Companies strive to grow by investing in projects. Growth is a key objective of any business and the only way to grow is to keep investing in projects. Identifying and selecting projects that add value to the firm is called capital budgeting. It refers to the decision and process of investing in long-term assets—buildings, plant and machinery, and intangibles such as brands and patents. As the name suggests, the company is budgeting for capital to be invested for long-term growth.

Investment in long-term projects is amongst the most critical decisions that a company takes. Capital investment is a high-value, high-impact decision which has the potential to significantly alter the fortunes of a company. When Nokia decided to invest in mobile telephones, using the Global system for mobile communication (GSM) technology, it was quite a change from paper products, footwear, tires and radio telephony that comprised the company's product portfolio at the time. The decision paved the way for its global dominance for two decades, from the mid-1990s to the 2000s. Recently, however, it was unable to correctly judge the shift in market preference to smartphones, and Nokia decided not to invest wholeheartedly in this space. The decision proved fatal and the company not only lost its leadership position but had to sell its mobile business to Microsoft Ltd in 2014.

Investment in long-term projects may fall under any of the following categories:

1. 1. Expansion in existing capacities: a cement company increasing its capacity, from the existing 10 million to 15 million tons

2. 2. Diversifying into new products: the Mahindra Group diversifying into real estate in the early years of the twenty-first century through Mahindra Lifespace Developers Ltd

3. 3. Expanding to new markets/customers: an Indian bank going global and opening branches in the United Kingdom (UK), Maruti Ltd moving to the premium car segment and targeting a new set of customers

4. 4. Acquisition: Kotak Mahindra Bank acquiring Vysya Bank for approximately ₹150 billion, Facebook's acquisition of WhatsApp for US$19 billion

5. 5. Changes in the way business is run: installing an enterprise resource planning (ERP) System

6. 6. Replacement of old machinery

7. 7. Investing in research and development (R&D)

8. 8. Others: pollution related, investing for regulatory compliance

Corporations are complex entities which witness a constant interplay of the policies of the management with the external environment, leading eventually to financial outcomes. At times, the financial outcomes are in accordance with the objectives of the company; at other times, the two may diverge. Whether the desired outcomes are being realized or not, the management needs to continually analyse the performance of the company and consider ways to improve upon it.

Ratio analysis is a tool that is extensively used to scrutinize the performance of a company. Its extensive usage is a reflection of the easy understanding and wide applicability of the concept. A ratio is an arithmetical relationship between two numbers, the numbers being usually picked from the accounting statements. It is important to pick numbers that have a meaningful relationship with each other and whose ratio reveals some key performance parameters of the company. Else, the ratio would be irrelevant, even misleading.

All stakeholders—shareholders, bond holders, bankers, suppliers, employees, customers and, above all, the management—use ratios to monitor various aspects of the performance of the company. Different stakeholders use different ratios, appropriate to their specific requirements. Investors in the stock market are interested in market-based ratios such as the price earnings (P/E) ratio and the market price to book value ratio. Long-term lenders value leverage and debt service coverage ratio. Short-term lenders prefer liquidity and, therefore, are keen to know the current ratio and the quick ratio. No single ratio or set of ratios can be appropriate for all occasions and purposes.

The ratios we calculate and analyse should be appropriate for our objectives, be it performance evaluation, credit analysis or equity investment. Ratios are just numbers that tell us nothing by themselves. The interpretations of these numbers is critical and we must compare ratios across industries and over time in order to draw legitimate conclusions.

Let us try and look at ratios differently, basing our analysis on the return on equity (ROE). It is a key parameter of performance. Given the risk profile of the company, managers try to maximize the return investors get on their equity investments. Let us see how different ratios dovetail into and capture the ROE.

Laker Airways enjoyed a lucrative business in the 1970s, carrying tourists from the United Kingdom (UK) to the United States of America (USA). The business was highly successful, and the company purchased additional aircraft to cater to the rising demand. It financed the aircrafts by borrowing in US dollars, thus creating a mismatch. While its earnings were primarily in GB pounds, it created liabilities in US dollars. In 1981, the US dollar strengthened and continued to remain strong for a few years. A high dollar (low value of GB pounds) increased the cost for British travellers and reduced the demand, and revenues, for Laker Airways. At the same time, the interest and repayment of loans, being in US dollars, became more burdensome. Eventually, the company became bankrupt.

