Maximize Shareholders’ Major Decisions by Financial Manager

Wealth and Welfare

• Investment Decision – what assets to own? What

Financial
mix of fix assets? What mix of current assets?
Management • Financing Decision – what securities to issue?
What mix of short-term credit, long-term debt and
equity?
Investment Financial Dividend • Dividend Decision – what percentage of earnings
Decision Decision Decision
should be given out in cash? Or should it be given
out as stocks?
A Framework for Financial Decision-Making

Board of Directors
Maximize
Maximize Price of the
Shareholders’ Firm’s or
President Wealth Company’s
Stock
VP for Mktg. VP for Finance VP for Prodn/Opn
Profit Maximization vs. Wealth Maximization
(taken from Fundamentals of Financial Mgmt by R.K.S. Rao)

Controller Alternative A:
Treasurer
•Cost Acctg. Co. A sells the rights to gold mining on its land to Co. B, for $100M in
•Cash Mgmt
•Financial Acctg. cash. However, the rights expire in 30 years and Co. A must spend an
•Customer Credit and estimated $101M to eliminate environmental damage caused by the
Collection •Internal Auditing
mining operation.
•Inventory •Budgeting
•Capital Budgeting Alternative B:
•Payroll
•Raising of ST and LT Funds Co. A can buy the mining equipment for $150M today and do its own
•Taxes
mining and get $151M after 30 years after clean-up. Note that Co. A has
no experience in mining.
The Financial Function (by R.K.S. Rao)

Weaknesses of Profit Maximization Determines

Price of the
(taken from Fundamentals of Financial Mgmt by R.K.S. Rao) Firm’s or
Cash Flow Company’s
Stock
• Difficulty of incorporating risk in a profit based
criterion.
Cash flow calculation not only recognize profits
• Too much emphasis on profit overshadows the but go a little further and measure the actual cash
timing when the returns could or would be available for the firm. It captures the economic
obtained. impact of managerial decisions.
• Profit is an accounting measure that may not
necessarily reflect the economic realities of a firm. Profits have no earning potential; cash
It is a book concept that is sensitive to how flow does.
accounting books of the company are kept.
 Ten Axioms/Principles of Basic
Financial Management
• The Risk-Return Trade-off - We Won’t Take on Additional Risk
Unless We Expect to Be Compensated with Additional Return.
• The Time Value of Money - A Dollar Required Today is Worth
More Than A Dollar Received in the Future
• Cash - Not Profit - Is King
• Consider Incremental Cash Flows - It’s Only What Changes
that Counts
• The Curse of Competitive Markets - Why Its Hard to Find
Exceptionally Profitable Projects
Key: Invest in Markets That Are Not Perfectly Competitive
How? 1. Differentiate your product.
2. Achieve a cost advantage over competitors.
Ten Axioms/Principles of Basic
Financial Management
• Efficient Capital Markets - The Markets Are Quick and
The Prices Are Right
- Efficient Market - market in which the values of all assets
and securities at any instant in time fully reflect all
available public information. The market price of a
security is a consensus among market players.
- Characteristics:
1. Security prices should reflect all available public
information about the economy, about financial
markets and about the specific co. involved.
2. Market prices of individual securities adjust very rapidly
to new information which can result in a change in the
“intrinsic” value of a security but subsequent security
price movements will follow what is known as “random
walk”.

Ten Axioms/Principles of Basic Ten Axioms/Principles of Basic

Financial Management
- Characteristics of Efficient Capital Market (Cont’d):
3. One simply cannot use past security prices to predict
future prices in such a way as to profit on average.
4. Unanticipated portion of return (expected return -
actual return) earned on a security is unpredictable
and does not systematically differ from zero over a
sufficient no. of observations. It is also not correlated
to any information be it publicly available or insider.
5. There is sufficiently large number of market
participants who in their attempts to earn profits
promptly receive and analyze all information that is
publicly available concerning companies whose
securities they follow.
Financial Management
• The Agency Problem - Managers Won’t Work for the Owners
Unless Its in Their Best Interest
• Taxes Bias Business Decisions
• All Risk is Not Equal - Some Risk Can Be Diversified Away and
Some Cannot
Diversification - allows good and bad events or observations to
cancel each other out thereby reducing total variability without
affecting expected return.

Financial Institutions:
•Commercial Banks
Ten Axioms/Principles of Basic •Mutual Savings Bank Suppliers and Users of
Funds:
Financial Management •Savings and Loan
Associations
•Individuals
•Pension Funds
Two Types of Risk: •Life Insurance Cos. •Businesses
•Investment Banking •Governments
Houses (or Brokerage
1. Systematic/Market/Unavoidable Risks. Ex: changes in Houses)
nation’s economy, tax reform by Congress. These are risk
that affect securities overall and consequently, cannot be
diversified away. Financial Markets - place where entities
Financial Markets: demanding funds are brought together with
2. Unsystematic/Diversifiable/Avoidable Risks. Ex: wildcat •Money Markets those having surplus funds.
stirke, entry of new competitor, technological
breakthrough that make product obsolete. These risks are •Capital Markets Money Markets - market for short-term
unique to a particular company, being independent of (< 1 yr.) debt securities.
economic, political and other factors that affect securities
in a systematic manner. Capital Markets - market for long-term
debt and corporate stocks.
• Ethical Behavior is Doing the Right Thing and Ethical
Dilemmas are Everywhere in Finance
 FUNDS FLOW ANALYSIS
Two Types of Funds

1. Involves the long-term funds cycle, which includes fixed assets, other long-term
assets and permanent fund sources like long-term debt and equity.
2. Involves the short-term or operating funds cycle, which consists of movements in
current assets and current liabilities.

