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BMMF5103 Managerial Finance
Part 1 Course Guide
BMMF5103 Managerial Finance
BMMF5103 Managerial Finance Part 1: Course Guide Contents
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
BMMF5103 Managerial Finance
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.
General Aim of the Course
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.
Objectives of the Course
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.
Please remember that deliberation on a single topic will be carried out according to a fixed schedule as presented in the Study Guide. new technology and innovations have brought a profound impact on the financial practices and markets. To enable you to understand Managerial Finance BMMF 5103. These topics are shown in the table below. challenging and ever-changing discipline. It is important that you participate in online discussions and group activity so that you can understand each topic completely. Managers are concerned with acquiring. In the sections below. 4 . Thus knowledge on financial management is essential for managers to perform their financial duties. You will follow the scheduled weekly activities and discussions assigned to you in the Study Guide for the duration of the course. we divide this course into three topics that are the foundation of the course. an overview of the course and a description of the content of each topic are provided.BMMF5103 Managerial Finance A. With the emergence of liberations and globalisation. Course Overview Finance is an exciting yet interesting. 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. 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. financing and managing the business assets under these changes.
Stocks and Their Valuation It discusses the key features of stocks and the legal rights and privileges of shareholders and stocks valuation. Financial Statements. Topic Overview Topic 1: Fundamental Concepts of Financial Management Chapter 1: An Overview of Financial Management. 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. and Taxes It Introduces and explains the purpose of balance sheet. Cash Flows. 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. Analysis of Financial Statements Using ratio analysis to evaluate the liquidity position. The various factors affecting the portfolio risk are also explained. leverage. 5 . preferred shares and common stock. profit and loss statement and cash flow statement. The popular asset pricing is presented and demonstrated how the required rate of return of an asset is determined. This includes bonds with semi-annual coupon and the impact on bond prices when there is a change in market interest rate. Bonds and Their Valuation It discusses the key features of bonds and their valuation. Time value of Money It introduces the importance of time line.BMMF5103 Managerial Finance B. goals of the corporation and agency relationship. It introduces the various types of organisations. future and present values for both even and uneven cash flows. Weighted average cost of capital is then computed. 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.
project classification. as soon as you are allocated a tutorial group. 6 . Chapter 11: LEARNING SUPPORT 1. The facilitator will also mark your assignment and give you the feedback on your performance. and when you do not understand the assigned readings. and be aware of all the requirements for successful completion of a course. do the assignment and prepare for the examinations. From time to time. 2. 4.BMMF5103 Managerial Finance Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows It discusses the importance of capital budgeting. inflation on cash flows. Therefore you should. times and location of these tutorials. your facilitator will provide academic assistance throughout the duration of the course. you have the support of online discussions in myVLE with your facilitator and your coursemates. tax effects. do not hesitate to discuss your problems with your facilitator. MyVLE Online Discussion Besides the face-to-face tutorial sessions. proquest and ebsco. 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. Cash Flows Estimation and Risk Analysis It focuses on estimating relevant cash flows. Feedback and Input from Facilitator As you work on the activities and the assigned text. Tutorials There are 15 hours of face-to-face tutorials provided in support of the course. materials from these databases will be assigned for additional reading and activities. and help you as you read the assigned text. The Digital Library For the purpose of referencing materials and doing library-based research. There will be FIVE tutorial sessions of 3 hours each. For this course you may use the following databases: infotrac. Your contributions to online discussions will greatly enhance your understanding of course content. OUM has a comprehensive digital library. be in touch with your facilitator and coursemates. when you have a question or problem with the assignment. capital decision rules and the various methods for evaluating projects viability. Should you need any assistance. 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. together with the names and phone number of your facilitator. at all times. You will be informed on the dates.
Time Commitment for Study You should plan to spend about 20 hours on each topic. Use the Summary and the Key Terms to check if you understand what you have just read. Whichever method you choose. the submission date of the assignment. (vi) After completing all topics. which includes the time spent doing all activities. If you have difficulty following the suggested strategy. able to do what is required. do the following: Study the Topic Overview and examine the relationship of one topic to the other topics. The main reason students are unable to cope is that they delay their course work. You ought to schedule your time to discuss your work online and spend enough time on each topic for this course. tutorials and the examination dates. such as your diary or a wall calendar. It is often more effective to distribute the study hours over a number of days rather than spend a whole day studying one topic. self-tests. Work on your assignments as the semester progresses so that you are able to systematically produce a commendable report or paper. and suggested readings. Review the objectives of the course to see if you have covered all the relevant parts of the course. make every effort to ‘stick to it’. discuss your problems with your facilitator either through the online forum or during the tutorial sessions. Proposed Study Strategy The following is a proposed strategy for working through the course. Put all this information in one place. review the course content to prepare for the final examination. Do all assigned Activities and conduct the Self-test to see if you have understood the various concepts and facts presented in a topic. 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. in fact. 7 . (ii) Organise a study schedule. Note the amount of time you are expected to spend on each topic. (iv) To begin work on a topic. (v) When you have completed a topic. (iii) Once you have created a study schedule. review the Learning Outcomes to confirm that you have achieved them and that you are. Do all Readings to gain knowledge of the various dimensions of the course. (i) The first and most important step is to read the contents of this Course Guide thoroughly. 2.BMMF5103 Managerial Finance STUDYPATHS FOR SUCCESS IN THE COURSE 1.
It contains details of the facilitator-marked assignment. General Criteria for Assessment of Assignment In general. b) Considered and appreciated a range of points of view. Please read through the entire guide at the beginning of the course. and developed your own view. and may provide a deeper understanding of the subject. 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. Assessment Format Please refer to myVLE. the Assessment Guide explains the basis on which you will be assessed in this course during the semester. Your facilitator will be looking for evidence that you have done the following: a) Reflected critically on issues raised in the course. submit it. 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. it is desirable in all graduate level education to demonstrate that you have read and researched more widely than the required minimum. c) Stated your argument clearly with supporting evidence and proper referencing of sources. 1. this guide also contains the marking criteria that will be used to assess the work you submit for each requirement. d) Drawn on your own experiences and integrated this information in the paper. When you have completed the assignments. the final examination and participation required for the course. For this reason. However.BMMF5103 Managerial Finance GUIDE TO ASSESSMENT IN POST-GRADUATE COURSES AT OPEN UNIVERSITY MALAYSIA In the following pages. including those in the course. 8 . together with a FMA form. using correct spelling and grammar. Make sure that your assignments reach the facilitator on or before the deadline. your facilitator will be expecting you to write clearly. to your facilitator. Using other references will give you a broader perspective on the course.
BMMF5103 Managerial Finance 2.com/) Insert quotation marks around ‘copy and paste’ clause. Other sources: Essays or papers written by other students or sold by unscrupulous organisations are submitted by students. The questions in the final examination are closely related to questions in the Study Guide and all areas of the course will be assessed. Works by others: Taking credit deliberately or not deliberately for work produced by another without giving proper acknowledgement. Double Credit: The student submits the same essay to two or more courses.psych. all our knowledge is derived from somewhere. This includes photographs. etc) submitted by a student must not be deceptive regarding the abilities. phrase.homestead. charts. video-clips. Clearly. drawings. and plagiarism may have been committed. and are not acknowledged as quotations. or amount of work contributed by the student. verbal exchanges such as interviews or lectures. statistics. Outright plagiarism: Large sections of the paper are simply copied from other sources. paragraph and cite the original source Paraphrase clause. knowledge. sentence. project. sentence or paragraph in your own words and cite your source Adhere to the APA (American Psychological Association) stylistic format. There are many ways that this rule can be violated. performances on television and texts printed on the web.ca/ugrad) Any written assignment (essays. Avoiding Plagiarism (Note: This information has been sourced from: http://www. Hence you may find it useful to review all items in the Study Guide in preparation for the examination. Paraphrasing: The student paraphrases a closely reasoned argument of an author without acknowledging that he or she has done so. phrase.mcgill. Students should demonstrate that they have achieved these outcomes in the examination. PLAGIARISM What is Plagiarism? (Note: This information has been sourced from: www. audioclips. when citing a source and when writing out the bibliography or reference page Attempt to write independently without being overly dependent of information from another’s original works 9 . but detailed arguments from clearly identifiable sources must be acknowledged. Here are some examples of plagiarism. graphs. 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. take-home exams. whichever applicable.
Direct Citation Simply having a list of thinking skills is no assurance that children will use it.horton.ca). (Note: The reference for this information is http://www. Indirect Citation 10 .5) According to Wurman (1988). Documenting Sources Whenever you quote. 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.ednet.BMMF5103 Managerial Finance Educate yourself on what may be considered as common knowledge (no copyright necessary). or copyright (legally protected). paraphrase. p. the new disease of the 21st century will be information anxiety. or otherwise refer to the work of another. Here are some of the most commonly cited forms of material. learner’s thinking skills tend to languish in a culture that doesn’t encourage thinking” (Tishman. “Just as children’s musical skills will likely lay fallow in an environment that doesn’t encourage music. you are required to cite its source parenthetical documentation.ns. summarize. 1995. Perkins & Jay. which has been defined as the ever-widening gap between what one understands and what one thinks one should understand. public domain (copyright has expired or not protected under copyright law).
