Unit 4: Business Finance mind map

The aims of financial management, the long-term sources a firm can use, and the time value of money formulas.

Financial decisions and objectives

Financial decisions and the aim of wealth maximisation

Finance has three decisions: invest, finance and distribute. The best aim is wealth (value) maximisation, not profit maximisation.

• Investment: what to buy. Financing: how to raise funds, including capital structure and leverage.
• Dividend decision: how much profit to pay out.
• Wealth is the present value of all expected future cash flows.

Profit can be shaped by accounting choices. Cash is real. Present value also brings in timing and risk. That is why value maximisation is the most persuasive and lasting aim.

Sustainable growth rate and flotation costs

The sustainable growth rate is the growth a firm can fund from its own profits. Flotation costs are the expenses of issuing new securities.

• Sustainable growth = return on equity x retention ratio.
• Retention ratio = 1 - dividend payout ratio.
• Flotation costs: legal fees, administrative expenses, brokerage, underwriting.
• A risk premium is not a flotation cost.

If ROE is 30 per cent and payout is 40 per cent, retention is 60 per cent. Growth is 30 x 0.6 = 18 per cent. The firm can grow at that rate without new equity or a change in leverage.

Private equity, venture capital and mezzanine capital

Private equity and venture capital invest in companies outside the public markets. Mezzanine capital sits between debt and equity.

• Venture capital funds young firms. Private equity funds established firms, often for restructuring.
• Mezzanine capital: subordinated debt or preferred equity.
• The main advantage of venture capital is expertise and guidance.

Both are set up as independent pools of capital and face few regulations. But using the money for financial or operating restructuring is typical of private equity, not venture capital. Venture capital usually means giving up some ownership.

Long-term sources: preference shares, ECB, GDR and bonds

A firm can raise long-term funds in India and abroad. Preference shares have a legal maximum tenure.

• Preference shares in India: maximum 20 years (30 for infrastructure).
• ECB: external commercial borrowing, a long-term source.
• GDR: issued abroad against shares held by a custodian.
• Eurobonds, global bonds and Yankee bonds are international bonds.

GDR steps: registration, regulatory approval, appointment of custodian and vesting of shares, GDR allotment, listing. A Yankee bond is denominated in US dollars and issued in the USA. A Eurobond is issued outside the country of its currency.

Off-balance sheet finance, green bonds and bond rates

Some funds do not show as a liability. Bond interest depends mainly on credit rating.

• Off-balance sheet: securitisation, factoring, forfaiting, operating lease.
• Credit rating is not a source of finance.
• Green bonds raise funds for green projects. The main concern is limited investor demand.
• A bond's interest rate depends mainly on its credit rating.

A higher rating means lower default risk, so investors accept a lower rate. The interest rate on government securities sets the base. The company's rating adds the spread.

Short-term sources of finance

Short-term sources fund working capital. Long-term sources fund fixed assets and permanent needs.

• Commercial paper, factoring and a line of credit are short term.
• External commercial borrowing is long term.
• Trade credit and bank credit are common short-term sources.

Match the period of the source to the period of the need. Short-term funds are cheaper but must be renewed. Using them for fixed assets creates liquidity risk.

Time value of money

Present value, future value and annuities

Money today is worth more than the same money later because it can earn interest. Present and future value formulas link the two.

• Future value = cash flow x (1 + r)^t.
• Present value = cash flow / (1 + r)^t.
• Annuity: equal payments each period. Perpetuity: equal payments forever.
• Present value of a perpetuity = cash flow / discount rate.

Compounding goes forward in time. Discounting goes backward. An annuity uses tables: FVIFA for future value and PVIFA for present value. A payment of Rs 1,000 every year for ever at 10 per cent is worth Rs 10,000 today.

The rule of 72 and the rule of 69

The doubling time of money can be estimated by a rule of thumb. The rule depends on how interest is compounded.

• Rule of 72 for discrete (yearly) compounding.
• Rule of 69 (more precisely 69.3) for continuous compounding.
• Doubling time = 72 / rate in per cent.

