Financial Management Volume 1 by Bagayao - Compress

INTRODUCTION TO FINANCIAL MANAGEMENT
CHAPTER 1
INTRODUCTION TO
FINANCIAL MANAGEMENT
It is a well-known fact that engaging in business is like
gambling, it is too risky. There are possibilities that your
investments will gain profits but there are also chances that
you will end up losing.
There is need to have enough capital in putting up a business

a
to be used for operations and investments. The business may

be in the form of sole proprietorship, partnership or
corporation. In addition, these capital or funds must be
managed properly in order to attain the operating and
financial objectives of the business. In a corporate form of
business, there is a need to employ separate managers who
will govern the business in behalf of the owners, known as
shareholders. These managers, as agents, are given the power
to decide on the investments, finance and operations of the
corporation.
In this chapter, we will introduce financial management by

discussing the following:
The kinds of business organization and their goals
Different characteristics of these business
organizations
Different kinds of corporations that are acceptable
and not acceptable under Philippines laws
Who are the financial managers and what are their
roles in the company
What is agency conflict and the how such conflicts be
resolved
Priority between ethics and profit goals
Financial Management is the process of planning, directing,

organizing, controlling and monitoring of the monetary
resources in order to achieve objectives and goals of the
business. The financial managers are responsible for the
management of these monetary resources of the business.
I. Kinds of Business Organizations:
A. Sole Proprietorship is regarded as the simplest form of

business organization. This is owned by an individual,
known as the sole proprietor, who has the full authority
in managing the assets of the business. This kind of
business organization is subject to fewer government
regulations as compared to partnership and
corporation. Thus, the registration is only through the

Department of Trade and Industry (DTI) and the
business income is not subject to separate taxation.
However there are disadvantages of forming a sole

proprietorship. One of which is the unlimited liability of
a sole proprietor. In this case, the debts and losses of
the business shall be borne by the personal assets of the
owner in time of bankruptcy. Another disadvantage is
the limited life of the business because the death of the
sole proprietor leads to termination of the
proprietorship. Lastly, the amount of capital raised is

significantly limited since the source of the funds of the
business is limited only the sole proprietor unlike in the
case of partnership and corporation.
B. Partnership, as provided by the New Civil Code (NCC) of

the Philippines, is a contract of two or more persons
who bind themselves to contribute money, property or
industry to a common fund, with the intention of
dividing the profits among themselves. Two or more
persons may also form a partnership for the exercise of

profession. More so, the partnership has a juridical
personality separate and distinct from that of each

partners (Article 1767-1768 of NCC)
A partnership may be constituted in any form, whether

oral or written, except where immovable property or
real rights are contributed thereto, in which case a
public instrument shall be necessary. In addition, the

capital of Three
contract of partnership having a
Thousand Pesos (P3,000) or more, in money or
property, is required to be:
1) In public instrument and

2) Recorded in the Office of the Securities and Exchange
Commission (SEC).
However, the failure to comply with the above

requirements shall not affect the liability of the
partnership and the members thereof to third persons.
(Article 1771-1772 of NCC)
Partnership may be classified as General or Limited
partnership. In a general partnership, all the partners

have unlimited liability like the sole proprietor, wherein
creditors of the partnership may have claim® against the
separate assets of the partners for payment of debt in
case of bankruptcy. However in a limited partnership,
there are partners known as limited partners that have
liability to the creditors only up to the extent of their
capital contribution, thus, their separate assets are safe
from the claims of these creditors.
Like Sole Proprietorship, the life of the partnership is

also limited in a sense that death of one of the partners
will result to the dissolution of the partnership.
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The following are the usual causes of dissolution of the

partnership:
1. Retirement of a partner/s
2. Admission of a partner/s
3. Incorporation of partnership®
4. Death of a partner/s
An advantage of partnership is that there is usually

more capital raised as compared to the sole
proprietorship because of larger number of source of
capital. On the contrary, it has less capital compared to

corporation. Moreover, it is subjected to 30% corporate
income tax since the Tax Code of the Philippines does
not distinguish, for tax purposes only, a partnership
from corporation.
C. Corporation, as provided by the Corporation Code of the

Philippines (CCP), is an artificial being created by the
operation of the law, having the right of succession and
the powers, attributes and properties expressly
authorized by law or incident to its existence. (Section 2
of CCP) This juridical entity is composed of five (5) or
more natural persons, not exceeding fifteen, who are
called incorporators and it must be also be registered
with the Securities and Exchange Commission (SEC).
Corporation is regarded as the most complex form of

business organization because of its fund raising
capabilities, unlimited life and being subject to stricter
government regulations. The owners are referred as

shareholders of the corporation who have limited
liability. Hence, the claim of the corporate creditors is
only up to the amount of capital investments of these
shareholders and the personal assets of the latter are

not subject to appropriations. These shareholders,

unlike partners, can sell their ownership to existing
shareholders or new investors without the need to
secure the consent of the other shareholders. Thus,
in a
there is an ease of transferring ownership
of the
corporate form of business. However, one
drawbacks of this form of business is the so called dual
taxation wherein the income of the corporation is
subject to corporate tax while the earnings of the

owners or shareholders are subject to separate
individual income tax.
FIGURE 1-1: The Characteristic of Business Organizations:
Characteristics of Sole Partnership Corporation

Business Proprietorship
Organization
1. Owner(s) are Manager Partners Shareholder
called S
2. Owner and NO NO YES
managers are
separate
3. Owner's Unlimited Unlimited Limited**
Liability
NO YES* YES
4. Separate
taxation
5. Life of the Limited Limited Unlimited
Business
*Except in General Professional Partnership (GPP), because this

partnership will not be taxed like a corporation. According to
Section 22(B) of the NIRC, "general professional partnerships
are those formed by person for the sole purpose of exercising
their common profession, no part of the income of which is
derived from engaging in any trade or business. Moreover, for

tax purposes, the term "corporation" shall include partnership,

no matter how created or organized, joint- stock companies,
joint venture accounts (cuentas en participacion), association,
or insurance companies but does not include general
professional partnerships and joint venture or consortium
formed for the purpose of undertaking construction projects or
engaging in petroleum, coal, geothermal or other energy
operations pursuant to an operating consortium agreement

under service contract with the Government" Hence, as an
exception GPP's income is not taxed separately using the 30%
corporate income tax.
***
Except when the doctrine of piercing the veil of corporate
fiction applies.
The said doctrine shall disregard the separate

personality of the corporation because the veil of
corporate fiction was used as a shield to perpetuate
fraud, justify wrong, defeat public convenience or defend

crime.
The effect of this doctrine is to make the directors,

officers and shareholders, involved in fraud or crime,
liable for the obligation of the corporation. (Sundiang-Aquino
Reviewer on Commercial Law, 2006 ed..pp.236-237).
Types of Corporation:
A. As to legal status:
De Jure Corporation - this is a corporation organized in
accordance with the law. There is a strict or substantial
compliance with the statutory requirements for its
incorporation. Hence, it exists in fact and in law.

De Facto Corporation - this is a corporation that exists

only in fact but not in law because there is a flaw in its
incorporation. Hence, it has no legal right to corporate

existence as against the state.
B. As to functions and governing law:

Public Corporation - these are organized by the state
for the government to promote general welfare of the
public. These are governed by Special laws and the
Local Government Code of the Philippines.
Private Corporation - these are organized by private

individuals for the purpose of generating profit. These
are governed by the Law on Private Corporation.
C. As to existence of stocks:
Stock Corporation A corporation in which capital

stock is divided into shares and is authorized to
distribute to the holders thereof of such shares
dividends or allotments of the surplus profits on the
basis of the shares held. (Sec. 3 of the Corporation Code

of the Philippines). The owners are called as
shareholders or stockholders.
Non-stock Corporation - A corporation which has no
stocks issuances and no distribution of dividends to its

members. However, a corporation is not automatically
considered as a stock corporation if there is a statement
of capital stock. The Supreme Court ruled that if the
dividends are not supposed to be declared or there is no
distribution of retained earnings, the corporation is still
a non-stock corporation. Moreover, the owners are

called members. (Sundiang-Aquino, Reviewer on Commercial Law
2006 ed., pp.243-246.
D. As to shares being traded in stock exchange:

Publicly listed Company- this is a corporation whose
shares are offered to public or traded in the Philippine
stock exchange. Hence, this corporation undergoes

initial public offering (IPO).
Privately owned Company - this is a corporation whose

shares are not traded in the stock market. Moreover,
this is a corporation "going private" because it restricts
the stockholders to a certain group, usually, family
member. This is sometimes called a close or closely held
corporation or privately held Corporation.
The following corporations are not acceptable in Philippine

Law:
Limited Liability Company - this is a business structure
which combines the tax advantage of a partnership

(General Professional Partnership) and limited liability
advantage of a corporation.
Professional Corporation - this is composed of persons
with same professions such as Doctors, Lawyers or
Certified Public Accountants.
Goals of the Corporation:
People venture into business with the hope of gaining

profits and the fear of incurring losses. It is a fact that all
forms of business organizations whether sole
proprietorship, partnership or corporation has the goal

of maximizing earnings or profits. More so, having big
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profit signals good financial and operating performance

of the business. Thus, profit maximization, as a measure
of success of the business, may be the end goal of the
sole proprietor or the partners who personally manage
their business. However, for a corporate form of
business, this profit maximization is just a means to an
ultimate end goal of the corporation.
The shareholders of the corporation will earn income
from their capital investments through dividend yield

and capital gains yield. The former is earned through
dividend declarations approved by the board of
directors (BOD) while the latter is through selling of
stocks or ownership to either prospective investors or
existing stockholders at a gain. This is when the stock

price is higher than the cost of investment. (in depth
discussion on dividend and capital gains yield will be on
Chapter 7 - Stock Valuation)
In connection with this, the ultimate goal of a
corporation is shareholder's wealth maximization. This
is sometimes referred to as stock price maximization.

the increase in the value of stock price resulting to
capital gains that shareholders will yield on their
investments. This is one of the reasons why

shareholders want the financial managers to maximize
the market value of the firm and not just to maximize its
profits.
The market value of the firm depends on the good

decision making of the financial managers regarding the
company's activities such as investment, financing and
operations. Moreover, the condition of the global
economy, inflation rates, taxes and laws imposed upon
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the firm and the volatility of the stock market are
factors that significantly affect the said market value.
The goal of maximizing the market value of the corporation is
more important than the goal of maximizing profits because of

the following reasons:
In maximizing the market value of the corporation,

discount rate which reflects the risks of capitalization
and the time value of money is taken into consideration
while profit maximization does not consider such.
In maximizing future profits, the company may opt to
decrease and postpone its dividend declaration and
instead, it will reinvest the freed up cash. If the

reinvestment is too risky and will not be successful, this
will be detrimental to the shareholders. Thus,
shareholder's wealth is not maximized.
The following are the inappropriate ways on how
management maximizes the profit of the corporation:
a) Management wants to accelerate sales by

materially increasing the selling prices of the goods
offered to the consumers, or
b) Management wants to reduce expenses by

cutting wage rates of the laborers or buying cheaper
materials for production.
These methods of maximizing profits will have a
negative impact on the future earnings of the company

and will result to agency conflicts.
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Stock price or market value per share considers both

cash flows for the current and future years. Profit on the
other hand, may refer to either current year's profit or
future year's profit. If the goal is profit maximization,
the question is which year's profit are we referring to?

For example, the company may maximize current year's
profit by decreasing advertising and promotion cost.

However, this may decrease the future years' profit
because sales of new products in the future may be
decreased by these costs cutting done in the current

year.
The profit computation varies depending on the
purpose. Thus, there are differences in the computation

of profit for tax purposes and profit for accounting
purposes.
IV. Financial Managers of the Corporation:
Financial managers are employees who are responsible

for managing the monetary resources of the corporation
in order to maximize firm's value. They are also
responsible for dealing with the different financial

markets such as stock market or bond market; and with
financial institutions like banks. These managers, who
are the agents of the shareholders (owners), are given
the authority to perform investment, financing and
operating decisions that will benefit the corporation.
Generally, the Financial Managers are:
Board of Directors (B.O.D.) - They are direct owners and

are elected by the shareholders to manage the
corporation. They are charged with ultimate
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governance of the corporation. Thus, they have the
ultimate responsibility for deciding on highly important

financial matters of the corporation. Moreover, BOD
decides on when to declare and how much dividends
per share to distribute.
Chief Financial Officer (C.F.O) - also known as the Vice

President for Finance (VP-Finance), who has
responsibility over financial planning and formulation

of financial corporate strategies. Under his supervision
are the Treasurer and the Controller.
Treasurer - one who focuses on the financial aspect of

the corporation; wherein he has the responsibility on
raising and managing the capital or funds of the
company. Moreover, he is responsible for transacting
and maintaining good relationship with various banks;
and the formulation of the company's credit policies and
collection.
Controller - One who focuses on the accounting and

budgeting aspect of the corporation; he is responsible
for the custody of financial records, preparation of the
financial statements, and interpretation of financial
data. Moreover, he is responsible for the management of
the budget for the efficient usage of funds.'
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FIGURE 1-2: To present the line of authority of these financial

managers, the organizational structure of the firm is shown
below:
BOARD of DIRECTORS
VP- Audit
Chief Executive Officer (CEO)
VP-Manufacturing Chief Financial Officer (VP- Finance) VP - Sales
Treasurer Controller
V. General Role of Financial Manager:
It is noted previously that financial managers are
responsible for managing the monetary resources of the

corporation. Managing these resources means how
much fund should be invested in the acquisition of real
assets, how much fund shall be retained and plowed

back to the corporation or how much shall be paid out
as dividends to the shareholders. Moreover, it is the
responsibility of these financial managers to raise

additional capital or funds to support the investments
and operations of the corporation.
Therefore, the financial managers shall perform these
roles which are geared towards the attainment of the

ultimate goal of the corporation:
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Investing Decision The investments made by these

financial managers should provide benefit to the
corporation in the future. This should be the main

consideration of the managers when investing in
tangible assets such as machineries, land or building;
investments in financial assets or investing in the
intangible assets such as patent, trademarks or

copyright. Thus, investing decision, also known as
capital budgeting, answers the question: 'what assets
should the corporation acquire in order to provide
better returns in the future'.
In addition, the amount or percentage return as well as

the period when to realize the said return, are
important factors in deciding whether to accept or
reject the investment.
Financing Decision There are many investment

opportunities that financial managers may encounter as
they manage the monetary resources of the corporation.
However, one of the main constraints of these managers
is the scarcity of available capital. This normally results
to forgone investment opportunities. Hence, in order to
finance these investments the financial managers

should raise capital or money through its financing
activities. Generally, the financial managers accumulate
funds through the following means:
1.) Performing long term financing through bank

loans if the prevailing interest rate is not high; or
2.) Issuance of financial assets such as share of stocks
(equity security) or bonds (debt security).
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In issuing share of stocks, the company accumulates
fund through selling certificates of ownership of the
corporation to the prospective investors or existing

shareholders. The cash received from these investors
will form part of the capital of the corporation and in
return, the latter will distribute profits to the
shareholders through dividend payments. On the

contrary, the issuance of bonds to the investors known
as bondholders does not indicate selling of ownership
but rather signifies borrowing of funds. These
bondholders are not owners but creditors of the
corporation who receive interest payment instead of

dividends. Hence, financing decision answers the
question: "how to raise funds in order to finance the
investments and operating activities of the firm.
Operating Decision - In order to support the daily

transactions or operations of the corporation, these
financial managers should decide on how much funds
should be allocated to each of its operating units. Funds

raised through financing decision are not only used for
the acquisition of real assets or long term investments
but also for operating expenses of the corporations.
These are payments for the salaries and wages of the
employees, overhead costs, acquisition of materials

used for production and etc. Hence, operating decision
answers the question: 'how much funds will be
allocated to support the day to day transactions of the

firm.
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VI. Resolution of Agency Problem:
the principal
Agency conflicts are problems between
and agent of the company. The conflicts arise when the
financial managers (agents) prioritize their own
personal interest rather than the best interest of the

shareholders of the company (principal). The existence
of these agency conflicts is detrimental on the part of
the shareholders.
Thus, the following are solutions to mitigate if not to
eliminate conflicts between the managers and the

stockholders:
Compensation Plans -
the compensation plans may
differ among the companies depending on its capacity
in terms of finances. As part of its compensation plan,
the companies would offer incentives to their managers
such as additional bonuses, percentage interest in net
income of the company and stock options. These are on
top of the annual basic salary of the managers. These

incentives are provided in order to motivate these
managers to perform better so that the goal of

maximizing the value of the firm may be achieved.
Say for instance, in comparing the compensation plan of

the Chief Executive Officers (CEO) of the two
companies: X and Y. If the CEO of Company X is given an

additional incentive of 5% of the net income above the
normal profitability of the corporation aside from his

basic salary while the CEO of Company Y is only
provided with annual salary of similar amount, we can
assume that the former is more driven to improve his

performance than that of the latter.
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However, these compensation plans sometimes provide

pressure to the managers wherein it results to the
commission of fraud. Say for example, if the CEO of

Company X prioritizes his personal interest and wants
to gain additional incentives, he can manipulate or

window dress the statement of comprehensive income.
Therefore, these compensation plans, if not taken

appropriately, shall motivate the managers to commit
fraud instead of maximizing the value of the firm.
Threats as to change in Board of Directors - these Board
of Directors (BOD) who are responsible for the ultimate

governance of the corporation are elected by the
shareholders. They are considered as passive
participants because most of them would only
participate during board meeting and not during
business day of the company. Having a position in the
board is not a permanent. The shareholders have the
power to elect new set of BOD if they are not satisfied

with the performance of the board particularly on how
they manage the business. Threatening the members of

the BOD may motivate them to become active in
governing the corporation.
Threats as to Management Takeover ~ the top level
managers who are responsible for the daily governance

of the corporation are merely appointees of the Board
of Directors (BOD). These managers are employees of
the corporation wherein they can be terminated or
replaced if they fail to deliver what is due to the

corporation. Management takeover indicates that the
old management team is replaced by the new
management. Threatening the old management may
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motivate them to improve their poor performance and

drive them to manage the business well.
Legal and Regulatory requirements these
requirements imposed upon the corporation, especially

those publicly listed companies, aim to provide security
on the part of the shareholders or investors. Say for
example, one of the regulatory requirements of the
Securities and Exchange Commissions (SEC) upon the
publicly listed corporations is to file an annual audited

Financial Statements. In auditing the Financial
Statements (FS), the external auditors gather

substantial and appropriate data to support the claims
of the management as regards the presentation of the
said Financial Statement. Then, the external auditors
will provide an opinion, qualified or unqualified,
regarding the said financial statement. This
requirement assures that the financial statements

prepared by the management are reliable and that there
is no material misstatements done. Therefore, this will
prevent the management from committing acts that are
against the interest of the owners such as fraud.
Specialist Monitoring - It is assumed that employees will

perform their functions well if they are monitored by
their superior. However, monitoring of performance is
not solely within the corporation because the external
parties such as investors or creditors may also examine
the performance of the company.
Say for example, the corporation is in need of funds and
the financial managers opt to apply for a loan in a bank.

