REVIEWER FINANCIAL MANAGEMENT

Checklist:

AMDG+ 1
CAPITAL BUDGETING FM-1
CAPITAL BUDGETING
• Planning significant investments in projects that have long- term implications
• Decisions that concern the commitment of money to resources or assets that generate future returns or benefits
• Screening decisions— whether a proposed project is acceptable and passes a preset hurdle
• Preference decisions—selecting among several ACCEPTABLE alternatives
• Despite the uncertainty and large cost involved in investments in automated equipment, any intangible benefits
from these projects are not ignored.

TIME VALUE OF MONEY

• The time value of money should be taken into account in investment decisions because a peso (or any currency)
received today is more valuable than a peso received in the future.
• Projects that promise earlier returns are preferable to those that promise later returns
• Annuity—series of identical cash flows
• Compound interest—process of paying interest on interest in an investment
• Discount rate—rate of return that is used to find the present value of a future cash flow
• Discounting—the process of finding the present value of a future cash flow
• Present Value—the value now of an amount that will be received in some future period
• Discounted cash flow techniques automatically provide for recovery of initial investment

METHODS THAT CONSIDER TIME VALUE OF MONEY

NPV Profitability Index IRR Modified IRR
PV of Net inflows 𝑁𝑃𝑉 At IRR, NPV = 0 𝐏𝐕 𝐨𝐟 𝐎𝐮𝐭𝐥𝐨𝐰𝐬 =
𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆
𝐏𝐈 = (𝟏 + 𝑴𝑰𝑹𝑹)𝒏
Less : PV of Net outflows 𝑃𝑉 𝑜𝑓 𝑁𝑒𝑡 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 Thus,
Net present value PV of Net inflows = PV of Net Where terminal value is the sum of
𝑃𝑉 𝑜𝑓 𝑁𝑒𝑡 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 outflows the PV of net inflows compounded
𝐏𝐈 = at the cost of capital
𝑃𝑉 𝑜𝑓 𝑁𝑒𝑡 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠

• tells us how much value each
project contributes to
shareholder wealth
• method that should be given the
greatest weight in capital
budgeting decisions.
• Accept only when positive, and
the highest NPV in mutually
exclusive projects
• Cannot be directly compared to
other projects unless the initial
investments are equal in
preference decisions
• Based on the assumption that
the cash flows can be
reinvested at the project’s risk-
adjusted WACC
• If a project has most of its cash
flows coming in the later years,
its NPV will decline sharply if
the cost of capital increases; but
a project whose cash flows
come earlier will not be
severely penalized by high
capital costs
• The project profitability
index is computed by
dividing the NPV of the
project by the required
initial investment.
• Used in Preference
decisions instead of the
NPV
• If NPV is positive,
Profitability index is
positive in approach 1 (or
negative if NPV is
negative)
• If NPV is positive,
Profitability index is more
than 100% in approach 2
(or less than 100% if NPV
is negative)
• The discount rate that forces a
project’s NPV to equal zero.
• Based on the assumption that
cash flows can be reinvested at
the IRR
• Accept only when IRR exceeds
the project’s Weighted Average
of Cost of Capital (WACC), and
choose the highest IRR in
mutually exclusive projects
• Measure profitability as a
percentage rate of return
• Provides information concerning
a project’s safety margin
• One defect is that the method
does not take proper account of
differences in the sizes of the
project
• The discount rate at which the
present value of the project’s
cost is equal to the present
value of its terminal value
• Assumes that cash flows are
reinvested at the cost of capital
• Eliminates the multiple IRR
problem***
***Multiple Internal Rates of
Return occur when signs of the
cash flows change more than once
(nonnormal cash flows) and is a
problem that arises when IRR
method is used
Normal cash flows: - - - + + +
Nonnormal cash flows: - + + + - + + +

❖ Some cash flows are relevant (should be included in capital budgeting analysis), while others should not be included.
The key question is: Is the cash flow incremental in the sense that it will occur if and only if the project is accepted?
❖ Sunk costs are not incremental costs – they are not affected by accepting or rejecting the project.
❖ The cash flows used to analyze a project are different from a project’s net income. One important factor is that
depreciation is deducted when net income is calculated, but because it is a noncash charge, it must be added back to
find cash flows.
❖ Many projects require additional net operating working capital. An increase in net operating working capital is an
additional outlay when the project is started but is an inflow at the end of the project’s life, when the capital is
recovered (i.e. the investment in operating working capital is reduced when the project is completed).
❖ Two types of projects are considered: expansion and replacement. For a replacement project, find the difference in
the free cash flows when the firm continues to use the old asset versus the new asset. If the NPV of the differential
flows is positive, the replacement should be made.

AMDG+ 2
ACIAT : Annual cash inflow after tax
Approach 1 Approach 2
Annual cash inflows before tax ZZZ Annual cash inflows before tax ZZZ (1-tax rate)
Less depreciation (XXX) plus Depreciation tax shield*
Annual net income before tax XXX Depreciation x tax rate DDD x tax rate
Less tax (XXX) ACIAT YYY
Annual net income after tax ANIAT XXX
Add depreciation DDD * Depreciation tax shield is always based on differential depreciation
Annual cash income after tax ACIAT YYY (new vs old); if there is no tax rate given, there is no DTS
Cash inflows → may be in the form of differential operating costs or savings or incremental contribution margin

SUMMARY OF INFLOWS, NET

ACIAT X PVA factor =
Salvage value (new) X (1-tax rate) X PV factor =
Working capital released X PV factor =
Less : Cash expense during the
life of the asset (i.e. future
overhaul/repair of new)

X (1-tax rate) X PV factor = ( )

NET INFLOWS

SUMMARY OF OUTFLOWS, NET

Cost of investment x1.0
Less : Salvage value
(old)* x1.0 ( )
Add : Working capital
Required x1.0
Less : Overhaul of old
Needed now x1.0 ( )
Net OUTFLOWS
*Salvage value (old)
Proceeds/ Market Value Proceeds/ Market Value
-Book value of old -Book value of old
Gain on sale (if P > BV) Loss on sale (if P < BV)
X Tax rate X Tax rate
Tax on gain Tax savings on loss

Salvage value Salvage value

Less : tax on gain Add : tax savings on loss
*Salvage value to be deducted from *Salvage value to be deducted from Investment outlay
Investment outlay

How to determine increase or decrease in units given an NPV*** How to determine increase or decrease in savings ***
NPV (positive) NPV (positive)
Divide by PVA factor Divide by PVA factor
Divide by (1-tax rate) Divide by (1-tax rate)
Divide by Contribution Margin per unit
Decrease in ACI before tax (or savings) if NPV is negative → increase in savings
Decrease in units as to current sales in units, if NPV is negative → increase in units
***Another method is reconstruction of the formula to find the increase or decrease in units in NPV and in peso savings

Minimum required rate of return

➢ The company’s cost of capital is usually regarded as the minimum required rate of return
➢ Cost of capital is the average rate of return the company must pay to its long-term creditors and shareholders for the use of
their funds.
COST OF CAPITAL AS A SCREENING TOOL
NPV method
• The cost of capital is used as the DISCOUNT RATE when computing the NPV of the project.
• Any project with NEGATIVE NPV is rejected
IRR method
• The cost of capital is used as the HURDLE RATE that a project must clear for acceptance.
• It is compared to the IRR of a project.
• Any project whose IRR is less than the cost of capital is rejected.

AMDG+ 3
METHODS NOT CONSIDERING TIME VALUE OF MONEY
Payback**** Accounting/ Simple/ Book Value Rate of Return
𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝐴𝑁𝐼𝐴𝑇
Book Value Rate of Return =
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑢𝑡𝑙𝑎𝑦 𝑜𝑟 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ∗
𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒐𝒖𝒕𝒍𝒂𝒚 (𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍)
𝒑𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑
𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝑨𝑪𝑰𝑨𝑻 → 𝐢𝐟 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝐚𝐫𝐞 𝐮𝐧𝐢𝐟𝐨𝐫𝐦 ∗ 𝑎𝑣𝑒. 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
2

• Indicates project liquidity and risk, with shorter projects providing
better liquidity
• The length of time required for an investment’s net revenues to
cover its cost; is a break-even calculation
• Flaws: (1) dollars received in different years are given the same
weight**; (2) Cash flows beyond the payback year are given no
consideration regardless of how large they might be; (3) there is no
relationship between investor’s wealth and the payback period
**addressed in the discounted payback period method
• Initial investment in the formula should be reduced by any salve
value realized from the sale of old equipment replaced
• Focuses on accounting net operating income rather than cash flows
• Compares project’s expected ARR with a hurdle rate or a desired rate
of return
• The only method that uses the annual net income after tax as a
measurement of the returns

****If cash inflows are not uniform in Payback period method:

Cash Outflow Cash flow in a Cumulative cash Unrecovered Payback period ∗ 𝒇𝒓𝒂𝒄𝒕𝒊𝒐𝒏𝒂𝒍 𝒑𝒂𝒓𝒕
year flows Investments 𝒃𝒂𝒍𝒂𝒏𝒄𝒆
300,000 100,000 100,000 200,000 1 =
𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒇𝒐𝒓 𝒕𝒉𝒂𝒕 𝒚𝒆𝒂𝒓
150,000 250,000 50,000 1
200,000 450,000 0.25
Fractional Part* *50,000/200,000

NOTES
1. The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the
net present value method (NPV) may be different when multiple projects have unequal lives and the size of the
investment for each project is different—see NPV profile lesson for clarification.
2. The disadvantage of NPV method is it does not provide the true rate of return on investment
3. The proper discount rate to use to calculating certainty equivalent net present value is the risk- free rate
4. The use of an accelerated method instead of the straight- line method of depreciation in computing the NPV of a
project will be increasing the present value of the depreciation tax shield in earlier periods
5. Increasing the discount rate would decrease the NPV
6. In an inflationary environment, adjustments should be made to increase the estimated cash inflows and increase
the discount rate
7. The future asset depreciation expense is not included in discounted flow analysis but the tax effects of future asset
depreciation is included.
8. When the problem does not state "IGNORE SALVAGE VALUE" or "WITHOUT ANY REDUCTION FOR
SALVAGE VALUE", include the salvage value in the computation
9. If the problem DOES NOT indicate AVERAGE investment, then use the original or initial investment in the
Accounting rate of return method
10. Note that the discounted payback period is LONGER THAN the traditional payback period.
11. Strategic Business Plan—a long run plan that outlines in broad terms the firm’s basic strategy for the next 5 to
10 years

AMDG+ 4
OTHER TOPICS ON CAPITAL BUDGETING FM+

AMDG+ 5
COST OF CAPITAL FM-2
BASICS
• A firm’s primary objective is to maximize its shareholders’ value. The principal way value is increased in by investing in
projects that earn more than their cost of capital.
• The rates of return that investors require on bonds and stocks represent the costs of those securities to the firm.
• The cost of capital is a key element in capital budgeting decisions

CAPITAL COMPONENT
 One of the types of capital used by firms to raise funds
 The investor-supplied items (debt, preferred stock, and common equity) are called capital components
 Increases in assets must be financed by increases in these capital components
 The cost of each component is called its component cost.

Cost of Common Equity

 The cost of common equity is based on the returns that investors require on the
company’s common stock.
Cost of Preferred  Equity raised by issuing common stock has a HIGHER cost than equity from
Cost of debt rd retained earnings due to flotation costs required to sell new common stock.
Stock rp  Raised in two ways: (1) by retaining some of the current year’s earnings and (2)
issuing new common stock
Cost of Retained Earnings rs Cost of New Com. Stock re
∗ 𝑟𝑠 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + (𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)(𝑏𝑒𝑡𝑎)

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑

∗∗ 𝑟𝑠 = +𝑔
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒

∗∗∗ 𝑟𝑠 = Bond yield + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑

𝒓𝒅 = 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞 𝐨𝐧 𝐧𝐞𝐰 𝐝𝐞𝐛𝐭 (𝟏 − 𝐓)
• Before- tax cost of debt—the
interest rate a firm must pay on
its new debt
• After- tax cost of debt—is the
interest rate on new debt less
tax savings because interest in
tax deductible
• After- tax cost of debt is used
in calculating the WACC
because stock price depends on
after- tax cash flows
• Interest rate on new debt can
be estimated by asking bankers
or by finding the yield to
maturity (or yield to call)
• Only debt has a tax adjustment
factor
• Tax rate for firm with losses is
0  When stock is in equilibrium,
• We can adjust for flotation
costs by deducting the
dollar flotation costs from
the issue price (par value of
the bond and calculating an
adjusted YTM
If Company M can borrow at
an interest rate of 10% and
the income tax rate is 30%.
The after-tax cost of debt is
7%
After-tax cost of debt
= 10 % x (1-0.30)
= 7%
Preferred Dividend
rp =
Preferred Stock Price
• Rate of return investors require on
the firm’s preferred stock
Company M does not have any
preferred stock outstanding, but the
company plans to issue some in the
future and has included it in its target
capital structure. The stock would
have a P10.00 dividend per share and
it would be priced at P97.50 per
share.
Cost of PS
= Dividend per share / current price
= P10.00 / P97.50
= 10.3 %
 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 = average return on stock −
risk free rate
 retention ratio or plowback= 1- Dividend
payout ratio
 growth rate (g)= return on equity x retention
ratio
 Return on equity= Net income/ equity
 No direct costs are associated
with retained earnings, but this
capital has an OPPORTUNITY
COST
 The firm needs to earn at least
as much on any earnings
retained as the stockholders
could earn an alternative
investment of comparable risk.
 Cost of Retrained Earnings are
hard to estimate, so reasonably
good techniques are employed
to estimate this: the required
rate of return for the CAPM
approach, and expected rate of
return for DCF approach
required rate of return equals
the expected rate of return
𝑟𝑒 =
𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 (1 − 𝑓𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 %)
+𝑔
 growth rate (g)= return on equity x retention ratio
 Cost of capital raised is the
investors’ required rate of
return plus the flotation cost
 Flotation cost—bankers’ fees
(investment bankers help the
company structure the terms,
set the price for the issue, and
sell the issue to investors); the
percentage cost of issuing a
new common stock
Suppose investors require a
13.7% return on their investment,
but flotation costs represent 10%
of the funds raised.
The firm actually keeps and
invests only 90% of the amount
that investors supplied
= 1.25 / 23.06 (1-0.10) + 8.3 %
=1.25 / 20.75 + 8.3 %
= 14.3 %
 The firm must earn about
14.3% on the available funds
in order to provide investors
with a 13.7% return on their
investment.
 This higher rate of return is
the flotation-adjusted cost of
equity

