investment of $100,000,
• the project is expected to generate a stream of net cash inflows over
its anticipated 5-year life of:
• $50,000 in year 1;
• $40,000 in year 2;
• $30,000 in year 3;
• $25,000 in year 4; and
• $5,000 in year 5.
• This type of project is called a conventional or normal project.
• Non-normal or nonconventional projects have cash flow patterns
with either more than one or no sign change(-ve cash flows) .
• Table illustrates the cash flow patterns for three sample projects X, Y
and Z.
• Projects X and Y can cause some analytical problems, Project X might
require that certain equipment be shut down and rebuilt in year 3,
and
• Project Y could be an investment in a (eg.) mining property, with the
negative cash flow in year 5 representing abandonment costs
associated with closing down the mine after its mineral wealth has
been depleted.
• Finally, Project Z, which generates negative cash flows over the entire
life of the investment, such as an investment in (eg.)pollution control
equipment.
• Regardless of whether a project’s cash flows are expected to be
normal or non-normal, certain basic principles should be applied
during their estimation, including the following:
1. Cash flows should be measured on an incremental basis.
• the cash flow stream for a particular project should be estimated from the
perspective of how the entire cash flow stream of the firm will be affected if
the project is adopted as compared if the project is not adopted.
2. Cash flows should be measured on an after -tax basis.
• Because the initial investment made on a project requires the outlay of after -
tax cash, the returns from the project should be measured in the same units.
3. All the indirect effects of a project should be included in the cash
flow calculations. (sudden infusion of working capital needs)
4. Sunk costs should not be considered when evaluating a project. A
sunk cost is an outlay that has already been made (or committed to be
made)
• Because sunk costs cannot be recovered, they should not be considered in the
decision to accept or reject a project.
• For example, in 2004, the Chemtron Corporation was considering constructing
a new chemical disposal facility. Two years earlier, the firm had hired the R.O.E.
Consulting Group to do an environmental impact analysis of the proposed site
at a cost of $500,000.
• Because this $500,000 cost cannot be recovered whether the project is
undertaken or not, it should not be considered in the accept –reject analysis
taking place.
5. The value of resources used in a project should be measured in
terms of their opportunity costs.
• Opportunity costs of resources (assets) are the cash flows those resources
could generate if they are not used in the project under consideration.
Sunk costs
• Money already spent and permanently lost. Sunk costs are past
opportunity costs that are partially (as salvage, if any) or totally
irretrievable and, therefore, should be considered irrelevant to future
decision making.
• Here are several examples of sunk costs:
• Marketing study. A company spends $50,000 on a marketing study to
see if its new auburn widget will succeed in the marketplace. The
study concludes that the widget will not be profitable. At this point,
the $50,000 is a sunk cost. The company should not continue with
further investments in the widget project, despite the size of the
earlier investment.
• Research and development. A company invests $2,000,000 over
several years to develop a left-handed smoke shifter. Once created,
the market is indifferent, and no one buys any no units. The
$2,000,000 development cost is a sunk cost, and so should not be
considered in any decision to continue or terminate the product.
• Training. A company spends $20,000 to train its sales staff in the use
of new tablet computers, which they will use to take customer orders.
The computers prove to be unreliable, and the sales manager wants
to discontinue their use. The training is a sunk cost, and so should
not be considered in any decision regarding the computers.
• Hiring bonus. A company pays a new recruit $10,000 to join the
organization. If the person proves to be unreliable, the $10,000
payment should be considered a sunk cost when deciding whether
the individual's employment should be terminated.
Terminal cash flow
Describe with suitable examples
a. Sensitivity analysis
A sensitivity analysis determines how different values of an independent variable affect a
particular dependent variable under a given set of assumptions. In other words, sensitivity
analyses study how various sources of uncertainty in a mathematical model contribute to the
model's overall uncertainty. This technique is used within specific boundaries that depend on
one or more input variables.

Sensitivity analysis is used in the business world and in the field of economics. It is commonly
used by financial analysts and economists, and is also known as a what-if analysis.

Example-
Sensitivity analysis can be used to help make predictions in the share prices of public
companies. Some of the variables that affect stock prices include company earnings, the
number of shares outstanding, the debt-to-equity ratios (D/E), and the number of competitors in
the industry. The analysis can be refined about future stock prices by making different
assumptions or adding different variables. This model can also be used to determine the effect
that changes in interest rates have on bond prices. In this case, the interest rates are the
independent variable, while bond prices are the dependent variable​.

b. Decision Tree analysis

A Decision Tree Analysis is a graphic representation of various alternative solutions that are
available to solve a problem. The manner of illustrating often proves to be decisive when
making a choice. A Decision Tree Analysis is created by answering a number of questions that
are continued after each affirmative or negative answer until a final choice can be made.
A Decision Tree Analysis is a scientific model and is often used in the decision making process
of organizations. When making a decision, the management already envisages alternative ideas
and solutions. By using a decision tree, the alternative solutions and possible choices are
illustrated graphically as a result of which it becomes easier to make a well-informed choice.
This graphic representation is characterized by a tree-like structure in which the problems in
decision making can be seen in the form of a flowchart, each with branches for alternative
choices.

Decision Tree Analysis example-

Suppose a commercial company wishes to increase its sales and the associated profits in the
next year.
The different alternatives can then be mapped out by using a decision tree. There are two
choice for both increase of sales and profits: 1- expansion of advertising expenditure and 2-
expansion of sales activities. This creates two branches. Two new choices arise from choice 1,
namely 1-1 a new advertising agency and 1-2 using the services of the existing advertising
agency. Choice 2 presents two follow-up choices in turn; 2-1-working with agents or 2-2- using
its own sales force.
 CORPORATE VALUATION
A business valuation is a general process of determining the economic value of a whole
business or company unit. Business valuation can be used to determine the fair value of a
business for a variety of reasons, including sale value, establishing partner ownership,
taxation, and even divorce proceedings. Owners will often turn to professional business
evaluators for an objective estimate of the value of the business.
The topic of business valuation is frequently discussed in corporate finance. Business
valuation is typically conducted when a company is looking to sell all or a portion of its
operations or looking to merge with or acquire another company. The valuation of a business
is the process of determining the current worth of a business, using objective measures, and
evaluating all aspects of the business.
A business valuation might include an analysis of the company's management, its capital
structure, its future earnings prospects or the market value of its assets. The tools used for
valuation can vary among evaluators, businesses, and industries. Common approaches to
business valuation include a review of financial statements, discounting cash flow models
and similar company comparisons.

