Financial Management BATIS 2022 4

FINANCIAL MANAGEMENT
STUDY COURSE DEVELOPER: MAKSIMS GRINČUKS, Turiba University

Goals and Objectives of Financial Management
Financial Management: Definition and Primary Objective
Financial management involves managing all of a company's assets and

liabilities, including monitoring operational financing items such as
expenditures, revenues, accounts receivable and accounts payable, cash
flow, and profitability.
Financial management can be defined as those business activities undertaken
with the goal of maximizing shareholder wealth, utilizing the principles of the
time value of money, leverage and diversification.
Primary objective of financial management – maximization of profit and

shareholders’ wealth using a rational financial policy.
Goals and Objectives of Financial Management
Financial management goals

Efficient use of financial resources

Cash flow management

Optimization of expenditures

Management of corporate financial risk

Maximization of profitability of the firm

Optimal use of capital structure

Evaluation of investment project profitability

Planning optimal dividend policy

Effective investment management of financial instruments
Chapter 1: VALUE-FOCUSED MANAGEMENT
Accounting Profit
Basic criterion of the firm efficiency is the main financing resource –
accounting profit (net income) (NI) which can be determined using the
profit and loss account data:
NI  R  TC
where:
R = total revenues
TC = total expenses (accounting costs)
However, a more informative indicator of the managerial performance is the

market value of the business, which includes all aspects of the business
activities and reflects the wealth of the company owners.
A modern approach to effective company management is based upon the
management of the business value.
According to this approach, the primary goal of a financial manager is to
maximize the value of the business or the company’s ordinary shares.
Economic Profit vs. Accounting Profit
Economic Profit
The key factor of the effective value-focused management is the economic
profit of the firm:
EP  IC  ( ROIC  rWACC ) where:

IC = invested capital (net operating capital) ;
ROIC = return on invested capital (%);
rWACC = weighted average cost of capital (%)
Return on invested capital:
NOPAT where:
ROIC  NOPAT = net operating profit after tax
IC
Net operating profit after tax:
where:
NOPAT  EBIT  (1  t ) EBIT = operating profit (profit before
interest and tax);
t = corporate income tax rate
Added Value Creation
EP  IC  ( ROIC  rWACC )
Return on invested Cost of capital, %

capital, %
Added Value Creation
EP  IC  ( ROIC  rWACC )
If ROIC > rWACC , the firm is generating added value
If this relationship holds, the financial result of the business activity is higher
than the financing costs.
As a result, the firm is able to meet the expectations of the company owners
(shareholders) and creditors and creates added value for all company
investors.
The higher the economic profit, the more attractive the business for financing.
Task 1.1.:
Assume that a firm was established one year ago.
Financials (beginning of year):
Loan obligations (firm’s liabilities) €4,000,000
Owners’ invested capital 4,000,000
Weighted average cost of capital 8%
Cost of equity 10%
Financials (end of year):

Net operating profit after tax €1,000,000
Interest expense 240,000
1. Find the return on invested capital (ROIC), %.

Task 1.1.:
Cost of equity 10%

Solution:
NOPAT €1,000,000
ROIC    0.125  12.5%
IC €8,000,000
Task 1.1.:
Cost of equity 10%

2. Find the economic profit (loss).

Task 1.1.:
Cost of equity 10%

Solution:
EP  IC  ( ROIC  rWACC )  €8,000,000(0.125  0.08)  €360,000

Free Cash Flow
Free Cash Flow
Another key factor of the efficiency of the value-focused management is the free
cash flow (FCF):
FCFt  NOPAT t  IC
where:
NOPAT = net operating profit after tax; NOPAT  EBIT (1  t )
t = corporate income tax rate
ΔIC = net investments in operating capital IC  ICt  ICt 1
Net Operating Profit After Tax (NOPAT)

NOPAT is the amount of profit a company would generate if it had no debt and held
no non-operating assets.
Free Cash Flow
Uses of Free Cash Flow
Free cash flow – financial resource which is available for all company investors
(shareholders and creditors).
Free cash flow is necessary for:
1. making interest payments and principal repayments to creditors

2. dividend payments to shareholders
3. share repurchases
4. making investments in short-term financial instruments
5. making investments in non-operating assets
According to modern financial theory, the fundamental value of the business is

driven by the present value of expected future free cash flows discounted at the
company’s weighted average cost of capital (rWACC).
Free cash flow represents the cash that is actually available for distribution to
investors. Therefore, the way for managers to make their firms more valuable is to
increase their free cash flow.
Free Cash Flow
Free Cash Flow Calculation
FCFt  NOPAT t  IC
ΔIC = change in net investments in operating capital over the accounting period.
Invested capital (IC) as of the end of the accounting period is calculated as:
IC  (C  A / R  INV )  ( A / P  AX )  OLTA
where:
C = cash,
A/R = accounts receivable,
INV = inventories,
A/P = accounts payable,
AX = accruals (a.k.a. accrued expenses),
OLTA = long-term operating assets (i.e. fixed assets necessary to sustain the
business).
Free Cash Flow
Calculation of invested capital (total net operating capital) (IC):
IC  C  A / R  INV   ( A / P  AX )  OLTA
Net working capital Investments in

investments fixed assets
Net operating working capital (NOWC ) =

operating current assets
– operating current liabilities
Operating current assets are assets that are:

 needed to support the business operations, and
 expected to be converted to cash in next 12 months.
They do not include current financial investments.
Free Cash Flow
Calculation of invested capital (total net operating capital) (IC):
IC  C  A / R  INV   ( A / P  AX )  OLTA
Net working capital Investments in

investments fixed assets
Net operating working capital (NOWC ) =

operating current assets
– operating current liabilities
Operating current liabilities are liabilities that are:

 undertaken to carry out the business operations, and
 expected to be settled in next 12 months.
They exclude any current loans or interest bearing liabilities.
Calculating FCF: Overview
Economic Value Added
Economic Value Added
Economic Value Added (EVA) is an analytical tool used to measure a

company's financial performance based on the residual wealth calculated
by deducting its cost of capital from its operating profit, adjusted for taxes
on a cash basis. EVA can also be referred to as economic profit, and it
attempts to capture the true economic profit of a company.
EVA  EBIT (1  t )  IC  rWACC
where:
EBIT = earnings before interest and tax;
t = corporate income tax;
EBIT (1 – t) = NOPAT = net operating profit after tax;
rWACC = weighted average cost of capital;
IC = invested capital (net operating capital)
Practice Examples
Example 1.2.:
Suppose the firm’s weighted average cost of capital – 11.0%.
Balance sheet data ($ ‘000, Dec 31):
: Assets 2020 2019
Current Assets
Cash and cash equivalents 10 80
Accounts receivable 375 315
Inventories 615 415
Total Current Assets 1,000 810
Fixed Assets
Net plant and equipment 1,000 870
Total Assets 2,000 1,680
Note: Cash fixed capital expenditures during 2020 = net fixed asset investments + depreciation expense = 130 + 100 = 230
Practice Examples
Liabilities and Shareholders’ Equity 2020 2019

Current Liabilities
Accounts payable 60 30
Accruals 140 130
Short-term loans 110 60
Total Current Liabilities 310 220
Long-term Liabilities
Long-term loans 750 580
Total Liabilities 1,060 800
Shareholders’ Equity
Common stock (50k shares) 130 130
Retained earnings 810 750
Total Equity 940 880
Total Liabilities and Equity 2,000 1,680
Practice Examples
Example 1.2.:
Profit and loss account data ($ ‘000):
2020 2019
Net Sales 3,000 2,850
Operating costs (excl. depreciation and amortization) 2,616.2 2,497
Depreciation and amortization 100 90
Total operating costs 2,716.2 2,587
Earnings before interest and taxes (EBIT) 283.8 263
Interest expense 88 60
Earnings before taxes (EBT) 195.8 203
Tax (40%) 78.3 81.2
Net income (NI) 117.5 121.8
1. Find the company’s free cash flow as of the end of 2020.

2. Find the company’s economic value added (EVA) as of 2020.
Practice Examples
Solution:
FCF2020 = NOPAT2020 – ΔIC = EBIT2020 (1 – t) – (IC2020 – IC2019)
IC2020 = (NOWC + OLTA)2020 = [(C + A/R + INV) – (A/P + AX) + OLTA]2020

= (10 + 375 + 615) – (60 + 140) + 1,000 = 800 + 1,000 = 1,800
IC2019 = (NOWC + OLTA)2019 = [(C + A/R + INV) – (A/P + AX) + OLTA]2019

= (80 + 315 + 415) – (30 + 130) + 870 = 650 + 870 = 1,520
Alternatively:
Sources of financing 2020 2019
Loans from credit institutions:
Short-term 110 60
Note:
Long-term 750 580 Accounts payable ($60)
and accruals ($140) are
Shareholders’ capital 940 880 excluded.
Invested capital (IC) 1,800 1,520
FCF2020 = EBIT2020 (1 – t) – (IC2020 – IC2019) = 283.8 (1 – 0.4) – (1,800 – 1,520) =

= 170.3 – 280 = – $109.7
Practice Examples
Solution:
Even though the company had a positive NOPAT, its significant investment in operating
capital resulted in a negative FCF.
Since FCF is what is available for distribution to investors, not only was there nothing for
investors, but investors actually had to provide more money to the company to keep the
business going.
EVA2020 = EBIT(1 – t) – IC × rWACC = 283.8 (1 – 0.4) – 1,800 × 0.11
= 170.3 – 198 = – $27.7
EVA2019 = EBIT(1 – t) – IC × rWACC = 263 (1 – 0.4) – 1,520 × 0.11
= 157.8 – 167.2 = – $9.4
EVA in both 2019 and 2020 was negative and continued to decline. Operating income
(NOPAT) rose, but EVA still declined, primarily because the amount of capital rose
more sharply than NOPAT — by about 18% versus 8% — and the cost of this
increased capital pulled EVA down even more.
Net income fell from 2019 to 2020, but not nearly so dramatically as the decline in EVA.
Net income does not reflect the amount of equity capital employed, but EVA does.
Because of this omission, net income is not as useful as EVA for setting corporate goals
and measuring managerial performance.
Chapter 2: TIME VALUE OF MONEY
Financial decisions often involve situations in which someone pays money at

one point in time and receives money at some later time. Money paid or
received at two different points in time is different, and this difference is
recognized and accounted for by time value of money (TVM) analysis.
Time Value of Money
Time value of money is the idea that money available at the present time is
worth more than the same amount in the future due to its potential earning
capacity. This core principle of finance holds that, provided money can earn
interest, any amount of money is worth more the sooner it is received.
Compounding and Future Value
Compounding and Future Value
Compounding is the process of determining the future value (FV) of a cash

flow or a series of cash flows. The compounded amount, or future value, is
equal to the beginning amount plus the interest earned.
Future value is the value of a sum of money or a stream of cash flows at a

specified date in the future. For example, assuming a 10% interest rate, the
future value of €100 received today is €110.
t=0 1
r = 10%
€100 FV1 = €110

