Chapter one overview of Financial

management

Financial Management –I
 An Overview of Financial Management
 Finance is the art and science of
managing money.
 FinanceManagement
Financial can be publicisormainly
private finance.
concerned with the effective funds
management in the business. Basic assumptions:
Another name of Financial  Existence of well-developed capital
Management is markets
 Corporation Finance (widely)  The context of Corporate form of
 Business business organizations
Finance as the
Finance area of study
(rarely).
Separate legal existence
Finance, in general, consists of three interrelated areas:
 Money and capital markets, which deal with securities
markets and financial institutions;
 Investments, which focus on the decision of investors, both
individuals and institutions, as they choose among securities for
their investment portfolios; and
Basic Assumptions and Principles of FM…
1.The risk-return trade-off -In financial decision
making, we don’t take additional risk unless we
expect to be compensated with additional return
2. The time value of money- A dollar received today is
worth more than a dollar to be received in the future
3.Cash – NOT profit – is a king - In measuring wealth or
value, we will consider cash flows, not accounting
profits
4.Incremental cash flows- cash flow which is the
difference between the cash flows if the decision is
made versus what they will be if the decision is not
made/Relevant cash flow analysis/
Basic Assumptions and Principles of FM…

1.The curse of competitive markets- If an industry is

generating large profits, new entrants usually attracted
2.Efficient capital markets- An efficient (informational
efficiency) capital market is a market in which the
values of all assets and securities at any instant in time
fully reflect all available public information.
3.The Agency problem- It is the problem resulting
from conflicts of interest between the managers
(agents of the stockholders) and the stockholders
4.Taxes bias business decision & Ethical behavior
…
 Scope of Financial Management (FM)
al management directly related with
Related field of FM:
functional departments like Accounting  Production
 personnel/HR, Economics Management
marketing and Mathematics/  Marketing
Statistics
production. Financial management  Human
decisions
Finance functions or decisions include: Resources
1.Investment or long-term asset mix decision (capital
budgeting ) - Investment decisions or capital budgeting involves
the decision of allocation of capital or commitment of funds to long
term assets that would yield benefits in the future.
2.Financing or capital mix decision - The mix of debt and equity is
known as the firm’s capital structure
3.Dividend or profit allocation decision - The financial manager
must decide whether the firm should distribute all profits or retain
them or distribute a portion and retain the balance
 Forms of Business Organization
Major forms of business organization around the globe.
4. Corporation
1. Sole Proprietorship
S Corporation
2. Partnership
Limited Liability Company
General Partnership
5. Cooperatives
Limited Partnership
Sole Proprietorship
Advantages Disadvantages
 Easiest to start  Limited to life of owner
 Least regulated  Equity capital limited to owner’s
 Single owner keeps personal wealth
all of the profits  Unlimited liability
 Taxed once as  Difficult to sell ownership interest
personal income
 Partnership
• Disadvantages
• Advantages • Unlimited liability
• Two or more owners • General partnership
• More capital available • Limited partnership
• Relatively easy to start • Partnership dissolves when
• Income taxed once as one partner dies or wishes to
personal income sell
Corporation • Difficult to transfer ownership
• Advantages • Disadvantages
• Limited liability • Separation of ownership and
• Unlimited life management (agency
• Separation of ownership and problem)
management • Double taxation (income taxed
• Transfer of ownership is easy at the corporate rate and then
• Easier to raise capital dividends taxed at personal
 Goal of Financial Management
hould be the goal of a corporation?  Maximize market share?
• Maximize  maximization of
profit? shareholders wealth ?
 The
• Minimize  Maximize
ultimate goal of FM is to maximize the shareholders
earningwealth
per
costs?
through per share of the existing
maximization of current valueshare?
stock.
 Does this mean financial manager should do anything and
The Agency Problem
everything
While to maximize
the goal owner wealth?
of the business firm will be maximization of
shareholders' wealth, in reality the agency problem may
interfere with the implementation of this goal.
The agency problem is the result of a separation of the
management and the ownership in firms.
 Stockholders (principals) hire managers (agents) to run the
 Financial Markets and the Corporation
• Physical Assets Vs. Financial Assets
 Physical Asset Markets – for such products as
wheat, autos, real estate, computers, and machinery.
 Financial Asset Markets – deal with stocks, bonds,
notes, mortgages, derivatives, & other financial
instruments.
• Time of Delivery: Spot Vs. Future
 Spot Markets – markets where assets are being
bought or sold for “on-the-spot” delivery (within a few
days).
 Futures Markets – for assets whose delivery is at
some future date, such as 6 months or a year into the
future.
 Financial Markets and the Corporation