R. (1996). C.. REFERENCES Brigham.. and the space of feminist theatre. 175-200. 335-367. We wish you success with the course and hope that you will find it interesting and useful for your development as a professional. pp. and sources of financing. "LOEX" of the West: Teaching and learning in a climate of constant change (pp. Evnine.BMMF5103 Managerial Finance Referencing All sources that you cite in your paper should be listed in the Reference section at the end of your paper.). J. CONCLUDING REMARKS This course aims to give you a foundation in managerial finance which provides the fundamental concepts. S. M. Kretlow. National Park Service. R. E. (Note: The reference for this information is owl. In T. hysteria. F. B. JTD: Journal of Theatre and Drama. CT: JAI Press Inc. Frank Sinatra dies at 82: Matchless stylist of pop. We hope you enjoy your experience with OUM and will continue your work as a life long learner with us. Leonhardt (Ed. Mind. & Ehrhardt. 110. South-Western: Thomson Publishing. The New York Times. asset analyses and valuations. 11 . S.. C. Cassel. Financial management . (1997).purdue. J. W. J. (2003. 2003. The lake of seduction: Silence. & Zambella. May 16). & Moyer.edu/handouts). Retrieved February 13.nps. (2001). Abraham Lincoln birthplace national historic site.. A1. (1996). from http://www. (2006). (2005). Greenwich.). The universality of logic: On the connection between rationality and logical ability [Electronic version].). (1998. J.gov/abli/ Fleming.english.Theory and practice (11th ed. T. South Western: Thomson Publishing. Contemporary financial management (10th ed. February 11). Holden. McGuigan. New York: Viking. 2. Without a net: Supporting ourselves in a tremulous atmosphere. Liberty! The American revolution. A22-A23. Here’s how you should do your Reference page. 75-92). E. W. From a Journal From an Online Journal From a Webpage From a Book From an Article in a Book From a Printed Newspaper Brown.
BMMF5103 Managerial Finance 12 .
......................................................................................................................16 Topic 2: Securities and Their Valuation...................14 Course Overview........36 Topic 3: Projects and Their Valuation .........................................................................BMMF5103 Managerial Finance Part 2 STUDY GUIDE Contents Components of Study Guide .........51 13 ...................................................15 Topic 1: Fundamental Concepts of Financial Management .......................
Activities Activities refer to a number of readings. Readings In this package. 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. 14 . this Study Guide has adopted the following features to assist you.BMMF5103 Managerial Finance COMPONENTS OF THE STUDY GUIDE As a distance learner. you may also find a number of readings given to you for a topic. To make this easier. To help you through each topic. You may answer the questions individually but you are encouraged to work with your course-mates during the online and tutorial sessions. 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. These are supplementary readings related to the contents of the topic and may be accessed from the Digital Library at OUM. Discussion Discussion questions are presented to help you discuss content matter through group interaction and discussion. Key Terms help to remember the main ideas in the chapter. This will help your review the activities and the content that you have gone through. These are usually found at the end of each chapter to make you aware of what you should have learnt. anywhere and at anytime. Summary The main ideas of each topic and its chapters are listed in brief sentences to provide a review of the content. Key Terms In addition to the self-test and the summary. You will go through the activities in each topic with the help of your facilitator and your course mates. questions and reviews that you have to go through for each topic. However. this course is designed to allow you to study at your own pace. tasks. numerous activities based on the assigned text are included under this Study Guide.
financing and managing the business assets under these changes. You will follow the weekly activities and discussions assigned to you in the Study Guide for the duration of the course.BMMF5103 Managerial Finance Finance is the art and science of handling money. With the emergence of liberations and globalisation. Managers are concerned with acquiring. 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. new technology and innovations have brought a profound impact on the financial practices and markets. Deliberation on a single topic will be carried out according to a fixed schedule as presented above. Thus knowledge on financial management is essential for managers to perform their financial duties. 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. challenging and ever-changing discipline. It is important that you participate in online discussions and group activity so that you cover each topic completely. BMMF5103 Managerial Finance Course Overview Finance is an exciting yet interesting. 15 .
16 . Identify and measure risk and return in investment. Apply and evaluate the time value of money concept in investment by using spread sheet. There are 5 chapters in this topic. goals of the corporations and agency relationship. Topic Overview This topic introduces the key concepts and information in managerial finance which includes forms of organisations. financial statements and analysis. Apply ratio analysis to evaluate the financial position and performance of a company. readings and activities for this topic you will be able to: Identify and evaluate the various types of organisations.BMMF5103 Managerial Finance Topic 1: Fundamental Concepts of Financial Management LEARNING OUTCOMES When you have completed all chapters. risk and return and time value of money.
and the corporations. Compare the advantages and disadvantages of the various forms of business organisation. A sole proprietorship is owned by a single owner. In addition. Disadvantages It has limited sources of funds and life. 3. 4 and 13. 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. the nature of the financial markets and the types of institutions operate in these markets are also discussed. The owner has unlimited liability.BMMF5103 Managerial Finance Study Topic for Week 1 to 5 Fundamental Concepts of Financial Management Chapters in Focus for Week 1 to 5: Chapters 1. you should be able to: 1. They are sole proprietorship. 1. 2. and Describe principal agent problem and discuss how this problem may be prevented or minimised. Identify and describe the responsibilities of financial manager of an organisation. 2. the determinants of a firm’s value. Identify and evaluate the different types of goals of a firm. Outline There are three forms of business organisations. 4. the partnership. 3. Advantages It is easy and inexpensive to form. It is subjected to few government rules and regulations and avoids corporate taxes. Chapter 1: An Overview of Financial Management Learning Outcomes When you have completed this chapter. 17 .
18 . Other objectives. the threat of firing and take over. such as the employee and community welfare are less important than stock price maximizing. Disadvantages Corporate earnings may be subject to double taxation. 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 company’s objective. long term investments and raising funds for these investment projects. Financial managers can achieve this goal through daily activities such as working capital management. a firm must be able maintain or improve its product quality and sell it at a competitive price. Advantages Low cost of formation. 3. The owner has unlimited liability. direct intervention by shareholders. A partnership – when an organisation consists of two or more persons to conduct non-corporate business. Limited liability and can raise capital from the capital markets. These include: managerial compensation. there are ways to motivate managers to act in shareholders’ best interest. The actions of maximizing stock price actually benefit society as to achieve this goal. This is the potential agency problem. The primary goal of financial manager is to maximize the wealth of the shareholders. Advantages Unlimited life and ownership can be easily transferred. Subject to a number of government and company rules and regulations. However. A corporation is a legal entity and it is separated and distinct from its owners and managers. Disadvantages Limited life and difficult to transfer ownership.BMMF5103 Managerial Finance 2. Thus this goal is not achieved at the expense of society’s benefits. It is subject to few government rules and regulations and avoids corporate taxes.
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. 7. (T or F) The objective of firm proposed in finance is to maximise profitability. 4. 5. 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. 2. 4. Activity 1. 6. What are the possible actions stockholders could take to ensure that management’s 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. 3. 2.2 Read the mini case on page 44 to 45 and answer all the questions. (T or F) Key Terms Agency theory Financial environment Financial markets Financial Statements Forms of organisation Goals of management Wealth maximisation 19 .1 1. (T or F) Shareholders are the residual owners of the corporation. Self-Test Questions 1. Distinguish between primary and secondary market transactions.BMMF5103 Managerial Finance Activity 1. If you were the president of a large. Corporate shareholders have unlimited liability. (T or F) The finance function in a corporation is developing financial statements. (T or F) Agency problems arise whenever the principal and agents are the same. 3.
20 . threats of fire and takeover. Agency problems can be mitigated through compensation scheme. 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.BMMF5103 Managerial Finance Summary There are three forms of business organisations and each has different advantages and disadvantages.
Cash Flow and Taxes Learning Objectives When you have completed this chapter. Earnings per share or the bottom line is the important information provided by this statement. The firm’s profit is not as important as the cash flow because the payment of dividends. 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. managers in the company must understand financial statements. 3. The statement of shareholders’ equity shows the changes in the various accounts under shareholders’ equity during the course of the year. In finance. 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 firm’s operating. 2. Overview In order to judge the impact of their actions. 21 . such as FIFO. Outline The balance sheet shows the firm’s resources or assets and claims against those assets. investing and financing activities on cash flow over an accounting period. Distinguish the differences among accounting profit. and Explain why financial managers must be concerned with taxation. the focus is on the cash flow rather the accounting profit. They must also be able to distinguish the difference between accounting profit and cash flow.BMMF5103 Managerial Finance Chapter 2: Financial Statement. The Statement of financial performance summarizes the firm’s revenues and expenses over a period of time. net cash flow and operating cash flow. Double taxation is the system of taxing income twice. LIFO and average stock valuations can affect the cost of goods. once at the corporate level and a second time when dividends are paid to stockholders. profits and inventory value. The statement of retained earnings reconciles the beginning and ending retained earnings with net profit. Different accounting methods. expenses and purchase of fixed and financial assets required cash. Balance sheet provides snapshot of the firm’s financial position at a point of time. you should be able to: 1. List the type of information found in a company’s annual report.