REASONS FOR BUSINESS VALUATION

Business valuation to a company is an important exercise since it can help in improving the
company. Here are some of the reasons to perform a business valuation.
1. Litigation
During a legal dispute, for example, an injury case, divorce, or where there is an issue
with the estimation of the business, you may need to give evidence of your
organization's worth so that in the event of any harms, they depend on the genuine
worth of your organizations and not inflated figures assessed by a legal counselor.
2. Exit strategy planning
In occasions where there is an arrangement to sell a business, it is savvy to concoct a
base an incentive for the organization and afterward think of a technique to upgrade
the organization's productivity in order to build its incentive as a leave procedure.
Your business leave methodology needs to begin early enough before the exit, tending
to both automatic and willful exchanges.
A valuation with yearly updates will keep the business prepared for surprising and
anticipated deal. It will likewise guarantee that you have right data on the organization

1|Pa g e
 honest evaluation and forestall capital misfortune because of absence of lucidity or
mistakes.
3. Buying a business
Despite the fact that dealers and purchasers as a rule have different feelings on the
value of the business, the genuine business esteem is the thing that the purchasers are
eager to pay. A decent business valuation will see economic situations, possible pay,
and other comparative worries to guarantee that the speculation you are making is
suitable. It might be reasonable to recruit a business specialist who can assist you with
the cycle.
4. Selling a business
At the point when you need to offer your business or organization to an outsider, you
have to verify that you get what it is worth. The asking cost should be alluring to
planned buyers, however you ought not leave cash on the table.
5. Strategic planning
The genuine estimation of resources may not be appeared with a devaluation plan, and
if there has been no change of the monetary record for different potential changes, it
might be unsafe. Having a current valuation of the business will give you great data
that will assist you with settling on better business choices.
6. Funding
A target valuation is generally required when you have to haggle with banks or some
other possible speculators for financing. Proficient documentation of your
organization's worth is normally needed since it improves your validity to the
moneylenders.
7. Selling a share in a business
For entrepreneurs, legitimate business valuation empowers you to know the value of
your shares and be prepared when you need to sell them. Much the same as during the
offer of the business, you should guarantee no cash is left on the table and that you get
great incentive from your share.

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DIFFERENT APPROACHES TO CORPORATE VALUATION
3 approaches to corporate valuation
 Asset Approach
 Income Approach
 Market Approach

There are methods within each of the approaches.

 ASSET BASED APPROACH (NAV)
The asset-based method views the business as a set of assets and liabilities that are used as
building blocks of a business value. The difference in the value of these assets and liabilities
on a book value basis, or realizable value basis or replacement cost basis is the business
value. However, the NAV reflected in books do not usually include intangible assets and
earning potential of the business and are also impacted by accounting policies which may be
discretionary at times. Thus, NAV is not perceived as a true indicator of the business value.

Adjusted Net Asset Method

For calculating the Adjusted NAV, the valuer should factor in the fair value of assets,
contingent liability, tax shield on accumulated losses, impact of Auditor qualification and
Due Diligence, money to be received from warrants, stock options and impact of
corresponding shares, etc.
 INCOME BASED APPROACH
This is based on the premise that the current value of any business is a function of the future
value that the company can expect to receive. It is generally used for valuing businesses that
are expected to continue operating for the foreseeable future.

Capitalisation of Earning Method (PECV)

Basically, divides the expected stable earnings of a business by the capitalisation rate, which
is a rate of return required to take on the risk of operating the business (the riskier the
business, the higher is the required rate). While determining a capitalisation rate, it is
necessary to compare with rates available to similarly risky investments.

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Discounted Free Cash Flow Method (DFCF)
Expresses the present value of the business as a function of its future of its future cash
earnings capacity. Works on the premise that the value of a business is measured in terms of
future cash flow streams, discounted to the present time at an appropriate discount rate. The
value of the firm is arrived at by estimating the Free Cash Flows (FCF) to Firm after all
operating expenses, taxes, working capital and capital expenditure is met.

 MARKET BASED APPROACH

In this approach, value is determined by comparing the subject, company with its peers in the
same industry of the similar size and region. Most valuations in capital markets / M&A
transactions are market based. This is also known as Relative Valuation Method and is easiest
to use when there are companies comparable to the one being valued, assets are priced in the
market, and there exists some common variable that can be used to standardize the price.

Comparable Company Market Multiples Method (CCM)

It uses the valuation ratio of a publicly traded company and applies the ratio to the company
being valued. The valuation ratio typically expresses the valuation as a function of a measure
of financial performance or book value (e.g., EBITDA, EBIT, EPS or Book Value). Based on
the current market stock price and is generally viewed as one of the best valuation metrics
because markets are considered somewhat efficient.

Comparable Transaction Multiples Method (CTM)

With this technique of valuing a company for a merger and acquisition, the transactions that
have taken place in the industry which are similar to the transaction under consideration are
taken into account. Similar acquisitions or divestitures are identified, and the multiples
implied by their purchase prices are used to assess the subject company’s value. The more
recent the transaction, the better this technique, with all other things being equal.

Market Value Method (For quoted securities)

This is generally the most preferred method in case of frequently traded equity shares of
companies listed on stock exchanges having nationwide trading as it is perceived that the
market value of listed equity shares over an appropriate period of time, takes into account the
true potential of any company.

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DISCOUNTED CASH FLOW (DCF)
It is a valuation method used to estimate the value of an investment based on its expected
future cash flows. DCF analysis attempts to figure out the value of an investment today,
based on projections of how much money it will generate in the future. This applies to both
financial investments for investors and for business owners looking to make changes to their
businesses, such as purchasing new equipment. The present value of expected future cash
flows is arrived at by using a discount rate to calculate the discounted cash flow (DCF). If the
discounted cash flow (DCF) is above the current cost of the investment, the opportunity could
result in positive returns. Companies typically use the weighted average cost of capital for the
discount rate, as it takes into consideration the rate of return expected by shareholders.

Limitations
 Operating Cash Flow Projections
The first and most important factor in calculating the DCF value of a stock is
estimating the series of operating cash flow projections. There are a number of
inherent problems with earnings and cash flow forecasting that can generate problems
with DCF analysis. The most prevalent is that the uncertainty with cash flow
projection increases for each year in the forecast—and DCF models often use five or
even 10 years' worth of estimates. The outer years of the model can be total shots in
the dark. Analysts may have a good idea of what operating cash flow will be for the
current year and the following year, but beyond that, the ability to project earnings
and cash flow diminishes rapidly. To make matters worse, cash flow projections in
any given year will most likely be based largely on results for the preceding years.
Small, erroneous assumptions in the first couple years of a model can amplify
variances in operating cash flow projections in the later years of the model.
 Capital Expenditure Projections
Free cash flow projection involves projecting capital expenditures for each model
year. Again, the degree of uncertainty increases with each additional year in the
model. Capital expenditures can be largely discretionary; in a down year, a company's
management may rein in capital-expenditure plans (the inverse may also be true).
Capital expenditure assumptions are, therefore, usually quite risky. While there are a
number of techniques to calculate capital expenditures, such as using fixed asset

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 turnover ratios or even a percentage of revenues method, small changes in model
assumptions can widely affect the result of the DCF calculation.
 Discount Rate and Growth Rate
Perhaps the most contentious assumptions in a DCF model are the discount rate and
growth rate assumptions. There are many ways to approach the discount rate in an
equity DCF model. Analysts might use the Markowitzian R = Rf + β(Rm - Rf) or
maybe the weighted average cost of capital of the firm as the discount rate in the DCF
model. Both approaches are quite theoretical and may not work well in real-world
investing applications. Other investors may choose to use an arbitrary standard hurdle
rate to evaluate all equity investments. In this way, all investments are evaluated
against each other on the same footing. When choosing a method to estimate the
discount rate, there are typically no surefire (or easy) answers. Perhaps the biggest
problem with growth rate assumptions is when they are used as a perpetual growth
rate assumption. Assuming that anything will hold in perpetuity is highly theoretical.
Many analysts contend that all going concern companies mature in such a way that
their sustainable growth rates will gravitate toward the long-term rate of economic
growth in the long run. It is therefore common to see a long-term growth rate
assumption of around 4%, based on the long-term track record of economic growth in
the United States. In addition, a company's growth rate will change, sometimes
dramatically, from year to year or even decade to decade. Seldom does a growth rate
gravitate to a mature company growth rate and then sit there forever.

