INTRODUCTION

Financial Management – means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.

Types of Finance

1. Personal Finance
2. Corporate Finance
3. Public Finance

Nature of Financial Management

 Financial management also referred to as managerial finance, corporate finance and business
finance is a decision-making process concerned with planning, acquiring, and utilizing funds in a
manner that achieves the firm’s desired goals.
 It is also described as the process for and the analysis of making financial decisions in the
business context.

PLANNING - ACQUIRING - UTILIZING FUNDS - DESIRED GOALS

Scope of Financial Management

 Procurement of short-term and long-term funds from financial institutions

 Mobilization of funds through financial instruments such as equity shares, preference shares,
debentures, bonds, notes, and so forth.
 Compliance with legal and regulatory provisions relating to funds procurement, use and
distribution as well as coordination of the finance function with the accounting function.

THREE MAJOR SPHERES OF FINANCIAL MANAGEMENT

1. PROCUREMENT OF FUNDS
2. ALLOCATION OF FUNDS
3. EFFICIENT AND EFFECTIVE MANAGEMENT OF CAPITAL

Financial Management Decisions

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working capital
decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.
3. Dividend decisions - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
1) Dividend for shareholders- Dividend and the rate of it has to be decided.
2) Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise
Objectives of Financial Management

1) To ensure regular and adequate supply of funds to the concern.

2) To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
3) To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
4) To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate
rate of return can be achieved.
5) To plan a sound capital structure, there should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.

Functions of Financial Management

1) Estimation of capital requirements – A finance manager has to make estimation with regards to
capital requirements of the company. This will depend upon expected costs and profits and
future programs and policies of a concern. Estimations have to be made in an adequate manner
which increases earning capacity of enterprise.
2) Determination of capital composition – Once the estimation has been made, the capital
structure has to be decided. This involves short- term and long- term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
3) Choice of sources of funds – For additional funds to be procured, a company has many choices:
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

4) Investment of funds - The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investmentand regular returns is possible.
5) Disposal of surplus - The net profits decision has to be made by the finance manager. This can
be done in two ways:
a. Dividend declaration - Itincludes identifying the rate of dividends and other benefits like
bonus.
b. Retained profits – The volume has to be decided which will depend upon expansion,
innovational, diversification plans of the company.
6) Management of cash – Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
7) Financial controls – The finance manager has not only to plan, procure and utilize the funds but
he also has to exercise control over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.
Significance of Financial Management

 Broad applicability – Financial management is equally applicable to all forms of business like
sole proprietorships, partnerships and corporations. It is also applicable to non-profit
organizations like trust, societies, government organizations, public sectors and so forth.
 Reduction of chances of failure – The strength of business lies in its financial discipline. Finance
function is treated as primordial which enables the other functions like production, marketing,
purchase, and personnel to be effective in the achievement of organizational goals and
objectives.
 Measurement of return on investment – Financial management studies the risk-return
perception of the owners and the time value of money. It considers the amount of cash flows
expected to be generated for the benefit of the owners, the timing of these cash flows and the
risk attached to these cash flows.

Role of a Financial Manager

 must work closely with financial personnel

 must track how money is flowing into and out of the firm
 will track day-to-day operational data
 will thoroughly study whether and when the company should open a new manufacturing facility
 will also suggest the most appropriate way to finance the project, raise the funds, and then
monitor the project’s implementation and operation
 use financial statements and other information prepared by accountants to make financial
decisions
 focus on cash flows, the inflows and outflows of cash. They plan and monitor the firm’s cash
flows to ensure that cash is available when needed.

Finance manager is expected to analyze the business firm and determine the following:

 The total funds requirements of the firm

 The assets or resources to be acquired
 The best pattern of financing the assets

Financial Manager’s Responsibilities and Activities

1. They analyze financial data prepared by accountants, monitor the firm’s financial status, and
prepare and implement financial plans.
2. One day they may be developing a better way to automate cash collections, and the next they
may be analyzing a proposed acquisition.

The key activities of the financial manager are:

1. Financial planning: Preparing the financial plan, which projects revenues, expenditures, and
financing needs over a given period.
2. Investment (spending money): Investing the firm’s funds in projects and securities that provide
high returns in relation to their risks.
 3. Financing (raising money): Obtaining funding for the firm’s operations and investments and
seeking the best balance between debt (borrowed funds) and equity (funds raised through the
sale of ownership in the business).

The main goal of the financial manager is to maximize the value of the firm to its owners.

To maximize the firm’s value, the financial manager has to consider both shortand long-term
consequences of the firm’s actions.