The foreign exchange market is the market for trading currencies of different countries. Each country has its own currency which can be used to purchase goods and services in that country. Indians earn in Indian rupees and spend in it. The citizens of Thailand earn in Thai baht and spend in the Thai baht. The currency of a country is acceptable within its boundaries but usually not outside it. However, there are currencies such as the US dollar, the GB pound, the euro and the yen, which are widely accepted by traders around the world. All the same, transborder trade and investment requires converting the currency of one country to that of another.

The Indian rupee is not a widely accepted currency outside India. When we travel abroad, we stock up on US dollars, GB pounds or euros to be able to pay for goods and services we buy locally in the country we visit. Similarly, when corporates make acquisitions abroad, they must pay in the currency of the other country as Tata Sons Ltd did when it paid in GB pound for purchasing the iconic Tetley Group, UK (GB£271 million).

As a simple illustration, when Infosys Ltd undertakes a project for General Electric in the USA, it earns in US dollars for the project.

The objective of a company is value maximization. Valuation is the theme that runs through the entire gamut of corporate finance; understanding valuation is critical in order to understand corporate finance.

1. 1. Fund managers and equity analysts determine the value of companies in order to take decisions on buying and selling equity shares. Valuation is the basis of equity research and portfolio management.

2. 2. Valuation guides M&A transactions. Acquisitions are undertaken at a certain price; without knowledge of the company's value, it becomes difficult to price mergers.

3. 3. Investment bankers value companies to arrive at the right price for an initial public offering (IPO).

4. 4. Venture capitalists need to value business proposals for them to undertake an investment.

5. 5. The management needs to know the right value of their own company to decide on stock repurchases (shares buyback).

6. 6. And, of course, managers must understand valuation and its principles to be able to maximize value for their ultimate owners, namely the shareholders.

Valuation is an elusive concept which no one has been able to master. It is not a precise science. The speed of travel can be measured to a precise number. Genetic characteristics remain the same irrespective of the scientist studying them. If one valence of magnesium is combined with two valences of chloride, the outcome will always be magnesium chloride. Value is, however, different for different people and even to the same person at different points in time. Vincent van Gogh produced over 800 paintings. In his entire lifetime, he was able to sell only one of them—for US$25. Some years back, one of those unsold paintings was auctioned for US$66 million! Absolute value is a myth.

Beauty lies in the eye of the beholder. Similarly, value depends on how much the buyer is willing and able to pay. The proof of value is when the investors loosen their purse to spend cash and buy the security. Investors need to back up with money what they say with their mouth.

Figure 5.1 shows annualized returns on investment in the US equities over a period of 92 years from 1926 to 2017. The return in any given year varied significantly from the average (10.20 per cent), varying from more than 50 per cent to being significantly in the red. The variability in returns can test the patience of even the most experienced investors. In 1930, the return was −44 per cent. This was on top of a negative return of over 27 per cent in the previous year. An investor who had invested US$100 in the US stocks at the end of 1928 would have been left with only US$41 after two years. Not many investors can bear such significant dilution of their investments. It is the prospect of such losses that keeps stock investors awake at night. It is significant and noteworthy that more than one in four years have experienced negative returns on equity investments.

From 1926 to 2017, the annualized average return on the US large stocks at 10.2 per cent per annum was of course much higher than returns on most other financial instruments (Figure 5.2). Investment in government securities over the same period yielded 5.5 per cent. The gap in returns leads to disproportionate impact in the amount of wealth, especially over a long period. An investment of US$1 in government securities amounts to US$131 (at 5.5 per cent per annum) after 92 years. A similar investment in equity is worth US$7,353 (at 10.2 per cent per annum).

Inflation (2.90 per cent) adjusted, the difference in wealth in real terms is even greater. Of course, riskier avenues of investment do exist if one has the heart to withstand even greater vicissitudes in return. Return on small stocks are more volatile than that of overall equity, but the return is also higher at 12.1 per cent and the wealth, at the end of a period of 92 years is far greater, at US$36,929.

Tata Motors Limited (TML) has a capacity to produce 790,000 cars annually. Based on the projected growth of the economy, it must estimate the future demand and decide whether to add another half a million to its capacity. The additional half million vehicles will require substantial investment. If the economy grows at the rate projected by the company's corporate planning department, the investment will prove extremely lucrative. On the other hand, if the growth slackens and other factors do not turn out to be favourable, it can spell doom for the company.

A decision to go ahead with the project would necessitate arrangement of funds for investment. The funds may be raised through either equity or debt. The debt can be short term, to be rolled over on maturity, or for a longer duration. Alternatively, the company can mobilize funds through instruments that are a combination of both debt and equity, as it had done in 1991 by issuing partially convertible bonds. The company can either directly approach a financial institution or it can undertake a public issue whereby it invites the public at large to participate in the financing. There are numerous options available and a choice must be made regarding the best possible combination with which the project can be financed.

