CB3410 Lecture Notes W Sol - B4midterm

Course Outline
Topic Reference
1 Introduction to Financial Management Chapter 1
2 Financial Statements Analysis Chapter 2, 3, 4
3 The Time Value of Money Chapter 5
4 Discounted Cash Flow Valuation Chapter 6
5 Investment Decisions Chapter 9
6 Bond and Stock Valuation Chapter 7, 8
7 Capital Budgeting Chapter 10, 11
8 Market Efficiency Chapter 12
9 Risk and Return Chapter 13
10 Cost of Capital Chapter 14
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1 Topic 1 Introduction to Financial Management .............................................................. 9
1.1 Introduction ................................................................................................................. 9
1.1.1 Why Study Financial Management ...................................................................... 9
1.1.2 The Objective of Financial Management ............................................................. 9
1.1.3 The Financial Decisions ....................................................................................... 9
1.2 The Corporate Firm ................................................................................................... 10
1.2.1 Sole Proprietorship............................................................................................. 10
1.2.2 Partnership ......................................................................................................... 11
1.2.3 Corporation ........................................................................................................ 11
1.2.4 A Comparison .................................................................................................... 12
1.3 The Agency Problem and Control of the Corporation .............................................. 12
1.3.1 Principal-Agency Relationship .......................................................................... 13
1.3.2 Evidence from the Oil Industry.......................................................................... 15
2 Topic 2 Financial Statements Analysis ......................................................................... 16
2.1 The Balance Sheet ..................................................................................................... 16
2.1.1 Assets ................................................................................................................. 17
2.1.2 Liabilities ........................................................................................................... 17
2.1.3 Equity ................................................................................................................. 18
2.1.4 The Accounting Identity .................................................................................... 18
2.1.5 Managerial Issues............................................................................................... 18
2.2 The Income Statement ............................................................................................... 19
2.2.1 Revenues ............................................................................................................ 19
2.2.2 Expenses ............................................................................................................ 20
2.2.3 Depreciation ....................................................................................................... 20
2.2.4 Taxes .................................................................................................................. 20
2.3 Cash Flow .................................................................................................................. 22
2.3.1 The Importance of Cash Flow............................................................................ 22
2.3.2 The Cash Flow Identity...................................................................................... 22
2.4 Financial Ratio Analysis ........................................................................................... 25
2.4.1 Liquidity Ratios ................................................................................................. 27
2.4.2 Solvency Ratios ................................................................................................. 27
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2.4.3 Asset Management Ratios.................................................................................. 28
2.4.4 Profitability Ratios ............................................................................................. 30
2.4.5 Market Value Ratios .......................................................................................... 30
2.4.6 Linking Ratios.................................................................................................... 32
2.4.7 Managerial Implications .................................................................................... 32
2.5 Growth Analysis ........................................................................................................ 33
2.5.1 Sustainable Growth ............................................................................................ 33
2.5.2 Du Pont Decomposition ..................................................................................... 34
2.5.3 Capital Structure and Sustainable Growth ......................................................... 35
2.5.4 A Note on Sustainable Growth Rate .................................................................. 35
3 Topic 3 The Time Value of Money .............................................................................. 37
3.1 A Motivating Example .............................................................................................. 37
3.1.1 Basis for Comparison ......................................................................................... 40
3.2 Future Value and Compounding ............................................................................... 40
3.2.1 Effects of Compounding .................................................................................... 40
3.2.2 Calculate Future Values with BAII Plus ............................................................ 43
3.3 Present Value and Discounting ................................................................................. 43
3.3.1 Effects of Discounting ....................................................................................... 44
3.3.2 Calculate Present Values with BAII Plus .......................................................... 45
3.4 The Discount Rate ..................................................................................................... 46
3.5 The Number of Periods ............................................................................................. 48
3.6 Spreadsheet Application ............................................................................................ 49
4 Topic 4 Discounted Cash Flow Valuation .................................................................... 50
4.1 Multiple Cash Flows ................................................................................................. 50
4.1.1 Future Value of a Series of Cash Flows............................................................. 50
4.1.2 Present Value of a Series of Cash Flows ........................................................... 51
4.2 Annuity ...................................................................................................................... 52
4.2.1 Present Value of an Annuity .............................................................................. 52
4.2.2 Future Value of an Annuity ............................................................................... 56
4.3 Annuity Due .............................................................................................................. 57
4.4 Perpetuity .................................................................................................................. 58
4.5 Comparing Rates ....................................................................................................... 58
4.5.1 Effective Annual Rate (EAR) ............................................................................ 59
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4.5.2 Annual Percentage Rate (APR) ......................................................................... 60
5 Topic 5 Investment Decisions ....................................................................................... 62
5.1 Capital Investment Projects ....................................................................................... 62
5.2 Net Present Value ...................................................................................................... 63
5.2.1 Why Positive NPV? ........................................................................................... 64
5.2.2 More than Two Alternatives .............................................................................. 65
5.2.3 Investment Projects with Different Lives .......................................................... 66
5.3 The Internal Rate of Return (IRR) ............................................................................ 67
5.3.1 Nonconventional Cash Flows ............................................................................ 69
5.3.2 Mutually Exclusive Investments ........................................................................ 70
5.4 The Payback Rule...................................................................................................... 72
5.5 The Average Accounting Return............................................................................... 74
5.6 Profitability Index ..................................................................................................... 75
5.7 Comprehensive Problems.......................................................................................... 76
6 Topic 6 Bond and Stock Valuation ............................................................................... 79
6.1 What is a Bond? ........................................................................................................ 79
6.2 How to Value Bonds? ............................................................................................... 79
6.2.1 Pure Discount Bonds.......................................................................................... 79
6.2.2 Coupon Bonds.................................................................................................... 80
6.2.3 Consol ................................................................................................................ 83
6.3 Yield to Maturity ....................................................................................................... 83
6.4 What is a Common Stock? ........................................................................................ 84
6.5 How to Value Stocks? ............................................................................................... 84
6.6 Modeling Dividends .................................................................................................. 85
6.6.1 Zero Growth ....................................................................................................... 86
6.6.2 Constant Growth ................................................................................................ 86
6.6.3 Nonconstant Growth .......................................................................................... 89
6.7 Total Return............................................................................................................... 89
6.8 Stock Price and Growth Opportunities...................................................................... 90
6.8.1 Concluding Remarks .......................................................................................... 94
7 Topic 7 Capital Budgeting ............................................................................................ 95
7.1 Identify the Project Cash Flows ................................................................................ 95
7.1.1 Relevant Cash Flows.......................................................................................... 96
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7.2 Compute the Project Cash Flows .............................................................................. 97
7.2.1 Operating Cash Flow ......................................................................................... 97
7.2.2 Depreciation ....................................................................................................... 99
7.2.3 After Tax Salvage ............................................................................................ 100
7.2.4 Changes in Net Working Capital ..................................................................... 102
7.3 A Comprehensive Example ..................................................................................... 103
7.4 Evaluating NPV Estimates ...................................................................................... 105
7.4.1 Scenario Analysis............................................................................................. 105
7.4.2 Sensitivity Analysis ......................................................................................... 107
7.5 Case Study Danforth & Donnalley Laundry Products Company ........................ 109
8 Topic 8 Market Efficiency .......................................................................................... 114
8.1 Differences between Investment and Financing Decisions..................................... 114
8.2 Efficient Capital Markets ........................................................................................ 115
8.2.1 Implications of the Efficient Market Hypothesis ............................................. 116
8.2.2 Three Forms of Market Efficiency .................................................................. 117
8.2.3 Weak Form Efficiency ..................................................................................... 117
8.2.4 Semi-strong Form Efficiency ........................................................................... 118
8.2.5 Strong Form Efficiency.................................................................................... 118
8.2.6 Concluding Remarks ........................................................................................ 118
9 Topic 9 Risks and Returns .......................................................................................... 119
9.1 Risk, Return and Investment Decision .................................................................... 119
9.2 Returns .................................................................................................................... 119
9.2.1 Dollar Returns .................................................................................................. 119
9.2.2 Percentage Returns........................................................................................... 120
9.2.3 The Historical Record ...................................................................................... 121
9.2.4 Arithmetic and Geometric Returns .................................................................. 122
9.3 Risks ........................................................................................................................ 123
9.3.1 Risk Premiums ................................................................................................. 123
9.3.2 Variance and Standard Deviation .................................................................... 123
9.4 Expectation .............................................................................................................. 124
9.4.1 Expected Returns ............................................................................................. 125
9.4.2 Expected Variance and Standard Deviation .................................................... 125
9.5 Portfolio Risks and Returns .................................................................................... 126
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9.5.1 Portfolio Expected Returns .............................................................................. 126
9.5.2 Systematic and Unsystematic Risks................................................................. 127
9.5.3 Diversification.................................................................................................. 127
9.5.4 Decomposition of Total Risk ........................................................................... 128
9.5.5 Measuring Systematic Risk.............................................................................. 129
9.5.6 Beta and the Risk Premium.............................................................................. 129
9.6 The Capital Asset Pricing Model (CAPM) ............................................................. 131
10 Topic 10 Cost of Capital ............................................................................................. 133
10.1 The Cost of Capital: Some Preliminaries ............................................................ 133
10.2 Cost of Equity ...................................................................................................... 134
10.2.1 The Dividend Growth Model Approach .......................................................... 134
10.2.2 The CAPM Approach ...................................................................................... 135
10.3 Cost of Debt ......................................................................................................... 136
10.4 Cost of Preferred Stock........................................................................................ 137
10.5 Weighted Average Cost of Capital ...................................................................... 138
10.6 A Comprehensive Example ................................................................................. 139
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The course begins with the assumption that you are the Chief Financial Officer (CFO) of City
Corporation. As a senior executive, every day, the major role of your job is going to make
corporate financial decisions. Every decision that you made has financial implications. If
your choice is right, then the implementation of business activities will subsequently create
value.
To prepare you to become a competent CFO, an understanding of why and how financial
decisions are made is essential. The focus of this course is to teach you how to make optimal
corporate financial decisions.
Before learning how to make optimal decisions, we better first think about What is the
objective of financial management?
In theory, the objective of financial management is to maximize firm value. Since you are
hat
increase the value of the stock. Any decision that increases the stock price is considered to be
In general, your role as a CFO will center on helping City Corporation find money to run and
develop its business, manage its assets, acquire other firms, and plan for their financial future.
More precisely, you will involve in deciding four major financial decisions:
1. Investment Decisions
How much should City Corporation invest?
Which project should City Corporation invest?
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2. Working Capital Decisions
What should be the level of investment in current assets?
How should City Corporation mange its short-term assets and liabilities?
3. Financing Decisions
How to finance the investment?
What is the optimal debt/equity ratio?
4. Distribution Decisions
How much dividend should be paid to shareholders?
At the startup, one problem of City Corporation is how to raise capital. Organizing the firm
as a corporation is the standard method for solving the problems encountered in raising large
amounts of cash. However, the firm can organize itself in other forms.
compare their advantages and