Before the application for a loan is granted, the bank
shall initially examine the capacity of the debtor to pay
20
its debt. Hence, if the bank lends money to the
corporation, this signifies a healthy financial condition

of the company.
Conflicts between Stockholders and Bondholders:
Aside from the conflicts between financial managers
and stockholders, there are also conflicts between the

two sources of funds. The stockholders and
bondholders are investors of the firm's equity and debt

securities respectively. As regards their conflict, the
stockholders, as owners of the firm, want the financial

managers to invest in risky investments while the
bondholders, as lenders of the firm, oppose to risky

investments. It should be noted that bondholders have
fixed income from interest payments of the firm while
the stockholder's income depends on the dividend yield
and capital gains yield. The former is more concerned
on the capacity of the firm to pay interest irrespective of

the result of the firm's operations and investments
while the latter is concerned on the dividend payments
which is usually dependent on the results of the firm's
operations and investments.
Say for example, if the financial managers of the firm

have the option to invest its P 100 Million in the
following unit investment trust funds (UITF):

a. 100% equity fund (High Risk)
b. 50% equity or 50% debt (balanced fund)
C. 100% debt fund (Low Risk)
Normally, the stockholders, as risk takers, would want

the P100 Million to be invested in 100% equity fund
because the said fund has the highest risk which will
21
provide the highest return. Hence, if the result of

investments is positive, the firm will gain high returns
which shows that the expected dividends to be
distributed is also high.
On the other hand, the bondholders want the managers

to invest the P100 Million in lower risk investment
such as the 100% debt fund or the balanced fund which
provides a lower return. For bondholders, they are

already assured of the fixed interest income as long as
the firm is solvent. Thus, they want the managers to
choose a low risk investment in order to avoid high
losses and still maintain its solvency.
In determining the optimal capital structure, we will

learn that the firm may be classified as unlevered
(without debt) and levered (with debt). More so, the

additional issuances of debt securities in order to
accumulate more funds make the firm more risky. In
connection with this, another conflict between

and stockholders may arise. The
Bondholders, as risk averse investor, would protect

their interest by entering into a bond covenant
restricting the firm from issuing additional debt
securities. In addition, they would opt to raise funds
through additional stock issuances in lieu of additional

debt. On the other hand, the stockholders, as risk takers,
would approve the manager's decision to increase debt
securities rather than stock issuances because the latter
may dilute their stock ownership. (Brigham-Houston

Fundamental of Financial Management, 13th ed.)
22
Ethical Considerations:
It is true that the ultimate

goal of the corporation is
maximizing the firm's market value or the maximization
of the shareholder's wealth. This goal should be
achieved not through fraudulent acts but in an ethical
manner of doing business. Moreover, the company
should maintain its Corporate Social Responsibility

(CSR) at all times such as avoiding things that has
adverse effects in the society and to the people. Ethics
and the goal of maximizing shareholder wealth
generally lean towards similar ends because ethical
behavior builds good reputation that will benefit the
organization in the long run. However, in case of conflict

between ethics and profit goals, the former shall prevail
because unethical dealings will provide results that
taint the goodwill of the company.
Say for example in the United States, the WorldCom

bankruptcy in 2002 was marked as one of the top
business scandals wherein the management led by CEO
Bernie Ebbers fraudulently inflated assets by $11 billion
and overstated the income of the company by $3.8
billion. The material misstatement is due to the failure

of the management to report such amount as operating
expenses. Moreover, WorldCom first reported the said
amount as capital expenditures rather than operating
expenses. It evident that the management of the
is
company window dressed the financial statements by

presenting a good financial performance but in fact the
business is already bankrupt. Due to this business
scandal, US Congress passed the so called Sarbanes-
Oxley Act which set a more stringent business
regulation.
23
In the Philippines, there are lots of business scandals

which must be addressed by the government. One of
which is the Globe Asiatique Fund Scam mastermind

allegedly by Mr. Delfin Lee. In this scandal, a developer,
with good track record like Delfin Lee, was allowed by
Pag-ibig to process the loan application of their buyers,
then will forward to Pag-ibig for the release the funds,
thereby making the process faster. However, it turned

out that 60% of the P7 billion Pag-ibig funds for housing
were lent to the fictitious borrowers processed
fraudulently by Globe Asiatique. Now, irrespective of
the reasons the management have in doing such, may it
be a move to save the company from bankruptcy, they
still committed a fraudulent and unethical act.
Therefore, the end no matter how noble, does not justify

the means. (opinion.inquirer.net/how--globe-asiatique-scam-was-
done by: Neal H. Cruz, March 19, 2014)
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CHAPTER EXERCISES
NAME SCORE:
SECTION: DATE:
TRUE or FALSE: Write X if the statement is true while M if false.
1. Financial Accounting is the process of planning, directing,

organizing, controlling and monitoring the monetary resources
of the company in order to achieve its objectives or goals.
2. The ultimate goal of the corporation is maximizing its market

value which is the same as shareholder's wealth maximization.
Profit maximization does not consider the discount rate which
reflects the risks of capitalization and the time value of money
unlike market value maximization.
4. Profit maximization and cost minimization are goals of any
business organization.
5. Profit maximization is the primary goal of all business
organization.
b. Shareholder's wealth maximization may be obtained through

increase in amounts of dividends declared and decrease of
company's stock price.
7. The roles of financial managers are to decide on its investing,
financing and operating activities.
8. The treasurer's responsibility mainly focuses on the accounting

and budgeting processes.
9. The controller's responsibility is to raise adequate funds and

maintain control of such funds for the company.
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10. The Chief Financial Officer is also known as the Vice President of
Finance Department who supervises the treasurer not the
controller.
11. The board of directors is considered owners who are responsible

for the overall governance of the corporation.
12. Board of directors decides on highly significant financial matters

of the firm while controller is responsible in the capital
budgeting aspect of the firm.
13. The external auditor not the controller has the ultimate
responsibility in preparing the financial statement of the firm
since they will provide an opinion whether qualified or
unqualified.
14. Funds raised through financing decision are not only used for
investments but also for the funding of the operating expenses of
the corporations.
15. In investing decision, the financial manager answers the question

how much fund must be raised in order to
finance the investing
activities.
16. The financial managers decide on the operating activities of the

firm wherein they allocate funds for the acquisition of non-
current assets or real assets.
17. Financing activities focuses on fund raising, an example of which

is through issuance of corporate bonds (equity security) or share
of stocks (debt security).
18. The acquisition of raw materials and equipment is an example of

investing and operating activity, respectively.
19. The sole proprietorship business is subject to lesser regulations

as compared to the Corporation as a business.
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20. The amount of capital of the corporation is usually smaller than

that of the partnership as a business.
21. The Corporation is a legal entity created by the state and is a
direct extension of the legal status of its owners and managers,

that is, the owners and managers are the corporation.
22. De Facto Corporation is a corporation that exists in fact and in

law because there is no flaw in its incorporation.
23. Even if there is statement of capital stock but the dividends are
not supposed to be declared, the corporation is still a non-stock
corporation.
24. Closed or Private Corporation, Public Corporation and

Professional Corporation are accepted in the Philippines.
25. The partnership form of organization has easy transferability of

ownership as opposed to corporation.
26. One disadvantage of forming a corporation is that shareholders

have limited liability.
27. Partnership must be registered in the Department of Trade and

Industry (DTI) rather than Securities and Exchange Commission
(SEC).
28. The liability of a sole proprietor is unlimited while the

shareholder's liability is limited only up to the amount of
investment in stocks.
29. The limited liability characteristic of owners of the corporation is

subject to an exception called the doctrine of piercing the veil of
corporate fiction.
30. The life of the corporation is limited only up to 50 years while

the life of a partnership business is unlimited since the original
27
partners may transfer their ownership to their heirs through

succession.
31. The actions that maximize a firm's stock price are inconsistent
with maximizing social welfare.
32. Limited Liability Company (LLC) is a new type of organization

that is hybrid between a partnership and a corporation. This
provides that they are taxed and has a limited liability like a
corporation.
33. The Limited Liability Company is not accepted in the Philippines

while the Limited Partnership is acceptable in the Philippines.
34. Publicly listed company is a corporation whose shares are traded
in the Philippine stock exchange while privately owned

company's shares are not offered to the public.
35. Professional corporation, like General professional partnership,

is composed of professionals and is acceptable business
organization in the Philippines.
36. Financial Managers are agents of the Shareholders, the latter being
the real owners of the corporation are principals.
37. If these agents do not prioritize the interest of the principal

owners rather their own interest, agency conflicts may exist.
38. Compensating managers with stock can reduce the agency

problem between stockholders and managers.
39. Paying these managers with large fixed salaries rather than
increasing the threat as to takeover can mitigate the agency
conflicts between stockholders and managers.
28
40. Threatening the old management may motivate them to rectify

their poor performance and drive them to manage the business
well.
41. There is a conflict between stockholders and bondholder

wherein the former wants the management to take risky
investments while the latter wants the less risky investments.
42. Bondholders are providers of funds since they invested in the

debt security issued by the firm, hence they are also deemed as
owners of the firm.
43. Good reputation may be attained through ethical business

practices and is considered as the best advertisement.
44. The firm should always consider their corporate social

responsibility in doing business.
45. Unethical behavior will eventually lead to failure of achieving the

organizations goals as mirrored by the results of this behavior on
Enron and WorldCom.
46. Ethics and the goal of maximizing shareholder wealth generally

lean towards of opposite ends since managers of an organization
would not profit from ethical behavior.
47. If there are conflict between profit maximization and ethical

consideration, the latter must prevail.
48. If there are conflict between shareholder's wealth maximization

and ethical consideration, the former should prevail.
49. One of the ways to minimize losses is to window dress the

financial statement in order to make it more attractive to
prospective investors.
29
50. The management in order to save the firm from bankruptcy may
perform unethical conduct since the end if it is with noble
intention may justify the means.
51. By allowing a culture of leniency towards any action, both legal

or otherwise, the organization greatly allows itself to profit in the
long-run thereby able to maximize shareholder wealth in the
process.
52. There is a very small amount of incentive in maintaining ethical

behavior in an organization.
53. Unethical behavior will eventually lead to failure of achieving the

organizations goals as mirrored by the results of this behavior on
Enron and WorldCom.
54. An entity wishing to ensure its selection as a government

contractor should ensure that government officials receive
sumptuous gifts. The benefits of being selected as a government

contractor far exceeds the cost of the gifts provided and justifies
the action undertaken since it will all inure to the benefit of the
shareholders.
55. The primary goal of a publicly-owned firm interested in serving its

stockholders should be to maximize expected EPS.
56. Restrictive covenants in debt agreements are an effective way to

reduce agency conflicts between stockholders and managers.
57. Managers generally welcome hostile takeovers since they often

increase the company's stock price.
58. One disadvantage of forming a corporation is that your

shareholders have limited liability.
59. Relative to sole proprietorships, corporations generally face more

regulations, but find it easier to raise capital.
30
60. Bondholders generally want managers to select risky projects, but

shareholders prefer that managers select safe projects.
61. Since they are guaranteed a certain set of cash flows, corporate
bondholders generally want corporate managers to select high
risk/high return projects.
62. The actions that maximize a firm's stock price are inconsistent
with maximizing social welfare.
63. The concepts

of social responsibility and ethical responsibility on
the part of corporations are completely different and neither is
relevant in maximizing stock
price.
64. One of the

ways in which firms can mitigate or reduce agency
problems between bondholders and stockholders is by increasing
the amount of debt in the capital structure.
65. The threat of takeover is way in which the agency problem

one
between stockholders and managers can be alleviated.
66. Managerial compensation can be structured to reduce agency

problems between stockholders and managers.
67. The threat of a takeover can reduce the agency problem between
bondholders and stockholders.
68. Closed/Private Corporation, Public Corporation and
Professional Corporation are accepted in the Philippines.
69. In part due to limited liability and ease of ownership transfer,

corporations have less trouble raising money in financial markets
than other organizational forms.
70. The ultimate goal of a publicly-owned firm interested in serving its

stockholders should be to increase profits and decrease costs.
"THAT IN ALL THINGS, GOD MAY BE GLORIFIED"
31
FINANCIAL ENVIRONMENT
CHAPTER 2
In chapter 1, we have learned that the ultimate goal of the
corporation is maximization of its market value or
shareholder's wealth maximization. One of the means to
achieve this primary goal is to maximize profits through
proper allocation of funds to its operating and investing
activities.
However, there are times when firm's capital is not sufficient

to support its investments and operational activities wherein
there is a need toraise additional funds through the utilization
of financial markets, financial institutions or stockholders
infusing additional capital. Companies under financial distress
may engage in the issuance of its financial assets (debt and
equity securities) in the financial markets or borrow money
from the financial institutions.
In this chapter, we will learn financial environments by discuss

the following:
The different kinds of markets

The different financial intermediaries
The transfer of financial assets Direct and Indirect
transfer
Stock market transactions
Stock market efficiency
Financial environments are factors and situations that
primarily affect the financial aspects of the corporation. The

principal factors are the sources of financing through A)
Financial Markets and B) Financial Intermediaries.
The main source of funds used for investments and operations

come from the savings of the investors. The financial managers
acquire these funds through equity financing and debt
financing. These financing transactions take place in the so
35
called financial markets and with the intervention of the
different financial intermediaries and institution.
On the other hand, there are other markets not classified as
financial markets but can affect the operating and investing

activities of the firm.
I. Different types of markets
A. Financial Markets are the place where financial assets such

as Equity Securities (shares of Stock) and Debt Securities
(Bond certificates) are issued and traded.
1. Stock Market - this is a market where equity securities

are being issued and traded. In this market, the
stockholders may sell their stock investments or the
firm may issue additional stocks if the stock price is

overvalued or may purchase stocks if undervalued.
For example, if the firm has to raise funds but wants to
avoid high interest rate, the firm may issue equity

securities in this market.
2. Bond Market - this is a market where debt securities are

being issued and traded. This is also referred as the
fixed-income market because the investors or so called
bondholders receive fixed interest payments from their
investments assuming they will hold the bond until
maturity or on a longer period of time.
For example, if the firm has to raise funds but the stock
price is undervalued, the firm may issue debt securities

rather equity securities in this market.
36
3. Money Market - this is a market where short-term debts
with maturities of one year or less are used as a source
of financing.
An example of this short-term debt security is a
Treasury bill which is issued by the government with

maturity of one year or less.
4. Capital Market - this is a market where long-term debt

and equity securities are involved, for financing.
The examples of the long-term debt security are

Treasury note and Treasury bond wherein the former is
a debt security issued by the government usually with
maturity of more than one year but not more than 10
years while the latter is a debt security issued by the
government with maturity of more than 10 years.
B. Other markets:
1. Physical Market is also known as real asset or tangible

markets because the products involved are real estate,
property plant and equipment, inventories, etc. Hence,

those assets not qualified as financial assets are sold in
this market.
Say for example, the acquisition of raw materials to be

used for the manufacture of products takes place in this
market. In addition, if the firm has to expand its
operations and increase its production, the firm has to
purchase machineries in this market.
2. Spot Market - this is a market where assets or goods are

sold for and delivered on the spot or today. Thus, the
37
determination of price and delivery of goods is on the
same date.
An example is when a rice dealer went to the farm

during harvest to purchase all the harvest at an agreed
price and to be delivered on the same day; this takes
place in spot market.
Another example is when a Philippine based
corporation purchased inventories on February 14,

2017 from a US based corporation to be imported and
paid on March 3, 2018, the Philippine corporation has
to pay in US dollars. This is an example of an exposed

liability position (ELP) where the amount of accounts
payable changes as the exchange rate changes.
Therefore, there is a need to purchase foreign currency
to settle the accounts payable. The purchase of foreign
currency will be on the settlement date, March 3, 2018.
Thus, the determination of exchange rate (price) and
delivery of investment in foreign currency (US dollars)
is on the spot.
3. Future Market - this is a market where future contracts

are sold. A future contract is a contract that gives the
purchaser an obligation to buy an asset (and the seller
an obligation to trade an asset) at a predetermined
price at a future date. Thus, the price is agreed today
but the delivery of goods is in the future.
An example is when a rice dealer went to the farm a
month before harvest to purchase all the future harvest

at an
agreed price today and to be delivered on the day
of harvest; this takes place in future market.
38
Another example, is investing in a 1.) forward contract

or
2.) option contract (both hedge instruments) to
hedge foreign currency transaction (hedge item).
In a forward contract,
the exchange rate used to value
the purchase or sale of foreign currency is a forward
rate. Hence, the forward rate (price) is already
determined today but the delivery of the investment in
foreign currency (ex. US Dollars -$) is in the future.
An option contract is an example of a derivative whose

value
is derived from the price of an "underlying" asset.
Option contracts are classified as call option (option to
buy) or put option (option to sell). This contract has an
option price set at the inception of the transaction

which is exercisable by the investor in the future, hence
making the transaction under future market.
4. Private Market - this is a market where negotiation and
agreement takes place personally between two parties.

Hence, making the contract unique or tailor-made.
Say for example, investing in a life insurance is personal

between the insured and insurer. The policy holder
being the insured while insurance company being the
insurer. Another example of transaction that takes
place in a private market is when a depositor opens a
savings or checking account in a bank.
5. Public Market - this is a market where a security or

contracts with standardized features are being traded
and held by individuals.
39
For example, in stock markets and bond markets, the

securities (stock certificates and bond certificates)
issued by the corporation have standard features.
Hence, making them available for trading or exchange
unlike the life insurance policy discussed above.
Financial Intermediaries:
Financial Intermediaries are the organizations that

provide financing to the individuals, corporation or
other organizations by raising funds or money from:
investors.
1. Mutual Funds (MF) - the investment company pools
money from the investors then invests these

accumulated amount in a portfolio of securities whether
equity (shares of stock), debt (bonds) or money market
(short term securities). In Mutual Fund, the investors
purchased shares of the investment company thereby
giving the former the right to receive dividends. The
body that regulates these mutual funds is the Securities
and Exchange Commission. An example of mutual fund
is
Sun Life Balanced Fund, Philequity Peso Bond Fund
or ALFM Growth Fund. (philpad.com/best-mutual-funds-
in-the-philippines-2015)
2.
Unit Investment Trust Fund (UITF) the investment
company sells units of investment to the investors to
accumulate a trust fund. The trust fund may be invested

also in equity, debt or balance of equity and debt. Hence,
the investors own units of investments not shares of
stock. The
regulatory body which supervises these unit
investment trust funds is the Banko Sentral ng Pilipinas.
An example of investment in UITF is the BPI Equity Index
40
Fund of the Bank of Philippine Island.

the
(philpad.com/mutual-fund-vs-uitt-similarities-and-
differences-advantages-and-disadvantages)
3. Pension Fund - these are pooled contribution from the
employees or from the employers that serves as the
investment plans for the retirement benefits of the

employees. The accumulated funds may be invested in
shares of stocks or in a mutual fund in order to increase

the amount of pensions received by the retirees.
4. Financial institution this is a kind of financial

intermediary that provide additional financial services
other than pooling and investing of funds. One type of
financial institution is a bank which may serve as debtor
and creditor at the same time by accepting cash
deposits from savers (borrowing) and providing loans

to individual or to other firms (lending). Another type
of financial institution is the insurance company that
sells protection against the losses from fortuitous

events like fire, accidents and death.
Transfer of Securities:
Direct Transfer
In a direct transfer of securities, the equity

securities evidenced by stock certificates and
debt securities evidenced by bond certificates
are issued directly to the investors. In turn, these
investors pay directly to the issuing company.
Thus, the securities do not pass through the
possession of any financial intermediaries.
41
Indirect Transfer:
In an indirect transfer of securities, the issuing
company seeks the aid of the financial institution
to easily issue their securities to the investors,
thus there is mediation between the issuer and
the investor. Moreover, the investor may acquire

securities from the intermediary that are
different from what have been issued by the

corporation. Therefore, indirect transfers of
securities are classified as:
Indirect transfer through Investment Bank
the securities of the company are bought by

the investment bank or the SO called
underwriter with the intention of reselling

them to a prospective investor. The securities
of the issuing company will be in the hands of
the investors. Thus, no new form of capital is

created.
Indirect transfer through Financial
Intermediary the securities of the company

are bought by these financial intermediaries
without the intention of reselling the said
securities; rather they will sell their own
securities to the new investors. The securities
of the issuing company are in the possession
of the financial intermediaries while the new

investors will get the securities issued by the
financial intermediaries e.g. Investors will
receive the insurance policies issued by the

Insurance Companies. Thus, new form of
capital is created.
42
IV. Stock Market Transaction:
Stock Markets are markets where shares of stocks of

corporation are sold to new investors and or
existing stockholders. The Philippines had two stock

markets, namely: 1.) Manila Stock Exchange (MSE)
which was established on August 8, 1927; and 2.).
Makati Stock Exchange (MkSE), which was
established on May 27, 1963. However, these two
markets were unified forming the Philippine Stock

Exchange on December 23, 1992 with eight (8)
constituent indices such as:
PSE Composite Index (PSEi)

PSE All shares Index (ALL)
PSE Holding Firms Index (HDG)
PSE Industrial Index (IND) note
→
PSE Financial Index (FIN)
PSE Mining and Oil Index (M-0)
PSE Property Index (PRO)
PSE Services Index (SVC)
The figure below illustrates the stock position of

portfolio investments with the performance of the
abovementioned indices.
43
Figure 2-1: The Stock Market Index and Stock Position of

investments
MARKET INDEX
ACCOUNT BALANCES
CASH 4,526.20
ALI 3,970.47 +18.15
6,966.18 67
FIN 1.547.59 +12.37 MARGIN/CREDIT 0.00
92 6.584.67 +73.57
BUYING POWER 4,526.20
+55.84 (+0.81%) IND 10.930.58 20.85
10.199.94 -3413
YIEW PORTFOLIO
TURNOVER 4.59B 203 PRO 2.988.77 +25.69
1,513.77 +8.32 VIEW ORDERS
STOCK POSITION
BUY / SELL CODE LAST DIFF BID VOLUME BID PRICE ASK PRICE ASK VOLUME
BUY SELL 85.75 .69 470 83.70 85.75 490,040
BUY I SELL 18.50 0.3400 87 46,700 18.50 18.88 5,300

SELL 6.94 0.0400 0.57 947,400 6.94 6.95 80,000
BUY I SELL 51.40 3.63 2,000 50.00 51.40 7,900
BUY ] SELL 46.50 -0.2000 0.4283 15,300 46.50 47.00 7,500
BUY [ SELL 2052.00 30.00 1.48 50 2,044.00 2,052.00 8,400
(SOURCE: www.bpitrade.com)
This figure shows that the investor has invested in the stocks
of the following company as shown in the CODE column:
• Bank of the Philippine Island (BPI)
East West Bank (EW)
Petron Corporation (PCOR)
Philippine National Bank (PNB)
San Miguel Corporation (SMC)
Philippine Long Distance and Telephone Company
(TEL)
The LAST column shows the current stock price while the
DIFF column is the peso value increase or decrease in the
said price of these stocks. The BID VOLUME column
displays the number of outstanding stocks that the willing
buyers want to buy while the ASK VOLUME column is the
number of outstanding stocks that willing sellers want to
sell. The BID PRICE column illustrates the stock prices that
buyers are willing to pay while the ASK PRICE column is the
stock prices that sellers are willing to accept. Say for
example, in BPI stock, the BID price is P 83.70 while the
44
ASK price is P 85.75.

There will be a bargain between the
willing buyer and seller until they meet at an agreed price.
Now, if the BID equals to ASK price, say for example at
agreed price of P84.50, this will be new current market
price of the stock to be shown in the LAST column.
The following are the stock market transaction:
1. Initial Public Offering (IPO) Markets are
markets where the stocks of a closely held
corporation, going public, are offered to the
=
public for the first time. The closely held
corporations undergo IPO in order to raise
additional capital to finance their operating and

investing activities. To aid these corporations in
going public, the investment banker may
purchase all the new offered shares at
underwriter's price then sell them to public at a
retail price. Hence, this is in the form of indirect
transfer through investment bank. However, the

corporation may also undergo IPO through
direct transfer where individual investors may
place their respective bid prices and the
corporation selling directly to them.
Generally, the IPO transaction is classified as
primary market transaction since the new stocks

were sold to the public, who are new
shareholders. An exception is when the
outstanding stocks of the corporation owned by

the existing shareholders were sold to the public,
the IPO transaction is under a secondary market
transaction.
45
2. Seasoned Offering is the issuance of additional

shares of stocks of the company after its first
time offering in order to finance the capital

budget or to improve its capital structure. This
kind offering may be done by family
corporations or publicly listed corporations.
3. Primary Markets - are involved with the issuance
or selling of new shares of stocks to the investors

through the aid of the investment bankers. The
cash proceed from primary market transaction

goes to the corporation. Thus, the transactions in
this market change the size of the capital
structure of the company.
4. Secondary Market - are involved with the sale of

the outstanding shares of stocks to the existing
shareholders or to new investors. The cash
proceed from secondary market transaction goes

to the selling shareholders, not the corporation.
Thus, the capital structure of the company is not
affected by the secondary market transactions.
To illustrate the stock market transactions:
In January 2, 2018, TRIPLE B CONSTRUCTION, a

family corporation engaged in construction
business, wants to raise additional fund in order
to finance their additional capital expenditure.

