Management

Introduction of Corporate Finance (FM/IBF) 1
TABLE OF CONTENTS
Chapter One Fundamentals of Finance Page 1
Chapter Two Financial Statement Page 8
Chapter Three Financial Statement Analysis Page 11
Chapter Four Short Term Financial Planning Page 37

Chapter Five Time Value of Money Page 47
Chapter Six Bonds Valuation Page 72
Chapter Seven Stock Valuation Page 121
Chapter Eight Capital Budgeting Page 147
FINANCIAL MANAGEMENT FORMULAE SHEET page 183-184
FINANCIAL RATIOS FORMULAE Page 185-187
MACRS TABLES Page 188 – 191
Present value interest factor of $1 per period at i% for n periods, PVIF page 192
Present value interest factor of an (ordinary) annuity of $1 per period
at i% for n periods, PVIFA(i,n). page 193
Future value interest factor of $1 per period at i% for n periods, FVIF(i,n). page 194
Future value interest factor of an ordinary annuity of $1 per period
at i% for n periods, FVIFA(i,n). page 195

Chapter One Fundamentals of Finance
Why study finance?
There is general perception in students that finance should only study by those students who
want to join accounts department or want to go in financial sector. Of course finance is their
specialized field but all other people who are not directly engaged in financial sector should also
study finance to understand:
 Why saving is important today for future plans?

 When to start saving and how much to save for retirement?
 Should we deposit in saving account or fixed deposit is good option?
 Whether a car loan or lease is more advantageous?
 Whether a particular stock is a good investment?
 What is the benefit to get debt for business?
 How to evaluate the terms of a home mortgage?
 Running finance is good option or long term loan.
 If discount rate is reduced/increased by SBP, what would be its impact on debt financing?
If you are doing business or job in any organization, there are lots of things where you
need basic financial understanding, for example
 Should business start by my own fund or debt financing is also required and why?
 Should firm buy all assets by its own fund or take on lease?
 Should your firm launch a new product?
 How to get understanding that new product will be profitable?
 Which supplier should your firm choose?
 Should your firm produce a part of the product or outsource production?
 Should your firm issue new stock or borrow money instead?
 How can you raise money for your start-up firm?
Types of Firms
There are mainly three types of firms:
1. Sole proprietorship
2. Partnership
3. Corporation
1. Sole Proprietorships
A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually
very small with few, if any, employees. These are most common type of firm in the world as
well as in Pakistan.
The majority of sole proprietorships operate in the wholesale, retail, service and construction
industries. Typically, the owner (proprietor), along with a few employees, operates the
proprietorship. The proprietor raises capital from personal resources or by borrowing,
he or she is responsible for all business decisions. As a result, this form of organization appeals
to entrepreneurs who enjoy working independently.
A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of
the business are the entrepreneur’s responsibility, and creditors can make claims against the
entrepreneur’s personal assets if the business fails to pay its debts.
Key features of a sole proprietorship.
1. Sole proprietorships business is easy to set up. Consequently, many new businesses use this
organizational form. This type of business may start with small amount and with little
experience.
2. The principal limitation of a sole proprietorship is that there is no separation between the firm
and the owner, the firm can have only one owner who runs the business.
3. The owner has unlimited personal liability for the firm’s debts. That is, if the firm defaults on
any debt payment, the lender can (and will) require the owner to repay the loan from personal
assets. An owner who cannot afford to repay a loan for which he or she is personally liable must
declare personal bankruptcy.
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult to transfer
ownership of a sole proprietorship. Generally this form of business has little expansion plan
unless owner decides to change form of ownership to partnership or company.
5.For most growing businesses, the disadvantages of a sole proprietorship outweigh the
advantages. As soon as the firm reaches the point at which it can borrow without the owner
agreeing to be personally liable, the owners typically convert the business into another form.
Partnerships
A partnership is a business owned and run by more than one owner. This is another common
form of business organization in Pakistan and particularly popular in our region. Key features
include the following:
1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay all
the firm’s outstanding debts. This is one of the most important disadvantages of partnership
business.
2. The partnership ends in the event of the death or withdrawal of any single partner.
3. Partners can avoid liquidation if the partnership agreement provides for alternatives such as a
buyout of a deceased or withdrawn partner. Some old and established businesses remain as
partnerships or sole proprietorships.
Often these firms are the types of businesses in which the owners’ personal reputations are the
basis for the businesses. For example, law firms, medical practices, and accounting firms are
frequently organized as partnerships. For such enterprises, the partners’ personal liability
increases the confidence of the firm’s clients that the partners will strive to maintain the firm’s
reputation.
A limited partnership is a partnership with two kinds of owners, general partners and limited
partners. In this case, the general partners have the same rights and privileges as partners in any
general partnership—they are personally liable for the firm’s debt obligations. Limited partners,
however, have limited liability—that is, their liability is limited to their investment. Their private
property cannot be seized to pay off the firm’s outstanding debts.
Corporations
A corporation is a legally defined, artificial being (a legal entity), separate from its owners. As
such, it has many of the legal powers that people have. It can enter into contracts, acquire assets,
and incur obligations, and it enjoys protection against the seizure of its property. Because a
corporation is a legal entity separate and distinct from its owners, it is solely responsible for its
own obligations. Consequently, the owners of a corporation (or its employees, customers, etc.)
are not liable for any obligations the corporation enters into. Similarly, the corporation is not
liable for any personal obligations of its owners.
Formation of a Corporation
A corporation must be legally formed, which means that corporation should apply to Security
and Exchange Commission of Pakistan (SECP) which must formally give its consent to the
incorporation by chartering it. Setting up a corporation is therefore considerably more costly than
setting up a sole proprietorship.
Most firms hire lawyers to create a corporate charter that includes formal articles of
incorporation and a set of bylaws. The corporate charter specifies the initial rules that govern
how the corporation is run.
Ownership of a Corporation
There is no limit on the number of owners a corporation can have. Because most corporations
have many owners, each owner owns only a fraction of the corporation. The entire ownership
stake of a corporation is divided into shares known as stock.
The collection of all the outstanding shares of a corporation is known as the owner’s equity of
the corporation. An owner of a share of stock in the corporation is known as a shareholder,
owner, stockholder, or equity holder. Shareholders are entitled to dividend payments; that is,
payments made at the discretion of the corporation to its equity holders. Board of directors have
discretion to decide how much earning should be paid as dividend, this is not fixed as per law.
Shareholders usually receive a share of the dividend payments that is proportional to the
amount of stock they own. For example, a shareholder who owns 5% of the firm’s shares
would be entitled to 5% of the total dividend payment announced by firm.
An important feature of a corporation is that there is no limitation on who can own its stock. That
is, an owner of a corporation need not have any special expertise or qualification. Any investor
can buy or sell company stock as and when wishes. This feature allows free and anonymous
trade in the shares of the corporation and provides one of the most important advantages of
organizing a firm as a corporation. Corporations can raise substantial amounts of capital because
they can sell ownership shares to anonymous outside investors.
Tax Implications for Corporate Entities

An important difference among the types of corporate organizational forms is the way they
are taxed. Because a corporation is a separate legal entity, a corporation’s profits are subject
to taxation separate from its owners’ tax obligations. In effect, shareholders of a corporation
pay taxes twice. First, the corporation pays tax on its profits, and then when the remaining profits
are distributed to the shareholders, the shareholders pay their own personal income tax on this
income. This system is sometimes referred to as double taxation.
Illustration
You are a shareholder in a corporation. The corporation earns Rs.5.00 per share after taxes.
Board of directors decided to pay 40% of current year earning as dividend. It means shareholders
will get Rs.2 per share dividend (assume par value of one share is Rs.10)
The dividend is income to you, so you will then pay taxes on these earnings. Your tax rate on
dividend income is 10%. How much net dividend you will receive?
Out of Rs.2, you will pay 10% tax, i.e. 0.20 paisa, so you net dividend will be Rs.1.8
Within the company, the financial manager term may be used for Chief Financial Officer (CFO)
who will be part of board of directors and has three main tasks:
1. Make investment decisions.

2. Make financing decisions.
3. Manage short-term cash needs.
The Goal of the Financial Manager

All of these decisions by the financial manager are made within the context of the overriding
goal of financial management—to maximize the wealth of the owners, the stockholders. The
stockholders have invested in the corporation, putting their money at risk to become the owners
of the corporation. Thus, the financial manager is a caretaker of the stockholders’ money,
making decisions in their interests.
The Corporate Management Team
The shareholders of a corporation exercise their control by electing a board of directors, a group
of people who have the ultimate decision-making authority in the corporation. In most
corporations, each share of stock gives a shareholder one vote in the election of the board of
directors, so investors with more shares have more influence. When one or two shareholders own
a very large proportion of the outstanding stock, these shareholders might either be on the board
of directors themselves, or they may have the right to appoint a number of directors.
The board of directors makes rules on how the corporation should be run (including how the top
managers in the corporation are compensated), sets policy, and monitors the performance of the
company. The board of directors delegates most decisions that involve the day-to-day running of
the corporation to its management. The chief executive officer (CEO) is charged with running
the corporation by instituting the rules and policies set by the board of directors. The size of the
rest of the management team varies from corporation to corporation. In some corporations, the
separation of powers between the board of directors and CEO is not always distinct. In fact, the
CEO can also be the chairman of the board of directors. The most senior financial manager is the
chief financial officer (CFO), often reporting directly to the CEO.
Agency Problems
Many people claim that because of the separation of ownership and control in a corporation,
managers have little incentive to work in the interests of the shareholders when this means
working against their own self-interest. Economists call this an agency problem—when
managers, despite being hired as the agents of shareholders, put their own self-interest ahead of
the interests of those shareholders. Managers face the ethical dilemma of whether to adhere to
their responsibility to put the interests of shareholders first, or to do what is in their own personal
best interests. This problem is commonly addressed in practice by minimizing the number of
decisions managers make that require putting their self-interest against the interests of the
shareholders. For example, managers’ compensation contracts are designed to ensure that most
decisions in the shareholders’ interest are also in the managers’ interests; shareholders often tie
the compensation of top managers to the corporation’s profits or even in some cases to its stock
price.
FINANCIAL MARKETS
Financial markets are forums in which suppliers of funds and demanders of funds can transact
business directly. Whereas the loans made by financial institutions are granted without the direct
knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their
funds are being lent or invested.
The two key financial markets are the money market and the capital market. Transactions in
short-term debt instruments, or marketable securities, take place in the money market. Long-term
securities—bonds and stocks—are traded in the capital market.
To raise money, firms can use either private placements or public offerings. A private
placement involves the sale of a new security directly to an investor or group of investors, such
as an insurance company or pension fund. Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds or stocks to the general public.
When a company or government entity sells stocks or bonds to investors and receives cash in
return, it is said to have sold securities in the primary market. After the primary market
transaction occurs, any further trading in the security does not involve the issuer directly, and the
issuer receives no additional money from the subsequent transactions.
Once the securities begin to trade between investors, they become part of the secondary market.
On large stock exchanges, millions of shares may trade between buyers and sellers on a single
day, and these are all secondary market transactions. Money flows from the investors buying
stocks to the investors selling them, and the company whose stock is being traded is largely
unaffected by the transactions. The primary market is the one in which “new” securities are sold.
THE MONEY MARKET
The money market is created by a financial relationship between suppliers and demanders of
short-term funds (funds with maturities of one year or less). The money market exists because
some individuals, businesses, governments, and financial institutions have temporarily idle funds
that they wish to invest in a relatively safe, interest-bearing asset. At the same time, other
individuals, businesses, governments, and financial institutions find themselves in need of
seasonal or temporary financing. The money market brings together these suppliers and
demanders of short-term funds.
Most money market transactions are made in marketable securities—short-term debt

instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit
issued by government, business, and financial institutions, respectively. Investors generally
consider marketable securities to be among the least risky investments available.
THE CAPITAL MARKET
The capital market is a market that enables suppliers and demanders of long-term funds to make
transactions. Included are securities issues of business and government. The backbone of the
capital market is formed by the broker and dealer markets that provide a forum for bond and
stock transactions. International capital markets also exist.
The key capital market securities are bonds (long-term debt) and both common stock and
preferred stock (equity, or ownership).
Bonds are long-term debt instruments used by business and government to raise large sums of
money, generally from a diverse group of lenders. Corporate bonds typically pay interest
semiannually (every 6 months) at a stated coupon interest rate. They have an initial maturity of
from 10 to 30 years, and a par, or face, value of $l, 000 that must be repaid at maturity.
As we know, shares of common stock are units of ownership, or equity, in a corporation.

Common stockholders earn a return by receiving dividends—periodic distributions of cash—or
by realizing increases in share price.
Preferred stock is a special form of ownership that has features of both a bond and common
stock. Preferred stockholders are promised a fixed periodic dividend that must be paid prior to
payment of any dividends to common stockholders. In other words, preferred stock has
“preference” over common stock.
Chapter Two FINANCIAL STATEMENT
Q No.1 Saleem provided following Trial Balance on December 31, 2015.
TITLE OF ACCOUNT DEBIT CREDIT

CASH 45,000
A/C RECEIVABLE 175,000
OFFICE EQUIPMENT 325,000
MARKETING EXPENSE 12,500
PREAPID ADVERTISING 8,500
OTHER EXPENSE 6,000
OFFICE SUPPLIES EXPENSE 3,500
INTEREST EXPENSE 16,000
MDS. INVENTORY-BEGINNING 27,800
PURCHASES 275,000
TRANSPORTATION-IN 22,000
SALES RETURN 12,000
SALARIES EXPENSE 65,000
SALES REVENUE 575,000
PURCHASES RETURN 1800
PURCHASES DISCOUNT 4500
INTEREST INCOME 27,000
A/C PAYABLE 35,000
CAPITAL-SALEEM 222,300
SHORT-TERM LOAN 55,000
BILL PAYABLE 22,700
LONG-TERM LOAN 50,000
TOTAL 993,300 993,300
ADJUSTMENT DATA:
1. Mds.inventory ending Rs.45,000

2. Depreciation on equipment cost 2%
3. Tax rate is 20% applied
Required: Prepare Income Statement

Prepare Classified Balance Sheet
Q No.2
AUSTIN SOUND SEREO CENTER, INC.
TRIAL BALANCE
DECEMBER 31,2015
TITLE OF ACCOUNT DEBIT CREDIT
Cash 110,350
Account receivable 54600
Note receivable 8000
Inventory-opening 40,500
Supplies 650
Prepaid insurance 1200
Furniture and Fixture 183,200
Accumulated depreciation-furniture 2400
Account payable 47,000
Note payable (long-term) 12,600
Capital-Frank 100,000
Sales revenue 338,000
Sales discount 1400
Sales return and allowance 2000
Interest revenue 600
Purchases 89,300
Purchases discount 3000
Purchases return and allowances 1200
Freight in 5200
Rent expense 8400
TOTAL 504,800 504,800
1. Inventory on hand at the end of the year $ 42,000

2. Depreciation on Furniture book value 2%
3. Tax rate is 10% applied
Required:
 Income Statement showing EBIT and EAT
 Balance Sheet
Q No.3
Super Sound Company as at 31 Dec, 2015
Title of Accounts Debit Credit

Cash 145,000
A/c receivable 75,000
Plant 325,000
Selling expenses 12,500
Prepaid Rent 8,500
Other expenses 6,000
Office supplies expense 3,500
Interest expense 16,000
Mds. Inventory-Beg 27,800
Purchases 275,000
Transportation-in 22,000
Sales return 12,000
Equipment 500,000
Acc dep-equipment 75,000
Acc dep- plant 100,000
All for bad debts 12,000
Salaries expenses 65,000
Marketable securities 45,000
Sales revenue 695,000
Purchases return 1,800
Purchases discount 4,500
Commission income 27,000
A/c payable 35,000
Capital 222,300
Short term loan 55,000
Long term loan 160,000
Bill payable 22,700
Retained earning 128,000
1,538,300 1,538,300
ADJUSTMENT DATA:
1. Depreciation charged 5% on equipment and 2% on plant book value.
2. Inventory on hand at the end of the year Rs. 12,000.

3. Tax rate 10%
Required: Income Statement and Balance Sheet
Chapter Three FINANCIAL STATEMENT ANALYSIS
TYPES OF RATIO COMPARISONS
Ratio analysis is not merely the calculation of a given ratio. More important is the
interpretation of the ratio value. A meaningful basis for comparison is needed to answer
such questions as “Is it too high or too low?” and “Is it good or bad?”
Two types of ratio comparisons can be made, cross-sectional and time-series.
Cross-Sectional Analysis
Cross-sectional analysis involves the comparison of different firms’ financial ratios at

the same point in time. Analysts are often interested in how well a firm has performed in
relation to other firms in its industry. Frequently, a firm will compare its ratio values to
those of a key competitor or group of competitors that it wishes to emulate. This type of
cross-sectional analysis, called benchmarking,
has become very popular. Comparison to industry averages is also popular.
For example we are interested to analyze Fauji Cement as well as Maple Leaf Cement
and for this purpose we decided to take Lucky Cement as benchmark and also obtained
information about overall cement industry ratios to compare both companies
performance.
Analysts have to be very careful when drawing conclusions from ratio comparisons. It’s
tempting to assume that if one ratio for a particular firm is above the industry norm, this
is a sign that the firm is performing well, at least along the dimension measured by that
ratio. However, ratios may be above or below the industry norm for both positive and
negative reasons, and it is necessary to determine why
a firm’s performance differs from its industry peers. Thus, ratio analysis on its own is
probably most useful in highlighting areas for further investigation.
Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to past

performance, using ratios, enables analysts to assess the firm’s progress. Developing
trends can be seen by using multiyear comparisons. Any significant year-to-year
changes may be symptomatic of a problem, especially if the same trend is not an
industry-wide phenomenon.
CATEGORIES OF FINANCIAL RATIOS
Financial ratios can be divided for convenience into five basic categories:
a) liquidity
b) activity
c) debt
d) profitability
e) market ratios
1. Liquidity ratios, which give us an idea of the firm’s ability to pay off debts that are
maturing within a year.
2. Asset management ratios, which give us an idea of how efficiently the firm is using its
assets.
3. Debt management ratios, which give us an idea of how the firm has financed its
assets as well as the firm’s ability to repay its long-term debt.
4. Profitability ratios, which give us an idea of how profitably the firm is operating and
utilizing its assets.
5. Market value ratios, which bring in the stock price and give us an idea of what
investors think about the firm and its future prospects.
Liquidity, activity, and debt ratios primarily measure risk. Profitability ratios measure
return. Market ratios
capture both risk and return.
As a rule, the inputs necessary for an effective financial analysis include, the income
statement and the balance sheet.
We will use the 2014 income statements and balance sheets for Hudson Company, to
demonstrate ratio calculations. Note, however, that the ratios presented in the
remainder of this chapter can be applied to almost any company other than financial
sector. Of course, many companies in different industries use ratios that focus on
aspects peculiar to their industry.
Hudson Co.
Balance Sheet
As at December 31, 2014
Assets Rs. Equities Rs.

Cash 710 Current Liabilities
A/c Receivable 2106 A/c Payable 1215
Inventory 4982 Accrued expenses 948
7798
Long Term Debt 4190
Owner’s Equities
Common
Stock(Rs.10) 10,000
Plant 18,584 Retained Earnings 10,029
26,382 26,382
Income Statement
For The Year Ended December 31, 2014
Rs.
Sales 28,000
Less: Cost of Goods Sold 13,740
Gross Profit 14,260
Less: Operating Expenses 6,000
Operating Profit(EBIT) 8,260
Interest expenses 419
EBT 7,841
Less: Tax (40%) 3,136
Net Income 4,705
Sales $28,000
Less: Cost of goods sold 11,600
Depreciation 2,140
Earnings before interest and

taxes $14,260
Less: Interest paid 980
Taxable Income $13,280

Taxes (35%) 4,648

Net Income $8,632
LIQUIDITY RATIO
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as
they come due. Liquidity refers to the solvency of the firm’s overall financial position—
the ease with which it can pay its liabilities. These ratios can provide early signs of cash
flow problems and impending business failure. Clearly it is desirable that a firm is able
to pay its liabilities, so having enough liquidity for day-to-day operations is important.
However, liquid assets, like cash held at banks and marketable securities, do not earn a
particularly high rate of return, so shareholders will not want a firm to overinvest in
liquidity. Firms have to balance the need for safety that liquidity provides against the low
returns that liquid assets generate for investors. The two basic measures of liquidity are
the current ratio and the quick (acid-test) ratio.
CURRENT RATIO
The current ratio, one of the most commonly cited financial ratios, measures the firm’s
ability to meet its short-term obligations. It is expressed as follows:
Current Ratio = Current assets/current liabilities
A higher current ratio indicates a greater degree of liquidity. How much liquidity a firm
needs depends on a variety of factors, including the firm’s size, its access to short-term
financing sources like bank credit lines, and the volatility of its business. For example, a
grocery store whose revenues are relatively predictable may not need as much liquidity
as a manufacturing firm who faces sudden and unexpected shifts in demand for its
products. The more predictable a firm’s cash flows, the lower the acceptable current
ratio. Generally 2:1 shows quite satisfactory and stable liquidity position.
QUICK RATIO
The quick (acid-test) ratio is similar to the current ratio except that it excludes
inventory, which is generally the least liquid current asset. The generally low liquidity of
inventory results from two primary factors:
(1) Many types of inventory cannot be easily sold because they are partially completed
items, special-purpose items, and the like; and (2) inventory is typically sold on credit,
which means that it becomes an account receivable before being converted into cash.
An additional problem with inventory as a liquid asset is that the times when companies
face the most urgent need for liquidity, when business is bad, are precisely the times
when it is most difficult to convert inventory into cash by selling it. The quick ratio is
calculated as follows:
Quick Ratio = Current Assets-Inventory/Current Liability
As with the current ratio, the quick ratio level that a firm should strive to achieve
depends largely on the nature of the business in which it operates. The quick ratio
provides a better measure of overall liquidity only when a firm’s inventory cannot be
easily converted into cash. If inventory is liquid, the current ratio is a preferred measure
of overall liquidity.
ACTIVITY RATIOS
Activity ratios measure the speed with which various accounts are converted into
sales or cash—inflows or outflows. In a sense, activity ratios measure how efficiently a
firm operates along a variety of dimensions such as inventory management,
disbursements, and collections. A number of ratios are available for measuring the
activity of the most important current accounts, which include inventory, accounts
receivable, and accounts payable. The efficiency with which total assets are used can
also be assessed.
INVENTORY TURNOVER
Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. It

is calculated as follows:
(a) Cost of Goods Sold/Average Inventory = Times
(b) Inventory in days = 365 days/……Times = days
If you are interested to find days, u can use alternative formulae for this purpose as
given below:
Inventory in days = Average inventory *365/ Cost of goods sold
Average inventory is computed with the support of beginning inventory and ending
inventory provided both information is given. If information is not given then use ending
inventory as average inventory.
In case question does not provide information about ‘cost of goods sold’, then we can
use ‘sales’ information as an alternative.
This ratio indicates, on average, in how many days firm is able to sell its inventory
which varies from industry to industry. The resulting turnover is meaningful only when it
is compared with that of other firms in the same industry or to the firm’s past inventory
turnover. An inventory turnover of 20 would not be unusual for a grocery store, whose
goods are highly perishable and must be sold quickly, whereas an aircraft manufacturer
might turn its inventory just four times per year.
.
AVERAGE COLLECTION PERIOD
The average collection period, or average age of accounts receivable, is useful in

evaluating credit and collection policies. It is arrived at by dividing the average daily
sales into the accounts receivable balance:
The average collection period is meaningful only in relation to the firm’s credit terms. If
Company has given 30-day credit terms to customers, an average collection period of
55 days may indicate a poorly managed credit or collection department, or both. It is
also possible that the lengthened collection period resulted from an intentional
relaxation of credit-term enforcement in response to competitive pressures. If the firm
had extended 60-day credit terms, the 55-day average collection period would be quite
acceptable. Clearly, additional information is needed to evaluate the effectiveness of the
firm’s credit and collection policies. It can be calculated as follows;
(a) Sales/Average A/c Receivable = Times
(b) 365 days/ Times = days
You can also use straight formulae to calculate Average A/c Receivable days:
Average A/c Receivable *365/Sales
AVERAGE PAYMENT PERIOD
The average payment period, or average age of accounts payable, is calculated in the
same manner as the average collection period:
(a) Purchases /Average A/c Payable = Times

