1. INCREMENTAL APPROACH FOR COMPUTING WORKING CAPITAL REQUIREMENTS The incremental approach for incorporation of working capital into DCF analysis, particularly where inflation is involved. Example:The cumulative working capital requirements of project A have been identified as follows: Year 0 1234 200300350350400 The above figures are based on present day costs. Working capital requirements are expected to increase by 7 % per year due inflation. The project has an expected life of four years. Requirements: What are the relevant working capital requirements for the appraisal of project " A" in nominal terms ? YearCumulative requirementIncrease / in nominal termsDecrease 1300 x 1.07= 321121 2350 x 1.1449=40180 3350 x 1.22504342928 4400 x 1.310796 524 95 4524 (324 + 200 = 524)

2. Derivatives: With the development of the financial markets and in particular the financial future markets, a number of financial instruments have arisen, which allows a treasurer to hedge interest rate risk. A company may wish to take precautions against interest rate moving up or down in the future, or may wish to change the existing structure of its funding or deposits, for instance from fixed rate of interest to floating rate. INTEREST RATE SWAPS: An interest rate swap is an exchange of interest rate commitments, such that fixed rate commitments is exchanged for a floating rate commitment. The parties to swap retain their obligations to the original lender, which means that the swap parties must accept the counter parties risk. An interest rate SWAP is simply the exchange of one stream of cash flows for an other in the same currency. Example A company have obtained funding through the issue, three years ago, of a 10 years debenture paying a fixed rate of interest of 10 percent per annum. It may now be more suitable to its needs to pay an interest rate based on current market rate LIBOR. Instead of redeeming the debenture and obtaining fresh floating rate finance, the company could simply under take a 7 year swap. It will pay floating rate of interest base upon LIBOR to Swaps counter party and will receive a fixed amount of 10 % per annum.

3. Company Swaps Counter party Debenture holders 10 % Fixed 10 % fixed LIBOR INTEREST RATE SWAPS

4. WE can see from the last diagram that the company had SYNTHETICALLY manufactured its remaining 7 years, fixed rate loan into one paying current market interest rates. The interest received from the Swap counter party will be used to pay the interest due to the debenture holders. It is much cheaper and easier for the Company’s management to transact a Swap arrangement rather than to renegotiate existing debt. Similarly, the company could have changed a floating rate interest liability into a fixed rate one, or a fixed or floating rate asset stream into different cash flow profile. Interest rate swaps are the most common interest rate product used these days. Interest rate SWAPS could be used to obtain cheaper financing rate, to change future cash flows, or to enhance returns.

5. Worked Example: M/s Lever Brothers have a high credit rating in the financial market. They can borrow at a fixed rate of interest @ 10 % or at a variable interest rate of LIBOR + 0.3 percent. However, M/s Lever Brothers would like to borrow at a variable rate of interest. M/s Tariq Enterprises have a lower credit rating. They can borrow at a fixed rate of interest @ 11 % or at a variable rate of interest LIBOR + 0.5 %. M/s Tariq Enterprises would like to borrow at a fixed rate. Using the principle of comparative advantages, both parties could benefit from SWAP arrangements. They agreed on the following terms: 1)M/s Lever brothers will borrow at a fixed rate of 10 %. 2)M/s Tariq enterprises will borrow at a variable rate of LIBOR + 0.5 % 3)The parties agreed a rate for swapping their interest commitments with, M/s Tariq Enterprises would pay a fixed interest rate of 10.1 percent to M/s Lever Brothers, and Lever brother paying a variable rate of LIBOR to M/s Tariq enterprise. How much saving each party will make ?

6. Lever Brothers Tariq Enterprises Lenders / Bank 10 % Fixed 10.1 % fixed LIBOR INTEREST RATE SWAPS Lenders / Bank LIBOR + 0.5 %

7. SOLUTION: THE OUT COME WILL BE AS FOLLOWS: M/s Lever Brothers: Borrows at 10 % Received from Tariq Enterprises(10.1%) Pays to Tariq Enterprises LIBOR Net Interest CostLIBOR –0.1 % Computation of Savings for M/s Lever Brothers: Original rate at which Co can borrow:LIBOR + 0.3 % As a result of Swap now Co can borrowLIBOR - 0.1 % Net Saving to the company 0.4 %

8. M/s Tariq Enterprises: Borrows at LIBOR + 0.5 % Received from Lever Brothers(LIBOR) Pays to Lever Brothers 10.1 % Net Interest Cost10.6 % Computation of Savings for Tariq Enterprises: Original rate at which Co can borrow:11 % As a result of Swap now Co can borrow10.6 % Net Saving to the company 0.4 % So We have seen that both the companies have take benefit of the SWAP arrangement.

