Banquil, Princess Joy M.

May 4, 2020
FINMAN 2 – SUMMARY OF FINAL TOPICS Dr. Alfredo M. Joson, CPA

A. CAPITAL BUDGETING

There are different methods adopted for capital budgeting. The traditional methods or non-discount
methods include: Payback period and Accounting rate of return method. The discounted cash flow
method includes the NPV method, profitability index method and IRR.

Payback period method

This method refers to the period in which the proposal will generate cash to recover the initial
investment made. It purely emphasizes on the cash inflows, economic life of the project and the
investment made in the project, with no consideration to time value of money.

Through this method selection of a proposal is based on the earning capacity of the project. With
simple calculations, selection or rejection of the project can be done, with results that will help gauge the
risks involved. However, as the method is based on thumb rule, it does not consider the importance of
time value of money and so the relevant dimensions of profitability.

Example:

Payback period of project B is shorter than A, but project A

provides higher returns. Hence, project A is superior to B.

Accounting rate of return method (ARR)

This method helps to overcome the disadvantages of the payback period method. The rate of
return is expressed as a percentage of the earnings of the investment in a project. It works on the criteria
that any project having ARR higher than the minimum rate established by the management will be
considered and those below the predetermined rate are rejected.

This method considers the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept of net
earnings. However, this method also ignores time value of money and does not consider the length of life
of the projects. Also, it is not consistent with the firm’s objective of maximizing the market value of shares.

Discounted cash flow method

The discounted cash flow technique calculates the cash inflow and outflow through the life of an
asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows
are then compared. This technique considers the interest factor and the return after the payback period.

Example: Your company is evaluating the purchase of a new project with a depreciable base of
$100,000, expected economic life of 4 years and change in earnings before taxes and depreciation of
$45,000 year 1, $20,000 year 2, $25,000 year 3 and $35,000 year 4. Assume straight line depreciation
and a 20% tax rate.

The depreciation in this example is $25,000 per year. ($100,000 ÷ 4)

Net present Value (NPV) Method

This is one of the widely used methods for evaluating capital investment proposals. In this
technique the cash inflow that is expected at different periods of time is discounted at a rate. The present
values of the cash inflow are compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and
is consistent with the objective of maximizing profits for the owners.

Example: What would the net present value for a project with a net investment of $40,000 and the
following net cash flows be if the company’s cost of capital is 5%? NCFs for year one is $25,000, for year
two is $36,000 and for year three is $5000.
Internal Rate of Return (IRR)

This is defined as the rate at which the net present value of the investment is zero. The discounted
cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It
tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated with the
project and not any rate determined outside the investment.

An example of a project with a net investment of $10,000, net cash flows of $5,000, $4,000,
$3,000, $2,000, $1,000 for years 1 through 5 returns an IRR of 20.27%.

Profitability Index (PI)

It is the ratio of the present value of future cash benefits, at the required rate of return to the
initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The
formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

Sources: https://study.com/academy/lesson/what-is-capital-budgeting-techniques-analysis-examples.html

https://smallbusiness.chron.com/definition-examples-capital-budgeting-21948.html

https://www.investopedia.com/terms/c/capitalbudgeting.asp
B. LEVERAGE AND CAPITAL STRUCTURE

In finance, leverage is a strategy that companies use to increase assets, cash flows, and returns,
though it can also magnify losses. There are two main types of leverage: financial and operating. To
increase financial leverage, a firm may borrow capital through issuing fixed-income securities or by
borrowing money directly from a lender. Operating leverage can also be used to magnify cash flows and
returns and can be attained through increasing revenues or profit margins. Both methods are
accompanied by risk, such as insolvency, but can be very beneficial to a business.

Financial Leverage

When a company uses debt financing, its financial leverage increases. More capital is available
to boost returns, at the cost of interest payments, which affect net earnings.

Example: Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to
make a 10% down payment and take a $450,000 mortgage for the rest of the payment (mortgage cost is
5% annually). Jim wants to purchase the house for $500,000 cash today. Who will realize a higher return
on investment if they sell the house for $550,000 a year from today?

Although Jim makes a higher profit, Bob sees a much higher return on investment because he made
$27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with a $500,000
investment).
Financial Leverage Ratio

The financial leverage ratio is an indicator of how much debt a company is using to finance its
assets. A high ratio means the firm is highly levered (using a large amount of debt to finance its assets).
A low ratio indicates the opposite.

Example: The balance sheet of Companies XYX Inc. and XYW Inc. are as follows. Which company has a
higher financial leverage ratio?

XYX Inc.

Total Assets = 1,100

Equity = 800

Financial Leverage Ratio = Total Assets / Equity = 1,100 / 800 = 1.375x

XYW Inc.

Total Assets = 1,050

Equity = 650

Financial Leverage Ratio = Total Assets / Equity = 1,050 / 650 = 1.615x

Company XYW Inc. reports a higher financial leverage ratio. This indicates that the company is financing
a higher portion of its assets by using debt.
Operating Leverage

Fixed operating expenses, combined with higher revenues or profit, give a company operating
leverage, which magnifies the upside or downside of its operating profit.

