Chapter 1 – Intro to Financial Management

* Highest finance function  CFO

Finance is NOT the same with Financial Management

- study of investments (not just stocks)
- dynamics of assets and liabilities over time under conditions of different degrees of uncertainty and risk
- science of money management
- subcategories: public finance, corporate finance, personal finance
> Public Finance
- role of govt. in the economy
- assesses the govt. revenue and expenditure of the public authorities and the
adjustment of one or the other to achieve desirable effects and avoid undesirable ones
- how to create value of the peso
> Personal Finance
- financial management which an individual or a family unit performs to budget, save, and spend
monetary resources overtime, taking into account various risks
> Corporate Finance
- business aspect
- sources of fundings and the capital structure of corporations and the actions that managers take
to increase the value of the firm to the shareholders, as well as the tools and analysis used to
allocate financial resources
* long-term investments
* how should the firms raise funds from the investments

Financial Management
- the efficient and effective management of money (funds) in such a manner as to accomplish the objectives
of the organization
- means planning, organizing, directing, and controlling the financial activities of the enterprise
How does FinMan work?

* who has the lesser cost of capital?

* what is a good mixture of CA and CL? Debt or no debt?

Note: Financial Management talks about the entirety of the balance sheet

Goal of Financial Management:

- maximize profit
* profit can be increased by reducing cost
* profit are not cash flows
* risk is not taken into account
- minimize cost
 * is just about maximizing profit
- maximize market share
* in order to increase market, the firm may take in large amounts in advertising and promotion
* having a large market share may not translate into higher profits if the firm cannot increase revenue
much more by increasing prices
- maximize shareholders’ wealth [value of the firm]
* select projects that create value
* making smart financing decisions
* make the most of the value of the shareholders; more than the profitability
* maximize my cash potential
* shareholders: MAY PERA BANG BUMALIK SA AKIN

Chapter 1 – Financial Analysis

 > Financial Management
- the primary goal is to maximize shareholders’ wealth
- how the statements are used by managers to improve the firm’s stock price, by lenders to evaluate the
likelihood that borrowers will be able to pay off loans, and by security analysts to forecast earnings,
dividends, and stock prices

> Financial Analysis

- involves:
(1) comparing the firm’s performance to that of other firms in the same industry
(2) evaluating trends in the firm’s financial position over time

Ratio Analysis

Ratios:
- technically help in evaluating financial statements
- different ratios are used to examine different aspects of the firm’s operations
Why are ratios useful?
 Ratios standardize numbers and facilitate comparisons
 Ratios are used to highlight weaknesses and strengths
 Ratio comparisons should be made through time and with competitors
o Trend analysis
o Industry analysis
o Benchmark (peer) analysis

Note: Although industry average figures/ratios are used for comparison, an industry average is not a magic number
that all firms should strive to maintain. But deviations from it should signal the analyst (or management) to
check further

1.) Liquidity Ratios - firm’s ability to pay off debts that are maturing within a year
- relationship of a firm’s CAs (nearly cash assets) to its CLs
Questions: Can we make required payments?

a.) Current Ratio

- the lower the ratio (greater current liabilities), the greater the risk or the weaker the liquidity
current assets
1<x<1
current liabilities

Note: Too high current ratios may also indicate:

- has too much old inventory that will have to be written off
- has too many old accounts receivable that may turn into bad debts
- has too much cash, receivables, and inventory relative to its sales, in which case these assets
are not being managed efficiently

b.) Quick or Acid Test Ratio

 - the lower the ratio (greater current liabilities), the greater the “trouble” or the weaker the liquidity
current assets−inventories
1<x<1
current liabilities
Note: Inventories are removed (or are not being relied on) because:
- inventories are typically the least liquid of a firm’s current assets
- if sales slow down, they might not be converted to cash as quickly
- inventories are the assets on which losses are most likely to occur in the event of liquidation

c.) Cash Ratio

- the lower the ratio (greater current liabilities), the greater the “trouble” or the weaker the liquidity
total cash
1<x<1
current liabilities

2.) Asset Management Ratios - how efficiently the firm is using its non-cash assets
- allow firms to strike a balance between having too much or too few assets
Questions: Does the amount of each type of asset seem reasonable, too high, or too low in view of current
and projected sales?
* When we acquire assets, we must obtain capital from banks or other sources and capital is
expensive
> if assets are too high, cost of capital will be too high, which will depress profits
> if its assets are too low, profitable sales will be lost

Note: for all Asset Management Ratios, always prioritize the use of averages (if available)
a.) Inventory Turnover Ratio
- “turnover ratios” divide sales by some asset (shows how many times a particular asset is turned over
or is sold then replaced during the year)
- the lower the ratio (greater inventories), the greater the unproductive inventories are on hand
COGS(¿ sales)
 how many times (efficiency in selling)
average inventories∨inventory end
* average A/R = (beg inv + end inv)/2

c.) Fixed Assets Turnover Ratio

- “turnover ratios” divide sales by some asset (shows how many times a particular asset is turned over
or is sold then replaced during the year during the year)
- the lower the ratio (greater net fixed assets), the greater the unproductive PPEs are on hand
sales
 how many times (efficiency of using fixed assets to generate sales)
average FA∨FA end

d.) Total Assets Turnover Ratio

 - “turnover ratios” divide sales by some asset (shows how many times a particular asset is turned over
or is sold then replaced during the year during the year)
- the lower the ratio (greater total assets), the greater the unproductive total assets are on hand
sales
 how many times (efficiency of using all assets to generate sales)
average TA∨TA end

e.) Accounts Receivable Turnover Ratio

sales
 how many times (efficiency in collecting)
average A /R∨ A / R end
* average A/R = (beg A/R + end A/R)/2

f.) Day Sales Outstanding Ratio (Average Collection Period or Days in Receivable)
- how many days’ sales are tied up in receivables
- represents the length of time the firm must wait after making a sale before receiving cash
- the lower the ratio (fewer receivables), the faster the receipt of cash when making a sale
average A /R∨ A / R end 365
∨  how many days
average sales per day A / R Turnover
* average sales per day = annual sales/365

f.) Days Inventory Outstanding Ratio

- the length of time between the purchase of inventory to its sale
average inventory ∨inventory end 365
∨  how many days
averageCOGS per day Inventory Turnover
* average COGS per day = annual COGS/365

3.) Debt Management Ratios - how the firm has financed its assets as well as the firm’s ability to repay its
long-term debt
(1) check the balance sheet to determine the proportion of total funds represented by debt
(2) review the income statement to see the extent to which interest is covered by operating profits

Note: The use of debt will increase, or “leverage up,” a firm’s ROE if the firm earns more on its assets than
the interest rate it pays on debt. However, debt exposes the firm to more risk than if it financed only
with equity

a.) Debt Ratio or Debt/Assets Ratio

- the lower the ratio (greater equity), the safer it is for creditors against the risk of losses
total liabilities
 % (portion of debt among the total assets)
total assets (¿ total liab+ SHE)

b.) Debt to Equity Ratio

 - the lower the ratio (greater equity financing), the lesser the weight of debt than equity
- the higher the ratio (greater debt and more interest), the greater the weight of debt than equity
long−term debt
 1 < x < 1 [x pesos of debt for every peso of equity]
SHE
* long-term debt = includes long-term N/P
(DOES NOT include A/P and accruals, which are operating items)

c.) Total Debt to Total Capital

total debt
%
total debt +SHE
* TOTAL debt = includes all short and long-term interest-bearing debt (includes short-term N/P)
(DOES NOT include A/P and accruals, which are operating items)

d.) Time-Interest-Earned (TIE) Ratio

- measure of the firm’s ability to meet its annual interest payments using its operating income
- the lower the ratio (greater interest charged over EBIT), the lower margin of safety and the lesser the
ability to pay the interest for how many times
EBIT
 pay how many times the interest charges
interest charges