LONG TERM FUNDS CYCLE

Sale of Investments
NET FIXED OTHER LONG
ASSETS TERM ASSETS
Sale of Assets

Purchase of Assets
Investments
NET WORKING
CAPITAL
Payments of Cash
Dividends
] Payment of Loan

Loan CAPITAL
LONG-TERM
STOCK
DEBT
Issuance of
stocks

Inflows > Outflows – company not reinvesting its earnings in productive capacity, is not
declaring dividends, the results is a build –up of working capital.

Working Capital - refers to the currents assets used in the operations of a firm
(sometimes called gross working capital)

Net Working Capital – current assets minus current liabilities.

IEFIMAN: Funds Flow Analysis Page 1 of 7

 OPERATING FUNDS CYCLE

Credit
A/R Sales INVENTORIES OTHER CURRENT
ASSETS

Cash Sales
Cash
Purchase Collection of
Payments for Acquisition advances,loans
Accruals
CASH

Payment of
Payments Payment
Loan
Deferred for Loans
Purchases Credit
ACCRUED WAGES, Allowed
SHORT-TERM
TAXES, & OTHER
TRADE PAYABLES DEBTS
EXPENSES

Funds flow statement – requires the balance sheet at two points in time and an income
statement covering the two balance sheet dates.

Statement of Funds as Working Capital – covers only non-current financial account

and is quite limited.
Statement of Funds as Cash- covers both current and non-current accounts.

Preparation of the Funds Flow Statement

1. Comparing balance sheet accounts and determining whether there have been
increases or decreases over time. Other information like dividends and sale of fixed
assets are also gathered.
2. Classifying the changes as either sources or uses of working capital or cash.
3. Classifying from the income statement the factors which increase or decrease
working capital or cash.

IEFIMAN: Funds Flow Analysis Page 2 of 7

Funds Flow Can be Categorized Into 3 Classes:
1. Operating Activities
- includes net income, depreciation and changes in current assets and current
liabilities other than cash or short-term debt.
2. Investing Activities
- includes investment in or sales of fixed assets
3. Financing Activities
- includes funds raised during the year by issuing short-term debt, long-term debt,
or stock. Funds used to buy back outstanding stock, bonds, pay debts and
dividends are also included here.

Statement of Funds as Working Capital

Sources of Funds Which Increase Working Capital

1. Funds provided by operations (net income).

2. A decrease in fixed assets (asset sale or disposition).
3. An increase in long-term debt (new borrowing).
4. Proceeds from sale of common or preferred stock.

Note: To determne any decrease( or increase ) in fixed assets during the period, the
depreciation should be added back to the current balance of the fixed asset account
before making the comparison against the previous fixed asset balance.

Uses of Funds Which Decrease Working Capital

1. An increase in fixed assets.

2. Repayment of long-term debt.
3. Purchase of own stock ( treasury stock).
4. Cash dividends.
5. Funds used in operation ( excess of net loss over depreciation and other non-cash
charges).

Statement of Funds as Cash

Sources of Funds Which Increase Cash

1. Changes which were previously classified as sources of funds which increase

working capital.
2. A net increase in any current liability ( new borrowings).
3. A net decrease in any current asset other than cash (liquidation of assets).

IEFIMAN: Funds Flow Analysis Page 3 of 7

Uses of Funds Which Decrease Cash

1. Changes which were previously classified as uses of funds which decrease working
capital.
2. A net increase in any current asset ( working capital build up).
3. A net decrease in any current liability ( repayment of debt).

Limitations of Funds Flow Statement

1. Funds depict net rather than gross changes of financial statement accounts over
point in time. We could determine the net asset increases or decreases from one
year-end to another but we could not describe how assets changed during the year.
2. Inability to trace very specific financing sources to particular fund uses.

IEFIMAN: Funds Flow Analysis Page 4 of 7

Sample: Funds Flow Statement (Statement of Funds as Cash)

Allied Food Products: Statement of Cash Flows for 2000

(in Millions of Dollars)

Operating Activities
Net Income $117.50

Additions (Sources of Cash)

Depreciation and Amortization $100.0
Increase in Accounts Payable $ 30.0
Increase in Accruals $ 10.0

Subtractions (Uses of Cash)

Increase in Accounts Receivable ($ 60.0)
Increase in Inventories ($200.0)

Net Cash Provided by Operating Activities ($ 2.5)

Investing Activities
Cash Used to Acquire Fixed Assets ($230.0)

Financing Activities

Additions (Sources of Cash

Increase in Notes Payable $ 50.0
Increase in Bonds $174.0

Subtractions (Uses of Cash)

Payment of Common and Preferred Div. ($61.5)

Net Cash Provided by Financing Activities $162.5

Net Decrease in Cash ($70.0)

IEFIMAN: Funds Flow Analysis Page 5 of 7

Exercises:

1. Serap-Jones, Inc. had the following financial statements for 19x1 and 19x2. Prepare
a source and use of funds statement on a cash basis.

