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Managerial

Finance
Lecture Notes

For

MBA/M.Com/MEF/BS/BB
S

Sir M.Faseeh Khan


Sir M.Faseeh Khan-MF(notes) Page 1 of 42 copyright @TM
Federal Urdu Art and Science University
e-mail: faseeh_u@yahoo.com

Managerial Finance – Course


Overview

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__________________________________________________________
___
Instructor: Sir M.Faseeh Khan e-mail:
faseeh_u@yahoo.com
Subject: Managerial Finance
Class: BBA/MBA Shift: Morning Session: Aug. – Dec.
2010

Purpose:
The course is design to assist the students in building a conceptual
framework which with to make prudent financial decision in their jobs, personal
financial planning and decision making.

Topics:
Part 1: Introduction to Managerial Finance
– What is a firm and what is the ideal goal of the firm?
Part 2: Financial Analysis and Planning
– How can we evaluate the quality of firms?
Part 3: Important Financial Concepts
– What is the time value of money?
Part 4: Long-Term Financing Decisions
– How can we measure risk? What is the relationship
between risk and return?
Part 5: Long-Term Investment Decisions
– How should bonds be valued?
– How should stock be valued?
Part 6: Working Capital Management
– What is the firm's cost of borrowing?
Part 7: Special Topics in Managerial Finance
– What measures can be used to evaluate proposed projects?
– How much debt should a firm have?
– What should the firm do with its profits?

Evaluation:
The grading component and Scale:
Final Examination ---------> 60 Marks
Mid-Term ---------> 20 Marks
Class Test ---------> 20 Marks(each @ 10)

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Part 1: Introduction to Managerial Finance
Chapter Outline
1. Finance and the Financial Manager
2. Forms of Business Organization
3. The Goal of Financial Management
4. The Agency Problem and Control of the Corporation
5. Financial Markets and the Corporation
Corporate Finance
• Some important questions that are answered using finance
• What long-term investments should the firm take on?
• Where will we get the long-term financing to pay for the investment?
• How will we manage the everyday financial activities of the firm?

Financial Manager
• Financial managers try to answer some or all of these questions
• The top financial manager within a firm is usually the Chief Financial
Officer (CFO)
• Treasurer – oversees cash management, credit management, capital
expenditures and financial planning
• Controller – oversees taxes, cost accounting, financial accounting and
data processing

Financial Management Decisions


• Capital budgeting
• What long-term investments or projects should the business take on?
• Capital structure
• How should we pay for our assets?
• Should we use debt or equity?
• Working capital management
• How do we manage the day-to-day finances of the firm?
Forms of Business Organization
• Three major forms in the United States
• Sole proprietorship
• Partnership
• General
• Limited
• Corporation
• S-Corp
• Limited liability company

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Sole Proprietorship
• Advantages
• Easiest to start
• Least regulated
• Single owner keeps all the profits
• Taxed once as personal income
• Disadvantages
• Limited to life of owner
• Equity capital limited to owner’s personal wealth
• Unlimited liability
• Difficult to sell ownership interest

Partnership
• Advantages
• Two or more owners
• More capital available
• Relatively easy to start
• Income taxed once as personal income
• Disadvantages
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves when one partner dies or wishes to sell
• Difficult to transfer ownership

Corporation
• Advantages
• Limited liability
• Unlimited life
• Separation of ownership and management
• Transfer of ownership is easy
• Easier to raise capital
• Disadvantages
• Separation of ownership and management
• Double taxation (income taxed at the corporate rate and then
dividends taxed at the personal rate)

Goal of Financial Management


• What should be the goal of a corporation?
• Maximize profit?
• Minimize costs?
• Maximize market share?

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• Maximize the current value of the company’s stock?
• Does this mean we should do anything and everything to maximize owner
wealth?

Part 2: Financial Analysis and Planning

Chapter Outline
1. The Balance Sheet
2. The Income Statement
3. Taxes
4. Cash Flow
5. Standardized Financial Statements
6. Ratio Analysis
7. The DuPont Identity
8. Using Financial Statement Information

Balance Sheet
• The balance sheet is a snapshot of the firm’s assets and liabilities at a given
point in time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets = Liabilities + Stockholders’ Equity

The Balance Sheet - Figure

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Net Working Capital and Liquidity
• Net Working Capital
• Current Assets – Current Liabilities
• Positive when the cash that will be received over the next 12 months
exceeds the cash that will be paid out
• Usually positive in a healthy firm
• Liquidity
• Ability to convert to cash quickly without a significant loss in value
• Liquid firms are less likely to experience financial distress
• But liquid assets earn a lower return
• Trade-off to find balance between liquid and illiquid assets

Market Vs. Book Value


• The balance sheet provides the book value of the assets, liabilities and
equity.
• Market value is the price at which the assets, liabilities or equity can actually
be bought or sold.
• Market value and book value are often very different. Why?
• Which is more important to the decision-making process?

Income Statement
• The income statement is more like a video of the firm’s operations for a
specified period of time.

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• You generally report revenues first and then deduct any expenses for the
period
• Matching principle – GAAP – ex: to show revenue when it accrues and
match the expenses required to generate the revenue

Sources and Uses


• Sources
• Cash inflow – occurs when we “sell” something
• Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
• Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock
• Uses
• Cash outflow – occurs when we “buy” something
• Increase in asset account
• Cash and other current assets
• Decrease in liability or equity account
• Notes payable and long-term debt

Statement of Cash Flows


• Statement that summarizes the sources and uses of cash
• Changes divided into three major categories
• Operating Activity – includes net income and changes in most
current accounts
• Investment Activity – includes changes in fixed assets
• Financing Activity – includes changes in notes payable, long-term
debt and equity accounts as well as dividends

Standardized Financial Statements


• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare financial information,
particularly as the company grows
• They are also useful for comparing companies of different sizes, particularly
within the same industry

Ratio Analysis
• Ratios also allow for better comparison through time or between companies
• As we look at each ratio, ask yourself what the ratio is trying to measure and
why is that information is important

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• Ratios are used both internally and externally