Example: The income statement of Companies XYZ and ABC are the same. Company XYZ’s operating
expenses are variable, at 20% of revenue. Company ABC’s operating expenses are fixed at $20.

Which company will see a higher net income if revenue increases by $50?

If revenue increases by $50, Company ABC will realize a higher net income because of its operating
leverage (its operating expenses are $20 while Company XYZ’s are at $30).

Operating Leverage Formula

The operating leverage formula measures the proportion of fixed costs per unit of variable or total
cost. When comparing different companies, the same formula should be used.

Example: Company A and company B both manufacture soda pop in glass bottles. Company A produced
30,000 bottles, which cost them $2 each. Company B produced 45,000 bottles at a price of $2.50 each.
Company A pays $20,000 in rent, and company B pays $35,000. Both companies pay an annual rent,
which is their only fixed expense. Compute the operating leverage of each company using both
methods.
Step 1: Compute the total variable cost

Company A: $2/bottle * 30,000 bottles = $60,000

Company B: $2.50/bottle * 45,000 bottles = $112,500

Step 2: Find the fixed costs

In our example, the fixed costs are the rent expenses for each company.

Company A: $20,000

Company B: $35,000

Step 3: Compute the total costs

Company A: Total variable cost + Total fixed cost = $60,000 + $20,000 = $80,000

Company B: Total variable cost + Total fixed cost = $112,500 + $35,000 = $147,500

Step 4: Compute the operating leverages

Method 1: Operating Leverage = Fixed costs / Variable costs

Company A: $20,000 / $60,000 = 0.333x

Company B: $35,000 / $112,500 = 0.311x

Method 2: Operating Leverage = Fixed costs / Total costs

Company A: $20,000 / $80,000 = 0.250x

Company B: $35,000 / $147,500 = 0.237x

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its
operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or
debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital expenditures,
acquisitions, and other investments. There are tradeoffs firms must make when they decide whether to
use debt or equity to finance operations, and managers will balance the two to find the optimal capital
structure.
Optimal capital structure

The optimal capital structure of a firm is often defined as the proportion of debt and equity that
results in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not
always used in practice, and firms often have a strategic or philosophical view of what the ideal
structure should be.

Cost of capital

A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known
as the weighted average cost of capital (WACC).

The formula is equal to: WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where: E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate

Sources: https://www.investopedia.com/articles/investing/111813/optimal-use-financial-leverage-corporate-capital-
structure.asp

https://www.thestreet.com/investing/earnings/capital-structure-14971332

https://xplaind.com/160137/capital-structure
C. MERGER AND ACQUISITION

A merger and acquisitions (M&A) refers to the agreement that between the two existing
companies to convert into the new company, or purchasing of the one company by another etc. which
are done generally in order to take the benefit of the synergy between the companies, expanding the
research capacity, expand operations into the new segments and to increase shareholder value etc.

M&A is defined as a combination of companies. When two companies combine to form one
company, it is termed as Merger of companies. While acquisitions are where one company is taken over
by the company.

In the case of Merger, the acquired company ends to exist and becomes part of the acquiring
company. In the case of Acquisition, the acquiring company takes over the majority stake in the acquired
company, and the acquiring company continues to be in existence. In short one in acquisition one
business/organization buys the other business/organization.

A typical 10-step M&A deal process includes:

1. Develop an acquisition strategy – Developing a good acquisition strategy revolves around the
acquirer having a clear idea of what they expect to gain from making the acquisition – what their
business purpose is for acquiring the target company (e.g., expand product lines or gain access to
new markets)
2. Set the M&A search criteria – Determining the key criteria for identifying potential target
companies (e.g., profit margins, geographic location, or customer base)
3. Search for potential acquisition targets – The acquirer uses their identified search criteria to look
for and then evaluate potential target companies
4. Begin acquisition planning – The acquirer makes contact with one or more companies that meet
its search criteria and appear to offer good value; the purpose of initial conversations is to get
more information and to see how amenable to a merger or acquisition the target company is
5. Perform valuation analysis – Assuming initial contact and conversations go well, the acquirer asks
the target company to provide substantial information (current financials, etc.) that will enable
the acquirer to further evaluate the target, both as a business on its own and as a suitable
acquisition target
6. Negotiations – After producing several valuation models of the target company, the acquirer
should have sufficient information to enable it to construct a reasonable offer; Once the initial
offer has been presented, the two companies can negotiate terms in more detail
7. M&A due diligence – Due diligence is an exhaustive process that begins when the offer has been
accepted; due diligence aims to confirm or correct the acquirer’s assessment of the value of the
target company by conducting a detailed examination and analysis of every aspect of the target
company’s operations – its financial metrics, assets and liabilities, customers, human resources,
etc.
8. Purchase and sale contract – Assuming due diligence is completed with no major problems or
concerns arising, the next step forward is executing a final contract for sale; the parties make a
final decision on the type of purchase agreement, whether it is to be an asset purchase or share
purchase
9. Financing strategy for the acquisition – The acquirer will, of course, have explored financing
options for the deal earlier, but the details of financing typically come together after the purchase
and sale agreement has been signed
10. Closing and integration of the acquisition – The acquisition deal closes, and management teams
of the target and acquirer work together on the process of merging the two firms