Maturity of Financial Asset: Short Vs. Long

Money Markets – for short-term, highly liquid debt
securities, < a year.
Capital Markets – for corporate stocks and debt
maturing > a year in the future.
Primary Markets Vs. Secondary Markets
Primary Markets – originally gov’ts & corporations
raise new capital.
Secondary Markets – existing, already-outstanding
securities are traded among investors.
Financial statement Analysis
part one

Financial Management –I
 Financial Statement Analysis
Analyzing financial statements involves
Characteristics
 Liquidity Comparison Bases: Tools of Analysis
 Intracompany  Horizontal
 Profitability
 Intercompany  Vertical
 Solvency
 Industry averages  Ratio
 Efficiency

Horizontal Analysis (HA)

 HA, also called trend analysis, is a technique for
evaluating a series of financial statement data over a
period of time.
 Purpose is to determine the changes that has taken
12
Financial Statement Analysis
Horizontal
• Analysis
Changes suggest
that the firm
expanded its asset
base during 2017
and
• Financed this
expansion primarily
by retaining income
rather than
assuming additional
13
Financial Statement Analysis
Horizontal Analysis
• Overall, gross
profit and net
income were up
substantially.
• Gross profit
increased 17.1%,
• Net income
increased 26.5%.
• Firm’s profit trend
appears favorable
14
 Vertical Analysis (VA)
• VA, also called common-size analysis, is a technique that
expresses each financial statement item as a percent of a base
amount.
• For instance, on an IS, we might say that selling expenses are
16% of net sales.
• VA is commonly applied to the SFP and the IS.

15
Vertical Analysis cont’d

 The firm appears

to be a profitable
firm that is
becoming even
more successful.

16
 Ratio Analysis

• Mathematical formulas which give insight on parts of the firm.

• Expresses the relationship among selected items of financial
statement data.
• Ratios are an analyst's microscope; they allow to get a better
view of the firm's financial health than just looking at the raw FS.
• Ratios are useful both to internal and external analysts of the
firm.

• But
Theadiscussion
single ratio by itself is not meaningful (see next slide).
of ratios will
include the
following types
of comparisons.
17
 Ratio Analysis Cont’d
Financial Ratios Classifications:
1. Liquidity Ratios (Short-term 4. Profitability
Solvency) Ratios
2. Financial Leverage Ratios 5. Market Value
(Long-term Solvency) Ratios
Liquidity Ratios
3. Asset Management
(Turnover) Ratios
 Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
 Short-term creditors such as bankers and suppliers are particularly
interested in assessing liquidity.
These ratios include:
1. The Current Ratio 2. Acid-
test Ratio 3. The Cash Ratio 18
 Ratio Analysis Cont’d
Liquidity Ratios Current Ratio
• Example:
Rule/guide:
• CR is better if 2:1
• In the example CR of 2.96:1
means that for every dollar of
current liabilities, firm has
$2.96 of current assets.
• Depends on the industry on
which the Firm involves
• Too much – less profitable
19
•
Ratio Analysis…
Liquidity Ratios Acid-test Ratio

Acid-test (quick) ratio measures immediate liquidity.

