Chapter one overview of Financial

management

Financial Management –I By
 An Overview of Financial Management
 Finance is the art and science of
managing money.
 FinanceManagement
Financial can be publicis or private
mainly concerned with
thefinance.
effective funds management in the business.
Another name of Financial Management Basic assumptions:
is
 Corporation Finance (widely)  Existence of well-developed capital markets
 Business Finance (rarely).  The context of Corporate form of business
organizations
Separate legal existence
Finance as the area of study
Finance, in general, consists of three interrelated areas:
 Money and capital markets, which deal with securities markets and financial
institutions;
 Investments, which focus on the decision of investors, both individuals and
institutions, as they choose among securities for their investment portfolios; and
 Financial management or "business finance" which involves the actual
 Basic Assumptions and Principles of FM…
1. The risk-return trade-off -In financial decision making, we don’t
take additional risk unless we expect to be compensated with
additional return
2. The time value of money- A dollar received today is worth more
than a dollar to be received in the future
3. Cash – NOT profit – is a king - In measuring wealth or value, we
will consider cash flows, not accounting profits
4. Incremental cash flows- cash flow which is the difference between
the cash flows if the decision is made versus what they will be if the
decision is not made/Relevant cash flow analysis/
 Basic Assumptions and Principles of FM…

1. The curse of competitive markets- If an industry is generating large

profits, new entrants usually attracted
2. Efficient capital markets- An efficient (informational efficiency)
capital market is a market in which the values of all assets and
securities at any instant in time fully reflect all available public
information.
3. The Agency problem- It is the problem resulting from conflicts of
interest between the managers (agents of the stockholders) and the
stockholders
4. Taxes bias business decision & Ethical behavior …
5. All risks are not equal – Some risks can be diversified away, and
 Scope of Financial Management (FM)
ancial management directly related with Related field of FM:
ious functional departments like Accounting  Production
 personnel/HR, Economics Management
marketing and Mathematics/  Marketing
production. Statistics  Human Resources
Financial management decisions
Finance functions or decisions include:
1. Investment or long-term asset mix decision (capital budgeting ) - Investment
decisions or capital budgeting involves the decision of allocation of capital or
commitment of funds to long term assets that would yield benefits in the future.
2. Financing or capital mix decision - The mix of debt and equity is known as the
firm’s capital structure
3. Dividend or profit allocation decision - The financial manager must decide whether
the firm should distribute all profits or retain them or distribute a portion and retain
the balance
4. liquidity or short-term asset mix decision (Working capital decision) - Financial
 Forms of Business Organization
Major forms of business organization around the globe .
4. Corporation
1. Sole Proprietorship
S Corporation
2. Partnership
Limited Liability Company
General Partnership
5. Cooperatives
Limited Partnership
Sole Proprietorship
Advantages Disadvantages
 Easiest to start  Limited to life of owner
 Least regulated  Equity capital limited to owner’s
 Single owner keeps all of personal wealth
the profits  Unlimited liability
 Taxed once as personal  Difficult to sell ownership interest
income
 Partnership
• Disadvantages
• Advantages • Unlimited liability
• Two or more owners • General partnership
• More capital available • Limited partnership
• Relatively easy to start • Partnership dissolves when one
• Income taxed once as personal partner dies or wishes to sell
income
• Difficult to transfer ownership
Corporation
• Advantages • Disadvantages
• Limited liability • Separation of ownership and
• Unlimited life management (agency problem)
• Separation of ownership and • Double taxation (income taxed at the
management corporate rate and then dividends
• Transfer of ownership is easy taxed at personal rate, while dividend
• Easier to raise capital paid are not tax deductible)
 Goal of Financial Management
hat should be the goal of a corporation?  Maximize market share?
• Maximize profit?  maximization of shareholders
• Minimize costs? wealth ?
 The ultimate goal of FM is to maximize the shareholders
 Maximizewealth through
earning per share?
maximization of current value per share of the existing stock.
 Does this mean financial manager should do anything and everything to maximize
owner wealth? The Agency Problem
While the goal of the business firm will be maximization of shareholders'
wealth, in reality the agency problem may interfere with the implementation of
this goal.
The agency problem is the result of a separation of the management and the
ownership in firms.
 Stockholders (principals) hire managers (agents) to run the company
 Financial Markets and the Corporation
• Physical Assets Vs. Financial Assets
 Physical Asset Markets – for such products as wheat, autos, real
estate, computers, and machinery.
 Financial Asset Markets – deal with stocks, bonds, notes,
mortgages, derivatives, & other financial instruments.
• Time of Delivery: Spot Vs. Future
 Spot Markets – markets where assets are being bought or sold for
“on-the-spot” delivery (within a few days).
 Futures Markets – for assets whose delivery is at some future date,
such as 6 months or a year into the future.
 Financial Markets and the Corporation

Maturity of Financial Asset: Short Vs. Long

Money Markets – for short-term, highly liquid debt securities, < a
year.
Capital Markets – for corporate stocks and debt maturing > a
year in the future.
Primary Markets Vs. Secondary Markets
Primary Markets – originally gov’ts & corporations raise new
capital.
Secondary Markets – existing, already-outstanding securities are
traded among investors.
Financial statement Analysis part one

Financial Management –I By
 Financial Statement Analysis
Analyzing financial statements involves
Characteristics
Comparison Bases: Tools of Analysis
 Liquidity
 Intracompany  Horizontal
 Profitability
 Intercompany  Vertical
 Solvency
 Industry averages  Ratio
 Efficiency

Horizontal Analysis (HA)

 HA, also called trend analysis, is a technique for evaluating a series
of financial statement data over a period of time.
 Purpose is to determine the changes that has taken place.
HA is commonly applied to the SFP, IS, and SREs. 12
Financial Statement Analysis
Horizontal Analysis
• Changes suggest that the
firm expanded its asset
base during 2017 and
• Financed this expansion
primarily by retaining
income rather than
assuming additional long-
term debt.

13
Financial Statement Analysis
Horizontal Analysis
• Overall, gross profit and
net income were up
substantially.
• Gross profit increased
17.1%,
• Net income increased
26.5%.
• Firm’s profit trend
appears favorable.

14
 Vertical Analysis (VA)
• VA, also called common-size analysis, is a technique that expresses each
financial statement item as a percent of a base amount.
• For instance, on an IS, we might say that selling expenses are 16% of net sales.
• VA is commonly applied to the SFP and the IS.