THE SHAREHOLDER VALUE APPROACH

It is a conceptually consistent, self-contained, market-based model for company valuation.
However, there are certain problems in its practical application, most of which relate to the
measurement techniques used. In reality, the capital markets are not perfect and estimates of
future developments will always remain fraught with uncertainty. The theoretical foundation
and comprehensive analysis of the shareholder value approach provides a means of corporate
valuation which is superior to traditional methods.

NEW APPROACHES TO SHAREHOLDER VALUATION

The concept of shareholder value is relatively straightforward in itself, yet many companies
still fail in putting it into practice. This is because expectations are too high. As is so often
true in business, there are no patent remedies or checklists which, when correctly applied,
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will automatically boost a company's value. Instead, each company must discover for itself
which lever to pull in order to generate added value. Major factors which help to create added
value are the followings:
 Cost leadership and differentiation: Michael Porter distinguishes between two types of
competitive advantage: cost leadership and differentiation. If a company decides on a
cost leadership strategy, its point will be to accomplish the most minimal expenses in
its industry for producing a given good or service. This will enable it to yield above-
average returns. With a strategy of differentiation, an organization endeavors to
separate itself from its rivals by choosing highlights which the clients need and which
can't be duplicated by different organizations in the same market.
 Organization: Constant change demands technology development from companies if
they are to survive in the global market. The commercialization of new technologies
requires special organizational structures, however. Creativity and technological
ability alone are not enough to succeed – innovation also needs to be backed up by
production processes, the marketing capacity to guarantee a successful launch,
effective channels of distribution and a service which maximizes the benefit to the
consumer.
 Strategic innovation: Strategic innovations do more than simply help achieve a
competitive advantage - they also help to undermine the position of competitors. To
do this, companies must either rebuild or restructure the value chain which breaks
their organization down into strategically relevant activities.
 Compensation and incentives: The division of ownership and control in major public
companies produces what are known as agency costs. High salaries, luxurious offices
and other forms of ―on-the-job‖ consumption reduce the value of the company at the
expense of the shareholders. In most cases, however, it is impossible to monitor the
efforts of a company's management in a cost-effective manner. Consequently, it
almost always makes sense to motivate managers into producing outstanding
performance by having the right incentive structures. Share and option schemes are
the most common form of incentive, turning managers into co-owners. Nowadays,
incentive structures are increasingly being extended to include ordinary staff share
schemes in addition to those for managers. They are used partly to retain a company's
intellectual capital and partly in order to increase productivity and commitment.

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  Optimizing capital structure: Since higher indebtedness often increases the overall
costs of capital, a company can create added value for its shareholders by repaying
surplus (equity) capital. In doing this, it has basically three options: share buy-backs ,
dividends (e.g. super dividends or bonus dividends), or reducing the par value of
equity securities. The most attractive option from a tax point of view is a reduction in
the par value of shares.
 Financial engineering: In the financial sector, in particular, there are numerous ways
in which financial engineering can increase the value of a company. For example, an
acquisition might release synergies by creating an ―internal capital market‖. As a
result, operating loans can be made from free cash flow instead of being sought
externally, or different currency positions can be netted against each other. A takeover
can also produce savings if the buyer's better credit rating means that the debts of the
target company can be refinanced at a lower interest rate. Simplifying the structure of
equity can also add value.
 Communications : Information is a key factor in maximizing shareholder value. The
more favorable investors judge the risk and return opportunities to be, the more likely
they are to make their capital available to companies on favorable terms. If investors
accept a lower return, the costs of capital are also lower, which directly increases the
value of the company. A transparent corporate communications policy boosts market
efficiency – which is also in the shareholders' interests.

FREE CASH FLOWS TO THE FIRM

 Free cash flow represents the amount of cash flows available for distribution from
operations, too, after depreciation expenses, taxes, working capital, and investments.
It is an estimation of an organization's benefit after all costs and reinvestments.
Likewise, it is one of the numerous benchmarks used to compare and analyze a
company's financial well-being. It is arguably the most important financial indicator
of a company's stock value. Positive FCFF esteem shows that the firm has money
staying after costs. A negative worth demonstrates that the firm has not produced
enough income to take care of its expenses and investment exercises. It incorporates
bondholders and investors as recipients while considering the cash left over for
financial specialists.

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  Formula for calculation:
FCFF = NI+NC+(I×(1−TR)) −LI−IWC
where:
NI = Net income
NC = Non-cash charges
I = Interest
TR = Tax Rate
LI = Long-term Investments
IWC = Investments in Working Capital

NOPLAT
 It stands for Net Operating Profit Less Adjusted Taxes. It represents the company's
earnings after subtracting income taxes related to core operations and adding back
overpaid taxes throughout an accounting period. It acts as a better indicator of
operating efficiency than net income as it uses income before taking interest payments
into account while calculating. In effect, this metric is a profit measurement that
includes the costs and tax benefits of debt financing.
 Formula for computing:
[(net income + tax + interest + non-operating gain/loss) * (1-tax rate)] + change in
adjusted taxes
 For example, if EBIT is $10,000 and the tax rate is 30%, the net operating profit after
tax is 0.7, which equals $7,000 (calculation: $10,000 x (1 - 0.3)). This is an
approximation of after-tax cash flows without the tax advantage of debt. Note that if a
company does not have debt, net operating profit after tax is the same as net income
after tax. When calculating net operating profit after tax, analysts like to compare
against similar companies in the same industry, because some industries have higher
or lower costs than others.
FREE CASH FLOW TO EQUITY
 Free cash flow to equity (FCFE) is the amount of cash a business generates that is
available to be potentially distributed to shareholders. It is calculated after all
expenses, reinvestment, and debt are paid. It is a measure of equity capital usage.
 The formula for calculation:
FCFE=Cash from operations − Capex + Net debt issued

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ECONOMIC VALUE ADDED
 Economic Value Added (EVA) or Economic Profit is a measure dependent on the
Residual Income strategy that fills in as a marker of the ventures' productivity. The
residual wealth is determined by deducting its capital expenditures from its operating
benefit and adjusted for taxes on a cash basis. Its primary reason comprises of the
possibility that genuine profitability happens when extra wealth is created for
investors and that undertakings should create returns over their capital expense. If a
company's EVA is negative, it means the company does not generate value from the
funds invested into the business. Conversely, a positive EVA shows a company is
producing value from the funds invested in it.
 The formula for computing:
EVA = NOPAT - (Invested Capital * WACC)
Where:
Invested capital = Debt + capital leases + shareholders' equity
WACC = Weighted average cost of capital