4.) Profitability Ratios - how profitably the firm is operating and utilizing its assets [asset + debt mgnt]

a.) Operating Margin

- the lower the ratio (lower EBIT due to large operating costs), the more unfavorable it is
EBIT∨operating income
 % (by how much)
sales

b.) (Net) Profit Margin

- the lower the ratio (lower net income due to interest charges), the more unfavorable it is
net income
 % (by how much)
sales
* net income is AFTER interest, which indicates the impact of debt (via interest charges)
Note:
c.) Return on Total Assets (ROA)
EBIT xx
- indicates a company's profitability in relation to its total assets Interest (%) (xx)
- the lower the ratio, the more unfavorable it is EBT xx
net income Taxes (%) (xx)
 % (by how much) Net Income xx
total assets (¿ total liab+ SHE)

d.) Return on Common Equity (ROE)

 - measures the rate of return on common stockholders’ investment
- the lower the ratio, the more unfavorable it is
net income
 % (by how much)
SHE

d.) Return on Invested Capital (ROIC)

- measures the total return that the company has provided for its investors
EBIT ( 1−Tax )
 % (by how much)
total invested capital
* total invested capital = TOTAL debt + SHE
 * TOTAL debt = includes all short and long-term interest-bearing debt (includes short-term N/P)
(DOES NOT include A/P and accruals, which are operating items)

e.) Basic Earning Power (BEP) Ratio

- shows the raw earning power of the firm’s assets before the influence of tax and debt
- useful when comparing firms with different debt and tax situations
EBIT
 % (by how much)
total assets

Effects of Debt on ROE and ROA

 Holding assets constant, if debt increases:
o Equity declines
o Interest expense increases – which leads to a reduction in net income
 ROA declines (due to the reduction in net income)
 ROE may increase or decrease (since both net income and equity decline c/o formula)

Problems with ROE

 ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure
of performance
o ROE does not consider risk
o ROE does not consider the amount of capital invested
 Given these problems, reliance on ROE may encourage managers to make investments that do not
benefit shareholders. As a result, analysts have looked to develop other performance measures,
such as EVA.

5.) Market Value Ratios - what investors think about the firm and its future prospects
- relate the stock price to earnings and book value price
Used in 3 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)
(3) by firms when they are deciding how much to offer for another firm in a potential merger
> ROE – reflects the effects of all of the other ratios
 - it is the single best accounting measure of performance
- investors like a high ROE
- high ROEs are correlated with high stock prices

a.) Piece/Earnings (P/E) Ratio

- conveys how much investors will pay per share for $1 of earnings
- the lower the ratio, the poorer the growth prospects
Note:
- higher or lower ratio is not necessarily better or bad
- it should not be too high (overpriced) or too low (underpriced)
- if it goes beyond 17x, it is essentially overpriced. Is the entity really that good for its MV to be high?
market price per share
earnings per share

b.) Market/Book (M/B) Ratio

- show how much investors are willing to pay per dollar of book value equity (SHE)
- the lower the ratio, the riskier the company is and the poorer the growth prospects
market price per share
book value per share

Note: P/E and M/B are high if ROE is high and risk is low

c.) Dividend Yield Ratio

- percentage of a company's share price that it pays out in dividends each year
(ex: if a company has a $20 share price and pays a dividend of $1 per year, its DY would be 5%)
dividends per share
 % (how much)
market price per share

d.) Dividend Payout Ratio

- shows how much of a company's earnings after tax are paid to shareholders
dividends per share
 % (how much)
earnings per share

e.) Earnings per Share

- shows how much of a company's earnings after tax are paid to shareholders
net income
 Pesos
outstanding shares

The DuPont Equation

DuPont Equation - shows that the rate of return on equity can be found as the product of profit margin, total
assets turnover, and the equity multiplier (shows WHY the ROE is a certain value)
- shows the relationships among asset management, debt management, and profit- ability
ratios
- allows firms to identify ways on how to improve performance (using per component)

ROE= profit margin x total assets turnover x equity multiplier

net income sales total assets
ROE= x x
sales totalassets equity

Effects of Improving Ratios

* refer to PPT sample problems (slides 29-32)

Examples:
a.) Reducing Day Sales Outstanding (and Reducing Receivable as a result)
 Reducing A/R will have no effect on sales
 Difference of old and new A/R initially shows up as addition to cash

b.) Reducing Receivables on Balance Sheet and Stock Price

Potential Uses of Freed Up Cash:
 Repurchase stock
 Share buybacks can create value for investors in a few ways: Repurchases return cash to
shareholders who want to exit the investment. With a buyback, the company can increase
earnings per share, all else equal
 Buying back stocks will DECREASE COMMON EQUITY, which increases the ROE ratio
 Expand business
 Reduce debt (= lower risk)
 All these actions would likely improve the stock price.

Potential Problems and Limitations of Financial Ratio Analysis

 Comparison with industry averages is difficult for a conglomerate firm that operates in many different
divisions.
 Different operating and accounting practices can distort comparisons.
 Sometimes it is hard to tell if a ratio is “good” or “bad.”
 Difficult to tell whether a company is, on balance, in a strong or weak position.
 “Average” performance is not necessarily good, perhaps the firm should aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can make statements and ratios look better than they actually are.
 Inflation has distorted many firms’ balance sheets, so analyses must be interpreted with judgment
Qualitative Factors Considered When Evaluating a Company’s Future Financial Performance

 Are the firm’s revenues tied to one key customer, product, or supplier?
 What percentage of the firm’s business is generated overseas?
 Firm’s competitive environment
 Future prospects
 Legal and regulatory environment

Chapter 2 – Working Capital Management

Working Capital
- usually refers to current assets

Net Working Capital

- current assets minus current liabilities

Net Operating Working Capital (NOWC)

- working capital that is used for operating purposes
- interest-bearing notes payable are deducted from current liabilities
(since it is a financing cost rather than a part of the company’s free cash flow)
NOWC=operating current assets−operating current liabilities
NOWC=( current assets−excess cash )−( current liabilities−notes payable)

Working Capital Management

- controlling cash, inventories, and A/R, plus short-term liability management.

Current Assets Investment Policies

* deciding the level of each type of current asset to hold, and how to finance current assets

Relaxed Investment Policy Restricted (Lean-and-Mean) Moderate Investment Policy

Investment Policy
Large amounts of current assets are Constrained or low amounts of Between relaxed and restricted
carried current assets are carried policies
(current assets are maximized)
Lower total assets turnover Higher total assets turnover Moderate
Lower ROE Higher ROE Moderate
Less exposure to shortage risks Exposes firm to risks of shortages Moderate

Current Assets Financing Policies

* investment in current assets must be FINANCED
* primary sources of funds: bank loans, credit from suppliers (A/P), accrued liabilities, long-term debt, and common equity

Permanent Current Assets

- current assets that a firm must carry or maintain even at the lowest point of its business cycles
Temporary Current Assets
- current assets that fluctuate with seasonal or cyclical variations in sales
- extra current assets beyond the permanent level

Current Assets Financing Policies:

Moderate Approach Aggressive Approach Conservative Approach
(Maturity Matching or Self-
Liquidating Approach)
Matching asset and liability Some of the permanent assets are Long-term capital is used to
maturities financed with short-term debt finance all the permanent assets
> fixed assets & permanent current and to meet some of the seasonal
assets are financed with long- Reason: needs
term capital  take advantage of the lower short-
> temporary current assets are term rates of interest (in
financed with short-term debt borrowing) than long-term rates

Issues: Issues:
(1) there is uncertainty about the (1) financing long-term assets
lives of assets with short-term debt is quite
(2) some common equity must be risky
used, and common equity has
no maturity

Short-Term vs Long-Term Loans:

Short-Term Loans Long-Term Loans
Cost is generally lower Cost generally higher

Riskier to the borrowing firm Less riskier to the borrowing firm

(1) because interest expense can fluctuate widely (1) because interest expense is relatively stable
(2) a temporary recession may adversely affect its
financial ratios and render it unable to repay
debt

Can generally be negotiated much faster Longer negotiation process

May offer greater flexibility in changing debt contract Lesser flexibility in changing debt contract and agreements
 and agreements

cash management
The Cash Conversion Cycle

Cash Conversion Cycle

- length of time funds are tied up in working capital (operating)
- length of time between paying for working capital and collecting cash from the sale of the working capital
- the shorter the cycle, the better because that will lower interest charges
* the entity should sell goods faster, collect receivables faster, or defer its payables longer

a.) Inventory Conversion Period (ICP)

