Financial management

By Prof. Augustin Amaladas M. Com., AICWA., PGDFM., B.Ed.

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Welcome To SCDL Financial Management
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1.FINANCIAL FUNCTION *2.FORMS OF BUSS.ORG.

*10.CAPITAL mARKET *11.CAPITAL BUDGETING *12.WORKING CAPITAL MANAGEMENT *13.CASH MANAGEMENT *14.RECEIVABLE MANAGEMENT *15.INVENTORY MANAGEMENT

*3.FINANCIAL STATEMENTS *4.RATIOS 5.FUND FLOW STATEMENT *5.CASH FLOW STATEMENTS *6.CAPITALISATION

*7.SOURCES OF LONG TERM AND MEDIUM TERM *8.CAPITAL STRUCTURE
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*16.DIVIDEND POLICY
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Welcome by SCDL to AZtecsoft

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MANAGEMENT PROCESSES, DEFICIENCY FINDING MANAGEMENT AUDIT MANAGEMENT PLANNING MANAGEMENT SERVICES PLANNING AND CONTROL SYSTEMS MANAGEMENT ACCOUNTING TAX PLANNING, TAX ADVICING TAX ACCOUNTING GOVERNMENT ACCOUNTING COST STANDARD, COST REVENUE ANALYSIS, COST ANALYSIS, COST AND PRODUCTION STATISTICS COST ACCOUNTING PRINCIPLES OF FINANCIAL REPORTING, AUDITING STANDARDS, UNIFORM STATEMENTS,AUDITING OF RECORDS AND STATEMENTS FINANCIAL AUDITING COMPUTERS, PUNCHED CARD RECORDS,TAX RECORDS, INCOME STATEMENT ANALYSIS, BALANCE SHEET EMPHASIS BOOK KEEPING(SINGLE ENTRY AND DOUBLE ENTRY ) 1775 1800 1825 1850 1875 1900 1925 1950 1975
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1985

1990

1995

2005

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• GROWTH OF ACCOUNTABILITY KNOWLEDGE:FINANCIAL ACCOUNTING ACTIVITY Cost accounting, BASED ACCOUNTING, Management Accounting LIFE CYCLE Tax accounting and COSTING, Management

COST MANAGEMENT:

VALUE CHAIN ANALYSIS, TARGET COSTING, KAIZEN COSTING

RESPONSIBILITY ACCOUNTING ,CURRENT COST ACCOUNTING, INFLATIONARY ACCOUNTING EDP ENVIRONMENTAL AUDIT HUMAN BEHAVIOUT, MANPOWER VALUES, INTER GOVERNMENTAL RELATIONS SOCIAL ACCOUNTING TOTALSYSTEMS PLANNING, INTER DECIPLINARY APPLICATIONS TOTAL SYSTEM RECVIEW EFFECTIVENESS AUDITING EFFECTIVENESS EVALUATIOn COMPUTERS CYBERNETICS INFORMATION SYSTEMS ORGANISATIONAL MODEL,

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ORGANISATIONAL PLANNING,

information

information

FLOW OF CASH/SHORT TERM AND LONG TERM
Information Debtors Work in progress information Accounts payable

Accounts receivable Labour Bad debts Overheads

RAW mATERIAL

Reserves Rights issue
CASH

Public deposits
GDR

Equity Preference Bonds(281) Leasing/Hr.Pur sharese-mail: aug_bang@yahoo.com www.augustin.co.nr Shares

ADR

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FLOW OF CASH - LONG TERM
Know how Patent rights goodwill Copy right

building

investments

land

CASH Short term Preference Equity Shares Long term loans shares aug_bang@yahoo.com www.augustin.co.nr e-mail: ADR

furniture

GDR

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information

information

FLOW OF CASH-SHORT TERM
Information Debtors Work in progress information Accounts receivable Labour Overheads Accounts payable

Bad debts Bad debts Bad debts

RAW mATERIAL cash cash

Commer Sale of fixed assets

Cial papers
creditors Bank overdraft Cash credit e-mail: aug_bang@yahoo.com www.augustin.co.nr

Issue of long term fund

Sale of investments Discounting bills 9

Working capital finance(361)
1.Spontaneous Trade credit loan Outstanding Expenses Letter of credit Inter corpo Rate deposits Commercial papers
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2.Bank guarantee

3.Fund based

4.Security

pledge overdraft Hypothecation Cash credit lien Bills discounts Packing credit mortgage
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Users of information and goals
liquidity banks Dividend/value in the share market shareholders Good name Benefactors Less pollution public tax government

Debenture holders Interest/return of capital

organisation

Loan vendor Interest/return of capital customers Preference shareholders dividend Good product creditors Timely payment debtors Timely supply
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Page-3
T h e P o s it io n o f C a p it a l B u d g e t in g F in a n c ia l G o a l o f t h e F ir m : W e a lt h M a x im is a t io n
I n v e s t m e n t D e c is o n
L o n g T e rm A s s e ts S h o r t T e r m A s s e ts

F in a n c in g D e c is io n
D e b t / E q u it y M ix

D iv id e n d D e c is io n
D iv id e n d P a y o u t R a t io

C a p ita l B u d g e tin g
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Scope of Financial Management

Financial Analysis Profit planning Financial Forecasting Financial Control Management of Current Assets Cash Marketable Securities Receivables Capital Budgeting Inventory Management

Financing Source identification Determine Financing mix Method of Raising funds

Dividend policy

Management of Mergers, reorganisation Identification Selection
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Implementation

Role of Finance in a Typical Business Organization-page- 9
Board of Directors President VP: Sales VP: Finance Treasurer Credit Manager Inventory Manager Capital Budgeting Director
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VP: Operations

Controller Cost Accounting Financial Accounting Tax Department
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Unit-2 Forms of Business organisation
q q q

Sole trading Partnership Companies

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My business!! My family?
What will happen if this deal does not materialise?

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Partnership
Should we build this plant?
h

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Ulta pultaCompany Ltd.???

Mini computer

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Nature of Financial Statements-Page-30

Financial accounting
2. Basic Accounting
4. BRS

Final accounts 3. Process of accounting 5. Rectification of Errors

1. Introduction
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Unit-3 Financial statements

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Chapter-2: Basics of financial accounting
q q q q q q q

1.Concepts 2.system of accounting 3.Types of Expenditure 4.Terms used in financial accounts 5.Double entry / Single entry 6. Depreciation methods 7. Practical consideration relating to depreciation
21

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1.concepts& conventions
q

Meaning: Basic assumptions upon which the basic process of accounting based.
a] Business entity conceptb] Dual aspect concept c] Going concern concept d] Accounting period concept e] Cost concept f] Money measurement concept g] Matching Concept

q q q q q q q

• Conventions
Coservativism Materiality Consistency

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a] Business entity conceptq q

q

q

Business is different from the owner We pass Journal entry when owner contributes towards capital. When amount / goods withdrawn for personal use we make an entry in the business When Income tax paid by the owner out of business money we make an entry In the books of accounts.

q

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b] Dual aspect concept Every debit has equal amount of credit Asset =Liability Liability creates asset If asset>Liability= profit If Liability> Assets= loss

q q q q q

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c] Going concern concept
q

q

q

Business will go for at least for a reasonable period. Depreciation is provided based on this assumption. If this assumption is not made all Fixed assets will be valued at realised value like current assets.

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d] Accounting period concept
q q q

q

q

q q

Fixing time limit for accounts Profit for the period It can be one week or two weekor 6 months/one year or 5 years But to find profit we normally consider 12 months period Financial year for income tax point of view 1st April-31st March of the following year Calendar year –January to December Divali to Divali
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e] Cost concept q The cost to the organisation (Actual) is recorded in the books q Assets are not recorded according to the market price every year. q Depreciation is calculated on cost not based on market price q Accounting records may not show the real worth of the business q Market price may be disclosed with in bracket in the balance sheet
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Exercise
q

q q q q q q q

Accounting Test Question SV No.1: Company XYZ uses a perpetual inventory system. Append below the following transaction relating to its merchandise inventory during the month of Nov’06 Date:Transaction Nov 1 inventory on hand - 3,000 units @ $8 each Nov 7Bought 5,000 units for $8.40 each Nov 13Sold 4,000 units for $14.00 each Nov 17Bought 6,000 units for $8.20 each Nov 24Sold 7,000 units for $14.00 each Nov 30Inventory on hand -3000 units
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q

q q q

Required: Compute the inventory balance Company XYZ would report on its November 30 2006 balance sheet and the cost of goods sold for the period of November 2006 income statement using each of the following inventory methodology: (1) First-in, first-out (FIFO) 2) Last-in, first-out (LIFO) (3) Average cost[ Refer Answer ]
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f] Money measurement concept
q

q

q q

Every thing which can be expressed in terms of Money is recorded in the books Beautiful women are working /Handsome boys working in AZTEC /Efficient engineers worth Rs.5000 crores –How do you record?. Good working environment? Highly motivated employees?

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g] Matching Concept
q q q

Matching Cost with revenue It is used to estimate correct profits Accrual/ cash basis of accounting
– Even cash paid /received if it belongs to accounting period we consider them as expenditure /income – Salary outstanding for the last month? – Income from Investments yet to be received? – Rent received in advance for next year?

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Conventions
q

q q q

Customs and traditions that are followed by the accountants while preparing the financial statements. Why do we respect elders? Why do we shake hands? Why do Young Indians hate receiving dowry?
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Coservativism
q q q

q

q

To be on the safer side Expect future losses as current year loss not future income is treated as current year income. Stock is valued cost price / market price which ever is lower Making provision for bad debts is based on this assumptions.
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Materiality
q

q

q q

Material impact on profitability are considered Insignificant transactions ignored from recording Pen purchased, pencil purchased? Wine purchased regularly?

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Consistency
q

q

q

q

Accounting policies and procedures should be followed consistently Method of depreciation should be followed consistently. Stock valuation- cost/market price whichever is lower is consistently followed If not followed it amount to change in the policy of the company
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2.system of accounting (26)

1.Cash system: q unless cash received /paid in the accounting year can not be considered as income/expenses respectively
q
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2.Mercantile
q q

q q

Mercantile/Accrual/due concept: Even cash received/paid but due for payment/due for receipt (yet to be received/payable) if they belong to current accounting year are considered. If last year expenditure paid this year? If you receive/paid in advance ?

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Mercantile love!!!!???
q

Last year I loved her? Next year I shall love him depends on type of bike model!!!!
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Life Education
q

q

If I do not get married to him I will not be happy- Girl said If I do not get married to her I will not be happy- Boy said
If both get married what will happen!!!!

q

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Structure of Financial Statement-(Chapter-3)page-34
q
40

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6.sales

3.General administration 4.Sales and distribution 5.profit Total cost + Factory cost/ works + cost Cost of sales + =

1.canteen

2
1.Factory administration +

Facility department

Stores ledger

1.Production Prime Cost

1.Godown Bin card

Danger
Cost calculations/operating activity
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Financial Statements
Balance Sheet q Income Statement q Cashflow Statement q Statement of Retained Earnings
q

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Review: Major Balance Sheet Items
q

Assets Current assets:
– Cash & securities – Receivables – Inventories

Liabilities and Equity q Current liabilities:
– Payables – Short-term debt
q

q

Fixed assets:
– Tangible assets – Intangible assets
q

Long-term liabilities Shareholders' equity
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An Example: Dell Abbreviated Balance Sheet-34
q

Assets:
– Current Assets: – Non-Current Assets: – Total Assets: $7,681.00 $3,790.00 $11,471.00 $5,192.00 $971.00 $5,308.00 $11,471.00

q

Liabilities:

– Current Liabilities: – LT Debt & Other LT Liab.: – Equity: – Total Liab. and Equity: e-mail: aug_bang@yahoo.com www.augustin.co.nr

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An Example: Dell Abbreviated Income Statement-page-47
Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT)
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$25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00
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Financial Statement Analysis
q

q

External users rely on publicly-available information to perform financial analysis Such information is contained in corporate annual report