Finance Department Functions

 basic bookkeeping to providing information to assisting managers in making strategic decisions

 bookkeeper will be responsible for all the day-to-day transactional accounting for the business
 responsible for management of the organization’s cash flow and ensuring there are enough
funds available to meet the day-to-day payments
 responsible for advising and sourcing longer term financing
 contribute to the management and improvement of the operations by measuring and reporting
regularly on key numbers crucial to the success of the organization
 will work with managers to prepare the organization’s budgets and forecasts, and to report back
on the progress against these throughout the year.
 should be called upon to provide information to assist managers in making key strategic
decisions, such as which markets or projects to pursue or the payback periods for large capital
purchases
 should be considered a resource to assist managers in the running of the business

Primary Goals of a Business

1. To earn a profit
 Positive bottomline
 EPS
2. To increase its own value as an economic entity
 Growth
o Increase in assets that appreciate in value
o Improved production capacity
o Increase in sales volume
o Increase in owners’ equity
 Stability
o The ability to weather economic crises or continue operations despite
anticipated risks in a business
o Margin of safety
3. To improve the quality of life in the community
 Emphasis on the social responsibility of business
o CSR
 Multiplier effect of businesses in a community
o Provide employment
o Affects the earning power of people directly involved in the business activities
o Increased demand for goods and services; promotes entrepreneurship
The art and science of managing the financial resources of a business.

 Allocation of financial resources

o Evaluate project proposals esp. risks
o Capital requirements
o Effects on the business
 Procurement of Funds
o Obtain funds at the least possible cost
o Cost of capital: interest, dividends, financing charges
 Efficient and effective utilization of financial resources
o Efficient:
 Refers to their economic use
 Financial resources are being used for what they have been intended
e.g. unnecessary expenditures, tardiness, nonproductive resources
o Effective:
 Use of resources towards the attainment of predetermined objectives
 Attain short-term and long-term goals

Sources of Data: Financial Reports

We find most historical data in the annual and quarterly reports released by the management.

Financial statements are required by law and must include a balance sheet, an income statement, a
statement of cash flows, an auditor's report, and a relatively detailed description of the company's
operations and prospects for the upcoming year.

The following information is presented in most financial reports, note that the order in which these are
presented might vary:

 Summary of the previous year.

 Information about the company in general, its history, products and line of business.
 Letter to shareholders from the President or the CEO.
 Auditor's report telling you that the results are accurate.
 An in-depth discussion about the financial results and other factors within the business.
 The complete set of financial statements (balance sheet, income statement, statement
of retained earnings, and cash flow statement)
 Notes to the Financial Statements.
 Other information on the company's management, officers, offices, new locations, etc.

The balance sheet highlights the financial condition of a company at a single point in time. This is
important, the cash flow and income statements record performance over a period of time, while the
balance sheet is a snapshot in time.

The income statement is the most popular financial statement in an annual or quarterly report. The
income statement is the "sexy" portion of the financial statements because it includes figures such as
revenue, net income, and earnings per share (EPS).
In essence, an income statement tells you how much money a company brought in (its revenues), how
much it spent (its expenses), and the difference between the two (its profit/loss), over a specified time.

Cash flow is similar to the income statement in that it records a company's performance over a specified
period of time, usually over the quarter or year.

The difference between the two is that the income statement also takes into account some non-cash
accounting items such as depreciation. The cash-flow statement strips away all of this and tells you how
much actual money the company has generated.

Cash flow shows us how the company has performed in managing inflows and outflows of cash. It
provides a sharper picture of the company's ability to pay bills, creditors, and finance growth.

The notes to the financial statements (sometimes called footnotes) are also an integral part of the
overall picture. If the income statement, balance sheet and statement of cash flows are the heart of the
financial statements, then the footnotes are the arteries that keep everything connected. If you aren't
reading the footnotes you're missing out on a lot of information.

The footnotes list important information that could not be included in the actual ledgers. The notes will
list relevant things like outstanding leases, the maturity dates of outstanding debt, and even details on
where the revenue actually came from.

(Accounting Methods, Disclosure)

LECTURE 2

Organizing a Business Based on ownership - GOCC, public or private

(non-public)
Promotion refers to the activities involved in
making a business ready to operate stages: Based on its relation to another corp. - Parent,
affiliate or subsidiary
 Discovery
 Financing
 Assembling
Components
Feasibility Study - a thorough and systematic
 Corporators
analysis of all factors to ascertain the viability of
 Incorporators
an undertaking
 Stockholders
 Marketing  Member
 Organization and Management  Board of Directors / Trustees
 Technical
Types of stock
 Financing
 Financial Aspects  Common and preferred
 Socio-economic benefits  Class “A” and class “B”
 Par and no-par
Corporations
 Founders’
Classifications

Based on nature of capital - Stock or non-stock

Financial Planning - Refers to the process of Main questions
determining the best uses of the financial
 Where are we now?
resources of an organization to attain its
predetermined objectives  How did we get here?
 Where do we want to go?

