COST OF

EQUITY AND
CAPITAL

Presentation by Group 3
Contents

•INTRODUCTION (THE COST OF EQUITY AND CAPITAL)

•RISKLESS RATE
•CURRENCY CHOICE AND REAL RATE
•RISK PREMIUM
•BETAS
•ESTIMATING THE COST OF EQUITY
•THE COST OF DEBT
•THE COST OF DEBT(ESTIMATION)
•THE COST OF HYBRID SECURITY
•MARKET VALUE DEBT RATION VERSUS BOOK VALUE DEBT RATION
•THE CAPITAL COST
THE COST OF EQUITY AND CAPITAL
To analyse firms, we have to know the cost of raising funds from equity investors, the interest rate they have t
o pay when they borrow and their overall cost of financing their operators and also to assess the quality of its
existing investment and to how much should they pay in dividends.
Only the portion of a firm’s risk that cannot be diversified away should be considered to be the equity risk in th
e firm and that the expected return on an equity investment should reflect the risk. Investors in equity in a firm
require this return to compensate for equity risk and the expected return is also the cost of equity to the firm.
A firm raise money from both equity investors and lends to fund their investments. Both the investors expect to
move a return.
The expected return for equity investors would include a premium for the equity risk in the investment. This is
known as Cost of equity.
The expected return that the lenders hope to move on their investments includes a premium for default risk an
d their expected return is known as a Cost of debt.
When we consider all the financing that the firm taker on, the composite cost of financing will be a weighted av
erage of the costs of equity and debt and this weighted cost is the Cost of Capital.

The need to know the cost of equity and capital

One of the fundamental decision that every assess business needs to move is to assess where to invest its fu
nds and to revaluate at regular intervals the equity of its existing investments.
The investment principle specifies that firms should invest in assets only if they expect them to earn more than
their handle rate.
THE COST OF EQUITY AND CAPITAL
The cost of equity and capital for a firm represent what the firm needs to move collectively on all its investment
s in order for them to be good investments.

Cost of Equity

The cost of equity is the rate of return. Investors require on an equity investors in a firm.

Expected return= Riskless rate + Beta (Risk premium)

This expected return to equity investors including compensation for the market rise in the investment and it is t
he cost of equity.
RISKLESS RATE
For an investment to be riskless over a specified time period two conditions are needed:

Firstly no default risk which means the government has to issue the security.

Secondly there is no uncertainty about reinvestment rates which states that there are no cash flows prior
to the end of our time horizon.

The Riskless rate is the rate on a zero coupon government bonds that matches the time horizon of the c
ash flow being analysed. Since the only cash flow is the principal on the bond coming due at no reinvest
ment risk

Riskless Rate when there is a Sovereign Risk

We have implicitly assumed in riskless rate that governments do not defaults on their obligations, that th
ey issue long term bonds and these bonds are traded to yield a market interest rate but in a number of e
conomic all these assumptions may be violated. The government might not issue long term bonds and b
est we can obtain is a short term government rate.
RISKLESS RATE
These are three ways in which can get around not having a long term default free rate.

•Bypassing the question of a riskless rate entirely by doing the analysis in a different currency where a riskless
rate is easy to obtain.

•The second is to find the rate at which the largest and safest corporation in that country can borrow long ter
m at the local currency and reduce that rate by a small default premium.

•Thirdly when short term government bond rate are available but not long term rates.
CURRENCY CHOICE AND REAL RATES
In most analysis many questions arise for Riskless rate. If we are working for example with an US compan
y then the riskless rate should always be a rate on an US company security and if that US Company plans
an investment in India, should use riskless rate and vice versa.

The answer is that the riskless rate has to be defined in the same terms as the cash flows on the analysis.
If the analysis is done in dollars terms then the riskless rate always has to be US government security eve
n if it is a US firm or non US and whether the project is in the United States or any other country.

We have no inflation considered in the currency that is some analysis is entirely based on real cash flows.
Thus risk has to be real visualize rate we can obtain that by

•If these are default free securities that guarantee a real note, that real rate is a real riskless note.

•If no such securities exist in the market then it can be approximated by a long term real growth rate of t
he economy.
RISK PREMIUM
A Risk premium is a measure of excess notes that is required by an individual to compensate for being subje
cted to an increased level of Risk. It should be a function of how risky reuse investors are and how risky they p
erceive stocks to be, related to a riskless investor.

Each investor in a market is lively to have a different perception of their premium; therefore the premium will b
e the weighted average of all these individual Premiums.

The two ways to estimate the Risk premium:-

Historical Risk premium

This is the most common approach to something the Risk premium is to be base it on historical data.

If we cannot use historical premiums then according to the fundamentals, the Risk Premium should be a functi
on of the volatility in the underlying Economy. To estimate we will use a two - part approach.

•Using country nothing to estimate default risk and spreads

•Adjust the country default spread to reflect the welfare volatility of the equity market.
RISK PREMIUM
Relative volatility of equity = Standard deviation of equity market in country / standard deviations of lo
ng term bonds issued by country.

A second approach to estimating risk premium does not need surveys or historical data. But it assumes that
overall market price stocks correctly.
BETAS
The second set of inputs that we need to put risk and return models into practice are the beta for investment. In the CAPM, the be
ta of an investment is the risk that the investment adds to the market portfolio. Three approaches are available for estimating the
se parameters:-

•Historical data on market prices for individual investments.