• Rule/guide:
• QR is better if 1:1
• Example:

 Quick Ratio = [CA – (Inventories + Prepaid

Expenses]/CL
 It tells us a measure of firm’s ability to pay off short-
20
 Ratio Analysis Cont’d

Assets Management Ratios

• Intended to describe how efficiently or
intensively a firm uses its assets to generate
sales.
• Also called asset utilization ratios – measures of
turnover.
• Some of the measures are:
• inventory turnover and days’ sales in
inventory
• receivables turnover and days’ sales in
receivables 21
Ratio Analysis…
Assets Management Ratios  ITO
• Inventory Turnover and Days Sales in Inventory
• Inventory measures tell us how fast we can sell product.
• 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 = (𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅)/(Average 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 )
• Inventory turnover varies by type of inventory.
• The higher inventory turnover indicates the improvement in inventory management.
• Example:

22
Ratio Analysis…
Assets Management Ratios  DSI
 Days Sales in Inventory

Or

• Where,
• It is a rough measure of the length of time it takes to
purchase, sell, and replace the inventory.
• The shorter this number indicates the improvement in
managing inventory. 23
Ratio Analysis…
Assets Management Ratios  ARTO & DS
 Receivables Turnover and Days Sales in Receivables
 Receivable measures tells us how fast we collect credit sales.

• The longer receivables turnover indicates that customers, on average,

are not paying their bills on time!
• This ratio makes more sense if we convert it to days, so here is the
days’ sales in receivables.

• Also called the average collection period (ACP). 24

Ratio Analysis…
Profitability Ratios
• Measure the income or operating success of a company for a given period of
time.
• Income, or the lack of it, affects the company’s ability to obtain debt and equity
financing, liquidity position, and the ability to grow.
• Ratios include:
• Profit Margin,
• Return On Assets,
• Return On Equity,
• Earnings Per Share,
• Price-earnings, and
• Payout Ratio.
25
Ratio Analysis…
Profitability Ratios  Profit Margin & ROA
• Profit Margin – measures the percentage of each dollar of sales that results in net
income.
• Example:

• Return on Assets – measure of profitability generated through the assets.

• Ex:

26
Ratio Analysis…
Profitability Ratios  ROE
• Return on Equity – shows how many dollars of net income the company earned for each
dollar invested by the owners.

• Example:

27
Ratio Analysis…
Profitability Ratios  EPS
• Earning per Share – a measure of the net income earned on each share of common
stock.

• Example:

28
Ratio Analysis…
Profitability Ratios  P-E ratio
• Price-Earnings ratio – measures the net income earned on each share of common
stock.

Assumption:
• Ex: • the market price of firm’s shares
is $8 in 2016 and $12 in 2017.

29
Ratio Analysis…
Profitability Ratios  Payout Ratio
• Payout Ratio – measures the percentage of earnings distributed in the form of cash
dividends.

• Example:

30
 Ratio Analysis Cont’d
Financial Leverage Ratios
• They are intended to address the firm’s long-term ability to
meet its obligations, or, more generally, its financial leverage.
• Commonly used measures are:
• Total debt ratio, debt–equity ratio, equity multiplier, Times
Interest Earned & Cash Coverage
Financial Leverage Ratios  Total Debt Ra
TDR takes into account all debts of all

TDR = (𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 −𝑻𝒐𝒕𝒂𝒍

maturities to all creditors.

𝑬𝒒𝒖𝒊𝒕𝒚)/
(𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔)
= (𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒆𝒔)/(𝑻𝒐𝒕𝒂𝒍
𝑨𝒔𝒔𝒆𝒕𝒔)
Rule: <50% 31
 Ratio Analysis Cont’d
Financial Leverage Ratios  Debt-Equity
• Debt-Equity Ratio – measures how much of the company is

• 𝑫𝑬𝑹 = (𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕)/(𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚

financed by debt and equity!
Example:
)
2017
DER =
$832,000/$1,003,000
• Rule: <100% [or, <1] = 83%
• The lower ratio indicates that the firm’s liabilities as a

• 𝑬𝒒𝒖𝒊𝒕𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 = (𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔)/(𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚)

proportion of equity is decreasing.