At 8 per cent a year, money doubles in about 72 / 8 = 9 years. The number 69.3 comes from the natural log of 2. For discrete compounding, 72 is a better fit because it has more divisors.

How a firm judges long-term projects: payback, accounting rate of return, NPV, IRR, profitability index, and the problems when they disagree.

Methods and calculations

The capital budgeting process

Capital budgeting follows a fixed order, from finding an idea to reviewing its performance. NPV needs cash flows and a discount rate first.

• Identify the proposal, screen it, evaluate it, select it, implement it, review it.
• NPV steps: forecast cash flows, find the discount rate, compute present values, compute NPV, rank.
• Multinational steps: net outlay, net cash flows, discount rate, evaluation technique.

You cannot choose a project until its NPV is known. NPV needs a discount rate. The discount rate needs cash flows. So the order is fixed. Many exam sequences use slight wording changes.

Payback period

Payback period is the time taken to recover the initial outlay. It cares about recovery of cost, not profit.

• It ignores cash flows after the payback point.
• It ignores the time value of money.
• It suits over-leveraged firms and uncertain markets.

Add the yearly inflows until they equal the outlay. If the last year is only part-used, take a fraction. Payback is not a discounted method and does not measure profitability.

Accounting rate of return

ARR is average profit after tax divided by average investment. It uses accounting profit, not cash flow.

• ARR = average annual profit after tax / average investment x 100.
• Average investment = salvage value + half of (cost - salvage value).
• Profits given after depreciation and tax are used as they are.

First find the average profit. If earnings are before depreciation and tax, deduct depreciation and then tax. Then find the average investment. With no salvage value, it is half the cost.

Net present value and profitability index

NPV is the present value of inflows minus the present value of outflows. The profitability index is their ratio.

• NPV positive: accept. It adds to shareholders' wealth.
• PI = present value of inflows / present value of outflows.
• PI above 1 means NPV is positive.
• NPV satisfies the value additivity principle.

NPV gives an absolute rupee gain. It considers all cash flows and the time value of money. It gives less weight to distant receipts, not more. PI is the same idea as a ratio.

Internal rate of return and reinvestment

IRR is the discount rate that makes NPV zero. It assumes cash flows are reinvested at the IRR itself.

• In the IRR method, cash flows and life are known. The rate is unknown.
• NPV assumes reinvestment at the discount rate or cost of capital.
• Modified IRR assumes reinvestment at a stated rate.
• IRR considers all cash flows and the time value of money.

IRR assumes that every inflow earns the project's own rate, which can be unrealistically high. NPV's assumption is more realistic. MIRR fixes the problem by using the cost of capital as the reinvestment rate.

Techniques at a glance and DCF methods

Discounted cash flow techniques account for the time value of money. Payback and ARR do not.

• DCF: NPV, IRR and profitability index.
• Non-DCF: payback and ARR.
• ARR is based on accounting profit.

A match question gives definitions. NPV is the sum of present values of inflows less outflows. IRR equates present values. ARR is average profit after tax divided by average investment. PI is the ratio of present value of inflows to the outlay.

Conflicts, rationing and risk

When NPV and IRR disagree

NPV and IRR can rank mutually exclusive projects differently. The causes are differences between the projects.

• Time disparity: cash flows come at different times.
• Cost (size) disparity: outlays differ.
• Life disparity: project lives differ.
• Cash flow pattern disparity.

IRR favours a project with early cash flows or a small size, even when NPV favours the other. When they conflict, rely on NPV because it measures the rupee gain to shareholders.

Capital rationing and the optimal budget

Capital rationing means a firm cannot fund all profitable projects. The optimal budget is where the investment opportunity curve meets the marginal cost of capital.

• Causes: capital market imperfection, fear of losing control, inability to manage, poor market information.
• IOC ranks projects by IRR, from highest to lowest.
• MCC rises as more capital is raised.

The firm accepts projects as long as the IRR is above the marginal cost of raising one more rupee. It stops where the two curves cross.

Risk analysis and terminal cash flows

Risk in projects is studied with sensitivity, scenario and simulation analysis. The terminal year has special cash flows.