•To estimate the betas from fundamental characteristics of the investment.
To use accounting data.

HISTORICAL MARKET BETAS

The conventional approach to estimating the beta of an investment is a regression of returns of the investment against the return
on market investment. In theory, the stock returns on the asset should be related to the returns on the market portfolio that is a po
rtfolio that includes all traded asset to estimate the betas of the assets, to estimate the betas of the asset. The standard procedure
for estimating betas is to regress stock returns (Rj) against the market return (Rm).
RJ = a + bRm
Where, a = Intercept form of the regression, and b = Slope of the regression = Covariance (RJ, Rm)/σ2m
The slope of the regression corresponds to the beta of the stock and measures the riskiness of the stock. The intercept of the regr
ession shows a simple measure of performance of the investment during the period of the regression, when returns are against t
he expected returns from the capital asset pricing model.
BETAS
Now we consider some arrangements:
RJ = Rf + β(Rm –Rf)
= Rf (1- β) + βRm
Now we compare this above equation, the return on an investment to the return equation from the regression, Rj = a + bRm
Thus by comparing we get,
Intercept a = Rf (1 – β)
If,
a > Rf (1 – β)……… Stock did better than expected during regression period.
a = Rf (1 – β)……… Stock did as well as expected during regression period.
a < Rf (1 – β)……… Stocks did worse than expected during regression period.

The difference between a and Rj (1 – β) is called Jensen’s alpha, it provides a measure of whether the investment earned a retur
n greater than or less than its required return, given both market p

FUNDAMENTAL BETAS

A second way to estimate betas is to look at the fundamentals of the business. It is determined by decision the firm has made o
n what business to be in and how much operating leverage to use in the business, as well as by the degree to which the firm uses
the financial leverage.
BETAS
The beta of the firm is determined by three variables:-
•The type of business
•The degree of operating leverage of the firm
•The firm’s financial leverage

What is the degree of operating leverage?

The degree of operating leverage is the function of the firm’s cost structure and is usually defined in terms of the relationship betw
een fixed costs and total costs. A firm that has high fixed costs relative to total costs is said to have high operating leverage. A fir
m with high operating leverage will also have higher variability in operating income than a firm producing a similar product with lo
w operating leverage. Hence keeping everything same, the higher variance in operating income will lead to a higher beta for the fi
rm with high operating leverage.

Can firms change their operating leverage?

Although some firms cost structure is mainly determined by the business it does in the market. Though firms in the United States
have clearly shown a decreasing fixed cost component in their total cost structure. Firms have made the cost structure more flexib
le by:-
•By negotiating labour contracts that emphasize flexibility and allow the firm to make its labour cost more flexible to its financial su
ccess, hence a way to reduce the fixed cost of the production.
BETAS
•By initiating joint venture agreements where the fixed costs are taken by someone else
•The reduction of expensive plant and equipment

Since operating leverage affects betas, it is difficult to measure a firm’s operating leverage, at least from the outside since the fix
ed and the variable cost are often aggregated in income statements.

Degree of operating leverage = % change in operating profit / % change in sales

Degree of Financial leverage:- Other things remaining the same, an inc in financial leverage will increase the beta of the equity i
n a firm. We would expect that the fixed interest payments on debt to results in high net income in good times and negative net in
come in bad times.

βL = βu[1 + (1 – t) (D/E)]
where,
βL = Levered beta for equity in the firm
βu = Unlevered beta of the firm
t = Corporate tax rate
D/E = Debt
BETAS
What is Unlevered beta?

The unlevered beta of the firm is determined by the types of business in which it operates and its operating leverage. It is often als
o called the asset beta because it is determined by the assets owned by the firm. Thus levered beta, which is also the beta o f an
equity investment of the firm, since it is determined by both the riskiness of the business it operates in and by the amount of financ
ial leverage risk it has taken on.

EFFECTS OF LEVERAGE ON BETAS:

Taking account of the regression period from 1993 to 1998, Boeing ( An American multinational corporation that was founded in 1
5th July 1916 that designs manufactures and sells airplanes rockets satellites) had a historical beta of 0.96, their average deb
t was
Average Debt between 1993 to 1998 = 17.88%
Now to estimate the unlevered beta over this period we will use the corporate tax to be 35%
Unlevered Beta = Current Beta/ 1 + (1 – tax rate)( Average debt or equity)
= 0.96/ 1+ (1 – 0.35)( 0.1788)
= 0.860
Hence the unlevered beta for Boeing over 1993 to 1998 was 0.86
The levered beta at different levels of debt can then be estimated, then
Levered Beta = Unlevered Beta x [ 1 + ( 1 – tax rate )(Debt or equity)]
BETAS
For example,
If we consider the debt equity ratio to be 10%
Levered Beta = 0.86 [ 1 + ( 1- 0.35)(0.10)]
= 0.92

BOTTOM UP BETAS:-

We estimate the beta of a firm in four steps:

•We identify the business in which the firm operates.
•We estimate the average unlevered betas of other publicly traded firms.
•We take the weighted Average of the unlevered betas using the proportion of firm value derived from each business. The weight
ed Average is called the Bottom up unlevered beta.
•We estimate the current market values of debt and equity at the firm and we use this debt to equity ratio to estimate a levered
beta. The betas estimated using this process are called Bottom Up Betas.