To address their financial needs, the board of
directors decided to have the corporation listed
in the Philippine Stock Exchange (PSE) so that
they can sell new stocks to the public. On
February 1, 2018, TRIPLE B CONSTRUCTION
46
sold its shares to the public for the first time. The
outstanding and authorized capital stocks of the
corporation are 500,000 and 1,000,000 shares
respectively.
In June 30, 2018 the TRIPLE B CONSTRUCTION,

now
a publicly listed company, sold additional
250,000 shares to fund their expansion projects.
Hence, the outstanding shares as of this date are
750,000.
One of the stockholders, named Don Bernabe,

owned 200,000 shares. He sold half of his
ownership to his brother Mr. Jeffries on October

30, 2018. On the other hand, TRIPLE B
CONSTRUCTION repurchased the remaining
100,000 shares of Don Bernabe On November
30, 2018.
Analysis of the transactions:
The Initial Public Offering (IPO) was performed on

February 1, 2018.
The Seasoned Offering (SO) was after the IPO, in

this illustration, it was done on June 30, 2018 when
additional 250,000 shares were sold.
The IPO and SO are considered as sale of shares

under primary market transaction.
The sale of outstanding shares by Don Bernabe to

Mr. Jeffries on October 30, 2018 is a secondary
market transaction since the capital structure of the
firm is not affected.
47
The stock repurchase by TRIPLE B CONSTRUCTION

from Don Bernabe on November 30, 2018 is
considered as primary market transaction because
such purchase affected the capital structure of the

firm.
Stock Market Efficiency:

Stock market may be considered as efficient or
inefficient market. If the stocks market shows that
the market prices of the stocks are about equal or
close to intrinsic values, there is market efficiency.

In this situation, the stock price reflects all publicly
available information hence, are fairly priced. Thus,
Investors returns or losses under efficient market
are relatively low.
On the other hand, if the stock market is inefficient,

the stock prices are considered to be highly
overvalued or undervalued. Hence, the investors are
not confident to invest unless they knew some
information over the others.
There are three levels of efficiency in Efficient

Market Hypothesis (EMH) namely:
Weak form this level shows that the
information regarding past or historical
prices of a particular stock is not conclusive

in predicting stock prices. Hence, an investor
cannot beat the market by simply analyzing
the past performances of the stock.
Semi-strong form this level shows that all
the available public information is already
48
incorporated in the stock prices. Hence, the

investors cannot beat the market solely by
analyzing the published financial reports of
the company unless they have information
from company insiders.
Strong form this level show that investors

cannot beat the market even with insider
information. Hence, the investors in this
efficient market cannot earn high returns.
The stock prices can be classified as:
a) Market value - also known as perceived value, is

the price of the stock which is currently traded
in the market. In the Philippines, the market
prices of the stocks of publicly listed companies
are readily available in the Philippine Stock
Exchange (PSE).
b) Intrinsic value this is the true value of the
stock. This is the price that the willing buyer will

bid and willing seller will ask provided that all
necessary information about the stock is
available. The intrinsic value can be estimated
using either the a) Dividend Discount Model or

b) Corporate Valuation Model. (In depth
discussion regarding these models will be on
Chapter 7 - Stock Valuation.)
If the so called market value (perceived value) is

equal to the intrinsic value (true value), the
stock price is at equilibrium. Hence, the investor

is neutral as to selling or buying stocks.
49
If the market value of the stock is higher than

the intrinsic value, the stock price is deemed as
overvalued. Thus, the stockholders are expected
to sell than to buy shares.
If the market value is lower than the intrinsic

value, the stock price is undervalued. Hence, the
investors are expected to purchase more shares

to take advantage of lower price. (Brigham-
Houston, Fundamentals of FINANCIAL MANAGEMENT
13th ed, page 46-49)
50
CHAPTER EXERCISES
NAME SCORE:
SECTION:_ DATE:
TRUE or FALSE: Write X if the statement is true while M if false.
1. Financial environments are factors and situations that primarily

affect the operating aspects of the corporation.
2. Financial Markets are where physical assets such as stocks and

bonds are issued and traded.
3. The firm may increase funds through the sale of equity security or
issuance of debt security in capital market.
4. The real asset or tangible markets are where financial assets are
sold or traded.
5. In a private market, the contracts between two persons are with
standardized feature making it available for trade.
6. An example of transaction in a private market is when an investor

signs a contract of deposit with a bank, while trading of stocks is
an example transaction in public market.
7. Public Market is market where a security or contracts with
tailor-made features are being traded and held by individuals.
financial market in which funds are borrowed

8. Money Market is a
or loaned for short periods.
Capital Markets involve instruments with maturities of longer
than one year.
10. In a secondary market the outstanding shares are sold by a

shareholder to an investor thereby increasing the capital structure
of the corporation.
51
11. If the goods are to be delivered in the future and the price is
determined today, it is a spot market transaction.
12. Treasury bonds are long term debt securities issued by the
corporation which provides for a fixed interest income for more
than 10 years.
13. Treasury bills are debts of the government with more than 10
years of maturity.
14. Mutual Funds are pooled contribution from the employees or

from the employers that serves as the investment plans for the
retirement benefits of the employees.
15. Spot Market is a market where assets or goods are delivered

today and the price of the said assets is determined today.
16. An example of spot market transaction is buying of foreign

currency using the forward rate.
17. A derivative is a contract whose value depends on the value of an

underlying asset.
18. Option contracts are transacted in the future market because

contract has
an option price set at the inception of the
transaction which is exercisable by the investor in the future.
19. Call option contract gives the investor a right to sell if the option
price (exercise price) is greater than the market price.
20. In a Put option contract, it is said to be

"in the money"
transaction if
the exercise strike price (option price) is lower
than the so called market price.
52
21. In an option to buy a foreign currency, when the spot market

price is lower than the exercise strike price it is said to be "out of
the money" transaction.
22. If the option price is equal to the spot market price, it said to be
"at the money" whether the option is put or call option.
23. Future market is a market where assets or goods are delivered in

the future while the price of the said assets is determined today.
24. If the investor ALEX has P 10,000 cash to invest in highly risky
investment, he should invest in bond market rather than stock
market to earn more.
25. In a primary stock market transaction, the transfer of capital from

seller to investor changes the capital structure of the corporation.
26. In a secondary stock market transaction, the transfer of capital

from seller to investor involves the sale of outstanding shares of
the corporation, thus, it changes the capital structure of the said
corporation.
27. Initial Public Offering is the first time offering of closely held
company's stocks to the public.
28. The IPO is classified as primary market transaction or secondary

market transaction, wherein the former transaction shows that
new stocks were sold to new investors while the latter shows that
new stocks were sold to existing stockholders.
29. In a seasoned offering, the additional shares of the company
were issued after its first time offering in order to finance its
investment and operations.
30. A transfer of securities through an intermediary in which the

investors will be holding the securities of the issuing corporation
is an indirect transfer through investment bank.
53
31. If APOLLO Bank, after knowing the plan of CHUA Corporation to

go public, purchased all the latter's shares at a certain price then
offered these shares to the public, the transfer is deemed as
indirect transfer through underwriter.
32. If APOLINARIO Corp, a life insurance company, purchased all the

shares of MANALO Corporation after knowing the plan of the
latter to go public then offered its own insurance policy to the
public, the transfer is known as indirect transfer through financial

intermediary.
33. Capital market involves investment is long term debt securities

only such as bonds and notes while stock market is where equities
are being sold and traded.
34. Mutual funds are investment companies that pools investment

from the public then place these funds in equity security but not in
debt security investments.
35. In a Unit Investment Trust Fund (UITF), the investor will buy units
of investment from the investment company while in Mutual Fund
(MF) the investor will purchase shares of the said investment
company.
36. If HENDRY SY invested his P 100,000 in mutual fund of Bee-Dee-
Owe while his P 50,000 was invested in UITF of Bee-Pee-Eye, the

former investment is regulated by BSP while the latter investment
is regulated by SEC.
37. An efficient stock market is where the stock prices are
considered to be highly overvalued or undervalued.
38. An undervalued stock will be a "good buy" because it shows that

the intrinsic value is lower than the market value.
54
39. The stock is undervalued if the perceived value is lower than

true value, hence the investors will be indifferent in buying or
selling.
40. In efficient market hypothesis, the strong form shows that

investors can beat the market with insider information and will
earn high returns.
41. In a weak form of efficient market, an investor cannot beat the

market by simply analyzing the past performances of the stock.
42. In a semi-strong form of efficient market, not all the available

public information is incorporated in the stock prices, Hence,
analyzing the published financial reports are significant to beat
the market.
43. Intrinsic value, also known as the perceived value, is the price
that the willing buyer will bid and willing seller will ask provided
that all necessary information about the stock is available.
44. Historically the Philippines had two stock markets but these
markets were unified forming the Philippine Stock with six (6).
constituent indices.
45. Treasury bonds and corporate bonds are both traded in capital
market but with different interest rates.
46. Ceteris paribus, the corporate bond's interest rate is always

higher than the interest rate of Treasury bond.
47. Investment in equity securities (stock) and debt securities
(bonds) are long term investments but the former is riskier than
the latter.
48. Ceteris paribus, investment in stocks is expected to provide

higher return than the investment in bonds because the higher
the risk, the higher the return.
55
49. Low interest rate triggers the firm to issue equity securities
(stocks) in the stock market instead of issuing debt securities

(bonds) in the bond market.
50. The Initial Public Offering is generally performed by family

corporations that are going public through issuance of stocks to
the public for the first time in the stock market; however, it may
also be performed by publicly listed companies through issuance
of corporate bonds for the first time in the bond market.
51. The main product under the secondary market is outstanding

shares which are sold by a shareholder to an investor thereby
increasing the capital structure of the corporation.
52. Issuing 2 million shares of DMZI new stock to the public is a kind
of secondary market transaction.
53. A financial market in which funds are borrowed or loaned for
short periods is a capital market.
54. Indirect Transfers through Investment Bankers is a transfer of
security particularly shares of stock through an intermediary

in
which the investors will be holding the securities of the
corporation / Business.
55. Investment Banks

usually specialize assisting organizations raise
capital by "syndicating" or arranging for the sale of the securities
offered by the borrower as opposed to Commercial Banks
performing general banking services such as depositary,
checking, trust and various loan products.
"In
everything you do, never forget to seek the blessings of the Lord
for he has the final answer."-ysb
56
FINANCIAL STATEMENT ANALYSIS
CHAPTER 3
Corporations, especially those publicly listed companies, are
mandated by the Securities and Exchange Commission (S.E.C.)

to file their annual Audited Financial Statements. These
financial statements are composed of:
1) Statement of Financial Position which is traditionally known

as Balance Sheet;
2) Statement of Comprehensive Income also known as Income
Statement;
3) Statement of Cash Flows,
4) Statement of Changes in Owner's Equity and
5) Notes to Financial Statements.
These aforementioned statements are the primary means to
communicate the material financial information to its users
regarding the operating performance, profitability and the

ability of company to meet its obligations. However, users
cannot easily determine the financial status of the company by
merely looking at the values stated in the Financial Statements.
Thus, there are tools and techniques developed by the financial
analysts that helps evaluate the company's performance and
conditions.
In this chapter, we will explore the following:
Different tools and techniques in analyzing the financial

statements of the company.
The significance and formulas of the different
performance measurement ratios that reflects the

liquidity, solvency, efficiency and profitability of the
company.
Inanalyzing the financial statements, financial managers

use the following tools and techniques such as: a) Horizontal
Analysis, b) Vertical Analysis, c) Financial Ratios and d) DuPont
Technique.
59
HORIZONTAL ANALYSIS
is a method of
Horizontal analysis of financial statements
comparing the Peso value or amount of the particular line
item in the Statement of Financial Position, Statement of
Comprehensive Income or Cash Flow Statements over a
two or more consecutive accounting period. Moreover, this

peso value can be converted into percentages for purposes
of comparing the performance of different companies in an
industry. Horizontal analysis, which is also known as trend
analysis, provides assessment of the significant increase or

decrease in these different items in the financial
statements. Thus, in performing Horizontal analysis as a
technique, we can use the a) Peso value or b) Percentage

change for comparison and evaluation of company's
performance.
% To illustrate, use following Statement of Financial Position

of FSA Corporation for the year 2014 and 2015 as shown in
table below:
TABLE 3-1: FSA Corporation Statement of Financial Position
STATEMENT OF FINANCIAL POSITION AS OF DECEMBER 31 (in Millions of Pesos)

2014 2015 2014
ASSET LIABILITIES and SHAREHOLDER'S EQUITY
Current Asset (CA) Current Liability(CL)
Cash 800 900 Accounts Payable 400
Accounts Receivable 1,300 1,100 Notes Payable 1,600 1,450
700 750 TOTAL CURRENT LIABILITY 2,000 1,900

Inventory
TOTAL CURRENT ASSET 2,800 2,750
Non-Current Liability (NCL)

Non-Current Asset (NCA) Bonds Payable 3,500 3,700
5,600 4,900 other Long Term Debt 2,400 2,600

Property,Plant and Equipment
2,600 2,350 TOTAL NON-CURRENT LIABILITIES 5,900 6,300
Intangible Asset
TOTAL NON-CURRENT ASSET 8,200 7,250
Shareholder's Equity
10000 Common Stocks 500 700
TOTAL ASSETS
Retained Earnings 2,600 1,100
TOTAL SHAREHOLDER'S EQUITY 3,100 1,800
TOTAL LIABILITIES AND EQUITY 11,000 10,000
60
If the financial manager will perform Horizontal or Trend

Analysis on the a) Cash and Cash equivalents item and b) Notes
Payable item as shown in the Statement of Financial Positions
above, what will be the assessment using: 1) Peso Value or 2)
Percentage Change?
In using Peso Value for comparison and analysis, the
amount of Cash and Cash Equivalents for the year 2015 was
increased by P 100 million while the amount of Notes
Payable decreased by 150 million. The increase in the

amount of cash may signify that there are revenues
generated or the inflows of cash are more than outflow. On

the other hand, the decrease in Notes Payable may imply
that there are payments of obligations made by the FSA
corporations.
In using Percentage for comparison and analysis, there is a
need to convert the Peso value into percentages where in
prior period values will serve as the base amount (100%).

To calculate the percentage change in values from prior
period to the current period, we will use the formula below:
Current Year Prior Year

Percentage Change =
Prior Year
If the percentage change resulted to a positive (+), this
implies that there is increase in the peso value of the line

item subject to evaluation while negative ( - ) percentage
means that there is decrease in the peso value.
Thus, the change in Cash and Cash Equivalent from P 800

P 900 million in 2015 will be
million for the year 2014 to
% increase in the value of cash or be
reported as 12.5
value of the prior period.
reported as 112.5% of the cash
61
Percentage Change =P 900 Million - P 800 Million_= 12.5%
P 800 Million
On the other hand, the change Notes Payable from P 1.6
Billion for the year 2014 to P 1.45 Billion in 2015 will be
reported as 9.375% decrease in the value of Notes Payable

or be reported as 90.625% of the Notes Payable value of
the prior period.
Percentage Change =P 1.45 Million- P 1.6 Billion = (- 9.375%)

P 1.6 Billion
II. VERTICAL ANALYSIS
Vertical analysis of financial statements is a technique that

involves assessment of the different line items in a single
period Financial Statement. These items which are
commonly shown in the Financial Statements using their

Peso values shall be expressed in percentage of a total
amount or the base amount. In this
technique, the financial
managers can appropriately evaluate the financial
information of companies of different sizes because
using
percentages for comparison provides more useful and
relevant conclusions than using the peso values in
comparing these companies of different sizes.
In addition, Vertical Analysis is performed on the Statement

of FinancialPosition (Balance Sheet) where in the base
amount in calculating the percentages is Total Assets while
the base amount for
the Statement of Comprehensive
Income (Income Statement) is Net Sales. After using this
technique, the financial statements prepared are known as
62
common
size financial statements. Thus, traditional balance
sheet and income statement shall be termed as common
size balance sheet and common size income statement,

respectively.
> To illustrate, let us assume the Statement of Financial

Position of FSA Corporation for the year 2015 as shown
in table 3-1. In using this technique, the balance sheet
items are presented as a proportion of the total assets.
Hence, the base amount for purposes of calculating the
percentages shall be Total Asset of FSA Corporation
amounting to P 10 Billion.
Say for example in computing the proportion of Cash
and Cash Equivalents to Total Assets, the Peso Value P
900 Million shown intable 3-1 shall be divided by the

P10 Billion Peso value to get 9%. The other items
presented in percentage form are shown in Table 3-2:
Table 3-2: FSA Corporation Common Size Balance Sheet
Common Size Balance Sheet as of December 31, 2015
ASSETS LIABILITIES and SHAREHOLDER'S EQUITY

Current Assets: Current Liabilities:
Cash and Cash Equivalents 900 9.00% Accounts Payable 450 4.50%
Accounts Receivable 1,100 11.00% Notes Payable 1,450 14.50%
Inventories 750 7.50% Total Current Liabilities 1,900 19.00%
Total Current Asset 2,750 27.50%
Non-Current Liabilities
Non-Current Assets: Bonds Payable 3,700 37.00%
Property, Plant and Equipment (net) 4,900 49.00% Other Long term debt
2,600 26.00%
Intangible Assets 2,350 23.50% Total Non-Current Liabilities 6,300 63.00%
Total Non-current Asset 7,250 72.50%
Shareholder's Equity:
TOTAL ASSETS 10,000 100.00% Common Stocks 700 7.00%
Retained Earnings
1,100 11.00%
Total Shareholder's Equity 1,800 18.00%
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY 10,000 100.00%
On the other hand, when applying this technique to the
Statement of Comprehensive Income, income and expenses are

compared to the Net Sales. For example, if the Net Sales
63
Revenue of FSA Corporation in 2015 is P 50 Million and the
total Cost of Goods Sold is P 25 million, the Cost of Goods Sold

will be reported as 50% of the Net Sales. Moreover, if the
resulting Net Income amounted to P 5 Million, the said Net
Income will be presented as 5%
FINANCIAL RATIO:
Financial ratio as a tool and technique in financial analysis is the
comparison between one of financial information with other
financial information. This comparison formulates relationship

that provides relevant information in evaluating the operating
performance and financial condition of the company.
Generally, financial ratios can be classified into four aspects
such as the following:
A. Liquidity Ratio - this measures the ability of the

company to meet its short term obligations.
B. Leverage Ratio - this measures the ability of the
company to meet its long term obligation when they fall

due.
C. Activity Ratio -
this measures how the company
productively uses or manages its assets.
D. Profitability Ratio this measures the overall financial

performance of the firm and its return on investments.
Classifications of Financial Ratios:
A. LIQUIDITY RATIOS are the ratios that measure the ability of

a company to pay its short term debt obligations when they
64
fall due. Moreover, it measures the capacity of the company

to convert short term assets into cash. The liquidity ratios
greater than 1 signifies that the company is in good
financial standing and that the current liabilities of the said
company will be met.
Financial managers or analysts commonly use these

following liquidity ratios:
Current Ratio
Quick Ratio
Cash Ratio
Working Capital To Total Asset Ratio
A.1. Current Ratio:
Current ratio, which is also termed as working capital

ratio, indicates whether or not the company has
sufficient resources to pay its debt obligations that are
due within 12 months. This ratio shows the liquidity of
a company which is the ability of assets to be easily and
quickly converted into cash at the lowest cost. The
acceptable current ratio varies for different industries

however; it is commonly ranging from 1.5:1 to 2:1. If the
current ratio ishigher than the acceptable level (rule of
thumb) of 2:1, this may signify that the company is not
utilizing its current assets efficiently. In contrary, low
current ratio means that the company will have
difficulty in paying its short term debts.
The current ratio is calculated by using the formula:
Total Current Assets

Current Ratio =
Total Current Llabilities
65
Illustrative Problem 3-3:
LEAD Company's Statement of Financial Position for

the year 2018 shows cash amounting to P
250,000.00, Marketable Securities of P 25,000.00,

Accounts receivable of P 50,000.00, Inventories of P
75,000.00, Non-current Assets of P600,000.00, and
the Total Shareholder's Equity and Long Term Debt
are P600,000.00 and P 200,000.00 respectively. What

is the Current Ratio?
SOLUTION:
Total Current Assets

Current ratio
Total Current Liabilities
Current ratio
Cash + Marketable Security + Accounts Receivable + Invenentory
Total Assets - [ Total Shareholder's Equity + Long term Debt]
250,000 + 25,000 + 50,000 + 75,000

Current ratio =
1,000,000 - 600,000 + 200,000]
400, 000
Current ratio = =2:1
200,000
A.2.Quick Ratio:
Quick ratio is a more stringent measurement of the

ability of the company to pay its short term debt
obligation using the quick assets of the company. The
quick assets used are composed of the most liquid asset
which is cash and those highly liquid current assets that
are easily convertible into cash such as marketable
securities and accounts receivables. Among the current
assets, the inventories are excluded as components of

the quick assets because of its difficulty to convert into
cash, thus it is considered as less liquid current asset.
66
The acceptable level of Quick ratio varies for different
industries but it is commonly set at 1. This ratio is also

known as the Acid Test ratio.
The Quick or Acid Test ratio is calculated by using the

formula:
Current Assets-Inventories
Quick Ratio =
Total Current Liability
Quick Ratio =
Cash+Marketable Securities+Accounts Receivable
% Illustrative Problem 3-4:

The 2018 Balance Sheet of PAREX Company has Total
current assets and total current liabilities amounting
to P 400,000.00 and P 200,000.00 respectively. The
current assets are composed of cash amounting to P
100,000.00, Marketable Securities of P 45,000.00,
Accounts receivable of P 95,000.00 and Inventories of
P 160,000.00 What is the Quick Ratio?
SOLUTION:
Quick Ratio
Cash + Marketable Securities + Accounts Receivable
=
100,000 + 45,000 + 95,000

Quick Ratio =
200,000
240,000
Quick Ratio = - 1.2:1
200,000
A.3. Cash Ratio:
Cash ratio is considered to be the most stringent and

conservative among the liquidity ratios because it only
67
uses cash and cash equivalents in paying the short term

obligations of the company. This ratio shows the
such as
comparison of the company's most liquid assets
Cash and marketable securities over its total current
liabilities.
The Cash ratio is calculated by using the formula:

Cash+Marketable Securities
Cash Ratio =
IYSB Company has Total current assets and total

current liabilities amounting to P 400,000.00 and
P 200,000.00 respectively. The current assets are
composed of cash amounting to P 100,000.00,

Marketable Securities of P 50,000.00, Accounts
receivable of P 90,000.00 and Inventories of P
160,000.00 What is the Cash Ratio?
SOLUTION:
Cash + Marketable Securities

