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Finance
Lecture Notes
For
MBA/M.Com/MEF/BS/BB
S
Purpose:
The course is design to assist the students in building a conceptual
framework which with to make prudent financial decision in their jobs, personal
financial planning and decision making.
Topics:
Part 1: Introduction to Managerial Finance
– What is a firm and what is the ideal goal of the firm?
Part 2: Financial Analysis and Planning
– How can we evaluate the quality of firms?
Part 3: Important Financial Concepts
– What is the time value of money?
Part 4: Long-Term Financing Decisions
– How can we measure risk? What is the relationship
between risk and return?
Part 5: Long-Term Investment Decisions
– How should bonds be valued?
– How should stock be valued?
Part 6: Working Capital Management
– What is the firm's cost of borrowing?
Part 7: Special Topics in Managerial Finance
– What measures can be used to evaluate proposed projects?
– How much debt should a firm have?
– What should the firm do with its profits?
Evaluation:
The grading component and Scale:
Final Examination ---------> 60 Marks
Mid-Term ---------> 20 Marks
Class Test ---------> 20 Marks(each @ 10)
Financial Manager
• Financial managers try to answer some or all of these questions
• The top financial manager within a firm is usually the Chief Financial
Officer (CFO)
• Treasurer – oversees cash management, credit management, capital
expenditures and financial planning
• Controller – oversees taxes, cost accounting, financial accounting and
data processing
Partnership
• Advantages
• Two or more owners
• More capital available
• Relatively easy to start
• Income taxed once as personal income
• Disadvantages
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves when one partner dies or wishes to sell
• Difficult to transfer ownership
Corporation
• Advantages
• Limited liability
• Unlimited life
• Separation of ownership and management
• Transfer of ownership is easy
• Easier to raise capital
• Disadvantages
• Separation of ownership and management
• Double taxation (income taxed at the corporate rate and then
dividends taxed at the personal rate)
Chapter Outline
1. The Balance Sheet
2. The Income Statement
3. Taxes
4. Cash Flow
5. Standardized Financial Statements
6. Ratio Analysis
7. The DuPont Identity
8. Using Financial Statement Information
Balance Sheet
• The balance sheet is a snapshot of the firm’s assets and liabilities at a given
point in time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets = Liabilities + Stockholders’ Equity
Income Statement
• The income statement is more like a video of the firm’s operations for a
specified period of time.
Ratio Analysis
• Ratios also allow for better comparison through time or between companies
• As we look at each ratio, ask yourself what the ratio is trying to measure and
why is that information is important
Simple Interest/Discount :
The future value (FV) of a simple interest calculation is derived by adding the
original principal back to the interest earned.
FV = P(1 + rt)
FV = (1000)+(1000)(.08)(3) = 1240
Simple Interest/Discount:
Note: usually simple interest is used in financial institutions for interest periods of
less than one year. If the rate is expressed as an annual rate (normal practice), then
the time period (t) must be a fraction of a year. Example: we invest $10,000 in an
8% , 90-day certificate of deposit. Our total proceeds at the end of the CD period
are:
FV = (10000)+(10000)(.08)(90/365) = $10,197.26
Simple Interest/ Discount (4):
Often, if a bank or other financial institution loans a sum for a short term, the lender
will prefer to calculate the interest up front and loan out the discounted principal, or
principal minus interest to be earned. The interest to be paid up front on a loan is
called discount and the discounted principal, or the actual amount loaned is called
the present value (PV)
FV
PV = (1+rt)
Simple Interest/Discount
Repeating the discount basic formula (simple interest):
FV
PV = (1+rt)
Example: If the bank loans out $10,000 for 90 days at 8% simple interest, the PV is:
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= $9,806.56
Compound Interest:
However, if interest is left in the account to accumulate for a longer period (usually
longer than one year) common practice (and usually state law!) requires that after
interest is earned and credited for a given period, the new sum of principal + interest
must now earn interest for the next period, etc. This is compound interest. To
distinguish from simple interest, we use "n" to refer to the number of "periods" in
which the interest is compounded and added to principal.
FV
FV = P(1 + r)n OR PV = (1+r)n
Compound Interest:
Suppose we invest our original $1,000 for three years at 8%, compounded quarterly:
(The rate per quarterly period is 8% / 4 or 2%.
The number of periods (n) is 3 x 4 = 12 quarterly periods.)
Payback Period
• How long does it take to get the initial cost back in a nominal sense?
• Computation
• Estimate the cash flows
• Subtract the future cash flows from the initial cost until the initial
investment has been recovered
• Decision Rule – Accept if the payback period is less than some preset limit
DBH suggestion: Use the required return as the “guess” rate requested by the Excel
function (in this case 12%) Since 16.13% > 12% we would accept the project.