Taking the Same example of the multinational company Boeing:

The company has undergone a significant changes in both its business and its financial leverage over the last five years. Com
mercial Aircraft which is Boeing core business of manufacturing commercial jet aircraft. For commercial aircraft we look at Boeing’
s own beta prior to its expansion in the defence business. The unlevered beta for Boeing as a company in 1998 can be estimated
by taking a value weighted Average of the betas of each of different areas.
BETAS
The weighted beta is estimated to be 0.88, the market value of equity of $32.60 bill and the value of debt of $8.2 bill , tax rate of
35% so the current beta of Boeing is
Equity Beta = 0.88[ 1 + (1 – 0.35)(8.2/32.60)]
= 1.014

ACCOUNTING BETAS:

A third approach to estimate Beta of an investment is to estimate the market risk parameters from accounting earnings rather tha
n from traded prices. Changes in earnings at a division or a firm on a quarterly or annual basis can be related to changes in earni
ngs for the market in the same period to estimate the Accounting betas.
First, accounting earnings tend to be smoothed out relative to the underlying value of the company as accounts spread expenses
and income over multiple periods.
Second, accounting earnings can be influenced by non-operating factors such as changes in depreciation or inventory methods
and allocations of corporate expenses at a divisional level.
Finally, accounting earnings are measured at most once every quarter and often only once in a year.

WHICH SHOULD WE USE? MARKET, BOTTOM UP AND ACCOUNTING BETAS

Betas can be estimated using accounting or market data or bottom up approach. We would mostly use historical market betas for
individual firms because of the standard errors in beta estimates the failure of the local indices and the inability of these
regressions to reflect the effects of major changes in the business mix and financial risk at the firm.
BETAS
In our view, bottom up betas provide the best beta estimates because
•they allow us to consider changes in business and financial mix.
•they use average betas across large numbers of firms,.
•it allows us to calculate betas by area of business for a firm, which is useful both in the context of investment analysis and valuati
on.
ESTIMATING THE COST OF EQUITY
In the following analysis, we are going to estimate the cost of equity using the CAPM approach to estim
ate the cost of equity. The following steps are :-
Step 1: Find the riskless rate of the market.
Step 2: compute or locate each company's beta.
Step 3: Calculate the risk premium
[The risk premium is calculated as the expected market return minus the market's riskless rate.]
Step 4: Now, by using the CAPM formula, how to calculate the cost of equity
Riskless Rate + Beta x Expected Risk Premium = Expected Return

Example,

Company A Company B
Riskless Rate 2.50% 2.50%
Beta 2.15 1.02
Expected risk
6.00% 6.00%
premium
ESTIMATING THE COST OF EQUITY
Expected return of company A = 2.50% + 2.15 x 6% = 15.4 %
As a result, the equity cost is 15.4 percent.
Expected return of company B = 2.50% + 1.02 x 6% = 8.6%.
Therefore cost of equity = 8.6%
The company with the highest beta is the company with the highest cost of equity and vice versa. The o
wner of a private firm generally invests the bulk of his or her wealth in business. Consequently, he or sh
e cares about the total area of the business rather than just the market risk. Thus, for a business, the bet
a we have estimated will understate the risk perceived by the owner.
THE COST OF DEBT
The cost of debt is the interest rate a business pays on its money owned. The cost of debts applies to
all outstanding debts, including the total value of business loans and bonds. The cost of capital is an exc
ellent indicator of a business's financial health, especially when it is considered alongside the total debt
amount.
Usually, the term "cost of debt" is used to describe the amount of debt after taxes are considered. As i
nterest expenses are tax deductible, the after-tax cost of debt is less than the cost of debt before it is tax
ed.
For example, a company with a low cost of equity may think it's worthwhile to take out an Rs. 1.5 lakh
mortgage for a retail store in another state because this branch is expected to make twice as much in its
first year of operation.
Businesses with a high cost of debt may delay this kind of business growth until they repay their debt an
d improve their cash flow.

ESTIMATING THE COST OF DEBT

We calculate the cost of the debt in the following ways.

[(total interest expense)/(total debt balance)] = effective interest rate x 100
(effective interest rate) (1-total tax rate) = Cost of debt
THE COST OF DEBT (ESTIMATION)
Example:

VPASS enterprise has two business loans:

(i) A loan of Rs. 1 lakh with an annual interest rate of 5%.
(ii) a Rs. 40,000 business loan with a 4% annual interest rate.
A VPASS enterprise pays a 20% central tax and a 5% state tax for a total company tax of 25%.

Solution:-
 Rs 1 lakh mortgage with a 5% annual interest = 5000
 A Rs. 40,000 business loan with a 4% annual interest rate = 1600
Total per weight loan factor (5000+1600 = 6600)
Effective interest rate = [6600/140000] x 100 = 4.71%
Cost of Debt = 4.71% x (1 - 25%) => 3.53%
THE COST OF HYBRID SECURITIES
Hybrid securities are those that combine the characteristics of two or more types of securities, typically in
cluding both debt and equity components. These securities allow companies and banks to borrow money
from investors and, although they are different mechanisms from bonds,

For example, Convertible Bonds - A convertible bond can be converted into equity, at the option of the bo
ndholder. A convertible bond can be viewed as a combination of straight bond (debt) and the conversion op
tion (equity).