Budgeting - The process of translating a plan, in quantitative terms.

A budget is a formal statement of a planned course of action expressed in quantitative terms.

Objectives

Planning - Profit plan, budgeted balance sheets, capex budgets, cash budget

Coordination - Synchronization of the different levels of management

Control - Provides management with a yardstick in evaluating performance

Financial Analysis (percentage)

 Refers to the examination of financial data of an entity to determine its profitability, growth,
solvency, stability, and effectiveness of management
 Horizontal analysis
 Vertical analysis
 Cost-volume profit analysis

Comparative Statements - Show the increases or decreases in account balances and their corresponding
percentages

Common size statements - A statement wherein each item is expressed in terms of a percentage of a
common base number

Ratio Analysis

Profitability ratios: (times, the higher = the better)

 ROA= net income ÷total assets

 ROE= net income ÷stockholders’ equity
 ROS= net income ÷sales
 Gross Profit margin= GP ÷sales
 Net Profit margin= (GP-opex) ÷sales
 Operating Cash flow to income= operating cash flow ÷sales

Utilization & efficiency ratios (times/days)

 Asset turnover= sales ÷assets

  A/R turnover= Net credit sales ÷A/R
 Inventory turnover=Cost of sales ÷Inventory
 Fixed Asset turnover= Sales ÷fixed asset
 Average collection period = 360/AR Turnover

Liquidity ratios: (higher = better)

 Current ratio: Current assets ÷current liabilities

 Quick ratio: (CA-inventory) ÷current liabilities
 Cash Ratio: (Cash +cash equivalents +marketable securities) ÷current liabilities

Solvency ratios: (lower = better)

 Debt to equity ratio: Total Liabilities ÷Total equity

 Long-term debt to equity ratio= Long-term liabilities ÷Total equity
 Times interest earned=EBIT ÷interest expense
 Financial Leverage ratio: Total assets ÷Common equity

Financial Market ratios:

 EPS: (Net income-preferred dividends) ÷No. of common shares outstanding

 Dividends per share: Dividends paid ÷no. of common shares outstanding
 Book value per share= Book value ÷no. of common shares outstanding
 P/E ratio= market price per share ÷EPS (times)
 Dividend payout ratio: Dividends paid ÷net income
 Price-to-book ratio: market price per share ÷book value per share
 Dividend yield: Dividends per share ÷market price per share (%)

Cost-Volume Profit Analysis

Break-even point analysis - The level of activity (production and sales) at which the company would be
able to avoid a loss. Requires analysis of costs whether fixed or variable.

 Fixed: costs that do not change as sales or production volume changes

 Variable: costs that change as sales or production volume changes
 Sales – Variable Cost = Contribution Margin
 Contribution Margin – Fixed Cost = Net Income

Contribution margin - The difference between sales and variable cost (amount available to pay fixed
cost)

Break-even point: Sales volume - Fixed costs÷Contribution margin per unit

Break-even point: Peso sales - Fixed costs÷Contribution margin percentage

cm per unit = cm/# of units sold

cm % = cm ÷ sales or cm/sales (per unit) ÷ selling price

EXAMPLE:

 Selling Price: ₱40

 VC/unit: ₱30
 FC = ₱80,000

BEP sv = fc÷CMperunit = 80,000/40-30 = 8,080 units

BEP ps = fc÷cm% = 80,000/10÷40 = 80,000/.25 = ₱320,000

Confirm:

Sales: 8,000×40 = 320,000

VC: 8,000×30 = -240,000

CM = 80,000

FC: -80,000

NI: 0

RISK ANALYSIS AND CAPM

Risk – a four-letter word

Risk/Uncertainty: Both concepts deal with the probability of loss or the chance of adverse outcomes

Risk: All possible outcomes of managerial decisions and their probabilities are not completely known

Uncertainty: The possible outcomes and their probabilities are known

General Risk Categories

 Business Risk – the chance of loss associated with a given managerial decision; typically, a by-
product of the unpredictable variation in product demand and cost conditions
 Market Risk – the chance that a portfolio of investments can lose money because of overall
swings in financial markets
 Inflation Risk – the danger that a general increase in the price level will undermine the real
economic value of corporate agreements
 Interest-rate Risk – another type of market risk that can affect the value of corporate
investments and obligations
 Credit Risk – the chance that another party will fail to abide by its contractual obligations
 Liquidity Risk – the difficulty of selling corporate assets or investments that have only a few
willing buyers or are otherwise not easily transferable at favorable prices under typical market
conditions
 Derivative Risk – the chance that volatile financial derivatives such as commodity futures and
index options could create losses by increasing rather than decreasing price volatility
  Currency Risk – the chance of loss due to changes in the domestic currency value of foreign
profits

Probability: likelihood of particular outcome occurring, denoted by p. The number p is always between
zero and one.

