managerial finance-course-outine

Managerial Finance

Lecture Notes

For

MBA/M.Com/MEF/BS/BBS

Sir M.Faseeh Khan

Sir M.Faseeh Khan-MF(notes) of 39 copyright @TM

Federal Urdu Art and Science Universitye-mail: [email protected]

Managerial Finance – Course Overview_____________________________________________________________Instructor: Sir M.Faseeh Khan e-mail: [email protected]: Managerial Finance Class: BBA/MBA Shift: Morning Session: Aug. – Dec. 2010

Purpose: The course is design to assist the students in building a conceptual

framework which with to make prudent financial decision in their jobs, personal financial planning and decision making.

Topics:Part 1: Introduction to Managerial Finance

– What is a firm and what is the ideal goal of the firm? Part 2: Financial Analysis and Planning

– How can we evaluate the quality of firms? Part 3: Important Financial Concepts

– What is the time value of money? Part 4: Long-Term Financing Decisions

– How can we measure risk? What is the relationship between risk and return?

Part 5: Long-Term Investment Decisions– How should bonds be valued? – How should stock be valued?

Part 6: Working Capital Management– What is the firm's cost of borrowing?

Part 7: Special Topics in Managerial Finance– What measures can be used to evaluate proposed projects? – How much debt should a firm have? – What should the firm do with its profits?

Evaluation:


The grading component and Scale:Final Examination ---------> 60 MarksMid-Term ---------> 20 Marks

Class Test ---------> 20 Marks(each @ 10)

Part 1: Introduction to Managerial Finance

Chapter Outline1. Finance and the Financial Manager2. Forms of Business Organization3. The Goal of Financial Management4. The Agency Problem and Control of the Corporation5. Financial Markets and the Corporation

Corporate Finance• Some important questions that are answered using finance

• What long-term investments should the firm take on?• Where will we get the long-term financing to pay for the investment?• How will we manage the everyday financial activities of the firm?

Financial Manager• Financial managers try to answer some or all of these questions• The top financial manager within a firm is usually the Chief Financial Officer

(CFO)• Treasurer – oversees cash management, credit management, capital

expenditures and financial planning• Controller – oversees taxes, cost accounting, financial accounting and data

processing

Financial Management Decisions• Capital budgeting

• What long-term investments or projects should the business take on?• Capital structure

• How should we pay for our assets?• Should we use debt or equity?

• Working capital management• How do we manage the day-to-day finances of the firm?

Forms of Business Organization• Three major forms in the United States

• Sole proprietorship• Partnership


• General• Limited

• Corporation• S-Corp• Limited liability company

Sole Proprietorship• Advantages

• Easiest to start• Least regulated• Single owner keeps all the profits• Taxed once as personal income

• Disadvantages• Limited to life of owner• Equity capital limited to owner’s personal wealth• Unlimited liability• Difficult to sell ownership interest

Partnership• Advantages

• Two or more owners• More capital available• Relatively easy to start• Income taxed once as personal income

• Disadvantages• Unlimited liability

• General partnership• Limited partnership

• Partnership dissolves when one partner dies or wishes to sell• Difficult to transfer ownership

Corporation• Advantages

• Limited liability• Unlimited life• Separation of ownership and management• Transfer of ownership is easy• Easier to raise capital

• Disadvantages• Separation of ownership and management• Double taxation (income taxed at the corporate rate and then dividends

taxed at the personal rate)

Goal of Financial Management


• What should be the goal of a corporation?• Maximize profit?• Minimize costs?• Maximize market share?• Maximize the current value of the company’s stock?

• Does this mean we should do anything and everything to maximize owner wealth?

Part 2: Financial Analysis and Planning

Chapter Outline

1. The Balance Sheet2. The Income Statement3. Taxes4. Cash Flow5. Standardized Financial Statements6. Ratio Analysis7. The DuPont Identity8. Using Financial Statement Information

Balance Sheet• The balance sheet is a snapshot of the firm’s assets and liabilities at a given point

in time• Assets are listed in order of liquidity

• Ease of conversion to cash• Without significant loss of value

• Balance Sheet Identity• Assets = Liabilities + Stockholders’ Equity

The Balance Sheet - Figure


Net Working Capital and Liquidity• Net Working Capital

• Current Assets – Current Liabilities• Positive when the cash that will be received over the next 12 months

exceeds the cash that will be paid out• Usually positive in a healthy firm

• Liquidity• Ability to convert to cash quickly without a significant loss in value• Liquid firms are less likely to experience financial distress• But liquid assets earn a lower return• Trade-off to find balance between liquid and illiquid assets

Market Vs. Book Value• The balance sheet provides the book value of the assets, liabilities and equity.• Market value is the price at which the assets, liabilities or equity can actually be

bought or sold.• Market value and book value are often very different. Why?• Which is more important to the decision-making process?

Income Statement• The income statement is more like a video of the firm’s operations for a specified

period of time.• You generally report revenues first and then deduct any expenses for the period• Matching principle – GAAP – ex: to show revenue when it accrues and match the

expenses required to generate the revenue


Sources and Uses• Sources

• Cash inflow – occurs when we “sell” something• Decrease in asset account (Sample B/S)

• Accounts receivable, inventory, and net fixed assets• Increase in liability or equity account

• Accounts payable, other current liabilities, and common stock• Uses

• Cash outflow – occurs when we “buy” something• Increase in asset account

• Cash and other current assets• Decrease in liability or equity account

• Notes payable and long-term debt

Statement of Cash Flows• Statement that summarizes the sources and uses of cash• Changes divided into three major categories

• Operating Activity – includes net income and changes in most current accounts

• Investment Activity – includes changes in fixed assets• Financing Activity – includes changes in notes payable, long-term debt

and equity accounts as well as dividends

Standardized Financial Statements• Common-Size Balance Sheets

• Compute all accounts as a percent of total assets• Common-Size Income Statements