- days it takes to sell the merchandise; technically, Day Inventory Outstanding (DIO)

b.) Average Collection Period (ACP)

- length of time customers are given to pay for goods following a sale
- technically, Day Sales Outstanding (DSO)

c.) Payables Deferral Period (PDP)

- length of time suppliers give the entity to pay for its purchases; technically, Day Payable Outstanding
(DPO)
CCC=ICP+(ACP∨DSO)−PDP
inventory receivables payables
CCC= + −
COGS/365 sales /365 COGS /365
WC = CCC x total cost
per unit Note:
(1) the entity will not receive any cash until ICP + ACP days into the cycle; it will not be able
to repay the loan on (2) until it collects from the customer on the (ICP + ACP)th day
(2) the entity will have to borrow money on the PDP-th day to pay for the merchandise
(3) For CCC days, the entity will owe the bank for the borrowed money and pay interest on
the debt

The Cash Budget

Cash Budget
- primary cash flow forecasting tool [forecasts cash inflows, outflows, and ending cash balances]
- can be monthly (for annual planning) or daily (for scheduling payments on a day-day basis)
> Monthly Cash Budget
(1) sales forecast for each month
(2) forecast of actual collections
(3) forecast of materials purchases
(4) forecast of payments for materials, labor, leases, new equipment, taxes, other expenses
(5) net cash gain/loss for each month
net cash gain/loss=forecasted collections−forecasted payments

Target Cash Balance

- desired cash balance that a firm plans to maintain in order to conduct business

Note: bad debt losses would reduce collections, which result to higher borrowing requirements
Cash and Marketable Securities
* needed for paying large one-time dividend, repurchasing stock, retiring debt, acquiring other firms, or financing major expansions

1.) Currency
- entities need to hold enough currency to support operations BUT holding more could raise capital costs
and tempt robbers
How to minimize cash holdings
- Use a lockbox
- Insist on wire transfers and debit/credit cards from customers
- Synchronize inflows and outflows
- Reduce need for “safety stock” of cash
> Increase forecast accuracy
> Hold marketable securities
> Negotiate a line of credit

2.) Demand or Checking Deposits

- used for transactions like paying for labor and raw materials, purchasing fixed assets, paying taxes,
servicing debt, paying dividends, etc.
- commercial ones typically earn no interest
How to optimize demand deposit holdings:
a.) Hold marketable securities rather than demand deposits to provide liquidity
- since securities pay interest, it increases profits
b.) Borrow on short notice
c.) Forecast payments and receipts better
d.) Speed up payments
e.) Use credit cards, debit cards, wire transfers, and direct deposits
f.) Synchronize cash flows

3.) Marketable Securities

- held for operations
- are managed in conjunction with demand deposits
- purchased as cash builds up from operations and is sold when cash is needed again

inventory management
Inventories: (1) supplies, (2) raw materials, (3) work in process, (4) finished goods

Types of Inventory Costs

1.) Carrying Costs storage and handling costs, insurance, property
taxes, depreciation, and obsolescence
2.) Ordering Costs cost of placing orders, shipping, and handling costs
3.) Costs of Running Short loss of sales or customer goodwill, and the
disruption of production schedules

 lower inventory levels = lower carrying costs = higher ordering costs = higher costs of running short

Note:
 - sales must be forecasted before target inventories can be established
- inventory management is important due to the lost sales or excessive carrying costs caused by errors in
setting the right inventory level

Role of the financial manager in inventory management:

a.) capital budgeting to determine the best inventory system
b.) raise capital needed to acquire additional inventory
c.) identify any area of weakness that affects the firm’s overall profitability, using ratios

accounts receivable management

Credit Policy

Credit Policy
- set of rules that include the firm’s credit period, discounts, credit standing, and collection procedures
offered
- primary determinant of accounts receivable
- under the administrative control of the CFO

1.) Credit Period

- length of time buyers are given to pay for their purchases
 customers prefer longer credit periods, so lengthening the credit period will stimulate sales
 longer credit period lengthens the CCC; hence, it ties up more capital in receivables
 shorter period reduces DSO and average A/R, but it may discourage sales.

2.) Discounts
- price reductions given for early payment
 discount amounts to a price reduction, which stimulates sales
 discounts encourage customers to pay earlier, which shortens the CCC and DSO
 discounts also mean lower prices—and lower revenues

3.) Credit Standards

- the financial strength customers must exhibit to qualify for credit
 when standards are set too low, bad debt losses will be too high
 when standards are set too high, the firm loses sales and thus profits; but reduce bad debt expense
(reduce DSO)

4.) Collection Policy

- procedures used to collect past due accounts, including the toughness or laxity used in the process

Credit Terms
- statement of the credit period and discount policy
- ex: 2/10, net 30
Setting and Implementing the Credit Policy
Credit policy is important for three main reasons:
(1) It has a major effect on sales
(2) It influences the amount of funds tied up in receivables
(3) It affects bad debt losses.

Credit Scores
- numerical scores that are based on a statistical analysis and provide a summary assessment of the
likelihood that a potential customer will default on a required payment.

Note: However, if it is possible to sell on credit and to impose a carrying charge on the receivables that are
outstanding, credit sales can actually be more profitable than cash sales

Monitoring Accounts Receivable

Total amount of accounts receivable outstanding is determined by the volume of credit sales and the average
length of time between sales and collections

accounts receivable=sales per day x (length of collection period∨DSO)

* either the sales or the collection period changes, so will the accounts receivable
sum of (% customers paying x
collection period)

accounts payable (trade credit)

Trade Credit
- debt arising from credit sales and recorded as an account receivable by the seller and as an account payable
by the buyer
- arises spontaneously from ordinary business transactions (furnished by suppliers)
- may be free, or it may be costly

Types of Trade Credit

1.) Free Trade Credit

- credit received during the discount period
- obtained without a cost (without foregoing discounts)

2.) Costly or Extra Trade Credit

- credit taken in excess of free trade credit, whose cost is equal to the discount lost.
- cost/amount (%) that you will be LOSING when you DO NOT avail the discount

Breaking Down Trade Credit

Example:
Suppose PCC Inc. buys 20 microchips each day, with a list price of $100 per chip on terms of 2/10, net 30
accounts payable(take discounts)=( 10 days ) ( 20 chips )( $ 98 per chip )=$ 19,600
 accounts payable(no discounts )=( 30 days )( 20 chips )( $ 98 per chip ) =$ 58,800

Credit Breakdown:
Total trade credit $ 58,800 * in order to receive the costly credit of 39,200,
Free trade credit ( $ 19,600) the firm must forego the discounts
Cost of extra credit $ 39,200

Nominal and Effective Cost of Trade Credit

Example:
Suppose PCC Inc. buys 20 microchips each day, with a list price of $100 per chip on terms of 2/10, net 30. It
operates 365 days a year

Without discount [GROSS] ( 365 days )( 20 chips ) ( $ 100 per chip )=$ 730,000
With discount [NET] ( 365 days )( 20 chips ) ( $ 98 per chip ) =$ 715,400
Annual cost of extra credit $ 14,600
(cash discount)

Note: The interest that comes with the cost of credit (once discount is availed) will be deducted to the total
cash discounts of purchases in order to get the savings on net income

1.) Nominal Rate or Cost

annual cost of extra credit
nominal annual cost of trade credit=
extra credit
or
disc . % 365
r nom= x
100−disc . % days credit isoutstanding−disc . period

2.) Effective Rate or Cost

> Periodic rate or cost per period = (disc. %)/(100 – disc. %)
> Periods/year [N] = (365)/(days credit is outstanding – disc. Period)

effective annual cost of trade credit=(1+ periodic rate)N −1

Note:
Nominal Rate  Interest Paid or Interest Received
Effective Rate  Interest Expense or Interest Income or Earned
bank loans
Promissory Note
- a document specifying the terms and conditions of a loan, including the amount, interest rate, and
repayment schedule
a.) Amount
b.) Maturity
c.) Interest Rate
d.) Interest only versus amortized
* amortized loans – installment loans
e.) Frequency of interest payments
f.) Discount interest
g.) Add-on loans
h.) Collateral
i.) Restrictive covenants
j.) Loan guarantees