= 1+ 𝑫𝑬𝑹
• Example: EM = TA/TE = $1,835,000/$1,003,000 = 1.83
times
EM = 1+ DER  1+ 0.83 = 1.83 times. 32
 Ratio Analysis Cont’d
Financial Leverage Ratios Times Intere
• Times Interest Earned - measures how well a company
has its interest obligations covered, and it is often

• 𝑻𝑰𝑬 𝑹𝒂𝒕𝒊𝒐 = 𝑬𝑩𝑰𝑻/𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕

called the interest coverage ratio.

• Interest expense is paid before income taxes i.e.,

interest expense is deducted in determining taxable
income.
TIE = EBIT/Interest
• Rule: the higher > $468,000/$36,000
the ratio, the more likely interest = 13 tim
payments will be.

33
 Ratio Analysis Cont’d
Financial Leverage Ratios  Cash Coverag
• Cash Coverage –
• Problem with the TIE ratio is that it is based on EBIT,
which is not really a measure of cash available to pay
interest.
• The reason is that depreciation, a noncash expense, has
been deducted out.
• Because interest is definitely a cash outflow (to

• 𝑪𝒂𝒔𝒉 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =

creditors).

(𝑬𝑩𝑰𝑻+𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏)/𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
• The numerator here, EBIT plus depreciation, is often
abbreviated EBITD (earnings before interest, taxes, and
depreciation). 34
•
Ratio Analysis…
Market Value Ratios  M/B ratio
• Market-to-Book Ratio – compares the market value of the firm’s investments to their cost.
• A value less than 1 indicates that the firm has not been successful overall in creating value for
its stockholders.

• Example:
• M/B = $12/$1 = 12

35
Thematic area Corporate
Finance
Course
Financial Management
Part I
Part III
III

Risk and Return

 Risk and Return
Risk is usually defined as the actual or potential
variability of returns from a project or portfolio
Risk-free returns are known with certainty
 Federal Government Treasury Bills are often
considered the risk-free security.
 The risk-free rate of return sets a floor under all other
Returns • Ex Post Returns (After the fact) Return that an investor actually
returns in the market
realizes
• Ex Ante Returns (Before the fact) Return that an investor expects to
earn
Holding Period Return
• Return for holding an investment for one period (i.e.
period of days, months, years, etc.)
• When there is no cash flow during the holding period,
 Holding Period Return
HPR = Holding Period Return P1 - P0
P1 = Ending Price HPR =
P0 = Beginning Price
P0
When there is a cash flow in addition to the ending price (such as
the payment of a dividend), the Holding Period Return formula is:
P1+Cash Flow  - P0
Example HPR = P0
You bought a stock one year ago for $10. Today, it is
worth $12. Yesterday, you received a $1 P1dividend.
+Cash Flow  - P0
HPR =
What is your holding period return? P 0


12  1  10
10
 0.30 or 30% 38
 Expected Return
r̂ ( ):
• When returns are not known with certainty, there will often
exist a probability distribution of possible returns with an
associated probability of occurrence.
• Expected return is a weighted average of nthe individual
possible returns (rj), with weights being
Possible
occurrence (pProbability
). of

r̂ the probability
j 1
rjp j of
jOccurrence
Return
n
-10% 5% r̂   rjp j
j 1
0% 10%
  10% .05   0% .10  
+5% 25%
5% .25  15% .50   25% .10 
+15% 50%
10.75%
+25% 10%
39
 Measurements of Risk
• Standard Deviation
 ( ): a statistical measure of the
r̂
dispersion, or variability, of outcomes around the mean
or expected value ( ).
• Low standard deviation means that returns are
tightly clustered around the mean
• Three common ways of calculating standard
• High standard deviation means that returns are
deviation:
widely dispersed
• Returns around
are known thecertainty
with mean
• Standard deviation of a population
• Standard deviation of a sample
• Returns are not known with certainty
40
 Standard Deviation (Historical) of a Population
First, calculate the variance ( 2):