• Compute all line items as a percent of sales• Standardized statements make it easier to compare financial information,

particularly as the company grows• They are also useful for comparing companies of different sizes, particularly

within the same industry

Ratio Analysis• Ratios also allow for better comparison through time or between companies• As we look at each ratio, ask yourself what the ratio is trying to measure and why

is that information is important• Ratios are used both internally and externally

Categories of Financial Ratios• Short-term solvency or liquidity ratios• Long-term solvency or financial leverage ratios


• Asset management or turnover ratios• Profitability ratios• Market value ratios

Computing Liquidity Ratios• Current Ratio = CA / CL

• 2256 / 1995 = 1.13 times• Quick Ratio = (CA – Inventory) / CL

• (2256 – 1995) / 1995 = .1308 times• Cash Ratio = Cash / CL

• 696 / 1995 = .35 times• NWC to Total Assets = NWC / TA

• (2256 – 1995) / 5394 = .05• Interval Measure = CA / average daily operating costs

• 2256 / ((2006 + 1740)/365) = 219.8 days

Computing Long-term Solvency Ratios• Total Debt Ratio = (TA – TE) / TA

• (5394 – 2556) / 5394 = 52.61%• Debt/Equity = TD / TE

• (5394 – 2556) / 2556 = 1.11 times• Equity Multiplier = TA / TE = 1 + D/E

• 1 + 1.11 = 2.11• Long-term debt ratio = LTD / (LTD + TE)

• 843 / (843 + 2556) = 24.80%

Computing Coverage Ratios• Times Interest Earned = EBIT / Interest

• 1138 / 7 = 162.57 times• Cash Coverage = (EBIT + Depreciation) / Interest

• (1138 + 116) / 7 = 179.14 times

Computing Inventory Ratios• Inventory Turnover = Cost of Goods Sold / Inventory

• 2006 / 301 = 6.66 times• Days’ Sales in Inventory = 365 / Inventory Turnover

• 365 / 6.66 = 55 days

Computing Receivables Ratios• Receivables Turnover = Sales / Accounts Receivable

• 5000 / 956 = 5.23 times• Days’ Sales in Receivables = 365 / Receivables Turnover

• 365 / 5.23 = 70 days

Computing Total Asset Turnover• Total Asset Turnover = Sales / Total Assets

• 5000 / 5394 = .93• It is not unusual for TAT < 1, especially if a firm has a large amount of

fixed assets


• NWC Turnover = Sales / NWC• 5000 / (2256 – 1995) = 19.16 times

• Fixed Asset Turnover = Sales / NFA• 5000 / 3138 = 1.59 times

Part 3: Important Financial Concepts

A Time Value of Money

Simple Interest and Discount: In its most basic form, interest is calculated by multiplying principal (amount invested) by rate (percent of interest) multiplied by time (number of periods the interest is calculated). This is called simple interest.

I = P r t Example: A $1,000 deposit at 8% per year for three years' simple interest: I = (1000)(.08)(3) = 240 A $1000 deposit at 8% simple interest for three years earns $240 interest.

Simple Interest/Discount :The future value (FV) of a simple interest calculation is derived by adding the original principal back to the interest earned.

$1,000 + $240 = $1,240 Expressed as a formula:

FV = P(1 + rt)FV = (1000)+(1000)(.08)(3) = 1240 Simple Interest/Discount:Note: usually simple interest is used in financial institutions for interest periods of less than one year. If the rate is expressed as an annual rate (normal practice), then the time


period (t) must be a fraction of a year. Example: we invest $10,000 in an 8% , 90-day certificate of deposit. Our total proceeds at the end of the CD period are: FV = (10000)+(10000)(.08)(90/365) = $10,197.26 Simple Interest/ Discount (4):Often, if a bank or other financial institution loans a sum for a short term, the lender will prefer to calculate the interest up front and loan out the discounted principal, or principal minus interest to be earned. The interest to be paid up front on a loan is called discount and the discounted principal, or the actual amount loaned is called the present value (PV)

FVPV = (1+rt)

Simple Interest/Discount Repeating the discount basic formula (simple interest): FV

PV = (1+rt) Example: If the bank loans out $10,000 for 90 days at 8% simple interest, the PV is:

PV = 10000 / [1 + (.08)(90/365)] = 10000/ 1.019726 = $9,806.56 Compound Interest:However, if interest is left in the account to accumulate for a longer period (usually longer than one year) common practice (and usually state law!) requires that after interest is earned and credited for a given period, the new sum of principal + interest must now earn interest for the next period, etc. This is compound interest. To distinguish from simple interest, we use "n" to refer to the number of "periods" in which the interest is compounded and added to principal.

FV

FV = P(1 + r)n OR PV = (1+r)n

Compound Interest:Suppose we invest our original $1,000 for three years at 8%, compounded quarterly: (The rate per quarterly period is 8% / 4 or 2%. The number of periods (n) is 3 x 4 = 12 quarterly periods.)

FV = (1000)(1.02)12 = $1,268.24 If we wanted to know how much we'd have to invest now (PV) at 8% compounded quarterly to earn $10,000 in three years:

PV = 10000 / (1.02)12 = $7,884.93

Net Present Value and Other Investment Criteria

Good Decision Criteria• We need to ask ourselves the following questions when evaluating capital

budgeting decision rules• Does the decision rule adjust for the time value of money?


• Does the decision rule adjust for risk?• Does the decision rule provide information on whether we are creating

value for the firm?

Project Example Information• You are looking at a new project and you have estimated the following cash

flows:• Year 0:CF = -165,000• Year 1:CF = 63,120; NI = 13,620• Year 2:CF = 70,800; NI = 3,300• Year 3:CF = 91,080; NI = 29,100• Average Book Value = 72,000

• Your required return for assets of this risk is 12%.

Payback Period• How long does it take to get the initial cost back in a nominal sense?• Computation

• Estimate the cash flows• Subtract the future cash flows from the initial cost until the initial

investment has been recovered• Decision Rule – Accept if the payback period is less than some preset limit

Computing Payback For The Project• Assume we will accept the project if it pays back within two years.

• Year 1: 165,000 – 63,120 = 101,880 still to recover• Year 2: 101,880 – 70,800 = 31,080 still to recover• Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

• Do we accept or reject the project?

