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WELCOME TO BMMF5103 MANAGERIAL FINANCE General aim of the course Objectives of the course Course overview Overview of topics

STUDYPATHS FOR SUCCESS IN THE COURSE GUIDE TO ASSESSMENT IN POST-GRADUATE COURSES AT OPEN UNIVERSITY MALAYSIA References CONCLUDING REMARKS

WELCOME TO BMMF5103

The course BMMF5103 Managerial Finance is one of the required courses for the Master of Business Administration (MBA) programme. The course assumes little previous knowledge and experience in financial management. However, you are encouraged to relate and integrate your work experience into this course. This is a three (3) credit course conducted over a 14 week semester.

The course aims to give you a foundation in managerial finance and explain why it is important for all functional managers to understand managerial finance.

After completing this course, you should be able to: 1. Identify the key objective of firm and understand the key concepts in financial management; 2. Evaluate the financial performance and position of a company; 3. Evaluate the value of stocks, bonds and projects; and 4. Evaluate the various sources of financing.

A. Course Overview

Finance is an exciting yet interesting, challenging and ever-changing discipline. With the emergence of liberations and globalisation, new technology and innovations have brought a profound impact on the financial practices and markets. Managers are concerned with acquiring, financing and managing the business assets under these changes. Thus knowledge on financial management is essential for managers to perform their financial duties. To enable you to understand Managerial Finance BMMF 5103, we divide this course into three topics that are the foundation of the course. These topics are shown in the table below.

Table 1: Schedule of Topics Topic 1 2 3 Title Fundamental Concepts of Financial Management Securities and Their Valuation Projects and Their Valuation Schedule Weeks 1-5 Weeks 6-10 Weeks 11-14

Each of these three topics is guided by a Study Guide which is communicated to you through (a) the online forum in myVLE before the first tutorial and (b) in print form after you have registered for the course. You will follow the scheduled weekly activities and discussions assigned to you in the Study Guide for the duration of the course. All topics and activities are based on the assigned textbook and discussion on a topic is carried out both in the online forum and in the face-to-face tutorials. Please remember that deliberation on a single topic will be carried out according to a fixed schedule as presented in the Study Guide. It is important that you participate in online discussions and group activity so that you can understand each topic completely. In the sections below, an overview of the course and a description of the content of each topic are provided.

B. Topic Overview

Topic 1: Fundamental Concepts of Financial Management Chapter 1: An Overview of Financial Management. It introduces the various types of organisations, goals of the corporation and agency relationship. Financial Statements, Cash Flows, and Taxes It Introduces and explains the purpose of balance sheet, profit and loss statement and cash flow statement. Analysis of Financial Statements Using ratio analysis to evaluate the liquidity position, leverage, profitability and asset management ability of the company. Risk and Return: The Basis It introduces the parameters used in investment decision and benefits of diversification. Time value of Money It introduces the importance of time line, future and present values for both even and uneven cash flows.

Chapter 3:

Chapter 13:

Chapter 4:

Chapter 2:

Topic 2: Securities and Their Valuation Chapter 5: Risk and Return: Portfolio Theory and Asset Pricing Theory It shows how portfolio return and risk are computed for the assets. The various factors affecting the portfolio risk are also explained. The popular asset pricing is presented and demonstrated how the required rate of return of an asset is determined. Bonds and Their Valuation It discusses the key features of bonds and their valuation. This includes bonds with semi-annual coupon and the impact on bond prices when there is a change in market interest rate. Stocks and Their Valuation It discusses the key features of stocks and the legal rights and privileges of shareholders and stocks valuation.

Chapter 6:

Chapter 7:

Topic 3: Projects and Their Valuation Chapter 9: The Cost of Capital It demonstrates the techniques used in determining the cost of debt, preferred shares and common stock. Weighted average cost of capital is then computed.

Chapter 10:

The Basics of Capital Budgeting: Evaluating Cash Flows It discusses the importance of capital budgeting, project classification, capital decision rules and the various methods for evaluating projects viability. Cash Flows Estimation and Risk Analysis It focuses on estimating relevant cash flows, tax effects, inflation on cash flows.

Chapter 11:

LEARNING SUPPORT

1. Tutorials There are 15 hours of face-to-face tutorials provided in support of the course. There will be FIVE tutorial sessions of 3 hours each. You will be informed on the dates, times and location of these tutorials, together with the names and phone number of your facilitator, as soon as you are allocated a tutorial group. MyVLE Online Discussion Besides the face-to-face tutorial sessions, you have the support of online discussions in myVLE with your facilitator and your coursemates. Your contributions to online discussions will greatly enhance your understanding of course content, and help you as you read the assigned text, do the assignment and prepare for the examinations. Feedback and Input from Facilitator As you work on the activities and the assigned text, your facilitator will provide academic assistance throughout the duration of the course. The facilitator will also mark your assignment and give you the feedback on your performance. Should you need any assistance, do not hesitate to discuss your problems with your facilitator. The tutorial sessions and the online forum can also be used for any of the following situations: when you have difficulty with the self-tests and activities; when you have a question or problem with the assignment; and when you do not understand the assigned readings.

2.

3.

It is important to bear in mind that communication is important for you to be able to get the most out of this course. Therefore you should, at all times, be in touch with your facilitator and coursemates, and be aware of all the requirements for successful completion of a course. 4. The Digital Library For the purpose of referencing materials and doing library-based research, OUM has a comprehensive digital library. For this course you may use the following databases: infotrac, proquest and ebsco. From time to time, materials from these databases will be assigned for additional reading and activities.

1. Time Commitment for Study You should plan to spend about 20 hours on each topic, which includes the time spent doing all activities, self-tests, and suggested readings. You ought to schedule your time to discuss your work online and spend enough time on each topic for this course. It is often more effective to distribute the study hours over a number of days rather than spend a whole day studying one topic. 2. Proposed Study Strategy The following is a proposed strategy for working through the course. If you have difficulty following the suggested strategy, discuss your problems with your facilitator either through the online forum or during the tutorial sessions. (i) The first and most important step is to read the contents of this Course Guide thoroughly.

(ii) Organise a study schedule. Note the amount of time you are expected to spend on each topic, the submission date of the assignment, tutorials and the examination dates. Put all this information in one place, such as your diary or a wall calendar. Whichever method you choose, you should decide on and jot down your own dates for working on each topic. You have some flexibility as there are 3 topics spread over a period of 14 weeks. (iii) Once you have created a study schedule, make every effort to stick to it. The main reason students are unable to cope is that they delay their course work. (iv) To begin work on a topic, do the following: Study the Topic Overview and examine the relationship of one topic to the other topics. Do all assigned Activities and conduct the Self-test to see if you have understood the various concepts and facts presented in a topic. Use the Summary and the Key Terms to check if you understand what you have just read. Do all Readings to gain knowledge of the various dimensions of the course. Work on your assignments as the semester progresses so that you are able to systematically produce a commendable report or paper.

(v) When you have completed a topic, review the Learning Outcomes to confirm that you have achieved them and that you are, in fact, able to do what is required. (vi) After completing all topics, review the course content to prepare for the final examination. Review the objectives of the course to see if you have covered all the relevant parts of the course.

In the following pages, the Assessment Guide explains the basis on which you will be assessed in this course during the semester. It contains details of the facilitator-marked assignment, the final examination and participation required for the course. One element in the assessment strategy of the course is that all students should have the same information as their facilitators about how performance on the various tests and assignments is assessed. For this reason, this guide also contains the marking criteria that will be used to assess the work you submit for each requirement. Please read through the entire guide at the beginning of the course.

Assessment Format

Please refer to myVLE. 1. FACILITATOR-MARKED ASSIGNMENT You will begin by accessing the assignments in the online forum and complete the assignment using the information and materials contained in the Study Guide and the Assigned Text. However, it is desirable in all graduate level education to demonstrate that you have read and researched more widely than the required minimum. Using other references will give you a broader perspective on the course, and may provide a deeper understanding of the subject. When you have completed the assignments, submit it, together with a FMA form, to your facilitator. Make sure that your assignments reach the facilitator on or before the deadline.

In general, your facilitator will be expecting you to write clearly, using correct spelling and grammar. Your facilitator will be looking for evidence that you have done the following: a) Reflected critically on issues raised in the course. b) Considered and appreciated a range of points of view, including those in the course, and developed your own view. c) Stated your argument clearly with supporting evidence and proper referencing of sources. d) Drawn on your own experiences and integrated this information in the paper.

2. FINAL EXAMINATION

The examination covers materials from the course content and it aims to examine if the learning outcomes of the course have been achieved. Students should demonstrate that they have achieved these outcomes in the examination. The questions in the final examination are closely related to questions in the Study Guide and all areas of the course will be assessed. Hence you may find it useful to review all items in the Study Guide in preparation for the examination.

PLAGIARISM

What is Plagiarism?

(Note: This information has been sourced from: www.psych.mcgill.ca/ugrad) Any written assignment (essays, project, take-home exams, etc) submitted by a student must not be deceptive regarding the abilities, knowledge, or amount of work contributed by the student. There are many ways that this rule can be violated, and plagiarism may have been committed. Here are some examples of plagiarism. Outright plagiarism: Large sections of the paper are simply copied from other sources, and are not acknowledged as quotations. Paraphrasing: The student paraphrases a closely reasoned argument of an author without acknowledging that he or she has done so. Clearly, all our knowledge is derived from somewhere, but detailed arguments from clearly identifiable sources must be acknowledged. Other sources: Essays or papers written by other students or sold by unscrupulous organisations are submitted by students. Works by others: Taking credit deliberately or not deliberately for work produced by another without giving proper acknowledgement. This includes photographs, charts, graphs, drawings, statistics, video-clips, audioclips, verbal exchanges such as interviews or lectures, performances on television and texts printed on the web. Double Credit: The student submits the same essay to two or more courses.