• Sensitivity: change one variable at a time.
• Scenario: change a combination of variables, such as best, base and worst cases.
• Simulation: a computer generates many scenarios from probability distributions.
• Terminal year: release of working capital and sale of assets, with tax on gains.

Sensitivity asks 'what if sales fall 10 per cent?'. Scenario analysis asks 'what if the economy is in recession?'. In the final year, working capital that was tied up comes back, and the asset is sold.

International capital budgeting and APV

Multinational projects add political and currency risk. The adjusted present value method values the base case and adds financing side effects.

• Political risk is part of multinational capital budgeting.
• APV rests on the value additivity principle.
• APV = base case NPV + present value of financing side effects.

First value the project as if all-equity financed. Then add the value of side effects such as interest tax shields and subsidised loans. The two parts are simply added.

What each source of funds costs, from debt to retained earnings, and how the costs combine into one overall rate.

Cost of each source

Meaning and use of the cost of capital

The cost of capital is the minimum return a firm must earn on an investment to keep its value unchanged.

• It is the discount rate in NPV.
• It is the cut-off rate for accepting projects.
• Each source has its own cost. The overall cost is their weighted average.

Debt is cheaper than equity, because lenders take less risk and interest saves tax. Equity is costlier because shareholders bear more risk and rank last in liquidation. A firm that earns less than its cost of capital destroys value.

Cost of debt

The cost of debt is the interest the firm pays, adjusted for tax and for any premium or discount on issue.

• After-tax cost = interest x (1 - tax rate) / net proceeds.
• A perpetual bond issued and redeemed at par costs its coupon, after tax.
• A premium raises the net proceeds and lowers the cost.
• A discount lowers net proceeds and raises the cost.

Interest is tax deductible, so the government shares part of the cost. A 7 per cent bond with tax at 30 per cent costs 7 x 0.7 = 4.9 per cent. For a bond issued at a premium, divide by the larger proceeds.

Cost of preference shares

Preference dividend is not tax deductible. The cost is the dividend divided by net proceeds, with an adjustment if the shares are redeemable.

• Irredeemable: dividend / net proceeds.
• Redeemable: add the yearly amortised gain, divide by the average of redemption value and proceeds.
• No tax adjustment is made.

For Rs 100 shares issued at Rs 95 with a 10 per cent dividend, cost is 10 / 95 = 10.53 per cent. The number of shares does not matter. For redeemable shares, the gap between redemption value and net proceeds is spread over the years.

Cost of equity: dividend growth model and CAPM

Cost of equity is the return shareholders require. It can be found by the dividend growth model or by CAPM.

• Dividend growth: Ke = D1 / P0 + g.
• With flotation cost f: Ke = D1 / (P0 x (1 - f)) + g.
• CAPM: Ke = Rf + beta x market premium.
• D1 = D0 x (1 + g).

If the dividend just paid is Rs 3 and grows 5 per cent, next year's dividend is Rs 3.15. At a price of Rs 63, yield is 5 per cent. Ke is 5 + 5 = 10 per cent. Under CAPM with Rf 6, beta 1.54 and premium 9, Ke = 6 + 13.86 = 19.86 per cent.

Retained earnings and implicit cost

Retained earnings are not free. They carry an implicit cost equal to the return shareholders give up.

• Implicit cost: no cash payment, but an opportunity cost.
• Equity share capital, debentures and preference capital involve explicit payments.
• A new issue is costlier than retained earnings because of flotation costs.

If profit is kept in the firm, shareholders lose the dividend they could have invested elsewhere. That forgone return is the cost. A new issue also pays underwriting and brokerage.

Weighted average cost of capital

The overall cost of capital is the weighted average of the cost of each source. Weights are the shares in the capital structure.

• WACC = sum of weight x cost.
• Use after-tax cost of debt when tax is given.
• With the NOI idea: overall cost = EBIT / value of the firm.

Take 20 per cent debt at 10 per cent and 80 per cent equity at 15 per cent. The weighted cost is 2 + 12 = 14 per cent. Another case: EBIT Rs 5 lakh, debt Rs 20 lakh at 10 per cent, equity cost 16 per cent. Equity value is 3 / 0.16 = Rs 18.75 lakh. Firm value is Rs 38.75 lakh. Overall cost is 5 / 38.75 = 12.9 per cent.

