Lecture 2

Question:
• Among all assets, one asset stands out to be a nation’s most valuable asset What is that
asset?

Answer:
• High quality people is a nation’s most valuable asset.
• Assets, financial or otherwise, cannot generate progress and growth without the
existence of competent individuals to manage the process.

Case on TIE Ratio

• Obsolete Technology Corporation (OTC) has debt in the form of a bank loan in the
amount of LE 800,000 and pays an interest rate of 10% annually on its bank loan.
• OTC 's annual sales are LE 3,200,000, its average tax rate is 40%, and its net profit (after
tax) is 6% of sales.
• Question: What is OTC's TIE ratio?

Solution :

TIE (Times Interest Earned) ratio =

EBIT (Earnings Before Interest & Tax)
Interest
Interest = LE 800,000 X 10% = LE 80,000
Net income = LE 3,200,000 X6% = LE 192,000
Pre-tax income = 192,000 / (1-40%)
= LE 192, 000 / 60% = LE 320,000
EBIT = LE 320,000 + LE 80,000 = LE 400.000
TIE ratio = LE 400,000 / LE 80,000 = 5 times
3- Fixed Charge Coverage ratio =

EBIT + Lease Payments___________

Interest + Lease + Sinking Funds payments (..times)
Charges Payments (1- tax rate)

Example:
If: EBIT LE 4,000,000
Lease payments LE 100,000
Interest charges LE 500,000
Sinking funds payments LE 1,000,000
Tax rate 40%
Then, Fixed Charge Coverage ratio =
4,000,000 +100,000
500,000 + 100,000 + 1,000,000
(1 – 40%)
= 4,100,000_____
600,000 +1,000,000
60%
= 4,100,000 = 4,100,000 = 1.8 times
600,000 + 1,666,666 2,266,666
Case on Ratio Analysis
Bad Food Company is evaluating an expansion project for its sales
outlets. To provide the financing needed for the project the
Company is negotiating an 18% interest bank loan. The following
information is obtained from the company:
1- Company total capital is LE 60 million, 40% in equity and 60% in
debt.
2- The debt portion is divided equally between a 14% interest bond
issue and a 15% interest bank loan.
3- The company feeds a sinking fund LE 1 million annually.
4- Company’s present cost of equity is 20%.
5- Annual sales are LE 50 million, of which LE 35 million in cash
sales and the other LE 15 million on credit.
6- Annual salaries and other expense LE 10 million.
7- Annual depreciation charges LE 5 million
8- After-tax net income 20% of annual sales.
9- The company uses leased facilities and annual lease payment is LE 3 million.
10- Tax rate is 40%.
A- Calculate TIE ratio and Fixed Charges Coverage ratio.
B- If company policy is to maintain a TIE ratio of no less than 6 times and a Fixed Charges
Coverage ratio of no less than 5 times, can the company take the new loan or not?
Sloution :
1- Calculating TIE ratio:
TIE ratio = EBIT
Interest payment
Amount of debt = Total capital X 60% = LE 36,000,000
Interest on bonds = 36,000,000 X 50% X 14% = LE 2,520,000
Interest on loan = 36,000,000 X 50% X 15% = LE 2,700,000
Total interest = LE 5,220,000
Net income after tax= SalesX20% = 50,000,000X20%=LE10,000,000
EBT = 10,000,000/(1-40%) = 10,000,000/0.60 = LE 16,666,666
EBIT = 16,666,666 + 5,220,000 = LE 21,886,666
TIE ratio = 21,886,666 = 4.2 times
5,220,000

2- Calculating Fixed Charges Coverage (FCCR) ratio:

FCCR ratio = EBIT + Lease payments
Interest + Lease payment +Sinking fund payment
1 – tax rate
= 21,886,666 + 3,000,000
5,220,000 + 3,000,000 + 1,000,000
0.60
= 24,886,666 = 24,886,666 = 2.5 times
8,220,000 + 1,666,667 9,886,667
More Questions
Question 1:
A firm's current ratio has steadily decreased over the past 3 years, from
2.9 three years ago to 1.1 today. What would a financial analyst be most
justified in concluding?
1. The firm's stock price has probably declined.
2. The firm's debt ratio will not be affected.
3. The firm's fixed assets turnover has probably deteriorated.
4. The firm's liquidity position has probably deteriorated.
5. The analyst would be unable to draw any conclusions from
this information.
Answer: The firm's liquidity position has probably deteriorated.
Question 2:
Which of the following statements is most correct?
A. Ratio analysis can be distorted by seasonal factors.
B. Ratio analysis is a great tool, because it allows a firm to be accurately compared to any
other company.
C. It is difficult to generalize financial ratios as being strictly good or bad.
D. Both A and C are correct.
E. All of the above are correct
Answer: Both A and C are correct.

Question 3:
Recently Company XYZ has been having problems and its financial
situation has deteriorated. Company approached its bank for a badly
needed loan, but the loan officer insisted that the current ratio (currently
0.7) be improved to at least close to 1.0 before the bank would even
consider making the loan. Which of the following actions would do the
most to improve the ratio in the short run and would likely be the least
costly to the Company?
a. Using some cash to pay off some long-term and short-term liabilities.
b. Purchasing additional raw materials on credit thereby increasing accounts payable.
c. Paying off some notes payable with cash to reduce the firm’s debt.
d. Selling some inventory for cash.
e. Collect some accounts receivable.
Answer: Purchasing some additional raw materials on credit thereby
increasing accounts payable.
Question 4:
A firm has total assets of $20 million and a debt/equity ratio of 0.60. Its sales are
$15 million, and it has total fixed costs of $6 million. If the firm's EBIT is $3 million,
its tax rate is 40%, and the interest rate on all of its debt is 9%, what is the firm's
ROE?
Answer:
1- Calculate total debt and equity:
$20,000,000 = Total equity + Total debt.
Total debt = 0.60(Total equity)
$20,000,000 = Total equity + 0.60(Total equity)
Total equity = $20,000,000/1.60 = $12,500,000.
Total debt = $20,000,000 - $12,500,000 = $7,500,000.
2- Calculate interest expense, net income, and ROE:
Debt interest = $7,500,000(0.09) = $675,000.
Net income = (EBIT - I)(1 - T)
= ($3,000,000 - $675,000)0.60 = $1,395,000.
ROE = $1,395,000/$12,500,000 = 11.16%.
 Lecture 11 B

Question 1: Solve the following problem:

Stone Age Technologies (SAT) has net income of LE 2,000,000 and it has 1,000,000 shares of
common stock outstanding. The company’s stock currently trades at LE 32 a share. SAT is
considering a plan where it will use available cash to repurchase 20% of its shares in the open
market. The repurchase is expected to have no effect on either net income or the company’s P/E
ratio. What will be SAT stock price following the stock repurchase?

SOLUTION

Net income LE 2,000,000

Number of shares outstanding 1,000,000 shares
Market price per share LE 32
Shares to repurchase = 1,000,000 X 20% = 200,000 shares
Shares remaining after repurchase 800,000 shares

EPS before repurchase = LE 2,000,000 = LE 2

1,000,000 shares

P/E ratio = LE 32 = 16 X.
2
EPS after repurchase = LE 2,000,000 = LE 2.5
800,000 shares

Expected stock price after repurchase = (P/E) (EPS)

= 16 X 2.5
= LE 40 / share
Question 2: Solve the following problem:
Flat Tire Transport (FTT) expects EBIT of LE 2,000,000 for the coming year. The firm’s capital
structure consists of 40% debt and 60%equity, and its tax rate is 40%. The cost of equity is 14%,
and the company pays 10% interest on its LE 5,000,000 of long-term debt. FTT has 1 million
shares of common stock outstanding.
In its next capital budgeting cycle, the firm expects to fund one large positive NPV project
costing LE 1,200,000, and it will fund this project in accordance with its target capital structure.
If the firm follows a residual dividend policy and has no other projects to fund, what is its
expected dividend payout ratio?