Example:

EVA Calculation

2016 2017 2018

Capital invested
$54,236.00 $50,323.00 $55,979.00
(beginning of year)
WACC 8.22% 8.28% 8.37%
Finance Charge $4,458.20 $4,166.74 $4,685.44

NOPLAT $7,265.00 $5,356.00 $4,336.00

Finance Charge $4,458.20 $4,166.74 $4,685.44
Economic Value
$2,806.80 $1,189.26 ($349.44)
Added

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ROI
Return on Investment (ROI) is a performance measure which is used to evaluate the
efficiency of an investment or we can say to compare the efficiency of a number of different
investments. ROI tries to directly measure the amount of return on a particular investment,
relative to the investment's cost.
Formula for calculating ROI is:
(Current Value - Beginning Value) / Beginning Value = ROI or ROI = Investment Gain /
Investment Base.
Example: An investor purchases property A, which is valued at $500,000. Two years later,
the investor sells the property for $1,000,000? Calculate ROI
We use the investment gain formula in this case.
ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%

EBIT
Earnings before interest and taxes (EBIT) is an indicator of a company's profitability. EBIT
can be calculated as revenue - expenses excluding tax and interest. EBIT is also referred to as
operating earnings, operating profit, and profit before interest and taxes. Generally, in
accounting and finance, earnings before interest and taxes is a measure of a firm's profit that
includes all incomes and expenses except the interest expenses and the income tax expenses.
Gross Sales – COGS and Business Expenses = EBIT or Net Profit + Interest and Taxes = EBIT

Example-Ron’s Lawn Care Equipment and Supply company manufacturers tractors for
commercial use. This year his income statement reports the following activities:
Sales: $1,000,000, CGS: $650,000, Gross Profit: $350,000, Operating Expenses: $200,000,
Interest Expense: $50,000, Income Taxes: $10,000, Net Income: $90,000
In this example, Ron’s company earned a profit of $90,000 for the year. In order to calculate
our EBIT ratio, we must add the interest and tax expense back in. Thus, Ron’s EBIT for the
year equals $150,000.

EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is essentially net
income (or earnings) with interest, taxes, depreciation, and amortization added back.
EBITDA can be used to analyse and compare profitability among companies and industries,
as it eliminates the effects of financing and capital expenditures.

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Gross Sales – COGS and Business Expenses = EBITDA OR Net Profit + Interest, Taxes,
Depreciation, and Amortization = EBITDA

ROCE
ROCE stands for Return on Capital Employed; it is a financial ratio that determines a
company's profitability and the efficiency the capital is applied. A higher ROCE implies a
more economical use of capital; the ROCE should be higher than the capital cost. A higher
ROCE shows a higher percentage of the company's value can ultimately be returned as profit
to stockholders. As a general rule, to indicate a company makes reasonably efficient use of
capital, the ROCE should be equal to at least twice current interest rates.
Return on capital employed formula is easy and anyone can calculate this to measure the
efficiency of the company in generating profit using capital. ROCE = EBIT/Capital
Employed (wherein EBIT is earnings before interest and taxes) EBIT includes profit but
excludes interest and tax expenses.
Example: Scott’s Auto Body Shop customizes cars for celebrities and movie sets. During the
year, Scott had a net operating profit of $100,000. Scott reported $100,000 of total assets and
$25,000 of current liabilities on his balance sheet for the year.

Accordingly, Scott’s return on capital employed would be calculated like this:

Return on Capital Employed Calculation= $100000/($100000-$25000)=1.3
As you can see, Scott has a return of 1.33. In other words, every dollar invested in employed
capital, Scott earns $1.33. Scott’s return might be so high because he maintains low assets
level.

RONA
Return on net assets (RONA) is a measure of financial performance calculated as net profit
divided by the sum of fixed assets and net working capital. Net profit is also called net
income.

The RONA ratio shows how well a company and its management are deploying assets in
economically valuable ways; a high ratio result indicates that management is squeezing more
earnings out of each dollar invested in assets. RONA is also used to assess how well a
company is performing compared to others in its industry.

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Return on net assets (RONA) is calculated by dividing a company's net income in a given
period by the total value of both its fixed assets and its working capital. Increases in RONA
indicate higher levels of profitability.

RONA = Net Income / (Fixed Assets + Working Capital)

For example, suppose that company XYZ owns, in a given period, $500k in fixed assets
accompanied by $300k in working capital. In the same period, XYZ generates $200k in net
income. XYZ's RONA would be calculated in the following way:

RONA = $200,000 net income / ($500,000 A Fixed + $300,000 C Working)

= $200,000 net income / $800,000 A Fixed and C Working
= 0.25 or 25%

In this instance, XYZ generated a 25% return on its working capital combined with its fixed
assets.

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Unit 6: Expansion and Financial Re-
structuring
Need for financial restructuring - Restructuring
through privatization-Restructuring of sick
companies - Mergers and amalgamations –
Calculation of purchase consideration- Share
exchange ratio- Evaluation of M&A decisions
(problems)- legal procedure for merger
–benefits and cost of merger; Corporate and
distress restructuring – Demergers- Leverage
buyout-share repurchases.
• Q 1. Which two leading telecommunication
companies merged with each other in the
year 2018?
• BSNL and Idea
• Vodafone and Idea
• Bharti Airtel and BSNL
• Jio and Vodafone
• BSNL and Jio
• Q 2. Which online food delivery platform
acquired Uber Eats in 2020, for around $350
million?
• Swiggy
• Zomato
• Flipkart Groceries
• Amazon Pantry
• None of the Above
• Q 3. Which leading private sector bank
acquired digital payment company,
Freecharge from Snapdeal in 2017?
• Axis Bank
• HDFC Bank
• ICICI Bank
• Citi Bank
• None of the Above
• Q 4. IDFC Bank and non-banking financial
company (NBFC) Capital First announced the
completion of their merger in which year?
• 2020
• 2005
• 2016
• 2017
• 2018
• Answer: (2) Vodafone and Idea
• Answer: (2) Zomato
• Answer: (1) Axis Bank
• Answer: (5) 2018
• https://byjus.com/govt-exams/mergers-
acquisitions-india/
• Corporate restructuring – business and
financial
• Debt/Equity restructuring
• Distress-induced restructuring
• Mergers & divestitures
• Leveraged financing
• A company is a “nexus of contracts” with
shareholders, creditors, managers, employees,
suppliers, etc
• Restructuring is the process by which these
contracts are changed – to increase the value of
all claims.
• Applications:
– restructuring creditor claims
– restructuring shareholder claims
– restructuring employee claims
 Why Restructure? Some Reasons
• Address poor performance
• Exploit strategic opportunities
• Correct valuation errors
 How Restructure?
• Fix the business
• Fix the financing
• Fix the ownership/control
• Create or preserve value
 The Privatization Initiative:
• Private sector led development is the cornerstone
of the economic development strategy in many
countries.
• For many nations privatisation has become the
only effective method of raising investment
capital on favourabale terms.
• High levels of past public sector borrowings have
put many nations under severe debt burdens.
• As a result these nations have been left with no
choice but to sell state assets to reduce debt,
generate revenue, and raise investment capital.
• Although privatisation has been going on in developed
countries since the early 1980s, it is a relatively new
phenomenon in developing Asia.
• In transition Asian economies, privatisation forms the core
of the fundamental systemic changes in their transition to
market economies.
• In some Asian economies, the recent financial crisis has
accelerated the increase of private-sector involvement.
• With the globalisation of the world economy, the global
marketplace is becoming more competitive.
• This would mean that in order to survive the developing
countries would have to achieve greater efficiency and
increased productivity.
 The privatization initiative has as its
objectives the following:
• To reduce the fiscal burden and to permit
industries to raise funds from the capital
market.
• To increase competition and efficiency and
induce technological modernisation as well as
provide better consumer services.
• To encourage broad-based share ownership in
the society.
• To create an enterprise culture.
• The privatization of SOEs is complemented and
supported by several other reform measures,
notably:
• strengthening the capital market;
• facilitating labour retrenchment and
compensation;
• reforming the taxation structure to create and
maintain an environment conducive to
privatization; and
• facilitating required regulatory activities.
Restructuring of sick companies
 CHAPTER 6