Line of Credit

Line of Credit
- agreement between a bank and a borrower indicating the maximum amount of credit the bank will extend
to the borrower
> Revolving Credit Agreement
- a formal, committed line of credit extended by a bank or other lending institution

Cost of Bank Loans

* The costs of bank loans vary for different types of borrowers at any given point in time and for all borrowers
over time
* Interest rates are higher: (1) for riskier borrowers, (2) on smaller loans because of the fixed costs involved in
making and servicing loans

Prime Rate
- a published interest rate charged by commercial banks to large, strong borrowers
- lowest rate the bank charges

Calculating Interest Charges:

1.) Regular or Simple Interest
- procedure used for most business loans
- no discount or add-on
- interest must be paid monthly, and the principal is payable “on demand” if and when the bank wants to
end the loan
 simpleinterest =(nominal rate)( face value of loan)
nominal rate
simpleinterest rate per day=
days ∈a year
interest charge for month=(rate per day)(face value of loan)(days ∈a month)

Note: In a simple interest paid ONCE A YEAR, the nominal rate is EQUAL to the effective rate:
simple interest
nominal rate=effective rate= x 100
face value of loan

If simple interest is paid on a MONTHLY BASIS, the effective rate will be:
effective rate=[(1+nominal rate/12)¿¿ 12−1] x 100 ¿

2.) Add-On Interest

- the interest is calculated and then added to the amount borrowed to determine the loan’s face value

interest paid
approximate annual rate add−on= x 100
(amount received )/2
Example:
• Amount of loan originally received = $100,000
• Interest = 0.08($100,000) = $8,000
• Face amount = $100,000 + $8,000 = $108,000
• Monthly payment = $108,000/12 = $9,000
• Avg. loan outstanding = $100,000/2 = $50,000
• Approximate cost = $8,000/$50,000 = 16.0%

Effective Rate
• To find the exact effective rate, recognize that the firm receives $100,000 and must make monthly
payments of $9,000 (like an annuity)
Chapter 3 – Financial Planning and Forecasting
Strategic Planning

1.) Mission Statement

2.) Corporate Scope
- defines the lines of business the firm plans to pursue and the geographic areas in which it will operate
3.) Statement of Corporate Objectives
- part of the corporate plan that sets forth the specific goals that operating managers are expected to
meet
4.) Corporate Strategies
- broad approaches developed for achieving a firm’s goals
5.) Operating Plan
- provides management detailed implementation guidance, based on the corporate strategy, to help
meet the corporate objectives
6.) Financial Plan
- includes assumptions, projected financial statements, and projected ratios and ties the entire
planning process together

> Financial Planning - often called value-based management, meaning that

- the effects of various decisions on the firm’s financial position and value are studied by
simulating their effects within the firm’s financial model

The Sales Forecast

Financial plans generally begin with a sales forecast, which starts with a review of sales during the past 5 years

The AFN Equation

> If growth (increase in sales) is low, there will be no required increase in assets
> If growth (increase in sales) is high, the requirement for additional assets will be large.
Thus, the increase in assets is fundamentally dependent on the growth rate in sales.

Primary Capital Sources:

1.) Spontaneous Increases in Accounts Payable and Accruals [Spontaneously Generated Funds]
- more purchases = more accounts payable
- more workers = more accrued wages
- higher sales, higher profits = higher taxes and accrued taxes
> Spontaneously Generated Funds
- Funds that arise out of normal business operations from its suppliers, employees, and the
government (such as accounts payable and accrued wages and taxes) that reduce the firm’s need
for external financing – increases with sales
2.) Addition to Retained Earnings
- The addition to retained earnings depends on the firm’s profit margin and its retention ratio
(the proportion of net income that is reinvested in the firm)
> Retention Ratio
- the proportion of net income that is reinvested in the firm, and is calculated as 1 minus the dividend
payout ratio

3.) AFN: Additional Funds Needed

- the amount of external capital (interest-bearing debt and preferred and common stock) that will be
necessary to acquire the required assets – since SPF and RE are not enough to fund increase in assets
- Note: if a company is growing very slowly and thus not increasing assets very much, its spontaneous
funds plus its addition to retained earnings may be larger than the required increase in assets
(in that case, the AFN is negative, indicating that a surplus of capital is forecasted)

AFN =projected change∈assets−spontaneous change∈liab−ℜ after dividends

Assets0 Liabilities0
AFN =( )(Δ Sales)−( )( ΔSales)−( PM 0 )(Sales¿ ¿1)(1−¿ Payout )¿
Sales0 Sales0

> Sustainable Growth Rate

- the maximum achievable growth rate without the firm having to raise external funds
- it is the growth rate at which the firm’s AFN equals zero

Factors Affecting AFN

1.) Higher dividend payout ratio INCREASE AFN (due to less RE)
2.) Higher profit margin DECREASE AFN (due to higher profits, more RE)
3.) Higher capital intensity ratio INCREASE AFN (need more assets given a level of
sales)
4.) Longer DPO DECREASE AFN (trade creditors supply more capital)

Excess Capacity Adjustments

- changes made to the existing asset forecast because the firm is not operating at full capacity
- sales wouldn’t change but assets would be lower, so turnovers would improve
- less new debt, hence lower interest and higher profits
Forecasted Financial Statements

I. Inputs

II. Forecasted Income Statement

III. Forecasted Balance Sheet

III. Ratios and EPS

Net Investment in Capital

Capital1=NOWC + Net ¿ Assets

Capital0 =x
Net Investment Capital=Capital 1−Capital0

FCF=EBIT ( 1−T ) −Net Investment Capital

Chapter 4 – Capital Budgeting
Note: In both security valuation and capital budgeting, we forecast a set of cash flows, find the present value
of those cash flows, and make the investment only if the PV of the inflows exceeds the investment cost

Capital Budgeting
- analysis of potential additions to fixed assets
- long-term decisions
- involves large expenditures
- very important to firm’s future

Steps to Capital Budgeting

1.) Estimate CFs (inflows & outflows).
2.) Assess riskiness of CFs.
3.) Determine the appropriate cost of capital.
4.) Find NPV and/or IRR.
5.) Accept if NPV > 0 and/or IRR > WACC
Criteria for deciding to accept or reject projects:
- Net Present Value
- Internal Rate of Return
- Modified Internal Rate of Return
- Regular Payback
- Discounted Payback

Independent and Mutually Exclusive Projects

1.) Independent
- if the cash flows of one are unaffected by the acceptance of the other
2.) Mutually Exclusive
- if the cash flows of one can be adversely impacted by the acceptance of the other
Normal and Nonnormal Cash Flow Streams

1.) Normal
- Cost (negative CF) followed by a series of positive cash inflows
- One change of signs.
2.) Non-Normal
- Most common: Cost (negative CF), then string of positive CFs, then cost to close project
- Two or more changes of signs
- Examples include nuclear power plant, strip mine, etc.