SOLUTION
EBIT LE 2,000,000
Interest (10% interest on LE 5,000,000 debt) (500,000)
EBT 1,500,000
Taxes (1,500,000 X 40%) (600,000)
Net income 900,000
Project funding (1,200,000 X 60% equity) (720,000)
Residual earning LE 180,000

Dividend payout ratio = 180,000 = 20%

900,000
 Lecture 11 A

Sole question: Solve the following problem:

A friend of yours received an offer to sell bonds and shares he owns. Details as follows:
1. The bonds: Bond has a par value of LE 1000, coupon interest rate of 10%, and
maturity of 15 years. The prevailing market interest rate is 5%. Offered price is
LE 1600 per bond.
2. The shares: The latest paid dividend was LE0.50 per share and the issuing
company has a growth rate of 10%. Shareholders expected rate of return is 12%.
Offered price is LE 25 per share.

a. Based on the above information calculate the current value of the bond and
that of the stock.

b. Based on your calculation of the value, would you recommend to your

friend to accept the offer to sell or to rteject it?

Solution:
Bond evaluation:
VB = INT(PVIFA,kd,N) + M(PVIF,kd,N)
= 100(PVIFA,5%,15 yrs.) + 1000(PVIF,5%,15yrs.)
= 100(10.3797) +1000(0.4810)
= 1037.97 + 481.- = LE 1518.97

Bond has a value of LE 1518.97 and should be sold for LE 1600.

Share evaluation:
Po = D1
Ks – g
D (latest dividend payment = LE0.50
g (yield growth rate) = 10%
Ks (expected rate of return on stock) = 12%
Po = 0.50(1.10) = 0.55 = LE 27.50
12% - 10% 2%

Share has a value of LE27.50. An offer to sell it for LE 25 should be rejected.

 Lecture 9

Assignment 1

Sea Horse Oil Company is targeting Dolphin Petroleum Company for acquisition in
2003. The following table shows Sea Horse estimation of target company sales
revenues and costs following the acquisition (numbers in million dollars):
Year 2004 Year 2005 Year 2006 Year 2007
Net sales 60.0 90.0 112.5 127.5
Cost of goods sold 36.0 54.0 67.5 76.5
Other expenses 4.5 6.0 7.5 9.0
Interest expense 3.0 4.5 4.5 6.0
Other available information:
- Target company applicable tax rate is 40%.
- Risk-free investment cost of capital is 9% and market average return is 13%.
- Target company’s beta coefficient (b) is 1.3
- Target company has 10 million shares outstanding and the last traded price was $9
per share.
- Sea Horse reached agreement with Dolphin Petroleum management to buy all
outstanding shares at last traded price plus $6 premium per share.
Calculate the following:
1. Target company annual cash flow for the years 2004 through 2007, considering that
no retentions from profits will be made.
2. The terminal value of the target company, assuming a 6% growth rate.
3. The net cash flow to Horizon Year.
4. The value of Dolphin Petroleum Company in 2003 as estimated by Sea Horse.
5. The amount remaining to Sea Horse from the merger synergy.

Assignment 2

Answer the following questions briefly:

1- What makes an acquisition “friendly” or “hostile”?

2- What actions could the management of the target company take to fend off an
attempted acquisition?
3- What are the main reasons (synergies) behind most of recent acquisitions?
Solution: Assignment 1

1- Cash Flow Statement after merger occurs (in million dollars):

Year 2004 Year 2005 Year 2006 Year 2007

Net sales 60.0 90.0 112.5 127.5
Cost of goods sold 36.0 54.0 67.5 76.5
Other expenses 4.5 6.0 7.5 9.0
Interest expense 3.0 4.5 4.5 6.0
EBT 16.5 25.5 33.0 36.0
Taxes (40%) 6.6 10.2 13.2 14.4
Net income 9.9 15.3 19.8 21.6
Retentions 0 0 0 0
Cash flow 9.9 15.3 19.8 21.6