Categories of Financial Ratios


• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
Computing Liquidity Ratios
• Current Ratio = CA / CL
• 2256 / 1995 = 1.13 times
• Quick Ratio = (CA – Inventory) / CL
• (2256 – 1995) / 1995 = .1308 times
• Cash Ratio = Cash / CL
• 696 / 1995 = .35 times
• NWC to Total Assets = NWC / TA
• (2256 – 1995) / 5394 = .05
• Interval Measure = CA / average daily operating costs
• 2256 / ((2006 + 1740)/365) = 219.8 days
Computing Long-term Solvency Ratios
• Total Debt Ratio = (TA – TE) / TA
• (5394 – 2556) / 5394 = 52.61%
• Debt/Equity = TD / TE
• (5394 – 2556) / 2556 = 1.11 times
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + 1.11 = 2.11
• Long-term debt ratio = LTD / (LTD + TE)
• 843 / (843 + 2556) = 24.80%
Computing Coverage Ratios
• Times Interest Earned = EBIT / Interest
• 1138 / 7 = 162.57 times
• Cash Coverage = (EBIT + Depreciation) / Interest
• (1138 + 116) / 7 = 179.14 times
Computing Inventory Ratios
• Inventory Turnover = Cost of Goods Sold / Inventory
• 2006 / 301 = 6.66 times
• Days’ Sales in Inventory = 365 / Inventory Turnover
• 365 / 6.66 = 55 days
Computing Receivables Ratios
• Receivables Turnover = Sales / Accounts Receivable
• 5000 / 956 = 5.23 times

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• Days’ Sales in Receivables = 365 / Receivables Turnover
• 365 / 5.23 = 70 days
Computing Total Asset Turnover
• Total Asset Turnover = Sales / Total Assets
• 5000 / 5394 = .93
• It is not unusual for TAT < 1, especially if a firm has a large amount
of fixed assets
• NWC Turnover = Sales / NWC
• 5000 / (2256 – 1995) = 19.16 times
• Fixed Asset Turnover = Sales / NFA
• 5000 / 3138 = 1.59 times

Part 3: Important Financial Concepts

A Time Value of Money


Simple Interest and Discount:
In its most basic form, interest is calculated by multiplying principal (amount
invested) by rate (percent of interest) multiplied by time (number of periods the
interest is calculated). This is called simple interest.
I=Prt
Example: A $1,000 deposit at 8% per year for three years' simple interest: I =
(1000)(.08)(3) = 240 A $1000 deposit at 8% simple interest for three years earns
$240 interest.

Simple Interest/Discount :
The future value (FV) of a simple interest calculation is derived by adding the
original principal back to the interest earned.

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$1,000 + $240 = $1,240
Expressed as a formula:

FV = P(1 + rt)
FV = (1000)+(1000)(.08)(3) = 1240

Simple Interest/Discount:
Note: usually simple interest is used in financial institutions for interest periods of
less than one year. If the rate is expressed as an annual rate (normal practice), then
the time period (t) must be a fraction of a year. Example: we invest $10,000 in an
8% , 90-day certificate of deposit. Our total proceeds at the end of the CD period
are:
FV = (10000)+(10000)(.08)(90/365) = $10,197.26
Simple Interest/ Discount (4):
Often, if a bank or other financial institution loans a sum for a short term, the lender
will prefer to calculate the interest up front and loan out the discounted principal, or
principal minus interest to be earned. The interest to be paid up front on a loan is
called discount and the discounted principal, or the actual amount loaned is called
the present value (PV)
FV
PV = (1+rt)
Simple Interest/Discount
Repeating the discount basic formula (simple interest):
FV
PV = (1+rt)
Example: If the bank loans out $10,000 for 90 days at 8% simple interest, the PV is:
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= $9,806.56
Compound Interest:
However, if interest is left in the account to accumulate for a longer period (usually
longer than one year) common practice (and usually state law!) requires that after
interest is earned and credited for a given period, the new sum of principal + interest
must now earn interest for the next period, etc. This is compound interest. To
distinguish from simple interest, we use "n" to refer to the number of "periods" in
which the interest is compounded and added to principal.

FV
FV = P(1 + r)n OR PV = (1+r)n

Compound Interest:
Suppose we invest our original $1,000 for three years at 8%, compounded quarterly:
(The rate per quarterly period is 8% / 4 or 2%.
The number of periods (n) is 3 x 4 = 12 quarterly periods.)

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FV = (1000)(1.02)12 = $1,268.24
If we wanted to know how much we'd have to invest now (PV) at 8% compounded
quarterly to earn $10,000 in three years:
PV = 10000 / (1.02)12 = $7,884.93

Net Present Value and Other Investment Criteria

Good Decision Criteria


• We need to ask ourselves the following questions when evaluating capital
budgeting decision rules
• Does the decision rule adjust for the time value of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on whether we are
creating value for the firm?

Project Example Information


• You are looking at a new project and you have estimated the following cash
flows:
• Year 0:CF = -165,000
• Year 1:CF = 63,120; NI = 13,620
• Year 2:CF = 70,800; NI = 3,300
• Year 3:CF = 91,080; NI = 29,100
• Average Book Value = 72,000
• Your required return for assets of this risk is 12%.

Payback Period
• How long does it take to get the initial cost back in a nominal sense?
• Computation
• Estimate the cash flows
• Subtract the future cash flows from the initial cost until the initial
investment has been recovered
• Decision Rule – Accept if the payback period is less than some preset limit

Computing Payback For The Project


• Assume we will accept the project if it pays back within two years.
• Year 1: 165,000 – 63,120 = 101,880 still to recover
• Year 2: 101,880 – 70,800 = 31,080 still to recover
• Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
• Do we accept or reject the project?

Decision Criteria Test - Payback


• Does the payback rule account for the time value of money? (No)
• Does the payback rule account for the risk of the cash flows? (No)

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• Does the payback rule provide an indication about the increase in value?
(No)
• Should we consider the payback rule for our primary decision rule?
(No)

Advantages and Disadvantages of Payback


• Advantages
• Easy to understand
• Adjusts for uncertainty of later cash flows
• Biased towards liquidity
• Disadvantages
• Ignores the time value of money
• Requires an arbitrary cutoff point
• Ignores cash flows beyond the cutoff date
• Biased against long-term projects, such as research and development,
and new projects

AAR and Discounted Payback


• Discounted payback is a variation on the payback rule that does allow for the
time value of money, but still requires an arbitrary cutoff.
• Average Accounting Return (AAR) doesn’t even measure cash flows, but
only whether average accounting income from the project = a set percentage
of return
• Neither effectively measures whether a long-term investment has added
value to the firm. For sake of time, we will ignore these methods.

Net Present Value


• The difference between the market value of a project and its cost
• How much value is created from undertaking an investment?
• The first step is to estimate the expected future cash flows.
• The second step is to estimate the required return for projects of this
risk level.
• The third step is to find the present value of the cash flows and
subtract the initial investment.
NPV – Decision Rule
• If the NPV is positive, accept the project
• A positive NPV means that the project is expected to add value to the firm
and will therefore increase the wealth of the owners.
• Since our goal is to increase owner wealth, NPV is a direct measure of how
well this project will meet our goal.