An appropriate dividend policy is critical to the company's future success. Shareholder earnings comprise dividends as well as capital gains. Shareholders keenly look forward to receiving dividends from the company. At the same time, the distribution of dividend reduces the cash flows available with the company for investment, besides its implications for capital structure and valuation. A long-term policy must be established that balances the desire of the shareholders to receive dividends on the one hand and the cash flow requirements of the company on the other.

Credit to dealers constitutes a significant proportion of the working capital. Should TML insist on payment on delivery from the dealers, or let them pay only after a vehicle has been sold to the eventual customer? What should be the inventory of vehicles to be stocked with the dealers and in TML's own factory, in addition to the inventory of components it must maintain?

Innovations have been a distinctive feature of global finance over the last half a century. Nothing has, however, been more overwhelming in its scope and breathless advance than financial instruments termed derivatives. Derivatives are not a new concept, having existed in rudimentary forms in the past; nevertheless, in recent times, they have taken the financial world by storm. No company or financial institution can claim to be working in the best interest of its stakeholders without fully taking advantage of derivatives to manage risk and maximize value.

India took its first hesitant step towards offering investors an opportunity to trade in derivatives in the year 2000 when the Securities and Exchange Board of India (SEBI) permitted the trading of equity-based index futures and options on the exchanges. Since then, terms such as index futures, swaptions, programme trading, synthetic cash, equity-indexed bonds, butterfly spreads, inverse floaters and portfolio insurance have become an integral part of the financial market lexicon. We may choose to be overwhelmed by, what to us are, as yet, esoteric terms. Or the excitement generated may lead us to a promising career in a field that has already become an integral part of the corporate life.

The future, of course, holds the greatest promise, and whether it is a career in traditional corporate finance, banking, investments or consultancy, expertise in derivatives would be crucial to success in the corporate sector.

The Concept

A derivative instrument is a financial contract whose pay-off structure is determined by, or derived from, the value of another asset.

A derivative is not an instrument in its own right; it has no direct value of its own but is based on some other instrument called the underlying. The value of the other variable determines the pay-off on the derivative. The pay-off, at any point in time, is a function of

1. 1. the price at which the derivative transaction is undertaken and

2. 2. the price in the cash market of the underlying variable upon which the derivative is based.

In physics, leverage is a device to increase force at the cost of greater movement. Companies use leverage to increase profits while being exposed to a higher risk. Leverage uses the concept of fixed and variable costs to understand the impact of a company's cost structure on its return and risk.

Fixed costs do not vary with a change in the volume of production; they stay constant at different levels of production. If the fixed costs at 100 units are X, even at 101 units of production, the fixed costs incurred by the company remain X. Its significance lies in the fact that this leads to a change in the per unit fixed cost. If the production level increases, the same fixed costs are allocated over a larger number of units, leading to a lower cost of production for each unit of output. Managerial remuneration, insurance, interest and depreciation are examples of costs which are fixed. Depending on the nature of a specific industry, some other costs may also be fixed. For example, a flight from Mumbai to Delhi will incur fixed fuel and personnel expenses whether there are 153 or 154 passengers. The additional passenger does not add to the flying cost.

Variable costs vary with the level of output. In general, the per unit cost remains constant irrespective of the level of output. Variable costs include raw material and wages.

Thus, as the level of output increases, while the per unit variable cost remains constant, the per unit fixed cost reduces, leading to a fall in the total cost of each unit of output. This has the potential to increase profits disproportionately at higher level of sales.

In Table 9.1, firm F has low variable costs but high fixed costs. At low level of sales (₹50,000), it incurs operating losses of ₹45,000, being unable to cover the high fixed costs. But when the sales are high (₹200,000), the profits earned are huge at ₹60,000.

In comparison, Firm V has high variable costs and low fixed costs. Even at a low level of sales (₹50,000), the company does not incur a loss. At the same time, when sales shoot up to ₹200,000, it makes a profit of only ₹30,000.

I have been teaching for over two decades. During this period, I have witnessed a quantum jump in the number of students pursuing business management in India and a significant decline in standards. Maybe, there is a correlation between the two. Business management as a course and the corporate sector as a career choice are demanding. Not everyone has the competence, or the inclination, to pursue it successfully. In our desire to be inclusive and to pass on the benefit of business management as a career to everyone, we may have diluted the standards significantly.

