Financial Management 2 Notes 

 
I. F
​ inancial Mgt 
 
1. Introduction to FM 
a. History 
 
II. C
​ oncepts in FM 
 
2. Financial Statements, Cash flow, and taxes 
 
3. Analysis of Financial Statements 
 
a. horizontal and vertical 
b. ratio analysis 
i. liquidity ratios 
ii. profitability ratios 
iii. activity ratios 
iv. leverage ratios 
c. recasting fs 
i. benchmarking (internal, competitive, strategic) 
 
4. Time Value of Money 
 
III. F
​ inancial Assets  
 
5. Interest Rates (aug 24) 
 
a. Definition 
b. Ph’s IR 
 
6. Bonds and their valuation (aug 24) 
 
a. Characteristics 
1. Face Value 
 2. The coupon rate 
3. Coupon Dates 
4. Maturity date 
5. Issue Price 
 
b. Categories of Bonds, (Features, benefits, requirements) 
1. Corporate 
2. Municipal 
3. Government 
4. Agency 
 
c. Retail Treasury Bonds 
i. sample terms of offering 
ii. why, how and where to invest in rtb 
iii. FAQs 
 
d. Government Securities 
i. Treasury Bills and Bonds 
ii. Fixed rate treasury notes 
iii. Features and Benefits 
 
7. Risks and rates of return and standard deviation (aug 17) 
a. expected return vs. standard deviation 
b. measurement of relative risk - statement 
c. coefficient of variation: measure of relative risk (CoV=SD/Ave.Ret)  
 
8. Stocks and their valuation 
 
IV. ​Long Term Investment Decision 
 
9. Capital Budgeting and Cash Flow Principles (sept 7) 
 
a. steps involved in evaluating a capital budgeting project 
b. Payback Period 
c. Discounted PbPd 
 d. NPV and IRR method 
e. ARR 
f. Profitability Index  
a. PI = ​PV of Future CF 
Initial Investment 
b. PI =  1 + NPV . 
Initial Investment  
 
10. Capital Budgeting Techniques (sept 14) 
 
a. Payback Pd 
b. ARR 
c. PI 
d. NPV and IRR rationale 
e. Multiple IRR 
i. Problems occur, normal CF vs Non-normal 
 
11. The cost of capital (Oct 5) 
 
a. WACC,composite or weighted 
i. Factors that affect WACC (management can and cannot 
control) 
b. Risk Premium 
c. Inflation and Investment Opportunities 
d. Cost of new common stock 
i. Flotation costs 
e. Cost of Debt, Preferred Stock and RE 
i. Cost of RE different approaches  
1. CAPM 
2. Bond-yield-plus-RP 
3. Discounted Cash 
Flow/Dividend-yield-plus-growth-rate 
4. Averaging the Alternative Estimate 
 
V. O
​ ther Topics 
 
12. Leverage and capital structure (oct 5) 
 
a. Definition 
b. Tradeoff theory 
i. Debt and equity financing 
c. Factors that influence capital structure decisions 
d. Business Risk Vs Financial Risks 
e. Operating Leverage 
f. Break even analysis 
 
13. Dividend Policy (oct 19) 
 
a. Dividends 
b. Types of Dividend Policy 
1. Regular Dividend Policy 
2. Irregular Dividend Policy 
3. No Dividend Policy 
4. DPS,EPS,DPOr 
c. Factors determining dividend policy 
1. Profitable position 
2. Legal constraints  
3. Liquidity position 
4. Sources of finance 
5. Growth rate of the firm 
d. Form of Dividend 
a. Cash Dividend 
i. Cumulative 
ii. Non-cumulative 
iii. Participating 
iv. Fully- Participating 
b. Stock Dividend 
c. Stock Split 
d. Stock repurchase 
 
 14. Hybrid & Derivative Securities (oct 19) 
 
a. Hybrid Securities (Combination of Debt and Equity) 
i. convertible bond 
b. Derivatives (derived from another…) 
i. Swap 
ii. Futures contract, forward 
iii. Options 
 
 
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INTEREST RATE 
Interest paid to savers depends on  
● the rate of return that producers expect to earn on invested capital 
● the saver’s time preferencew for current vesus future consumption 
● the riskiness of the loan 
● the expected future rate of inflation 
 
 
COST OF CAPITAL 
 
WACC, composite or weighted 
Factors that affect WACC (management can and cannot control) 
The weighted average cost of capital (WACC) is the rate that a company is expected 
to pay on average to all its security holders to finance its assets.  
The WACC is commonly referred to as the firm's cost of capital. Importantly, it is 
dictated by the external market and not by management.  
The WACC represents the minimum return that a company must earn on an existing 
asset base to satisfy its creditors, owners, and other providers of capital, or they will invest 
elsewhere. 
 
Companies raise money from a number of sources: common stock, preferred stock, 
straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, 
executive stock options, governmental subsidies, and so on.  
 Different securities, which represent different sources of finance, are expected to 
generate different returns.  
The WACC is calculated taking into account the relative weights of each component 
of the capital structure. The more complex the company's capital structure, the more 
laborious it is to calculate the WACC. 
 
WACC = Cost of Equity x %Equity + Cost of Debt x %Debt * (1-Tax Rate) 
+ Cost of Preferred Stock x %Preferred Stock 
 
WACC = (% of Debt)(After tax cost of Debt) + (% of preferred stock)(Cost of PS) 
+ 
( % of common equity) (Cost of Common equity) 
 
Weighted Average Cost of Capital - A weighted average of the component cost of 
debt, ps, and ce. 
 