     
2 2 2

2
r1 - r + r2 - r +...+ rN - r
σ =
N
The standard deviation ( ) is the square root
of the variance:
r = Mean return σ= σ2
ri = Return i
N = Number of returns
You have been given the following sample of stock returns,
r1 + r2 + ... + rN
for which you would like to calculate
AM = the standard deviation:
N
{12%, -4%, 0%, 22%, 5%} 12 - 4  0  22  5

p 1: Calculate Arithmetic Return 5
41
 7%
 Standard Deviation: Example
Step 2: Calculate Variance
r - r  + r - r  +...+ r - r 
2 1
2
2
2
N
2

S =
N-1
12  7    4  7   0  7   22  7   5  7 
2 2 2 2 2


5 1
106
s = S2
3: Calculate Standard Deviation
 106
10.3%

Standard Deviation – Returns Not Certain

rj = return at time period j
 
n 2
σ2 = rj - r p j = expected return
j=1
pj = probability of return j occurring
42
 Standard Deviation: Example
You have been provided with the following possible
returns and their associated probabilities. Calculate the
expected return and
State of Economy Returnthe standard
Probability deviation of return.

Boom 30% 15%

Normal 15% 60%

Recession 0% 25%
n
Step #1: Calculate the Expected Return r̂   rjp j
j 1

 30% .15   15% .60   0% .25 

13.5%
43
 Standard Deviation: Solution
Step #2: Calculate the Variance
State of Economy Return Probability

Boom 30% 15%

Normal 15% 60%

 
n 2
2
σ = rj - r p j Recession 0% 25%
j=1

= 30-13.5  .15 + 15-13.5  .60 + 0-13.5  .25 

2 2 2

= 87.75
Step #3: Calculate the Standard Deviation σ= σ2
= 87.75
= 9.4%

44
 Concept of Efficient Portfolios
• Has the highest possible expected return for a given level of risk
(or standard deviation)
• Has
A the lowest possible level of it
risk forthe
a given expected return
dominates B because has same expected
return for a given risk.
C dominates B because it has a higher expected
r̂ return for a given risk.
C

A B


45
 Coefficient of Variation (v)
 deviation ( ) r̂to the expected value
The ratio of the standard
( ).
Tells us the risk per unit of return.

An appropriate measure of total risk when comparing two
v
investment projects of different size.
r̂
Example: You are asked to rank the following set of investments
according to their risk
Security per unit
Return of return.
Standard
Deviation
A 6% 7%

B 10% 13%

C 18% 21%
46
 Coefficient of Variation
Security Return Standard Coefficient of
Deviation Variation

A 6% 7% 7
1.17
6
B 10% 13% 13
1.3
Most Risk 10
C 18% 20% 20
1.1
Least Risk 18

Relationship Between Risk and Return

Risk-Return Relationship
 The riskier, or the more variable, the expected cash flow
stream, the higher the required rate of return.
 Required Rate of Return = Risk-free Rate of Return +
 Risk Premium
Risk-free Rate: rate of return on securities that are free of
47
default risk, such as T-bills.
 Relationship Between Risk and Return
Risk Premium: expected “reward” the investor expects to earn for assuming risk

 Risk-free Rate of Return (rf) = Real Rate of Return + Exp.

 Inflation
Real RatePremium
of Return: the reward for deferring consumption
 Expected Inflation Premium: compensates investors for the
loss of purchasing power
Types ofdue to inflation
Risk Premiums
 Maturity risk  Marketability risk
premium premium
 Default risk  Business risk
48

 Modern Portfolio Theory
Modern portfolio theory was introduced by Harry Markowitz in 1952.
Markowitz, Sharpe & Miller were co-recipients of the Nobel Prize in
Economics in 1990 for their pioneering work in portfolio theory