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Life education
q

Lady in a seashore

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Chapter Learning Objectives
1. Use the statement of cash flows in decision making 2. Compute the standard financial ratios used for decision making 3. Use ratios in decision making 4. Measure economic value added by a company’s operations
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What do you learn??
q q

q

q q q

q

Here's how you'll benefit from this course: Understand the contents of the balance sheet, cashflow, and income statements Contribute to better costing and working capital management Review production capacity and investment proposals Evaluate long, medium and short term financing Review financial statements and analyse them using ratios to determine your business strengths and weaknesses Apply techniques to make decisions that create genuine value
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Annual Report Contents FOUR BASIC FINANCIAL STATEMENTS

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS 1

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS 1 2

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS 1 2 3

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS 1 2 3 4

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS AUDITOR’S REPORT
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1 2 3 4 5

Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS AUDITOR’S REPORT COMPARATIVE FINANCIAL DATA e-mail: aug_bang@yahoo.com www.augustin.co.nr FOR A SERIES OF YEARS 1 2 3 4 5 6
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Financial Statement Analysis
q

Pick the one annual report component which provides investors and creditors with the most descriptive information about the corporation’s activities and financial condition

Before you jump to a decision, consider the following: 1. Financial statements provide data about what happened during the accounting period
q
57

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Financial Statement Analysis
2. Investors and creditors use information contained in the annual report to: q Forecast future income and cash flows q Assess risk of investing in or lending to the corporation
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Financial Statement Analysis

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS

4

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Financial Statement Analysispage-51

Management’s discussion and analysis (MD&A) includes: q Evaluation of current business operations q Assessment of future operations
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Tools to Evaluate Financial Information

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Tools to Evaluate Financial Information
Horizontal Analysis
1

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Tools to Evaluate Financial Information
Horizontal Analysis
1 2

Vertical Analysis

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Tools to Evaluate Financial Information
Horizontal Analysis
1 2 3

Vertical Analysis Ratio Analysis
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Perform a horizontal analysis of comparative financial statements

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Tools to Evaluate Financial Information

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Tools to Evaluate Financial Information
Horizontal Analysis
1

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Horizontal Analysis
q

q

q

Examines percentage change in each item on the financial statements Compares current year’s dollar amount with prior year’s dollar amount Expresses the change in
– Dollars – Percentage
68

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Horizontal Analysis
First, calculate dollar change from base year (prior year) to current year

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Horizontal Analysis
First, calculate Rupee/dollar change from base year (prior year) to current year Second, divide Rupee/ dollar change by base-year dollar amount
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Horizontal Analysis

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

%
Receivables (net)

1996
$325,384

1995
$272,225

Dollars

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

%
Receivables (net)

2007
$325,384

2006

Dollars

$272,225

Difference
74

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Horizontal Analysis
Amounts in thousands

DOLLAR AMOUNT INCREASE (DECREASE)

Dollars

Receivables (net) $53,159

%

1996
$325,384

1995
$272,225

Difference

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

2007

2006

Dollars
$53,159 41,918

%
19.5% 15.3

Receivables (net) $325,384 $272,225 Leasehold Improv. 314,933 273,015 Notes Receivable 54,715 32,528

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Trend Percentages
q

q

Specialized form of horizontal analysis Shows trend of financial statement items over longer time periods such as 5 or 10 years

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Trend Percentages
q

q

Base year (earliest year in the time series) set at 100% All other years expressed as percentage of base year

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Trend Percentages
q

q

Income statement amounts for Ray’s Seafood Shack are presented in the next slide Compute the trend percentages for these items
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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 $502 2005 $474 2004 2003 $451 $346

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 2005 2004 2003 $502 $474 $451 $346

Divide x 100 Net Sales 100% 206% 160% 145% 137% 130%

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 2005 $502 $474 2004 2003 $451 $346

Divide x 100 Net Sales 100% 206% 160% 145% 137% 130%

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 $502 2005 $474 2004 $451 2003 $346

Divide x 100 Net Sales 100% 206% 160% 145% 137% 130%

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 $502 2005 $474 2004 $451 2003 $346

Divide x 100 Net Sales 100% 206% 160% 145% 137% 130%

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales 2008 $714 2007 $553 2006 $502 2005 $474 2004 $451 2003 $346

Divide x 100 Net Sales 100% 206% 160% 145% 137% 130%

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales Cost of Sales 2008 $714 373 2007 $553 265 2006 $502 201 2005 $474 259 2004 $451 280 2003 $346 193

Net Sales 100% Cost of Sales

206% 193

160% 137

145% 104

137% 134

130% 145 100

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TrendTHOUSANDS ) Percentages (AMOUNTS IN
Net Sales Cost of Sales Gross Profit 2008 $714 373 341 2007 $553 265 288 2006 $502 201 301 2005 $474 259 215 2004 $451 280 171 2003 $346 193 153

Net Sales 100% Cost of Sales Gross Profit

206% 193 223

160% 137 188

145% 104 197

137% 134 140

130% 145 112 100 100
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Horizontal Analysis and Trend Percentages: A Summary

Tools used to compare financial results of companies of different sizes and/or in different industries

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Vertical Analysis

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Vertical Analysis

2

Vertical Analysis

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Vertical Analysis
q q

q

Compares each item on the financial statement to a key, or base, item Base-item dollar amount always set to 100% Income statement
– Net sales = 100%

q

Balance sheet
– Total assets = 100%
91

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Vertical Analysis
% Net sales Cost of Goods Sold Gross Profit Selling, General & Admin. Income from Operations Income Taxes Net Income 2007 AMOUNT % 2006 AMOUNT $362,386 100% 284,897 79 77,489 21 65,096 18 12,393 3 4,350 2 $8,043 2%
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$430,013 100% 336,589 78 93,424 22 72,363 17 21,061 5 7,072 2 $13,989 3%

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Vertical Analysis
q

q

Once financial statement items are converted into percentages of the base item, users can compare one company’s financials against another’s These are called common-size statements

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Prepare common-size financial statements for benchmarking against the industry average and key competitors
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Common-Size Statements
q

Show all items as percentages of the key, or base, amount
– Use no dollar amounts

q

q

Facilitate financial statement comparison among different sized companies Improve user’s ability to assess company performance against industry averages
95

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Common-Size Statements
q

Can also be used to evaluate company performance over time

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Benchmarking Against the Industry Average

Benchmarking is a term used to describe the process of comparing a company’s activities to a standard of excellence achieved by industry leaders
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Benchmarking Against Key Competitors
q

q q

A company also can compare its common-size financials to those of its industry’s leaders Determine where it differs Design and implement business processes to bring financial results in line with these benchmark entities
98

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Benchmarking Against Key Competitors

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Life education
•Chineese tree

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Interpretation of Financial Statements-Ratio Analysis-Unit-4

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Interpretation of Financial Statement Analysis( Ratio Analysis)-page 55- Unit-4

By Prof. Augustin Amaladas

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PROCTER & GAMBLE and BRISTOLMYERS SQUIBB
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A leading company in the health-care and consumer products industry Sales revenues of $14billion Assets of $13-billion

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PROCTER & GAMBLE and BRISTOL-MYERS SQUIBB
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How would you compare Bristol-Myers Squibb’s performance against other industry competitors? Companies differ in size, so you can’t compare absolute dollar amounts Need to use ratios - tools to translate financial data into percentages - which can be compared across companies
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PROCTER & GAMBLE and BRISTOL-MYERS SQUIBB
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 Assets 28.0

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 Assets 28.0 BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income 1.8 Assets 13.0

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 Assets 28.0
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BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income 1.8 Assets 13.0

Which company was better in generating e-mail: aug_bang@yahoo.com www.augustin.co.nr

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 Assets 28.0
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BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income 1.8 Assets 13.0
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Which company was better in generating e-mail: aug_bang@yahoo.com www.augustin.co.nr

You can use the return on sales ratio to

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 $2.6 $33.4 = 7.78%
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PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 $2.6 $33.4 = 7.78% BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income 1.8

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Opening Vignette -Bristol-Myers Squibb
BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income $1.8 $13.7 = 13.13% 1.8

PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6 $2.6 $33.4 = 7.78%

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Opening Vignette Bristol-Myers Squibb
PROCTER & GAMBLE Sales revenues $33.4 BRISTOL-MYERS SQUIBB Sales revenues $13.7

Although P&G’s sales were higher

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PROCTER & GAMBLE Sales revenues $33.4 Net income 2.6

BRISTOL-MYERS SQUIBB Sales revenues $13.7 Net income 1.8 $1.8 $13.7 = 13.13%
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$2.6 Bristol-Myers’ return on sales was $33.4 nearly twice that of P&G = 7.78%
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Financial Statement Analysis
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External users rely on publicly-available information to perform financial analysis Such information is contained in corporate annual report

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Financial Statement Analysis: Lecture Outline
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Review of Financial Statements Ratios
– Types of Ratios – Examples

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The DuPont Method Ratios and Growth Summary
– Strengths – Weaknesses – Ratios and Forecasting

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Financial Analysis
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Assessment of the firm’s past, present and future financial conditions Done to find firm’s financial strengths and weaknesses Primary Tools:
– Financial Statements – Comparison of financial ratios to past, industry, sector and all firms

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The Main Idea
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Value for the firm comes from cashflows Cashflows can be calculated as:
• (Revt - Costt - Dept)x(1-τ) + Dept —OR— • (Revt - Costt)x(1-τ) + τxDept —OR— • Revtx(1-τ) - Costtx(1-τ) + τxDept

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Review: Major Balance Sheet Items
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Assets Current assets:
– Cash & securities – Receivables – Inventories

Liabilities and Equity q Current liabilities:
– Payables – Short-term debt
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Fixed assets:
– Tangible assets – Intangible assets
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Long-term liabilities Shareholders' equity
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An Example: Dell Abbreviated Balance Sheet
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Assets:
– Current Assets: – Non-Current Assets: – Total Assets: $7,681.00 $3,790.00 $11,471.00 $5,192.00 $971.00 $5,308.00 $11,471.00

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Liabilities:

– Current Liabilities: – LT Debt & Other LT Liab.: – Equity: – Total Liab. and Equity: e-mail: aug_bang@yahoo.com www.augustin.co.nr

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Absorption Costing vs. Variable Costing Income Statements
Absorption Costing Sales Cost of sales Gross profit Operating expenses: Variable Fixed Total operating expenses Income $6,000 20,000 $26,000 $4,000 $60,000 30,000 $30,000 Variable Costing: Sales Variable costs: Cost of sales Operating expenses Total variable costs Contribution margin: Fixed costs Income 30,000 6,000 $36,000 $24,000 20,000 $4,000
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$60,000

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Absorption Costing Income Statement
Sales Cost of Goods Sold: Beginning inventory Cost of goods manufactured Cost of goods available Ending inventory Cost of goods sold Gross Margin Operating Expenses: Selling Administrative Income before Taxes XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

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ABSORPTION COSTING PROFORMA
££Sales Revenue Less Absorption Cost of Sales Opening Stock (Valued @ absorption cost) Add Production Cost (Valued @ absorption cost) Total Production Cost Less Closing Stock (Valued @ absorption cost) Absorption Cost of Production Add Selling, Admin & Distribution Cost Absorption Cost of Sales Un-Adjusted Profit Fixed Production O/H absorbed Fixed Production O/H incurred (Under)/Over Absorption Adjusted Profit
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xxxxx xxxx xxxx xxxx (xxx) xxxx xxxx (xxxx) xxxxx xxxx (xxxx) xxxxx xxxxx
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Variable Costing Income Statement
Sales Cost of Goods Sold: Beginning inventory Cost of goods manufactured Cost of goods available Ending inventory Variable cost of goods sold Product Contribution Margin Variable Selling Expense Total Contribution Margin Fixed Expenses: Factory Selling Administrative Income before Taxes
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XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

XXX XXX
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Marginal costing cost sheet
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££Sales Revenue Less Marginal Cost of Sales Opening Stock (Valued @ marginal cost) Add Production Cost (Valued @ marginal cost) Total Production Cost Less Closing Stock (Valued @ marginal cost) Marginal Cost of Production Add Selling, Admin & Distribution Cost Marginal Cost of Sales Contribution Less Fixed Cost Marginal Costing Profit

xxxxx

q q q q q q

xxxx xxxx xxxx xxx) xxxx xxx (xxxx) xxxxx (xxxx) xxxxx
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q q

q q q

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An Example: Dell Abbreviated Income Statement
Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT)
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$25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00
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Objectives of Ratio Analysis
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Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations

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Rationale Behind Ratio Analysis
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A firm has resources It converts resources into profits through
– production of goods and services – sales of goods and services

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Ratios
– Measure relationships between resources and financial flows – Show ways in which firm’s situation deviates from
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Its own past Other firms The industry All firms128

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Benchmarking Against Key Competitors
financials can be used in benchmarking

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Using Ratios to Make Business Decisions

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Using Ratios to Make Business Decisions

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Ratio Analysis
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Types of Ratios-59
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Financial Ratios:
– Liquidity Ratios
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Assess ability to cover current obligations Assess ability to cover long term debt obligations

– Leverage Ratios
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Operational Ratios:
– Activity (Turnover) Ratios
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Assess amount of activity relative to amount of resources used Assess profits relative to amount of resources used Assess market price relative to assets or earnings
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– Profitability Ratios
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Valuation Ratios:
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Using Ratios to Make Business Decisions
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Ratios - the relationship between two items on financial statements - permit users to calculate a variety of financial comparisons These ratios can be compared to: Prior years’ financial results Industry averages Benchmark entities’ ratios
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Using Ratios to Make Business Decisions
Ratios measure an entity’s ability to: q Pay current liabilities q Sell inventory and collect receivables q Pay long-term debt q Generate profits from operations q Sustain shareholder wealth

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Measuring the Company’s Ability to Pay Current Liabilities-Page-59
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One measure of entity’s ability to pay its current obligations is to look at working capital Current assets - current liabilities 2 ratios help users assess working capital information

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Measuring the Company’s Ability to Pay Current Liabilities
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One measure of entity’s ability to pay its current obligations is to look at working capital Current assets - current liabilities 2 ratios help users assess working capital information
– Current ratio

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Measuring the Company’s Ability to Pay Current Liabilities
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One measure of entity’s ability to pay its current obligations is to look at working capital Current assets - current liabilities 2 ratios help users assess working capital information
– Current ratio – Quick (acid-test) ratio

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Using Ratios to Make Business Decisions

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Ability to Pay Current Liabilities
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Current ratio

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Ability to Pay Current Liabilities
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Current ratio Current assets Current liabilities

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Ability to Pay Current Liabilities-page-59
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Current ratio Current assets Current liabilities $7,681.00 $5,192.00
= 1.48

Assets: Current Assets: $7,681.00 Non-Current Assets: $3,790.00 Total Assets: $11,471.00 Liabilities: Current Liabilities: $5,192.00 LT Debt & Other LT Liab.: $971.00 Equity: $5,308.00 Total Liab. and Equity: $11,471.00

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Ability to Pay Current Liabilities-page-60
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Quick ratio

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Ability to Pay Current Liabilities
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Quick ratio Current assets - inventory - prepaid items Current liabilities

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Ability to Pay Current Liabilities
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Liquid ratio Current assets - inventory - prepaid items Current liabilities
$25,240 $114,744 = .22

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Measuring the Company’s Ability to Sell Inventory and Collect Receivables
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Entity’s operating cycle
– Time to go from cash to inventory to receivables to cash

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is critical to generating cash inflows from operating activities 3 ratios help users assess management’s skill in selling inventory and collecting receivables
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Sell Inventory and Collect Receivables-page-63

Inventory turnover

1

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Measuring the Company’s Ability to Sell Inventory and Collect Receivables

Inventory turnover

A/R turnover

1 2
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Sell Inventory and Collect Receivables
Inventory turnover A/R turnover Days’ sales in receivables

1 2 3
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Inventory Turnover-page-63
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2008

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Number of times the average level of inventory is sold during the accounting year Measures time required to earn return on company’s investment in inventory
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Inventory Turnover
Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT) Average inventory Average debtors $25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00 $ 4000 $5000

Cost of goods sold Average inventory =$19,891/$4000 =4.972 times

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High ratio indicates ability to quickly sell inventory Too high a ratio may indicate inadequate inventory levels Turnover ratio should be compared to historical and industry averages Analyze significant variances
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Inventory Turnover

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Accounts Receivable Turnover-page-65
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Number of times the average level of A/R is collected during the accounting year Measures ability to collect cash from credit customers

$

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Accounts Receivable Turnover
Net credit sales Average net A/R

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Accounts Receivable Turnover
Net credit sales* Average net A/R
$25,265.00 5000 = 5.053 times

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Days’ Sales in Receivables
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$
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Number of equivalent days’ sales revenue represented by the outstanding A/R balance Measures A/R balance in terms of number of days it would take to generate the equivalent dollar amount of sales

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Days’ Sales in Receivables
Average net A/R (Net sales / 365 days)
$5000 ($25265 / 365 days) = 72.23 days

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Measuring the Company’s Ability to Pay Long-Term Debt-67
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Bondholders and long-term lenders are concerned about an entity’s ability to repay debt principal and accumulated interest on long-term notes and loans 2 ratios help these users assess the entity’s ability to pay its long-term obligations Debt ratio Times-interest-earned ratio
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Debt Ratio-page-67
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Relationship between company’s total liabilities and total assets Measures proportion of total assets provided through debt 1 - debt ratio = proportion of assets provided by equity
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Debt Ratio-page 67
Total Liabilities Total Equity

Assets: Current Assets: $7,681.00 Non-Current Assets: $3,790.00 Total Assets: $11,471.00 Liabilities: Current Liabilities: $5,192.00 LT Debt & Other LT Liab.: $971.00 Equity: $5,308.00 Total Liab. and Equity: $11,471.00

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Debt Ratio
Total Liabilities Total Assets
$971.00 $5,308.00 =.1829

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Debt Ratio
Total Liabilities Total Assets 2,00000 $323,497 = .38

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Debt Ratio
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If debt ratio = 1.0, company used all debt to finance acquisition of its assets
– A highly unlikely situation

LOANS, NOTES, BONDS, ETC.

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Thus, debt ratio is generally less than 1.0
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Debt Ratio
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The higher the ratio, the more cash the company must commit toward paying annual interest expense and loan principal As a result, company’s cash flow might be negatively affected
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Debt Ratio
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Lenders and creditors might require company to appropriate portion of retained earnings to ensure sufficient assets to repay interest and loan principal
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Times-Interest-Earned Ratiopage-70
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Relationship between company’s net income from operations and interest expense Measures ability of company to cover, or pay for, its interest expense out of operating income
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Times-Interest-Earned Ratio
Income from operations Interest expense

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Times-Interest-Earned Ratio
$25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00 $ 4000 $5000

es sts of Goods Sold oss Profit sh operating expense ITDA preciation & Amortization her Income (Net) T rest T ome Taxes ecial Income/Charges Income (EAT) verage inventory verage debtors

Income from operations Interest expense 2,613.00
0 = &
167

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Times-Interest-Earned Ratio
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high ratio indicates ease in meeting debt interest payments

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Times-Interest-Earned Ratio

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A low ratio would signal possible difficulties in making payments to lenders and bondholders
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Measuring a Company’s Profitability
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Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices
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Measuring a Company’s Profitability
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4 profitability ratios are commonly used in financial statement analysis

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Measuring a Company’s Profitability
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4 profitability ratios are commonly used in financial statement analysis Return on sales

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Measuring a Company’s Profitability
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4 profitability ratios are commonly used in financial statement analysis Return on sales Return on assets

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Measuring a Company’s Profitability
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4 profitability ratios are commonly used in financial statement analysis Return on sales Return on assets Return on equity

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Measuring a Company’s Profitability-page-74
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4 profitability ratios are commonly used in financial statement analysis Return on sales Return on assets Return on equity Earnings per share

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Return on Sales
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Relationship between a company’s net income and net sales Measures management’s ability to efficiently and effectively manage company operations Shows percentage of each net sales dollar earned as net income
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Return on Sales-Net profit ratio73
Net income Net sales revenue

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Return on Sales
Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT) $1,666.00 Average inventory Average debtors $25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00 $ 4000 $5000 178

Net income Net sales revenue
$1,666.00 $25,265.00 =0 .065

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Return on Sales
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Net Income

Higher rate tells users that more net sales dollars add to a company’s profits
– And fewer dollars go to cover company expenses

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Company conducts its business effectively, manages expenses
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Return on Assets-74
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Ratio of the return to the two groups that provide financing to the company
– Creditors and investors

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and average assets owned during the period Measures company’s success in generating income from its available resources

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Return on Assets
Net income + interest expense Average total assets

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Return on Assets
Sales Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 Average inventory $ 4000 Average debtors $5000 Average total assets $9000 e-mail: aug_bang@yahoo.com www.augustin.co.nr

Net income + interest expense Average total assets $25,265.00 $1,666.00 + 0 9000

= .185
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Return on Assets
Why do we add back interest expense to net income?

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Return on Assets
Total assets are financed by 2 sources:
– Investors (equity) – Creditors (debt)

Net income is the return attributable to investors in the company’s stock q Interest expense is the return paid to creditors for using their funds to e-mail: aug_bang@yahoo.com www.augustin.co.nr acquire assets
q

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Return on Equity-75
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Relationship between net income available to common stockholders and the equity they provide Measures company’s success in using stockholders’ investments to generate net income

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Return on Equity
Net income - preferred dividends Common contributed capital + retained earnings

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Return on Equity
Net income - preferred dividends Common contributed capital + retained earnings $30,555* ($286,676 + $255,773) / 2 = .1126
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Earnings Per Share-77
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Relationship between net income available to common stockholders and the number of shares of common stock issued Expresses net income in terms of one share of the company’s common stock
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Earnings Per Share
Net income - preferred dividends # of shares of common stock outstanding

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Earnings Per Share
Net income - preferred dividends # of shares of common stock outstanding $30,555,000* 40,221,000 shares = $.76
190

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Earnings Per Share
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Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory

q

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q q
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In addition to net income, EPS is presented for several other elements on the corporate income statement Discontinued operations Extraordinary items Cumulative effect of accounting change

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Analyzing the Company’s Stock as an Investment

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Analyzing the Company’s Stock as an Investment
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Investors expect to receive 2 types of returns on their investments in a corporation’s common stock Gains earned when they sell the corporation’s stock Periodic dividends paid by the corporation to its stockholders
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Analyzing the Company’s Stock as an Investment
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Financial analysts use several ratios to assess value of stock investments Price/earnings ratio Dividend yield Book value
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Price/Earnings Ratio-77
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Relationship between a stock’s market price and its earnings per share Measures the number of times one share of stock sells above the current period’s reported earnings Assists financial analysts in deciding if a stock is overpriced or underpriced

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Price/Earnings Ratio
Calculating the P/E ratio

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Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share

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Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
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Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year

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Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
q q

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year The income statement reports EPS of $.92

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199

Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
q q

q

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year The income statement reports EPS of $.92 What is Asian Art’s price/earnings ratio?
200

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Price/Earnings Ratio
Market value of stock Earnings per share

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201

Price/Earnings Ratio
Market value of stock Earnings per share $15.75 $.92 = 17.12
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P/E ratio
q

q

q

If a stock has low P/E ratio say 3/1 it may be considered as an undervalued stock. If the ratio is 80/1 it may be viewed as overvalued. This ratio is more popular in the secondary market.

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203

Dividend Yield
q q

q

Ratio of dividends per share of stock to the stock’s market value Indicates the percentage of a stock’s market value “returned” to the stockholder in the form of dividends Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock
204

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Dividend Yield
Annual dividends per share Stock’s market value per share
q

If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?