Computing NPV for the Project


• Using the formulas:

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2 3
• NPV = 63,120/(1.12) + 70,800/(1.12) + 91,080/(1.12) – 165,000 =
12,627.42
• Many financial calculators also have templates for calculating NPV
• Do we accept or reject the project?

Since NPV is positive at 12%, we should accept the investment.

Decision Criteria Test - NPV


• Does the NPV rule account for the time value of money? (Yes)
• Does the NPV rule account for the risk of the cash flows? (Yes)
• Does the NPV rule provide an indication about the increase in value? (Yes)
• Should we consider the NPV rule for our primary decision rule?
(Yes)

Internal Rate of Return


• This is the most important alternative to NPV
• It is often used in practice and is intuitively appealing
• It is based entirely on the estimated cash flows and is independent of interest
rates found elsewhere
IRR – Definition and Decision Rule
• Definition: IRR is the return that makes the NPV = 0
• Decision Rule: Accept the project if the IRR is greater than the required
return
Computing IRR For The Project
• If you do not have a financial calculator, then this becomes a trial and error
process
• Again many financial calculators have templates for estimating IRR
• But IRR is most easily estimated using a spreadsheet (See Excel, next slide)
• Do we accept or reject the project?

DBH suggestion: Use the required return as the “guess” rate requested by the Excel
function (in this case 12%) Since 16.13% > 12% we would accept the project.
Decision Criteria Test - IRR
• Does the IRR rule account for the time value of money? (Yes)
• Does the IRR rule account for the risk of the cash flows? (Yes)
• Does the IRR rule provide an indication about the increase in value? (Yes,
by %)
• Should we consider the IRR rule for our primary decision criteria? (Not
primary, see following slides)

Part 4: Long-Term Financing Decisions


Expected Return :

Sir M.Faseeh Khan-MF(notes) Page 14 of 42 copyright @TM


Most investments carry some degree of risk.
Generally only U.S. securities (specifically T-bills) are considered risk free [R ]
f
because the Federal government can raise taxes or borrow as necessary to avoid
default.
Expected Return :

Suppose Investment A has probable returns as follows:


• In the previous "go-go" market, it had earned 12%.
• In the recent market slump, it earned only 4%.
• If we project a 60% probability of renewed boom and a 40% probability
of bust, then the expected return of A [ E(RA) ] is as follows:

E(RA) = (.60 x .12) + (.40 x .04)


= .072 + .016
= .088 or 8.8%

Risk Premium:
Risk Premium is the difference between the expected return on the proposed
investment and the risk free rate.
If U.S. security G is earning 4% then the risk premium for investment A (from
previous slide, E(R) = 8.8%) is:
Risk = E(R ) - R
A A f
= .088 - .04 = .048 or 4.8%

Variance & Standard Deviation


The Variance, or squared deviations from the expected return gives us a
measurement of how much risk movement is in an investment. For Investment A:
σ 2A = [prob1 x (return1 - E(RA)2] + [prob2 x (return2 - E(RA)2]
σ 2A = [.60 x (.12 - .088)2] + [.40 x (.04 - .088)2]
= [.60 x .001024 ] + [.40 x .002304 ]
= [.00036864] + [.0009216]
= .00129024

The Standard deviation is the square root of the variance. For A:


σ A = SQRT of .00129024 =+-0.03592 = + or - 3.59%
This gives some idea of the potential movement in Investment A

Investment Portfolios
A portfolio of investments enables us to diversify and therefore minimize the
portion of risk that relates to "surprises" or unexpected movement in individual
securities.

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A portfolio won't remove risk related to the market as a whole ("market risk").

Portfolio Illustration
Suppose we mix a portfolio of 40% in Investment A (previous) + 40% in Investment
B, which may earn only 7% in a good market but booms to 14% in a recession, and
we put the other 20% in government investment G earning 4%. Portfolio Expected
Return for Portfolio "P" :

E(RP) = [.40 x E(RA)] + [.40 x E(RB)] + [.20 x E(RG)]

Where E(RA) =8.8% , E(RB) =9.8% , and E(RG) = 4% (the risk-free rate)

E(RP) = ( .40 x .088) + (.40 x .098) + (.20 x .04)


E(RP) = .0824 or 8.24%

Portfolio Illustration (continued):


Note: The percentage weights are based on the total dollars invested in each
security. If we invested $100,000 as follows: $40,000 in A, $40,000 in B, and
$20,000 in G, then we would have the 40%-40%-20% mix above.

The variance of this portfolio is 0.00000434062 and the standard deviation is .


0020736 or about + or - 2/10 of 1%. In other words, diversifying eliminated
almost all of the diversification risk or unexpected return.

Risk & Beta :


Total risk of any investment = both
• the market risk (which can't be diversified) and
• the diversifiable risk, which can be minimized or eliminated by
diversification in a portfolio.
• The market risk is called systematic and the diversifiable risk is called
unsystematic.

Total risk = Systematic risk + Unsystematic risk


(market risk) (diversifiable risk)
Risk & Beta:

Total risk = Systematic risk + Unsystematic risk


(market) (diversifiable)
The unsystematic risk is asset-specific and relates to individual investments which
can be minimized through diversification. The systematic risk, or market risk, can
affect all market investments. A recession or a war, for example, might impact all
investments in a portfolio. Since we can usually eliminate the unsystematic risk,
we focus primarily on the systematic risk.

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Expected return of any asset , or E(Rasset), depends only on the asset's systematic
risk. We measure the systematic risk by the beta coefficient, or β .

Risk & Beta :


The Beta of an asset = Covariance of asset returns with
The market index portfolio
Variance with the market portfolio

I don't want to figure that out--do you? There are people on this planet who live for
this stuff and do that for most publicly traded assets. (Your facilitator is NOT one
of them!) Therefore we will assume the Beta is given for any investment we work
with.

The general rule for β is as follows:


If β = 1.0 then the investment has "normal" market risk
If β < 1.0 then the investment has below normal market risk
(for example U.S. securities' β = 0 or zero risk)
If β > 1.0 then the investment has a greater than normal
market risk (higher risk)

Sir M.Faseeh Khan-MF(notes) Page 17 of 42 copyright @TM


Part 5: Long-Term Investment Decisions
Bonds and Their Valuation

 Key features of bonds


 Bond valuation
 Measuring yield
 Assessing risk

BOND VALUATION

The financial value of any asset, be it a security, real estate, business, etc., is
the present value of all future cash flows. The easiest thing to value (conceptually)
is a bond since the promised cash flows are known with certainty.
Consider a bond that pays a 10% coupon (or stated) rate of interest, has a
par (or stated) face value of $1,000 and matures in 5 years. Suppose also that the
market rate of interest for such a bond (i.e., your required rate of return, k) is 8%.
Thus,

Par = $1,000
Coupon Rate = 10%
Maturity = 5 years
K = 8%

The cash flows that are promised by the company include interest payments
of $100 per year (although most corporate bonds pay interest semi-annually, we
will assume annual payments—we have already seen how to adjust for semi-
annual cash flows) for five years and the payment of the face value (stated, or par,
value) of $1,000 at the end of five years.