(b) 365 days / Times = days
You can use alternative formulae to calculate days:
Average A/c Payable *365/ Purchases
This days is meaningful only in relation to the average credit terms extended to the firm.
If Company’s suppliers have extended, on average, 30-daycredit terms, an analyst
would give company a low credit rating because it was taking too long to pay its
liabilities. Prospective lenders and suppliers of trade credit are interested in the average
payment period because it provides insight into the firm’s liabilities paying patterns.
TOTAL ASSET TURNOVER
The total asset turnover indicates the efficiency with which the firm uses its assets to
generate sales. Total asset turnover is calculated as follows:
Assets Turnover = Sales /Total Assets
Generally, the higher a firm’s total asset turnover, the more efficiently its assets have
been used. This measure is probably of greatest interest to management because it
indicates whether the firm’s operations have been financially efficient.
Fixed Assets Turnover Ratio
The fixed assets turnover ratio, which is the ratio of sales to net fixed assets, measures
how effectively the firm uses its plant and equipment:
Fixed Assets Turnover = Sales / Fixed Assets
DEBT RATIO
Debt, the amount borrowed by firm for short term or long term is always attached with
cost. Firm obtains loan to get more benefits than its cost. The debt position of a firm
indicates the amount of other people’s money being used to generate profits. In general,
the financial analyst is most concerned with long-term debts because these commit the
firm to a stream of contractual payments over the long run. The more debt a firm has,
the greater its risk of being unable to meet its contractual debt payments. Because
creditors’ claims must be satisfied before the earnings can be distributed to

shareholders, current and
prospective shareholders pay close attention to the firm’s ability to repay debts.
Lenders (who given funds) are also concerned about the firm’s indebtedness. In
general, the more debt a firm uses in relation to its total assets, the greater its financial
leverage.
Financial leverage is the magnification of risk and return through the use of fixed-cost
financing, such as debt and preferred stock. The more fixed-cost debt a firm uses, the
greater will be its expected risk and return.
TIMES INTEREST EARNED RATIO
The times interest earned ratio, sometimes called the interest coverage ratio, measures the
firm’s ability to make contractual interest payments. The higher its value, the better able the firm
is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:
EBIT/Interest expense = time interest earned
The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits
shown in the income statement. Higher the time interest earned, better for firm.
Debt-to-Equity Ratio.
To assess the extent to which the firm is using borrowed money, we may use several different
debt ratios.
debt-to-equity ratio = total debt of the firm/ shareholders’ equity
For example if debt to equity ratio is 0.81, it means that creditors are providing 0.81 rupee of
financing for each Rs.1 being provided by shareholders.
Creditors would generally like this ratio to be low. The lower the ratio, the higher the level of the
firm’s financing that is being provided by shareholders, and the larger the creditor cushion
(margin of protection) in the event of shrinking asset values or outright losses.
Debt-to-Total-Assets Ratio.
The debt-to-total-assets ratio = total debt/ total assets:

This ratio serves a similar purpose to the debt-to-equity ratio. It highlights the relative
importance of debt financing to the firm by showing the percentage of the firm’s assets that is
supported by debt financing. If this ratio is 40%, means that 40 percent of the firm’s assets are
financed with debt, and the remaining 60 percent of the financing comes from shareholders’
equity. Theoretically, if the firm were liquidated right now, assets could be sold to net as little as
40percent on the rupee before creditors would face a loss. Once again, this points out that the
greater the percentage of financing provided by shareholders’ equity, the larger the cushion of
protection afforded the firm’s creditors. In short, the higher the debt-to-total-assets ratio, the
greater the financial risk; the lower this ratio, the lower the financial risk.
Profitability Ratios
Profitability ratios are of two types – those showing profitability in relation to sales and those
showing profitability in relation to investment. Together, these ratios indicate the firm’s overall
effectiveness of operation.
Profitability in Relation to Sales.
gross profit margin:
Gross Profit margin = Gross Profit/Sales
This ratio tells us the profit of the firm relative to sales, after we deduct the cost of producing the
goods. It is a measure of the efficiency of the firm’s operations, as well as an indication of how
products are priced. If gross profit margin is significantly above the industry, indicating that it is
relatively more effective at producing and selling products above cost.
net profit margin:
Net Profit margin = Net Profit / Sales
The net profit margin is a measure of the firm’s profitability of sales after taking account of all
expenses and income taxes. It tells us a firm’s net income per rupee of sales.
By considering both ratios jointly, we are able to gain considerable insight into the operations of
the firm. If the gross profit margin is essentially unchanged over a period of several years but the
net profit margin has declined over the same period, we know that the cause is either higher
selling, general, and administrative expenses relative to sales, or a higher tax rate. On the other
hand, if the gross profit margin falls, we know that the cost
of producing goods relative to sales has increased. This occurrence, in turn, may be due to lower
prices or to lower operating efficiency in relation to volume.
Return on Total Assets
Net income divided by total assets gives us the return on total assets (ROA):
ROA = Net Profit / Total Assets
You must look at a number of ratios, see what each suggests, and then look at the
overall situation
when you judge the performance of a company and consider what actions it should
undertake to improve.
Return on Equity (ROE).
Another summary measure of overall firm performance is return on equity. Return on equity
(ROE) compares net profit after taxes (minus preferred stock dividends, if any) with the equity
that shareholders have invested in the firm. Analysts and financial managers often evaluate the
firm’s return on investment by comparing its income to its investment using ratios such as the
firm’s return on equity
ROE = Net Profit / Stock holder’s equity
A high ROE may indicate the firm is able to find investment opportunities that are very
profitable. Of course, one weakness of this measure is the difficulty in interpreting the book
value of equity. ROE reflects the effects of all of the other ratios, and it is the single best
accounting
measure of performance. Investors like a high ROE, and high ROEs are correlated with high
stock prices. However, other things come into play. For example, financial leverage generally
increases the ROE but also increases the firm’s risk; so if a high ROE is achieved by using a
great deal of debt, the stock price might end up lower than if the firm had been using less debt
and had a lower ROE.
Valuation Ratios/Market value ratios
We use market value ratios, which relate the stock price to earnings and book value price. If the
liquidity,
asset management, debt management, and profitability ratios all look good and if investors think
these ratios will continue to look good in the future, the market value ratios will be high, the
stock price will be as high as can be expected, and management will be judged to have been
doing a good job.
The market value ratios are used in three primary ways: (1) by investors when they are deciding
to buy or sell a stock, (2) by investment bankers when they are setting the share price for a new
stock issue (an IPO), and (3) by firms when they are deciding how much to offer for another firm
in a potential merger.
Analysts and investors use a number of ratios to gauge the market value of the firm. The
most important is the firm’s price-earnings ratio (P/E):
P/E Ratio = Share Price/Earnings per Share
That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a
total basis or on a per-share basis. The P/E ratio is a simple measure that is used to assess
whether a stock is over- or under-valued, based on the idea that the value of a stock should be
proportional to the level of earnings it can generate for its shareholders.
P/E ratios can vary widely across industries and tend to be higher for industries with high growth
rates.
Market/Book Ratio
The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies that are well regarded investors, which mean low risk and high
growth—have high M/B ratios.
Book value per share= Common equity/Shares outstanding
We then divide the market price per share by the book value per share to get the market/book
(M/B) ratio:
Market to Book Value = Market price per share/Book value per share
Exercise:
Q No. 1 Prepare a multiple-step income statement for ABC Company from the
following data:
Cost of goods sold $450

Interest expense 30
Depreciation expense 120
Net sales 990
Interest income 80
Income tax expense 70
Advertising expense 100
General and administrative expenses 150
Q No.2 Using the following information to prepare a common size income

statement:
Net sales $1,000

Cost of goods sold 600
Gross profit $ 400
General and administrative expenses 250
Selling expenses 120
Operating profit $ 30
Net profit $ 20
Q No.3 Use the following information to analyze the BJ Company. Calculate any profit
measures deemed necessary in order to discuss the profitability of the company .
BJ Company
Income Statements
For the Years Ended Dec. 31, 2014 and 2015
2014 2015
Net sales Rs.174,000 Rs.167,000
COGS 114,000 115,000
Gross profit 60,000 52,000
General and administrative expenses 54,000 46,000
Operating profit 6,000 6,000
Interest expense (1,000) (1,000)
Earnings before taxes 5,000 5,000
Income taxes 2,000 2,000
Net income 3,000 3,000
Q No.4 Use the following selected financial data for Happy Valley Co. to answer questions.
Net sales Rs.200,000

Cost of goods sold 90,000
Operating expenses 80,000
Net income 10,000
Total assets 180,000
Total liabilities 120,000
Calculate (1)debt ratio (2) operating profit margin (3) return on equity (4) net profit
margin (5) Gross Profit ratio (6) Operating expense ratio (7) Assets turnover
Q No.5
Use the following selected financial information for Cascabel Corporation to answer
questions
Cascabel Corporation
Balance Sheet
December 31, 2015
Assets Liabilities and stockholders' equity

Current assets Current liabilities
Cash 2 Accounts payable 36
Short-term investments 10 Accrued liabilities 25
Accounts receivable 52 Total current liabilities 61
Inventory 57
Other current assets 8 Long-term debt 102
Total current assets 129 Total liabilities 163
Long-term assets Stockholders' equity

Net Plant 195 Common stock (10) 110
Retained earnings 51
Total stockholders' equity 161
Total assets 324 Total liabilities and equity 324
Cascabel Corporation
Income Statement
For the Year Ended December 31, 2015
Net sales 345

Cost of goods sold 248
Gross profit 97
Operating expenses 74
Operating profit 23
Interest expense 8
Earnings before taxes 15

Net profit 11
Additional information: Market price of stock is Rs.25. Firm declared and paid
dividend 20% on par value of stock.
Compute following ratios:
Current ratio (2) Quick ratio (3)Debt ratio (4)Equity ratio (5)Inventory turnover in
days(use 360 days) (6) Receivable turnover in days(use 360 days) (7) Earnings per share
(8)Book value per share (9)Interest coverage ratio (10) Gross Profit ratio
Q No.6
Belmont Industries
Balance Sheet
As at 31-Dec-01
Assets Liabilities & Equity
Cash $ 100,000 Current Liabilities
Receivables Long Term Debt
Inventory Total Debt
Plant Common Equity $ 600,000
Total Assets Total Claims
Current Ratio 2.5
Average Collection Period 54 days
Total Debt to Total Assets 40%
Total Asset Turnover 2
Inventory Turnover 5
Q No. 7
Illinois Paper Products
Balance Sheet
As at 31-Dec-01
Cash Current Liabilities
Inventory Total Debt $ 700,000
Plant Common Equity
Total debt to Net Worth 1.4
Total Asset Turnover 3
Current Ratio 3.3
Quick Ratio 1.3

Q No.8 The Shannon Corporation has Sales of $750,000. Given the following ratios, fill in the balance
sheet below:
Total asset turnover 2.5 times

Cash to total assets 2.0 percent
Accounts Receivable Turnover 10.0 times
Inventory turnover 15.0 times
Current Ratio 2.0 times
Debt to Total assets 45.0 percent
SHANNON CORPORATION
BALANCE SHEET , 1999
Assets Liabilities & Shareholder's Equity
Cash Total Current Liabilities

Accounts Receivable Long term Debt
Total Current assets
Net Worth
Fixed Assets
Total Assets Total Liabilities & Equity
Q No.9 The following data are from the U Guessed it Company’s financial statements. This company
is a manufacturer of board games for young adults. The market is fiercely competitive, therefore all
sales ($20 million) for the year 1983 were on credit. Given the following ratios, fill in the balance
sheet below:
Sales to total assets 2 times

Total debt to assets 40%
Current Ratio 3.0 times
Inventory turnover 5.0 times
Average collection period 18 days
Fixed asset turnover 5.0 times
U GUESSED IT CO.
BALANCE SHEET , 1983
Assets Liabilities & Shareholder's Equity
Cash Total Current Liabilities

Accounts Receivable Long term Debt
Total Current assets
Net Worth
Fixed Assets
Total Assets Total Liabilities & Equity
Q No.10
Smolira Golf Corp.

Balance Sheet
As at 31-Dec-15
Cash 100000 Current Liabilities
Inventory Total Debt 200000
Plant Common Equity
Total Debt to Total Assets 0.25

Total Asset Turnover 1.5
Current Ratio 2.25
Required: Complete balance sheet

Assignment
Q No.11
SMOLIRA GOLF CORP.

Balance Sheet as of
December 31, 2015
LIABILITIES & OWNER'S

ASSETS EQUITY
Current Assets: Current Liabilities:

Cash Rs.710 Accounts Payable Rs.1,215
Accounts
Receivable 2106 Notes Payable 718
Inventory 4982 Other 230
Total Rs.7,798 Total C L Rs.2,163
Fixed Assets: Long-term debt Rs.4,190

Net plant and
Equipment Rs.18,584 Owner's Equity:
Common Stock and
paid-in surplus Rs.10,000
Retained Earnings Rs.10,029
Total Rs.20,029
Total Assets Rs.26,382 Total Rs.26,382

SMOLIRA GOLF CORP.
Income Statement as on
December 31, 2011
Sales Rs.28,000
Depreciation 2,140
Earnings before interest and

taxes Rs.14,260
Less: Interest paid 980
Taxable Income Rs.13,280

Taxes (35%) 4,648
Net Income Rs.8,632
Dividend Rs.4000
Addition to retained
earnings 4,632
Calculate following ratios:
Short-term solvency ratios
a. Current Ratio
b. Quick Ratio
c. Cash Ratio
Asset utilization ratios
d. Total asset turnover

e. Inventory turnover
f. Receivables turnover
Long-term solvency ratios
g. Total debt ratio

h. Debt-equity ratios
i. Equity multiplier
j. Times interest earned ratio
Profitability Ratios:
k. Profit Margin
l. Return on Assets
m. Return on equity
Q No.12
1. The December 31, 2015, balance sheet and income statement for Mayberry Cafeterias, Inc.
are given
a. Compute the specified ratios, and compare them to the industry average (better or
worse).
b. If you were appointed financial manager of the company, what decisions would you
make based on your findings?
Balance Sheet
Cash $ 17 Accounts Payable $7
Marketable Securities 5 Notes Payable 3
Accounts Receivable 3 Taxes Payable 2
Inventory 16 Other Accruals 3
Prepaid Expenses 6 Current Liabilities $ 15
Current Assets $ 47
Long-term debt $ 35
Gross plant and $ 126 Preferred Stock 10
equipment (57) Common Stock 20
Less: Accumulated Dep. 69 Capital contributed in excess
Net Plant and Equipment of par 10
Retained Earnings 26
Total Assets $ 116 Total Liabilities and $ 116
Stockholders’ equity
Income Statement
Net Sales $ 1,072
Cost of Goods sold 921
Gross Profit 152
Selling Expense 86
General and Administrative expense 26
Depreciation 6
Net Income $ 33
Interest Expense 4
Profit Before taxes $ 29
Taxes 12
Net Income
$ 17
2015 Better or Worse 2015 Industry Average

Ratios to Compute Mayberry (%)
Current 2.86
Quick 2.31
Debt-Equity 0.51
Times interest period 12.36
Average Collection period 1.06
Inventory Turnover 95.71
Fixed-asset turnover 16.15
Operating profit margin 0.036
Net profit margin 0.019
Book return on assets 0.192
Book return on equity 0.271

Chapter Four Short Term Financial Planning

The first step in short-term financial planning is to forecast the company’s future cash flows.
This exercise has two distinct objectives. First, a company forecasts its cash flows to determine
whether it will have surplus cash or a cash deficit for each period. Second, management needs to
decide whether that surplus or deficit is temporary or permanent. If it is permanent, it may affect
the firm’s long-term financial decisions. For example, if a company anticipates an ongoing
surplus of cash, it may choose to increase its dividend payout. Deficits resulting from
investments in long-term projects are often financed using long-term sources of capital, such as
equity or long-term bonds.
In this chapter, we focus specifically on short-term financial planning. With this perspective,
we are interested in analyzing the types of cash surpluses or deficits that are temporary and,
therefore, short-term in nature. When a company analyzes its short-term financing needs, it
typically examines cash flows at quarterly intervals.
The cash budget often gives the best insight into the borrower’s short-term credit needs. If
maximum or peak borrowing needs over the forthcoming year are estimated at Rs.800,000, a
company might seek a line of credit of Rs.1 million to give it a margin of safety. Whether the
bank will go along with the request will depend, of course, on its evaluation of the
creditworthiness of the firm. If the bank agrees, the firm then may borrow on a short-term basis
usually through a series of specific promissory notes whose average maturity is around 90 days
up to the full Rs.1 million line.
Short-term financial planning begins with the sales forecast. From it, companies develop
production plans that take into account lead (preparation) times and include estimates of the
required raw materials. Using the production plans, the firm can estimate direct labor
requirements, factory overhead outlays, and operating expenses. Once these estimates have been
made, the firm can prepare a pro forma income statement and cash budget. With these basic
inputs, the firm can finally develop a pro forma balance sheet.
Cash Budget
The cash budget, or cash forecast, is a statement of the firm’s planned inflows and outflows of
cash. It is used by the firm to estimate its short-term cash requirements, with particular attention
being paid to planning for surplus cash and for cash shortages.
Typically, the cash budget is designed to cover a 1-year period, divided into smaller time
intervals. The number and type of intervals depend on the nature of the business. The more
seasonal and uncertain a firm’s cash flows, the greater the number of intervals. Because many
firms are confronted with a seasonal cash flow pattern, the cash budget is quite often presented
on a monthly basis. Firms with stable patterns of cash flow may use quarterly or annual time
intervals
PREPARING THE CASH BUDGET
The general format of the cash budget is presented in Table below:
Particulars Jan. Feb. March

Opening Balance
Receipts:
Collections of A/R
Payments:
Paid to suppliers
Payment of expenses
Ending Balance
We will discuss each of its components individually.
Cash Receipts
Cash receipts include all of a firm’s inflows of cash during a given financial period. The most
common components of cash receipts are cash sales, collections of accounts receivable, and
other cash receipts.
Cash Disbursements
Cash disbursements include all outlays of cash by the firm during a given financial period. The
most common cash disbursements are Cash purchases Fixed-asset outlays Payments of accounts
payable Interest payments Rent (and lease) payments Cash dividend payments Wages and
salaries Principal payments (loans) Tax payments Repurchases or retirements of stock It is
important to recognize that depreciation and other noncash charges are NOT included in the
cash budget, because they merely represent a scheduled write-off of an earlier cash outflow. The
impact of depreciation, as we noted earlier,
is reflected in the reduced cash outflow for tax payments.
Net Cash Flow, Ending Cash, Financing, and Excess Cash
Look back at the general-format cash budget in Table above. We have inputs for the first two
entries, and we now continue calculating the firm’s cash needs. The firm’s net cash flow is
found by subtracting the cash disbursements from cash receipts in each period. Then we add
beginning cash to the firm’s net
cash flow to determine the ending cash for each period.
Finally, we subtract the desired minimum cash balance from ending cash to find the required
total financing or the excess cash balance. If the ending cash is less than the minimum cash
balance, financing is required. Such financing is typically viewed as short-term and is therefore
represented by notes payable. If the ending cash is greater than the minimum cash balance,
excess cash exists. Any
excess cash is assumed to be invested in a liquid, short-term, interest-paying vehicle—that is, in
marketable securities.
Q No.1
Cash Balance for Greenwell Corporation The Greenwell Corporation collects 60% in the
quarter of sale and 40% in next quarter and wishes to maintain a $160 million minimum cash
balance. Based on this and the information given in the following cash budget, complete the cash
budget. What conclusions do you draw?
GREENWELL CORPORATION
Cash Budget (in millions)
Q1 Q2 Q3 Q4
Beginning receivables $240
Sales 150 $165 $180 $135
Total cash disbursements 170 160 185 190

Q No.2 Repeat above question by assuming that 75% collected in the quarter of sale and 25% in
next quarter. What change you observed in cash budget?
Q No.3
Calculating the Cash Budget Here are some important figures from the budget of Nashville
Nougats, Inc., for the second quarter of 2015:
April May June

Credit sales $330,000 $372,000 $432,000
Credit purchases 132,000 150,000 185,000
Cash disbursements
Wages, taxes, and expenses 20,400 22,200 25,200
Interest 9,600 9,600 9,600
Equipment purchases 70,000 84,000 -------
The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its
sales will be collected in the month of the sale, and the remaining 60 percent will be collected in
the following month. Credit purchases will be paid in the month following the purchase.
In March 2002, credit sales were $210,000, and credit purchases were $156,000. Complete cash
budget for the month of April, May and June. Show June closing A/c Receivable balance.
Q No.4
A company has a cash balance of Rs.27000 at the beginning of March and you are required to
prepare a cash budget for March, April and May having regard to the following information.
Creditors give 1 month credit
Salaries are paid in the current month
Fixed costs are paid one month in arrears and include a charge for depreciation of Rs.5000 per
month.
Credit sales are settled as follows:
40% in month of sales
45% in next month and 12% in the following month. The balance represents bad debts.
Month Cash sales Credit sales purchases Salaries Fixed expense

Jan 74000 55200 9000 30000
Feb 82000 61200 9000 30000
March 20,000 80000 60000 9500 30000
April 22000 90000 69000 9500 32000
May 25000 100,000 75000 10000 32000
Q No.5
The opening cash balance on 1st Jan was expected to be Rs. 30,000. The sales budget was as
follows:
November Rs.80,000
December 90,000
January 75,000
February 75000
March 80000
Analysis of records shows that debtors settle according to the following pattern:
60% within the month of sales, 25% the month following, 15% the month following.
Extracts from the purchases budget were as follows:

December Rs.60000
January 55000
February 45000
March 55000
All purchases are on credit and past experience shows that 90% are settled in the month of
purchases and the balance settled the month after.
Wages are Rs.15000 per month and overheads of Rs.20,000 per month ( including Rs.5000
depreciation) are settled monthly.
Taxation of Rs.8000 has to be settled in February and company will receive settlement of an
insurance claim of Rs.25000 in March.
Required: Prepare cash budget for Jan, Feb and March

Q No.6
In the fourth quarter of 2003, Casey Wholsalers had the following net income.
Sales Rs.500,000
Gross Profit 250,000
Selling and administrative exp 200,000
Income before tax 50,000
Income tax 17,500
Net income 32,500
Purchases in the fourth quarter amounted to Rs.300,000.
Estimated data for Casey Wholsalers, Inc. for 2004 are as follows:
Qtr 1 Qtr 2 Qtr 3 Qtr 4

Sales Rs.600,000 Rs.700,000 Rs.800,000 Rs.900,000
Cost of sales 300,000 350,000 400,000 450,000
Purchases 350,000 400,000 450,000 485,000
Selling and Adm. 200,000 200,000 200,000 200,000
Taxes are 35% of pretax income. 60% of sales are collected in the quarter of sales and 40% in
the next quarter. 80% of purchases are paid in the quarter of purchase and 20% in the next
quarter. Selling and administrative expenses are paid in the quarter incurred except for Rs.10,000
of depreciation included in selling and administrative expense. A capital expenditure for
Rs.50,000 is planned for the fourth quarter of 2004.
Required
Prepare cash receipts and disbursements budget for each quarter of 2004.
Chapter Five Time Value of Money
This is one of the most important chapter which leads to better understanding of finance. The
concepts we will discuss in this chapter will be used in coming all chapter in this workbook as
well as in rest of the subjects you will study relevant to financial matters.
A rupee in hand today is worth more than a rupee to be received in the future because,
if you had it now, you could invest it, earn interest, and end up with more than one
dollar in the future. The process of going from today’s values, or present values (PVs),
to future values (FVs) is called compounding.
Basic terms:
PV = present value, or beginning amount, assume January 1 as present time.
R = interest rate investor can get per year. The interest earned is based on the balance at the
beginning of each year, and we assume that it is paid at the end of the year. You can also use
term like “I” or “k” as used by various authors.
FV = future value, or ending amount, of your account at the end of n years.
N or n = number of periods involved in the analysis.
Future Value:
The following formula will be used to calculate future value of any deposit.
FV = PV ( 1 + r )n
Illustration No.1
Suppose you have Rs.5000 today that you decided to deposit in bank account and bank
offered rate is 6%. Now question is how much you have in account after one year?
For this purpose you will calculate future value of this amount.
N=1
PV = Rs.5000
Rate = 6% FV = PV ( 1 + r )n
FV = Rs. 5300
In Rs.5300, interest amount is Rs.300 and your own investment is Rs.5000
Illustration No.2
What is the future value of Rs.5,000 invested today if it earns 10% interest for two years?
Since you are depositing for two years, we assume that compounding interest will be applied i.e.
whatever interest you will earn at the end of first year will remain in your account and bank will
compute interest in the second you on the total amount including interest. To calculate it by
formulae we keep ‘N’ as 2 to get answer.
PV = Rs. 5000
N=2
Rate = 10%
FV = PV ( 1 + r )n
Future Value = Rs. 6050
Illustration No.3
What is the future value in eight years if you deposit Rs.3000 in two years and
Rs.5000 at the end of five years? Assume an annual compound rate of 8.5%.
You are depositing two amount at different time while bank rate is same i.e. 8.5% for both
deposit. First calculate future value of Rs.3000 by taking N = 6 and then calculate future value of
another amount Rs.5000 by taking N = 3. When you get future value of both amounts, add it to
get your final answer.
PV at the end of 2 years = Rs.3000