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205

Dividend Yield-78
Annual dividends per share Stock’s market value per share

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206

Dividend Yield
Annual dividends per share Stock’s market value per share $1.25 $15.75 = .079
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Book Value
q

q

Relationship between common stockholders’ equity and number of common shares outstanding Measures the accounting value of one share of the corporation’s common stock

DEBIT CREDIT

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Book Value
Total equity - preferred equity # of shares of common stock outstanding The book value of one share of Lands’ End common stock is: $201,192,000 4,02,21,000 shares = $5.00/share
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Review: Major Income Statement Items
q q

q q q q

Gross Profit = Sales - Costs of Goods Sold EBITDA = Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares
210

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Life education

Thomas Cooper – Dictionary

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211

Accounting Test Question No IFS 4:
q q q

q q q q

q q q q

Effect of Management Decisions On Ratios Require: Put by letter whether each of the actions listed below will immediately -increase (I), -decrease (D) or -have no effect (N) on the ratios shown. Current ratio Acid-test ratio Debt to Equity ratio 1.Company issued ordinary shares for cash 2.Bought raw material on account 3.Received money from accounts receivable 4.Expiration of prepaid rent
212

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q q

q

q q

q

5.Payment of cash dividend 6.Purchase long term investment with cash 7.Sale of fixed assets for cash with no gain or loss 8.Stock write off 9.Refinance on a long term basis currently matured debt 10.Bought fixed asset with a 6 month note
213

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Answer to Accounting Test Question IFS No 4:
q

q

q q

q

Current ratio Acid-test ratio Debt to equity ratio 1.Company issued ordinary shares for cash I I D 2.Bought raw material on accountI D I 3.Received money from accounts receivable N N N 4.Expiration of prepaid rent D N I
214

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q q

5.Payment of cash dividendDDI 6.Purchase long term investment with cash
– D D N

q

q q

q

7.Sale of fixed assets for cash with no gain or loss I I N 8.Stock write off D N I 9.Refinance on a long term basis currently matured debt I I N 10.Bought fixed asset with a 6 month note D D I
215

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q q q q q

Accounting Test Question No IFS 1: Details of financial performance of Company XYZ For year 2005 Income Statement: Net Sales $ 7 million, Cost of Goods sold $ 3 million
– Net Income – Balance Sheet ($’000):-2007 $1.2 million

q q q q q

Assets Cash Accounts Receivable Inventory Property, plant and equipment ( net) Total Assets
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$2,00,240 $8,10,620 $8,30,710 $2,59,02,420 $4,43,03,990
216

q

q q q q q

Liabilities & Shareholders’ Equity: Current liabilities710640 Notes payable550990 Paid-in capital1,5001,500 Retained earnings1,670860Total Liabilities & Shareholders’ Equity4,4303,990The average industry for
217

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q q q q q q

Company’s line of business are: Inventory Turnover 5 times Average Collection period 45 days Asset Turnover 2 times Required: Evaluate Company XYZ’s asset management relative to its industry.
218

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Accounting Test Question No IFS 2:
q

q q q q q q

q

Append below Company TIM s Income Statement and Balance Sheet: Income Statement (000) 2006-2007 Net Sales Rs.7,05,06,200 Net Income Rs.3,40,410 Balance Sheet (000):-Assets2006-2007 Current Assets Rs.1,84,01,570 Property, plant and equipment ( net) Rs.2,59,02,420 Total Assets www.augustin.co.nr Rs.4,43,03,990 e-mail: aug_bang@yahoo.com

219

q q q q q q q q q q

Current Liabilities1,15,01,190 Long term liabilities RS. 8,10,440 Paid-in capital1 RS.50,01,500 Retained earnings Rs.9,70,860 Required: Determine the following ratios for 2006- 2007: profit margin on sales return on assets (ROA) return on shareholders equity (2) Determine the amount of dividends paid to the shareholders during2006- 2007

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220

Answer to Accounting Test Question IFS No 2: q 1(a) Profit margin on sales q = Net Income/ Net Sales q = Rs.340,000/Rs.7,050,000 q = 4.8% q 1(b) Return on Assets (ROA) q = Net Income/(Average Total Assets)/2 q =RS.340,000/(Rs.4,430,000+3,990,000)/2 q = 8.1%
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q q q q

1(c) Return on Shareholders equity = Net Income/ (Average Total Shareholder fund)/2 =Rs.340,000/(Rs.3,170,000+2,360,000)/2 =12.3% Computation of Dividend paid during Year 2005: Retained earnings beginning of year 2005 RS.860,000 Add: Net Income Rs.340,000 Less: Retained earnings end of year 2005 (Rs.970,000) Dividends paid during 2007 Rs.230,000
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q q

q q

q

q q

q q q q q

Accounting Test Question No IFS 3: Append below Company XYZ’s Income Statement and Balance Sheet: Income Statement ($’000)2005 Net Sales 7,100 Interest expense 40 Income tax expense 150 Net Income 210

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223

q q q q q q q q q q q q q

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Balance Sheet ($’000):Assets2005 Cash 200 Accounts Receivable 810 Inventory 830 Property, plant and equipment ( net) 2,590 Total Assets 4,430 Liabilities & Shareholders’ Equity: Current liabilities 710 Long-term liabilities 550 Paid-in capital 1,500 Retained earnings 1,670 Total Liabilities & Shareholders’ Equity4,430

224

q q q q q q

Required: Determine the following ratios for 2005: (a) current ratio (b) acid-test ratio (c) debt to equity ratio (d) times interest earned ratio

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225

Answer:3
q q q

(a) current ratio= Current asset/current liabilities = ($200,000+$810,000+$830,000)/$710,000)= 2.59 (b) acid-test ratio= (Current assets- inventory)/current liabilities =($200,000+$810,000)/$710,000= 1,42

q q q

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226

q q q q q

(c) debt to equity ratio =(Total liabilities)/Shareholders fund =($710,000+$550,000)/($1,500,000+ $1,670,000) =0.39 (d) times interest earned ratio =(Net Income+ Interest Expense+ Income Tax)/InterestExpense =($210,000+$40,000+$150,000)/$40,000 =10 times
227

q q

q q

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Some difficulty in ratios
q

q

q

q

All profitability and expenses ratios Sales in the denominator All turn over ratios, sales in the numerator. Propritory ratio=Total assets/owner’s funds Shareholders’ funds=Equity shares+Reserves and surplus
228

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Exercise problems-103
q q q q q

1.1.NC 1.2 decrease 1.3 NC 1.4 NC 1.5 Increase

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229

Exercise-2.
q q q

q q

1.GP ratio=15*100/30=50% 2.NP ratio=5*100/30=16.67% 3.STR=COGS/Average stock=15/2.5=6.0 times 4.CR=8/3=2.67 5.LR=6/3=2

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230

Exercise-3
q q q q q q q

GP 33.33% NP 20% ROCE 15% STR 4 CR 1.5 D/E 0.17241 Capital employed=3.4-.2=3.2

35% 25% 20% 5 2 0.24

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231

Exercise-4
q q q

q q q

1. current ratio=550/200=2.75 2.Acid test ratio=400/200=2 3.Operating ratio=1480*100/1800=82.22% 4.STR=1150/200=5.75 times 5. DTR=1800/250=7.2 times 6.ROPR=
232

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Prob.13.
q q q q q

1.sales=3,20,000 2.sundry debtors=80,000 3. sundry creditors=80,000 4. closing stock=31,000 5. Opening stock=29,000

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233

Prob.12
q q q q q q q q q q q q q

Balance sheet: General reserve at the beginning=2,00,000 Proposed addition=1,00,000 Profits and loss appro.=20,000 10% Debentures=1,00,000 Current liabilities(Proposed dividend)=2,00,000 Fixed assets=7,20,000 Stock=2,53,125 Sundry debtors=84,375 Tranfer to general reserve=1,00,000 Balance transferred to balance sheet=20,000 Net profit=2,50,000 Provision for tax=7500 Net profit=2,50,000;gross profit=6,07,500;sales=10,12,500; purchases=1,30,625.
234

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Prob.9
Balance sheet. Liabilities Equity shares 2,25,000 R/S 1,75,000 Long term liabilities Over draft Sundry creditors
q

Assets 2,00,000 Fixed assets 1,00,000 current liabilities NIL 60,000 40,000 4,00,000

4,00,000

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235

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236

Chapter Objective 5
Use ratios in decision making

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237

Limitations of Financial Analysis
No one ratio or year’s worth of financial information should be relied upon to provide a complete assessment of a corporation’s financial condition Analysts should: q Examine trends over time q Benchmark to industry and key competitors q Seek answers about why ratios are e-mail: aug_bang@yahoo.com www.augustin.co.nr different
q

238

Limitations of Financial Analysis

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239

Limitations of Financial Analysis
q

Grant’s ratios were reasonably good up until several years before its failure

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240

Limitations of Financial Analysis
q

Grant’s ratios were reasonably good up until several years before its failure

q

But analysts and the investing public continued to believe the company’s strong history would carry it forward

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241

Limitations of Financial Analysis
q

Grant’s ratios were reasonably good up until several years before its failure

q

q

But analysts and the investing public continued to believe the company’s strong history would carry it forward Financial statement users didn’t consider the social and economic changes of the early 1970s and how these affected the retailer!
242

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The Complexity of Business Decisions
Business environment is complicated by numerous local, regional, national, and global issues - all must be considered when evaluating current financial condition or forecasting future potential for income

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243

An Example: Dell Abbreviated Balance Sheet
q

Assets:
– Current Assetsinventories$391 $7,681.00 – Non-Current Assets: $3,790.00 – Total Assets: $11,471.00

q

Liabilities:
$5,192.00 $971.00 $5,308.00 $11,471.00

– Current Liabilities: – LT Debt & Other LT Liab.: – Equity: – Total Liab. and Equity: e-mail: aug_bang@yahoo.com www.augustin.co.nr

244

Liquidity Ratio Examples: Dell
q

Current Ratio:

q

Quick (Acid Test) Ratio:

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245

Ratio Comparison: Current Ratio
2.5 2 1.5 1 0.5 0

Current Ratio

Jan-96 Dell Industry 2.08 1.80

Jan-97 1.66 1.80

Jan-98 1.45 1.90

Jan-99 1.72 1.60

Jan-00 1.48

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246

Leverage Ratio Examples: Dell
q

Debt Ratio:

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247

Ratio Comparison: Debt Ratio
0.8 0.7 0.6

Debt Ratio

0.5 0.4 0.3 0.2 0.1 0

Jan-96 Dell Industry 54.70% 62.96%

Jan-97 73.07% 60.00%

Jan-98 69.70% 52.38%

Jan-99 66.25% 62.96%

Jan-00 53.73%

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248

Profitability Ratio Examples: Dell
q

Return on Assets (ROA):

q

Return on Equity (ROE):

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249

Profitability Ratio Examples: Dell
q

Net Profit Margin:

q

Retention Ratio

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250

Ratio Comparison: ROE
80% 70% 60% 50% 40% 30% 20% 10% 0%

ROE

Jan-96 Dell Industry 28.13% 22.30%

Jan-97 64.27% 30.60%

Jan-98 73.01% 25.50%

Jan-99 62.90% 18.00%

Jan-00 31.39%

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251

Ratio Comparison: ROA
25% 20% 15% 10% 5% 0%

ROA

Jan-96 Dell Industry 12.66% 6.80%

Jan-97 17.31% 10.90%

Jan-98 22.12% 7.20%

Jan-99 21.23% 5.70%

Jan-00 14.52%

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252

Ratio Comparison: Profit Margin
9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Profit Margin

Jan-96 Dell Industry 5.14% 3.40%

Jan-97 6.68% 4.74%

Jan-98 7.66% 3.79%

Jan-99 8.00% 2.85%

Jan-00 6.59%

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253

Activity (Turnover) Ratio Examples: Dell
q

Total Asset Turnover Ratio:

q

Inventory Turnover Ratio:

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254

Ratio Comparison: Asset Turnover
350% 300%

Asset Turnover

250% 200% 150% 100% 50% 0%

Jan-96 Dell Industry 2.47 2.00

Jan-97 2.59 2.30

Jan-98 2.89 1.90

Jan-99 2.65 2.00

Jan-00 2.20

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255

The DuPont System
q

Method to breakdown ROE into:
– ROA and Equity Multiplier

q

ROA is further broken down as:
– Profit Margin and Asset Turnover

q

q

Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers
256

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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

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257

The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier Net Income Total Assets = × Total Assets Common Equity
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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover Net Income Sales = × Sales Total Assets
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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier Net Income Sales Total Assets = × × Sales Total Assets Common Equity
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The DuPont System: Dell
Net Income Sales Total Assets ROE = × × Sales Total Assets Common Equity = Profit Margin × Total Asset Turnover × Equity Multiplier = ROA × Equity Multiplier $1,666.00 $25,265.00 $11,471.00 ROE = × × $25,265.00 $11,471.00 $5,308.00 = 0.0659 × 2.2025 × 2.1611 = 0.1452 × 2.1611 = 31.39%
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A Note on Sustainable Growth and Stock Returns
q