How much debt a firm should use: the approaches of Durand, Modigliani and Miller, the trade-off idea, and the three kinds of leverage.

Capital structure theories

Net income, net operating income and traditional approaches

These approaches ask whether debt changes firm value. Net income says yes, net operating income says no, and the traditional approach says up to a point.

• Net income (NI): more debt raises value and lowers the overall cost.
• Net operating income (NOI): value is unaffected, because equity cost rises linearly.
• Traditional: value rises, then falls beyond an optimum.
• NI and NOI are both by David Durand.

Under NI, cost of debt and equity stay constant. Under NOI, the cost of equity rises linearly with leverage. The traditional view lets cost of equity rise slowly at first, then sharply. The firm has an optimal capital structure.

Modigliani and Miller

Modigliani and Miller say capital structure does not matter in a perfect market. With corporate tax, debt adds value through the tax shield.

• Without tax: value is independent of leverage.
• Assumptions: perfect markets, no taxes, rational investors, 100 per cent payout, homogeneous risk, same expectations.
• With tax: levered value = unlevered value + tax rate x debt.
• Arbitrage through home-made leverage keeps values equal.

If two firms have the same earnings but different values, investors buy the cheap firm and sell the dear one, using personal borrowing. That arbitrage pushes values together. Asymmetric information is not an MM assumption.

Trade-off, pecking order and signalling

Newer theories explain real financing behaviour.

• Static trade-off: borrow until the tax benefit equals the cost of financial distress.
• Pecking order: internal funds first, then debt, then new equity. No target capital structure.
• Signalling: financing choices send a message to investors.
• Both pecking order and signalling rest on asymmetric information.

Managers know more than outsiders. If a firm issues new shares, investors suspect the shares are overpriced. So firms prefer internal funds. The match question pairs each theory with its key idea.

Debt capacity, target and optimum structure

A firm's debt capacity is the amount of debt it can carry safely. Target and optimum structures are goals.

• Debt capacity depends on the ability to generate cash flows.
• Optimum structure: the debt-equity mix that maximises firm value.
• Target structure: the debt ratio management aims to reach.
• A low debt ratio suits a new business because early earnings are uncertain.

The cash flow approach sets a tolerance limit on default risk. It estimates the cash flow distribution and finds the debt that meets the limit. A new firm should avoid heavy debt. Debt service is fixed, while its profits are low.

Interest coverage and the cost of more debt

Interest coverage tests how safely a firm can pay interest. More debt carries both explicit and implicit costs.

• Interest coverage = EBIT / interest.
• Preference dividend is not interest.
• Implicit cost of debt: shareholders demand a higher return as financial risk rises.

With EBIT of Rs 35 lakh, a 15 per cent loan of Rs 50 lakh gives Rs 7.5 lakh of interest. A 20 per cent loan of Rs 30 lakh gives Rs 6 lakh. Deposits of Rs 15 lakh at 14 per cent give Rs 2.1 lakh. Total interest is Rs 15.6 lakh. Coverage is 35 / 15.6 = 2.24 times.

Leverage

Operating, financial and combined leverage

Leverage magnifies change. Operating leverage links sales to EBIT. Financial leverage links EBIT to EPS. Combined leverage links sales to EPS.

• Operating leverage = contribution / EBIT.
• Financial leverage = EBIT / EBT.
• Combined leverage = contribution / EBT = operating x financial.
• EPS = EAT / number of equity shares.

Contribution is sales minus variable cost. EBIT is contribution minus fixed cost. EBT is EBIT minus interest. Take sales Rs 40 lakh, variable cost Rs 10 lakh, fixed cost Rs 15 lakh, interest Rs 5 lakh. Contribution is 30, EBIT 15, EBT 10. Operating leverage is 2, financial 1.5, combined 3.

Working out operating leverage from EBIT and fixed cost

Contribution can be found by adding fixed cost to EBIT. PBT is not needed for operating leverage.

• Contribution = EBIT + fixed cost.
• Operating leverage = (EBIT + fixed cost) / EBIT.
• PBT is used for financial leverage.