AMDG+ 6
 Cost of Common Equity
Required Rate of Return = Expected Rate of Return
Risk-free rate + Risk premium = Dividend yield + Growth rate
*CAPITAL ASSET PRICING MODEL (CAPM) **DIVIDEND YIELD PLUS GROWTH RATE OR
DISCOUNTED CASH FLOW (DCF) MODEL
Step 1 : Estimate the risk-free rate. (Use either 10-yr Treasury bond rate M Company’s stock sells for P23.06, its next expected dividend
or the short-term Treasury bill rate) is P1.25 and security analysts expect its growth rate to be 8.3 %.
The company’s expected and required rates of return or the
Step 2 : Estimate the stocks beta coefficient, b, and use it as an index of
the stock’s risk. Cost of RE = Dividend per share + Growth

Step 3 : Estimate the market risk premium. This is the difference Current price rate
between the return that investors require on an average stock and the
risk-free rate. = 1.25 / 23.06 + 8.3%

Step 4 : Substitute the preceding values in the CAPM equation to = 13.7 %

estimate the required rate of return on the stock in question
Assume that in today’s market, risk-free rate is 5.6%, the market risk
premium is 5% and M Company’s beta is 1.48. Using the CAPM
approach,
Cost of equity = risk-free rate + (risk premium)(beta)
= 5.6 % + (5%)(1.48)
= 13 %
 13.7 % is the minimum rate of return that should be earned
on retained earnings to justify plowing earnings back into
the business rather than paying them out as dividends.
 Since investors are thought to have an opportunity to earn
13.7 % if earnings are paid out as dividends, the
opportunity cost of equity from retained earnings is 13.7 %.
 Expected growth rate = Return on equity X retention ratio
 Retention ratio or plowback ratio = 1 – Dividend payout
ratio

Beta coefficient—a measure of an asset’s systematic risk; a measure of a • Use the next or expected dividend per share, not the current
stock volatility relative to the overall stock market; the sensitivity of dividend per share
stock’s returns to the returns on some market index; A beta greater than
1 indicates greater volatility (price movements) than the market while
less than 1 would mean lesser volatility.

***Other methods are: (1) Bond yield plus risk premium approach BY+ RP (2) averaging the alternatives (weight results of CAPM,
DCF, BY+RP methods)

WHEN MUST NEW COMMON STOCK BE ISSUED?

• Firms should utilize retained earnings first before issuing new common stock
• Retained earnings breakpoint—total amount of capital that can be raised before new stock must be issued
𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑟𝑒𝑎𝑘𝑝𝑜𝑖𝑛𝑡 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛
Example: Addition to retained earnings in 2020 is expected to be P66 million; and its target capital structure consists of
45% debt, 2% preferred, and 53% equity
Retained earnings breakpoint= 66/ 0.53= 124.5 million

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

• A weighted average of the component costs of debt, preferred stock, and common equity
% of debt x After- tax cost of debt = DDD
% of preferred stock x Cost of preferred stock = + PPP
% of Common stock x Cost of common equity = + CCC
WACC

FACTORS THAT AFFECT WACC

FACTORS THE FIRM CANNOT CONTROL
 INTEREST RATES IN THE ECONOMY
 THE GENERAL LEVEL OF STOCK PRICES
 TAX RATES
FACTORS THE FIRM CAN CONTROL
 BY CHANGING ITS CAPITAL STRUCTURE
 BY CHANGING ITS DIVIDEND PAYOUT RATIO
 BY ALTERING ITS CAPITAL BUDGETING DECISION RULES
TO ACCEPT PROJECTS WITH MORE OR LESS RISK THAN
PROJECTS PREVIOUSLY UNDERTAKEN

NOTES
1. A substantial increase in nominal rate with no effect on the future dividends for a company over the long run would result in a decrease of the
company’s stock price.
2. A higher degree of operating leverage compared with the industry average implies that the firm has profit that is more sensitive to changes in
sales volume
3. Maximizing the net worth of the firm is consistent with the plans to finance future investment so that firm will achieve an optimum capital
structure.
4. In problems asking for marginal WACC, assume that all retained earnings have been used, meaning that the weight percentage of the cost of
common equity are ALL weight percentage of Cost of New Common Equity
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
5. Price Per Earnings Ratio =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
6. Dividend Payout Ratio =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
7. An increase in marginal tax rate, ceteris paribus, would DECREASE the cost of debt

AMDG+ 7
RISK AND RATES OF RETURN FM- 3
BASICS
1. Risk can be measured in different ways, and different conclusions about an asset’s riskiness can be reached
depending on the measure used.
2. All business assets are expected to produce cash flows, and the riskiness of an asset is based on the riskiness of its
cash flows. The riskier the cash flows, the risker the asset.

3. Assets can be categorized as financial assets and real assets, with our focus on financial assets especially stock.
4. Risk—chance that some unfavorable evet will occur
5. A stock’s risk can be considered in two ways: (a) stand alone, (b) portfolio context; important difference is that
a stock held by itself may be much less risky when held as a larger portfolio.
6. Stand alone risk—risk an investor would face if he or she held only one asset
7. Portfolio—collection of investment securities
8. In a portfolio context, a stock’s risk can be divided into two :
a) diversifiable risk, which can be diversified away and eliminated;
b) market risk, which reflects the risk of a general stock market decline and CANNOT be eliminated by
diversification. Only market risk is relevant to rational investors.
9. A stock with high market risk must offer a relatively high expected rate of return to attract investors. No
investment should be undertaken unless the expected rate of return is high enough to compensate perceived risk.
10. If investors think a stock’s expected return is too low to compensate for its risk, they will start selling it, driving
down its price and boosting its expected return.
11. Conversely, if the expected return on a stock is more than enough to compensate for the risk, people will start
buying it, raising its price and thus lowering its expected return.
12. The stock will be in EQUILIBRIUM, with neither buying nor selling pressure, when its expected return is
exactly sufficient to compensate for its risk.

RISK- RETURN TRADE- OFF

• To entice investors to take on more risk, higher expected returns should be provided.
• The slope of risk-return line depends on the individual investor’s willingness to take on risk: A steeper line
indicates that the investor is more risk averse.
• The slope of the cost of capital line depends on the willingness of the average investor in the market to take on
risk : A steeper line indicates that the average investor is more risk averse.

STATISTICAL MEASURES OF STAND- ALONE RISK

Probability distribution: A listing of possible outcomes or events with a
probability (chance of occurrence) assigned to each outcome;
𝑛

the tighter (or more peaked) the probability distribution of expected 𝑟̂ = ∑(Probability of Demand)𝑖 (Rates of Return)𝑖
future returns, the smaller the risk of given investment. 𝑖=1

Expected rate of return (𝒓̂ “r hat”): rate of return expected to be

realized from an investment
Standard deviation (𝝈 “sigma”): used to quantify the tightness of the 𝑛
probability distribution; measure of how far the actual return is likely to
deviate from the expected return; σ = √∑(Actual return − 𝑟̂ )2 (Probability of demand)𝑖
the smaller the standard deviation, the tighter the probability 𝑖=1
distribution, the lower the risk
Historical, or past realized, rate of return (𝒓 “r bar”): historical 𝝈 can 𝑛
be used as an estimate of the future risk (𝑟𝑡 − 𝑟𝑎𝑣𝑔 )2
estimated σ = √∑
𝑁−1
𝑡=1
Coefficient of variation: standardized measure of the risk per unit of
return; shows the risk per unit of return, and it provides a more
meaningful risk measure when the expected returns on two alternatives 𝝈
𝑪𝑽 =
are not the same: one has the higher expected return, the other has the 𝒓̂
lower standard deviation;
the higher the coefficient of variation, the riskier

AMDG+ 8
CALCULATING THE STATISTICAL MEASURES
Economy Probability of Deviation:
Rate of Returns If Demand Deviation
Which Affects Demand Product (2)x(3) Actual - 12% (2) x (6)
Occurs Squared
Demand Occuring Expected Return
(1) (2) (3) (4) (5) (6) (7)
Strong 0.26 96% 24.96% 12.96% 1.68% 0.004367
Normal 0.51 12% 6.12% -5.88% 0.35% 0.00176329
Weak 0.23 -83% -19.09% -31.09% 9.67% 0.02223153
1.00 Expected return= 12% Variance= 0.02836182
Standard deviation 16.84%
Note: Probability of demand occurring must equal to 100%

RISK AVERSION AND REQUIRED RETURNS

• Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities
Implications of risk aversion for security prices and rates of return: Other things held constant, the higher a
security’s risk, the higher its required return; and if this situation does not hold, prices will change to bring about
the required condition.
• Risk Premium—the difference between the expected rate of return on a given risky asset and that on a less risky
asset.
In a market dominated by risk-averse investors, riskier securities compared to less risky securities must have
higher expected returns as estimated by the marginal investor. If this situation does not exist, buying and selling
will occur until it does exist.
RISK AND RETURNS IN A PORTFOLIO CONTEXT
The risk and return of an individual stock should be analyzed in terms of how the security affects the risk and return of the
portfolio in which it is held.

Capital Asset Pricing Model (CAPM)—model based on the proposition that any stocks required rate of return is equal
to the risk free rate of return plus a risk premium that reflects only the risk remaining after diversification.

A. Expected Portfolio Returns

• Expected return on a portfolio 𝑟̂𝑝 —weighted average of the expected returns on the assets held in the portfolio
• Realized rate of return—the return that was actually earned during some past period. The actual return usually
turns out to be different from the expected return except for riskless assets
𝑛

𝑟̂𝑝 = ∑(fraction of the asset in the portfolio)𝑖 (𝑟̂ )𝑖

𝑖=1

Stock Expected Return Dollars Invested Percent of Total (2) x (4)

(1) (2) (3) (4) (5)
A 18.00% ₱25,000.00 25.00% 4.50%
B 16.85% ₱25,000.00 25.00% 4.21%
C 13.45% ₱25,000.00 25.00% 3.36%
D 9.20% ₱25,000.00 25.00% 2.30%
Average 14.38% ₱100,000.00 100.00% 14.38%

B. Portfolio Risk
• Portfolio Risk 𝛔𝒑 —generally smaller than the average of the stocks’ standard deviations because diversification
lowers the portfolio’s risk. It is not an appropriate measure of the risk held in a portfolio. Beta Coefficient is used
instead.

Expected return is the weighted average of the expected returns on its individual stocks; not the weighted average
of the individual stock’s standard deviation
• Correlation—tendency of two variables to move together
• Correlation coefficient (𝜌 "𝑟ℎ𝑜")— measures the degree of relationship between two variables
i. 𝜌 = −1.0 perfectly negative correlation, variables move in opposite direction
ii. ∗∗ 𝜌 = +1.0 perfectly positive correlation, variables move in the same direction
iii. 𝜌 = 0 indicates that two variables are not related and are independent from each other
**Note: diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly positively correlated
• As a rule, on average, portfolio risk declines as the number of stocks in a portfolio increases
• Diversifiable risk (company-specific/ unsystematic risk)—part of a security’s risk associated with random
events; can be eliminated by proper diversification
• Market risk (non-diversifiable/ systematic/ beta risk)—risk that remains in a portfolio after diversification has
eliminated all company- specific risk; stems from systematic macro factors. Measured by Beta coefficient.
• Market portfolio—a portfolio consisting of all stocks.
• Investors cannot hold the market portfolio because of (1) high administrative and commission cost (2) index funds
can diversify for investors (3) people think they can pick stocks that can beat the market

AMDG+ 9
C. Beta Coefficient
• Relevant Risk in a portfolio context—risk that remains once a stock is in a diversified portfolio is its contribution
to the portfolio’s market risk. It is measured by the extent to which the stock moves up or down with the market.
• Beta coefficient—metric that shows the extent to which a given stock’s returns move up and down with the stock
market. Beta thus measures market risk not diversifiable risk (important: always asked in theories)
i. 𝑏 = 1.0 is an average stock’s beta, moving up and down in step with the general market
ii. 𝑏 = 2.0 is twice as volatile, or risky, as an average stock
iii. 𝑏 = 0.5 is only half as volatile, or risky, as the average stock
iv. Negative beta is uncommon, stock’s returns would tend to rise whenever other stock’s returns fell
𝑛
• Beta of a portfolio b𝑝 = ∑𝑖=1(fraction of the stock in the portfolio)𝑖 (b)𝑖

RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

• Market risk premium— additional return over the risk- free rate needed to compensate investors for assuming
an average amount of risk. 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 − 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
• Security Market Line (SML) equation—equation showing the relationship between risk as measured by beta
and the required rates of return on individual securities
𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 = 𝑹𝒊𝒔𝒌 − 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆 + (𝑴𝒂𝒓𝒌𝒆𝒕 𝒓𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎) (𝑺𝒕𝒐𝒄𝒌’𝒔 𝒃𝒆𝒕𝒂)

Dollars Percent of Dollars Percent of Risk Free Risk

Stock Beta
Stock Beta Invested Total Rate Premium
Invested Total
(1) (2) (3) (4) (5) (6)
X ₱25,000 33.33% 0.80 = 0.267 A ₱400,000 10.00% 6% 8% 1.5 = 1.8%
Y ₱25,000 33.33% 1.20 = 0.400 B ₱600,000 15.00% 6% 8% -0.5 = 0.3%
C ₱1,000,000 25.00% 6% 8% 1.25 = 4.0%
Z ₱25,000 33.33% 1.60 = 0.533
D ₱2,000,000 50.00% 6% 8% 0.75 = 6.0%
Portfolio Beta 1.200 ₱4,000,000 Fund Required Rate of Return = 12.1%

THE IMPACT OF EXPECTED INFLATION

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 = 𝑟𝑒𝑎𝑙 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
• Note that an increase in the risk-free rate leads to equal increase in the rates of return on all risky assets because
the same inflation premium is built into required rates of return on both riskless and risky assets.