In the long run
– Sustainable growth and long run capital gains (g) = ROE x ρ

q

Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0):
– r = g + D1/P0 = g + Do(1+g)/P0

q

Note: r & g must be quarterly if D is quarterly and annual if D is annual

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262

Example: Predicted Sustainable Growth for Dell
q

Based on the most recent numbers:
– ROE = 31.39% & ρ = 100% – g = 0.3139 x 1 = 31.39% – r = 0.3139 + 0/P = 31.39%

q

Based on 5 year averages:
– ROE = 51.94% & ρ = 100% – g = 0.5194 x 1 = 51.94% – r = 0.3139 + 0/P = 51.94%

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263

Summary of Financial Ratios
q

Ratios help to:
– Evaluate performance – Structure analysis – Show the connection between activities and performance

q

Benchmark with
– Past for the company – Industry

q

Ratios adjust for size differences
264

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Limitations of Ratio Analysis
q

q

q q

q

q

A firm’s industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios

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265

Ratios and Forecasting
q

Common stock valuation based on
– Expected cashflows to stockholders – ROE and ρ are major determinants of cashflows to stockholders

q

Ratios influence expectations by:
– Showing where firm is now – Providing context for current performance

q

Current information influences expectations by:
– Showing developments that will alter future performance

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266

How Might Ratios Help Me on the IEM?
q

Analysis of AAPL, IBM and MSFT, and comparisons to the S&P500 companies can help to:
– Assess the (absolute and relative) financial state of each company – Show each company’s strengths and weaknesses – Predict sustainable growth rate

q

Combined with current information, this can help to:
– Assess likely future performance – Predict future valuation and earnings growth – Predict returns

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267

Financial Statement Analysis: Lecture Outline
q q

Review of Financial Statements Ratios
– Types of Ratios – Examples

q q q

The DuPont Method Ratios and Growth Summary
– Strengths – Weaknesses – Ratios and Forecasting

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268

Financial Analysis
q

q

q

Assessment of the firm’s past, present and future financial conditions Done to find firm’s financial strengths and weaknesses Primary Tools:
– Financial Statements – Comparison of financial ratios to past, industry, sector and all firms

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269

Sources of Data
q

Annual reports
– Via mail, SEC or company websites

q

Published collections of data
– e.g., Dun and Bradstreet or Robert Morris

q

Investment sites on the web
– Examples
q q

http://moneycentral.msn.com/investor http://www.marketguide.com
270

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The Main Idea
q

q

Value for the firm comes from cashflows Cashflows can be calculated as:
• (Revt - Costt - Dept)x(1-τ) + Dept —OR— • (Revt - Costt)x(1-τ) + τxDept —OR— • Revtx(1-τ) - Costtx(1-τ) + τxDept

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271

An Example: Dell Abbreviated Balance Sheet
q

Assets:
– Current Assets: – Non-Current Assets: – Total Assets: $7,681.00 $3,790.00 $11,471.00 $5,192.00 $971.00 $5,308.00 $11,471.00

q

Liabilities:

– Current Liabilities: – LT Debt & Other LT Liab.: – Equity: – Total Liab. and Equity: e-mail: aug_bang@yahoo.com www.augustin.co.nr

272

Review: Major Income Statement Items
q q

q q q q

Gross Profit = Sales - Costs of Goods Sold EBITDA = Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares
273

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An Example: Dell Abbreviated Income Statement
Sales Costs of Goods Sold Gross Profit Cash operating expense EBITDA Depreciation & Amortization Other Income (Net) EBIT Interest EBT Income Taxes Special Income/Charges Net Income (EAT)
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$25,265.00 -$19,891.00 $5,374.00 -$2,761.00 2,613.00 -$156.00 -$6.00 $2,451.00 -$0.00 $2,451.00 -$785.00 -$194.00 $1,666.00
274

Objectives of Ratio Analysis
q q q

q

q q

Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations

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275

Rationale Behind Ratio Analysis
q q

A firm has resources It converts resources into profits through
– production of goods and services – sales of goods and services

q

Ratios
– Measure relationships between resources and financial flows – Show ways in which firm’s situation deviates from
q q q q

Its own past Other firms The industry All firms276

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Types of Ratios
q

Financial Ratios:
– Liquidity Ratios
q

Assess ability to cover current obligations Assess ability to cover long term debt obligations

– Leverage Ratios
q

q

Operational Ratios:
– Activity (Turnover) Ratios
q

Assess amount of activity relative to amount of resources used Assess profits relative to amount of resources used Assess market price relative to assets or earnings
277

– Profitability Ratios
q

q

Valuation Ratios:
q

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Liquidity Ratio Examples: Dell
q

Current Ratio:

q

Quick (Acid Test) Ratio:

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278

Ratio Comparison: Current Ratio
2.5 2 1.5 1 0.5 0

Current Ratio

Jan-96 Dell Industry 2.08 1.80

Jan-97 1.66 1.80

Jan-98 1.45 1.90

Jan-99 1.72 1.60

Jan-00 1.48

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279

Leverage Ratio Examples: Dell
q

Debt Ratio:

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280

Ratio Comparison: Debt Ratio
0.8 0.7 0.6

Debt Ratio

0.5 0.4 0.3 0.2 0.1 0

Jan-96 Dell Industry 54.70% 62.96%

Jan-97 73.07% 60.00%

Jan-98 69.70% 52.38%

Jan-99 66.25% 62.96%

Jan-00 53.73%

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281

Profitability Ratio Examples: Dell
q

Return on Assets (ROA):

q

Return on Equity (ROE):

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282

Profitability Ratio Examples: Dell
q

Net Profit Margin:

q

Retention Ratio

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283

Ratio Comparison: ROE
80% 70% 60% 50% 40% 30% 20% 10% 0%

ROE

Jan-96 Dell Industry 28.13% 22.30%

Jan-97 64.27% 30.60%

Jan-98 73.01% 25.50%

Jan-99 62.90% 18.00%

Jan-00 31.39%

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284

Ratio Comparison: ROA
25% 20% 15% 10% 5% 0%

ROA

Jan-96 Dell Industry 12.66% 6.80%

Jan-97 17.31% 10.90%

Jan-98 22.12% 7.20%

Jan-99 21.23% 5.70%

Jan-00 14.52%

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285

Ratio Comparison: Profit Margin
9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Profit Margin

Jan-96 Dell Industry 5.14% 3.40%

Jan-97 6.68% 4.74%

Jan-98 7.66% 3.79%

Jan-99 8.00% 2.85%

Jan-00 6.59%

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286

Activity (Turnover) Ratio Examples: Dell
q

Total Asset Turnover Ratio:

q

Inventory Turnover Ratio:

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287

Ratio Comparison: Asset Turnover
350% 300%

Asset Turnover

250% 200% 150% 100% 50% 0%

Jan-96 Dell Industry 2.47 2.00

Jan-97 2.59 2.30

Jan-98 2.89 1.90

Jan-99 2.65 2.00

Jan-00 2.20

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288

The DuPont System
q

Method to breakdown ROE into:
– ROA and Equity Multiplier

q

ROA is further broken down as:
– Profit Margin and Asset Turnover

q

q

Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers
289

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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

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290

The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier Net Income Total Assets = × Total Assets Common Equity
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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover Net Income Sales = × Sales Total Assets
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The DuPont System
ROE ROA P ro fit M a rg in E q u ity M u ltip lie r

T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier Net Income Sales Total Assets = × × Sales Total Assets Common Equity
e-mail: aug_bang@yahoo.com www.augustin.co.nr 293

The DuPont System: Dell
Net Income Sales Total Assets ROE = × × Sales Total Assets Common Equity = Profit Margin × Total Asset Turnover × Equity Multiplier = ROA × Equity Multiplier $1,666.00 $25,265.00 $11,471.00 ROE = × × $25,265.00 $11,471.00 $5,308.00 = 0.0659 × 2.2025 × 2.1611 = 0.1452 × 2.1611 = 31.39%
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A Note on Sustainable Growth and Stock Returns
q

In the long run
– Sustainable growth and long run capital gains (g) = ROE x ρ

q

Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0):
– r = g + D1/P0 = g + Do(1+g)/P0

q

Note: r & g must be quarterly if D is quarterly and annual if D is annual

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295

Example: Predicted Sustainable Growth for Dell
q

Based on the most recent numbers:
– ROE = 31.39% & ρ = 100% – g = 0.3139 x 1 = 31.39% – r = 0.3139 + 0/P = 31.39%

q

Based on 5 year averages:
– ROE = 51.94% & ρ = 100% – g = 0.5194 x 1 = 51.94% – r = 0.3139 + 0/P = 51.94%

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296

Sell Inventory and Collect Receivables

Inventory turnover A/R turnover Days’ sales in receivables
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1 2 3
297

Inventory Turnover
q

1998

q

Number of times the average level of inventory is sold during the accounting year Measures time required to earn return on company’s investment in inventory
298

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Inventory Turnover
Cost of goods sold Average inventory

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299

Inventory Turnover
Cost of goods sold Average inventory
$588,017 ($164,816 + $168,652) / 2 = 3.53
e-mail: aug_bang@yahoo.com www.augustin.co.nr 300

q

q

q

q

High ratio indicates ability to quickly sell inventory Too high a ratio may indicate inadequate inventory levels Turnover ratio should be compared to historical and industry averages Analyze significant variances
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Inventory Turnover

301

Accounts Receivable Turnover
q

q

Number of times the average level of A/R is collected during the accounting year Measures ability to collect cash from credit customers

$

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302

Measuring a Company’s Profitability
q

q

Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices
303

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Measuring a Company’s Profitability
q

4 profitability ratios are commonly used in financial statement analysis

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304

Measuring a Company’s Profitability
q

4 profitability ratios are commonly used in financial statement analysis Return on sales

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305

Measuring a Company’s Profitability
q

4 profitability ratios are commonly used in financial statement analysis Return on sales Return on assets

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306

Measuring a Company’s Profitability
q

4 profitability ratios are commonly used in financial statement analysis Return on sales Return on assets Return on equity

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307

Return on Equity
Net income - preferred dividends Common contributed capital + retained earnings

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308

Return on Equity
Net income - preferred dividends Common contributed capital + retained earnings $30,555* ($286,676 + $255,773) / 2 = .1126
e-mail: aug_bang@yahoo.com www.augustin.co.nr * Lands’ End does not have preferred

stock

309

Earnings Per Share
q

q

Relationship between net income available to common stockholders and the number of shares of common stock issued Expresses net income in terms of one share of the company’s common stock
310

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Earnings Per Share
Net income - preferred dividends # of shares of common stock outstanding

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311

Earnings Per Share
Net income - preferred dividends # of shares of common stock outstanding $30,555,000* 40,221,000 shares = $.76
* Lands’ End does not have preferred stock; e-mail: aug_bang@yahoo.com www.augustin.co.nr numbers shown are actual amounts
312

Earnings Per Share
q

Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory

q

q

q q
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In addition to net income, EPS is presented for several other elements on the corporate income statement Discontinued operations Extraordinary items Cumulative effect of accounting change

313

Analyzing the Company’s Stock as an Investment

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314

Analyzing the Company’s Stock as an Investment
q

q

q

Investors expect to receive 2 types of returns on their investments in a corporation’s common stock Gains earned when they sell the corporation’s stock Periodic dividends paid by the corporation to its stockholders
315

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Analyzing the Company’s Stock as an Investment
q

q q q

Financial analysts use several ratios to assess value of stock investments Price/earnings ratio Dividend yield Book value
316

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Price/Earnings Ratio
q

q

q

Relationship between a stock’s market price and its earnings per share Measures the number of times one share of stock sells above the current period’s reported earnings Assists financial analysts in deciding if a stock is overpriced or underpriced

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317

Price/Earnings Ratio
Calculating the P/E ratio

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318

Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share

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319

Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
q

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year

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320

Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
q q

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year The income statement reports EPS of $.92

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321

Price/Earnings Ratio
Calculating the P/E ratio Market value of stock Earnings per share
q q

q

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year The income statement reports EPS of $.92 What is Asian Art’s price/earnings ratio?
322

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Price/Earnings Ratio
Market value of stock Earnings per share

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323

Price/Earnings Ratio Market value of stock
Earnings per share $15.75 $.92 = 17.12

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324

Dividend Yield
q q

q

Ratio of dividends per share of stock to the stock’s market value Indicates the percentage of a stock’s market value “returned” to the stockholder in the form of dividends Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock
325

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Dividend Yield
Annual dividends per share Stock’s market value per share
q

If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?