Discount rate calculation:

Ks (target) = Krf + (Km – Krf)b target
= 9% + (13% - 9%)1.3 = 9% + (4%)1.3 = 14.2%

2- Terminal value calculation:

Horizon value = (2006 cash flow) (1+g)
Ks - g

= 21.6(1.06) = $279.2 million

0.142 – 0.06
3- Net cash flow to Horizon year:
Year 2004 Year 2005 Year 2006 Year 2007
Annual cash flow 9.9 15.3 19.8 21.6
Terminal value --- --- --- 279.2
Net cash flow 9.9 15.3 19.8 300.8

4- Value of Dolphin Company in 2003:

Value = 9.9 + 15.3 + 19.8 + 300.8
 (1.142)1 (1.142)2 (1.142)3 (1.142)4
= 8.67 + 11.73 + 13.29 + 176.85 = $210.54 million

5- Amount remaining from synergy:

 Purchase value paid to target shareholders = (Market price + Premium) X number of
shares = $9 + $6 = $15 X 10 million = $150 million

 Amount remaining to Sea Horse from the merger synergy

= $210.54 million - $150 million = $60.54 million
 Lecture 10

Case for the class: Southeast Airlines Rights Offering:

Southwest Airlines plans to raise $10 million of new equity capital through a rights offering at a
price of $80 per share. The following are the company’s partial Balance Sheet and Income
Statement before the rights offering:
Partial Balance Sheet
Total debt 40,000,000
Common stock 10,000,000
Retained earnings 50,000,000
Total assets $100,000,000 Total Liabilities $100,000,000
Partial Income Statement
Earnings before interest and taxes 16,121,212
Interest on debt 4,000,000
Income before taxes 12,121,212
Taxes (34%) 4,121,212
Net income $8,000,000
Earnings per share (1,000,000 shares) $8
Market price of stock (price/earnings ratio of 12.5) $100
Questions:
1- How many rights will be required to purchase a share of the newly issued stock?
2- What is the value of each right?
3- What effect will the rights offering have on the price of the existing stock?
Solution:
1- Number of rights required to purchase one new share:
The amount of new capital to raise in new equity is $10,000,000 and the price of each new stock
is $80. Therefore, The number of new shares = Funds to be raised
Subscription price
= $10,000,000 = 125,000 shares
$80
2- Number of rights: = 1,000,000 old shares = 8
125,000 new shares
Meaning that a shareholder has to own 8 old shares to be entitled to purchase 1 new share
3- Value of a right:
Total market value of Southeast before the offering =
1 million shares X $100 per share = $ 100,000,000
Total market value of Southeast after the offering =
$ 100,000,000 + $10,000,000 = $110,000,000

New market value per share = $110,000,000 = $97.78

1,000,000 + 125,000
Saving on price per new share = $97.78 - $ 80.00 = $17.78
Since 8 rights are required to buy ONE new share. Then each right has a value of
$17.78 = $2.22
8
4- The introduction of a new block of stocks, thus increasing the number of shares available,
resulted in reducing the price of the existing stock from $100 to $97.78 per share.
 Lecture 3

Case on Cost of Capital

Black Hawk Corporation is evaluating a project to build a 5 stars
Hotel in El Falluja, Iraq. Project will be funded with a mixture of
equity and debt as follows:
20% in retained earnings 40% in common stocks
10% in preferred stocks 30% in a bank loan
• Other information available:
- Company pays 17% interest on its current debt.
- New loans are available at 20% interest rate
- New common stocks will be priced at LE 45 per share.
- New preferred stocks will have 20% coupon and priced at LE 50 per share
- Last paid dividend on common stocks was LE 3.00 per share.
- Company growth rate is 8%.
- Return on risk-free investment is 10% and return on average market investment is 14%.
- Company riskiness is 0.6 and project riskiness is 1.2
- Company cost of retained earnings is the average of the DCF and the CAPM methods.
- Bank floatation cost is 2%.
- Company tax rate is 40%.
Calculate project’s WACC.