Discounting and Present Value
Discounting and Present Value
Discounting is the process of determining the present value (PV) of a

payment or a stream of payments that is to be received in the future.
Discounting is the primary factor used in pricing a stream of tomorrow's
cash flows.
Present value is the current worth of sum of money or stream of cash flows
that will be received in the future, given the interest rate. For example, given
an interest rate of 10%, the PV of $110 that will be received in one year is
$100.
t=0 1
r = 10%
PV = €100 €110
Time Value of Money and Interest Rates
Interpreting Interest Rates
Interest rates can be thought of in three ways:
• The minimum rate of return that you require to accept a payment at a

later date.
• The discount rate that must be applied to a future cash flow in order to
determine its present value.
• The opportunity cost of spending the money today as opposed to saving it

for a certain period and earning a return on it.
Cost of Money: Interest Rates as Compensation for Risks
The Five Components of Interest Rates
Interest rates are determined by the demand and supply of funds. They are
composed of the real risk‐free rate plus compensation for bearing different
types of risks:
• The real risk‐free rate (RRFR) is the single‐period return on a risk‐free

security assuming zero inflation. With no inflation, every unit of currency
holds on to its purchasing power, so this rate purely reflects individuals’
preferences for current versus future consumption.
• An inflation premium (IP) is added to the real risk‐free rate to reflect the
expected loss in purchasing power over the term of a loan. The real risk‐
free rate plus the inflation premium equals the nominal risk‐free rate.
• The default risk premium (DRP) compensates investors for the risk that
the borrower might fail to make promised payments in full in a timely
manner.
Cost of Money: Interest Rates as Compensation for Risks
• The liquidity premium (LP) compensates investors for any difficulty that
they might face in converting their holdings readily into cash at their fair
value. Securities that trade infrequently or with low volumes require a higher
liquidity premium than those that trade frequently with high volumes.
• The maturity premium (MRP) compensates investors for the higher

sensitivity of the market values of longer term debt instruments to changes
in interest rates.
For example, the required rate on a debt security, rd can be shown as:
rd  RRFR  IP  DRP  LP  MRP

Calculating FV and PV
Future Value of a Single Cash Flow
where:
FVn  PV (1  r ) n n = compounding period,
r = interest rate per compounding period
Example:
If you deposited €100 in a savings account, and interest rates were 6%, what would be
the future value of your money in one year, and in two years?
Solution:
In one year the value of €100 will be:
€100 × (1+ 0.06)1 = €106
In two years the value of €100 will be:
€100 × (1+ 0.06)2 = €112.36.
• On your investment of €100 you earn 0.06 x 100 = €6 in simple interest each year.
In the second year, the €6 simple interest earned in Year 1 also earns interest in
addition to the principal. This €6 x 0.06 = €0.36 of additional interest earned is
compound interest. Over the two years, total interest earned equals €6 + €6 +
€0.36 = €12.36
Timeline
Timelines is convenient way how a manager can deal with cash flows.
A general timeline for the future value concept looks like this:
r = 10%
0 1 2 3 n-1 n
PV FVn = PV (1 + r)n
For a given interest rate, the future value increases as the number of periods
increases.
For a given number of periods, the future value increases as the interest rate
increases.
Practice Problems
Problem 1-1:
Calculate the future value of €750 at the end of 12 years if the annual interest
rate is 7%.
Solution:
FV = €1,689.14
Problem 1-2:
Calculate the value after 20 years of an investment of €500, which will be made
after 7 years. The expected annual rate of return is 8%.
Solution:
FV = €1,359.81
Present Value of a Single Cash Flow
Calculating the present value involves determining the value in today’s terms of
a cash flow or cash flow stream that will be received in the future.
FVn
PV 
(1  r ) n
Example:
• If you were offered a payment of €106 a year from today, and interest rates
were 6%, calculating the PV of this cash flow would involve determining the
amount, which invested today at 6%, would yield €106 in a year.
n=0 r = 6% 1 106
PV   100
(1  0.06) 1
PV = ? €106
Practice Problems
Problem 1-3:
Given a discount rate of 10%, what is the PV of a €1,500 cash flow that will be
received in 6 years?
Solution:
PV = €846.71
Problem 1-4:
What is the present value of a cash flow of €1,200 that will be received in 15
years if the discount rate is 8%?
Solution:
PV = €378.29
Practice Problems
Problem 1-5:
An insurance company has issued a Guaranteed Investment Contract (GIC)
that promises to pay $100,000 in six years with an 8% return rate. What
amount of money must the insurer invest today at 8% for six years to make
the promised payment?
Solution:
FV6 = $100,000
r = 8% = 0.08
n=6
PV = FVn(1 + r)-n
= $100,000(1 + 0.08)-6
= $63,016.96
We can say that $63,016.96 today, with an interest rate of 8%, is equivalent to
$100,000 to be received in six years. Discounting the $100,000 makes a
future $100,000 equivalent to $63,016.96 when allowance is made for the
time value of money.
PV and FV Calculation: Variable Interest Rates

If the interest rate, r is variable over the time horizon n, then the formulas for
FV and PV are:
FVn  PV (1  r1 )(1  r2 )...(1  rn ) FVn

PV  n
n  (1  rk )
FVn  PV  (1  rk ) k 1
k 1
Example:
The beginning balance of the investment account is €200,000. The expected
annual returns on the investment account over year 1, 2 and 3, are 8.5%,
7.2% and 5.4% respectively. What will be the ending balance of the
investment account at the end of year 3?
Solution:
FV3 = 200,000 (1 + 0.085) (1 + 0.072) (1 + 0.054) = €245,185.7
Calculation of the Period n and Interest Rate r
Calculation of Period n
The formula for the period n is:
FVn
ln
n PV
ln(1  r )
Example:
How long will it take to double a capital attracting the annual rate of return of
10%?
Solution:
FVn / PV = 2
r = 10% = 0.1
ln 2 0.6930
n   7.27( years)
ln(1  0.1) 0.0953
Example:
The initial amount of investment is €75,000. How much time will it take the
invested capital to reach €200,000 if the annual rate of return is expected to
be 8%?
Solution:
200
ln
75 0.982
n   12.75( years)
ln(1  0.08) 0.077
Calculation of Interest Rate r
The interest rate r (or, alternatively, the growth rate g) is calculated as follows:
FVn
r n 1
PV
Example:
What should be the annual rate of return for the capital to grow from $100,000
to $150,000 over a 5-year period?
Solution:
150,000
r5  1  0.0845  8.45%
100,000
FV and PV of a Series of Cash Flows
Ordinary Annuities
An annuity is a finite set of level sequential cash flows. Put differently, it is

defined as a series of equal periodic payments for a specified number of
periods.
An ordinary annuity is an annuity where the cash flows occur at the end of
each compounding period.
• Calculating future values and present values for annuities is different from
calculating future values and present values for single sums because we
have to find the value of a stream of periodic payments, each of which is
denoted by the variable, PMT (i.e. annuity payment).
Future Value of Ordinary Annuity
Future Value of an Ordinary Annuity
The general formula for the future value of ordinary annuity (FVA) is:

FVAn  PMT (1  r ) n 1  (1  r ) n  2  (1  r ) n 3  ...  (1  r )1  (1  r ) 0 
which simplifies to:
 (1  r ) n  1
FVAn  PMT  
 r 
where:
PMT = annuity amount
n = number of time periods
r = interest rate per period
the term in brackets is the future value annuity factor
Example:
The example demonstrates the calculation of the future value of ordinary
annuity. There are three equal cash flows of €100 each, the interest rate is
10%. The cash flows can be shown on the timeline:
n=0 r = 10%
1 2 3
FV of Ordinary Annuity
PMT = 100 100 100
100(1+0.1)
110
100(1+0.1)2
121
FVA3 = €331
The formula approach gives the same result:
 (1  0.1) 3  1
FVA3  100    100(3.31)  €331
 0 .1 
Example:
Consider an ordinary annuity paying 5% annually. Suppose we have five separate
deposits of $1,000 occurring at equally spaced intervals of one year, with the first
payment occurring at t = 1. Find the future value of this ordinary annuity after the
last deposit at t = 5.
Alternatively,
 (1  0.05) 5  1
FVA5  $1,000    $5,525.63
 0.05 
Practice Problems
Problem 1-6:
You plan to invest €20,000 per year in a stock index fund for the next 30 years.
Historically, this fund has earned 9% per year on average.
Assuming that you actually earn 9% a year, how much money will you have
available for retirement after making the last payment?
Practice Problems
Solution:
PMT = €20,000
r = 9% = 0.09
n = 30
 (1  0.09) 30  1
FVA30  €20,000    €20,000(136.307539)  €2,726,150.77
 0.09 
Assuming the fund continues to earn an average of 9% per year, you will have
€2,726,150.77 available at retirement.
Present Value of Ordinary Annuity
Present Value of an Ordinary Annuity
The general formula for PV of ordinary annuity is:
PMT PMT PMT PMT PMT

PVAn     ...  n 1

(1  r ) (1  r ) (1  r )
2 3
(1  r ) (1  r ) n
where:
PMT = annuity amount
n = number of annuity payments
r = interest rate per period corresponding to the frequency of payments (e.g.
annual, quarterly or monthly)
The shortcut expression is:
 1 
1 
 (1  r ) n 
PVAn  PMT  
 r 
 
Example:
The example demonstrates the calculation of the present value of ordinary
annuity. There are three equal cash flows of €100 each, the discount rate is
10%. The cash flows are shown on the timeline:
n=0 1 2 3
r = 10%
PV of Ordinary Annuity
PMT = 100 100 100
100(1+0.1)-1
90.91 100(1+0.1)-2
82.64 100(1+0.1)-3
75.13
PVA3 = €248.68
The formula approach yields the same result:
 1 
1 
 (1  0.1) 3 
PVA3  100    100(2.4868)  €248.68
 0.1 
 
Example:
Suppose you are considering purchasing a financial asset that promises to pay
€1,000 per year for five years, with the first payment one year from now.
The required rate of return is 12% per year.
How much should you pay for this asset?
Solution:
PMT =1,000
r = 12% = 0.12
n=5
 1 
1 
 (1.12) 5 
PVA5  €1,000    €1,000(3.604776)  €3,604.78
 0.12 
 
Example:
How much can the firm borrow if the interest rate is 18%, the firm can afford to
pay €100,000 at the end of each year, and it wants to clear the loan in 10
years?
Solution:
PMT =100,000
r = 18% = 0.18
n = 10
 1 
1 
 (1.18)10 
PVA5  €100,000    €449,408.63
 0.18 
 
Annuity Due
Annuities Due
An annuity due is an annuity where the periodic cash flows occur at the
beginning of every period.
To calculate the present and future values of annuities due the following
formulas are used:
 1 
D
1  (1  r ) n 
PVAn  PMT   (1  r )
 r 
 
D  (1  r ) n  1
FVAn  PMT   (1  r )
 r 
Present Value of Annuity Due
Example:
The example demonstrates the calculation of the present value of annuity due.
There are three equal cash flows of €100 each, the discount rate is 10%.
The cash flows can be shown on the timeline:
r = 10%
0 1 2 3
PV of Annuity Due
PMT = 100 100 100
100(1+0.1)
-1
90.91
100(1+0.1)-2
82.64
PVA3D = €273.55
Note that the PVA is the sum of the present values of the cash flows. The
present value of annuity due can be also found with the formula:
 1 
1 
 (1  0.1) 3 
D
PVA3  100   (1  0.1)  €273.55
 0.1 
 
Future Value of Annuity Due
Example:
The example demonstrates the calculation of the future value of annuity due.
There are three equal cash flows of €100 each, the interest rate is 10%.
The cash flows can be shown on the timeline:
0 r = 10%
1 2 3
FV of Annuity Due
PMT = 100 100 100
110
121
133.1
FVA3D = €364.1
The formula approach gives the same result:
D  (1  0.1) 3  1
FVA3  100   (1  0.1)  €364.1
 0. 1 
What is the difference between an ordinary annuity and an annuity due?
Ordinary Annuity
0 1 2 3
r%
PMT PMT PMT
Annuity Due
0 1 2 3
r%
PMT PMT PMT

Annuity Due
Example:
What is the value at the end of Year 4 of an annuity that pays $500 at the
beginning of each of the next 4 years, starting today?
Assume that the cash flows can be invested at an annual rate of 8%.
Solution:
We need to find the FV of annuity due.
PMT = 500, n = 4, r = 0.08
0 r = 8%
1 2 3 4
PMT = 500 500 500 500