15
Vertical Analysis cont’d

 The firm appears to

be a profitable firm
that is becoming even
more successful.

16
 Ratio Analysis

• Mathematical formulas which give insight on parts of the firm.

• Expresses the relationship among selected items of financial statement data.
• Ratios are an analyst's microscope; they allow to get a better view of the firm's
financial health than just looking at the raw FS.
• Ratios are useful both to internal and external analysts of the firm.
• But a single ratio by itself is not meaningful (see next slide).

 The discussion of
ratios will include
the following types
of comparisons.
17
 Ratio Analysis Cont’d
Financial Ratios Classifications:
1. Liquidity Ratios (Short-term Solvency) 4. Profitability Ratios
2. Financial Leverage Ratios (Long-term 5. Market Value Ratios
Solvency)
3. Asset Management (Turnover) Ratios
Liquidity Ratios
 Measure the short-term ability of the company to pay its maturing obligations
and to meet unexpected needs for cash.
 Short-term creditors such as bankers and suppliers are particularly interested in
assessing liquidity.
These ratios include:
1. The Current Ratio 2. Acid-test Ratio
3. The Cash Ratio 4. The Net18
 Ratio Analysis Cont’d
Liquidity Ratios Current Ratio
• Example:
Rule/guide:
• CR is better if 2:1
• In the example CR of 2.96:1 means that
for every dollar of current liabilities, firm
has $2.96 of current assets.
• Depends on the industry on which the
Firm involves
• Too much – less profitable
• Too low – Risky 19
Ratio Analysis…
Liquidity Ratios Acid-test Ratio

Acid-test (quick) ratio measures immediate liquidity.

• Rule/guide:
• QR is better if 1:1
• Example:

 Quick Ratio = [CA – (Inventories + Prepaid Expenses]/CL

 It tells us a measure of firm’s ability to pay off short-term obligations
without relying on the sale of inventories. 20
 Ratio Analysis Cont’d

Assets Management Ratios

• Intended to describe how efficiently or intensively a firm uses its
assets to generate sales.
• Also called asset utilization ratios – measures of turnover.
• Some of the measures are:
• inventory turnover and days’ sales in inventory
• receivables turnover and days’ sales in receivables
• asset turnover ratios

21
Ratio Analysis…
Assets Management Ratios  ITO
• Inventory Turnover and Days Sales in Inventory
• Inventory measures tell us how fast we can sell product.
• 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 = (𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅)/(Average 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 )
• Inventory turnover varies by type of inventory.
• The higher inventory turnover indicates the improvement in inventory management.
• Example:

22
Ratio Analysis…
Assets Management Ratios  DSI
 Days Sales in Inventory

Or

• Where,
• It is a rough measure of the length of time it takes to purchase, sell, and replace
the inventory.
• The shorter this number indicates the improvement in managing inventory. 23
Ratio Analysis…
Assets Management Ratios  ARTO & DSAR
 Receivables Turnover and Days Sales in Receivables
 Receivable measures tells us how fast we collect credit sales.

• The longer receivables turnover indicates that customers, on average,

are not paying their bills on time!
• This ratio makes more sense if we convert it to days, so here is the
days’ sales in receivables.

• Also called the average collection period (ACP). 24

Ratio Analysis…
Profitability Ratios
• Measure the income or operating success of a company for a given period of
time.
• Income, or the lack of it, affects the company’s ability to obtain debt and equity
financing, liquidity position, and the ability to grow.
• Ratios include:
• Profit Margin,
• Return On Assets,
• Return On Equity,
• Earnings Per Share,
• Price-earnings, and
• Payout Ratio.
25
Ratio Analysis…
Profitability Ratios  Profit Margin & ROA
• Profit Margin – measures the percentage of each dollar of sales that results in net
income.
• Example:

• Return on Assets – measure of profitability generated through the assets.

• Ex:

26
Ratio Analysis…
Profitability Ratios  ROE
• Return on Equity – shows how many dollars of net income the company earned for each
dollar invested by the owners.

• Example:

27
Ratio Analysis…
Profitability Ratios  EPS
• Earning per Share – a measure of the net income earned on each share of common
stock.

• Example:

28
Ratio Analysis…
Profitability Ratios  P-E ratio
• Price-Earnings ratio – measures the net income earned on each share of common
stock.

Assumption:
• Ex: • the market price of firm’s shares
is $8 in 2016 and $12 in 2017.

29
Ratio Analysis…
Profitability Ratios  Payout Ratio
• Payout Ratio – measures the percentage of earnings distributed in the form of cash
dividends.

• Example:

30
 Ratio Analysis Cont’d
Financial Leverage Ratios
• They are intended to address the firm’s long-term ability to meet its
obligations, or, more generally, its financial leverage.
• Commonly used measures are:
• Total debt ratio, debt–equity ratio, equity multiplier, Times Interest Earned
& Cash Coverage
Financial Leverage Ratios  Total Debt Ratio
TDR takes into account all debts of all maturities to
all creditors.
TDR = (𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 −𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚)/
(𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔)
= (𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒆𝒔)/(𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔)
Rule: <50%
Two useful variations on the TDR:
the debt–equity ratio & the equity multiplier 31
 Ratio Analysis Cont’d
Financial Leverage Ratios  Debt-Equity Ratio
• Debt-Equity Ratio – measures how much of the company is financed by debt and
equity!
• 𝑫𝑬𝑹 = (𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕)/(𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚) Example:
2017
DER = $832,000/$1,003,000
= 83%
• Rule: <100% [or, <1]
• The lower ratio indicates that the firm’s liabilities as a proportion of
equity is decreasing.
• 𝑬𝒒𝒖𝒊𝒕𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = (𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔)/(𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚) = 1+ 𝑫𝑬𝑹
• Example: EM = TA/TE = $1,835,000/$1,003,000 = 1.83 times
EM = 1+ DER  1+ 0.83 = 1.83 times.
32
 Ratio Analysis Cont’d
Financial Leverage Ratios Times Interest Earned
• Times Interest Earned - measures how well a company has its interest
obligations covered, and it is often called the interest coverage ratio.
• 𝑻𝑰𝑬 𝑹𝒂𝒕𝒊𝒐 = 𝑬𝑩𝑰𝑻/𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
• Interest expense is paid before income taxes i.e., interest expense is
deducted in determining taxable income.
• Rule: the higher the ratio, the more likely interest payments will be.
TIE = EBIT/Interest > $468,000/$36,000 = 13 times

33
 Ratio Analysis Cont’d
Financial Leverage Ratios  Cash Coverage
• Cash Coverage –
• Problem with the TIE ratio is that it is based on EBIT, which is not really a
measure of cash available to pay interest.
• The reason is that depreciation, a noncash expense, has been deducted out.
• Because interest is definitely a cash outflow (to creditors).
• 𝑪𝒂𝒔𝒉 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 = (𝑬𝑩𝑰𝑻+𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏)/𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
• The numerator here, EBIT plus depreciation, is often abbreviated EBITD
(earnings before interest, taxes, and depreciation).
• EBITDA – variation for when amortization applies.