Frequency: estimate of probability, p=n/N, where n is number of times a particular outcome occurred
during N trials.

Subjective probability: If we do not have frequency, we often resort to informed guesses. Subjective
probabilities must follow the same rules of the probability calculus, if we are dealing with rational
decision-makers.

Probability Distribution

Discrete probability distribution: deals with “events” whose “states of nature” are discrete. The
“event” is the state of the economy. The “states of nature” are recession, normal, and boom.

Continuous probability distribution: deals with “events” whose “states of nature” are continuous
values. The “event” is profits, and the “states of nature” are various profit levels.

Event P
(probabilty)
State of Economy

Recession 0.2

Normal 0.6

Boom 0.2

Payoff Matrix: A table that shows outcomes associated with each possible state of nature

State of Economy Project A Project B Probability of State of Economy

Recession $4,000 $0 0.2

Normal $5,000 $5,000 0.6

 Boom $6,000 $12,000 0.2

Project A more desirable in a recession.

Project B more desirable in a boom.

In a normal economy, the projects offer the same profit potential.

Decision to Make: A firm must choose only one of the two investment projects (choose Project A or
Project B). Each calls for an outlay of $10,000.

Expected Value

 The payoffs of all events: x1, x2, …, xN

 The probability of each event: p1, p2, …, pN
 Expected value of x:
EV(x) is a weighted-average payoff, where the weights are defined by the probability distribution.
 Use the payoff matrix in the previous slide, together with the probability of each state of the
economy.
Expected profit of Project A and B under different economic states of nature

Variance and Standard Deviation: measuring risk

The payoffs of all events: x1, x2, …, xN

The probability of each event: p1, p2, …, pN

Expected value of x:

Variance:

Standard deviation: square root of variance

For project A, what are the variance and standard deviation? EV(A) = $5,000

Variance (σ2) = ($4,000-5,000)2 (.2) + ($5,000-$5,000)2 (.6) + ($6,000-$5,000)2 (.2)

(σ2) = ($1,000)2 (.2) + ($0)2 (.6) + ($1,000)2 (.2)

(σ2) = $400,000 (units are in terms of squared dollars)

σA = $632.46

For project B, what are the variance and standard deviation? EV(B) = $5,400

Variance (σ2) = ($0-5,400)2 (.2) + ($5,000-$5,400)2 (.6) + ($12,000-$5,400)2 (.2)

(σ2) = 5,832,000 + 96,000 + 8,712,000 (units are in terms of squared dollars)

(σ2) = 14,640,000 (units are in terms of squared dollars)

σB = $3,826.23

Project B has a larger standard deviation; therefore, it is the riskier project

Risk Measurement

Absolute Risk: Relative Risk

- Overall dispersion of possible payoffs - Variation in possible returns compared with

- Measurement: variance, standard deviation
- The smaller variance or standard deviation,
the lower the absolute risk.
the expected payoff amount
- Measurement: coefficient of Variation (CV),
- The lower the CV, the lower the relative risk.

Project A σ B = $3,826.23
EV(A) = $5,000
σA = $632.46 Coefficient of variation
CVA = = 0.1265
Project B CVB = = 0.7086
EV(B) = $5,400

Coefficient of variation measures the relative risk; the variation in possible returns compared with the
expected payoff amount.

Risk Attitudes

 Risk Aversion - characterizes decision makers who seek to avoid or minimize risk.
 Risk Neutrality - characterizes decision makers who focus on expected returns and disregard the
dispersion of returns.
  Risk Seeking (Taking) - characterizes decision makers who prefer risk.

Decision-making under risk

Possible Criteria to consider: - Minimize coefficient of variation

- Maximize expected value - Maximin criterion

- Minimize variance or standard deviation - Minimax criterion

*GAME THEORY, MAXIMIN AND MINIMAX NOT INCLUDED ON DEPARTMENTALS*

Risk and Return Fundamentals: Risk Defined in Finance

Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more
formally, the variability of returns associated with a given asset.

Return is the total gain or loss experienced on an investment over a given period of time; calculated by
dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of-period
investment value.

The expression for calculating the total rate of return earned on any asset over period t, rt, is commonly
defined as

where

rt = actual, expected, or required rate of return during period t

Ct = cash (flow) received from the asset investment in the time period t – 1 to t

Pt = price (value) of asset at time t

Pt – 1 = price (value) of asset at time t – 1

Example:

At the beginning of the year, Apple stock traded for $90.75 per share, and Wal-Mart was valued at
$55.33. During the year, Apple paid no dividends, but Wal-Mart shareholders received dividends of
$1.09 per share. At the end of the year, Apple stock was worth $210.73 and Wal-Mart sold for $52.84.