FVA4D = ?
D  (1  0.08) 4  1
FVA4  500   (1  0.08)  500(4.506112 )(1.08)  €2,433.30
 0.08 
Perpetuity
Present Value of a Perpetuity
A perpetuity is a never-ending series of equal payments, where the first cash

flow occurs in the next period (at t = 1).
A perpetuity can also be seen as an ordinary annuity which extends indefinitely.
The formula for the PV of a perpetuity is:
 1 

PVP  PMT   t
t 1  (1  r ) 
As long as interest rates are positive, the sum of PV factors converges and
PMT
PVP 
r
Perpetuity
Example:
The British government once issued a type of security called a consol bond,
which promised to pay a level cash flow indefinitely.
If a consol bond paid £100 per year in perpetuity, what would it be worth today
if the required rate of return were 5%?
Solution:
PMT = £100
r = 5% = 0.05
100
PVP   2,000
0.05
The bond would be worth £2,000.
Perpetuity
Example:
ABC Corporation pays a $10 per share annual dividend on its preferred stock.
Given a 5% rate of return and assuming that this dividend policy will
continue forever, what is the value of ABC stock?
Solution:
The value of ABC’s preferred stock can be seen as the present value of a
perpetuity:
10
PVP   $200
0.05
Perpetuity
Example:
Assume that the net profit per one hectare of land will amount to €50 per year
over an indefinite period of time. Determine the value of one hectare of land
if the opportunity cost of capital is 11%.
Solution:
The profit per one hectare of land can be considred a perpetuity because the
investment horizon is indefinite and the payments are equal. Thus, the
fundamental market value of the land is:
50
PVP   €454.55
0.11
Unequal Cash Flows
Present Value of Unequal Cash Flows
In an annuity, all cash flows are identical. Faced with a series of unequal cash
flows, we must first calculate the present value of each individual cash flow
separately and then sum the respective present values.
The formula for the present value of unequal cash flows (CF) is:
t
n
 1 
PV   CFt  
t 1 1  r 
Unequal Cash Flows
Example:
The figure illustrates the calculation of the PV of a series of unequal cash flows
at r = 10%:
r = 10%
n=0 1 2 3 4 5 6 7
CF =
100 150 200 230 200 0 1,000
90.91 100(1+0.1)
-1
150(1+0.1)-2
123.97
200(1+0.1)-3
150.26
230(1+0.1)-4
157.09
200(1+0.1)-5
124.18
0(1+0.1)-6
0
1,000(1+0.1)-7
513.16
PV = €1,159.57
Unequal Cash Flows
Future Value of Unequal Cash Flows
We can find the future value of a series of unequal cash flows by compounding
the cash flows one at a time (see the figure below). The formula is:
n
FVn   CFt (1  r ) n t
t 1
r = 10%
n=0 1 2 3 4 5 6 7
CF = 100 150 200 230 200 0 1,000

0
200(1+0.1)
2
242.00
230(1+0.1)
3
306.13
200(1+0.1)4
292.82
150(1+0.1)5
241.58
100(1+0.1)6
177.16
FV7 = €2,259.68
Unequal Cash Flows
Example:
Max wants to pay off his student loan in three annual installments: €2,000,
€4,000 and €6,000, respectively, in the next three years.
How much should he deposit into his bank account today if he wants to use the
account balance to pay off the loan? Assume that the bank pays 8%
interest, compounded annually.
Solution:
n=0 1 r = 8% 2 3
2,000 4,000 6,000

2,000(1.08)-1
1,852
4,000(1.08)-2
3,429
6,000(1.08)-3
4,763
PV = €10,044
To pay off the loan, Max should deposit €10,044.
Frequency of Compounding
Many financial contracts call for more frequent payments; for example,
mortgage and auto loans call for monthly payments and most bonds pay
interest semiannually. Similarly, most banks compute interest daily.
When compounding occurs more frequently than once a year, this fact must be
recognized.
In general, with more than one compounding period in a year, we can express
the formulas for present value and future value as:
 nm nm
 rs   rs 
PV  FVn 1   FVn  PV 1  
where:  m  m
m = number of compounding periods per year
rs = nominal (a.k.a. stated or quoted) annual interest rate
n = number of years
rs / m = periodic interest rate
nm = total number of compounding periods
Stated (Nominal) Interest Rate, rs
Rather than quote the periodic monthly interest rate, financial institutions often
quote an annual interest rate, referred to as the stated annual interest
rate.
When dealing with TVM problems, the stated annual interest rate must be
adjusted for the number of compounding periods (i.e. number of times
interest on interest is earned), which results in a periodic interest rate
(rs / m).
Example:
Compute the ending balance after 5 years of £5,000 invested at 13% assuming
quarterly compounding.
Solution:
m=4
n=5
PV = 5,000
rs = 13% = 0.13
rs / m = 0.13 / 4 = 0.0325 (periodic interest rate)
number of compounding periods (nm) = 5(4) = 20
FV5 = £5,000(1+ 0.0325)20 = £9,479.19

Important Note:
The periodic rate and total number of
compounding periods should be used for
calculations and shown on time lines.
Example:
A bank offers the company to pay 6% compounded monthly. The company
decides to invest €1m for one year.
What is the future value of the investment if interest payments are reinvested at
6%?
Solution:
PV = €1,000,000
rs = 6% = 0.06
m = 12
periodic interest rate (rs / m) = 0.06 / 12 = 0.0050
n=1 Note:
nm = 12(1) = 12 interest periods If the company had been paid 6% with
112
annual compounding, the future amount
 0.06  would be only €1,000,000(1.06) =
FV1  €1,000,0001    €1,061,677.81 €1,060,000 instead of €1,061,677.81
 12 
with monthly compounding.
Example:
$1,000 is deposited into a savings account that pays 3% interest with monthly
compounding.
What is the accumulated amount after two and a half years? What is the amount
of interest earned over this period?
Solution:
The investment interval is 30 months (or 30 compounding periods). Thus, the
accumulated amount is
30
 0.03 
FV2.5  $1,0001    $1,077.78
 12 
The amount of interest earned over this period is
1,077.78  1,000  $77.78

More frequent compounding results in larger accumulated amounts:
The table also shows that a $1 investment earning 8.16% compounded annually
grows to the same future value at the end of one year as a $1 investment
earning 8% compounded semiannually. This result leads to the distinction
between the stated annual interest rate and the effective annual rate (EAR).
For an 8% stated annual interest rate with semiannual compounding, the EAR is
8.16%.
Effective Annual Rate
If we are comparing the costs of loans that require payments more than once a
year, or the rates of return on investments that pay interest more frequently,
then the comparisons should be based on effective (or equivalent) annual
rates of return using this formula:
EAR  (1  Periodic interest rate) m  1
The periodic interest rate equals the stated interest rate divided by the number
of compounding periods in one year (i.e., rs / m).
Example:
Consider two investment schemes A and B. Scheme A offers 12% interest with
annual compounding. Scheme B offers 11.5% interest with monthly
compounding.
Calculate the effective equivalent rates of interest of the two investments. Which
scheme should be chosen?
Solution:
The effective rate of interest of Scheme A is equal to its nominal rate of interest, i.e.,
12%, because m = 1.
The effective rate of 12interest of Scheme B is
 0.115  EARB  EAR A
EARB  1    1  12.13%
 12 
Although Scheme A has a higher nominal rate of interest, Scheme B offers a higher
effective rate of interest. Hence, while an investment of €100 in Scheme A will
generate an interst of €12 after one year, a similar investment in Scheme B will
generate an interst of €12.13 over the same period. Thus, Scheme B is
preferred.
Loan Amortization Schedule
Amortized loans
An amortized loan is one that is paid off in equal payments over a specified
period.
An amortization schedule shows how much of each payment constitutes
interest, how much is used to reduce the principal, and the unpaid balance
at each point in time. For example:
Loan Amortization Schedule, 6% Interest Rate
Beginning Repayment Remaining
Year amount Payment Interest of principal
a b
balance
(1) (2) (3) (2) – (3) = (4) (1) – (4) = (5)
1 €1,000.00 €374.11 €60.00 €314.11 €685.89
2 685.89 374.11 41.15 332.96 352.93
3 352.93 374.11 21.18 352.93 0.00
€1.122.33 €122.33 €1.000.00
a
Interest is calculated by multiplying the loan balance at the beginning of the year by the interest rate. Therefore,
interest in Year 1 is €1,000(0.06) = €60; in Year 2 it is €685.89(0.06) = €41.15; and in Year 3 it is €352.93(0.06) =
€21.18.
b
Repayment of principal is equal to the payment of €374.11 minus the interest charge for each year.
Loan Amortization
Problem 1- 9:
A firm is considering raising capital by borrowing from a local bank. The
amount of the loan is €100,000. The bank will lend the money at a rate of
10% and requires that the loan be paid off in five equal end-of-year
payments.
1. Calculate the amount of the annual payment that the firm must make in
order to fully amortize the loan in five years.
2. Construct the detailed loan amortization schedule.

Loan Amortization
Solution:
The situation can be shown on the timeline:
r = 10%
n=0 1 2 3 4 5
- 100,000 PMT PMT PMT PMT PMT
r = 10%, n = 5, PVA5 (present value of annuity) = €100,000.

To find the annual end-of-year payment, use the formula for the present value
of ordinary annuity:
 1 
1 
 (1  r ) n 
PVAn  PMT  
 r 
 
Loan Amortization
It is possible to set up the equation and solve for the unknown variable PMT:
 1 
1 
 (1  0.1) 5 
100,000  PMT  
 0 .1 
 
100,000  PMT  3.790787
PMT  26,379.75
The general formula that can be used to find the amount of the annual end-of-
year payment is
PVAn  r
PMT 
1  (1  r )  n
Loan Amortization
Loan Amortization Schedule, 10% Interest Rate

Beginning Repayment Remaining
Year amount Payment Interest a
of principal b balance
(1) (2) (3) (2) – (3) = (4) (1) – (4) = (5)
1 €100,000.00 €26,379.75 €10,000.00 €16,379.75 €83,620.25
2 83,620.25 26,379.75 8,362.03 18,017.72 65,602.53
3 65,602.53 26,379.75 6,560.25 19,819.50 45,783.03
4 45,783.03 26,379.75 4,578.30 21,801.44 23,981.59
5 23,981.59 26,379.75 2,398.16 23,981.59 0.00
Total €131,898.74 €31,898.74 €100,000.00
Chapter 3: ANALYSIS OF FINANCIAL STATEMENTS
Principles of Financial Statement Analysis
Financial statement analysis applies analytical tools to financial statements

and related data to make investment decisions.
It involves transforming accounting data into information useful for analysis,
forecasting, and decision‐making.
Financial statement analysis generally begins with a set of financial ratios

designed to reveal the strengths and weaknesses of a firm as compared
with other firms in the same industry, and to show whether a firm’s financial
position has been improving or deteriorating over time.
Uses and Types of Financial Ratios
A ratio expresses a mathematical relationship between two quantities in terms

of a percentage or a proportion. Ratios may be computed using data directly
from companies’ financial statements or from other available databases.
Ratios standardize numbers and facilitate comparisons.
Uses of Ratio Analysis
Financial ratios provide insights into:
• Microeconomic relationships within the company that can be used to project

the company’s earnings and cash flows.
• A company’s financial flexibility.
• Management’s ability.
• Changes in the company and industry over time.
• How the company compares to peer companies and the industry overall.
Types of Financial Ratios
Liquidity ratios measure the company’s ability to meet its short-term

obligations.
Activity ratios measure how effectively a firm is managing its assets.
Solvency ratios reveal (1) the extent to which the firm is financed with debt and
(2) its likelihood of defaulting on its debt obligations.
Profitability ratios measure a company’s ability to generate an adequate return

on invested capital.
Market value ratios relate the firm’s stock price to its earnings, cash flow, and
book value per share, thus giving management an indication of what
investors think of the company’s past performance and future prospects.
Ratios: Interpretation and Context
The financial ratios of a company are compared to those of its major

competitors in cross-sectional analysis.
A company’s ratios for a given year can also be compared to its own prior
period ratios to identify trends.
The goal of ratio analysis is to understand the causes of material differences in
ratios of a company compared to its peers.
Note:
○ Not all ratios are important to every industry.
○ Companies may have several lines of business, which can cause aggregate
financial ratios to be distorted. In such a situation, one should evaluate ratios
for each segment of the business in relation to relevant industry averages.
○ Companies might be using different accounting standards.
○ Companies could be at different stages of growth or may have different
strategies. This can result in different values for various ratios for firms in the
same industry.
Structure of the Balance Sheet
Balance Sheet
The balance sheet provides a snapshot of a company’s assets.