Avoiding Plagiarism

(Note: This information has been sourced from: http://www.homestead.com/) Insert quotation marks around copy and paste clause, phrase, sentence, paragraph and cite the original source Paraphrase clause, phrase, sentence or paragraph in your own words and cite your source Adhere to the APA (American Psychological Association) stylistic format, whichever applicable, when citing a source and when writing out the bibliography or reference page Attempt to write independently without being overly dependent of information from anothers original works

Educate yourself on what may be considered as common knowledge (no copyright necessary), public domain (copyright has expired or not protected under copyright law), or copyright (legally protected).

Documenting Sources

Whenever you quote, paraphrase, summarize, or otherwise refer to the work of another, you are required to cite its source parenthetical documentation. Here are some of the most commonly cited forms of material. (Note: The reference for this information is http://www.horton.ednet.ns.ca).

Direct Citation Simply having a list of thinking skills is no assurance that children will use it. In order for such skills to become part of day-to-day behaviour, they must be cultivated in an environment that value and sustains them. Just as childrens musical skills will likely lay fallow in an environment that doesnt encourage music, learners thinking skills tend to languish in a culture that doesnt encourage thinking (Tishman, Perkins & Jay, 1995, p.5) According to Wurman (1988), the new disease of the 21st century will be information anxiety, which has been defined as the ever-widening gap between what one understands and what one thinks one should understand.

Indirect Citation

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Referencing

All sources that you cite in your paper should be listed in the Reference section at the end of your paper. Heres how you should do your Reference page. (Note: The reference for this information is owl.english.purdue.edu/handouts).

From a Journal From an Online Journal From a Webpage From a Book From an Article in a Book From a Printed Newspaper Brown, E. (1996). The lake of seduction: Silence, hysteria, and the space of feminist theatre. JTD: Journal of Theatre and Drama, 2, 175-200. Evnine, S. J. (2001). The universality of logic: On the connection between rationality and logical ability [Electronic version]. Mind, 110, 335-367. National Park Service. (2003, February 11). Abraham Lincoln birthplace national historic site. Retrieved February 13, 2003, from http://www.nps.gov/abli/ Fleming, T. (1997). Liberty! The American revolution. New York: Viking. Cassel, J., & Zambella, B. (1996). Without a net: Supporting ourselves in a tremulous atmosphere. In T. W. Leonhardt (Ed.), "LOEX" of the West: Teaching and learning in a climate of constant change (pp. 75-92). Greenwich, CT: JAI Press Inc. Holden, S. (1998, May 16). Frank Sinatra dies at 82: Matchless stylist of pop. The New York Times, pp. A1, A22-A23.

CONCLUDING REMARKS

This course aims to give you a foundation in managerial finance which provides the fundamental concepts, asset analyses and valuations, and sources of financing. We wish you success with the course and hope that you will find it interesting and useful for your development as a professional. We hope you enjoy your experience with OUM and will continue your work as a life long learner with us.

REFERENCES

Brigham, E. F., & Ehrhardt, M. C. (2005). Financial management - Theory and practice (11th ed.). South Western: Thomson Publishing. McGuigan, J. R., Kretlow, W. J., & Moyer, R. C. (2006). Contemporary financial management (10th ed.). South-Western: Thomson Publishing.

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Contents Components of Study Guide ......................................................................14 Course Overview......................................................................................15 Topic 1: Fundamental Concepts of Financial Management ..............................16 Topic 2: Securities and Their Valuation........................................................36 Topic 3: Projects and Their Valuation ..........................................................51

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As a distance learner, this course is designed to allow you to study at your own pace, anywhere and at anytime. However, the course is also structured to provide a great deal of learning support to help you organise your thoughts on the subject and to guide your learning of the various topics in the course. To help you through each topic, numerous activities based on the assigned text are included under this Study Guide. You will go through the activities in each topic with the help of your facilitator and your course mates. To make this easier, this Study Guide has adopted the following features to assist you.

Activities Activities refer to a number of readings, tasks, questions and reviews that you have to go through for each topic. Most activities will be drawn from the Assigned Text for the course and you will often be requested to apply concepts to authentic business-related situations. Summary The main ideas of each topic and its chapters are listed in brief sentences to provide a review of the content. This will help your review the activities and the content that you have gone through. Key Terms In addition to the self-test and the summary, Key Terms help to remember the main ideas in the chapter. These are usually found at the end of each chapter to make you aware of what you should have learnt. Discussion Discussion questions are presented to help you discuss content matter through group interaction and discussion. You may answer the questions individually but you are encouraged to work with your course-mates during the online and tutorial sessions. Readings In this package, you may also find a number of readings given to you for a topic. These are supplementary readings related to the contents of the topic and may be accessed from the Digital Library at OUM.

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Finance is an exciting yet interesting, challenging and ever-changing discipline. With the emergence of liberations and globalisation, new technology and innovations have brought a profound impact on the financial practices and markets. Managers are concerned with acquiring, financing and managing the business assets under these changes. Thus knowledge on financial management is essential for managers to perform their financial duties.

TABLE 1: Schedule of Topics Topic 1 2 3 Title Fundamental Concepts of Financial Management Securities and Their Valuation Projects and Their Valuation Schedule Weeks 1-5 Weeks 6-10 Weeks 6-10

Each topic is guided by a Study Guide which is communicated to you through the online forum in myVLE before the first tutorial. You will follow the weekly activities and discussions assigned to you in the Study Guide for the duration of the course. All topics and activities are based on the assigned textbook and discussion on a topic is carried out both in the online forum and in the face-toface tutorials. Deliberation on a single topic will be carried out according to a fixed schedule as presented above. It is important that you participate in online discussions and group activity so that you cover each topic completely.

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LEARNING OUTCOMES

When you have completed all chapters, readings and activities for this topic you will be able to: Identify and evaluate the various types of organisations, goals of the corporations and agency relationship; Apply ratio analysis to evaluate the financial position and performance of a company; Identify and measure risk and return in investment; Apply and evaluate the time value of money concept in investment by using spread sheet.

Topic Overview

This topic introduces the key concepts and information in managerial finance which includes forms of organisations, financial statements and analysis, risk and return and time value of money. There are 5 chapters in this topic.

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Study Topic for Week 1 to 5 Fundamental Concepts of Financial Management Chapters in Focus for Week 1 to 5: Chapters 1, 2, 3, 4 and 13. Chapter 1: An Overview of Financial Management

Learning Outcomes

When you have completed this chapter, you should be able to: 1. 2. 3. 4. Identify and describe the responsibilities of financial manager of an organisation; Compare the advantages and disadvantages of the various forms of business organisation; Identify and evaluate the different types of goals of a firm; and Describe principal agent problem and discuss how this problem may be prevented or minimised.

Overview

The major thrust of this chapter is to establish the objectives of financial management and the importance of the financial manager to the organization. In addition, the determinants of a firms value, the nature of the financial markets and the types of institutions operate in these markets are also discussed.

Outline

There are three forms of business organisations. They are sole proprietorship, the partnership, and the corporations. 1. A sole proprietorship is owned by a single owner. Advantages It is easy and inexpensive to form. It is subjected to few government rules and regulations and avoids corporate taxes. Disadvantages It has limited sources of funds and life. The owner has unlimited liability.

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2.

A partnership when an organisation consists of two or more persons to conduct non-corporate business. Advantages Low cost of formation. It is subject to few government rules and regulations and avoids corporate taxes. Disadvantages Limited life and difficult to transfer ownership. The owner has unlimited liability.

3.

A corporation is a legal entity and it is separated and distinct from its owners and managers. Advantages Unlimited life and ownership can be easily transferred. Limited liability and can raise capital from the capital markets. Disadvantages Corporate earnings may be subject to double taxation. Subject to a number of government and company rules and regulations.

The primary goal of financial manager is to maximize the wealth of the shareholders. Financial managers can achieve this goal through daily activities such as working capital management, long term investments and raising funds for these investment projects. Other objectives, such as the employee and community welfare are less important than stock price maximizing. The actions of maximizing stock price actually benefit society as to achieve this goal, a firm must be able maintain or improve its product quality and sell it at a competitive price. Thus this goal is not achieved at the expense of societys benefits. An agency relationship (principal agent relationship) arises when the owners (shareholders) hire other individuals (agents) to run the organization. These managers who manage the organization may not make decisions that are in line with the companys objective. This is the potential agency problem. However, there are ways to motivate managers to act in shareholders best interest. These include: managerial compensation, direct intervention by shareholders, the threat of firing and take over.

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Activity 1.1

1. 2. 3. 4. What are the three main areas of finance? How does expertise in finance help a company become successful? Discuss your answer with your peers in the myVLE online forum. Distinguish between primary and secondary market transactions. If you were the president of a large, publicly owned company, would you make decisions to maximise stockholders welfare or your own personal interest? Discuss your views with your fellow students via the myVLE online forum. What are the possible actions stockholders could take to ensure that managements interest and those of stockholders coincided? What is the difference between stock price maximisation and profit maximisation? Under what conditions might profit maximisation not lead to stock price maximisation?

5. 6. 7.

Activity 1.2

Read the mini case on page 44 to 45 and answer all the questions. Self-Test Questions 1. 2. 3. 4. 5. Corporate shareholders have unlimited liability. (T or F) Shareholders are the residual owners of the corporation. (T or F) The objective of firm proposed in finance is to maximise profitability. (T or F) Agency problems arise whenever the principal and agents are the same. (T or F) The finance function in a corporation is developing financial statements. (T or F)

Key Terms

Agency theory Financial environment Financial markets Financial Statements Forms of organisation Goals of management Wealth maximisation

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Summary

There are three forms of business organisations and each has different advantages and disadvantages. The primary goal of management is to maximize stockholders wealth and is done through value creation. There are different markets dealing with different investment instruments and financing. Agency problems can be mitigated through compensation scheme, threats of fire and takeover.