disadvantages under each form.
A sole proprietorship is a business owned by a single individual.
The advantage:
It is the simplest type of business to start.
It is the least regulated form of organization.
The owner of a sole proprietorship keeps all the profits.
The disadvantage:
The owner has unlimited liability for business debts.
Ownership of a sole proprietorship may be difficult to transfer.
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Partnership is a business formed by two or more individuals or entities.
In a general partnership,
All the partners share in gains or losses, and all have unlimited liability for all
partnership debts.
The partners share gains and losses as described in the partnership agreement.
In a limited partnership,
One or more general partners will run the business and have unlimited liability.
There will be one or more limited partners who do not actively participate in the
business.
partnership.
The advantage:
It is based on relatively informal agreement and is easy and inexpensive to form.
The disadvantage:
The partnership terminates when a general partner wishes to sell out or dies.
Ownership by a general partner is not easily transferred since a new partnership must
be formed.
Although a limited partner can sell his interest without dissolving the partnership,
finding a partner may be difficult.
Corporation is a business created as a distinct legal entity owned by one or more individuals
or entities. s
many of the rights, duties, and privileges of an actual person.
Corporations can borrow money and own property, can sue and be sued, and can enter into
contracts.
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The advantage:
Stockholders in a corporation have limited liability.
The separation of ownership and management makes transferring of ownership a lot
easier.
Easier to raise capital.
The disadvantage:
There is agency problem as a result of the separation of ownership and management.
Double taxation.
characteristics between partnership and corporation.
Partnership Corporation
Liquidity Subject to substantial Shares can be easily
restrictions exchanged
Voting Rights General partner is in charge Usually each share gets one
Limited partners may have vote
some voting rights
Taxation Partners pay taxes on Double taxation
distributions
Reinvestment and All net cash flow is Broad latitude
Dividend Payout distributed to partners
Liability General partners have Limited liability
unlimited liability
Limited partners enjoy
limited liability
Continuity Limited life Perpetual life
The separation of ownership and management can facilitate shares exchange. Usually in a
large corporation, the ownership is dispersed. This means that a corporation has large
number of shareholders who only own small number of shares.
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Those small shareholders do not have effective control over the corporation. The
shareholders (the principal) will hire managers (the agent) to represent their interest.
However, we are not sure whether the managers will act in the best interests for them.
The possibility of conflict of interest between owners and management of a corporation is

called an agency problem.
Here are some possibilities of conflict of interest between owners and managers in daily life:
1. Career Concern
Managers may reluctant to take risky investments because there is a possibility
that things will turn out badly and the management jobs will be lost.
2. Empire Building
Managers would tend to maximize the amount of resources over which they have
control.
They have intention to over expand. For example, acquire and overpay irrelevant
businesses just to demonstrate corporate power.
3. Private Benefits of Control

Managers may take advantage of inside information for personal trading.
They may overuse corporate resources, such as frequent business travel with first
class ticket.
4. Shirking
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Example 1.1
Suppose City Corporation is going to hire a salesman, and you decide to offer him an annual
wage of w. Your objective is to hire a hardworking salesman with a minimum wage. If the
salesman works hard, he can bring $270,000 revenue to the firm; otherwise, he can only bring
$70,000 revenue if he does not work hard.
The salesman utility can be described as U w, e w e . His reservation level of utility is

81,000. Once e = 25,000 e = 0)
effort.
What is the minimum wage that you have to offer to this salesman for accepting the job?
That is, w 81, 000 .
Will the salesman act in the best interests (by working hard) of City Corporation?
No.
City Corporation can only get $70,000 but paying $81,000 wage.
How should you decide the wage if you want to hire a hardworking salesman?
His utility from working hard should exceed his reservation utility.
That is,
U w, e 81,000
w 25, 000 81, 000
w 106, 000
The first-best contract should offer the salesman $106,000
work hard.
From this example, the salesman (agent) takes an action that affects his utility as well as the
corporation (principal). The insight of this example is to show you the agent does not
necessarily choose the action in the interest of the principal.
aligned with those of shareholders.
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The radical changes in the oil market since 1973 generated large increases in free cash flow in
the industry.
Price increases generated large cash flows in the industry. For example, the 1984 cash flows
of the ten largest oil companies were US$48.5 billion, 28% of the total cash flows of the top
The management did not pay out the excess resources to shareholders. Instead, the industry
continued to spend heavily on exploration and development (E&D) activity even though
average returns were below the cost of capital. Two studies indicate that oil industry E&D
John McConnell and Chris Muscarella (1986) find that announcements of increases
in E&D expenditures by oil companies in the period 1975 1981 were associated
with systematic decreases
did not earn
even a 10% return on its pretax outlays in the period 1982 1984.
Oil industry managers also launched diversification programs to invest funds outside the
industry. For example:
Retailing: Marcor by Mobil.
Manufacturing: Reliance Electric by Exxon.
Office equipment: Vydec by Exxon.
Mining: Kennecott by Sohio; Anaconda Minerals by Arco; Cyprus Mines by Amoco.
These acquisitions turned out to be among the least successful, partly because of bad luck and
partly because of a lack of managerial expertise outside the oil industry.
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The focus of this topic is not on preparing financial statements. As a CFO, what you need is
to understand the information inside the financial statements, and recognize the importance of
cash flow.
To start with, financial statements are the key source of information for financial decisions.
The two important financial statements that we often use are:
1. The Balance Sheet
2. The Income Statement

over a period of time.
The balance sheet is a snapshot of the firm. It summarizes what a firm owns (the assets) and
what a firm owes (the liabilities), and the difference between the two (the equity).
A simplified balance sheet:
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Below is a balance sheet for U.S. Corporation.
An asset is a resource controlled by the corporation as a result of past events and from which
future economic benefits are expected to flow to the corporation.
Assets can be classified into current and fixed.

Current asset has a life of less than a year, for example, inventory.
Fixed asset has a relatively long life, for example, land and building.
A liability is an obligation owed by the corporation to repay the claims in the future.
Liabilities can also be classified into current and long-term.

Current liability reflects the amount of money the firm owes and must pay within the
coming year, for example, accounts payable.
Long-term liability is debt due after one year from the date of the balance sheet.
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is the residual value remained to the shareholders after repaying all debts by selling its assets.
Equity can be separated into capital stock and retained earnings.
Retained earnings represent the accumulated total of after-tax earnings and losses
from operations over the life of the firm that has been retained in the corporation.
The most basic accounting identity is that the balance sheet must balance. That is,
Assets = Liabilities + Equity
Although this balance sheet identity is trivial, understanding the implication behind this
identity is important. You need to know how the changes in asset value in City Corporation
would have impact on your debtholders and equityholders. For example, during the financial
crisis, the asset value of the firm dropped much. The fall in the asset value must be
compensated by the drop in either the value of debt or equity, or both.
1. Net Working Capital
current liabilities.
The level of working capital naturally expands and contracts with sales activities.
Too little working capital can put a firm in a bad position since the firm may be
unable to pay its bills or to take advantage of profitable opportunities.
Too much working capital reduces profitability since that capital has a carrying
cost.
2. Inventory
Having too many inventories can fill customer orders without delay and provides
a buffer against potential production stoppages.
The flip side of plentiful inventory is the risk of deterioration in the market value
of inventory itself.
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3. Financial Leverage
Financial leverage refers to the use of debt in acquiring an asset. The more debt a
firm has, the greater is its degree of financial leverage.
Financial leverage creates an opportunity for a firm to gain a higher return on the
capital invested.
The income statement indicates the results of operations over a specified period. Unlike the
balance sheet, which is a snapshot of the firm
statement indicates cumulative business results within a defined time frame.
The simple income statement equation is:
Revenues Expenses = Income
An income statement for U.S. Corporation is shown below:
According to the recognition principle,

revenue is recognized when the earnings process is virtually complete and the value of an
exchange of goods or services is known or can be reliably determined.
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Expenses shown on the income statement are based on the matching principle. The basic
idea is to first determine revenues and then match those revenues with the costs associated
with producing them.
As a result of the way revenues and expenses are reported, the figures reported in the
statements may not be at all representative of the actual cash inflows and outflows that
occurred during a particular period.
Depreciation is counted on the income statement as an expense, even though it involves no

cash outflows. Depreciation is a way of estimating the consumption of an asset over time.
For example, if a computer loses about a third of its value each year, the firm would not
expense the full value of the computer in the first year of its purchase, but deduct one-third
each year as an expense.
The depreciation deduction is simply an application of the matching principle in accounting.
In making financial decisions, it is important to distinguish between average and marginal

tax rates.
Average tax rate is the total taxes paid divided by total taxable income.
Marginal tax rate is the amount of tax payable on the next dollar earned.
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Example 2.1
The corporate tax rates in effect for 2007 are shown below.
Taxable Income Tax Rate

0 - 50,000 15%
50,001 - 75,000 25%
75,001 - 100,000 34%
100,001 - 335,000 39%
335,001 - 10,000,000 34%
10,000,001 - 15,000,000 35%
15,000,001 - 18,333,333 38%
18,333,334 + 35%
Suppose City Corporation earns $4 million in taxable income.
0.15 50, 000 0.25 75, 000 50, 000 0.34 100, 000 75, 000
0.39 335, 000 100, 000 0.34 4, 000, 000 335, 000
1, 360, 000
What is the average tax rate?