Companies can use WACC to see if the investment projects available to them are 
worthwhile to undertake. 
 
Risk Premium 
Inflation and Investment Opportunities 
Cost of new common stock 
Flotation costs 
Cost of Debt, Preferred Stock and RE 
Cost of RE different approaches 
CAPM 
  Bond-yield-plus-RP 
Discounted Cash Flow/Dividend-yield-plus-growth-rate 
Averaging the Alternative Estimate 
 
HYBRID AND DERIVATIVES SECURITIES 
 
Hybrid Security - A form of debt or equity financing that possesses characteristics of both 
debt and equity financing 
 
Example includes: 
● Convertible securities 
● Leases 
● Stock purchase warrants  
 
A c​ onvertible bond ​is a fixed-income debt security that yields interest payments, but can be 
converted into a predetermined number of common stock or equity shares. The conversion 
from the bond to stock can be done at certain times during the bond's life and is usually at 
the discretion of the BoNDHOLDER. 
 
Preferred shares ​Is a type of stock which may have any combination of features not 
possessed by common stock including properties of both an equity and a debt instrument, 
and is generally considered a hybrid instrument   
 
Leasing -​ The process by which a firm can obtain the use of certain fixed assets for which it 
must make a series of contractual, periodic, tax-deductible payments. 
 
TYPES 
Operating leases 
A cancellable contractual arrangement whereby the lesee agrees to make periodic 
payments to the lessor, often for 5 or fewer years, to obtain an asset’s services, generally, 
the total payments over the term of the lease are less than the lessor’s initial cost of the 
leased asset. 
 
Financial lease  
a longer term lease than an operating lease that is non cancellable and obligates the 
lessee to make payments for the use of an asset over a predefined period of time. The total 
payments over the term of the lease are greater than the lessor’s initial cost of the leased 
asset 
 
● Maintenance clauses are provisions normally included in an operating lease that 
require the lessor to maintain the assets and to make insurance and tax payments. 
● Renewal options are provisions especially common in an operating lease that grants 
the lessee the right to re-lease assets at the expiration of the lease. 
 ● Purchase options are provisions frequently included in both operating and financial 
leases that allow the lessee to purchase the leased asset at maturity, typically for a 
prespecified price. 
 
Leasing Arrangements 
 
Direct Lease 
is a lease under which a lessor owns or acquires the assets that are leased to a given 
lessee 
 
Sale-Leaseback Arrangement  
is a lease under which the lessee sells an asset to a prospective lessor and then leases back 
the same asset, making fixed periodic payments for its use. 
 
Leveraged lease  
is a lease under which the lessor acts as an equity participant, supplying only about 20 
percent of the cost of the asset, while a lender supplies the balance 
 
Lease vs Purchase Decision - It is the decision facing firms needing to acquire new fixed 
assets whether to lease the assets or to purchase them, using borrowed funds or available 
liquid resources. 
 
Stock Purchase Warrants 
-Is an instrument that gives its holder the right to purchase a certain number of shares of 
common stock at a specified price over a certain period of time. 
 
-Warrants are often attached to debt issues as “sweeteners” 
 
-Often, when a new firm is raising its initial capital, suppliers of debt will require warrants 
to permit them to share in whatever success the firm achieves. 
 
-In addition, established companies sometimes offer warrants with debt to compensate for 
risk and thereby lower the interest rate and/or provide for fewer restrictive covenants. 
 
 The lease-versus-purchase decision involves application of capital budgeting 
techniques. First, we determine the relevant cash flows and then apply present value 
techniques. The following steps are involved in the analysis 
 
Step 1 
Find the after-tax cash outflows for each year under the lease alternative. This step 
generally involves a fairly simple tax adjustment of the annual lease payments. In 
addition, the cost of exercising a purchase option in the final year of the lease term 
must frequently be included. 
 
Step 2 
Find the after-tax cash outflows for each year under the purchase alternative. This 
step involves adjusting the sum of the scheduled loan payment and maintenance 
cost outlay for the tax shields resulting from the tax deductions attributable to 
maintenance, depreciation, and interest. 
 
Step 3 
Calculate the present value of the cash outflows associated with the lease (from 
Step 1) and purchase (from Step 2) alternatives using the after-tax cost of debt as 
the discount rate. The after tax cost of debt is used to evaluate the 
lease-versus-purchase decision because the decision itself involves the choice 
between two financing techniques- leasing and borrowing. 
 
Step 4 
Choose the alternative with the lower present value of cash outflows from Step 3. It 
will be the least-cost financing alternative. 
 
 
Derivatives 
A security that is neither debt nor equity but derives its value from an underlying asset that 
is often another security, called “derivatives” for short. 
 
FUTURE 
 
An agreement between the 2 parties, A buyer and a seller to buy something at a future date  
 
 
OPTION  
 
Is a contract which gives the buyer the right , but not the obligation to buy or sell an 
underlying asset or instrument at a specified price on or before a specified date.  
 
FORWARDS  
 
Agreement between the 2 parties, A buyer and a seller to purchase or sell something at a 
later date at a price agreed upon. 
 
 
SWAP 
 
An agreement in which one party trades something with another party.