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Learning Objectives

When you have completed this chapter, you should be able to: 1. 2. 3. List the type of information found in a companys annual report; Distinguish the differences among accounting profit, net cash flow and operating cash flow; and Explain why financial managers must be concerned with taxation.

Overview

In order to judge the impact of their actions, managers in the company must understand financial statements. They must also be able to distinguish the difference between accounting profit and cash flow.

Outline

The balance sheet shows the firms resources or assets and claims against those assets. Assets are shown on the left-hand size while the liabilities and owners equity are found on the right-hand size of the balance sheet. Different accounting methods, such as FIFO, LIFO and average stock valuations can affect the cost of goods, profits and inventory value. Balance sheet provides snapshot of the firms financial position at a point of time. The Statement of financial performance summarizes the firms revenues and expenses over a period of time. Earnings per share or the bottom line is the important information provided by this statement. The statement of retained earnings reconciles the beginning and ending retained earnings with net profit. The statement of shareholders equity shows the changes in the various accounts under shareholders equity during the course of the year. In finance, the focus is on the cash flow rather the accounting profit. The firms profit is not as important as the cash flow because the payment of dividends, expenses and purchase of fixed and financial assets required cash. Net cash flow can be estimated by using this formula: Net cash flow = Net income + depreciation The statement of cash flow indicates the impact of a firms operating, investing and financing activities on cash flow over an accounting period. Double taxation is the system of taxing income twice, once at the corporate level and a second time when dividends are paid to stockholders.

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Gains and losses on sale of capital assets such as stocks, bonds, and real assets are normally subject to lower taxes.

Activity 2.1

1. List four types of financial statements that usually included in the annual report. 2. What are balance sheet and statement of financial performance and what information they provide? 3. Explain why do changes in retained earnings occur. 4. Differentiate net cash flow and accounting profit. 5. Identify and explain the three types of activities presented in the statement of cash flows.

Activity 2.2

Discuss the mini case on page 123-125 with your classmates through the myVLE online forum and answer all the questions given.

Self-test Questions

1. The balance sheet is a financial statement measuring the flow of funds into and out of various accounts over time while the income statement measures the progress of the firm at a point in time. (T or F) If the tax laws stated that RM0.50 out of every RM1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant. (T or F) Interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability. (T or F) Operating working capital is equal to the operating current assets minus the operating current liabilities. (T or F) Net Total operating capital is equal to net fixed assets. (T or F) Retained earnings are the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and thus, these cash accounts, when added together, will always be equal to the total retained earnings of the firm. (T or F)

2.

3. 4. 5. 6.

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7.

The time dimension is important in financial statement analysis. While the balance sheet and income statements represent the firm's financial position at a point in time, the statement of cash flows reports changes that were made to the firm's accounts over a period of time. (T or F) In order to accurately estimate cash flow from operations, depreciation must be added back to net income. The reason for this is that even though depreciation is deducted from revenue it is really a non-cash charge. (T or F) In accounting, emphasis is placed on determining net income. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary consideration is cash flow because that's what is used to run the business. (T or F) Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. (T or F)

8.

9.

10.

Key Terms

Balance sheet Double taxation Statement of financial performance Statement of cash flows Statement of retained earnings Statement of Owners equity

Summary

This chapter reviews the major financial statements, emphasises the difference between accounting profit and cash flows. It also features personal and corporate taxes.

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When you have completed this chapter, you should be able to: 1. 2. 3. 4. Explain why ratio analysis is usually the first step in the analysis of a companys financial statements; List and interpret the five groups of ratios that reveal the five aspects of company; Identify and evaluate benchmarking and its purpose; and Identify and discuss the limitations of ratio analysis.

Overview

One can determine the relative strengths and weaknesses of a company by using ratio analysis. Various users of information will need this financial analysis to highlight the key aspects of a companys operations. However the financial ratios must be used with cautious.

Outline

Financial ratios are used by investors, managers and creditors. Liquidity ratios are employed to determine the ability of a firm to meet its shortterm obligations as they come due. The current ration, which is the most commonly used measure of short-term solvency, can be computed by dividing current assets by current liabilities. The quick or acid test ratio is a more stringent test of a firms ability to meet its short-term obligations. To compute this ratio, inventory is excluded from the current assets. Asset management ratios measure how effectively a firm utilizing its assets in generating operating cash flows. The inventory or stock turnover is defined as sales divided by inventories. Normally, the higher the turnover, the better it is for the company. The average collecting period is computed by dividing accounts receivables by average daily sales to find the number of days sales tied up in receivables. Fixed asset turnover measures how effectively the firm utilizing its plants and equipments. The higher it is the better. Total asset turnover ratio measures how effectively the firm employing its total assets in generating revenues.

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Debt ratios measure the extent to which a firm is employing debt financing. Financial leverage has three important implications: Raising funds through debt means the stockholders can maintain their control of a firm; if the stockholders provided only a small proportion of the total financing, the firms risk borne mainly by its creditors; the return to the owners capital is magnified if the firm earns more on investments financed with borrowed funds than it pays in interest. Total debt to total assets measures the percentage of funds provided by creditors. Total debt includes both current and long-term debt. The times-interest-earned ratio measures the extent to which operating profit before interest and taxes can decline before the firm is unable to meet its annual interest costs. Profitability ratios indicate the combined effects of liquidity, asset management, and debt on operating profits. The profit margin on sales provides the profit per dollar of sales. The return on total asset measures the return on all the firms asset after interest and taxes. The return on equity measures the rate of return on the stockholders investment. Investment or market value ratios refer to the firms stock price to its earnings and book value per share which indicate the companys past performance and future prospects. The price/earnings ratio (P/E) shows how much investors are willing to pay per dollar of reported profits. The market /book (MB) ratio is determined by dividing market price per share by book value per share. It is important to analyse the trend and absolute values of the information. Trend analysis can assist one to determine whether the firms financial health is likely to improve or deteriorate in the future. To determine a firms relative financial position and performance, the companys ratios must compare with industry norm or benchmark. There are some inherent limitations to ratio analysis, these are: Ratios may be distorted by seasonal factors, or manipulated by management by using creative accounting. The use of industry average for comparison may not help firm achieving challenging target. It can be difficult to find a suitable benchmark. Limitations on the financial statements. (example, not all assets are recognised in the balance sheet). Inflation can distort the information.

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Activity 3.1

1. 2. Identify two ratios used for analysing a firms liquidity and write out their equations. What potential problem could arise when comparing different firms fixed assets turnover? Compare your answer with your classmates through the myVLE forum. What does ROE measure? Since interest expense lowers profits, does using debt lower ROE? If one firms P/E ratio is lower than that of another, what are the some factors might explain the difference? What important information does a trend analysis provide? What are the qualitative factors analysts should consider when evaluating a companys future financial performance?

3. 4. 5. 6.

Activity 3.2

Discuss problem 13-9 (page 470) with your classmates through the myVLE online forum and answer all the questions given.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. The current ratio will never exceed the quick ratio. (T or F) The gross profit margin is greater than the net profit margin. (T or F) A short average collection period is a sign of efficient accounts receivable management. (T or F) the return on total equity equals the net profit margin times the total asset turnover. (T or F) The dividend yield ratio tells you what proportion of the firms earnings are paid out as dividends. (T or F) A change in inflation would have no effect on a firms current ratio since the current ratio is based on short-term accounts. (T or F) The basic rational for historical cost is that it is a measure of current value. (T or F) leverage ratios measure how efficiently the firm is employing its resources. (T or F) Revenues (T or F) increase net worth, while expenses decrease net worth.

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Key Terms

Asset management ratio Debt ratio DuPont analysis Investment ratio Liquidity ratio Profitability ratio Industry average Benchmark

Summary

Financial statements provide useful inputs for investor to predict the firms future earnings and dividends. As for the management, financial statement analysis is useful both for future planning and identifying the strengths and weaknesses of the company. Financial ratios are meant to assist one to evaluate a firms financial position and performance.

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When you have completed this chapter, you should be able to: 1. 2. 3. 4. Identify risk and calculate the expected rate of return, standard deviation, and coefficient of variation for a probability distribution; Analyse how risk aversion influences required rate of return; Explain the Capital Asset Pricing Model (CAPM) and illustrate how a portfolios risk may be reduced; and Explain and compute the stocks beta coefficient, and use the Security Market Line to determine a stocks required rate of return.

Overview

Risk is an important concept in financial analysis, especially in investment decision making. Investment risk is related to the probability distribution of returns.

Outline

Risk refers to the potential variability of returns from a project or portfolio of projects. Investment risk is related to the probability of actual return less than the expected return. The expected return of an asset is the sum of the products of each possible outcome times its associated probability. Expected Return = A weighted average of the individual possible returns One measure of risk is the standard deviation. Standard Deviation is an absolute measure of risk. Another useful measure of risk is the coefficient of variation. The coefficient of variation is an appropriate measure of total risk when comparing two investment projects of different size. It is computed by dividing standard deviation by the expected return. It shows the risk per unit of return and provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same. The average investor is risk averse, which means that he or she must be compensated for holding risky assets. Portfolio assets are less risky compared to the same assets held in isolation.

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An assets total risk = diversifiable (unsystematic) risk + market (systematic) risk. The relevant risk of an asset in a well-diversified portfolio is the assets market risk. It is this risk that the investor will be rewarded for holding it. A stock beta is used to measure the market risk. It measures the responsiveness of the stock relative to the market. The beta of a portfolio is a weighted average of the betas of individual securities in the portfolio. Bp = Wi Bi

The security market line (SML) shows the relationship between a securitys market risk and its required rate of return. Required rate of return = Risk-free return + Risk premium Where the risk premium =

(rm rf),

Slope of security market line. Will increase or decrease with uncertainties about the future economic outlook the degree of risk aversion of investors.