1,360, 000
34%
4, 000, 000
What is the marginal tax rate?

34%
income by $1
million, what tax rate should you use in your analysis?
We should use the marginal rate with an expected additional $340,000 in taxes.
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Cash flow is simply the difference between the number of dollars that came in and the
number that went out.
Remember that the objective of financial management is to maximize firm value. As a CFO,
your job is to create value
activities, but how?
The answer is that you must create more cash flow than it uses. For example:
Try to buy assets that generate more cash than they cost.
Sell bonds and stocks that raise more cash than they cost.
In order to understand how to create more cash flow, let us step back and study the cash flow
identity.
Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Shareholders
This identity says that a firm generates cash through its various activities, and that cash is
either used to pay creditors or to distribute back to shareholders.
Here, we can break down the identity in details.
1. Cash Flow from Assets

= Operating Cash Flow Net Capital Spending Change in Net Working Capital
2. Cash Flow to Creditors

= Interest Paid Net New Borrowing
3. Cash Flow to Shareholders

= Dividend Paid Net New Equity Raised
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Example 2.2
Using the financial statements of U.S. Corporation, calculate the cash flow from assets, cash
flow to creditors, and cash flow to shareholders in 2008.
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1. Calculate Cash Flow from Assets
a. Operating Cash Flow
= EBIT + Depreciation Tax
= 694 + 65 212
= 547
b. Net Capital Spending

= Ending Net Fixed Assets Beginning Net Fixed Assets + Depreciation
= 1,709 1,644 + 65
= 130
c. Change in Net Working Capital

= Ending NWC Beginning NWC
= (CA CL)2008 (CA CL)2007
= (1,403 389) (1,112 428)
= 1,014 684
= 330
Thus, Cash Flow from Assets

= Operating Cash Flow Net Capital Spending Change in Net Working Capital
= 547 130 330
= 87
2. Calculate Cash Flow to Creditors

= Interest Paid Net New Borrowing
= 70 (454 408)
= 70 46
= 24
3. Calculate Cash Flow to Shareholders

= Dividend Paid Net New Equity Raised
= 103 (640 600)
= 63
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Next, we are going to analyze the financial statements in a meaningful manner.
Quantitatively, we can compute financial ratios to interpret the financial results.
Financial ratios can help us to examine the financial health of a corporation. The ratios fall
into five classes:
Liquidity
Solvency
Asset Management
Profitability
Market Value
Let us look at the financial statements of City Corporation and calculate some common
financial ratios.
City Corporation
2008 Income Statement
($ in thousands)
Sales 1,506
Less: Cost of goods sold 1,004
Gross profit 502
Depreciation 10
Lease rental costs 30
Other operating expenses 360
EBIT 102
Interest 5
Taxable income 97
Tax 47
Net income 50
Less: Dividends
- Preferred 1
- Common 29
Change in retained earnings 20
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City Corporation
Balance Sheet as of 31 December, 2007 2008
($ in thousands)
2008 2007
Current assets:
Cash 20 30
Accounts receivable 95 95
Inventory 130 110
Total current assets 245 235
Fixed assets:
Land 10 10
Building and equipment 120 100
Total fixed assets 130 110
Other assets:
Goodwill 10 10
TOTAL ASSETS 385 355
Current liabilities:
Accounts payable 50 40
Estimated income taxes payable 10 10
Total current liabilities 60 50
Fixed liabilities:
Mortgage bonds, 10% 50 50
TOTAL LIABILITIES 110 100
Convertible preferred stock, 5% 20 20

Common stock (10,000 shares) 50 50
Retained earnings 205 185
275 255
TOTAL LIABILITIES AND

385 355
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1. Current Ratio
Current Assets
Current Liabilities
245
The current ratio in 2008 4.1 times
60
The higher the ratio, the more protection the firm has against liquidity problems.
However, the ratio may be distorted by seasonal influences, slow-moving
inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.
2. Quick Ratio (Acid-Test Ratio)

Current Assets - Inventory
Current Liabilities
245 130
The quick ratio in 2008 1.9 times
60
-
immediately extinguish its current liabilities.
3. Cash Ratio
Cash
Current Liabilities
20
The cash ratio in 2008 0.3 times
60
Very short-term creditor might be interested in this ratio.
-term debt payment.
1. Total Debt Ratio

Total Liabilities
Total Assets
110
The total debt ratio in 2008 0.29
385
-
and long-term credit sources.
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Another variation of this ratio is to measure the relative mix of funds provided by the owners
and the creditors.
2. Debt-equity Ratio
Total Liabilities
Shareholders' Equity
110
The debt-equity ratio in 2008 0.4
275
3. Times Interest Earned Ratio

EBIT
Interest
102
Times interest earned in 2008 20.4 times
5
This ratio indicates the extent to which operating profits can decline without
-term debt.
4. Cash Coverage Ratio

EBIT Depreciation
Interest
102 10
Cash coverage in 2008 22.4 times
5
This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.
Asset management ratios measure how a firm manages its investment and fixed assets. The
focus of these ratios is on the efficiency of the uses of the assets. That is, how good a firm
utilizes its assets.
1. Inventory Turnover
Cost of Goods Sold
Inventory
1, 004
The inventory turnover in 2008 7.7 times
130
The inventory turnover ratio indicates how fast inventory items move through a
business.
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2.
365 days
Inventory Turnover
365
47 days
7.7
This ratio estimates the average length of time items spent in inventory.
3. Receivables Turnover
Sales
Accounts Receivable
1,506
The receivable turnover in 2008 15.9 times
95
Only credit sales should be used.
This ratio
the credit sales.
4. Average Collection Period

365 days
Receivables Turnover
365
The average collection period in 2008 23 days
15.9
5. Asset Turnover
Sales
Total Assets
1,506
The asset turnover in 2008 3.9 times
385
This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
High turnover rates suggest efficient asset management.
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We look at profits in two ways. First, as a percentage of net sales; second, as a return on the
funds invested in the business.
1. Profit Margin
Net Income
Sales
50
The profit margin in 2008 3.3%
1,506
It measures the total operating and financial ability of management.
2. Return on Assets (ROA)

Net Income
Total Assets
50
The ROA in 2008 13%
385
This ratio measures the return on total assets after recognition of taxes and
financing costs.
3. Return on Equity (ROE)

Net Income
Total Equity
50
The ROE in 2008 18%
275
financial leverage.
The market value ratios are based on information on the market price of the stocks. These
measures can be calculated directly for publicly traded companies.
1. Earnings Per Share (EPS)

Net Income
Shares Outstanding
50
The EPS in 2008 $5 per share
10
30
2. Price-Earnings Ratio (PE)
Price Per Share
Earnings Per Share
Assume the price for the stock of City Corporation is $40, the PE ratio
40
8 times
5
PE ratio measures how much investors are willing to pay per dollar of current
earnings.
Higher PEs are often taken to mean that the firm has significant prospects for
future growth.
3. Price-Sales Ratio
Price Per Share
Sales Per Share
Assume the price for the stock of City Corporation is $40, the price-sales ratio
40
0.27 times
150.6
Price-Sales ratio can be used when the firm reported negative earnings for the
period.
4. Market-to-Book Ratio (MB)

Market Value Per Share
Book Value Per Share
40
The MB ratio in 2008 1.45 times
27.5
Note that book value per share is total equity divided by the number of shares
outstanding.
A value less than 1 could mean that the firm has not been successful overall in
creating value for its shareholders.
31
financial ratios.
1. ROA
Profit Margin Asset Turnover = ROA
Net Income Sales Net Income
Sales Total Assets Total Assets
3.3% 3.9 13%
This formula indicates that the return on assets is closely related to the
profitability and turnover.
2. ROE (Du Pont Identity)

Profit Margin Asset Turnover Equity Multiplier = ROE
Net Income Sales Total Assets Net Income
Sales Total Assets Total Equity Total Equity
3.3% 3.9 1.4 18%
Du Pont identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.
So far, we have looked at the five major types of financial ratios. As a CFO, you would
interpret
A simple way to analyze the overall picture is to group the ratios into a matrix. For example:
Liquidity / Solvency Profitability Implications

Liquid / Solvent High Low Risk but High Return
Illiquid / Insolvent High High Risk and High Return
Liquid / Solvent Low Low Risk and Low Return
Illiquid / Insolvent Low High Risk but Low Return
32
Some caveats when you are using financial ratios:
Ratio analysis deals only with quantitative data. It does not look at qualitative factors
such as the quality of management.
Management can take short-run actions to influence the ratios.
Comparison of ratios between companies must be on a comparable accounting basis.
Differences in accounting practices in such areas as depreciation, income recognition
and intangible assets can make the comparisons misleading.
Accounting records are maintained in historical dollars. In periods of inflation the
ratios may be biased upwards.
Ratios must be evaluated in a correct business context.
Past data does not necessarily reflect current situation or future expectations.
The past and the expected growth

major focus of the analysis. We are interested because there is a close relationship between
the growth rate and the equity value.
Sustainable growth rate is the most realisti

assuming that the corporation does not alter its capital structure. A common method of
estimation is:
Sustainable Growth = Return on Equity Retention Rate
g = ROE b
The retention rate (b) is the percentage of earnings retained by the firm not paid out in the
form of dividends.
33
Example 2.3
City Corporation had earnings of $10 million during the year just ended; a net worth of $100
million at the beginning of that year; and a permanent dividend payout policy of 50%.
Thus, City Corporation earned 10% on its beginning net worth, retained $5 million of
earnings. And the ending net worth will be $105 million.
If the 10% return on beginning equity is repeated during the next year, then the firm s earning
will grow to $10.5 million.
This 5% earnings growth rate will be repeated annually as long as City Corporation continued
to earn 10% on each year s beginning net worth and pay out 50% of its earnings in dividends.
This growth rate is assumed to be sustainable because the firm is growing from internally
generated funds. We can associate the sustainable growth with fundamental factors using Du
Pont decomposition.
Recall that:
Net Income
ROE
Total Equity
Net Income Sales Total Assets
Sales Total Assets Total Equity
EPS DPS
Retention Rate
EPS
DPS
=1
EPS
=1 Dividend Payout Ratio
Putting the two equations together and remembering that capital structure is held constant,
we can see the sustainable growth is affected by profitability, asset utilization, and earnings
retention.
g ROE b
Net Income Sales Total Assets DPS
1
Sales Total Assets Total Equity EPS
34
We can link the sustainable growth to fundamental factors.
Fundamental Factors Relationship with Sustainable Growth