Decision Criteria Test - Payback• Does the payback rule account for the time value of money? (No)• Does the payback rule account for the risk of the cash flows? (No)• Does the payback rule provide an indication about the increase in value? (No)• Should we consider the payback rule for our primary decision rule? (No)

Advantages and Disadvantages of Payback• Advantages

• Easy to understand• Adjusts for uncertainty of later cash flows• Biased towards liquidity

• Disadvantages• Ignores the time value of money• Requires an arbitrary cutoff point• Ignores cash flows beyond the cutoff date


• Biased against long-term projects, such as research and development, and new projects

AAR and Discounted Payback• Discounted payback is a variation on the payback rule that does allow for the time

value of money, but still requires an arbitrary cutoff.• Average Accounting Return (AAR) doesn’t even measure cash flows, but only

whether average accounting income from the project = a set percentage of return• Neither effectively measures whether a long-term investment has added value to

the firm. For sake of time, we will ignore these methods.

Net Present Value• The difference between the market value of a project and its cost• How much value is created from undertaking an investment?

• The first step is to estimate the expected future cash flows.• The second step is to estimate the required return for projects of this risk

level.• The third step is to find the present value of the cash flows and subtract

the initial investment.NPV – Decision Rule

• If the NPV is positive, accept the project• A positive NPV means that the project is expected to add value to the firm and

will therefore increase the wealth of the owners.• Since our goal is to increase owner wealth, NPV is a direct measure of how well

this project will meet our goal.

Computing NPV for the Project• Using the formulas:

• NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42

• Many financial calculators also have templates for calculating NPV• Do we accept or reject the project?

Since NPV is positive at 12%, we should accept the investment.

Decision Criteria Test - NPV• Does the NPV rule account for the time value of money? (Yes)• Does the NPV rule account for the risk of the cash flows? (Yes)• Does the NPV rule provide an indication about the increase in value? (Yes)• Should we consider the NPV rule for our primary decision rule? (Yes)

Internal Rate of Return• This is the most important alternative to NPV• It is often used in practice and is intuitively appealing• It is based entirely on the estimated cash flows and is independent of interest rates

found elsewhere


IRR – Definition and Decision Rule• Definition: IRR is the return that makes the NPV = 0• Decision Rule: Accept the project if the IRR is greater than the required return

Computing IRR For The Project• If you do not have a financial calculator, then this becomes a trial and error

process• Again many financial calculators have templates for estimating IRR• But IRR is most easily estimated using a spreadsheet (See Excel, next slide)• Do we accept or reject the project?

DBH suggestion: Use the required return as the “guess” rate requested by the Excel function (in this case 12%) Since 16.13% > 12% we would accept the project.

Decision Criteria Test - IRR• Does the IRR rule account for the time value of money? (Yes)• Does the IRR rule account for the risk of the cash flows? (Yes)• Does the IRR rule provide an indication about the increase in value? (Yes, by %)• Should we consider the IRR rule for our primary decision criteria? (Not

primary, see following slides)

Part 4: Long-Term Financing Decisions

Expected Return : Most investments carry some degree of risk. Generally only U.S. securities (specifically T-bills) are considered risk free [Rf] because

the Federal government can raise taxes or borrow as necessary to avoid default.Expected Return :

Suppose Investment A has probable returns as follows:• In the previous "go-go" market, it had earned 12%. • In the recent market slump, it earned only 4%. • If we project a 60% probability of renewed boom and a 40% probability of

bust, then the expected return of A [ E(RA) ] is as follows:

E(RA) = (.60 x .12) + (.40 x .04)

= .072 + .016 = .088 or 8.8%

Risk Premium:Risk Premium is the difference between the expected return on the proposed investment and the risk free rate. If U.S. security G is earning 4% then the risk premium for investment A (from previous slide, E(R) = 8.8%) is:

RiskA = E(RA) - Rf


= .088 - .04 = .048 or 4.8%

Variance & Standard DeviationThe Variance, or squared deviations from the expected return gives us a measurement of how much risk movement is in an investment. For Investment A:

s2A = [prob1 x (return1 - E(RA)2] + [prob2 x (return2 - E(RA)2]

s2A = [.60 x (.12 - .088)2] + [.40 x (.04 - .088)2]

= [.60 x .001024 ] + [.40 x .002304 ] = [.00036864] + [.0009216] = .00129024 The Standard deviation is the square root of the variance. For A: sA = SQRT of .00129024 =+-0.03592 = + or - 3.59%

This gives some idea of the potential movement in Investment A

Investment PortfoliosA portfolio of investments enables us to diversify and therefore minimize the portion of risk that relates to "surprises" or unexpected movement in individual securities. A portfolio won't remove risk related to the market as a whole ("market risk").

Portfolio IllustrationSuppose we mix a portfolio of 40% in Investment A (previous) + 40% in Investment B, which may earn only 7% in a good market but booms to 14% in a recession, and we put the other 20% in government investment G earning 4%. Portfolio Expected Return for Portfolio "P" : E(RP) = [.40 x E(RA)] + [.40 x E(RB)] + [.20 x E(RG)]

Where E(RA) =8.8% , E(RB) =9.8% , and E(RG) = 4% (the risk-free rate)

E(RP) = ( .40 x .088) + (.40 x .098) + (.20 x .04)

E(RP) = .0824 or 8.24%

Portfolio Illustration (continued):Note: The percentage weights are based on the total dollars invested in each security. If we invested $100,000 as follows: $40,000 in A, $40,000 in B, and $20,000 in G, then we would have the 40%-40%-20% mix above. The variance of this portfolio is 0.00000434062 and the standard deviation is .0020736 or about + or - 2/10 of 1%. In other words, diversifying eliminated almost all of the diversification risk or unexpected return.

Risk & Beta :


Total risk of any investment = both • the market risk (which can't be diversified) and • the diversifiable risk, which can be minimized or eliminated by diversification in

a portfolio. • The market risk is called systematic and the diversifiable risk is called

unsystematic.