It summarizes, at a given point in time, the company’s assets and liabilities
(which are, by definition, equal).
Assets refer to the resources available to the company to carry out its
business. They are classified by degree of liquidity (i.e., availability) and
broken down into current assets and fixed assets.
Liabilities represent claims against a company’s assets. They comprise equity

and debt capital, and are ranked by seniority of the claims.
The rule of thumb is that the current assets should be sufficient to cover short-
term debt obligations (such as operating loans), and long-term liabilities
(both debt and equity) should be sufficient to finance fixed assets.
Structure of the Balance Sheet
Exhibit 3.1. contains the financial reports of ABC Company, which we will use to
calculate and interpret various financial ratios.
Note that we have already analyzed the economic efficiency of this company in
Chapter 1.
Exhibit 3-1: Selected Financial reports, ABC Company
Balance Sheet as of Dec 31, 2015,

$ ‘000
Assets 2015 2014
Current Assets
Cash and cash equivalents 10 80
Accounts receivable 375 315
Inventories 615 415
Total Current Assets 1,000 810
Fixed Assets
Net plant and equipment 1,000 870
Total Assets 2,000 1,680
Note: Cash fixed capital expenditures during 2015 = net fixed asset
investments + depreciation expense = 130 + 100 = 230
Liabilities 2015 2014
Current Liabilities
Accounts payable 60 30
Accruals 140 130
Notes payable 110 60
Total Current Liabilities 310 220
Long-term debt 750 580
Total Liabilities 1,060 800
Shareholders’ Equity
Common stock (50k shares) 130 130
Retained earnings 810 750
Total Shareholders’ Equity 940 880
Total Liabilities and Shareholders’ Equity 2,000 1,680

Income Statements for years ending Dec 31, $ ‘000
2015 2014
Net Sales 3,000 2,850

Operating costs (excl. depreciation and amortization) 2,616.2 2,497
Depreciation and amortization 100 90
Total operating costs 2,716.2 2,587
Earnings before interest and taxes (EBIT) 283.8 263
Interest expense 88 60
Earnings before taxes (EBT) 195.8 203
Tax (40%) 78.3 81.2
Common dividends 57.5 53
Common stock price 23.06 26.00
Earnings per share (EPS) 2.35 2.44
Dividends per share (DPS) 1.15 1.06
Book value per share (BVPS) 18.80 17.60

Liquidity Ratios
Liquidity Analysis
Analysis of a company’s liquidity ratios aims to evaluate a company’s ability to

meet its short-term obligations. Liquidity measures how quickly a company
can convert its assets into cash at prices that are close to their fair values.
This analysis is especially important for lenders and creditors, who want to gain
some idea of the financial situation of a borrower or customer before
granting them credit.
Commonly used ratios are:
• Current ratio
• Quick ratio
• Cash ratio
Liquidity Ratios
Current Ratio
Current assets
Current ratio 
Current liabilities
It indicates the extent to which current liabilities are covered by those assets
expected to be converted to cash in the near future.
Current assets normally include cash, marketable securities, accounts
receivable, and inventories. Current liabilities consist of accounts payable,
short-term notes payable, current maturities of long-term debt, accrued taxes,
and other accrued expenses (principally wages).
A higher ratio is desirable because it indicates a higher level of liquidity.
The current ratio assumes that inventory and accounts receivable can readily be
converted into cash at close to their fair values.
Liquidity Ratios
Using the balance sheet data of the ABC company (see Exhibit 3-1), the
current ratio (CR) is
1,000
CR2015   3.2
310
CR (industry average) = 4.2
Comment:
The company’s CR is well below the average for its industry, 4.2, so its liquidity
position is relatively weak.
Liquidity Ratios
Quick Ratio
Cash  ShortTerm marketable investments  Receivables

Quick ratio 
Current liabilities
A measure of the firm’s ability to pay off short-term obligations without relying on
the sale of inventories.
This ratio considers the fact that inventory cannot be immediately liquidated at
its fair value.
When inventory is illiquid, this ratio is a better indicator of liquidity than current
ratio.
Using the balance sheet data of ABC company, the quick ratio (QR) is
10  375
QR2015   1.2
310
The industry average quick ratio is 2.1, so the company’s 1.2 ratio is low in
comparison with other firms in its industry.
Still, if the accounts receivable can be collected, the company can pay off its
current liabilities without having to liquidate its inventory.
Liquidity Ratios
Cash Ratio
Cash  ShortTerm marketable investments

Cash ratio 
Current liabilities
It is the most conservative liquidity measure.
The higher the cash ratio, the more likely it is that the company will be able to
pay its short-term bills
The cash ratio is a very reliable measure of an entity’s liquidity position in the
event of an unforeseen crisis. This is because it only includes cash and highly
liquid short‐term investments in the numerator.
For ABC company, the cash ratio (KR) is
10
KR2015   0.032
310
The company’s cash and cash equivalents are far from being sufficient to cover
the current obligations.
Activity Ratios
Asset Management Analysis
Activity ratios are also known as asset utilization ratios or operating efficiency
ratios.
They measure how well a company manages its operations and particularly
how efficiently it manages its assets—working capital and long‐lived assets.
• Inventory turnover
• Days of sales outstanding
• Fixed asset turnover
• Total asset turnover

Activity Ratios
Inventory Turnover Ratio
Sales
Inventory turnover ratio 
Inventories
This ratio is used to evaluate the effectiveness of a company’s inventory

management.
Generally, this ratio is benchmarked against the industry average.
A high inventory turnover ratio relative to industry norms might indicate highly
effective management. Alternatively, it could also indicate that the company
does not hold adequate inventory levels, which can hurt sales in case
shortages arise.
A low inventory turnover relative to the rest of the industry can be an indicator of
slow moving or obsolete inventory. It suggests that the company has too
many resources tied up in inventory.
Activity Ratios
For the ABC company (see Exhibit 3-1), inventory turnover ratio (INV T/O) is
3,000
INV T / O2015   4.9 times
615
INV T/O (industry average) = 9.0 times
Comment:
As a rough approximation, each item of the company’s inventory is sold out
and restocked, or “turned over,” 4.9 times per year.
The company’s turnover of 4.9 times is much lower than the industry average
of 9 times. This suggests that the company is holding too much inventory.
Excess inventory is unproductive, and it represents an investment with a
low or zero rate of return.
The company’s low inventory turnover ratio also makes us question the current
ratio. With such a low turnover, we must wonder whether the firm is actually
holding obsolete goods not worth their stated value.
Activity Ratios
Days Sales Outstanding
Receivables Receivables
Days sales outstanding  
Average sales per day Annual sales / 365
Days sales outstanding (DSO) represents the average length of time that the
firm must wait after making a sale before receiving cash, which is the
average collection period.
It is considered desirable to have a collection period close to the industry norm.
A collection period that is too high might mean that customers are too slow in
paying their bills, which means too much capital is tied up in assets.
A collection period that is too low might indicate that the firm's credit policy is too
rigorous, which might be hampering sales.
Activity Ratios
DSO ratio for ABC company is
375
DSO 2015   46 days
(3,000/365)
DSO (industry average) = 36 days
Comment:
The company has 46 days sales outstanding, well above the 36-day
industry average, which may indicate that customers are, on average,
not paying their bills on time.
Note:
DSO should also be evaluated by comparison with the terms on which the firm sells its goods. For example, if the
company’s sales terms call for payment within 30 days, the fact that 46 days’ sales, not 30 days’, are outstanding
indicates that customers, on the average, are not paying their bills on time. This deprives the company of funds that it
could use to invest in productive assets.
Moreover, in some instances the fact that a customer is paying late may signal that the customer is in financial trouble,
in which case the company may have a hard time ever collecting the receivable. Therefore, if the trend in DSO over the
past few years has been rising, but the credit policy has not been changed, this would be strong evidence that steps
should be taken to expedite the collection of accounts receivable.
Activity Ratios
Fixed Asset Turnover Ratio
Sales
Fixed assets turnover ratio 
Net fixed assets
A higher ratio indicates more efficient use of fixed assets in generating revenue.
A low ratio could be an indicator of operating inefficiency. However, a low fixed
asset turnover can also be the result of a capital intensive business
environment.
Companies that have recently entered a new business that is not fully
operational also report low fixed asset turnover ratios.
The fixed asset turnover ratio will be lower for a firm whose assets are newer
than for a firm whose assets are relatively older. The older‐asset firm will
have depreciated its assets for a longer period so the book value of its fixed
assets will be lower.
Activity Ratios
Fixed assets turnover (FA T/O) ratio for ABC company is

3,000
FA T / O2015   3.0 times
1,000
FA T/O (industry average) = 3.0 times
Comment:
The company’s ratio of 3.0 times is equal to the industry average, indicating
that it is using its fixed assets about as intensively as are other firms in its
industry.
Therefore, the company seems to have about the right amount of fixed assets
in relation to other firms.
Note:
If all firms in the industry have been expanding at about the same rate (the balance sheets of the comparison firms
are reasonably comparable), the ratio may be useful for comparison, otherwise, a more detailed analysis of the
industry fixed asset base is required.
Activity Ratios
Total Asset Turnover Ratio
Sales
Total assets turnover ratio 
Total assets
Different types of industries might have considerably different turnover ratios.

Manufacturing businesses that are capital-intensive might have asset
turnover ratios near 1.0, while retail businesses might have turnover ratios
near 10.0.
It is desirable for the total asset turnover ratio to be close to the industry norm.
Low asset turnover ratios might mean that the company has too much capital
tied up in its asset base.
A turnover ratio that is too high might imply that the firm has too few assets for
potential sales, or that the asset base is outdated.
Activity Ratios
Total assets turnover (TA T/O) ratio for ABC company is
3,000
TA T / O2015   1.5 times
2,000
TA T/O (industry average) = 1.8 times
Comment:
The company’s ratio is somewhat below the industry average, indicating that
the company is not generating a sufficient volume of business given its total
assets investment.
Sales should be increased, some assets should be disposed of, or a
combination of these steps should be taken.
Financial Leverage
Financial Leverage
The extent to which a firm uses debt financing is called financial leverage.
Generally, companies with relatively high ratios of tangible assets to total

assets or those with revenues that have below‐average business cycle
sensitivity are able to use more financial leverage than companies with
relatively low ratios of tangible assets to total assets or those with revenues
that have high business cycle sensitivity.
This is because stable revenue streams and assets that can be used as
collateral make lenders more comfortable in extending credit to a company.
Effects of Larger Proportion of Debt

The larger the proportion of debt in a company’s capital structure, the greater
the sensitivity of net income to changes in operating income, and therefore
the greater the company’s financial risk. Taking on more debt magnifies
profitability upward, if the company is performing well, and magnifies losses
if the company is performing badly (see example on the next slide).
Leveraging Role of Debt
Example:
The Leveraging Role of Debt
Firm U uses only shareholders’ funds to finance its assets. Firm L uses both debt and
equity capital for this purpose.
Firm U (unleveraged)
Current assets 50 Debt 0
Fixed assets 50 Common equity 100
Total assets 100 Total liabilities and equity 100
Scenarios
Expected Conditions Bad Conditions
Sales 100.00 82.50
Operating costs 70.00 80.00
Operating income (EBIT) 30.00 2.50
Interest 0.00 0.00
Earnings before taxes 30.00 2.50
Taxes (40%) 12.00 1.00
Return on Equity (ROE) = NI / Common Equity 18.00% 1.50%
NI 18 13.5
Expected conditions: ROEU    18% ROE L   27%
TE 100 50
NI 1.5 3
Bad conditions: ROEU    1 .5 % ROE L   6%
TE 100 50
Firm L (leveraged)
Current assets 50 Debt (cost of debt, rd = 15%) 50
Fixed assets 50 Common equity 50
Total assets 100 Total liabilities and equity 100
Scenarios
Expected Conditions Bad Conditions
Sales 100.00 82.50
Operating costs 70.00 80.00
Operating income (EBIT) 30.00 2.50
Interest 7.50 7.50
Earnings before taxes 22.50 (5.00)
Taxes (40%) 9.00 (2.00)
Net income (NI) 13.50 (3.00)
Return on Equity (ROE) = NI / Common Equity 27.00% (6.00%)
Solvency Ratios
Debt Management Analysis
Solvency refers to a company’s ability to meet its long‐term debt obligations.