In this section we consider the best way to estimate the cost of such securities, those are
Preferred stock:- It is a type of hybrid investment that acts like a mix between a common stock and Bond a
preferred stock gives us a piece of ownership of a company and like bonds we get a steady stream of inco
me in the form of dividend payments also known as preferred dividends the payments of preferred dividend
s are not that deductible.
The cost of preferred stock can be calculated by the following way:-
Cost of preferred stock = [preferred dividend per share / market price per preferred share] x 100

Example:-

In march 2015 General Motors had preferred stock that paid a divided of Rs 2.28 annually and traded at Rs
26.38 per share
Therefore cost of preferred share = [2.28/26.38] x 100 = 8.64%
MARKET VALUE DEBT RATION VERSUS
BOOK VALUE DEBT RATION
Market Value of debt is the value at which the investors in the company are ready to buy the debt, wher
eas, on the other hand.
Book Value of debt is the value of debt calculated as per the value present on the balance sheet of the
company.
It is easier to calculate the book value of debt as all the values are already present on the balance sheet
and one just has to add the value of all the components that are to be considered while calculating the bo
ok value of debt.
It is comparatively difficult to calculate the market value of debt because all the debts are not traded or tr
aded like in the case of a bank, they do not trade in the market and also their values tend to change from
time to time due to inflation factors. For debt that is not publicly traded, it is difficult to calculate its market
values.

Book value of company = Total assets - Total liabilities

Market value of a company = Current market price (per share) × Total no. of outstanding shares

An Example of the Book Value of a Company

Elite Enterprise's balance sheet for the fiscal year ending June 2020.
It reported total assets of around Rs. 3 lakh and total liabilities of about Rs. 1 lakh.
=> The book value of Elite Company is = (3,00,000–10,00,000) = Rs. 2,00,000/-
MARKET VALUE DEBT RATION VERSUS
BOOK VALUE DEBT RATION
An example of the market value of a company:

Elite Enterprise had Rs.10,00,000/- shares outstanding at the end of its fiscal year on June 30,2020.
On that day, the company's stock closed at Rs. 203.51 per share.
=> The market value of Elite company = (Rs.10,00,000 × Rs. 203.51) = Rs. 20,35,10,000
This market value is over 13 times the value of the company on the books.
THE CAPITAL COST
A company's calculation of the minimum return that would be necessary in order to justify undertaking a capita
l budgeting project, such as building a new factory.
The term “Cost of Capital" is used by analysts and investors, but it is always an evaluation of whether a proj
ected decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an inves
tment's potential return in relation to its cost and its risks.

Since a firm can raise its money from these sources: equity, debt, and preferred stock,
Therefore, the cost of capital is defined as the weighted average of each of those costs.

Cost of Capital = ke (E/D+E+PS)+ kd(D/D+E+PS)+kps(PS/D+E+PS)

Where,
ke = Cost of Equity
kd = Cost of Debt
kps = Cost of preferred stock
E = Equity
D = Debt
PS= Preferred Stock
THE CAPITAL COST
Example :
Suppose company A has the following details:
Equity Share Capital = 8,00,000
Debts = 6,00,000
Preferred share capital = 6,00,000
Total = (equity share capital + debt + preferred share capital)
=(8,00,000+6,00,000+6,00,000) = 20,00,000/-
Given,
ke = 16%
kd = 9%
kps = 12%
Therefore,

Cost of Capital

= 0.16 (8,00,000/20,00,000) + 0.09 (6,00,000/20,00,000) + 0.12 (6,00,000/20,00,000)

= 0.052+0.027+0.036
=0.115
=11.5%
Determining cost of capital is one of the key factors in deciding the investment. It helps us in evaluating the diff
erent investment projects on the basis of their cost benefits and risk.
INVESTMENT RETURNS
AND CORPORATE
STRATEGIES
Contents

•INTRODUCTION
•CHARACTERISTICS OF INVESTMENT
•ANALYSING A FIRM’S EXISTING PROJECT
•NPV (NET PRESENT VALUE)
•ANALYSING A FIRM’S PROJECT PORTFOLIO
•ACCOUNTING EARNING ANALYSIS
•GOOD PROJECTS
•MANAGEMENT ACTIONS IN INVESTMENT RETURNS
•ACQUISITIONS
•CORPORATE STRATEGY
•UNDERPERFORMING PROJECTS
INTRODUCTION

A main instrument of financial economics is Investment. A good investment creates value for the firm by giving a return that is greater th
an its hurdle rate. Actual returns or actual performance of the projects are most likely to deviate from the expected earning s. Some inve
stments do better than expected and some investments do worse than expected.

If the existing projects are making returns in excess of their hurdle rates, we look into the sources of those excess returns. They may ari
se from the consistent comparative advantage that a firm enjoys.

When existing projects are earning less than the hurdle rate, we mostly look into 4 issues.

1) The reason because of which the project did not provide anticipated returns, which was initially expected.
2) We next look into the systematic errors and biases that the investment may suffer.
3) We see how the firms can act to reduce the likelihood of investing in the wrong projects.
4) How the bad investments (where one gets a lower return than expected) are to be dealt with.
CHARACTERISTIC OF INVESTMENT
1. Risk Factor : Every investment contains certain portions of risk. It is the key features of investment which refers to loss o
f principal, delay in payment of interest and capital. Most investors prefer to invest in less riskier securities.