Net Present Value

Note: investors are concerned with free cash flow—the net cash that is available for all investors after taking
into account the necessary investments in fixed assets (capital expenditures) and NOWC

Net Present Value (NPV)

- method of ranking investment proposals ; inherent reinvestment assumption at WACC
- tells us how much a project contributes to shareholder wealth
- present value of the project’s free cash flows discounted at the cost of capital
- the larger the NPV, the more value the project adds ; added value means higher stock price

N
CF t
NPV =∑ t
t=0 (1+r )
CF 1 CF 2 CF N
NPV =CF 0 + 1
+ 2
+… N
(1+r ) (1+ r) (1+ r )

CF t – expected cash flow at Time t Excel:

r – project’s risk-adjusted cost of capital (WACC) = NPV (% , Inflows) + Year 0 Cash Flow
N – life

Note: Projects generally require an initial investment—therefore, initial investment is a negative cash flow

Rationale for the NPV Method

* NPV = PV of inflows – Cost
= Net gain in wealth
> If projects are independent, accept if the project NPV > 0
> If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most
value
Example: accept S if mutually exclusive (NPVS > NPVL), and accept both if independent
Internal Rate of Return

Note: a project’s IRR is the same as a bond’s YTM (yield to maturity)

Internal Rate of Return (IRR)

- the discount rate that forces the PV of inflows to equal its cost (equivalent to forcing the NPV to equal zero)
- an estimate of a project’s rate of return
- IRR method assumes CFs are reinvested at IRR
N
CF t
NPV =∑ t
Excel:
t=0 (1+ IRR) = IRR (All cash flows)

CF 1 CF 2 CF N
0=CF 0 + 1
+ 2
+… N
(1+ IRR) (1+ IRR) (1+ IRR)

Rationale for the IRR Method

> If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’
returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
> If projects are independent, accept both projects, as both IRR > WACC
> If projects are mutually exclusive, accept project with higher IRR, provided that IRR is greater than WACC

Note: IRR > WACC = NPV is positive

IRR < WACC = NPV is negative

Multiple Internal Rates of Return

Multiple Internal Rates of Return (MIRR)

- where a project has two or more IRRs due to possible non-normal cash flows
- NPV equals zero for multiple IRRs
- discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs
* TV is found by compounding inflows at WACC
- assumes cash flows are reinvested at the WACC

N
COF t
∑ CIF t (1+ r)N−t
∑ (1+ r)t = t =0(1+ MIRR)N Excel:
t =0
= MIRR (All CFs, %, %)
TV
PV costs= N
(1+ MIRR )
Why MIRR over IRR?
- MIRR assumes reinvestment at the opportunity cost = WACC
- MIRR also avoids the multiple IRR problem.
- Managers like rate of return comparisons, and MIRR is better for this than IRR.

NPV Profile

Net Present Value Profile

- A graph showing the relationship between a project’s NPV and the firm’s cost of capital.

Crossover Rate
- The cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects’ NPVs are
equal

Payback Period

Payback Period
- the length of time required for an investment’s cash flows to cover its cost
- “How long does it take to get our money back?”
- Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns
positive

Unrecovered cost at start of the year

Payback=Number of years prior ¿ full recovery+
Cash flow during full recovery year
 Strengths and Weaknesses of Payback
> Strengths
- Provides an indication of a project’s risk and liquidity
- Easy to calculate and understand
> Weaknesses
- Ignores the time value of money
- Ignores CFs occurring after the payback period

Discounted Payback Period

Discounted Payback Period

- the length of time required for an investment’s cash flows, discounted at the investment’s cost of capital,
to cover its cost
- time value of money is taken into account
Chapter 5 – Cost of Capital
When calculating WACC, the concern is capital provided by investors—interest bearing debt, preferred stock,
and common equity

Target Capital Structure

- the mix of debt, preferred stock, and common equity the firm plans to raise in order to fund its future
projects

Basic Definitions

Capital Components
 - one of the types of capital used by firms to raise funds
- investor-supplied items: debt, preferred stock, and common equity
- an increase in assets must be financed by increases in capital components
> Component Cost
- cost of each capital component
- combined to form a WACC

a.) r d – interest rate on the firm’s NEW debt

- this is a before-tax component cost of debt
b.) r d (1−T ) – this is an after-tax component cost of debt
- this is the debt cost used to calculate the weighted average cost of capital
c.) r p – component cost of preferred stock
- yield investors expect to earn on the preferred stock
- note: preferred dividends are not tax deductible

d.) r s – component cost of common equity raised by retained earnings or internal equity
- cost of all NEW equity
e.) r e – component cost of common equity raised by issuing a new stock or external equity

f.) w d , w p , w c – target weights of debt, preferred stock, and common equity (retained earnings/internal equity
and new common stock/external equity)
- percentages of the different types of capital
g.) WACC – firm’s weighted average, or overall, cost of capital (debt, preferred stock, and common equity)
WACC =( % of debt ) ( after−tax cost of debt )+ ( % of preferred stock )( cost of preferred stock )
+(% of common equity)(cost of common equity )
¿ w d r d ( 1−T ) +w p r p+ wc r s

Cost of Debt, r d (1−T )

Before-Tax Cost of Debt (r ¿¿ d ) ¿

- interest rate the firm must pay on new debt
After-Tax Cost of Debt (r ¿¿ d (1−T ))¿
- relevant cost of new debt, taking into account the tax deductibility of interest
- used to calculate WACC
rate(1−tax rate)

Note: stock prices depends on after-tax cash flows

Cost of Preferred Stock, r p

Cost of Preferred Stock (r p )

- the rate of return investors require on the firm’s preferred stock
 - preferred dividend divided by the current price
Dp
r p=
Pp

Cost of Retained Earnings, r s

Cost of Retained Earnings (r s)

- rate of return required by stockholders on a firm’s common stock
Why is there a cost for retained earnings?
 Earnings can be reinvested or paid out as dividends.
 Investors could buy other securities, earn a return.
 If earnings are retained, there is an opportunity cost (the return that stockholders could earn on
alternative investments of equal risk).
o Investors could buy similar stocks and earn rs.
o Firm could repurchase its own stock and earn rs.
Three Ways to Determine the Cost of Common Equity, r s
a.) Capital Asset Pricing Model (CAPM)
 r s=r RF + ( RPM ) b
Security Market Line (SML) Equation
 r s=r RF + ( r M −r RF ) b
r s or r – return that investors require on an average stock
r M – return that is required on the stock market
r RF – risk-free rate
RP M – market risk premium
b – beta coefficient

b.) Bond-Yield-Plus-Risk-Premium
- This RP is not the same as the CAPM RPM.
- This method produces a ballpark estimate of rs, and can serve as a useful check
 r s=bond yield+ risk premium
 r s=r d +RP

c.) Discounted Cash Flow Method (DCF) [Pure DCF Cost]

 r s= ( )
D1
P0
+g
D 1=¿ Common Dividend for end of the current year
P0 = Current Price
* D1=D0 ( 1+ g ) g=¿ Capital Gain/Growth
D1
* P0=
r s−g

>> Reasonable Estimate of r s

Example:
Cost of New Common Stock, r e

Cost of New Common Stock (r e )

- the cost of external equity
- based on the cost of retained earnings, but increased for flotation costs necessary to issue new common
stock
 r e =r s +flotation cost adjustment
old stock price−new stock price
F %=
old stock price
Flotation Costs - bankers’ fees
- percentage cost of issuing new common stock
Total Cost of Capital Raised - investors’ required return plus the flotation cost

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
 When a company issues new common stock, they also have to pay flotation costs to the underwriter.
 Issuing new common stock may send a negative signal to the capital markets, which may depress the
stock price

Two Approaches in Taking Account of Flotation Costs in r e

a.) Add Flotation Costs to a Project’s Cost
- sum of flotation costs (for debt, preferred and common stock) PLUS initial investment cost

b.) Increase Cost of Capital [Adjusted DCF Cost]

- adjusting the cost of capital rather than increasing the project’s investment cost
D1
 re= +g
P0 (1−F )
 F – percentage flotation cost required to sell the new stock
P0 (1−F ) – net price per share received by the company

Flotation Cost Adjustment

- amount that must be added to r s to account for floatation costs to find r e
= Adjusted DCF Cost – Pure DCF Cost

Composite, or Weighted Average, Cost of Capital, WACC

Factors that Affect the WACC

 Market conditions
 The firm’s capital structure and dividend policy
 The firm’s investment policy. Firms with riskier projects generally have a higher WACC
Chapter 6 – Risk and Rates of Return
Trade-Off Between Risk and Return
- investors who are less comfortable bearing risk tend to gravitate toward lower-risk investments, while
investors with a greater-risk appetite tend to put more of their money into higher-risk, higher-return
investments
- if a company is investing in riskier projects, it must offer its investors (both bondholders and stockholders)
higher expected returns; riskier companies trying to increase their stock price must generate higher returns
to compensate their stockholders for the additional risk

Risk
- the chance that some unfavorable event will occur
* An asset’s risk can be analyzed in two ways:
(1) on a stand-alone basis, where the asset is considered by itself
(2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio

Stand-Alone Risk

Stand-Alone Risk
- the risk an investor would face if he or she held only one asset; asset held in isolation

Note: No investment should be undertaken unless the expected rate of return is high enough to compensate
for the perceived risk.