34
Ratio Analysis…
Market Value Ratios  M/B ratio
• Market-to-Book Ratio – compares the market value of the firm’s investments to their cost.
• A value less than 1 indicates that the firm has not been successful overall in creating value for
its stockholders.

• Example:
• M/B = $12/$1 = 12

35
Thematic area Corporate Finance

Course Financial
Management
Part I
Part III
III

Risk and Return

 Risk and Return
Risk is usually defined as the actual or potential variability of returns
from a project or portfolio
Risk-free returns are known with certainty
 Federal Government Treasury Bills are often considered the risk-
free security.
 The risk-free rate of return sets a floor under all other returns in the
Returns • Ex Post Returns (After the fact) Return that an investor actually realizes
market
• Ex Ante Returns (Before the fact) Return that an investor expects to earn

Holding Period Return

• Return for holding an investment for one period (i.e. period of days,
months, years, etc.)
• When there is no cash flow during the holding period, then:
 Holding Period Return
HPR = Holding Period Return P1 - P0
P1 = Ending Price HPR =
P0 = Beginning Price
P0

When there is a cash flow in addition to the ending price (such as the
payment of a dividend), the Holding Period Return formula is:
P1+Cash Flow  - P0
Example HPR = P0
You bought a stock one year ago for $10. Today, it is worth $12.
Yesterday, you received a $1 dividend. What is your
 holding
P1+Cash period
Flow  - P0
return? HPR =
P 0


12  1  10
10
 0.30 or 30% 38
 Expected Return r̂( ):
• When returns are not known with certainty, there will often exist a
probability distribution of possible returns with an associated
probability of occurrence.
n
• Expected return is a weighted average of the individual possible
returns
Possible (rj), with weights
Probability
r̂   r p
of being the probability of occurrence (p j).
j1
j j
Return Occurrence
n
-10% 5% r̂  rp
j1
j j

0% 10%
  10% .05   0% .10  
+5% 25%
5%.25  15% .50   25% .10 
+15% 50%
 10.75%
+25% 10%
39
 Measurements of Risk
• Standard Deviation  ( ): a statistical measure of the dispersion, or
r̂
variability, of outcomes around the mean or expected value ( ).
• Low standard deviation means that returns are tightly clustered
around the mean
• •High standard deviation means that returns are widely dispersed
Three common ways of calculating standard deviation:
around the mean
• Returns are known with certainty
• Standard deviation of a population
• Standard deviation of a sample
• Returns are not known with certainty

40
 Standard Deviation (Historical) of a Population
First, calculate the variance (2):

     
2 2 2

2
r1 - r + r2 - r +...+ rN - r
σ =
N
The standard deviation ( ) is the square root
of the variance:
r = Mean return σ= σ2
ri = Return i
N = Number of returns
You have been given the following sample of stock returns, for which you
r1 + r2 + ... + rN
would like to calculate the standard deviation:
AM =
N
{12%, -4%, 0%, 22%, 5%} 12 - 4  0  22  5

Step 1: Calculate Arithmetic Return 5
 7%
41
 Standard Deviation: Example
Step 2: Calculate Variance r - r  + r - r  +...+ r - r 
2 1
2
2
2
N
2

S =
N-1
12  7    4  7   0  7   22  7   5  7 
2 2 2 2 2


5 1
 106
s = S2
Step 3: Calculate Standard Deviation
 106
 10.3%

Standard Deviation – Returns Not Certain

rj = return at time period j
 
n 2
σ2 = rj - r p j = expected return
j=1
pj = probability of return j occurring
42
 Standard Deviation: Example
You have been provided with the following possible returns and their
associated probabilities. Calculate the expected return and the standard
deviation of return. Return
State of Economy Probability

Boom 30% 15%

Normal 15% 60%

Recession 0% 25%
n
Step #1: Calculate the Expected Return r̂   rjp j
j 1

 30% .15   15% .60   0% .25 

 13.5%
43
 Standard Deviation: Solution
Step #2: Calculate the VarianceState of Economy Return Probability

Boom 30% 15%

Normal 15% 60%

 
n 2
2
σ = rj - r p j Recession 0% 25%
j=1

= 30-13.5  .15  + 15-13.5  .60  + 0-13.5  .25 

2 2 2

= 87.75
Step #3: Calculate the Standard Deviation σ= σ2
= 87.75
= 9.4%

44
 Concept of Efficient Portfolios
• Has the highest possible expected return for a given level of risk (or standard
deviation)
• Has
 Athe lowest possible level of
dominates B because it risk
has for
theasame
given expected
expected return
return for a given
risk.
 C dominates B because it has a higher expected return for a given
r̂ risk.
C

A B


45
 Coefficient of Variation (v)

The ratio of the standard deviation r̂
( ) to the expected value ( ).
Tells us the risk per unit of return.
An appropriate measure of total risk when comparing two investment projects of

different size.
v
r̂
Example: You are asked to rank the following set of investments according to
their risk per unit of return.
Security Return Standard
Deviation
A 6% 7%

B 10% 13%

C 18% 21%
46
 Coefficient of Variation
Security Return Standard Coefficient of
Deviation Variation
7
A 6% 7%  1.17
6
B 10% 13% 13
 1.3
Most Risk 10
C 18% 20% 20
 1.1
Least Risk 18

Relationship Between Risk and Return

Risk-Return Relationship
 The riskier, or the more variable, the expected cash flow stream, the
higher the required rate of return.
 Required Rate of Return = Risk-free Rate of Return + Risk Premium
 Risk-free Rate: rate of return on securities that are free of default risk,
47
such as T-bills.
 Relationship Between Risk and Return
Risk Premium: expected “reward” the investor expects to earn for assuming risk
 Risk-free Rate of Return (rf) = Real Rate of Return + Exp. Inflation Premium
 Real Rate of Return: the reward for deferring consumption
 Expected Inflation Premium: compensates investors for the loss of purchasing
power due to inflationTypes of Risk Premiums