Harry Markowitz William F. Sharpe Merton Miller

Expected Return of portfolio

The expected return on a portfolio is the weighted average of
the returns of each asset within the portfolio
Example: A portfolio is comprised of three securities with
the following returns:
49
 Expected Return
n
Security Return % of Portfolio
r̂   rjw j
j 1
A 5% 30%
B 10% 45%  5% .30   10% .45   15% .25 
C 15% 25%  9.75%
rj = return at time period j,
r̂ = expected return
wj = proportion of the portfolio comprised of
asset j Portfolio Risk: Two Risky Assets
Standard deviation of a two-asset
portfolio is calculated as follows σ = standard deviation
2 2 2 2 wA = the proportion of the portfolio comprised of A
σ = wA σ A + wBσ B + 2w AwBρ A,Bσ Aσ B
ρA,B= the correlation coefficient between A & B
50
 Portfolio Risk: Two Risky Assets
e ts
s
2 2 2 2 as
σ= w σ
A A + w σ + 2w AwBρ A,Bσ Aσ B
B B o s e
r.
h o h e
, c ot
k
ris e ach
l io v e
th
r tfo t ha wi
po tha ions
Portfolio risk is driven mainly by the ize la t
m re
correlation between the assets!! ini co
r
m
To low
e ry
Correlation v

Correlation is a measure of the linear relationship between two assets

Correlation varies between perfect negative (-1) to perfect positive
(+1)
Perfect negative correlation: when the return on asset A rises, the
return on Asset B falls and vice versa
Perfect positive correlation: the returns on asset A and Asset B move
in perfect unison 51
 Total Standard Deviation (or
Risk)
Unique or
Market or
Non-systematic Risk
Systematic Risk

Diversifiable Non- Diversifiable

 We need to measure the Market risk that
cannot be diversified away
The market will not compensate us for
risk that can be diversified away.
Market Risk
(measured with Beta)

Unique Risk
The market will compensate us for
market risk – the risk that cannot
52
 Capital Asset Pricing model (CAPM)
• Only systematic risk is relevant
• Systematic, or non-diversifiable, risk is caused by factors affecting the
entire market
• interest rate changes
• changes in purchasing power
• change in business outlook
• Unsystematic, or diversifiable, risk is caused by factors unique to the
firm
• strikes
• regulations
• management’s capabilities
 When assets are put into a well-diversified portfolio,
some of the unique or nonsystematic risk is diversified
away 53
 Diversifying Unique Risk
• Beta is a measure of the volatility
Risk of a security’s return compared
Portfolio
Risk
to the volatility of the return on
the Market Portfolio
Covariance j,Market
Unique
βSecurity j  VarianceMarket
Risk

Market Risk

Number of Securities
54
 Security Market Line (SML)
Shows the relationship between required rate of
return and beta (ß).
Required
Rate of Required Rate of Return (CAPM)
Return Security
Market Line • The required return for any
security j may be defined in
kj terms of systematic risk, j, the
expected market return, rm, and
the expected risk free rate, rf.
rf
k j ˆr β j (ˆr  ˆr )
ßj f m f
ß

55
 Security Market Line (SML)
EXAMPLE: A security has a Beta of 1.25. If the yield
on Treasury Bills is 5% and the return on the market
portfolio is 11%, what is the expected return for
holding the security? k ˆr β (ˆ
j f
r)
r  ˆ j m f

=5+1.25 11- 5  12.5%

An investor expects a return of 12.5% to hold the security.
Market Risk Premium
• The reward for bearing risk
• Equal to (rm – rf),Equal to the slope of security market
line (SML)
• Will increase or decrease with
• uncertainties about the future economic outlook
• the degree of risk aversion of investors 56
 Security Market Line (Again)
CAPM
Assumptions Return SML
Investors hold well-diversified
A
portfolios
RM
Competitive markets A – return is too high;
price is too low
Borrow and lend at the risk-free B
B – return is too low;
rate price is too high

Investors are risk averse

M 
No taxes
Investors are influenced by 57
 Market Efficiency
Capital markets are efficient if prices adjust fully and
instantaneously to new information affecting a security’s
prospective return.
e Degrees of Market Efficiency
 Weak form
 Semi-strong form
 Strong form
eak Form Market Efficiency
 Security prices capture all of the information contained
in the record of past prices and volumes
 Implication: No investor can earn excess returns using
historical price or volume information. Technical
analysis should have no marginal value.
58
 Semi-Strong Form Market Efficiency
Security prices capture all of the information contained in the public
domain.
Implication: No investor can earn excess returns using publicly available
information. Fundamental analysis should have no marginal value.

ng Form Market Efficiency

 Security prices capture all information,
both public and private.
 Markets are quite efficient (but it is illegal
to use private information for personal
gain, when trading securities)!