NOTES
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑜𝑟 𝑑𝑖𝑣𝑖𝑑𝑖𝑣𝑒𝑛𝑑
1. 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 =
𝑆𝑡𝑜𝑐𝑘 ′ 𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒
2. In reality, most stocks are positively correlated but not perfectly so. Study suggests that average correlation lies at
0.30.
3. CAPM method gauges risk only relative to returns on the market portfolio, meaning the market risk (important:
asked in theories)
4. When assessing performance, the real returns (what you have left after inflation) is what matters. It follows that
as expected inflation increases, investors need to receive higher nominal returns
5. The risk of an investment often depends on how long you plan to hold the investment. Stocks are less risky when
held as part of a long- term portfolio.
6. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the
portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the
portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
7. It could never be true that the beta of the portfolio is lower than the lowers of the three betas of three randomly
selected stocks
8. Rank of investment from highest to lowest risk (and return): small- company stocks, large- company stocks,
long- term corporate bonds, long- term government bonds, U.S Treasure bills
9. Note that risk free rate is based on T- bonds, not short- term T- bills.
10. Assume that the required rate of return on the marketed at 10%. If the yield curve were upward sloping, then the
SML would have a steeper slope if 1- year Treasure securities were used as the risk- free rate than if 30- year
Treasury bonds were used.
𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑁
11. 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = (1 + ) −1
𝑃𝑟𝑖𝑐𝑒

AMDG+ 10
STOCKS AND THEIR VALUATION FM-4
BASICS
• Cash flows provided by bonds are easy to predict since it is set by contract.
• Preferred share dividends are also set by contract, which makes them similar to bonds; they are valued in much
the same way
• However, common or ordinary share dividends are NOT contractual, they depend of the firm’s earnings, which in
turn depend on many random factors, making their valuation more difficult.
• Two models are used to estimate stock’s intrinsic (or true) values
i. Discounted Dividend model
ii. Corporate Valuation model
• STOCK is bought → price is less than its estimated intrinsic value; expected return > required return
• STOCK is sold → price is greater than its estimated intrinsic value; required return > expected return

Marginal investor
Market Price
Growth rate (g)
Required rate of return
Expected rate of return /
Expected Total Return
Realized Rate of return
Dividend Yield
Capital Gains Yield
Supernormal growth
Negative growth
Terminal (Horizon) Date
Terminal (Horizon) Value
• Representative investor whose actions reflect the beliefs of those people who are currently trading a stock
• The one who determines the stock price
• Price at which a stock sells in the market
𝒈 = (𝟏 − 𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐)𝒙 𝑹𝑶𝑬 The expected rate of growth in dividends per share
• The minimum rate of return on a common stock that a stockholder considers acceptable
r = Expected dividend yield + Expected Rate of return on a common stock that a shareholder expects to receive in
growth rate or Capital gains yield the future
• Rate of return on a common stock that actually received by stockholders in some past period;
• this may be greater than or less than expected rate of return
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑫𝑷𝑺 Expected dividend divided by current price of share of stock
𝑫𝒀 =
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
̂ 𝟏 − 𝑷𝟎
𝑷 Capital gain during the year divided by the beginning price
𝑪𝑮 =
𝑷𝟎
• Part of the firm’s life cycle in which it grows much faster than the economy as a whole
• Indicates a declining company
• Date when the growth rate becomes constant. At this date, it is no longer necessary to forecast the individual
dividends
• The value at the horizon date of all dividends expected thereafter

DISCOUNTED DIVIDEND MODEL** CORPORATE VALUATION MODEL***

• Useful for mature, stable companies for it is easier to use • More flexible and better for use with companies that do not pay
• Assumes that analysts can forecast future dividends reasonably well dividends or whose dividends would be especially hard to predict
1. Expected dividends as the basis for stock values*: the values of a • Valuation model used as an alternative to the discounted dividend
share of stock must be established as the present value of the stock’s model to determine a firm’s value, especially one with no history of
EXPECTED dividend stream dividends, or the value of a division of a larger firm;
̂ 𝟎 = 𝐏𝐕 𝐨𝐟 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬
𝑷 • It first calculates the firm’s free cash flows, then finds their present
values to determine the firm’s value .
2. Constant Growth (Gordon) Model*: used to find the value of a [EBIT x (1- tax rate)] + Depreciation & Amortization
constant growth stock Less Capital Expenditures + Change in net operating working capital
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑫𝑷𝑺 FREE CASH FLOWS
𝒓= +𝒈
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
Can also be calculated as:
𝑭𝑪𝑭 = 𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙𝒆𝒔 − 𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
Required conditions for this model:
i. The required rate of return > growth rate
Market value of company = PV of expected future free cash flows***
ii. Growth rate must be constant in the future ***Note: Discount rate used is the WACC

𝑭𝑪𝑭 𝒐𝒏𝒆 𝒚𝒆𝒂𝒓 𝒂𝒇𝒕𝒆𝒓 𝒉𝒐𝒓𝒊𝒛𝒐𝒏 𝒅𝒂𝒕𝒆

𝑯𝒐𝒓𝒊𝒛𝒐𝒏 𝑽𝒂𝒍𝒖𝒆 =
𝑾𝑨𝑪𝑪 − 𝒈
*DIVIDENDS VERSUS GROWTH • EBIT—earnings before interest and taxes
• A higher value for Dividend Yield increases a stock’s price • Free Cash flows— is the amount of cash that could be withdrawn without
• However, a higher growth rate also increases the stock’s price harming a firm’s ability to operate and to produce future cash flows
• Dividends are paid out of earnings. Therefore, growth in dividends requires
Cash flow actually available for payments to all investors after the company
growth in earnings. Earnings growth in the long run occurs primarily
has made the investments in fixed assets, new products, and working capital
because firms retain earnings and reinvest them in the business. Therefore,
required to sustain ongoing operations
the higher the percentage of earnings retained, the higher the growth rate as
shown in the equations:
Positive FCF indicates that the firm is generating more than enough cash to
Next year’s earnings= Prior earnings + (ROE x Retained Earnings)
finance its current investments in fixed assets and working capital
Next year’s dividends= Payout ratio x Next year’s earnings
Growth rate= (1- Payout ratio) x ROE
Negative FCF means not enough funds, and that new money must be raised in
Conclusion: In the long run, all things constant, growth in dividends depends
the capital markets; bad for the firm when caused by negative operating
primarily on the firm’s payout ratio and its ROE.
income; exception might be startup companies, those launching new product
lines, high- growth companies
• There is a trade- off between high current dividend or a high growth rate.
Logically, retain more earnings if the firm has exceptionally good FCF is regarded as the single and most important number that can be
investment opportunities. On the other hand, prefer higher payout if developed from accounting statements, even more important than net income
investment opportunities are poor.

AMDG+ 11
**VALUING NONCONSTANT GROWTH STOCKS FM
Step 1: Find the PV of each dividend during the period of nonconstant growth and sum them

Step 2: Find the expected Stock price at the end of the nonconstant growth period, at which point it has become a constant growth stock so it can be valued with the
constant growth model, and discount this price back to the present with the pv a year before the horizon date.
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒐𝒏𝒆 𝒚𝒆𝒂𝒓 𝒂𝒇𝒕𝒆𝒓 𝒉𝒐𝒓𝒊𝒛𝒐𝒏 𝒅𝒂𝒕𝒆
𝑯𝒐𝒓𝒊𝒛𝒐𝒏 𝑽𝒂𝒍𝒖𝒆 =
𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝐫 − 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆 𝐠
Step 3: Add these two components to find the stock’s intrinsic value
Example: Nachman Industries just paid a dividend of P1.32. Analysts expect the company’s dividend to grow by 30% this year, by 10% in Year 2, and at a constant growth rate of 5% in Year 3
and thereafter. The required return on this low- risk stock is 9%. What is the best estimate of the stock’s current value?
R= 9%
Year 0 1 2 3
Growth rate 30% 10% 5%
Dividend P1.32 1.716 P1.888 1.982
𝐷 49.550
Terminal value= 3
𝑟𝑠 −𝑔3
TOTAL CFs 1.716 51.437
PV of CFs discounted @ r 1.574 43.294
Stock price = P44.87

**EVALUATING STOCKS THAT DON’T PAY DIVIDENDS

If a firm currently pays no dividends but is expected to pay future dividends, the value of its stock can be found as follows:
Step 1: Estimate at what point dividends will be paid, the amount of the first dividend, the growth rate during the supernormal growth period, the length of the
supermodel growth period, the long- run (constant) growth rate, and the rate of return required by investors

Step 2: Use the Constant Growth model to determine the price of the stock after the firm reaches a stable growth situation

Step 3: Set out on a time line the cash flows (dividends during the supernormal growth period and the stock price once the constant growth rate is reached); then find the
present value of these cash flows. That present value represents the value of the stock today.

***CALCULATING CASH FLOWS USING THE FINANCIAL STATMENETS

ABC Company Statement of Cash Flows 2019 Free Cash Flows, 2019
I. Operating activities
Profit and Loss Net income 117.5 EBIT (1-tax) 170.3
For the Years Ending December 31 Depreciation and amortization 100.0 + Depreciation and amortization 100.0 270.3
in millions of Pesos Increase in inventories (200.0)
Less
Increase in accounts receivable (60.0)
2019 2018 Increase in accounts payable 30.0 Capital expenditures 230.0
Net Sales 3,000.0 2,850.0 Increase in accrued wages and taxes 10.0 Change in net operating working capital
Operating costs except Net cash provided by (used in)
Decrease in cash and cash equivalents (70.0) CA
operating activities (2.5)
depreciation and amortization 2,616.2 2,497.0
Increase in inventories 200.0 CA
Depreciation and amortization 100.0 90.0 II. Long-Term Investing activities
Increase in accounts receivable 60.0 CA
Total operating costs 2,716.2 2,587.0 Additions to PPE (230.0)
Net cash used in investing activities (230.0) Increase in accounts payable (30.0) CL
Increase in accrued wages and taxes (10.0) CL
Earnings before interest and taxes 283.8 263.0 III. Financing activities
Less Interest 88.0 60.0 Increase in Notes payable (LT) 50.0
150.0 380.0
Earnings before tax 195.8 203.0 Increase in Bonds Payable 170.0
Payment of dividends to shareholders (57.5) Free Cash Flow (109.7)
Taxes 40 % 78.3 81.2 Net cash provided by financing activities 162.5
Net income 117.5 121.8 negative
Net decrease in cash and cash equivalents (70.0) largely attributable to 230 million capex
Cash and cash equivalents, beginning 80.0
Total dividends 57.5 53.0 Cash and cash equivalents, ending 10.0
Capex and working capital are needed
Additions to retained earnings 60.0 68.8 to support a firm's rapid growth

Statement of Cash Flows Indirect Method

Net income
Depreciation, Amortization Added back
Losses addition in operating activities
Increase in Current Assets (Decrease in Current Assets) deduction in operating activities (addition in operating activities)
Increase in Current Liabilities (Decrease in Current Liabilities) addition in operating activities (deduction in operating activities)
Increase in Noncurrent Asset (Decrease in Noncurrent Asset) deduction in investing activities (addition in investing activities)
Gains addition in investing activities
Increase in Noncurrent Liabilities (Decrease in Noncurrent Liabilities) addition in financing activities (deduction in investing activities)
Payment in dividends deduction in financing activities
Proceeds in sale of Stock addition in financing activities

***CORPORATE VALUATION MODEL EXAMPLE

Belgrade Company invests a large sum of money in R&D; as a result, it retains and reinvests all of its earnings. In other words, the company does not pay an dividends and it has no plans to
pay dividends in the near future. A major pension fund is interested in purchasing Belgrade’s stock. The pension fund manager has estimated Belgrade’s free cash flows for the next four years
as follows: P3 million, P6 million, P10 million, and P15 million. After the 4th year, free cash flow is projected to grow at a constant growth rate of 7% Belgrade’s WACC is 12%. The market
value of its debt and preferred stock totals P60 million, and it has 10 million shares of common stock. What is the Estimate of Belgrade’s price per share?