2.

3. 4.

Using stock index as proxy for market portfolio. Determining an appropriate rf. Betas are frequently unstable over time. Required returns are determined by macroeconomic factors.

Self-test Questions

1. When adding new securities to a portfolio, the higher (that is, more positive) the degree of correlation between these securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification. (T or F) 2. Portfolio diversification reduces the variability of returns on each security held in the portfolio. (T or F) 3. If investors become less risk averse, the slope of the Security Market Line will increase. (T or F) 4. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the non-market (or company-specific) risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all market risk. (T or F)

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5. A portfolio with a beta of minus 2 has the same degree of risk to its holder, relative to the market, as a portfolio with a beta of plus 2. However, the holder of either portfolio could lower his or her risk exposure by buying some "normal" stocks. (T or F) 6. Because of differences in the expected values of different securities, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation will always allow an investor to properly compare the relative risks of any two securities. (T or F) 7. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we know that Portfolio B will have the lower systematic (or market) risk; that is, Portfolio B will have the lower beta. (T or F) 8. The only condition under which risk may be completely eliminated is to find securities which are perfectly negatively correlated (r = -1.0) with each other. (T or F) 9. The distributions of rates of return for Company AA and BB are given below: State of Economy Boom Normal Recession Probability of State Occurring 0.2 0.6 0.2 AA 30% 10 -5 BB -10% 5 50

We can conclude from the above information that any rational risk-averse investor will add Security AA to a well-diversified portfolio over Security BB. (T or F) 10. If the price of money increases due to greater anticipated inflation, the riskfree rate will reflect this fact. Although kRF will increase, it is possible that the SML required rate of return for a stock will decrease because the market risk premium (kM - kRF) will decrease. (Assume that beta remains constant.) (T or F)

Activity 4.1

1. 2. 3. 4. Explain what is meant by average investors are risk averse. How does one compute the standard deviation of an asset? Compare your answers with your fellow classmates via the myVLE online forum. Explain what is correlation and why it is important in portfolio formation. An asset held as part of a portfolio is generally less risky than held in isolation. Explain.

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Activity 4.2

Solve problems 4-14 on page 167-168. Once you have solved the problems, discuss your answers with your classmates through the myVLE forum.

Key Terms

Correlation Covariance Coefficient of variation Diversifiable risk Expected return Market risk Standard deviation Systematic risk Unsystematic risk

Summary

This chapter illustrates the trade-off between risk and return. The risk measures and their calculations are shown and distinguished. The stand-alone risk and systematic risk are explained. The benefits of diversification are illustrated and finally the CAPM is introduced and explained.

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Learning Outcomes

When you have completed this chapter, you should be able to: 1. 2. 3. 4. 5. Explain the relationship between (between future and present value); compounding and discounting

Compute the future value of a series of equal, periodic payments (an annuity) as well as the present value of such an annuity; Distinguish the difference between an ordinary annuity and annuity due; Distinguish among the following interest rates: Nominal Rate, Periodic Rate and Effective Annual Rate; and Construct a loan amortisation schedule.

Chapter Overview

A ringgit in hand today is worth more than a ringgit to be received in the future because a ringgit today can be invested and earn interest. Time value of money concept has wide applications in finance, ranging from valuation of securities to project evaluation. In fact, of all the concepts used in finance, this is the most important one.

Outline

Simple Interest means interest paid on the principal sum only Compound Interest means interest paid on the principal and on prior interest that has not been paid or withdrawn Notation t PV0 FVn to denote time = principal amount at time 0 = future value n time periods from time 0

Future Value of a Cash Flow At the end of year n for a sum compounded at interest rate i is FVn = PV0 (1 + i)n Finding present value is called discounting, it is the reverse of compounding. In general, PV0 = FVn(PVIFi, n) Annuity- A series of equal dollar CFs for a specified number of periods

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Ordinary annuity is where the CFs occur at the end of each period. Annuity due is where the CFs occur at the beginning of each period. Future Value of an Ordinary Annuity FVANn = PMT(FVIFAi, n) Future Value of an Annuity Due FVANDn = PMT(FVIFAi, n)(1 + i) Present Value of an Annuity Due PVAND0 = PMT(PVIFAi, n)(1 + i) Payments on a Loan PMT = PVAN0/(PVIFAi, n) Present Value of a Perpetuity PVPER0 = PMT/i Effective annual rate of interest ieff = (1 + inom/m)m 1 An amortized loan schedule shows how much of each payment is interest and how much is used to reduce the principal. It also shows the unpaid balance at each point in time.

Self-test Questions

1. 2. 3. If the discount rate decreases, the present value of a given future payment decreases. (T or F) If the interest increases, the compound sum of an annuity and present value of an annuity both increase. (T or F) If one bank pays 8 percent compounded annually on its savings deposit and a second bank pays 8 percent compounded semi-annually, the second bank is paying approximately twice as much interest. (T or F) The time value of money recognizes that the value of any cash flow depends on its amount and its timing. (T or F) The end-of-year accumulated amounts will increase as the frequency of compounding increases. (T or F) The difference between an ordinary annuity and an annuity due is: a. the interest rate b. the timing of the payments c. the amount of the payments d. the number of periods

4. 5. 6.

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7.

future values and present More frequent compounding results in values than less frequent compounding at the same interest rate. a. higher, higher b. lower, higher c. higher, lower d. lower, lower

Activity 5.1

1. Would you rather have a savings account that pays 6 percent interest compounded semi-annually or one that pays 6 percent interest compounded monthly? Explain your answer and compare it with your classmates through the myVLE online forum. What is an opportunity cost rate?

2.

Activity 5.2

Discuss the mini case on page 88- 89 and post your views online through the myVLE forum.

Key Terms

Annuity due Annuity Compounding Effective interest rate Future value Nominal rate Ordinary annuity Perpetual Present value Time line

Summary

This chapter introduces the concepts and skills necessary to understand the time value of money and its applications. It demonstrates the simple process of computing future values and present values of a lump sum and a series of cash flow streams. It also presents some special applications of time value techniques in common financial decision making.

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Assignment 1

1. 2. Compare the three principal forms of business organization? You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 12 percent, and X = 6 percent. The expected return for Y is 15 percent, and Y = 8 percent. The correlation coefficient, rXY is 0.70. a. b. Calculate kp and p for 100 percent, 75 percent, 50 percent, 25 percent, and 0 percent in Stock X. Suppose kM = 12 percent, M = 4 percent, and kRF = 6 percent. What would be the required and expected return on a portfolio with P = 10 percent? Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this information, along with data given previously, to determine Stock Xs and Stock Ys beta coefficients.

c.

3.

Company A has sales of RM1,000, assets of RM500, a debt ratio of 30 percent, and an ROE of 15 percent. Company B has the same sales, assets, and net income, but its ROE is 30 percent. What is B's debt ratio? (Hint: Begin by looking at the Du Pont equation.) Find the interest rates on each of the following: a. b. c. You borrow RM2,100 and promise to pay back RM2247 at the end of 1 year. You borrow RM42,500 and promise to paid back RM100,614.50 at the end of 10 years. Bank Bumi pays 8 percent interest, compounded quarterly, on its fixed deposit accounts. The managers of Maybank want its fixed deposit account to equal Bank Bumis effective annual rate, but interest is to be compounded on a monthly basis. What nominal rate must Maybank offer?

4.

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LEARNING OUTCOMES

When you have completed all the readings and activities for this topic you will be able to: Describe the key features of bonds and stocks; Identify the cash flows of securities and apply appropriate valuation techniques for these securities; and Employ corporate valuation as alternative to dividend discounted model for valuation.

Topic Overview Study Topic for Week 6 - 10 Securities and Their Valuation Chapters in Focus for Week 6- 10: Chapters 5, 6, 7 & 8

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When you have completed this chapter, you should be able to: 1. 2. 3. 4. 5. Identify the common characteristics of bonds; Calculate the value of a bond with annual or semi-annual interest payments; Compute the current yield, the yield to maturity; Differentiate between interest risk, reinvestment risk, and default risk; and Explain the importance of bond ratings and their criteria used for ratings.

Overview

This chapter explains the basic features of bonds and then uses the present value concept to determine the value of bonds. Bonds can be sold at a discount, at par or at a premium, depending on the current interest rate and the bonds coupon rates. The interest rate risk, reinvestment risk and default risk are also explained and illustrated. Finally the importance of bond rating and the criteria used for rating bonds are identified.

Outline

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bonds. Bonds are classified into four types: Treasury, corporate, municipal and foreign. Each type differs in expected return and degree of risk. Due to differences in contractual provisions, the strength of the companies backing the bonds, the bonds expected returns and risk would be different for different corporations. The par value is the stated face value of the bond, usually RM1,000. It represents the amount of money the firm borrows and promises to repay on the maturity date. The coupon interest rate is the amount of interest each year (or, more typically, each six months) that is paid to a bondholder by the issuer of bonds. This payment is a fixed amount which is determined at the time the bond is issued. The maturity date is the date on which the par value must be repaid by the issuer.

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Most corporate bonds contain a call provision, which gives the issuing corporations the right to call the bonds for redemption. The call provision generally states that if the bonds are called, the company must pay the bondholders an amount greater than the par value, a call premium. Some bonds include a sinking fund provision to facilitate orderly retirement of the bond issue. This can be done in either of two ways: 1. 2. The company can call in for redemption (at par value) a certain percentage of the bonds each year; The company may buy the required number of bonds on the open market.

Convertible bonds are bonds that are convertible into shares of common stock, at a fixed price, at the option of the bondholder. Bonds issued with warrants are similar to convertible bonds. Warrants are options which allow the holder to buy stock for a stated price, thereby providing a capital gain if the stock price rises. The value of bond is simply the present value of the cash flows the bond is expected to produce. The cash flows from a specific bond depend on its contractual features.