 Maturity risk  Marketability risk premium

premium  Business risk
 Default risk  Financial risk
48
 Modern Portfolio Theory
Modern portfolio theory was introduced by Harry Markowitz in 1952. Markowitz, Sharpe &
Miller were co-recipients of the Nobel Prize in Economics in 1990 for their pioneering work in
portfolio theory

Harry Markowitz William F. Sharpe Merton Miller

Expected Return of portfolio

The expected return on a portfolio is the weighted average of the returns of each
asset within the portfolio
Example: A portfolio is comprised of three securities with the following
returns:
49
 Expected Return
n
Security Return % of Portfolio r̂  r w
j 1
j j
A 5% 30%
B 10% 45%
 5% .30   10% .45  15% .25 

C 15% 25%  9.75%

rj = return at time period j,
r̂ = expected return
wj = proportion of the portfolio comprised of asset j
Portfolio Risk: Two Risky Assets
Standard deviation of a two-asset portfolio is
calculated as follows σ = standard deviation
2 2 2 2 wA = the proportion of the portfolio comprised of A
σ = wA σ A + wBσ B + 2w AwBρ A,Bσ Aσ B
ρA,B= the correlation coefficient between A & B
50
 Portfolio Risk: Two Risky Assets
ets
s
2 2 2 2 as
σ= w σ
A A + w σ + 2w AwBρ A,Bσ Aσ B
B B os
e
r.
h o h e
, c ot
k ch
ris e ea
l i o v h
t
rt fo t h a w i
po tha ions
Portfolio risk is driven mainly by the ize l a t
m re
correlation between the assets!! in i co
r
m
To low
e ry
Correlation v

Correlation is a measure of the linear relationship between two assets

Correlation varies between perfect negative (-1) to perfect positive (+1)
Perfect negative correlation: when the return on asset A rises, the return
on Asset B falls and vice versa
Perfect positive correlation: the returns on asset A and Asset B move in
perfect unison 51
 Total Standard Deviation (or
Risk)
Unique or
Market or
Non-systematic Risk
Systematic Risk

Diversifiable Non- Diversifiable

 We need to measure the Market risk that cannot be

diversified away
The market will not compensate us for risk that
can be diversified away.
Market Risk
(measured with Beta)

Unique Risk
The market will compensate us for market
risk – the risk that cannot be diversified
52
 Capital Asset Pricing model (CAPM)
• Only systematic risk is relevant
• Systematic, or non-diversifiable, risk is caused by factors affecting the entire
market
• interest rate changes
• changes in purchasing power
• change in business outlook
• Unsystematic, or diversifiable, risk is caused by factors unique to the firm
• strikes
• regulations
• management’s capabilities
 When assets are put into a well-diversified portfolio, some of the unique
or nonsystematic risk is diversified away
53
 Diversifying Unique Risk
• Beta is a measure of the volatility of a
Risk security’s return compared to the
Portfolio
Risk
volatility of the return on the Market
Portfolio
Covariance j,Market
Unique
βSecurity j  VarianceMarket
Risk

Market Risk

Number of Securities
54
 Security Market Line (SML)
Shows the relationship between required rate of return and
beta (ß).
Required
Rate of Required Rate of Return (CAPM)
Return Security
Market Line • The required return for any security j
may be defined in terms of systematic
kj risk, j, the expected market return, rm,
and the expected risk free rate, rf.
rf
kj  ˆ
rf β j(ˆ
rm  ˆ
rf )
ßj ß

55
 Security Market Line (SML)
EXAMPLE: A security has a Beta of 1.25. If the yield on Treasury
Bills is 5% and the return on the market portfolio is 11%, what is
the expected return for holding the security?
kj  ˆ
rf β j(ˆ
rm  ˆ
rf )
=5+1.25 11-5   12.5%
An investor expects a return of 12.5% to hold the security.
Market Risk Premium
• The reward for bearing risk
• Equal to (rm – rf),Equal to the slope of security market line (SML)
• Will increase or decrease with
• uncertainties about the future economic outlook
• the degree of risk aversion of investors
56
 Security Market Line (Again)
CAPM
Assumptions Return SML
Investors hold well-diversified portfolios
A
Competitive markets RM
A – return is too
Borrow and lend at the risk-free rate high; price is too low

Investors are risk averse B

B – return is too low;
price is too high
No taxes
Investors are influenced by systematic risk M 

Freely available information

Investors have homogeneous expectations 57
 Market Efficiency
Capital markets are efficient if prices adjust fully and instantaneously to
new information affecting a security’s prospective return.

hree Degrees of Market Efficiency

 Weak form
 Semi-strong form
 Strong form
Weak Form Market Efficiency
 Security prices capture all of the information contained in the record
of past prices and volumes
 Implication: No investor can earn excess returns using historical price
or volume information. Technical analysis should have no marginal
value.
58
 Semi-Strong Form Market Efficiency
Security prices capture all of the information contained in the public domain.
Implication: No investor can earn excess returns using publicly available
information. Fundamental analysis should have no marginal value.

rong Form Market Efficiency

 Security prices capture all information, both public
and private.
 Markets are quite efficient (but it is illegal to use
private information for personal gain, when trading
securities)!

59
Thematic area Corporate Finance

Course Financial
Management
Part I
Part III
IV

Time Value Of Money (TVM)

 Payment of Interest
• Interest is the cost of money
• Interest may be calculated as: 1. Simple interest 2. Compound interest
ple Interest : Interest is paid on the principal amount only
Example: $1,000 is invested to earn 6% per year, simple interest.
0 1 2 3

-$1,000 $60 $60 $60

Compound Interest
 Interest paid on both the initial principal and on interest that has been paid &
reinvested$1,000 invested to earn 6% per year, compounded annually.
Example:
0 1 2 3

-$1,000 $60.00 $63.60 $67.42

61
 Future Value
• The value of an investment at a point in the future, given some rate of return.
Simple Interest Compound Interest
FVn = PV0+(PV0  i  n) FVn = PV0 (1 + i)n
FV = future value FV = future value
PV = present value PV = present value
i = interest rate i = interest rate per compounding period (r/m)
n = number of periods n = number of compounding (m*t)
M=no. of compounding per year
Future Value: Simple Interest T= no. of years