19x1 19x2
Assets
Cash and Cash Equivalents $140,000 $ 31,000
Accounts Receivable $346,000 $ 528,000
Inventories $432,000 $683,000
Current Assets $918,000 $1,242,000
Net Fixed Assets $1,113,000 $1,398,000
Total $2,031,000 $2,640,000

Liabilities and Equity

Accounts Payable $413,000 $627,000
Accruals $226,000 $314,000
Bank Borrowings $100,000 $235,000
Current Liabilities $739,000 $1,176,000
Common Stock $100,000 $100,000
Retained Earnings $1,192,000 $1,364,000
Total $2,301,000 $2,640,000
Note: Depreciation was $189,000 for 19x2 and no dividends were paid.

2. Kohn Corporation comparative balance sheets at December 31 (in millions):

Assets 19x1 19x2 Liabilities and Equity 19x1 19x2

Cash $5 $3 Notes Payable $20 $0
Accounts Receivable $15 $22 Accounts Payable $5 $8
Inventories $12 $15 Accrued Wages $2 $2
Fixed Assets, net $50 $55 Accrued Taxes $3 $5
Other Assets $8 $5 Long-Term Debt $0 $15
Common Stock $20 $26
Retained Earnings $40 $44
Total Assets $90 $100 Total Liabilities and $90 $100
Equity

IEFIMAN: Funds Flow Analysis Page 6 of 7

Kohn Corporation statement of income and retained earnings year ended December 31,
19x2:
Net Sales $48,000,000
Expenses
Cost of Goods Sold $25,000,000
Selling, General and Administrative $5,000,000
Depreciation $5,000,000
Interest $2,000,000 $37,000,000
Net Income Before Taxes $11,000,000
Less: Taxes $4,000,000
Net Income $7,000,000
Add: Retained Earnings at 12/31/x1 $40,000,000
Subtotal $47,000,000
Less: Dividends $3,000,000
Retained Earnings at 12/31/x2 $44,000,000

a. Prepare a source and use of funds statement on cash basis for 19x2.
b. Prepare a source and use of working capital statement for 19x2.

3. Financial statements for the Sennet Corporation follows:

Sennet Corporation Balance Sheet, December 31 (in millions)
Assets 19x1 19x2 Liabilities and Equity 19x1 19x2
Cash $4 $5 Notes Payable $5 $5
Accounts Receivable $7 $10 Accounts Payable $8 $10
Inventories $12 $15 Accrued Wages $2 $3
Current Assets $23 $30 Accrued Taxes $3 $2
Net Plant $40 $40 Current Liabilities $18 $20
Long-Term Debt $20 $20
Common Stock $10 $10
Retained Earnings $15 $20
Total Assets $63 $70 Total Liabilities and $63 $70
Equity

Sennet Corporation Income Statement, 19x2 (in millions)

Net Sales $95
Expenses
Cost of Goods Sold $50
Selling, General and Administrative $15
Depreciation $3
Interest $2 $70
Net Income Before Taxes $25
Less: Taxes $10
Net Income $15
a. Prepare a source and use of funds statement for Sennet (cash basis).
b. Prepare a source and use of funds statement for Sennet (working capital basis).

IEFIMAN: Funds Flow Analysis Page 7 of 7

 Net Working and Total Operating Capital
Funds Flow (Cash Basis) (assuming all assets are operational)
for NWC basis removed all current accounts from consideration
C A Free and Net Working
Operations: Operations: U S Spontaneous
Current
Operating Capital =
•Net Profit •Net Loss R S
R E Liabilities All current assets –
•Increase CL (except •Decrease CL (except E T All current liabilities
interest bearing debt) interest bearing debt) N S Net Working that do not charge
•Decrease CA (other •Increase CA (other than T Operating Capital
than cash) cash)
interest
N Interest
Investing: Investing: O
N
bearing debt Total Operating
•Decrease in FA (after •Increase in FA (after and owners’ Total Operating
C A Capital Capital = Investor
adding back dep’n) adding back dep’n) money
U S Supplied Funds
Financing: R S (Investor
Financing: supplied
R E
•Increase in ST or LT •Decrease in ST or LT E T funds)
debt debt Note: There is no restriction for net working
N S
•Buy back of stocks T operating capital to be always positive.
•Sale/Issuance of Stocks
•Payment of cash
dividends

Free Cash Flow (FCF) Other Useful Information That Can be Obtained
Investment in FA FCF = NOPAT-Net Investment from Acctg. Data
in Optg. Capital
For sustaining -OR-
• NOPAT (Net Operating Profit After Taxes) = Earning
operations (WC) Before Interest & Taxes (EBIT)*(1-Tax Rate)
CASH FCF = Optg, CF – Gross
Investment in Optg. Capital • Optg. Cash Flow = NOPAT + Dep’n and Amortization
Payment to
• Gross Investment in WC = Net Investment in
creditors/debtors Operating Capital + Dep’n and Amortization
• Net Investment in Operating Capital = Total Optg,
Dividends for P/S CapitalT - Total Optg, Capital(T-1)
FCF • MVA (Market Value Added) = (Shares of Stocks
Money for C/S Outstanding)*(Stock Price) – Total Common Equity
(retained and Net Cash Flow • EVA (Economic Value Added) = NOPAT – [Investor
given out) Supplied Optg. Capital*After-Tax % Cost of Capital]

Determinant of Firm’s Value

FCF

FCF1 FCF2 FCF

Value   
(1  WACC )1 (1  WACC ) 2 (1  WACC )

WACC
 Tools:
Common-Size Financial Statements
Analysis of Financial Statements 

 Indexed Financial Statements

 Financial Ratios

The Du Pont Equation:

Return on Equity (ROE) Ratio 3 Determinants of ROE
 Equals: Net Income/Shareholder’s Equity Net Income
ROE 
 Measures the efficiency with which a Shareholders ' Equity
company employs owners’ capital Net Income Sales Assets
 x x
 Gives the “bang per buck” Sales Assets Shareholders ' Equity
 Ametek 2001 ROE: 66.1 / 335.1 = 19.7%

Operating Resource Leverage Usage

Profitability Utilization
Efficiency

A Road Map for Ratio Analysis Profit Margin Ratio

ROE
 Equals: Net Income / Sales
 Measures the fraction of each dollar of
Profit
Margin
Asset
Turnover
Financial
Leverage
sales that trickles down to profit.
 Reflects the company’s pricing strategy

Gross Margin

Tax Rate

Day’s Sales in Cash 
Debt to Asset and ability to control operating costs.

Collection Period 
Ametek’s 2001 PM: 66.1 / 1019.3 = 6.5%

Percentage TIE

Inventory Turnover 
Times Burden 
Income 
Fixed Asset Turnover
Variant : Gross Profit Margin Ratio
Statement Coverage

Payables Period 
Current Ratio 

(GPM)
Percentage Balance 
Acid Test Ratio
Sheet
Asset Turnover
 Equals: Sales / Total Assets
 Measure of asset intensity
 Dependent on the nature of company’s
products, its competitive strategy and
management diligence and creativity
 Ametek’s 2001 Asset Turnover:
1019.3 / 1029.3 = 1.0
Standard Control Ratio Related
to Asset Turnover
 Inventory Turnover:
CGS / Ending Inventory
(Variant : Day’s Inventory = Number of Days in A
Year / Inventory Turnover)
 Collection Period:
A/R / Credit Sales per Day
(Variant : A/R Turnover = Credit Sales / A/R)
Return on Assets (ROA)
 Equal: Net Income / Assets
 Or: Profit Margin x Asset Turnover
 Measures the efficiency with which a
company allocates and manages its
resources, or profit as a % of money
provided by owners and creditors.
 Ametek’s 2001 ROA: 66.1 / 1029.3=6.4%
Why Compare Asset to Sales?
 Assets (specially the “current” type) will
move with sales – the ratio corrects for
changes in sales and allows one to
evaluate how well management used
the resources available.
Standard Control Ratio Related
to Asset Turnover
 Day’s Sales in Cash:
Cash and Securities / Sales per Day
 Payables Period:
A/P / Credit Purchases per Day
(this is a control ratio for liability, if credit purchases is unkown,
CGS can be used in its place)
 Fixed – Asset Turnover:
Sales / Net Property, Plant and Equip.
(a measure of capital intensity, important for firms that rely on
large investments in long-lived assets to produce their goods)
Financial Leverage
 The extent to which debt financing is
used in a business.
 Not necessarily that the higher it is the
better. Need to balance it with the risks
associated with the usage of debt.
 ROA and financial leverage tend to be
inversely related.
Debt Ratios Coverage Ratios
 Debt to asset ratio:  Address weakness of debt ratios.
Total Liabilities / Total Assets  Measures income available for debt service.
 Debt to equity ratio: (Can the business pay its way?)
EBIT
Total Liabilities / Shareholders’ Equity Times Interest Earned 
Interest Expense
Note: These ratios can be used to assess if the
EBIT
company has over-borrowed however it should be Times Burden Covered 
kept in mind that the financial burden a company  Pr incipal Re payment 
Interest   
faces by using debt financing ultimately depends not  1  Tax Rate 
on the size of its liabilities relative to assets or to  Ametek’s 2001 TIE: 112.3/27.9 = 4
equity but on its ability to meet the annual cash
payments the debt requires. TBC: 112.3 / [27.9+1.3/(1- {18.3/84.4})] = 3.8

Liquidity Ratios Liquidity Rations

 Liquidity of assets is a determinant of a Current Ratio 
Current Assets
company’s debt capacity. Current Liabilities
 These are crude measures of liquidity: (1) Acid Test 
Current Assets  Inventory
rolling over some current liabilities involves Current Assets
no insolvency risk provided the company is at Current Liabilities
least marginally profitable (2) unless
company intends to go out of business, most  Ametek’s 2001 Current Ratio: 379.3 / 336.2 = 1.1
of cash generated by liquidating current Acid Test: (379.3-152.5) / 336.2 = 0.7
assets cannot be used to reduce liabilities
because it must be plowed back into the
business

Three Deficiencies of ROE

(if used as the main financial yardstick)
 The Timing Problem: ROE is backward
looking and single year- focused
 The Risk Problem: ROE says nothing about
the risk a company has taken to generate it
 The Value Problem: ROE measures return on
shareholder’s investment using book value of
shareholder’s equity not the market value
Using Ratios: Some Guidelines
 One or even several ratios by itself or
themselves might not yield important
insights about a corporation but
combined with other knowledge of a
company’s management and economic
circumstances, it can tell a very
revealing story (think of ratios as clues
in a detective story).
Using Ratios: Some Guidelines
 Ratios has no single correct value. A
high current ratio maybe a positive sign
for a short-term creditor but might not
be viewed similarly by management as
it might indicate too liberal credit terms
or too much inventory.
Using Ratios: Some Guidelines
 Comparing a company’s ratios to
industry ratios provides a useful feel for
how the company measures up to its
competitors, provided you bear in mind
that company-specific differences can
result in entirely justifiable deviations
from industry norms.
(More given in your handouts.)
 Vertical or Common Size Analysis
• A vertical analysis shows you the relationships
among components of one financial statement,
Horizontal and Vertical measured as percentages. On your balance
Analysis Details sheet, each asset is shown as a percentage of
total assets; each liability or equity item is shown
as a percentage of total liabilities and equity. On
your statement of profit and loss, each line item
is shown as a percentage of net sales.