Profitability Positive
Asset Utilization Positive
Financial Leverage Held Constant
Dividend Payout Negative
When we define sustainable growth, we assume the corporation does not alter its capital
structure. A firm s capital structure is its mix of debt and equity that is used to finance its
long-term investment.
The intuition is that even a corporation could grow by simply increasing its borrowing, but
this practice is eventually not sustainable because there is a point at which the corporation
may not be able to handle the debt burden.
Therefore, sustainable growth is determined assuming that the firm s capital structure
remains the same. In other words, if the firm generates and retains earnings hence
increasing its equity, it is assumed that the firm would also borrow so that the firm s capital
structure is constant. This is consistent to the idea that a corporation usually maintains a
relatively constant target capital structure.
Recall that ROE is calculated as net income divided by total equity. If the total equity is
beginning of the period, then:
g = ROE b
ending balance sheet, then the formula changes

slightly:
ROE b
g
1 ROE b
35
To reconcile the two formulae, denote:
TEb Total Equity taken from the "beginning" of the period

TEe Total Equity taken from the "ending" of the period
ROEe b
g
1 ROEe b
NI
b
TEe
NI
1 b
TEe
NI
b
TEe TEe
NI
1 b TEe
TEe
NI b
TEe NI b
NI b
TEb
NI
b
TEb
ROEb b
36
As a CFO of City Corporation, you have to oversee many investment decisions from time to
time. You invest the money now in hopes of yielding future returns.
However, making such decisions is difficult for a number of reasons. Perhaps the most
significant one is to predict future returns. Even if the future returns could be forecasted with
certainty, choosing among alternative investments is not without its difficulties. The problem
is that the timing of the returns associated with each alternative investment may be different.
In this topic, we are going to deal with this problem by introducing the concept of the time
value of money, understanding the relationship between future value and present value.
City Corporation has two simple investment projects. The projects have three things in
common. Each requires an initial outlay of $50,000, has returns lasting just three years into
the future, and these returns are certain to occur.
Investment 1 returns $20,000 per year at the end of the next three years. And Investment 2
pays $40,000 a year from now, and $9,000 per year at the end of the second and third years.
We can show these future patterns of returns and initial investment graphically.
So which one of these investments do you prefer? When you sum up the cash flows,
Investment 1 pays back $60,000.
Investment 2 pays back only $58,000.
Can you simply conclude you prefer Investment 1 because it pays you $2,000 more than
Investment 2?
You notice that Investment 2 pays $20,000 more in the first year. You may suggest to City
Corporation that you could do something with that extra $20,000. At least you could get -
say 5% - from a deposit account. If you are smart, you can do even better.
37
You think the time that you get the money is important as well as how much you get.
Suppose you know where to invest your extra funds and you are smart enough to earn 10%
interest. compare the two investments when the interest rate is 10%.
38
Investment 1
Year 1 Year 2 Year 3
Beginning balance 0 20,000 42,000
Earnings on the balance at 10% 0 2,000 4,200
Inflow at the end of year 20,000 20,000 20,000
Ending balance 20,000 42,000 66,200
Investment 2
Ending balance 40,000 53,000 67,300
The results indicate that Investment 2 leaves you better off if you can earn 10% interest.
What happens if you can only earn 5% interest?
Investment 1
Ending balance 20,000 41,000 63,050
Investment 2
Ending balance 40,000 51,000 62,550
In this case, Investment 1 looks better.
This example shows that not only the amount of cash flows is important, but also the timing
of receipt. The more you can earn on the receipts, the better if you can get them earlier.
39
time unit
can only compare money in the same time units. For instance, it does not make sense to
compare $20,000 received today with $20,000 received next year.
In order to have a fair comparison, we have to ensure the two monetary values have the same
time units.
One way to obtain the same time units is to get the future value. Future value refers to the
amount of money an investment will grow to over some period of time at some given interest
rate. By compounding, we can move the time units forward.
Example 3.1
Instead of investing the $50,000 in the project, you decide to deposit the $50,000 in a bank
for three years at 10%. We assume the interest rate does not change. How much you can get
after three years?
Beginning Ending
Year Interest Formula
Balance Balance
1
1 50,000 5,000 55,000 50, 000 1.1
2
2 55,000 5,500 60,500 50, 000 1.1
3
3 60,500 6,050 66,550 50, 000 1.1
In general, the formula for future value when interest is compounded annually is:
t
Vt V0 1 r
In the motivating example, we understand that if we can earn a higher interest rate, it will be
better to have earlier cash flows. The secret behind this effect comes from the power of
interest on interest. That is, there will be interest earned on the reinvestment of previous
interest payment.
40
Example 3.2
Given the interest rate is 10%, what would your $100 be worth after five years?
t
Vt V0 1 r
5
100 1.1
161.05
Without compounding, you can only earn a simple interest, that is, interest is only earned on
the principal. The simple interest is 100 10% 10 per year . Over the five year span of
investment, you accumulate $50 simple interest.
The difference $11.05 is the interest on interest from compounding.
Future values depend critically on the assumed interest rate, particularly for long-lived
investments.
41
We can study how $1 of investment grows at different rates and lengths of time.
Notice that the future value of $1 after 10 years is about $6.20 at a 20% return, but it is only
about $2.60 at 10%. Doubling the interest rate more than doubles the future value.
42
We use Example 3.2 as an illustration. Given the interest rate is 10%, what would your $100
be worth after five years?
1. Clear the Registers

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

-100 PV
10 I/Y
5N
3. Compute and Return the Outputs

CPT FV
The screen should show you FV = 161.0510
Another way to obtain the same time units is to get the present value. Present value is the
current value of future cash flows discounted at the appropriate discount rate. By discounting,
we can move the time units backward.
Example 3.3
Suppose you need $66,550 in three years, and you can earn 10% on your money. How much
do you have to invest today in order to reach your goal?
t
Vt V0 1 r
3
66,550 V0 1.1
V0 50, 000
In general, the formula for present value is:
Vt
V0 t
1 r
43
The two simple examples serve to illustrate discounting and compounding are the inverse of
one another.
Future Value of $50,000 in three years at 10%:
Present Year 1 Year 2 Year 3

Cash Flow 50,000
66,550
Present Value of $66,550 in three years at 10%:
Present Year 1 Year 2 Year 3

Cash Flow 66,550
50,000
There are two important relationships between present value, interest rate and time:
For a given interest rate, the longer the time period, the lower the present value.
For a given time period, the higher the interest rate, the smaller the present value.
We can plot out the present value of $1 for different periods and rates.
44
Redo Example 3.3. Figure out the present value.

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

66,550 FV
10 I/Y
3N

CPT PV
You should get PV = -50,000.0000
Example 3.4
Instead of comparing the future value for the two investments in our motivating example,
s figure out the present value of each investment under a 10% discount rate.
Present Value of Investment 1 at 10%:
Present Value Year 0 Year 1 Year 2 Year 3

-50,000.00 -50,000 +20,000 +20,000 +20,000
20, 000
18,181.82
1.1
20, 000
16,528.93
1.12
20, 000
15,026.30
1.13
-262.96
45
Present Value of Investment 2 at 10%:
Present Value Year 0 Year 1 Year 2 Year 3

-50,000.00 -50,000 +40,000 +9,000 +9,000
40, 000
36,363.64
1.1
9, 000
7,438.02
1.12
9, 000
6,761.83
1.13
563.49
Once again, we confirm Investment 2 is better.
We always need to determine what discount rate is implicit in an investment. Recall that the
present value is found by discounting the future cash flow:
FVt
PV t
1 r
Rearrange the equation, the discount rate is:
1
FVt t
r 1
PV
Example 3.5
You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
1
FVt t
r 1
PV
1
1, 200 5
1
1, 000
3.71%
46
Using financial calculator,

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

1,200 FV
- 1,000 PV
5N

CPT I/Y
We can verify I/Y = 3.7137%
Example 3.6
Suppose you are offered an investment that will allow you to double your money in 6 years.
You have $10,000 to invest. What is the implied rate of interest?
1
FVt t
r 1
PV
1
20, 000 6
1
10, 000
12.25%
In this example, of r. For reasonable

rates of return, the time it takes to double your money is given approximately by 72 / r.
72
6
r
r 12%
47
Example 3.7
You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10%
per year and you currently have $15,000, how long will it be before you have enough money
to pay cash for the car?
We start with the present value formula.
FVt
PV t
1 r
Rearrange the formula and solve for t,
ln FVt ln PV
t
ln 1 r
In this example,
ln FVt ln PV
t
ln 1 r
ln 20, 000 ln15, 000
ln1.1
3.02

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

20,000 FV
- 15,000 PV
10 I/Y

CPT N
We can verify N = 3.0184
48
We can also use Excel to solve for the problems of time value of money. So far, we have
learnt to solve for any one of the following four potential unknowns:
Future value
Present value
Discount rate
Number of periods
In Excel, there is a separate formula to solve for each of the unknown.
To Solve for Excel Formula