WACC= 12%
Year 0 1 2 3 4 1. What is the PV of
Free Cash Flows 3,000,000 6,000,000 10,000,000 FCF projected during
𝐹𝐶𝐹
4 $15,000,000 (1.07) the next 4 years?
Terminal value= 𝑊𝐴𝐶𝐶−𝑔 321,000,000 0.12 − 0.07
= $321,000,000.
4
3M x 0.893= 2,679,000
6M x 0.797= 4,782,000
TOTAL CFs 3,000,000 6,000,000 331,000,000 10M x 0.712= 7,120,000
PV of CFs 2,679,000 4,782,000 220,652,612 15Mx 0.636= 9,540,000
Total Firm Value 228,113,612 Total= 24,121,000

Less: Market value, debt + preferred 60,000,000

Market Value of equity 168,113,612
Divide by # of outstanding shares 10,000,000
Stock Price P16.81

AMDG+ 12
 OTHER APPROACHES TO VALUING COMMON STOCKS+++
Price- to- Earnings (P/E) Multiple Approach
• Company’s P/E ratio shows how much investors are • the approach requires that analysts forecast when the stock will begin paying
willing to pay for each dollar of reported earnings
• Stocks with low P/E ratios are undervalued, vice
versa.
• Riskier stocks have low P/E ratios
• Companies with stronger growth opportunities
should trade at higher P/E ratios
• Weakness of the approach is that it depends on
reported accounting earnings
+++ may be skipped in reviewing
Economic Value Added (EVA) Approach
dividends, what the dividends will be once it is established, and what the future
dividend growth rate will be
• EVA equation suggests that companies can increase EVA by investing in projects
that provide shareholders with returns that are above their cost of equity capital
EVA = (Equity capital) (ROE - Cost of equity Capital)
Market value of equity = Book value + PV of all future EVAs
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝐹𝑢𝑛𝑑𝑎𝑚𝑒𝑛𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 =
# 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

BASICS OF PREFERRED STOCK VALUATION DISCUSSED MORE THOROUGHLY IN HIGHER ACCOUNTING SUBJECTS
• Preferred stock has a par value and a fixed dividend that must be paid before dividends can be paid on the common
stock. However, directors can omit that the preferred dividend without throwing the company into bankruptcy.
• Preferred stock entitles its owners to regular, fixed dividend payments.

𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 =
𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

NOTES

1. Investors perspective: common stock are more risky than bonds; Corporate issuer’s perspective: bonds are more
risky.
2. Two conditions for equilibrium: (1) stock’s market price must equal its intrinsic value as seen by the marginal
investor and (2) the expected return as seen by the marginal investor must equal this investor’s required return.
3. An increase in a firm’s expected growth rate would cause its required rate of return to possibly increase, decrease,
or remain constant.
4. For a stock to be in equilibrium, that is, for there to be no long- term pressure for its price to depart from its
current level, then the expected future returns must be equal to the required return
𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑁
5. 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = (1 + 𝑃𝑟𝑖𝑐𝑒
) −1
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
6. 𝑃𝑟𝑖𝑐𝑒 − 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
7. 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 − 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

AMDG+ 13
YIELD TO MATURITY AND BOND VALUATION FM+
Par value The face value of a bond
Coupon payment The specified number of pesos of interest paid each year
Coupon interest rate The stated annual interest rate on a bond
Fixed-rate bond A bond whose interest rate is fixed for its entire life
Floating-rate bond A bond whose interest rate fluctuates with shifts in the general level of
interest rates
Zero coupon bond A bond that pays no annual interest if sold at a discount below par, thus
compensating investors in the form of capital appreciation
Original Issue Discount OID Any bond originally offered at a price below its par value
Bond
Maturity Date A specified date on which the par or a bond must be repaid
Original maturity The number of years to maturity at the time a bond is issued
Call provision A provision in a bond contract that gives the issuer the right to redeem the
bonds under specified terms prior to the normal maturity date
Sinking fund provision A provision in a bond contract that requires the issuer to retire a portion of
the bond issue each year
Convertible bond A bond that is exchangeable at the option of the holder for the issuing firm’s
common stock
Warrant A long-term option to buy a stated number of shares of common stock at a
specified price
Putable bond A bond with a provision that allows its investors to sell it back to the
company prior to maturity at a prearranged price
Income bond A bond that pays interest only if it is earned
Indexed (Purchasing Power) A bond that has interest payments based on an inflation index so as to
bond protect the holder from inflation
Discount bond A bond that sells below its par value; occurs whenever the going rate of
interest is above the coupon rate
Premium bond A bond that sells above its par value; occurs whenever the going rate of
interest is below the coupon rate
Yield to Maturity YTM The rate of return earned on a bond if it is held to maturity
Yield to Call YTC The rate of return earned on a bond when it is called before its maturity date

Effective rate, Market rate, or Yield is the rate that exactly discounts estimated future cash payments through the expected
life of the bonds; the actual or true rate of interest which the bondholder earns on the bond investment. This the Current
Yield.

YIELD TO MATURITY
• total return anticipated on a bond if the bonds is held until it matures
• Considered a long- term bond yield but is expressed as an annual rate
• Annual return that a bond is expected to generate if it is held till its maturity given its coupon rate, payment
frequency and current market price
• Essentially the internal rate of return of a bond, the discount rate at which the present value of a bond’s coupon
payments and maturity value is equal to its current market price
• Even though it is not a perfect measure of cost of debt, it is better than the current yield and or the coupon rate.
• An important input in determining a company’s weighted average cost of capital – as the before tax cost of debt.
• Can be calculated using the approximation formula:
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 𝐹−𝑃
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 + 𝐶+
𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑇𝑖𝑙𝑙 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑛
𝑌𝑇𝑀 = 𝑜𝑟 𝑌𝑇𝑀 =
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 + 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 𝐹+𝑃
2 2

Example: Company D's 10-year bond with par value of $1,000 and semiannual coupon of 8% is currently trading at $950.
Find the yield to maturity on the bond.
We know that annual coupon C is $80, face value F is $1,000, price P is $950 and n is 10. Plugging these numbers, we
find that approximate yield to maturity is 8.72%.
$80 + ($1,000 − $950)/10
YTM = = 8.72%
($1,000 + $950)/2

AMDG+ 14
CAPITAL STRUCTURE AND LEVERAGE FM-5
BASICS
• A change in Capital Structure affect the risk and cost of each type of capital, and all this can change the WACC.
• A change in WACC will affect capital budgeting decisions, and ultimately, the stock price.
• The effects of debt on risk and on the optimal capital structure need to be considered
• Financial executives generally treat the optimal capital structure as a range rather than as a precise point.
• Leverage— the ability of the firm to increase its wealth by using key variables

OPTIMAL CAPITAL STRUCTURE

• Optimal Capital Structure → the structure that would maximize its stock price
• Target Capital Structure → mix of debt, preferred stock, and common equity the firm wants to have
• If the actual debt ratio is significantly below the target level, management will raise capital by issuing debt.
• If debt ratio is above the target, equity will be used.
• The optimal capital structure is the one that maximizes the price of the firm’s stock, and this generally calls for
a debt ratio that is lower than the one that maximizes expected EPS

TRADE OFF BETWEEN RISK AND RETURN

• Using more debt will raise the risk borne by the stockholders
• Using more debt generally increases the expected Return on Equity (ROE)
• Firms should find the capital structure that strikes a BALANCE between RISK and RETURN so as to maximize
the stock price
4 PRIMARY FACTORS THAT INFLUENCE CAPITAL STRUCTURE DECISIONS
BUSINESS RISK • The risk inherent in the firm’s operations if it used NO DEBT.
• the greater the firm’s business risk, the lower its optimal debt ratio
• If the company has no debt, its ROE = ROA
THE FIRM’S TAX POSITION • A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt.
• However, if most income is already sheltered from taxes by depreciation tax shields or tax loss carry
forwards, its tax rate will be low. In this case, additional debt would not be advantageous as it would be to a
firm with a higher effective tax rate
FINANCIAL FLEXIBILITY • The ability to raise capital on reasonable terms even under adverse market conditions.
• The greater the probability that capital will be needed and the worse the consequences of a funds shortage
combine to influence its target capital structure, the less debt the firm should have on its balance sheet
MANAGERIAL CONSERVATISM • Aggressive managers are more willing to use debt in an effort to boost profits.
OTHER FACTORS
Sales Stability • Firm can safely take on more debt and incur higher fixed cost as long as sales are stable
Asset Structure • Firms whose assets are suitable as security for loans tend to use debt heavily
Operating leverage • Ceteris paribus, firm with less operating leverage is better able to employ financial leverage
Growth rate • Ceteris paribus, faster- growing firms must rely heavily on external capital
Profitability • Observed that firms with high rates of return on investment use relatively little debt
Control • Control considerations can lead to use of debt or equity; debt as response to risk of takeover, equity at risk of
default and losing their jobs
Lender and rating agency attitudes • Corporations discuss capital structures with lenders and give much weight to their advice
Market Conditions • Conditions in the stock and bond markets undergo long- and- short- run changes
Firm’s internal condition • Ex: firms will not issue new stock if the price has not caught up with the intrinsic value

BUSINESS RISK
• The riskiness of the firm’s assets if no debt is used
• Single most important determinant of capital structure
• Note: (1) Any action that increases business risk in the sense of stand- alone risk will generally increase a firm’s
beta coefficient (2) that a part of business as we define it will generally be company- specific and hence subject to
elimination as a result of diversification by the firm’s stockholders

BUSINESS RISK DEPENDS ON A NUMBER OF FACTORS

Demand Variability • The more stable the demand for product, the lower the business risk
Sales Price Variability • Firms exposed to volatile markets are exposed to more business risk
Input Cost Variability • Input cost which are uncertain are exposed to high degree of business risk
Ability to adjust output prices for • The greater the ability, the lower the degree of business risk
changes in input costs
Ability to develop new products in a • The faster the products become obsolete, the greater the firm’s business risk
timely, cost- effective manner
Foreign risk exposure • Generating high percentage earnings overseas are subject to exchange rate fluctuations; the
firm is also subject to political risk in politically unstable area
Extent to which costs are fixed • High operating leverage will relatively expose the firm to a high degree of business risk
(Operating leverage)

AMDG+ 15
OPERATING LEVERAGE FM-5
• The extent to which costs are fixed
• If a high percentage of its cost are fixed (and hence do not decline when demand falls), the firm will be exposed to
a relatively high degree of business risk.
• A high degree of operating leverage, other factors held constant, implies that a relatively small change in sales
results in a large change in profit and ROE.
• To a large extent, Operating leverage is determined by technology.
• Act as a multiplier in any percentage change in sales. Change in Sales Percentage x DOL = percentage change in
EBIT. Thus, companies with high DOL will be advantageous when sales increase; they will be greatly affected
when DOL is high and sales decreased. Therefore, DOL is a measure of sensitivity to profit in any percentage
change in sales.

FINANCIAL RISK
• An increase in stockholder’s risk, over and above the firm’s basic business risk, resulting from the use of financial
leverage
• The additional risk placed on common stockholders as a result of the decision to finance with debt

FINANCIAL LEVERAGE
• The extent to which fixed- income securities (debt and preferred stock) are used in a firm’s capital structure
• Using leverage has both positive and negative effects: higher leverage increases expected EPS, but it also
increases risk.

Break- even quantity 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
Net Income Sales
Less: Variable Cost
Contribution Margin
Less: Fixed Cost
Net Income
Degree of Operating Leverage 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Degree of Financial Leverage 𝐸𝐵𝐼𝑇
𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 −
1 − 𝑇𝑎𝑥
Degree of Total Leverage 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑥 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
(𝑆𝑎𝑙𝑒𝑠−𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(1−𝑇) (𝐸𝐵𝑇−1)(1−𝑇)
Earnings Per Share 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
or
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Return on Equity
* Important note: in finding the ROE, if there is a preferred stock, deduct preferred 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 ∗
dividends to the net income after tax. The net income should represent the earnings for 𝐸𝑞𝑢𝑖𝑡𝑦
ordinary shareholders only.

WACC and CAPITAL STRUCTURE CHANGES

• WACC is found as follows when there is no preferred stock:
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑑𝑒𝑏𝑡 + 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝐴 𝐴
• An increase in the debt ratio increases the costs of both debt and equity.

THE HAMADA EQUATION

• Stock’s beta is the relevant measure of risk for a diversified investor.
• Beta increases with financial leverage
• Assumption on the Hamada equation:
i. Beta of the company’s debt is zero
ii. The level of debt is constant
iii. The values of the company’s interest tax shields are discounted at the before- tax cost of debt
iv. Assets are reported at market values rather than accounting book values
• Unlevered Beta → the firm’s beta coefficient if it has no debt; can be solved as:
𝐷
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑒𝑡𝑎 𝐷 𝐴
𝑏𝑒𝑡𝑎 = 𝐷 where, 𝐸
= 𝐷
1+(1−𝑇)( ) 1−
𝐸 𝐴

UNDERSTANDING THE CAPITAL STRUCTURE THEORY

• Trade off theory—capital structure theory that states that firms trade off the tax benefits of debt financing against
problems caused by potential bankruptcy.
• Signaling theory—In a nutshell, the announcement of a stock offering is generally taken as a signal that the
firm’s prospects as seen by its management are not bright. Therefore, we would expect a firm with very favorable

AMDG+ 16
 prospects to avoid selling stock and instead raise any required new capital by using new debt even if this moved
its debt ratio beyond the target level
• Reserve Borrowing Capacity—ability to borrow money at a reasonable cost when good investment
opportunities arise. Firm often use less debt than specified by the MM optimal capital structure in “normal” times
to ensure that they can obtain debt capital later if necessary.
• Symmetric information—situation where investors have identical information about the firm’s prospects
• Asymmetric information—situation where managers have different information about firm’s prospect than do
investors
• Using debt financing reduce excess cash flow which constraints manager to finance their pet projects and
consequently perform better

NOTES
1. Initially as Leverage increases, ROE also increases; but interest expense increases when leverage increases. Thus
ROE will reach a maximum level, then inevitably declines.
2. As leverage increases, ROE increases up to a point; As risk increases with increased leverage, cost of debt
increases. After ROE peaks, it then begins to fall
3. As leverage increases, the measures of risk (standard deviation and coefficient of variation) increase with each
increase in Leverage.
4. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash
flows.
5. If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline
in earnings per share that is larger than X.
6. Increasing a company’s debt ratio will typically increase the marginal cost of both debt and equity financing.
However, this action still may lower the company’s WACC.
7. As a firm increases the operating leverage used to produce a given quantity of output, this will normally lead to a
reduction in its fixed assets turnover ratio.
8. If debt financing is used, the percentage change in net income will be greater than the percentage change in net
operating income.
9. When Financial leverage is positive, ROA > after tax cost of debt. A positive financial leverage explains why
ROE > ROA.
10. A company with higher debt ratio will have a lower Return on Assets when compared to another company. It has
a higher ROE, but its risk as measured by the standard deviation of ROE is also higher.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
11. Return on Investor’s Capital (ROIC)— rate of return on total investor capital 𝐸𝑞𝑢𝑖𝑡𝑦
12. Times-interest- earned (TIE) ratio—measures the extent to which operating income can decline before the firm is
𝐸𝐵𝐼𝑇
unable to meet its annual interest costs 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶ℎ𝑎𝑟𝑔𝑒𝑠
13. Financial leverage will not impact Returns on Invested Capital.

