01.

THE FOUR KEY FINANCIAL STATEMENTS: • Income statement • Balance sheet • Statement of retained earnings •
Statement of cash flows
Income statement: - The income statement provides a financial summary of a company’s operating results during a specified
period.
Balance sheet: - The statement balances the firm’s assets (what it owns) against its financing, which can be either debt (what it
owes) or equity (what was provided by owners).
Statement of Retained Earnings: - The statement of retained earnings reconciles the net income earned during a given year,
and any cash dividends paid, with the change in retained earnings between the start and the end of that year.
Statement of Cash Flows: - The statement of cash flows provides a summary of the firm’ s operating, investment, and financing
cash flows and reconciles them with changes in its cash and marketable securities during the period.
02. TYPES OF FINANCIAL ANALYSIS • Ratio Analysis • Du-Pont Analysis • Common Size Statement Analysis and • Index
Analysis
Ratio Analysis: - Ratio analysis involves methods of calculating and interpreting financial ratios to analyse and monitor the
firm’s performance. A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number
by the other.
Du-Pont Analysis: - The DuPont system of analysis is a diagnostic tool used to find the key areas responsible for the firm’s
financial performance. It enables the firm to break the return on common equity into three components: profit on sales, efficiency
of asset use, and use of financial leverage.
Common-size Analysis: -An analysis of percentage financial statements where all balance sheet items are divided by total assets
and all income statement items are divided by net sales or revenues.
Index Analyses: - An analysis of percentage financial statements where all balance sheet or income statement figures for a base
year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.
03. TYPES OF RATIO COMPARISONS
• Cross-sectional analysis is the comparison of different firms’ financial ratios at the same point in time; involves comparing
the firm’s ratios to those of other firms in its industry or to industry averages
• Benchmarking is a type of cross-sectional analysis in which the firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes to emulate.
• Comparison to industry averages is also popular, as in the following example.
• Time-series analysis is the evaluation of the firm’s financial performance over time using financial ratio analysis
• Comparison of current to past performance, using ratios, enables analysts to assess the firm’s progress.
• Developing trends can be seen by using multiyear comparisons.
• The most informative approach to ratio analysis combines cross-sectional and time-series analyses.
04. CAUTIONS ABOUT USING RATIO ANALYSIS
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem.
2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.
05. PROFITABILITY RATIOS: - Profitability ratios indicate how efficiently a company generates profit and value for
shareholders. It includes gross profit margin (GPM), operating margin (OM), Net profit Margin, earning per share, return on
assets (ROA), and return on equity (ROE).
06. EXPECTED RETURN: -The expected return is the profit or loss that an investor anticipates on an investment that has
known historical rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and
then totaling these results.
07. VARIANCE: - The variance is the average of the squared differences from the mean. To figure out the variance, first
calculate the difference between each point and the mean, then square and average the results. The larger the variance, the more
volatile a security.
08. COVARIANCE: - Covariance measures the directional relationship between the returns on two assets. A positive
covariance means that asset returns move together while a negative covariance means they move inversely.
09. CORRELATION: - Correlation is an important statistical tool used to measure the strength of a relationship between two
or more variables. It is denoted by 'r' or the Greek letter rho (ρ). X and Y would be negatively correlated if the price of X typically
goes up when Y falls.
10. INTERPRETATION OF THE CORRELATION COEFFICIENT: - The coefficient can take any values from -1 to 1.
The interpretations of the values are:
-1: Perfect negative correlation. The variables tend to move in opposite directions (i.e., when one variable increases, the other
variable decreases).
0: No correlation. The variables do not have a relationship with each other.
1: Perfect positive correlation. The variables tend to move in the same direction (i.e., when one variable increases, the other
variable also increases).
11. PORTFOLIO’S EXPECTED RETURN, SD AND VARIANCE: - A portfolio is the total collection of all investments
held by an individual or institution. The efficient portfolio consists of investments providing the greatest return for the risk, or
— alternatively stated — the least risk for a given return. To assemble an efficient portfolio, one needs to know how to calculate
the returns and risks of a portfolio, and how to minimize risks through diversification.
12. CAPM MODEL: - It would be a difficult task to calculate the correlations when we have thousands of possible investments.
Capital Asset Pricing Model or the CAPM provides a relatively simple measure of risk.
13. • WHAT IS DIVIDEND: - a financial ratio that tells you the percentage of a company's share price that it pays out in
dividends each year. For example, if a company has a $20 share price and pays a dividend of $1 per year, its dividend yield
would be 5%.
14. TYPES OF DIVIDEND POLICY: - There are basically 4 types of dividend policy
• Regular dividend policy in this type of dividend policy the investors get dividend at usual rate. Here the investors are
generally retired persons or weaker section of the society who want to get regular income. This type of dividend payment
can be maintained only if the company has regular earning.
• Merits of Regular dividend policy: • It helps in creating confidence among the shareholders. • It stabilizes the market value
of shares. • It helps in marinating the goodwill of the company. • It helps in giving regular income to the shareholders. 2)