Future Value = FV(rate, nper, pmt, pv)
Present Value = PV(rate, nper, pmt, fv)
Discount Rate = RATE(nper, pmt, pv, fv)
Number of Periods = NPER(rate, pmt, pv, fv)
Some tricks when you are using Excel spreadsheet:

The rate should be entered as a decimal, instead of a percentage.
Put a negative sign on the present value.
49
In Topic 3, most of the examples only focus on single cash flows. In reality, most
investments have multiple cash flows. For example, if City Corporation is planning to open a
convenient store, there will be a large cash outlay in the beginning and then cash inflows for
many years.
Building on the concept of time value of money, we offer you more tools to value cash flows.
In particular, we will look at some special cash flows annuity and perpetuity. We will also
compare various interest rates in depth.
Example 4.1
You estimate that an investment project will receive net cash inflows at the end of each of the
first five years. They are $10,000, $20,000, $30,000, $45,000, and $60,000. What is the
future value of these cash flows at the end of year 5, if the interest rate is 20% per annum?
n
n t
FV Ct 1 r
t 1
4 3 2
10, 000 1.2 20, 000 1.2 30, 000 1.2 45, 000 1.2 60, 000
212, 496
50
Example 4.2
What is the present value of three cash flows $100, $200 and $600, to be received at the end
of year 1, 3 and 6, respectively, if the discount rate is 10% per annum?
n
Ct
PV t
t 1 1 r
100 200 600
3 6
1.1 1.1 1.1
579.85
If you use financial calculator, first, notice the cash flow pattern.
Year Cash Flow

0 0
1 100
2 0
3 200
4 0
5 0
6 600
Noted that the F displayed in the calculator means the number of times a given cash flow
occurs in consecutive years. For example, at year 4, there are 2 consecutive years of having
zero cash flow.

2nd {CLR TVM}
2nd {CLR Work}
51
2. Input
CF
(CF0=) 0 ENTER
(C01=) 100 ENTER
(F01=) 1 ENTER
(C02=) 0 ENTER
(F02=) 1 ENTER
(C03=) 200 ENTER
(F03=) 1 ENTER
(C04=) 0 ENTER
(F04=) 2 ENTER
(C05=) 600 ENTER
(F05=) 1 ENTER
NPV
(I=) 10 ENTER
CPT
You can verify the answer is 579.85.
Annuity formula is useful in discounted cash flow valuation. Annuity means the value of
cash flows is the same for a number of years.
To use the ordinary annuity formula, the following conditions should be satisfied:
The value of the cash flows in each period is the same.
The period or the interval for the cash flows remains unchanged.
The receipt / payment of the cash flows should occur at the end of each regular period.
1 1
Present Value of an Annuity C 1 t
r 1 r
52
Example 4.3
A project is
cash inflows is estimated to be $2,000 for each year and this is to be received at the end of
each year. The appropriate discount rate is 15% per annum. What is the present value of this
Using our old discounting approach,

n
Ct
PV t
t 1 1 r
2, 000 2, 000 2, 000 2, 000 2, 000

2 3 4 5
1.15 1.15 1.15 1.15 1.15
6, 704.31
Using the annuity formula,

1 1
PV C 1 t
r 1 r
1 1
2, 000 1 5
0.15 1.15
6, 704.31
To find annuity present value with financial calculators, we need to use the PMT key.

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

2,000 PMT
5N
15 I/Y

CPT PV
You will also get PV = - 6,704.31.
53
Example 4.4
follows. For the first nine years the project does not generate any cash inflow. For the next
eleven years, that is, from the tenth to the twentieth years inclusive, it generates $60 per year.
The discount rate is 10% per annum. What is the present value of this project?
0 0 60 60
PV 9 10 20
1.1 1.1 1.1 1.1
165.27
There is another way to view this example. We know the annuity cash flows only start at
year 10. Therefore, we can first figure out the present value of this annuity at year 9 and then
discount the whole sum back to year 0.
1 1 1
PV 9
60 1 11
1.1 0.1 1.1
165.27
Example 4.5
You are 20 years old now and want to retire as a millionaire by the time you turn 70. How
much will you have to save at the end of each year if you can earn 5% compounded annually?
1 1
PV C 1 t
r 1 r
1, 000, 000 1 1
50
C 1 50
1.05 0.05 1.05
C 4, 776.74
54
Example 4.6
Suppose you want to borrow $20,000 for new car. You can borrow at 8% per year,
compounded monthly (8/12 = 0.67% per month). If you take a 4-year loan, what is your
monthly payment?
1 1
PV C 1 t
r 1 r
1 1
20, 000 C 1 48
0.0067 1.0067
C 488.63
Example 4.7
Suppose you borrow $10,000 from your friend. You agree to pay $207.58 per month for 60
months. What is the monthly interest rate?

2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs

- 207.58 PMT
60 N
10,000 PV

CPT I/Y
You will also get I/Y = 0.7499.
55
Without a financial calculator, then you have to go through the trial and error process.
Choose an interest rate and compute the PV of the payments based on this rate.
Compare the computed PV with the actual loan amount.
If the computed PV > loan amount, then the interest rate is too low.
If the computed PV < loan amount, then the interest rate is too high.
Adjust the rate and repeat the process until the computed PV and the loan amount are
equal.
We already know the formula of present value of annuity. To get the future value of an
t
annuity, we can simply multiply that present value by 1 r .
t
1 r 1
Future Value of an Annuity C
r
Example 4.8
Suppose you begin saving for your retirement by depositing $2,000 per year in MPF. If the
interest rate is 7.5%, how much will you have in 40 years?
t
1 r 1
FV C
r
40
1.075 1
2,000
0.075
454,513.04
56
Recall that one of the conditions for applying ordinary annuity is that the receipt / payment of
the cash flows should occur at the end of each regular period.
In many situations, however, the cash flows occur at the beginning of the period. For
example, when you lease an apartment, the first lease payment is usually due immediately.
An annuity due is an annuity for which the cash flows occur at the beginning of each period.
To calculate the annuity due value, we simply multiply the ordinary annuity by 1 r .
Annuity Due Ordinary Annuity 1 r
Example 4.9
Suppose an annuity due has five payments of $400 each, and the relevant discount rate is
10%. What is the present value of the cash flows?
Using the annuity due formula,
Annuity Due Ordinary Annuity 1 r
1 1
C 1 t
1 r
r 1 r
1 1
400 1 5
1.1
0.1 1.1
1, 667.95
We can verify the answer by finding the present value of each cash flow.
400 400 400 400

PV 400 2 3 4
1.1 1.1 1.1 1.1
1,667.95
57
Perpetuity is a special case of an annuity in which the number of equal cash flows is infinite.
The formula for the present value of a perpetuity is:
C
Present Value of a Perpetuity
r
Example 4.10
In the early 1900's the Canadian Government issued $100 par value 2% Consol bonds. The
holder of these bonds is entitled to receive a coupon (or interest) payment of $2 per year
forever. If the current appropriate discount rate is 5% p.a. and the next coupon is due one
year from now, how much is one of the Consols worth?
C
PV
r
2
0.05
40
Suppose a bank offers you two deals: (1) pays you 10% interest per year or (2) pays you 5%
interest compounded every six months. Which deal would you prefer?
If you invest $1, then after a year,
Option (1) will give you:

$1 1.1 $1.1
Option (2) will give you:

2
$1 1.05 $1.1025
Obviously, option 2 is better as you can enjoy the interest on interest. As the example
illustrates, 10% compounded semiannually is actually equivalent to 10.25% per year.
58
In the example, the 10% is called the quoted interest rate. The 10.25%, which is actually the
rate that you can earn, is called the effective annual rate (EAR). If you want to compare two
alternative investments with different compounding periods, you need to compute the EAR
and use that for comparison.
To get the effective annual rate,
m
Quoted Rate
EAR 1 1
m
Where m is the number of times the interest is compounded during the year.
Example 4.11
Suppose a bank offers a nominal interest rate of 5% on your time deposit. Compare the
different EARs with various times the interest is compounded each year.
Compounding Formula Effective Annual Rate

1
0.05
Annually r 1 1 5.0000%
1
2
0.05
Semiannually r 1 1 5.0625%
2
4
0.05
Quarterly r 1 1 5.0945%
4
12
0.05
Monthly r 1 1 5.1162%
12
52
0.05
Weekly r 1 1 5.1246%
52
365
0.05
Daily r 1 1 5.1267%
365
8760
0.05
Hourly r 1 1 5.1271%
8760
Continuously r e0.05 1 5.1271%
You will always prefer more compounding periods to less.
59
Example 4.12
You are looking at two savings accounts. HSBC pays you 5.25%, with daily compounding.
BOC pays 5.3% with semiannual compounding. Which account should you use?
HSBC:
365
0.0525
EAR 1 1
365
5.3899%
BOC:
2
0.053
EAR 1 1
2
5.3702%
Another rate we often calculate is the annual percentage rate (APR). APR is the interest rate
charged per period multiplied by the number of periods per year. Since the law requires that
lenders disclose an APR on all loans, this rate must be displayed on a loan document in an
unambiguous way.
Example 4.13
What is the APR if (1) the monthly rate is 0.5%; (2) the semiannual rate is 0.5%?
For (1):
APR 0.5% 12 6%
For (2):
APR 0.5% 2 1%
Remember, APR is only an annual rate that is quoted by law. In order to figure out the
actual rate, you need to compute the EAR.
60
The relationship between EAR and APR:
m
APR
EAR 1 1
m
If you have an effective rate, you can compute the APR.
1
APR m 1 EAR m 1
Example 4.14
Suppose you want to earn an effective rate of 12% and you are looking at an account that
compounds on a monthly basis. What APR must this account pay?
1
APR m 1 EAR m 1
1
12 1.12 12 1
11.39%
61
After learning the techniques of discounted cash flow valuation, you are now ready to deal
-
City Corporation has $40,000 that it can expand the current production of its smart phone by
investing in any or all of the four capital projects.
Cash Flow
Project Year 0 Year 1 Year 2 Year 3
A Investment -10,000
Revenue 21,000
Expenses 11,000
B Investment -10,000
Revenue 15,000 17,000
Expenses 5,833 7,833
C Investment -10,000
Revenue 10,000 11,000 30,000
Expenses 5,555 4,889 15,555
D Investment -10,000
Revenue 30,000 10,000 5,000
Expenses 15,555 5,555 2,222
All the will be depreciated to zero on a straight-line basis. The

marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.
What is your advice to the management?
In this case, City Corporation processes four possible investments. Some are valuable and
some are not. Of course, our important goal is to identify which are which. We will try to
present several investment criteria commonly used in practice and introduce the techniques
used to analyze investment decisions.
62
The net present value (NPV) of an investment is defined as the present value of all future
cash flows produced by an investment, less the initial cost of the investment.
n
Ct
NPV t
I0
t 1 1 r
Whether an investment is worth undertaking, we have to see if it creates value for its owner.
A positive NPV says the investment is worth more than it costs, and therefore creates value.
A negative NPV suggests once the investment is implemented, it will destroy value.
Based on the simple logic, in determining whether to accept or reject a particular investment,
the NPV decision rule is:
Accept an investment if its NPV > 0.
Reject an investment if its NPV < 0.
Example 5.1
Consider the following investment proposal:
Year 0 Year 1 Year 2 Year 3 Year 25