2. Expectation of Return : Return expectation is the main objective of investment. Investor expect regularity of high and co
nsistent income for their capital.

3. Safety : Investors expect safety for their capital. They desire certainty of return and protection of their investment or princi
pal amount.

4. Liquidity : Liquidity means easily sale or convert the capital or investment into cash without any loss. So most investors
prefer liquid investment.

5. Marketability : It is another feature of investment that they are marketable. It means buying and selling or transferability
of securities in the market.

6. Stability of income : Investors invest their capital with high expectation of income. So, return on their investment should
be adequate and stable.
ANALYSING A FIRM’S EXISTING PROJECT
A large firm always carries out a large number of projects. So, they have a very huge number of existing projects on their boo
ks. So, the actual question lies at the fact that “do they earn a return greater than the hurdle rate”?

So here the process of “ANALYSING AN INDIVIDUAL PROJECT USING ITS CASH FLOWS” comes into play.

Here the analysis of the project performance is mainly done by the actual cash flows generated by investment and measurin
g the return relative to the original investment in the project. They are mainly done by the accounting basis – we estimate a N
et Present Value and Internal Rate of Return for the project.

Unlike the NPV of a new project, which measures the value that will be added to the firm by investing in the project, the NPV
of an old project is always considered.
1) If the NPV is negative, the firm cannot reverse its investment on the project, but it might learn from its past mistakes.
2) If the NPV is positive, the projects effect on firm value is in the past.

Unlike the NPV of a project that is based on expected numbers, the NPV on an existing project is based on actual numbers.
NPV (NET PRESENT VALUE)
Net present value is a capital budgeting analysis technique used to determine whether a long-term project will be
profitable. The premise of the NPV formula is to compare an initial investment to the future cash flows of a project.

NPV Formula :
If there's one cash flow from a project that will be paid one year from now, then the calculation for the NPV is as follo
ws:
NPV = [ Cash flow/ (1 + i)^t] - (initial investment)
where: i = Required return or discount rate and t= Number of time periods
If analyzing a longer-term project with multiple cash flows, then the formula for the NPV of a project is as follows:
NPV = Σ Rt/ (1 + i)^t
Where: Rt = net cash inflow-outflows
i = discount rate or return
t = number of time periods
NPV (NET PRESENT VALUE)

A numerical example :
Suppose initial investment of a firm – Rs 80000
Cash flow of the firm - Rs 100000
Time period- 2 years
Rate of return – 10%

So, NPV = Cash flows/(1+i)^t – initial investment

= 100000/(1+0.1)^3 – 80000
= 57,174.21
As NPV > 0, so the firm will accept the project.
NPV (NET PRESENT VALUE)

A numerical example :
Suppose initial investment by a firm = Rs 5000
Cash flows at different time periods = Rs 1000, Rs 200, Rs 300
Cost of ca[ital of the firm = 12%
So NPV = -5000+(1000/1+0.12)+200/(1+0.12)^2 +300/(1+0.12)^3
= -Rs 3733.48.
As NPV<0, so the project should be rejected
Analysing a Firm’s Project Portfolio:

Analysing projects individually becomes impractical when a firm has dozens or even hundreds of projects. So, two approaches
are taken: a cash flow-based approach, whereby we measure returns based on cash flows and an earning-based approach, wh
ere we look at accounting returns.

Cash Flow Analysis:

Return on investment (CFROI) for a firm measures the internal rate of return earned by the firm's existing projects. It is calculat
ed using four inputs. The first is the gross investment (GI) that the firm has in its assets-in-place. This is computed by adding de
preciation back to the book value of the assets (net asset value) to arrive at an estimate of the original investment in the asset.
The gross investment, thus estimated, is converted into a current dollar value to reflect the inflation that has occurred since the
asset was purchased.

Gross Investment (GI):

= Net Asset Value + Cumulated Depreciation on Asset + Current Dollar Adjustment

.
ANALYSING A FIRM’S PROJECT PORTFOLIO:

The second input is the gross cash flow (GCF) earned in the current year on that asset. This is usually defined as the sum of the aft
er-tax operating income of a firm and the noncash charges against earnings, such as depreciation and amortization
The third input is the expected life of the assets (n) in place, at the time of the original investment, which can vary from business to
business but reflects the earning life.

We estimated this average cost of capital, based on the treasury bond rates at the start of each of the last 12 years, the firm's current
bottom-up beta, and the debt ratio for each year. We could have tried re-estimating the beta each year but chose not to do so. The c
ost of debt was estimated each year based upon the treasury bond rate that year.

The expected value of the assets (SV) at the end of the life, in current dollars, is the final input. This is usually assumed to be the portio
n of the initial investment, such as land and buildings, that is not depreciable, adjusted to current dollar terms.
ACCOUNTING EARNING ANALYSIS:
Earning based approach remain widespread popular because of two reasons:

1) Earnings can be easily obtained from firms’ financial statement

2) Earning s for a portfolio of projects can be linked to the cash flows on these projects.

The returns on equity and on capital are widely used accounting measures of return.

Return on Equity (ROE)= Net Income / Average Book Value of Equity.

Example - a company with an annual income of $1,800,000 and average shareholders' equity of $12,000,000. This compan
y's ROE would be 15%, or $1.8 million divided by $12 million.

Return on Capital (ROC)= Earnings before interest and taxes(1-tax rate) / Average Book Value of Capital.