Cash Ratio =
100,000 + 50,000
Cash Ratio =
200,000
150,000
Cash Ratio = : 0.75 : 1
200,000
A 4. Working Capital to Total Asset Ratio:
Companies usually have higher value of current assets

over the value of the current liabilities. Working Capital,
which measures the company's potential value of cash
reserves, is the difference between the total current
68
assets and total current liabilities. This is sometimes

called as
Net Working Capital. Financial managers often
compare this Net Working Capital over the value of the
Total Assets.
The Working Capital to Total Asset Ratio is calculated
by using the formula:
Working Capital to Total Asset Ratio = Current Assets-Current Liabilities

Total Assets
JMS Company's Statement of Financial Position

for the year 2018 shows Total current assets of P
200,000.00 and Non-current assets of P
300,000.00, and the Total Shareholder's Equity

and Long Term Debt are P 300,000.00 and P
100,000.00 respectively.
a. What is the amount of Net

Working Capital?
b. What is the Net Working Capital to Total
Assets Ratio?
SOLUTION:
Net Working Capital = Total Current Assets - Total Current Llabilities
Net Working Capital = 200,000 100,000
Net Working Capital = 100,000
Net Working Capital

Net Working Capital To Total Assets Ratio =
Total Assets
100,000
Net Working Capital To Total Assets Ratio =
500,00
Net Working Capital To Total Assets Ratio = 0.20 or 20 %
69
Total Shareholder's Equity

Equity Ratio =
Total Asset
ADCM Incorporated has a total Net worth of P
2,500,000.00 in 2018. an
outstanding Loans payable, Bonds payable and

Accounts payable amounting to P 600,000.00, P
1,400,000.00 and P 500,000.00, respectively.
What is the Equity ratio of ADCM Incorporated?
SOLUTION:

Equity Ratio =
Total Asset

Equity Ratio =
Total Equity + Total Liability
2,500,000
Equity Ratio =
2,500,000 + 2,500,000
2, 500, 000
Equity Ratio = = 0.5 or 50 %
5, 000, 000
B.3. Debt to Equity Ratio:
Debt to Equity ratio is a ratio that shows the proportion
of company's funds financed by debt compared to funds

financed by equity. This ratio is a good measure of the
financial status of the company. The higher debt to
equity ratio implies that the company is highly financed
by debt or creditors, thus increases the financial risk of
the company. On the contrary, lower debt to equity ratio
signifies that the contribution from the stockholders is
more than from creditors, thus the company has better

standing in terms of solvency yet it does not increase
earnings through leverage.
72
The debt to equity ratio is calculated by using the

formula:
Total Liability
Debt to Equity Ratio =
In 2018, ALGER Corporation has total assets
amounting to P 5,000,00 0.00 and total
stockholder's equity of P 2,000,000.00. What is
the Debt to Equity ratio of ALGER Corporation?
SOLUTION:
Total Liability
Debt to Equity Ratio

Total Asset - Total Shareolder's Equity
5,000,000 - 2,000,000
2,000,000
3, 000, 000
Debt to Equity Ratio = = 1.5
2, 000, 000
B.4. Times Interest Earned Ratio (TIER):
Times Interest Earned Ratio, which is sometimes

referred as interest coverage ratio, is a ratio that
indicates the degree to which interests are covered by

earnings before interest and taxes (EBIT). This ratio
measures the number of times the interest payments
can be made by the company through the use of EBIT. If
the TIER of a company is low, this implies that the
ability of the company to meet its interest expenses is

impaired because of less earning generated from
73
operations. However, higher TIER shows a good

financial standing of the company.
The Times Interest Earned Ratio is calculated by using

the formula:
Earnings Before Interest and Tax (EBIT)

Times Interest Earned Ratio =
Interest Expense
* Illustrative Problem 3-10:
CDA Corporation's Statement of Comprehensive

Income presented a total Gross Profit of P
1,500,000.00, Operating expenses amounting to P
300,000.00 and Interest expense amounting to P
400,000.00. The tax rate is 30%. What is the
Times Interest Earned Ratio of CDA Corporation?
SOLUTION:
Times Interest Earned Ratio
Earnings Before Interest and Tax (EBIT)

Interest Expense
Times Interest Earned Ratio
Gross Profit - Operating Expense

Interest Expense
1,500,000 - 300,000
400,000
1, 200, 000
400, 000
3 times
B.5. Cash Coverage Ratio:
Cash Coverage Ratio is a ratio that indicates the extent
to which interests are covered not only by earnings but
by the cash flows generated from operations. This ratio
shows the use of company's earnings exclusive of non-
74
cash expenses in meeting its interest expenses. Thus,

this measures how many times the interest payment
can be made by the company through earnings before
interest and taxes after adding back
Depreciation.
The Cash Coverage Ratio is calculated by using the

formula:
Cash Coverage Ratio =
Earnings Before Interest and Tax (EBIT)+ Depreciation

Interest Expense
CCR Corporation's Statement of Comprehensive

Income presented a total Gross Profit of P
to P
750,000.00, Operating expenses amounting
150,000.00 and Interest expense amounting to P
200,000.00. The tax rate is 30% and one-third

from
(1/3) of the Operating expenses comes
annual depreciation. What is the Cash Coverage

Ratio of CCR Corporation?
SOLUTION:
Cash Coverage Ratio

Earnings Before Interest and Tax (EBIT) + Depreciation
Interest Expense
Cash Coverage Ratio

(Gross Profit - Operating Expense) + Depreciation
Interest Expense
(750,000- 150,000) + 50,000

Cash Coverage Ratio =
200,000
650,000
Cash Coverage Ratio = 3.25 times
200,000
75
C. ACTIVITY RATIO measures how efficiently the company

produces revenue through the management of its assets.
Moreover, this ratio indicates the company's capacity of
converting its assets into the sales revenue. Activity ratios
are also known as efficiency ratio or asset management
ratio.
the following activity ratios in

Financial managers use
analyzing the financial statements:
Asset Turnover Ratio

Accounts Receivable Turnover Ratio
Days' Sales Receivable

Inventory Turnover Ratio
Days' Sales in Inventory
Accounts Payable Turnover Ratio
Days Payable Outstanding
Cash Conversion Cycle
C.1.Asset Turnover Ratio:
Asset Turnover Ratio, which is also referred as Sales to

Asset ratio, indicates the value of peso sales generated
by the each peso of asset employed by the company. It is
assumed that high asset turnover ratio signifies the
effective use of company's assets. However, if this ratio
is determined at a low level, which implies an inefficient
use of assets, there is a need to analyze the performance
of key assets such as receivable and inventories.
The Asset Turnover Ratio is calculated by using the

formula:
Sales Revenue
Asset Turnover Ratio =
Average Assets
76
~ Illustrative Problem 3-12:
Corporation's 2018 Statement of
Comprehensive Income presented a total Sales
Revenue of P 1,200,000.00 and Cost of Sales of P

750,000.00. The total assets of JCOO Corporation
in 2014 amounted to P 400,000.00 which is
higher by P 200,000 as of 2018. What is the Asset
Turnover Ratio of JCOO Corporation?
SOLUTION:
Sales Revenue
Asset Turnover Ratio
Average Assets
1,200,000
Asset Turnover Ratio =
( 400,000 + 600,000)/ 2
1, 200, 000
Asset Turnover Ratio = 2.4 times
500, 0000
C.2.Accounts Receivable Turnover Ratio and Days' Sales

Receivable:
Accounts Receivable Turnover Ratio indicates how many

times the company collects its average accounts
receivables during an accounting period. Thus,
measuring how fast the Collection Department of the
company collects its credit sales. In Addition, the higher
the Accounts Receivable Turnover Ratio, the more
efficient the company is managing its credits granting to
customers, and vice versa.
The Accounts Receivable Turnover Ratio is calculated

using the formula:
77
Credit Sales
Accounts Receivable Turnover Ratio =
Average Accounts Receivable
Days' Sales Receivable indicates how fast the company

collects it credit sales in terms of days. This is also
known as Average Collection Period. In measuring the
average collection period of the company in days,
financial manager uses the formula:
Average Receivables (AR)

Days'Sales Receivable =
Average Daily Sales
[ Beginning AR +Ending AR)]

Days' Sales Receivable =
(Sales Revenue
Revenue of P 3,600,000.00. The 2018 accounts

receivable of BERMEO Corporation amounted to P
400,000.00 which is higher by P 200,000 in 2017.

a. What is the Accounts Receivable Turnover
Ratio?
b.
What is the Days' Sales Outstanding or the
Average Collection Period?
SOLUTION:

Credit Sales
Average Accounts Receivable

3,600,000
(200,000 + 400,000)/2
78
3, 600, 000
Accounts Receivable Turnover Ratio =
300, 000
= 6 times

Average Daily Sales
(200,000 + 400,000)/2
3,600,000/360
300,000
Days'Sales Receivable = = 30 days
10,000
The analysts evaluate the two foregoing ratios by

comparing them to the company's credit policy and
industry average.
C.3.Inventory Turnover Ratio and Days' Sales Inventory:
Inventory Turnover Ratio measures the number of times

the company replaces its average inventories during an
accounting period due to sales. This ratio shows how
the company manages its inventory efficiently. Thus,
high inventory ratio implies better sales efficiency while
low inventory ratio may signify obsolete inventories or
that too much inventory is held in stock.
The Inventory Turnover Ratio is calculated using the

formula:
Cost of Sales Sales

Inventory Turnover Ratio
Average Inventory
Days' Sales Inventory indicates how quick the company

can sell its inventories in terms of days or the number of
days the company holds these inventories before selling
to customers. This is also known
as Average Inventory
Period. In measuring the average inventory period of
the company in days, financial manager uses the
formula:
79
Average Inventory (Inv.)

Days'Sales Inventory = Average Daily Sales
( Beginning Inv.+Ending Inv.)

Days'Sales Inventory = Sales
(Cost of
360

Revenue of P 5,000,000.00 and Cost of Goods Sold
of P 3,000,000.00. The Statement of Financial
Position shows Inventory value of P 350,000.00 in
2018 and P 250,000.00 in 2017.
C. What is the Inventory Turnover Ratio?

d. What is the Days' Sales Inventory?
SOLUTION:
Cost of Sales
Inventory Turnover Ratio =
Average Inventory
3,000,000
Inventory Turnover Ratio =
(250,000 + 350,000)/2
3, 000,000
Inventory Turnover Ratio = = 10 times
300, 000
Average Inventory
Days'Sales Invetory
Average Daily Cost of Sales
(250,000 + 350,000)/2
Days 'Sales Receivable =
3,000,000/360
300, 000
Days'Sales Receivable 36 days
8,333.33
80
C.4.Accounts Payable Turnover Ratio and Days' Sales

Inventory:
Accounts Payable Turnover Ratio indicates the number

of times the company pays its outstanding average
accounts payable during an accounting period. This
ratio shows the creditworthiness of the company or
how it manages its payments to the creditors. Thus,

high accounts payable turnover ratio means that the
company pays its purchase on account in a short period

of time.
The Accounts Payable Turnover Ratio is calculated

using the formula:
Accounts Payable Turnover Ratio =

Purchases*
Average Accounts Payable
*Purchases = Cost of Goods Sold + Ending
Inventory - Beginning Inventory
Days' Payable Outstanding shows the number of days it
will take for the company to pay its liability from date of
purchase. This is also termed as Accounts Payable

Period. In measuring the accounts payable period of the
company in days, financial manager uses the formula:
Average Accounts Payable (AP)

Days' Payable Outstanding = Average Daily Purchases
[( Beginning AP+Ending AP)/2]

Days'payable Outstanding (Purchases*/360)
81
The Statement of Comprehensive Income of DPO

Industries in 2018 shows an amount of P
750,000.00 Cost of Goods Sold. Its 2018
Statement of Financial Position shows Inventory

value of P 175,000.00 and Accounts Payable of P
250,000.00. Last year, Inventory and Accounts

Payable amounted to P 125,000.00 and P 150,000
respectively.
a. What is the Accounts Payable Turnover Ratio?

b. What is the Days' Payable Outstanding?
SOLUTION:

Purchases
=
Average Accounts Payable
* Purchases
= Cost of Goods Sold

+ Ending Inventory
Beginning Inventory
* Purchases = 750,000 + 175,000- 125,000 = 800, 000

800,000
(150,000 + 250,000)/2
800, 000
Accounts Payable Turnover Ratio =
200, 000
= 4 times
Days 'Payable Outstanding

Average Daily Purchases
Days' Payable Outstanding = (150,000 + 250,000)/2

(800,000 /360 days)
82
200,000
Days' Payable Outstanding = 2222.22 90 days
C.5. Normal Operating Cycle:
This cycle starts from the purchase of materials from

the supplier, followed by the sale of finished goods
inventory to the customers then finally the collection of
cash payments made by these customers. The delay of
time between purchase of materials and the sale of

finished goods is called the Average Inventory period
(AIP); and the delay of time between sale of finished
goods and the collection of customer payment is the
Average Receivable Period (ARP). Normal Operating

Cycle is the summation of these two periods, the AIP
and ARP, thus, is the delays in collecting cash payments.
On the contrary, the delay of time between purchase of
materials and the payment made to the supplier is
referred as Accounts Payable Period (APP). (These

periods which are considered as components of the
working capital were discussed above.)
Cash Conversion Cycle measures the number of days

from cash being paid to the suppliers up to the time
cash is received from sales. Hence, it is the period of
time from the purchase of raw materials up to the
collection of receivable.
The objective in working capital management is to

shorten the cash conversion cycle by implementing a
policy that speeds up the collections from customers
and slows down the payment to the supplier. The cash

conversion cycle can be calculated by using the formula:
83
Cash Conversion Cycle = AIP + ARP APP
CCC Company's Statement of Comprehensive

Income in 2018 presented Sales Revenue
amounting to P 1,000,000.00 and Cost of Goods
Sold of P 750,000.00. Its 2018 Statement of
Financial Position shows Inventory value of P
175,000.00, Accounts Receivable of P 50,000.00

and Accounts Payable of P 250,000.00. Last year,
Inventory, Accounts Receivable and Accounts
Payable amounted to P 125,000.00, P 150,000.00
and P 150,000.00 respectively.
a. Calculate the Average Receivable Period or

Average Collection Period
b. Calculate the Average Inventory Period
C. Calculate the Accounts Payable Period
d. Calculate the Cash Conversion Cycle
SOLUTION:
A. Average Receivable Period

=
Average Daily Sales
(150,000 + 50,000)/2
Average Receivable Period =
1,000,000/360 days
100,000
Average Receivable Period = =
36 days
2,777.77
B. Average Inventory Period

Average Inventory (INV)
Average Daily Cost of Sales
(125,000 + 175,000)/2
Average Inventory Period =
750,000/360 days
84
150,000
Average Inventory Period = 72 days
2,083.33
C. Accounts Payableble Period

Average Daily Purchases
(150,000 + 250,000)/2
Accounts Payable Period =
800,000/360 days
200,000
Accounts Payable Period = = 90 days
2,222.22
D. Cash Conversion Cycle = ARP + AIP - APP
Cash Conversion Cycle = NOC - APP
Cash Conversion Cycle = (36 days +

72 days) 90duys
Cash Conversion Cycle = 18 days
> Notes:
Account Receivable Period is also known as

Day's Sales Outstanding
Day's Sales Receivable
Average Collection Period
Inventory Period is also known as
Day's Sales Inventory

Average age of Inventory
Inventory Conversion Period
Accounts Payable Period is also known as
Day's Purchases Payable

Average age of Payable
85
D. PROFITABILITY RATIO measures the overall financial
performance of the company provided by returns

as
generated from investments and sales. The Profitability

ratios can be classified into a) Margins b) Returns and
c) Shareholder's Interest. The following are major

profitability ratios used by financial managers to
analyze the Financial Status of the company:
1. As to Margins:
Gross Profit Margin (GPM)

Operating Profit Margin (0PM)
Net Profit Margin (NPM)
2. As to Returns
Return on Sales (ROS)
Return on Assets (ROA)
Return on Equity (ROE)
3. As to Shareholder's Interest
Earnings Per Share (EPS)
Price-Earnings Ratio (PER)
Dividend Yield (DY)
Pay Out Ratio (POR)
Plow Back Ratio (PBR)
D.1. Margins:
Statement of Comprehensive Income shows the
earnings of the company in terms of gross profit,

operating profit and net profit. The Gross profit is
calculated by deducting the production cost from sales

revenue while Operating profit is computed after
deducting the operating expenses incurred by the
company from its gross margin. The Operating profit is
also referred as Earnings Before Interest and Tax

(EBIT). On one hand, the Net profit is equal to EBIT less
the interest expenses and taxes.
86
Gross Profit Margin indicates the proportion of gross

profit over the sales revenue generated by the company
from operations. This shows the earning capacity of the
company after taking into account the cost of
production. Thus, the formula is:
Gross Profit
Gross Profit Margin = Net Sales
Operating Profit Margin shows the percentage of

operating profit or the EBIT over the sales revenue
generated by the company from operations. Thus, the
formula is:
Operating Profit
Operating Profit Margin = Net Sales
Net Profit Margin reveals the percentage of the Net

Income After Tax (NIAT) over the sales revenue
generated from operations. This shows the earning
capacity of the company after paying all its expenses

such as production costs, operating costs, financing
costs and taxes. Thus, the formula is:
Net Income After Tax

Net Profit Margin =
Net Sales
SGV Company's Statement of Comprehensive

Income in 2018 revealed Sales Revenue
amounting to P 2,000,000.00 and Cost of Goods
Sold of P1,000,000.00. The Operating expenses
and interest expense incurred by the company are
P 400,000.00 and P 100,000.00, respectively. The
tax rate is 30%.
87
a. Calculate the Gross Profit Margin of SGV
Company.
b. Calculate the Operating Profit Margin of SGV
Company.
C. Calculate the Net Profit Margin of SGV
Company.
SOLUTION:
Net Sales 2,000,000.00
less: (Cost of Goods Sold) 1,000,000.00
Gross Profit 1,000,00 0.00
less: (Operating Expenses) 400,000.00
Operating Income / EBIT 600,000.00
less: (Interest Expense) 100,000.00
Earnings Before Tax 500,000.00
less: (Income Tax) 150,000.00
Net Income After Tax 350,000.00
Gross Profit
1. Gross Profit Margin =
Net Sales
1, 000, 000
Gross Profit Margin = 0.5 or 50%
2, 000, 000
Operating Profit
B. Operating Profit Margin
Net Sales
600, 000
Operating Profit Margin =
2, 000, 000
= 0.3 or 30%

C. Profit Margin =
Net Sales
350,000
Net Profit Margin = = 0.175 or 17.50%
2, 000,000
88
These ratios indicate the profitability of the company

through the relationship of the peso value of income
generated from sales, employment of assets and

investment in equity. The major components of these
profitability ratios are a) Return on Sales b) Return on
Assets and c) Return on Equity.
Return on Sales shows the proportion of profit, after

payment of all expenses, over the sales revenue. This
ratio is the same as the net profit margin discussed

above. Thus, the formula is:
Net Income
Return on Sales =
Net Sales
Return on Assets measures the relationship of the peso

value of income generated for every peso of asset
employed by the company. It shows how the company

efficiently uses its assets. This ratio expresses the
percentage of net income of the company over its total

assets. Thus, the formula is:
Net Income
Return on Assets
Average Assets
Return on Equity illustrates the relationship of the peso

value of income earned per equity investments by the
shareholders. This ratio is one of the most significant
profitability ratios, especially to the owners or
shareholders, because it shows how profitable the

company is through the use of investments from its
owners. Thus, the formula is:
Net Income
Return on Equity
Average Equity
89
o Illustrative Problem 3-17:
LEAD REVIEW Company's Statement of
Comprehensive Income in 2018 revealed Sales

Revenue amounting to P 4,000,000.00 and Cost of
Goods Sold of P 2,000,000.00. The Operating
expenses and interest expense incurred by the
company are P 800,000.00 and P 200,000.00,
respectively. The tax rate is 30%.
The 2018 Statement of Financial Position of LEAD
REVIEW Company shows a Total Assets of P
6,000,00 0.00 and Total Liabilities of P
2,000,000.00. Last Year, the Total Assets

amounted to P 4,000,000.00 and Total Equity
amounted to P 3,000,000.00
a. Calculate the Return on Sales of LEAD
REVIEW Company.
b. Calculate the Return on Asset of LEAD
REVIEW Company.
C.
Calculate the Return on Equity of LEAD
REVIEW Company.
SOLUTION:
Net Sales
4,000,000.00
less: (Cost of Goods Sold) 2,000,000.00
Gross Profit
2,000,000.00
less: (Operating Expenses) 800,000.00
Operating Profit / EBIT 1,200,000.00
less: (Interest Expense) 200,000.00
Earnings Before Tax
1,000,000.00
less: (Income Tax)
300,000.00
700,000.00
90
Net Income
A. Return on Sales =
Net Sales
700, 000
Return on Sales = 0.175 or17.50%
4, 000, 000

B. Return On Assets =
Average Assets
700,000
Return on Assets =
(4,000,000 + 6,000,000)/2
700,000
Return on Assets = = 0.14 or 14 %
5, 000, 000

C. Return on Equity =
Average Equity
700,000
Return on Equity
(3,000,000 + 4,000,000)/2
700, 000
Return on Equity = = 0.20 or 20 %
3, 500, 000
D.2.Shareholder's Interest:
The stockholders or investors may expect return on

their investments through the dividends paid by the
company or the capital gains from increasing stock
price. Thus, these stockholders primarily look into the
earnings, dividend policy and stock prices of the
company throughout their investment. To aid them in

their decision making, there are ratios that show the
profitability of the company and its impact to the

interest of these shareholders or investors. These ratios
are usually translated in terms of share of stocks to
highlight the said impact on shareholder's interest.
91
Earnings Per Share indicates the ratio of the annual
income and the common stocks of the company. In

addition, this shows how much of the total earnings
may be given to each share of common stocks. Thus, the
formula is:
Net Income - Preferred Dividends

Earnings Per Share
Number of Outstanding Common Stocks
Price Earnings Ratio reflects the ratio of the market
price per share of common stock and the earnings per

share. This ratio is used by the investors or
stockholders in assessing the ability of the company to

sustain growth and generate cash flows in the future.
Thus, the formula is:
Market Price Per Share

Price Earnings Ratio =
Earnings Per Share
Payout Ratio shows the proportion of earnings that is
paid out to shareholders as dividends. Investors, who
prefer short term returns like cash dividends rather

than capital gains, usually search for companies with
high pay-out ratio. Thus, the formula is:
Dividends Per Share