AMDG+ 17
WORKING CAPITAL MANAGEMENT FM-6&7
WORKING CAPITAL MANAGEMENT
• Involves finding the optimal levels for cash, marketable securities, accounts receivable, and inventory, and then
financing that working capital at the least cost. Effective working capital management can generate considerable
amounts of cash.
• The administration and control of the company’s working capital. The primary objective is to achieve a balance
between return (profitability and risk)

Working capital
• For financial analysts, working capital equals current assets. For accountants, working capital equals current asset
minus current liabilities (or net working capital in Bringham)
• current assets are called such because these assets “turn over” (are used and replaced all during the year).
• Current assets not used in normal operations, such as excess cash held to pay for a plant under construction, are
deducted and this not included in working capital.

Net working capital

• Current assets less payables and accruals, which represents the amount of money that the firm must obtain from
non- free sources to carry its current assets.
• Explanation: When a firm buys inventory on credit, its suppliers in effect lend it the money used to finance the
inventory. The firm could have borrowed from its bank or sold stock to obtain the money, but it received the
funds from its suppliers. These loans are recorded as accounts payable, and they are typically “free” because they
do not bear interest.
• Current liabilities— their liquidation requires the use of current assets or incurrence of other current liabilities.
They include trade accounts payable, unearned revenues, accrued expenses, short- term debt, and the current
portion of long- term debt.

Current Asset Investment Policies: “the optimal strategy is the one that maximizes the firm’s long- run earnings and the stock’s intrinsic value”
Relaxed • Large amount of cash, marketable securities, and inventories are carried
• a liberal credit policy results in a high level of receivables
• minimizes operating problems such as work stoppages, unhappy customers
• low assets turnover ratio, lowers ROE, ceteris paribus.
Restricted/ Lean-and • Holdings of cash, marketable securities, inventories and receivables are constrained
mean/ Tight • Low level of assets, high total assets turnover ratio, high ROE, ceteris paribus.
• Exposes the firm to risks because shortages can lead to work stoppages, unhappy customers, and serious long- run problems
Moderate • Between the relaxed and restricted policies

𝑩𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈+𝑬𝒏𝒅
How working capital management affects ROE using DuPont Equation. *Note: All balance sheet items are averaged ( )
𝟐
ROE = Profit Margin X Total Assets Turnover X Leverage Factor or Equity Multiplier
= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 ∗ 𝐴𝑠𝑠𝑒𝑡𝑠
𝑆𝑎𝑙𝑒𝑠 ∗ 𝐴𝑠𝑠𝑒𝑡𝑠 ∗ 𝐸𝑞𝑢𝑖𝑡𝑦
Tells us how much the firm on its sales. The multiplier that tells us how many Adjustment factor
This ratio depends primarily on costs and times the profit margin is earned each
sales prices—if a firm can command a year
premium price and hold down its costs, its
profit margin will be high, which will help
its ROE.

CURRENT ASSET FINANCING POLICIES

• Assets financing policies are the way current assets are financed
• Current Assets— reasonably expected to be realized in cash or consumed or sold during the normal operating
cycle of the business. Includes cash, marketable securities, receivables, and inventory.
• Permanent Current Assets— current assets that a firm must carry even at the low point of the business cycle.
• Temporary Current Assets— current assets that fluctuate with seasonal or cyclical variations in sales.
• Three approaches:
1. Maturity matching/ Self liquidating/ Hedging— fixed assets + permanent current assets are financed with
long- term capital; temporary current assets are financed with short- term debt.
2. Aggressive— finances some of its permanent assets with short- term debt; subject to dangers from loan
renewal as well as problems with rising interest
3. Conservative—long- term capital is used to finance all permanent and temporary assets; company uses small
amount of short- term credit to meet its peak requirements, but it also meets part of its season needs by storing
marketable securities
• Short term debt is riskier to the borrowing firm because (1) long- term borrowing cost is stable overtime, short-
term are fluctuating; (2) temporary recession may adversely affect its financial ratios and render it unstable to
repay this debt

AMDG+ 18
 • The yield curve is generally upward slopping, hence, short term rates are generally lower than long- term rates
• Short term loans can be negotiated much faster than long- term loans. It may also offer greater flexibility.

+DECIDING ON AN APPROPRIATE WORKING CAPITAL POLICY

The amount of net working capital that a company should have depends on the amount of risk it is willing to take. The
primary consideration therefor is trade- off between returns and risk associated with:
1. Asset Mix Decision— appropriate mix of current and non- current assets.
2. Financing Mix Decision— appropriate mix of short- term and long- term liabilities to finance current assets

+RISK RETURN TRADE- OFF

• The greater the risk, the greater the potential for larger returns
• More current assets lead to greater liquidity but yield lower returns
• Fixed assets earn greater returns than current assets
• Long- term financing has less liquidity risk than short- term debt, but has a higher explicit cost, hence, lower
return

CASH CONVERSION CYCLE

• Foundation of knowing capital needs
• The length of time where funds are tied up in working capital
• The length of time between paying for working capital and collecting cash from the sales of the working capital
• The length of time it takes for the initial cash outflows for goods and services (materials, labor, etc) to be realized
as cash inflows from sales (cash sales and collection of accounts receivable).

CCC = Inventory Conversion Period + Average Collection Period or - Payables Deferral Period
Days Sales Outstanding
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 ∗∗ 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑃𝑒𝑟 𝐷𝑎𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟 𝐷𝑎𝑦 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 ∗∗∗
365 365 365
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Where Inventory Turnover = Where Receivables turnover = Where Payables Turnover =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
The average time required to convert raw The average length of time required to The average length of time between the
materials into finished goods and then to convert the firm’s receivables into cash, purchase of materials and labor and the
sell them. that is, to collect cash following a sale. payment of cash for them

Note: All balance sheet items are **Note: Only Trade receivables are ***Note: COGS may be used in the
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔+𝐸𝑛𝑑 relevant. Note receivables are generally formula, under the assumption that
averaged ( )
2
non- trading. inventories did not change in the year.

SOLVING FOR CAPITAL FREED UP BY SHORTER CASH CONVERSION CYCLE AND CHANGE IN
PRETAX PROFITS
Example: Ruby has P15,000,000 of sales, P2,000,000 of inventories, P3,000,000 of receivables and P1,000,000 of payables. Its cost of goods sold is
80% of sales, and it finances working capital with bank loan at 8% rate.
CCC = 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅 𝑷𝒆𝒓 𝑫𝒂𝒚 𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔 𝑷𝒆𝒓 𝑫𝒂𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅 𝑷𝒆𝒓 𝑫𝒂𝒚
2,000,000 3,000,000 1,000,000
32,877 41,096 32, 877
103.41 = 60.83 + 73 - 30.42

If Ruby lower its inventories and receivables by 10% each and increase its payables by 10%, all without affecting sales or cost of goods sold. How
much cash will be freed up and how much would this affect the pretax profits?

In the new situation, the cash conversion cycle would be 87 days (computed as 54.75+ 65.70- 33.46). To know how much cash was freed up, we
compare each component of the CCC and multiply the difference to the average COGS/Purchases per day or average sales (for days sales
outstanding).
60. 83- 54.75 = 6.08 x 32 877= 199 892
73 – 65.70 = 7.30 x 41 096 = 300 000
30.42 – 33.46 = 3.04 x 32 877 = (99 946)
Total: 399, 946 cash freed.

Since there 399, 946 cash are freed, the company may lower its borrowings in the bank by that amount and save a total interest of P31, 996
(computed as 399,946 x 8%), thus, increasing pretax profit by P31, 996.

CASH: CURRENCY AND DEMAND DEPOSITS

• Cash— currency and demand deposits in addition to very safe, highly liquid marketable securities that can be sold
quickly at a predictable price and thus be converted to bank deposits.
• The following techniques are used to optimize demand deposit holdings:
▪ Hold marketable securities rather than demand deposits to provide liquidity
▪ Borrow on short notice
▪ Forecast payments and receipts better

AMDG+ 19
 ▪ Speed up payments such as use of lockbox. A lockbox is a post office box operated by a bank to which
payments are sent; used to speed up effective receipts of cash
▪ Use credit cards, debts cards, wire transfers and direct deposits
▪ Synchronize cash flows

+CASH MANAGEMENT
• Involves the maintenance of the appropriate level of cash and investment in marketable securities to meet the
firm’s cash requirements and to maximize income on idle funds
• Collection, handling, control, and investment of cash and cash equivalents, to ensure optimum utilization of the
firm’s liquid resources to ensure optimum utilization of the firm’s liquid resources.
• Objective: to invest excess cash for return while retaining sufficient liquidity to satisfy future needs

+Functions of Cash Management

• Investing idle cash to utilize surplus funds
• Controlling cash flows
• Planning of cash
• Managing cash flows through cost- cutting and profit generation to attain positive cash flows
• Optimizing cash level which maintains the required level of liquidity and cash for business operations

+Reasons For Holding Cash

1. Transaction purposes— use in the conduct of ordinary business transactions
2. Compensating balance requirements— certain amount of cash that a firm must leave in its checking account at all
times as part of a loan agreement.
3. Precautionary reserves— used to handle unexpected problems or contingencies due to uncertain cash flows
• Cost of Maintaining liquidity— income foregone on cash balance
4. Potential investment opportunities— excess cash reserves are allowed to build up in anticipation of a future
investment opportunity
5. Speculation— delay purchases and store up cash for use later to take advantage of possible changes in prices of
materials, equipment, and securities, as well as changes in currency exchange rate

+Float In Cash Management

• Float— difference between the bank’s balance for a firm’s account and the balance that the firm shows on its
books,
• Two aspects: (1) the time it takes a company to process its check internally; (2) the time consumed in clearing the
check through the banking system
• Types of float:
i. Negative — book balance exceeds bank balance, meaning that there is more cash tied up in collection and
it earns a 0% rate of return
➢ Mail Float— peso amount of customers’ payments that have been mailed by a customer but not
yet received by the seller
➢ Processing Float— peso amount of customers’ payment that have been received by the seller but
not yet deposited
➢ Clearing Float— peso amount of customers’ checks that have been deposited but not yet cleared
➢ Good cash management dictates that above float must be minimized, if not eliminated.
ii. Positive (disbursement float)— firm’s bank balance exceeds its book balance [example: checks written/
issued by the firm have not yet been cleared]. Management should increase this type of float

+CASH MANAGEMENT STRATEGIES

+CASH MANAGEMENT STRATEGIES
Accelerate Cash Collections
a) Bill customers promptly
b) Offer cash discounts for prompt payments
c) Use lockbox system
d) Establish local collection office
e) Request customers to make direct payment
to the firm’s depository bank
f) Use of automatic fund transfer or Electronic
Fund Transfer (EFT)
Control Disbursements Reduce Need for
a) Stretch payables by paying as late as possible within the Precautionary cash balance
credit period a) more accurate cash
b) Maintain zero- balance accounts— checks are written from budgeting
special disbursements accounts having zero-peso balance. b) have ready lines of credit
Funds are automatically transferred from a master account c) invest idle cash in highly
when a check drawn from ZBA is presented. liquid, short- term
c) Play the float— increase positive float investments instead of
d) Less frequent payroll and schedule issuance of checks to holding idle precautionary
suppliers cash balance

+CASH FLOW MANAGEMENT

1. Determining Optimal Cash Balance Using the Baumol Cash Management Model
• An EOQ- type model which can be used to determine the optimal cash balance where the costs of maintaining and obtaining cash are at the
minimum.
• Such costs are the:
i. Cost of securities transactions or cost of obtaining a loan
ii. Opportunity cost of holding cash which includes the return foregone by not investing in marketable securities or the cost of
borrowing cash

AMDG+ 20
 2𝑇𝐷
𝑂𝑝𝑖𝑡𝑎𝑚𝑙 𝐶𝑎𝑠ℎ = √
𝑖
T = transaction cost which is a fixed amount per transaction. It includes the cost of securities transactions or cost of obtaining a loan
i = interest rate on marketable securities or the cost of borrowing cash
D = total demand for cash over a period of time

2. Preparing cash budgets

Cash Budget
July August Sept Oct Nov Dec
Sales (gross) 300 400 500 350 250 200
Total collections 254 3313 408 459 344 249

Purchases 280 350 245 175 140

Payments 265 350 465 415 230 215

Example: materials, wages, salaries, lease payments,
taxes, plant construction

Net Cash flows: (Total collections - Payments) (11) (37) (57) 44 114 34
Cumulative Cash Flows (11) (48) (105) (61) 53 87

Cash Surplus (or loan requirement)

Target cash balance 10 10 10 10 10 10
Surplus Cash (loan needed) (21) (58) (115) (71) 43 77
[computed as cumulative cash flows - target
cash balance]
Maximum requried loan 115
Maximum available for investment 77

• Cash budget— table showing receipts, disbursements, and balances over some period.
• Target cash balance— desired cash balance that a firm plans to maintain in order to conduct business
• The maximum required loan is P115 million, and the maximum projected surplus is P77. The treasurer will need to arrange a line of credit
so that the firm can borrow up to P115 million, increasing the loan over time as funds are needed and repaying it later when cash flows
become positive.