Solution :
a- Cost of retained earnings (Ks):
• CAPM method:
Ks = Krf + (Km-Krf) bi = 10% + (14% -10%) 1.2
= 10 + 4(1.2) = 10 + 4.8 = 14.8%
• DCF method:
Ks = D1 + g = LE 3X 1.08 + 8% = 3.24 + 8%
Po LE 45 45
= 7.2% + 8% = 15.2 %
Ks average = 14.8% + 15.2% = 15%
2
b- Cost of new common stock (external equity) (Ke):
Ke = D1 + g = LE 3X 1.08 + 8% = 3.24 + 8% =
Po (1-F) LE 45 (1-2%) 45 X 98%
= 3.24 + 8% = 7.35 % + 8% = 15.35%
44.10

c- Determination of the cost of the new preferred stock (Kps)

Kps = Dps = 50 x 20% = 10 = 20.4%
Pn(1-F) 50 (98%) 49
d- Determination of the cost of the new debt Kd (1-T):
Kd (1-T) = 20% (1-40%) = 20% (60%) = 12.0%
 • The weighted average cost of the new project:
Weighted Ks = 15% X 20% = 3.00%
Weighted Ke = 15.35% X 40 = 6.14%
Weighted Kps = 20.4% X10% = 2.04%
Weighted Kd = 12.0% X 30% = 3.60%
Total weighted cost of new capital WAAC:

= 3.00+ 6.14 + 2.04 + 3.60 = 14.78%

 Lecture 6

Exam-type Case Estimating Cash Flows

• Fast Cure Drug Co. intends to build an extension to its factory on a piece of land owned
by the company.
• The company bought the land 5 years ago at a price of LE 500,000 plus a registration fee
of LE 200,000.
• If the project is not done, the company has an offer to sell the land for a price of
LE1,500,000.
• If the project is done the company will discontinue the use of outside production
facilities which cost the company LE 2,000,000 per year.
• Company pays LE 250,000 annual interest on current loans.
• Company WACC is 12% and hurdle rate is 16%.
• The following details are taken from the project feasibility study (all amounts in LE):

2006 2007 2008 2009

Initial Costs:
New building 14,000,000
New equipment 10,000,000
Increase in Working Capital 8,000,000
Continuing Costs:
Variable costs 22,000,000 25,000,000 27,000,000
Fixed costs 5,000,000 5,000,000 5,000,000
Depreciation 1,250,000 2,500,000 2,500,000
Revenues:
Sales 35,000,000 40,000,000 45,000,000
• The increase in working capital is recovered at 90% of its initial amount at the end of
year 2009.
• Capital assets salvage value is recovered at the end of 2009 in the amount of LE
10,607,000, which is higher than the book value by LE 1,000,000.
• Company tax rate 40%.
1. Calculate project’s estimated net cash flow for years 2006 through 2009.
 2. Using NPV for project evaluation, should the company approve the project or
reject it? Explain briefly why.
Calculation of tax saved on sale of land:
Cost ol land (Book Value) (500,000)
Registration fee (200,000)
Total cost of land (700,000)
Sales price 1,500,000
Profit on sale of land 800,000
Tax on profit @ 40% (*) 320,000
Calculation of tax on profit from sale of
assets (**):
Increase in assets salvage
value over book value 1,000,000
Tax on profit @ 40% 400,000

2- NPV Calculation:
Year zero net cash outflow (33,180.00)
Year 1 net cash inflow 5,603.40
Year 2 net cash inflow 6,093.90
Year 3 net cash inflow 17,558.50
NPV (3,924.20)
Project's NPV is negative, therefore, it should be rejected. However, if project has a
strategic value to Company, it could be done if costs are lowered and/or revenues
raised to increase net cash flow to a level that generates positive NPV.
 Lecture 8