Example: You invest $1,000 for three years at 6% simple interest per
year.
FV = PV +(PV  i  n)
0 6% 1 6% 2 6% 3
3 0 0
-$1,000
= $1,000  $1,000  0.06  3 
= $1,180.00
62
 Future Value
uture Value: Compound Interest
Example: You invest $1,000 for three years at 6%, compounded annually.
6% 6% 6%
FV3 = PV0 (1 + i)n
0 1 2 3
= $1,000 1  0.06 
3

-$1,000
= $1,191.02
Future values can be calculated using a table method, whereby “future value
interest factors” (FVIF) are provided.
FVn = PV0 (FVIFi,n ), where: FVIFi,n = 1+i
n

Where FV = future value

PV = present value
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years 63
 Future Value
Example: You invest $1,000 for three years at 6% compounded
annually.
Table 4.1 Excerpt: FVIFs for $1
End of Period (n) 5% 6% 8% FV3 = PV0(FVIF6%,3 )
2 1.102 1.124 1.166
=$1,000(1.191) =$1,191.00
3 1.158 1.191 1.260
4 1.216 1.262 1.360

Present Value
What a future sum of money is worth today, given a particular interest
(or FVn rate.
discount) FV = future value
PV0  PV = present value
1+i
n
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years 64
 Present Value
Example: You will receive $1,000 in three years. If the discount rate is
6%, what is 0the present
6% 1value?
6% 2 6% 3

$1,000
FV3 $1,000
PV0    $839.62
1+i 1  0.06 
n 3

Present values can be calculated using a table method, whereby “present

value interest factors” (PVIF) are provided. 1
PV0 = FVn(PVIFi,n ), where: PVIFi,n =
1+i
n
FV = future value
PV = present value
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
65
 Present Value
Example: What is the present value of $1,000 to be received in three years,
given a discount rate of 6%?
Table 4.2 Excerpt: PVIFs for $1
End of Period (n) 5% 6% 8%
2 0.907 0.890 0.857
3 0.864 0.840 0.794
4 0.823 0.792 0.735

PV0 = FV3(FVIF6%,3 )
=$1,000(0.840) =$840.00

66
 Annuities
The payment or receipt of an equal cash flow per period, for a specified
number of periods.
Examples:
Ordinary mortgages,
annuity: car occur
cash flows leases, retirement
at the income
end of each period
Example: 3-year, $100 ordinary annuity
0 1 2 3

$100 $100 $100

Annuity Due: cash flows occur at the beginning of each period

Example: 3-year, $100 annuity due
0 2 3

$100 $100 $100

67
 Annuities
Future value of an annuity - sum of the future values of all individual
cash flows. 0 1 2 3

$100 $100 $100 FV

FV
FV
FV of Annuity
uture value of an ordinary annuity
 1+in -1 
FVOrdinary= PMT  
Annuity  i 
 
FV = future value
PMT = periodic payment
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
68
 Annuities
Example: What is the future value ofn a three year ordinary annuity with a
cash flow of $100FV
per year,  1+i6%?
earning  -1 
= PMT  
Ordinary
Annuity  i 
 
 1.06 3  1 
 100  
 . 06 
 
 $318.36
uture value of an annuity due:
 1+in -1 
FVAnnuity= PMT   1 + i FV = future value
Due  i  PMT = periodic payment
  i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
69
 Annuities
Example: What is the future value of a three year annuity due with a
cash flow of $100 per year, earning 6%?
 1+i  -1 
n

FVAnnuity = PMT   1+i

Due  i 
 
 1.06 3  1 
 100   1.06 
 . 06 
 
 $337.46
The future value of an ordinary annuity can be calculated using Table 4.3 (p. 145),
where “future value of an ordinary annuity interest factors” (FVIFA) are provided.
FVANn = PMT(FVIFA i,n )
PMT = equal periodic cash flow
i = the (annually compounded) interest rate
1  i
n
1 , where: n = number of periods
FVIFA i,n = FVAN = future value (ordinary annuity)
i
FVIFA = future value interest factor 70
 Annuities
Ordinary Annuity: Future Value
Example: What is the future value of a 3-year $100 ordinary annuity if the
cash flows are invested at 6%, compounded
End of Periodannually?
Table 4.3 Excerpt: FVIFA for $1 per period
(n) 5% 6% 10%
2 2.050 2.060 2.100
3 3.152 3.184 3.310
4 4.310 4.375 4.641

Calculated using Table FVANn = PMT(FVIFA i,n )

FVANDn = PMT FVIFAi,n 1  i =$100 3.184   $318.40

1  i
n
1
FVIFA i,n =
i 71
 Annuities
nnuity Due: Future Value
Example: What is the future value of a 3-year $100 annuity due if the cash
Table 4.3 Excerpt: FVIFA for $1 per period
flows are invested at 6%End
compounded annually?
of Period (n) 5% 6% 10%
2 2.050 2.060 2.100
3 3.152 3.184 3.310
4 4.310 4.375 4.641

FVANDn = PMT FVIFA i,n 1  i 

 $100 3.184(1.06)  $337.50

72
 Annuities
Annuities: Present Value
The present value of an annuity is the sum of the present values of all
individual
0 cash flows.
1 2 3
 1- 1+i 
-n

$100 PVOrdinary= PMT  

PV $100 $100 Annuity  i 
PV  
PV
PV of Annuity
Example: What is the present value of a three year, $100 ordinary
annuity, given a discount rate of 6%?  1- 1+i  -n

PVOrdinary =PMT  
Annuity  i 
 
 1 - 1.06 -3 
 100  
 .06 
 
 $267.30 73
 Annuities
Present value of an annuity due:
 1- 1+i-n 
PVAnnuity = PMT   1+i
Due  i 
 

Example: What is the present value of a three year, $100 annuity due, given a
discount rate of 6%?
 1- 1+i-n  The present value of an ordinary annuity
PVAnnuity = PMT   1+i
Due  i  can be calculated using:
 
 1  1.06 3 
 100   1.06 
 .06 
 
 $283.34
PVAN0 = PMT(PVIFA i,n ), where:
1- 1+i-n 
PVIFA i,n =  
i 74
 Annuities
Example: What is the present value of a 3-year $100 ordinary annuity if
current interest rates are 6%Table
compounded annually?
4.4 Excerpt: PVIFA for $1 per period
End of Period (n) 5% 6% 10%
2 1.859 1.833 1.736
3 2.723 2.673 2.487
4 3.546 3.465 3.170

PVAN0 = PMT(PVIFA i,n )