Activity 2. (T or F) 2. 22 . and real assets are normally subject to lower taxes. 4.1 1. these cash accounts. 5. Explain why do changes in retained earnings occur. 6. List four types of financial statements that usually included in the annual report. 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) Net Total operating capital is equal to net fixed assets. Differentiate net cash flow and accounting profit. when added together. (T or F) Operating working capital is equal to the operating current assets minus the operating current liabilities. (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.00 of interest paid by a corporation was allowed as a tax-deductible expense. Retained earnings are kept in cash or near cash accounts and thus. 3. (T or F) If the tax laws stated that RM0. Activity 2. other things held constant. Identify and explain the three types of activities presented in the statement of cash flows. 5. bonds. hence they decrease the firm's tax liability. (T or F) Interest and dividends paid by a corporation are considered to be deductible operating expenses.BMMF5103 Managerial Finance Gains and losses on sale of capital assets such as stocks.2 Discuss the mini case on page 123-125 with your classmates through the myVLE online forum and answer all the questions given.50 out of every RM1. What are balance sheet and statement of financial performance and what information they provide? 3. 2. it would probably encourage companies to use more debt financing than they presently do. 4. Self-test Questions 1. will always be equal to the total retained earnings of the firm.
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. This treatment. The reason for this is that even though depreciation is deducted from revenue it is really a non-cash charge. but dividends paid are not deductible. It also features personal and corporate taxes. 23 . emphasis is placed on determining net income. (T or F) In accounting. depreciation must be added back to net income. In finance. 9. the statement of cash flows reports changes that were made to the firm's accounts over a period of time. the primary emphasis is also on net income because that is what investors use to value the firm. tends to encourage the use of debt financing by corporations. a secondary consideration is cash flow because that's what is used to run the business. (T or F) In order to accurately estimate cash flow from operations. The time dimension is important in financial statement analysis. However. 10. While the balance sheet and income statements represent the firm's financial position at a point in time. other things held constant. emphasises the difference between accounting profit and cash flows.BMMF5103 Managerial Finance 7. (T or F) 8. (T or F) Interest paid by a corporation is a tax deduction for the paying corporation.
4. Liquidity ratios are employed to determine the ability of a firm to meet its shortterm obligations as they come due. Overview One can determine the relative strengths and weaknesses of a company by using ratio analysis. List and interpret the five groups of ratios that reveal the five aspects of company. and Identify and discuss the limitations of ratio analysis. which is the most commonly used measure of short-term solvency. Normally. the higher the turnover. Various users of information will need this financial analysis to highlight the key aspects of a company’s operations. 24 . The inventory or stock turnover is defined as sales divided by inventories. managers and creditors. Identify and evaluate ‘benchmarking” and its purpose. the better it is for the company. Asset management ratios measure how effectively a firm utilizing its assets in generating operating cash flows. can be computed by dividing current assets by current liabilities. 3. To compute this ratio. 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. However the financial ratios must be used with cautious. inventory is excluded from the current assets.BMMF5103 Managerial Finance Chapter 3: Analysis of Financial Statement Learning Objectives When you have completed this chapter. Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements. Total asset turnover ratio measures how effectively the firm employing its total assets in generating revenues. you should be able to: 1. The higher it is the better. Fixed asset turnover measures how effectively the firm utilizing its plants and equipments. Outline Financial ratios are used by investors. The quick or acid test ratio is a more stringent test of a firm’s ability to meet its short-term obligations. 2. The current ration.
or manipulated by management by using creative accounting.BMMF5103 Managerial Finance Debt ratios measure the extent to which a firm is employing debt financing. The return on equity measures the rate of return on the stockholders’ investment. these are: Ratios may be distorted by seasonal factors. It can be difficult to find a suitable benchmark. To determine a firm’s relative financial position and performance. Trend analysis can assist one to determine whether the firm’s financial health is likely to improve or deteriorate in the future. The return on total asset measures the return on all the firm’s asset after interest and taxes. It is important to analyse the trend and absolute values of the information. 25 . Total debt includes both current and long-term debt. asset management. not all assets are recognised in the balance sheet). and debt on operating profits. if the stockholders provided only a small proportion of the total financing. the company’s ratios must compare with industry norm or benchmark. There are some inherent limitations to ratio analysis. Inflation can distort the information. Investment or market value ratios refer to the firm’s stock price to its earnings and book value per share which indicate the company’s past performance and future prospects. (example. The market /book (MB) ratio is determined by dividing market price per share by book value per share. Total debt to total assets measures the percentage of funds provided by creditors. The profit margin on sales provides the profit per dollar of sales. the firm’s risk borne mainly by its creditors. The use of industry average for comparison may not help firm achieving challenging target. 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. the return to the owners’ capital is magnified if the firm earns more on investments financed with borrowed funds than it pays in interest. The price/earnings ratio (P/E) shows how much investors are willing to pay per dollar of reported profits. Profitability ratios indicate the combined effects of liquidity. Financial leverage has three important implications: Raising funds through debt means the stockholders can maintain their control of a firm. Limitations on the financial statements.
(T or F) The gross profit margin is greater than the net profit margin. Activity 3.1 1. (T or F) The dividend yield ratio tells you what proportion of the firm’s earnings are paid out as dividends. (T or F) 26 . Identify two ratios used for analysing a firm’s liquidity and write out their equations.2 Discuss problem 13-9 (page 470) with your classmates through the myVLE online forum and answer all the questions given. 2. 9. What does ROE measure? Since interest expense lowers profits. Firms with current ratio below 2 are having liquidity problem. The current ratio will never exceed the quick ratio. 6. (T or F) The basic rational for historical cost is that it is a measure of current value. 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 company’s future financial performance? 3. while expenses decrease net worth. (T or F) A change in inflation would have no effect on a firm’s current ratio since the current ratio is based on short-term accounts. does using debt lower ROE? If one firm’s P/E ratio is lower than that of another. 4. 4. 6. (T or F) leverage ratios measure how efficiently the firm is employing its resources. (T or F) A short average collection period is a sign of efficient accounts receivable management. 5. 10. 3. 5. 7. Self –test Questions 1. 2. (T or F) Revenues (T or F) increase net worth. (T or F) the return on total equity equals the net profit margin times the total asset turnover.BMMF5103 Managerial Finance Activity 3. What potential problem could arise when comparing different firms’ fixed assets turnover? Compare your answer with your classmates through the myVLE forum. 8.
BMMF5103 Managerial Finance 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 firm’s future earnings and dividends. 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 firm’s financial position and performance. As for the management. 27 .
3. Another useful measure of risk is the coefficient of variation. Explain the Capital Asset Pricing Model (CAPM) and illustrate how a portfolio’s risk may be reduced. The coefficient of variation is an appropriate measure of total risk when comparing two investment projects of different size. Standard Deviation is an absolute measure of risk. 28 . standard deviation. and use the Security Market Line to determine a stock’s required rate of return. Expected Return = A weighted average of the individual possible returns One measure of risk is the standard deviation. It is computed by dividing standard deviation by the expected return. Outline Risk refers to the potential variability of returns from a project or portfolio of projects. Overview Risk is an important concept in financial analysis. 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. Identify risk and calculate the expected rate of return.BMMF5103 Managerial Finance Chapter 4: Risk and Return Learning Objectives When you have completed this chapter. and Explain and compute the stock’s beta coefficient. and coefficient of variation for a probability distribution. you should be able to: 1. which means that he or she must be compensated for holding risky assets. 2. 4. Portfolio assets are less risky compared to the same assets held in isolation. Investment risk is related to the probability distribution of returns. Analyse how risk aversion influences required rate of return. The average investor is risk averse. 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. especially in investment decision making.
Slope of security market line. more positive) the degree of correlation between these securities and those already in the portfolio. 3. 2. Required rate of return = Risk-free return + Risk premium Where the risk premium = (rm – rf). through diversification. It measures the responsiveness of the stock relative to the market. A stock beta is used to measure the market risk. eliminate all of the non-market (or company-specific) risk inherent in owning stocks. the higher (that is. Bp = ΣWi Bi The security market line (SML) shows the relationship between a security’s market risk and its required rate of return. Will increase or decrease with uncertainties about the future economic outlook the degree of risk aversion of investors. Major Problems in the Practical Application of the CAPM 1. If investors become less risk averse. (T or F) 2. The beta of a portfolio is a weighted average of the betas of individual securities in the portfolio. Self-test Questions 1. but as a general rule it will not be possible to eliminate all market risk. It is this risk that the investor will be rewarded for holding it. If an investor buys enough stocks. the greater the benefits of the additional portfolio diversification. the slope of the Security Market Line will increase. 4. Portfolio diversification reduces the variability of returns on each security held in the portfolio. Required returns are determined by macroeconomic factors. Using stock index as proxy for market portfolio.BMMF5103 Managerial Finance An asset’s total risk = diversifiable (unsystematic) risk + market (systematic) risk. (T or F) 4. Betas are frequently unstable over time. (T or F) 3. When adding new securities to a portfolio. The relevant risk of an asset in a well-diversified portfolio is the asset’s market risk. he or she can. Determining an appropriate rf. (T or F) 29 .