Decision Criteria Test - IRR
• Does the IRR rule account for the time value of money? (Yes)
• Does the IRR rule account for the risk of the cash flows? (Yes)
• Does the IRR rule provide an indication about the increase in value? (Yes,
by %)
• Should we consider the IRR rule for our primary decision criteria? (Not
primary, see following slides)
Risk Premium:
Risk Premium is the difference between the expected return on the proposed
investment and the risk free rate.
If U.S. security G is earning 4% then the risk premium for investment A (from
previous slide, E(R) = 8.8%) is:
Risk = E(R ) - R
A A f
= .088 - .04 = .048 or 4.8%
Investment Portfolios
A portfolio of investments enables us to diversify and therefore minimize the
portion of risk that relates to "surprises" or unexpected movement in individual
securities.
Portfolio Illustration
Suppose we mix a portfolio of 40% in Investment A (previous) + 40% in Investment
B, which may earn only 7% in a good market but booms to 14% in a recession, and
we put the other 20% in government investment G earning 4%. Portfolio Expected
Return for Portfolio "P" :
Where E(RA) =8.8% , E(RB) =9.8% , and E(RG) = 4% (the risk-free rate)
I don't want to figure that out--do you? There are people on this planet who live for
this stuff and do that for most publicly traded assets. (Your facilitator is NOT one
of them!) Therefore we will assume the Beta is given for any investment we work
with.
BOND VALUATION
The financial value of any asset, be it a security, real estate, business, etc., is
the present value of all future cash flows. The easiest thing to value (conceptually)
is a bond since the promised cash flows are known with certainty.
Consider a bond that pays a 10% coupon (or stated) rate of interest, has a
par (or stated) face value of $1,000 and matures in 5 years. Suppose also that the
market rate of interest for such a bond (i.e., your required rate of return, k) is 8%.
Thus,
Par = $1,000
Coupon Rate = 10%
Maturity = 5 years
K = 8%
The cash flows that are promised by the company include interest payments
of $100 per year (although most corporate bonds pay interest semi-annually, we
will assume annual payments—we have already seen how to adjust for semi-
annual cash flows) for five years and the payment of the face value (stated, or par,
value) of $1,000 at the end of five years.
0 1 2 3 4 5
Suppose we purchase the bond for $1,079.87. After one year, we collect
$100 in interest. The $100 represents a 9.26% return on our investment of
$1,079.87, not an 8% rate of return. What are we ignoring?
0 1 2 3 4
1,000
Note that this time, the interest payment in the last year was included as a
part of the present value of an annuity calculation while the par value was
discounted as a lump sum of $1,000. As indicated, the value of the bond when only
four years to maturity remain is only $1,066.21. This is a decrease in value of
$13.66. When expressed as a percentage of the original value of $1079.87, this
represents a loss of 1.26%. The total return of 8% that we built into our valuation
when the bond had five years left to maturity is comprised of two components:
Par = $1,000
Coupon Rate = 10%
Maturity = 10 years
K = 8%
0 1 2 3 4 5 6 7 8 9
10
100 100 100 100 100 100 100 100 100 100
As was expected, the additional five years’ worth of an extra $20 per year in
interest payments results in a larger premium for a ten-year bond relative to a five-
year bond.
1,000
The value of the five-year bond has increased from $1,079.87 to $1,168.54
or $88.67 due to the fall in market rates of interest from 8% to 6%. The $88.67
increase in price represents an 8.2% appreciation relative to its original value.
0 1 2 3 4 5 6 7 8 9
10
100 100 100 100 100 100 100 100 100 100
The increase in price for the ten year bond amounts to $160.20 or 14.1%.
Why do we calculate the change in price as a percent of its original value?
The reason the change in price is much larger for a long-term bond is due to
the fact that the longer period of time for compounding has a more pronounced
effect on the ten-year bond than it does on a five-year bond since, on average, the
five-year bond is generating cash flows much sooner than the ten-year bond. If
long-term bonds are more sensitive to changes in interest rates than short-term
bonds, can you guess whether a high coupon bond or a low coupon bond is more
sensitive to changes in interest rates? (See Handout #2.)
N Interest Par
Bond Value = ∑ +
t=1 (1+k)t (1+k)N
C. Perpetuities
Interest
Value of a perpetuity = K
While there are not a lot of perpetuities that trade in the marketplace, there
is a financial security which is, essentially, a perpetuity. Do you know what security
pays a constant dollar amount each year and never matures?
D. Preferred Stock
The classic version of preferred stock is a share that pays a fixed dollar
amount of dividend and never matures. It is, therefore, a perpetuity. The formula
for the value of a share of preferred stock is
Dividend
Value of Preferred Stock =
Kp
So if you expect that interest rates are going to decrease in the future, what
type of bond would you want to buy?