MERGERS AND ACQUISITIONS

Define and distinguish between the concepts of merger, takeover and

amalgamation. Illustrate your answer with suitable examples in the Indian
context.
A merger is said to occur when two or more companies combine into one company.

One or more companies may merge with an existing company or they may merge to

form a new company. In merger, there is complete amalgamation of the assets and

liabilities as well as shareholders’ interests and businesses of the merging companies.

There is yet another mode of merger. Here one company may purchase another

company without giving proportionate ownership to the shareholders’ of the acquired

company or without continuing the business of the acquired company. Laws in India use

the term amalgamation for merger. When an acquisition is a ‘forced’ or ‘unwilling’

acquisition, it is called a takeover.

Explain the concepts of horizontal, vertical and conglomerate merger with

examples.
Horizontal merger: This is a combination of two or more firms in similar type of

production, distribution or area of business. Examples would be combining of two book

publishers or two luggage manufacturing companies to gain dominant market share.

Vertical merger: This is a combination of two or more firms involved in different stages of

production or distribution. Joining of a TV manufacturing (assembling) company and a TV

marketing company or the joining of a spinning company and a weaving company are

examples of vertical merger. Vertical merger may take the form of forward or backward

merger. When a company combines with the supplier of material, it is called backward

merger and when it combines with the customer, it is known as forward merger.

Conglomerate merger: This is a combination of firms engaged in unrelated lines of

business activity. A typical example is merging of different businesses like manufacturing

of cement products, fertilizers products, electronic products, insurance investment and

advertising agencies. Voltas Limited is an example of a conglomerate company.

What are the advantages and disadvantages of mergers and takeovers?

The most common motives and advantages of mergers and acquisitions are:
▪ Maintaining or accelerating a company’s growth, particularly when the
internal growth is constrained due to paucity of resources;
▪ Enhancing profitability, through cost reduction resulting from economies
of scale, operating efficiency and synergy;
▪ Diversifying the risk of the company, particularly when it acquires those
businesses whose income streams are not correlated;
▪ Reducing tax liability because of the provision of setting-off accumulated
losses and unabsorbed depreciation of one company against the profits of
another;
▪ Limiting the severity of competition by increasing the company’s market
power.

What are the important reasons for mergers and takeovers?

A number of reasons are attributed for the occurrences of mergers and
acquisitions. For example, it is suggested that mergers and acquisition are
intended to:
▪ Limit competition
▪ Utilize the under-utilized market power
▪ Overcome the problem of slow growth and profitability in one’s own
industry
▪ Achieve diversification
▪ Gain economies of scale and increase income with proportionately less
investment
▪ Establish a transnational bridgehead without excessive startup costs to
gain access to a foreign market
▪ Utilise under-utilized resources—human and physical—and managerial
skills
▪ Displace existing management
▪ Circumvent government regulations
▪ Reap speculative gains attendant upon new security issue or change in P/E
 ratio
▪ Create an image of aggressiveness and strategic opportunism, empire
building and to amass vast economic powers of the company.

Discuss in brief the legislation applicable to mergers and takeovers in India. What
are the objectives of such legislation?
In India, mergers and acquisitions are regulated through the provision of the Companies
Act, 1956, the Monopolies and Restrictive Trade Practice (MRTP) Act, 1969, the
Foreign Exchange Regulation Act (FERA), 1973, the Income Tax Act, 1961, and the
Securities and Controls (Regulations) Act, 1956. The Securities and Exchange Board of
India (SEBI) has issued guidelines to regulate mergers, acquisitions and takeovers.
Mergers and acquisitions may degenerate into the exploitation of shareholders,
particularly minority shareholders. They may also stifle competition and encourage
monopoly and monopolistic corporate behaviour. The objective of these legislations is
to prevent such practices.

What do you mean by ‘tender offer’? What tactics are used by a target company
to defend itself from a hostile takeover?
A tender offer is a formal offer to purchase a given number of a company’s shares
at a specific price. Tender offer can be used in two situations. First, the
acquiring company may directly approach the target company for its takeover.
If the target company does not agree, then the acquiring company may
directly approach the shareholders by means of a tender offer. Second, the
tender offer may be used without any negotiations, and it may be tantamount
to a hostile takeover.
A target company in practice adopts a number of tactics to defend itself from
hostile takeover through a tender offer. These tactics include:
 Divestiture
 Crown jewels
 Poison pill
 Greenmail
 White knight
 Golden parachutes

What do you understand by leveraged buyout and management buyout? Explain

 the steps involved in the evaluation of LBO?
. A leveraged buyout (LBO) is an acquisition of a company in which the
acquisition is substantially financed through debt. When the managers buy their
company from its owners employing debt, the leveraged buyout is called
management buyout (MBO).
The evaluation of LBO transactions involves the same analysis as for
mergers and acquisitions. The DCF approach is used to value an LBO. As LBO
transactions are heavily financed by debt, the risk of lender is very high. Therefore,
in most deals, they require a stake in the ownership of the acquired firm.

What leads to the failure of a merger or acquisition? How should a company

ensure that merger or acquisition is successful?
Reasons responsible for the failure of a merger or acquisition are:-
1. Excessive premium
2. Faulty Evaluation
3. Lack of research
4. Failure to manage post merger integration
A company can ensure that the merger and acquisition is successful by proper
planning, search and screening, financial evaluation and most importantly, post-
merger integration.