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.” Explain.) (T or F) Activity 4. (Assume that beta remains constant. 2. (T or F) 7. Explain what is meant by average investors are risk averse. the coefficient of variation will always allow an investor to properly compare the relative risks of any two securities. (T or F) 9. However. that is. the holder of either portfolio could lower his or her risk exposure by buying some "normal" stocks. we know that Portfolio B will have the lower systematic (or market) risk. Because of diversification. (T or F) 6. (T or F) 10. while Portfolio B has 100 securities.1 1. 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. 30 .kRF) will decrease. Portfolio A has but one security.0) with each other.BMMF5103 Managerial Finance 5. it is possible that the SML required rate of return for a stock will decrease because the market risk premium (kM . Explain what is correlation and why it is important in portfolio formation. Portfolio B will have the lower beta.2 0. relative to the market. Because of differences in the expected values of different securities. as a portfolio with a beta of plus 2. 4. How does one compute the standard deviation of an asset? Compare your answers with your fellow classmates via the myVLE online forum. 3.6 0. the standard deviation is not always an adequate measure of risk. If the price of money increases due to greater anticipated inflation. the riskfree rate will reflect this fact. Although kRF will increase. However. “An asset held as part of a portfolio is generally less risky than held in isolation. The only condition under which risk may be completely eliminated is to find securities which are perfectly negatively correlated (r = -1. A portfolio with a beta of minus 2 has the same degree of risk to its holder. (T or F) 8.
The risk measures and their calculations are shown and distinguished. 31 .BMMF5103 Managerial Finance Activity 4. Once you have solved the problems. discuss your answers with your classmates through the myVLE forum. The benefits of diversification are illustrated and finally the CAPM is introduced and explained.2 Solve problems 4-14 on page 167-168. 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 stand-alone risk and systematic risk are explained.
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. 4. Time value of money concept has wide applications in finance.BMMF5103 Managerial Finance Chapter 5: Time Value of Money Learning Outcomes When you have completed this chapter. 2. 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.A series of equal dollar CFs for a specified number of periods 32 . In fact. you should be able to: 1. n) Annuity. Explain the relationship between (between future and present value). of all the concepts used in finance. PV0 = FVn(PVIFi. 5. 3. Distinguish the difference between an ordinary annuity and annuity due. and Construct a loan amortisation schedule. Distinguish among the following interest rates: Nominal Rate. this is the most important one. In general. Periodic Rate and Effective Annual Rate. ranging from valuation of securities to project evaluation. it is the reverse of compounding. 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.
the timing of the payments c. (T or F) The difference between an ordinary annuity and an annuity due is: a. 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. Annuity due is where the CFs occur at the beginning of each period. 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. 33 .BMMF5103 Managerial Finance Ordinary annuity is where the CFs occur at the end of each period. n)(1 + i) Present Value of an Annuity Due PVAND0 = PMT(PVIFAi. Self-test Questions 1. Future Value of an Ordinary Annuity FVANn = PMT(FVIFAi. It also shows the unpaid balance at each point in time. the amount of the payments d. n) Future Value of an Annuity Due FVANDn = PMT(FVIFAi. the interest rate b. the number of periods 4. If the discount rate decreases. 6. the present value of a given future payment decreases. (T or F) The time value of money recognizes that the value of any cash flow depends on its amount and its timing. 5. 3. 2. (T or F) The end-of-year accumulated amounts will increase as the frequency of compounding increases. n)(1 + i) Payments on a Loan PMT = PVAN0/(PVIFAi. (T or F) If the interest increases. the second bank is paying approximately twice as much interest.
lower d. higher.BMMF5103 Managerial Finance 7. 34 . What is an opportunity cost rate? 2.89 and post your views online through the myVLE forum. It demonstrates the simple process of computing future values and present values of a lump sum and a series of cash flow streams. higher. lower Activity 5. Activity 5.1 1. higher c. future values and present More frequent compounding results in values than less frequent compounding at the same interest rate. lower. 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. higher b.2 Discuss the mini case on page 88. It also presents some special applications of time value techniques in common financial decision making. 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. a. lower.
assets of RM500. What would be the required and expected return on a portfolio with P = 10 percent? Suppose the correlation of Stock X with the market. compounded quarterly. The correlation coefficient. c. b. M = 4 percent. You borrow RM2. and an ROE of 15 percent. or some combination of the two.) Find the interest rates on each of the following: a.100 and promise to pay back RM2247 at the end of 1 year.50 at the end of 10 years. Calculate kp and p for 100 percent.8. 35 . Suppose kM = 12 percent. while rYM = 0. Company A has sales of RM1. The expected return for X is 12 percent. a. 3. and X = 6 percent. Compare the three principal forms of business organization? You plan to invest in Stock X. assets. to determine Stock X’s and Stock Y’s beta coefficients. You borrow RM42. 2.BMMF5103 Managerial Finance Assignment 1 1. and kRF = 6 percent. and 0 percent in Stock X.614. is 0. The managers of Maybank want its fixed deposit account to equal Bank Bumi’s effective annual rate. along with data given previously. but its ROE is 30 percent. 75 percent.9. Bank Bumi pays 8 percent interest. The expected return for Y is 15 percent. 25 percent. 50 percent. Company B has the same sales. rXM. rXY is 0. Stock Y. and net income. and Y = 8 percent.000. What is B's debt ratio? (Hint: Begin by looking at the Du Pont equation. What nominal rate must Maybank offer? 4. c. Use this information. a debt ratio of 30 percent. but interest is to be compounded on a monthly basis. b. on its fixed deposit accounts.70.500 and promise to paid back RM100.
and Employ corporate valuation as alternative to dividend discounted model for valuation. Identify the cash flows of securities and apply appropriate valuation techniques for these securities.10: Chapters 5.10 Securities and Their Valuation Chapters in Focus for Week 6. 7 & 8 36 . 6. Topic Overview Study Topic for Week 6 .BMMF5103 Managerial Finance Topic 2: Securities and Their Valuation 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.
usually RM1. the yield to maturity. you should be able to: 1. The par value is the stated face value of the bond. Compute the current yield. reinvestment risk and default risk are also explained and illustrated. Bonds are classified into four types: Treasury.BMMF5103 Managerial Finance Chapter 6: Bonds and Their valuation Learning Outcomes When you have completed this chapter. Differentiate between interest risk. It represents the amount of money the firm borrows and promises to repay on the maturity date. Finally the importance of bond rating and the criteria used for rating bonds are identified. Bonds can be sold at a discount. reinvestment risk. more typically. This payment is a fixed amount which is determined at the time the bond is issued. Each type differs in expected return and degree of risk. the strength of the companies backing the bonds. each six months) that is paid to a bondholder by the issuer of bonds. 2. Identify the common characteristics of bonds. municipal and foreign. 37 . the bonds’ expected returns and risk would be different for different corporations. and Explain the importance of bond ratings and their criteria used for ratings. at par or at a premium. 4. 5. 3. on specific dates. The interest rate risk. depending on the current interest rate and the bonds’ coupon rates. The maturity date is the date on which the par value must be repaid by the issuer. Due to differences in contractual provisions. Outline A bond is a long-term contract under which a borrower agrees to make payments of interest and principal. and default risk. The coupon interest rate is the amount of interest each year (or. Calculate the value of a bond with annual or semi-annual interest payments. Overview This chapter explains the basic features of bonds and then uses the present value concept to determine the value of bonds. to the holders of the bonds.000. corporate.
when the appropriate interest rate rd. The cash flows from a specific bond depend on its contractual features. 2. the company must pay the bondholders an amount greater than the par value. Bonds issued with warrants are similar to convertible bonds. at the option of the bondholder. a fixed rate bond will sell at par value. This can be done in either of two ways: 1. An adjustment to the formula must be made if the bond pays interest semiannually: divide INT and rd by 2 and multiply N by 2.000 bond paying $80 annually. The call provision generally states that if the bonds are called. 3. a fixed rate bond will rise above its par value. The value of bond is simply the present value of the cash flows the bond is expected to produce. Such bond is called discount bond. Convertible bonds are bonds that are convertible into shares of common stock. thus selling at par initially. the coupon rate is set to equal the going rate when a bond is issued. a fixed rate bond’s price will fall below its par value. is 12%. that is they tend to move in the opposite direction from each other. at a fixed price.BMMF5103 Managerial Finance Most corporate bonds contain a call provision. a 10-year.322) = $774. Some bonds include a sinking fund provision to facilitate orderly retirement of the bond issue. When the going rate of interest is equal to the coupon rate. a call premium. thereby providing a capital gain if the stock price rises. 2. Whenever the going rate of interest falls below the coupon rate. The company may buy the required number of bonds on the open market. 38 . The company can call in for redemption (at par value) a certain percentage of the bonds each year. 1. which is called premium bond. the value of the bond VB = $80 (5. $1. Whenever the going rate of interest rises above the coupon rate.650) + $1. N Bond Value = Σ INT / (1 + rd)t + M / (1 + rd)N t=1 For example. Warrants are options which allow the holder to buy stock for a stated price.000 (0. Bond prices and interest rates are inversely related. Normally. which gives the issuing corporations the right to call the bonds for redemption.