A Vertical Analysis Example A Vertical Analysis Example

• Jafar's Colorful Kites Statement of Profit and Loss for the Year Ended Dec. 31, 2011 • Jafar's Colorful Kites Balance Sheet December 31, 2011
• Amount Percent • Assets
• Sales $ 18,000 100.00 %
• Cost of Goods Sold 7,000 38.89 % • Current Assets: Amount Percent Cash
• Gross Profit $ 11,000 61.11 % $ 600 14.12 %
• Selling Expenses
• Advertising $ 500 2.78 %
• Inventory 2,000 47.06 %
• Commissions 750 4.17 % • Prepaid Insurance 250 5.88 %
• Delivery Fees 1,200 6.67 %
• Salaries 5,000 27.78 % • Total Current Assets $ 2,850 67.06 %
• Total Selling Expenses $ 7,450 41.39 % • Fixed Assets:
• General & Administrative Expenses
• Insurance $ 800 4.44 % • Office Equipment $ 1,800 42.35 %
• Rent 1,200 6.67 % • Less: Accumulated Depreciation (400) (9.41) %
• Depreciation 200 1.11 %
• Utilities 400 2.22 % • Total Fixed Assets $ 1,400 32.94 %
• Total General & Administrative
• Total Assets $ 4,250 100.00 %
• Expenses $ 2,600 14.44 %
• Net Profit $ 950 5.28 %

A Vertical Analysis Example Interpretation

• Jafar's Colorful Kites Balance Sheet December 31, 2011 • In the statement of profit and loss, Jafar's gross profit is
sizable, at 61 percent. The selling expenses, though, are
• Liabilities & Owner's Equity eating up a huge chunk of the revenues, even more than
• Current Liabilities: product costs; that could be an area in which to cut back.
• Accounts Payable $ 1,800 42.35 % General operating expenses take up a reasonable percentage
• Taxes Payable 500 11.76 %
of sales, leaving Jafar with about a 5 percent bottom-line
profit.
• Total Liabilities $ 2,300 54.12 %
• Owner's Equity $ 1,950 45.88 % • As for the company's balance sheet, inventory makes up the
lion's share of his current assets, which could translate into
• Total Liabilities &
cash-flow problems down the line. Also, his company is
Owner's Equity $ 4,250 100.00 %
financed with more debt than equity. That's not uncommon for
new businesses, but all of this debt is current, which could
suck up all the current assets of the company.
 A Horizontal Analysis Example
Horizontal or Indexed Analysis
• Jafar's Statement of Profit and Loss for the Years Ended 12/31/2010 and 12/31/2011
• A horizontal analysis provides you with a way to • 2011 Amount 2010 Amount Change in Dollars Percent Change

compare your numbers from one period to the • Sales $ 18,000 $ 15,000 $ 3,000 20.00 %
•
next, using financial statements from at least two •
Cost of Goods Sold
Gross Profit
7,000
$ 11,000
6,000
$ 9,000
$ 1,000 16.67 %
$ 2,000 22.22 %
distinct periods. Each line item has an entry in a • Selling Expenses
• Advertising $ 500 $ 200 $ 300 150.00 %
current period column and a prior period column. • Commissions 750 400 $ 350 87.50 %
•
Those two entries are compared to show both •
Delivery Fees
Salaries
1,200
5,000
720
5,000
$ 480 66.67 %
$ - 0.00 %
the peso difference and percentage change • Total Selling Expenses $ 7,450 $ 6,320 $ 1,130 17.88 %
• General Administrative Expenses
between the two periods. • Insurance $ 800 $ 800 $ - 0.00 %
• Rent 1,200 1,200 $ - 0.00 %
• Depreciation 200 200 $ - 0.00 %
• Utilities 400 280 $ 120 42.86 %
• Total General & Administrative
• Expenses $ 2,600 $ 2,480 $ 120 4.84 %
• Net Profit $ 950 $ 200 $ 750 375.00 %

Interpretation
• First, Jafar's sales went up by about 17 percent,
while his product costs went up by only around 14
percent. That helps add to his profitability on both
sides — increased revenues and decreased costs.
Most of his selling expenses increased as well, but
that seems to have contributed to additional sales
without increasing as much as sales did. Jafar was
also able to keep most of his general operating
expenses under control, leading to much greater
profits in 2011 than the company saw the prior year.
Cooley Textile 2000 financial statements are shown below:

Cooley Textile: Balance Sheet as of December 31, 2000 (Thousand of

Dollars)
Cash $1,080 Accounts Payable $4,320
Receivables $6,480 Accruals $2,880
Inventory $9,000 Notes Payable $2,100
Total Current $16,560 Total Current $9,300
Assets Liabilities
Mortgage Bonds $3,500
Net Fixed Assets $12,600 Common Stocks $3,500
Retained Earnings $12,860
Total Assets $29,160 Total Liabilities and $29,160
Equities