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326

Dividend Yield
Annual dividends per share Stock’s market value per share

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327

See you in the next chapter BRS

q

Life education

God and Poor man
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TIME TO REST

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329

Chapter-8 capital structure& cost of capital

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330

Chapter 16: Capital Structure Decisions: The Basics
q q q q q q

Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory Example: Choosing the optimal structure Setting the capital structure in practice

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331

Basic Definitions
q q q

q q

V = value of firm FCF = free cash flow WACC = weighted average cost of capital rs and rd are costs of stock and debt re and wd are percentages of the firm that are financed with stock and debt.
332

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How can capital structure affect value?

V =


t =1

FCFt t (1 + WACC)

WACC = wd (1-T) rd + we rs
(Continued…)
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333

A Preview of Capital Structure Effects
q

The impact of capital structure on value depends upon the effect of debt on:
– WACC – FCF

(Continued…)
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334

The Effect of Additional Debt Debtholders on WACC have a prior claim on cash flows relative to stockholders.
q

– Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. – Cost of stock, rs, goes up.
q

Firm’s can deduct interest expenses.
– Reduces the taxes paid – Frees up more cash for payments to investors – Reduces after-tax cost of debt
(Continued…)

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335

The Effect on WACC (Continued) risk of bankruptcy Debt increases
q

– Causes pre-tax cost of debt, rd, to increase
q

Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with highcost equity (we) Net effect on WACC = uncertain.
(Continued…)
336

q

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The Effect of Additional Debt on FCF
q

Additional debt increases the probability of bankruptcy.
– Direct costs: Legal fees, “fire” sales, etc. – Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers
(Continued…)

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337

q

Impact of indirect costs
– NOPAT goes down due to lost customers and drop in productivity – Investment in capital goes up due to increase in net operating working capital (accounts payable goes up as suppliers tighten credit).

(Continued…)
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338

q

Additional debt can affect the behavior of managers.
– Reductions in agency costs: debt “precommits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions. – Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects.
(Continued…)
339

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Asymmetric Information and Signaling
q q

q

Managers know the firm’s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
340

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What is business risk?
Uncertainty about future pre-tax operating income (EBIT).
Probability
Low risk High risk

0

E(EBIT)

EBIT

Note that business risk focuses on operating income, so it ignores financing effects.
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q

Business Risks- Unit-9 Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Degree of operating leverage (DOL).

q q q q q

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342

What is operating leverage, and how does it affect a firm’s business risk?-9.3( 252)
q

q

Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

(More...)
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q

Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.
$ Rev. $ TC Rev.

} EBIT
TC F

F QBE Sales QBE Sales
(More...)
e-mail: aug_bang@yahoo.com www.augustin.co.nr 344

Operating Breakeven
q

Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating breakeven = QBE QBE = F / (P – V) Example: F=$200, P=$15, and V=$10: QBE = $200 / ($15 – $10) = 40.
(More...)
345

q

q

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Probability

Low operating leverage High operating leverage

EBITL

EBITH

 In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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Business Risk versus Financial Risk-253

q

Business risk:
– Uncertainty in future EBIT. – Depends on business factors such as competition, operating leverage, etc.

q

Financial risk:
– Additional business risk concentrated on common stockholders when financial leverage is used. – Depends on the amount of debt and preferred stock financing.

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347

Consider Two Hypothetical Firms Firm U No debt $20,000 in assets 40% tax rate Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate

Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.
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348

Impact of Leverage on Returns Firm U EBIT Interest EBT Taxes (40%) NI ROE $3,000 0 $3,000 1 ,200 $1,800 9.0% Firm L $3,000 1,200 $1,800 720 $1,080 10.8%
349

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Why does leveraging increase return?
q

More EBIT goes to investors in Firm L. – Total dollars paid to investors:
U: NI = $1,800. q L: NI + Int = $1,080 + $1,200 = $2,280.
q

– Taxes paid:
q

U: $1,200; L: $720.

q

Equity $ proportionally lower than NI.
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Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?

Continued…
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Firm U: Unleveraged Bad Prob. 0.25 EBIT $2,000 Interest 0 EBT $2,000 Taxes (40%) 800 NI $1,200
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Economy Avg. Good 0.50 $3,000 0 $3,000 1,200 $1,800 0.25 $4,000 0 $4,000 1,600 $2,400
352

Firm L: Leveraged Bad Prob.* 0.25 EBIT* $2,000 Interest 1,200 EBT $ 800 Taxes (40%) 320 NI $ 480 *Same as for Firm U.
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Economy Avg. 0.50 $3,000 1,200 $1,800 720 $1,080

Good 0.25 $4,000 1,200 $2,800 1,120 $1,680

Firm U BEP ROIC ROE TIE Firm L BEP ROIC ROE TIE

Bad 10.0% 6.0% 6.0% n.a. Bad 10.0% 6.0% 4.8% 1.7x

Avg. 15.0% 9.0% 9.0% n.a. Avg. 15.0% 9.0% 10.8% 2.5x

Good 20.0% 12.0% 12.0% n.a. Good 20.0% 12.0% 16.8% 3.3x
354

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Profitability Measures: E(BEP) E(ROIC) E(ROE) Risk Measures:

U 15.0% 9.0% 9.0%

L 15.0% 9.0% 10.8%

σ

σ ROIC

ROE

2.12%

2.12% 4.24%

2.12%

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355

Conclusions
q

Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA) are unaffected by financial leverage. L has higher expected ROE: tax savings and smaller equity base. L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk. (More...)
356

q

q

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q

In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.
– U and L: σ ROIC = 2.12%. – U: σ ROE = 2.12%. – L: σ ROE = 4.24%.

q

L’s financial risk is σ ROE - σ ROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.)
(More...)
357

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 For leverage to be positive (increase expected ROE), BEP must be > rd.  If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE.  In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”
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Life education

Fighting Spirit

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359

Capital Structure Theory-261
q

MM theory
– Zero taxes – Corporate taxes – Corporate and personal taxes

q q q

Trade-off theory Signaling theory
360

Debt financing as a managerial constraint e-mail: aug_bang@yahoo.com www.augustin.co.nr

MM Theory: Zero Taxes
q

MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:
– VL = VU.

q q

Therefore, capital structure is irrelevant. Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.

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361

MM Theory: Corporate Taxes
q

Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. MM show that: VL = VU + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
362

q

q q

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MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V VL TD VU Debt

0

Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
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MM relationship between capital costs and leverage when corporate taxes are considered.
Cost of Capital (%) rs

0

20

40

60

80

WACC rd(1 - T) Debt/Value 100 Ratio (%)
364

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Miller’s Theory: Corporate and Personal Taxes- Page261(9.4)
q

Personal taxes lessen the advantage of corporate debt:
– Corporate taxes favor debt financing since corporations can deduct interest expenses. – Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.

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365

Miller’s Model with Corporate and Personal Taxes

(1 - Tc)(1 - Ts) VL = VU + 1 D. (1 - Td) Tc = corporate tax rate. Td = personal tax rate on debt income. Ts = personal tax rate on stock income.
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[

]

Tc = 40%, Td = 30%, and Ts = 12%. (1 - 0.40)(1 - 0.12) (1 - 0.30) VL = V U + 1 D

[

]

= VU + (1 - 0.75)D = VU + 0.25D. Value rises with debt; each $1 increase in debt raises L’s value by $0.25. 367

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Conclusions with Personal Taxes
q

Use of debt financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt. Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.
368

q q

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Trade-off Theory
q

q

q

q

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.
369

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Signaling Theory
q

q

MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would:
– Sell stock if stock is overvalued. – Sell bonds if stock is undervalued.

q

q

Investors understand this, so view new stock sales as a negative signal. Implications for managers?
370

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Debt Financing and Agency Costs
q

One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage:
– Bonds “free cash flow.” – Forces discipline on managers to avoid perks and non-value adding acquisitions.
(More...)
371

q

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q

A second agency problem is the potential for “underinvestment”.
– Debt increases risk of financial distress. – Therefore, managers may avoid risky projects even if they have positive NPVs.

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372

Choosing the Optimal Capital Structure: Example Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; rs = 12%; P0 = $25; T = 40%; b = 1.0; rRF = 6%; RPM = 6%.
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Estimates of Cost of Debt Percent financed with debt, wd rd 0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.
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The Cost of Equity at Different Levels of Debt: Hamada’s Equation
q

MM theory implies that beta changes with leverage.

q

bU is the beta of a firm when it has no debt (the unlevered beta) bL = bU [1 + (1 - T)(D/S)]

q

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375

The Cost of Equity for wd = 20%
q

q

Use Hamada’s equation to find beta: bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs = rRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%
376

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Cost of Equity vs. Leverage
wd 0% 20% 30% 40% 50% D/S 0.00 0.25 0.43 0.67 1.00 bL 1.000 1.150 1.257 1.400 1.600 rs 12.00% 12.90% 13.54% 14.40% 15.60%
377

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The WACC for wd = 20%
q q

WACC = wd (1-T) rd + we rs WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%) WACC = 11.28% Repeat this for all capital structures

q

q

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378

WACC vs. Leverage
wd 0% 20% 30% 40% 50% rd 0.0% 8.0% 8.5% 10.0% 12.0% rs 12.00% 12.90% 13.54% 14.40% 15.60% WACC 12.00% 11.28% 11.01% 11.04% 11.40%
379

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Corporate Value for wd = 20%
q q

V = FCF / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). NOPAT = ($500,000)(1-0.40) = $300,000. V = $300,000 / 0.1128 = $2,659,574.
380

q

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Corporate Value vs. Leverage
wd 0% 20% 30% 40% 50% WACC 12.00% 11.28% 11.01% 11.04% 11.40% Corp. Value $2,500,000 $2,659,574 $2,724,796 $2,717,391 $2,631,579
381

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Debt and Equity for wd = 20%
q

The dollar value of debt is: D = wd V = 0.2 ($2,659,574) = $531,915. S=V–D S = $2,659,574 - $531,915 = $2,127,659.

q

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382

Debt and Stock Value vs. Leverage
wd S 0% 20% 30% 40% 50% $0 $531,915 $817,439 $1,086,957 $1,315,789 $2,500,000 $2,127,660 $1,907,357 $1,630,435 $1,315,789
383

Debt, D

Stock Value,

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Note: these are rounded; see Ch 16 Mini Case.xls for

Wealth of Shareholders
q

q

Value of the equity declines as more debt is issued, because debt is used to repurchase stock. But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).
384

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Stock Price for wd = 20%
q

The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase stock. Stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible).
(More…)
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q

q

Stock Price for wd = 20% (Continued)
q

The stock price after debt is issued but before stock is repurchased reflects shareholder wealth:
– S, value of stock – Cash paid in repurchase.
(More…)
386

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Stock Price for wd = 20% (Continued)
q

D0 and n0 are debt and outstanding shares before recap. D - D0 is equal to cash that will be used to repurchase stock. S + (D - D0) is wealth of shareholders’
387

q

q

after the debt is issued but immediately (More…) before the repurchase. e-mail: aug_bang@yahoo.com www.augustin.co.nr

Stock Price for wd = 20% (Continued)
q

P = S + (D – D0) n0 P = $2,127,660 + ($531,915 – 0) 100,000 P = $26.596 per share.
388

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Number of Shares Repurchased
q

# Repurchased = (D - D0) / P # Rep. = ($531,915 – 0) / $26.596 = 20,000.

q

# Remaining = n = S / P n = $2,127,660 / $26.596 = 80,000.
389

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Price per Share vs. Leverage
# shares wd 0% 20% 30% 40% 50% P $25.00 $26.60 $27.25 $27.17 $26.32 Repurch. 0 20,000 30,000 40,000 50,000 # shares Remaining 100,000 80,000 70,000 60,000 50,000
390

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Optimal Capital Structure
q

wd = 30% gives:
– Highest corporate value – Lowest WACC – Highest stock price per share

q

But wd = 40% is close. Optimal range is pretty flat.
391

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What other factors would managers consider when setting the target capital structure?
q

Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender and rating agency attitudes (impact on bond ratings).
392

q

q

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q q q

Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible, and hence suitable as collateral? Tax rates.

q

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393

Life Education

War prisoner’s wife
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Capital Budgeting-Chapter11(297)

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395

Ch. 11: Capital Budgeting Decision Criteria

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© 1999, Prentice Hall, Inc.