Most bonds are purchased by institutional investors and many of them are restricted to investment-grade securities. and investors could estimate the expected rate of return on bond as the yield to call (YTC). sinking fund. and regulation. times-interest-earned ratio. EBITDA coverage ratio. If the issuer defaults. maturity. the greater the exposure to interest rate risk. Bond issues are normally assigned quality ratings that reflect their probability of going into default. The risk of an income decline due to a drop in interest rates is called reinvestment rate risk. 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 bond’s coupon rate. Current yield = Annual interest payment / (current bond price) Interest rates fluctuate over time. while reinvestment rate risk relates to the income the portfolio produce. but if the bond sells at a price other than its par value. measurable influence on the bond’s interest rate and the firm’s cost of debt. the greater the risk of a decrease in interest rates. The longer the maturity of the bond.debt ratio. 39 . stability in sales and earnings. investors receive less than the promised return on the bond. then a callable bond is likely to be called. The shorter the maturity of the bond. Bond ratings are important both to firms and investors because the rating has a direct. at sites such as http://www. Corporate bonds are traded primarily in the over-the-counter market. N YTC = Σ INT / (1 + rd)t t=1 + Call price / (1 + rd)N The current yield is the annual interest payment divided by the bond’s current price.BMMF5103 Managerial Finance 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. It provides information regarding the amount of cash income that a bond will generate in a given year. Bond ratings are based on both qualitative and quantitative factors like: financial ratios. Default risk is influenced by both the financial strength of the issuer and the terms of the bond contract. guarantee provisions. mortgage provisions. Bond data are available on the internet. Interest rate risk relates to the value of the bonds in a portfolio.bondsonline. The YTM for a bond that sells at par consists entirely of interest yield. The risk of a decline in bond values due to rising interest rates is called interest rate risk. Most bonds are owned by and traded among the large financial institutions.
(T or F) 2. 4. high yield debt instrument typically used to finance a leveraged buyout or a merger. If the coupon rate is 10 percent.BMMF5103 Managerial Finance Activity 6." repayment of a bond. with annual interest payments. b. f. or "call for. and there are 10 years to maturity.2 Read the mini case on page 246 to 247 and answer all the questions. d. 6. 5. and required returns increase as the ratings get lower. calls are exercised if interest rates rise. Name the major rating agencies. Activity 6. 40 . you should make the purchase if your required return on investments of this type is 12 percent.000 par value bond for $800. h. (T or F) A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells) at par.1 a. (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. e. (T or F) You have just noticed in the financial pages of the local newspaper that you can buy a $1. and list some factors that affect bond ratings. you would. be subject to much more interest rate risk if you purchased a 30-day bond than if you bought a 30-year bond. Because short-term interest rates are much more volatile than long-term rates. c. g. or to provide financing to a company of questionable financial strength. because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. 3. therefore providing compensation to investors in the form of capital appreciation. 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. Typically. in the real world. (T or F) A call provision gives bondholders the right to demand. Self-Test Questions 1. (T or F) A junk bond is a high risk.
(T or F) 8. (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.BMMF5103 Managerial Finance 7. Bond prices and interest rates are inversely related. Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers. The yield to maturity is a measure of the return that investors require on a bond. Such covenants are contained in the bond's indenture. 9. 41 . other things equal and held constant. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds. Bonds with lower ratings must offer investors higher yields. (T or F) Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise. one must first estimate the assets’ future cash flows and then discount them at an appropriate discount rate. 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. 10. Bond rating agencies help investors evaluate the risk of bonds. (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.
BMMF5103 Managerial Finance Chapter 7: Stocks and Their Valuation Learning Objectives When you have completed this chapter. The market for stock that is just being offered to the public is called initial public offering (IPO) market. Overview Holders of common stock are owners of firms. 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 . The pre-emptive right gives the current shareholders the right to purchase any additional shares sold by the firm. who. A common stock is valued by discounting its expected future dividend stream. you should be able to: 1. Determine the value of ordinary shares using the dividend discounted model. The primary market also handles new public offerings of shares in firms that were formerly closely held. It is similar to bonds in some aspects and to common stock in others. elect the officers who manage the business. and Define preference share and determine the value of a preference share. in turn. Understand the rights of a stockholder. publicly owned companies. they have certain rights and privileges. 2. 3. The primary market deals with additional shares sold by established. including the right to control the firm via election of directors and the right to the firm’s residual earnings. The total rate of return on a stock comprises of dividend yield and a capital gains yield. Common stocks are valued by finding the expected cash flow stream. Outline Common stockholders have the right to elect a firm’s directors. Preferred stock is a hybrid security. As owners. Companies raise additional capital by selling in this market. Stock market transactions may be classify into three distinct types: The secondary market deals with outstanding shares or used shares.
Gordon. then the value of the stock will be D/ rs . 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. the total expected return. 43 . Most firms encounter periods of non-constant growth.BMMF5103 Managerial Finance 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. the value of the stock can be determined as follows: 1. who have developed this model. Preferred stock is a hybrid security. For companies where their earnings and dividends are expected to grow at some normal. 2. Add these two components to find the stock’s present value. the value of preferred stock is determined as follows: Vpre = Dpre / rpre Activity 7. For all stocks. the value of the stock is: = D1/ ( rs -g ) or D0 (1 + g)/ ( rs -g ). and discount this price back to present value. or constant rate. If the payments last forever. rs is composed of an expected dividend yield plus expected capital gains yield. after which time their growth rate settles to a rate close to that of the economy as a whole. at which point it has become a constant growth stock. Most preferred stocks entitle the owners to regular fixed dividend payments. 5.it is similar to bonds in some aspects and to common stock in other aspects. 2. 3. rs = [D1 / Vs ]+ g. Differentiate between primary and secondary markets. This equation for valuing a constant growth stock is often termed Gordon Model. Find the present of the dividends during the period of non-constant growth.1 1. If the company is paying a constant dividend. Find the price of the stock at the end of the non-constant growth period. that is zero dividend growth. For such firms. after Myron J. 3. explain. 4. For a constant growth stock. Preferred stock is a hybrid.
10% b.53 $118.29 $107.BMMF5103 Managerial Finance Activity 7. the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock. In addition. 4. (T or F) A share of preferred stock pays a dividend of $0. (T or F) A proxy is a document giving one party the authority to act for another party. 6.25 at the end of Year 2. 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. d.2 Discuss the mini case on page 282-283 and answer part a to e. typically the power to vote shares of common stock. A proxy can be an important tool relating to control of the firm. Self-test Questions 1. 5. (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. e.74 44 . what is your nominal (not effective) annual rate of return? a. on a pro rata basis. c. 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) The pre-emptive right gives current stockholders the right to purchase. 2. but you will receive a dividend of $9. 8% 6% 3.35 $131. any new shares sold by the firm. d. 14% 7. how much should you be willing to pay for this stock today? a. If you are willing to pay $20. This right protects current stockholders against both dilution of control and dilution of value.19 $ 75.50 each quarter. 12% e. If your expected rate of return is 16 percent. c. you expect to sell the stock for $150 at the end of Year 2. (T or F) According to the basic stock valuation model. b. $164.00 for this preferred stock.
e. e. c. what is the price of the stock today? a. What should be the current price per share of common stock? a. What is the current price of Klein's common stock? a.57 9.33 $42.BMMF5103 Managerial Finance 8. 45 . b.75 percent. If the company’s beta is 1.3. $15.10 $24. $21. The last dividend paid by Klein Company was $1. (MHI) is presently in a stage of abnormally high growth because of a surge in the demand for motor homes.14 $57.50. c. c.16 $58.66 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. after which time there will be no growth (g = 0) in earnings and dividends. D0 = $2. the return on the market is currently 12.6. MHI's beta is 1. The company expects earnings and dividends to grow at a rate of 20 percent for the next 4 years. b. d.00 $68. Thames Inc. The company's last dividend was $1. e. The risk-free rate is 5 percent and the return on the market is 9 percent.21 $19. It also discusses the framework for valuing these securities.25 $50.17 $17.00 $33.06 $60. after which dividends are expected to grow at a rate of 10 percent forever. The dividend is expected to grow at a rate of 6 percent per year.28 $22. d.40 per share (i. d.’s most recent dividend was $2. and the risk-free rate is 4 percent. Klein's required rate of return on equity (ks) is 12 percent..40).75 10. e. Klein's growth rate is expected to be a constant 5 percent for 2 years. $72.00.14 $40. b. Motor Homes Inc.