Solvency ratios measure the relative amount of debt in a company’s capital
structure and the ability of earnings and cash flows to meet debt-servicing
requirements.
The amount of debt in the capital structure is important to assess a company’s
degree of financial leverage (its financial risk).
• Debt-to-assets ratio
• Times interest earned ratio
• Debt-to-equity ratio
Solvency Ratios
Debt-to-Assets Ratio
Total debt
Debt - to - assets ratio 
Total assets
Measures the percentage of funds provided by creditors.

Total debt includes both current liabilities and long-term debt.
A higher D/A ratio is undesirable because it implies higher financial risk and a
weaker solvency position.
Creditors prefer low debt-to-assets ratios because the lower the ratio, the
greater the cushion against creditors’ losses in the event of liquidation.
Stockholders, on the other hand, may want more leverage because it
magnifies expected earnings.
Solvency Ratios
For the ABC company , debt-to-assets ratio (D/A) is
310  750
D / A2015   0.53  53%
2,000
D/A (industry average) = 40%
Comment:
Company’s debt ratio is 53.0%, which means that its creditors have supplied
more than half the total financing.
The fact that the company’s D/A ratio exceeds the industry average should be
a concern and may make it costly for company to borrow additional funds
without first raising more equity capital. Creditors may be reluctant to lend
the firm more money, and management would probably be subjecting the
firm to the risk of bankruptcy if it sought to increase the D/A ratio any further
by borrowing additional funds.
Solvency Ratios
Times Interest Earned Ratio
EBIT
Times interest earned (TIE) ratio 
Interest charges
Measures the number of times a company’s operating earnings (earnings

before interest and tax, or EBIT) cover its annual interest payment obligations.
A higher ratio provides assurance that the company can service its debt from
operating earnings.
Solvency Ratios
For the ABC company , TIE ratio is
283.8
TIE 2015   3.2 times
88
TIE (industry average) = 6.0 times
Comment:
Company’s interest is covered 3.2 times. Since the industry average is 6 times,
the company is covering its interest charges by a relatively low margin of
safety. Thus, the TIE ratio reinforces the conclusion from our analysis of the
D/A ratio that the company would face difficulties if it attempted to borrow
additional funds.
Profitability Ratios
Profitability Analysis
Profitability is the net result of a number of policies and decisions.

Profitability ratios show the combined effects of liquidity, asset management,
and debt on operating results.
• Net profit margin
• Basic earning power ratio
• Return on assets
• Return on equity
Net Profit Margin
Net income
Net profit margin 
Sales
Net profit margin shows how much profit a company makes for every euro it
generates in revenue.
Managers should be concerned if this ratio is too low.
Note:
If two firms have identical operations in the sense that their sales, operating costs, and EBIT are the same, but if
one firm uses more debt than the other, it will have higher interest charges. Those interest charges will pull net
income down, and since sales are constant, the result will be a relatively low profit margin. In such a case, the low
profit margin would not indicate an operating problem, just a difference in financing strategies. Thus, the firm with
the low profit margin might end up with a higher rate of return on its stockholders’ investment due to its use of
financial leverage.
For the ABC company , net profit margin (NPM) is
117 .5
NPM 2015   0.039  3.9%
3,000
NPM (industry average) = 5%
Comment:
Company’s profit margin is below the industry average of 5%. This result
occurs because costs are too high. High costs, in turn, generally occur
because of inefficient operations. However, the company’s low profit margin
is also a result of its heavy use of debt.
Basic Earning Power
EBIT
Basic earning power (BEP) 
Total assets
Shows the raw earning power of the firm’s assets, before the influence of taxes
and leverage, and it is useful for comparing firms with different tax situations
and different degrees of financial leverage.
For the ABC company , basic earning power (BEP) is
283.8
BEP2015   0.142  14.2%
2,000
BEP (industry average) = 17.2%
Comment:
The company is not earning as high a return on its assets as is the average
company in the industry.
Return on Assets
Net income
Return on assets (ROA) 
Total assets
Measures the return earned by the company on its assets.

The higher the ROA, the greater the income generated by the company given
its total assets.
Note:
It is recommended to use average total assets in the formula.
For the ABC company , return on assets (ROA) is
117 .5
ROA2015   5.9%
2,000
ROA (industry average) = 9.0%
Comment:
The company’s 5.9% return is well below the 9% average for the industry.
This low return results from:

(1) the company’s low basic earning power plus
(2) high interest costs resulting from its above-average use of debt, both of
which cause its net income to be relatively low.
Return on Equity
Net income
Return on equity (ROE) 
Total equity
Measures the rate of return earned by a company on its equity capital.

Normally, equity capital includes minority equity, preferred equity, and common
equity.
It measures a firm’s efficiency in generating profits from every euro of net assets
(assets minus liabilities), and shows how well a company uses its investment
euros to generate earnings.
ROE is commonly used to compare the profitability of a company to that of other
firms in its industry.
Note:
It is recommended to use average total equity in the formula.
For the ABC company, return on equity (ROE) is
117 .5
ROE2015   12.5%
940
ROE (industry average) = 15.0%
Comment:
Shareholders invest to get a return on their money, and this ratio tells how well
they are doing in an accounting sense. The company’s 12.5% return is
below the 15% industry average, but not as far below as the return on total
assets.
This somewhat better result is due to the company’s greater use of debt.
DuPont Analysis
DuPont System and Return on Equity
DuPont analysis is designed to show how the net profit margin, the assets
turnover ratio, and the use of debt interact to determine the rate of return on
equity (ROE).
The firm’s management can use the DuPont system to analyze ways of
improving the firm’s performance.
It is arguably the most important equation in ratio analysis, since it breaks
down a very important ratio, ROE, into three key components:
Net income Sales Average total assets

ROE   
Sales Average total assets Average shareholders' equity
Net profit margin Total asset turnover Leverage

DuPont Analysis
A three-way DuPont decomposition demonstrates that a company’s ROE is a

function of its net profit margin, total asset turnover, and financial leverage.
Net profit margin is an indicator of profitability. It shows how much profit a

company generates from each money unit of sales.
Total asset turnover is an indicator of efficiency. It tells us how much revenue

(sales) a company generates from each money unit of assets.
Financial leverage is an indicator of solvency. It reflects the total amount of a

company’s assets relative to its equity capital.
For the ABC company , we can decompose the ROE into three elements:
117 .5 3,000 (2,000  1,680) / 2

ROE2015     12.9%
3,000 (2,000  1,680) / 2 (940  880) / 2
Comment:
The management can use the Du Pont system to analyze ways of improving
performance.
Focusing on the net profit margin side of its modified DuPont chart, the
company’s marketing department can study the effects of raising sales
prices (or lowering them to increase volume), of moving into new products
or markets with higher margins etc.
The company’s cost accountants can study various expense items and seek
ways to hold down costs.
On the asset turnover side, the firm’s financial analysts, working with both
production and marketing department, can investigate ways to reduce the
investment in various types of assets.
At the same time, the treasury staff can analyze the effects of alternative
financing strategies, seeking to hold down interest expense and the risk of
debt while still using leverage to increase the ROE.
DuPont Analysis
Decomposing ROE into Five Elements
To separate the effects of taxes and interest, we can further decompose ROE
into five elements.
Interest burden
Net income EBT EBIT Sales Average total assets

ROE     
EBT EBIT Sales Average total assets Average shareholders' equity
Tax burden EBIT margin Total asset turnover Leverage

DuPont Analysis
A five-way DuPont decomposition illustrates that a company’s ROE is a function

of the company’s tax burden, interest burden, operating profitability, efficiency,
and leverage.
Tax burden basically measures the percentage of its pretax profits that a
company gets to keep. A higher tax burden ratio implies that the company can
keep a higher percentage of its pretax profits. A decrease in the tax burden
ratio implies the opposite.
Interest burden ratio captures the effect of interest expense on ROE. High
borrowing costs reduce ROE. As interest expense rises, earnings before tax
(EBT) will fall as a percentage of EBIT, the interest burden ratio will fall, and
ROE will also fall.
EBIT margin captures the effect of operating profitability on ROE.
Total asset turnover is an indicator of the overall efficiency of the company,

while
Leverage ratio measures the total value of a company’s assets relative to its
equity capital.
DuPont Analysis
Example:
Consider the company’s financials given in the table below:
2015 2014 2013
ROE 20.62% 14.42% 10.17%
Tax burden 64.88% 62.52% 60.67%
Interest burden 130.54% 112.60% 130.50%
EBIT margin 6.51% 6.40% 4.84%
Total asset turnover 1.55 1.38 1.19
Leverage 2.42 2.32 2.24
Based on the data, comment on the positive trend in the company’s ROE.
Comment:
The trend in ROE (doubling in 3 years) did not result from a single aspect of
the company’s performance, but instead was a function of lower average
tax rates, increasing operating profits, greater efficiency, and increased use
of leverage.
DuPont Analysis
Problem 3-1:
Consider the following information about the company:
2011 2010 2009 2008 2007
ROE 9.47% 15.00% 24.31% 25.82% 24.07%
Tax burden 64.85% 59.37% 63.24% 58.20% 62.58%
Interest burden 92.58% 92.45% 92.74% 92.85% 92.61%
EBIT margin 8.63% 10.41% 13.24% 15.69% 14.35%
Total asset turnover 0.85 1.21 1.47 1.44 1.58
Leverage 2.15 2.17 2.13 2.19 2.18
Based on the data, comment on the negative trend in the company’s ROE.
DuPont Analysis
Solution:
The following conclusions may be drawn from the given information:
The tax burden ratio has varied with no obvious trend over the years. The
recent increase in tax burden ratio (from 59.37% in 2010 to 64.85% in 2011)
indicates that taxes declined as a percentage of pre‐tax profits. Average tax
rates may have declined as a result of (1) new legislation or (2) greater
revenue generated in lower tax jurisdictions.
The interest burden ratio remained fairly constant over the period, which
suggests that the company’s capital structure has remained fairly constant.
The EBIT margin declined over the period, indicating that the company’s
operations were less profitable.
The company’s asset turnover declined over the period, which suggests that
the company is becoming increasingly inefficient.
The financial leverage ratio remained fairly constant over the period, which is
consistent with the stable interest burden ratio.
Overall, the decline in the company’s ROE is mainly caused by a decline in the
EBIT margin (profitability) and asset turnover (efficiency).
Altman Z-Score
Ratios and Credit Analysis
Ratios have been used to analyze and predict firm bankruptcies.