=$100 2.673   $267.30
sing Table present value of Annuity due =
PVAND0 = PMT PVIFA i,n(1  i)
75
 Annuities
ther Uses of Annuity Formulas
• Sinking Fund Problems: calculating the annuity payment that must be
received or invested each year to produce a future value.
Ordinary Annuity Annuity Due
FVANn FVANn
PMT= PMT=
FVIFA i,n FVIFA i,n 1  i

Loan Amortization and Capital Recovery Problems: calculating the

payments necessary to pay PMT=
off, or PVAN
amortize,
0 a loan.
PVIFA i,n

76
 Perpetuities
• Financial instrument that pays an equal cash flow per period into the
indefinite future (i.e. to infinity). Example: dividend stream on common
and preferred stock 0

$60
1

$60
2 3

$60
4

$60


PMT
PVPER 0   PMT
t 1 (1+i)n
PVPER 0 
i
Example: What is the present value of a $100 perpetuity, given
a discount rate of 8% compounded annually?
PMT $100
PVPER 0    $1,250.00
i 0.08 77
 More Frequent Compounding
Nominal Interest Rate: the annual percentage interest rate, often referred to as
the Annual Percentage Rate (APR).
Example: 12% compounded semi-annually
12%

0 6% 0.5 6% 1 6% 1.5

-$1,000 $60.00 $63.60 $67.42

Increased interest payment frequency requires future and present value
formulas to be adjusted to account for the number of compounding
periods per year (m).Future Value Present Value
mn FVn
 inom  PV0 
FVn  PV0 1    inom 
mn

 m   1+
m 
  78
 More Frequent Compounding
Example: What is a $1,000 investment
mn worth in five years if it earns 8%
interest, compounded inom 
 quarterly?
FVn  PV0 1  
 m 
(4)(5)
 0.08 
 $1,000 1  
 4 
 $1, 485.95
Example: How much do you have to invest today in order to have $10,000 in 20
years, if you can earn 10% interest, compounded
PV 
FVn monthly?
0 mn
 inom 
 1+
 m 
$10,000
 (12)(20)
 $1,364.62
 0.10 
1+ 12 
  79
 Impact of Compounding Frequency
$1,000 Invested at Different 10% Nominal Rates for One Year
$1,106
$1,105
$1,104
$1,103
$1,102
$1,101
$1,100
$1,099
$1,098
$1,097
Annual Semi- Quarterly Monthly Daily
Annual

Effective Annual Rate

(EAR)
The annually compounded interest rate that is identical to some nominal rate,
m ieff  effective annual rate
compounded “m” times
 iper year.
nom 
ieff  1+  1 inom  nominal interest rate
 m  m = compounding frequency per year
80
 Effective Annual Rate (EAR)
EAR provides a common basis for comparing investment alternatives.
Example: Would you prefer an investment offering 6.12%, compounded quarterly
or one offering 6.10%, compounded
 i  monthly?
m
m
ieff  1+ nom   1  inom 
 m  ieff  1+  1
4
 m 
 0.0612  12
 1+  1  0.061 
 4   1+  1
 12 
 6.262%
 6.273%

81
Cost of Capital By
Kibrysfaw 82
 An Overview
Terms required return, appropriate discount rate, and cost of capital are more
or less interchangeably used.
We take the firm’s financial policy – capital structure as given that a firm uses
both debt and equity capital.
Hence, a firm's cost of capital will reflect both its
• cost of equity capital and
• cost of debt capital.
 We know that the return earned on assets depends on the risk of those assets
 The return to an investor is the same as the cost to the company
 Our cost of capital provides us with an indication of how the market views the
risk of our assets
 Knowing our cost of capital can also help us determine our required return
for capital budgeting projects 83
 The Cost of Equity
Cost of equity = the return that equity investors require on their investment in the firm.
There two approaches to determining the over all cost of equity:
1) the dividend growth model approach and
2) the security market line (SML) approach.

• Assumption: Dividend Growth Model Approach

• The firm’s dividend will grow at
a constant rate, g, Where,
D0 is the dividend just paid
• The price per share of the stock, D1 is the next period’s projected
P0, can be written as: dividend
, RE (the E stands for equity) for the
required return on the stock 84
 The Cost of Equity
• Dividend Growth Model Approach
• Rearrange to solve for RE as:RE = + g
• Because RE is the return that the shareholders require on the stock, it can be
interpreted as the firm’s cost of equity capital.
• EX.1: Suppose GS Co., a large public utility, paid a dividend of br 4 per share last
year. The stock currently sells for br 60 per share. It is estimated that the dividend
will grow steadily at a rate of 6% per year into the indefinite future. What is the
cost of equity capital for GS?
• 0.06 = 0.13 =13%

EX.2: ABC Co. is expected to pay an annual dividend of br 0.80 a share next year.
The market price of the stock is expected to be br 22.40 and the growth rate is 5%.
What is the firm's
• 0.05 cost =8.6%
= 0.086 of equity?
85
 The Cost of Equity
• Advantages and Disadvantages of Dividend Growth Model:
• Advantage – easy to understand and use
• Disadvantages:
• Only applicable to companies currently paying dividends
• Not applicable if dividends are not growing at a reasonably constant rate
• Extremely sensitive to the estimated growth rate – an increase in g of 1%
increases the cost of equity by 1%
• Does not explicitly consider risk.
The SML Approach/Model:
The notion here is that required/expected return on a risky investment depends on
three things:
1) The risk-free rate, Rf
2) The market risk premium, E(RM) - Rf 86
 The Cost of Equity
Using the SML, we can write the expected return on the company’s equity,
E(RE), as:

• Ex1: Suppose your company has an equity beta of 0.58, and the current risk-
free rate is 6.1%. If the expected market risk premium is 8.6%, what is your
cost of equity capital?
• Given: Rf = 6.1%, E = 0.58, RM-Rf = 8.6%
• RE = Rf + β (RM – Rf)
• RE = 6.1% + 0.58(8.6%) = 0.11088 = 11.1%

87
 The Cost of Equity
• Advantages and Disadvantages of SML
• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can estimate beta, 
• Disadvantages
• Have to estimate the expected market risk premium, which does
vary over time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is not always
reliable

88
 The Cost of Debt
• Cost of debt measures the current cost to the firm of borrowing funds to finance projects, such
as
interest expense, transaction cost, bond printing cost, taxes
• It is measured by the effective interest rate or yield paid to bondholders.
• i.e., before tax cost of debt is equal to the yield to maturity on bond issue.
• If the debt is publically issued, floatation cost incurred.
• But required return to debt holders is not equal to the firm’s cost of debt
b/c interest payments are deductible, which means the government in
effect pays part of the total cost.
• after-tax cost of debt is