3. and other resources. This chapter develop and illustrate the corporate valuation model. Assets-in-place include tangible assets plus intangible assets. The corporate stockholders. To achieve this. Value-based Management and Corporate Governance Learning Objectives When you have completed this chapter. experience. which were reported on the asset side of the balance sheet. and Understand the importance of corporate governance and the two primary mechanisms used in corporate governance. valuation model shows how corporation decisions affect The set of rules and procedures used to motivate managers falls under the area of corporate governance. Outline The corporate valuation model does not depend on dividends. you should be able to: 1. Second investment in other businesses. including stockholders. Apply the corporate valuation model to divisions. Free cash flow is the cash from operations that is actually available for distribution to investors. Growth options are opportunities to expand that arise from the firm’s current operating knowledge. Overview The primary objective of management is to maximize shareholders’ value. Operating assets can be assets-in-place and growth options. and it can be applied to divisions and sub-units as well as to the entire firm. Corporate assets are of two types: operating and non-operating. Identify the four value drivers in value-based management. bondholders and preferred stockholders. 46 .BMMF5103 Managerial Finance Chapter 8: Corporate Valuation. 2. Companies practise value-based management by systematically using the corporate valuation model to guide their decisions. subunits and to the entire firm. managers need a tool for estimating the impacts of alternative strategies. 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.
1 1. Activity 8. The corporate valuation model cannot be used for a company that doesn’t pay dividends. 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. capital requirement and WACC. What are the four value drivers? Activity 8. WACC. 5. 2. Self –test Questions 1.BMMF5103 Managerial Finance 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.com. (T or F) Free cash flows should be discounted at the weighted average cost of capital to find the value of a company’s operations. 3. to access any Cyber problems.2 Please go to Web site: http://brigham. (T or F) 47 .swlearning. 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. plus the value of its non-operating assets. operating profitability. 2. 4.
$ 913 million $1.000 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.BMMF5103 Managerial Finance 3. (T or F) The corporate valuation model discounts free cash flows by the required return on equity. d. e. 6. e. the value of a company’s operations is $750 million. If the overall cost of capital is 14 percent. 4. free cash flow will grow at a constant rate of 4 percent per year forever. (T or F) Which of the following is not always a way to increase the value of a company? a. c. Increase the operating profitability (NOPAT/Sales). what is the current value of operations. what is the current value of operations? a. If the company’s weighted average cost of capital is 15 percent. The balance sheet also shows $100 million in accounts payable. 7. b.500 million $2. $150 million $167 million $200 million $208 million $228 million 9. Using the corporate valuation model.000 million $1. 5. Increase the growth rate of sales. The company’s balance sheet shows $50 million in short-term investments that are unrelated to operations. After the second year. (T or F) Two important issues in corporate governance are the rules that affect the threat of a CEO’s removal and the rules that allow a CEO to fire members of the board of directors. capital requirements. profitability. b. Value-based management focuses on sales growth. e. $200 million in long-term debt. Increase the expected return on invested capital. Suppose a company’s current free cash flow is $100 million and is expected to grow at a constant rate of 5 percent. What is your best estimate for the market value of equity? 48 . d. b. and dividend growth. $100 million in notes payable. $40 million in common stock (par plus paid-in-capital). Decrease the capital requirement (Capital/Sales).050 million $1. d. to the nearest million? a. c. c. the weighted average cost of capital. Decrease the weighted average cost of capital. and $160 million in retained earnings.
BMMF5103 Managerial Finance a. the value of a company’s operations is $400 million. e. 10. d. 49 . $90 million in notes payable. d. $40 million in preferred stock. $30 million in long-term debt. c. The balance sheet also shows $50 million in accounts payable. The value of operations is the present value of all the future free cash flows expected from operations when discounted at the WACC. b. If the company has 10 million shares of stock. e. $200 million $300 million $400 million $500 million $600 million Using the corporate valuation model. c. and $100 million in total common equity. The company’s balance sheet shows $20 million in shortterm investments that are unrelated to operations. b. what is your best estimate for the stock price per share? a. $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 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.
3 years after the initial offering. a RM1. After three years the dividend is expected to grow at a constant rate of 7 percent a year.25 percent. Suppose that the conditions in part a) existed.75. The analyst believes that the stock is fairly priced. Three years after the bonds were issued. 20 percent next year. 4. Explain why do the prices of fixed rate bonds fall if expectations of for inflation rise. A financial analyst has been following Fast Start Bhd.that is. and that Fast Start's beta is 1. 2. just describe) b. She estimates that the current risk-free rate is 6. At what price would the bonds sell? c. 3. Suppose further that the interest rate remained at 5 percent for the next 4 years.000 par value. Differentiate between interest rate risk and reinvestment rate risk. TEN Bhd sold an issue of bonds with a 8-year maturity. and semi-annual interest payments. At what price would the bond sell? Suppose that. the going rate of interest on bond such as these fell to 6 percent. The current earnings per share (EPS0) is RM0. What is the current price of the stock? 50 . a 8 percent coupon rate.25. and 15 percent the following year. The analyst estimates that the company's dividend will grow at a rate of 25 percent this year.BMMF5103 Managerial Finance Assignment 2 1.. a. the going interest rate had risen to 10 percent. What would happen to the price of the Ten Bhd bonds over time? (no calculations are required. interest rate fell to 5 percent 3 years after the issue date. a new highgrowth company. the market risk premium is 5 percent. The company is expected to maintain its current payout ratio. The company has a 40 percent payout ratio.
Employ and evaluate the various capital budgeting techniques. 10. and Explain the concept of optimal capital structure.14 Projects and Their Valuation Chapters in Focus for Week 11. Topic Overview Study Topic for Week 11 . 11 & 16. Differentiate between a firm’s business risk and its financial risk.BMMF5103 Managerial Finance Topic 3: Projects and Their Valuation 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.14: Chapters 9. Estimate the project cash flows. 51 .
Each capital component has a component cost and can be calculated as follows: The after-tax cost of debt. Employ different methods to estimate the component cost of retained earnings. Explain and calculate the firm’s composite or weighted average cost of capital. Net price means the price the firm receives after deducting flotation costs. and Identify some of the factors that affect the cost of capital. is the rate of return stockholders require on equity capital the firm obtains from earnings. 4. rda = rd (1 – T). The component cost of preferred stock. they need to be evaluated based on the cost of capital. Define and calculate the component costs of debt and preferred stock. rre. Overview Cost of capital is a critical element in most business decisions. merger and acquisitions often require substantial amount of capital. Three methods typically are used: CAPM. 3. Calculate the component cost of newly issued common stock. you should be able to: 1. Outline The sources of capital of a firm can come from debt. and the bond-yield-plus-risk premium technique.BMMF5103 Managerial Finance Chapter 9: The Cost of Capital Learning Outcomes When you have completed this chapter. where rd is the interest rate on debt and T is the tax rate. preferred stocks or common stocks. Each type of capital has different costs. 2. rpre = Dpre / NP where Dpre is the preferred dividend and NP is the net price. Undertaking projects. 5. No tax adjustments are made when computing rpre because preferred dividends are not expense and hence not tax deductible. The capital can be in the form of debt. The cost of retained earnings. the discounted cash flow method. common stock. retained earnings and preferred stock. In order to determine whether the projects will create any value to the firm. The equity capital comes from retained earnings (internal sources) or new equity (external sources). 52 .
re. When discounted cash flow method is employed. To compute the cost of external (new) equity. the discounted cash flow approach requires adjustment as follows: re = D1 / P0 ( 1 – F) + expected growth rate.BMMF5103 Managerial Finance The Capital Asset Pricing Model is used for the first method: rre = RF + b (Rm – RF ) Where RF is the risk-free rate. the weights used should be based on market values of the different securities. is higher than the cost of retained earnings. re. rre. the cost of debt capital increases because firms have to pay higher rate of interest to the bondholders. Another approach is by using the retention rate multiply with the return on equity. because there are flotation costs incurred in issuing new common stock. Theoretically. and tax rate. 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. WACC = Wd rd (1 – T) + Wpre rpre + Wre (rre or re) Where W is the component capital weightage. book values are used as the proxies of market values if they are reasonably close to each other. 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). The cost of capital is affected by a number of factors. where F are the flotation costs. The bond yield-plus-risk premium method estimated re . 53 . Factors the firm unable to control include: the level of interest rate. market risk premium. b is the stock beta coefficient as an measure of risk. that is: G = (retention rate) x ROE The cost of new common equity. Some are beyond the firm’s control while others are influenced by the firm’s financing and investment policies. and Rm is the expected rate of return on the market. However. If interest rates in the economy rise. by adding a risk premium of 3 to 5 percentage points to the firm’s own bond yield. Higher interest rates also increase the cost of common and preferred stocks.