N

Bond Value =

INT / (1 + rd)t

M / (1 + rd)N

t=1

For example, a 10-year, $1,000 bond paying $80 annually, when the appropriate interest rate rd, is 12%, the value of the bond VB = $80 (5.650) + $1,000 (0.322) = $774.

An adjustment to the formula must be made if the bond pays interest semiannually: divide INT and rd by 2 and multiply N by 2. Bond prices and interest rates are inversely related, that is they tend to move in the opposite direction from each other. 1. When the going rate of interest is equal to the coupon rate, a fixed rate bond will sell at par value. Normally, the coupon rate is set to equal the going rate when a bond is issued, thus selling at par initially. Whenever the going rate of interest rises above the coupon rate, a fixed rate bonds price will fall below its par value. Such bond is called discount bond. Whenever the going rate of interest falls below the coupon rate, a fixed rate bond will rise above its par value, which is called premium bond.

2.

3.

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Yield to maturity (YTM) is the rate of return you would earn on your investment if you bought the bond and held it to maturity. The YTM for a bond that sells at par consists entirely of interest yield, but if the bond sells at a price other than its par value, the YTM will consist of the interest yield plus a positive or negative capital gains yield. If the current interest rates are well below an outstanding bonds coupon rate, then a callable bond is likely to be called, and investors could estimate the expected rate of return on bond as the yield to call (YTC).

N

YTC

INT / (1 + rd)t

t=1

The current yield is the annual interest payment divided by the bonds current price. It provides information regarding the amount of cash income that a bond will generate in a given year. Current yield = Annual interest payment / (current bond price) Interest rates fluctuate over time. The risk of a decline in bond values due to rising interest rates is called interest rate risk. The longer the maturity of the bond, the greater the exposure to interest rate risk. The risk of an income decline due to a drop in interest rates is called reinvestment rate risk. The shorter the maturity of the bond, the greater the risk of a decrease in interest rates. Interest rate risk relates to the value of the bonds in a portfolio, while reinvestment rate risk relates to the income the portfolio produce. If the issuer defaults, investors receive less than the promised return on the bond. Default risk is influenced by both the financial strength of the issuer and the terms of the bond contract. Bond issues are normally assigned quality ratings that reflect their probability of going into default. Bond ratings are based on both qualitative and quantitative factors like: financial ratios- debt ratio, times-interest-earned ratio, EBITDA coverage ratio; mortgage provisions; guarantee provisions; sinking fund; maturity; stability in sales and earnings; and regulation. Bond ratings are important both to firms and investors because the rating has a direct, measurable influence on the bonds interest rate and the firms cost of debt. Most bonds are purchased by institutional investors and many of them are restricted to investment-grade securities. Corporate bonds are traded primarily in the over-the-counter market. Most bonds are owned by and traded among the large financial institutions. Bond data are available on the internet, at sites such as http://www.bondsonline.

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Activity 6.1

a. b. c. d. e. f. g. h. What are the four main types of bonds? Why is a call provision advantageous to a bond issuer? Why do bonds with warrants and convertible bonds have lower coupons than straight bonds? What is a discount bond? Explain the difference between the yield to maturity and the yield to call. Could current yield exceed the total return? Differentiate between interest rate risk and reinvestment rate risk. Name the major rating agencies, and list some factors that affect bond ratings.

Activity 6.2

Read the mini case on page 246 to 247 and answer all the questions.

Self-Test Questions

1. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, be subject to much more interest rate risk if you purchased a 30-day bond than if you bought a 30-year bond. (T or F) A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. (T or F) A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells) at par, therefore providing compensation to investors in the form of capital appreciation. (T or F) There is an inverse relationship between bond ratings and the required return on a bond. The required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. (T or F) A junk bond is a high risk, high yield debt instrument typically used to finance a leveraged buyout or a merger, or to provide financing to a company of questionable financial strength. (T or F) You have just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. If the coupon rate is 10 percent, with annual interest payments, and there are 10 years to maturity, you should make the purchase if your required return on investments of this type is 12 percent. (T or F)

2.

3.

4.

5.

6.

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7.

The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things equal and held constant. (T or F) A bond with a $100 annual interest payment with five years to maturity (not expected to default) would sell for a premium if interest rates were below 9 percent and would sell for a discount if interest rates were greater than 11 percent. (T or F) Restrictive covenants are designed so as to protect both the bondholder and the issuer even though they may constrain the actions of the firm's managers. Such covenants are contained in the bond's indenture. (T or F) Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise. Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers. (T or F)

8.

9.

10.

Key Terms

Indenture Interest rate risk Maturity date Mortgage bonds Par value Premium Reinvestment rate risk Sinking fund Yield to call Yield to maturity

Summary

To determine the value of bonds, one must first estimate the assets future cash flows and then discount them at an appropriate discount rate. The yield to maturity is a measure of the return that investors require on a bond. Bond prices and interest rates are inversely related. Bond rating agencies help investors evaluate the risk of bonds. Bonds with lower ratings must offer investors higher yields.

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When you have completed this chapter, you should be able to: 1. 2. 3. Understand the rights of a stockholder; Determine the value of ordinary shares using the dividend discounted model; and Define preference share and determine the value of a preference share;

Overview

Holders of common stock are owners of firms. As owners, they have certain rights and privileges, including the right to control the firm via election of directors and the right to the firms residual earnings. A common stock is valued by discounting its expected future dividend stream. The total rate of return on a stock comprises of dividend yield and a capital gains yield. Preferred stock is a hybrid security. It is similar to bonds in some aspects and to common stock in others.

Outline

Common stockholders have the right to elect a firms directors, who, in turn, elect the officers who manage the business. The pre-emptive right gives the current shareholders the right to purchase any additional shares sold by the firm. Stock market transactions may be classify into three distinct types: The secondary market deals with outstanding shares or used shares. The primary market deals with additional shares sold by established, publicly owned companies. Companies raise additional capital by selling in this market. The primary market also handles new public offerings of shares in firms that were formerly closely held. The market for stock that is just being offered to the public is called initial public offering (IPO) market.

Common stocks are valued by finding the expected cash flow stream. The expected cash flows consist of the expected dividends in each year and the price investors expect to receive when they sell the stock. 42

Value of stock Vs

D1/ (1 + rs )1 + D2/ (1 + rs )2 + D/ (1 + rs )

t=1

Dt/ (1 + rs )t

Stock valuation is more complex task than bond valuation because dividends are not expected to remain constant in the future and dividends are harder to predict. If the company is paying a constant dividend, that is zero dividend growth, then the value of the stock will be D/ rs . For companies where their earnings and dividends are expected to grow at some normal, or constant rate, the value of the stock is: = D1/ ( rs -g ) or D0 (1 + g)/ ( rs -g ).

This equation for valuing a constant growth stock is often termed Gordon Model, after Myron J. Gordon, who have developed this model. For all stocks, the total expected return, rs is composed of an expected dividend yield plus expected capital gains yield. For a constant growth stock, rs = [D1 / Vs ]+ g. Most firms encounter periods of non-constant growth, after which time their growth rate settles to a rate close to that of the economy as a whole. For such firms, the value of the stock can be determined as follows: 1. 2. Find the present of the dividends during the period of non-constant growth. Find the price of the stock at the end of the non-constant growth period, at which point it has become a constant growth stock, and discount this price back to present value. Add these two components to find the stocks present value.

3.

Preferred stock is a hybrid- it is similar to bonds in some aspects and to common stock in other aspects. Most preferred stocks entitle the owners to regular fixed dividend payments. If the payments last forever, the value of preferred stock is determined as follows: Vpre = Dpre / rpre

Activity 7.1

1. 2. 3. 4. 5. Differentiate between primary and secondary markets. What is IPO? What are the two components of most stocks expected return? Write out and explain the valuation formula for a constant growth stock. Preferred stock is a hybrid security, explain.

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Activity 7.2

Discuss the mini case on page 282-283 and answer part a to e.

Self-test Questions

1. 2. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. (T or F) According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock. (T or F) A proxy is a document giving one party the authority to act for another party, typically the power to vote shares of common stock. A proxy can be an important tool relating to control of the firm. (T or F) The pre-emptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares sold by the firm. This right protects current stockholders against both dilution of control and dilution of value. (T or F) When stock in a closely held corporation is offered to the public for the first time the transaction is called "going public" and the market for such stock is called the new issue market. (T or F) A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred stock, what is your nominal (not effective) annual rate of return? a. 10% b. c. 8% 6%

3.

4.

5.

6.

d. 12% e. 14% 7. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today? a. b. c. d. e. $164.19 $ 75.29 $107.53 $118.35 $131.74

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8.

Thames Inc.s most recent dividend was $2.40 per share (i.e., D0 = $2.40). The dividend is expected to grow at a rate of 6 percent per year. The risk-free rate is 5 percent and the return on the market is 9 percent. If the companys beta is 1.3, what is the price of the stock today? a. b. c. d. e. $72.14 $57.14 $40.00 $68.06 $60.57

9.

The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein's required rate of return on equity (ks) is 12 percent. What is the current price of Klein's common stock? a. b. c. d. e. $21.00 $33.33 $42.25 $50.16 $58.75

10.

Motor Homes Inc. (MHI) is presently in a stage of abnormally high growth because of a surge in the demand for motor homes. The company expects earnings and dividends to grow at a rate of 20 percent for the next 4 years, after which time there will be no growth (g = 0) in earnings and dividends. The company's last dividend was $1.50. MHI's beta is 1.6, the return on the market is currently 12.75 percent, and the risk-free rate is 4 percent. What should be the current price per share of common stock? a. b. c. d. e. $15.17 $17.28 $22.21 $19.10 $24.66

Key Terms

Constant growth model Capital gains yield Dividend yield Initial public offering (IPO) Pre-emptive rights

Summary

This chapter describes the features of common stock and preferred stocks. It also discusses the framework for valuing these securities.