0 1 2 3 4 5

100 100 100 100 100


1,000
1,100
PVIFA 8%,4 = 3.3121
331.21
PVIF 8%,5 = .6806
748.66
$1,079.87

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The value of the bond is $1,079.87 which is selling at a premium relative to
the par value of $1,000. (A bond selling at less than par is said to be selling at a
discount.)

What does the premium represent? As we saw when we looked at present


values, it represents the present value of the additional interest of $20 per year
(because it pays $100 in interest when we only require $80 for a $1,000 investment
($20 * 3.9927 = $79.85 with two cents rounding error). Any time the market rate of
interest is less than the coupon rate of interest, the bond will sell at a premium.
Similarly, when market rates of interest are greater than the coupon rate, the bond
will sell at a discount. Recall from economics that, when interest rates go up, bond
prices go down, and when interest rates go down, bond prices go up. This is a
consequence of the mathematics of present value calculations.

Suppose we purchase the bond for $1,079.87. After one year, we collect
$100 in interest. The $100 represents a 9.26% return on our investment of
$1,079.87, not an 8% rate of return. What are we ignoring?

The 9.26% is referred to as the current yield (as in accounting, where


“current” refers to within one year). What is being ignored is the fact that we paid a
premium for the bond which, at maturity will be worth only $1,000. Thus, over the
five years to maturity, the value of the bond will decrease. Let’s look at what the
bond will be worth one year from now. In one year, there will only be four years left
to maturity:

0 1 2 3 4

100 100 100 100

1,000

PVIFA 8%,4 = 3.3121


331.21
PVIF 8%,4 = .7350
735.00
$1,066.21

Note that this time, the interest payment in the last year was included as a
part of the present value of an annuity calculation while the par value was
discounted as a lump sum of $1,000. As indicated, the value of the bond when only
four years to maturity remain is only $1,066.21. This is a decrease in value of
$13.66. When expressed as a percentage of the original value of $1079.87, this
represents a loss of 1.26%. The total return of 8% that we built into our valuation
when the bond had five years left to maturity is comprised of two components:

Total Yield = Current Yield + Capital Gain Yield

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Current Yield = One Year’s Interest/Current Price

Total Yield = 9.26% + <1.26%>


= 8.00%
Note that the premium for the four-year bond is smaller than the premium
for the five-year bond since we are only paying for four years’ worth of additional
interest payments.

A. Bond Maturities & Premiums/Discounts

If a five-year bond sells at a premium of $1,079.87, what do you think the


premium for a ten-year bond will be? (Recall that the premium is the present value
of the additional amount of interest being paid.)
A ten-year 10%, $1,000 par value bond should sell at a larger premium
since we are paying for ten years’ worth of an extra $20 per year of interest. For
example,

Par = $1,000
Coupon Rate = 10%
Maturity = 10 years
K = 8%

0 1 2 3 4 5 6 7 8 9
10

100 100 100 100 100 100 100 100 100 100

PVIFA 8%,10 = 6.7101


1,000
671.01
PVIF 8%,10 = .4632
$ 463.20
$1,134.21

As was expected, the additional five years’ worth of an extra $20 per year in
interest payments results in a larger premium for a ten-year bond relative to a five-
year bond.

B. Sensitivity to Changes in Interest Rates

As we determined previously, as interest rates fall, bond prices rise. Which


type of bond rises more, short-term or long-term bonds? (Hint: Do we really care
what interest rates do today for a bond that matures tomorrow?)
Suppose that interest rates fall from 8% to 6%. Let’s see what happens to
the values of our five-year and ten-year bond prices.

Sir M.Faseeh Khan-MF(notes) Page 20 of 42 copyright @TM


0 1 2 3 4 5

100 100 100 100 100

1,000

PVIFA 6%,5 = 4.2124


421.24
PVIF 6%,5 = .7473
747.30
$1,168.54

The value of the five-year bond has increased from $1,079.87 to $1,168.54
or $88.67 due to the fall in market rates of interest from 8% to 6%. The $88.67
increase in price represents an 8.2% appreciation relative to its original value.

The ten-year bond’s increase in price is calculated in the following manner:

0 1 2 3 4 5 6 7 8 9
10

100 100 100 100 100 100 100 100 100 100

PVIFA 6%,10 = 7.3601


1,000
736.01
PVIF 6%,10 = .5584
$ 558.40
$1,294.41

The increase in price for the ten year bond amounts to $160.20 or 14.1%.
Why do we calculate the change in price as a percent of its original value?
The reason the change in price is much larger for a long-term bond is due to
the fact that the longer period of time for compounding has a more pronounced
effect on the ten-year bond than it does on a five-year bond since, on average, the
five-year bond is generating cash flows much sooner than the ten-year bond. If
long-term bonds are more sensitive to changes in interest rates than short-term
bonds, can you guess whether a high coupon bond or a low coupon bond is more
sensitive to changes in interest rates? (See Handout #2.)

The equation for the value of a bond can be written as follows:

N Interest Par
Bond Value = ∑ +
t=1 (1+k)t (1+k)N

Sir M.Faseeh Khan-MF(notes) Page 21 of 42 copyright @TM


= Interest (PVIFA) + Par (PVIF)

= Present Value of the Interest Payments + Present Value of


the Par

C. Perpetuities

There is a type of bond that never matures called a perpetuity, or a consol.


(The term “consol” comes from the fact that the first perpetuities were issued by the
British government following the Napoleonic Wars to “consolidate” their war debts.)
Canada issued some perpetuities in the late 1970s. If long-term bonds are more
sensitive to changes in interest rates than short-term bonds, what type of bond is
the most sensitive to interest rate changes? (A consol, of course.)

When N is infinity, the value of a perpetual bond reduces to

Interest
Value of a perpetuity = K

While there are not a lot of perpetuities that trade in the marketplace, there
is a financial security which is, essentially, a perpetuity. Do you know what security
pays a constant dollar amount each year and never matures?

D. Preferred Stock

The classic version of preferred stock is a share that pays a fixed dollar
amount of dividend and never matures. It is, therefore, a perpetuity. The formula
for the value of a share of preferred stock is

Dividend
Value of Preferred Stock =
Kp

So if you expect that interest rates are going to decrease in the future, what
type of bond would you want to buy?