Statistical Measures on Stand-Alone Risk

1. Probability distributions
- the tighter (or more peaked) the probability distributions, the more likely the actual outcome will be
close to the expected value and, consequently, the less likely the actual return will end up far below the
expected return
- the tighter the probability distribution, the lower the risk

2. Expected rates of return, r (r^ )

- the rate of return expected to be realized from an investment
- the weighted AVERAGE of the probability distribution of possible results

3. Historical, or past realized, rates of return, r (“r bar”)

4. Standard deviation, s (σ )
- measure of how far the actual return is likely to deviate from the expected return
- variability of a set of observations

5. Coefficient of variation (CV)

- standardized measure of the risk per unit of return
- calculated as the standard deviation divided by the expected return
- shows the risk per unit of return, and it provides a more meaningful risk measure when the expected
returns on two alternatives are not the same
6. Sharpe Ratio
- a measure of stand-alone risk that compares the asset’s realized excess return to its standard deviation
over a specified period
- an investment with a higher ratio has performed better than one with a lower ratio
 SR=( Expected Return−Risk Free Rate)/ Standard Deviation
SR=(r−r F )/ SD

Risk Aversion and Required Returns

Expected Ending Value−Cost

Expected Rate of Return=
Cost

Risk Aversion
- risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier
securities
- choosing the less risky investment

Risk Premium (RP)

- the difference between the expected rate of return on a given risky asset and that on a less risky asset
- represents the additional compensation investors require for bearing a higher risk

Portfolio Risk
 r s=r RF + ( RP M ) b
Capital Asset Pricing Model (CAPM)  r s=r RF + ( r M −r RF ) b
- a model based on the proposition that any stock’s required rate of return is equal to the risk-free rate of
return plus a risk premium that reflects only the risk remaining after diversification
Note: the risk of a stock held in a portfolio is typically lower than the stock’s risk when it is held alone

Expected Portfolio Returns

Expected Return on a Portfolio, r^ p

- the weighted average of the expected returns on the assets held in the portfolio

r^ i = expected return on the ith stock

w i = weight of the stock (percentage of the total value of the portfolio
invested in each stock)

Portfolio Risk

Portfolio’s Risk (σ p)
 - is not the weighted average of the individual stocks’ standard deviations
- is generally smaller than the average of the stocks’ σ because diversification lowers the portfolio’s risk.

Correlation
- the tendency of two variables to move together
Correlation Coefficient, r
- a measure of the degree of relationship between two variables

As a rule, on average, portfolio risk declines as the number of stocks in a portfolio increases.
 1.) The portfolio’s risk declines as stocks are added, but at a decreasing rate; once 40 to 50 stocks are in the
portfolio, additional stocks do little to reduce risk.
2.) The portfolio’s total risk can be divided into two parts, diversifiable risk and market risk
a.) Diversifiable Risk - is the risk that is eliminated by adding stocks
- portion of a security’s stand-alone risk that can be eliminated through proper
diversification
- aka company-specific or unsystematic risk
b.) Market Risk - is the risk that remains even if the portfolio holds every stock in the market
- portion of a security’s stand-alone risk that cannot be eliminated through
diversification
- measured by beta
- aka non-diversifiable or systematic or beta risk.
3.) Most investors are rational in the sense that they dislike risk, other things held constant. Consequently, for
many investors an ideal strategy is to hold a large diversified market portfolio that has low transactions
costs and fees.
> Market Portfolio - a portfolio consisting of all stocks

Risk in a Portfolio Context: The Beta Coefficient

When a stock is held by itself, its risk can be measured by the standard deviation of its expected returns.
However, SD is not appropriate when the stock is held in a portfolio, as stocks generally are. So how do we
measure a stock’s relevant risk in a portfolio context?

Relevant Risk
- the risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio’s market
risk.
- measured by the extent to which the stock moves up or down with the market

Beta Coefficient, b
- a metric that shows the extent to which a given stock’s returns move up and down (volatility) with the
stock market
- it measures market risk
- indicates how risky a stock is if the stock is held in a well-diversified portfolio
* Average Stock’s Beta, b A
- by definition, its value is 1 because an average-risk stock is one that tends to move up and down in step
with the general market.
[Comments on Beta:]
 If beta = 1.0, the security is just as risky as the average stock.
 If beta > 1.0, the security is riskier than average.
 If beta < 1.0, the security is less risky than average.
* Most stocks have betas in the range of 0.5 to 1.5.

Calculation of Beta
* The slope of the regression line is defined as the beta coefficient for the security

1.) The market risk of a stock is measured by its beta coefficient, which is an index of the stock’s relative
volatility. Here are some benchmark betas (examples):
b = 0.5: Stock is only half as volatile, or risky, as an average stock
b = 1.0: Stock is of average risk.
b = 2.0: Stock is twice as risky as an average stock.

2.) A portfolio consisting of low-beta stocks will also have a low beta because the beta of a portfolio (bp) is a
weighted average of its individual securities’ betas, found using this equation:
b p=w 1 b 1+ w2 b2 +…+ wN bN

3.) Here b p is the beta of the portfolio, and it shows how volatile the portfolio is relative to the market; w i is
the fraction of the portfolio invested in the ith stock; and b i is the beta coefficient of the ith stock. To
illustrate, if an investor holds a $100,000 portfolio consisting of $33,333.33 invested in each of three stocks
and if each of the stocks has a beta of 0.70, the portfolio’s beta will be b p = 0.70:

the slope of its regression line would be 0.70, which is less than that for a portfolio of average stocks
4.) Now suppose one of the existing stocks is sold and replaced by a stock with b i = 2.00. This action will
increase the portfolio’s beta from b p1 = 0.70 to b p2 = 1.13:

5.) Because a stock’s beta coefficient determines how the stock affects the riskiness of a diversified portfolio,
beta is, in theory, the most relevant measure of a stock’s risk.

Relationship Between Risk and Rates of Return

Security Market Line (SML) Equation

- shows the relationship between risk as measured by beta and the required rates of return on individual
securities

 r L =r RF + ( RP M ) b
 r L =r RF + ( r M −r RF ) b
Chapter 7 – Stocks and Their Valuation
Facts About Common Stock

 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price

Intrinsic Value vs Stock Price

Stock Price
- is simply the current market price (from the impression of the market)
- easily observed for publicly traded companies
Intrinsic Value
- the “true” value of the company’s stock
- cannot be directly observed and must instead be estimated

 Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s
intrinsic value ( P0)
 In equilibrium, we assume that a stock’s price equals its intrinsic value
o Outsiders estimate intrinsic value to help determine which stocks are attractive to buy
and/or sell
o Stocks with a price below (above) its intrinsic value are undervalued (overvalued).
Two basic models are used to estimate intrinsic values:
(1) discounted dividend model
- focuses on dividends
(2) corporate valuation model
- goes beyond dividends and focuses on sales, costs, and free cash flows

Discounted Dividend Model

The value of a share of common stock depends on the cash flows it is expected to provide:
(1) the dividends the investor receives each year while he or she holds the stock; and
(2) the price received when the stock is sold
 The final price includes the original price paid plus an expected capital gain

Marginal Investor
- a representative investor whose actions reflect the beliefs of those people who are currently trading a stock
- determines a stock’s price

Important Terms:

1.) Last Dividend Paid ( D 0 ¿

2.) Dividend Paid at the End of Year 1 ( D 1 ¿

> Dividend Expected at the End of Year 2, 3… ( D 2 , D3 … ¿
Note: D0 is known with certainty, but D 1∧D2 , and all other future dividends are expected values, and different
investors can have different expectations

3.) Market Price (P¿¿ 0) ¿

- actual market price at which a stock sells in the market

4.) Expected Price and Expected Intrinsic Value ( ^Pt ¿

- based on the investor’s estimates of the dividend stream and the riskiness of that stream
- however, for the marginal investor, P0 must equal ^Pt otherwise a disequilibrium would exist

