Corporate Finance Concepts-

Applicable to Infrastructure
sector

Ernst & Young LLP

Key Financial Terms

► Time Value of Money

► Discount Rate
► Discounted Cash Flow
► Net Present Value
► Amortization
► Tenor
► Cost of Capital
► Weighted Average Cost of Capital (WACC)
► Internal Rate of Return (IRR)
► Rental yield
► DSCR (Debt service coverage ratio)
► Depreciation
► Moratorium

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 Time Value of Money

► Basic foundation of all finance-business finance, consumer finance and govt. finance

► Isbased on the premise that money today is preferable to the same amount of money in
future, all other things being equal

► Time value of money happens because of the concept of interest

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 Time Value of Money

►Present Value: How much you have now?

►Future Value: How much what you have now grows to when
compounded at a given rate?
►For Example:
► Rs. 100 today becomes Rs. 110 next year @ interest rate of 10% p.a.
► In other words, earning Rs. 110 next year is equivalent to earning Rs. 100 now @ interest rate/discounting rate of 10%
p.a.
► Thus, one has to discount future years’ cash-flows to determine today’s value, in other words, Present Value (PV) at a
discounting rate which can be either Cost of Debt or Cost of Equity or Weighted Average Cost of Capital (WACC), as the
case may be

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Discount Rate

►The interest rate used in determining the present value of future cash
flows

►For example:
►Let's say you expect INR 1,000 in one year's time. To determine the present value

of this INR 1,000 (what it is worth to you today) you would need to discount it by a
particular rate of interest. Assuming a discount rate of 10%, the INR 1,000 in a
year's time would be the equivalent of INR 909.09 to you today (1000/[1.00 +
0.10]).

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Discounted Cash flow

►Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its future cash flows. DCF analysis finds the present of
expected future cash flows using a discount rate. A present value estimate is then
used to evaluate a potential investment. If the value calculated through DCF is
higher than the current cost of the investment, the opportunity should be
considered.

►The DCF method is an approach to valuation, whereby projected future cash

flows are "discounted" at an interest rate (also called: "rate of return"), that
reflects the perceived riskiness of the cash flows. The discount rate reflects two
things:

►The time value of money (investors would rather have cash immediately than
having to wait and must therefore be compensated by paying for the delay)

►A risk premium that reflects the extra return investors demand because they
want to be compensated for the risk that the cash flow might not materialize
after all

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Net present Value

►Net Present Value (NPV) method involves following steps:

a. Estimate the cash flows for each period for the life of the project, b.
Discount these cash flows at an appropriate discount rate to arrive at
present values of the cash inflows,
c. Subtract the initial investment from b) above to arrive at net present
value,
►NPV = ∑1-n Cft/(1+r)t-Cfo

CF0 = Cash outflow now (Initial Investment)

CFt = Cash inflow for Period ‘t’ (Normally 1 period = 1year)
t = Period ‘t’
n = Life of the project in number of periods
r = Discount Rate

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Amortization

►Amortization is the distribution of a single lump-sum cash flow into many smaller
cash flow installments, as determined by an amortization schedule. Amortization is
chiefly used in loan repayments. A greater amount of the payment is applied to
interest at the beginning of the amortization schedule, while more money is applied
to principal at the end.

►Amortization Schedule is a table detailing each periodic payment on a loan, as

generated by an amortization calculator.

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Cost of Capital

►The opportunity cost of an investment; that is, the rate of return that a
company would otherwise be able to earn at the same risk level as the
investment that has been selected.

►For example, when an investor purchases stock in a company, he/she

expects to see a return on that investment. Since the individual expects
to get back more than his/her initial investment, the cost of capital is
equal to this return that the investor receives, or the money that the
company misses out on by selling its stock

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Cost of Debt

►Cost of Debt (Kd): The effective rate that a company pays on its
current debt.

►The cost of debt is computed by taking the rate on a risk free bond
whose duration matches the term structure of the corporate debt,
then adding a risk premium.

► A company will use various debt instruments like bonds, loans and
other forms of debt; cost of debt reflects the overall rate paid by the
company for debt financing.

► Since interest expense is tax deductible, the after-tax cost of debt is

most often used. To get the after-tax cost of debt, the before-tax rate
is multiplied by one minus the tax rate.

►After Tax Cost of Debt = Before Tax Cost of Debt X (1 – Tax Rate)

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Cost of Equity

►Cost of equity is the return a firm theoretically pays to its equity

►investors.
►It is the compensation that the equity investor demands in exchange
for owning the asset and bearing the risk of ownership.
►Alternatively cost of equity is the rate of return that should have been
earned by putting the money in to a different investment with equal
risk.
►Cost of equity is difficult to calculate as share capital charges no
explicit cost.
► Debt is cheaper than equity because of followings:
►Extra compensation to equity holder for risk
►Tax advantage on debt

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Cost of Equity

► Re = Rf + b (Rm-Rf),

Where,

► Re = Cost of Equity
► Rf = Risk-free rate of return

► Rm = The historical return of the stock market / equity market

► b (b or Beta) = is a number describing the correlated volatility of an asset in relation to

the volatility of the benchmark that said asset is being compared to.

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 Weighted Average Cost of Capital (WACC)

►A calculation of a firm's cost of capital in which each category of

capital is proportionately weighted. All capital sources - common
stock, preferred stock, bonds and any other long-term debt - are
included in a WACC calculation.

►The weighted average cost of capital (WACC) is used in finance to

measure a firm's cost of capital. It had been used by many firms in
the past as a discount rate for financed projects, since using the
cost of the financing seems like a logical price tag to put on it.