3. Preparing Cash break- even chart

• It shows the cash break- even point where the amount of sales in pesos or the number of units to be sold so that the total cash inflows is
equal to the cash outflows
• Shows the amount of cash deficiency when sales is below the cash break- even point, or the amount of excess cash when sales is above the
cash- break even point.

ACCOUNTS RECEIVABLE
• Accounts receivable— funds due from a customer
• Total amount of AR outstanding at any given time is determined by
𝐴𝑅 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠 𝑥 𝐿𝑒𝑛𝑔𝑡ℎ 𝑜𝑓 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
Any changes in sales or collection period will have the same effect on AR, if one doubles, the AR doubles.
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
• 𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟 𝐷𝑎𝑦 Note: Already shown above, Cash Conversion Cycle table.
• 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑖𝑒𝑑 𝑢𝑝 𝑖𝑛 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠 𝑥 𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
• Cost of Carrying Receivables = Investment in Receivables x Cost of Funds
• The firm’s credit policy is the primary determinant of accounts receivable and sales.

Credit Policy
Credit Period • The length of time customer have to pay for purchases
• Customers prefer longer credit periods, so lengthening it will stimulate sales
• A longer credit period lengthens the cash conversion cycle, ties up more capital in receivables
• The longer a receivable is outstanding, the higher the probability that a customer will default
Discounts • Price reduction given for early payments
• Benefits: (1) stimulates sales; (2) encourage customers to pay earlier, shortening the cash conversion
cycle
• It lowers prices, and lower revenues
Credit Standards • The financial strength customers must exhibit to qualify for credit
• When standards are set too low, bad debt losses will be high;
• When standards are set too high, firm loses too many sales and thus profits
• The “5 Cs” of Credit are factors to consider in establishing credit standard
Collection Policy • The degree of toughness in enforcing the credit terms

AMDG+ 21
COMPUTING AR- RELATED PROFIT
SALES “5 CS OF CREDIT”
1. Character customer’s willingness to pay
Less : VARIABLE COSTS
2. Capacity customer’s ability to generate cash flows
CONTRIBUTION MARGIN 3. Capital customer’s financial sources
Less : AR-RELATED COSTS
4. Conditions current economic or business conditions
5. Collateral
(1) Cost of Carrying Receivable

(2) Bad Debts expense

(3) Collection costs

Total

PROFIT BEFORE TAX

Less : Income-tax

PROFIT AFTER TAX

+MANAGEMENT OF ACCOUNTS RECEIVABLES

• Formulation and administration of plans and policies related to sales on account and ensuring the maintenance of
receivables at a predetermined level and their collectability as planned.
• Process that ensures customers pay on time; helps prevent running out of working capital; prevents overdue
payments or non- payments
• Objective: to have both the optimal amount of receivables outstanding and the optimal amount of bad debts.
• Optimal balance requires the trade- off between (a) the benefits of more credit sales; (b) the costs of accounts
receivable such as collection, interest, and bad debt cost
• Another main objective is to minimize the Days Sales Outstanding and processing costs while maintaining good
customer relations

+Effect on Tightening or Relaxing Credit Policy

• Total Sales
• Percentage of Credit Sales to Total Sales
• Percentage of Bad Debts
• Collection Costs
• Cost of Carrying Receivables

+Benefits of Accounts Receivable Management

1. Better cash flow
2. Lower working capital requirements
3. Lower interest costs
4. Better bargaining with sellers

+Ways of Accelerating Collection of Receivables +Determinants of the size of receivables +Aids in Analyzing Receivables
1. Shorten ccredit terms 1. Terms of sales 1. Ratio of receivables to net
2. Offer special discounts 2. Paying practices of customers credit sales
3. Speed up the mailing time of payments from customers to the firm 3. Collection Policies and practices 2. Receivable turnover
4. Minimize float, reduce the time during which payments received by 4. Volume of credit sales 3. Average collection period
the firm remain uncollected funds 5. Credit extension policies and practices 4. Aging of accounts
6. Cost of capital

ACCOUNTS PAYABLE (Trade Credit)

• Trade credit— largest single category of short- term debt. It is a spontaneous source of financing as it arises
spontaneously from ordinary business transactions. It is spontaneous, easy to get, but cost can be high
• Expanding sales and lengthening the credit period generate additional financing
• Two types of trade credit
i. Free trade credit— credit received during the discount period; obtained without a cost, and it consists of
all trade credit that is available without giving up discounts
▪ Free trade credit = cost of purchases per day net of discounts x discount period
ii. Costly trade credit— credit taken in excess of free trade credit whose cost is equal to the discount lost;
any trade credit over and above the free trade credit
▪ Costly trade credit = Additional credit obtained
▪ Total trade credit = Free credit + Costly credit
• 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑛𝑒𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑥 (𝑑𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 – 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑)
• Additional credit is costly credit because the firm must give up discounts to get it.
• 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑥𝑡𝑟𝑎 𝑐𝑟𝑒𝑑𝑖𝑡 = 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 𝑥 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡

AMDG+ 22
 • Firms should always use the free component, but they should use the costly component only if they cannot obtain
funds at a lower cost from another source.

Nominal annual cost 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 % 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓

= 𝒙
of trade credit 𝟏𝟎𝟎% − 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕% 𝑫𝒂𝒚𝒔 𝑪𝒓𝒆𝒅𝒊𝒕 𝒊𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 − 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝑷𝒆𝒓𝒊𝒐𝒅
1% 365
= 𝑥
99% (40 − 10)
12.29% = 1.01 % periodic rate x 12.167 period per year
If the firm can borrow from its bank for LESS THAN 12.29%, it should take the discount.

SOLVING the EFFECTIVE COST OF TRADE CREDIT

Periodic rate = 𝟎. 𝟎𝟏⁄𝟎. 𝟗𝟗 = 𝟏. 𝟎𝟏%
Periods per year = 365/ (40-10) = 12.167

𝑬𝑨𝑹 = (𝟏 + 𝑷𝒆𝒓𝒊𝒐𝒅𝒊𝒄 𝒓𝒂𝒕𝒆)𝑷𝒆𝒓𝒊𝒐𝒅𝒔 𝒑𝒆𝒓 𝒚𝒆𝒂𝒓 − 𝟏

= (𝟏. 𝟎𝟏𝟎𝟏)𝟏𝟐.𝟏𝟔𝟔𝟕 − 𝟏
=13.01%

INVENTORIES
• Includes (1) supplies, (2) raw materials, (3) work in process, (4) finished goods, which are essential part of
business operations
• Optimal inventory levels depend on sales, so sales must be forecasted before target inventories can be established.
• Errors in setting inventory levels lead to lost sales or excessive carrying costs

+MANAGEMENT OF INVENTORIES
• Formulation and administration of plans and policies to efficiently and satisfactorily meet production and
merchandising requirements and minimize costs relative to inventories.
• Having the right product in the right place at the right time
• Component of supply chain management, supervises the flow of goods from manufacturers to warehouses and
from these facilities to point of sales
• Inventory visibility— knowing when to order
• Objective: to maintain inventory at a level that best balances the estimates of actual savings, the cost of carrying
additional inventory, as well as the time of ordering, in order to meet future business requirements.

+INVENTORY MANAGEMENT TECHNIQUES

Inventory Planning
Determination of the quality and
quantity and location of inventory, as
well as the time of ordering, in order to
meet future business requirements
a) EOQ Model
b) Reorder point
c) Just- in time (JIT)
Inventory Control Modern Inventory Management
Regulation of inventory within predetermined level; adequate stocks should Often applied in the context of
be available to meet business requirements, but the investment in inventory automated manufacturing
should be at the minimum
a) Fixed order quantity system— order for a fixed quantity when reorder a) Materials Requirement Planning
point is reached (MRP)
b) Fixed reorder cycle system— orders are made after a review of inventory b) Manufacturing Resource Planning
levels has been done at regular intervals (MRP-II)
c) Optional Replacement System c) Enterprise Resource Planning
d) ABC classification system: (ERP)
A- high value items, highest control
B- medium cost, normal control
C- low cost items, simple control

+INVENTORY MODELS
A basic inventory model exists to assist in two inventory questions: (1) how many units should be ordered; (2) when
should the units be ordered?

Economic Order Quantity

• Quantity to be ordered, which minimizes the sum of the ordering and carrying costs
• When applied to manufacturing operations, EOQ formula may be used to compute the Economic Lot Size (ELS)
Economic Order Quantity
𝟐(𝑨𝒏𝒏𝒖𝒂𝒍 𝑼𝒔𝒂𝒈𝒆 𝒊𝒏 𝑼𝒏𝒊𝒕𝒔)(𝑶𝒓𝒅𝒆𝒓 𝑪𝒐𝒔𝒕)
√
(𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒓𝒓𝒚𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕)
Economic Lot Size
2(𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡)(𝑺𝒆𝒕 𝒖𝒑 𝒄𝒐𝒔𝒕)
√
(𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡)
Total Carrying Cost (Average Inventory + Safety Stock) x Carrying Cost per Unit
Average Inventory 𝐸𝑂𝑄⁄2
Total Ordering Cost 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
𝑥 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡
𝐸𝑂𝑄
Re- Order Point Lead Time Usage + Safety Stock
Average Daily Usage x Maximum lead time
Lead time Usage Average Daily Usage x Normal Lead Time in Days
Safety Stock Average Daily Usage x (Maximum lead time – Normal lead time)

AMDG+ 23
 Carrying Costs Ordering Costs
1. Costs of capital 1. Transportation (delivery costs)
2. Interest Costs Administrative Cost of Purchasing and costs of receiving and
3. Taxes inspecting goods:
4. Insurance 2. Developing and sending purchase orders
5. Spoilage 3. Processing and inspecting incoming inventory
6. Theft 4. Bill paying
7. Obsolescence 5. Inventory inquiries
8. Salaries and Wages for warehouse employees 6. Utilities, phone bills, and so on for the purchasing department
9. Utilities and building costs for the warehouse 7. Salaries and wages for purchasing department employees
10. Supplies such as forms and paper for the warehouse 8. Supplies such as forms and paper for the purchasing department

Assumptions of the EOQ Model:

1. Demand occurs at a constant rate throughout the year
2. Lead time on the receipt of the orders is constant
3. The entire quantity ordered is received at one time
4. The unit costs of the items ordered are constant; thus, there can be no quantity discounts.
5. There are no limitations on the size of the inventory

MARKETABLE SECURITIES
• Marketable securities— short- term money market instruments that can easily be converted to cash
• Marketable securities are divided into two categories
1. Operating short- term securities— held primarily to provide liquidity and are bought and sold as needed to
provide funds for operations
2. Other short- term securities— holdings in excess of the amount needed to support normal operations
• A trade- off between risk and returns is involved, earn high returns but treasurers want to hold that can be sold
very quickly at a known price. That means a high- quality, short- term instruments.
• Not suited for marketable securities portfolio: (1) long- term bonds because their prices decline when interest rates
rise; (2) short- term securities issued by risky companies because their prices decline when the issuer’s problems
worsens.
• Suitable holdings: (1) treasury bills; (2) comer paper; (3) bank certificates of deposits; (4) money market funds
• Corporations shop for securities all around the world, buying wherever risk- adjusted rates are highest. Companies
also buy securities from stronger currencies where firms will earn interest and enjoy additional gain from the
change in exchange rates.

+ REASONS FOR HOLDING MARKETABLE SECURITIES

1. MS serves as substitute for cash balances.
2. MS serve as temporary investment that yields return while funds are idle.
3. Cash is invested in MS to meet known financial obligations such as tax payments and loan amortizations.

+DECISION CRITERIA FOR HOLDING MARKETABLE SECURITIES

1. Risk.
a. Default risk— refers to the chances that the issuer may not be able to pay the interest or principal on time
or not at all.
b. Interest Rate risk— refers to fluctuations in securities’ price caused by changes in market interest rates.
As rates change, the value of a debt security changes in the opposite direction.
c. Inflation risk— refers to the risk that inflation will reduce the “real value” of the investment.
2. Marketability— refers to how quickly a security can be sold before maturity without a significant price
concession
3. Term to Maturity— maturity dates of marketable securities held should coincide, when possible, with the date at
which the firm needs cash, or when the firm will no longer have cash to invest

NOTES
1. In ratio analysis, when balance sheet and income statement items are compared, balance sheet items are averaged
(beginning + ending balance, sum divided by 2).
2. There is 0 or no cost of trade credit to customers who take the discount. The cost of trade credit to customers who did
not take the discount is the nominal annual cost of trade credit.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 𝑁𝑒𝑡 𝑜𝑓 𝑇𝑎𝑥
3. ROA = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
4. Paying late will reduce the calculated cost of trade credit
5. If a profitable firm finds that it simply must “stretch” its AP, then this suggests that it is undercapitalized, that is, it
needs more working capital to support its operations.

AMDG+ 24
SHORT TERM FINANCING FM-8
BASICS
• Short- term credit— debt scheduled to be paid within one year.
• Prime Interest Rate – the rate charged by commercial banks to their best business clients. It is usually the lowest
rate charged by banks.