396

Capital Budgeting: the process of planning for purchases of longterm assets. example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? q Will the machine be profitable? q Will our firm earn a high rate of return on the investment?
q
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397

Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?
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Capital Budgeting
q

q

Time value of money is a fundamental concept. If the interest rate in the economy is 10%, $1 today is worth $1.10 net year, $1.21 two years from today and $1.331 three years from today etc… So, $1.10 next year $1.21 two years from now, $1.331 three years from now are all worth $1 today.
399

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q q q q q q q q q q

100(1+.12)=112(1.12)=125.44 100=112 100=125.44 112=100 125.44=100 Today’s worth of 112 at the end 1st year is =100 today 100=112/1.12 (1+K) A(1+K)^n=FV PV(1+K)^n=FV
400

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Capital Budgeting
q

q

Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I be willing to pay for the right to this stream of cash flows assuming that my only other alternative is to put the money in a bank account and get 10% interest? Ans: $3, why?
401

– Each year’s cash inflow is worth a dollar today. e-mail: aug_bang@yahoo.com www.augustin.co.nr

Capital Budgeting
q

q

If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project is _____ Ans: 10cents. How computed?
– The cash inflows are worth $3 in today’s dollars, the outflows are $2.90 in today’s dollars, so the NPV (always in current dollars) is Cash Inflows – Cash Outflows = $0.10.

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402

Capital Budgeting
q

The basic equation of compound interest is shown on p. 96:
PV(1+r)n = FV

q q

(1+r)n is called the “factor” To get the present value of a stream of cash inflows divide each future inflow amount by the factor for that year (this is called deflating the FV) and add all the deflated inflows … this is the formula on
403

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Capital Budgeting
q

q

q

q

To get the present value of a stream of cash outflows compute the sum of the deflated cash outflows. To compute NPV of a project subtract PV(outflows) from PV(Inflows). To do the computations by hand you can use special formulas for perpetuities and annuities. We will ignore this. For this course, you should know how to do the computations using a financial calculator.
404

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Principles underlying Cash Flows
q

q

q

1. Decision based on cash flows-Non cash charges not considered ie.Depreciation for tax calculation only. We add depreciation after calculating tax with profit after tax 2.The amount of long term funds are used for capital investment purpose are considered. 3.Cash inflow is defined as profit after tax but before depreciation

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405

Principles underlying Cash Flows
q

q

q

4.Interest on long term loan is not considered as it is used for discounting purpose. 5. Incremental cost and incremental benefits are considered. 6.Quantify the detremental impact or benefits are considered.

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406

Principles underlying Cash Flows
q q

q

q

7.Sunk cost are irrelevant. 8.Opportunity costs are to be considered. 9. share of existing overheads has no value 10. short term loan –interest on such loan to be deducted from contribution.
407

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Principles underlying Cash Flows
q

q

q

11. salvage value to be determined and tax benefit on short term capital gain to be deducted from salvage value. And tax benefit on short term capital loss to be added to salvage value. 12. while valuing lease/buy tax benefit on interest payment and tax benefit on depreciation have to be deducted from equated annual/monthly instalment. 13. While valuing lease net lease payment after tax has to be considered.
408

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Relevant cost and relevant benefit
q q q

q

q

Required for decision making Costs that are affected by by the decision Costs and benefits that are independent of a decision are not relevant and need not be considered. Future cash inflows and future outflows are relevant. Sunk costs are irrelevant
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Relevant cost and relevant benefit
q q

q

q

Allocated common costs are irrelevant Opportunity costs are relevant (shadow price) Incremental costs are relevant incremental benefits are relevant. Avoidable costs are relevant and unavoidable costs are irrelevant for decision making.
410

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Relevant and irrelevant
q

q

Five engineers already employed on monthly salary but will not be sent out if not employed in an another project. The salary paid to those engineers are relevant or irrelevant to estimate the price for the project? Two more engineers are selected exclusive to the new project-are the costs relevant to take decision for new project?
411

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q

q

1.Aztec. Spent Rs.20,00,000 for feasibility study before expansion is dead cost (sunk cost) therefore it is not considered as cash outflow. 2. If feasibility study can be sold to other companies say, for Rs. 5,00,000 is an opportunity cost which should be considered as cash inflow for the project.

Examples:

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412

Examples:
q

3. Plant is Rs. 36,00,000, working capital is Rs. 24,00,000 required for a project. The company issues Equity capital Rs.26,00,000 and term loan Rs.16,00,000 then the cash outflow for the project is Rs. 42,00,000 as long term funds such as Equity capital and long term loan equal to Rs.42,00,000. If short term funds are employed for long term purpose we do not consider such funds as out flow.
413

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Depreciation
4. Depreciation should be calculated as per Block assets method. The assets are similar nature having the rate of depreciation the costs are to be clubbed together. If any new asset(s) purchased during the year the amounts incurred on such asset are to be added. Depreciation can not be calculated in the year of sale but the sale value(scrap ) is deducted from the block value. If the some of the assets of the block are not sold and WDV(Balance in the block) exceeds sale value of the assets of the same block we can provide depreciation on the balance.
q
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If Sale value exceeds the block WDV value there is a capital gain which attracts capital gain. In such situation sale minus tax on short term capital gain will be cash inflow. If all assets of the block is sold and the WDV of the block exceeds sale value we get short term capital loss. The real cash inflow is equal to scrap plus tax benefit on short term capital loss . Example:1. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000 The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is 25% . How do we calculate depreciation? Life is 3 years

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415

.75*5,00,000= = =2,10,937.5-1,00,000 q = 1,10,937(loss) q 1,00,000+1,10937(.339) q =1,37,607(Inflow) q Suppose salvage value is 3,00,000 Short term capital gain= 3,00,000-2,10,937 =89,063 Tax on 89,063=89063*.339=30,192 Net cash inflow =3,00,000-30,192 =2,69,807.This should be discounted to today’s value
q

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416

Depreciation and their impact By Prof.Augustin in fin.A/c, fin.Mgt.,Income tax Amaladas etc. M.Com.,AICWA.,B.
ED.,PGDFM

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417

Meaning
q

q q

q q

Reduction in the value of fixed assets due to wear and tear and due to effluction of time. All assets except land can be depreciated. The underlying principle of depreciation is that cash flows generated by an asset over its life cannot be considered income until provision is made for asset’s replacement. It is an allocation of past cash flows. Depreciation expense appears on the income statement, but has no impact on the statement of cash flows.
418

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Depreciation methods
q q q q q q q q q

Straight line method Written down value method Sinking fund method Machine Hour rate method Unit cost method Depletion asset method Depreciation Fund method Sum of digits method Accelerated depreciation method
419

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Impact on books
q q q q q q q q q q q

Depreciation Expense Net income Asset Equity Return on assets Return on Equity Turnover Ratios Cash flow NPV IRR Pay back

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420

Impact of Tax
q q q q q

q

Block asset method Purchase of Asset Sale of Asset Short term/Long-term Capital asset Asset used less than 180 days during the previous year Asset purchased preceding previous year but put into use less than 180 days during the current previous year

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421

Impact of Tax

q

Rate decided by whom?

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422

Inflation and Depreciation
q

q

If prices are rising, Incomes and taxes will be over stated / Under stated Replacement?

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423

Accounting Standard
q q

AS-06 As-10

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424

Tax planning
q q

q

q

q

U/S-32 of IT act When own funds used in plant and machinery -18.66% saving When borrowed funds used –Tax savings through depreciation-22.91% Depreciation on intangible assets can be provided at 25% rate. The eligible assets are: Know how, patent right, copy right, Trade mark, licenses, franchises, any other commercial rights
425

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Carry forward and set of depreciation in the subsequent periods
q

Any number of years provided filed returns

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426

Amalgamation, absorption, reconstruction and demerger
CAN NEW CO. CARRY FORWAD AND SET OF LOSS AND DEPRECIATION? SEC 72 A TO BE FULFILLED 3. ACCUMULATED LOSSES REMAIN UNABSORBED FOR 3 OR MORE YEARS 4. 75% OF BOOK VALUE TO BE HELD ATLEAST FOR 2 YEARS BEFORE AMALGAMATION

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427

l

l

l

THE AMALGAMATED CO. CONTINUES TO HOLD 3/4TH OF BOOK VALUE ATLEAST FOR 5 YEARS NEW CO. SHOULD CONTINUE FOR ANOTHER 5 YEARS NEW CO. SHOULD ACHIEVE ATLEAST 50%OF INSTALLED CAPACITY BEFORE END OF 5 YEARS AND SHOULD CONTINUE FOR 5 YEARS
428

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A LTD AMALGAMATES WITH B LTD AS ON 2007

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429

OTHER TAX BENEFITS
1.

2.

3.

Expenditure on amalgamation or de-merger – allowed under sec 35DD both revenue and capital expenditure allowed Expenditure on scientific research can be carried forward Expenditure on acquisition of patent rights copyrights – depreciation can be provided

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430

OTHER TAX BENEFITS
1.

2. 3.

4.

Expenditure for obtaining license for tele-communication service can be written off Preliminary expenses Capital expenditure on family planning Bad debts are allowed
431

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Calculation of Depreciationcontinues
q

Example:1. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000 The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is 25% . Life is 3 years. Tax rate=30% surcharge 10% and 3% educational cess. How do we calculate Capital loss? Cash Inflow at the end of third year?. Short term capital loss Block value at the end of 2nd year- scrap at the end of three years =Rs.2,81,750-Rs. 1,00,000 =Rs. 1,81,750 Cash Inflow at the end of third year =Rs.1,00,000+(*33.90% *1,81,750) = Rs.1,61,613

*Tax= 30%+10%(30%)+3%*33=33.99%
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Depreciation as per Income tax act
Year 1 2 3 Beginning value 5,00,000 3,75,000 2,81,750 Depreciation 25% 1,25,000 93,750 No End value 3,75,000 2,81,750

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433

owned funds Vs borrowed funds
q

q

q

If owned funds are invested in plant and machinery one can get tax saving on depreciation. If assets are acquired on borrowed funds one can get tax benefit on depreciation and also tax benefit on interest. The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest.
434

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Exercise-2 owned funds Vs borrowed funds
q

q

q q q

An assessee who carries on a business, acquires a plant and machinery costing Rs.10,00,000 in a year one. This plant is used for 5 years and will be discarded at the end of 5th year for Rs. 2,00,000. Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 5th year. Cost of Capital is 10% and rate of depreciation is 15%. Required: 1. Evaluate when owned funds are invested 2. When 75% cost of plant is financed by deposit taken from public at the rate of 9%pa.
435

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year

beginning

Depreciati on

discount Tax benefit facto present End value on depre r value 8,50,000 7,22,500 6,14,125 50,850 43,223 36,739 31,228 0.909 0.826 0.751 0.683 0.62 50,799 35,702 27,591 21,328

1 10,00,000 1,50,000 2 8,50,000 3 7,22,500 4 6,14 112 5,22,006 5 Present value 1,27,500 1,08,375

92119 5,22,006

1,35,420

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436

Present value of scrap =*3,09,158*.620=1,91,678 q *Scrap value=2,00,000 q *Calculation of short term capital gain as the asset is depreciated Book value at the end of 4th year-scrap value=5,22,000-2,00,000 =3,22,000 Tax savings on STCG=3,22,000*.339 =*1,09,158 Present value on tax saving on STCG= 1,09,158*0.620=37,004=67,678 Net present cash out flow value Initial cash out flow-Present value of tax savings on depreciationpresent value of cash inflow on scrap Rs.10,00,000-Rs.1,35,420-Rs.1,91,678=Rs.6,72,902
q

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437

Lease vs Purchase
q q

q

q q

Purchase with Borrowed Funds:If assets are acquired on borrowed funds one can get tax benefit on depreciation and also tax benefit on interest. The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest. LeaseDeduction can be claimed in respect of lease rentals and lease management fees.