Total risk = Systematic risk + Unsystematic risk(market risk) (diversifiable risk)

Risk & Beta:

Total risk = Systematic risk + Unsystematic risk(market) (diversifiable)

The unsystematic risk is asset-specific and relates to individual investments which can be minimized through diversification. The systematic risk, or market risk, can affect all market investments. A recession or a war, for example, might impact all investments in a portfolio. Since we can usually eliminate the unsystematic risk, we focus primarily on the systematic risk. Expected return of any asset , or E(Rasset), depends only on the asset's systematic risk.

We measure the systematic risk by the beta coefficient, or b.

Risk & Beta :The Beta of an asset = Covariance of asset returns with The market index portfolio

Variance with the market portfolio I don't want to figure that out--do you? There are people on this planet who live for this stuff and do that for most publicly traded assets. (Your facilitator is NOT one of them!) Therefore we will assume the Beta is given for any investment we work with.

The general rule for b is as follows: If b = 1.0 then the investment has "normal" market risk If b < 1.0 then the investment has below normal market risk (for example U.S. securities' b = 0 or zero risk) If b > 1.0 then the investment has a greater than normal market risk (higher risk)


Part 5: Long-Term Investment Decisions

Bonds and Their Valuation

Key features of bonds Bond valuation Measuring yield Assessing risk

BOND VALUATION

The financial value of any asset, be it a security, real estate, business, etc., is the present value of all future cash flows. The easiest thing to value (conceptually) is a bond since the promised cash flows are known with certainty.

Consider a bond that pays a 10% coupon (or stated) rate of interest, has a par (or stated) face value of $1,000 and matures in 5 years. Suppose also that the market rate of interest for such a bond (i.e., your required rate of return, k) is 8%. Thus,

Par = $1,000Coupon Rate = 10%Maturity = 5 yearsK = 8%


The cash flows that are promised by the company include interest payments of $100 per year (although most corporate bonds pay interest semi-annually, we will assume annual payments—we have already seen how to adjust for semi-annual cash flows) for five years and the payment of the face value (stated, or par, value) of $1,000 at the end of five years.

0 1 2 3 4 5

100 100 100 100 100 1,000 1,100

PVIFA 8%,4 = 3.3121 331.21 PVIF 8%,5 = .6806 748.66 $1,079.87

The value of the bond is $1,079.87 which is selling at a premium relative to the par value of $1,000. (A bond selling at less than par is said to be selling at a discount.)

What does the premium represent? As we saw when we looked at present values, it represents the present value of the additional interest of $20 per year (because it pays $100 in interest when we only require $80 for a $1,000 investment ($20 * 3.9927 = $79.85 with two cents rounding error). Any time the market rate of interest is less than the coupon rate of interest, the bond will sell at a premium. Similarly, when market rates of interest are greater than the coupon rate, the bond will sell at a discount. Recall from economics that, when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. This is a consequence of the mathematics of present value calculations.

Suppose we purchase the bond for $1,079.87. After one year, we collect $100 in interest. The $100 represents a 9.26% return on our investment of $1,079.87, not an 8% rate of return. What are we ignoring?

The 9.26% is referred to as the current yield (as in accounting, where “current” refers to within one year). What is being ignored is the fact that we paid a premium for the bond which, at maturity will be worth only $1,000. Thus, over the five years to maturity, the value of the bond will decrease. Let’s look at what the bond will be worth one year from now. In one year, there will only be four years left to maturity:

0 1 2 3 4

100 100 100 100

1,000

PVIFA 8%,4 = 3.3121 331.21 PVIF 8%,4 = .7350


735.00 $1,066.21

Note that this time, the interest payment in the last year was included as a part of the present value of an annuity calculation while the par value was discounted as a lump sum of $1,000. As indicated, the value of the bond when only four years to maturity remain is only $1,066.21. This is a decrease in value of $13.66. When expressed as a percentage of the original value of $1079.87, this represents a loss of 1.26%. The total return of 8% that we built into our valuation when the bond had five years left to maturity is comprised of two components:

Total Yield = Current Yield + Capital Gain Yield

Current Yield = One Year’s Interest/Current Price

Total Yield = 9.26% + <1.26%> = 8.00%

Note that the premium for the four-year bond is smaller than the premium for the five-year bond since we are only paying for four years’ worth of additional interest payments.

A. Bond Maturities & Premiums/Discounts

If a five-year bond sells at a premium of $1,079.87, what do you think the premium for a ten-year bond will be? (Recall that the premium is the present value of the additional amount of interest being paid.)

A ten-year 10%, $1,000 par value bond should sell at a larger premium since we are paying for ten years’ worth of an extra $20 per year of interest. For example,

Par = $1,000Coupon Rate = 10%Maturity = 10 yearsK = 8%

0 1 2 3 4 5 6 7 8 9 10

100 100 100 100 100 100 100 100 100 100

PVIFA 8%,10 = 6.7101 1,000 671.01 PVIF 8%,10 = .4632$ 463.20$1,134.21

As was expected, the additional five years’ worth of an extra $20 per year in interest payments results in a larger premium for a ten-year bond relative to a five-year bond.


B. Sensitivity to Changes in Interest Rates

As we determined previously, as interest rates fall, bond prices rise. Which type of bond rises more, short-term or long-term bonds? (Hint: Do we really care what interest rates do today for a bond that matures tomorrow?)

Suppose that interest rates fall from 8% to 6%. Let’s see what happens to the values of our five-year and ten-year bond prices.

0 1 2 3 4 5

100 100 100 100 100

1,000

PVIFA 6%,5 = 4.2124 421.24 PVIF 6%,5 = .7473 747.30 $1,168.54

The value of the five-year bond has increased from $1,079.87 to $1,168.54 or $88.67 due to the fall in market rates of interest from 8% to 6%. The $88.67 increase in price represents an 8.2% appreciation relative to its original value.

The ten-year bond’s increase in price is calculated in the following manner:

0 1 2 3 4 5 6 7 8 9 10

100 100 100 100 100 100 100 100 100 100

PVIFA 6%,10 = 7.3601 1,000 736.01 PVIF 6%,10 = .5584$ 558.40$1,294.41

The increase in price for the ten year bond amounts to $160.20 or 14.1%. Why do we calculate the change in price as a percent of its original value?