59
Thematic area Corporate
Finance
Course
Financial Management
Part I
Part III
IV

Time Value Of Money (TVM)

 Payment of Interest
• Interest is the cost of money
• Interest may be calculated as: 1. Simple interest 2.
Compound interest
terest : Interest is paid on the principal amount only
Example: $1,000 is invested to earn 6% per year, simple
0 3
interest. 1 2

-$1,000 $60 $60 $60

mpound Interest
 Interest paid on both the initial principal and on interest that
has been $1,000
Example: paid & reinvested
invested to earn 6% per year, compounded
annually. 0 1 2 3

-$1,000 $60.00 $63.60 $67.42

61
 Future Value
• The value of an investment at a point in the future, given some rate of return.
Simple Interest Compound Interest
FVn = PV0+(PV0 i n) FVn = PV0 (1 + i)n
FV = future value FV = future value
PV = present value PV = present value
i = interest rate i = interest rate per compounding period (r/m)
n = number of periods n = number of compounding (m*t)
M=no. of compounding per year
ure Value: Simple InterestT= no. of years
Example: You invest $1,000 for three years at 6%
simple interest per
FV = PV +(PV i n) year. 0 6% 1 6% 2 6% 3
3 0 0
-$1,000
= $1, 000  $1, 000 0.06 3 
= $1,180.00
62
 Future Value
e Value: Compound Interest
Example: You invest $1,000 for three years at 6%,
compounded
6%
annually.
6% 6%
FV3 = PV0 (1 + i) n
0 1 2 3
= $1, 000 1  0.06 
3

-$1,000
= $1,191.02
Future values can be calculated using a table method, whereby
“future value interest factors” (FVIF) are provided.
FVn = PV0 (FVI Fi,n ) , where: FVI Fi,n = 1+i
n

Where FV = future value

PV = present value
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years 63
 Future Value
Example: You invest $1,000 for three years at 6%
compounded
Table 4.1 Excerpt: annually.
FVI Fs for $1
End of Period (n) 5% 6% 8% FV3 = PV0(FVIF6%,3 )
2 1.102 1.124 1.166
=$1,000(1.191) =$1,191.00
3 1.158 1.191 1.260
4 1.216 1.262 1.360

Present Value
What a future sum of money is worth today, given a
FVn interest (or discount)
particular FV = future value
rate.
PV0  PV = present value
1+i
n
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years 64
 Present Value
Example: You will receive $1,000 in three years. If the
discount rate
0 is 6%,
6% 1 what
6% is2 the 6%
present
3 value?
$1,000
FV3 $1, 000
PV0    $839.62
1+i 1  0.06 
n 3

Present values can be calculated using a table method,

whereby “present value interest factors” (PVIF)1are provided.
PV0 = FVn(PVI Fi,n ) , where: PVI Fi,n =
1+i
n
FV = future value
PV = present value
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
65
 Present Value
Example: What is the present value of $1,000 to be received
in three years, given a discount rate of 6%?
Table 4.2 Excerpt: PVI Fs for $1
End of Period (n) 5% 6% 8%
2 0.907 0.890 0.857
3 0.864 0.840 0.794
4 0.823 0.792 0.735

PV0 = FV3(FVI F6% ,3 )

=$1,000(0.840) =$840.00

66
 Annuities
The payment or receipt of an equal cash flow per period,
for a specified number of periods.
Examples:
Ordinary mortgages,
annuity: car
cash flows leases,
occur retirement
at the end of income
each period
Example: 3-year,
0 $100 ordinary
1 annuity
2 3

$100 $100 $100

Annuity Due: cash flows occur at the beginning of each

period
Example:
0 3-year, $100 annuity
2 due 3
$100 $100 $100
67
 Annuities
Future value of an annuity - sum of the future values of all
0 1 2 3
individual cash flows.
$100 $100 $100 FV
FV
FV
FV of Annuity
re value of an ordinary annuity
 1+in -1 
FVOrdinary= PMT  
Annuity  i 
 