89
90
 The Cost of Debt
• Ex1: assume that ABC’s tax rate is 40%, the cost of new, or marginal, debt is 9%,
then its after-tax cost of debt is
• Soln: after-tax cost of debt is

• EX2:

91
 Cost of Preferred Stock
• Cost of preferred stock is quite straightforward b/c:
• Preferred stock generally pays a constant dividend each period
• Dividends are expected to be paid every period forever
• Preferred stock is a perpetuity, so cost of preferred stock, RP,
• RP = D / P 0
• Ex1: Your company has preferred stock that has an annual dividend of
br 3. If the current price is br 25, what is the cost of preferred stock?
• RP = 3/25 = 12%

92
Cost of Preferred Stock

93
 The Weighted Average Cost of Capital
• We can use the individual costs of capital that we have computed to get our
“average” cost of capital for the firm.
• This “average” is the required return on the firm’s assets, based on the market’s
perception of the risk of those assets.
• The weights are determined by how much of each type of financing is used.
• WACC:
• After calculating individual CC, now can combine them  WACC.
• WACC = cost of equity + cost of debt + cost of preferred stock

• Where W = Weights
• Firm should accept any project with a return which is more than WACC.
• In other words, it’s the minimum return for a project must be at least equal to
WACC. 94
 Capital Structure Weights
• Notation
• E = market value of equity = # of outstanding shares times price per share
• D = market value of debt = # of outstanding bonds times bond price
• V = market value of the firm = D + E
• CS Weights
• wE = E/V = percent financed with equity
• wD = D/V = percent financed with debt
• Suppose you have a market value of equity equal to $520,000 and a market
value of debt equal to $480,000.
• What are the capital structure weights?
• V = $520,000 + $480,000 = $1,000,000
• wE = E/V = 520,000 / 1,000,000 = 0.52 = 52%
• wD = D/V = 480,000/ 1,000,000 = 0.48 = 48% 95
 Taxes and the WACC
• We are concerned with after-tax cash flows, so we also need to consider the
effect of taxes on the various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• After-tax cost of debt = RD(1-T)
• Dividends are not tax deductible, so there is no tax impact on the cost of
equity
• WACC = wERE + wDRD(1-T)

96
 WACC - Example
Suppose a firm has following capital structure which it considers optimal:
Debt – 30%, Preferred shares – 18%, Share Capital (Common shares) –
52%. The firm paid a dividend of $2/share last year and its stock currently
sells at $80/share. Tax rate is 35% and investors expect earnings and
dividend to grow at a constant rate of 12% in the future. New Common
stocks have a flotation cost of 12%. New Preferred stock would be sold at
$100/share with a dividend of $9. Flotation is $6/share. For debt, it’s a 9%
irredeemable $1,000 debt with a current value of $1,100. Annual interest
payment has just been made.
• Cost of debt: Cost of Preferred Stock:
• What
• RD is
= the weighted=average
$90/$1,100 8.18% after-tax
 costs of capital of the firm?
9%*$100 = $90
• RDT = 8.18%*(1 – 35%)
• RDT = 8.18%*(1 – 35%)
• RDT = 5.32% 97
 WACC – Solution…

• What is the weighted average after-tax costs of capital of the

firm?
• Cost of Common Stock:

• WACC:

98
 Check your understanding!
• Question:
• The market values of common stock and debts of a company are $150
million and $35 million respectively, in which the required return for
common stock is 17% whilst 7% for debts. The book value of common stock
and debts are $100 million and $20 million respectively.
• Calculate the WACC for this company if they are subject to a 40% tax rate.

99
 Thanks!
End of the Chapter,

100
 long term By
investment decision Kibrysfaw G
Investment Decisions – An Overview
• Investment Decision is concerned with the selection of assets in which funds
will be invested by a firm.

• Where to Invest the MONEY?

• The investment of funds has to be made after CAREFUL ASSESSMENT of
various projects through CAPITAL BUDGETING [CB].
• CB is the PROCESS of making decision regarding capital investment in fixed
assets such as machinery, land, building, etc.
Investment Decisions – An Overview…
• PROCESS of Capital Budgeting: Implementation

Selection • Control
• Review
Evaluation • One/more projects
• More/most profitable

Planning • Estimation of CFs

• Evaluation Techniques
• How much Money?
• Possible Alternatives?
CB Evaluation Techniques
•

CB Evaluation Techniques
Non-
Discounting Discounted
Modified
Average Internal
Net Present Internal
Payback Rate of Rate of Profitability
Value Rate of
Period [PP] Return Return Index [PI]
[NPV] Return
[ARR] [IRR]
[MIRR]
1. Payback Period (PBP)
• Payback Period (PBP):
• How long does it take to get back our MONEY back?
• How soon can we get our CASH back?
• Answer: the number of YEARS required to recover a project’s cost (initial cost).
• The Cash Flows maybe take the form of:
• Annuity (Uniform) CFs:
• returns from capital investment paid back in a series of regular payments

• Mixed Stream (Fluctuating) CFs:

• CFs paid back are not equal/irregular payments.
 1. Payback Period (PBP) – Examples
Ex. 1: Suppose the project requires an initial investment of Br 500,000 and the
annual after-tax cash flows of Br 150,000 for eight years.
Determine Payback Period for this project.
PBP= Initial 𝟓𝟎𝟎 , 𝟎𝟎𝟎 = 3.33 years or
investment 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 =
After tax cash 𝟏𝟓𝟎 , 𝟎𝟎𝟎 3 years & 4 months
flow
Ex. 2: Suppose the project requires an initial investment of Birr 500,000 and the
annual after-tax cash flows of Br 180,000; Br 240,000; Br 320,000; Br 600,000and
Br 150,000 for years 1 – 5 respectively.
Determine Payback Period for this project.
 year After tax Cummulative
1 CF CF
PBP = 2+ 80/320 = 2.25
2 180,000 180,000
Years or 2 years and 3
3 240,000 420,000
months
4 320,000 740,000 Cut-off - a designated time
5 600,000 limit by management during
• Based on the150,000
PBP and MANAGEMENTwhich Cut-off:
the project initial
• Payback Period < Cut-off  Accept investment will be
• Payback Period > Cut-off  Reject recovered.
Assume in the previous examples, if the senior management had set a cut-off
period of 3 years for the projects, what would be your decision?
• Types of projects?
• Independent projects – Accept all projects which fulfill the bench mark .
• Mutually exclusive projects – Select the shortest payback period project.
1. Payback Period (PBP) – Strengths & Weaknesses
• Strengths:
Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
• Weaknesses:
Ignores the time value of money.
Ignores the CFs after the payback period.
Does not consider any required rate of return.
Cut-offs are subjective.
 2. Average Rate of Return (ARR)
• ARR also called Accounting Rate of Return.
• This technique considers the EARNINGS from the investment over its
WHOLE LIFE.