+Factors Considered in Selecting the Source of Short- term Financing

1. Cost • Short term debt is less expensive
• Short term rates are usually lower than long- term rates
• Short term debts do not normally involve flotation or placement costs
2. Availability of the short-term fund when needed
3. Flexibility • Short term credit is more flexible than long- term debt
• Short term loans can be arranged more quickly
4. Risk • Short term rates are riskier
• Interest rates may fluctuate and more frequent debt servicing is required
5. Restrictions Certain restrictions are imposed, such as requiring a minimum level of net working capital
6. Effect on credit rating some sources of short- term credit may negatively affect the company’s credit rating
7. Expected money- market conditions
8. Inflation
9. Profitability, liquidity positions, and stability of operations

SPONTANEOUS SOURCES
A. Accounts Payable (Trade Credit)
• automatically obtained when a firm purchases good or services on credit from a supplier.
• It is a continuous source of financing
• It is more readily available than other negotiated sources of short-term credit.

Cost of Trade Credit

• Cost is implicit in the terms of credit agreed upon (the discount policy and the credit period).
• Note : Trade discount in Financial Management is Cash discount (discount granted to / availed of due to prompt payment of account)

1. No trade discount
• Purchases on credit without trade discount are usually priced higher than cash purchases.
• Cost of credit = selling price for credit purchases – selling price for cash purchases

2. With trade discount

• If a supplier allows a trade discount for prompt payment, an implicit cost is incurred if the discount is not availed
of
• The cost of additional financing is the discount foregone, which is, in effect a penalty or interest cost.
• 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 𝑛𝑒𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑥 (𝑑𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 – 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑)
• Additional credit is costly credit because the firm must give up discounts to get it.
• 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑥𝑡𝑟𝑎 𝑐𝑟𝑒𝑑𝑖𝑡 = 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 𝑥 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡

Example: credit term is 2/10, n/30 – the purchaser is given 2% discount if the account is paid within 10 days. Assuming 360 days in a year is used in
the calculations, the annual rate in this example is:

Nominal annual cost 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 % 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒚𝒆𝒂𝒓

= 𝒙
of trade credit 𝟏𝟎𝟎% − 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕% 𝑫𝒂𝒚𝒔 𝑪𝒓𝒆𝒅𝒊𝒕 𝒊𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 − 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝑷𝒆𝒓𝒊𝒐𝒅
2% 360
= 𝑥
98% (30 − 10)
36.73% = 2.04 % periodic rate x 18 period per year

B. Accruals (Accrued Expenses)

• represent liabilities for services that have been provided to the company but have not yet been paid for
• continually recurring short- term liabilities, especially accrued taxes and accrued wages.
• COST OF ACCRUALS – none, whether implicit or explicit cost. They are free because no interest is paid on them
• Firms cannot control their accruals because the time of wage payments is set by contract or industry custom and
tax payments are set by law, meaning, the company has little control over the level of accruals

C. Deferred Income
• customers’ advance payments or deposit for goods or services that will be delivered at some future date
• COST OF DEFERRED INCOME – None

AMDG+ 25
NEGOTIATED SOURCES

Unsecured Short-Term Credit

A. Commercial Bank Loans
• short-term business credit provided by commercial banks, requiring the borrower to sign a promissory note to
acknowledge the amount of debt, maturity and interest
• Promissory Note— document specifying the terms and conditions of a loan, including the amount, interest rate,
and repayment schedule. Some key features:
➢ Interest rates— can be fixed or floating. For larger loans, indexed at the prime rate, T- bill rate, or to the London Interest Bank
Offer Rate (LIBOR). The indicated rate is the nominal rate
➢ Interest only— only interest is paid during the life of the loan, with principal repaid at maturity
➢ Amortized or Installment Loans— some of the principal is repaid in each payment date
➢ Discount Interest— interest is paid in advance ; the borrower receives less than the face amount and this increases the effective
cost
➢ Add- on Loans— interest charges are added to the face amount of the loan, raising the effective cost
➢ Restrictive Covenants— requiring the buyer to maintain ratios at specified levels and spelling out what will happen if the
borrower defaults on the covenant
➢ Loan Guarantees
• Line of credit— the bank agrees to lend up to a maximum amount of credits to a firm. This is applicable to firms
that need frequent funding in varying amounts.
• Revolving credit agreement – the bank makes a formal, contractual commitment to provide the maximum
amount to a firm. The firm pays a minimal commitment fee per year on the average unused portion of the
commitment.
• Transaction loan (a single payment loan)— short-term credit for a specific purpose.

Cost of Bank Loans

• Interest rates are higher for riskier borrowers, and rates are higher on smaller loans because of the fixed costs
involved in making and servicing loans.
• When economy is booming, loan demand is typically strong, the Fed restricts the money supply to fight inflation,
resulting to high interest rates
• Compensating balance— a certain percentage of the face amount of the loan that must be maintained by a
borrower on his account

Regular Interest Rate 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 ∗

𝑩𝒐𝒓𝒓𝒓𝒐𝒘𝒆𝒅 𝑨𝒎𝒐𝒖𝒏𝒕
Discounted Interest Rate 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐵𝑜𝑟𝑟𝑟𝑜𝑤𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Effective Interest Rate 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑙𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 ∗∗
Interest on Add- on Loans 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑
2
Simple interest rate per day 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
Interest charge for month (rate per day) (Amount of loan) (days in month)
Amount that should be borrowed 𝑛𝑒𝑒𝑑𝑒𝑑 𝑓𝑢𝑛𝑑𝑠
𝑙𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 ∗∗
*interest expense is NET of interest income
** compensating balance is NET of the transactional balance
***note: could be in prices or in percentages. Percentages is easier
usable loan amount = loan amount – discount interest - compensating balance
.
B. Commercial Paper
• short-term, unsecured promissory notes (IOUs) issued by large firms with great financial strength and high credit
rating to other companies and institutional investors, such as trust funds, banks, and insurance companies.
• entail lower cost than bank financing (the interest rate is usually lower that the prime rate* and the costly financial
arrangements avoided).
• Disadvantage: limited access and availability.
• Only the largest firms with the greatest financial strength can issue commercial papers.
• The amount of funds available is limited to the excess liquidity of big corporations.
• Prime Interest Rate— the rate charged by commercial banks to their best business clients. It is usually the
lowest rate charged by banks.

Cost of Commercial Paper

Example: Giant Corporation plans to issue P500 million in commercial paper for 180 days at a stated, discounted interest rate of 10%. Dealers of the
commercial paper usually charge P200,000 in placement fees and flotation cost. (use 360 days in a year)

Effective Annual 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒐𝒔𝒕 𝒑𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 + 𝒕𝒓𝒂𝒏𝒔𝒂𝒄𝒕𝒊𝒐𝒏 𝒄𝒐𝒔𝒕 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒚𝒆𝒂𝒓
= 𝒙
Interest Rate 𝑼𝒔𝒂𝒃𝒍𝒆 𝑳𝒐𝒂𝒏 𝑨𝒎𝒐𝒖𝒏𝒕 ∗ 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑫𝒂𝒚𝒔 𝑭𝒖𝒏𝒅𝒔 𝑨𝒓𝒆 𝒃𝒐𝒓𝒓𝒐𝒘𝒆𝒅
*the transaction cost is deducted
10.61% 25𝑀 + 200,000 360
=
500𝑀 − 25𝑀 − 200,000 180

AMDG+ 26
Price of treasury bills
𝐷𝑎𝑦𝑠 𝑈𝑛𝑡𝑖𝑙 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 = 𝐹𝑎𝑐𝑒 − ( 𝐹𝑎𝑐𝑒 𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 % 𝑥 )
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑌𝑒𝑎𝑟𝑠

+Secured Short- Term Credit %

A. Pledging Receivables
• certain peso amount of receivables is provided by the borrowers as collateral for a short- term loan.

B. Pledging Inventories
• part or all of the borrower’s inventories are provided by the borrowers as collateral for a short- term loan.

Classifications of Inventory Loans

Floating Lien
• The creditor (lender) has a general claim on
all of the borrower’s inventory
• Creditor acquires title to the inventory
• Borrower cannot control inventory size or
disposition
Trust Receipt
• Lender holds title to specific units of
inventory which are identified in writing on
documents called trust receipts
Warehouse Receipt
• Inventory pledged is placed under the
lender’s physical and legal possession
• Inventory is stored in a warehouse
controlled by the warehousing company
• Inventory is released to the borrower only
when such release is authorized by the
lender

OTHER SOURCES OF SHORT- TERM FUNDS

A. Factoring of accounts Receivable
• A factor buys the accounts receivable of a firm and assumes the risk of collection
• Factor— entity who buys the account receivable of a firm and assumes the risk of collection

Fees and interest are not deducted in Advance: A company offers into an agreement with a firm that will factor the company’s account receivable.
The factor agrees to buy the company’s receivables, which average P100,000 per month and have an average collection period of 30 days. The factor
will advance up to 80% of the face value of receivables at an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller
of the company estimates the company would save P18,000 in collection expenses over the year. Fees and interest are not deducted in advance.
Assuming a 360- day year, what is the annual cost of financing?

8,000= 100,000 x 80% x 10%

plus 24,000 = 100,000 x 2% x 12 months
less 16, 000 = savings .
14, 000 result divided by (100, 000 x 80%) = 17.5 %

Fees and interest deducted in advance: A firm often factors its account receivable. Its finance company requires a 6% reserve and charges a 1.4%
commission on the amount of the receivables. The remaining amount to be advanced is further reduced by an annual interest charge of 15%. What
proceeds (rounded to the nearest peso) will the firm receive from the finance company at the time a P100,000 account due in 60 days is factored. Use
360 days in a year.

100, 000
Less 6,000 = 100,000 x 6%
Less 1,400 = 100,000 x 1.4%
92,600 = advanced amount
Less 2, 315 = 92,600 x 15% x 60/360
90, 285 proceeds from factoring

B. Banker’s Acceptance
• Used by importers and exporters, these are drafts drawn by a non- financial firm on deposits at a bank. The bank’s
acceptance is a guarantee of payment at maturity.

NOTES
1. The primary factor to consider when evaluating any investment alternative as a use for short- term excess cash is
safety of principal

AMDG+ 27
FINANCIAL FORECASTING FM-9
BASICS
• A company needs a plan, one that starts with the firm’s general goals and details the steps that will be taken to get
there.
• Financial planners begin with a set of assumptions, see what is likely to happen based on those assumptions, and
then see if modifications can help the firm achieve better results.
• Both investors and corporations use forecasting techniques to help value a company’s stock; to estimate the
benefits of potential projects; and to estimate how changes in capital structure, dividend policy, and working
capital policy influence shareholder value.
• If the projected operating results are unsatisfactory, management can “go back to the drawing board”, reformulate
its plans, and develop more reasonable targets for the coming year.
• The funds required to meet the sales forecast simply may not be obtainable. If not, it is obviously better to know
this in advance and to scale back projected operations than to suddenly run out of cash and have operations grind
to an abrupt halt.

STRATEGIC PLANNING
• Mission statement— condensed version of a firm’s strategic plan.
• Corporate scope— defines the firm’s lines of business and geographic areas of operation.
• Statement of Corporate objectives— sets forth specific goals to guide management
• Corporate Strategies— broad approaches developed for achieving a firm’s goals.
• Operating plan— provides management with detailed implementation guidance based on the corporate strategy to
help meet the corporate objectives
• Synergy— situation where the whole is greater than the sum of the parts, and it’s sometimes called the 2 + 2 = 5
effect.

FINNANCIAL PLANNING or VALUE- BASED MANAGEMENT

• Financial plan— document that includes assumptions, projected financial statements, and projected ratios and ties
the entire planning process together.
• Involves four steps:
i. Assumptions are made about the future levels of sales, costs, interest rates for use in the forecast.
ii. Set of projected financial statements is developed
iii. Projected ratios are calculated and analyzed.
iv. Plan is re- examined, the assumptions are reviewed, and management considers how additional changes in
operations might improve results.

SALES FORECAST
• Financial plans generally begin with sales forecast
• Management likes higher sales growth, but not at any cost
• Sales growth cannot occur without a concurrent increase in capacity, and that too is costly.
• Sales growth must be balanced against the cost of achieving that growth
• Consequences of off sales forecast:
i. When market expands, will be unable to meet demand, losing market share
ii. Overly optimistic projections will end up with too much PPE, inventory, leading to low turnover ratios,
high costs for depreciation and storage, and write- offs of spoiled inventory; resulting to low profits and
depressed stock price

ADDITIONAL FUNDS NEEDED (AFN)

Projected Increase in Spontaneous
AFN = Projected Increase in Assets - - Increase in retained earnings
Liabilities
𝐶𝑌 𝐴𝑠𝑠𝑒𝑡𝑠 ∗∗ 𝐶𝑌 𝑠𝑝𝑜𝑛 𝑙𝑖𝑎𝑏 ∗∗∗ (Projected sale x forecasted Profit Margin) x (1-
= ( ) 𝑥 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 - ( ) 𝑥 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠 -
𝐶𝑌 𝑆𝑎𝑙𝑒𝑠 𝐶𝑌 𝑆𝑎𝑙𝑒𝑠 Payout Ratio)
Retention rate = (1- Payout Ratio)
**Also known as capital *** known as spontaneous liabilities-
intensity ratio to- sales ratio 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
Retention rate = 1 -
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

• The amount of external capital (interest- bearing debt, and preferred and common stock) needed to acquire the
needed assets
• The need for external financing depends on the following key factors:
1. Sales growth— rapidly growing companies require large increases in assets
2. Capital intensity ratio— companies with high assets to sales ratio require more assets for a given increase in
sales; hence, have a greater need for external financing
3. Spontaneous liabilities-to-sales ratio— companies that spontaneously generate a large amount of funds from
accounts payable and accrued liabilities have a REDUCED need for external financing
4. Profit margin— the higher the profit margin, the larger the net income available to support increases in assets
; hence, the lower the need for external financing

AMDG+ 28
 5. Retention ratio— companies that retain a high percentage of earnings rather than paying them out as dividends
generate more retained earnings, thus LESS external financing
• Sustainable growth rate— the maximum achievable growth rate without the firm having to raise external funds. It
is the growth rate where AFN = 0
• The more capital intensive the firm is, the higher the AFN.