If you expect that interest rates are going to rise in the future, what type of
bond do you want to buy?

Key Features of a Bond

Sir M.Faseeh Khan-MF(notes) Page 22 of 42 copyright @TM


1. Par value: Face amount; paid at maturity. Assume $1,000.
2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of
interest.
3. Maturity: Years until bondmust be repaid. Declines.
4. Issue date: Date when bond was issued.
5. Default risk: Risk that issuer will not make interest or principal payments.

How does adding a call provision affect a bond?


 Issuer can refund if rates decline. That helps the issuer but hurts the
investor.
 Therefore, borrowers are willing to pay more, and lenders require more, on
callable bonds.
 Most bonds have a deferred call and a declining call premium.

What’s a sinking fund?


 Provision to pay off a loan over its life rather than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average maturity.
 But not good for investors if rates decline after issuance.

STOCKS and their VALUATION


Stocks can be divided into two categories: Common Stock and Preferred Stocks.
Preferred stock is a hybrid security, sharing features of both bonds and common
stock.
Firms usually issue preferred stock with a stated par value and promise to
periodically pay a percentage of the par value as dividend.
Dp
Dp
P=
kp ∞

where, P
D = Dividend of Preferred Stock
kp = Required rate of return on the Preferred Stock
P = Price of the Preferred Stock

The cash flow pattern of preferred stock is like perpetuity. It starts from period one,
has no gaps, all payments are equal, and payments continue forever.

Sir M.Faseeh Khan-MF(notes) Page 23 of 42 copyright @TM


Common stock represents an ownership position in the firm. Common Stock is a
long-term financial asset that provides to the common stockholders (owners of the
firm) legal rights and privileges such as:
a. Residual claim on the income and assets of the firm
The claim is residual because stockholders can claim on the firm’s income and
assets only after all claims of all stakeholders (bondholders, employees,
suppliers, and the government) are satisfied. Although stockholders are last in
line to enforce their claim, they can claim everything that remains in the firm
and they have a limited liability, meaning that the stockholders’ liability to the
stakeholders are limited to the equity they contributed.
b. Voting power
Voting power is the power to elect directors (who in turn elect managers and
officers to the company). Usually in annual meetings stockholders elect 1/3 of
the directors for 3 years. Voting mechanism could be either “majority voting” or
“cumulative voting.” Stockholders could vote either in person or by means of a
proxy.
c. Preemptive right
Preemptive right is a provision in the corporate charter or bylaws that gives
common stockholders the right to purchase on a pro rata basis new issues of
common stock or convertible securities. It serves for two purposes. First it
enables current stockholders to maintain control. If this safeguard were not in
place, the management of the corporation could issue large numbers of
additional shares and purchase these shares itself and thereby seize control of the
firm. Second, it protects stockholders against a dilution of value. If this
safeguard were not in place, selling common stock at a price lower than the
market value would transfer wealth from the present stockholders to those who
were allowed to purchase the new shares.

Sir M.Faseeh Khan-MF(notes) Page 24 of 42 copyright @TM


Terminology used in Stock Valuation
1. Intrinsic Value
Intrinsic value is the value of an asset that in the mind of a particular investor is
justified by the facts. Intrinsic value may be different form current market price
or its book value or both.
2. Proxy
Proxy is a document giving one person the authority to act for another, typically
the power to vote shares of common stock.
3. Proxy Fight
Proxy fight is an attempt by a person or group to gain control of a firm by
getting its stockholders to grant that person or group the authority to vote their
shares to place a new management into office.
4. Takeover
Takeover is an action by a person or group to take control of the company and
oust the firm’s management. That could be done either through proxy fight or by
purchasing majority of outstanding stock.
5. Founder’s Shares
Founder’s shares are Stocks owned by the firm’s founders that have sole voting
rights but restricted dividends for a specified number of years.
6. Classified Stock
Classified stock is common stock that is given a special designation such as
Class A, Class B, and so forth. One class may have no voting right but may have
rights to dividends, another may have no rights to dividends but may have voting
rights.
7. Closely Held Corporation
Closely held corporation (also called privately owned corporation) is a
corporation that is owned by a few individuals who are typically associated with
the firm’s management. The shares of the firm are not traded actively.

Market Mechanism that determines the Stock Value


The price of a firm’s stock represents the value of the firm per share of stock. Since
the value of firm change continuously, so do stock prices. Institutional and
individual investors constantly value stocks so that they can capitalize on expected
changes in stock prices.
New information about economic conditions or other factors, including firm-specific
conditions, causes investors to revalue stocks. When new information suggest that a
firm will experience more favorable cash flows or lower risk (and therefore lower
required rate of return = lower cost to obtain funds), investors will revalue the
corresponding stock upward. As these investors attempt to purchase the stock, there
is an immediate upward adjustment in the stock’s market price.

1. Common Stock Valuation Methods


There are several methods (models) to assess the value of a stock
A. Price-Earning (PE) Model
A relatively simple method of valuing a stock.

Sir M.Faseeh Khan-MF(notes) Page 25 of 42 copyright @TM


Stock Price of a firm = (Expected earnings of the firm per share for the
current year) x (Mean value of expected PE ratio of
the competitors of the firm)
E. Divided Discount Model
This approach assumes that the investors are interested in the dividend
payments of the company. To compute the value of the stock, all expected
future dividend
payments are discounted at an appropriate rate to the Present Value.
D1 D2 D∞
S0 = + +... +
(1 +k s ) (1 +k s ) 2
(1 +k s ) ∞
where,
S0 = current Stock Price
D1 = Dividend Payment in Period-1 (one period from now)
ks = Required rate of return on the Stock

The above formula could be presented in a much compact form as the


following:

Dt
S0 = ∑
t =1 (1 + k s ) t

where,
t = index for period

Since it is impossible to forecast all the expected future dividend payments


(up to infinity), there are several practical adjustments to this approach.

i. Zero Growth Model: If we assume that the dividend payments will


remain constant then the formula could be written as:

D D D
S0 = + +... +
(1 +k s ) (1 +k s ) 2
(1 +k s ) ∞

D
S0 =
ks

Cash flow pattern of zero growth stock is (like preferred stock)


perpetuity.

ii. Constant Growth Model: This model assumes that the dividend
payments are growing each year at a constant rate of “g”.

Sir M.Faseeh Khan-MF(notes) Page 26 of 42 copyright @TM


D0 (1 + g )1 D0 (1 + g ) 2 D0 (1 + g ) ∞
S0 = + +... +
(1 + k s )1 (1 + k s ) 2 (1+ k s ) ∞

The cash flow pattern of Constant Growth Stock looks like the
following:
D0(1+g)
It starts from period-1, has

no gaps, cash flows grow
D1 at a constant rate, and
forever.