N= 6
Rate= 8.5%
FV = Rs.4894.4
PV at the end of 5 years = Rs.5000

N=2
Rate = 8.5%
FV = Rs.5886
So total amount in account at the end of 8th year will be = Rs.10780.4
Present Value:
Suppose you need Rs. 110,000 after one year while bank offered rate is 10%. You are
interested to know how much you should deposit to get your required amount. For this
kind of question you can use Future value formula to find PV. The process to come to
PV from future value is called discounting and the rate that we use is generally called
‘discount rate’.
PV = FV ( 1 + r )-n
Important note:
Remember you can use future value formula to calculate any missing information like
FV, PV, n and ‘r’.
Effective Annual Rate
Sometimes compounding interval is not assumed on annual basis but rather half yearly,
quarterly or monthly basis.
Illustration No.4
Suppose investor deposit Rs. 100,000 for one year and bank offered rate is 10%. Now
apply this information to following separate cases:
(a) Bank offered 10% rate per annum and interest will be calculated at the end of
year i.e. compounding annually. How much investor has in account after one
year?
PV = 100,000
N =1
r = 10%
FV = PV ( 1 + r )n
So total amount in investor account will be Rs.110,000.
(b) Now suppose bank offered rate is 10% per annum but compounding on half
yearly basis. It means bank will give 5% interest after six months, this interest
will remain in account and added in deposit amount, later on 5% interest will
be computed at year end on total amount. Now total amount in account will be
higher than case (a) above.
So bank offered rate is 10% per annum but compounding half yearly is
actually giving you more amounts. If you convert this amount in the form of
rate, this rate will be higher than offered rate of 10% and we call it ‘effective
annual rate’ (EAR).
PV = 100,000
N =1
r = 10%(compounding half yearly)
m
 quoted rate 
EAR = 1 +  - 1
 m
where m is the number of periods per year

In this question ‘m’ is equal to 2, because compounding is on half yearly
basis.
FV = 110,250
So total amount in investor account will be Rs.110,250. When we convert this

information in effective rate, this rate will be 10.25%. In similar pattern, if we
increase number of compounding intervals in a year, we will get more future
amount, hence effective annual rate will be on higher side as compared to
annual rate offered by bank. This annual offered rate is called APR (annual
percentage rate) and we use term EAR (effective annual rate) for actual rate
that we received.
Annuities
Series of payment with finite time period is called annuity. It may be classified as:
(a) Annuity Due

Suppose you are saving Rs.100 each year for five years. This amount is treated as
annuity. If first amount deposited today, it would be treated as ‘annuity due”.
(b) Ordinary Annuity

Annuity that starts at the end of year is called ordinary annuity. If question is not helping
to identify, assume ‘ordinary
Illustration No.5
An investor deposited Rs.5000 each year for next five years. Bank offered rate is
6%. How much amount investor will accumulate at the end of fifth year?
PMT = We use this symbol for annuity payment.
All other symbols will remain same as discussed earlier in single amount condition.
Now
Pmt = Rs.5000
N =5
R = 6%
FV = ?
FV = Pmt [ ( 1 + r )n –1 ] / r
Answer: Rs. 28,185
Illustration No.6
An investor deposited Rs.8000 each year for next five years. Bank offered rate is
7%. What would be its present value?
Now
Pmt = Rs.8000
N =5
R = 7%
PV = ?
PV = Pmt [ 1 – ( 1 + r )-n ] / r
Answer: Rs. 32,801
Illustration No.7
An investor deposited Rs.8000 each year for next five years. First payment starts
today. Bank offered rate is 7%. What would be its future value at the end of fifth year?
This is annuity due case. Formulae will be slightly changed and total value will be higher
than ordinary annuity.
Now
Pmt = Rs.8000
N =5
R = 7%
FV = ?
FV = Pmt [ ( 1 + r )n –1 ] / r *(1+r)
or
FV = ordinary annuity * ( 1 + r )
Answer: Rs. 49,226
Illustration No.8
An investor deposited Rs.8000 each year for next five years. First payment starts
today. Bank offered rate is 7%. What would be its present value?
This is annuity due case. Formulae will be slightly changed and total value will be higher
than ordinary annuity.
Now
Pmt = Rs.8000
N =5
R = 7%
PV =?
PV = Pmt [ 1 – ( 1 + r )-n ] / r *(1+r)
Or
PV = ordinary annuity *( 1 + r )
Answer: Rs. 35,097
Loan Amortization
When a business man borrows fund from bank, it is possible that he can ask the banker
that he is willing to pay whole loan with interest in fixed installment basis. We assume
that interest rate is fixed and loan duration is also set by banker, in this case bank will
use annuity concept to calculate loan installment. This loan installment may be divided
on yearly basis or quarterly basis as planned by business man. When all installment
paid by business man, whole loan with interest will be finished.
This whole exercise is presented in the form of loan amortization table that presented
here.
Illustration No.9
You borrow Rs.50,000 from bank on which rate of interest is 15% per annum. You
asked the banker that you will pay whole loan with interest in 5 years and requested to
make fixed installment of the whole loan and interest.
This fixed installment is actually “annuity” because it meets all the characteristics of
annuity. We can calculate it with the help of annuity formulae.
PV = Rs.50,000
N= 5
R = 15%
Pmt = ?
Loan Amortization Table

Year Installment Interest Principle Unpaid bal
1 14915.78 7500 7415.778 42584.22
2 14915.78 6387.633 8528.144 34056.08
3 14915.78 5108.412 9807.366 24248.71
4 14915.78 3637.307 11278.47 12970.24
5 14915.78 1945.536 12970.24 0
Remember that actual interest payment will decline as you will pay installments and
actual loan payment will increase.
Perpetuity:
Series of cash flow forever is called ‘perpetuity’.
Because a perpetuity has an infinite number of cash flows, we can’t compute

its value by discounting each one. We can use a simple formula to calculate present value of a
perpetuity.
PV for a perpetuity = cash flow/discount rate
For example, an investment offers a perpetual cash flow of Rs.5000 every year. The return
you require on such an investment is 10 percent. What is the value of this investment?
The value of this perpetuity is:
Perpetuity PV= C/r = 5000/.10 = Rs. 50,000
So this person should invest Rs.50,000 to get perpetual cash inflow of Rs.5000.
Nominal rate
Nominal rate is generally called “quoted rate” that we use in business transactions and in
financial activities. It is assumed that inflation is already included in nominal rate. We are
interested to calculate real rate offered by economy, this rate may be calculated as follows:
Illustration No.
Nominal rate in economy is 12% while inflation is 7%. What should be real rate in economy?
1+ real rate = 1+nominal/1+inflation
So real rate is 4.7%.

1. Your grandfather has offered you a choice of one of the three alternatives: $ 5,000 now; $ 1,000 a
year for eight years; or $12,000 at the end of eight years, assuming you could earn 15 percent
annually, which alternative should you choose?
2. You need $30,750 at the end of eight years, bank is offering you 12 percent interest on your deposit
(compounded annually). How much amount should you deposit?
3. Brain Hirt started business on January 1, 2000. Every year he plans to deposit Rs.2500 in his bank
account, which earns 8 percent annually. First payment will start at the end of year 2000. On
December 31, 2005, he used the entire balance in his bank account to invest in a certificate of
deposit at 12 percent annually. How much will he have on December 31, 2010?
4. On January 1, 2010, Mr. Strong bought 100 shares of stock for $13 per share. On December 31,
2012, he sold the stock for $20.50 per share. What is his annual rate of return?
5. Donald Johnson has just given an insurance company $20,000. In return, he will receive an annuity
of $1,800 for 20 years. At what rate of return must the insurance company invest this $20,000 in
order to make the annual payments?
6. Mary Mills has retired after 35 years with the Electric Company her total pension funds have an
accumulated value of $300,000, and her life expectancy is 18 more years. Her pension fund manager
assumes that she can earn an 8 percent return on her assets. What will her yearly annuity be for the
next 18 years?
7. You wish to retire in 20 years, at which time you want to have accumulated enough money to
receive an annuity of $12,000 for 25 years after retirement. During the period before retirement you
can earn 8 percent annually, while after retirement you can earn 10 percent on your money. What
are your annual contributions to the retirement fund to allow you to receive the $12,000 annuity?
8. If you borrow $9,725 and are required to repay the loan in five equal annual installments of $2,500,
what is the interest rate associated with the loan?
9. If your uncle borrows $50,000 from the bank at 10 percent interest over the eight-year life of the
loan, what equal annual payments must be made to discharge the loan, plus pay the bank its
required rate of interest (round to the nearest dollar)? How much of his first payment will be
applied to interest? To principle? How much of his second payment will be applied to each?
Amortization Schedule
10. If investors are to earn a 4 percent real interest rate, what nominal interest rate must they earn if
the inflation rate is:
a. zero
b. 4 percent
c. 6 percent
11. Perpetuities. A local bank will pay you $100 a year for your lifetime if you deposit $2,500 in the bank
today. If you plan to live forever, what interest rate is the bank paying?
12. Perpetuities. A property will provide $10,000 a year forever. If its value is $125,000, what must be
the discount rate?
13. Perpetuities. A local bank advertises the following deal: “Pay us $100 a year for 10 years and then
we will pay you (or your beneficiaries) $100 a year forever.” Is this a good deal if the interest rate
available on other deposits is 8 percent?
14. Jim Thomas borrows $70,000 at 12 percent interest toward the purchase of a
home. His mortgage is for 30 years.
a. How much will his annual payments be? (Although home payments are usually on monthly
basis, we shall do our analysis on an annual basis for ease of computation. We get reasonably
accurate answer.
b. How much interest will he pay over the life of the loan?
c. How much should he be willing to pay to get out of a 12 percent mortgage and into a 10 percent
mortgage with 30 years remaining on the mortgage? Assume that current interest rates are 10
percent. Disregard taxes.
15. Your younger sister, Susie, will start college in five years. She has just informed your parents that
she wants to go to Collegiate U., which will cost $ 8,000 per year for four years (assumed to come at
the end of end year). Anticipating Susie’s ambitions, your parents started investing $ 1,000 per year
five years ago and will continue to do so for five more years.
How much more will your parents have to invest each year for the next five years to have the
necessary funds for Susie’s education? Use 10 percent as the appropriate interest rate throughout
this problem (for discounting or compounding).
16. Retirement Savings. You believe you will need to have saved $500,000 by the time you retire in 40
years in order to live comfortably. If the interest rate is 6 percent per year, how much must you save
each year to meet your retirement goal?
17. Retirement Savings. How much would you need in the previous problem if you believe that you will
inherit $10,000 in 10 years?
18. Retirement Savings. You believe you will spend $40,000 a year for 20 years once you retire in 40
years. If the interest rate is 6 percent per year, how much must you save each year until retirement
to meet your retirement goal?
19. Retirement Planning. A couple thinking about retirement decide to put aside $3,000 each year in a
savings plan that earns 8 percent interest. In 5 years they will receive a gift of $10,000 that also can
be invested.
a. How much money will they have accumulated 30 years from now?
b. If their goal is to retire with $800,000 of savings, how much extra do they need to save every
year?
20. Retirement Planning. A couple will retire in 50 years; they plan to spend about $30,000 a year in
retirement, which should last about 25 years. They believe that they can earn 8 percent interest on
retirement savings.
a. If they make annual payments into a savings plan, how much will they need to save each year?
Assume the first payment comes in 1 year.
b. How would the answer to part (a) change if the couple also realizes that in 20 years, they will
need to spend $60,000 on their child’s college education?
Practice Questions: TVM
1. What is the future value of $2,000 invested today if it earns 10% interest for one year?
2. What is the future value of $2,000 invested today if it earns 10% interest for two years?
3. What is the future value of $6,000 invested today if it earns 8.5% interest for seven Years?
4. What is the future value of $6,000 invested today if it earns 8% for 10.5 years?
5. An investor deposits $100 into his credit union account that pays interest at the rate of 3.25%
per year (payable at the end of each year). He leaves the money and all accrued interest in the
account for 7 years. How much will he have at the end of the 7 years?
6. What is the future value in SEVEN years if you receive $300 in two years and $500 at the end
of five years? Assume an annual compound rate of 8.5%.
7. What is the value of $2000 after one year if bank compounding half yearly and offered rate is
10%. ( note: compare your answer with the answer of question no.1, give comments)
8. What is the value of $2000 after one year if bank compounding quarterly and offered rate is
10%. ( note: compare your answer with the answer of question no.1 and 7, give comments)
9. What is the value of $2000 after one year if bank compounding monthly and offered rate is
10%. ( note: compare your answer with the answer of question no.1,7 and 8 give comments)
10. What is the present value of $2,000 to be received 2 years from today when the annual
discount rate is 10%?
11. What is the present value of $500 to be received 10.5 years from today when the annual
discount rate is 8%?
12. What is the present value of $700 to be received in two equal installments ($350 each), two
years and five years from today, when the annual discount rate is 10%?
13. Suppose Capitol Federal Bancorp offers a certificate of deposit that pays $10,000 in five
years for exchange for $8,000 today. What interest rate is Capitol Federal Bancorp
offering?
14. Suppose Bank One offers a certificate of deposit that pays $5,000 in four years for exchange
for $4,000 today. What interest rate is Bank One offering?
15. How many years will take $10,000 to grow to $20,000 if bank offered rate is 10%.
16. How many years will take $25,000 to grow to $120,000 if bank offered rate is 18%.
17. Your grandfather placed $2,000 in trust fund for you. In 10 years the fund will be worth
$5,000. What is the compound annual rate of return on the trust fund?
18. Your rich aunt puts $35,000 into a bank account earning 4.00%. You are not to withdraw the
money until the balance has doubled. About how many years will you have to wait?
19. Sales of current year are 75,000 and sales of a company after four years is $375,000. What is
the rate of growth?
20. Consider an APR of 12% with monthly compounding. What is the EAR ( effective annual rate)?
21. Consider an APR of 13.5% with quarterly compounding. What is the EAR ( effective
annual rate)?
22. Consider an EAR of 13.75% with quarterly compounding. What is the APR ( annual
percentage rate)?
23. Consider an EAR of 18.25% with monthly compounding. What is the APR ( annual
percentage rate)?
24. Suppose you save $4,000 per year at the end of each year for 3 years and earn 5% interest per
year. How much will you have at the end of 3 years?
25. Suppose you save $4,000 per year at the end of each year for 10 years and earn 8.5% interest
per year. How much will you have at the end of 10 years?
26. Suppose you save $4,000 per year at the beginning of each year for 3 years and earn 5%
interest per year. How much will you have at the end of 3 years? Compare this answer with
question no. 24 and give comments.
27. Suppose you save $4,000 per year at the beginning of each year for 10 years and earn 8.5%
interest per year. How much will you have at the end of 10 years? Compare this answer with
question no. 25 and give comments.
28. A person deposited Rs.5000 at the end of six months in each of the next five years. Bank
offered rate is 10%. Calculate how much he has at the end of five years.
29. A person saved Rs.2500 at the end of each month in the next three years. Bank offered rate
is 12.25%. Calculate how much he has at the end of three years.
30. Suppose you save $4,000 per year at the end of each year for 30 years and earn 5% interest
31. Suppose you save $500 per year at the end of each year for 20 years and earn 8.25% interest
interest per year. How much will you have at the end of 15 years?
interest per year. How much will you have at the end of 15 years?
36. Suppose you save $1,000 per year at the beginning of each year for 3 years and earn 5%
interest per year. What is the present value of this annuity
37. Suppose you save $500 per year at the end of each year for 15 years and earn 8.25% interest
per year. What is the present value of this annuity?
38. Suppose you can save $100 per year at the end of each year for 10 years and earn 5.45%
interest per year. However, you cannot start saving for four years. How much will you have at
the end of 14 years?
39. Suppose that the constant and perpetual cash flow is $1,000 and the discount rate is 8%. What
is the value of this perpetuity?
40. Suppose that the constant and perpetual cash flow is $1,000 and the discount rate is 10%.
What is the value of this perpetuity?
41. Suppose you can save $200 per year at the end of each year for 15 years and earn 7.49%
interest per year. However, you cannot start saving for five years. What is the present value of
this annuity?
42. What are the annual payments for a 4-year $4,000 loan if the interest rate is 9% per year?
Make up a loan amortization schedule.
43. You are planning to take a car, its cash price is Rs.800,000. Bank is offering seven year monthly
payment plan at 18%. How much monthly installment will be offered by bank?
44. Suppose you are accepting bank offer as given in Q No.43 but want to amortize whole loan in
five years. What monthly installment will be offered by bank?
45. Suppose you are planning to accept bank offer as given in Q No.43 but instead of monthly
payment plan, you are interested in quarterly installment. Compute the amount you will pay
after each quarter.
46. Suppose you are planning to take this car through bank loan but you already have saving of
Rs.150,000 which you paid to bank as down payment and rest you are agree on monthly
installment at 18%. Compute monthly payment.
47. Repeat Q No.43 to Q No.46 assuming bank is following annuity due condition.
48. Consider the following future value problem. The respective cash flows for t = 0, 1, 2, and 3
are $3,000, $2,000, $8,000, and $5,000 and the discount rate is ten percent. What is the future
value at t = 4?
49. You are offered a signing bonus of $2,000,000 or a future payment of $2,500,000 at the end of
three years from now. If you can earn 7% on invested funds, would you take the signing bonus
or wait for the future payment?
Chapter Six Bonds Valuation
Bond is a debt instrument issued for a period of more than one year with the purpose of raising
capital by borrowing. So bonds are long-term debt or funded debt, issued by corporations, and
governments and their agencies to finance operations or special projects. Corporations pay back
interest and principal from earnings, whereas governments pay from taxes, or revenues from
special projects.
Most individual bonds have five features when they are issued: issue size, issue date, maturity
date, maturity value, and coupon. Once they are issued, yield to maturity becomes the most
important figure for determining the actual yield an investor will receive. Here yield means
return.
Issue size – The issue size of a bond offering is the number of bonds issued multiplied by the
face value. For example, if an entity issues two million bonds with a 1000 Rupees face price, the
issue size is 2000 million Rupees or 2 billion Rupees. The issue size reflects both the borrowing
needs of the entity issuing the bonds, as well as the market’s demand for the bond at a yield
that’s acceptable to the issuer.
Issue date – The issue date is simply the date on which a bond is issued and begins to accrue
interest. For example, if bond is issued on January 1st then the bond issuer will have to pay
coupon/interest from that day to the bond holders.
Maturity date – The maturity date is the date on which an investor can expect to have his or her
principal repaid. It is possible to buy and sell a bond in the open market prior to its maturity date.
After the maturity day when the principal is paid bond issuers have no business with the bond
holders.
Maturity value – the amount of money the issuer will pay the holder of a bond at the maturity
date. This can also be referred to as “par value” or “face value.” Normally it is either 1000
Rupees or 100,000 Rupees which should be paid to the bond holders at the maturity date.
Periodically, the issuer pays interest to the investor, which is calculated by multiplying the
par value by the interest rate divided by the number of payments in a year. Example: if the
interest rate is 14% and the par value is 1,000 Rupees, then the interest earned annually is
140 Rupees. If the company pays interest semi-annually, which most do, and then the
bondholder will receive 2 payments of 70 Rupees every year until maturity. When the bond
matures, then the current owner gets back the par value of the bond. In other words, the loan
is paid off. Because the amount of interest the bond pays is fixed, bonds are a type of fixed-
income security.
Since bonds trade on the open market from their date of issuance until their maturity, their
market value will typically be different than their maturity value. However, if we think the risk
of default is non-existence; investors can expect to receive the maturity value at the specified
maturity date, even if the market value of the bond fluctuates during the course of its life.
Coupon – The coupon rate is the periodic interest payment that the issuer makes during the life
of the bond. For instance, if a bond with a 100,000 Rupees maturity value offers a coupon of
14%, the investor can expect to receive 14,000 Rupees each year until the bond matures. The
term “coupon” comes from the days when investors would hold physical bond certificates with
actual coupons that they would cut off and present for payment.
Yield to Maturity – Since corporate bonds trade on the open market, the actual yield an investor
receives if they purchase a bond after its issue date (the “yield to maturity”) is different than the
coupon rate.
For example, a company issues 10-year bonds with a face value of 100,000 Rupees each and a
coupon of 14%. In the two years following the issuance, the company experiences rising
earnings, which adds cash to its balance sheets and provides it with a stronger financial position.
All else equal, its bonds would rise in price, say to 101,000 Rupees, and the yield would fall
(since prices and yields move in opposite directions). While the coupon would remain at 14%,
meaning that investors would receive the same payment each year (14,000 Rupees), an investor
who purchased the bond after it had already risen in price would receive a lower yield to
maturity. In this case 14,000 Rupees coupon divided by the 101,000 Rupees, for a yield to
maturity of 13.86% instead of 14% coupon. In this way, a bond’s coupon and its actual yield are
not necessarily the same. Yield to maturity, and not the coupon, is the yield an investor will
actually receive after they buy a bond.
Types of Bonds
Bonds can be classified on various bases. One classification may be based on the nature of the
issuer. It is called government bonds and corporate bonds. There are many types of corporate
bonds that can be offered in order to finance corporate activity. Each corporation chooses the
particular type of bond that it offers depending on a variety of factors. These include general
financial market conditions, the financial strength of the corporation, the length of time during
which the funds are needed, and so on. On the other side of the coin, investors choose among
available types of bonds depending on their investment goals. Some investors are seeking safety,
while others are seeking high current yields and are willing to take more risk.
Pakistan government’s Treasury Bills are for 3, 6 and one year maturity, but Pakistan Investment
Bonds mature in 3, 5, 10 & 20 years which is considered as intermediate term bond and the long-
term Treasury bond has a maturity over 20 years.
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility
as to how much debt they can issue: the limit is whatever the market will bear. Corporate bonds
are characterized by higher yields because there is a higher risk of a company defaulting than a
government. The upside is that they can also be the most rewarding fixed-income investments
because of the risk the investor must take on. The company's credit quality is very important: the
higher the quality, the lower the interest rate the investor receives. We will discuss the credit
ratings of a company later on.
Variations on corporate bonds include Convertible bonds, Callable bonds, Floating rate bonds,
Zero coupon bonds, Debentures, and so on.
Convertible bonds
Convertible bonds are bonds that are issued by corporations and that can be converted to shares of
the issuing company's stock at the bondholder's discretion.
Issuing convertible bonds is one way for a company to minimize negative investor interpretation
of its corporate actions. For example, if an already public company chooses to issue stock, the
market usually interprets this as a sign that the company's share price is somewhat overvalued.
To avoid this negative impression, the company may choose to issue convertible bonds, which
bondholders will likely convert to equity should the company continue to do well.
From the investor's perspective, a convertible bond has a value-added component built into it: it
is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of
return in exchange for the value of the option to trade the bond into stock.
Callable bonds
A bond that can be redeemed by the issuer prior to its maturity is known as callable bonds.
Usually a premium is paid to the bond owner when the bond is called. It is also known as a
"redeemable bond." By issuing this type of bonds, the issuer reserves the right but no obligation
to call the bond prior to the prescribed maturity. One of the benefits for corporations to issue this
type of bond is to save interest payment when the interest rate is falling or now have a better
financing deal. So it can pay off the high coupon payment and reissue it with lower rate. Since it
puts the investors at a disadvantaged position, usually a premium is paid to the bond owners
when the bond is called.
Floating rate bonds
Floating rate bonds are so named because the coupon rate is tied to some basic rate such as T-
bill rates, Fed Fund rate or Karachi Interbank Offered rate (KIBOR). These provide protection
against inflation and interest rate risk and keep bonds selling close to their par values.
Debentures
A debenture is a bond that is not secured by any property or collateral. Debentures are
backed only by the general creditworthiness and reputation of the issuer. Its safety depends
on the assets and earning power of the issuer. Thus, debentures are not as safe as other bonds
from the same company, but will usually pay a higher interest rate to compensate for the
added risk.
Zero Coupon Bonds
Bonds that pay no coupons or interest payments to the bond holders are known as zero
coupon bonds. These bonds have a face value that is redeemed at the end of maturity.
Instead, investors buy zero coupon bonds at a deep discount from their face value, which is
the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond
matures, the investor will receive one lump sum equal to the initial investment.
Junk Bonds
A junk bond, also known as a "high-yield bond" or "speculative bond," is a bond rated "BB" or
lower because of its high default risk. Since junk bonds have a higher risk of defaults, it typically
offers interest rates much higher than safer government bonds or even other corporate bonds.
Sovereign Bonds
A long term debt security issued by a national government for international capital investors and
institutional buyers and usually denominated in a foreign currency. The foreign currency used
will most likely be a hard currency, and may represent significantly more risk to the bondholder.
Pakistan has issued a new 10-year bond of $500 million in the international Euro bond market, at
a coupon rate of 8.25 per cent.
Islamic Bonds
Shariah is the law of Islam which bans usury and interest payments—consequently, it also
bans conventional bonds. As if Muslim countries can benefit from international investment,
and so international investors can invest in projects in Muslim countries, variations of the
typical bond have been financially engineered to work somewhat like bonds, but still be
compliant with Shariah—thus, they are called Islamic bonds.
One such structured product is the lease-back, or ijarah, structure. If a company wanted to
raise money to build a plant, for instance, using this method, it would set up a special entity
specifically for this project that would buy the plant. Investors would lend money to the
special entity, in return for lease payments, in lieu of interest, for the term of the deal. At the
end of the term, the principal is returned to investors, and the project becomes the property
of the company.
Another way to avoid paying interest, at least in name, is to form a joint venture called
a musharakah. The joint venture partners buy Islamic bonds and receive a percentage of
profits over the term of the loan. An example of Islami bond in Pakistan is sukuk bonds.
Main Reasons for Issuing Bonds are as follows:

Governments have no choice but to borrow when they are unable to meet their expenses from
current revenue. Corporations, on the other hand, have a wider choice in the matter of financing
their operations e.g., retained earnings, new equity issues, etc. But they still prefer to go in for
borrowing for the following reasons:
1. To Reduce the Cost of Capital :
Bonds are the cheapest source of financing. A corporation is willing to incur the risk of
borrowing in order to reduce the cost of capital by financing a portion of its assets with securities
bearing a fixed rate of return in hope of increasing the ultimate return to the equity holder.
2. To Gain the Benefit of Leverage:
The presence of debt and/or preference shares in the company’s financial structure means that it
is using financial leverage. When financial leverage is used, changes in earnings before interest
and tax (EBIT) translate into the larger changes in earnings per share.
However, leverage is a two-edged sword as EBIT can rise or fall. If it falls, and financial
leverage is used, the equity holders endure negative changes in EPS that are larger than the
relative decline in EBIT. For example, if a company can borrow at 10% and put the funds to
works to earn more than 10%, the earnings on the equity holders are increased and vice versa.
3. To Effect Tax Saving:
Unlike dividends on equity, the interest on bonds is deductible in figuring up corporate income
for tax purposes. Hence, the EPS increases if the financing is through bonds rather than with
preference or equity shares.
4. To Widen the Sources of Funds:
By issuing bonds, the corporation can attract funds from individual investors and especially from
those investing institutions which are reluctant or not permitted to purchase equity shares.
5. To Preserve Control:
An increase in debt does not diminish the voting power of present owners since bonds ordinarily
carry no voting right. However, a manager must be concerned with the effect of fixed cost
securities on both EPS and the price earnings ratio.
An increase in risk has a depressing influence on a price- earnings ratio, while an increase in
growth will tend to increase the price-earnings ratio.
Fixed cost securities affect both risk and growth. If the risk effect outweighs the growth effect,
then the price-earnings ratio will decline. If the growth effect outweighs the risk effect, then the
price earnings ratio will increase.
Bond Principles: Terms of Repayment
Interest only - the periodic payments are entirely interest.
Sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the
bonds are retired.
Balloon loan - the debt may be partially amortized with each payment.
Income bond- interest is payable only if it is earned.
Annuities - most bonds are annuities plus an ultimate repayment of principal.
Zero coupon - only the par value is returned at maturity.
Variable (adjustable) rate - the rate fluctuate in accordance with some market index or
predetermined schedule.
Inflation-indexed Treasury bonds - the principal value is adjusted based on the consumer price
index.
Why would an investor invest in bond market?
There are various reasons for an investor to consider in investing bonds like:
 Diversification
 Regular income
 Potential tax benefits
 Preservation of principal.
Cash Flows of a Bond
Cash flows of a typical bond consists of two parts- the periodic coupon payments and the
final redemption payment.
Consider a bond that pays a 10% coupon, has a par or face value of 1,000 Rupees and matures in
5 years. Suppose also that the market rate of interest for such a bond (i.e., your required rate of
return, kb) is 8%. Thus,
Par = 1,000 Rupees
Coupon Rate = 10%
Maturity = 5 years
Kb = 8%
The cash flows that are promised by the company include interest payments of 100 Rupees per
year for five years and the payment of the face value of 1,000 Rupees 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 Rupees
The value of the bond is 1,079.87 Rupees which is selling at a premium relative to the par value
of 1,000 Rupees. (A bond selling at less than par is said to be selling at a discount.)
Pricing of Bonds
The price or value of a bond is determined by discounting the bond's expected cash flows to the
present using the appropriate discount rate. The price of the bond should equal the present value
of its expected cash flows. The coupons and principal repayment of 1,000 Rupees are known and
the present value, or price, can be determined by discounting these future payments from the
issuer at a appropriate required yield, r, for the issue.
This relationship is expressed for coupon bond by the following formula:
PV of a Bond = C. Pmt*{1 – (1+ r/n) –t*n} + Face Value

n r/n (1+r/n)t*n
Where,
C = the annual coupon payment,
r = the required return on the bond, and
t = the number of years remaining until maturity.
n = Number of compounding in a year.
Problem 3.1: If a 1000 Rupees face value bond paying 15% coupon whereas it is maturing in 10
years and the interest rate is 12%. How much should you pay for this bond?
Face Value Coupon rate Maturing time Interest rate
1000 15% 10 years 12%
PV of a Bond = C. Pmt*{1– (1+ r/n) –t*n} + Face Value

n r/n (1+r/n)t*n
=150*[{1-(1+.12) }/.12] + (1000/1.1210)
-10
=150*5.6502230+ 321.973
=847.53345+321.973
=1169.50 Rupees.
So, an investor should pay maximum 1159.50 Rupees for this bond.
Problem 3.2: If a 12% semi-annual bond maturing in 10 years is selling in the market for 750
Rupees when the market interest rate is 16%. Should you buy this bond at 750 Rupees?
Face Value Coupon rate Maturing Interest rate
1000 Annual 12% or 6% 10 years or 20 semi- Annual 16% or semi-

semi-annual annual annual 8%
PV of a Bond = C. Pmt*{1– (1+ r/n) –t*n} + Face Value

n r/n (1+r/n)t*n
=120/2*[{1- (1+.16/2)-10*2}/.16/2] + (1000/(1+.16/2) 10*2)
= 803.63 Rupees.
Yes, we should buy the bond because its intrinsic value 803.63 Rupees is higher than the market
price of 750 Rupees.
Discount and premium bonds
 A bond whose market price is less than its par value is selling at a discount. It is called
discount bond. The price of such bonds rise as maturity approaches.
 If the market price is more than the par value, the bond is selling at a premium. It is
called premium bond. The price of such bonds fall as maturity approaches.
Yield on the bond
The return of a bond is largely determined by its interest rate, which, in turn, is determined
by the prevailing interest rate and the creditworthiness of the issuer, assessed by credit rating
companies, such as Standard & Poor’s and Moody’s. A higher credit rating allows the issuer
to sell its bonds for a higher price, i.e. at a lower interest rate.
Nominal yield, or the coupon rate, is the stated interest rate of the bond, which is a
percentage of par value, which, in most cases, is 1,000 Rupees for corporate bonds. The
coupon is usually paid semiannually. Thus, a bond that pays 14% interest pays 140 Rupees
per year in 2 semi-annual payments of 70 Rupees. The return of a bond is the
return/investment, or in the example just cited, 140/1,000 = 14%.
Bonds trading in the secondary market will usually have prices that are less or more than par
value, thus yielding an interest rate that differs from the nominal yield, called the current
yield, or current return. So the price of bonds moves in the opposite direction of
interest rates.
Current Yield:
Because current bond prices fluctuate, an investor can pay more or less than the par value for a
bond. If the investor holds the bond until maturity, he will lose money if he paid a premium for
the bond, and he will earn money if he paid for it at a discount. Current yield measure looks at
the current price of a bond instead of its face value and represents the return an investor would
expect if he or she purchased the bond and held it for a year. This measure is not an accurate
reflection of the actual return that an investor will receive in all cases because bond prices are
constantly changing due to market factors.
Current Yield Formula
Current Yield = Annual Interest Payment

Current Market price of Bond
Problem 3.3: If a bond is paying 14% annual coupon which is now selling in the market for
880 Rupees, what is the current yield of this bond?
Current Yield = 140/880 = 15.91%.
Recall that if the market price of a bond goes down, the current yield will go up. Using the above
example, if the current bond piece goes down to 700 Rupees instead 880 Rupees, the current
yield would be: 140/700 = 20%.
Yield to Maturity:
The yield-to-maturity, or true yield, of a bond that is held to maturity will have to account
for the gain or loss that occurs when the par value is repaid. The yield to maturity is the
single interest rate that, when applied to the stream of cash flows associated with a bond,
causes the present value of those cash flows to equal the bond’s market price.
Yield to Maturity and Present Value of a Bond
The yield to maturity is found in the present value of a bond formula:

n
Value of the bond = Price, P0 = Σ Ct + Face Value

1
( 1 + YTM)t ( 1 + YTM)n
Assuming investment at the current price of the bond, YTM of the bond is the internal rate of
return on the investment of the bond. So, the yield to maturity is the interest rate that will make
the present value of the cash flows equal to the price of the bond.
Example, If a 1000 Rupees face value with 12% annual coupon with maturity of 6 years is now
trading for 900 Rupees and assuming that the investors buys it for 900 Rupees and hold it until
maturity. The cash flows of the bond can be shown below:
Price of the bond, P0 = 900 = 120 + 120 + 120 + 120 + 120 + 120 + 1000
1+r (1+r) 2 (1+r) 3 (1+r) 4 (1+r) 5 (1+r) 6 (1+r) 6
The solution to determine the YTM of the bond can be attempted through trial and error method
by taking an approximate value of r and checking if the right hand side of the equation matches
with the price of the bond. The Scientific calculator or excel spreadsheet will give us the yield to
maturity of 14.62%.
For calculating yield to maturity, the price of the bond, or present value of the bond, is already
known. Calculating YTM is working backwards from the present value of a bond formula and
trying to determine what r (YTM) is.
The formula for yield to maturity is complicated and difficult to solve, but it generally will
yield an interest rate comparable to newly issued bonds with the same credit rating. The
following formula provides an approximation:
Approximate YTM = Coupon Payment + Face Value – Market value
No. of years to maturity
(Face value + Market value)/2
Notice that the formula shown above is used to calculate the approximate yield to maturity. To
calculate the actual yield to maturity requires trial and error by putting rates into the present
value of a bond formula until P, or Price, matches the actual price of the bond. Some financial
calculators and computer programs can be used to calculate the yield to maturity.
But if we use our approximation equation of YTM on our above example where the actual YTM
was given at 14.62% using the scientific calculator but by using our approximation, we get
Approximate YTM = 120 + (1000 +900)/6
(1000 +900)/2
= 120 + 16.666
950
= 14.385% which is close to 14.62%.
Problem 3.4: The price of a bond is 920 Rupees with a face value of 1000 Rupees which is the
face value of many bonds. Assume that the annual coupons are 100 Rupees, which is a 10%
coupon rate, and that there are 10 years remaining until maturity. What is the YTM of this bond?
Solution: Using the approximate YTM formula:
Approximate YTM = 100 + (1000 – 920)/10
(1000 + 920)/2
= 11.25%.
After solving this equation, the estimated yield to maturity is 11.25%. But if you use the
computer generated trial and error software it will give you the exact YTM of 11.38% which is
pretty close.
YTM takes into account the capital loss or gain upon maturity as well as the time value of
money. Current yield considers neither. If the current price of the bond is less than its face value,
YTM shall be greater than the current yield as the investor would have capital gain upon
maturity. But if the bond is selling above face value, YTM shall be lower than current yield since
upon maturity the investor would incur a capital loss.
Normally when a bond is issued, it is traded at face value and if this is the case then the YTM
and the coupon will be the same. Simply speaking if the price of the bond is selling at par (face
value) the YTM will remain the same which equals to coupon rate. Only a change in price above
or value to face value will change the YTM and there is an inverse relationship between the price
and the YTM of the bond which means if the price of a bond rises the YTM falls and vice versa.
Assumptions on YTM:
The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), a
promised rate of return that will occur only under certain assumption. It is the compound
rate (not simple) of return an investor will receive only under certain assumption:
 The bond is held to maturity.

 The coupons received while the bond is held are reinvested at the calculated yield to
maturity.
 If a bond pays periodic interest, it is not possible to lock in a prescribed yield to
maturity.
When a bond is bought at a discount, yield to maturity will be greater than the current yield
and if bought at a premium, the yield to maturity will be less. If a bond trades at a discount,
an investor will earn a return both from receiving the coupons and from receiving a face
value that exceeds the price paid for the bond. On the other hand, if a bond trades at a
premium its coupon rate will exceeds its yield to maturity.
The yield to maturity formula is used to calculate the yield on a bond based on its current price
on the market. The yield to maturity formula looks at the effective yield of a bond based on
compounding as opposed to the simple yield which is found using the dividend yield formula.
YTM measures three sources of a bond’s return:

Coupon return: Return from coupon payments (current yield).
Capital gain return: Capital gain / loss when bond matures, or is sold / called at a predictable
point in the future.
Reinvestment return: Interest income generated from the reinvestment of coupons (“interest on
interest”).
Problem 3.5: If a 1000 Rupees face value bond paying 15% coupon whereas it is maturing
in 10 years and the interest rate is 12%. If it is trading for 1150 Rupees, what is the current
yield and YTM?
Solution: Current Yield = (Annual Coupons/Current bond price)
= (150/1150)
= 0.1304 Or 13.04%
YTM = (150+{1000-1150)/10)/{(1000+1150)/2)
=135/1075
=0.1256 Or 12.56%.
Problem 3.6: If a 12% annual bond maturing in 10 years is selling in the market for 750 Rupees
when the market interest rate is 16%. What is the current yield and YTM of this bond?
Solution: Current Yield
= (Annual Coupons/Current bond price)
= (120/750)
= 0.16
Or 16%.
YTM = {120+{1000-750)/10}/{(1000+750)/2}
=145/875
=0.1657
Or 16.57%
Yield to Call
The term Yield to Call is often abbreviated as YTC, defined that the bond is called on the next
eligible call date. The yield is calculated from the cash flows from the coupon payments plus the
cash flow of the redemption proceeds at the time of the call. When bond issuers include call
options in indenture then it becomes their discretion whether they will expire the bonds early
after the call date. Since bond may not wait until maturity and may be redeemed prior to the
maturity YTM becomes useless to count. In that case, it would be more relevant to compute the
yield to the point of earliest call which is known as yield to call (YTC).
Like the yield to maturity, the yield to call usually cannot be solved for directly. It generally
must be determined using trial and error or an iterative technique. Fortunately, financial
calculators make the task of solving for the yield to maturity quite simple.
To calculate the yield to first call, the YTM formula is used, but the number of periods until
the first call date substituted for the number of periods until maturity and the call price
substituted for the face value. Issuers often pay a call premium for a specific period of time
to call a bond, and therefore the call price usually differ either by an extra coupon payment
or fixed at the time of issuance.
Yield to call can be approximately calculated from the formula given below:
When it comes to estimate the actual return on a callable bond, yield to maturity has a flaw. If
the bond is called, the par value will be repaid and interest payments will come to an end, thus
reducing its overall yield to the investor. Therefore, for a callable bond, you also need to know
what the yield would be if the bond were called at the earliest date possible. That figure is known
as its yield to call. The calculation is the same as with yield to maturity, except that the first call
date is substituted for the maturity date. YTC is therefore a good measurement gauge for the
expected investment return of a bond at a callable time
Many bonds, especially those issued by corporations, are callable. This means that the issuer of
the bond can redeem the bond prior to maturity by paying the call price, which is usually greater
than the face value of the bond, to the bondholder. Often, callable bonds cannot be called until 5
or 10 years after they were issued. When this is the case, the bonds are said to be call protected.
The date when the bonds can be called is referred to as the call date.
The yield to call is the rate of return that an investor would earn if he bought a callable bond at
its current market price and held it until the call date given that the bond was called on the call
date. It represents the discount rate which equates the discounted value of a bond's future cash
flows to its current market price given that the bond is called on the call date.
Example, if a 12% annual coupon bond with a face value of 1000 Rupees maturing in 10 years
has a call provision which states that the issuer can call the bond after 4 years at a call price of
1050 Rupees. If the bond is selling at 900 Rupees in the market then what is the yield to call of
this bond?
Value of the bond = 900 = 120/(1+YTC) + 120/(1+YTC)2 + 120/(1+YTC)3 + 120/(1+YTC)4
Approximate, YTC = 120 + (1050 – 900)/4
(1050+900)/2
= 157.5/975 = 16.15%
Using scientific calculator or excel function we get YTC of 16.59%.
Bond rating
Table 1. Quality Ratings Used by Moody’s and Standard & Poor's

Moody's Rating Standard & Poor's Interpretation

System
Rating System
Aaa AAA High-quality debt instruments
Aa AA
A A Strong to adequate ability to pay
Baa BBB principal and interest
Ba BB
B B
Caa CCC Ability to pay principal and
Ca CC interest speculative
C C
DDD
DD In default
Note: Both rating services use factors to amend the above rating categories to indicate a range
within a given rating. Moody's uses a 1, 2, or 3 factor, and Standard & Poor's uses a plus or
minus factor. For example, a Moody's rating of Aa2 indicates a firm that is in the midrange of all
firms with a double-A rating.
Perpetuities
There is a type of bond that never matures called 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.) If long-term bonds are more sensitive to
changes in interest rates than short-term bonds, then consol is more sensitive to changes in
interest rates.
When N is infinity, the value of a perpetual bond reduces to
Value of a Consol = Coupon payment/ market interest rate
Problem 3.9: if a consol (perpetuity bond) is paying 140 Rupees per year forever what should be
the value of that bond given the market interest rate is 12%?
Value of that Consol = 140/0.12 = 1166.67 Rupees.
Problem 3.10: A perpetual bond has a 10% coupon. The bond yields 8% and the par value is
1000. What is the price of the bond?
The price of this bond = 100/0.08 = 1250 Rupees.
The “dirty” (or “full”) price is the amount that the buyer agrees to pay the seller, which is the
agreed-upon price plus accrued interest. The price of a bond without accrued interest is called the
clean price. The exceptions are bonds that are in default. Such bonds are said to be quoted flat,
that is, without accrued interest.
Term Structure of Interest Rates
A plot of interest rates against time to maturity is known as a yield curve. The term structure of
interest rates is a schedule showing the yields of securities that are alike in all respects except for
their term to maturity (number of years until the bonds mature). As mentioned above, the longer
the time to maturity, the riskier the bond and (usually) the higher the yield. The term structure of
interest rates is usually demonstrated using U.S. Treasury securities as shown below:
Term Structure for U.S. Treasury Debt

Time to Maturity Yield
1 month .01%
3 months .20%
6 months .50%
1 year 1.00%
5 years 1.50%
10 years 2.00%
20 years 3.00%
30 years 3.80%
Notice that the required return on U.S. Treasury bonds rises as the time to maturity of the bonds
rises. This is the normal state of things. However, on rare occasions, the returns on long-term
bonds are lower than those on short-term bonds.
The data in the table can be graphed with the time to maturity on the X axis and the required
return or yield on the Y axis as shown below.
U.S. Treasury Securities Yield Curve

Kd (Yield) Normal (positively

sloped) yield curve
4.0%
3.0%
2.0%
1.0%
Maturit
0
y
1 mo 6 mo 1 yr 5 yrs 10 yrs 20 yrs 30 yrs
The graph shows the longer the time to maturity the higher the yield on Treasury bonds. This is
called a normal (because this is normally the shape of the yield curve) or positively sloped yield
curve. Investors interpret a normal yield curve as indicating rising inflation in the future
(because the inflation is expected to rise in the future) or as indicating an expanding economy
(meaning the real rate of interest is expected to rise).
The graph shown below portrays a declining or negatively-sloped yield curve. Notice the rates
on longer-term bonds are lower than those of shorter-term bonds. This shape of yield curve is
rare, but when it occurs it is usually interpreted to mean a recession is about to occur.
Kd (Yield)
Declining (negatively -
4.0% sloped) yield curve
3.0%
2.0%
1.0%
1 mo 6 mo 1 yr 5 yrs 10 yrs 20 yrs 30 yrs
Finally, a flat yield curve is shown on the following page. The required return is the same
regardless of maturity. Again, this is rare and indicates an economy in transition from expanding
to contracting or contracting to expanding.
Kd (Yield)
Flat yield
4.0% curve
3.0%
2.0%
1 mo 6 mo 1 years 5 years 10 years 20 years 30 years
Pricing of zero-coupon bonds
An investor normally receive return from bond investment from two way- one is the periodic
coupon payments, and the second one is capital gains from the difference between selling value
and buying value. But not all bonds will give you return in this way. We may have zero-coupon
bonds which do not pay any interest and instead provide all the returns in the form of capital
gains by issuing the bond at a price substantially lower than the par value and redeeming them on
maturity at par value. This is why it is sometimes called deep discount bond.
Some features of Zero-Coupon Bond (Zero)
 Does not make coupon payments.