Cooley Textile: Income Statement for December 31, 2000 (Thousand of

Dollars)
Sales $36,000
Operating Costs $32,440
Earnings Before Interest and Taxes $3,560
Interest $560
Earnings Before Taxes $3,000
Taxes (40%) $1,200
Net Income $1,800
Dividends (45%) $810
Addition to Retained Earnings $990

Suppose 2001 sales are projected to increase by 15% over 2000 sales.
Determine the additional funds needed. Assume that the company was
operating at full capacity in 2000, that it cannot sell off any of its fixed
assets, and that any required financing will be borrowed as notes payable.
Also, assume that assets, spontaneous liabilities and operating costs are
expected to increase in proportion to sales. Use the projected financial
statement method to develop a pro forma balance sheet and income
statement for December 31, 2001.
Cooley Textile 2000 financial statements are shown below:

Cooley Textile: Balance Sheet as of December 31, 2000 (Thousand of

Dollars)
Cash $1,080 Accounts Payable $4,320
Receivables $6,480 Accruals $2,880
Inventory $9,000 Notes Payable $2,100
Total Current $16,560 Total Current $9,300
Assets Liabilities
Mortgage Bonds $3,500
Net Fixed Assets $12,600 Common Stocks $3,500
Retained Earnings $12,860
Total Assets $29,160 Total Liabilities and $29,160
Equities

Cooley Textile: Income Statement for December 31, 2000 (Thousand of

Dollars)
Sales $36,000
Operating Costs $32,440
Earnings Before Interest and Taxes $3,560
Interest $560
Earnings Before Taxes $3,000
Taxes (40%) $1,200
Net Income $1,800
Dividends (45%) $810
Addition to Retained Earnings $990

Suppose 2001 sales are projected to increase by 15% over 2000 sales.
Determine the additional funds needed. Assume that the company was
operating at full capacity in 2000, that it cannot sell off any of its fixed
assets, and that any required financing will be borrowed as notes payable.
Also, assume that assets, spontaneous liabilities and operating costs are
expected to increase in proportion to sales. Use the projected financial
statement method to develop a pro forma balance sheet and income
statement for December 31, 2001.
 The Financial Environment: Markets, Institutions and
Interest Rates

Financial Markets and Institutions

Financial Markets - people and organizations wanting to borrow money brought

together with those having surplus funds resulting to a transfer of capital.

Different Types of Financial Markets:

Market Description
Money Markets Markets for short-term, highly liquid debt
securities (<1 year).
Capital Markets Markets for intermediate- or long-term debt and
corporate stocks (>1 year).
Primary Markets Markets in which corporations raise capital by
issuing new securities.
Secondary Markets Markets in which existing, already outstanding,
securities are traded among investors.
Initial Public Offering (IPO) A subset of the primary market where firms “go
Market public” by offering shares to the public.

Business borrowings can be done:

1. Privately (private markets) – transactions are worked out directly between two
parties. Securities offered privately are more tailor-made but less liquid.
2. Publicly (public markets) – standard contracts or securities are traded on
organized exchanges. Securities offered publicly are more liquid and subject to
greater standardization.

3 Ways by Which Capital Transfer Could Occur:

1. Direct Transfer – occur when a business (borrower) sells its stocks or bonds
directly to savers (lenders).
2. Transfer through Investment Banking Houses – occurs when business
(borrower) goes to an investment banking house to issue its securities where
the investment banking house first buy the securities and resell them after
holding it for some time.
Investment banking houses – organization that underwrites and distributes new investment
securities and helps businesses obtain financing.
3. Transfer through Financial Intermediary – occurs when the financial
intermediary obtains funds from savers in exchange for its own securities and
the funds are then used to purchase and hold businesses’ (borrower) securities.

The Financial Environment Page 1 of 4

Financial Intermediaries – specialized financial firms that facilitates the transfer
of funds from savers to demanders of capital.

Major Classes of Intermediaries:

1. Commercial Banks – the “department stores of finance” serving a wide variety of
savers and borrowers.
2. Savings and Loans Associations – takes the fund of many small savers and then
lend this money to home buyers and other type of borrowers.
3. Mutual Savings Bank – similar to savings and loans associations, these accept
savings from individuals and lend mainly on a long-term basis to home buyers and
consumers.
4. Credit Unions – cooperative associations whose members are supposed to have a
common bond, these unions are often the cheapest source of funds available to
individual borrowers.
5. Life Insurance/Insurance Companies – take savings in the form of annual
premiums and invest these in business securities.
6. Mutual Fund Companies – corporations that accept money from savers and then
use these funds to buy stocks, long-term bonds or short-term debt instruments
issued by businesses or government units. Pooling of funds (money of savers)
enables reductions of investment risk by diversification and permits
achievement of economies of scale in analyzing, buying and selling securities and
managing portfolios.

The Cost of Money

Interest Rate – price paid on borrowed/debt capital.

Cost of Equity Money – dividends investors/owners expect to receive and capital
gains.

The cost of capital of a firm is formed by both interest rate and cost of equity
money.

Fundamental Factors Affecting the Cost of Money:

1. Production Opportunities – returns available within an economy from
investments in productive or cash-generating assets.
2. Time Preferences for Consumption – preferences of consumers for current
consumption as opposed to saving for future consumption.
3. Risk – the chance that an investment will provide a low or negative return or the
chance that the actual return of an investment will deviate from what is
expected.
4. Inflation – amount by which prices increase over time. (Current real rate of
interest is the gap between the current interest rate and the current inflation

The Financial Environment Page 2 of 4

 rate because it shows how much investors really earned after taking out the
effects of inflation.)