Cash Flow -100 11 11 11 11 11
Assuming the discount rate is 10%, is it a worthwhile investment?
n
Ct
NPV t
I0
t 1 1 r
25
11
t
100
t 1 1.1
1 1
11 1 100
0.1 1.125
0.15 0
Since NPV < 0, we should reject the proposal.
63
Example 5.2
You have the following investment project:
Year 2010 Year 2011 Year 2012 Year 2013

Cash Flow -100 50 30 80
The discount rate is 10%. What is the NPV of the project?
n
Ct
NPV t
I0
t 1 1 r
50 30 80
100
1.1 1.12 1.13
30.35 0
We understand this is a good investment project since the NPV is greater than zero. But what
does this 30.35 really mean?
The 30.35 is exactly the additional amount of money you can spend today if you take the
project. Suppose you can borrow and lend at 10%, then you can do the following strategy:
Spend 30.35 today and borrow the money from the bank.
Repay the loan by using the project cash flows.
Let us illustrate the strategy with the following table.
Year 2010 Year 2011 Year 2012 Year 2013

Project Cash Flow -100.00 +50.00 +30.00 +80.00
Loan Cash Flow +130.35 -50.00 -30.00 -80.00
Interest 0.00 13.04 9.34 7.27
Balance -130.35 -93.39 -72.73 0.00
Your Cash Flow 30.35 0.00 0.00 0.00
A positive NPV means you can earn extra cash flow for your consumption. In the example
here, 30.35 is your riskless profit since your project cash flow can completely repay your loan
in future. Hence, if you undertake this project, you will be better off.
64
In many cases, a firm will be faced with a choice between more than two alternatives. For
example, a firm may be considering whether to rebuild a new office building or to refurbish
an old building.
When there are more than one investment projects, the decision rule becomes:
For many independent projects, take all with positive NPV.
For mutually exclusive projects, take the one with the highest and positive NPV.
Example 5.3
City Corporation is deciding purchasing new machines, A and B. The two machines will
bring the firm the following cash flows.
Machine A
Year 0 1 2 3 4
Cash Flow -3,000 1,000 1,000 1,000 1,000
Machine B
Year 0 1 2 3 4
Cash Flow -2,000 700 700 700 700
The discount rate is 10%. What are the NPVs of the two machines?
1, 000 1, 000 1,000 1,000

NPV A 3, 000
1.1 1.12 1.13 1.14
169.87
700 700 700 700

NPV B 2, 000
1.1 1.12 1.13 1.14
218.91
Purchasing both machines will bring positive NPV to the firm. When there is no constraint,
City Corporation should purchase both machines. However, if the purchasing decisions are
mutually exclusive (either purchasing Machine A or B), then the decision is to choose the
highest NPV. Machine B is thus the preferred alternative.
65
Example 5.4
In the coming year, City Corporation decides to replace the old machine. It is deciding
between Machine C and D. Machine C has a life of 4 years and Machine D has a life of 2
years. Both machines cost $1,000.
Machine C
Year 0 1 2 3 4
Cash Flow -1,000 350 350 350 350
Machine D
Year 0 1 2
Cash Flow -1,000 750 500
The discount rate is 10%. What are the NPVs of the two machines?
350 350 350 350

NPV C 1, 000
1.1 1.12 1.13 1.14
109.45
750 500
NPV D 1, 000
1.1 1.12
95.04
Should the firm choose Machine C or Machine D?
Even though Machine C has a higher NPV, we cannot simply draw a conclusion that
Machine C is more preferred since it has a longer useful life than Machine D. In order to
have a fair comparison, one way is to compute the relevant NPV and compare the annual
equivalent cash flows of the two alternative machines.
The equivalent annuity is a useful tool for simplifying the analysis of problems of investment
projects with different lives. The idea is to calculate the annualized net present value. The
66
The decision rule is to choose the one with highest equivalent annuity. In our example,
Machine C:
EAC EAC EAC EAC
109.45
1.1 1.12 1.13 1.14
EAC 34.53
Machine D:
EAD EAD
95.04
1.1 1.12
EAD 54.76
Surprisingly, although Machine D has a lower NPV than Machine C, the firm should select
Machine D as it has a higher equivalent annuity.
The internal rate of return (IRR) is the discount rate that makes the NPV of an investment
zero. The IRR solves the following equation:
n
Ct
0 t
I0
t 1 1 IRR
In determining whether to accept or reject an investment, the IRR decision rule is:
Accept an investment if IRR > required return.
Reject an investment if IRR < required return.
The logic of IRR reverses the one of the NPV. When computing NPV, we calculate the NPV
for a given discount rate on an investment, and accept an investment whenever the NPV is
positive. If we use IRR rule, we calculate the discount rate that makes the NPV equal to zero.
The two methods are related.
67
Example 5.5
Consider the following investment project:
What is the IRR?
50 100 150
0 200 2 3
1 IRR 1 IRR 1 IRR
IRR 19.4377%

2nd {CLR TVM}
2nd {CLR Work}
2. Input
CF
(CF0=) -200 ENTER
(C01=) 50 ENTER
(F01=) 1 ENTER
(C02=) 100 ENTER
(F02=) 1 ENTER
(C03=) 150 ENTER
(F03=) 1 ENTER
IRR CPT
68
If we graph NPV versus the discount rate, we can see the IRR is actually the x-intercept.
We can see that the NPV of the project decreases as we increase the discount rate. The line
cuts the x-axis at the IRR of 19.44%. For all discount rate above 19.44%, the NPV of the
project is negative; for all discount rate below the IRR, the NPV of the project is positive.
the required rate of return is 10%, then based on both decision rules (NPV &
IRR), they all come to the same conclusion the project should be accepted.
One problem with the IRR comes about when the cash flows are not conventional.
Example 5.6
Consider the following investment project:
What is the IRR?
69
From the graph, there are two IRRs for this project. The curve crosses the x-axis at 0% and
100%.
The idea is that when cash flows change signs more than once, there will be more than one
IRR. In this situation, you will have to use your judgment to decide which IRR should be
used.
Another problem with IRR comes about when we are trying to compare two or more
mutually exclusive investments.
Example 5.7
City Corporation has two mutually exclusive projects, A and B. The cash flows of the two
projects are as follow:

Project A -500 325 325
Project B -400 325 200
If the required return for both projects is 10%, which project should the firm accept?
70
We try to compute the NPV and IRR for both projects.
325 325
NPV A 500
1.1 1.12
64.05
325 200
NPV B 400
1.1 1.12
60.74
325 325
0 500 2
1 IRRA 1 IRRA
IRRA 19.43%
325 200
0 400 2
1 IRRB 1 IRRB
IRRB 22.17%
In this example, NPV(A) > NPV(B) but IRR(B) > IRR(A). Based on NPV rule, we should
choose Project A. However, if we rely on IRR rule, the rule suggests us to choose Project B.
The two rules give conflicting conclusions.
The conflict between the NPV and IRR for mutually exclusive investments can be illustrated
by plotting their profiles.
71
The crossover point of the two curves can be found by setting NPV(A) = NPV(B).
Crossover point:
NPV A NPV B
325 325 325 200
500 2
400 2
1 r 1 r 1 r 1 r
r 11.80%
Below the crossover point, both NPV and IRR share the same decision investing in Project
B is more preferred. Notice that when the discount rate is less than 11.8%, the NPV for
Remarks:
Whenever there is a conflict between NPV and IRR, you should always use NPV.
IRR is unreliable in the situations of nonconventional cash flows and mutually
exclusive projects.
The payback period is the length of time it takes to recover the initial investment of the
investment.
The payback decision rule is:

Accept an investment if payback period < pre-specified payback period.
Reject an investment if payback period > pre-specified payback period.
For mutually exclusive projects, accept the one with the lowest payback period (if payback
period < pre-specified period).
72
Example 5.8
City Corporation is considering purchasing either one machine (mutually exclusive
Machine E
Year 0 1 2 3
Cash Flow -1,000 200 800 25
Machine F
Year 0 1 2 3
Cash Flow -1,000 600 300 1,000
If City Corporation requires a payback period of three years or less, which machine would
you purchase?
The payback period:

Machine E: 2 years.
Machine F: 3 years.
The payback rule dictates that Machine E should be accepted. However, if we calculate the
NPV of the two machines, we get:
200 800 25
NPV E 1, 000
1.1 1.12 1.13
138.24
600 300 1, 000
NPV F 1, 000
1.1 1.12 1.13
544.70
Based on NPV rule, purchasing Machine E is actually not a good investment choice. This
example shows that there are problems with the payback method:
1. It ignores the time value of money.