If EBIT is Rs 1,120 and fixed cost Rs 700, contribution is Rs 1,820. Operating leverage is 1,820 / 1,120 = 1.625. Financial leverage is 1,120 / 320 = 3.5.

How much profit to pay out: the theories of Walter, Gordon and Modigliani and Miller, the residual idea, and bonus and split decisions.

Dividend theories

Walter's model

Walter says the best payout depends on the firm's return on investment compared with the cost of equity.

• r above Ke (growth firm): best payout is 0 per cent.
• r equals Ke (normal firm): payout does not matter.
• r below Ke (declining firm): best payout is 100 per cent.
• Price = [D + (r / Ke) x (E - D)] / Ke.

A growth firm earns more on retained profit than shareholders could elsewhere, so it should keep all. A declining firm earns less, so it should pay out everything. A Walter question gives EPS, r, Ke and payout ratio.

Gordon's model and the bird in hand

Gordon says dividends matter. Investors prefer a sure dividend today to an uncertain capital gain later.

• Bird in hand argument: Gordon.
• Assumptions: Ke greater than growth, perpetual life, constant retention ratio, constant cost of capital, no taxes.
• Growth g = retention ratio x r.

If Ke were less than g, the price would be infinite. So Ke must be greater than g. Gordon assumes r and Ke are constant, not changing. The dividend payout ratio is the part of earnings paid to equity shareholders.

Modigliani and Miller on dividends

MM say dividends are irrelevant in a perfect market. The value of a firm depends on its investment policy, not on how profit is split.

• Assumptions: perfect markets, no taxes, certainty about future prices and dividends.
• The investment policy is fixed ahead of time and does not change with dividends.
• Any shortfall in funds is met by new outside financing.

When the firm pays more dividend, it raises new shares to fund the same projects. Shareholders are no better off, so the price does not change. This is the opposite of Gordon's view.

Residual theory, stock splits and payout facts

The residual theory pays dividends only from what is left after good projects are funded. A stock split cuts the price per share.

• Residual: accept all positive NPV projects, then pay what is left.
• Stock split aims: reduce market price and encourage wider ownership.
• Capital profits can be distributed as dividends if the articles allow and they are realised.
• Dividends are a cash outflow and affect liquidity.

A Rs 1,000 share split 1:10 trades near Rs 100. A lower price attracts small investors. The idea that dividends do not affect liquidity is false.

How a firm manages its short-term funds: the operating cycle, inventory, cash and receivables, and the financing mix.

Concepts and the cycle

Gross and net working capital

Gross working capital is the investment in current assets. Net working capital is current assets minus current liabilities.

• Negative net working capital means short-term funds have been used for fixed assets.
• The schedule of changes in working capital follows set rules.
• Higher net working capital does not always mean higher profit.

If current liabilities exceed current assets, some short-term money has paid for long-term items. In a schedule of changes: a rise in current assets raises working capital. A rise in current liabilities lowers it.

Operating cycle and working capital cycle

The operating cycle is the time from buying raw material to collecting cash. Subtract the payables period to get the net cycle.

• Order: raw material, work in progress, finished goods, receivables, payables deferral.
• Net cycle = gross cycle - credit from suppliers.
• A longer cycle needs more working capital.

A firm holds raw material 60 days, production takes 15, finished goods stay 30, debtors take 30 days. That is 135 days. Suppliers give 15 days of credit. The net working capital cycle is 120 days.

Determinants and financing approaches

Working capital needs depend on the nature of business and credit policy. The financing mix can be matching, conservative or aggressive.

• Determinants: nature of business, technology and manufacturing policy, credit policy, market conditions, business cycle.
• Aggressive: part of permanent working capital financed by short-term funds. Higher profit, lower liquidity.
• Conservative: more long-term funds. Higher liquidity, lower profit.
• Matching: maturity of funds matches the need. Trade-off is a compromise.

Short-term funds are cheaper but risky because they must be renewed. Long-term funds are dearer but safer. Operating cycle approach is a way to estimate the amount, not a financing mix.