►WACC should be ideally greater than Project IRR in terms of

Infrastructure project.

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 Weighted Average Cost of Capital (contd.)

►WACC is calculated by multiplying the cost of each capital

component by its proportional weight and then summing:

WACC= E/V*Re + D/V*Rd*(1-Tc)

WHERE:
► Re = cost of equity, Rd = cost of debt ,

► E = market value of the firm's equity,

► D = market value of the firm's debt,

► V = E + D,

► E/V = percentage of financing that is equity,

► D/V = percentage of financing that is debt,

► Tc = corporate tax rate

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 Internal Rate of Return (IRR)

►The Internal Rate of Return (IRR) is the discount rate that results in a
net present value of zero for a series of future cash flows. It is a
Discounted Cash Flow (DCF) approach to valuation and investing just
as Net Present Value (NPV).

►The major difference is that while NPV is expressed in monetary terms,

the IRR is the interest rate yield expected from an investment
expressed as a percentage.

►Both IRR and NPV are widely used to decide which investments to
undertake and which investments not to undertake.

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 Internal Rate of Return (IRR)

Ct = net cash inflow during the period t

Co = total initial investment costs
r = the discount rate, and
t = the number of time periods

IRR is sometimes referred to as "economic rate of return" or "discounted

cash flow rate of return." The use of "internal" refers to the omission of
external factors, such as the cost of capital or inflation, from the calculation.

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 Equity & Project IRR
► EquityIRR-Calculation of the internal rate of return considering the cash flows net of financing gives
us the equity IRR. It means the project is funded by a mix of debt and equity. If the project is fully
funded by equity, the project IRR and Equity IRR will the same. If the project is fully funded by the
debt, equity IRR simply doesn’t exist.

► ProjectIRR- Project IRR is determined at the project level, without considering cash flows related to
financing. In this computation of project IRR, interest and debt-service payments are kept out

► Most of the time equity IRR is greater than Project IRR because cost of debt is less than equity.

► The big question Can equity IRR be lower than project IRR?
► The equity IRR will be lower than the project IRR whenever the cost of debt exceeds the project IRR.
Note it is the cost of debt and not the weighted average cost of capital. when the cost of debt is
equal to the project IRR, the equity IRR is equal to the project IRR.

► Note that the cost of equity doesn’t impact either the project IRR or the equity IRR. Cost of equity
affects the weighted average cost of capital (WACC) and hence the NPV calculation. It affects both
project NPV and NPV for the equity holders.

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 Rental Yield (Real-estate specific)

►Rental Yield is the net amount of money a landlord receives in rent over one
year (after deducting operating expenses), shown as a percentage of the
money invested in the property.
►Rental yield= (Net Annual Rent/ Cost or Current Market Value) X 100

►Rental Yield is also called Cash Yield.

►Cash Yield or Rental Yield is calculated on Net Operating Income without

considering interest payment, tax and depreciation.

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 Rental Yield

►Rental Yield is the net amount of money a landlord receives in rent over one
year (after deducting operating expenses), shown as a percentage of the
money invested in the property.
►Rental yield= (Net Annual Rent/ Cost or Current Market Value) X 100

►Rental Yield is also called Cash Yield.

►Cash Yield or Rental Yield is calculated on Net Operating Income without

considering interest payment, tax and depreciation.

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 DSCR (Debt Service Coverage Ratio)

► DSCR-It is a measurement of the cash flow available to pay current debt obligations. The ratio
states net operating income as a multiple of debt obligations due within one year, including interest,
principal, lease payments etc.

► Typically, a DSCR greater than 1 means the entity – whether a person, company or government – has
sufficient income to pay its current debt obligations.

► The minimum DSCR a lender will demand can depend on macroeconomic conditions. If the economy
is growing, credit is more readily available, and lenders may be more forgiving of lower ratios

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Depreciation

► Straight-line depreciation is a very common and simple method of calculating the expense. In
straight-line depreciation, the expense amount is the same every year over the useful life of the asset.
► Depreciation Formula for the Straight Line Method:

► Depreciation Expense = (Cost – Salvage value) / Useful life

► Itis used in cash flow (in calculating Net Inflow PAT + Dep) and P&L Statement of Financial
analysis.

► Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and a Rs.0
salvage value. The depreciation expense per year for this equipment/ created asset would be as
follows:

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Depreciation

► Written down value depreciation is also known as Reducing Balance or Reducing Instalment
Method or Diminishing Balance Method. Under this method, the depreciation is calculated at a certain
fixed percentage each year on the decreasing book value commonly known as WDV of the asset
(book value less depreciation).

► The use of book value (the balance brought forward from the previous year) and fixed rate of
depreciation result in decreasing depreciation charges over the life span of the asset.

► While applying the depreciation rate both salvage or scrap value and removal costs are ignored. It is
not possible to reduce the book value to zero; but it can be reduced close to its salvage value at the
end of its useful life.

► In Infrastructure projects Financial analysis it used in Tax depreciation which can be listed as an
expense on a tax return for a given reporting period under the applicable tax laws. It is used to reduce
the amount of taxable income reported by a business. It is used in Taxation sheet of Financial analysis
to get net Tax liability.

► Depreciation as per Income Tax Act (Section 32) Depreciation is allowable as expense in Income Tax
Act, 1961 on basis of block of assets on Written Down Value (WDV) method, the percentage of
depreciation is taken as 10%.
Reference: https://www.incometaxindia.gov.in/charts%20%20tables/depreciation%20rates.html

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