9. FORWARD RATE AGREEMENTS: A forward rate agreement (FRA) is an agreement whereby an enterprise can lock in an interest rate today for a period of time starting in the future. On the future date the two counter parties in the FRA settle up and, depending on which way the interest go, one will pay an amount of money to the other representing the difference between the FRA rate and the actual rate. Example: M/s Tahir enterprises have a Rs 1 Million loan outstanding, on which interest rate is reset every 6 months for the following 6 months, and the interest is payable at the end of that 6 months period.The next 6 month reset period may now be just 3 months away, but The treasurer of the Tahir and Company thinks that interest rates are likely To Rise between now and then. Current six months rate is 8 % and the Treasurer can get a rate of 8.1 percent for a six month FRA starting in 3 months time. By transacting an FRA the treasurer can lock in a rate today of 8.1 %.If interest rate rise as expected to say 9 % M/s Tahir has reduced its interest charges as it will pay 9 % on the loan but will receive from the FRA counter party the difference between 9 % and 8.1 %. Like wise if interest rate drops to 7 % then again the effective rate will be 8.1 % as M/s Tahir will pay the difference between 8.1 % and 7 % to the FRA counter party.

10. Solution: If interest rates are 9 % in the three months time: Interest payable on the loan 9% x 1,000,000 x 6/12 = Rs 45,000 Amount receivable on FRA ( 9 %-8.1 %) x Rs 1,000,000) x 6/12 (4,500) Net amount Rs 40,500 Effective interest rate : (40,500 / 1,000,000) x (100) x2 = 8.1 %

11. If interest rates are 7 % in the three months time: Interest payable on the loan 7% x 1,000,000 x 6/12 = Rs 35,000 Amount payable on FRA ( 8.1 %-7 %) x Rs 1,000,000) x 6/12 5,500) Net amount Rs 40,500 Effective interest rate : (40,500 / 1,000,000) x (100) x2 = 8.1 %

12. INTEREST RATE FUTURES: Future are STANDARDISED TRADED forms of FRA. FRA’s are normally traded with banks and other financial institutions, and because of this they are tailor made to suit the dates and amounts that each individual company requires.However, interest rate futures are exchange traded and each contract is for a pre-specified amount and pre-specified date. Comparison between FRA and Futures FRA’sFutures AmountAny Amount Only standard round sum amount Dates Any dates Only pre specified dates normally March, June,September & December Payments Only settlementInitial and there after daily variation datemargin payments DeliveryAs per contractMost are liquidated before maturity CreditWith Counter Very limited risk because of margin partypayments and the exchange acts as buyer and seller of every contract. MarketOver the counter Exchange traded (LIFFE – London International Future and option Exchange)

13. INTEREST RATE OPTIONS: AN Option is the right, but not the obligation, to carry out a transaction at a price set today, at some time in the future. Swaps, FRA’s and futures are all contract which two parties agree to transact and which must be carried out even if circumstances change. An option however, gives the buyer the choice of whether to transact or not. A company would generally buy an option from an option seller or an option writer. An option is a form of insurance, and as such a premium is paid at the time the option is taken out, for the period of the option. Example : Instead of FRA lets assume an option was bought ( in the previous example ) entitling the buyer of the option to pay the same interest rate of 8.1 %. This is known as the strike price. The period of option is for 3 months, which is when the renewal period for the loan starts. Suppose that the option premium paid today is Rs 1000. In three months time we could have the same scenarios:

14. If interest rates are 9 % in the three months time: Interest payable on the loan 9% x 1,000,000 x 6/12 = Rs 45,000 Amount receivable on Option writer ( 9 %-8.1 %) x Rs 1,000,000) x 6/12 (4,500) Plus premium paid 1,000 Net amount Rs 41,500 Effective interest rate : (41,500 / 1,000,000) x (100) x2 = 8.3 %

15. If interest rates are 7 % in the three months time: Interest payable on the loan 7% x 1,000,000 x 6/12 = Rs 35,000 Plus premium paid 1,000 Net amount Rs 36,000 Effective interest rate : (36,000 / 1,000,000) x (100) x2 = 7.2 % Important : Interest rate options can be purchased from the banks, while standardised interest rate options are traded on LIFFE. A number of companies now also use swap-options which are options on transacting a swap at a future date, and some companies may find these useful.

16. CAPS, FLOORS AND COLLARS: CAPS : Interest rate cap is an option which sets a maximum interest rate on future borrowings for an agreed length of time. FLOOR: A floor is an option that sets minimum interest rate on future borrowings for an agreed length of time. COLLAR: A Collar arises when a borrower buys an interest rate CAP and at the same time sells an interest rate floor. The premium received from selling the floor will reduce the cost of the premium paid for the cap. INTEREST RATE % CAP TIME Floor COLLAR

17. EXAMPLE: A Company can currently borrow at 11 percent, but it is concerned with that interest rates may rise in the near future to 14 percent or more. In this situation the Company could buy an interest rate CAP from the bank which will fix the maximum rate for borrowing. A premium is to be paid to the bank at the time of purchase of CAP. The bank will reimburse the company if the market interest rates rises above the CAP rate. As part of the arrangement, the company may also agree that it will pay a floor of say 10 %. The bank will pay a PREMIUM to the Company for agreeing to this floor rate.