Edward Altman (2000) developed a Z-score that is useful in predicting bankruptcies
of manufacturing firms (a low score indicates high probability of failure):
Z - Score  1.2 A  1.4 B  3.3C  0.6 D  1.0 E
where: A score below 1.8 means it's

likely the company is headed
A = working capital / total assets
for bankruptcy, while
B = retained earnings / total assets companies with scores
C = EBIT / total assets above 3 are not likely to go
D = market value of equity / total liabilities bankrupt.
E = sales / total assets
In 2012, Altman released an updated version called the Altman Z-score Plus that
one can use to evaluate public and private companies, manufacturing and
nonmanufacturing companies, and U.S. and non-U.S. companies. One can use
Altman Z-score Plus to evaluate corporate credit risk.
Chapter 4: CAPITAL BUDGETING
Businesses should pursue any investment opportunities that create added

value and increase shareholder wealth.
However, because the amount of capital any business has available for new
investments is limited, management uses capital budgeting techniques to
determine which investment projects will yield the best return over an
applicable period.
Commonly-used capital budgeting techniques:
• Net present value (NPV),

• Internal rate of return (IRR),
• Profitability index (PI)
Effective capital budgeting decisions maximize the company value .

Categories of Projects
Categories of Projects
Capital budgeting projects may be divided into the following categories:
Replacement projects to maintain the business

These are normally made without detailed analysis. The only issues are
whether the existing operations should continue and, if so, whether existing
procedures or processes should be maintained.
Replacement projects for cost reduction

Determine whether equipment that is obsolete, but still usable, should be
replaced. A fairly detailed analysis is necessary in this case.
Expansion projects
These are taken on to expand the business and involve a complex decision-
making process since they require an explicit forecast of future demand. A
very detailed analysis is required.
Interactions Between Projects
Independent Projects vs. Mutually Exclusive Projects
Independent project is one where the decision to accept or reject the project
has no effect on any other projects being considered by the company. The
cash flows of an independent project have no effect on the cash flows of other
projects or divisions of the business.
e.g. the decision to replace a company's computer system would be considered independent of a decision to
build a new factory.
Mutually exclusive projects compete directly with each other for acceptance.
For independent projects, the NPV and IRR criteria for acceptance lead to the
same result:
• Accept the project if NPV > 0.
• Accept the project if IRR > cost of capital.
For mutually exclusive projects, NPV and IRR may offer different
recommendations. In such a situation, a company should select the project
with the higher NPV. NPV is a better criterion because of its more realistic
reinvestment rate assumption.
Principles of Capital Budgeting
Key Principles of Capital Budgeting
Capital budgeting process involves five key principles:
1. Decisions are based on cash flows, not accounting income
Relevant cash flows to consider as part of the capital budgeting

process are incremental cash flows, i.e. the changes in cash flows that
will occur if the project is undertaken.
2. Cash flows are based on opportunity costs.
Opportunity costs are cash flows that a firm will lose by undertaking the
project under analysis.
These are cash flows generated by an asset the firm already owns that
would be forgone if the project under consideration is undertaken.
Opportunity costs should be included in project costs.
3. The timing of cash flows is important.
Capital budgeting decisions account for the time value of money, which
means that cash flows received earlier are worth more than cash flows
to be received later.
4. Cash flows are analyzed on an after-tax basis.
Impact of taxes must be considered when analyzing all capital budgeting

projects.
Firm value is based on cash flows they get to keep, not those they send to
the government.
5. Financing costs are reflected in the project's required rate of return.
Financing costs are reflected in the required rate of return from an

investment project, so cash flows are not adjusted for these costs.
Evaluation of Expansion Projects
Cash Flow Estimation for Expansion Projects
An expansion project is an independent investment that does not affect the

cash flows for the rest of the company.
Generally, we can classify incremental cash flows for capital projects as:
1. Initial investment outlay,
Initial investment outlay (CF0) is the up-front costs associated with the
investment project:
CF0  FCInv  NWCInv
Fixed capital investments Investments in net working capital:

Price of a fixed asset,
Noncash current assets  Nondebt current liabilities
( + shipping and installation
costs), cost of land

2. Annual After-Tax Operating Cash Flows
These are incremental operating cash flows generated by the project:
ATOCFt  ( S t  Ct  Dt )  (1  t )  Dt

Cash Sales
(generated over period t)

Cash operating expenses

(incurred over period t)

Although depreciation is a noncash
Depreciation expense, it has an impact on operating
(accumulated over period t) cash flow as it reduces the amount of
taxes paid by the company.
The higher the depreciation charged by
the company, the higher the resulting tax
savings.

Tax rate

3. Terminal Year After-Tax Non-Operating Cash Flow
At the end of the project's life, there are certain cash inflows that occur. These
are the after-tax salvage value and the return of the net working capital:
TNOCFT  SVT  NWCInv  t  ( SVT  BVT )


Salvage value:
pre-tax cash proceeds from sale
of fixed capital
(end of period T)

recovery of
working capital investment

Book value of
the fixed capital sold
(end of period T)
Evaluation of Expansion Projects using NPV Criterion
Net present value (NPV) is the sum of the present values of all the expected
incremental cash flows if a project is undertaken. The discount rate used is
the firm's cost of capital, adjusted for the risk level of the project.
ATOCF1 ATOCF2 ATOCF3 ATOCFT  TNOCFT

NPV  CF0     ... 
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r )T
where:
CF0 = initial investment outlay (this amount is typically negative)
ATOCFt = after-tax operating cash flow (over period t)
TNOCFt = terminal year after-tax non-operating cash flow (at the end of period t)
r = required rate of return for a project
Evaluation of Expansion Projects using NPV Criterion
Net present value (NPV) is the sum of the present values of all the expected
incremental cash flows if a project is undertaken. The discount rate used is
the firm's cost of capital, adjusted for the risk level of the project.
ATOCF1 ATOCF2 ATOCF3 ATOCFT  TNOCFT

NPV  CF0     ... 
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r ) T
NPV DECISION RULE:
IF... It means... Then...

NPV > 0 the investment would add value to the firm the project may be accepted
NPV < 0 the investment would subtract value from the firm the project may be rejected
the investment would neither gain nor lose value we should be indifferent in the decision
NPV = 0
for the firm whether to accept or reject the project.
Net Present Value
Example 4.1:
Using the project cash flows presented in the table below, compute the NPV of
each project’s cash flows and determine for each project if it should be
accepted or rejected. Assume that the cost of capital is 10%.
Year Project A Project B
0 -€2,000 -€2,000
1 1,000 200
2 800 600
3 600 800
4 200 1,200
1,000 800 600 200
NPV A  2,000      €157.64
(1  0.1) (1  0.1) (1  0.1) (1  0.1)
1 2 3 4
200 600 800 1,200

NPVB  2,000      €98.36
(1  0.1)1 (1  0.1) 2 (1  0.1) 3 (1  0.1) 4
Decision: Both Project A and B have positive NPVs, so both should be accepted (assuming
they are independent). If the projects were mutually exclusive, project A should be chosen.
Internal Rate of Return
Internal Rate of Return
For a normal project, internal rate of return (IRR) is the discount rate that
makes the present value (PV) of the expected incremental after-tax cash
inflows just equal to the initial cost of the project. More generally, the IRR is
the discount rate that makes the present values of a project's estimated
cash inflows equal to the present value of the project's estimated cash
outflows. That is, IRR is the discount rate that makes the following
relationship hold:
PV (cash inflows) = PV (cash outflows)
The IRR is also the discount rate for which the NPV of a project is equal to
zero.
n
CF1 CF2 CFn CFt
NPV  0  CF0    ...  
(1  IRR) (1  IRR)
1 2
(1  IRR) n
t  0 (1  IRR )
t
IRR Decision Rule
IRR Decision Rule
• First, determine the required rate of return for a given project. This is usually
the firm's cost of capital (rWACC).
• Note that the required rate of return may be higher or lower than the firm's
cost of capital to adjust for differences between project risk and the firm's
average project risk.
If IRR > required rate of return, accept the project.
If IRR < required rate of return, reject the project.
The higher the IRR on a project and the greater the amount by which it
exceeds the cost of capital, the higher the net cash flows to the investor.
Relative Advantages and Disadvantages of NPV and IRR
• A key advantage of NPV is that it is a direct measure of the expected

increase in the value of the firm. NPV is the theoretically best method. Its
main weakness is that it does not include any consideration of the size of the
project.
e.g., an NPV of €100 is great for a project costing €100 but not so great for a project costing € 1million.
• A key advantage of IRR is that it measures profitability as a percentage,

showing the return on each euro invested. IRR provides information on the
margin of safety that the NPV does not. From the IRR, we can tell how much
below the lRR (estimated return) the actual project return could fall, in
percentage terms, before the project becomes uneconomic (has a negative
NPV).
• Disadvantages of the IRR method are

(1) the possibility of producing rankings of mutually exclusive projects different
from those from NPV analysis, and
(2) the possibility that there are multiple IRRs or no IRR for a project.
Example 4.2:
The company would like to set up a new plant (expand). Currently, it has an
option to buy an existing building at a cost of €24,000. Necessary
equipment for the plant will cost €16,000, including installation costs. The
project would also require an initial investment of €12,000 in net working
capital. The initial working capital investment will be made at the time of the
purchase of the building and equipment.
1. Determine the initial cash outlay.

Example 4.2:
The company would like to set up a new plant (expand). Currently, it has an
option to buy an existing building at a cost of €24,000. Necessary
equipment for the plant will cost €16,000, including installation costs. The
project would also require an initial investment of €12,000 in net working
capital. The initial working capital investment will be made at the time of the
purchase of the building and equipment.
Solution:
CF0  FCInv  NWCInv  (24,000  16,000)  12,000  52,000
Example 4.2:
The project is expected to generate annual sales of €80,000 over four years.
The production department has estimated that variable manufacturing costs
will total 60% of sales and that fixed overhead costs, excluding
depreciation, will be €10,000 a year.
The effective tax rate = 40%. Cost of capital = 12%.
Depreciation expense will be determined for the year in accordance with the
accelerated depreciation method. Pre-tax depreciation for the building and
equipment is as follows:
Depreciation expense
Year 1 3,512
Year 2 5,744
Year 3 3,664
Year 4 2,544
2. Find the after-tax operating cash flows for years 1 – 4.

Example 4.2:
Year 1 3,512
Year 2 5,744
Year 3 3,664
Year 4 2,544
Solution:
ATOCF1  (80,000  58,000  3,512)  (1  0.4)  3,512  14,605
ATOCF2  (80,000  58,000  5,744)  (1  0.4)  5,744  15,498

Example 4.2:
Year 1 3,512
Year 2 5,744
Year 3 3,664
Year 4 2,544
Solution:
ATOCF3  (80,000  58,000  3,664)  (1  0.4)  3,664  14,666
ATOCF4  (80,000  58,000  2,544)  (1  0.4)  2,544  14,218

Example 4.2:
The project's estimated economic life is 4 years. At the end of that time, the
building is expected to have a market value of €15,000 and a book value of
€21,816, whereas the equipment is expected to have a market value of
€4,000 and a book value of €2,720.
3. Find the terminal year after-tax non-operating cash flows.