2. the higher the dividend payout.1 1. When we estimate the cost of capital. Given the level of earnings. However. 4. Tax rates are used in the calculation of the cost of debt as used in the WACC. and thus reducing the retained earnings break point in the marginal cost of capital (MCC). These rates indicate the risk of the firm’s existing assets.BMMF5103 Managerial Finance The perceived risk inherent in stocks and investors’ aversion to risk determine the market risk premium. an increase in the use of debt will increase the riskiness of both debt and equity. Factors the firm can control included: Capital structure policy. dividend policy and investment policy. it influences the weights in the WACC which will tend to reduce the WACC. 6. and these increases will tend to increase the WACC. 54 . Activity 9. 5. which would reduce the cost of equity relative to that of debt. If the firm uses more debt and less common equity. 3. we use as a starting point the required rate of return on the firm’s stock and its cost of new debt as reflected in the yield on its outstanding bonds. thus offset the change in weights. the lower the level of retained earnings. It would incorrect to assume that if the firm has dramatically change its investment policy.2 Read the mini case on page 340 to 341 and answer part a to part i. The firm can change its capital structure to affect its cost of capital. Lowering the capital gains tax rate relative to the rate on ordinary income would make stocks more attractive. Activity 9. 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. 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.
In that sense. 2. beta may be a poor measure of the firm's true investment risk. e. or the cost c. 55 . 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 equity financing is greater than or equal to the cost of debt financing. which is lower than the after-tax cost. 4. depending on tax rates. in fact. b. the attitude of investors. (T or F) The before-tax cost of debt. The WACC represents the cost of capital based on historical averages. The cost of equity capital is generally easier to measure than the cost of debt. The WACC is calculated on a before-tax basis. e. The cost of retained earnings exceeds the cost of issuing new common stock. and other factors. The component costs of capital are market-determined variables in as much as they are based on investors' required returns.BMMF5103 Managerial Finance Self-Test Questions 1. One problem with the CAPM approach to estimating the cost of equity capital is that if a firm's stockholders are. flotation costs. (T or F) The cost of equity raised by retaining earnings can be less than. since this is a free source of funding to the firm. 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. or greater than the cost of external equity raised by selling new issues of common stock. Which of the following statements is most correct? a. Which of the following statements is most correct? a. 7. which varies daily with interest rates. 3. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital. it does not represent the marginal cost of capital. 5. The WACC exceeds the cost of equity financing. d. c. the firm should always consider retained earnings as the first source of capital. (T or F) In capital budgeting and cost of capital analyses. (T or F) The cost of common stock is the rate of return stockholders require on the firm's common stock. 6. not well diversified. (T or F) A company has a capital structure which consists of 50 percent debt and 50 percent equity. is used as the component cost of debt for purposes of developing the firm's WACC. d. equal to.
9. 6. Given the following information. calculate the firm's weighted average cost of capital. d. c.6% 9. its last dividend (D0) was RM2.2% 7. Which of the following statements is most correct? a. d. ks? a.2% 8. The next task is to combine the component costs to determine the WACC. c. b.8% 10. 56 .0% 7.BMMF5103 Managerial Finance 8.2% 9.00 a. corporations should focus on before-tax cash flows when calculating the weighted average cost of capital (WACC).0% 6. kd = 6% Tax rate = 40% P0 = RM25 Growth = 0% D0 = RM2. d.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. Answers a and b are correct. and its growth rate is a constant 5 percent. c. b. 9.0% 9. e.00. b. firms should rely on historical costs rather than marginal costs of capital. firms should include the cost of accounts payable. e. None of the answers above is correct. Since stockholders do not generally pay corporate taxes. A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. When calculating the weighted average cost of capital. What is the cost of common stock. Your company's stock sells for RM50 per share. The weights are based on the firm’s capital structure. When calculating the weighted average cost of capital.0% 10. e.
List the steps involved in evaluating a capital budgeting project. discounted payback. 2. Determine the riskiness of the projected cash flows. accept the project. Overview Capital budgeting is the decision process that managers use to identify value added projects. A more detailed analysis is required for cost reduction replacement. otherwise. net present value (NPV). accounting rate of return) and discounted cash-flows methods (net present value. Determine the appropriate discount rate. Compute the present value of the cash flows to obtain the estimated asset’s value to the firm. 57 . It normally involves substantial expenditure. internal rate of return (IRR) and modified internal rate of return (MIRR). reject the project. Project evaluation will involve the following steps: Determine the project cost. The payback period is defined as the expected number of years required to recover the original investment. Deduct the initial outlay from the present value of the expected cash flows. Outline Firms classify projects into different categories to enable them to analyse them differently. Project evaluation techniques include: payback. you should be able to: 1. If the difference is positive.BMMF5103 Managerial Finance Chapter 10: The Basics of Capital Budgeting Learning Objectives When you have completed this chapter. internal rate of return) to evaluate independent and mutually exclusive projects. and new product decisions than for simple replacement and maintenance decisions. and Use both non-discounted cash-flows techniques (payback. It is therefore important that a careful evaluation of the project be carried out before a decision is made to implement it. expansion. Define capital budgeting and classify project proposals. Failure to do so may result in having large funds tied up in the project. Estimate the project cash flows. Larger investment require increasing detailed analysis and approval at a higher level within the firm. 3.
BMMF5103 Managerial Finance
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 project’s 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 project’s cost of capital, second, sum these discounted cash flows to obtain the project’s 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
where CFt is the expected net cash flow in period t and k is the project’s 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 project’s expected cash flows to the present value of the project’s 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 project’s 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 project’s cost of capital. The IRR method implicitly assumes that project cash flows are reinvested at the project’s IRR. = 0
BMMF5103 Managerial Finance
The opportunity cost of a project’s cash flows is the project’s 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.
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 project’s NPV?
Discuss the mini case on page 376- 377 and answer part a to e.
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)
BMMF5103 Managerial Finance
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.
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.
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.
Independent project Internal rate of return (IRR) Modified internal rate of return Mutually exclusive project Net present value (NPV) Payback period
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.
Externalities related to the effects of a project on other parts of the firm. Opportunity costs must be included in the analysis as they can affect the decision. Capital budgeting decisions must be based on cash flows. net working capital changes and disposal values should also be incorporated to determine the correct cash flows. 2. not accounting profits and only incremental cash flows are relevant. insurance.BMMF5103 Managerial Finance Chapter 11: Cash Flow Estimation and Risk Analysis Learning Objectives When you have completed this chapter. you should be able to: 1. 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. and Analyse a replacement project and determine whether the project should be accepted based on the capital budgeting techniques. operating cash-flows and terminal cash-flows of a project.investment outlays and the annual net cash flows after project is in operation. In addition. Identify the initial outlays. No sunk costs should be incorporated in the cash flows as these costs are irrelevant. To estimate the cash flows. but also most difficult in capital budgeting is estimation of project’s cash flows. opportunity costs. Interest payments should not be deducted as cash outflows because the interest rate on debts are already incorporated in the cost of capital. Discuss the difficulties and relevant considerations in estimating net cash flows. 61 . Deducting interest payments would result in double counting. Shipping. Outline The most important . Net cash flows should be adjusted to reflect all non-cash charges. installation. 3. Any incremental working capital must be deducted as an outflow first and will be recovered when the project expires. only the incremental cash flows should be considered. Overview One of the most difficult tasks in capital budgeting is the cash flow estimation. and their impact need to be considered in the analysis.
disposal of asset and disposal gain or loss must be estimated. 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) . 62 . All the working capital will be recovered at the end of the project’s life. To evaluate a replacement project. Activity 11. the yearly cash flows are estimated by taking profit after tax + allowable depreciation. The net working capital must be added back at this stage as the amount has been recovered. they must discounted by after-tax project’s cost of capital. It will have a five-year life and.000 and would cost another RM5.000 to modify it for special use by the firm. When after-tax cash flows are used. is evaluating the proposed acquisition of a new machine. 2. In addition.or (+) disposal gain/ loss x tax rate. at the end of that time the equipment used will be sold off for RM6. These include the after-tax salvage value of the fixed asset plus the recovery of the net working capital.BMMF5103 Managerial Finance At the end of the project’s life.1 1. working capital will increase by RM10.000 and to incur annual cash operating costs of RM20. Bhd. 5. 3.000. Activity 11.000 from the start of the project.2 Suvi Sdn. the terminal year cash flows are received. 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.000. that is: Annual cash flow = Profit after tax + allowable depreciation At the terminal period. The machine will require a capital expenditure outlay of RM63. 4. Replacement project analysis is different from expansion projects because the cash flows from the old asset need to be considered. first estimate the initial outlay. The company believes that an after-tax discount rate of 12% would be appropriate. The project is expected to generate annual revenues of RM45. For the operating periods.