S0

D1 D1
S0 = kS = +g
ks − g S0

Where,
g = expected growth rate in dividends = (ROE)*(p)
D1 = Expected Dividend Payments in the next period = D0(1+g)
D0 = Most recent Dividend Payment
D1/S0 = Dividend yield
ROE = Return on Equity = (Net income) / (Common Stock Book Value)
q = dividend pay out ratio
Dt = q*(Earnings)t
iii. Variable Growth Model: This model assumes that the company and
its dividend payments grow much faster then the economy for a certain
period at the beginning and then settles to a constant growth rate.

B. Capital Asset Pricing Model (CAPM)


CAPM determines appropriate required rate of return on a stock.

k i =k rf +βi ( k m −k rf )

Where,
ki = Required rate of return on Stock “i”
krf = Risk free rate
km = Return on market
(km - krf) is also called market risk premium. That is required rate of return to
bear market’s risk.

Sir M.Faseeh Khan-MF(notes) Page 27 of 42 copyright @TM


βi = Beta of stock “i". Beta of a stock reflects how risky a stock is compared
to market. Market’s beta is one (βm =1). If firm-i’s beta is more than one
(βi >1) that means that firm-i is more riskier than the market and that in
turn results in higher risk premium, thus, higher required return for the
firm-i.

The key to the Capital Asset Pricing Model is the market risk. This model
recognizes only one risk, market risk, and calls it also systematic risk or non-
diversifyable risk. In this model risk of a financial asset is expressed as a
fraction of the market risk.

C. Arbitrage Pricing Model (APT)


Like CAPM this model tries to determine the required rate of return on a
particular stock. However, Arbitrage Pricing Model recognizes more than
one fundamental factor as source of risk. There are many factors (such as
economic growth, level of inflation, etc.) that could be source for risk.
However, there is no single set of factors that everyone agrees upon.
Sensitivity of a stock to each of these factors should be determined first in
order to calculate the required rate of return on that particular stock.
2. Factors Affecting Stock Prices
There are three types of factors, firm specific, economic, and market related, that
can affect a stock’s value.
a. Expectations
Investors do not necessarily wait for a firm to announce a new policy before
they revalue the firm’s stock. They make their decision on the basis of some
(most of the time incomplete) information in order to act before other
investors. Expectations on the future cash flows of a company affect the
stock’s value.
b. Earnings Surprises
Recent earnings are used to forecast future earnings and therefore earning
surprises affect future cash flow estimates and consequently the stock’s
price.
c. Acquisitions & Divestiture
An expected acquisition of a firm typically results in an increase demand for
the target’s stock and therefore raises the stock prices. Divestitures tend to be
regarded as a favorable signal and are interpreted as an attempt of the firm to
focus on the core business.
d. Stock Offerings & Repurchase
Some investors believe that firms attempt to issue stock when they feel that
their stock is overpriced and repurchase the stock when under priced.
e. Dividend Policy Changes
An increase in dividends may reflect the firm’s expectations that it can more
easily afford to pay higher dividends.
f. Interest Rates

Sir M.Faseeh Khan-MF(notes) Page 28 of 42 copyright @TM


Risk-free rate affects required return on stocks and therefore the market
value of stocks.
g. Economic growth
Economic growth affects projections for corporate earnings and therefore
stock value.
h. Exchange Rates
Foreign investors tend to purchase domestic stocks when the domestic
currency is weak and sell them when it is near its peak.
i. January Effect
Because many portfolio managers are evaluated over the calendar year, they
tend to invest in riskier small stocks at the beginning of the year and shift to
larger companies near the end of year. This tendency puts upward pressure
on small stocks in January every year.
j. Noise Trading
Many uninformed traders (noise traders) may buy or sell positions that push
a stock’s price away from its fundamental value. Given the uncertainty about
the stock’s fundamental value, informed investors may be unwilling to
capitalize on the discrepancy.
3. Measure of Risk for Stocks
There are two measures of risk, stock volatility and beta.
a. Volatility of a Stock
It is measured by the standard deviation of stock’s return (or price) over a
period of time. It captures total volatility of the stock and is appropriate if
there is no trend in volatility.
b. Beta of a Stock
Beta is a measure that reflects the tendency of a stock to move up or down
with the market. It measures the systematic risk of the stock.
Beta of a stock = (covariance between stock and the market returns) x
(variance of market returns)
4. Stock Performance Measure
The performance of a stock (or stock portfolio) can be measured by its excess
return (return over risk free rate → r-rf ) over that period divided by its risk. Two
common methods of measuring stock (or stock portfolio) performance are the
Sharpe index and Treynor Index.
a. Sharpe Index
It assumes that the total variability is the appropriate measure of risk
_ _
r −r f
Sharpe Index =
σ

Where,
_
r = Average return on stock

Sir M.Faseeh Khan-MF(notes) Page 29 of 42 copyright @TM


_
r f = Average risk-free rate
σ = Standard deviation of stock’s return
b. Treynor Index
It assumes that the beta is the most appropriate measure of risk

_ _
r −r f
Treynor Index =
β

Where,
β = Stock’s beta
Part 6: Working Capital Management
Working capital management is concerned with current assets and current
liabilities and their relationship to the rest of the firm. Working capital policies
affect the future returns and risk of the company; consequently, they
have an ultimate bearing on shareholder wealth.

What is Working Capital?

A business person usually sells on credit, stocks goods and keeps some
cash in the bank and the office.

Working capital refers to the total investment in current assets.

Net working capital refers to the difference between current assets and
current liabilities.

Working capital management involves two major types of decisions:

1. The level of investment in current assets.


2. The method of financing (short-term VS long-term)

Level of Investment in Current assets

Sir M.Faseeh Khan-MF(notes) Page 30 of 42 copyright @TM


Determination of the appropriate level of working capital involves a
tradeoff between risk and profitability.