Payout Ratio =
Earnings Per Share
Plowback Ratio, which is also referred as Retention

Ratio, shows the proportion of earnings that is not paid
out to stockholders rather it is plowed back or
reinvested to
the company to be used for its expansion
and growth. This ratio is the complement of the payout
ratio; hence, the higher the payout ratio will result to a
lower plow back ratio. Thus, the formula is:
Plow Back Ratio =

Earnings Per Share - Dividends Per Share
Earnings Per Share
92
Or alternatively, Plowback Ratio can be calculated

using this formula:
Plow Back Ratio = 1 - Payout Ratio
Dividend Yield indicates the return on investment for

the stockholders in terms of dividend paid. In addition,
this implies how much the investors will receive as
dividend income for every peso invested in the
company's share of stock. Thus, the formula is:
Dividend Per Share

Dividend Yield =
DMZI Company's Statement of Comprehensive

Income in 2018 reflects a total Net Income of P
2,000,000.00. DMZI Company has a total of
500,000 outstanding common stocks which can
be sold at a market price of P 40.00 a share. It is
the policy of the company to pay annual cash
dividends of P 1.00 per share to common stocks.
a. Calculate the Earnings Per Share of DMZI

Company.
b. Calculate the Price Earnings Ratio of DMZI
Company.
C. Calculate the Payout Ratio of DMZI
Company.
d. Calculate the Plowback Ratio of DMZI
Company.
e. Calculate the Dividend Yield of DMZI
Company
93
SOLUTION:
A. Earnings Per Share

Net Income - Preferred Dividends
-
Number of Outstanding Common Stocks
2, 000, 000 - 0
Earnings Per Share =
500,000
= 4 per share

B. Price Earnings Ratio =
Earnings Per Share
40
Price Earnings Ratio = = 10:1
Dividend Per Share

C. Payout Ratio =
Earnings Per Share
Payout Ratio = 0.25: 1
D. Plowback Ratio
Earnings Per Share - Dividend Per Share
Earnings Per Share
4 -
Plowback Ratio = = 0.75: 1
Dividend Per Share

E. Dividend Yield
Dividend Yield = 0.025 or 2.5%

40
IV. DuPont Technique is a tool that analyzes the return on
asset and return on equity of the company by breaking

down into component ratios.
Hence, these component
ratios are factors affecting the return on asset and
equity.
94
The Return on Asset, which indicates the amount of

earnings for every peso of assets employed, can be
broken down into two component ratios such as: net
profit margin and asset turnover. On the other hand, the

Return on Equity, which shows the amount of income
earned for every peso of equity invested by the
shareholders, is calculated by multiplying the following

ratios: leverage factor, asset turnover and net profit
margin.
Thus the formulas are:

Return on Asset = Asset Turnover x Net Profit Margin
Net Sales_ Net Income

Return on Asset =
Average Assets Net Sates
Net Income
Return on Asset =
Average Asset
Return on Equity =
Net Profit Margin
Leverage Factor x Asset Turnover X
Average Asset Net Sales Net Income

Return on Asset =
Net Sales
Average Equity Average Assets
Net Income
Return on Equity = Average Equity
95
INVESTMENTS: RISK AND RETURN
CHAPTER 4
Generally, financial managers tasked to functions
are perform
requiring them to invest corporate funds in different types of
investment. The
idea is that these corporate funds earn a profit
or
return. Like starting up a business, investments have
potential returns as well as it may also involve
potential losses.
These losses are viewed in the business as risks. Losses are
direct manifestations of risks. In essence, returns and risks are
direct opposites. Undeniably, investors wish that they would

have higher returns but lower risks or have returns without
risks. However, it is a reality that returns hand in hand with
go
risks.
In fact, some old adage say that "the higher the risk, the
higher the return." In this chapter, we shall validate this maxim
and see if it is indeed true.
In this chapter, we will deal with the following concept of risk

and returns and some of the theories that existed before we
enjoyed the simplicity of the models we utilize for computing
risks and returns.
INVESTMENT
Overview of Investment in a single asset or Stand-alone

Investments
It is with business, as with human behavior, that we try to

place our money and efforts in some activity that would give us
a reward. Say for instance, we try to plant avocado seeds with
the hope that one day we shall reap from this avocado seeds
once it has become a full-grown seed. Similarly, businesses
have assets that they want to utilize to be able to reap

or enjoy
the profits or return in the future. More SO, it is
actually the
idea of starting a business: investing or putting up money or
seed capital with the hope of recouping this investment and
117
shall
earn profit in the future. In this discussion, we
particularly deal with investments in securities.
Securities generally pieces of paper containing the cost of

are
=
be
investing in such securities and the kind of return to
idea of
expected in the future by holding such securities. The
securities comes from the two-way concept of business. Some
②
① their businesses while others
companies need money to run
that needs
have money to spare. When these two meet, the one
money from the one who has the money.
money shall borrow
The one borrowing shall issue a paper (security) as a

commitment or promise to the holder of the security
(investor) to have a claim in the future for their investment.
While the concept may be simple, securities vary from form-to-

form and may involve several complexities. A concept is
prevalent with securities: they represent economic claims

against future benefits. Further to this concept investments
have common important features which is risk and return. The
ultimate goal of understanding risks and returns is to
determine what kind and how much return do investors want
and the accompanying risk they will undertake. Or simply, for a

financial theory point of view, we want to discover the amount
of return the investors will demand for investing or putting up

money in a security with a particular level of risk. In the
sections below, we shall be dealing with a single type of
security or a single-asset investment or a stand-alone

investment. Further topics will then focus on investment in a
portfolio of securities or assets.

is a
isang tao ,
hanak
RETURN (Stand-alone or single asset) lang
Behaviorally speaking, a person who controls a disposable

income has the free reign on what to do with such income. As
succinctly discussed in the previous section, a person invests
because of a potential income from executing such particular
118
investment. In fact, it is the return or profit-making

characteristic of a person that drives
him/her to invest. The
expectation of return is inherent in investing. In fact, the
motivation to increase wealth is, by far, the most important
reason for investing.
What then is return? Return is simply a profit earned on
let
top of the investment made. Simply put, it is the percentage of
the growth
of an investment. Mathematically speaking, it can
be represented through the formula:
proceeds or current value of investment - investment

return (%) =
investment
The above formula shows that return could simply be a

percentage change equation. Investors typically measure
return in terms of how much cash flow as generated when such
investment is collected (proceeds) or how much is the current
value of the investment. Below is an example of the application
of return:
* Illustrative Problem 4-1

Mr. Alexis recently placed his P1,000,000
inherited from his father to a money market
placement today. After one year, Mr. Alexis
decided to move the funds and instead use the
money to purchase shares in Sam Michael

Corporation. Mr. Alexis received P1,040,000 from
the money market placement.
To determine the return Mr. Alexis generated:

proceeds or current value of investment - investment
return (%) =
investment
P1,040,000 - P1,000,000
return (%)
P1,000,000
return (%) = 4%
119
Therefore, Mr. Alexis generated a 4% return on
his investment in the money market placement.
The above example shows us a typical computation of

return. However, for some other securities, there may be other
computation considering the different
forms of return or yield
circumstance and complexity of the security in particular.

Narrowing down these complexities, we can identify two
behaviors of returns: fixed returns and variable returns. As
evident from the name of the return type, investments or
securities behave in a manner relative to how their returns
behave. Below are some cases of describing the returns of both

fixed- and variable-income investments:
CASE 1: Fixed-income
Mr. Billyilly recently purchased a bond at a nominal rate
of 3% for P1,000,000. He immediately researched the
quality of the bonds with similar features and found

that such bond is expected to have a return or yield of
4%.
In the above problem, there is no need to compute for
the return as it is already provided: 4%. Note however

that the nominal rate of 3% is not the return as it
represents only the annual interest payment to be made

by the issuer to the bondholder.
CASE 2: Variable-income (series of time)
Mr. Clarkson purchased the stock of IY Convergence,

Inc. which proposed a five year return plan. After one
year of holding their stock, Mr. Clarkson is expected to
earn 7%. Returns for the succeeding years are 5%, 10%,
8% and 9%.
120
INVESTMENTS. RISK AND RETURN
To determine the expected return of Mr. Clarkson, the

average return of IY Convergence, Inc. must be
computed:
return =
7% + 5% + 10% + 8% + 9%
return = 7.8%
CASE 3: Variable-income (probability-based)

Mr. Dylan purchased stock of Benguett Consolidated
a
Mining Corp. which provided, in its prospectus, pay-

off table of the amount of return expected in a given
market condition for copper which is its prime product.
The pay-off table is as follows:
Demand for copper Return on Probability

particular of demand
demand
High (>10 billion metric 18% 20%
tons)
Normal (5-10 billion metric 12% 50%
tons)
Low (<5 billion metric tons) 8.7% 30%
In the problem above, we can compute for Mr. Dylan's

expected return on Benguett by extending the pay-off
table to include expected returns on each particular
condition by multiplying the return on particular
demand by its probability of occurring:
121
Demand for Return on Probability Expected

copper particular of demand return
demand
High >10 18% x 20% = 3.6%
billion metric
tons)
Normal (5-10 12% x 50% = 6%
billion metric
tons)
Low (<5 billion -8.7% x 30% = -2.61%
metric tons) -
Expected Return
Expected
on Benguett = 6.99% z→ Return
stock
By looking at the three scenarios above, we can see that the
computation of returns may vary depending on the situation of

the particular security. You can particularly expect that Case 3
above may show a realistic example on how returns are
computed in real life. In some of our discussions below, we
may refer to Case 3 as an example.
Notes:
Expected Rate of Return -

the percentage or rate of
return that is expected to be realized on an investment
after taking into account the probability of possible
outcomes.
Required Rate of Return - the minimum rate of return

acceptable by the investor on the portfolio investment.
122
Actual Rate of
Return the percentage or rate that is
actually earned by the investor on the portfolio
investment.
Market Equilibrium - the event when the required rate

of return is equal to the expected rate of return on an
investment.
RISK (Stand-alone or single asset)

It is quite difficult to discuss with ease the concept of risk
without touching on the topic of return. More importantly, it

should be emphasized that risk involves a probability of loss on
the part of the investor. As it was previously mentioned, the
losses incurred are actually manifestations of risk. Risk, on the
other hand, is a measure of the chance of loss.
to
While several measures of risk are available, the standard
deviation is one of the primary tools by financial managers in
determining the level of risk. Why standard deviation?
Standard deviation is a statistical tool to determine the amount
of variability or dispersion of data from the average, the mean

or the midpoint. Generally, a low standard deviation indicates
that the data points tend to be very close to the mean; high
standard deviation indicates that the data points are spread
out over a large range of values. To refresh, standard
deviation's formula (population) is:
x)2P where;
o = standard deviation
X= data within the population

x = mean or average of the population
P = the corresponding probability of each data
123
Translating this to investments, the higher the standard

deviation means a higher the probability of experiencing
different amounts of return. Now, what is wrong in
experiencing the different amounts of return? The problem
with different amounts of return is that there is a danger of
experiencing a loss. Let us discuss the impact of standard
deviation using Case 3 above:
Illustrative Problem 4-2
Mr. Dylan purchased a stock of Benguett Consolidated

Mining Corp. which provided, in its prospectus, a pay-off
table of the amount of return expected in a given market
condition for copper which is its prime product. The pay-
off table is as follows:
A B C
Demand for copper Return on Probability
particular of demand
demand
High >10 billion metric 18% 20%
tons):
Normal (5-10 billion metric 12% 50%
tons)
Low (<5 billion metric 8.7% 30%
tons)
In this problem, we are given the same information and we

are to find out the standard deviation of Benguett
Consolidated to
measure its corresponding risk. Again we
will create additional columns in the table but this to

include several other new columns to account for
components of the standard deviation computation:
124
A B C D
Demand for copper Return on Probability Expected
particular of demand return
demand
High (>10 billion 18% 20% 3.6%
metric tons)
Normal (5-10 billion 12% 50% 6%
metric tons)
Low (<5 billion metric -8.7% 30% -2.61%
tons)
Expected Return on
6.99%
Benguett stock (x)
E F G
(x-x)2 (x - x)2P
[B - x] [E2] [C x F]
High >10 billion 18%-6.99% = 1.212201% 0.24244%
metric tons) 11.01% or
0.0024244
Normal (5-10 billion 12%-6.99% = 0.251001% 0.12550%
metric tons) 5.01% or
0.0012550
Low (<5 billion -8.7%-6.99% 2.461761% 0.73853%
metric tons) or
-15.69% 0.0073853
i
E(x - x)2P 0.0110647
(variance)
0.1051889
or
(standard deviation)
10.51889%
125
conclude that Benguett'

As computed above, we can
Consolidated Mining's standard deviation is around 10.52%.

This means that the return expected from Benguett
Consolidated Mining is between 10.52% above or below its
expected return of 6.99%. Further expounding, investors can

expect, with this level of risk (standard deviation) that it could
statistically earn anywhere close to -3.53% (6.99% 10.52%)
and 17.51% (6.99% + 10.52%).
If we are to look at the general notion of risk as presented

above using standard deviation, it seems that risk is about the
dispersal of the possible returns rather than the loss itself.

That notion is exactly the notion of risk. It is the possible range
of return that could be expected from a security. If we are to
look at Investor Mr. Billy from Case 1, we notice that the
investor expects a single amount of return which is 4%. This is

virtually riskless as the investor expects no other return lower
than 4%. However, he must expect as well that no other return
will occur higher than 4%. Consequently, Mr. Dylan from Case
3 and Illustrative Problem 3-2 holding Benguett Consolidated
Mining expects a return of 6.99% subject however to the
possibility of earning a lower or a higher amount. As such, Mr.

Dylan has no assurance that he shall receive the expected
6.99%. He runs the risk of earning a negative return or a return
lower than 6.99%.
Special Metric: Coefficient of Variation
It is quite easy to compare investments with similar return but

different standard deviations or investments with similar
standard deviations but different returns. However, it is quite
difficult to compare investments which have different returns
and different standard deviations. So to allow investors to

compare different investments, the coefficient of variation may
be utilized.
126
The coefficient of variation is a formula to represent the

relative level of risk
(standard deviation) per unit of return:
O
Using the coefficient of variation, investors could easily
compare several investments with different returns and risks.
Risk Aversion and Risk Premium
Again, comparing Case 1 and 3 above, we notice that the
"riskless" security acquired in Case 1 by Mr. Billy earned a 4%

yield while the "risky" security in Case 3 for Mr. Dylan has an
expected return of 6.99%. We notice that the earlier maxim
mentioned ("The higher the risk, the higher the return") is
actually true. Naturally, investors who take on more risks with

"risky" securities tend to demand a higher return. In fact, most
financial management and financial economic theories are
developed under the assumption that a normal investor
behaves in that way. That behavior is what we call risk
aversion. Ideally, investors do not want risk but if you provide

them securities with a considerable amount of risk, they will
ask for a higher return. Consequently, securities that have

higher risk tend to have higher returns.
In the cases mentioned, the riskier asset (Benguett

Consolidated Mining in Case 3) has a higher return at 6.99%
with
than the less risky asset (the bond in Case 1) a return of
4%. The difference of 2.99% is what we call the risk premium.
Risk premium is the additional or excess return provided to
investors for taking on a more risky security.
127
iba 't -
iba hanak
PORTFOLIO j nd Stoll
In the previous sections, we discussed return and risk in the

context of a stand-alone investment. Realistically speaking
however, investments are executed using various types of
securities. These securities operate, interact and correlate with

each other in a given market. The idea of portfolio is that
investors do not put their money in a single type of investment
but instead put it in several types of investment. The mere act
of putting money in several types of investment already

constitutes establishing a portfolio. What then is a portfolio?
A portfolio is a collection of assets or securities that a
particular firm has for it investors. If you can remember that a
security is a piece of paper, then portfolio

figuratively a
a is
place where you put all your "paper" securities. While there
are largely similar concepts for returns and risks in stand-
alone investment and a
portfolio, there are largely other
concepts that are different.
Risk in
a Portfolio context: Diversifying portfolios by adding
more securities
It was discussed
previously that risk can be measured by a
securities' standard deviation. Moreover, we established that
the higher the standard deviation, the higher the expected risk
that
investors assume on the security. However, risk in a
portfolio context involves
another element. Notice that
securities do not
"stand alone" but coexist with several other
securities.
The market (environment) is actually a large
portfolio of securities, each of which has its own risk and
return. Nonetheless, even if
each security has its own
characteristics, its coexistence with other securities exhibit

characteristic that
is essential in the context of a portfolio:
correlation.
128
Correlation, statistically speaking, is the measure of the

relationship between two variables. In the context of
investments
and portfolio, correlation is the measure of the
kind of coexistence between two securities. For instance, In 0 Offset
Security A increased its return by 10% while Security B N lang

'
decreasedits return by 10%. We can simply say that Security A

is inversely related to Security B. We note, however, that
Security A has its own risk as well as Security B. When we
place them together in a portfolio, the risk is eventually
reduced or tempered. This is due to the fact that the two
securities are negatively correlated.
If we add more securities to the portfolio of Security A

and B, we expect that the relevant risk of the whole portfolio is
decreasing. We should note, though, that while the risk
decreases as we add more securities to the portfolio, we can
never eliminate risk. The process of adding more securities and
thus decreasing the risk is what we call diversification. During

diversification, the risk of the overall portfolio decreases up to
a point that the risk stops decreasing. The risk that can be
eliminated through diversification is called unsystematic or
diversifiable risk. On the other hand, the risk that can never be
eliminated even if the investment is fully diversified is called
the systematic, non-diversifiable or market risk. In addition,
the market risk represents the particular risk of a security in
relation to its existence in the market containing all types of
securities. Consequently, among these two kinds of risk, we are
more interested with the systematic or the market risk as
provides us a picture of the true risk of a security or the risk

that is common to all investors. Furthermore, this market risk
directly impacts the return of a particular security which will
be discussed in the immediately succeeding section.
129
Returns in a Portfolio context
It was discussed in detail that returns are the potential profits

of each
particular type of security. Return in a portfolio context
is not at all difficult; it is simply the weighted average of all the
returns of each type of security. However, we emphasize that

returns computed in a portfolio context shall be directly
related to the risk determined also in a portfolio context and in
particular its market risk. Financial theorists developed
model to help estimate or determine a particular security's
required return by taking into account benchmark returns as
well as the market risk identified in the previous section. This

model is what we call the Capital Asset Pricing Model or CAPM.
Capital Asset Pricing Model or CAPM

Before we deal with the totality of the CAPM, we should
first equip ourselves with its basic assumptions, as
compiled and summarized by William N. Goetzmann:
1. All assets/securities in the world are traded.

2. All assets/securities are infinitely divisible.
3. All investors in the world collectively hold all assets.
4. For every borrower, there is a lender.
5. There is a riskless security in the world.
6. All investors borrow and lend at the riskless rate.
7. Everyone agrees on the inputs to the Mean-STD (the

return and risk in a stand-alone context) picture.*
8. Preferences are well-described by simple utility
functions.*
9. Security distributions are normal, or at least well

described by two parameters.*
10. There are only two periods of time in our world.
* Represent those statistical parameters essential to
develop the model though may not necessarily reveal an
economic condition.
130
The list above simply describes the characteristics of a
perfect frictionless economy. Nonetheless, more than
anything listed above, the CAPM simply wants to put a
security's risk as the only variable in the model. The CAPM
factors out nuances of imperfection to fully identify how a
security would behave in terms of risk and return in a

portfolio context. With the above condition, the risk, the
only remaining variable in the model, will help determine

the amount of return a particular security must provide or
simply determines the required return from a particular

security. Before we provide the mathematical model, we
must first identify the components needed:
r = the required return of a particular security

I= refers to the risk-free rate of return or the return of the
riskless security; An example of a riskless securities
are government notes and bonds (Treasury Notes,

Treasury Bills and Treasury Bonds) which exhibit
virtually a low amount of risk.
I'm = refers to the market return or the overall return of the
whole market containing all the "risky" and "non-
risky" securities
MRP = refers to the market risk premium or the additional
or excess return provided by the market as a
premium for having "risky" securities; this can be

determined by subtracting the risk-free rate of
return from the market return
B = Beta This is the measure of the riskiness of a security.