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438

Exercise-3 Lease vs Purchase
q q

q q

q

An assessee who carries on a business, acquires a plant and machinery costing Rs.10,00,000 in a year one. This plant is used for ten years and will be discarded at the end of ten years for Rs. 2,00,000. Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 10th year. Discounting rate is 10% and rate of depreciation is 15%. Required: 1. Evaluate when plant taken on lease by paying lease rental of Rs. 3,50,000 for the first five years in the beginning and 50,000 thereafter for the remaining years. 2. When 75% cost of plant is financed by deposit taken from public at the rate of 9%p.a.

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439

q q

Purchase by instalment vs Hire Purchase by instalment vs Hire

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440

Life education

Apologies to the --------e-mail: aug_bang@yahoo.com www.augustin.co.nr 441

Life education

q

shoes
442

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Short cut techniques by using ordinary calculator.
Future value at 10% year 1. 1.1 Year 2. 1.1*= Year 3. 1.1*= = Year 5. 1.1*= = = =
q

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443

Scientific calculator
q q q

Amount*1.1= for the first year Amount *1.1*1.1= for the second year Amount *1.1*1.1= = = = 6th year value

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444

Present value by ordinary calculator
q q q

1st year 1.1/= 2nd year 1.1/= = 6rd year 1.1/= = = = = =

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445

WDV value
15% depreciation as per WDV value at the end of 1st year= 0.85*asset value= Value at the end of 2nd year =0 .85*asset value= = Value at the end of 6th year=0.85*asset value= = = = = =
q

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446

Decision-making Criteria in Capital Budgeting
q

The Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.
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Payback Period
q

q

The number of years needed to recover the initial cash outlay. How long will it take for the project to generate enough cash to pay for itself?

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448

Payback Period
q

How long will it take for the project to generate enough cash to pay for itself?
150

(500) 150 150 150 150 150 150 150

0

1

2

3

4

5

6

7

8

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449

Payback Period
q

How long will it take for the project to generate enough cash to pay for itself?
150

(500) 150 150 150 150 150 150 150

0

1

2

3

4

5

6

7

8

Payback period = 3.33 years.
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q q q

q

q

Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the payback calculation to some standard set by the firm. If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? Accept the project.
451

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Drawbacks of Payback Period:
q q q

q

Firm cutoffs are subjective. Does not consider time value of money. Does not consider any required rate of return. Does not consider all of the project’s cash flows.

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452

Drawbacks of Payback Period:
q

Does not consider all of the project’s cash flows.
0

(500) 150 150 150 150 150 (300) 0

0

1

2

3

4

5

6

7

8

Consider this cash flow stream!
e-mail: aug_bang@yahoo.com www.augustin.co.nr 453

Drawbacks of Payback Period:
q

Does not consider all of the project’s cash flows.
0

(500) 150 150 150 150 150 (300) 0

0

1

2

3

4

5

6

7

8

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
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454

Discounted Payback
q

q

q q q

Discounts the cash flows at the firm’s required rate of return. Payback period is calculated using these discounted net cash flows. Problems: Cutoffs are still subjective. Still does not examine all cash flows.
455

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year
0 1

Cash Flow
-500 250

CF (14%)
-500.00 219.30

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456

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year
0 1

Cash Flow
-500 250

CF (14%)
-500.00 219.30 280.70 1 year

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457

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow CF (14%)
0 1 2 -500 250 250 -500.00 219.30 280.70 192.38 1 year

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458

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow CF (14%)
0 1 2 -500 250 250 -500.00 219.30 280.70 192.38 88.32 1 year 2 years
459

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow CF (14%)
0 1 2 3 -500 250 250 250 -500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years
460

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year
0 1 2 3

Cash Flow
-500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years .52 years
461

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year
0 1 2 3

Cash Flow

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years 280.70
250 250 192.38 88.32 168.75

CF (14%)
1 year 2 years .52 years
462

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Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: q Examines all net cash flows, q Considers the time value of money, and q Considers the required rate of return.
e-mail: aug_bang@yahoo.com www.augustin.co.nr 463

Net Present Value
• NPV = the total PV of the annual net cash flows - the initial outlay.

NPV =

Σ
t=1

n

ACFt (1 + k) t

- IO

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464

Net Present Value

Decision Rule:

If NPV is positive, ACCEPT. • If NPV is negative, REJECT.

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NPV Example
q

Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.

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466

NPV Example
q

Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. 83,000 83,000 83,000 116,000

83,000 (276,400)

0

1

2

3

4

5
467

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NPV with the HP10B:
q q q q q q q

-276,400 CFj 83,000 CFj 4 shift Nj 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71.
468

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NPV with the HP17BII:
q q q q q q q q

Select CFLO mode. FLOW(0)=? -276,400 INPUT FLOW(1)=? 83,000 INPUT #TIMES(1)=1 4 INPUT FLOW(2)=? 116,000 INPUT #TIMES(2)=1 INPUT EXIT CALC 15 I% NPV You should get NPV = 18,235.71
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NPV with the TI BAII Plus:
q

Select CF mode.

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470

NPV with the TI BAII Plus:
q q

Select CF mode. CFo=? -276,400

ENTER

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471

NPV with the TI BAII Plus:
q q q

Select CF mode. CFo=? -276,400 C01=? 83,000

ENTER ENTER

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472

NPV with the TI BAII Plus:
q q q q

Select CF mode. CFo=? -276,400 C01=? 83,000 F01= 1 4

ENTER ENTER ENTER

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473

NPV with the TI BAII Plus:
q q q q q

Select CF mode. CFo=? -276,400 C01=? 83,000 F01= 1 4 C02=? 116,000

ENTER ENTER ENTER ENTER

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474

NPV with the TI BAII Plus:
q q q q q q

Select CF mode. CFo=? -276,400 C01=? 83,000 F01= 1 4 C02=? 116,000 F02= 1

ENTER ENTER ENTER ENTER ENTER

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475

NPV with the TI BAII Plus:
q q q q q q q

Select CF mode. CFo=? -276,400 C01=? 83,000 F01= 1 4 C02=? 116,000 F02= 1 NPV I= 15
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ENTER ENTER ENTER ENTER ENTER ENTER

CPT
476

NPV with the TI BAII Plus:
q q q q q q q q

Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER You should get NPV = 18,235.71
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CPT
477

Profitability Index

NPV =

Σ
t=1

n

ACFt t (1 + k)

- IO

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478

Profitability Index

NPV =

Σ
t=1

n

ACFt t (1 + k)

- IO

PI

=

Σ
t=1

n

ACFt (1 + k) t

IO
479

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Profitability Index

Decision Rule:

If PI is greater than or equal to 1, ACCEPT. • If PI is less than 1, REJECT.

e-mail: aug_bang@yahoo.com www.augustin.co.nr 480

q q q q q q q q q q

-276,400 CFj PI with 83,000 CFj the 4 shift Nj HP10B: 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71. Add back IO: + 276,400 Divide by IO: / 276,400 = You should get PI = 1.066
481

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Internal Rate of Return (IRR)
q

IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

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482

Life education

q

Toss a coin
483

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Internal Rate of Return (IRR)

NPV =

Σ
t=1

n

ACFt (1 + k) t

- IO

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484

Internal Rate of Return (IRR)

NPV =

Σ
t=1 n

n

ACFt (1 + k) t

- IO

IRR:

Σ
t=1

ACFt t (1 + IRR)

= IO
485

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Internal Rate of Return (IRR)

IRR:
q

Σ
t=1

n

ACFt t (1 + IRR)

= IO

q

IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
e-mail: aug_bang@yahoo.com www.augustin.co.nr 486

Calculating IRR
q q

Looking again at our problem: The IRR is the discount rate that makes the PV of the projected cash flows equal to the present value of outlay.
83,000 83,000 83,000 116,000

83,000 (276,400)

0

1

2

3

4

5
487

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83,000 83,000 83,000 83,000 116,000 (276,400)

q

0 1 2 3 4 This is what we are actually doing:

5

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

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488

83,000 83,000 83,000 83,000 116,000 (276,400)

q

0 1 2 3 4 This is what we are actually doing:

5

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400
q

This way, we have to solve for IRR by trial and error.
e-mail: aug_bang@yahoo.com www.augustin.co.nr 489

IRR with your Calculator
q

q

q

IRR is easy to find with your financial calculator. Just enter the cash flows as you did with the NPV problem and solve for IRR. You should get IRR = 17.63%!
490

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IRR
• •

Decision Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.
491

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IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) q Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
q

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492

IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) q Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
q

(500) 0

200 1

100 2

(200) 3

400 4

300 5
493

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IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) q Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
q

(500) 0

200 1

100 2

(200) 3

400 4

300 5
494

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Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) q We could find 3 different IRRs!
q

1 (500) 0 200 1 100 2

2 (200) 3

3 400 4 300 5
495

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Summary Problem:
q q q q

Enter the cash flows only once. Find the IRR. Using a discount rate of 15%, find NPV. Add back IO and divide by IO to get PI. (900) 0 300 1 400 2 400 3 500 4 600 5
496

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Summary Problem:
q q

q

IRR = 34.37%. Using a discount rate of 15%, NPV = $510.52. PI = 1.57. 300 1 400 2 400 3 500 4 600 5
497

(900) 0

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NPV Profiles
q

A graphical representation of project NPVs at various different costs of capital. k 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5
498

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Drawing NPV profiles
NPV 60 ($)
50

. 40 .
30 20 10 0

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

. .
15

S

5 -10

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)
499

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Comparing the NPV and IRR methods
q

q

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive …
– If k > crossover point, the two methods lead to the same decision and there is no conflict. – If k < crossover point, the two methods lead to different accept/reject decisions.

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500

Finding the crossover point
1. 2.

3. 4.

Find cash flow differences between the projects for each year. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. Can subtract S from L or vice versa, but better to have first CF negative. If profiles don’t cross, one project dominates the other.
501

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Reasons why NPV profiles cross
q

q

Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects. Timing differences – the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.
502

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Reinvestment rate assumptions
q

q

q

q

NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
503

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Since managers prefer the IRR to the NPV method, is there a better IRR measure? q Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. q MIRR assumes cash flows are reinvested at the WACC.

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504

Calculating MIRR
0 -100.0
10%

1 10.0
10% MIRR = 16.5%

2 60.0
10%

3 80.0 66.0 12.1 158.1
TV inflows

-100.0
PV outflows

$100 =

$158.1 (1 + MIRRL)3

MIRRL = 16.5%
e-mail: aug_bang@yahoo.com www.augustin.co.nr 505

Why use MIRR versus IRR?
q

q

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.

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506

Project P has cash flows (in 000s): CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000. Find Project P’s NPV and IRR.
0 -800
q

k = 10%

1 5,000

2 -5,000

q q q

Enter CFs into calculator CFLO register. Enter I/YR = 10. NPV = -$386.78. IRR = ERROR Why?

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507

Multiple IRRs
NPV

NPV Profile
IRR2 = 400%

450 0 -800 100 IRR1 = 25%
508

400

k

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Why are there multiple IRRs?
q

q

q

q

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0. At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0. In between, the discount rate hits CF2 harder than CF1, so NPV > 0. Result: 2 IRRs.
509

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Solving the multiple IRR problem
q

Using a calculator
– Enter CFs as before. – Store a “guess” for the IRR (try 10%) 10 ■ STO ■ IRR = 25% (the lower IRR) – Now guess a larger IRR (try 200%) 200 ■ STO ■ IRR = 400% (the higher IRR) – When there are nonnormal CFs and more than one IRR, use the MIRR.

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510

When to use the MIRR instead of the IRR? Accept Project P?
q

When there are nonnormal CFs and more than one IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314. – TV of inflows @ 10% = $5,500. – MIRR = 5.6%.

q

Do not accept Project P.
– NPV = -$386.78 < 0. – MIRR = 5.6% < k = 10%.

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511

Capital Budgeting
q

Moral:

– Use NPV as the first step in evaluating projects. – If capital is in short supply, try and find the best mix of projects to take using simulation rather than use some arbitrary short-cuts (IRR etc.). – Look at payback period as a second step, especially if the projects are otherwise comparable (in magnitude of investment, life of cash flows). If strategic flexibility in the firm’s investment base matters, payback period is a healthy tool in spite of serious theoretical deficiencies. e-mail: aug_bang@yahoo.com www.augustin.co.nr

512

Life education
q

Bringing rain inside
513

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Thank You
e-mail: aug_bang@yahoo.com www.augustin.co.nr 514