 Always (almost always) sells at a discount (a price lower than face value), so they are
also called pure discount bonds.
Example: Suppose that a one-year, risk-free, zero-coupon bond with a 100,000 Rupees face
value has an initial price of 97,323.60 Rupees. The cash flows would be:
Although the bond pays no “coupon,” your compensation is the difference between the initial
price and the face value.
Example: If F = 100,000 Rupees; T = 8 years; and the annual discount rate is 9%, the bond
should sell for 100,000/1.098= 50,186.63 Rupees
Exercises: What is the price of a Rs.1000 face value bond paying 6% semi-annual coupon if
the required yield is 15%?
Solution: We have a 10-year 6% coupon bond with a par value of Rs.1,000 and a required yield
of 15%. Given C = 0.06(Rs.1,000) / 2 = Rs.30, n = 2(10) = 20 and r = 0.15 / 2 = 0.075, the
present value of the coupon payments is:
 1   1   
1  1  r n 1  1
  (1.075) 20  1  4.2478511  1  0.2354131 
P=C   = $30   = $30   = $30   =
 r   0.075   0.075   0.075
Rs.30[10.1944913] = Rs.305.835.
M $1, 000 $1, 000

The present value of the par or maturity value of Rs.1,000 is: = =
1+ r  n
1.075  20
4.2478511
=
Rs.235.413. Thus, the price of the bond (P) = Rs.305.835 + Rs.235.413 = Rs.541.25.
(b) What is the price of this bond if the required yield increases from 15% to 16%, and by
what percentage did the price of this bond change?
If the required yield increases from 15% to 16%, then we have:

 1   1 
1  1  r n  1 
 (1.08) 20 
P=C   = $30   = $30 9.8181474 = Rs.294.544.
 r   0.08 
M $1, 000
The present value of the par or maturity value of Rs.1,000 is: = = Rs.214.548.
1+ r  n
1.08 20
Thus, the price of the bond (P) = Rs.294.544 + Rs.214.548= Rs.509.09.
$509.09  $541.25
The bond price falls with percentage fall is equivalent to = 0.059409 or
$541.25
about 5.94%.
(c) What is the price of this bond if the required yield is 5%?
If the required yield is 5%, then we have:
 1   1 
1  1  r n  1  (1.025) 20 
P=C   = $30   = $30 15.5891623 = Rs.467.675.
 r   0.025 
M $1, 000
The present value of the par or maturity value of Rs.1,000 is: = =
1+ r  n
1.025 20
Rs.610.271.
Thus, the price of the bond (P) = Rs.467.675 + Rs.610.271 = Rs.1,077.95.

(d) What is the price of this bond if the required yield increases from 5% to 6%, and by
what percentage did the price of this bond change?
If the required yield increases from 5% to 6%, then we have:
 1   1 
1  1  r n   1  
(1.03) 20
P=C   = $30   = $30 14.87747486 = Rs.446.324.
 r   0.03 
M $1,000
The present value of the par or maturity value of Rs.1,000 is: = = Rs.553.676.
1+ r  n
(1.03)
20
The price of the bond (P) = Rs.446.324 + Rs.553.676 = Rs.1,000.00. [NOTE. We already knew
the answer would be Rs.1,000 because the coupon rate equals the yield to maturity.]
The bond price falls with the percentage fall equal to (Rs.1,000.00 – Rs.1,077.95) / Rs.1,077.95
= 0.072310 or about 7.23%.
(e) From your answers to Question 9, parts b and d, what can you say about the relative
price volatility of a bond in a high-interest-rate environment compared to a low-interest-
rate environment?
We can say that there is more volatility in a low-interest-rate environment because there was a
greater fall (7.23% versus 5.94%).
Exercise: A 10-year, 1000 Rupees corporate bond with a 10 percent annual coupon rate is
currently selling for 850 Rupees:
(a) Calculate its current yield.

(b) Calculate its yield to maturity
Solution: (a) current yield = Coupon______

Current market price
= 100/850 = 11.76 percent

b) Approx. YTM = 100 + (1000 + 850)/10
(1000 + 850)/2
= 115/925 = 12.43% (Approximately)
Exercise: Two 10 percent coupon bonds are selling at par. Bond A has a 15 year maturity
and Bond B has a 25 year maturity. If the appropriate required rate of return for these two
bonds drops to 8 percent, calculate the percentage change in the price of each bond, using a
financial calculator. Assume interest is paid semi-annually.
Solution: Bond A = original price = Rs.1,000; new price = 1000 FV, 8 interest
rate, 50 pmt, 30 N, solve for PV = Rs.1,172.92
Percentage change in price = 1172.92 - 1000
1000 = .1179 = 11.79%
Bond B = original price = Rs.1,000; new price = 1000 FV, 8 interest
rate, 50 pmt, 50 N, solve for PV = Rs.1,214.82
Percentage change = 1214.82 - 1000
1000 = .2148 = 21.48%
Exercise: Calculate the duration of a bond with a 7 percent coupon and a 3-year maturity
currently priced at Rs.1,000. Interest is paid annually.
Solution:
Year Cashflow Present Value PV of CF PV/ Price Year X PV/Price
1 Rs.70 .9346 Rs.65.42 .065 .065

2 Rs.70 .8734 Rs.61.14 .061 .122
3 Rs.1070 .8163 Rs.873.44 .873 2.619
Rs.1000 2.806 years
Exercise:
Face Value = 1000
Coupon Rate = 15%
Maturity = 10 Years
Interest rate = 12%
So the price of the bond is
PV = C.Pmt * [{1-(1+r/n)^-t*n} / (r/n)] + {Face Value / (1+r/n)^t*n}
PV = 150 * [{1-(1+.12)^-10} / (.12)] + {1000 / (1+.12)^10}
PV = 850+321.97
PV = 1172
So the present value of the bond is 1172.
The current Yield is
Current Yield = (Annual coupons / Current Bond Price)
= 150 / 1150
= 0.1304
The YTM is
Appx. YTM = [{C+(F-P)/n}\] / {(F+P)/2}
= [{150+(1000-1150)/10}\] / {(1000+1150)/2}
= 135/1075
= 0.1255
So the YTM is 12.56%

Case Study 1: Dissecting the numbers and trying to make some sense in bond
valuation.
Mr. Akram is confused about the corporate bond market in Pakistan. He finds the coupon
rate is quite handsome compare to the fixed deposit rate or even with the government
Treasury bond. He is wondering if it is too good to be true. He is evaluating these three
options and trying to work out some numbers. He is asking for your help!
Offer 1: Fixed deposit on one lac Rupees is paying 1,000 Rupees per month forever.
Offer 2: Pakistan government’s Treasury bond is paying 12.50% annual coupon which
matures in 10 years.
Offer 3: ABC Company issued a corporate bond of 1000 Rupees face value. It is paying
15% annual coupon which is a medium sized company who are involved in textile sector.
This bond has a maturity of 15 years but callable after 5 years. The market price of this bond
today is 925 Rupees.
Mr. Akram wants to know where he should invest his one lac Rupees. The market
expectation is that interest rate will fall in coming months since the inflation has fallen back
to single digit and it seems to continue the trend in the next 3-4 years. He is asking for your
financial management knowledge which will help him in making the right decision.
Question 1: What is the Current Yield, YTM, and YTC of ABC Company?
Question 2: How does it differ investing in Treasury instrument compare to corporate bond?
Question 3: What are some of the risk involved in corporate bond?
Question 4: How fallen inflation will affect the return from bond investment?
Case Study 2: Bond investing risks: So you think bonds are totally safe and
predictable?
Many people believe they can't lose money in bonds. Wrong! Although the interest payments
you'll get from owning a bond are "fixed," your return is anything but. Here are the major risks
that can affect your bond's return:
Inflation risk
Since bond interest payments are fixed, their value can be eroded by inflation. The longer the
term of the bond, the higher the inflation risk. On the other hand, bonds are a classic deflation
hedge; deflation increases the value of the Rupees that bond investors get paid.
Interest rate risk
Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall
because new bonds are issued that pay higher coupons, making the older, lower-yielding bonds
less attractive. Conversely, bond prices rise when interest rates fall because the higher payouts on
the old bonds look more attractive relative to the lower rates offered on newer ones.
The longer the term of the bond, the greater the price fluctuation - or volatility - that results from
any change in interest rates. There is a close connection between inflation risk and interest rate
risk since interest rates tend to rise along with inflation. Interest rate shifts are also a concern for
mortgage-backed bondholders, but for a different reason: If interest rates fall, home owners may
decide to prepay their existing mortgages and take out new ones at the lower rates. That doesn't
mean you'll lose your principal if you hold such a bond. But it does mean you get your principal
back much sooner than expected, forcing you to reinvest it at the newly lower rates. For that
reason, the prices of mortgage-backed securities don't get as big a boost from falling rates as
other kinds of bonds.
Note that price fluctuations only matter if you intend to sell a bond before maturity, or you invest
in a bond fund whose manager trades regularly. If you hold a bond to its maturity, you will be
repaid the bond's full face value. But what if interest rates fall and the issuer of your bond wants
to lower its interest costs?
Call risk
Many corporate bond issuers reserve the right to redeem, or "call," their bonds before they
mature, at which point the issuer is required to pay bondholders only par value. Typically, this
happens if interest rates fall and the issuer sees it can lower its costs by selling new bonds with
lower yields.
If you happen to own one of the called bonds, not only do you get less than the market price of
the bond, but you also have to find a place to reinvest the money. Because of the risk that you
won't get the income you expect, callable bonds usually pay a higher rate of interest than
comparable, non-callable bonds. So, when you buy bonds, make sure to ask not only about the
time to maturity, but also about the time to a likely call.
Credit risk
This is the risk that your bond issuer will be unable to make its payments on time - or at all - and
it depends on the type of bond you own and the borrower's financial health. Pakistan
government’s Treasuries are considered to have virtually no credit risk and junk bonds having
the highest default risk.
Bond rating agencies such as Standard & Poor's and Moody's evaluate corporations and
municipalities for their credit worthiness. Bonds from the strongest issuers are rated triple-A.
Junk bonds are rated Ba and lower from Moody’s or BB and lower from S&P.
Liquidity risk
In general, bonds aren't nearly as liquid as stocks because investors tend to buy and hold bonds
rather than trade them. While there is always a ready market for super-safe Treasuries, the
markets for other bonds, especially junk bonds, can be highly illiquid. If you are forced to unload
a thinly-traded bond, you will probably get a low price.
Market risk
As with most other investments, bonds follow the laws of supply and demand. The more popular
or less plentiful a bond, the higher the price it commands in the market. During economic
meltdowns in Asia and Russia, for example, the price of safe-haven U.S. Treasuries rose
dramatically.
Question 1: Is it true that the governments Treasuries are totally risk free?
Question 2: How changes in inflation would impact the return from bond investment?
Question 3: Why should an investor read the indenture to make sure the bond has a call
provision? How does it impact the return from bond investment?
MULTIPLE CHOICE QUESTIONS:
1. The coupon rate of a bond equals:

A) Its yield to maturity.
B) A percentage of its face value.
C) The maturity value.
D) A percentage of its price.
2. Periodic receipts of interest by the bondholder are known as:

A) The coupon rate C) the default premium
B) A zero-coupon D) coupon payments
3. Which of the following presents the correct relationship? As the coupon rate of a bond
increases, the bond's:
A) Face value increases. C) Current price decreases.
B) Interest payments increase. D) Maturity date is extended
4. What happens when a bond's expected cash flows are discounted at a rate lower than the
bond's coupon rate?
A) The price of the bond increases.
B) The coupon rate of the bond increases.
C) The par value of the bond decreases.
D) The coupon payments will be adjusted to the new discount rate.
5. A __________ bond is a bond where the bondholder has the right to cash in the bond
before maturity at a specific price after a specific date.
A) Callable B) coupon C) puttable D) treasury
6. Everything else equal the __________ the maturity of a bond and the __________ the
coupon the greater the sensitivity of the bond's price to interest rate changes.
A) Longer; higher C) shorter; higher
B) Longer; lower D) shorter; lower
7. A coupon bond which pays interest of 60 Rupees annually, has a par value of 1,000
Rupees, matures in 5 years, and is selling today at a 75.25 Rupees discount from par
value. The current yield on this bond is _________.
A) 6.00% B) 6.49% C) 6.73% D) 7.00%
8. A coupon bond which pays interest of 4% annually, has a par value of 1,000 Rupees,
matures in 5 years, and is selling today at 785 Rupees. The approximate yield to maturity
on this bond is _________.
A) 7.2% B) 8.8% C) 9.1% D) 9.6%
9. A callable bond pays annual interest of 60 Rupees, has a par value of 1,000 Rupees,
matures in 20 years but is callable in 10 years at a price of 1,100 Rupees, and has a value
today of 1055.84 Rupees. The approximate yield to call on this bond is _________.
A) 6.00% B) 6.58% C) 8.00% D) 7.20%
10. Consider a 7-year bond with a 9% coupon and a yield to maturity of 12%. If interest
rates remain constant, one year from now the price of this bond will be _________.
A) Higher B) lower C) the same D) indeterminate
11. The YTM calculation assumes:

A) Reinvestment of interest is at the coupon rate.
B) No reinvestment of interest.
C) Reinvestment of interest is at YTM rate.
D) Reinvestment of interest is at the risk-free rate.
12. If you are holding a premium bond you must expect a _______ each year until maturity.
If you are holding a discount bond you must expect a _______ each year until maturity.
A) Capital gain; capital loss C) capital loss; capital gain
B) Capital gain; capital gain D) capital loss; capital loss
13. Which of the following statements is correct for a 10% coupon bond that has a current
yield of 7%?
A) The face value of the bond has decreased.
B) The bond's maturity value exceeds the bond's price.
C) The bond's internal rate of return is 7%.
D) The bond's maturity value is lower than the bond's price.
14. A bond's yield to maturity takes into consideration:

A) Current yield but not price changes of a bond.
B) Price changes but not current yield of a bond.
C) Both current yield and price changes of a bond.
D) Neither current yield nor price changes of a bond.
15. A debenture is _________.

A) Secured by other securities held by the firm
B) Secured by equipment owned by the firm
C) Secured by property owned by the firm
D) Unsecured.
16. The discount rate that makes the present value of a bond's payments equal to its price is
termed the:
A) Rate of return. C) Yield to maturity.
B) Current yield. D) Coupon rate.
17. What is the coupon rate for a bond with three years until maturity, a price of 1,053.46
Rupees, and a yield to maturity of 6%?
A) 6% B) 8% C) 10% D) 11%
18. What is the yield to maturity for a bond paying 100 Rupees annually that has six years
until maturity and sells for 1,000 Rupees?
A) 6% B) 8% C) 10% D)11%
19. Which of the following factors will change when interest rates change?
A) The expected cash flows from a bond
B) The present value of a bond's payments
C) The coupon payment of a bond
D) The maturity value of a bond.
20. What happens to the coupon rate of a bond that pays 80 Rupees annually in interest if
interest rates change from 9% to 10%?
A) The coupon rate increases to 10%.
B) The coupon rate remains at 9%.
C) The coupon rate remains at 8%.
D) The coupon rate decreases to 8%.
21. Which of the following is fixed (e.g., cannot change) for the life of a given bond?
A) Current price. B) Current yield C) Yield to maturity. D) Coupon rate
22. What is the rate of return for an investor who pays 1,054.47 Rupees for a three-year
bond with a 7% coupon and sells the bond one year later for 1,037.19 Rupees?
A) 5% B) 5.33% C) 6.46% D) 7%
23. The __________ of a bond is computed as the ratio of coupon payments to market
price.
A) Nominal yield B) current yield C) yield to maturity D) yield to call
24. A bond has a par value of Rs.1,000, a time to maturity of 10 years, and a coupon rate of
8% with interest paid annually. If the current market price is Rs.750, what is the
approximate capital gain yield of this bond over the next year?
A) 0.7% B) 1.8% C) 2.5% D) 3.4%
25. A bond is selling at a discount if the:
A) yield-to-maturity is greater than the coupon rate.
B) yield-to-maturity is less than the coupon rate.
C) Market price is greater than the par value.
D) yield-to-call is less than the coupon rate.

26. All other factors constant, the -------------- of a bond, the shorter the duration.
A) Longer the term C) higher the risk
B) Higher the coupon rate D) higher the rating
27. Duration can be used to:

A) Minimize default risk
B) Minimize reinvestment risk.
C) Minimize interest rate risk.
D) Maximize return.
SHORT QUESTIONS:
1. What is a bond? How it is different from equity? What are the four types of bonds?
2. Why isn’t Pakistan government’s treasure bonds not necessarily risk-free?
3. Define consol and zero coupon bonds.
4. Why there is a interest rate risk in bond investment, when coupon amounts are fixed?
5. Why do bond prices and yield to maturity vary inversely?
6. If there are two bonds which matures in 10 years. One has 12% coupon and the other has
8% coupon but both has the same yield to maturity. Which bond should you buy and
why?
7. How do you think the value of a bond would change with
a) Increasing face value
b) Increasing coupon rate
c) Increasing the periodicity of coupon
d) Increasing the term to maturity.
8. What is the difference between yield to maturity and yield to call?

9. Describe how the annual bond valuation formula is changed to evaluate semi-annual
coupon bonds. Then write out the revised formula.
10. Why does the coupon rate affect the volatility of bond price?
11. To which type of risk are holders of long-term bonds?
12. How does value of a bond change as it nears its maturity?
13. What factors may aafect the bond ratings?
14. Why are bond ratings important both to firms and to investors?
BROAD QUESTIONS:
1. A 6 year bond with par value 1000 Rupees has a current yield 7.5 percent and a coupon
rate of 8 percent. What is the bond’s price?
2. A 6 year bond with 1000 Rupees par value pays 80 Rupees interest annually and sells for
950 Rupees. What is the coupon rate, current yield and yield to maturity?
3. A firm sells bonds with a par value of 1000 Rupees, carry a 8% coupon rate, with a
maturity period of 9 years. The bond sells at a yield to maturity of 9%.
a. What is the interest payment you should receive each year?
b. What is the selling price of the bond?
c. What will happen to the bond price, if the yield to maturity falls to 7%?
4. Pakistan bank issues a 10 year treasury bond at 12% coupon with the par value of 1000
Rupees. If the market yield increases shortly afterwards, what happens to the following
parameters:
a) coupon rate b) price c) current yield d) yield to maturity.
5. Why is a call provision advantages to a bond issuer? When will the issuer initiate a
refunding call? Why?
6. ABC corporation has issued 12 percent annual coupon 1000 Rupees par value bonds
maturing in 10 years. What should be the current price of this bond if the interest rate is 15
percent?
7. ABC corporation has issued 14% coupon bond with a par value of 1000 Rupees which
matures in 20 years. The bond is callable in 5 years at 1140 Rupees. This bond currently
sells for 1050 Rupees.
a. What is the current yield?
b. Yield to call
c. Yield to maturity
8. Vermex bonds currently sell for 975 Rupees which has got 7 years maturity with a 12 percent
annual coupon and have a per value of 1000 Rupees. What is their YTM? What is their current
yield.
9. Why is the yield to call a more appropriate measure to use for callable bonds with high
coupons rather than the yield to maturity?
10. Calculate the present value of 6 year bond with a par value of 1000 Rupees and having 9%
coupon rate if the current interest rate is 12%?
11. The interest rate increases from 10% to 12% suddenly. Find the present values of the two
bonds given below both before and after the change.
a) Both the bonds have same coupon rate of 11%.
b) Bond 1 has a maturity of 5 years and bond 2 has a maturity of 15 years.
(Note: 5 year bond sells at 1012 Rupees before the increase in interest rate. Now after the rise in
interest rate it is trading at 940 Rupees. Decrease is 7.11%. On the other hand, the 15 year bond
sells at 1060 before the rise in inters rate and now after the change in interest rate it is trading at
720 Rupees. There is a fall of almost 32% decrease in price.
12. X corporation 1000 Rupees par value bonds currently sell for 1250 Rupees. These bonds can
be called five years at a call price of 1120 Rupees and pay an annual coupon of 120 Rupees.
What is their yield to call?
13. What is bond rating? Why is it so important for both bond issuers and bond investors? What
factors are looked upon by the credit rating agencies in grading a bond?
14. Interpreting Bond Yields Is the yield to maturity on a bond the same thing as the required return? Is
YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two
years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond
now? The YTM?
15. Interpreting Bond Yields Suppose you buy a 7 percent coupon, 20-year bond today when it’s first
issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why?
16. Bond Prices WMS, Inc., has 7 percent coupon bonds on the market that have 10 years left to
maturity. The bonds make annual payments. If the YTM on these bonds is 9 percent, what is the current
bond price?
17. Bond Yields Finley Co. has 10 percent coupon bonds on the market with nine years left to maturity.
The bonds make annual payments. If the bond currently sells for $1,075.25, what is its YTM?
18. Coupon Rates Mustaine Enterprises has bonds on the market making annual payments, with 13
years to maturity, and selling for $850. At this price, the bonds yield 7.4 percent. What must the coupon
rate be on Mustaine’s bonds?
19. Bond Prices Mullineaux Co. issued 11-year bonds one year ago at a coupon rate of 8.6 percent. The
bonds make semiannual payments. If the YTM on these bonds is 7.5 percent, what is the current bond
price?
20. Bond Yields Clapper Corp. issued 12-year bonds 2 years ago at a coupon rate of 7.8 percent. The
bonds make semiannual payments. If these bonds currently sell for 108 percent of par value, what is the
YTM?
21. Coupon Rates Barely Heroes Corporation has bonds on the market with 14.5 years to maturity, a
YTM of 9 percent, and a current price of $850. The bonds make semiannual payments. What must the
coupon rate be on Barely Heroes’ bonds?
22. Calculating Real Rates of Return If Treasury bills are currently paying 8 percent and the inflation
rate is 6 percent, what is the approximate real rate of interest? The exact real rate?
23. Inflation and Nominal Returns Suppose the real rate is 3.5 percent and the inflation rate is 3
percent. What rate would you expect to see on a Treasury bill?
24. Calculate the price of a 10 year bond paying a 6 percent annual coupon (half of the 6
percent semiannually) on a face value of $1,000 if investors can earn 8 percent on similar
risk investments.
25. A major auto manufacturer has experienced a market re-evaluation lately due to a number
of lawsuits. The firm has a bond issue outstanding with 15 years to maturity and a
coupon rate of 8% (paid semiannually). The required rate has now risen to 16%. At what
price can these securities be purchased on the market?
26. The current market price of a Jones' Company bond is $1,297.58. A 10% coupon interest
rate is paid semi-annually, and the par value is equal to $1,000. What is the YTM (on an
annual basis) if the bonds mature 10 years from today?
27. Commonwealth Company has 100 bonds outstanding (maturity value = $1,000). The
required rate of return on these bonds is currently 10%, and interest is paid semiannually.
The bonds mature in 5 years, and their current market value is $768 per bond. What is
the annual coupon interest rate?
28. You have just been offered a bond for $847.88. The coupon rate is 8%, payable annually,
and interest rates on new issues of the same degree of risk are 10%. You want to know
how many more interest payments you will receive, but the party selling the bond cannot
remember. Can you help him out?
29. Ford and GM have similar bond issues outstanding. The Ford bond has interest payments
of $80 paid annually and matures in the year 2002 (20 years from today). The GM bond
has interest payments of $80 paid semiannually and also matures in the year 2002. If the
required rate of return (kd) is 12%, what is the difference in current selling price of the
two bonds?
30. Acme Products has a bond outstanding with 8 years remaining to maturity and a coupon
rate of 5% paid semiannually. If the current market price is $729.05, what is the yield to
maturity?
31. Recently, TLE, Inc., filed bankruptcy papers. The firm was reorganized as DL, Inc., and
the court permitted a new indenture on an outstanding bond issue to be put into effect.
The issue has 10 years to maturity and a coupon rate of 10%, paid annually. The new
agreement allows the firm to pay no interest for 5 years and then at maturity to repay
principal and any unpaid interest (no interest on the unpaid interest). If the required
return is 20%, what should such bonds sell for in the market today?
32. In order to assess accurately the capital structure of a firm, it is necessary to convert the
balance sheet to a market value basis. The current balance sheet is as follows:
Long-term debt (bonds) $10,000,000