The Beta also measures the responsiveness of a
particular security with the fluctuations of returns in
the market. In relation to the earlier discussion on
risk, the Beta is conceptually the measurement of the

systematic or market risk of
particular security.
131
'
to
As such, the formula for the CAPM is:
T= T, + B(MRP)
r= Risk free rate + Risk Premium
From the equation, we can fully understand that all other
components except the Beta is constant in the CAPM
context. The Beta, therefore, represents the security and, in
particular, its risk in relation to the market. We can

ultimately see that a security's return is largely dependent
on the level of risk that particular security exhibits.
Illustrations below are provided to show several cases
involving various levels of Beta:
CASE 1: Beta is exactly 1.0 (Average Beta)
Company A recently acquired the shares of

PDMT with a Beta of 1.0. It wishes to determine
the required return of such particular stock. The
government Treasury Bills yield 4%. On the
other hand, the prevailing market return is 10%.
To determine the required return on PDMT

shares:
r= 4% + 1.0(10% 4%)
r = 4% + 1.0(6%)
r = 10%
Notice that the return of PDMT shares is 10%

which is equal to market return. This means that
PDMT shares will respond directly to the
fluctuations of the market. Simply put, a 10%
132
increase in the return of the market will also
make PDMT shares increase by 10%. Conversely,

a 50% decrease in the market return will make
PDMT shares decrease by 50%.
CASE 2: Beta is below 1.0 (Defensive or Conservative Beta)

Company B recently acquired the shares of ABBA
Equity Ventures with a Beta of 0.8. It wishes to
determine the required return of such particular

stock. The government Treasury Bills yield 4%.
On the other hand, the prevailing market return

is 10%.
To determine the required return on ABBA

shares:
r= 4% + 0.8(10% 4%)
r= 4% + 0.8(6%)
r= 8.8%
In this example, we see that ABBA's return is less

than the market return. This means that in
periods of fluctuations, ABBA shares will
respond directly at a lower degree than it could

have responded had its Beta been 1.0. This
means that a 20% increase in the market return
will translate to a lower increase in the return
for ABBA. Note however, that it is not simply a
matter of proportion (meaning 1:0.8 ratio) but

rather a degree of responsiveness. Further to
this, we could also conclude that a 30% decrease
in the market return will translate to a lower
decrease in return for ABBA and thus minimized
the losses experienced.
133
CASE 3: Beta is above 1.0 (Aggressive Beta)

Company C recently acquired the shares of
Carcamo Corporation with a Beta of 1.5. It
wishes to determine the required return of such

particular stock. The government Treasury Bills
yield 4%. On the other hand, the prevailing
market return is 10%.
To determine the required return on Carcamo
Corporation shares:
r'= B(r'm
If +
r= 4% + 1.5(10% 4%)
r= 4% + 1.5(6%)
r = 13%
Taking the applied concepts above, Carcamo's

return is higher than that of the market.
Consequently, any change or fluctuation in the
market returns will cause a higher degree of
change for Carcamo. However, note that in the

three cases above, the direction of the movement
of the shares shall be in the same direction as the
movement of the market only that we could

notice the varying degrees of responsiveness
with the market.
The Security Market Line (SML)

The
Security Market Line was developed together with the
CAPM to graphically depict the interaction between the
Beta (risk) and the required rates of returns. The SML can
further encapsulate several scenarios that could occur in
relation to the changes in risk-free rates of returns and
market returns as well as the Beta of individual securities.
134
The
basic graphical representation of the SML is shown in
Figure 4-1 below:
Figure 4-1
The Security Market Line
The
Security
Required
Rate of
Return
A line
representing
the risk-free
rate of return
Beta
In the figure above, the elements of the Security Market

Line is provided. Note that a special line is drawn
representing the risk-free rate of return. The region from
the horizontal axis to the special line represents the risk-

free rate of return. As the Beta increases, the required rate
of return plotted along the Security Market Line also
increases consistent with how Beta behaves in the CAPM
formula. In fact the SML is has an equation similar to that of
the CAPM:
In some instances, the Security Market Line shifts due to
changes occurring with its components most especially

with the risk-free rate of return and the market return.
First, when inflation expectations increase, the risk-free
rate also increases. However, it should be emphasized that
the market return must also increase in the same degree as
the risk-free rate:
135
Previously, the Treasury bills yield 4% while the market

return is at 10%. Currently, the investors believe that
due to expected inflation, the risk-free rate of return
should be pegged at 6% rather than 4%.
The SML Equation previously would have looked like:

SML = 4% + B(10% - 4%)
Because of the expected inflation, the SML equation

would become:
SML = 6% + B(12% - 6%)
Note that a 2% increase in the risk-free rate of return

also translated to an increase in the market return of
2%. Thus the risk-free rate of return and the market
return shifted to 6% and 12%. Note also that the
increase in inflation expectations SHOULD NOT change
the market risk premium (MRP). In the example above,
the 6% MRP from the original equation (10% 4%) did
not change in the new SML equation (12% 6%). We
can graphically depict this situation in Figure 4-2 below:
Figure 4-2
Change in SML due to change in inflation expectations
136
We can see that the SML equation shifted upward as a
result of the change in inflation expectation.

Second, the SML may change because of a consequent
change in the behavior of investors. More importantly,

there is a considerable amount of change in the risk
aversion of the investors. The change in the risk aversion of
the investors manifest through the increase in the risk
premium they are demanding for "risky" securities. The
change may occur because of the restlessness of the
markets or extreme changes in macroeconomic factors or
any other factor that will drive the investors to change their
behavior towards "risky" securities.
Currently, the risk-free rate of return based on the yield

of Treasury bills amount to 4%. During the previous
year, investors project the market return at 10%.
However, due to the increasing volatility of the European
market, the investors have become more averse of the
risk involved in holding securities other than
government-issued securities. As a result, the investors

believe that the market risk premium should increase by
2%.
The first SML equation should be presented as:

SML = 4% + B(10% 4%)
SML = 4% + B(6%)
We notice that the MRP in the first SML equation is 6%.
Now we present the second SML equation to reflect the

change in risk aversion of the investors:
SML = 4% + B(12% 4%)
SML = 4% + B(8%)
137
by 2% to become 8% to
Note that the MRP increased
reflect the increase in risk aversion of the investors.
10% should
Consequently, the market return of
increase also by 2% to 12%. In this case, we hold the
risk-free rate of return constant as there are no changes
in inflation expectations but rather a change in risk-
averse behavior of the investors. We can also
graphically depict this situationin Figure 4-3:
Figure 4-3
investors' risk aversion
Change in SML due to change in
In this situation, rather than shifting upward, the SML's slope

became steeper due to the increase in the investors' risk
aversion.
138
INTEREST RATES
CHAPTER 5
INTEREST RATES
When investors put
up money in particular securities, they
demand a certain cost for the use
of their money. In the
previous chapter, we identified that this is the return. Similar
to that of profit, the return is
the cost of using investor or
lender's money. As we discovered the concept of risk premium,
we also know that investors would demand
a higher return.
Thus, this is in line with the maxim that "the
higher the
expected risk, the higher the expected return".
In this section, we shall focus

particular kind of security
on a
which is debt. Moreover, we will be discussing the following:
Nominal interest rates and Annual percentage rate

Effective interest rates and Annual percentage yield
Real risk free rate
Inflation premium
Default risk premium

Liquidity premium
Maturity risk premium
INTEREST RATES
Most of us are more familiar with the term interest rates than
return. Interest rates are essential as they are commonly used

as benchmark for other types of securities in determining an
acceptable level of required return. More importantly, interest
rates depict certain macroeconomic factors. Essentially, debt
securities would show a quoted or nominal interest rate to
indicate how much would the lender be paid upon settlement
of such debt. The interest may be paid annually, semi-annually,
quarterly or monthly. More so, the interest may either be
simple interest or compounded interest.
The Nominal Interest Rate, also known as stated or coupon
rate, is the interest rate used to compute the interest payment
157
INTEREST RATES
received by the investors from debt securities. The interest
payment does not consider compounding effect.
Annual Percentage Rate (APR) is the cost of source of
financing that considers simple interest. This rate is
computed using the formula:
APR =
Where:
I- is the interest amount
P - is the principal
T- is the time period
Antonio Tenedero Company (ATC) issued 100 bond

certificates with P1,000 face value each. The total
interest of P3,000 is payable semi-annually. What is the
Annual
Percentage Rate of Interest or Coupon rate?
SOLUTION:
APR:
P3,000
APR =
180
P100,000 x
360
APR = 6%
The result shows that the annual percentage rate or

coupon rate or nominal rate is 6%. Hence, the issuer
pays interest of P6,000 per year or P 3,000 every six
months.
158
INTEREST RATES
The Effective Interest Rate, also known as the discount rate, is
the interest rate used to compute the present value factors.

The interest payment considers the compounding effect.
%
Annual Percentage Yield (APY) is the cost of
source of fund that considers the effect of
compounding. This is also known as Effective

Annual Rate. This yield is computed using the
formula:
APY or EAR or Eff%= {[1+ m Im - 1}

Where:
APY - is the Annual Percentage Yield

i - is the nominal interest rate per year
m is the number of compounding

periods within a year
% Illustrative Problem 5-2:
ABC Company borrowed P 200,000 for 180 day period.

The firm will repay the P 200,000 principal amount and
P6,000 interest. What is the Annual Percentage Yield
considering the compounding effect?
SOLUTION: APR =
P6,000
APR =
180
P200,000 x
360
APR = 6%
Based on the Annual Percentage Rate formula, the

nominal interest rate in this problem is 6% without
be used
considering compounding effect. This rate shall
in computing for the Annual Percentage Yield (APY).
159
INTEREST RATES
Since the said loan matures in 180 days, the number of

360
compounding period within a year is 2 m = semi-
annual]. Thus,
APY = ([1 + m
]m - 1}
APY = {1.0609 - 1}
APY = 0.0609 or 6. 09%
The result shows that the cost of short term fund is

6.09%. This is the effective rate of interest considering
the effect of compounding.
Assume instead that the loan is payable or outstanding

for 90-day period. What is the Annual Percentage Yield
(APY)?
APR =
P6,000
APR =
90
P200,000 x
360
APR = 12%
Based on the Annual Percentage Rate formula, the

nominal interest rate in this problem is 12% without
considering the effect of compounding. This rate shall
be used in computing for the Annual Percentage Yield
(APY). Since the said loan matures in 90 days, the
number of compounding period within a year is 4 [m =
360
quarter]. Thus,
160
INTEREST RATES
APY = ([1+ 44 ]4 - 1}
APY = {1.1255 1}
APY = 0..1255 or 12.55%
This time the cost of short term fund is 12.55% after

assuming that the loan is payable in 90 days.
Components of Nominal Interest Rates:
Real risk-free interest rate (r*)
The real risk-free rate of interest represents the actual

yield of risk-free debt security. Common to many
territories, government-issued Treasury bills simulate
risk-free debt securities. However, these Treasury bills
are infused with inflation premium to provide a
premium for the possibility of encountering inflation.

The real risk-free interest rate is the "true" risk-free
rate assuming there is no expected inflation.
Risk-free interest rate (ror r* + IP)
We have previously encountered and utilized above the

risk-free interest rate as a component of the Capital
the risk-free rate of
Asset Pricing Model (CAPM). Again,
return serves as a component of the nominal interest
rate.However, we may closely attribute this to the
preceding component which is the real risk-free interest
rate. As itis noted in the title of this section, the risk-
free interest rate is imputed with inflation premium
(IP) to protect the investors from the effects of inflation.
161
INTEREST RATES
Risk-free ratesmay also be either applicable to short-

term or long-term securities and would definitely differ
under the two.
As discussed in the previous chapter, the Security

Market Line (SML) changes due to the increase or
decrease in the inflation rates. In this chapter, the
nominal risk free rate or simply risk free rate (r) is
calculated using either a) simple format or b) cross

term format. The simple format, [r r* + IP], is used
when the real risk free rate and inflation rate is
relatively low thereby having an immaterial cross term

result. On the other hand, the cross term format shall be
used to compute the nominal risk free rate if the real
risk free rate and inflation is relatively high. In this case,
the cross term result shall be material or significant.
Thus, the cross term format is:
* Rfr = r* + IP + (r* X IP)
Inflation Premium (IP)
Inflation generally affects investment decisions as it
technically "eats" up the interest to be received by a

lender-investor after a certain period of time. The
inflation premium, as described previously, protects the

lender from the effects of inflation. But how does
inflation affect interest?
We all know that interest is a form of return. Suppose

you have money today amounting to P1,000 pesos. You
have no immediate use for the money today so you

chose to invest your investible money at a particular
investment opportunity that will provide a 5% interest
for one year. As such, you expect to receive P1,050
pesos at the end of one year. Before you made the
162
INTEREST RATES
investment, you noticed a nice USB flash disk costing

P1,000. Since you really do not need one at that time,
you have forgone purchasing the same. After one year,

you receive your P1,050, the principal you lent plus the
5% interest rate. Shortly thereafter, you needed the USB
flash disk for school work. Upon seeing the same flash
disk you saw one year ago in the store, the price had
already gone up to P1,070. This is because there was
7% inflation for the year.
In the illustration above, the lender lost the opportunity

to purchase the USB flash disk because the proceeds he
received one year after was not enough to pay for the
new price of the item. Now, to protect lenders from this

situation, the real risk-free interest rates are increased
or "padded" by an inflation premium to provide
allowance for possible inflation.
Default Risk Premium (DRP)
The default risk premium originated from the risk

where the borrower is unable to make timely interest or
principal payments. Normally, sovereign state-issued
debt securities or governments-issued debt securities
carry no default risk as most sovereign states and
governments ensure timely payment of interest and

principal. Therefore, default risk premium is closely
inherent to corporate-issued debt securities where the
possibility of default is present. In most instances, the
default risk premium depends on several credit
characteristics of the issuing corporation. These
characteristics are ultimately embodied in some credit

scores or credit ratings. The lower the credit score or
163
INTEREST RATES
credit rating, the higher will the default risk premium

be.
Liquidity Premium (LP)
Liquidity premium is an additional interest provided for

debt securities that are fairly more difficult to convert
to cash. Liquidity, per se, refers to the ability of an

instrument to be easily converted into cash. Therefore,
securities that are easier to be converted into cash have
low liquidity premium as they have less risk of not

being convertible into cash. Conversely, securities that
are more difficult to be converted into cash have higher
liquidity premium to compensate for the risk assumed
by investors of not being able to dispose or convert
these securities into cash.
Maturity Risk Premium (MRP)
Generally, market interest rates increase. However, the

price of debt instruments decrease when interest rates
increase. This phenomenon is further discussed in
Chapter 6 of this text. In this section, we are more
concerned with risk generated by the decrease in the

price of debt instruments caused by the general
increase in interest rates. To offset the losses that could
be encountered by the decreasing price of debt
instruments, a maturity risk premium is imputed on
long-term debt securities.
Nominal interest rate, therefore, is the sum total of the
components mentioned above. The formula for which is:
NIR = [r* + IP] + DRP + LP + MRP
164
INTEREST RATES
However, it is noteworthy to mention that not all kinds of debt

security can hold the same component altogether. The
components of interest rates depend on the kind of debt
securities being issued such whether this security is either:
A. Government issued or Corporate issued
B. Short term or Long term security
INTEREST RATES COMPONENTS OF THE GOVERNMENT AND

CORPORATE ISSUED SECURITIES:
Short- term debt security:

Government issued security such as Treasury Bill or
T-Bill.
Interest rate = r* + IP
Corporate issued security such as Corporate Note.

Interest rate = r* + IP + DRP + LP
> Long term debt security:

Government issued security such as Treasury Bond
Interest rate = r* + IP + MRP
Corporate issued security such as Corporate Bond

Interest rate = r* + IP + DRP + LP + MRP
165
VALUATION OF BONDS
CHAPTER 6
VALUATION OF BONDS
Companies primarily accumulate cash inflows through its
earnings from the operating and investing activities. However,

these earnings may not be enough to fund other activities of
the company. Thus, there is a need to raise additional fund
through issuance of financial instruments to the investors such

as equity or debt instruments. The issuance of equity
instruments such as shares of stock is selling interest of the
company. The investors of these equity instruments, who are
part owner of the company, are known as shareholders. On the

other hand, the issuance of debt instruments such as bonds is
borrowing money with the intention to repay at a certain date.
The investors of these debt instruments, who are not part
owners but lenders of the company, are known as
bondholders.
In this chapter, we will discuss the following:
Characteristics of bonds
Valuation of bonds: issued at par, at a premium or at a
discount
Determine the difference between yield to maturity
and yield to call
Computation of the required rate of return
Computation of the expected total returns on bond
investments
A Bond is along-term debt instrument issued by government

to raise needed
agencies or corporations to the public in order
funds. Moreover, it is a long term contract indicating that the
holder of these instruments will receive a fixed interest
payment, known as coupon payment, each year until its
maturity date and also receive a principal payment, known as

face value, on the said maturity date.
183
VALUATION OF BONDS
CHARACTERISTICS OF BONDS:
There are different kinds of bonds in the market. In general,

bonds are issued at par in which the coupon interest rate is in
equilibrium with the market interest rate. However, bonds can

be valued above or below its face value depending on the
fluctuation of interests in the market. Some bonds would have

attached provisions which give rights or privilege to the issuer
or bondholder while other bonds do not have. Though these

bonds have differences, they still have common characteristics.
A. Common Characteristics:
Maturity Date is the date specified in the bond on

which payment of the Face Value is to be made by
the issuer.
Face Value is the amount borrowed by the issuer

which is to be paid at maturity date. It is also known
as the Par value or Maturity value. For illustrations
and problem solving, we assume that the face value

of the bond is P1,000. (Note however that any other
amount which is multiple of P1,000 such as P10,000
or P500,000 can be used)
>
Coupon Payment is the amount of interest payment
fixed each year until maturity of the bond. It is

calculated by multiplying the coupon interest rate to
the face value of the bond.
Coupon Interest Rate is the rate stated in the bond

which is used for annual interest payment
calculation. It is also known as Stated Interest rate
or Nominal Interest Rate.
184
VALUATION OF BONDS
% CBM Corporation issued a 20 year, P1000 bond

with stated rate of 6% on January 31. 2012.
The Maturity Date is January 31, 2032

which is 20 years from the date of
issuance.
The Face Value or Par Value is P1000
which shall be redeemed on January 31,

2032 (maturity date)
The Coupon interest rate or stated rate is
6%
The Annual Coupon Payment is P60 [Face

Value x Stated Rate]
B. Other Characteristics:
1. Issued with Call Provision - A provision that gives
rights or privilege to the issuer to redeem the bond

at a certain "call price" prior to its maturity. This
feature is normally attached to a corporate bond but

not to a treasury bond. Bonds with call provision are
referred to as callable bonds. These callable bonds
may have a provision stating that

A) the issuer may exercise the right to call the bond
starting from issue date, or
B) the issuer may not call until five(5) years after
issuance.
The bond which provides a deferred call

contains a call protection such as callable bond
with provision B.
When to exercise its rights to call?

The issuer will call the bond provided that the
right to call is already exercisable, such that the
185
VALUATION OF BONDS
call protection of the bond expires. Moreover, the

decline in the market interest rate which causes
the value of the bond to appreciate will initiate

the issuer to call the said bond.
In the event that the market interest rate

significantly declines, it is more advantageous,
cost-wise, for the issuer to call the old bonds and
replace them by new bonds at a lower interest
rate.
* Will investor demand higher interest rate?
Since the issuer will call the bond any time prior
to its maturity provided that the right is
exercisable and the market interest rates
declines, it will be detrimental to the long term
investors who will reinvest in a lower interest
rate bond after the call made by the issuer. Thus,
this is the risk borne by a callable bondholder. In
contrast with the Non-Callable Bond, there is no
risk of
early redemption of bonds, thus,
bondholder may retain the bond until it matures.
Because of the higher risk to be borne
by
investors in a Callable bond than in Non-callable
bond, the investors in former bond will demand
a
higher interest rate in addition to call premium
than in the latter bond.
C) Issued with Put Provision - It is a provision that

gives right or privilege to the bondholder to "put
back" or require the issuer to repurchase the
said bond at a certain "put price" prior to
186
VALUATION OF BONDS
maturity. Bonds with put provisions are called
putable bond.
When to exercise its rights

to put back?
The bondholder will require the issuer to
repurchase the bond prior to its maturity
provided that the right to put back is already
exercisable. Moreover, the rise in the market
interest rate which causes the value of the bond
to decline will initiate the bondholder to put

back the said bond.
D) Issued with Convertible features -this gives the

bondholders the right or option to convert the
bond into number of shares of common stocks at
a predetermined price. The bondholders do not
have to pay cash in order to exercise their option

rather they have to exchange the bonds for
certain number of stocks. Therefore, the bond is
considered as the payment in exchange for the
stocks. The bond with such features is known as
convertible bonds. The coupon payment offered
to a convertible bond is practically lower than

those offered to a non-convertible bond with
same credit risk.
Issued with Warrants this gives the bondholder
the right or option not to convert the bond but

an option to buy shares of common stock from a
company at a predetermined price. The
bondholders have to pay cash in order to
exercise their rights provided by warrant.
187
VALUATION OF BONDS
PARTIES IN THE ISSUANCE OF BONDS:
The parties involved in the issuance of bonds are: Bondholder
and Issuer.
1. The Bondholder is the investor who extends loans to

the company certain amount of money equivalent to the
value of the bond issued. These Bondholders are also
known as lenders or creditors of the company.
2. The Issuers of bonds may either be the Government or a

Corporation.
> The bonds issued by the government are generally

referred to as Treasury bonds or Government bonds.
Since these bonds are issued by the government
which is an entity that does not go bankrupt, it is
certain that the bondholder will receive payment at
maturity date, thus, Treasury bonds has no default

risk or credit risk. However, the prices of these
bonds vary indirectly as to market interest rates. As
the market interest rate increases, the value of the
bond decreases, and vice versa.
The bonds issued by the corporation are known as
corporate bonds. It is a reality that some of the

corporations encounter financial crisis or worse,
they turn into bankruptcy. A corporation facing

these scenario may not be able to pay the agreed
interest and the face value of the bond, thus, there is
a high probability of default risk in these kinds of
bonds. It is well settled that the higher the expected

risk, the higher the expected return. Since corporate
bonds have higher default or credit risks as
188
VALUATION OF BONDS
compared to Treasury bonds, the investors of the

former type of bond may demand additional yield or
interest in order
to compensate for default risk. This
additional yield on a corporate bond is called default
premium.
Default Risk - it is the risk that the issuer may
not pay its obligation. It is also known as Credit
risk
Default Premium the additional yield that the

investor of a bond requires due to credit or
default risk is embedded in such bond.
VALUATION OF BONDS:
There are four factors affecting the valuation of the bonds.

These are coupon interest rates, the discount rate, years until
maturity or call, and the face value of the bond.
The coupon interest rate or simply, interest rate is the rate
peso amount of interest payments to be

used to compute the
made by the issuer throughout the life of the bond. This rate is
bond upon its
also known as the "stated rate" indicated in the
issuance and it will be constant until the bond matures.
referred to as the effective interest

The discount rate, which is
This is also
rate is used to compute the present value factors.
which is the minimum
known as the required rate of return
for an investor. This rate fluctuates over time
acceptable rate
the financial status of the issuing
as an adjustment based on
and economic status and other factors.
company, the political
classified either as Nonzero Coupon Bond or Zero

Bonds are
former offers a stream of coupon interest

Coupon Bond. The
of the bond while the latter does not
Payments during the life
189
VALUATION OF BONDS
pay any interest at all. However, both kinds of bonds pay the
terminal value or the face value at the maturity date.
A. Nonzero Coupon Bond:
The Value of this Bond isequal to the present values of cash

flows from interest or coupon payments and cash flow from
the terminal or face value which is the maturity value of the
bond. The equation used to calculate present values of these

cash inflows in order to determine the bond's value (BV) is
(1 + D1 (1+D)2 (1+ D)T T (1 + D)T
Where CP is the Coupon Payment or the Interest payment per
year, FV is the Face Value or the maturity value and n is the
number of years until maturity of the bonds.
Alternatively, the Bond's Value can also be computed by

getting the present value of the cash inflows of interest
payments and face value through the following formula:
1) Interest payments or coupon payments:

CP = [CIR x FV]
>
PVCP= [ CP X PV(OA - D. D) ]
2) Face value or par value.