The reason the change in price is much larger for a long-term bond is due to the fact that the longer period of time for compounding has a more pronounced effect on the ten-year bond than it does on a five-year bond since, on average, the five-year bond is generating cash flows much sooner than the ten-year bond. If long-term bonds are more sensitive to changes in interest rates than short-term bonds, can you guess whether a high coupon bond or a low coupon bond is more sensitive to changes in interest rates? (See Handout #2.)

The equation for the value of a bond can be written as follows:


N Interest Par Bond Value = + t=1 (1+k)t (1+k)N

= Interest (PVIFA) + Par (PVIF)

= Present Value of the Interest Payments + Present Value of the Par

C. Perpetuities

There is a type of bond that never matures called a perpetuity, or a consol. (The term “consol” comes from the fact that the first perpetuities were issued by the British government following the Napoleonic Wars to “consolidate” their war debts.) Canada issued some perpetuities in the late 1970s. If long-term bonds are more sensitive to changes in interest rates than short-term bonds, what type of bond is the most sensitive to interest rate changes? (A consol, of course.)

When N is infinity, the value of a perpetual bond reduces to

Interest

Value of a perpetuity = K

While there are not a lot of perpetuities that trade in the marketplace, there is a financial security which is, essentially, a perpetuity. Do you know what security pays a constant dollar amount each year and never matures?

D. Preferred Stock

The classic version of preferred stock is a share that pays a fixed dollar amount of dividend and never matures. It is, therefore, a perpetuity. The formula for the value of a share of preferred stock is

DividendValue of Preferred Stock =

Kp

So if you expect that interest rates are going to decrease in the future, what type of bond would you want to buy?

If you expect that interest rates are going to rise in the future, what type of bond do you want to buy?


Key Features of a Bond1. Par value: Face amount; paid at maturity. Assume $1,000. 2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. 3. Maturity: Years until bondmust be repaid. Declines.4. Issue date: Date when bond was issued.5. Default risk: Risk that issuer will not make interest or principal payments.

How does adding a call provision affect a bond? Issuer can refund if rates decline. That helps the issuer but hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on

callable bonds. Most bonds have a deferred call and a declining call premium.

What’s a sinking fund? Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens average maturity. But not good for investors if rates decline after issuance.

STOCKS and their VALUATION

Stocks can be divided into two categories: Common Stock and Preferred Stocks.Preferred stock is a hybrid security, sharing features of both bonds and common stock.Firms usually issue preferred stock with a stated par value and promise to periodically pay a percentage of the par value as dividend.

where,D = Dividend of Preferred Stockkp = Required rate of return on the Preferred StockP = Price of the Preferred Stock

The cash flow pattern of preferred stock is like perpetuity. It starts from period one, has no gaps, all payments are equal, and payments continue forever.

Common stock represents an ownership position in the firm. Common Stock is a long-term financial asset that provides to the common stockholders (owners of the firm) legal rights and privileges such as:a. Residual claim on the income and assets of the firm


∞

Dp

P

The claim is residual because stockholders can claim on the firm’s income and assets only after all claims of all stakeholders (bondholders, employees, suppliers, and the government) are satisfied. Although stockholders are last in line to enforce their claim, they can claim everything that remains in the firm and they have a limited liability, meaning that the stockholders’ liability to the stakeholders are limited to the equity they contributed.

b. Voting powerVoting power is the power to elect directors (who in turn elect managers and officers to the company). Usually in annual meetings stockholders elect 1/3 of the directors for 3 years. Voting mechanism could be either “majority voting” or “cumulative voting.” Stockholders could vote either in person or by means of a proxy.

c. Preemptive rightPreemptive right is a provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock or convertible securities. It serves for two purposes. First it enables current stockholders to maintain control. If this safeguard were not in place, the management of the corporation could issue large numbers of additional shares and purchase these shares itself and thereby seize control of the firm. Second, it protects stockholders against a dilution of value. If this safeguard were not in place, selling common stock at a price lower than the market value would transfer wealth from the present stockholders to those who were allowed to purchase the new shares.


Terminology used in Stock Valuation1. Intrinsic Value

Intrinsic value is the value of an asset that in the mind of a particular investor is justified by the facts. Intrinsic value may be different form current market price or its book value or both.

2. ProxyProxy is a document giving one person the authority to act for another, typically the power to vote shares of common stock.

3. Proxy FightProxy fight is an attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares to place a new management into office.

4. TakeoverTakeover is an action by a person or group to take control of the company and oust the firm’s management. That could be done either through proxy fight or by purchasing majority of outstanding stock.

5. Founder’s SharesFounder’s shares are Stocks owned by the firm’s founders that have sole voting rights but restricted dividends for a specified number of years.

6. Classified StockClassified stock is common stock that is given a special designation such as Class A, Class B, and so forth. One class may have no voting right but may have rights to dividends, another may have no rights to dividends but may have voting rights.

7. Closely Held CorporationClosely held corporation (also called privately owned corporation) is a corporation that is owned by a few individuals who are typically associated with the firm’s management. The shares of the firm are not traded actively.

Market Mechanism that determines the Stock ValueThe price of a firm’s stock represents the value of the firm per share of stock. Since the value of firm change continuously, so do stock prices. Institutional and individual investors constantly value stocks so that they can capitalize on expected changes in stock prices.New information about economic conditions or other factors, including firm-specific conditions, causes investors to revalue stocks. When new information suggest that a firm will experience more favorable cash flows or lower risk (and therefore lower required rate of return = lower cost to obtain funds), investors will revalue the corresponding stock upward. As these investors attempt to purchase the stock, there is an immediate upward adjustment in the stock’s market price.

1. Common Stock Valuation MethodsThere are several methods (models) to assess the value of a stockE. Price-Earning (PE) Model

A relatively simple method of valuing a stock.