Example 4.2:
Solution:
TNOCF4  SV4  t  ( SV4  BV4 )  NWCInv

TNOCF4  [15,000  0.4  (15,000  21,816)]  [4,000  0.4  (4,000  2,720)]  12,000  33,214
Example 4.2:
4. Find the net present value. Would the expansion add value to the firm?
Example 4.2:
Solution:
ATOCF1 ATOCF2 ATOCF3 ATOCF4  TNOCF4
NPV  CF0    
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r ) 4
14,605 15,498 14,666 14,218  33,214

NPV  52,000      13,978
(1  0.12)1 (1  0.12) 2 (1  0.12) 3 (1  0.12) 4
IRR (using spreadsheet modeling or financial calculator) = 21.9%

Since NPV > 0, and the IRR > 12%, setting up a new plant would create value
for the firm.
Spreadsheet Solution (cash flows collected by year):
Year 0 1 2 3 4
Initial outlay:
FCInv – 40,000
NWCInv – 12,000
– 52,000
After-tax operating CFs:
Sales 80,000 80,000 80,000 80,000
Cash operating expenses 58,000 58,000 58,000 58,000
Depreciation 3,512 5,744 3,664 2,544
Operating income before taxes 18,488 16,256 18,336 19,456
Taxes on operating income 7,395 6,502 7,334 7,782
Operating income after taxes 11,093 9,754 11,002 11,674
Add back: depreciation 3,512 5,744 3,664 2,544
After tax operating CF 14,605 15,498 14,666 14,218
Terminal year after-tax non-operating CF:
After-tax salvage value 21,214
Return of NWC 12,000
TNOCF 33,214
Total after-tax CF – 52,000 14,605 15,498 14,666 47,432
NPV (12%) 13,978
IRR 21.9%
Evaluation of Replacement Projects
Cash Flow Estimation for Replacement Projects
Replacement project analysis occurs when a firm must decide whether to

replace an existing asset with a newer or better asset.
Cash flow analysis for a replacement project is more complicated because we

must deal with the differences between cash flows that occur with the new
investment and cash flows that would have occurred from the old investment
(the one being replaced).

Step 1:
We must first reflect the sale of the old asset in the calculation of the initial outlay
(CF0). The initial investment (cash outflow) for a replacement project is
reduced by the salvage value of the equipment being replaced (SV0) (cash
inflow) and increased by taxes paid on any gain on sale of the equipment
being replaced (cash outflow).
CF0  FCInv  NWCInv  SV0  t  ( SV0  BV0 )
Investments in new asset:

Current market price
of a new asset

Step 1:
Investments in net working capital


Step 1:
Salvage value of old asset:

pre-tax cash proceeds from sale
of old asset
(beginning of period)

Step 1:
Current book value of old asset


Step 1:
Tax paid on sale of old asset


Step 2:
Calculate the incremental operating cash flows as the cash flows from the new
asset minus the cash flows from the old asset.
ATOCFt  (S t  Ct )  (1  t )  tDt When calculating after‐tax operating

cash flow for replacement projects, we
only consider the changes in cash flow
ATOCFt  (S t  Ct  Dt )  (1  t )  Dt that result from the replacement.
Increase in sales
as a result of replacement

Step 2:

Increase in cash operating expenses


Step 2:

Increase in depreciation

Step 3:
At the end of the project, fixed capital is sold and taxes are paid on any gain on
sale.
Since only incremental cash flows are relevant in the analysis of a replacement
project, terminal year after-tax non operating cash flow consists of:
• Incremental cash flow over the selling price of an old fixed asset (ΔSVT);
• Recovery of additional investment in net working capital (NWCInv);
• Incremental cash flow from taxes on gains on disposal.
TNOCFT  SVT  NWCInv  t  (SVT  BVT )

Example 4.3:
Suppose the company wants to replace an existing printer with a new high-speed
copier. The existing printer was purchased 10 years ago at a cost of €15,000.
The printer is being depreciated using straight line basis assuming a useful life of
15 years and no salvage value (i.e., its annual depreciation is €1,000). Currently,
the printer has a net book value of €5,000.
The new high-speed copier can be purchased for €24,000 (including freight and
installation). Over its 5-year life, it will reduce labor and raw materials usage
sufficiently to cut annual operating costs from €14,000 to €8,000. This reduction
in costs will cause before-tax profits to rise by €14,000 – €8,000 = €6,000 per
year.
It is estimated that the new copier can be sold for €4,000 at the end of 5 years; this
is its estimated salvage value. The old printer's current market value is €2,000,
which is below its €5,000 book value. If the new copier is acquired, the old
printer will be sold to another company.
The company's tax rate is 40%, and the replacement copier is of slightly below-
average risk. Net working capital requirements will also increase by €3,000 at
the time of replacement. The project's cost of capital is set at 11.5%.
According to the accelerated depreciation method, the pre-tax depreciation for the
equipment is:
Year 1 = €7,920; Year 2 = €10,800; Year 3 = €3,600; Year 4 = €1,680; Year 5 = €0
Determine whether the project should be accepted using NPV analysis.

Solution:
Initial investment outlay:
CF0  FCInv  NWCInv  SV0  t ( SV0  BV0 )

CF0  24,000  3,000  2,000  0.4(2,000  5,000)  23,800
After-tax operating cash flows:
ATOCFt  (S t  Ct )  (1  t )  tDt
ATOCF1  [0  (6,000)](1  0.4)  (0.4)(7,920  1,000)  6,368

ATOCF2  [0  (6,000)](1  0.4)  (0.4)(10,800  1,000)  7,520
ATOCF3  [0  (6,000)](1  0.4)  (0.4)(3,600  1,000)  4,640
ATOCF4  [0  (6,000)](1  0.4)  (0.4)(1,680  1,000)  3,872
ATOCF5  [0  (6,000)](1  0.4)  (0.4)(0  1,000)  3,200
Terminal year cash flow:
TNOCF5  SV5  t (SV5  BV5 )  NWCInv

TNOCF5  (4,000  0)  0.4[(4,000  0)  (0  0)]  3,000  5,400
Given the company’s incremental cash flows and a cost of capital of 11.5%, NPV for
the project can be computed as:
ATOCF1 ATOCF2 ATOCF3 ATOCF4 ATOCF5  TNOCF5
NPV  CF0     
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r ) 4
(1  r ) 5
6,368 7,520 4,640 3,872

NPV  23,800     
(1  0.115) (1  0.115) (1  0.115) (1  0.115)
1 2 3 4
3,200  5,400
  1,197.28
(1  0.115) 5
IRR = 9.46% (using MS Excel)
Decision: Since NPV < 0 and IRR < cost of capital, the company should not replace
the printer with the new copier, because this would .
Capital Rationing
Capital Rationing
In an ideal world, companies would be able to invest in all available positive‐

NPV projects and maximize shareholder wealth. However, companies
typically have limited amounts of capital so they must choose between
projects and invest the capital budget in a manner that maximizes
shareholder wealth given the budgetary constraint. This is known as capital
rationing.
There are two types of capital rationing:
• Under hard capital rationing, the budget is fixed. In such situations,

managers should use the NPV and PI (profitability index) capital budgeting
methods.
• Under soft capital rationing, managers may be allowed to exceed their
budgets if they can convince senior management that the projects will
enhance shareholder wealth.
Profitability Index
Profitability Index
The profitability index (PI) of an investment equals the present value (PV) of
a project’s future cash flows divided by the initial investment. Therefore, the
PI is the ratio of future discounted cash flows to the initial investment.
PI indicates the value that a company receives in exchange for one unit of
currency invested. It is also known as the “benefit‐cost” ratio.
A company should invest in a project if its PI > 1. The PI is greater than 1 when
NPV is positive.
Profitability index (PI) is calculated as:
n
CFt

t 1 (1  r )
t
NPV
PI   1
CF0 CF0
Profitability Index
Example 5.4:
Consider a project which has the following cash flows:
Year Cash flow
0 –1,000
1 200
2 300
3 400
4 500
Assuming the required rate of return of 5%, determine the project’s profitability
index (PI).
Solution:
200 300 400 500

  
(1  0.05)1 (1  0.05) 2 (1  0.05) 3 (1  0.05) 4
PI   1.219
1,000
Profitability Index
Under capital rationing, a situation may arise where a company chooses a

project that has a lower NPV over a project that has a higher NPV in order to
maximize shareholder wealth given the budget constraint.
Example 5.5:
The management of the firm has a capital budget of €2,000 that it can use to
invest in the following projects. Assuming that the projects are not divisible,
which project(s) should the company invest in?
Project Investment outlay (CF0) NPV PI IRR(%)

A €1,200 250 1.21 12%
B 200 30 1.15 13%
C 600 –45 0.93 7%
D 400 80 1.20 11%
E 500 150 1.30 10%
Total investment €2,900
Profitability Index
Solution:
If the company had an unlimited capital budget, it would invest in Projects A, B,

D, and E (all positive‐NPV projects). However, given the fixed capital
budget (€2,000) the company must choose which project(s) to prioritize,
given the aim of shareholder wealth maximization.
When a company has a fixed capital budget, the profitability index (PI) is
extremely useful as it measures profitability per unit of investment.
If we rank the projects based on their PI’s, Project E has the highest PI,
followed by Projects A, D and B. Given the fixed budget, the company
would definitely invest in Projects E and A (combined investment: €1,700;
combined NPV €400), but would only have €300 left over, which is
insufficient to undertake Project D (the next most‐lucrative project).
However, it can accept Project B, and maximize NPV (given the budget
constraint) at €430 with a total capital investment of €1,900.
Mutually Exclusive Projects With Different Lives
When 2 projects are mutually exclusive, the firm may choose one project or
the other, but not both. If mutually exclusive projects have different lives,
and the projects are expected to be replaced indefinitely as they wear out,
an adjustment needs to be made in the decision-making process.
There are 2 procedures to make this adjustment:
• Least common multiple of lives approach.
• Equivalent annual annuity (EAA) approach.
Example:
Project A Project B
Initial investment $2,000 $1,000
Life of project 4 years 3 years
Annual after-tax cash flows Year 1: $600 Year 1: $500
Year 2: $800 Year 2: $800
Year 3: $1,000 Year 3: $800
Year 4: $1,200
Cost of capital 10% 10%
NPV $777.54 $716.75
IRR 24.89% 44.07%
Least Common Multiple of Lives Approach
In this approach, both projects are repeated until their “chains” extend over the same time
horizon. Given equal time horizons, the NPVs of the two project chains are compared
and the project with the higher chain NPV is chosen.
In the example above, Project A has a life of 4 years, while Project B has a life of 3 years.
The least common multiple of 4 and 3 is 12, which means that in order to compare the
two projects (over an identical time horizon) we would need to replicate Project A
three times and Project B four times.
Timeline 2: Project A
NPV (Project A 12-year chain) = $1,671.34
Timeline
- 2: Project B
Timeline 3: Project A
NPV (Project A 12-year chain) = $1,671.34
Timeline 4: Project B
NPV (Project B 12-year chain) = $1,963.82
Over an identical horizon, the replacement chain for Project B has a higher NPV
than the replacement chain for Project A. Therefore, the company should
choose Project B.
Equivalent Annual Annuity (EAA) Approach
This approach calculates the annuity payment (equal annual payment) over the
project’s life that is equivalent in present value (PV) to the project’s NPV. The
project with the higher EAA is chosen.
For our example, the EAAs of the two projects are calculated as:
Project A:
n = 4; r = 0.1; PVAn = 777.54
Using PV of ordinary annuity formula, solve for PMT (annuity payment):
 1   1 
1  1 
 (1  0.1) 4 
 (1  r ) n 
PVAn  PMT   777.54  PMT  
 r   0.1 
   
PMT (equivalent annual annuity) = 245.29
Project B:
n = 3; r = 0.1; PVAn = 716.75
PMT = 288.22
Since Project B has a higher EAA, it should be chosen over Project A.
Capital Projects: Risk Analysis
Sensitivity Analysis
Sensitivity analysis involves changing an input (independent) variable to see

how sensitive the dependent variable is to the input variable.
• For example, by varying sales, we could determine how sensitive a project's