What are the problems of post-merger integration? How can integration be

achieved?
Problems of post-merger integration are:-
1. Deciding authority and responsibility of employees
2. Cultural integration of the employees
3. Skill and competencies upgradation
4. Structural adjustments
5. Control systems
Peter Drucker provides the following five rules for the integration process:
▪ Ensure that the acquired firm has a “common core of unity” with the
parent. They should have overlapping characteristics like shared
technology or markets to exploit synergies.
▪ The acquirer should think through what potential skill contribution it can
make to the acquiree.
 ▪ The acquirer must respect the products, markets and customers of the
acquired firm.
▪ The acquirer should provide appropriately skilled top management for the
acquiree with in a year.
▪ The acquirer should make several cross-company promotion within a year.

What is the difference between the pooling of interest and purchase methods of
accounting for mergers? Illustrate your answer.
The merger should be structured as pooling of interest. In the case of acquisition,
where the acquiring company purchases the shares of the target company, the
acquisition should be structured as a purchase.
In the pooling of interests method of accounting, the balance sheet items
and the profit and loss items of the merged firms are combined without recording
the effects of merger. This implies that assets, liabilities and other items of the
acquiring and the acquired firms are simply added at the book values without
making any adjustments. Thus, there is no revaluation of assets or creation of
goodwill.
Under the purchase method, the assets and liabilities of the acquiring firm
after the acquisition of the target firm may be stated at their exiting carrying
amounts or at the amounts adjusted for the purchase price paid to the target
company. The assets and liabilities after merger are generally re-valued under the
purchase method. If the acquirer pays a price greater than the fair market value of
assets and liabilities, the excess amount is shown as goodwill in the acquiring
company’s books. On the contrary, if the fair value of assets and liabilities is less
than the purchase price paid, then this difference is recorded as capital reserve.
 Unit 7: Ethical Aspects in SFM
Ethical Dilemma faced by Financial Managers -
Need for corporate social responsibility -
Corporate governance- Key stakeholders of an
organization-shareholders, lenders, directors,
employees, customers, suppliers and the
government- Principles of Corporate
Governance- Audit Committee- Role of BOD-
Good CG practices
• Corporate Social Responsibility is a
management concept whereby companies
integrate social and environmental concerns
in their business operations and interactions
with their stakeholders.
• The evolution of CSR as a concept dates back
to the 1950’s when the first stirrings of social
conscience among management
practitioners and theorists were felt.
 Need
• 1. Better Public Image:
Each firm must enhance its public image to secure
more customers, better employees and higher profit.
Acceptance of social responsibility goals lead to
improve public image.
2. Conversion of Resistances Into Resources:
If the innovative ability of business is turned to social
problems, many resistances can be transformed into
resources and the functional capacity of resources can
be increased many times.
• 3. Long Term Business Interest:
A better society would produce a better environment in which the
business may gain long term maximization of profit. A firm which
is sensitive to community needs would in its own self interest like
to have a better community to conduct its business. To achieve
this it would implement social programmes for social welfare.
4. Avoiding Government Intervention:
Regulation and control are costly to business both in terms of
money and energy and restrict its flexibility of decision making.
Failure of businessmen to assume social responsibilities invites
government to intervene and regulate or control their activities.
The prudent course for business is to understand the limit of its
power and how to use that power carefully and responsibly
thereby avoiding government intervention.
 Importance of Social Corporate
Responsibility
· It aims at consumer protection.
· It aims at protection of local and global
environment .
· It ensures respect for human rights.
· It results in avoiding bribery and corruption.
· It promotes adherence to labour standards by
companies and their business partners.
 Benefits of Corporate Social
Responsibility
• · Productivity and Quality: Improved working conditions, reduced
environmental impacts or increased employee involvement in
decision making which leads to – increased productivity and
defective rate in a company.
• Improved Financial Performance: Socially responsible business
are linked to positive financial performances. Improved financial
results are attributed to stable socio political legal environment,
enhanced competitive advantage through better corporate
reputation and brand image, improved employee recruitment,
retention and motivation and a more secure environment to
operate in.
• • Brand Image And Reputation:
A company considered socially responsible can
benefit both from its enhanced reputation with
the public as well as its reputation within the
business community, increasing the company’s
ability to attract trading partners.
• Access To Capital: The growth of socially
responsible investing concept means companies
with strong CSR performance have increased
access to capital that might not otherwise have
been available.
 Corporate Governance
• Corporate Governance refers to the way a
corporation is governed. It is the technique by
which companies are directed and managed.
It means carrying the business as per the
stakeholders’ desires. It is actually conducted
by the board of Directors and the concerned
committees for the company’s stakeholder’s
benefit. It is all about balancing individual and
societal goals, as well as, economic and social
goals.
Benefits of Corporate Governance
• Good corporate governance ensures corporate success and
economic growth.
• Strong corporate governance maintains investors’ confidence, as
a result of which, company can raise capital efficiently and
effectively.
• It lowers the capital cost.
• There is a positive impact on the share price.
• It provides proper inducement to the owners as well as managers
to achieve objectives that are in interests of the shareholders and
the organization.
• Good corporate governance also minimizes wastages, corruption,
risks and mismanagement.
• It helps in brand formation and development.
• It ensures organization in managed in a manner that fits the best
interests of all.
• Agenda – 20/11/2020; 21/11/2020
• Ethical dilemma
• Principles of CG
• Case studies on CG
The role of ethics in financial management
is to balance, protect and preserve
stakeholders' interests.
1. Act with honesty and integrity.
2. Avoid conflicts of interest in professional
relationships. Also, avoid the appearance of such
conflicts.
3. Provide people with accurate, objective,
understandable information. Disclose all relevant
information, positive and negative, so that your
listeners have an accurate picture.
4. Comply with all rules and regulations governing your
position and your company.
5. Act with good faith and independent judgment.
6. Never share confidential information or use it for
personal gain.
7. Maintain an internal controls system
8. Report anyone you see violating the code.
• An Ethical Dilemma/Moral Dilemma/Ethical
Paradox is a problem in the DM Process of
personal, social and Professional Life

• Examples are
1. Taking credit for others’ work
2. Offering a client a worse product for your own
profit
3. Utilizing inside knowledge for your own profit
• Approaches to solve ethical dilemma are
1. Refute the paradox
2. Value theory approach
3. Find alternative solutions
• Principles of CG is built on the following four pillars
1. Fairness - stakeholders

2. Transparency – financial/operational

3. Accountability – good faith, due diligence and

care of BOD

4. Responsibility – Corporate Citizenship

• Major Outcomes of 18 member committee on CG constituted by
SEBI ON 07/05/1999. which was chaired by KM Birla, CA and
Industrialist