Preferred stock 2,000,000

Common stock ($10 par) 10,000,000
Retained earnings 4,000,000
-----------
Total debt and equity $26,000,000
The bonds mature in 10 years. Interest is payable semiannually and the yield to maturity is
12%. The coupon rate is 4 percent. What is the current market value of the firm's debt?
33. Calculate the yield to maturity (on an annual basis) of an 8 percent coupon, 10-year bond
that pays interest semiannually if its price is now $770.60.
34. The XYZ Company recently issued a 20-year, 7 percent semiannual coupon bond at par.
After three months, the market interest rates on similar bonds increased to 8 percent. At
what price should the bonds sell?
35. IBX has a bond issue outstanding that is callable in three years at a 5 percent call
premium. The bond pays a 10 percent annual coupon and has a remaining maturity of 23
years. If the current market price is $1000, than what is the yield to call?
Practice Questions: Bonds Valuation
1. A 5-year bond with a coupon rate of 4% has a face value of $1000. What is the annual interest
payment?
2. A 3-year bond with 10% coupon rate and $1000 face value yield to maturity is 8% . Assuming
annual coupon payment, calculate the price of the bond.
3. A 10-year bond with 12.5% coupon rate and $1000 face value yield to maturity is 14.5% .
Assuming annual coupon payment, calculate the price of the bond.
4. A 10-year bond with 12.5% coupon rate and $1000 face value yield to maturity is 14.5% .
Assuming semi annual coupon payment, calculate the price of the bond.
5. A four-year bond has an 8% coupon rate and a face value of $1000. If the current price of the
bond is $878.31, calculate current yield assuming annual interest payments.
6. A five -year bond has an 8% coupon rate and a face value of $1000. If the current price of the
bond is $1075, calculate current yield assuming annual interest payment.
7. A twenty year bond is currently selling at $850 and current yield is 8%. What coupon rate
offered by company?
8. A twenty year bond is currently selling at $1250 and current yield is 8%. What coupon rate
offered by company?
9. A three-year bond has 8.0% coupon rate and face value of $1000. If the yield to maturity on the
bond is10%, calculate the price of the bond assuming that the bond makes semi-annual coupon
interest payments.
10. A four-year bond has an 8% coupon rate and a face value of $1000. If the current price of the
bond is $878.31, calculate the yield to maturity of the bond (assuming annual interest
payments).
11. A ten -year bond has an 10% coupon rate and a face value of $1000. If the current price of the
bond is $1150, calculate the yield to maturity of the bond (assuming annual interest payments).
12. A 9.3% annual coupon bond with a 10-year maturity and a $1,000 par value has a yield to
maturity of 8%. Assuming that the yield curve is flat and doesn’t shift, calculate the holding
period return you would achieve from buying the bond, holding it for one year only.
13. Suppose you want to offer zero coupon bond with a face value of $1,000 maturing in twenty
years. If the yield to maturity (YTM) on the bond is 8.00%, what will the price of the bond
offered by your company?
14. Suppose you offer zero coupon bond at $245 with a face value of $1,000 maturing in twenty
years. If the yield to maturity (YTM) on the bond is 8.00%, what will the price of the bond after
two years?
15. A bond for J. Morris, Inc. a coupon rate of 6%. The yield to maturity is 7%. The bond has a
remaining life of 20 years and makes semi-annual coupon payments? What is the present value
of the bond’s face value?
16. A bond for Firebird, Inc. has a coupon rate of 7%. The yield to maturity is 6.8%. The bond has a
remaining life of 30 years and makes annual coupon payments? What is this bond’s current
market value?
17. A bond for J. Morris, Inc. a coupon rate of 6%. The yield to maturity is 7%. The bond has a
remaining life of 20 years and makes semi-annual coupon payments? What is this bond’s
current market value?
18. A bond for Ballhawkers, Inc. has a coupon rate of 7%. The yield to maturity is 6.8%. The bond
has a remaining life of 30 years and makes semi-annual coupon payments? What is this bond’s
current market value?
Chapter Seven STOCK VALUATION
Placing a value on a share of common stock is a more challenging task than we faced in valuing
bonds. Remember that common stock represents an ownership stake in a firm and those
shareholders are paid after other suppliers of capital (primarily lenders) have been paid. So, the
cash flows available to shareholders can be fairly uncertain (i.e., risky). However, if investors
can form an expectation about the amount of dividends that will be paid per share in the future,
then we should be able to apply time value of money principles to find the price of stock.
If
Dt = dividend per share paid at year t.
ks = required rate of return on stock s.
D1 D2 D
Pˆ0    ...... 
(1  k s ) (1  k s )
1 2
(1  k s ) 
Then
In words, the current price of a share of stock should be the present value (PV) of its future
dividends discounted at the required rate of return for the stock.
Notice that the dividend cash flows are projected to go on forever. This reflects the fact that the
ownership claim of shareholdings has no maturity. Given the “forever” nature of the cash flows
from a share of stock, we generally try to forecast some type of systematic pattern for future
dividends to make the above equation more workable.
 Characteristics of common stocks

Ownership with residual claims
Advantages and disadvantages of common stock ownership
Advantages
Higher returns
Easy to buy and sell (liquidity)
Disadvantages
Higher risk
Less current income
 Valuation by comparables
Stocks with similar characteristics should sell for similar prices
Book value: the net worth of common equity according to a firm’s balance sheet
Liquidation value: net amount that can be realized by selling the assets of a firm and
paying off the debt
Replacement cost: cost to replace a firm’s assets
Tobin’s q: the ratio of market value of the firm to replacement cost
P/E ratio approach
Price-to-sales ratio approach
Market-to-book value approach
Price-to-cash flow approach
Valuing a stock with no projected growth in dividends per share

D D D
Pˆ0    ...... 
(1  k s )1 (1  k s ) 2 (1  k s ) 
Suppose that we are trying to value the stock of a firm that is expected to pay a “constant”
dividend over time. Then our equation above becomes
D
Pˆ0 
ks
In mathematics, this type of equation represents the sum of a geometric progression. It is a fact
that this equation reduces to:
This equation solves for the value of perpetuity. Perpetuity is an equal payment at regular
intervals that lasts forever.
Assume that you are considering an investment in a stock that is expected to pay a constant
dividend of $3 per share forever and that you will receive your first dividend payment 1 year
from now. Further, you have determined that you require a 15% return on an investment in this
stock. What is the value of this stock?
$3
Pˆ0   $20
0.15
Note what happens to the price if investors require higher or lower rates of return on the stock. If
investors require a 20% return on an investment in this stock, the value would be only $15 ($3 /
0.20). On the other hand, if the required return on the stock is 10%, the stock’s value would be
$30 ($3 / 0.10). Sudden changes in investor’s required rates of return on buying stocks can cause
significant changes in the values of stock (this is one reason why actual stock prices can be
volatile).
We can also use the structure of this formula to find the expected rate of return on this stock (if
we know the “actual” price).
D
kˆs 
P0
Note that the price variable has “lost its hat”, while the return variable, k, has “put on a hat.” This
reflects that from this equation, we are using a known price (which does not have to equal the
“theoretical” price, P-hat) to solve for an “expected” rate of return (which does not have to equal
the “required” rate of return).
Suppose that this stock sells for $20 per share. What is its expected return based on this price?
$3
kˆs   0.15
$20
Based on our earlier computation of the value of the stock, is it fairly priced?
Note that for a zero-growth stock, the expected return consists entirely of the stock’s dividend
yield, D1/P0. To illustrate this, calculate the price of this stock in 1 year (but immediately after
the dividend is paid).
$3
Pˆ1   $20
0.15
Note that the price 1 year from now is expected to be $20. Therefore, if you sold the share after 1
year, you would expect to receive no capital gain. Your entire expected return would be from the
$3 dividend received. If you plan to sell your share after 1 year, illustrate why the $20 at t=0 is a
fair price.
0 1
-20 23
What’s the PV of $23 received in 1 year discounted at 15% (annual compounding)?
Valuing a stock with constant growth in dividends per share

Our initial analysis of a “zero-growth” stock should provide you with a basic understanding of
the valuation process. However, an assumption of zero dividend growth is unrealistic for a large
majority of companies. Most companies constantly strive to find new profit opportunities for
their businesses. In other words, they are trying to “grow” and add value. If they are successful,
they will be more profitable and be able to pay larger dividends. Thus, we need a valuation
model that can incorporate growth.
Suppose the stock that we are evaluating just paid a $3 per share dividend (i.e., yesterday).
Future dividend payments on this stock are expected to grow at a rate of 5% forever. Investors
require a 15% return on an investment in this stock.
The expected dividend payment in 1 year = $3(1.05) = $3.15
The expected dividend payment in 2 years = $3(1.05)2 = $3.3075
The expected dividend payment in 3 years = $3(1.05)3 = $3.472875
And this pattern will continue on forever.
ˆ D0 (1  g )1 D0 (1  g ) 2 D0 (1  g ) 
P0    ..... 
(1  k s )1 (1  k s ) 2 (1  k s ) 
It is a mathematical fact that this equation is equivalent to the following.
D (1  g ) D1
Pˆ0  0 
ks  g ks  g
So, the value of the constant growth stock discussed above is
$3(1  0.05) $3.15

Pˆ0    $31.50
0.15  0.05 0.15  0.05
As with the zero-growth case, the value equation may be manipulated to find the expected rate of
return on a constant growth stock (if the actual price is known). Assume that this stock trades at
$31.50 currently.
D
kˆs  1  g
P0
The first term is the expected dividend yield. The second term reflects the expected capital gains
yield.
$3.15
kˆs   0.05  0.10  0.05  0.15
$31.50
So, the expected return on this stock is composed of a dividend yield of 10% and an expected
capital gains yield of 5%. To see this, let’s calculate the expected price of this stock 1 year from
now (immediately after the first dividend has been paid).
$3.15(1  0.05) $3.3075

Pˆ1    $33.075
0.15  0.05 0.15  0.05
So, after 1 year, I expect a capital gain of $1.575 ($33.075 - $31.50) which is a 5% gain over my
purchase price of $31.50. Combining this capital gain with the dividend yield of 10%, the total
expected return is 15%.
How will the current price of the stock be impacted by changes in 1) the required rate of return,
or 2) the growth rate?
Suppose the required rate of return for this stock jumps to 20% from 15%.
$3.15
Pˆ0   $21.00
0.20  0.05
A rise in the required rate will cause stock price to fall, all else being equal. On the other hand, a
decrease in the required rate of return will cause stock price to increase, all else being equal.
Suppose the growth rate of dividends is suddenly projected to be 8% forever rather than 5%.
$3(1  0.08) $3.24

Pˆ0    $46.29
0.15  0.08 0.15  0.08
Clearly, a greater growth rate in dividends is good news for the stock price, while lower growth
rates will cause a decline in price. Please note that we are talking about permanent dividend
changes, not temporary manipulations by firm management trying to boost stock price. The
market should not be fooled by temporary changes!
Valuing a stock with non constant (supernormal) growth in dividends per share
Many companies go through rapid growth phases before maturing into more stable (and lower)
growth patterns. Note from the constant growth formula that growth cannot be greater than the
required rate of return forever (otherwise the formula would yield a negative stock value).
Therefore, if the growth rate is higher than the required rate of return for some period of time,
then we must alter our valuation procedure.
Suppose that the stock under consideration for investment just paid a $3 per share dividend, and
projects 25% growth in dividends for the next 3 years. After that point in time, dividends are
expected to grow at a 5% annual rate forever. Assume that the required rate of return on this
stock is 15%. What is the value of this stock?
The standard procedure to follow for valuing a non constant growth stock is as follows:
1) Find the PV of the dividends during the period of non constant growth.
2) Find the price of the stock at the end of the non constant growth period (using the constant
growth formula). Find the PV of this price.
3) Add the PV’s found in steps 1) and 2) to find the current value of the stock.
Step 1:
Expected dividend at year 1 = $3(1.25) = $3.75
Expected dividend at year 2 = $3(1.25)2 = $4.6875
Expected dividend at year 3 = $3(1.25)3 = $5.859375
PV of D1 (at 15%) = $3.26086957
PV of D2 (at 15%) = $3.54442344

PV of D3 (at 15%) = $3.85263417
Sum of PV of dividends during supernormal growth = $10.65792718
Step 2:
$5.859375(1  0.05) $6.15234375

Pˆ3    $61.5234375
0.15  0.05 0.10
PV of value at year 3 (at 15%) = $40.45265883
Step 3:
Pˆ0  $10.65792718  $40.45265883  $51.11
So, a fair price for this stock is $51.11!
Stock Market Equilibrium (Overpriced and Underpriced stocks)

Suppose a stock’s computed value is different than the observed price of its stock. Then, we
would say that such a stock is mispriced (if the model used to value the stock is correct).
Assume that the stock we examined earlier with a value of $31.50 is observed to trade at $30.
This stock is underpriced (i.e., investors can buy the stock at a price less than its value).
Another way of looking at this is to calculate the expected return on the stock (as we did earlier).
D $3.15
kˆs  1  g   0.05  0.155
P0 $30
At a price of $30, this stock has an expected return of 15.5%. This is greater than the required
rate of return of 15%. The current market for this stock is out of equilibrium. The buying
pressure will force current price higher (thus decrease the expected return). Once price has
reached $31.50, the expected return equals the required return and the market for this stock is in
equilibrium.
Suppose instead that the stock is actually trading at $35. The price is greater than value;
therefore, the stock would be overpriced. Investors would rush to sell such a stock, driving its
price down to its fair value of $31.50.
Stock price and PVGO (present value of growth opportunity)
Dividend payout ratio (1-b) vs. plowback ratio (b, earnings retention ratio)
Price = no-growth value per share + PVGO

E1 E
P0   PVGO , where 1 is the no-growth value per share
k k
Example: assume E1 = $5.00, k = 12.5%, ROE = 15%
If D1 = $5.00, then g = 0% (g = ROE * b, b = 0)
P0 = 5/0.125 = $40.00
If b = 60%, then g = 15%*0.6 = 9%, D1 = 5*(1-0.6) = $2.00
P0 = $57.14 (from constant DDM)
PVGO = 57.14 – 40.00 = $17.14
(3) Life cycle and multistage growth models: the growth rates are different at different stages,
but eventually it will be a constant
Two-stage growth DDM
Example: Honda Motor Co.
Expected dividend in next four years:
$0.90 in 2009 $0.98 in 2010 $1.06 in 2011 $1.15 in 2012
Dividend growth rate will be steady beyond 2012
Assume ROE = 11%, b = 70%, then long-term growth rate g = 7.7%
Honda’s beta is 1.05, if the risk-free rate is 3.5% and the market premium is 8%, then k = 11.9%
(from CAPM)
Using constant DDM, P2012 = 1.15*(1 + 0.077) / (0.119 - 0.077) = $29.49
$29.49
$0.90 $0.98 $1.06 $1.15
2008 2009 2010 2011 2012
Discount all the cash flows to the present at 11.9%, V2008 = $21.88
Multistage growth DDM: extension of two stage DDM
 Alternative models
P/E ratio approach
If g = ROE*b, the constant growth DDM is
P0 1 b
 , with k>ROE*b.
E1 k  ( ROE * b)
Since P/E ratio indicates firm’s growth opportunity, P/E over g (call PEG ratio) should be
close to 1.
If PEG ratio is less than 1, it is a good bargain. For the S&P index over the past
20 years, the PEG ratio is between 1 and 1.5.
Price-to-book ratio approach
Price-to-cash flow ratio approach
Price-to-sales ratio approach
 Free cash flow valuation approach

Free cash flow: cash flow available to the firm or to the shareholders net of capital
expenditures
Free cash flow to the firm (FCFF)
FCFF = EBIT*(1-tc) + depreciation – capital expenditures – increase in NWC
Use FCFF to estimate firm’s value by discounting all future FCFF (including a terminal
value, PT) to the present
Free cash flow to equity holders
FCFE = FCFF – interest expense*(1-tc) + increases in net debt
Use FCFE to estimate equity value by discounting all future FCFE (including a terminal
value, PT) to the present
1. Dividend Yield. Favored stock will pay a dividend this year of $2.40 per share. Its dividend yield is 8
percent. At what price is the stock selling?
2. Constant-Growth Model. Waterworks has a dividend yield of 8 percent. If its dividend is expected to
grow at a constant rate of 5 percent, what must be the expected rate of return on the company’s
stock?
3. Rate of Return. Steady As She Goes, Inc., will pay a year-end dividend of $3 per share. Investors
expect the dividend to grow at a rate of 4 percent indefinitely.
a. If the stock currently sells for $30 per share, what is the expected rate of return on the stock?
b. If the expected rate of return on the stock is 16.5 percent, what is the stock price?
4. Dividend Yield. BMM Industries pays a dividend of $2 per quarter. The dividend yield on its stock is
reported at 4.8 percent. What price is the stock selling at?
5. Stock Values. Integrated Potato Chips paid a $2 per share dividend yesterday. You expect the
dividend to grow steadily at a rate of 4 percent per year.
a. What is the expected dividend in each of the next 3 years?

b. If the discount rate for the stock is 12 percent, at what price will the stock sell?
c. What is the expected stock price 3 years from now?
d. If you buy the stock and plan to hold it for 3 years, what payments will you receive? What is the
present value of those payments? Compare your answer to (b).
6. Constant-Growth Model. A stock sells for $40. The next dividend will be $4 per share. If the rate of
return earned on reinvested funds is 15 percent and the company reinvests 40 percent of earnings
in the firm, what must be the discount rate?
7. Negative Growth. Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are
all shrinking at a rate of 10 percent per year.
a. If r = 15 percent and DIV1 = $3, what is the value of a share?

b. What price do you forecast for the stock next year?

c. What is the expected rate of return on the stock?
8. Nonconstant Growth. You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in
each of the next 3 years. You believe the stock will sell for $20 at the end of the third year.
a. What is the stock price if the discount rate for the stock is 10 percent?
b. What is the dividend yield?
9. Constant-Growth Model. Here are data on two stocks, investor required return is 15 percent:
Stock A Stock B
Return on Equity 12% 10%
Earnings Per Share $2.00 $1.50
Dividends per share $1.00 $1.00
a. What are the dividend payout ratios for each firm?

b. What are the expected dividend growth rates for each firm?
c. What is the proper stock price for each firm?
11. The DAP Company has decided to make a major investment. The investment will
require a substantial early cash out-flow, and inflows will be relatively late. As a result, it is
expected that the impact on the firm's earnings for the first 2 years will be a negative growth of
5% annually. Further, it is anticipated that the firm will then experience 2 years of zero growth
after which it will begin a positive annual sustainable growth of 6%. If the firm's cost of capital
is 10% and its current dividend (D0) is $2 per share, what should be the current price per share?
12. The Radley Company has decided to undertake a large new project. Consequently, there
is a need for additional funds. The financial manager decides to issue preferred stock which has
a stated dividend of $5 per share and a par value of $30. If the required return on this stock is
currently 20%, what should be the stock's current market value?
13. SNG's stock is selling for $15 per share. The firm's income, assets, and stock price have
been growing at an annual 15% rate and are expected to continue to grow at this rate for 3 more
years. No dividends have been declared as yet, but the firm intends to declare a $2.00 dividend
at the end of the last year of its supernormal growth. After that, dividends are expected to grow
at the firm's normal growth rate of 6%. The firm's required rate of return is 18%. You should:
14. BBP, Inc., has experienced a recent resurgence in business as it has gained new national
identity. Management is forecasting rapid growth over the next 4 years (annual rate of 15%).
After that, it is expected that the firm will revert to its historical growth rate of 2% annually. The
last dividend paid was $1.50 per share, and the required return is 10%. What is the current price
per share, assuming equilibrium?
15. The Club Auto Parts Company has just recently been organized. It is expected to
experience no growth for the next 2 years as it identifies its market and acquires its inventory.
However, Club will grow at an annual rate of 5% in the third and fourth years and, beginning
with the fifth year, should attain a 10% growth rate which it will sustain thereafter. The last
dividend paid was $0.50 per share. Club has a cost of capital of 12%. What should be the
present price per share of Club common stock?
16. A share of DRV, Inc., stock paid a dividend of $1.50 last year, and the dividend is
expected to grow at a constant rate of 4% in the future. The appropriate rate of return on this
stock is believed to be 12%. What should the stock sell for today?
17. The Pet Company has recently discovered a type of rock which, when crushed, is
extremely absorbent. It is expected that the firm will experience (beginning now) an unusually
high growth rate (20%) during the period (3 years) when it has exclusive rights to the property
where this rock can be found. However, beginning with the fourth year the firm's competition
will have access to the material, and from that time on the firm will assume a normal growth rate
of 8% annually. During the rapid growth period, the firm's dividend payout ratio will be
relatively low (20%), to conserve funds for reinvestment. However, the decrease in growth will
be accompanied by an increase in dividend payout to 50%. Last year's earnings were $2.00 per
share (E0) and the firm's cost of equity is 10%. What should be the current price of the common
stock?
18. IT&M, Inc., a large conglomerate, has decided to acquire another firm. Analysts are
forecasting that there will be a period (2 years) of extraordinary growth (20%) followed by
another 2 years of unusual growth (10%), and that finally the previous growth pattern of 6%
annually will resume. If the last dividend was $1 per share and the required return is 8%, what
should the market price be today?
19. A share of DRV, Inc., stock paid a dividend of $1.50 last year, and the dividend is
expected to grow at a constant rate of 4% in the future. The appropriate rate of return on this
stock is believed to be 12%. Suppose DRV stock were selling for $25 today. What would be the
implied value of ks , assuming the other data remain the same?
20. The Canning Company has been hit hard due to increased competition. The company's
analysts predict that earnings (and dividends) will decline at a rate of 5% annually into the
foreseeable future. Assume that ks = 11% and D0 = $2.00. What will be the price of the
company's stock in three years?
21. IBM is currently selling at $65 per share. Next year's dividend is expected to be $2.60.
If investors on this particular day expect a return of 12% on their investment, what do they think
IBM's growth rate will be?
22. The MM Company has fallen on hard times. Its management expects to pay no dividends
for the next 2 years. However, the dividend for Year 3 (D3) will be $1.00 per share, and it is
expected to grow at a rate of 3% in Year 4, 6% in Year 5, and 10% in Year 6 and thereafter. If
the required return for MM Co. is 20%, what is the current equilibrium price of the stock?
23. Your brother-in-law, a stockbroker at Invest, Inc., is trying to sell you a stock with a
current market price of $20. The stock had a last dividend (D0) of $2.00 and a constant growth
rate of 8%. Your required return on this stock is 20%. From a strict valuation standpoint, you
should:
24. Negative Limited is expected to grow for four years at a rate of 50 percent. After four
years, the product fad is expected to decline, and Negative will grow at a negative growth rate of
5 percent. Negative currently pays a dividend of $1.00 per share and stockholders have a
required rate of return of 18 percent. What should be the market value for a share of Negative
Limited stock?
25. Dexter, Inc., has just paid a dividend of $2.00. Its stock is now selling for $48 per share.
The firm is half as volatile as the market. The expected return on the market is 14% and the
yield on U.S. Treasury bonds is 11%. If the market is in equilibrium, what rate of growth is
expected?
Practice Questions: Stock Valuation
1. If current price of stock is $25 and you hold it for one year and received dividend of $2.5. You
sold it at $27. How much return you received? Show dividend yield and capital gain separately.
2. If investor required return is 20% and capital gain is 8% how much dividend company should
pay?
3. Current price of stock is $20 and expected price after one year is 22.5. If investor required return
is 18%. What percentage of dividend should company pay?
4. You own a stock that will start paying $0.50 annually at the end of the year. It has zero growth in
future. If the required rate of return is 14%, what should you pay per share?
5. You own a stock that will start paying $0.50 annually at the end of the year. It will then grow
each year at a constant annual rate of 5%. If the required rate of return is 14%, what should you
pay per share?
6. What should you pay for a stock assuming you expect the following: a dividend of $1.00 paid at
the end of years 1 and 2; cost of equity equal to 8 percent; and, a selling price of $31 at the end
of two years?
7. Assume that IBM is expected to pay a total cash dividend of $5.60 next year and that dividends
are expected to grow at a rate of 5% per year forever. Assuming annual dividend payments,
what is the current market value of a share of IBM stock if the required return on IBM common
stock is 10%?
8. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio (POR) is 0.4, its
EPS1 is $2.00, and its expected return on the money retained (i) is 0.10. What is investor’s
required rate of return?
9. You own a stock that is currently selling for $50. You expect a dividend of $1.50 next year and
you require a 12% rate of return. What is the dividend growth rate for your stock assuming
constant growth?
10. What would you pay for a stock expected to pay a $2.50 dividend in one year if the expected
dividend growth rate is zero and you require a 10% return on your investment?
11. What would you pay for a stock expected to pay a $2.25 dividend in one year if the expected
dividend growth rate is 3% and you require a 12% return on your investment?
12. You are considering investing in ICI. Suppose ICI currently paid $3 dividend and enjoying super
growth and expected to pay 30% more in dividends each year for 3 years. After these three
years the dividend growth rate is expected to be 2% per year forever. If the required return for
ICI common stock is 11%, what is a share worth today?
13. You are considering investing in ICI. Suppose ICI is currently undergoing expansion and is not
expected to change its cash dividend while expanding for the next 4 years. This means that its
current annual $3.00 dividend will remain for the next 4 years. After the expansion is
completed, higher earnings are expected to result causing a 30% increase in dividends each year
for 3 years. After these three years of 30% growth, the dividend growth rate is expected to be
2% per year forever. If the required return for ICI common stock is 11%, what is a share worth
today?
1. In the calculation of rates of return on common stock, dividends are _______ and capital gains
are _____.
A. guaranteed; not guaranteed
B. guaranteed; guaranteed
C. not guaranteed; not guaranteed
D. not guaranteed; guaranteed
2. What dividend yield would be reported in the financial press for a stock that currently pays a $1
dividend per quarter and the most recent stock price was $40?
A. 2.5%
B. 4.0%
C. 10.0%
D. 15.0%
3. Which of the following values treats the firm as a going concern?
A. market value
B. book value
C. liquidation value
D. none of the above.
4. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the stock's current
price?
A. $4.50
B. $18.00
C. $22.22
D. $40.50
5. How many round lots were traded in a specific stock on a day in which 467,800 shares changed
hands?
A. 467.8 round lots
B. 4,678 round lots
C. 467,800 round lots
D. Price must be known to determine round lots.
6. The book value of a firm's equity is determined by:
A. multiplying share price by shares outstanding.
B. multiplying share price at issue by shares outstanding.
C. the difference between book values of assets and liabilities.
D. the difference between market values of assets and liabilities.
7. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity,
500,000 shares of stock outstanding, and a price/book value ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00
8. If the liquidation value of a firm is negative, then:
A. the firm's debt exceeds the market value of assets.
B. the firm's debt exceeds the book value of equity.
C. the book value of assets exceeds the firm's debt.
D. the market value of assets exceeds the firm's debt.
9. A firm's liquidation value is the amount:

A. necessary to repurchase all shares of common stock.
B. realized from selling all assets and paying off its creditors.
C. a purchaser would pay for the firm in bankruptcy.
D. equal to the book value of equity.
10. Which of the following is least likely to account for an excess of market value over book value of
equity?
A. Inaccurate depreciation methods.
B. High rate of return on assets.
C. The presence of growth opportunities.
D. Valuable off-balance sheet assets.
11. Firms with valuable intangible assets are more likely to show a(n):
A. excess of book value over market value of equity.
B. high going-concern value.
C. low liquidation value.
D. low P/E ratio.
12. Which of the following is inconsistent with a firm that sells for very near book value?
A. Low current earning power
B. No intangible assets
C. High future earning power
D. Low, unstable dividend payment
13. The main purpose of a market-value balance sheet is to:
A. show an inflated value of the firm.
B. avoid the recording of certain liabilities.
C. value assets and liabilities without GAAP restrictions.
D. improve the credit rating of the firm.
14. A stock paying $5 in annual dividends sells now for $80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A. $82.20
B. $86.20
C. $87.20
D. $91.20
15. Which of the following statements is correct about a stock currently selling for $50 per share
that has a 16% expected return and a 10% expected capital appreciation?
A. Its expected dividend exceeds the actual dividend.
B. Its expected return will exceed the actual return.
C. It is expected to pay $3 in annual dividends.
D. It is expected to pay $8 in annual dividends.
16. The expected return on a common stock is composed of:
A. dividend yield.
B. capital appreciation.
C. both dividend yield and capital appreciation.
D. capital appreciation minus the dividend yield.
17. Firms having a higher expected return have a higher:

A. level of expected risk.
B. dividend yield.
C. market value of equity.
D. degree of certainty concerning their returns.
18. How much should you pay for a share of stock that offers a constant growth rate of 10%,
requires a 16% rate of return, and is expected to sell for $50 one year from now?
A. $42.00
B. $45.00
C. $45.45
D. $47.00
19. According to the dividend discount model, the current value of a stock is equal to the:
A. present value of all expected future dividends.
B. sum of all future expected dividends.
C. next expected dividend, discounted to the present.
D. discounted value of all dividends growing at a constant rate.
20. How is it possible to ignore cash dividends that occur far into the future when using a dividend
discount model? Those dividends:
A. will be paid to a different investor.
B. will not be paid by the firm.
C. have an insignificant present value.
D. ignore the tax consequences of future dividends.
Chapter Eight CAPITAL BUDGETING
• Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing owner wealth.
• A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over
a period of time greater than 1 year.
• An operating expenditure is an outlay of funds by the firm resulting in benefits received within 1
year.
Steps in the Process

The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects are made at all levels within
a business organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal review and analysis to assess
the merits of investment proposals
3. Decision making. Firms typically delegate capital expenditure decision making on the
basis of dollar limits.
4. Implementation. Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are compared with those
that were expected. Action may be required if actual outcomes differ from projected
ones.
Basic Terminology
Independent versus Mutually Exclusive Projects
– Independent projects are projects whose cash flows are unrelated to (or independent
of) one another; the acceptance of one does not eliminate the others from further
consideration.
– Mutually exclusive projects are projects that compete with one another, so that the
acceptance of one eliminates from further consideration all other projects that serve a
similar function.
Unlimited Funds versus Capital Rationing
– Unlimited funds is the financial situation in which a firm is able to accept all
independent projects that provide an acceptable return.
– Capital rationing is the financial situation in which a firm has only a fixed number of
dollars available for capital expenditures, and numerous projects compete for these
dollars.
Accept-Reject versus Ranking Approaches
– An accept–reject approach is the evaluation of capital expenditure proposals to
determine whether they meet the firm’s minimum acceptance criterion.
– A ranking approach is the ranking of capital expenditure projects on the basis of some
predetermined measure, such as the rate of return.
Capital Budgeting Techniques

ABC Company is a medium sized firm that is currently contemplating two projects: Project A
requires an initial investment of Rs42,000, project B an initial investment of Rs45,000. The
relevant operating cash flows for the two projects are presented in Table 1.1.
Table 1.1 Capital Expenditure Data for XYZ Company
Project A Project B
Initial Investment Rs.42,000 Rs.45,000
Year Operating Cash Inflows
1 Rs.14,000 Rs.28,000
2 Rs.14,000 Rs.12,000
3 Rs.14,000 Rs.10,000
4 Rs.14,000 Rs.10,000
5 Rs.14,000 Rs.10,000
Payback Period
The payback method is the amount of time required for a firm to recover its initial investment
in a project, as calculated from cash inflows.
Decision criteria:
– The length of the maximum acceptable payback period is determined by management.
– If the payback period is less than the maximum acceptable payback period, accept the
project.
– If the payback period is greater than the maximum acceptable payback period, reject
the project.
We can calculate the payback period for XYZ Company’s projects A and B using the data in Table
1.1.
Payback = Number of years prior to full recovery + (Unrecovered Cost at start of year )
Cash flow during full recovery year
– For project A, which is an annuity, the payback period is 3.0 years (Rs42,000 initial
investment ÷ Rs14,000 annual cash inflow).
– Because project B generates a mixed stream of cash inflows, the calculation of its
payback period is not as clear-cut.
• In year 1, the firm will recover Rs28,000 of its Rs45,000 initial investment.
• By the end of year 2, Rs40,000 (Rs28,000 from year 1 + Rs12,000 from year 2)
will have been recovered.
• At the end of year 3, Rs50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of Rs10,000 is needed to complete the
payback of the initial Rs45,000.
– The payback period for project B is therefore 2.5 years (2 years + 50% of year 3).
Pros and Cons of Payback Analysis

– The payback method is widely used by large firms to evaluate small projects and by small firms
to evaluate most projects.
– Its popularity results from its computational simplicity and intuitive appeal.
– By measuring how quickly the firm recovers its initial investment, the payback period also gives
implicit consideration to the timing of cash flows and therefore to the time value of money.
– Because it can be viewed as a measure of risk exposure, many firms use the payback period as a
decision criterion or as a supplement to other decision techniques.
– The major weakness of the payback period is that the appropriate payback period is merely a
subjectively determined number.
– It cannot be specified in light of the wealth maximization goal because it is not based on
discounting cash flows to determine whether they add to the firm’s value.
– A second weakness is that this approach fails to take fully into account the time factor in the
value of money.
– A third weakness of payback is its failure to recognize cash flows that occur after the payback
period.
Limits on Payback Analysis

– While easy to compute and easy to understand, the payback period simplicity brings
with it some drawbacks.
– Whatever the weaknesses of the payback period method of evaluating capital projects,
the simplicity of the method does allow it to be used in conjunction with other, more
sophisticated measures.
– In your view, if the payback period method is used in conjunction with the NPV method,
should it be used before or after the NPV evaluation?
Discounted Payback Period
Uses discounted cash flows rather than raw CFs.

Discounted Payback period: The length of time until the accumulated discounted cash flows
from the investment equal or exceed the original cost. We will assume that cash flows are
generated continuously during a period.
The Discounted Payback Rule: An investment is accepted if its calculated discounted payback
period is less than or equal to some pre-specified number of years.
Example: Consider the previous investment project analyzed with the NPV rule. The initial
cost is Rs600 million. The discounted payback period is 3 years. The appropriate discount rate
for these cash flows is 20%. Using the discounted payback rule, should the firm invest in the
new product?
Discounted
Accumulated
Year Cash Flow Present Value Cash Flow
Factor
1 Rs200.00 0-833 167
2 Rs220.00 0.694 320
3 Rs225.00 0.578 450
4 Rs210.00 0.482 551
Analyzing the Discounted Payback Rule:

 Involves discounting as in the NPV rule
 It does not consider the risk differences between investments. Yet, we can discount with a
higher interest rate for a riskier project.
 How do you come up with the right discounted payback period cut-off? Arbitrary number.
Advantages
 If a project ever pays back on a discounted basis, then it must have a positive NPV.
 Biased toward liquidity
 Easy to understand
Disadvantages
 May reject positive NPV projects

 Arbitrary discounted payback period
 Biased against long-term projects
Personal Finance Example

Seema Mehdi is considering investing Rs20,000 to obtain a 5% interest in a rental property.
Seema is in the 25% tax bracket.
Her real estate agent conservatively estimates that Seema should receive between Rs4,000 and
Rs6,000 per year in cash from her 5% interest in the property.
Seema’s calculation of the payback period on this deal begins with calculation of the range of
annual after-tax cash flow:
After-tax cash flow = (1 – tax rate)  Pre-tax cash flow

= (1 – 0.25)  Rs4,000 = Rs3,000
= (1 – 0.25)  Rs6,000 = Rs4,500
Seema Mehdi is considering investing Rs20,000 to obtain a 5% interest in a rental property.

Seema is in the 25% tax bracket.
Dividing the Rs20,000 initial investment by each of the estimated after-tax cash flows, we get
the payback period:
Payback period= Initial investment ÷ After-tax cash flow

= Rs20,000 ÷ Rs3,000 = 6.67 years
= Rs20,000 ÷ Rs4,500 = 4.44 years
Net Present Value (NPV)

Net present value (NPV) is a sophisticated capital budgeting technique; found by subtracting a
project’s initial investment from the present value of its cash inflows discounted at a rate equal to
the firm’s cost of capital.
NPV = Present value of cash inflows – Initial investment
Decision criteria:
– If the NPV is greater than Rs0, accept the project.

– If the NPV is less than Rs0, reject the project.

If the NPV is greater than Rs0, the firm will earn a return greater than its cost of capital. Such
action should increase the market value of the firm, and therefore the wealth of its owners by an
amount equal to the NPV.
Figure 1.2 Calculation of NPVs for XYZ Company’s Capital Expenditure

Alternatives
Project A Project B
0 (Rs.42,000) (Rs.45,000)
1 Rs.14,000 Rs.28,000
2 Rs.14,000 Rs.12000
3 Rs.14,000 Rs.10,000
4 Rs.14,000 Rs.10000
5 Rs.14,000 Rs.10,000
If the cost of capital is 10%
NPV=PV of cash inflow – PV of cash outflow
For Project A:
NPV= 14000 [{1-(1+0.1)^-5} / (0.1)] -42000 = 11071
For Project B:
NPV =
{(28000/1.1)+(12000/1.1^2)+(10000/1.1^3)+(10000/1.1^4)+(10000/1.1^5)} – 45000 = 10924
NPV and the Profitability Index

For a project that has an initial cash outflow followed by cash inflows, the profitability index (PI)
is simply equal to the present value of cash inflows divided by the initial cash outflow:
When companies evaluate investment opportunities using the PI, the decision rule they follow is
to invest in the project when the index is greater than 1.0.
We can refer back to Figure 10.2, which shows the present value of cash inflows for projects A
and B, to calculate the PI for each of XYZ’s investment options:
PIA = Rs53,071 ÷ Rs42,000 = 1.26
PIB = Rs55,924 ÷ Rs45,000 = 1.24
NPV and Economic Value Added

• Economic Value Added (or EVA), a registered trademark of the consulting firm, Stern
Stewart & Co., is another close cousin of the NPV method.
• The EVA method begins the same way that NPV does—by calculating a project’s net
cash flows.
• However, the EVA approach subtracts from those cash flows a charge that is designed to
capture the return that the firm’s investors demand on the project.
• EVA determines whether a project earns a pure economic profit–a profit above and
beyond the normal competitive rate of return in a line of business.
• Suppose a certain project costs Rs1,000,000 up front, but after that it will generate net
cash inflows each year (in perpetuity) of Rs120,000. If the firm’s cost of capital is 10%,
then the project’s NPV and EVA are:
• NPV = –Rs1,000,000 + (Rs120,000 ÷ 0.10) = Rs200,000
• EVA = Rs120,000 – Rs100,000 = Rs20,000
Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a sophisticated capital budgeting technique; the discount
rate that equates the NPV of an investment opportunity with Rs0 (because the present value of
cash inflows equals the initial investment); it is the rate of return that the firm will earn if it
invests in the project and receives the given cash inflows.
Decision criteria:
– If the IRR is greater than the cost of capital, accept the project.
– If the IRR is less than the cost of capital, reject the project.
These criteria guarantee that the firm will earn at least its required return. Such an outcome
should increase the market value of the firm and, therefore, the wealth of its owners.
Figure Calculation of IRRs for XYZ Company’s Capital Expenditure Alternatives

Calculating the IRR

• To find the IRR using the preprogrammed function in a financial calculator, the
keystrokes for each project are the same as those for the NPV calculation, except that the
last two NPV keystrokes (punching I and then NPV) are replaced by a single IRR
keystroke.
• Comparing the IRRs of projects A and B given in Figure 10.3 to XYZ Company’s 10%
cost of capital, we can see that both projects are acceptable because
– IRRA = 19.9% > 10.0% cost of capital
– IRRB = 21.7% > 10.0% cost of capital
• Comparing the two projects’ IRRs, we would prefer project B over project A because
IRRB = 21.7% > IRRA = 19.9%.
• It is interesting to note in the preceding example that the IRR suggests that project B,
which has an IRR of 21.7%, is preferable to project A, which has an IRR of 19.9%.
• This conflicts with the NPV rankings obtained in an earlier example.
• Such conflicts are not unusual.
• There is no guarantee that NPV and IRR will rank projects in the same order. However,
both methods should reach the same conclusion about the acceptability or non-
acceptability of projects.
Alternatively we can use the formula below to find out the approximate figure of IRR.
IRR= [P+ {(N-P) x p/p-n}]

P= Positive % of NPV
N= Negative % of NPV
p= positive amount of npv
n= negative amount of npv
How project’s IRR similar to a bond’s YTM?

 They are the same thing.
 Think of a bond as a project. The YTM on the bond would be the IRR of the “bond”
project.
Rationale for the IRR Method

 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.
Multiple IRRs
Personal Finance Example

Shah is evaluating an investment opportunity. He feels that this investment must earn a minimum
compound annual after-tax return of 9% in order to be acceptable. Shah’s initial investment
would be Rs.7,500, and he expects to receive annual after-tax cash flows of Rs.500 per year in
each of the first 4 years, followed by Rs.700 per year at the end of years 5 through 8. He plans to
sell the investment at the end of year 8 and net Rs.9,000, after taxes.
– Shah finds the investment’s IRR of 9.54%.

– Given that the expected IRR of 9.54% exceeds Shah’s required minimum IRR of
9%, the investment is acceptable.
Comparing NPV and IRR Techniques: Net Present Value Profiles

Net present value profiles are graphs that depict a project’s NPVs for various discount rates.
To prepare NPV profiles for XYZ Company’s projects A and B, the first step is to develop a
number of discount rate-NPV coordinates and then graph them as shown in the following table
and figure.
Table 1.4 Discount Rate–NPV Coordinates for Projects A and B
NET PRESENT VALUE
DISCOUNT RATE PROJECT A PROJECT B
0% Rs28,000 Rs25,000
10% Rs11,071 Rs10,924
19.9% 0 ---
21.7% ---- 0
Figure
NPV Profiles
Comparing NPV and IRR Techniques: Conflicting Rankings

• Conflicting rankings are conflicts in the ranking given a project by NPV and IRR,
resulting from differences in the magnitude and timing of cash flows.
• One underlying cause of conflicting rankings is the implicit assumption concerning the
reinvestment of intermediate cash inflows—cash inflows received prior to the
termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes
that they are reinvested at the IRR
A project requiring a Rs170,000 initial investment is expected to provide cash inflows of

Rs52,000, Rs78,000 and Rs100,000. The NPV of the project at 10% is Rs16,867 and its IRR is
15%. Table 1.5 on the following table demonstrates the calculation of the project’s future value
at the end of its 3-year life, assuming both a 10% (cost of capital) and 15% (IRR) interest rate.
Table 1.5 Reinvestment Rate Comparisons for a Project
If the future value in each case in Table 1.5 were viewed as the return received 3 years from
today from the Rs170,000 investment, then the cash flows would be those given in Table 1.6 on
the following slide.
Table 1.6 Project Cash Flows After Reinvestment
Modified IRR (MIRR)

The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two
weaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s cost of
capital and avoids the problem of multiple IRRs. However, please note that the MIRR is not
used as widely as the IRR in practice.
There are 3 basic steps of the MIRR:
(1) Estimate all cash flows as in IRR.
(2) Calculate the future value of all cash inflows at the last year of the project’s life.
(3) Determine the discount rate that causes the future value of all cash inflows determined in
step 2, to be equal to the firm’s investment at time zero. This discount rate is known as the
MIRR.
Project L:
MIRRS = 16.9%.
MIRR is better than IRR because
1. MIRR correctly assumes reinvestment at project’s cost of capital.
2. MIRR avoids the problem of multiple IRRs.
PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares the present value of future cash inflows with the
initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash
flows (PVCF) to the initial investment of the project.
In this method, a project with a PI greater than 1 is accepted, but a project is rejected when its PI
is less than 1. Note that the PI method is closely related to the NPV approach. In fact, if the net
present value of a project is positive, the PI will be greater than 1. On the other hand, if the net
present value is negative, the project will have a PI of less than 1. The same conclusion is
reached, therefore, whether the net present value or the PI is used. In other words, if the present
value of cash flows exceeds the initial investment, there is a positive net present value and a PI
greater than 1, indicating that the project is acceptable.
PI is also known as a benefit/cash ratio.
Project L
Accept if PI > 1.0
Reject if PI < 1.0
Timing of the Cash Flow

Another reason why the IRR and NPV methods may provide different rankings for investment
options has to do with differences in the timing of cash flows.
– When much of a project’s cash flows arrive early in its life, the project’s NPV
will not be particularly sensitive to the discount rate.
– On the other hand, the NPV of projects with cash flows that arrive later will
fluctuate more as the discount rate changes.
– The differences in the timing of cash flows between the two projects does not
affect the ranking provided by the IRR method.
Table 1.7 Ranking Projects A and B Using IRR and NPV Methods
Magnitude of the Initial Investment

The scale problem occurs when two projects are very different in terms of how much money is
required to invest in each project.
– In these cases, the IRR and NPV methods may rank projects differently.
– The IRR approach (and the PI method) may favor small projects with high returns
(like the Rs2 loan that turns into Rs3).
– The NPV approach favors the investment that makes the investor the most money
(like the Rs1,000 investment that yields Rs1,100 in one day).
Which Approach is Better?

On a purely theoretical basis, NPV is the better approach because:
– NPV measures how much wealth a project creates (or destroys if the NPV is
negative) for shareholders.
– Certain mathematical properties may cause a project to have multiple IRRs—
more than one IRR resulting from a capital budgeting project with a
nonconventional cash flow pattern; the maximum number of IRRs for a project is
equal to the number of sign changes in its cash flows.
Despite its theoretical superiority, however, financial managers prefer to use the IRR approach
just as often as the NPV method because of the preference for rates of return.
Matter of Fact
Which Methods Do Companies Actually Use?
– A recent survey asked Chief Financial Officers (CFOs) what methods they used to
evaluate capital investment projects.
– The most popular approaches by far were IRR and NPV, used by 76% and 75%
(respectively) of the CFOs responding to the survey.
– These techniques enjoy wider use in larger firms, with the payback approach
being more common in smaller firms.
Focus on Ethics
Nonfinancial Considerations in Project Selection
– For most companies ethical considerations are primarily concerned with the
reduction of potential risks associated with a project.
– However, The Kuwait Fund was established as the first institution in the Middle
East that took an active role in international development efforts. The fund
finances development projects and their feasibility studies in developing
countries.
– One of the major objectives of the Kuwait Fund is to build a solid bridge of
friendship and solidarity between the state of Kuwait and the developing nations.
– The success of the Kuwait Fund in achieving this objective helped the state of
Kuwait to get the necessary votes in the United Nations and the U.N. Security
Council for the war against Iraq to liberate Kuwait in 1991.
– The Kuwait Fund offers many forms of assistance, including direct loans or the
provision of guarantees, and grants-in-aid to finance technical, economic, and
financial studies.
– What are the potential benefits to the state of Kuwait of the ethical behavior of the
Kuwait Fund?
CONCLUSION
Six capital budgeting decision criteria:
NPV, IRR, MIRR, PI, Payback and Discounted Payback
NPV is the single best criterion.
NPV – direct measure of value the project adds to shareholder wealth

IRR & MIRR – measures profitability
PI - the ratio of the present value of cash flows (PVCF) to the initial investment of the project
Payback and Discounted Payback – measures liquidity
Understand the key elements of the capital budgeting process.
– Capital budgeting techniques are the tools used to assess project acceptability and
ranking. Applied to each project’s relevant cash flows, they indicate which capital
expenditures are consistent with the firm’s goal of maximizing owners’ wealth.
Calculate, interpret, and evaluate the payback period.
– The payback period is the amount of time required for the firm to recover its
initial investment, as calculated from cash inflows. Shorter payback periods are
preferred. The payback period is relatively easy to calculate, has simple intuitive
appeal, considers cash flows, and measures risk exposure. Its weaknesses include
lack of linkage to the wealth maximization goal, failure to consider time value
explicitly, and the fact that it ignores cash flows that occur after the payback
period.
Calculate, interpret, and evaluate the net present value (NPV) and economic value added (EVA).
– NPV measures the amount of value created by a given project; only positive NPV
projects are acceptable. The rate at which cash flows are discounted in calculating
NPV is called the discount rate, required return, cost of capital, or opportunity
cost. By whatever name, this rate represents the minimum return that must be
earned on a project to leave the firm’s market value unchanged.
– The EVA method begins the same way that NPV does—by calculating a project’s
net cash flows. However, the EVA approach subtracts from those cash flows a
charge that is designed to capture the return that the firm’s investors demand on
the project. That is, the EVA calculation asks whether a project generates positive
cash flows above and beyond what investors demand. If so, then the project is
worth undertaking.
– Calculate, interpret, and evaluate the internal rate of return (IRR).
– Like NPV, IRR is a sophisticated capital budgeting technique. IRR is the compound
annual rate of return that the firm will earn by investing in a project and receiving the
given cash inflows. By accepting only those projects with IRRs in excess of the firm’s
cost of capital, the firm should enhance its market value and the wealth of its owners.
– Use net present value profiles to compare NPV and IRR techniques.
– A net present value profile is a graph that depicts projects’ NPVs for various discount
rates. The NPV profile is prepared by developing a number of “discount rate–net present
value” coordinates (including discount rates of 0 percent, the cost of capital, and the IRR
for each project) and then plotting them on the same set of discount rate–NPV axes.
– Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical
strengths of each approach.
– Conflicting rankings of projects frequently emerge from NPV and IRR as a result of
differences in the reinvestment rate assumption, as well as the magnitude and timing of
cash flows. NPV assumes reinvestment of intermediate cash inflows at the more
conservative cost of capital; IRR assumes reinvestment at the project’s IRR. On a purely
theoretical basis, NPV is preferred over IRR because NPV assumes the more
conservative reinvestment rate and does not exhibit the mathematical problem of multiple
IRRs that often occurs when IRRs are calculated for nonconventional cash flows. In
practice, the IRR is more commonly used because it is consistent with the general
preference of business professionals for rates of return, and corporate financial analysts
can identify and resolve problems with the IRR before decision makers use it.
Relevant Cash Flows

Relevant Cash Flows: the incremental cash flows associated with the decision to invest in a
project.
Incremental Cash Flows: Any changes in the firm's future cash flows that are a direct
consequence of taking the project.
The Stand-Alone Principle: The evaluation of a project based on the project's incremental cash
flows. View each project as a "mini firm" with its own assets, revenues and costs.
Aspects of Incremental Cash Flows

(Which costs should be included in incremental cash flows?)
 Sunk Costs: A cash flow already paid or already promised to be paid.