Management education in India presents a contrast. The top few business schools are demanding in terms of who they accept and the inputs they provide during the two years of the course. Only the best and the toughest emerge unscathed, ready to take on the challenges the corporate sector throws at them. They compete with the best global business schools on equal terms and the students have, over time, proven their competence in the corporate world throughout the world.

At the bottom are a large number of schools lacking in funding, competent faculty, infrastructure and, of course, students who can stand up to the rigour demanded by the study and practice of management. Of course, the desire to establish standards may also be lacking. The consequent dilution in quality has created a wide chasm, which has destroyed the credibility of management education in the country. MBA is not an inclusive course; by trying to make it inclusive, we have diluted its core and it no longer commands the respect it earlier did.

At the same time, management education in the country cannot be restricted to the top few. Not only would that be an elitist approach, it would ensure that the country is unable to provide for and meet the rising demand for professionals for a fast-expanding corporate sector.

This demand is currently fulfilled by business schools in the mid-range that may not match the best in the country but are able to provide inputs to students that enable them to pursue a lucrative career.

To stay where you are, as the adage goes, you need to keep running. Sustained growth is the mantra of companies. Long-term growth is possible only with continuous investment in projects. Companies can finance investment in projects either through equity or by way of debt. Being a cheaper source of funds, there is a strong temptation to rely on debt rather than on equity. But higher debt makes equity riskier and its returns more volatile. Does the mix of debt and equity have an impact on the value of a company?

Capital structure (debt–equity mix) and its impact on a company's value has, over the years, been one of the most debated and hotly contested issues in corporate finance. Work on capital structure has elevated the theory (and practice) of corporate finance to great heights and earned it the respect it never enjoyed earlier. Corporate finance, in its modern avatar, took root with the Modigliani–Miller (MM) theorem on the capital structure of companies. Capital structure theory is rich in terms of learning and debate and is the kind of stuff that makes its study worthwhile. Not only has it revolutionized the subject but also enabled the corporate sector to formulate its capital structure policy by relying on the work carried out by such luminaries as Merton Miller, Franco Modigliani, Eugene Fama, Stuart Myers, Paul Samuelson, Harry Markowitz, James Tobin, William Sharpe, Fisher Black and Myron Scholes to add value. It is only appropriate that most of these contributors were recipients of the Nobel Prize in economics for their original and outstanding work on the subject. The few who failed to get it died young; Nobel Prizes are not awarded posthumously. The option pricing model was discovered by Fisher Black and Myron Scholes in 1972. Scholes received recognition by the Nobel Committee in 1997. Unfortunately, Black had passed away a few years back and could not be awarded the prize. No one has ever believed Black's contribution to be any less than that of Scholes!

Microsoft was started, with remarkable success, by Bill Gates and Paul Allen in 1975. Over the next few years, the company established itself as the premier software company in the world. Windows became the standard operating software that everyone installed on their computers. The company earned large profits and accumulated huge cash flows over the years.

However, Microsoft did not pay dividends to its shareholders for the first 28 years of its existence. Then, in 2003, it announced what CFO John Connors (quoted in CBS News, 2003) called ‘a starter dividend’ of US$0.08 per share. A year later, on 20 July 2004, Microsoft stunned the financial markets by announcing plans to pay the single largest cash dividend in the history of the US corporate sector, a one-time dividend of US$3 per share amounting to US$32 billion. In addition, Microsoft announced plans to repurchase up to US$30 billion of its stock over the next four years and pay regular quarterly dividends at an annual rate of US$0.32 per share.

Over the years, Microsoft has been steadily enhancing its dividend payout. The dividend has increased from US$0.32 to US$1.47 per share which amounts to an annual cash outflow of over US$11 billion. Some analysts have started terming Microsoft as a dividend play; they recommend buying Microsoft for its dividend yield and not for potential capital gains. A software company as a dividend play? That too a market leader!

What is the significance of the company's ‘no dividend’ policy prior to 2003 and the high dividends now? Is the dividend policy immaterial, as the Modigliani–Miller Model claims, or does it have a significance beyond just the dividend yield a shareholder obtains?

A company can use its earnings in four ways:

1. 1. Retain and invest in long-term projects

2. 2. Pay off liabilities

3. 3. Pay cash dividends to shareholders

4. 4. Repurchase its own equity (stock buyback)

Cash dividends and the repurchase of equity transfer funds from the company to the shareholders and are the primary means by which shareholders earn from their investments in the company.