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Finance

Lecture Notes

For

MBA/M.Com/MEF/BS/BB

S

Sir M.Faseeh Khan-MF(notes) Page 1 of 42 copyright @TM

Federal Urdu Art and Science University

e-mail: faseeh_u@yahoo.com

Overview

__________________________________________________________

___

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)

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

• 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

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)

• What should be the goal of a corporation?

• Maximize profit?

• Minimize costs?

• Maximize market share?

• Maximize the current value of the company’s stock?

• Does this mean we should do anything and everything to maximize owner

wealth?

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

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

• 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.

• 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

• 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 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

• 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

• Ratios are used both internally and externally

• 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

• 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

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.

$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.)

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

• 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?

• 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

• 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?

• 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)

• 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

• 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

• 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.

• 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.

• Using the formulas:

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?

• 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)

• 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)

Expected Return :

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 :

• 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:

= .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%

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

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.

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" :

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

E(RP) = .0824 or 8.24%

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.

0020736 or about + or - 2/10 of 1%. In other words, diversifying eliminated

almost all of the diversification risk or unexpected return.

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.

(market risk) (diversifiable risk)

Risk & Beta:

(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.

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 .

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.

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)

Part 5: Long-Term Investment Decisions

Bonds and Their Valuation

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

1,000

1,100

PVIFA 8%,4 = 3.3121

331.21

PVIF 8%,5 = .6806

748.66

$1,079.87

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.)

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?

“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

1,000

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:

Current Yield = One Year’s Interest/Current Price

= 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.

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

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.

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.

0 1 2 3 4 5

1,000

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.

0 1 2 3 4 5 6 7 8 9

10

100 100 100 100 100 100 100 100 100 100

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.)

N Interest Par

Bond Value = ∑ +

t=1 (1+k)t (1+k)N

= Interest (PVIFA) + Par (PVIF)

the Par

C. Perpetuities

(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.)

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?

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.

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.

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 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.

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.

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.

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.

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.

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

following:

∞

Dt

S0 = ∑

t =1 (1 + k s ) t

where,

t = index for period

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

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

perpetuity.

ii. Constant Growth Model: This model assumes that the dividend

payments are growing each year at a constant rate of “g”.

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.

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.

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.

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

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

_

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.

A business person usually sells on credit, stocks goods and keeps some

cash in the bank and the office.

Net working capital refers to the difference between current assets and

current liabilities.

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

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

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)

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

(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

◆

reduces the firm’s ability Policy A

to meet its financial

obligations. More risk! Policy B

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.

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

TIME

Temporary

Working Capital

The amount of current assets that varies

DOLLAR AMOUNT

TIME

Working Capital requirements are for a short period of time as Current

Assets are self-liquidating.

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

2. Inventory stocked in the Warehouse. Merchandise Inventory

3. Goods are sold on credit. Accounts Receivable

4. Cash is collected. Cash

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:

4. Cash is collected.

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

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.

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).

Short

term

ssets

e nt c u rrent a

n

Perma

Long-term

Fixed Assets

(LOW Risk; LOW Return approach)

Assets by long-term debt

Temporary current assets

Short

term

ts

re nt asse

ent cur

Perman

Long-term

Fixed Assets

(Conservative Approach)

◆ Less worry in refinancing short-term obligations

◆ Less uncertainty regarding future interest costs

◆ 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.

(HIGH Risk; HIGH Return approach)

Temporary current assets

Short

term

ssets

ent cu rrent a

n

Perma

Long-term

Fixed Assets

(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.

Financing strategies

AGGRESSIVE PLAN

(SHORT TERM FINANCING/LOW LIQUIDITY)

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)

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).

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)

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

“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

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)

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

(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%

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.

HPR(holding period return):

Ending value of Investment / Beg. Value of Investment

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:

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

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