Stock Price of a firm = (Expected earnings of the firm per share for the current year) x (Mean value of expected PE ratio of the competitors of the firm)

F. Divided Discount Model This approach assumes that the investors are interested in the dividend payments of the company. To compute the value of the stock, all expected future dividend payments are discounted at an appropriate rate to the Present Value.

where,S0 = current Stock PriceD1 = Dividend Payment in Period-1 (one period from now)ks = Required rate of return on the Stock

The above formula could be presented in a much compact form as the following:

where,t = index for period

Since it is impossible to forecast all the expected future dividend payments (up to infinity), there are several practical adjustments to this approach.

i. Zero Growth Model: If we assume that the dividend payments will remain constant then the formula could be written as:

Cash flow pattern of zero growth stock is (like preferred stock) perpetuity.

ii. Constant Growth Model: This model assumes that the dividend payments are growing each year at a constant rate of “g”.

The cash flow pattern of Constant Growth Stock looks like the following:


It starts from period-1, has no gaps, cash flows grow at a constant rate, and forever.

Where,g = expected growth rate in dividends = (ROE)*(p)D1 = Expected Dividend Payments in the next period = D0(1+g)D0 = Most recent Dividend PaymentD1/S0 = Dividend yieldROE = Return on Equity = (Net income) / (Common Stock Book Value)q = dividend pay out ratioDt = q*(Earnings)t

iii. Variable Growth Model: This model assumes that the company and its dividend payments grow much faster then the economy for a certain period at the beginning and then settles to a constant growth rate.

G. Capital Asset Pricing Model (CAPM) CAPM determines appropriate required rate of return on a stock.

Where,ki = Required rate of return on Stock “i”krf = Risk free ratekm = Return on market(km - krf) is also called market risk premium. That is required rate of return to bear

market’s risk.βi = Beta of stock “i". Beta of a stock reflects how risky a stock is compared to

market. Market’s beta is one (βm =1). If firm-i’s beta is more than one (βi >1) that means that firm-i is more riskier than the market and that in turn results in higher risk premium, thus, higher required return for the firm-i.

The key to the Capital Asset Pricing Model is the market risk. This model recognizes only one risk, market risk, and calls it also systematic risk or non-


∞

D1

S0

D0(1+g)∞

diversifyable risk. In this model risk of a financial asset is expressed as a fraction of the market risk.

H. Arbitrage Pricing Model (APT) Like CAPM this model tries to determine the required rate of return on a particular stock. However, Arbitrage Pricing Model recognizes more than one fundamental factor as source of risk. There are many factors (such as economic growth, level of inflation, etc.) that could be source for risk. However, there is no single set of factors that everyone agrees upon. Sensitivity of a stock to each of these factors should be determined first in order to calculate the required rate of return on that particular stock.

2. Factors Affecting Stock PricesThere are three types of factors, firm specific, economic, and market related, that can affect a stock’s value.a. Expectations

Investors do not necessarily wait for a firm to announce a new policy before they revalue the firm’s stock. They make their decision on the basis of some (most of the time incomplete) information in order to act before other investors. Expectations on the future cash flows of a company affect the stock’s value.

b. Earnings SurprisesRecent earnings are used to forecast future earnings and therefore earning surprises affect future cash flow estimates and consequently the stock’s price.

c. Acquisitions & DivestitureAn expected acquisition of a firm typically results in an increase demand for the target’s stock and therefore raises the stock prices. Divestitures tend to be regarded as a favorable signal and are interpreted as an attempt of the firm to focus on the core business.

d. Stock Offerings & RepurchaseSome investors believe that firms attempt to issue stock when they feel that their stock is overpriced and repurchase the stock when under priced.

e. Dividend Policy ChangesAn increase in dividends may reflect the firm’s expectations that it can more easily afford to pay higher dividends.

f. Interest RatesRisk-free rate affects required return on stocks and therefore the market value of stocks.

g. Economic growthEconomic growth affects projections for corporate earnings and therefore stock value.

h. Exchange RatesForeign investors tend to purchase domestic stocks when the domestic currency is weak and sell them when it is near its peak.

i. January EffectBecause many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift to larger


companies near the end of year. This tendency puts upward pressure on small stocks in January every year.

j. Noise TradingMany uninformed traders (noise traders) may buy or sell positions that push a stock’s price away from its fundamental value. Given the uncertainty about the stock’s fundamental value, informed investors may be unwilling to capitalize on the discrepancy.

3. Measure of Risk for StocksThere are two measures of risk, stock volatility and beta.a. Volatility of a Stock

It is measured by the standard deviation of stock’s return (or price) over a period of time. It captures total volatility of the stock and is appropriate if there is no trend in volatility.

b. Beta of a StockBeta is a measure that reflects the tendency of a stock to move up or down with the market. It measures the systematic risk of the stock. Beta of a stock = (covariance between stock and the market returns) x (variance

of market returns)4. Stock Performance Measure

The performance of a stock (or stock portfolio) can be measured by its excess return (return over risk free rate → r-rf ) over that period divided by its risk. Two common methods of measuring stock (or stock portfolio) performance are the Sharpe index and Treynor Index.a. Sharpe Index

It assumes that the total variability is the appropriate measure of risk

Where, = Average return on stock

= Average risk-free rate

= Standard deviation of stock’s return

b. Treynor IndexIt assumes that the beta is the most appropriate measure of risk

Where, β = Stock’s beta


Part 6: Working Capital Management

Working capital management is concerned with current assets and current liabilities and their relationship to the rest of the firm. Working capital policies affect the future returns and risk of the company; consequently, they have an ultimate bearing on shareholder wealth.

What is Working Capital?

A business person usually sells on credit, stocks goods and keeps some cash in the bank and the office.

Working capital refers to the total investment in current assets.

Net working capital refers to the difference between current assets and current liabilities.

Working capital management involves two major types of decisions:

1. The level of investment in current assets.2. The method of financing (short-term VS long-term)

Level of Investment in Current assets

Determination of the appropriate level of working capital involves a tradeoff between risk and profitability.

The above figure tells us that


Summary


Impact on Impact on Expected ProfitabilityExpected Profitability

Return on Investment Return on Investment =

Net ProfitNet ProfitTotal AssetsTotal Assets

Let Current Assets Current Assets =(Cash + Rec. + Inv.)