If you expect that interest rates are going to rise in the future, what type of
bond do you want to buy?
where, P
D = Dividend of Preferred Stock
kp = Required rate of return on the Preferred Stock
P = Price of the Preferred Stock
The cash flow pattern of preferred stock is like perpetuity. It starts from period one,
has no gaps, all payments are equal, and payments continue forever.
where,
t = index for period
D D D
S0 = + +... +
(1 +k s ) (1 +k s ) 2
(1 +k s ) ∞
D
S0 =
ks
ii. Constant Growth Model: This model assumes that the dividend
payments are growing each year at a constant rate of “g”.
The cash flow pattern of Constant Growth Stock looks like the
following:
D0(1+g)
It starts from period-1, has
∞
no gaps, cash flows grow
D1 at a constant rate, and
forever.
∞
S0
D1 D1
S0 = kS = +g
ks − g S0
Where,
g = expected growth rate in dividends = (ROE)*(p)
D1 = Expected Dividend Payments in the next period = D0(1+g)
D0 = Most recent Dividend Payment
D1/S0 = Dividend yield
ROE = Return on Equity = (Net income) / (Common Stock Book Value)
q = dividend pay out ratio
Dt = q*(Earnings)t
iii. Variable Growth Model: This model assumes that the company and
its dividend payments grow much faster then the economy for a certain
period at the beginning and then settles to a constant growth rate.
k i =k rf +βi ( k m −k rf )
Where,
ki = Required rate of return on Stock “i”
krf = Risk free rate
km = Return on market
(km - krf) is also called market risk premium. That is required rate of return to
bear market’s risk.
The key to the Capital Asset Pricing Model is the market risk. This model
recognizes only one risk, market risk, and calls it also systematic risk or non-
diversifyable risk. In this model risk of a financial asset is expressed as a
fraction of the market risk.
Where,
_
r = Average return on stock
_ _
r −r f
Treynor Index =
β
Where,
β = Stock’s beta
Part 6: Working Capital Management
Working capital management is concerned with current assets and current
liabilities and their relationship to the rest of the firm. Working capital policies
affect the future returns and risk of the company; consequently, they
have an ultimate bearing on shareholder wealth.
A business person usually sells on credit, stocks goods and keeps some
cash in the bank and the office.
Net working capital refers to the difference between current assets and
current liabilities.
Working Capital
Capital Issues
Optimal Amount (Level) of Current Assets
Assumptions
)
units of production Policy B
◆ Continuous Policy C
production
◆ Three different Current Assets
policies for current
asset levels are
possible 0 25,000 50,000
OUTPUT (units)
Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis
Policy A
Policy Liquidity
ASSET LEVEL (AED)
A High Policy B
B Average Policy C
C Low
Current Assets
Greater current asset
levels generate more
liquidity all other
0 25,000 50,000
factors held constant. OUTPUT (units)
Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
ASSET LEVEL (AED)
Return on Investment =
Policy A
Net Profit
Total Assets Policy B
Sir M.Faseeh
Net Profit Khan-MF(notes)
Current + Fixed Assets
Page 31 of 42 copyright @TM
Current Fixed Assets
0 25,000 50,000
OUTPUT (units)
Impact on Risk
Optimal Amount (Level) of Current Assets
Decreasing cash
Summary
1. More conservative policies involve holding a greater amount of
current
assets relative to sales. More aggressive policies hold less.
2. More conservative working capital policies have lower expected
profitability (measured as return on total assets) since more assets
are used to produce a given level of income.
3. More conservative working capital policies have a lower risk of
insufficient cash to pay bills and insufficient inventory to meet
demand.
4. The optimal level of working capital investment is the level which is
expected to maximize shareholder wealth.
Summaryof theOptimal
Amount of Current Assets
SUMMARY O F O PTIMAL C URRENT A SSET A NALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High
1. Profitabilityvariesinverselywith
liquidity.
2. Profitabilitymovestogether withrisk.
(riskandreturngohand-in-hand!)
Sir M.Faseeh Khan-MF(notes) Page 32 of 42 copyright @TM
Nature of Current Assets
Current assets usually fluctuate from month to month. During months when
sales are relatively high, firms usually carry a lot of inventory, accounts
receivable and cash.
The level of inventory declines in other months when there is less selling
activity. But at any given point of time, the firm always has some current
assets.
Permanent
Working Capital
The amount of current assets required to
DOLLAR AMOUNT
TIME
Temporary
Working Capital
The amount of current assets that varies
DOLLAR AMOUNT
TIME
4. Cash is collected.
⇒ Finance that was arranged between steps 2 & 3 can now be re-paid.
Self-LiquidatingNature
of Short-TermLoans
◆ Seasonal ordersrequirethepurchaseof
inventorybeyondcurrent levels.