 Opportunity Costs: Any cash flow lost by taking one course of action rather than another.
 Side Effects: Projects often hurt or help one another
Erosion: Revenues gained by a new project at the expense of the firm's other products or
services.
 Net Working Capital: In all capital budgeting projects we will assume that net working
capital is recovered at the end of the project.

 Financing Costs: Interest, principal on debt and dividends
Capital Budgeting: Pro Forma and DCF Valuation
Pro forma financial statements: Financial statements forecasting future years' operations
 Use pro forma income and balance sheet statements (exclude interest expense) for capital
budgeting.
 Determine sales projections, variable costs, fixed costs and estimated capital requirements.
 Use pro forma statements to compute project cash flows
Project Cash Flows = + Project operating cash flow
 Project capital spending
 Project additions to net working capital
Depreciation
 Economic and future market values are ignored.
 Straight line: A fixed percentage of the asset base.
 Since depreciation has cash flow consequences only because it affects the tax bill, the way
depreciation is computed for tax purposes is the relevant method for capital investment
decisions.
 Modified Accelerated Cost Recovery System (MACRS): 1986 Tax Reform Act allows
firms to "front-load" depreciation charges.
Modified ACRS Property Classes
Class Examples
3-year Equipment used in research
5-year Autos, computers
7-year Most industrial equipment

Modified ACRS Depreciation Allowances
Year 3-year 5-year 7-year
1 33.33% 20.00% 14.26%
2 44.44 32.00 24.49
3 14.82 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.93
7 8.93
8 4.45
 Book versus Market Value: If an asset's value when sold (i.e., salvage value) exceeds (is
lower than) its book value, the difference is treated as a gain (loss) for tax purposes.
Straight Line versus ACRS Depreciation
The Union Company purchased a new computer system for its office with an installed cost of
Rs30,000. The computer is treated as a 5-year property under MACRS and is expected to have a
salvage value of zero after six-years. What is the yearly depreciation allowances using ACRS
depreciation? Using straight-line depreciation?
MACRS Depreciation:
Year MACRS Percentage MACRS Straight-line

Depreciation Depreciation
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
Why might a firm prefer accelerated depreciation, such as MACRS tables, to straight-line
depreciation?
Additions to Net Working Capital
 Given NWC at the beginning of the project (date 0), we will calculate future NWC in either
of two ways.
1. NWC will grow at a rate of X percent per period.
2. NWC will equal Y percent of sales/revenues each period.
Recovering NWC at the end of the Project
Year NWC Additions to NWC
0 Rs500,000
1 Rs600,000
2 Rs800,000
Year NWC Additions to NWC
0 Rs500,000
1 Rs700,000
2 Rs600,000
Two Ways to Do Capital Budgeting Problems
1. Item by item discounting
 Separately forecast revenues, costs and depreciation and discount each item.
 Can use different discount rates
2. Whole project discounting
 Determine project cash flows from financial statements

a. Operating Cash Flow
b. Net Capital Spending
i. We will only buy equipment at date 0.
ii. We will only sell equipment at the end of the project. If, at the end
of the project, we sell the equipment and the market value is
greater than the book value, we record the after-tax cash flow from
the sale.
c. Additions to NWC
i. We will always recover NWC at the end of the project.
Capital budgeting practice problems.

1. Evaluation of Cash Flows. Below are the cash flows for two mutually exclusive projects.
Year CFX CFY

0 (5,000) (5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
a. Calculate the payback for both projects.
b. Initially, the cost of capital is uncertain, so construct NPV profiles for the two projects (on the
same graph) to assist in the analysis. The profiles cross at what cost of capital? What is the
significance of that?
c. It is now determined that the cost of capital for both projects is 14%. Which project should be
selected? Why?
d. Calculate the MIRR for both projects, using the 14% cost of capital.
2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive projects
are shown below:
Year CFM CFN

0 (100) (100)
1 10 70
2 60 50
3 80 20
Both projects have a cost of capital of 10%.
a. Calculate the payback for both projects.

b. Calculate the NPV for both projects.
c. Calculate the IRR for both projects.
d. Calculate the MIRR for both projects.
3. Expansion Project. A machine has a cost of $180. It will have a life of 3 years, and will be
depreciated straight line to zero salvage value. It will result in sales revenue of $200 per year and
cash operating costs of $110 per year. Use of the machine will require an increase in working
capital of $70 for the 3 years, beginning at year 0. The appropriate discount rate is 8% and the
firm’s tax rate is 40%.
a. Calculate the initial cash flow at time 0.

b. Calculate the annual operating cash flows (they are identical each year).
c. Calculate the relevant terminal cash flows at the end of year 3.
d. What is the NPV for the machine?
4. Inflation adjustment: A project requires an initial investment of $8,000, has a 4-year life and
provides expected cash flows as follows, based on year 1 prices and costs:
annual revenue = $5,000
annual cash operating costs = $2,000
annual depreciation = $2,000
terminal cash flow = 0
cost of capital = 14%
T = 30%
a. Calculate the annual operating cash flows without adjusting for inflation. (Are these cash
flows real or nominal?) Calculate the associated NPV.
b. Adjust the cash flows to reflect the effects of inflation, which is expected to affect sales
revenue and cash operating expenses at the rate of 4% annually. (Are these cash flows real or
nominal?) Calculate the associated NPV.
c. Which NPV is the correct one for evaluating the project?
5. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House is trying to
choose between two new coffee bean roasters. The required rate of return for either machine is
10%. Shown below are the after-tax cash flows associated with each machine:
year CFX CFY
0 (50,000) (30,000)
1 20,000 20,000
2 20,000 20,000
3 20,000
4 20,000
a. Calculate the replacement chain NPV for each project.

b. Calculate the equivalent annual annuity for each project.
c. Which project should be selected? Why?
6. Risk Adjustment and Project Selection. Acme Mfg is considering two projects, A & B, with
cash flows as shown below:
period CFA CFB

0 -50,000 -100,000
1 20,000 60,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
The opportunity cost of capital for A is 14 percent. The opportunity cost of capital for B is 10
percent.
a. Calculate the NPV for each project.

b. Calculate the IRR for each project.
c. Which project(s) should be accepted in each of the following situations:
(1) The projects are mutually exclusive and there is no capital constraint.
(2) The projects are independent and there is no capital constraint.
(3) The projects are independent and there is a total of $100,000 of financing for capital outlays
in the coming period.
d. Explain why the cost of capital for A might be higher than for B.
8. Replacement project: Existing machine was purchased 2 years ago at a cost of $3,200. It is
being depreciated straight line over its 8 year life. It can be sold now for $3,000 or used for 6
more years at which time it will be sold for an estimated $500. It provides revenue of $5,000
annually and cash operating costs of $2,000 annually.
A replacement machine can be purchased now for $7,800. It would be used for 6 years, and
depreciated straight line. It will result in additional sales revenue of $1,500 annually, but
because of its increased efficiency it would reduce cash operating costs by $600 per year. The
new machine would require additional inventories of $700, and accounts receivable would
increase by $300. Its expected salvage value in 6 years is $2,000.
The tax rate is 40% and the required rate of return is 13%. Should the old machine be replaced?
a. Calculate the incremental cash flow at time 0.
b. Calculate the incremental annual operating cash flows that result from the new machine.
c. Calculate the incremental terminal cash flow.
d. Show the incremental CFs in the table below.
Year Cash Flow

0 ________
1 ________
2 ________
3 ________
4 ________
e. Calculate the NPV for this project.

9. Capital Budgeting Scenario Analysis

Acme Mfg. is considering a project that requires initial investment of $9,600 and has a 4-year
life. Acme’s corporate weighted average cost of capital (WACC) is 10%.
The probability distribution of annual operating cash flows (over its 4-year life) is shown below.
There are no other cash flows associated with the project.
Scenario prob Ann CF NPV @ that Ann CF
Worst Case .3 $2,500 -$1,675
Most Likely .4 3,000 -90
Best Case .3 4,000 $3,079
a. Calculate the expected NPV.
b. Calculate the standard deviation of NPV.
c. Calculate the coefficient of variation (CV) of NPV.
Acme classifies projects into high, average, or low risk according to the CV of NPV as shown
below:
CV risk
Below 2 low
Between 2 and 3 average
Above 3 high
To determine the risk-adjusted discount rate (RADR) for each project, Acme adds or subtracts
2% to the corporate WACC based on the CV.
d. What is the RADR for this project?
e. Calculate the expected NPV using the RADR.
f. Should the project be accepted or rejected? State what your decision is based on.
Sample Capital Budgeting Problems
10 A company is considering a project that requires an initial investment of $24M to

build a new plant and purchase equipment. The investment will be depreciated as a
MACRS 7-year class asset. The new plant will be built on some of the company's
land which has a current, after-tax market value of $4.3M. The company will
produce units at a cost of $130 each and will sell them for $420 each. There are
annual fixed costs of $0.5M. Unit sales are expected to be 150,000 each year for the
next 6 years, at which time the project will be abandoned. At that time, the plant
and equipment is expected to be worth $8M (before tax) and the land is expected to
be worth $5.4M (after tax). To supplement the production process, the company
will need to purchase $1M worth of inventory. That inventory will be depleted
during the final year of the project. Cost of capital is 15%. The company's marginal
tax rate is 40%. Should the project be accepted?
11. A company is considering the purchase of new equipment to replace some old,
existing equipment. The old equipment is fully depreciated and has a current market
value of $1.2M. The new equipment costs $10.4M and will be depreciated using the
5 year MACRS class. The equipment is used to produce items with constant annual
revenues of $18M. Current costs (using the old equipment) are $3M per year. The
new equipment will not change the expected revenues (they will remain at $18M
per year), but will allow the company to cut costs by $1M per year. The project is
expected to last for 4 years, at which time the new equipment would be worth
$6.0M. If the old equipment is kept, it will be worthless in 4 years. The company's
marginal tax rate is 35%. Cost of capital is 15%. Should the project be accepted?
12. A firm is considering a project that requires an investment of $10M in equipment.

The equipment will be depreciated using the 3-year MACRS class, but will be used for
a five year project. At the end of the project, the equipment should be worth $3M.
The equipment will be used to produce items at a cost of $35 each. Those items will
be sold for $60 each. Projected sales are 60,000 each year. Historically, the firm has
maintained an inventory to sales ratio of 0.1 (measured in units, not dollars). The
firm's marginal tax rate is 35% and its WACC is 12%. Should the firm take the
project?
13. A company is considering two projects and can only accept one of them. The
projected cash flows are as follows:
Year Project A Cash Flow Project B Cash Flow
0 -$10,000,000 -$15,000,000
3 $15,000,000 $21,700,000
The company's WACC is 10%. Compute the payback, NPV, and IRR for each project. Which
project should be chosen? Explain the logic behind your choice.
FINANCIAL MANAGEMENT FORMULA SHEET
FCF1 FCF2 FCF r  r *  IP  DRP  LP  MRP

Value =   ... 
( 1  WACC ) ( 1  WACC )2
( 1  WACC )
rTbill r RF  r * IP
FVn  PV(1  i) n  PV(FVIFi,n )
I1  I 2  ...  I n
IPn 
1 n
PV0  FVn  FV(1  i) -n  FV(PVIFi,n )
(1  i) n
m
 i 
EAR  1  nom   1
(1  i) n  1  m 
FVA n  PMT   PMT  (FVIFA i,n )
i mn
 i  PMT
FVn  PV1  nom  PV 
FVAD n  FVA n  (1  i)  PMT  (FVIFA i,n )  (1  i)  m  i
1  (1  i) -n n n
PVA 0  PMT 
i
 PMT  (PVIFA i,n ) r̂   Pi ri
i 1
 ( r  ˆr ) P
i 1
i
2
i
PVAD 0  PVA 0  PMT  (PVIFA i,n )  (1  i) n
( r t  r Avg )2

 t 1
CV 
t
 1 
  CFt PVIFi ,t 
n n
PV   CFt  n 1 ˆr
t 1  1  i  t 1
n
ˆrP   w iˆri = w AˆrA  ( 1  w A )ˆrB
FV   CFt 1  i   CFt FVIFi ,t 
n n
t
i 1
t 1 t 1
n
NOWC = OCA – OCL NOWC = C + AR + IN – AP – ACRU Cov( AB )   ( rAi  ˆrA )( rBi  ˆrB )P
t 1
NOPAT = EBIT (1-T)

n
Cov AB
FCF = NOPAT + Depreciation – Gross investment in operating capital  AB   P   w ii
AB i 1
MVA = Market value of stock + market value of debt – total capital
EVA = EBIT(1-T) – NOWC*WACC = (Operating capital)(ROIC – WACC)
Cov( ri , rM )  i 
bi    iM
 r  ˆrp  Pi = w   ( 1  w A )   2w A ( 1  w A ) AB A  B
n
p 
2
2M 
2 2 2 2
pi A A B  M
i 1
 ˆr  r  D ps
N
INT M 1  ( 1  rd ) N M ˆrp  rRF   M RF p rps 
VB     INT    M  Vps
t 1 ( 1  rd ) ( 1  rd ) ( 1  rd )N
t N
rd
2N
INT 2 M N
INT Call price ri  rRF  (rM  rRF )i  rRF  RPM i
VB    VB   
t 1 ( 1  rd 2 ) ( 1  rd 2 )2 N (1  rd ) (1  rd ) N
t t
t 1
D1
rs  rRF  (RPM )Firm ˆrS  g
P0
ˆ  D1  D 0 (1  g)

Dt D ps ˆ D1
P̂0   P Vps  re  g
t 1 (1  rs ) t
0
rs  g rs  g rps P0 (1  F )
WACC = wdrd(1-T) + wpsrps + wce*rs

D N1
ˆ  D1 D2 DN r g
  ...   s N
n
CFt
P0
1  rs  1  rs 
1 2
1  rs N 1  rs  NPV    CF0
t 1 (1  r )t
Unrecov ered costatstartofyear

Paybacks  Yearbeforefullrecov ery  PVoutflows 
FV inf lows
Cashflowduringyear
(1 MIRR)n
CA Sales
CR  Inventoryturnoverratio  EBIT NI
CL Inventories BEP  ROA 
TA TA
CA  Inventories AR NI
QR  DSO  Pr ofitM arg in  NI Sales TA
CL Sales / 365 Sales ROE  x x
Sales TA CE
Sales D/ A D/ E
Totalassetturnoverratio  D/ E D/ A CGS
TA 1 D / A 1 D / E Sales 
1 GPM
Pr icepershare NI Sales NI
P/ E  ROA  x ROE 
Earningpershare Sales TA CE
NWC = CA – CL TA = CA + NFA
Table 1:
MACRS Rates--Half-Year Convention
Recovery Period
Year 3 years 5 years 7 years 10 years 15 years

1 33.33% 20.00% 14.29% 10.00% 5.00%
2 44.45% 32.00% 24.49% 18.00% 9.50%
3 14.81% 19.20% 17.49% 14.40% 8.55%
4 7.41% 11.52% 12.49% 11.52% 7.70%
5 11.52% 8.93% 9.22% 6.93%
6 5.76% 8.92% 7.37% 6.23%
7 8.93% 6.55% 5.90%
8 4.46% 6.55% 5.90%
9 6.56% 5.91%
10 6.55% 5.90%
11 3.28% 5.91%
12 5.90%
13 5.91%
14 5.90%
15 5.91%
16 2.95%
Table 2:
MACRS Rates--Mid-Quarter Convention--First Quarter
Recovery Period

1 58.33% 35.00% 25.00% 17.50% 8.75%
2 27.78% 26.00% 21.43% 16.50% 9.13%
3 12.35% 15.60% 15.31% 13.20% 8.21%
4 1.54% 11.01% 10.93% 10.56% 7.39%
5 11.01% 8.75% 8.45% 6.65%
6 1.38% 8.74% 6.76% 5.99%
7 8.75% 6.55% 5.90%
8 1.09% 6.55% 5.91%
9 6.56% 5.90%
10 6.55% 5.91%
11 0.82% 5.90%
12 5.91%
13 5.90%
14 5.91%
15 5.90%
16 0.74%
Table 3:
MACRS Rates--Mid-Quarter Convention--Second Quarter
Recovery Period

1 41.67% 25.00% 17.85% 12.50% 6.25%
2 38.89% 30.00% 23.47% 17.50% 9.38%
3 14.14% 18.00% 16.76% 14.00% 8.44%
4 5.30% 11.37% 11.97% 11.20% 7.59%
5 11.37% 8.87% 8.96% 6.83%
6 4.26% 8.87% 7.17% 6.15%
7 8.87% 6.55% 5.91%
8 3.33% 6.55% 5.90%
9 6.56% 5.91%
10 6.55% 5.90%
11 2.46% 5.91%
12 5.90%
13 5.91%
14 5.90%
15 5.91%
16 2.21%
Table 4:
MACRS Rates--Mid-Quarter Convention--Third Quarter
Recovery Period

1 25.00% 15.00% 10.71% 7.50% 3.75%
2 50.00% 34.00% 25.51% 18.50% 9.63%
3 16.67% 20.40% 18.22% 14.80% 8.66%
4 8.33% 12.24% 13.02% 11.84% 7.80%
5 11.30% 9.30% 9.47% 7.02%
6 7.06% 8.85% 7.58% 6.31%
7 8.86% 6.55% 5.90%
8 5.53% 6.55% 5.91%
9 6.56% 5.90%
10 6.55% 5.90%
11 4.10% 5.91%
12 5.90%
13 5.91%
14 5.90%
15 5.91%
16 3.69%
Table 5:
MACRS Rates--Mid-Quarter Convention--Fourth Quarter
Recovery Period

1 8.33% 5.00% 3.57% 2.50% 1.25%
2 61.11% 38.00% 27.55% 19.50% 9.88%
3 20.37% 22.80% 19.68% 15.60% 8.89%
4 10.19% 13.68% 14.06% 12.48% 8.00%
5 10.94% 10.04% 9.98% 7.20%
6 9.58% 8.73% 7.99% 6.48%
7 8.73% 6.55% 5.90%
8 7.64% 6.55% 5.90%
9 6.56% 5.90%
10 6.55% 5.91%
11 5.74% 5.90%
12 5.91%
13 5.90%
14 5.91%
15 5.90%
16 5.17%
Table 6:
Residential Real Property--27.5 Years
Recovery Period
Month Placed Year

in Service 1 2-9 10 11 12 13-27 28 29
1 3.485% 3.636% 3.637% 3.636% 3.637% * 1.970% --
2 3.182% 3.636% 3.637% 3.636% 3.637% * 2.273% --
3 2.879% 3.636% 3.637% 3.636% 3.637% * 2.576% --
4 2.576% 3.636% 3.637% 3.636% 3.637% * 2.879% --
5 2.273% 3.636% 3.637% 3.636% 3.637% * 3.182% --
6 1.970% 3.636% 3.637% 3.636% 3.637% * 3.485% --
7 1.667% 3.636% 3.637% 3.636% 3.637% * 3.636% 0.152%
8 1.364% 3.636% 3.637% 3.636% 3.637% * 3.636% 0.455%
9 1.061% 3.636% 3.637% 3.636% 3.637% * 3.636% 0.758%
10 0.758% 3.636% 3.637% 3.636% 3.637% * 3.636% 1.061%
11 0.455% 3.636% 3.637% 3.636% 3.637% * 3.636% 1.364%
12 0.152% 3.636% 3.637% 3.636% 3.637% * 3.636% 1.667%
*In years 13-27, the rate alternates between 3.636% and 3.637%.
Residential property is property rented out for nontransient living purposes.

Table 7:
Nonresidential Real Property--39 Years
Recovery Period
Month Placed Year

in Service 1 2-39 40
1 2.461% 2.564% 0.107%
2 2.247% 2.564% 0.321%
3 2.033% 2.564% 0.535%
4 1.819% 2.564% 0.749%
5 1.605% 2.564% 0.963%
6 1.391% 2.564% 1.177%
7 1.177% 2.564% 1.391%
8 0.963% 2.564% 1.605%
9 0.749% 2.564% 1.819%
10 0.535% 2.564% 2.033%
11 0.321% 2.564% 2.247%
12 0.107% 2.564% 2.461%
Nonresidential property includes all property not used for dwelling purposes. That includes offices,
stores, warehouses, hotels and motels, etc. It also includes the portion of a home used for business.

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Introduction of Corporate Finance (FM/IBF) 1

Chapter One Fundamentals of Finance Page 1

Chapter Two Financial Statement Page 8

Chapter Three Financial Statement Analysis Page 11

Chapter Four Short Term Financial Planning Page 37

Chapter Seven Stock Valuation Page 121

Chapter Eight Capital Budgeting Page 147

FINANCIAL MANAGEMENT FORMULAE SHEET page 183-184

FINANCIAL RATIOS FORMULAE Page 185-187

MACRS TABLES Page 188 – 191

Present value interest factor of an (ordinary) annuity of $1 per period

at i% for n periods, PVIFA(i,n). page 193

Future value interest factor of an ordinary annuity of $1 per period

at i% for n periods, FVIFA(i,n). page 195

Chapter One Fundamentals of Finance

Why study finance?

 Why saving is important today for future plans?

There are mainly three types of firms:

Key features of a sole proprietorship.

Tax Implications for Corporate Entities

1. Make investment decisions.

The Goal of the Financial Manager

The Corporate Management Team

THE MONEY MARKET

Most money market transactions are made in marketable securities—short-term debt

THE CAPITAL MARKET

As we know, shares of common stock are units of ownership, or equity, in a corporation.

Chapter Two FINANCIAL STATEMENT

Q No.1 Saleem provided following Trial Balance on December 31, 2015.

TITLE OF ACCOUNT DEBIT CREDIT

1. Mds.inventory ending Rs.45,000

Required: Prepare Income Statement

1. Inventory on hand at the end of the year $ 42,000

Title of Accounts Debit Credit

2. Inventory on hand at the end of the year Rs. 12,000.

Chapter Three FINANCIAL STATEMENT ANALYSIS

TYPES OF RATIO COMPARISONS

Two types of ratio comparisons can be made, cross-sectional and time-series.

Cross-sectional analysis involves the comparison of different firms’ financial ratios at

Time-series analysis evaluates performance over time. Comparison of current to past

CATEGORIES OF FINANCIAL RATIOS

Assets Rs. Equities Rs.

Earnings before interest and

Taxable Income $13,280

Taxes (35%) 4,648

Current Ratio = Current assets/current liabilities

Quick Ratio = Current Assets-Inventory/Current Liability

Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. It

(a) Cost of Goods Sold/Average Inventory = Times

(b) Inventory in days = 365 days/……Times = days

Inventory in days = Average inventory *365/ Cost of goods sold

The average collection period, or average age of accounts receivable, is useful in

(a) Sales/Average A/c Receivable = Times

(b) 365 days/ Times = days

Average A/c Receivable *365/Sales

AVERAGE PAYMENT PERIOD

(a) Purchases /Average A/c Payable = Times

(b) 365 days / Times = days

You can use alternative formulae to calculate days:

Average A/c Payable *365/ Purchases

TOTAL ASSET TURNOVER

Assets Turnover = Sales /Total Assets

Fixed Assets Turnover Ratio