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Chapter 8: Corporate Valuation, Value-based Management and Corporate Governance Learning Objectives

When you have completed this chapter, you should be able to: 1. 2. 3. Apply the corporate valuation model to divisions, subunits and to the entire firm; Identify the four value drivers in value-based management; and Understand the importance of corporate governance and the two primary mechanisms used in corporate governance.

Overview

The primary objective of management is to maximize shareholders value. To achieve this, managers need a tool for estimating the impacts of alternative strategies. This chapter develop and illustrate the corporate valuation model. Companies practise value-based management by systematically using the corporate valuation model to guide their decisions.

Outline

The corporate valuation model does not depend on dividends, and it can be applied to divisions and sub-units as well as to the entire firm. The corporate stockholders. valuation model shows how corporation decisions affect

The set of rules and procedures used to motivate managers falls under the area of corporate governance. Corporate assets are of two types: operating and non-operating. Operating assets can be assets-in-place and growth options. Assets-in-place include tangible assets plus intangible assets. Growth options are opportunities to expand that arise from the firms current operating knowledge, experience, and other resources. Both assets provide an expected streams of cash flows. Non-operating assets come in two forms: First the marketable securities portfolio over and above the cash needed to operate the business. Second investment in other businesses, which were reported on the asset side of the balance sheet. Free cash flow is the cash from operations that is actually available for distribution to investors, including stockholders, bondholders and preferred stockholders.

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The value of operation is the present value of all the future free cash flows expected from operations when discounted at the weighted average cost of capital:

V0peration

FCFt / (1 + WACC)t

t= 1

Value of a corporation can be computed by discounting its expected free cash flows from operations by its weighted average cost of capital, WACC, plus the value of its non-operating assets. The value of equity is the total value of the company minus the value of the debt and preferred stock. The four value drivers are: growth rate in sales, operating profitability, capital requirement and WACC.

Activity 8.1

1. 2. 3. 4. 5. Why is the corporate valuation model applicable in more circumstances than the dividend growth model? What is value-based management? What is corporate governance? Explain how to estimate the price per share using the corporate valuation model. What are the four value drivers?

Activity 8.2

Please go to Web site: http://brigham.swlearning.com, to access any Cyber problems.

1. 2. The corporate valuation model cannot be used for a company that doesnt pay dividends. (T or F) Free cash flows should be discounted at the weighted average cost of capital to find the value of a companys operations. (T or F)

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3.

Value-based management focuses on sales growth, profitability, capital requirements, the weighted average cost of capital, and dividend growth. (T or F) Two important issues in corporate governance are the rules that affect the threat of a CEOs removal and the rules that allow a CEO to fire members of the board of directors. (T or F) The corporate valuation model discounts free cash flows by the required return on equity. (T or F) Which of the following is not always a way to increase the value of a company? a. b. c. d. e. Increase the growth rate of sales. Increase the operating profitability (NOPAT/Sales). Decrease the capital requirement (Capital/Sales). Decrease the weighted average cost of capital. Increase the expected return on invested capital.

4.

5. 6.

7.

Suppose a companys current free cash flow is $100 million and is expected to grow at a constant rate of 5 percent. If the companys weighted average cost of capital is 15 percent, what is the current value of operations? a. b. c. d. e. $ 913 million $1,000 million $1,050 million $1,500 million $2,000 million

8.

A company forecasts free cash flow in one year to be -$10 million and free cash flow in two years to be $20 million. After the second year, free cash flow will grow at a constant rate of 4 percent per year forever. If the overall cost of capital is 14 percent, what is the current value of operations, to the nearest million? a. b. c. d. e. $150 million $167 million $200 million $208 million $228 million

9.

Using the corporate valuation model, the value of a companys operations is $750 million. The companys balance sheet shows $50 million in short-term investments that are unrelated to operations. The balance sheet also shows $100 million in accounts payable, $100 million in notes payable, $200 million in long-term debt, $40 million in common stock (par plus paid-in-capital), and $160 million in retained earnings. What is your best estimate for the market value of equity?

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a. b. c. d. e. 10.

$200 million $300 million $400 million $500 million $600 million

Using the corporate valuation model, the value of a companys operations is $400 million. The companys balance sheet shows $20 million in shortterm investments that are unrelated to operations. The balance sheet also shows $50 million in accounts payable, $90 million in notes payable, $30 million in long-term debt, $40 million in preferred stock, and $100 million in total common equity. If the company has 10 million shares of stock, what is your best estimate for the stock price per share? a. b. c. d. e. $10 $21 $24 $26 $42

Key Terms

Assets-in-place Corporate governance Free cash flow Growth options Non-operating assets Operating assets Value-based management

Summary

Corporate assets consist of operating and financial (non-operating) assets. The value of operations is the present value of all the future free cash flows expected from operations when discounted at the WACC. The corporate valuation model can be used to calculate the total value of a company by finding the value of operations plus the value of non-operating assets.

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Assignment 2

1. 2. 3. Explain why do the prices of fixed rate bonds fall if expectations of for inflation rise. Differentiate between interest rate risk and reinvestment rate risk. TEN Bhd sold an issue of bonds with a 8-year maturity, a RM1,000 par value, a 8 percent coupon rate, and semi-annual interest payments. a. Three years after the bonds were issued, the going rate of interest on bond such as these fell to 6 percent. At what price would the bond sell? Suppose that, 3 years after the initial offering, the going interest rate had risen to 10 percent. At what price would the bonds sell? c. Suppose that the conditions in part a) existed- that is, interest rate fell to 5 percent 3 years after the issue date. Suppose further that the interest rate remained at 5 percent for the next 4 years. What would happen to the price of the Ten Bhd bonds over time? (no calculations are required, just describe)

b.

4.

A financial analyst has been following Fast Start Bhd., a new highgrowth company. She estimates that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast Start's beta is 1.75. The current earnings per share (EPS0) is RM0.25. The company has a 40 percent payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent this year, 20 percent next year, and 15 percent the following year. After three years the dividend is expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its current payout ratio. The analyst believes that the stock is fairly priced. What is the current price of the stock?

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LEARNING OUTCOMES

When you have completed all the readings and activities for this topic you will be able to: Identify and compute the weighted average cost of capital; Employ and evaluate the various capital budgeting techniques; Estimate the project cash flows; Differentiate between a firms business risk and its financial risk; and Explain the concept of optimal capital structure.

Topic Overview Study Topic for Week 11 - 14 Projects and Their Valuation Chapters in Focus for Week 11- 14: Chapters 9, 10, 11 & 16.

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When you have completed this chapter, you should be able to: 1. 2. 3. 4. 5. Define and calculate the component costs of debt and preferred stock; Employ different methods to estimate the component cost of retained earnings; Calculate the component cost of newly issued common stock; Explain and calculate the firms composite or weighted average cost of capital; and Identify some of the factors that affect the cost of capital;

Overview

Cost of capital is a critical element in most business decisions. Undertaking projects, merger and acquisitions often require substantial amount of capital. The capital can be in the form of debt, preferred stocks or common stocks. Each type of capital has different costs. In order to determine whether the projects will create any value to the firm, they need to be evaluated based on the cost of capital.

Outline

The sources of capital of a firm can come from debt, common stock, retained earnings and preferred stock. Each capital component has a component cost and can be calculated as follows: The after-tax cost of debt, rda = rd (1 T), where rd is the interest rate on debt and T is the tax rate. The component cost of preferred stock, rpre = Dpre / NP where Dpre is the preferred dividend and NP is the net price. Net price means the price the firm receives after deducting flotation costs. No tax adjustments are made when computing rpre because preferred dividends are not expense and hence not tax deductible. The equity capital comes from retained earnings (internal sources) or new equity (external sources). The cost of retained earnings, rre, is the rate of return stockholders require on equity capital the firm obtains from earnings. Three methods typically are used: CAPM, the discounted cash flow method, and the bond-yield-plus-risk premium technique.

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The Capital Asset Pricing Model is used for the first method: rre = RF + b (Rm RF )

Where RF is the risk-free rate, b is the stock beta coefficient as an measure of risk, and Rm is the expected rate of return on the market. When discounted cash flow method is employed, the constant growth model is assumed: rre = D1 / P0 + expected growth rate

The expected growth rate may be estimated by looking at the past growth rates if they have been relatively stable. Another approach is by using the retention rate multiply with the return on equity, that is: G = (retention rate) x ROE The cost of new common equity, re, is higher than the cost of retained earnings, rre, because there are flotation costs incurred in issuing new common stock. To compute the cost of external (new) equity, re, the discounted cash flow approach requires adjustment as follows: re = D1 / P0 ( 1 F) + expected growth rate, where F are the flotation costs. The bond yield-plus-risk premium method estimated re , by adding a risk premium of 3 to 5 percentage points to the firms own bond yield. re = Bond yield + risk premium

The capital structure and along with the component costs of capital are used to compute the weighted average cost of capital (WACC). WACC = Wd rd (1 T) + Wpre rpre + Wre (rre or re) Where W is the component capital weightage. Theoretically, the weights used should be based on market values of the different securities. However, book values are used as the proxies of market values if they are reasonably close to each other. The cost of capital is affected by a number of factors. Some are beyond the firms control while others are influenced by the firms financing and investment policies. Factors the firm unable to control include: the level of interest rate, market risk premium, and tax rate. If interest rates in the economy rise, the cost of debt capital increases because firms have to pay higher rate of interest to the bondholders. Higher interest rates also increase the cost of common and preferred stocks.