NPV is to changes in sales, assuming that all other factors are held
constant. The key to sensitivity analysis is to only change one variable at a
time.
With sensitivity analysis, we start with the base-case scenario. Base case
would be the:
• NPV we determined by using the project's input estimates. We change one

of the selected variables by a fixed percentage point above and below the
base case, noting the effect this change has on the project's NPV. We could
do this for all the variables used in the analysis.
Example:
The company is analyzing an expansion project with the following cash flow
forecasts:
Expansion project base-case scenario data

Project life 3 years
Unit sales (per year) 1,500
Price €50.00
Variable cost (per unit) €20.00
Fixed cost (per year) €5,000
Fixed capital investments €60,000
Fixed assets are depreciated straight-line over 3 years to book value of zero
Net working capital investments €15,000
Salvage value at the end of three €10,000
years
Marginal tax rate 40%
Cost of capital 15%
Determine the project’s NPV under the base-case scenario. Run the sensitivity
analysis of the key inputs assuming a 20% increase and decrease in each
variable, holding the others constant. Determine to which inputs are the NPV
and the IRR estimates (1) most sensitive and (2) least sensitive?
Solution:
Base-case scenario NPV is calculated as:
FCInv  60,000
NWCInv  15,000
CF0  FCInv  NWCInv  60,000  15,000  75,000
S  Q  P  1,500  50  75,000
C  TVC  FC  (20  1,500)  5,000  35,000
initial fixed asset cost 60,000
D(using straight - line approach)    20,000
useful life 3
ATOCF13  ( S  C  D)(1  t )  D  (75,000  35,000  20,000)(1  0.4)  20,000  32,000
TNOCF3  SV3  t ( SV3  BV3 )  NWCInv  10,000  0.4(10,000  0)  15,000  21,000
Using the cost of capital of 15%, the NPV of the project is calculated as
3
32,000 21,000
NPV  75,000     €11,871
t 1 (1  0.15) (1  0.15)
t 3
IRR  23.5%
Input Estimate Down 20% Base Case Up 20% Comment:
Unit sales NPV – €458 €11,871 €24,200 The project’s NPV and IRR are
most sensitive to changes in
IRR 14.7% 23.5% 32.2% price because when price
Price NPV – €8,678 €11,871 €32,420 drops by 20% the NPV goes
from positive to negative.
IRR 8.6% 23.5% 37.8% The project is also sensitive to
Variable costs NPV €20,091 €11,871 €3,651 changes in unit sales because
IRR 29.3% 23.5% 17.6% a 20% drop in sales will
generate a negative NPV.
Fixed costs NPV €13,241 €11,871 €10,501
IRR 24.5% 23.5% 22.5% The project appears to be
least sensitive to changes in
Salvage value NPV €11,083 €11,871 €12,660 the estimate of salvage value
IRR 23% 23.5% 24% and fixed costs.
Scenario Analysis
While sensitivity analysis allows us to evaluate the impact of a change in one

input variable on NPV, scenario analysis calculates the NPV of a project in
a number of different scenarios where each scenario consists of changes in
several input variables.
The greater the dispersion in NPV across the given scenarios, the higher the
risk of the project.
In scenario analysis, we study the different possible scenarios, such as worst

case, best case, and base case.
Example:
Continuing with the previous example, we can run a scenario analysis of the
company as shown in the table:
Worst Case Base Case Best Case
Unit sales Down 20% 1,500 Up 20%
Price Down 20% €50.00 Up 20%
Variable costs Up 20% €20.00 Down 20%
Fixed costs Up 20% €5,000 Down 20%
Salvage value Down 20% €10,000 Up 20%
NPV – €25,632 €11,871 €60,882
IRR – 4.4% 23.5% 56.8%
Simulation Analysis
Simulation analysis (or Monte Carlo simulation) results in a probability distribution of

project NPV outcomes, rather than just a limited number of outcomes as with
sensitivity or scenario analysis (e.g., base case, best case, worst case).
Example:
The steps in simulation analysis may be as follows:
Step 1: Assume a specific probability distribution for each input variable. For example, we
might assume that unit sales are normally distributed with a mean of 100,000 and a
standard deviation of 15,000, unit prices are normally distributed with a mean of €40
and a standard deviation of €5, and so on for each input variable. We don't
necessarily have to assume a normal distribution for each variable, however.
Step 2: Simulate a random draw from the assumed distribution of each input variable.
That results in a single value for each of the inputs. For example, our first draw might
be unit sales of 85,000, a unit price of €42.00, and so on.
Step 3: Given each of the inputs from Step 2, calculate the project NPV
Step 4: Repeat Step 2 and Step 3 10,000 times.
Step 5: Calculate the mean NPV, the standard deviation of the NPV, and the correlation
of NPV with each input variable.
Step 6: Graph the resulting 10,000 NPV outcomes as a probability distribution.
For example, our NPV probability distribution for a simulation analysis might look like one
in the Figure. Notice that the probability distribution in the Figure is not symmetrical or
necessarily perfectly normal. That will typically be the case, although with a large
number of observations, the distribution is likely to be approximately normal.
Mean NPV = €12,000

Standard deviation = 10,000
Discount Rate Based on Market Risk Methods
Calculation of Discount Rate for a Capital Project Using Market Risk Methods
Market risk depends not only on the variation of a project’s cash flows but also
on how those cash flows correlate with market returns.
When using market risk measures, the applicable discount rate should reflect
the rate of return required by a diversified investor, and the risk premium
should only reflect factors that are priced in the marketplace (as opposed to
those that can be diversified away).
Practitioners typically use the capital asset pricing model (CAPM) to calculate
this discount rate (although others like the APT can also be used). The
CAPM breaks down total risk into:
• Systematic risk that is related to the market and is nondiversifiable. It is
typically measured by beta (β). Only systematic risk is priced in the market.
Diversified investors demand a risk premium for bearing systematic risk.
• Unsystematic risk is nonmarket risk that can be diversified away.
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The
rationale behind this technique contends that a portfolio constructed of different kinds of investments will,
on average, yield higher returns and pose a lower risk than any individual investment found within the
portfolio.
The security market line (SML) expresses the asset’s required rate of return
as a function of β (systematic risk).
ri  RF   i ( E ( RM )  RF )
Note:
Stand‐alone risk measures (such as the
where:
dispersion of a project’s expected NPVs
ri = required return for project or asset i and IRRs) are inappropriate when the
company is diversified or when its
RF = risk-free rate of return shareholders are diversified investors.
β = beta of project or asset i
[E(RM) – RF] = market risk premium
According to the SML, the required rate of return (or hurdle rate) varies with
each project according to its systematic risk (beta). The required rate of
return can be used to calculate NPVs and to evaluate IRRs, and then to
make capital budgeting decisions.
Example:
Using the SML to Find the Required Rate of Return for a Project
The management of Beta Construction is provided with the following information
regarding a new investment. Determine whether the company should invest in
the project.
Initial outlay $500,000

Annual after-tax operating cash flows $120,000
Project life 5 years
Terminal year after-tax non-operating $230,000
cash flow
Risk-free rate 5.5%
Expected market return 10.5%
Project beta 1.1
Solution:
First, we use the SML to determine the required rate of return for the project.
ri  RF   i ( E ( RM )  RF )  0.055  1.1[(0.105  0.055)]  0.11  11 %
Given a hurdle rate of 11%, NPV equals $80,001.45. The IRR equals 16.18%.
Both these capital budgeting techniques indicate that the company should
invest in the project.
Note:
Using a project's beta to determine discount rates is important when the risk of a project is different
from the risk of the overall company. Such a project-specific discount rate is also called a hurdle
rate. Hurdle rates vary from project to project.
The cost of capital (rWACC) reflects the riskiness of the company’s assets and its financial structure. It
represents the average risk of all projects undertaken by the company. Using the rWACC as the
discount rate will result in an overstated NPV for a relatively risky project, and an understated
NPV for a relatively conservative project.
Important Considerations in Capital Budgeting
Common Capital Budgeting Pitfalls
• Failing to incorporate economic responses into the analysis. For

example, if a profitable project is in an industry with low barriers to entry,
competitors may undertake a similar project, lowering profitability.
• Using the IRR criterion for project decisions. Using IRR may result in
conflicts with the NPV approach for mutually exclusive projects. The NPV
criterion is economically sound, accurately reflects the goal of maximizing
shareholder wealth, and should drive the project accept/reject decision when
IRR and NPV are in conflict.
• Poor cash flow estimation. For a complex project, it is easy to double

count or fail to include certain cash flows in the analysis. For example, the
effects of inflation must be properly accounted for.
• Using the incorrect discount rate. The required rate of return on the
project should reflect the project's risk. Simply using the company's WACC
as a discount rate without adjusting it for the risk of the project may lead to
significant errors when estimating the NPV of a project.

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Financial Management BATIS 2022 4

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FINANCIAL MANAGEMENT

STUDY COURSE DEVELOPER: MAKSIMS GRINČUKS, Turiba University

Financial Management: Definition and Primary Objective

Financial management involves managing all of a company's assets and

Primary objective of financial management – maximization of profit and

However, a more informative indicator of the managerial performance is the

EP  IC  ( ROIC  rWACC ) where:

Return on invested capital:

Net operating profit after tax:

Return on invested Cost of capital, %

If ROIC > rWACC , the firm is generating added value

Financials (end of year):

1. Find the return on invested capital (ROIC), %.

Financials (end of year):

Financials (end of year):

2. Find the economic profit (loss).

Financials (end of year):

EP  IC  ( ROIC  rWACC )  €8,000,000(0.125  0.08)  €360,000

FCFt  NOPAT t  IC

Net Operating Profit After Tax (NOPAT)

Free cash flow is necessary for:

1. making interest payments and principal repayments to creditors

According to modern financial theory, the fundamental value of the business is

FCFt  NOPAT t  IC

Calculation of invested capital (total net operating capital) (IC):

IC  C  A / R  INV   ( A / P  AX )  OLTA

Net working capital Investments in

Net operating working capital (NOWC ) =

Operating current assets are assets that are:

Calculation of invested capital (total net operating capital) (IC):

IC  C  A / R  INV   ( A / P  AX )  OLTA

Net working capital Investments in

Net operating working capital (NOWC ) =

Operating current liabilities are liabilities that are:

Economic Value Added

Economic Value Added (EVA) is an analytical tool used to measure a

EVA  EBIT (1  t )  IC  rWACC

Liabilities and Shareholders’ Equity 2020 2019

1. Find the company’s free cash flow as of the end of 2020.

IC2020 = (NOWC + OLTA)2020 = [(C + A/R + INV) – (A/P + AX) + OLTA]2020

IC2019 = (NOWC + OLTA)2019 = [(C + A/R + INV) – (A/P + AX) + OLTA]2019

FCF2020 = EBIT2020 (1 – t) – (IC2020 – IC2019) = 283.8 (1 – 0.4) – (1,800 – 1,520) =

EVA2020 = EBIT(1 – t) – IC × rWACC = 283.8 (1 – 0.4) – 1,800 × 0.11

= 170.3 – 198 = – $27.7

EVA2019 = EBIT(1 – t) – IC × rWACC = 263 (1 – 0.4) – 1,520 × 0.11

= 157.8 – 167.2 = – $9.4

Financial decisions often involve situations in which someone pays money at

Time Value of Money

Compounding and Future Value

Compounding is the process of determining the future value (FV) of a cash

Future value is the value of a sum of money or a stream of cash flows at a

€100 FV1 = €110

Discounting and Present Value

Discounting is the process of determining the present value (PV) of a

Interpreting Interest Rates

Interest rates can be thought of in three ways:

• The minimum rate of return that you require to accept a payment at a

• The opportunity cost of spending the money today as opposed to saving it

The Five Components of Interest Rates

• The real risk‐free rate (RRFR) is the single‐period return on a risk‐free

• The maturity premium (MRP) compensates investors for the higher

rd  RRFR  IP  DRP  LP  MRP

Future Value of a Single Cash Flow

PV and FV Calculation: Variable Interest Rates