We can calculate the annual rate of return, r, for each stock.

Apple: ($0 + $210.73 – $90.75) ÷ $90.75 = 132.2%

Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 = –2.5%

Risk of a Single Asset: Risk Assessment

Scenario analysis is an approach for assessing risk that uses several possible alternative outcomes
(scenarios) to obtain a sense of the variability among returns.

One common method involves considering pessimistic (worst), most likely (expected), and optimistic
(best) outcomes and the returns associated with them for a given asset.

Range is a measure of an asset’s risk, which is found by subtracting the return associated with the
pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.

Example:

Norman Company wants to choose the better of two investments, A and B. Each requires an initial
outlay of $10,000 and each has a most likely annual rate of return of 15%. Management has estimated
the returns associated with each investment. Asset A appears to be less risky than asset B. The risk
averse decision maker would prefer asset A over asset B, because A offers the same most likely return
with a lower range (risk).

Risk of a Single Asset: Risk Measurement

Standard deviation (σr) is the most common statistical indicator of an asset’s risk; it measures the
dispersion around the expected value.

Expected value of a return (r) is the average return that an investment is expected to produce over
time.
where

rj = return for the jth outcome

Prt = probability of occurrence of the jth outcome

n = number of outcomes considered

Risk of a Single Asset: Standard Deviation

The expression for the standard deviation of returns, σr, is

In general, the higher the standard deviation, the greater the risk.

The Calculation of the Standard Deviation of the Returns for

Assets A and B
Risk of a Single Asset: Coefficient of Variation

The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risks
of assets with differing expected returns.

A higher coefficient of variation means that an investment has more volatility relative to its expected
return.

Using the standard deviations (from Table 8.4) and the expected returns (from Table 8.3) for assets A
and B to calculate the coefficients of variation yields the following:

CVA = 1.41% ÷ 15% = 0.094

CVB = 5.66% ÷ 15% = 0.377

Risk of a Portfolio: Portfolio Return and Standard Deviation

The return on a portfolio is a weighted average of the returns on the individual assets from which it is
formed.

where

wj = proportion of the portfolio’s total dollar value represented by asset j

rj = return on asset j

Example

James purchases 100 shares of Wal-Mart at a price of $55 per share, so his total investment in Wal-Mart
is $5,500. He also buys 100 shares of Cisco Systems at $25 per share, so the total investment in Cisco
stock is $2,500.

– Combining these two holdings, James’ total portfolio is worth $8,000.

– Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000) and 31.25% is invested in

Cisco Systems ($2,500/$8,000).

– Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

Risk of a Portfolio: Correlation

Correlation is a statistical measure of the relationship between any two series of numbers.

- Positively correlated describes two series that move in the same direction.
- Negatively correlated describes two series that move in opposite directions.

The correlation coefficient is a measure of the degree of correlation between two series.

- Perfectly positively correlated describes two positively correlated series that have a
correlation coefficient of +1.
- Perfectly negatively correlated describes two negatively correlated series that have a
correlation coefficient of –1.

Risk of a Portfolio: Diversification

- To reduce overall risk, it is best to diversify by combining, or adding to the portfolio,

assets that have the lowest possible correlation.
- Combining assets that have a low correlation with each other can reduce the overall
variability of a portfolio’s returns.
- Uncorrelated describes two series that lack any interaction and therefore have a
correlation coefficient close to zero.
Risk and Return: The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is the basic theory that links risk and return for all assets.

The CAPM quantifies the relationship between risk and return.

In other words, it measures how much additional return an investor should expect from taking a little
extra risk.

Risk and Return: The CAPM: Types of Risk

 Total risk is the combination of a security’s nondiversifiable risk and diversifiable risk.
 Diversifiable risk is the portion of an asset’s risk that is attributable to firm-specific, random
causes; can be eliminated through diversification. Also called unsystematic risk.
 Nondiversifiable risk is the relevant portion of an asset’s risk attributable to market factors that
affect all firms; cannot be eliminated through diversification. Also called systematic risk.
 Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable
risk, the only relevant risk is nondiversifiable risk

 The beta coefficient (b) is a relative measure of nondiversifiable risk. An index of the degree of
movement of an asset’s return in response to a change in the market return.

o An asset’s historical returns are used in finding the asset’s beta coefficient.

o The beta coefficient for the entire market equals 1.0. All other betas are viewed in
relation to this value.

*BETA IS GIVEN ON THE DEPARTMENTALS

 The market return is the return on the market portfolio of all traded securities.

● The beta of a portfolio can be estimated by using the betas of the individual assets it includes.