b. 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. Answers b and c are correct. Company tax is charged at 28% and depreciation is on a straight-line method. What is the initial cash outlay for the new project? Determine cash flows in Years 1-5. multiplied by the tax rate. Required: a. b. Any opportunity costs associated with the project. and the terminal cash flows) at the company’s cost of capital (WACC). e. b. d.000 at 10%. An increase in net operating working capital is treated as an outflow when the project begins and as an inflow when the project ends. 2. 63 . The company’s CFO plans to calculate the project’s NPV by discounting the relevant cash flows (which include the initial up-front costs. Should the new machine be implemented? Why? Self –test Questions 1. The after-tax market value of the old equipment is treated as an inflow at t = 0. Which of the following factors should the CFO include when estimating the relevant cash flows? a. A company is considering an expansion project. the operating cash flows. c. c. d. The present value of depreciation expenses on the new equipment. c. Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0. Any interest expenses associated with the project. The working capital would be financed out of the company’s retained earnings. e. Any sunk costs associated with the project. All of the answers above are correct.BMMF5103 Managerial Finance The project would be financed with a two-year term loan of RM45. is treated as an inflow. The present value of the after-tax cost reduction benefits resulting from the new investment is treated as an inflow. which of the following statements is false? a. Regarding the net present value of a replacement decision.
the capital budgeting technique be applied to determine whether to accept or reject the project. After which. When estimating cash flows.BMMF5103 Managerial Finance Key Terms Allowable depreciation Externalities Initial outlay Opportunity costs Sunk costs Salvage value Summary The value of any asset depends on the amount. only relevant. that is incremental cash flows should be considered. To facilitate analysis. The most important but most difficult part in capital budgeting is the estimation of project cash flows. 64 . divide the project cash flows in three stages: initial. Ignore sunk costs but incorporate opportunity costs and externalities in the analysis. operating and terminal. timing and the riskiness of the cash flows it produces.
and the cost of capital. Business risk depends on a number of factors: demand variability. A firm’s value is affected by either the free cash flows or the cost of capital. Distinguish between a firm’s business risk and its financial risk. Define financial risk and explain its effect on expected roe and the risk borne by stockholders. Business risk is the riskiness of the firm’s stock if it uses no debt. sales price variability. 3. The firm’s mixture of debt and equity is called its capital structure. which in turn means uncertainty about its operating profit and its capital requirements. All these will affect the WACC even though interest is tax deductible. input cost variability. The probability of financial distress or bankruptcy also goes up. most firms try to keep their financing mix close to a target capital structure. 4. the cost of debt will increase as the debt-holders will demand for higher yield. ability to develop new product in a timely. Different capital structures will have different effects on stock prices. Increase in debt means the increase in the cost of stock. 2.BMMF5103 Managerial Finance Chapter 16: Capital structure Decisions: The Basics Learning Objectives When you have completed this chapter. earnings per share. Operating leverage is the extent to which a firm uses fixed costs in its production operations. higher bankruptcy risk reduces FCF. and Explain what is meant by optimal capital structure. the greater its operating leverage. In addition. The higher a firm’s fixed costs. With higher bankruptcy risk. cost-effective manner. Outline The actual levels of debt to equity may vary over time. The capital structure decision can affect the WACC and free cash flow (FCF). Overview A firm’s optimal capital structure is that mix of debt and equity that maximises the stock prices. foreign risk exposure. It arises from the uncertainty about its projections of the firm’s cash flows. ability to adjust output prices for changes in input costs. High operating leverage means that a relatively small change in sales will result in a large change in operating profit. 65 . Ways that a higher proportion of debt can affect WACC and FCF: Debt-holders have a prior claim on the firm’s cash flows relative to shareholders. Explain how operating leverage contributes to a firm’s business risk. you should be able to: 1. and the extend to which costs are fixed.
managers can consider a trial capital structure. Activity 16. The optimal capital structure is that level of capital structure that maximum value is achieved. What happens to the cost of debt and equity when the leverage increases? Activity 16. Explain. The firm’s present market value capital structure. The extent to which a firm employs financial leverage will affect its expected earnings per share (EPS) and the riskiness of these earnings. Manager should choose the capital structure that maximises shareholders’ wealth. and then estimate the wealth of the shareholders’ under this capital structure. This is repeated until an optimal capital structure is identified. During the year. is considered to be optimal. Briefly describe some ways in which the capital structure decision can affect the WACC and FCF. shown below. Financial risk is the additional risk placed on the common stockholders as a result of the decision to finance with debt. based on the market values of the debt and equity. the higher its business risk. 4. the company plans to raise and invest RM300 million in new projects.1 1. 2. (RM) Million Debt Common stock 450 450 66 . other things held constant. Financial leverage refers to the firm’s use of fixed –income securities. the total market value of Resort World was RM900 million. and how can it be measured? How does operating leverage affect business risk? “Using leverage has both good and bad effect”. In order to achieve this optimal level.2 On January 1. 3. What is business risk.BMMF5103 Managerial Finance Degree of operating leverage = Contribution / Operating profit Or = Q (P – VC) / [ Q( P – VC) – FC] Where P = price per unit. 5. Assume that there is no short-term debt. VC= variable cost per unit and FC = fixed costs The higher a firm’s operating leverage.
(T or F) Two firms could have identical financial and operating leverage. while operating leverage only affects EBIT. However. Qualitatively speaking.75/RM15 = 5%) The marginal corporate tax rate is 28 percent. what will happen to the WACC? c. e. (The next expected dividend is RM0. which of the following statements is most correct? 67 . An increase in the corporate tax rate. The firm's business risk is largely characteristics of its industry. 7. An increase in the company’s operating leverage. the company’s CFO does estimate that it will increase the company’s earnings per share (EPS). What is the WACC? Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. An increase in the personal tax rate. (T or F) Which of the following events is likely to encourage a company to raise its target debt ratio? a. Self –test Questions 1. (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. Common stock is currently selling at RM15 a share. (T or F) Financial leverage affects both EPS and EBIT. c. Stockholders’ required rate of return is estimated to be 15 percent. To maintain the present capital structure. 5. b. so RM0. and they will be sold at par. which will also increase the company’s interest expense. d. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its common stock. The company’s CFO expects that the plan will not change the company’s total assets or operating income. yet have different degrees of risk as measured by the variability of EPS. consisting of a dividend yield of 5 percent and an estimated growth rate of 8 percent. Volga Publishing is considering a proposed increase in its debt ratio. 6. 2. All of the statements above are correct. a. (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. 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. Statements a and c are correct. 3.BMMF5103 Managerial Finance New bond will have an 10 percent coupon rate. b. 4. Assuming the CFO’s estimates are correct.75.
10. The percentage change in net operating income is less than the percentage change in net income. The other method would use a less expensive machine (fixed cost = RM5. 8. operating income (EBIT).00 per deck of cards. b. is also higher than Company B’s. d. Company A and Company B have the same total assets. however. e. d. but it would require greater variable costs (RM1.000 and variable costs of RM1.000). Since the plan is expected to increase EPS. has a much higher debt ratio than Company B. Statements a and c are correct. Since the proposed plan increases Volga’s financial risk. b. d. tax rate. Which of the following statements is most correct? a.BMMF5103 Managerial Finance a. the company’s stock price still might fall even though its EPS is expected to increase. All of the statements above are correct. c. Company A’s basic earning power (BEP) exceeds its cost of debt financing (kd). this implies that net income is also expected to increase. Company A has a higher return on equity (ROE) than Company B. Statements b and c are correct. e. The percentage change in net operating income is greater than a given percentage change in net income. The degree of operating leverage is greater than 1. b.50 per deck of cards). The Congress Company has identified two methods for producing playing cards. c. Company A. One method involves using a machine having a fixed cost of RM10. The percentage change in net operating income is equal to a given percentage change in net income. which of the following is true? a. 9. and its risk. and business risk. as measured by the standard deviation of ROE. the company’s stock price is also likely to decline. If debt financing is used. at what level of output will the two methods produce the same net operating income? 68 . c. Company A has a higher times interest earned (TIE) ratio than Company B. The percentage change in net income relative to the percentage change in net operating income depends on the interest rate charged on debt. If the plan reduces the company’s WACC. If the selling price per deck of cards will be the same under each method. Company A has a higher return on assets (ROA) than Company B. Statements a and b are correct.
which can lowers the stock price. On the hand. A firm’s optimal capital structure is that mix of debt and equity that maximises the stock price.000 decks 20. 69 .000 decks Key Terms Business risk Financial risk Operating leverage Financial leverage Target capital structure Summary The use of debt tends to increase EPS. e. c.000 decks 15.000 decks 25.BMMF5103 Managerial Finance a. 5. d. b. the use of debt also increases the risk borne by stockholders. which will bring stock prices higher.000 decks 10.
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