Inventory, cash and receivables

Economic order quantity and inventory control

EOQ is the order size that minimises ordering and carrying cost. Control techniques classify items.

• EOQ = root of (2 x annual usage x ordering cost / carrying cost).
• Carrying cost per unit may be a percentage of unit price.
• Orders per year = annual usage / EOQ.
• ABC classifies by value. FSND by usage rate. JIT brings stock just in time.

Always convert usage to a year first. If monthly consumption is 1,350 units, annual is 16,200. Carrying cost 30 per cent of Rs 20 is Rs 6. EOQ is the square root of (2 x 16,200 x 2,400 / 6), which is 3,600 units.

Cash management models

Baumol and Miller-Orr models manage cash balances. Cash budgets can be prepared in three ways.

• Baumol model treats cash like inventory. Needs are known and steady.
• Miller-Orr model suits uncertain cash flows. It sets upper and lower limits and a return point.
• Cash budget methods: receipts and payments, adjusted net income, pro forma balance sheet.
• Financial slack is a cash reserve built from internal funds.

Baumol assumes cash needs are known with certainty. If the firm cannot forecast its needs, the Baumol assumption fails. Cash cycle is not a cash budget method.

Credit policy and receivables

A firm's credit policy has three parts: terms of sale, credit analysis and collection policy.

• Terms of sale: credit period, discounts, limits.
• Credit analysis: checking customers' creditworthiness.
• Collection policy: chasing overdue accounts.
• Factoring and credit rating are not components.

Factoring is a way to finance receivables by selling them. A credit rating is an external assessment. The policy itself is made of terms, analysis and collection.

How risk is measured and priced: CAPM, beta, diversification, APT, bond and share valuation.

Risk and return

Types of risk

Total risk splits into systematic and unsystematic risk. Business, financial and liquidity risk are more specific.

• Systematic (market) risk affects all firms and cannot be diversified.
• Unsystematic risk belongs to one firm and can be diversified.
• Business risk: fluctuation in profits. Financial risk: from capital structure.
• Liquidity risk: inability to pay dues on time.

An increase in corporate tax affects every firm, so it is systematic. A competitor entering the market hurts one firm, so it is unsystematic. Beta measures sensitivity to the market. The risk-free rate is the compensation for time.

CAPM, beta and real return

CAPM links expected return to systematic risk. Real return removes inflation.

• Expected return = Rf + beta x (Rm - Rf).
• Beta is influenced by portfolio size, estimation period, trading volume and return interval.
• Real return = (1 + nominal) / (1 + inflation) - 1.

With Rf 6, beta 1.5 and market return 10, the premium is 4. Expected return is 6 + 1.5 x 4 = 12 per cent. With a nominal return of 12.5 and inflation of 3.5, the real return is 1.125 / 1.035 - 1 = 8.70 per cent. The shortcut 9 per cent is only an approximation.

Bond prices and interest rates

Bond prices and interest rates move in opposite directions. Long-term bonds are more sensitive.

• When rates rise, bond prices fall.
• When rates fall, bond prices rise.
• Coupon rate = annual coupon / face value.
• Yield to maturity is the market rate required on the bond.

A long-term government bond fixes its coupon. If market rates rise, buyers will pay less for the old coupon. So the price falls. That is interest rate risk.

Portfolio management

Diversification and portfolio risk

Diversification reduces unsystematic risk. The benefit depends on the correlation between securities.

• Perfect positive correlation: no risk reduction.
• Perfect negative correlation: risk can be reduced to zero.
• Diversification cannot remove market (systematic) risk.
• The portfolio approach aims at risk optimisation.

If two securities move together exactly, a portfolio of them is just an average. If they move in opposite directions, the ups and downs cancel. The portfolio is judged as a whole, so the aim is the best risk-return trade-off.

Total return and international diversification

Total return is income plus capital gain over the purchase price. International diversification has barriers.

• Total return = (periodic receipts + capital gains) / purchase price.
• Barriers: exchange rate movements, market frictions, price manipulation, unequal information.
• A foreign equity should offer a better return to justify extra risks.

Buy at Rs 100, get Rs 5 dividend, sell at Rs 110. Total return is (5 + 10) / 100 = 15 per cent. The base is always the purchase price.