Stable dividend policy: - Stable dividend policy means payment of certain minimum amount of dividend regularly. This
dividend policy consists of the following three important forms: Constant dividend per share Constant pay-out ratio Stable
rupee dividend plus extra dividend
• Irregular dividend policy: - As the name suggests here the company does not pay regular dividend to the shareholders.
The company uses this practice due to following reasons: • Due to uncertain earning of the company. • Due to lack of liquid
resources. • The company sometime afraid of giving regular dividend due to uncertainty of earnings. • Due to not so much
successful business.
• No dividend policy: - The company may use this type of dividend policy due to requirement offends the growth of the
company or for the working capital requirement.
15. WALTER’S THEORY ON DIVIDEND POLICY Walter’s theory on dividend policy believes in the relevance concept
of a dividend. According to this concept, a dividend decision of the company affects its valuation. The companies paying higher
dividends have more value as compared to the companies that pay lower dividends or do not pay at all. Walter’s theory further
explains this concept in a mathematical model.
Bottom line of Walter’s Model
Prof. James E Walter formed a model for share valuation that states that the dividend policy of a company has an effect on its
valuation. He categorized two factors that influence the price of the share viz. dividend payout ratio of the company and the
relationship between the internal rate of return of the company and the cost of capital.
16. ASSUMPTIONS OF THE MODEL • All the investments are financed by the firm through retained earnings. No new
equity or debt is issued for the same
• The internal rate of return (r) and the cost of capital (k) of the firm are constant. The business risks remain same for all the
investment decisions.
• Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be used in the
model, but they are assumed to remain constant while determining a value.
• All the earnings of the company are either reinvested internally or distributed as dividends • the company has an infinite or
a very long life
• Valuation Formula and its Denotations: Walter’s formula to calculate the market price per share (P) is P=D/k+{r*(E-
D)/k}/k
• P = market price per share
• D = dividend per share
• E = earnings per share
• r = internal rate of return of the firm
• k = cost of capital of the firm
• The mathematical equation indicates that the market price of the company’s share is the total of the present values of an
infinite flow of dividends, and the formula can be used to calculate the price of the share if the values of other variables are
available. •An infinite flow of gains on investments from retained earnings.
17. GORDON’S THEORY ON DIVIDEND POLICY: -• Gordon’s theory on dividend policy is one of the theories believing
in the ‘relevance of dividends’ concept.
• It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are important in determining the value of the
firm.Gordon’s model is one of the most popular mathematical models to calculate the market value of the company using its
dividend policy.
18. BOTTOM LINE OF GORDON’S MODEL: -Myron Gordon’s model explicitly relates the market value of the company
to its dividend policy. The determinants of the market value of the share are the perpetual stream of future dividends to be paid,
the cost of capital and the expected annual growth rate of the company.
19. VALUATION FORMULA AND ITS DENOTATIONS Gordon’s formula to calculate the market price per share (P) is
P = {EPS * (1-b)} / (k-g)
Where, P = market price per share. EPS = earnings per share. b= retention ratio of the firm. (1-b) = payout ratio of the firm. k
= cost of capital of the firm. g = growth rate of the firm = b*r
EXPLANATION • the above model indicates that the market value of the company’s share is the sum total of the present
values of infinite future dividends to be declared. The Gordon’ s model can also be used to calculate the cost of equity, if the
market value is known and the future dividends can be forecasted.
20. INDIFFERENCE POINT: - It is that level of EBIT at which EPS of different capital structures remain unchanged.
21. TAX SHIELD: -The interest tax shield is the tax saving attained by a firm from interest expense.
• Assumptions:
– Perpetual cash flows
– No depreciation
– No fixed asset
For example, a firm is considering to go from $0 debt to $400 debt at 10%. What is the tax savings?
22. EXAMPLE—HOME-MADE LEVERAGE AND ROE
Home-made leverage is the use of personal borrowing to alter the degree of financial leverage. Investors can replicate the
financing decisions of the firm in a costless manner. Example
Original capital structure and home-made leverage → investor uses $500 of their own and borrows $500 to purchase 100 shares.
Proposed capital structure → investor uses $500 of their own, together with $250 in shares and $250 in bonds.
23. ASSUMPTIONS OF THE MODIGLIANI-MILLER MODEL: - Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information --No transaction costs --No taxes
24. ASSUMPTIONS & LIMITATIONS OF CAPM
Assumption Limitations

Investors are rational and risk averse Rate of return is only valid as long as its inputs are valid
•Investors are fully diversified – only consider systematic risk •Difficult to estimate beta
•Capital markets are in equilibrium and have perfect •Only considers fully diversified portfolios
information
•No transaction costs
•Can borrow and lend at the risk-free rate

25. THE EFFICIENT SET FOR TWO ASSETS

% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6% Portfolo Risk and Return Combinations
Portfolio Return

20% 3.7% 7.8%

25% 2.6% 8.0%
12.0%
30% 1.4% 8.2%
35% 0.4% 8.4% 11.0%
40% 0.9% 8.6% 10.0%
45% 2.0% 8.8% 9.0%
50.00% 3.08% 9.00% 8.0%
55% 4.2% 9.2%
7.0%
60% 5.3% 9.4%
65% 6.4% 9.6% 6.0%
70% 7.6% 9.8% 5.0%
75% 8.7% 10.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
80% 9.8% 10.2%
85% 10.9% 10.4% Portfolio Risk (standard deviation)
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
We can consider other portfolio weights besides 50% in stocks and 50% in bonds …
Note that some portfolios are “better” than others. They have higher returns for the same level of risk or less.