Return on Investment Return on Investment =

Net ProfitNet ProfitCurrent Current + Fixed AssetsFixed Assets

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

(A

ED

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on RiskImpact on Risk

Decreasing cashreduces the firm’s abilityto meet its financialobligations. More risk!More risk!

Stricter credit policiesreduce receivables andpossibly lose sales andcustomers. More risk!More risk!

Lower inventory levelsincrease stockouts andlost sales. More risk!More risk!

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

(A

ED

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

1. More conservative policies involve holding a greater amount of current assets relative to sales. More aggressive policies hold less.

2. More conservative working capital policies have lower expected profitability (measured as return on total assets) since more assets are used to produce a given level of income.

3. More conservative working capital policies have a lower risk of insufficient cash to pay bills and insufficient inventory to meet demand.

4. The optimal level of working capital investment is the level which is expected to maximize shareholder wealth.

Nature of Current Assets

Current assets usually fluctuate from month to month. During months when sales are relatively high, firms usually carry a lot of inventory, accounts receivable and cash.The level of inventory declines in other months when there is less selling activity. But at any given point of time, the firm always has some current assets.

Permanent current assets and Temporary current assetsThe amount of current assets required to meet a firm's long-term minimum needs are called Permanent current assets.Current assets that fluctuate due to seasonal or cyclical demand are called


TemporaryTemporaryWorking CapitalWorking Capital

The amount of current assets that variesThe amount of current assets that varieswith seasonal requirements.with seasonal requirements.

Permanent current assetsPermanent current assets

TIME

DO

LL

AR

AM

OU

NT

Temporary current assetsTemporary current assets

Summary of the OptimalSummary of the OptimalAmount of Current AssetsAmount of Current Assets

SSUMMARYUMMARY O OFF O OPTIMALPTIMAL C CURRENTURRENT A ASSETSSET A ANALYSISNALYSIS

PolicyPolicy Liquidity Liquidity ProfitabilityProfitability RiskRisk

A A High High Low Low Low Low

B B AverageAverage Average Average Average Average

C C Low Low High High High High

1. Profitability varies inversely withliquidity.

2. Profitability moves together with risk.(risk and return go hand-in-hand!)

temporary current assets.Need for financing of Current assetsWorking Capital requirements are for a short period of time as Current Assets are self-liquidating.

Take a look at the following steps (a simple model):

1. Inventory purchased on credit. Accounts Payable2. Inventory stocked in the Warehouse. Merchandise Inventory3. Goods are sold on credit. Accounts Receivable4. Cash is collected. Cash

Usually somewhere between steps 1 and 4, money has to be paid to the supplier. Let’s assume in this model that money is paid between steps 2 & 3. In this case Cash is not yet collected. So some sort of finance has to be arranged till Cash is collected for a short term. Once cash is collected then the money (from whichever source) that was arranged can be repaid. With the arrangement of Finance the steps above can be modified as under:

1. Inventory purchased on credit.

2. Inventory stocked in the Warehouse.

Finance arranged to pay the supplier

3. Goods are sold on credit.

4. Cash is collected.

Finance that was arranged between steps 2 & 3 can now be re-paid.

The above cycle gets repeated.

So Financing needs are short term for Working Capital.

Nature of Financing (Short-term VS. Long-term)


Self-Liquidating Nature Self-Liquidating Nature of Short-Term Loansof Short-Term Loans

Seasonal orders require the purchase ofinventory beyond current levels.

Increased inventory is used to meet theincreased demand for the final product.

Sales become receivables.

Receivables are collected and become cash.

The resulting cash funds can be used to payoff the seasonal short-term loan and coverassociated long-term financing costs.

Conservative Policy of Financing:

(LOW Risk; LOW Return approach)

All fixed assets + permanent curr. assets + part of temporary curr. Assets by long-term debt


Financing NeedsFinancing Needs

Fixed assets and the non-seasonal portionof current assets are financed with long-term debt and equity (long-term profitabilityof assets to cover the long-term financingcosts of the firm).

Seasonal needs are financed with short-term loans (under normal operationssufficient cash flow is expected to cover theshort-term financing cost).

Fixed Assets

Temporary current assets

Shortterm

Ideal Pattern of FinancingIdeal Pattern of Financing

Aggressive policy of financing :

(HIGH Risk; HIGH Return approach)


Fixed Assets

Temporary current assets Shortterm

Lon

g-term

Conservative working capital policyConservative working capital policy

RisksRisks vs vs. Returns Trade-Off. Returns Trade-Off(Conservative Approach)(Conservative Approach)

Long-Term Financing BenefitsLong-Term Financing Benefits

Less worry in refinancing short-term obligations Less uncertainty regarding future interest costs

Long-term Financing RisksLong-term Financing Risks Borrowing more than what is necessary

Borrowing at a higher overall cost (usually)

ResultResult

Manager accepts less expected profits inexchange for taking less risk.

I. Combining Level of Current assets with Financing strategies

AGGRESSIVE PLAN (SHORT TERM FINANCING/LOW LIQUIDITY)

If you adopt a financing plan which uses short term funds, and your asset liquidity is low then it is an aggressive and risky approach for the following reasons:


Fixed Assets

Temporary current assets

Shortterm

Aggressive working capital policyAggressive working capital policy

RisksRisks vs vs. Returns Trade-Off. Returns Trade-Off(Aggressive Approach)(Aggressive Approach)

Short-Term Financing BenefitsShort-Term Financing Benefits

Financing long-term needs with a lower interestcost short-term debt

Borrowing only what is necessary

Short-Term Financing RisksShort-Term Financing Risks Refinancing short-term obligations in the future Uncertain future interest costs

ResultResult

Manager accepts greater expected profits inexchange for taking greater risk.

1. Profit factor - There is a possibility of high profits because your assets are less liquid and therefore well invested in the business.

2. Profit factor - You are using short term financing and hence the interest costs could be low resulting in lesser interest expense thereby helping profits.