1. Audit and Remuneration Committee

2. One/more independent Directors from the above
3. Recognition of leadership role of chairman
4. Enforcement of Accounting standards
5. More disclosure on Annual financial Reports
6. Effective use of Power
7. Influence of Institutional shareholders
 Yahoo!
The $100Million Man
 Henrique De Castro
• In January 2014, Yahoo’s Chief Operating
Officer (COO), Henrique De Castro, was fired
after a mere 15 months on the job.
• Job history of De Castro:
1. Google,
2. McKinsey & Company
3. Dell,
• Firstly, De Castro would receive an annual
base salary of US$600,000, eligible for an
annual bonus set at 90%
• Secondly, he was also entitled to Long-Term
Incentive Equity Awards.
• Thirdly, De Castro was awarded a One-Time
Make-Whole Bonus of US$1 million
• A SEC filing by Yahoo in April 2014 revealed
that the package was worth US$57.96 million.
This included cash, Restricted Stock Units
(RSUs) that vested over time, stock options
linked to performance, and make-whole RSUs.
• The compensation package, which was worth
only US$17 million at the time the
employment contract was signed in 2012, was
inflated to more than three times at the
termination date2014.
• Analysts traced the increase in stock price to
Yahoo’s 24% stake in China’s Alibaba Group
• Alibaba going public on the New York Stock
Exchange, Yahoo would be able to reap a
multi-billion dollar windfall from its holdings
in the company.
• This would further inflate the compensation
packages of Yahoo’s senior executives.
• De Castro’s severance package was widely
seen as a golden parachute. These golden
parachutes provide a “soft landing” for the
executive upon termination2
1. Discuss the role that a company’s shareholders should play in
determining executive remuneration packages.
2. What factors may have contributed to Mayer’s decision to
nominate De Castro as the COO?
3. What are the roles of the Nominating and Remuneration
Committees in the hiring and remuneration of senior
executives such as De Castro?
4. What are the key features of De Castro’s remuneration
package? What are the key problems associated with the size
and structure of his remuneration package?
 SERVICES

Satyam case study

 Introduction
Satyam incorporated in 1987 as a Private limited company providing software &
consultancy services.

Satyam was involved in other business like construction & textile.

In 1991 company went for an IPO which was oversubscribed by 17 times.

In 1999 satyam had a presence in 30 countries across the world .

In 2001 satyam was listed on National Association of securities Dealer

Automated Quotation.

Satyam revenue grew to over us $2 Billion & net income us $ 417 billion.
 Background
Rammohan Roy resigned as the dean of ISB the resignation followed the
announcement previous day by Raju (Founder & Chairman) of India’s
fourth largest IT service company Satyam computer service limited.

The company had been inflating the revenue and profit for past several
years.

Rao resigned from the board of satyam with two other independent
directors.

The resignation of these directors were the result of deal by satyam to

acquire two companies run by Raju’s son one was the properties company
and the other was infrastructure.

The investors did not find any synergies in an IT company acquiring

companies involved in construction & infrastructure.
Governance
Practices
 Practices at Satyam
According to Satyam Annual Reports, Corporate governance was given
high importance in the company.
Core Value- Associate Delight, Investor Delight, Customer Delight
& Pursuit of Excellence

Delighting Stakeholders formed the cornerstone of all activities.

The directors and employees of Satyam were governed by a code of
conduct. The code specified that the employees and directors needed to
carry out their duties legally, honestly and ethically; comply with all the
laws governing the operations of the company and maintain high moral,
ethical and legal standards; avoid activities that created a conflict between
their own interests and the interests of the company and make timely
accurate disclosures to regulatory authorities.

The code of conduct also stated that “the policies and the procedures of the
company expect that the directors and associates avoid conduct of business
of the company with their relatives or their significantly associated
companies, firms and other businesses. In case of conflicts, disclosure shall
be made to the board of directors and its approval shall be obtained before
proceeding further.”

The company also had a whistleblower policy.

 Ethical
Standards
 Ethical standards:-
• Pressure to maintain this pace of growth
• Gap became a gulf
• Not following corporate As a part of ethical standards, They had very low
ethical standards in terms of corporate governance.

• Satyam’s point of view

• Increasing competition forced big corporations to do somethingbeyond
• their reach.
•
• Tata Consultancy Services (TCS)
• Infosys Technologies
• Wipro
• governance norms
• Tampering the financial data
• Misleading the shareholders fund
• Putting self-interest at the expense of shareholder’s interests
• Satyam scam is unparalleled in the corporate history of
India, and as some keen corporate observers point out, the world
itself.

• The idea of a corporation, and the values and principles that

should guide its governance have hardly been imbibed by
promoters.
• An careless administration, ill-equipped regulatory system and
terribly delayed justice delivery process only make things easier
for the corporate crooks to make a killing.
• Corporate governance framework needs to be implemented in
letter as well as spirit. The increasing rates of white collar crimes
demands stiff penalties and punishment.
• Creating an awareness of the large consequences of small lies may
help some to avoid this trap.
 Measures by Govt.
• New Board of directors.
• MCA appointed 3 new directors.
• Creation of audit committee.
• Appointment of internal auditor and legal
advisors.
• BCG was appointed as management advisors.
• CLB increased the share capital from 1.6
billion to 2.8 billion.
 The Aftermath
• Auditors will be held responsible.
• Tenure of auditor.
• Term of independent director.
• Accountability of independent director.
 Chanda Kochhar , The former the Managing Director (MD)
and the Chief Executive Officer (CEO) of ICICI bank. ICICI
bank is India’s largest private bank and overall second largest
bank in the country.
 She is widely recognised for her role in shaping the retail
banking sector in India and for her leadership of the ICICI
Group, as well as her contributions to various forums in India
and Globally.
 In 2014, she has been named among fortune’s 50 most
powerful women in business women in the fourth
consecutive year. Under the leadership of Kochhar, ICICI has
transformed itself from corporate bank into a retail bank, and
now a universal bank.
The leading private sector bank of the country is
never bereft(unbeloved) of women in senior
management.

Beginning with Lalita Gupte, the group has many women

executives- Kalpana Morparia, Shikha Sharma, Chanda
Kochhar and Renuka Ramnath.

Though the legendary CEO, K.V. Kamath groomed the next

generation leaders- Vishakha Mulye and Madhabi Puri-Buch, it is
Kochhar who made new as his successor.
 Problem: with Rajiv Kochhar
The CBI questioned ICICI bank CEO Chanda Kochhar’s brother-in- law
Rajiv Kochhar in connection with a preliminary enquiry (PE) into
allegations of nepotism and corruption in loans granted by the private
sector lender to the Videocon Group.

Questioned and then letoff.

This came days after the agency questioned a few ICICI Bank executives
to ascertain whether there was any wrongdoing in the bank issuing a Rs
3250 cr loan to Videocon Group in 2012.

Rajiv Kochhar, an NRI, is the CEO of Singapore- based Avista

Advisory Group which advises companies on financial restructuring,
mergers and acquisitions, and fund-raising.
 It was alleged that the company may have benefited from its founder’s
relationship with the ICICI bank CEO and got the mandate to restructure
foreign currency- denominated debt deals of seven companies, all borrowers
of the bank, as part of quid pro quo. (in favor)

 It was further alleged that the company may have got a commission of as
much as 5% for brokering loans from ICICI bank.

 Kochhar had denied any links with ICICI bank and allegations of any
wrongdoing.

 He had said that his company dealt with only international investors and not
Indian banks, and that he did not do business with his brother Deepak,
Chanda Kochhar’s husband and founder director of NuPower Renewables,
so there was no question of favouritism and conflict of interest.
 Problem: with Deepak and Dhoot
 In this case, the agency had registered a PE about two months
ago into dealings between Deepak Kochhar, Dhoot and
unidentified bank officials.