Determining the Optimal Capital Structure

Company XYZ
A. Calculation of EBIT (LE)
Sales 200,000
Fixed costs 40,000
Variable costs 120,000
Total cost (except interest) 160,000
EBIT 40,000

B. Calculation of EPS at different levels of debt (LE)

At 0% debt: At 40% debt:
EBIT 40,000 EBIT 40,000
Less: Interest
Less: Interest 0 (10%X80,000) 8,000
EBT 40,000 EBT 32,000
Taxes (40%) 16,000 Taxes (40%) 12,800
Net Income (N.I.) 24,000 Net Income (N.I.) 19,200
EPS (=N.I. / 10,000 shares) 2.40 EPS (=N.I. / 6,000 shares) 3.20

At 20% debt: At 50% debt:

EBIT 40,000 EBIT 40,000
Less: Interest
Less: Interest (8.3%X40,000) 3,320 (12%X100,000) 12,000
EBT 36,680 EBT 28,000
Taxes (40%) 14,672 Taxes (40%) 11,200
Net Income (N.I.) 22,008 Net Income (N.I.) 16,800
EPS (=N.I. / 8,000 shares) 2.75 EPS (=N.I. / 5,000 shares) 3.36
B. Calculation of EPS at different levels of debt (Continued)
At 60% debt: At 70% debt:
EBIT 40,000 EBIT 40,000
Less: Interest
Less: Interest (15%X120,000) 18,000 (18.5%X140,000) 25,900
EBT 22,000 EBT 14,100
Taxes (40%) 8,800 Taxes (40%) 5,640
Net Income (N.I.) 13,200 Net Income (N.I.) 8,460
EPS (=N.I. / 4,000 shares) 3.30 EPS (=N.I. / 3,000 shares) 2.82

What the Optimal Capital Structure for this Company is?

Debt/ Expected Estimated Estimated Resulting

Assets Kd EPS(and Beta Ks Stock Price P/E Ratio WACC
DPS)
0% - $2.40 1.50 12.-% L.E 20.- 8.33 12.-%
10 8.0% 2.56 1.55 12.2 20.98 8.20 11.46
20 8.3 2.75 1.65 12.6 21.83 7.94 11.08
30 9.- 2.97 1.80 13.2 22.50 7.58 10.86
40 10.- 3.20 2.- 14.- 22.86 7.14 10.80
50 12.- 3.36 2.30 15.2 22.11 6.58 11.20
60 15.- 3.30 2.70 16.8 19.64 5.95 12.12
70 18.5 2.82 2.85 17.4 16.21 5.75 12.99
How Example is solved?

1. Debt/Asset ratios and Cost of Debt (Kd) are assumed as in the

example.

2. Expected EPS (and DPS since company pays out all earnings
without retention) is as calculated in the example.

3. The beta coefficient is as estimated by management.

4.Assuming that KRF = 6% and KM = 10%, the cost of equity (Ks) is
calculated for each level of debt financing as follows:

Ks = KRF + (KM – KRF)b

For example, at the level of 50% debt (and 50% equity), Ks is calculated
as follows:

KS = 6% + (10% - 6%) 2.3

= 6% + (4%) 2.3
= 6% + 9.2% = 15.2%5.Assuming zero growth rate in dividends and
in stock price, the Estimated Stock Price is calculated for each level of
debt financing as follows:
Po = DPS
Ks
Therefore, at the level of 50% debt, Po is calculated as follows:
Po = 3.36 = L.E. 22.11
15.2%

5.The Weighted Average Cost of Capital (WACC) is as calculated for

each level of debt as follows:

WACC = WdKd(1-T) + WceKs

WACC = weight of debt X cost of debt (1 – tax rate)

 +
weight of common equity X cost of equity

Therefore, at the level of 50% debt, WACC is calculated as follows:

WACC = WdKd(1-T) + WceKs

WACC = 0.5 X12% (1-40%) + 0.5 X15.2%
= 6% X60% + 7.6%
= 3.6% + 7.6% = 11.2%