(Supply and demand of capital also affects the cost of money.)

The Determinants of Market Interest Rates

- the quoted or nominal interest rate on a debt security, k, is composed of a real

risk-free rate of interest, k*, plus several premiums

k = k*+IP+DRP+LP+MRP

The Real Risk-Free Rate of Interest, k*

- interest rate that would exist on a riskless security if no inflation were
expected (can be peg at the interest of Treasury securities in an inflation-free
world)

The Nominal or Quoted Risk-Free Rate of Interest, kRF

kRF = k* + IP
- IP is the inflation premium, which is equal to the average expected inflation
rate over the life of the security.
- Nominal or quoted risk-free rate of interest means interest rate on a totally
risk-free security- one that has no risk of default, no maturity risk, no liquidity
risk, no risk of loss if inflation increases and no risk of any other type. (There
is no such security in the actual world, the closest would be Treasury
securities.)

The Default Risk Premium, DRP

- covers the risk that a borrower will default on a loan, which means non-payment
(or non-timely payment) of interest or the principal
- can be measured to be the difference between the interest rate on a Treasury
security and a corporate security of equal maturity and marketability

Liquidity Premium, LP
- premium added to the equilibrium interest rate on a security if that security
cannot be converted to cash on short notice and at close to “fair market value”.

Maturity Risk Premium, MRP

- premium added to cover the risk brought about by movement or fluctuation in
interest rates.

The Financial Environment Page 3 of 4

- Interest Rate Risk – MRP for long-term securities, occurs whenever interest
rate rises leading to the decline in the prices of long-term securities. MRP is
then higher the longer the years to maturity.
- Reinvestment Rate Risk – MRP for short-term securities, the risk that a
decline in interest rates will lead to lower income when securities mature and
the funds are reinvested.

Term Structure of Interest Rates

- describes the relationship between long term and short term interest rates.
- Yield curve – a graph showing the relationship between maturity and interest
rate yield of securities.
Types of Yield Curves:
A. Normal Yield Curve – upward sloping yield curve.
B. Inverted (“Abnormal”) Yield Curve – downward sloping yield curve.
C. Humped Yield Curve – yield curve where interest rates on medium-term
maturities are higher than rates on both short-term and long-term
maturities.

Why short-term rates are normally lower than long-term rates?

1. Because short-term debts generally have lower MRPs than the ones that
are long-term.
2. Because short-term debts generally have lower default risk, leading also
to a lower liquidity risk than long-term debt.

When do short-term rates become higher than the long-term?

1. If inflation is expected to decline over the future.
2. If movement in short-term interest rates fluctuates more than that of
the long-term.

“ Even if it is difficult to predict future interest rate levels, it is easy to predict

that interest rates will fluctuate. A sound financial policy calls for using a mix of
long-term and short-term debt as well as equity to position the firm enabling it to
survive any interest rate environment. The optimal financial policy of a firm would
then vitally depend on the nature of its assets.”

The Financial Environment Page 4 of 4

Quiz 1 Reviewer

Weatherford Industries Inc. has the following ratios: A0 / S 0  1.6;  0.4; profit
* *
L /S
0 0
margin =0.10; and retention ratio = 55%.
Sales last year were $100M. Assuming that these ratios remain constant:

a. Use the AFN equation to determine the maximum growth rate (sustainable growth rate) it can
achieve without having to employ non-spontaneous external funds.
b.Suppose financial consultants report (1) that the inventory turnover ratio: Sales/Inventory = 3X
versus an industry average of 4X and (2) inventories can be reduced and thus raise its turnover
to 4 without affecting sales, profit margin or other asset turnover ratios. Determine the amount
of additional funds the company will require next year if sales grow by 20%.
c. Suppose 40% of the company’s present asset holdings is fixed asset while the remainder are all
current assets which increase proportionately with sales. If the company is not yet operating at
full capacity and an additional 15% of sales increase next year can be ably absorbed by the
slack capacity, determine the additional amount of external financing needed.

Questions Answer Pts

a. Maximum growth rate? 2
b.1 What is the projected level of inventory if company 2
succeeds to improve its turnover next year?
b.2 What is the new asset to sales proportion with the 4
improvement in the inventory turnover ratio?
b.3 What is the total current amount of external 3
financing employed by the company?
b.4 What additional external funds would the company 5
require next year to fund its 20% sales growth
c.1 What is the projected total asset amount next year 2
with the 15% sales increase.
c.2 What additional amount of external funds would be 2
required?

The following data apply to Sinotronics (in millions):

Cash and equivalents 120

Fixed Assets 267.5
Sales 1,100
Net Income 52
Current Liabilities 106.8
Current Ratio 3.1X
DSO 41.25 days
ROE 12.5%
Use a 365-day year
Sinotronics has no preferred stocks- only common equity, current liabilities and long-term debt.

A. Determine the following (1pt. each):

Acct/Ratio Answer Acct/Ratio Answer

Accounts Rec. Common Equity
Current Assets Quick Ratio
Total Assets Long-term Debt
ROA

B. If Sinotronics’ could reduce its DSO from 41.25 days to 30.4 days while holding other
things constant, this would generate cash. The company plans to use this cash to buy back
common stocks (at book value) thus reducing common equity.

Questions Answer Pts.

b.1 How much cash would 2
it generate?
How would the buy back affect the following (just indicate increase or decrease):
b.2 ROE 1
b.3 ROA 1
b.4 Financial Leverage 1

C. Suppose Filtronics, the erstwhile competitor of Sinotronics’, has a current ratio of 2.9 and
a quick ratio of 2.5.

Question Answer Pts

What weakness does this reveal about 3
the asset holdings of Sinotronics?