● Letting wj represent the proportion of the portfolio’s total dollar value represented by asset j,
and letting bj equal the beta of asset j, we can use the following equation to find the portfolio
beta, bp:
The betas for the two portfolios, bv and bw, can be calculated as follows:

bv = (0.10 × 1.65) + (0.30 × 1.00) + (0.20 × 1.30) + (0.20 × 1.10) + (0.20 × 1.25)

= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈ 1.20

bw = (0.10 × .80) + (0.10 × 1.00) + (0.20 × .65) + (0.10 × .75) + (0.50 × 1.05)

= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91

Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing model (CAPM) is
given in the following equation:

rj = RF + [bj × (rm – RF)]

where

rt = required return on asset j

RF = risk-free rate of return, commonly measured by the return on

a U.S. Treasury bill

bj = beta coefficient or index of nondiversifiable risk for asset j

rm = market return; return on the market portfolio of assets

The CAPM can be divided into two parts:

1. The risk-free rate of return, (RF) which is the required return on a risk-free asset,
typically a 3-month U.S. Treasury bill.

2. The risk premium.

• The (rm – RF) portion of the risk premium is called the market risk premium,
because it represents the premium the investor must receive for taking the

• average amount of risk associated with holding the market portfolio of assets.
Example

Benjamin Corporation, a growing computer software developer, wishes to determine the required
return on asset Z, which has a beta
of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting
bZ = 1.5, RF = 7%, and
rm = 11% into the CAPM yields a return of:

rZ = 7% + [1.5 × (11% – 7%)] = 7% + 6% = 13%

 The security market line (SML) is

the depiction of the capital asset
pricing model (CAPM) as a graph
that reflects the required return in
the marketplace for each level of
nondiversifiable risk (beta).
 It reflects the required return in the
marketplace for each level of
nondiversifiable risk (beta).
 In the graph, risk as measured by
beta, b, is plotted on the x axis, and required returns, r, are plotted on the y axis.

 The CAPM relies on historical data which means the betas may or may not actually reflect
the future variability of returns.
 Therefore, the required returns specified by the model should be used only as rough
approximations.
 The CAPM assumes markets are efficient.
 Although the perfect world of efficient markets appears to be unrealistic, studies have
provided support for the existence of the expectational relationship described by the CAPM
in active markets such as the NYSE.
BOND AND STOCK VALUATION

Long Term Debt - These are obligations that are to mature beyond one year. Examples are bonds and
stocks (although stocks are technically not considered as debt, they are a form of long-term financing).

The interest rate is usually applied to debt instruments such as bank loans or bonds; the compensation
paid by the borrower of funds to the lender; from the borrower’s point of view, the cost of borrowing
funds.

The required return is usually applied to equity instruments such as common stock; the cost of funds
obtained by selling an ownership interest.

Several factors can influence the equilibrium interest rate:

1. Inflation, which is a rising trend in the prices of most goods and services.
2. Risk, which leads investors to expect a higher return on their investment
3. Liquidity preference, which refers to the general tendency of investors to prefer short-
term securities

*NOMINAL RATES NOT INCLUDED ON DEPARTMENTALS*

 The term structure of interest rates is the relationship between the maturity and rate of return
for bonds with similar levels of risk.
 A graphic depiction of the term structure of interest rates is called the yield curve.
 The yield to maturity is the compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.

Bonds – It is defined as a certificate of indebtedness; Also known as a formal, unconditional promise to

pay a specified amount of money at a determinable future date and to make periodic interest payments
at a stated rate until the principal amount is paid.

 A bond is a long-term debt instrument indicating that a corporation has borrowed a certain
amount of money and promises to repay it in the future under clearly defined terms.
 The bond’s coupon interest rate is the percentage of a bond’s par value that will be paid
annually, typically in two equal semiannual payments, as interest.
 The bond’s par value, or face value, is the amount borrowed by the company and the amount
owed to the bond holder on the maturity date.
 The bond’s maturity date is the time at which a bond becomes due and the principal must be
repaid.
 The bond indenture is a legal document that specifies both the rights of the bondholders and
the duties of the issuing corporation.
 Standard debt provisions are provisions in a bond indenture specifying certain record-keeping
and general business practices that the bond issuer must follow; normally, they do not place a
burden on a financially sound business.
 Restrictive covenants are provisions in a bond indenture that place operating and financial
constraints on the borrower.
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan default.
 2. Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause
a long-run cash shortage if proceeds were used to meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed
assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or
additional borrowing may be subordinated to the original loan. Subordination means
that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
5. Limit the firm’s annual cash dividend payments to a specified percentage or amount.