Or, (Net income-Dividents)/(Debt+equity)= Return on capital

Example- Company A has Rs 100000 in net income, Rs 600000 in total debt and Rs 100000 in shareholder equity.
So, company A s ROC will be =100000/(100000+600000) = 14.3 %.

Accounting returns can be good substitutes for the cash flow returns if the following holds:

1) The income used is derived from existing investments and is not skewed by expenditures designed to provide future growth.
2) The book value of equity and capital measures the actual investment that the firm has in its existing investments.
GOOD PROJECTS
Good projects earn returns higher than their required returns. They are positive net present value for the farms investing in them
and increase firm value. A key requirement for the existence of a good project is the creation and maintenance of barriers to new
or existing competitors taking on some projects.

If there are no barriers to entry, the excess return will disappear, and no farm will be able to consistently invest in good projects.
These barriers can take different forms, like:-

•Economies of scale
•Cost advantages
•Capital requirements
•Product differentiation
•Access to distribution channels
•Legal barriers.

In this section, first, we consider the barriers to entry and how they provide firms with the opportunity to earn excess retu rns on inv
estments. Secondly, we develop a series of propositions that will allow us to analyze whether a firm will be able to maintain exces
s returns in the future too.
GOOD PROJECTS
Economies of Scale

Projects might earn high returns only if they are done on a large scale, thus restricting competition from smaller companies. For exampl
e, Walmart became the largest retailer by the mid-1990 in terms of total revenue, they started with a few stores in Arkansas in the 1980
s. They gained a huge amount of returns from its strategy of opening large retail stores providing a wide range of products at minimum
cost. This restricted the smaller stores because they couldn't match Walmart's price.

On the contrary, size doesn't guarantee that any firm will continue to earn access returns on projects.

For example, consider the automotive sector, where economies of scale is associated with producing cars. The strong competition amo
ng both domestic and foreign manufacturers for the automobile market has driven down the returns earned by these manufacturer s on t
heir projects.

PROPOSITION 1: “THE GREATER THE ECONOMIES OF SCALE ASSOCIATED WITH THE TYPE OF INVESTMENT, THE GREATER THE LIKELIHOOD
THAT LARGER BUSINESS ENGAGING IN THIS TYPE OF INVESTMENT WILL CONTINUE TO EARN HIGH RETURNS, RELATIVE TO SMALLER BUSINE
SSES.”

• Cost advantages
A company can develop cost advantage over its competitors either by using arrangements that its competitors cant use or buy u sing mo
re efficient.
For example:- South west Airlines established cost advantage over its competitors in late 1980s. They hired non union employees whic
h helped them to charge less per tickets hence attracting more passengers.
GOOD PROJECTS
PROPOSITION 2 : “FIRMS THAT HAVE ESTABLISHED A COST ADVANTAGE OVER THERE COMPETITORS IN A PARTICULAR BUSINESS ARE MUCH
TO LIKELY TO FIND GOOD PROJECTS. AS THERE COST ADVANTAGE DETERIORATES, THE NUMBER OF GOOD PROJECTS WILL ALSO DECLINE.”

In order to discourage new entrants, companies required a huge amount of investment.

For example, Boeing had high returns on investments in its aircraft business, which attracted competitors. But the large init ial investmen
t required to enter the business allowed going to gain there are high returns. This wasn't permanent for Boeing. In 1980, Air bus Industri
es was formed and financed by European countries that competed with Boeing to drive down the excess returns.

We need to keep in mind that, with relatively few firms competing in a business with capital requirements for new entrants prohibited, th
e chances of collusion between the existing competitors' increase.

PROPOSITION 3 : “FIRMS INVOLVED IN BUSINESS THAT REQUIRED A SUBSTANTIAL INITIAL INVESTMENT FOR COMPETITORS TO ENTER ARE MU
CH MORE LIKELY TO EARN EXCESS RETURN IN THEIR PROJECTS THEN ARE BUSINESSES WHERE NEW FIRM CAN ENTER AT LOW COST.”

Differentiation of products can be created in different ways:-

(i) An extensive advertising and promotion:- The main goal of advertising and promotion is to showcase the product with special feat
ures, perceived or real.
For example, Kellogg and General Foods continue to earn excess returns on their projects by advertising heavily and charging higher p
rices for their brand name. But this isn't sufficient. For a brand name to acquire value, consistency in product quality and genuine conce
rn for customer needs are essential.
GOOD PROJECTS
PROPOSITION 4: “COMPANIES THAT HAVE RECOGNIZED AND VALUABLE BRAND NAMES ARE MUCH MORE LIKELY TO EARN EXCESS RETURNS
ON THEIR PROJECTS THAN ARE COMPANIES THAT DO NOT.”

(ii) Technical Expertise.

Large research and development expenditures, better trained personnel, and superior production facilities are all sources of technical e
xpertise.

PROPOSITION 5 : “THE LIKELIHOOD OF EARNING EXCESS RETURNS ON A PROJECT WILL INCREASE IF THE COMPANY CONSIDERING THE PROJ
ECT HAS THE TECHNICAL EXPERTISE OR THE PRODUCTION FACILITY TO CREATE A PRODUCT THAT IS QUALITATIVELY BETTER THAN THOSE PR
ODUCE BY ITS COMPETITORS .”