3. Risk Factor - Since the financing is short term there is every possibility that the interest rates could go up resulting in a higher interest expense when the finances need to be renewed or the lender may refuse to renew.

4. Risk Factor - Since the assets are less liquid there may not be enough cash to meet short term obligations.MODERATE PLAN(SHORT TERM FINANCING/HIGH LIQUIDITY OR LONG TERM FINANCING/LOW LIQUIDITY)

This sort of plan is considered moderate because:

1. Risk factor (Short term/Highly liquid)- Even though borrowing is short term with the possibility of the financing arrangement not being renewed or a higher interest expense (which is the risk factor) the Assets are highly liquid hence even if the loan has to be repaid funds would be available.

2. Profit factor (Short term/Highly liquid)- With short term financing the interest cost could be low and therefore help profits but the Assets being less liquid would not help returns (profits).

3. Risk factor (Long term/Low liquid)- Since the financing arrangement is long term there will not be any threat of immediate repayments but the assets being less liquid could be a problem.

4. Profit factor (Long term/Low liquid)- When the assets are kept less liquid it would help the profits because they would be well invested but the interest cost could be high because of long term borrowing.

Conservative (Long term Financing/Highly liquid assets)

1. Risk Factor - This will be negligible because there is no threat of immediate repayment as the borrowing is long term and in any case if anything has to be repaid the business would have the finance anyway as the assets are highly liquid.


2. Profit Factor - Profitability will be low because the Assets are highly liquid and

the interest rates could be high too.

Part 7: Special Topics in Managerial Finance

“Cost of Capital?”When we say a firm has a “cost of capital” of, for example, 12%, we are saying:The firm can only have a positive NPV on a project if return exceeds 12%The firm must earn 12% just to compensate investors for the use of their capital in a projectThe use of capital in a project must earn 12% or more, not that it will necessarily cost 12% to borrow funds for the projectThus cost of capital depends primarily on the USE of funds, not the SOURCE of funds

Weighted Average Cost of Capital (overview)A firm’s overall cost of capital must reflect the required return on the firm’s assets as a wholeIf a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firm’s capital structureThis is called the Weighted Average Cost of Capital (WACC)

Cost of Equity


The Cost of Equity may be derived from the dividend growth model as follows:P = D / RE – g

Where the price of a security equals its dividend (D) divided by its return on equity (RE) less its rate of growth (g). We can invert the variables to find RE as follows: RE = D / P + gBut this model has drawbacks when considering that some firms concentrate on growth and do not pay dividends at all, or only irregularly. Growth rates may also be hard to estimate. Also this model doesn’t adjust for market risk.

Cost of Equity :Therefore many financial managers prefer the security market line/capital asset pricing model (SML or CAPM) for estimating the cost of equity: RE = Rf + βE x (RM – Rf)or Return on Equity = Risk free rate + (risk factor x risk premium)Advantages of SML: Evaluates risk, applicable to firms that don’t pay dividendsDisadvantages of SML: Need to estimate both Beta and risk premium (will usually base on past data, not future projections.)

Cost of DebtThe cost of debt is generally easier to calculateEquals the current interest cost to borrow new fundsCurrent interest rates are determined from the going rate in the financial marketsThe market adjusts fixed debt interest rates to the going rate through setting debt prices at a discount (current rate > than face rate) or premium (current rate < than face rate)

Weighted Average Cost of Capital (WACC)WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structureWACC=(E/ V) x RE + (D/ V) x RD x (1-TC)(E/V)= Equity % of total value(D/V)=Debt % of total value(1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible

WACC Illustration

ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % = .8576 and Debt % = .1424Risk free rate is 4%, risk premium=7% and ABC’s β=.74Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40% Current yield on market debt is 11%WACC = (E/V) x RE + (D/V) x RD x (1-Tc)


= .8576 x .0918 + (.1424 x .11 x .60) = .088126 or 8.81%

Final notes on WACCWACC should be based on market rates and valuation, not on book values of debt or equity. Book values may not reflect the current marketplaceWACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firm’s Beta used to calculate the firm’s RE. In the case of ABC Co., the relatively low WACC of 8.81% reflects ABC’s β=.74. A riskier investment should reflect a higher interest rate.

<<< The End >>>

Subject : Managerial Finance (Formula sheet)HPR(holding period return):Ending value of Investment / Beg. Value of InvestmentAnnual HPR = [(HPR) ^(1/n) – 1] * 100HPY(holding period yield) = Annual HPR - 1

Historical Return:A.M = sum(HPY) / nG.M = {(HPR1 * HPR2 * HPR3 *…. HPRn)}^1/n - 1Expected Rate of Return:E(R) =Sum (Probability of Return * Possible of Return) ORE( R) = [(P1)(R1) + (P2)(R2) + (P3)(R3) + …..(Pn*Rn)]Risk of Expected Rate of Return:

1. Variance = Sum(Probability) [( Possible of Return - Expected Return)^2]2. Standard Deviation = [Sum{(Probability) (R – E(R)}] ^ ½3. Co-efficient of Variance = Standard deviation of Return / Expected Rate of Return

Rate of Return:Kt = [Ct + Pt – (Pt-1)] / Pt-1Total Return:


TR = [( CFt + (Pe – Pb)) / Pb ] Bond Return: Bond TR = [(It + (Pe – Pb)) / Pb ] Stock Return:Stock TR = [(Dt + (Pe – Pb)) / Pb ] Inflation Return = [ (1 + TR) / (1 - If ) ] – 1

Valuation of Assets:V = [ CF1 * (PVIF(k,1))] + [ CF1 * (PVIF(k,2))] + [ CF1 * (PVIF(k,3))]………Valuation of Bond:B = I * [(PVIFA(kd,n))] + M*[(PVIF(kd,n))]Basic Stock Valuation:Po =[D1/(1+Ks)^1] + [D2/(1+Ks)^2] + [D3/(1+Ks)^3] + …….

Common stock Value:Po = D1 / Ks


whereCFt = Cash Flow Pe = Price in endingPb = Price in Beg. It = Interest PaymentDt = Dividend PaymentIf = Rate of Inflation

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