Classification of Bonds

Main classifications:

 According to tenor: short-term, medium term and long term

 According to issuing entity: corporate, government
 According to maturity: straight, serial, convertible, callable
 According to payment of interest: Coupon bonds, zero-coupon
 According to coupon interest: fixed, floating
 According to transferability: bearer, registered, coupon

 In general, the longer the bond’s maturity, the higher the interest rate (or cost) to the firm.
 In addition, the larger the size of the offering, the lower will be the cost (in % terms) of the
bond.
 Also, the greater the default risk of the issuing firm, the higher the cost of the issue.
 Finally, the cost of money in the capital market is the basis for determining a bond’s coupon
interest rate.
General Features of a Bond Issue

 The conversion feature of convertible bonds allows bondholders to change each bond into a
stated number of shares of common stock.

o Bondholders will exercise this option only when the market price of the stock is greater
than the conversion price.

 A call feature, which is included in nearly all corporate bond issues, gives the issuer the
opportunity to repurchase bonds at a stated call price prior to maturity.

o The call price is the stated price at which a bond may be repurchased, by use of a call
feature, prior to maturity.

o The call premium is the amount by which a bond’s call price exceeds its par value.

Components of Bonds

There are three main parts to a bond:

 Face Value (P)

 Coupon rate (R)
 Maturity date (T)

These parts are integral to the understanding of bond valuation since at its simplest, we use the simple
interest formula to compute for the earnings from the bond.

Because most corporate bonds are purchased and held by institutional investors, such as banks,
insurance companies, and mutual funds, rather than individual investors, bond trading and price data
are not readily available to individuals.

 Although most corporate bonds are issued with a par, or face, value of $1,000, all bonds are
quoted as a percentage of par.
* A $1,000-par-value bond quoted at
94.007 is priced at $940.07
(94.007%  $1,000). Corporate bonds are
quoted in dollars and cents.
Thus, Company C’s price of 103.143 for the
day was $1,031.43—that is, 103.143% 
$1,000.
Valuation is the process that links risk and return to determine the worth of an asset.

There are three key inputs to the valuation process:

1. Cash flows (returns)

2. Timing
3. A measure of risk, which determines the required return

The value of any asset is the present value of all future cash flows it is expected to provide over the
relevant time period.

The value of any asset at time zero, V0, can be expressed as:
where

v0 = Value of the asset at time zero EXAMPLE

 Celia Sargent wishes to estimate the
CFT = cash flow expected at the end of year t value of three assets she is considering
investing in:
r = appropriate required return (discount rate)
 Stock in Michaels Enterprises Expect to
n = relevant time period receive cash dividends of $300 per year
indefinitely.
 Oil well Expect to receive cash flow of $2,000 at the end of year 1, $4,000 at the end of
year 2, and $10,000 at the end of year 4, when the well is to be sold.
 Original painting Expect to be able to sell the painting in 5 years for $85,000.
 With these cash flow estimates, Celia has taken the first step toward placing a value on each of
the assets.

 Consider two scenarios:

o Scenario 1—Certainty A major art gallery has contracted to buy the painting for $85,000
at the end of 5 years. Because this is considered a certain situation, Celia views this
asset as “money in the bank.” She thus would use the prevailing risk-free rate of 3% as
the required return when calculating the value of the painting. Oil well Expect to receive
cash flow of $2,000 at the end of year 1, $4,000 at the end of year 2, and $10,000 at the
end of year 4, when the well is to be sold.

o Scenario 2—High Risk The values of original paintings by this artist have fluctuated
widely over the past 10 years. Although Celia expects to be able to sell the painting for
$85,000, she realizes that its sale price in 5 years could range between $30,000 and
$140,000. Because of the high uncertainty surrounding the painting’s value, Celia
believes that a 15% required return is appropriate.

 In the case of Michaels stock, the annual cash flow is $300, and Celia decides that a 12%
discount rate is appropriate for this investment. Therefore, her estimate of the value of
Michaels Enterprises stock is

$300 ÷ 0.12 = $2,500

  Using a 20% required return, Celia estimates the
oil well’s value to be

* Finally, Celia estimates the value of the painting by discount the expected $85,000 lump sum
payment in 5 years at 15%

$85,000 ÷ (1 + 0.15)5 = $42,260.02

The basic model for the value, B0, of a bond is

given by the following equation:

Where EXAMPLE:

B0 = value of the bond at time zero
I = annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd = required return on a bond
Mills Company, a large defense contractor, on January
1, 2007, issued a 10% coupon interest rate, 10-year bond
with a $1,000 par value that pays interest semiannually.
* Investors who buy this bond receive the contractual
right to two cash flows: (1) $100 annual interest (10%
coupon interest rate  $1,000 par value) distributed as
$50 (1/2  $100) at the end of each 6 months, and (2) the
$1,000 par value at the end of the tenth year.