 The complaint in this regard was first made by investor

Arvind Gupta in 2016 in a letter to the PM, the
Enforcement Directorate, the CBI, the Reserve Bank of
India and other government agencies, seeking a probe into
the matter.
 Problem: with Deepak and Dhoot
 The ICICI bank has twice refuted(rejected) allegations that
it had given a loan to the Videocon Group due to the
group’s dealing with the bank CEO’s husband.

 Bank Chairman MK Sharma said Chanda Kochhar had

made all the necessary disclosure. The bank said that it
was only one of consortium of 20 lenders led by State Bank
of India that had granted about Rs 40000 Cr in loans to the
Videocon Group. It said the amount lent by ICICI bank was
less than 10% of the total amount.
 Problem: with Chanda Kochhar
 Question of Propriety:

 Now, for the first time, she has her back to the wall. And her
silence is as surprising as it is eloquent.

 Yes, the board of directors has come to her support. Their

defence is on these lines- there was no conflict of interest as
Videocon was not an investor in NuPower, the joint venture;
that the credit committee had many independent directors; that
the loan was part of a consortium; and that she made
disclosures as required under various laws.
 Problem: with Chanda Kochhar

The arguments are cleverly worded but this is an issue

that was never only about legality. It was about Ethics.
Propriety demanded that she should have disclosed to
the board her ‘interest’ in the Videocon loan on the
grounds that her husband had a business dealing with
the group.
 Second, the highest standards of Corporate
Governance demand that she should have
recused herself from the discussion at the
board and voting on the deal.

 To merely say that the board committee

sanctioning the loan was chaired by someone
else or that the committee had many
independent directors doesn’t let her off the
hook. A proposal worth Rs 3250 Cr doesn’t get
passed at the board level in any bank without it
being backed or pushed by top officials.
 What is the outcome?

 There is no easy way of saying it- but the way out of this
whole mess is for her to resign.

 Perhaps the Board may have to suggest it to her informally

and provide her an honourable exit.

 The current climate of public resentment as well as

intolerance for grey zones with regard to bad loans may
demand nothing less.
 What is the outcome?

 The damage to her as well as the bank’s reputation is colossal.

Her moral standing and ability to demand total integrity from
her staff and her effectiveness as a leader stands weakened.
And the damage goes beyond just affecting the morale of the
bank staff. What about those who looked up to her as a role
model and aspired to reach the top?

 Think of the setback to those who have been arguing for

privatisation of public sector banks on the grounds that they
are cesspools of corruption and ineff.
 Integrity, ethics and law

A woman is sexually harassed by a top-level senior executive in a large company. She sues
the company, and during settlement discussions she is offered an extremely large monetary
settlement. In the agreement, the woman is required to confirm that the executive did nothing
wrong, and after the agreement is signed the woman is prohibited from discussing anything
about the incident publicly. Before the date scheduled to sign the settlement agreement, the
woman's lawyer mentions that she has heard the executive has done this before, and the
settlement amount is very large because the company probably had a legal obligation to
dismiss the executive previously. The company however wants to keep the executive
because he is a big money maker for the company.

Q. What are the issues of integrity, ethics and law posed in the case study? What options does
the woman have, and what should she do and why?

Formulation o f Strategy (Cha pter 1 )

Alton Towers

Alton Towers was voted the UK’s number one theme park again this year. It is
located in th e h eart of En gland in Staffordshire, where there is easy access from both
the M1 and M6, altho ugh access through the village of Alton towards the site is
difficult. The roads are narro w and there are twisting bends, which coaches find
d if ficult to manoeuvre round.

The site evo lved from bein g a trad itional English garden attraction in the 1950s to an
ex citin g leisure park af ter a co mpany decision was made in the 1980s to convert the
gardens to an American-style theme park. The aim was to attract more visitors. The
idea was a success and ov er the years the park has been constantly updated with
increasin gly b igger and mo re ex citing rides and spectacular attractions. Alton
Towers set out to be th e market leader f rom the beginning. It boasts the best
attractions in the UK. It was the f irst to have the largest f lume in the world in 1982.

The co mpany was taken ov er by the Tussauds Group in 1990. Changes were made
to existing attractions and layo ut of the park. Other changes included a short walk
to wards Thund er Valley, leading to the Haunted House.

In 1994 the most spectacular rid e ever seen in the UK was introduced. This was
Nemesis – an inverted roller coaster. The thrilling suspended ride – Oblivion – was
op ened in 1998. This is a vertical drop roller coaster. The latest addition to the park
in 20 00 is the Hex – the legend of the Towers. This is a disorientating ‘haunted’
swin g. These ‘white-knuckle’ rides are now located in the X-Sector. In 1996 a
£ 1 0 m th emed hotel on the outskirts of the park was opened.
Participan ts in th e Haun ted House and X-Sector rides are photo graphed as they take
part. These ph otographs are ready for viewing and purchasing at the end of the
rid es.

There is an admission charge to the park, but once inside the park all the rides and
attractions are free. Ticket p rices are differentiated and include Peak and Off-Peak,
Day Tick ets, Family Tickets and Season Tick ets.
Visitors to the park can choose to eat at a variety of restaurants dotted all over the
p ark .
Each ride has its own souv enir shop attached and there are also gif t shops where
Alto n To wers merchandise can be purchased at prices to suit all pockets.
Alton Towers is op en every day to visitors from around 24 March until 31 October
each year. Every year 2.7 million visitors visit the park. The volume of visitors in
the su mmer means that lon g queues can form, although a ticket reservation process
is in operation for th e most popu lar rides. Alton Towers is not seeking to increase
the nu mber of visitors p assing through the gates, but to encourage people to spend
mo re o n f ood an d merchan dise and to come back again.

Alto n To wers: questions

1. (a) Alton Towers set ou t to be the ‘market leader’. Explain what this
mean s.

(b) What ev idence is given in the case study to suggest Alton

Towers is ach iev ing its objective of being market
lead er?

2. (a) State two advantages Alton Towers gained by being part of the
Tussaud’s group?

(b) Name one other Tu ssaud’s attraction .

3 . Exp lain ho w Alton Towers kept ahead of the competition in the years from
1 9 8 2 until present.

4. Explain the benefits to Alton Towers of having restaurants and

sou venir sh ops dotted around the site?

5 . Why does Alton Towers use differentiated prices for their admission
tick ets?

6 . Exp lain ho w Alton Towers can use field research and desk research to
f in d out if they are achieving th eir o b jectives.

7. Lately th ere h as been a lot of adverse publicity in the press concern ing
accidents on ‘white-knu ckle’ rides on the Pleasu re Beach, Blackpool. Do you
th ink this adverse publicity could have an effect on Alton Towers Theme
Park ? Explain your answer.
8 . Give two examples of how Alton Towers can promote itself as a safe park
to v isit.

9. State one advantage f or Alto n To wers o f selling tickets o n th e in ternet.

1 0 . Give one advantage f or customers of purchasing tickets on the internet