Sources: https://www.accountingtools.com/summary-mergers-acquisitions
http://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/mna-valuation-
techniques/
https://study.com/academy/lesson/what-are-mergers-and-acquisitions-definition-examples-quiz.html
D. DIVIDEND POLICY

A company’s dividend policy dictates the number of dividends paid out by the company to its
shareholders and the frequency with which the dividends are paid out. When a company makes a profit,
they need to decide on what to do with it. They can either retain the profits in the company (retained
earnings on the balance sheet), or they can distribute the money to shareholders in the form of dividends.

What is a Dividend?

A dividend is the share of profits that is distributed to shareholders in the company and the return
that shareholders receive for their investment in the company. The company’s management must use the
profits to satisfy its various stakeholders, but equity shareholders are given first preference as they face
the highest amount of risk in the company. A few examples of dividends include:

1. Cash dividend - A dividend that is paid out in cash and will reduce the cash reserves of a company.

2. Bonus shares - Bonus shares refer to shares in the company are distributed to shareholders at no cost.
It is usually done in addition to a cash dividend, not in place of it.

Examples of Dividend Policies

The dividend policy used by a company can affect the value of the enterprise. The policy chosen
must align with the company’s goals and maximize its value for its shareholders. While the shareholders
are the owners of the company, it is the board of directors who make the call on whether profits will be
distributed or retained.

Dividend Payout Ratio Formula

Where: Dividends Paid is the dollar amount of dividends distributed to shareholders.

Net Income is the company’s income minus the cost of goods sold (COGS), expenses, and taxes.
Example: Colin is an analyst looking to determine the future dollar dividend payouts of Company A. The
company follows a constant dividend payout ratio policy of 25%. Through the estimated forward earnings
per share for fiscal 2020, 2021, and 2022 below, determine the expected dollar dividend payout per share.

With a constant payout ratio policy of 25%, a quarter of the company’s forward earnings per share will
be distributed as dividends to shareholders. The dollar expected dividend payout per share is as follows:

The expected dollar dividend payout through the fiscal years 2020-2022 is $0.375 + $0.575 + $0.675 =
$1.625.

With a constant dividend payout ratio policy, the number of dividends paid to shareholders
fluctuates directly in proportion to the earnings of a company. Therefore, such a dividend policy comes
with the potential to generate very volatile dividend payouts.

The dividend payout policy also offers companies more flexibility as they do not need to alter the
payout(s) during deteriorating market conditions (since the payout is a proportion of earnings and not a
dollar amount), which typically sends a negative signal to market participants.

Major Considerations

There are several things that a company should keep in mind when setting a constant dividend
payout ratio policy. They include:

1. Current business life cycle - Companies that operate in the launch, growth, and shake-out stage
of the business life cycle tend to offer a lower payout ratio compared to more mature and established
firms. In the early stages of a company, it will tend to choose to follow a low payout ratio policy so that it
can reinvest its earnings back into the business.

2. Industry outlook - Setting a constant dividend payout ratio requires forward thinking –
pullbacks to a company’s dividend policy result in an adverse effect and signals a weakening company. A
company must consider its prospects and its earning potential before setting a constant dividend rate.

Sources: http://www.yourarticlelibrary.com/company/dividend-policy/dividend-policy-significance-and-concepts-
with-formulas/72289

https://mercercapital.com/article/introduction-dividends-dividend-policy/

https://study.com/academy/lesson/dividend-payout-ratio-definition-formula-analysis.html

https://study.com/academy/lesson/what-is-a-dividend-policy-overview-components-goal.html
E. TREASURY MANAGEMENT

Treasuries are the custodians of cash in a business, they control this through 1) the amount held
and 2) its liquidity. The two levers of this are through the sheer size of the balance sheet and the relative
stickiness (liquidity) of assets and liabilities held. Their management of this enables the fundamentals of
an organization: allowing teams to operate and conduct activities by ensuring that there is cash on hand,
be it in the petty cash box or an opportunistic M&A raid.

In addition to enabling business-as-usual (BAU) activities, treasuries partake in the macro-

financial direction of a company and oversee the execution of company-wide strategies. For example, if
the board decides to buy a business or expand into new territories, Treasury will help to determine the fit
of the company from a balance sheet perspective and find the cash (or issue stock) to purchase it
ultimately.

By actively managing liquidity, treasuries ensure that businesses stay alive, save money, and can
respond quickly to change.

Sources: https://en.wikipedia.org/wiki/Treasury_management

https://businessjargons.com/treasury-management.html