Excess Capacity Adjustments

• Changes made to the existing asset forecast because the firm is not operating at full capacity
Full Capacity Sales 𝐀𝐜𝐭𝐮𝐚𝐥 𝐒𝐚𝐥𝐞𝐬
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐨𝐟 𝐂𝐚𝐩𝐚𝐜𝐢𝐭𝐲 𝐚𝐭 𝐰𝐡𝐢𝐜𝐡 𝐟𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 𝐰𝐞𝐫𝐞 𝐨𝐩𝐞𝐫𝐚𝐭𝐞𝐝
Target fixed assets- sales- ratio 𝐴𝑐𝑡𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐹𝑢𝑙𝑙 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑆𝑎𝑙𝑒𝑠
Required Level of Fixed Assets Target fixed assets- sales- ratio X Projected Sales
Additional Fixed Assets 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐴𝑐𝑡𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

NOTES
1. Non- trade Notes payables are not spontaneous liabilities as noted in the working capital management chapter.

AMDG+ 29
DIVIDENDS AND SHARE REPURCHASES FM-10
BASICS
• Target payout ratio— percentage of net income to be paid out as cash dividends
𝐷
• Investor preference is considered in the model 𝑃 = . An increase in the payout ratio will increase dividend,
𝑟−𝑔
causing the stock price to rise if taken alone. However, it will consequently decrease expected growth rate
(because less money is reinvested) and tends to lower the stock price. Therefore, changes in payout policy will
have two opposing effects.
• Optimal Dividend Policy— strikes a balance between current dividends and future growth and maximizes the
firm’s stock price.

DIVIDEND IRRELEVANCE THEORY

• Dividend policy has no effect on either the price of a firm’s stock or its cost of capital, given a stringent set of
assumptions: (1) no taxes are paid (2) no transaction cost (3) everyone has the same information
• Firm’s value is determined only by its basic earning power and its business risk, meaning, firm’s value depends
only on the income produced by assets.

Investor Preference: Dividends

• Gordon: Required rate of return on equity decline as the dividend payout is increased because investors are less
certain of receiving capital gains
• Bird- in- the- Hand Fallacy— MM’s name for Gordon- Lintner’s theory that a firm’s value will be maximized by
setting a high dividend payout ratio, because in MM’s view, the riskiness of the firm’s cash flows to investors in
the long run is determined by the riskiness of operating cash flows, not by dividend payout policy.
• Investors who are looking for a steady stream of income would logically prefer that companies pay dividends
• If firm retains income, those who need current income will go to the trouble and expense of selling off some of
their shares to obtain cash

Investor Preference: Capital Gains

• Stockholders on their peak- earning years might prefer reinvestment because they have less need for current
investment income and simply reinvest dividends received after incurring income taxes and brokerage costs
• Long- term investors who want to reinvest their dividends incur transaction costs, prompting companies to
establish dividend reinvestment plans
• Taxes must be paid on dividends the year they are received while capital gains taxes are incurred when stocks are
sold. Dollar taxes paid in the future will have lower effective cost than taxes paid today.

OTHER DIVIDEND POLICY ISSUES

A. Information Content (Signaling) Hypothesis
• Theory that investors regard dividend changes as signals of management’s earnings forecast
• Signal— an action taken by management to provide clues to investors about how management views the firm’s
prospects
• Higher- than- expected dividend increase is a signal that management forecasts good future earnings
• Dividend reduction is a signal to investors that management forecasts poor future earnings.
• If this is correct, stock price changes after dividend increases or decreases do not demonstrate a preference for
dividends over retained earnings, rather, dividend announcements have information content, or signaling, about
future earnings.

B. Clientele effect
• Tendency of a firm to attract a set of investors that like its dividend policy
• Different groups of stockholders prefer different dividend payout policies, hence, that a change in dividend policy
might upset the majority clientele and have negative effect on the stock’s price
• This suggests that a company should follow a stable, dependable dividend policy so as to avoid upsetting its
clientele
• Catering Theory— suggests investors’ preference for dividends vary over time and that corporations adapt their
dividend policies to cater to the current desires of investors

SETTING THE TARGET PAYOUT RATIO

• Three considerations in deciding how much to distribute to stockholders:
i. The objective is to maximize shareholder value
ii. Cash flows belong to shareholders so management retain income IF AND ONLY IF it can reinvest at
higher rates of return than shareholders can earn themselves
iii. If good investments are available, it is better to finance them with retained earnings than with new stock
because it is cheaper.
• The Optimal payout ratio is a function of four factors which are combined in the Residual dividend model
i. Management’s opinion about its investors’ preferences for dividends versus capital gains

AMDG+ 30
 ii. Firm’s investment opportunities
iii. Firm’s target capital structure
iv. Availability and cost of external capital
• Payout ratio is interpreted in two ways:
i. the percentage of net income paid out as cash dividends
ii. the percentage of net income distributed to stockholders through dividends and stock repurchases

Residual Dividend Model

• Model in which the dividend paid is set equal to net income minus the amount of retained earnings necessary to
finance the firm’s optimal capital
• Under this model, we assume that investors are indifferent between dividends and capital gains
• The firm follows these four steps to establish its target payout ratio
i. Determines the optimal capital budget
ii. Given the capital structure, determine the amount of equity needed to finance that budget
iii. Uses retained earnings to meet equity requirements to extent possible
iv. Pays dividends only if more earnings are available
Retained Earnings Required to help finance new
Dividends = Net Income -
investements
= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 - (𝑇𝑎𝑟𝑔𝑒𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜) 𝑥 (𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡)
• As long as a firm finances with the optimal mix of debt and equity and uses only internally generated equity, the
marginal cost of each new dollar of capital will be minimized. At the point where new stock must be sold, the cost
of equity (and consequently the marginal cost of capital) rises
• Under the residual value, dividend and payout ratio would vary with investment opportunities. Therefore,
following the residual dividend model will almost certainly lead to fluctuating and unstable dividends.
• Firms operate as follows to counter the fluctuating and unstable dividends: (1) estimate earnings and investment
opportunities, on average, over the next 5 or so years; (2) find the average residual model amount of dividends;
(3) set the payout policy based on the projected data
• Thus, the firms should use the residual policy to help set their long- term target payout ratios, but not as a guide
to payout in any one year.
• Low- Regular- Dividend- Plus- Extras— policy of announcing a low regular dividend that can be maintained no
matter what and then when time are good, paying a designated “extra” dividend.

Earnings, Cash Flows, and Dividends

• Cash flows are more important determinants of dividends than earnings
𝐷𝑃𝑆
• 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐸𝑃𝑆 are more volatile compared to Cash flow per share.
𝐷𝑃𝑆
• 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑝𝑎𝑦𝑜𝑢𝑡 = 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 is relatively stable

Payment Procedures
1. Declaration date— date on which a firm’s directors issue a statement declaring dividends.
2. Holder-of-Record date— if the company lists the stockholder as a n owner on this date, then the stockholder
receives the dividend
3. Ex- Dividend Date— the date on which the right to the current dividend no longer accompanies a stock; usually 2
business days prior to the holder- of- record date
4. Payment date— date on which a firm actually mails dividend checks
• We would normally expect the price of a stock to drop approximately the amount of the dividend on the ex- dividend
date. Thus, if 0.50 dividend is paid on a stock priced at P30.50 on closing, it would probably open at about P30.
• The amount of rise and subsequent fall would be the Dividend (1- T), where T is the tax rate on individual dividends

+DIVIDEND REINVESTMENT PLANS

• Plan that enables a stockholder to automatically reinvest dividends received back into the stock of the paying
firm

SUMMARY OF FACTORS INFLUENCING DIVIDEND POLICY

A. Constraints
1. Bond indentures— contracts often stipulate that no dividends be paid unless current ratio, TIE ratio, and other
safety ratios exceed stated minimums
2. Preferred stock restrictions— preferred arrearages must be satisfied before common dividends can be resumed
3. Impairment of capital rule— dividend payments cannot exceed the balance sheet item “retained earnings” to
protect creditors
4. Availability of cash— shortage of cash can restrict dividend payment

B. Investment Opportunities
1. Large number of profitable investment opportunities will lower payout ratio and vice versa
2. An ability to accelerate or postpone projects permit firms to adhere more closely to a stable dividend policy

AMDG+ 31
C. Alternative Sources of Capital
1. Cost of selling new stock sets the payout ratio at a low level
2. If the firm can adjust its debt ratio without raising its WACC, it can pay the expected dividend, even if earnings
fluctuate, by additional borrowings
3. Management concerned of maintain control will be reluctant to issue new stock.

D. Effects of Dividend Policy on Required Return on Equity, r

• Affected by four factors as discussed earlier: (1) stockholder’s desire for current versus future income (2)
perceived riskiness of dividends versus capital gains (3) tax advantage of capital gains (4) signaling

STOCK DIVIDENDS
• Originally used by firms that were short of cash; today, the primary purpose is to increase the number of shares
outstanding to lower the stock’s price in the market
• Stock dividends are used on a regular annual basis keep the stock price more or less constrained

STOCK SPLITS
• Primary purpose is to increase the number of shares outstanding to lower the stock’s price in the market, similar
to stock dividends.
• Stock splits are generally used after a sharp price run- up to produce a large price reduction
• Stock splits far more often than stock dividends because stock dividends create bookkeeping problems and
unnecessary expenses
• Reverse splits— reduce the shares outstanding

Effect of Stock Splits And Dividends On Stock Price

1. Increase in stock prices shortly after announcing stock split or dividend as a result of a favorable signal for
earnings and dividends
2. Stock prices will tend to rise, but it will drop back to earlier level if the firm does not announce an increase in
earnings and dividends
3. Creates more share and lowers stock price, stock splits may increase the stock’s liquidity. This increases firm
value

STOCK REPURCHASES
• Transaction in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing
EPS (substituting capital gains for dividends), and often increasing the stock price
• Three principal types of stock repurchase:
i. Where the firm has cash available for distribution to its stockholders and it distributes this cash by
repurchasing shares rather than by paying cash dividends
ii. Situations where the firm concludes that its capital structure is too heavily weighted with equity and its
sells debt and uses the proceeds to buy back its stock, and
iii. Situations where the firm has issued options to employees and it uses open market repurchases to obtain
stock for use when the options are exercised
• Stock repurchases are generally made in one or three ways
i. Through a broker on the open market
ii. Make a tender offer, permitting stockholders to send in (or tender) their shares to the firm in exchange for
a specified price per share
iii. Repurchase a block of shares from one large holder on a negotiated basis
• Treasury stocks— stock that has been repurchased by a firm

Effects of Stock Repurchases

Steps 1: calculate Current EPS and Price per Earnings Ratio
Step 2: Calculate how much shares will be repurchased, and deduct this to the outstanding number of shares
Step 3: Calculate the new EPS
Step 4: Calculate the expected market price after repurchasing

𝑻𝒐𝒕𝒂𝒍 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝟒.𝟒 𝒎𝒊𝒍𝒍𝒊𝒐𝒏

Current EPS = Current EPS = = 4.00 per share
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑺𝒉𝒂𝒓𝒆𝒔 𝟏.𝟏 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆 20
P/E ratio = P/E Ratio= = 5 times
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆 4
4.4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Firm believes it could repurchase 100,000 shares so EPS = = 4.40
1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Expected Market Price after repurchase = (P/E) (EPS) Expected Market Price = (5) (4.40) = 22 per share
*Note: this is just an application of the P/E ratio equation

AMDG+ 32
 Advantages Disadvantages
1. Positive signal of management’s belief that shares are 1. Cash dividends are generally dependable than repurchases
undervalued 2. Selling stockholders might not be fully aware of all the
2. Stockholders have a choice to sell or not implications of a repurchase
3. Remove overhanging stocks that keeps the price per share down 3. Corporation may pay too high a price for the repurchased stock,
4. Prefer repurchase than declaring cash dividends that cannot be to the disadvantage of remaining stockholders
maintained
5. Gives flexibility in adjusting the total distribution, into a
dividend component and into a repurchase component
6. Produce large- scale changes in capital structure
7. Avoids issuing new shares which dilutes EPS, and distributing
repurchased stocks as employee compensation

Conclusions on Stock Repurchases

1. Because of deferred tax on capital gains, repurchases have a tax advantage over dividends
2. A company can set its dividend at a level low enough to keep dividend payments from constraining operations and
then use repurchases on a more or less regular basis to distribute excess cash.
3. Useful when firm wants to make a large, rapid shift in its capital structure, wants to distribute cash from a one- time
event such as the sale of a division, or wants to obtain shares for use in a n employee stock option plan

NOTES
1. If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan
would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend
reinvestment plan would probably make more sense.

AMDG+ 33
FINANCIAL STATEMENT. CASH FLOW, TAXES FM+

DSFASDSA

SFASFSA

ASFAS

AMDG+ 34
ANALYSIS OF FINANCIAL STATEMENTS FM+

ASFS

AMDG+ 35
FINANCIAL FORECASTING FM+
DSAFSDFAS
SSFSDFAS

AMDG+ 36
INTEREST RATES FM+
DSAFSFASDF
ASFDASFSA

AMDG+ 37
TIME VALUE OF MONEY FM+
DSFSAFD
SDFASFAS
SAFSFSA

AMDG+ 38
FINANCIAL MARKETS AND INSTITUTIONS FM+

AMDG+ 39