Access to Distribution Channels

Companies that have much better way in to the distribution channels for their products that their competitors are better able to e
arn excess returns. In other words, one company owns the distribution channel and other competitors can’t develop their own dist
ribution channel because of cost restrictions. Example, phone and cable companies using their existing infrastructure they also pro
vide other services.
GOOD PROJECTS
PROPOSITION 6 : “FIRMS THAT HAVE PREFERENTIAL OR LOWER COST ACCESS TO DISTRIBUTION CHANNELS HAVE A MUCH GREATER CHANCE
OF MAKING EXCESS RETURNS ON PROJECTS THAT USE THESE CHANNELS.”

Legal and Government Barriers

In some cases firms owning product patent, enjoys the exclusive right to produce a product. Keeping in mind that owning produ ct patent
doesn’t ensure project success because other companies can develop their own products which are close .Thus, cutting off exce ss retu
rns. Example, Glaxo gaining extraordinary returns on ulcer drug because of parent rights to the drugs

PROPOSITION 7 : “A FIRM THAT POSSESSES A PATENT ON A PRODUCT INCREASES ITS LIKLIHOOD OF EARNING EXCESS RETURNS ON RELAT
ED PROJECTS, AT LEAST FOR THE LIFE OF THE PATENT. THE EXCESS RETURNS ARE LIKELY TO INCREASE IF THE CAPACITY OF COMPETITORS
TO PRODUCE CLOSE SUBSTITUTES DECREASES.”

Government restrictions on entry into an existing business helps the existing firms to earn excess returns. Similarly government ta
riff and quota on foreign goods help the domestic producers of such goods to charge higher prices and hence earn excess return
s.

PROPOSITION 8 : “FIRMS OPERATING IN BUSINESSES WHERE ENTRY IS RESTRICTED BY THE GOVERNMENT ARE MUCH MORE LIKELY TO .EARN
EXCESS RETURNS THAN FIRMS OPERATING IN BUSINESSES WHERE THERE ARE NO SUCH RESTRICTIONS”
MANAGEMENT ACTIONS IN INVESTMENT RETURNS

In a marketing context, return on investment is the amount of revenue a company generates per dollar spent on the tactics used to m
arket your product or service. This is important to measure to ensure that marketing activities are helping to build business (rather than
act as a cost center).

A well management team can increase both the number of good investments and the return from the investments by using their advant
age of existing competition or creating new ones. Although, the quality of management depends upon the quality of projects a firm poss
esses, but the existence of a good management team doesn’t always proves the existence of good projects. Chance influences the out
come of all projects and even the best plans of the management team to create project opportunities maybe destroyed by outsid e event
s.
ACQUISITIONS

An acquisition is when cash rich companies with limited investment opportunities acquire other firms with a ready supply of high return
projects.

Drawback of Acquisition

If the tangent firms are publicly traded, then their market price already reflects the expected higher returns not only on th eir existing proj
ects but also on their expected future projects.

In terms of present values,

Value of Firms = Present value of cash flows from existing projects + Net present value if cash flows from expected future proj
ects.

Thus, firms earning excess returns from existing projects and would like to maintain this in future will sell at prices that reflects this expe
ctations. The acquiring company has to earn more than the expected excess returns to be able to claim any added value from th e acqui
sition.
ACQUISITIONS

An acquisition will earn excess returns from the acquirer if and only if one of the condition hold.

•The acquisition price is below the fair price (i.e., the target company is significantly undervalued).

•The acquisition reflects the expectation that the firm will earn 25%, but the acquirer manages to earn an even higher return, say 30%, o
n future projects.

•The acquisition enables the target firm to accept projects that it would not have taken as an independent firm; the net present value of t
hese additional projects will then be a bonus earned by the acquiring firm. This increased value is the essence of synergy.

•The acquisition lowers the discount rate on projects, leading to an increase in net present value, even though the cash flow has not inc
reased.
CORPORATE STRATEGY

Corporate strategy is a unique framework that is long term in nature, designed with an objective to enable a firm to develop a lo
ng term capacity to differentiate itself and earn higher returns than its competitors. The effectiveness of a corporate strategic choi
ce is evaluate through its effect on the firm’s capacity to earn excess returns on its projects.

Two strategies suggested by leading thinker on corporate strategy, Michael Porter (1980) on how a firm can compete effectively
are:

•The firm can attempt to produce a product similar to those of its competitors but at a lower cost, thus giving cost advantage an
d becoming a “low cost leader ”.

•It can attempt to produce a better quality product that its competitors and use this product difference to charge a higher price o
r sell more quality of products.
CORPORATE STRATEGY

Empirical Evidence on Corporate Strategy Choices

• Evidence on relationship between competitive advantage and profitability. [Grant (1999)]

• Late entrants into consumer goods market incur additional advertising and promotional expenses amounting to 2.12% of reverse
s relative to earlier entrants.
• Profitability is higher in industries with very high entry barriers, relative to industries where barriers are moderate to low.
• Firms with more unionised employees are less profitable than firms with fewer or no unionised employees.

• Clark and Fujimoto (1999) shows evidence that Japanese volume producers were much quicker in developing new products t
han their U.S or European competitors.

• Fuller and Stopford (1992) show evidence that in mature industries, firms that are strategic innovators becomes winner.
UNDERPERFORMING PROJECTS:
In this section we concentrate how and why a project fails to generate less revenue than expected and
also how a firm can reduce it’s likelihood of investing in wrong projects and what they can do with the
bad investment.