• Where,

• WC
 3. Average Rate of Return (ARR) – Example
• Suppose the project with initial investment of Br. 70,000, Salvage value of
Br 6,000, tax rate of 40% & no working capital. If the firm applies straight
line method of depreciation, determine ARR given the ff CFs:
Years 1 2 3 4
CFs, before tax 40,000 42,000 36,000 50,000

• =  Br 168,000 – Br 64,000 – Br 41,600 = Br 62,400

• Average Profit = Br 62,400/4 yrs = Br 15,600
• Average Investment = [Br 70,000 + Br 6,000]/2 = Br 38,000
• ARR = Br 15,600/Br 38,000 = 0.41 = 41%
• For Br 1 invested in the project, there is an average return of 41 cents in the
form of net profit per year over the entire life of the project.
 3. Discounted Payback Period (DPBP)
• Discounted Payback Period (DPBP):
• This technique is the same with PBP except that it adds one more factor – discount
rate (simply interest rate = WACC). Accordingly Then DPBP is calculated using
discounted net CFs.
• Similar to PBP, DPBP focuses on investment liquidity.
• DPBP is still not perfect (problems of DPBP):
• Still does not examine all CFs & Cut-offs are still subjective.
Initial Cost After-Tax, End-of-Year Cash Inflows, [CFt ]
Year Total
0 1 2 3 4 Inflows
Project S – $10,000 $5000 $4,000 $3,000 $1,000 $13,000
Project L – $10,000 $1000 $3000 $4000 $6750 $14,750
 For both projects risk-adjusted cost of capital, WACC = r =
10%.
 Determine DPBP for Projects S&L.
 year After tax Discounting Discounted ACCUM CF
1 CF Factor CF 4,545
2 5,000 0.909 4,545 7,849
3 4,000 0.826 3,304 10,102
4 3,000 0.751 2,253
1, 000 0.683 683
PBP = 2+ 2,151/2,253 = 2.955
Years or 2 years and 11
year After tax CF months
Discounted
Discounted
1 (L) CFL CFL
2 1,000 909 909
3 3,000 2,478 3,396
4 4,000 3,004 6,400
6, 750 4,610 11,010
PBP = 3+ 3,600/4,600 = 3.783 Years or 3 years and 9
 4. Net Present Value (NPV)
 Is the difference between the present values of future cash inflows and the
present value of cash outflows, discounted at the given cost of capital, or
opportunity cost of capital.
NPVN= PVCF - II
• NPV considers TVM in evaluating capital investments.
•  + + ……… - II
• Where,
• CF0 = Initial Investment,
• CFt = Net CFs at year, t;
• n = life of the project (in years)
• i = cost of capital = r = WACC
 Initial Cost After-Tax, End-of-Year Cash Inflows, [CFt ]
Year Total
0 1 2 3 4 Inflows
Project S – $10,000 $5000 $4000 $3000 $1000 $13,000
Project L – $10,000 $1000 $3000 $4000 $6750 $14,750
risk-adjusted cost of capital, WACC = r
= 10%.
year After tax CF After tax CF Discounting Discounted Discounted
1 (S) (L) Factor CFs CFL
2 5,000 1,000 0.909 4,545 909
3 4,000 3,000 0.826 3,304 2,478
4 3,000 4,000 0.751 2,253 3,004
1, 000 6, 750 0.683 PV CF683
s= PV4,610
CFL =
NPVs= PVCF- II= 10,785-
10,785 11,101
10,000 = 785
NPVL= PVCF- II= 11,101-
10,000 = 1,101
 4. Net Present Value (NPV) – Decision Rule
•  Accept Reject
• Types of projects?
• Independent projects – Accept all NPV+ projects.
• Mutually exclusive projects – Select the highest NPV+ projects.
• If no project has a positive NPV, reject them all.

Strengths:
 Consistent with shareholders
wealth maximization.
 Consider both magnitude & timing
of CFs.
 Indicates whether a proposed
project will yield the investor’s
required rate of return.
Weaknesses:
Many users find it difficult to work
with a birr [dollar] return than a
percentage return.
Hard to determine the discount rate as
it changes over the life.
 5. Profitability Index (PI) (Cost benefit ratio)
Profitability index is the ratio of the present value of the expected net cash flow
of the project and its initial investment outlay.
PI = PVCF /II
Profitability index provides or measure of profitability in a more readily
understandable terms. It simply converts the NPV criterion into a relative
measure.
PI s = ( 10,785)/ 10,00 = PI (L) = ( 11,101)/ 10,00 = 1.11
1.078
If NPV is +VE PI If NPV is -VE
>1 PI <1
6. Internal Rate of Return (IRR)
• Internal Rate of Return (IRR):
• IRR is discount rate that equates the PV of net CFs of a project to its CF0.
• IRR is a discount rate to obtain NPV of zero.

• IRR is the return on the firm’s invested capital or

• IRR is the rate of return that the firm earns on its CB projects.
• To determine IRR one of the three procedures can be used:
• Trial and error – iterative process solution
• Excel solution
• Financial Calculator solution
6. Internal Rate of Return (IRR) – Decision Rule

•  Accept
•  Reject
• Types of projects?
• Independent projects:
• If IRR exceeds the project’s WACC, accept the project.
• If IRR is less than the project’s WACC, reject it.
• Mutually exclusive projects:
• Accept the project with the highest IRR, provided that IRR is greater than WACC.
• Reject all projects if the best IRR does not exceed WACC.
 Summary on CB Evaluation Techniques
• Mathematically, the NPV, IRR, MIRR, and PI methods will always lead
to the same ACCEPT/REJECT decisions for, independent projects.
• If a project’s NPV is positive, its IRR and MIRR will always exceed
WACC and its PI will always be greater than 1.
• But, these methods can give conflicting rankings for mutually exclusive
projects if the projects differ in size or in the timing of cash flows.
• If the PI ranking conflicts with the NPV, then the NPV ranking should be
used.

Thank you !