A remedy for this problem is to use the discounted payback period.
2. It ignores the cash flows after the payback period.
3. The standard for payback period is arbitrary.
73
The average accounting return
average book value. By definition,
Average Net Income

AAR
Average Book Value
The decision rule is:

Accept an investment if AAR > target AAR.
Reject an investment if AAR < target AAR.
Example 5.9
You are looking at a three-year project with a projected net income of $1,000 in year 1,
$2,000 in year 2, and $4,000 in year 3. The cost is $9,000, which will be depreciated
straight-line to zero over the three-year of the project. What is the average accounting return?
1, 000 2, 000 4,000

Average Net Income
3
2,333.33
9, 000 0
Average Book Value
2
4,500
Average Net Income

AAR
Average Book Value
2,333.33
4,500
51.85%
Although the AAR seems very impressive, there are some drawbacks about this measure.
1. It is not a true rate of return and it also ignores the time value of money.
2. It uses an arbitrary cutoff rate.
3. It is based on accounting net income and book values, not cash flows and market values.
74
Profitability index (PI) is the present value of an investment
initial cost. PI measures the benefit per unit cost, based on the time value of money.
PV
PI
I0
The decision rule for PI is:

Accept an investment if PI > 1.
Reject an investment if PI < 1.
Example 5.10
City Corporation has a list of investment projects in the coming year. You have prepared a
table summarizing the key measures.
Project Cost PV NPV PI

A 1,000 1,600 600 1.60
B 4,000 6,000 2,000 1.50
C 6,000 8,400 2,400 1.40
D 2,000 2,700 700 1.35
E 5,000 5,500 500 1.10
In the meeting, you know from the budget that $12,000 will be available to invest in the
coming year. Which projects will you select?
By investing all projects, it will cost the firm $18,000. Since the firm only has $12,000
capital, it is not feasible to invest all projects even though all projects have positive NPV. In
this situation,
top of the list until the capital budget is exhausted.
Based on the PI rule, you will select Project A, B and C as the three projects will give you
highest PI.
75
However, the PI will lead you to the wrong conclusion. If you calculate the aggregate NPV
of various combinations, you have:
NPV A B C 600 2, 000 2, 400

5, 000
NPV B C D 2, 000 2, 400 700

5,100
In this example, the best alternative is Project B, C and D with an aggregate NPV of $5,100.
We revisit our opening case. City Corporation has $40,000 that it can expand the current
production of its smart phone by investing in any or all of the four projects.
Cash Flow
A Investment -10,000
Revenue 21,000
Expenses 11,000
B Investment -10,000
Revenue 15,000 17,000
Expenses 5,833 7,833
C Investment -10,000
Revenue 10,000 11,000 30,000
Expenses 5,555 4,889 15,555
D Investment -10,000
Revenue 30,000 10,000 5,000
Expenses 15,555 5,555 2,222
All the will be depreciated to zero on a straight-line basis. The

marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.
76
For purpose of analysis,
1. Rank the four investments according to the four commonly used criteria:
a. The payback period.
b. The average accounting return. The formula of AAR in this problem can be
modified as [Average Net Income / (Required Investment / 2)].
c. Internal rate of return.
d. Net present value, assuming alternately a 10% discount rate and a 35% discount
rate.
2. Why do the rankings differ? What does each technique measure and what assumptions
does it make?
3. If the investment projects are independent of each other, which should be accepted? If
they are mutually exclusive, which one is the best?
77
The procedures for analyzing the problems involve:
Step 1: Compute the Cash Flows
A B C D
Year 1 Year 1 Year 2 Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Revenue 21,000 15,000 17,000 10,000 11,000 30,000 30,000 10,000 5,000
Less: Expenses (11,000) (5,833) (7,833) (5,555) (4,889) (15,555) (15,555) (5,555) (2,222)
Less: Depreciation (10,000) (5,000) (5,000) (3,333) (3,333) (3,333) (3,333) (3,333) (3,333)
EBIT 0 4,167 4,167 1,112 2,778 11,112 11,112 1,112 (555)
Less: Tax (40%) 0 1,667 1,667 445 1,111 4,445 4,445 445 (222)
Net Income 0 2,500 2,500 667 1,667 6,667 6,667 667 (333)
EBIT 0 4,167 4,167 1,112 2,778 11,112 11,112 1,112 (555)

Depreciation 10,000 5,000 5,000 3,333 3,333 3,333 3,333 3,333 3,333
Tax 0 1,667 1,667 445 1,111 4,445 4,445 445 (222)
OCF 10,000 7,500 7,500 4,000 5,000 10,000 10,000 4,000 3,000
A summary of the project cash flows:
Cash Flow
A -10,000 10,000
B -10,000 7,500 7,500
C -10,000 4,000 5,000 10,000
D -10,000 10,000 4,000 3,000
Step 2: Compute the Four Measures
Project Payback AAR IRR NPV(10%) NPV(35%)

A 1 0% 0% -909 -2,593
B 2 50% 32% 3,017 -329
C 3 60% 34% 5,282 -229
D 1 47% 43% 4,651 822
Step 3: The Rankings
Rankings Payback AAR IRR NPV(10%) NPV(35%)

1 A, D C D C D
2 B C D C
3 B D B B B
4 C A A A A
78
When a firm needs funds for investment, it can borrow money by issuing bonds or stocks, or
both. The focus of this topic is to give you an overview on how to value bonds and stocks.
A bond is a certificate showing that a borrower owes a specified sum. To repay the money,
the borrower has agreed to make interest and principal payments on designated dates.
Example 6.1
City Corporation issued 2,000 bonds for $1,000 each, where the bonds have a coupon rate of
5% and a maturity of two years. Interest on the bonds is to be paid annually.
This means that:

$2,000,000 has been borrowed by the firm.
The firm must pay interest of $100,000 at the end of one year.
The firm must pay both $100,000 of interest and $2,000,000 of principal at the end
of two years.
The pure discount bond promises a single payment at a fixed future date. If the payment is
one year from now, it is called a one-year discount bond. If it is two years from now, it is
called a two-year discount bond, and so on.
The date when the issuer of the bond makes the last payment is called the maturity date of the
bond. The payment at maturity is termed the bond s face value or par value.
Pure discount bonds are often called zero coupon bonds to emphasize the fact that the
bondholder receives no cash payments until maturity.
79
Consider a zero coupon bond that pays a face value of F in T years. The value of this zero
coupon bond is the present value of the face amount.
F
P T
1 r
Example 6.2
A zero coupon bond that matures in 20 years has a par value of $1,000. If the required return
is 4.3%, what is the value of the zero?
F
P T
1 r
1, 000
1.04320
430.83
Corporate bonds usually offer cash payments not just at maturity, but also at regular times in
between.
The payments on corporate bonds are made every six months until the bonds mature. These
payments are called the coupons of the bond.
The cash flow for a coupon bond consists of an annuity of fixed coupon interest and the par
value at maturity.
$C $C $C $C+$F
1 2 3 T
80
In general, the price of a bond is given by:
C C C C F
P 2 T 1 T
1 r 1 r 1 r 1 r
1 1 1 1
C 2 T
F T
1 r 1 r 1 r 1 r
1 1 1
C 1 T
F T
r 1 r 1 r
Example 6.3
A 30-year bond with an 8% (4% per 6 months) coupon rate and a par value of $1,000 has the
following cash flows:
Semiannual coupon = $1,000×4% = $40
Par value at maturity = $1,000
Therefore, there are 60 semiannual cash flows of $40 and a $1,000 cash flow 60 six-month
periods from now.
$40 $40 $40 $40+$1,000
1 2 3 60
The price of this 30-year bond:
40 40 40 1, 040
P
1 r
2 59 60
2 1 r 1 r 1 r
2 2 2
where :
r annual discount rate
81
Suppose the discount rate is 8% annually or 4% per 6-month, the price of the bond is:
1 1 1
P C 1 T
F T
r 1 r 1 r
1 1 1
40 1 60
1, 000 60
0.04 1.04 1.04
904.94 95.06
1, 000
What if the discount rate rises to 10% annually, then the bond price will fall by $189.29 to
$810.71.
1 1 1
P 40 1 60
1000 60
0.05 1.05 1.05
757.17 53.54
810.71
The central feature of fixed income securities is that there is an inverse relation between bond
price and discount rate.
82
In this example, the price/interest relationship for a 30-year, 8% coupon bond:
Interest 4% 6% 8% 10% 12%

Price 1,695.22 1,276.76 1,000.00 810.71 676.77
Note:
When the coupon rate equals the discount rate, the price equals the par value.
When the coupon rate is less than the discount rate, the price is less than the par
value.
When the coupon rate is greater than the discount rate, the price is greater than the
par value.
Not all bonds have a final maturity. Consol is a bond that never stop paying a coupon, has no
final maturity date. Thus, a consol is a perpetuity.
Example 6.4
What is the price of a consol with a yearly interest of $50 if the interest rate is 10%?
C
P
r
50
0.1
500
Yield to maturity (YTM) is the average rate of return that will be earned on a bond if it is
bought now and held until maturity.
Given its maturity, the principal and the coupon rate, there is a one to one mapping between
the price of a bond and its YTM.
T
Ct F
P t T
t 1 1 YTM 1 YTM
83
Example 6.5
Consider a 30-year bond with $1,000 face value has an 8% coupon. Suppose the bond sells
for $1,276.76, the YTM:
60
40 1000
1276.76 t 60
t 1 1 YTM 1 YTM
2 2
Solve for the discount rate, YTM = 6%.
The yield-to-maturity considers the return from interest-on-interest. It assumes that the
coupon interest can be reinvested at YTM.
A common stock represents an ownership interest in a firm and confers three rights on the
owner of a share:
Vote at the company meetings.
Collect periodic dividend payments.
Sell the share at the owner s discretion.
Contrary to payments to bondholders, payments to common stockholders are uncertain in

both magnitude and timing.
There are some important characteristics of common stock:

Residual claim.
Limited liability.
Voting rights.
Like bonds and other assets, the value of a stock can be determined by the present value of its
future cash flows. A stock provides two kinds of cash flows. First, stocks often pay
dividends. Second, an investor will receive the sale price when selling the stock.
84
Let s assume you buy a stock and hold it for one year. The price you are willing to pay for
the stock today is equal to the present value of the cash flows you will receive for holding a
year:
Div1 P1
P0
1 r 1 r
P1 can be determined by the dividend you will receive and the sale price at year 2:
Div2 P2
P1
1 r 1 r
You can substitute the expression of P1 back into P0 :

Div2 P2
Div1 1 r 1 r
P0
1 r 1 r
Div1 Div2 P2
2 2
1 r 1 r 1 r
If you repeat this logic, the stock price for today eventually becomes:
Div1 Div2 Div3
P0 2 3
1 r 1 r 1 r
Divt
t
t 1 1 r
the expected future dividends. The method that we have applied to value common stocks is
called dividend discount model.
To apply dividend discount model, what we have to do is to estimate the pattern of future
dividends. We can make some simplifying assumptions about the pattern.
85
The case of zero growth assumes that dividend is constant through time. So the value of the
stock is:
Div Div Div
P0 2 3
1 r 1 r 1 r
Div
r
Suppose that the dividend always grows at a constant rate g in perpetuity. That is,
Div1 Div0 1 g
The dividend in two periods will be:

Div2 Div1 1 g
Div0 1 g 1 g
2
Div0 1 g
If we repeat this process, then:

t
Divt Div0 1 g
Thus, the value of a stock under this constant growth dividend is:
Div1 Div2 Div3
P0 2 3
1 r 1 r 1 r
2 3
Div0 1 g Div0 1 g Div0 1 g
2 3
1 r 1 r 1 r
86
Simplifying the expression,
2 3
Div0 1 g Div0 1 g Div0 1 g
P0 2 3
1 r 1 r 1 r
2 3
1 g 1 g 1 g
Div0
1 r 1 r 1 r
2 3
1 r 1 g 1 g 1 g
P0 Div0 1
1 g 1 r 1 r 1 r
1
Div0
1 g
1
1 r
Div0 1 g
P0
r g
Div1
r g
The price of the stock P0 is higher when:

The expected dividend per share is larger.
The risk-adjusted discount rate or the required rate of return is lower.
The expected growth rate of dividend is higher.
Example 6.6
Suppose City Corporation just paid a dividend of $0.50. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15%, how much should the stock
be selling for?
Div0 1 g
P0
r g
0.5 1 0.02
0.15 0.02
3.92
87
Example 6.7
The next dividend for City Corporation will be $4 per share and it is expected to grow at 6%
per year. The required return is 16%.
What is the current price?
Div1
P0
r g
4
0.16 0.06
40
What is the price expected to be in year 4?
Div4 1 g
P4
r g
3
Div1 1 g 1 g
r g
4
4 1.06
0.16 0.06
50.5
What is the implied return given the change in price during the four year period?
4
P4 P0 1 r
4
50.5 40 1 r
r 6%
This example illustrates that the constant growth model makes the implicit assumption that
the stock price will grow at the same constant rate as the dividend. In this model, both stock
price and dividends grow at g.
88
To value stock price using zero and constant growth model, the models require the growth
rate must be less than the required return. In reality, however, there are cases where growth
Example 6.8
Suppose City Corporation is expected to increase dividends by 20% in one year and by 15%
in two years. After that, dividends will increase at a rate of 5% per year indefinitely. If the
last dividend was $1 and the required return is 20%, what is the price of the stock?
Div1 1 1.2 1.2

Div2 1.2 1.15 1.38
Div3 1.38 1.05 1.449
Div1 Div2 P2
P0 2 2
1 r 1 r 1 r
Div3
Div1 Div2 r g
2 2
1 r 1 r 1 r
1.449
1.2 1.38 0.2 0.05
1.2 1.2 2 1.22
8.67
Div1
Rearranging the dividend growth model P0 , the model implies:
r g
Div1
r g
P0
Div1
This expression tells us that the total return has two components. The first part is
P0
called the dividend yield, and the second part of the return is the capital gain.
89
Example 6.9
Suppose a share of City Corporation is selling for $10.50. It just paid a $1 dividend and
dividends are expected to grow at 5% per year. What is the required return?
Div1
r g
P0
1 1.05
0.05
10.5
15%
As a CFO, you will be interested to know how your investment decisions are going to affect
the stock price. Let us look at the relationship between stock price and growth opportunities
in the following examples.
Example 6.10
The firm pays out part of the earnings and the rest is reinvested. The payout ratio is 0.4, ROE
is 15% and the required rate of return is 12.5%, what is its stock price?
Div Payout ratio EPS

0.4 5
2
g ROE b
0.15 0.6
0.09
Div1
P0
r g
2
0.125 0.09
57.14
90
Example 6.10
- exactly the same asset that generates an expected $5 EPS

each year. This company pays out all its earnings as dividend, what is its stock price?
Since this company pays out all its earnings as dividend,

Div EPS 5
g ROE b
0.15 0
0
Div1 EPS
P0
r g r
5
0.125
40
The difference between the stock price with growth and the stock price without growth is
called the present value of growth opportunities (PVGO).
EPS
P0 PVGO
r
57.14 40 17.14
The stock is like perpetuity if PVGO is 0. $40 is the present value of perpetuity with $5 each
year. It is also called capitalized earnings, or value of assets in place.
The two examples illustrate that stock price has two components:
Present value of earnings under a no-growth policy.
Present value of growth opportunities.
91
Example 6.11
City Corporation currently has assets in place that generates x of EBIT in perpetuity. At
time t, there is an investment opportunity I t that gives a return of r * in perpetuity.
Let:
x EBIT of current activities (perpetuity)
It Investment at time t
*
r Return on investment
r Discount rate
The cash flows of City Corporation will be:
What is the present value of current assets in place?
x
PV0 AIP
r
What is the present value of income streams from investment at time t?
r * It
PVt I
r
92
What is the NPV of the investment at time t?
r *It
NPVt I It
r
r* r
It
r
What is the NPV of the investment at time 0?
1 r* It
NPV0 I t
It
1 r r
1 r* r
t
It
1 r r
What is the price of the firm at time 0?
x 1 r* r
P0 t
It
r 1 r r
If at each year t there is an investment = I t , what will be the price then?
x 1 r* r
P0 t
It
r t 1 1 r r
Once again, this example shows that the stock price equals the present value of assets in place
plus the net present value of growth opportunities.
93
Example 6.11 demonstrates how the investment decisions will affect the stock price. If City
Corporation is satisfied with its current activities by only relying on its current assets in place
x
to generate cash flows, then its stock price will stay at .
r
When City Corporation takes the investment, its stock price will be changed accordingly. In
the case where the investment has a positive NPV ( r * r ), the stock price will be increased
by such amount. In the previous topic, we always emphasis firms should only accept an
investment when the NPV is greater than zero. Because by undertaking the investment, we
x 1 r* r x
can increase the value of the firm as P0 t
It .
r 1 r r r
However, the stock price will be decreased when firms undertake a negative NPV investment
( r * r ). It is always bad to have negative NPV investment since it will destroy the value of
x 1 r* r x
the firm. It is better not to undertake the investment as P0 t
It .
r 1 r r r
94

CB3410 Lecture Notes W Sol - B4midterm

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CB3410 Lecture Notes W Sol - B4midterm

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compare their advantages and

A sole proprietorship is a business owned by a single individual.

Ownership of a sole proprietorship may be difficult to transfer.

characteristics between partnership and corporation.

The possibility of conflict of interest between owners and management of a corporation is

3. Private Benefits of Control

The salesman utility can be described as U w, e w e . His reservation level of utility is

That is, w 81, 000 .

aligned with those of shareholders.

1. The Balance Sheet

2. The Income Statement

A simplified balance sheet:

Assets can be classified into current and fixed.

Liabilities can also be classified into current and long-term.

Equity can be separated into capital stock and retained earnings.

Assets = Liabilities + Equity

1. Net Working Capital

The simple income statement equation is:

Revenues Expenses = Income

An income statement for U.S. Corporation is shown below:

According to the recognition principle,

Depreciation is counted on the income statement as an expense, even though it involves no

The depreciation deduction is simply an application of the matching principle in accounting.

In making financial decisions, it is important to distinguish between average and marginal

Taxable Income Tax Rate

Suppose City Corporation earns $4 million in taxable income.

What is the average tax rate?

What is the marginal tax rate?

Here, we can break down the identity in details.

1. Cash Flow from Assets

2. Cash Flow to Creditors

3. Cash Flow to Shareholders

b. Net Capital Spending

c. Change in Net Working Capital

Thus, Cash Flow from Assets

2. Calculate Cash Flow to Creditors

3. Calculate Cash Flow to Shareholders

TOTAL ASSETS 385 355

TOTAL LIABILITIES 110 100

Convertible preferred stock, 5% 20 20

TOTAL LIABILITIES AND

2. Quick Ratio (Acid-Test Ratio)

-term debt payment.

1. Total Debt Ratio

3. Times Interest Earned Ratio

4. Cash Coverage Ratio

4. Average Collection Period

2. Return on Assets (ROA)

3. Return on Equity (ROE)

1. Earnings Per Share (EPS)

4. Market-to-Book Ratio (MB)

2. ROE (Du Pont Identity)

Liquidity / Solvency Profitability Implications

The past and the expected growth

Sustainable growth rate is the most realisti

Sustainable Growth = Return on Equity Retention Rate

Fundamental Factors Relationship with Sustainable Growth

ending balance sheet, then the formula changes

TEb Total Equity taken from the "beginning" of the period

What happens if you can only earn 5% interest?

In this case, Investment 1 looks better.

The difference $11.05 is the interest on interest from compounding.