* Assuming that interest on the Mills Company bond issue is paid annually and that the required
return is equal to the bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000, and n = 10
years.

Bond Values

 A bond issuer has to determine the value of the bonds (or the price at which investors would be
willing to buy the bonds), which is dependent their desired rate of return.
 The value of the bonds is equal to the present value of future cash flows that an investor may
expect from the bond, discounted at their desired rate of return.
 Example: On January 1 2007, X Corp. issued 10%, 5-year bonds with face value of Php 1,000
each. Considering the risks involved, investors desire a 12% rate of return on their investments.
What should be the bond quotation to attract investors?
 Computation:
* VB: PV of annual interest of Php 100, discounted at 12% for 5 years + PV of Php 1,000
discounted at 12% for 5 years.
* VB = (Php 100 x 3.605) + (Php 1,000 x .567) = Php 360.50 + 567 = Php 927.50 or Php 928
  An investor in bonds may determine the approximate yield of the bond using the following
formula:
 AY= Interest per annum + [(principal – value)/n]/ (principal + value)/2
 AY = Php 100 + [(Php 1,000 – 928)/5]/ (Php 1,000 + 928)/2 =Php 100 + 14.40)/Php 964
=11.86%
 The yield to maturity (YTM) is the rate of return that investors earn if they buy a bond at a
specific price and hold it until maturity. (Assumes that the issuer makes all scheduled interest
and principal payments as promised.)
 The yield to maturity on a bond with a current price equal to its par value will always equal the
coupon interest rate.
 When the bond value differs from par, the yield to maturity will differ from the coupon interest
rate.

Bond premiums and discounts:

 When bonds are sold for higher than face value, the difference is called the bond premium, the
reverse case is called a bond discount.
 Bonds are quoted in percentages, thus if a bond issue is at 96, it means the issue price is 96% of
face value
 Example: On January 1, 2006, XXX Corp. issued Php 1,000,000 worth of 5-year 15%
bonds with each bond having a face value of Php 10,000, quoted at 96. Interest is
payable every December 31st, with flotation cost amounting to Php 34,000. Bonds will
mature on January 1, 2011.
* [Face Value of bonds (whole issue) x discount] – flotation cost = net proceeds
* (Php 1,000,000 x 96%) – Php 34,000 = Php 926,000
* Original discount is at Php 40,000, but with the flotation costs, total discount is
at Php 74,000.

Stocks

 A corporation’s capital stock may be divided into two or more classes to attract different kinds
of investors.

Classifications:

 Common: entitles holder to equal division of profits without any advantage or preference over
other classes of stock (RESIDUAL)
 Preferred: entitles holder to some preferences over other classes of stock (FIXED)

Classifications of stock: (preferred)

 Dividend claim: Cumulative vs. non-cumulative

 Convertibility: Convertible vs. non-convertible
 Callability: Callable vs. non-callable
 Trading: Listed vs. Over-the-counter
 Participation: Participating vs. non-participating
Book Value of Stocks - Refers to the amount of net assets (assets minus liabilities) that a corporation
has for every share outstanding of its common stock. Also known as net asset value (NAV)

 Book value = Common stock equity/no. of common shares outstanding

 Common stock equity = Total Stockholder’s Equity – Account balances relating to capital stock
other than common stock

Stock Dividends - Refers to earnings distribution in the form of shares of capital stock.

 It entails no reduction in the resources of the company because it is just a transfer from retained
earnings to contributed capital.
 Stock dividends of less than 20% are taken up at market value while those of 20% or more are
taken up at par value.

EXAMPLE: Alto Corporation issues a stock dividend on Jan 15, 2006 when the market price per share of
its contributed capital is Php 120 and its stockholders’ equity shows:

 Capital Stock, par value Php 100: Php 500,000

 Retained earnings: Php 400,000
 Total stockholders’ equity: Php 900,000

How many shares are to be issued if the stock dividend rate were a) 50%, b) 15%

A) Stock dividend rate is 50%

The corporation issues 2,500 shares

Par value of shares outstanding x stock dividend% = Php 500,000 x 50% = Php250,000

B) Stock dividend rate is 15%

The corporation issues 750 shares

[(Php500,000/Php100) x Php120] x 15% = Php 90,000; or (5000 shares x 15%) x Php120

Dividend Discount Model (DDM) Approach

Valuing a common stock

 P0 = D1 / (kce – g)
 Therefore: kce = (D1 / P0) + g

Assumption: Dividends are expected to grow at a constant rate, g.

Estimating the growth rate

 Use projections by security analysts.

 Estimate a firm’s sustainable growth rate
 g = retention rate (return on equity)
 g = (1 – payout rate) (ROE)
*G IS GIVEN ON THE DEPARTMENTALS