>
PVrV = [FV X PV(- D, D) 1
Where: CP is Coupon Payment
CIR is
Coupon Interest Rate or the Stated Rate
FV is the Face Value or the
Par Value of the Bond
PV CP is the Present Value of the
Coupon Payment
PVFy is the Present Value of the Face
Value
(OA- D, n) is the Present Value Factor
Ordinary Annuity
payment
190
VALUATION OF BONDS
PV (-D. n) is the Present Value Factor of One or Single

payment
Dis the Discount Rate or the Effective Interest Rate
n is the number of years or periods for discounting
Thus, the Bond's Value is (BV) = [PV cP +
Investors of bonds (creditor) pay certain amount to the issuer

(debtor) in exchange for the bond's value. The amount of
payment could be equal to the face value of the bond which is
known as issued at par, above the face value of the bond which
is known as issued at a premium; or below the face value of the

bond which is known as issued at a discount.

What is the value of a fifteen-year (15), P1000
corporate bond with stated rate of 10% per annum?
Assume that:
A. The bond of similar quality yields 10% rate.

B. The bond of similar quality yields 8% rate.
C. The bond of similar quality yields 12% rate
Scenario A: The bond yields a rate of 10% and the stated rate of
10%.
+
(1+D)"
(1+ D)1 (1+ D)2 (1 + D) (1+ D)"
100 100 100 1,000

(1+ 0.1)1 (1+ 0.1)2 (1+ 0.1)15 (1+ 0.1)15
191
VALUATION OF BONDS
Alternatively;
= [ (CP x PV(OA- D. n) ) + (FV x PV(1- D.n) ) ]
=[(10% x P1000) x PV(0A-10%.15)]+[P1,000 x PV(1- 10%, 15) ]
= [P100 x 7.36669] + [P1,000 x 0.26333]
736.67 + 263.33
= P 1,000
The Present Value factor of ordinary annuity payment at 10%

for a period of fifteen (15) periods is 7.36669. The present
value factor for one or single payment for fifteen (15) periods
at the same discount rate of 10% is 0.26333. The present value
of the cash inflows from interest payments amount to P736.67

while the principal payment which is the face value has a
present value of P 263.33. Moreover, the following analyses are

discussed below.
Analyses: If the Discount rate is equal to the Stated rate;
The Market Value of the bond amounts to
P1,000 which is equal to the Face or Par

value.
The Amount to be paid by the investor is
equal to the Face or Par value.

> The Bond is issued at
par or at face.
Scenario B: The bond yields a rate of 8% and the stated rate of

10%.
+
(1+D)"
(1+ D)1 (1+ D)2 (1 + Dya (1 + D)"
192
VALUATION OF BONDS
100 100 100 1,000

+
(1+ 0.08)1 (1+ 0.08)2 (1+ 0.08)15 (1+ 0.08)15
BV = P 1,171.19
Alternatively;
= [ (CP x PV(0A- D.n)) + (FV x PV(1- D. n) ) ]
=[(10% x P1000): PV(0A-8%, 15) ]+[P1,000 x PV(1 - 8%,15) ]
= [P100 x 8.55948] + [P1,000 x 0.31524]
= P855.95 + P315.24
= P1,171.19
The Present Value factor of ordinary annuity payment at 8%
for a period of fifteen (15) periods is 8.55948. The present
at the 8% discount rate is 0.31524. The present value of the
cash inflows from interest payments amounted to P855.95
while the present value of the principal payment is P315.24.
Moreover, the following analyses are discussed below.
Analysis: If the Discount rate is lower than the Stated

rate;
The Market value of the bond amounts to
P1,171.19 which is above the Face or Par

value.
The Amount to be paid by the investor is
higher than the Face or Par value.

The Bond is issued at a premium.
The difference between the market value of
the bond and the face value is called bond
premium.
193
VALUATION OF BONDS
Scenario C: The bond yields a rate of 12% and the stated rate of
10%.
+
(1+D)"
(1+ D)1 + D)2 (1+ D)" (1 + D)"
100 100 100 1,000

+
(1+ 0.12)1 (1+ 0.12)2 (1+ 0.12)15 (1 + 0.12)15
Alternatively;
= [ (CP x PV(0A-D.m)) + (FVXPV@-D.m)) ]
=[(10% x P1000) x PV(0A- 12%, 15) ]+[P1,000xPV(1 - 12%.15) ]
= [ P100 x 6.81086] + [P1,000 x 0.18269]
= P681.09 + P182.69
= P 863.78
The Present Value factor of

ordinary annuity payment at 12%
for a
period of fifteen (15) periods is 6.81086. The present
at the 12% discount rate is 0.18269.
The present value of the
cash inflows from interest payments amounted to P681.09
while
the present value of the principal payment is P182.78.
Moreover, the following analyses are discussed below.
Analyses: if the Discount rate is

higher than the Stated
rate;
The Market value of the bond amounts to P
863.78 which is below the Face or Par value.
194
VALUATION OF BONDS
The Amount be paid by the investor

to is
lower than the Face or Par value.

The Bond is issued at discount.
The difference between the market value of

the bond and the face value is called bond
discount.
B. Zero Coupon Bonds:
This bond has no coupon interest payment but are
usually sold below its Face Value or issued at a discount.

The
investors of this kind of bonds receive earnings
through the appreciation or rise in the bond's value
from
the discounted selling price (price paid by the
bondholder) to the Face value (price paid by the issuer)
when redeemed at the date of maturity. Since there are
no periodic interest payments in this kind of bonds, the

only cash inflow to be expected by the bondholder is the
principal payment or face value. Thus, to calculate the
valuation of zero coupon bond, the
a
following
equations can be used:
= [FV xPV(1-D,n) ]
BlueBlurry Corporation issued a zero coupon bond with

15 years until maturity and a P1000 Face value.
Determine the value of the bond if the Discount rates
(required rate of return) are as follows:
195
VALUATION OF BONDS
A. 8%
B. 9%
Case A: If the Discount rate or the required rate of return is 8%:
(1+ D)"
1,000
(1+ 0.08)15
Alternatively;
[P1000x PV(1- D,n ]
=
[P1000 x 0.31524]
= P315.24
The present value factor for one or single payment at 8%
discount or required rate of return for 15 periods is 0.31524.
Using the formula for valuing a Zero Coupon Bond, the bond
can is selling at P315.24. Thus, the investor who will eventually

be the bondholder can purchase the bond at P315.24 today
then wait for 15 years until maturity in order to receive the
amount of P1,000 which is the face value of the said bond.
Case B: If the Discount rate or the required rate of return is 9%:
(1+ D)n
1,000
(1 + 0.09) 15
BV = P 274.54
Alternatively;
PV Face Value
196
VALUATION OF BONDS
[P1000 x PV(1- D,n) ]
[P1000 x 0.27454]
= P274.54
The present value factor for one or single payment at 9%
discount or required rate of return for 15 periods is 0.27454.

Thus, the investor can purchase the bond at a value of P274.54
today but will receive the amount of P1000 which is the face
value when maturity date comes.
NOTE: In compounding other than annual payments, such as
semi-annual or quarterly payment, determine first the number

of payment periods in a year. Adjust number of periods (n) by
multiplying the number of payment periods per year by
number of years until maturity. Before computing the coupon
payment (CP), adjust the coupon interest rate (CIR) by dividing
the number of payment period from the annual coupon
interest rate. Also, for the adjusted discount rate (D) used in
present value functions, divide the Discount rate by the
number of payment periods in a year.
If a bond issued and sells at 100, this means that the

selling price of the bond or the value of the bond is 100 percent
of the par value, thus issued at par. However if the bond is
selling at 90, this means that the value of the bond is 90
percent of the par, thus issued at a discount; while selling at
110 means that the value of the bond is 110 percent of its
par
value, thus issued at a premium.
REQUIRED RATE OF RETURN:
A bond's yield is the required rate of return or discount rate
that will make the discounted value of the expected future cash
inflows equal to the current market value of the bond. When
the intrinsic value of a bond to the investor equates to the
197
VALUATION OF BONDS
market value, there is equilibrium between the required rate of
return of a bond and the bond's yield.
The bond's yield is commonly known as the yield to maturity

(YTM) which is the required rate of return on a bond if the
bondholder does not intend to sell the bond but rather hold it
until its maturity.
The YTM is the discount rate used to compute the present

value factors for single payment and annuity due which in turn
are used to calculate the bond's market value. This is
sometimes referred to as the internal rate of return which can
be calculated through interpolation; or trial and error solution.

Thus, using the above formula shown in the Nonzero Coupon
Bond Valuation discussion which is;
BV = 21-17 +
(1+D)"
or
[PV Coupon Payment + PV Face Value]
We can do interpolation or trial and error calculation for the

YTM or the Discount rate (D) given the current market value of
the bond, the coupon payment and the face value or maturity
value. The aim here is to get the economic rate of return or the
estimated discount rate that will equate the current market

value of the bond and the discounted cash inflows from the
coupon payments and principal payment. The Bond Valuation
(BV) to be used must be the current market value of the bond
or the bond price.
A P1000 ABCD Corporate bond was issued on January 1,

2018 with annual coupon interest rate of 8%. The
current market value of the bond is P935.82 and it

matures in 10 years.
198
VALUATION OF BONDS
Determine the Discount rate or the Yield to
Maturity.
The current market value is P935.82 which is below
the bond's par value of P1000. It shows that the bond

was issued at a discount. Based from the analyses
summarized in Scenario 3 where the Bond Valuation
(BV) calculated is also at a discount, here it is safe to

assume that the discount rate must be higher than the
stated rate of 8%. Since we want to equalize the
current market value with the present values of the
expected cash inflows, the discount rate that should be
used in calculating the present values may be any rate

not below 8%, thus let us try to interpolate using 8.5%
and 9.5%.
Using 8.5% as the discount rate, we must first
determine the present values of the expected cash

inflows of the bond. The present value factor for a
single payment is 6.56135 while the present value
factor of ordinary annuity is 0.44229. Using such

factors, the bond valuation with 8.5% discount rate
is calculated as follows:
BV = [ PVcoupon Payment + PVFace value]
BV = [ P 80 (6.56135) + P 1000 (0.44229)]
BV = P 524.91 + P 442.29
BV = P967.20
The valuation of a bond with the following

characteristics: 8.5% discount rate, 8% stated rate
and 10 years until maturity; amounted to P967.20
which is higher than the current market value of P
935.82. Thus, we must now determine a bond
199
VALUATION OF BONDS
valuation lower than the current market value of P
935.82. It is well settled that the there is an inverse
relationship with the Discount rate and the present

value factors. We now try a higher discount rate of
9.5%.
With 9.5% as the discount rate, the present value

factorsfor a single payment and ordinary annuity
are 0.40351 and 6.278798. The bond valuation
with the following factors is calculated as follows:
PV Coupon Payment +
BV = [ P 80 (6.278798) + P 1000 (0.40351)]
BV = P 502.30 + P 403.51
BV = P905.81
The above computation shows that the valuation of

a bond with the 9.5% discount rate amounted to
P905.81 which is below than the current market
value of P 935.82. Since the current market value of
P935.82 is between the bond prices of P905.81 and
P967.20, we can assume that the Yield to Maturity

or the appropriate Discount rate for the current
market value is any rate between 8.5 to 9.5%.
To illustrate, we interpolate rates between 8.5%

and 9.5%:
Table A: Summary of Rates and Bond Prices
Discount Rates 8.50% 9.50%
Bond Prices 967.20 P 935.82 P 905.81
200
VALUATION OF BONDS
Interpolation Process
R1 - R2 P1 - P2
R1 - R3 P1 -P3
The above table shows the summary of the

discount rates with their corresponding Bond
Prices calculated from the given the Sample
Problem 6-3. The said problem required to
calculate the Discount Rate (R) or the Yield to
Maturity (YTM). It is clearly shown in Table A that
Discount Rate (R2) signifies the YTM with
corresponding bond price (P2) of P935.82.
Thus, in determining the value of R2(YTM), we

must use the interpolation process formula as
follows:
STEP 1: Interpolation Process Formula
8.5% P967.20 - P935.82
8.5% 9.5% P967.20 - P905.81
8.5% P31.38
(-1%) P61.39
[8.5%- R2]
(P61.39) P31.38 (-1%)
201
VALUATION OF BONDS
P5.21815 P61.39 R2 (- P0.3138)

P5.21815 + P0.3138 P61.39 R2

P5.53195 P61.39 R2
P 5.53195 P61.39 R2
P61.39 P61.39
= P5.53195 : P61.39
= 0.090111 or 9 %
From the Interpolation Process, we determined the

Discount Rate (R2) or The Yield to Maturity of the given
bond with a current market value of P935.82. The YTM
which is also known as

the internal rate of return (/RR)
calculated from the given sample problem is
approximately 9%.
In order to check if the approximated YTM or Discount
rate of 9% equates the present values of the expected

cash inflows from the bond and the current market
value, we must use the Present value factors of 9% and
substitute it to the bond valuation formula.
202
VALUATION OF BONDS
PV Coupon Payment + PVFace value]
BV = [ P 80 (6.41766) + P 1000 (0.42241)]
BV = P 513.41 + P 422.41
The present value factors for single payment and

ordinary annuity of the 9% discount rate are 0.42241
and 6.41766, respectively. Using such PV factors, the

present value of interest payments amounted to
P531.41 while present value of the Face value or
maturity value amounted to 422.241. Thus, summation

of these present value cash inflows equates to the
current market value of P935.82.
We illustrated the process of determining the

YTM through interpolation. Aside from the
interpolation process, there are other ways on
how to calculate the approximated required rate

of return or the YTM such as using excel and
financial calculator.
> Alternatively, we can approximate YT using

this equation:
CP + [(Face Value - Bond Value)/t]

Bond Value (0.6) + Face Value (0.4)
Yield to Maturity is the rate of return earned by the

bondholder who held the bond until maturity. However, there
are bonds with features that prevent the bondholder from
holding the bond until maturity, such as callable bond. The call
203
VALUATION OF BONDS
provision shall be exercised by the issuer prior to the maturity

of the bond especially when the market interest rate falls
below the coupon rate of the bond.
In the perspective of the issuer, it is advantageous to call or
redeem the bond because there is an increase in the bond price
when market interest rate falls. the issuing

Moreover,
company can save annual interest payments if they redeem a

high rate coupon bond when such rate falls. The amount paid
call
by the issuer in order to call or redeem the bond is price
which is usually equal to the par value plus one year interest.
As to the perspective of the bondholders or investors, there is

the risk that their income from a bond portfolio will decline if
the interest rate falls. This risk, which is significant on callable
bonds, is SO called reinvestment risk This shows that the
expected savings in the perspective of the issuer is the

corresponding expected decline in the income of the
bondholder when the former will exercise its right to call.
To illustrate, assume that a 10 year callable bond has 12%

coupon interest rate upon issuance and assume that it was
issued at 1,000 par value. This bond is with call protection

period of 4 years from issuance, meaning, the issuer cannot call
the bond from issue date (year 0) until the end of fourth year
(year 4). In the beginning of year 5, the market interest rate falls
from 12% to 10%. The call premium is 5%.
The market interest rate decline to 10% will increase

the bond value from P 1,000 to P 1,087.11
BV = [ PVCoupon Payment t PV Face valuel

BV = [P 120 (4.35526) + P 1000 (0.5644739)]
BV = P 522.63 + P 564.47
BV = P1, 087.11
204
VALUATION OF BONDS
The issuer, in exercising its right to call, will have to pay

the call price of P1,050 [P1,000 face value + 50 call
premium] to the bondholder and in turn redeem the P
1,000 callable bond. This shows that the issuer is willing

to pay the excess or premium of P50 on the fifth year
(year 5) to redeem the 12% callable bond and replace
these with 10% bond. Hence, assuming the new bonds
will still be issued at par value, (effective interest rate
equals nominal interest rate) the issuer will save
interest payment of 2% due to the decline in market

rate from 12% to 10%. Or, if it will be issued at the new
bond price of P 1,087.11, the bond premium received

amounting to P87.11 is higher than the call premium
paid of P50, thus earning excess amount.
The savings or earnings of the issuer, due to decline in
interest rate, are the corresponding decline in the

income of the bondholder. Thus in this case, when
interest rate decreased and issuer redeemed the bond,
the payment received by the bondholder in year 5 shall
be reinvested at a lower rate of 10%. This illustrates the
SO called reinvestment risk discussed above.
On the other hand, when the interest rate increases resulting to

decline in the bond price, the risk is known as interest rate risk
or price risk
Thus, if the issuer exercised its right to call when interest rate
fall, the rate of return that will be earned by the bondholder of
this kind of bond is SO called yield to call (YTC). Shown below
is the equation on how to calculate the approximate YTC:
Call Price
t=1
205
VALUATION OF BONDS
Where:
Dc is the Yield to Call or the Rate of return when

called
CP is the Coupon interest payment
Call Price is the price paid by the issuer upon

exercise of its right to call
n is the number of years until the issuer can call
or redeem the bond
Alternatively, we can approximate YTC using this equation:
CP + [(Call Price - Bond Price)/ n]

Bond Price (0.6) + Call Price (0.4)
CBA Corporation has bonds outstanding with P1000 face

value and 10 years left until maturity. They have 12
annual coupon payments, and the current market value
is P1120. These bonds can be called starting 5
years at
105% of the face value.
1. Determine the Yield to Maturity assuming the

Corporation did not exercise its rights to call.
2. Determine the Yield to Call if
assuming the
corporation called in 5 years.
Approximate Yield to Maturity (YTM):
CP + (Face
Value - Bond Value)/t]
Bond Value (0.6) + Face Value (0.4)
[P120 + (P1000 - P1120) / 10]
P1120 (0.6) + P1000 (0.4)

Y
= 10.075%
206
VALUATION OF BONDS
The approximate YTM which is the required rate of return the

bondholder will receive at maturity date is 10.075%. This rate
is also the Discount rate that which equates the Present value
of the income stream: interest payments and maturity value;
with the current market value of the bond. To check whether
the approximated TYM is correct, let us determine the current
market value of the bond:
BV = P 1,117.90 or P1,118
Using the Approximated YTM of 10.075% in discounting the

income streams, the approximated bond value calculated
amounted to P1,118 which is near the current market value of
P1,120. There is a discrepancy due to rounding off differences

in the Present value factors. Thus, we can use this formula in
lieu of the interpolation process for convenience.
Approximate Yield to Call (YTC):
[CP + (Call Price Bond Price)/n]
Bond Price (0.6) + Call Price (0.4)
= [P120 + (P1050 - P1120)/ 5]
P1120 (0.6) + P1050 (0.4)
P106
P1092
= 9.707%
The approximated Yield to call (YTC) is 9.707% which is the

rate of return earned by the bondholder, who bought : callable
207
VALUATION OF BONDS
bond with a price of P1120, when the issuing corporation

called or redeemed the bond 5 years from today.
The callable bond given in Sample Problem 6-4 has a call
protection which is 4 years. This means that the issuer can only
exercise its rights to call starting on the 5th years from the
issuance of the bond, thereby protecting the bondholder from

redeeming the bond. However, after the protection period, the
call protection ceases and the bondholder now bears the risk of
redemption prior to maturity. In this case, when the issuing
company exercised its rights to call on the 5th year, the
bondholder's return will be 9.707% (YTC) instead of 10.075%
(YTM) because the bond was redeemed prior to maturity.
Moreover, when the right of the company to call is already

exercisable, it does not mean that the issuing company will call
or redeem outright the said bond. Thus, the issuer may or may
not redeem the bond depending on the interest rates or the
bond values in the market. If the bond price on the call period
is higher than call price, the issuer will be expected to redeem
or call the bond.
Note: for discussion and problem solving, we assume that the

bonds are not callable unless otherwise stated or if it deals
with the yield to call calculation.
Expected Total Returns on Bonds:
The expected total returns on bonds are the amount of cash
inflows from interest payments, maturity value (face value)

and call price. The total return attributable to the bondholder
can either be the Yield to Maturity (YTM) if the bond is held
until maturity, or the Yield to Call (YTC) if the bond was called
by the issuer prior to maturity. Moreover, the bondholder may

opt not to hold the bond until maturity but sell it to other
investors when the market interest rate declines. When this
208
VALUATION OF BONDS
happens, the bondholder's return on such investment will be

the cash inflows from the interest payments and the gain on
sale of the said bond. In this case, we can use another equation
to calculate the expected total return on the bond without

using the YTM and YTC formula. The expected total return
formula on a bond is the summation of the Current Yield and
Capital Gain / (Loss) Yield:
ETR =
+ CG/(L)Y
ETR +
Where:
ETR is the Expected Total Return or the rate of return

on investment
CY is the Current Yield which is the rate of return on the
interest payments received
CGY/(L)Y is the Capital Gains/Loss Yield which is the

rate of return when the bond is sold
BPn is the Bond Price New (Selling Price) calculated

after the change in the Discount rate
BPo is the Bond Price Old (Cost) which is the current
market value of the Bond
AMV purchased on January 1, 2017 a P1000 face value

bond issued by CBM Corporation with 9% annual coupon
interest and 10 years to maturity for P950. If AMV sold
the bond on January 1, 2018 for P970 to Wash Sy Gorres,

what is the total rate of return earned by AMV on the
investment?
209
VALUATION OF BONDS
ETR = CY + CG/(L)Y
ETR =
+
ETR =. 90 + 970 - 950
950 950
ETR = 11.58%
The Expected total return received by AMV from selling the

bond 1 year from issuance is 11.58% which is composed of the
current yield of 9.47% and the capital gains yield of 2.11%. The
price of the bond increases from P950 to P970 which
encouraged the bondholder to sell the bond to other investor
(Wash Sy Gorres). In case that the bondholder did not sell the
said bond but held it until maturity, the expected total returns
received will not be 11.58% rather the Yield to Maturity (YTM)
which is 9.79% (calculated using the approximate YTM
formula). Therefore, in selling the said bond, the bondholder
earned a higher return by 1.79%.
210
VALUATION OF STOCKS
CHAPTER 7
VALUATION OF STOCKS
Stock or share of stocks generally represents some form of

ownership in an entity. Shares may take several forms for
different organizations and these several forms entitle the
owner or the shareholder different rights. Some classes have
voting rights while some do not have. Other classes may
receive priority rights in dividends distribution and liquidation
over all other classes of shares. By merely
looking at these
benefits from stocks, it could be easily compared to bonds
(which were previously discussed in Chapter 6 of this book).
One very important difference between stocks and bonds is the
regularity of cash flows. For bonds, the contractual cash flows
in the form of interest payments are made periodically while
the dividends for stocks may not be made regularly.
In this chapter, we will discuss the following:

Different kinds of stocks
Different kinds of preference shares
Non-discounted method in valuing stocks

Discounted method in valuing stocks:
Discounted Dividend Model
Corporate Valuation Model
Stocks or shares of stock, in this chapter, shall be construed as
common or ordinary shares of stock. A separate portion in this

chapter shall deal with preference shares. Stocks are securities
that represent ownership of a company and entitlement of
such company's net assets and profits. Usually, stocks are

classified into common or ordinary and preferred. There are
several distinctions between ordinary and preferred shares. In
the table below, the characteristics of each class of shares are

briefly provided:
231
VALUATION OF STOCKS
Table 7-1
Characteristics of Ordinary and Preference Shares
Ordinary Preference
1. Claim over Yes Yes but with
assets priority in
distribution
during
liquidation
2. Claim over Yes but Yes but with
earnings depends on priority in

distribution the plan dividend
(dividends) distribution distribution
of
Preference
Shares
May not
receive
dividends
3. Voting rights Yes No
(influence/control
over corporate
actions)
While ordinary and preference shares may have common

characteristics such as par value or stated value, preference
shares have more distinct kinds. This is due to the fact that
preference shares are considered hybrid having

characteristics of bond or an instrument/security with liability
and that of a stock. Below is a list of different kinds of
preference shares:
232
VALUATION OF STOCKS
1. Cumulative - Those shares which entitle the holder to

current dividends as well as those dividends in arrears
or those dividends which were not provided in previous

years.
2. Non-cumulative - Those shares which entitles the
holder to only current dividends. The company is no
longer liable for dividends not declared in previous
years to holders of these shares.
3. Participating - Those shares that entitles the holder to

surplus profits after the provision of the basic dividend
to all classes of shares.
4. Non-participating Only the basic dividend shall be

provided to holders of this kind of preference shares.
Surplus profits after the provision of the basic dividend
shall be given to other classes of shares.
5. Redeemable - These are preference shares that grant

the issuing company the right or power to redeem,
purchase or "buy back" the shares after a certain period.
6. Convertible These are shares that can be converted

into another class of shares (usually convertible to
ordinary shares).
The succeeding segments on this chapter will discuss how the
value of two classes of stock are determined and why it is
necessary to determine such value.
233
VALUATION OF STOCKS
Stock Valuation
Stock Valuation is simply the process of determining a stock's

value. In some countries, stock value is a part of a service
rendered to an entity called Fairness Opinion or Valuation

Services. In the Philippines, non-listed and -traded entities
wishing to trade in the local stock exchange are mandated to

acquire a Fairness Opinion or a Valuation Report from
accredited firms. The opinion or report contains a computation
of the value of the company's stock. However, why is it
necessary to determine the value of a stock?
Investors make decisions by simply determining the potential

for profit or loss. Each security an investor hold may either
give such investor gains or losses in a particular period of time.
As in the case of stocks, investors profit from the appreciation
of the stock's value. It is necessary therefore that the investor
is guided in determining whether a stock shall profit or not.