Reason for project failure:

There are several reasons for which a project can fail. Those are discussed in the following section –

•Unanticipated Movements in Interest Rates and Inflation Rate: To analyse new investment we focus on c
urrent level of interest rates and expectations of inflation and overall economic growth in cash flows and disco
unts rates are built on that basis.

•Loss of Competitive Advantage: For a consistent good investment firm should have competitive advantage
s. If the competitive advantage at initial stage disappears during the lifetime of the project the excess return wil
l also disappear.

•Errors in Initial Investment Analysis: The assumptions ( project life, expenses, revenues, taxes and workin
g capital needs) contains some errors though showing the best information at the analysis time. Risky and lon
g term projects have more estimation errors than short term projects.
UNDERPERFORMING PROJECTS:
• Bias in Investment Analysis: There are three type of biases – Estimation Bias, Forecasting Bias and Op
timistic Bias.

• Manager’s preconceptions about projects and investment decisions give rise to estimation biases which ar
e not surprising to a analyst.
• Due to optimistic cash flows some bad projects are accepted sometimes which leads to a positive forecasti
ng bias in investment analysis.
• When the person prepare and evaluate the forecast and make investment decision then optimation bias se
ems to be pronounced.

Response to Bad Investment:

The most common response to correct a bad investment is to liquidate them but this response is sometimes n
ot appropriate:

1. Due to the huge cost of the existing large investment the firm will not necessarily recover the capital invest
ed by liquidating investment.
2. The cash flow on an existing project have to be evaluated entirely on a incremental basis. Thus , if the firm
is considering terminating the project, the incremental cash flow is the difference between the cash flow th
e firm can expect from continuing the project and the cashbox it could lose if the project is terminated . If th
e firm has already committed itself to the expenses on the project, for contractual or legal reasons it may n
ot save by terminating the project
UNDERPERFORMING PROJECTS:
Avoiding bad investments

As we have seen that projects which give fewer returns than required a firm should always avoid to invest in t
hose kind of projects. The firm can reduce the likelihood of investing in bad projects by taking a series of actio
ns that are given below :

Firstly, firm can organize the Investment analysis process to reduce the likelihood of conceptual errors and bi
as in the process. For instance, since bias seems to be greatest when analysis and decision making a combin
ed, form should consider separating the two roles.

Secondly ,firms can improve the quality of information available to managers when they are analyzing a parti
cular project

Thirdly, firm should hold managers responsible for their focus on investments. The analysis of existing invest
ments and the comparison of actual cash flows generated by an investment to the cash flows anticipated at th
e time of investment was initiated is an effective way of holding manager responsible for their forecast. It is als
o good way of highlighting problems of biases in the investment process and

Lastly, firms can even reduce their exposure to some external risk, such as interest rate or inflation risk, by us
ing risk management products and derivatives.
UNDERPERFORMING PROJECTS:
There is another process by which firm can reduce their investments in bad projects :

The firms can attempt to control the investment process by adding more constraints on project decisions, inclu
ding size constraints (such as project costing more than a certain amount will have to be sent back to corporat
e headquarters for approval)
Secondly payback requirements (for example only projects that pay off within 10 years can be accepted) or b
y setting the hurdle read well above the cost of equity or capital.
These constraints may protect the firm to invest in bad investments but this constraint create several costs tho
se are given below:
1. Good project may be rejected because they do not meet one or more of the arbitrary constraints created to
control the investment process
2. Managers may spend considerable time and resources figuring out ways to get around the constants and
end up accentuating the problems. For instance, investment required at forms with size constraints are oft
en broken up into smaller components to enable divisions to preserve their decision-making authority over
this project .
3. And lastly the investment process may be delayed, allowing competitors to print the form and introduce si
milar products.
CONCLUSION
COST OF EQUITY AND CAPITAL:

1. When we analyze the investments of a firm or assess its value, we need to know the cost that the firm faces in
raising equity, debt, and capital. The risk and return models can be used to estimate the costs of equity and capit
al for a firm.

2. Building on the premise that the cost of equity should reflect the riskiness of equity to investors in the firm, we
need three basic inputs to estimate the cost of equity for any firm, i.e., the riskless rate, the risk premium, and th
e beta.

3. The cost of capital is a weighted average of the costs of the different components of financing with the weights
based on the market values of each component. The cost of debt is the market rate at which the firm can borro
w, adjusted for any tax advantages of borrowing. The cost of preferred stock, on the other hand, is the preferred
dividend yield.
CONCLUSION
INVESTMENT RETURNS AND CORPORATE STRATEGY:

1. An Investments should earn a return greater than the hurdle rate and should have a positive net present val
ue in order to be a “GOOD INVESTMENT”.

2. We develop two measures of a firm overall project quality - a cash flow based measure called “Cash Flow Ret
urn On Investment” and accounting return based measure called “Economic Value Added”.

3. Good managers find ways to augment their existing competitive advantages and create new ones, and in the
process they create the way for continuing positive excess returns on new investments .

4. Consistent excess returns come from a firms competitive advantages including economies of scale, patents a
nd brand names.

5. Lastly, firms should liquidate underperforming investments only if the salvage value ( the value if the damaged
or worn out property) is greater than the present value of the expected cash flows from continuing with the invest
ment.
THANK YOU