Working Capital
Capital Issues
Optimal Amount (Level) of Current Assets

Assumptions

ASSET LEVEL (AED


Policy A
◆ 50,000 maximum

)
units of production Policy B

◆ Continuous Policy C
production
◆ Three different Current Assets
policies for current
asset levels are
possible 0 25,000 50,000
OUTPUT (units)

The above figure tells us that

Impact on Liquidity
Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy A
Policy Liquidity
ASSET LEVEL (AED)

A High Policy B

B Average Policy C

C Low
Current Assets
Greater current asset
levels generate more
liquidity all other
0 25,000 50,000
factors held constant. OUTPUT (units)

Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
ASSET LEVEL (AED)

Return on Investment =
Policy A
Net Profit
Total Assets Policy B

Let Current Assets = Policy C


(Cash + Rec . + Inv .)
Current Assets
Return on Investment =

Sir M.Faseeh
Net Profit Khan-MF(notes)
Current + Fixed Assets
Page 31 of 42 copyright @TM
Current Fixed Assets
0 25,000 50,000
OUTPUT (units)
Impact on Risk
Optimal Amount (Level) of Current Assets
Decreasing cash

ASSET LEVEL (AED)



reduces the firm’s ability Policy A
to meet its financial
obligations. More risk! Policy B

◆ Stricter credit policies Policy C


reduce receivables and
possibly lose sales and
customers. More risk! Current Assets
◆ Lower inventory levels
increase stockouts and
lost sales. More risk! 0 25,000 50,000
OUTPUT (units)

Summary
1. More conservative policies involve holding a greater amount of
current
assets relative to sales. More aggressive policies hold less.
2. More conservative working capital policies have lower expected
profitability (measured as return on total assets) since more assets
are used to produce a given level of income.
3. More conservative working capital policies have a lower risk of
insufficient cash to pay bills and insufficient inventory to meet
demand.
4. The optimal level of working capital investment is the level which is
expected to maximize shareholder wealth.

Summaryof theOptimal
Amount of Current Assets
SUMMARY O F O PTIMAL C URRENT A SSET A NALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitabilityvariesinverselywith
liquidity.
2. Profitabilitymovestogether withrisk.
(riskandreturngohand-in-hand!)
Sir M.Faseeh Khan-MF(notes) Page 32 of 42 copyright @TM
Nature of Current Assets

Current assets usually fluctuate from month to month. During months when
sales are relatively high, firms usually carry a lot of inventory, accounts
receivable and cash.
The level of inventory declines in other months when there is less selling
activity. But at any given point of time, the firm always has some current
assets.

Permanent current assets and Temporary current assets


The amount of current assets required to meet a firm's long-term minimum
needs are called Permanent current assets.
Current assets that fluctuate due to seasonal or cyclical demand are called
temporary current assets.

Permanent
Working Capital
The amount of current assets required to
DOLLAR AMOUNT

meet a firm’s long -term minimum needs.

Permanent current assets

TIME

Temporary
Working Capital
The amount of current assets that varies
DOLLAR AMOUNT

with seasonal requirements.

Temporary current assets

Permanent current assets

TIME

Need for financing of Current assets


Working Capital requirements are for a short period of time as Current
Assets are self-liquidating.

Sir M.Faseeh Khan-MF(notes) Page 33 of 42 copyright @TM


Take a look at the following steps (a simple model):

1. Inventory purchased on credit. Accounts Payable


2. Inventory stocked in the Warehouse. Merchandise Inventory
3. Goods are sold on credit. Accounts Receivable
4. Cash is collected. Cash

Usually somewhere between steps 1 and 4, money has to be paid to the


supplier. Let’s assume in this model that money is paid between steps 2 & 3.
In this case Cash is not yet collected. So some sort of finance has to be
arranged till Cash is collected for a short term. Once cash is collected then
the money (from whichever source) that was arranged can be repaid. With
the arrangement of Finance the steps above can be modified as under:

1. Inventory purchased on credit.

2. Inventory stocked in the Warehouse.

⇒ Finance arranged to pay the supplier

3. Goods are sold on credit.

4. Cash is collected.

⇒ Finance that was arranged between steps 2 & 3 can now be re-paid.

The above cycle gets repeated.

So Financing needs are short term for Working Capital.

Self-LiquidatingNature
of Short-TermLoans
◆ Seasonal ordersrequirethepurchaseof
inventorybeyondcurrent levels.
◆ Increasedinventoryisusedtom eet the
increaseddem andforthefinal product.
◆ Salesbecom ereceivables.
◆ R eceivablesarecollectedandbecom ecash.
◆ Theresultingcashfundscanbeusedtopay
off theseasonal short-termloanandcover
associatedlong-termfinancingcosts.

Sir M.Faseeh Khan-MF(notes) Page 34 of 42 copyright @TM


Nature of Financing (Short-term VS. Long-term)

FinancingNeeds

◆ Fixedassetsandthenon-seasonal portion
of current assetsarefinancedwithlong-
termdebt andequity(long-termprofitability
of assetstocover thelong-termfinancing
costsof thefirm).
◆ Seasonal needsarefinancedwithshort-
termloans(under normal operations
sufficient cashflowisexpectedtocover the
short-termfinancingcost).

Temporary current assets


Short
term

ssets
e nt c u rrent a
n
Perma
Long-term

Fixed Assets

Ideal Pattern of Financing

Conservative Policy of Financing:


(LOW Risk; LOW Return approach)

All fixed assets + permanent curr. assets + part of temporary curr.


Assets by long-term debt

Sir M.Faseeh Khan-MF(notes) Page 35 of 42 copyright @TM


Temporary current assets
Short
term

ts
re nt asse
ent cur
Perman

Long-term
Fixed Assets

Conservative working capital policy

Risks vs . Returns Trade-Off


(Conservative Approach)

◆ Long-Term Financing Benefits


◆ Less worry in refinancing short-term obligations
◆ Less uncertainty regarding future interest costs

◆ Long-term Financing Risks


◆ Borrowing more than what is necessary
◆ Borrowing at a higher overall cost (usually)
◆ Result
◆ Manager accepts less expected profits in
exchange for taking less risk.

Aggressive policy of financing :


(HIGH Risk; HIGH Return approach)

Sir M.Faseeh Khan-MF(notes) Page 36 of 42 copyright @TM


Temporary current assets
Short
term

ssets
ent cu rrent a
n
Perma

Long-term
Fixed Assets

Aggressive working capital policy

Risks vs . Returns Trade-Off


(Aggressive Approach)

◆ Short-TermFinancingBenefits
◆ Financinglong-termneeds witha lower interest
cost short-termdebt
◆ Borrowing only what is necessary
◆ Short-TermFinancingRisks
◆ Refinancingshort-termobligations inthe future
◆ Uncertainfuture interest costs
◆ Result
◆ Manager accepts greater expectedprofits in
exchange for taking greater risk.

F. Combining Level of Current assets with


Financing strategies
AGGRESSIVE PLAN
(SHORT TERM FINANCING/LOW LIQUIDITY)

Sir M.Faseeh Khan-MF(notes) Page 37 of 42 copyright @TM


If you adopt a financing plan which uses short term funds, and your asset
liquidity is low then it is an aggressive and risky approach for the following
reasons:

1. Profit factor - There is a possibility of high profits because your assets are
less liquid and therefore well invested in the business.