That is the time stock valuation enters. Fundamentally
speaking, investors are at advantage if it would be able to
estimate properly a stock's intrinsic (or "true") value. By
comparing the intrinsic value with the amount at which a stock
is traded, an investor will be guided. The basic principle of

using the intrinsic value is shown below as:
Intrinsic Value > Stock Price (Traded Price) "undervalued" =

Buy/Acquire
Intrinsic Value < Stock Price (Traded Price) ¾ "overvalued" =

Sell/Do not acquire
The rules provided above are rudimentary rules

developed to guide an investor in possession of the correct
intrinsic value.
234
VALUATION OF STOCKS
Methods of Stock Valuation
A. Non-discounted Techniques
The valuation of stocks may involve a computation based,
summarily, on financial statements and fundamental
information. This method of stock valuation takes into
consideration the financial performance of the company or the
current book value of its shareholders' equity. Furthermore,

these techniques utilize market information and employ the
market information to the net income of the firm being valued.
1. Book Value or Net Asset Value Approach

The net asset value or book value approach utilizes the total
shareholders' equity portion of the financial statements. The
objective of this approach is to determine the Net Asset Value
Per Share or the Book Value Per Share which ultimately

represents the equity or the value of each ordinary share. It is
also the amount that would be paid on each share assuming
that the company is liquidated. The term net asset value is
generally used for funds (such as mutual funds) while book
value is general term used for different types of businesses. In
several applications of this approach, the book values of the
net assets are adjusted to reflect its current fair value rather
than historical costs.
The formula for the book value or net asset value
approach is:
Book Value or Net Asset Value per share

Total Shareholders'Equity (or Total Assets Total Liabilities)
Number of outstanding shares
In this formula, it is assumed that the company is using

only a single class of shares which are common or ordinary
shares. However, in instances when there are other classes of
235
VALUATION OF STOCKS
shares other than ordinary shares, the portion of the

reflect the correct value per
preference shares are excluded to
share:
Book Value or Net Asset Value per share

Total Shareholders'Equity- Total equity attributable to preference shares
Number of outstanding common shares
In both situations, the total assets of the company may

be adjusted as deemed necessary to reflect its current fair
market value.
This approach is commonly used for companies that are

currently not traded in any market or companies that are
closely-held. This approach is also prevalently used by mutual
funds to represent the value of each unit of the fund. It
commonly uses the notation NAVPU which is the Net Asset
Value Per Unit. While it can be seen from that the value of stock
can be computed with ease, it is not all too perfect for a
valuation approach. One prevailing weakness of this formula is,

on hand, very evident from its definition. It assumes that the
company shall liquidate presently and that the value computed

shows approximately how much the shareholders will receive
upon liquidation. This condition, however, goes against the
very basic principle of accounting which is the Going Concern

principle. The Going Concern principles simply states that an
accounting method shall be adopted under the assumption that
the company will continue operations for an indefinite period
of time and under no circumstances that it shall liquidate in the
near future. Furthermore, it also factors out the expected
profits in future periods.
236
VALUATION OF STOCKS

SEC Company has the following information derived
from its most recent audited financial statements:
Total Assets = P20,000,000,000

Total Liabilities = P10,000,000,000
Total Shareholders' Equity = P10,000,000,000
No. of ordinary shares issued and outstanding =
1,000,000,000 shares
To determine the NAVPS or BVPS:
Total Shareholders' Equity

No. of ordinary shares issued and outstanding
P10,000,000,000
NAVPS or BVPS
1,000,000,000
NAVPS or BVPS = P10 per share
If the company had another class of stock such as

preferred shares amounting to 600,000,000 shares with
a total equity of P2,500,000,000, then the NAVPS or
BVPS shall be P7.50 per share.
Total Shareholders'Equity - Total equity attributabte to preference shares

P10,000,000,000 - P2,500,000,000
1,000,000,000
NAVPS or BVPS = P7.50 per share
2. Price-Earnings Relative Valuation Approach

Several investors believe that the value (price) of a stock is
related to its financial performance, particularly its net income.
Furthermore, these investors believe that the change in the
237
VALUATION OF STOCKS
price of a stock is directly attributable to its earnings. We

understand from the discussion in Chapter 3
(Financial
Statement Analysis) that a multiplier can be derived
by using
the price of a stock and its earnings - that is the Price-Earnings
company in target, the prevailing
Ratio. In the valuation of a
Price-Earnings Ratio (or also called the Price-Earnings

Multiple) of similar or comparable entities is utilized to
determine the value of the target stock.
The basic argument of this approach is that the income

statement provides a more accurate view in valuing a business
It also argues that the value of an operating business arises
from its ability to generate income and not from historical
accumulation of assets. Furthermore, income statement data

are substantially derived from a particular reporting period
and as such encounters a
considerably lower level of distortion
than the balance sheet with which values come from varying
periods.
The computation of the value of the stock using this

approach can be illustrated using this formula:
Corporate Value
= Net Income
X PE Ratio or
PE Multiple of similar companies
Value of Stock = Corporate Value

In the above formula, the current (or projected) net

income
of the company is multiplied by the Price-Earnings
Ratio or Multiple of similar companies. Similar companies may
be interpreted in the manner most relative to the entity being
valued such as it may be companies in the same geographical
same sector or industry or other qualifications
area, that iS
deemed appropriate.
238
VALUATION OF STOCKS
NA Technologies, Inc. has a net income of P1 billion

reported on the previous year's audited financial
statements. In the same period, the company has 1
billion in shares issued and outstanding. NA
Technologies is currently operating in the computer and

gadgets industry. Information has been gathered that the
prevailing P/E Ratio (price-earnings ratio) in the
computer industry is 5x.
To determine the value of the stock:
Corporate Value = Net Income

X PE Ratio or PE Multiple of similar companies
Corporate Value = P1 billion x 5x
Corporate Value = P5,000,000,000
Corporate Value
Value of Stock =
P5 billion
Value of Stock =
billion shares
Value of Stock = P5 per share
Note: In some instances, the corporate value is reduced by a
Liquidity Discount to reflect or adjust the expected

marketability of a stock. This is usually done during initial
public offerings. Christopher Glover, in his book Valuation of
Unquoted Companies (5th ed.), mentioned that the most
popular level of discount is 25%. Applying the same in the case
above, the Corporate Value of P5 billion should be reduced by

25% to equal P3.75 billion.
B. Discounted Techniques
The most common valuation techniques involve the
consideration of future cash flows that may generated from
239
VALUATION OF STOCKS
such stock. Considering that the computations may involve

future cash flows, appropriate discounting should be made to
place these future cash flows to its present value.
Discounted Dividend Model
This model takes into consideration the expected cash flows of

investment in stocks which are dividends and stock price upon
sale. Simply put, the value of the stock depends on the present
value of all the dividends and the price of the stock once it is
sold. This model primarily relies on the proper estimation of a

stock's growth rate which is one of the key features of this
valuation method.
Common elements exist in this stock valuation method:
Po stock price today

D1 or D - dividends or dividend at the end of the year
ke or r - required return or cost of equity

g growth rate
TD - terminal date or horizon

TV - terminal value
The Discounted Dividend Model assumes that dividends grow

in three possible ways namely:
a) Zero or No Growth stocks - A situation where a

stock and its dividends do
not grow. Considering
that this valuation model is primarily based on
dividends and growth rate, preferred shares
exhibit the same characteristics as that of zero or
no growth ordinary stocks. Under this

assumption, dividends today (Do) is equal to
future dividends such as D1. D2, D3 and so on.
240
VALUATION OF STOCKS
The formula for the valuation of zero or no growth stockis:
Po
110
RF Hotels Corporation has paid P5.00 dividends last year
to its stockholders. The company expects that this
dividend will not grow in its succeeding years of
operation. The shareholders expect a 10% return on RF's
stock.
To determine RF's stock price:
D
Po - -
r
P5.00
Po =
10%
Po= P50.00
b) Constant Growth stocks - A situation where a

stock and its dividends grow at a constant rate
throughout its life. Constant growth stocks
exhibit a kind of growth rate that does not
change during the life of such stock. In fact, zero

or no growth stock may be a form of constant
growth stock, only that it has zero or no growth
during the life of that stock.
The formula for the valuation of constant growth stock is:
Po =
Emphasis should be drawn on the D1 component. The dividend

used in this formula should always be the dividend at the end
of the year and not any other dividend such as dividends
241
VALUATION OF STOCKS
recently declared (Do). Further the formula above, however,

must be used with care as the growth rate must always be less
than the required rate of return. Otherwise, the formula may

become
inoperable or illogical.

NN Stock is expected to declare a P7.00 dividend at the
end of the year. Similar stocks return 16%. NN's stock is
expected to grow at a rate of 6% annually for the rest of
the stock's life.
To determine NN's stock price:
Po =
P7.00
Po =
16% - 6%
P. E P70.00
c Non-constant Growth stocks A situation where
a stock and its dividends grow at a different rate

at the earlier part of its life. Such
growth shall
terminate at a horizon or terminal date where
the stock and its dividends begin to grow at a

constant rate. As such, there are two phases in
the life of non-constant growth stocks: the non-
constant growth phase and the constant growth
phase. The non-constant growth phase consists
of dividends growing at a varying rate or at a
rate different from the constant growth rate.
After the non-constant phase (at the terminal

date), the constant growth phase then consists of
dividends growing constantly until infinity.
242
VALUATION OF STOCKS
As mentioned above, the terminal date is the period in
which the dividends stop growing non-constantly and begins

growing at a constant rate forever. In relation to this terminal
date, relevant value comes up which is called the terminal
value. The terminal value is computed similarly to a constant
growth stocks in which the dividends in the constant growth

phase of the stock is collected and discounted to the terminal
date.
The formula for the valuation of non-constant growth stock is:
Po:
(1+r) (1+r)2 (1+ r)3
In computing for dividends beyond D1, the growth rate

applicable may be utilized on a D1 to compute for succeeding
dividends. This concept can be illustrated in this equation:
D2 = D, X (1 + g)
D3 = D, X (1 + 9) or D2 X (1+g)
In the above formulas, care must be taken in using a correct

growth rate if the dividend is within the non-constant growth
phase or already at the constant growth phase.
Once the non-constant growth phase stops (at the terminal
date), the dividends then grow constantly. Analyzing the

situation at the terminal date, it could be understood that
dividends will grow at the same rate until infinity. To be able to
express these dividends, it should be "collected" (discounted)

at the terminal date. The terminal value is then computed as:
TV =
243
VALUATION OF STOCKS
It should be emphasized that the dividend in the terminal value
computation is the dividend after the terminal date in which
the growth rate utilized is the constant growth rate.
A Industries, Inc. expects to pay P3.00 per share dividend to its

common stockholders at the end of the year. The dividend is
expected to grow 25 percent a year until the end of the third

year (t = 3), after which time the dividends is expected to grow
at a constant rate of 5 percent a year. A Industries' stockholders
require a 12% return on this stock
To determine the A's stock price:

A timeline should be made to assist the analyst in
understanding the characteristics of the stock, the dividends
and the relevant periods in which these dividends appear.
Proper analysis should be made on how the dividends are to be
recognized and placed on the timeline.
25% growth in dividends 5% growth in dividends forever
D. D. D. D.
D1 = P3.00
D2 = D1 X (1 + r)
D2 = P3.00 X (1 + 25%)
D2 = P3.75
D3 = D2 X (1 + r)
D3 = P3.75 x (1 + 25%)
D3 = P4.6875
244
VALUATION OF STOCKS
Note: D3, in this problem, is the dividend at the terminal date
D4 = D3 X (1 + r)
D4 = P4.6875 X (1: 5%)
D4 = P4.921875
Note: The growth rate for D4 now becomes 5% (as opposed to

25%) considering that the stock has already entered the
constant growth phase. Further, D4 is the dividend after the
terminal date (DTD+1).
TV =
P4.921875
TV =
12% - 5%
TV = P70.3125
With all the components of the stock price already determined

and pre-computed, the stock price can already be computed:
Po = +
P3.00 P3.75 P4.6875 P70.3125
(1 + 12%) (1+ 12%)2 (1+ 12%)3 (1 + 12%)3

P.= P59.05
Note: It should be emphasized that the terminal value should

be discounted at the same rate as that of the dividend at the
terminal date (D3 in this problem).
245
VALUATION OF STOCKS
1. Corporate Valuation or Free Cash Flow Model
This model computes a npany's market value based on the
present value of the company's free cash flows. Upon

determination of the market value of the company, the long-
term debt and preferred share capital is deducted leaving the
market value of the common stock to be divided by the number
of outstanding common shares to determine the stock's
intrinsic value.
The discounting concepts are very similar to that of the

discounted dividend model, however with some new elements:
Po - stock price today

MV Firm market value of the firm
_ Debt+Preferred market value of debt and preferred stock
free cash flow at the end of year
WACC - weighted average cost of capital
g - growth rate
TD - terminal date or horizon
TV - terminal value
OCS - outstanding common stock
As mentioned previously, the corporate valuation or

free cash flow model uses the same structure of discounting as
thatof the discounted dividend model. It may also be in the
form of a zero or no growth,
constant growth or non-constant
growth stock. Before we discuss the formulas in
computing the
stock price, we should first familiarize ourselves with the new
elements of this valuation method.
The market value of the firm represents the total value

of the company (the total market value of its assets). It is the
sum of
all the free cash flows of the company discounted to its
246
VALUATION OF STOCKS
present value. It should also be noted that these assets are
primarily sourced out from the firm's liabilities, preference

shares and ordinary shares. It is understood that these three
types of sources each have claim over the market value of the
firm. In the same manner, considering the three sources of cash
each have their own required returns, the WACC or weighted

average cost of capital should be used to discount such free
cash flows.The WACC, therefore, is the composite weighted
average of all the required returns of creditors, preference
shareholders and ordinary shareholders. The computation of

the WACC is discussed in detail in Chapter 7 of this text.
The free cash flow (FCF) is the cash generated before

any payment is made to the above investors (the sources
creditors and shareholders). Free cash flow originally comes
from the computation of the net income but distinctly modified
to reflect the actual cash flows of the firm:
FCF = [EBIT(1 - TAX RATE) + Depreciation and Amortization]

- [Capital Expenditures + ANet Working Capital]
Before being able to compute the stock price using the

free cash flow model, it is first important to determine the
market value of the firm. The market value firm is computed as
follows:
Zero or no growth firms:
MV Firm
Constant growth firms:
-
Firm
- g
247
VALUATION OF STOCKS
Non-constant growth firms:

MV Firm (1+ WACC)™D
(1+ WACC) (1 + WACC)2 (1 + WACC)3
(1+ WACC)™D
After computing for the market value of the firm
(MV Firm), the stock price can already be computed by dividing

the market value of the firm minus the sum of the market
values of debt and preferred shares by the number of
outstanding common stock:
MVFirm - MVDebt+Preferred
Po =
The market value of the firm less the market value of
debt and preferred shares represent the remainder of the

firm's market value that is available to common or ordinary
shareholders. This amount then represents the intrinsic value
of the firm's common stock.
8479 Corporation has projected Earnings Before Interest and

Tax (EBIT) for the next year of P600 million, with tax rate of
40%, projected depreciation expense, capital expenditures and

increase in working capital for the next year of P100 million,
P200 million
and P120 million, respectively. The capital
structure of the company is 40% for debt and 60% for equity. Its
WACC is 10%. The company's free cash flow is expected to grow
at a constant rate of 6 percent a year. The firm has P500 million
in debt and preferred shares with 20 million preferred shares
outstanding and 300 million ordinary shares outstanding.
248
VALUATION OF STOCKS
To compute for 8479's stock price:
It is first important to compute for the correct free cash flow of

the company. Considering that this is a constant growth stock,
it is also important to note that the free cash flow needed for
the computation is the free cash flow at the end of the year
(FCF1).
+ANet Working Capital]
FCF:=[P600 million (1-40%)+P100 million]-[P200 million+P120 million]
FCF.=P140 million
After computing the correct FCF, the market value of the firm
should be computed next:
WACC - g
P140 million
10% 6%
= P3.5 billion
Once the market value of the firm is computed, the market
values of debt and preferred must first be deducted from the

market value of the firm. The resulting market value of
common or ordinary shares shall be divided by the number

outstanding ordinary shares:
Po =
P3.5 billion - P500 million

Po =
300 million shares
P.= P10 per share
249
VALUATION OF STOCKS
Choosing the best valuation method

Valuation methods above present to us various kinds of
the price of the
techniques and points-of-view in computing for
stock. As investors are wary of each kind of valuation
technique, choosing the best valuation method does not all the
more mean picking the most accurate one. As it is in providing
Fairness Opinions and luations, uncertainties arising from
valuation method are addressed by
each different
comparatively looking at the results of each valuation method.

Rather than choosing one alternative, it is best to look at the
varying results as a reasonable range of the correct intrinsic or
"true" value.
250

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Financial Management Volume 1 by Bagayao - Compress

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INTRODUCTION TO FINANCIAL MANAGEMENT

There is need to have enough capital in putting up a business

to be used for operations and investments. The business may

In this chapter, we will introduce financial management by

Priority between ethics and profit goals

Financial Management is the process of planning, directing,

business. The financial managers are responsible for the

management of these monetary resources of the business.

I. Kinds of Business Organizations:

A. Sole Proprietorship is regarded as the simplest form of

corporation. Thus, the registration is only through the

However there are disadvantages of forming a sole

proprietorship. Lastly, the amount of capital raised is

B. Partnership, as provided by the New Civil Code (NCC) of

persons may also form a partnership for the exercise of

personality separate and distinct from that of each

A partnership may be constituted in any form, whether

real rights are contributed thereto, in which case a

public instrument shall be necessary. In addition, the

Thousand Pesos (P3,000) or more, in money or

property, is required to be:

1) In public instrument and

However, the failure to comply with the above

Partnership may be classified as General or Limited

partnership. In a general partnership, all the partners

Like Sole Proprietorship, the life of the partnership is

will result to the dissolution of the partnership.

The following are the usual causes of dissolution of the

An advantage of partnership is that there is usually

proprietorship because of larger number of source of

capital. On the contrary, it has less capital compared to

C. Corporation, as provided by the Corporation Code of the

Corporation is regarded as the most complex form of

government regulations. The owners are referred as

shareholders and the personal assets of the latter are

not subject to appropriations. These shareholders,

subject to corporate tax while the earnings of the

individual income tax.

FIGURE 1-1: The Characteristic of Business Organizations:

Characteristics of Sole Partnership Corporation

2. Owner and NO NO YES

3. Owner's Unlimited Unlimited Limited**

5. Life of the Limited Limited Unlimited

*Except in General Professional Partnership (GPP), because this

derived from engaging in any trade or business. Moreover, for

tax purposes, the term "corporation" shall include partnership,

operations pursuant to an operating consortium agreement

exception GPP's income is not taxed separately using the 30%

corporate income tax.

The said doctrine shall disregard the separate

corporate fiction was used as a shield to perpetuate

fraud, justify wrong, defeat public convenience or defend

The effect of this doctrine is to make the directors,

compliance with the statutory requirements for its

incorporation. Hence, it exists in fact and in law.

De Facto Corporation - this is a corporation that exists

incorporation. Hence, it has no legal right to corporate

B. As to functions and governing law:

Private Corporation - these are organized by private

Stock Corporation A corporation in which capital

basis of the shares held. (Sec. 3 of the Corporation Code

Non-stock Corporation - A corporation which has no

stocks issuances and no distribution of dividends to its