Given below are the balance sheets as of Dec 31, 1979 and Dec 31, 1980 as well as the income
statement.

Electronics Limited
Comparative Balance Sheets (in ‘000)
Dec 31, 1979 Dec 31, 1980
Cash 74,000 37,000
Accounts Receivable 54,000 47,000
Inventories 312,000 277,000
Prepaid Expenses 6,000 4,000
Land 60,000 60,000
Patents, Net 55,000 65,000
Buildings and Equipment 420,000 480,000
Less: Acc. Depreciation (105,000) (120,000)
Total Assets 876,000 850,000

Accounts Payable 58,000 94,000

Notes Payable 28,000 8,000
Income Tax Accrued 86,000 12,000
Social Security Tax 3,000 5,000
Accrued
Long Term Debt 220,000 60,000
Capital 250,000 460,000
Retained Earnings 231,000 211,000
Total Liabilities & Equities 876,000 850,000

Electronics Limited
Income Statement (in ‘000)
Net Sales 1,970,000
Less: CGS (1,480,000)
Gross Profit 490,000
Less: Operating Expenses (500,000)
Net Loss from Operations (10,000)
Add: Other Revenues 7,000
Less: Other Losses (Net Loss on Machine Sale) (1,000)
Net Loss (4,000)

Retained Earnings, Beginning 231,000

Less: Dividend Paid (16,000)
Retained Earnings, Ending 211,000
During the year, a specialized machine that originally cost 15M was sold. The accumulated
depreciation of this machine at the time of the sale was 8M. The machine was sold for 6M and
full payment was received in cash. Yearly amortization of intangible asset stands at 6M.

A. (19pts) Do a funds flow statement on cash basis:

OPERATING ACTIVITIES
Sources of Cash Amount Uses of Cash Amount
NET CASH GENERATED BY OPERATING ACTIVITIES =
INVESTING ACTIVITIES
Sources of Cash Amount Uses of Cash Amount

NET CASH GENERATED BY INVESTING ACTIVITIES =

FINANCING ACTIVITIES
Sources of Cash Amount Uses of Cash Amount

NET CASH GENERATED BY FINANCING ACTIVITIES =

NET CHANGE IN CASH =

B. Answer the following (assume no tax charges for operational loss and ‘Net Loss from
Operations’ will serve as EBIT).
Questions Answer Pts.
b.1 Compute the total operating capital or 2
investor supplied funds for the company on
1980.
b.2 Compute the company’s FCF for 1980. 3
b.3 If after-tax cost of capital is 12%, what is 2
the company’s EVA for 1980?
b.4 Comment on the company’s state of 3
working capital, return to shareholders,
financing activities vis-à-vis the investment it
is undertaking. What should the company
watch out for?
CHAPTER 4 Types of financial markets
The Financial Environment:  Physical assets vs. Financial assets
Markets, Institutions, and Interest Rates
 Money vs. Capital
 Primary vs. Secondary
 Financial markets  Spot vs. Futures
 Types of financial institutions  Public vs. Private
 Determinants of interest rates
 Yield curves
4-1 4-2

Capital Formation Process Types of financial intermediaries

Direct Transfers

Business
Securities (Stocks or Bonds)
Savers  Commercial banks
Savings and loan associations
Dollars


Mutual savings banks

Through Investment Bankers


Credit unions
Securities Securities
Business Investment Bank Savers 

Pension funds
Dollars Dollars

Through Financial Intermediary
 Life insurance companies
Business’s Intermediary’s

Business
Securities
Intermediary
Securities
Savers  Mutual funds
Dollars Dollars
4-3 4-4

What four factors affect the cost

The cost of money of money?
 The price, or cost, of debt capital is  Production
the interest rate. opportunities
Time preferences for
 The price, or cost, of equity capital is 

consumption
the required return. The required
 Risk
return investors expect is composed of
Expected inflation
compensation in the form of dividends 

and capital gains.

4-5 4-6
 Premiums added to k* for
Determinants of interest rates different types of debt
k = k* + IP + DRP + LP + MRP
IP MRP DRP LP
k = required return on a debt security S-T Treasury 
k* = real risk-free rate of interest
L-T Treasury  
IP = inflation premium
DRP = default risk premium S-T Corporate   
LP = liquidity premium
L-T Corporate    
MRP = maturity risk premium
4-7 4-8

Yield curve and the term Term Structure of Interest

structure of interest rates Rates
 Term structure – Abnormal Yield Curve

relationship between
16 Humped Yield Curve
14 Normal Yield Curve
interest rates (or 12
yields) and maturities.
Interest %

10
 The yield curve is a 8
graph of the term 6
structure. 4

 A Treasury yield curve 2

from October 2002 0

can be viewed at the 6 mos 1 year 5 years 10 years 30 years

right. Tim e

4-9 4-10

Other factors that influence

Hypothetical yield curve interest rate levels
Interest  An upward sloping  Federal reserve policy
Rate (%)
yield curve.
15 Maturity risk premium  Federal budget surplus or deficit
 Upward slope due
to an increase in  Level of business activity
10 Inflation premium
expected inflation  International factors
and increasing
5 maturity risk
Real risk-free rate premium.
0 Years to
1 10 20 Maturity
4-11 4-12