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The perceived risk inherent in stocks and investors aversion to risk determine the market risk premium. Tax rates are used in the calculation of the cost of debt as used in the WACC. Lowering the capital gains tax rate relative to the rate on ordinary income would make stocks more attractive, which would reduce the cost of equity relative to that of debt. Factors the firm can control included: Capital structure policy, dividend policy and investment policy. The firm can change its capital structure to affect its cost of capital. If the firm uses more debt and less common equity, it influences the weights in the WACC which will tend to reduce the WACC. However, an increase in the use of debt will increase the riskiness of both debt and equity, and these increases will tend to increase the WACC, thus offset the change in weights. Given the level of earnings, the higher the dividend payout, the lower the level of retained earnings, and thus reducing the retained earnings break point in the marginal cost of capital (MCC). When we estimate the cost of capital, we use as a starting point the required rate of return on the firms stock and its cost of new debt as reflected in the yield on its outstanding bonds. These rates indicate the risk of the firms existing assets. We implicitly assume that the new capital will be invested in assets of the same type and with the same degree of risk as is embedded in the existing assets. It would incorrect to assume that if the firm has dramatically change its investment policy.

Activity 9.1

1. 2. 3. 4. 5. 6. Why is the after-tax cost of debt rather than the before-tax used to calculate the WACC? Should the cost of debt on already outstanding debt or new debt be used ? Why no tax adjustment is made to the cost of preferred stock and common stock? Explain why there is a cost to using retained earnings? How is the WACC calculated? Explain how change in interest rates in the economy would impact each component of the WACC.

Activity 9.2

Read the mini case on page 340 to 341 and answer part a to part i.

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Self-Test Questions

1. 2. The component costs of capital are market-determined variables in as much as they are based on investors' required returns. (T or F) The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. (T or F) The cost of common stock is the rate of return stockholders require on the firm's common stock. (T or F) In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm. (T or F) The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. (T or F) A company has a capital structure which consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct? a. b. c. d. The cost of equity financing is greater than or equal to the cost of debt financing. The WACC exceeds the cost of equity financing. The WACC is calculated on a before-tax basis. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the marginal cost of capital. The cost of retained earnings exceeds the cost of issuing new common stock.

3. 4.

5.

6.

e. 7.

Which of the following statements is most correct? a. b. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project. The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt. One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are, in fact, not well diversified, beta may be a poor measure of the firm's true investment risk. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital. The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost

c.

d.

e.

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8.

Which of the following statements is most correct? a. Since stockholders do not generally pay corporate taxes, corporations should focus on before-tax cash flows when calculating the weighted average cost of capital (WACC). When calculating the weighted average cost of capital, firms should include the cost of accounts payable. When calculating the weighted average cost of capital, firms should rely on historical costs rather than marginal costs of capital. Answers a and b are correct. None of the answers above is correct.

b. c. d. e. 9.

Your company's stock sells for RM50 per share, its last dividend (D0) was RM2.00, and its growth rate is a constant 5 percent. What is the cost of common stock, ks? a. b. c. d. e. 9.0% 9.2% 9.6% 9.8% 10.0%

10.

A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. Given the following information, calculate the firm's weighted average cost of capital. kd = 6% Tax rate = 40% P0 = RM25 Growth = 0% D0 = RM2.00 a. b. c. d. e. 6.0% 6.2% 7.0% 7.2% 8.0%

Key Terms

Cost of debt Cost of equity Cost of preferred stock Flotation costs Weighted average cost of capital

Summary

The WACC is developed in the following manner: First compute the cost of each capital component. The next task is to combine the component costs to determine the WACC. The weights are based on the firms capital structure.

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When you have completed this chapter, you should be able to: 1. 2. 3. Define capital budgeting and classify project proposals; List the steps involved in evaluating a capital budgeting project; and Use both non-discounted cash-flows techniques (payback, accounting rate of return) and discounted cash-flows methods (net present value, internal rate of return) to evaluate independent and mutually exclusive projects;

Overview

Capital budgeting is the decision process that managers use to identify value added projects. It normally involves substantial expenditure. It is therefore important that a careful evaluation of the project be carried out before a decision is made to implement it. Failure to do so may result in having large funds tied up in the project.

Outline

Firms classify projects into different categories to enable them to analyse them differently. A more detailed analysis is required for cost reduction replacement, expansion, and new product decisions than for simple replacement and maintenance decisions. Larger investment require increasing detailed analysis and approval at a higher level within the firm. Project evaluation will involve the following steps: Determine the project cost. Estimate the project cash flows. Determine the riskiness of the projected cash flows. Determine the appropriate discount rate. Compute the present value of the cash flows to obtain the estimated assets value to the firm. Deduct the initial outlay from the present value of the expected cash flows. If the difference is positive, accept the project; otherwise, reject the project. Project evaluation techniques include: payback, discounted payback, net present value (NPV), internal rate of return (IRR) and modified internal rate of return (MIRR). The payback period is defined as the expected number of years required to recover the original investment.

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The advantages of payback method are: use cash flows, simple to compute and easy to understand. The disadvantages include: it ignores time value of money and fails to consider the cash flows after the payback period. Discounted payback method is similar to the regular payback period except that the expected cash flows are discounted by the projects cost of capital. Thus it is the number of years required to recover the investment from the discounted net cash flows. Net present value method considers all the cash flows and the time value of money in project evaluation. To implement the NPV, first find the present value of each cash flow and discounted at the projects cost of capital, second, sum these discounted cash flows to obtain the projects NPV. Accept the project if the NPV is positive. NPV = CF0 + CF1/ (1 + k)1 + CF2/ (1 + k)2 ++ CFn/ (1 + k)n = n CFt/ (1 + k)t t=1

Or NPV

where CFt is the expected net cash flow in period t and k is the projects cost of capital. All independent projects with positive NPV should be accepted. If two projects are mutually exclusive (only one can be accepted), then the one with the higher NPV should be chosen. If both have negative NPVs, neither will be accepted. The internal rate of return (IRR) is that discount rate that equates the present value of a projects expected cash flows to the present value of the projects costs. IRR: PV (inflows) = PV (investment costs)

The equation for computing the IRR is as follows: n CFt/ (1 + IRR)t t=0 Solve the IRR by trial and error. If IRR is greater than the projects cost of capital, accept the project. If it is less than the cost of capital, reject the project. In many respects the NPV is better than IRR. However, the IRR is widely used by managers. The NPV implicitly assumes that project cash flows are reinvested at the projects cost of capital. The IRR method implicitly assumes that project cash flows are reinvested at the projects IRR. = 0

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The opportunity cost of a projects cash flows is the projects cost of capital, thus the reinvestment at the cost of capital is the correct assumption. NPV is more superior than the IRR. When projects are independent, the NPV and IRR methods provide the same accept/ reject decision. However, when evaluating mutually exclusive projects, NPV method should be used. Multiple IRRs can happen when the project has non-normal cash flows. To overcome the problem related to the reinvestment rate in IRR method, modified IRR (MIRR) can be used. The MIRR is that discount rate which forces present value costs equate present value of terminal value where the terminal value is the future value of the inflows compounded at the cost of capital. MIRR also avoids the problem of multiple IRRs.

Activity 10.1

1. 2. 3. 4. 5. Why are capital budgeting decisions so important? List two weaknesses of payback method. NPV method is more superior than that of IRR method. Why? What are the primary differences between the MIRR and regular IRR? Should capital budgeting decisions be made solely on the basis of a projects NPV?

Activity 10.2

Discuss the mini case on page 376- 377 and answer part a to e.

Self-test Questions

1. One advantage of the payback period method of evaluating fixed asset investment possibilities is that it provides a rough measure of a project's liquidity and risk. (T or F) The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows. (T or F) Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favour of the project with the higher NPV. (T or F)

2.

3.

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4.

If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm will select X rather than Y if X has a NPV > 0. (T or F) a. b. c. d. e. Both projects have a positive net present value (NPV). Project A must have a higher NPV than Project B. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A. Statements a and c are correct. Statements a, b, and c are correct.

5.

The post-audit is used to a. b. c. d. e. Improve cash flow forecasts. Stimulate management to improve operations and bring results into line with forecasts. Eliminate potentially profitable but risky projects. All of the answers above are correct. Answers a and b are correct.

6.

Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Which of the following statements is most correct? a. b. c. d. e. Project X must have a higher net present value than Project Y. If the two projects have the same WACC, Project X must have a higher net present value. Project X must have a shorter payback than Project Y. Both answers b and c are correct. None of the above answers is correct.

Key Terms

Independent project Internal rate of return (IRR) Modified internal rate of return Mutually exclusive project Net present value (NPV) Payback period

Summary

Capital budgeting refers to long-term investment and is one of the most important tasks of managers to create value for the firm. Various techniques that use in capital budgeting were discussed. Each approach provides a different piece of information. NPV is the best method.

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Learning Objectives

When you have completed this chapter, you should be able to: 1. 2. 3. Identify the initial outlays, operating cash-flows and terminal cash-flows of a project; Discuss the difficulties and relevant considerations in estimating net cash flows; and Analyse a replacement project and determine whether the project should be accepted based on the capital budgeting techniques.

Overview

One of the most difficult tasks in capital budgeting is the cash flow estimation. To estimate the cash flows, only the incremental cash flows should be considered. In addition, opportunity costs, net working capital changes and disposal values should also be incorporated to determine the correct cash flows.