Arbitrage pricing theory

APT says expected return depends on several macroeconomic factors, not on market beta alone.

• Identify the macroeconomic factors.
• Estimate the risk premium for each factor.
• Estimate each factor sensitivity.

Factors can be inflation, GDP growth and interest rates. Each has a premium and the security has a sensitivity to each. APT is built on the idea that arbitrage removes mispricing.

Valuation

Earnings valuation ratios and growth opportunities

Valuation ratios compare price with earnings or book value. Price can be split into no-growth value plus growth value.

• P/E = price / EPS. Earnings yield = EPS / price.
• P/B = price / net worth per share. Relative P/E = firm P/E / index P/E.
• Price = EPS / capitalisation rate + PVGO.

If price is Rs 80 and the present value of growth opportunities is Rs 20, the no-growth part is Rs 60. At a 15 per cent capitalisation rate, EPS is 60 x 0.15 = Rs 9.

Risk management process

Risk management follows a logical order, from identifying the risk to getting feedback.

• Identify the risk variable.
• Determine frequency and severity.
• Select a risk model.
• Apply a risk instrument, then give feedback.

A firm asks what can go wrong, how often and how badly, which model to use, and then buys insurance or hedges. Feedback closes the loop.

Options and other derivatives, lease types, mergers and takeover defences, and how a firm hedges currency risk.

Derivatives and leasing

Options: calls, puts and terms

A call option gives the right to buy at a fixed price. A put option gives the right to sell at a fixed price.

• Call: right to buy. Put: right to sell.
• European option: exercised only at maturity. American: any time up to maturity.
• Option premium: paid by the buyer to the seller upfront.
• In-the-money: immediate exercise has positive value.

A question may swap the definitions of call and put. Currency option price depends on the spot rate, the exercise rate, the foreign risk-free rate and time to expiry. Black-Scholes assumes that underlying prices are log-normally distributed.

Uses and advantages of derivatives

Derivatives are used by hedgers, speculators and arbitrageurs. They have advantages and a danger.

• Hedgers: commercial producers who protect against price change.
• Arbitrageurs: earn riskless profit.
• Advantages: liquidity, insurance against risk, reduced price volatility.
• Leverage increases risk, so it is not an advantage.

Commodity futures began in Osaka in Japan. Financial derivatives came to India to manage the risk from greater volatility. Derivatives let people control a large position with little money. But losses are magnified as well.

Leasing

Types of lease and lease versus buy

A lease gives the use of an asset for rent. Types differ by who bears the risks and by how many parties are involved.

• Finance lease: lessor transfers substantially all risks and rewards.
• Operating lease: lessor keeps them.
• Sale and lease back: sell an asset and lease it back.
• Leveraged lease: three parties, with a financier.

A sale and lease back suits a firm with a liquidity crisis. It turns a fixed asset into cash and the firm keeps using it. A firm buys when the equivalent annual cost of owning is less than the best lease rate. The tax shield on depreciation and interest matters to both lessor and lessee.

Mergers and international finance

Mergers and takeover defences

Some mergers are arranged under supervision. Targets use defence strategies to resist hostile takeovers.

• Arranged merger: under BIFR supervision, a weak firm merged into a healthy one.
• Pacman defence: the target makes a counter bid for the bidder's shares.
• Crown jewels: the most valuable segments, wanted by the acquirer.
• White knight: a friendly third party who helps the target.

Cash cows are segments with high market share in slow-growth markets. Greenmail and poison pill are other defences. Poison pill makes the target less attractive. Greenmail buys back the raider's shares at a premium.

Hedging currency risk and cross-listing

Firms hedge currency exposure with operational and financial techniques. Cross-listing widens the investor base.

• Operational techniques: leading and lagging.
• Financial hedge: forward, money market, swap.
• A currency swap hedges foreign exchange risk.
• Cross-listing can lower the cost of capital.

Leading and lagging change the timing of foreign currency flows and do not need a contract. Pooling holds group cash centrally. Netting offsets receivables against payables. Cross-listing expands the investor base, improves liquidity and can raise the share price.