5.) Growth Rate ( g)

- expected rate of growth in dividends per share
- if dividends are expected to grow at a constant rate, g should also equal the expected growth rate in
earnings and
the stock’s price

6.) Required Rate of Return (r s ¿

- minimum rate of return on a common stock that a stockholder considers acceptable

7.) Expected Rate of Return ( r^ ¿¿ s)¿

- rate of return on a common stock that a stockholder expects to receive in the future
- the expected return can be above or below the required return, but a rational investor will buy the stock
 if r^ sexceeds r s, sell the stock if r^ sis less than r s, and simply hold the stock if these returns are equal

8.) Actual (Realized) Rate of Return (r s)

- after-the-fact rate of return
- rate of return on a common stock actually received by stockholders in some past period
- may be greater or less than r^ s and/orr s

9.) Dividend Yield ( D1 / P0 ¿

- the expected dividend divided by the current price of a share of stock

10.) Capital Gains Yield [ ( ^

P1−P0 ¿/ P0 ¿
- the capital gain during a given year divided by the beginning price

11.) Expected Total Return, ( r^ ¿¿ s)¿ + [( ^

P1−P0 ¿/ P0 ¿
- expected dividend yield plus expected capital gains yield

>> Discounted Dividend Model

- value of a stock is the present value of the expected future dividends to be generated by the stock

Constant Growth Stocks

A stock whose dividends are expected to grow forever at a constant rate, g.

D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t

>> Constant Growth (Gordon) Model

- used to find the value of a constant growth stock

^ D0 (1+ g)1 D0 (1+ g)2 D0 (1+ g)∞

P 0= + +…+
(1+r )1 (1+r )2 (1+r )∞
D0 (1+ g) D1
^
P 0= =
r s−g r s−g

Example:
Expected Rate of Return = Expected Dividend Yield + Expected Growth Rate (or Capital Gains Yield)

( )
r^ s=
D1
P0
+g

Note: The constant growth model can only be used if:

– rs > g.
– g is expected to be constant forever.

Dividends vs Growth

The discounted dividend model shows that, other things held constant, a higher value for D1 increases a
stock’s price. However, it also shows that a higher growth rate also increases the stock’s price.
But now recognize the following:
• Dividends are paid out of earnings.
• Therefore, growth in dividends requires growth in earnings.
• Earnings growth in the long run occurs primarily because firms retain earnings and reinvest them in the
business.
• Therefore, the higher the percentage of earnings retained, the higher the growth rate.

Valuing Non-Constant Growth Stocks

Supernormal (Nonconstant) Growth

- part of the firm’s life cycle in which it grows much faster than the economy as a whole

Horizon (Terminal) Date

- the date when the growth rate becomes constant. At this date, it is no longer necessary to forecast the
individual dividends

Horizon (Continuing) Value

- the value at the horizon date of all dividends expected thereafter
D
Horizon Value ( ^
P N )= N +1
r s−g

The stock’s intrinsic value today, ^

P0, is the present value of the dividends during the nonconstant growth
period plus the present value of the horizon value
The Corporate Valuation Model

Corporate Valuation Model (or Free Cash Flow Method)

- a valuation model used as an alternative to the discounted dividend model to determine a firm’s value,
especially one with no history of dividends, or the value of a division of a larger firm
- calculates the firm’s free cash flows, then finds their present values to determine the firm’s value.

FCF= [ EBIT ( 1−T ) + Dep∧ Amort ] −[CAPEX+ ∆ NOWC ]

Issues Regarding the Corporate Valuation Model

 Often preferred to the discounted dividend model, especially when considering number of firms that
don’t pay dividends or when dividends are hard to forecast
 Similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate
 Horizon value (HVN) represents value of firm at the point that growth becomes constant.

Applying the Corporate Valuation Model

Market Value of Compan y ' s Operations (MV of Firm)

¿ V Compan y s Operations =PV of Expected Future FC
'

FCF 1 FCF 2 FCF ∞

¿ 1
+ 2
+…+
(1+WACC ) (1+WACC ) (1+ WACC) ∞

1.) Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.
2.) Subtract MV of firm’s debt and preferred stock to get MV of common stock.
3.) Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).
Firm Multiples Method

Analysts often use the following multiples to value stocks.

 P/E
 P/CF
 P/Sales
EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to
back out an estimate of the stock price.
EVA Approach

EVA = Equity capital (ROE – Cost of equity)

MVEquity = BVEquity + PV of all future EVAs
Value per share = MVEquity/# of shares

Preferred Stock

Preferred Stock
 Hybrid security
 Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid
to common stockholders
 However, companies can omit preferred dividend payments without fear of pushing the firm into
bankruptcy

Dp
V p=
rp
Dp
r^ p =
Vp
Where V pis the value of the preferred stock, D p is the preferred dividend, and r p is the required rate of return
on the preferred (r^ p is the expected return)
Chapter 8 – Capital Structure
Capital
- Investor-supplied funds such as long-and short-term loans from individuals and institutions, preferred
stock, common stock, and retained earnings (accounts payable and accruals are NOT included)

Capital Structure
- The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets.
- Total is 100%

Optimal Capital Structure

- The capital structure that maximizes a stock’s intrinsic value.

Measuring Capital Structure

How should the capital structure be measured? Book or Market Value? Target Ratio Range?
 Note: the target range is likely to change over time as conditions change

The firms’ actual capital structures change over time, and for two quite different reasons:
1.) Deliberate Actions
- if a firm is not currently at its target, it may deliberately raise new money in a manner that moves the
actual structure toward the target
2.) Market Actions
- the firm could incur high profits or losses that lead to significant changes in book value equity as
shown on its balance sheet and to a decline in its stock price
- although the book value of its debt would probably not change, interest rate changes due to changes in
the general level of rates and/or changes in the firm’s default risk could cause significant changes in its
debt’s market value.

Business and Financial Risk

Business Risk

Business Risk
- the riskiness of the firm’s assets if no debt is used
- a commonly used measure of business risk is the standard deviation of the firm’s return on invested capital
* Because ROIC does not vary with changes in capital structure, the standard deviation of ROIC
measures the underlying risk of the firm before considering the effects of debt financing, thereby
providing a good measure of business risk.
  The more uncertainty there is about future EBIT and thus ROIC, the greater the company’s business risk

Factors that affect business risk:

 Competition
 Uncertainty about demand (sales)
 Uncertainty about output prices
 Uncertainty about costs
 Product obsolescence
 Foreign risk exposure
 Regulatory risk and legal exposure
 Operating leverage

Operating Leverage
- The extent to which fixed costs (rather than variable costs) are used in a firm’s operations
- the higher a firm’s fixed costs, the greater its business risk
- a high degree of operating leverage, other factors held constant, implies that a relatively small change in
sales results in a large change in ROIC

Operating Breakeven
- The output quantity at which EBIT = 0
- EBIT =PQ−VQ−F=0
Here P is average sales price per unit of output, Q is units of output, V is variable cost per unit, and F is fixed operating costs.

Breakeven Quantity
F
QBE =
P−V
Financial Risk

Financial Risk
- An increase in stockholders’ risk, over and above the firm’s basic business risk, resulting from the use of
debt or financial leverage

Financial Leverage
- The extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure
- The use of debt or financial leverage, concentrates the firm’s business risk on the stockholders.
(the debtholders will receive a fixed payment, and it will come before the stockholders receive anything)
- Changes in the use of debt would cause changes in earnings per share (EPS) as well as changes in risk—
both would affect the stock price
Business Risk vs Financial Risk
Business Risk Financial Risk
Depends on business factors such as competition, Depends only on the types of securities issued
product obsolescence, and operating leverage

More debt, more financial risk

Concentrates business risk on stockholders.
The Effect of Leverage on Profitability and Debt Coverage

Conclusions (from the examples):

 Return on invested capital (ROIC) is unaffected by financial leverage.
 L has higher expected ROE because ROIC > rd(1 – T).
 L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is
accompanied by higher risk.