Outline

The most important , but also most difficult in capital budgeting is estimation of projects cash flows- investment outlays and the annual net cash flows after project is in operation. Capital budgeting decisions must be based on cash flows, not accounting profits and only incremental cash flows are relevant. Net cash flows should be adjusted to reflect all non-cash charges. Interest payments should not be deducted as cash outflows because the interest rate on debts are already incorporated in the cost of capital. Deducting interest payments would result in double counting. No sunk costs should be incorporated in the cash flows as these costs are irrelevant. Opportunity costs must be included in the analysis as they can affect the decision. Externalities related to the effects of a project on other parts of the firm, and their impact need to be considered in the analysis. Shipping, installation, insurance, renovations which are attributable to the project must be taken into consideration when determine the full cost of the equipment as this cost will be used as the depreciation basis when capital allowance/ allowable depreciation are calculated. Any incremental working capital must be deducted as an outflow first and will be recovered when the project expires.

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At the end of the projects life, the terminal year cash flows are received. These include the after-tax salvage value of the fixed asset plus the recovery of the net working capital. Replacement project analysis is different from expansion projects because the cash flows from the old asset need to be considered. To evaluate a replacement project, first estimate the initial outlay. Initially outlay = Price of the asset + shipping + installation + insurance + any other cost that is due to this project + increase in net working capital + disposal value of old asset (to be replaced) - or (+) disposal gain/ loss x tax rate. For the operating periods, the yearly cash flows are estimated by taking profit after tax + allowable depreciation, that is: Annual cash flow = Profit after tax + allowable depreciation

At the terminal period, disposal of asset and disposal gain or loss must be estimated. The net working capital must be added back at this stage as the amount has been recovered. When after-tax cash flows are used, they must discounted by after-tax projects cost of capital.

Activity 11.1

1. 2. 3. 4. 5. What is the most important step in a capital budgeting analysis? Why companies use project cash flow rather than accounting profit when evaluating project? What is net operating working capital and how it should handled in capital budgeting? What are the three types of cash flows must be considered when evaluating a proposed project? Explain how shipping and installation can affect the cash flows.

Activity 11.2

Suvi Sdn. Bhd. is evaluating the proposed acquisition of a new machine. The machine will require a capital expenditure outlay of RM63,000 and would cost another RM5,000 to modify it for special use by the firm. It will have a five-year life and, at the end of that time the equipment used will be sold off for RM6,000. In addition, working capital will increase by RM10,000 from the start of the project. All the working capital will be recovered at the end of the projects life. The project is expected to generate annual revenues of RM45,000 and to incur annual cash operating costs of RM20,000. The company believes that an after-tax discount rate of 12% would be appropriate.

62

The project would be financed with a two-year term loan of RM45,000 at 10%. The working capital would be financed out of the companys retained earnings. Company tax is charged at 28% and depreciation is on a straight-line method. Assume that depreciation allowance for accounting purposes and tax purposes are the same and taxes are payable in the year in which income is earned. Required: a. b. c. What is the initial cash outlay for the new project? Determine cash flows in Years 1-5. Should the new machine be implemented? Why?

1. A company is considering an expansion project. The companys CFO plans to calculate the projects NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the companys cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows? a. Any sunk costs associated with the project. b. Any interest expenses associated with the project. c. Any opportunity costs associated with the project. d. Answers b and c are correct. e. All of the answers above are correct. 2. Regarding the net present value of a replacement decision, which of the following statements is false? a. The present value of the after-tax cost reduction benefits resulting from the new investment is treated as an inflow. b. The after-tax market value of the old equipment is treated as an inflow at t = 0. c. The present value of depreciation expenses on the new equipment, multiplied by the tax rate, is treated as an inflow. d. Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0. e. An increase in net operating working capital is treated as an outflow when the project begins and as an inflow when the project ends.

63

Key Terms

Allowable depreciation Externalities Initial outlay Opportunity costs Sunk costs Salvage value

Summary

The value of any asset depends on the amount, timing and the riskiness of the cash flows it produces. The most important but most difficult part in capital budgeting is the estimation of project cash flows. When estimating cash flows, only relevant, that is incremental cash flows should be considered. Ignore sunk costs but incorporate opportunity costs and externalities in the analysis. To facilitate analysis, divide the project cash flows in three stages: initial, operating and terminal. After which, the capital budgeting technique be applied to determine whether to accept or reject the project.

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When you have completed this chapter, you should be able to: 1. 2. 3. 4. Distinguish between a firms business risk and its financial risk; Explain how operating leverage contributes to a firms business risk; Define financial risk and explain its effect on expected roe and the risk borne by stockholders; and Explain what is meant by optimal capital structure;

Overview

A firms optimal capital structure is that mix of debt and equity that maximises the stock prices. Different capital structures will have different effects on stock prices, earnings per share, and the cost of capital.

Outline

The actual levels of debt to equity may vary over time, most firms try to keep their financing mix close to a target capital structure. The firms mixture of debt and equity is called its capital structure. A firms value is affected by either the free cash flows or the cost of capital. The capital structure decision can affect the WACC and free cash flow (FCF). Ways that a higher proportion of debt can affect WACC and FCF: Debt-holders have a prior claim on the firms cash flows relative to shareholders. Increase in debt means the increase in the cost of stock. The probability of financial distress or bankruptcy also goes up. With higher bankruptcy risk, the cost of debt will increase as the debt-holders will demand for higher yield. All these will affect the WACC even though interest is tax deductible. In addition, higher bankruptcy risk reduces FCF. Business risk is the riskiness of the firms stock if it uses no debt. It arises from the uncertainty about its projections of the firms cash flows, which in turn means uncertainty about its operating profit and its capital requirements. Business risk depends on a number of factors: demand variability, sales price variability, input cost variability, ability to adjust output prices for changes in input costs, ability to develop new product in a timely, cost-effective manner, foreign risk exposure, and the extend to which costs are fixed. Operating leverage is the extent to which a firm uses fixed costs in its production operations. The higher a firms fixed costs, the greater its operating leverage. High operating leverage means that a relatively small change in sales will result in a large change in operating profit.

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Where P = price per unit, VC= variable cost per unit and FC = fixed costs The higher a firms operating leverage, the higher its business risk, other things held constant. Financial risk is the additional risk placed on the common stockholders as a result of the decision to finance with debt. Financial leverage refers to the firms use of fixed income securities. The extent to which a firm employs financial leverage will affect its expected earnings per share (EPS) and the riskiness of these earnings. The optimal capital structure is that level of capital structure that maximum value is achieved. Manager should choose the capital structure that maximises shareholders wealth. In order to achieve this optimal level, managers can consider a trial capital structure, based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure. This is repeated until an optimal capital structure is identified.

Activity 16.1

1. 2. 3. 4. 5. Briefly describe some ways in which the capital structure decision can affect the WACC and FCF. What is business risk, and how can it be measured? How does operating leverage affect business risk? Using leverage has both good and bad effect. Explain. What happens to the cost of debt and equity when the leverage increases?

Activity 16.2

On January 1, the total market value of Resort World was RM900 million. During the year, the company plans to raise and invest RM300 million in new projects. The firms present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt. (RM) Million Debt Common stock 450 450

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New bond will have an 10 percent coupon rate, and they will be sold at par. Common stock is currently selling at RM15 a share. Stockholders required rate of return is estimated to be 15 percent, consisting of a dividend yield of 5 percent and an estimated growth rate of 8 percent. (The next expected dividend is RM0.75, so RM0.75/RM15 = 5%) The marginal corporate tax rate is 28 percent. a. b. To maintain the present capital structure, how much of the new investment must be financed by common stock? Assume that there is sufficient cash flow such that Resort World can maintain its target capital structure without issuing additional shares of equity. What is the WACC? Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?

c.

1. 2. The firm's business risk is largely characteristics of its industry. (T or F) determined by the financial

Financial risk refers to the extra risk stockholders bear as a result of the use of debt as compared with the risk they would bear if no debt were used. (T or F) The trade-off theory tells us that the capital structure decision involves a trade-off between the costs of debt financing and the benefits of debt financing. (T or F) Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT. (T or F) Two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS. (T or F) Which of the following events is likely to encourage a company to raise its target debt ratio? a. b. c. d. e. An increase in the corporate tax rate. An increase in the personal tax rate. An increase in the companys operating leverage. Statements a and c are correct. All of the statements above are correct.

3.

4. 5. 6.

7.

Volga Publishing is considering a proposed increase in its debt ratio, which will also increase the companys interest expense. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its common stock. The companys CFO expects that the plan will not change the companys total assets or operating income. However, the companys CFO does estimate that it will increase the companys earnings per share (EPS). Assuming the CFOs estimates are correct, which of the following statements is most correct?

67

a.

Since the proposed plan increases Volgas financial risk, the companys stock price still might fall even though its EPS is expected to increase. If the plan reduces the companys WACC, the companys stock price is also likely to decline. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. Statements a and b are correct. Statements a and c are correct.

b. c. d. e. 8.

If debt financing is used, which of the following is true? a. b. c. The percentage change in net operating income is greater than a given percentage change in net income. The percentage change in net operating income is equal to a given percentage change in net income. The percentage change in net income relative to the percentage change in net operating income depends on the interest rate charged on debt. The percentage change in net operating income is less than the percentage change in net income. The degree of operating leverage is greater than 1.

d. e. 9.

Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company As basic earning power (BEP) exceeds its cost of debt financing (kd). Which of the following statements is most correct? a. b. c. Company A has a higher return on assets (ROA) than Company B. Company A has a higher times interest earned (TIE) ratio than Company B. Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company Bs. Statements b and c are correct. All of the statements above are correct.

d.

10.

The Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of RM10,000 and variable costs of RM1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = RM5,000), but it would require greater variable costs (RM1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income?

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a. b. c. d. e.

5,000 decks 10,000 decks 15,000 decks 20,000 decks 25,000 decks

Key Terms

Business risk Financial risk Operating leverage Financial leverage Target capital structure

Summary

The use of debt tends to increase EPS, which will bring stock prices higher. On the hand, the use of debt also increases the risk borne by stockholders, which can lowers the stock price. A firms optimal capital structure is that mix of debt and equity that maximises the stock price.

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