2. Profit factor - You are using short term financing and hence the interest
costs could be low resulting in lesser interest expense thereby helping
profits.

3. Risk Factor - Since the financing is short term there is every possibility
that the interest rates could go up resulting in a higher interest expense
when the finances need to be renewed or the lender may refuse to renew.

4. Risk Factor - Since the assets are less liquid there may not be enough
cash to meet short term obligations.
MODERATE PLAN
(SHORT TERM FINANCING/HIGH LIQUIDITY OR
LONG TERM FINANCING/LOW LIQUIDITY)

This sort of plan is considered moderate because:

1. Risk factor (Short term/Highly liquid)- Even though borrowing is short term
with the possibility of the financing arrangement not being renewed or a
higher interest expense (which is the risk factor) the Assets are highly liquid
hence even if the loan has to be repaid funds would be available.

2. Profit factor (Short term/Highly liquid)- With short term financing the
interest cost could be low and therefore help profits but the Assets being
less liquid would not help returns (profits).

3. Risk factor (Long term/Low liquid)- Since the financing arrangement is


long term there will not be any threat of immediate repayments but the
assets being less liquid could be a problem.

4. Profit factor (Long term/Low liquid)- When the assets are kept less liquid it
would help the profits because they would be well invested but the interest
cost could be high because of long term borrowing.

Conservative
(Long term Financing/Highly liquid assets)

Sir M.Faseeh Khan-MF(notes) Page 38 of 42 copyright @TM


1. Risk Factor - This will be negligible because there is no threat of
immediate repayment as the borrowing is long term and in any case if
anything has to be repaid the business would have the finance anyway as
the assets are highly liquid.

2. Profit Factor - Profitability will be low because the Assets are highly liquid

and the interest rates could be high too.

Part 7: Special Topics in Managerial Finance

“Cost of Capital?”
When we say a firm has a “cost of capital” of, for example, 12%, we are saying:
The firm can only have a positive NPV on a project if return exceeds 12%
The firm must earn 12% just to compensate investors for the use of their capital in a
project
The use of capital in a project must earn 12% or more, not that it will necessarily
cost 12% to borrow funds for the project
Thus cost of capital depends primarily on the USE of funds, not the SOURCE of
funds

Sir M.Faseeh Khan-MF(notes) Page 39 of 42 copyright @TM


Weighted Average Cost of Capital (overview)
A firm’s overall cost of capital must reflect the required return on the firm’s assets
as a whole
If a firm uses both debt and equity financing, the cost of capital must include the
cost of each, weighted to proportion of each (debt and equity) in the firm’s capital
structure
This is called the Weighted Average Cost of Capital (WACC)

Cost of Equity
The Cost of Equity may be derived from the dividend growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D) divided by its return on equity
(RE) less its rate of growth (g). We can invert the variables to find RE as follows:
RE = D / P + g
But this model has drawbacks when considering that some firms concentrate on
growth and do not pay dividends at all, or only irregularly. Growth rates may also
be hard to estimate. Also this model doesn’t adjust for market risk.

Cost of Equity :
Therefore many financial managers prefer the security market line/capital asset
pricing model (SML or CAPM) for estimating the cost of equity:
RE = Rf + βE x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x risk premium)
Advantages of SML: Evaluates risk, applicable to firms that don’t pay dividends
Disadvantages of SML: Need to estimate both Beta and risk premium (will usually
base on past data, not future projections.)

Cost of Debt
The cost of debt is generally easier to calculate
Equals the current interest cost to borrow new funds
Current interest rates are determined from the going rate in the financial markets
The market adjusts fixed debt interest rates to the going rate through setting debt
prices at a discount (current rate > than face rate) or premium (current rate < than
face rate)

Weighted Average Cost of Capital (WACC)


WACC weights the cost of equity and the cost of debt by the percentage of each
used in a firm’s capital structure
WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value
(D/V)=Debt % of total value

Sir M.Faseeh Khan-MF(notes) Page 40 of 42 copyright @TM


(1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be
considered because interest on corporate debt is deductible

WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per share =$28 million.
Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the
market. Total market value of both equity + debt thus =$32.65 million. Equity %
= .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40%
Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%

Final notes on WACC


WACC should be based on market rates and valuation, not on book values of debt or
equity. Book values may not reflect the current marketplace
WACC will reflect what a firm needs to earn on a new investment. But the new
investment should also reflect a risk level similar to the firm’s Beta used to calculate
the firm’s RE.
In the case of ABC Co., the relatively low WACC of 8.81% reflects ABC’s
β=.74. A riskier investment should reflect a higher interest rate.

<<< The End >>>

Subject : Managerial Finance (Formula sheet)


HPR(holding period return):
Ending value of Investment / Beg. Value of Investment

Sir M.Faseeh Khan-MF(notes) Page 41 of 42 copyright @TM


Annual HPR = [(HPR) ^(1/n) – 1] * 100
HPY(holding period yield) = Annual HPR - 1
Historical Return:
A.M = sum(HPY) / n
G.M = {(HPR1 * HPR2 * HPR3 *…. HPRn)}^1/n - 1
Expected Rate of Return:
E(R) =Sum (Probability of Return * Possible of Return)
OR
E( R) = [(P1)(R1) + (P2)(R2) + (P3)(R3) + …..(Pn*Rn)]
Risk of Expected Rate of Return:
1. Variance = Sum(Probability) [( Possible of Return - Expected Return)^2]
2. Standard Deviation = [Sum{(Probability) (R – E(R)}] ^ ½
3. Co-efficient of Variance = Standard deviation of Return / Expected Rate of Return
Rate of Return:
Kt = [Ct + Pt – (Pt-1)] / Pt-1
Total Return:

TR = [( CFt + (Pe – Pb)) / Pb ] where


CFt = Cash Flow
Bond Return:
Pe = Price in ending
Bond TR = [(It + (Pe – Pb)) / Pb ] Pb = Price in Beg.
Stock Return: It = Interest Payment
Stock TR = [(Dt + (Pe – Pb)) / Pb ] Dt = Dividend Payment
If = Rate of Inflation
Inflation Return = [ (1 + TR) / (1 - If ) ] – 1

Valuation of Assets:
V = [ CF1 * (PVIF(k,1))] + [ CF1 * (PVIF(k,2))] + [ CF1 * (PVIF(k,3))]………
Valuation of Bond:
B = I * [(PVIFA(kd,n))] + M*[(PVIF(kd,n))]
Basic Stock Valuation:
Po =[D1/(1+Ks)^1] + [D2/(1+Ks)^2] + [D3/(1+Ks)^3] + …….
Common stock Value:
Po = D1 / Ks

Sir M.Faseeh Khan-MF(notes) Page 42 of 42 copyright @TM