Optimal Capital Structure

Optimal Capital Structure

- maximizes the price of the firm’s stock ( P0)
- generally calls for a Debt/Capital ratio that is lower than the one that maximizes expected EPS
a.) to the extent that higher debt levels raise expected EPS, financial leverage works to increase the
stock price
b.) however, higher debt levels also increase the firm’s risk, which raises the cost of equity and works
to reduce the stock price.

The firm’s optimal capital structure can be determined two ways:

a.) Minimizes WACC.
b.) Maximizes stock price.
 Both methods yield the same results.
Many managers use the estimated relationship between capital structure and the WACC to guide their
capital structure decisions
Sequence of Events in a Recapitalization
1.) Firm announces the recapitalization.
2.) New debt is issued.
3.) Proceeds are used to repurchase stock.
 The number of shares repurchased is equal to the amount of debt issued divided by price per share.
The Hamada Equation

Note: Increasing the debt ratio increases the risk that bondholders face and thus the cost of debt; More debt
also raises the risk borne by stockholders, which raises the cost of equity – harder to quantify leverage’s
effects on the cost of equity

Hamada Equation
If the entity uses no debt, it has no financial
 b L =bU [1+(1−T )( D/ E)]
risk. Therefore, the risk premium is
attributable entirely to business risk.
>> Unlevered Beta
- the firm’s beta coefficient if it has no debt. If the entity changes its capital structure by
b U =b L /[1+(1−T )(D /E)] adding debt, this would increase the risk
stockholders would have to bear.
Example:
That, in turn, would result in a higher risk
premium. Conceptually, a firm’s cost of equity
consists of the following component:
Chapter 9 – Distribution to Shareholders
Distribution and Preference of Dividends

Target Payout Ratio

- target percentage of net income paid as cash dividends
- should be based (in large) on investors’ preferences for dividends versus capital gains

Scenario A
 Payout Ratio =  Dividends per share =  Stock Price
Scenario B
 Payout Ratio =  Dividends per share =  Money for Reinvestments =  Growth Rate =  Stock Price

Dividend Policy
- the decision to pay out earnings versus retaining and reinvesting them
- it includes:
 High or low dividend payout?
 Stable or irregular dividends?
 How frequent to pay dividends?
 Announce the policy?
>> Optimal Dividend Policy
- dividend policy that strikes a balance between current dividends and future growth and maximizes the
firm’s stock price.

Dividend Irrelevance Theory

- investors are indifferent between dividends and retention-generated capital gains
- a firm’s dividend policy has no effect on either its value or its cost of capital
- investors can create their own dividend policy
 If they want cash, they can sell stock.
 If they don’t want cash, they can use dividends to buy stock.
- proposed by Modigliani and Miller
- based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true.
- need an empirical test

Why Investors Might Prefer Dividends:

- May think dividends are less risky than potential future capital gains.
- Investors would value high-payout firms more highly (e.g., high payout would result in a high stock price)
and thus would maximize the firm’s value – Bird-in-the-Hand Fallacy

Why Investors Might Prefer Capital Gains:

- May want to avoid transactions costs (since dividends increase transaction costs)
- Maximum tax rate is the same as on dividends, but:
 Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever
the stock is sold.
  If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost
basis and escape all previously accrued capital gains.

Information Content, or Signaling, Hypothesis

Information (Signaling) Content

- the theory that investors regard dividend changes as signals of management’s earnings forecasts.
 Since managers hate to cut dividends, they won’t raise dividends unless they think the increase is
sustainable
- on the other hand, a stock price increase at time of a dividend increase could also reflect higher
expectations for future EPS and NOT a desire for dividends.

Clientele Effect
- tendency of a firm to attract a set of investors who like its dividend policy.
- firm’s past dividend policy determines its current clientele of investors.
- this effect impedes changing dividend policy
(since the current group would only prefer the firm’s current policy and not wanting to change it)
 e.g., taxes and brokerage costs hurt investors who have to switch companies
>> Clienteles
- different groups of investors who prefer different dividend payout policies.

Catering Theory
- a theory that suggests investors’ preferences for dividends vary over time and that corporations adapt
their dividend policies to cater to the current desires of investors.

Establishing the Dividend Policy in Practice

When a firm is deciding how much cash to distribute to stockholders, it should consider two points:
(1) The overriding objective is to maximize shareholder value
(2) The firm’s cash flows really belong to its shareholders, so management should not retain income unless
they can reinvest those earnings at higher rates of return than shareholders can earn themselves.
Note: If good investments are available, it is better to finance them with retained earnings than with new
stock

The Residual Dividend Model

- a model in which the dividend paid is set equal to net income minus the amount of retained earnings
necessary to finance the firm’s optimal capital budget.
- policy implies that dividends are paid out of “leftover” earnings
- this policy minimizes flotation and equity signaling costs, hence minimizes the WACC.
Conceptual Steps in the Residual Dividend Model
> First, under this model, we assume that investors are indifferent between dividends and capital gains
> Then the firm follows these four steps to establish its target payout ratio:
(1) It determines the optimal capital budget
(2) Given its target capital structure, it determines the amount of equity needed to finance that budget
(3) It uses retained earnings to meet equity requirements to the extent possible
(4) It pays dividends only if more earnings are available than are needed to support the optimal capital
budget.

Example:

How would a change in investment opportunities affect dividends under the residual policy?
a.)  Good Investments =  Capital Budget =  Dividend Payout
b.)  Good Investments = Capital Budget =  Dividend Payout

Comments on Residual Dividend Policy

Advantages Disadvantages
Minimizes new stock issues and flotation costs Results in variable dividends
Sends conflicting signals
Increases risk
Doesn’t appeal to any specific clientele.
Conclusion: Consider residual policy when setting long-term target payout, but don’t follow it rigidly from
year to year
Setting the Dividend Policy
1. Forecast capital needs over a planning horizon, often 5 years.
2. Set a target capital structure.
3. Estimate annual equity needs.
4. Set target payout based on the residual model.
5. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital
structure somewhat if necessary

Dividend Reinvestment Plan [DRIP]

Dividend Reinvestment Plan

- plans that enable stockholders to automatically reinvest dividends received back into the stocks of the
paying firms
- get more stock than cash

a.) Open Market

- old, outstanding stocks
- dollars to be reinvested are turned over to trustee, who buys shares on the open market.
- brokerage costs are reduced by volume purchases.
- convenient, easy way to invest, thus useful for investors.

b.) New Stock

- newly issued stock
- firm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money and
uses it to buy assets.
- firms that need new equity capital use new stock plans.
- firms with no need for new equity capital use open market purchase plans.
- most NYSE listed companies have a DRIP – Useful for investors.

Stock Dividends and Stock Splits

Stock Split
- an action taken by a firm to increase the number of shares outstanding, such as doubling the number of
shares outstanding by giving each stockholder two new shares for each one formerly held

Stock Dividends
- a dividend paid in the form of additional shares of stock rather than in cash
Common characteristics:
 Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided
into smaller pieces.”
 Unless the stock dividend or split conveys information, or is accompanied by another event like higher
dividends, the stock price falls so as to keep each investor’s wealth unchanged.
 But splits/stock dividends may get us to an “optimal price range.”

Stock Repurchases

Stock Repurchases [Treasury]

- transactions in which a firm buys back shares of its own stock, thereby decreasing shares outstanding,
increasing EPS, and, often, increasing the stock price.

Reasons for repurchases:

 As an alternative to distributing cash as dividends.
 To make a large capital structure change.
 To obtain stock for use when options are exercised.

Advantages Disadvantages
Stockholders can tender or not. May be viewed as a negative signal (firm has poor
investment opportunities).
Helps avoid setting a high dividend that cannot be IRS could impose penalties if repurchases were
maintained. primarily to avoid taxes on dividends.
Repurchased stock can be used in takeovers or Selling stockholders may not be well informed,
resold to raise cash as needed. hence be treated unfairly.
Remove a large block of stock “overhanging” the Firm may have to bid up price to complete purchase,
market and depressing the stock price. thus paying too much for its own stock.
Stockholders may take as a positive signal;
management thinks stock is undervalued.