◆ Increasedinventoryisusedtom eet the
increaseddem andforthefinal product.
◆ Salesbecom ereceivables.
◆ R eceivablesarecollectedandbecom ecash.
◆ Theresultingcashfundscanbeusedtopay
off theseasonal short-termloanandcover
associatedlong-termfinancingcosts.
FinancingNeeds
◆ Fixedassetsandthenon-seasonal portion
of current assetsarefinancedwithlong-
termdebt andequity(long-termprofitability
of assetstocover thelong-termfinancing
costsof thefirm).
◆ Seasonal needsarefinancedwithshort-
termloans(under normal operations
sufficient cashflowisexpectedtocover the
short-termfinancingcost).
ssets
e nt c u rrent a
n
Perma
Long-term
Fixed Assets
ts
re nt asse
ent cur
Perman
Long-term
Fixed Assets
ssets
ent cu rrent a
n
Perma
Long-term
Fixed Assets
◆ Short-TermFinancingBenefits
◆ Financinglong-termneeds witha lower interest
cost short-termdebt
◆ Borrowing only what is necessary
◆ Short-TermFinancingRisks
◆ Refinancingshort-termobligations inthe future
◆ Uncertainfuture interest costs
◆ Result
◆ Manager accepts greater expectedprofits in
exchange for taking greater risk.
1. Profit factor - There is a possibility of high profits because your assets are
less liquid and therefore well invested in the business.
2. Profit factor - You are using short term financing and hence the interest
costs could be low resulting in lesser interest expense thereby helping
profits.
3. Risk Factor - Since the financing is short term there is every possibility
that the interest rates could go up resulting in a higher interest expense
when the finances need to be renewed or the lender may refuse to renew.
4. Risk Factor - Since the assets are less liquid there may not be enough
cash to meet short term obligations.
MODERATE PLAN
(SHORT TERM FINANCING/HIGH LIQUIDITY OR
LONG TERM FINANCING/LOW LIQUIDITY)
1. Risk factor (Short term/Highly liquid)- Even though borrowing is short term
with the possibility of the financing arrangement not being renewed or a
higher interest expense (which is the risk factor) the Assets are highly liquid
hence even if the loan has to be repaid funds would be available.
2. Profit factor (Short term/Highly liquid)- With short term financing the
interest cost could be low and therefore help profits but the Assets being
less liquid would not help returns (profits).
4. Profit factor (Long term/Low liquid)- When the assets are kept less liquid it
would help the profits because they would be well invested but the interest
cost could be high because of long term borrowing.
Conservative
(Long term Financing/Highly liquid assets)
2. Profit Factor - Profitability will be low because the Assets are highly liquid
“Cost of Capital?”
When we say a firm has a “cost of capital” of, for example, 12%, we are saying:
The firm can only have a positive NPV on a project if return exceeds 12%
The firm must earn 12% just to compensate investors for the use of their capital in a
project
The use of capital in a project must earn 12% or more, not that it will necessarily
cost 12% to borrow funds for the project
Thus cost of capital depends primarily on the USE of funds, not the SOURCE of
funds
Cost of Equity
The Cost of Equity may be derived from the dividend growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D) divided by its return on equity
(RE) less its rate of growth (g). We can invert the variables to find RE as follows:
RE = D / P + g
But this model has drawbacks when considering that some firms concentrate on
growth and do not pay dividends at all, or only irregularly. Growth rates may also
be hard to estimate. Also this model doesn’t adjust for market risk.
Cost of Equity :
Therefore many financial managers prefer the security market line/capital asset
pricing model (SML or CAPM) for estimating the cost of equity:
RE = Rf + βE x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x risk premium)
Advantages of SML: Evaluates risk, applicable to firms that don’t pay dividends
Disadvantages of SML: Need to estimate both Beta and risk premium (will usually
base on past data, not future projections.)
Cost of Debt
The cost of debt is generally easier to calculate
Equals the current interest cost to borrow new funds
Current interest rates are determined from the going rate in the financial markets
The market adjusts fixed debt interest rates to the going rate through setting debt
prices at a discount (current rate > than face rate) or premium (current rate < than
face rate)
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per share =$28 million.
Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the
market. Total market value of both equity + debt thus =$32.65 million. Equity %
= .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40%
Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
Valuation of Assets:
V = [ CF1 * (PVIF(k,1))] + [ CF1 * (PVIF(k,2))] + [ CF1 * (PVIF(k,3))]………
Valuation of Bond:
B = I * [(PVIFA(kd,n))] + M*[(PVIF(kd,n))]
Basic Stock Valuation:
Po =[D1/(1+Ks)^1] + [D2/(1+Ks)^2] + [D3/(1+Ks)^3] + …….
Common stock Value:
Po = D1 / Ks