FV = future value
PMT = periodic payment
i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
68
 Annuities
Example: What is the future nvalue of a three year ordinary
annuity with aFV
cash =
flow  1+i
of 
$100 -1 per year, earning 6%?
PMT 
Ordinary 
Annuity  i 
 
 1.06 3  1 
100  
 . 06 
 
$318.36
re value of an annuity due:
 1+in -1 
FVAnnuity= PMT   1 + i FV = future value
Due  i  PMT = periodic payment
  i = interest rate per compounding period (r/m)
n = number of compounding (m*t)
M=no. of compounding per year
T= no. of years
69
 Annuities
Example: What is the future value of a three year
annuity due with a cash flow ofn$100
 1+i -1  per year, earning
FVAnnuity = PMT   1+i
6%? Due  i 
 
 1.06 3  1 
100   1.06 
 . 06 
 
$337.46
The future value of an ordinary annuity can be calculated using
Table 4.3 (p. 145), where “future value of an ordinary annuity
interest
FVAN = factors” (FVIFA)
PMT(FVI FA ) are provided.
n i,n
PMT = equal periodic cash flow
i = the (annually compounded) interest rate
1  i
n
1 , where: n = number of periods
FVI FAi,n = FVAN = future value (ordinary annuity)
i
FVIFA = future value interest factor 70
 Annuities
Ordinary Annuity: Future Value
Example: What is the future value of a 3-year $100 ordinary
annuity if the cash flows are
End invested
of Period ( n)at 6%, compounded
Table 4.3 Excerpt: FVI FA for $1 per period
5% 6% 10%

annually? 2
3
2.050
3.152
2.060
3.184
2.100
3.310
4 4.310 4.375 4.641

lculated using Table FVANn = PMT(FVI FAi,n )

FVANDn = PMT  FVI FAi,n 1  i =$100 3.184  $318.40

1  i
n
1
FVI FAi,n =
i 71
 Annuities
uity Due: Future Value
Example: What is the future value of a 3-year $100 annuity
due if the cash flows are invested at
5%6% compounded
Table 4.3 Excerpt: FVI FA for $1 per period
End of Period ( n) 6% 10%

annually? 2
3
2.050
3.152
2.060
3.184
2.100
3.310
4 4.310 4.375 4.641

FVANDn = PMT  FVI FA i,n 1  i 

 $100  3.184(1.06)  $337.50

72
 Annuities
Annuities: Present
The present value of an annuity is the sum of the present
Value
values
0 of all individual
1 2cash flows.
3
 1- 1+i-n 
$100 PVOrdinary= PMT  
PV $100 $100 Annuity  i 
PV  
PV
PV of Annuity
Example: What is the present value of a three year, $100
ordinary annuity, given a discount
 1-rate
1+iof 6%?
-n

PVOrdinary =PMT  
Annuity  i 
 
 1 - 1.06 -3 
100  
 .06 
 
$267.30 73
 Annuities
Present value of an annuity due:
 1- 1+i-n 
PVAnnuity = PMT   1+i
Due  i 
 

Example: What is the present value of a three year, $100

annuity due, given a-n discount rate of 6%?
 1- 1+i  The present value of an ordinary
PVAnnuity = PMT   1+i
Due  i  annuity can be calculated using:
 
 1  1.06  3 
100   1.06 
 .06 
 
$283.34
PVAN0 = PMT(PVI FAi,n ), where:
 1- 1+i-n 
PVI FAi,n =  
i 74
 Annuities
Example: What is the present value of a 3-year $100
ordinary annuity if current interest
Table 4.4 Excerpt: rates are
PVI FA for $1 6%
per period

compounded annually? End of Period (n)

2
5%
1.859
6%
1.833
10%
1.736
3 2.723 2.673 2.487
4 3.546 3.465 3.170

PVAN0 = PMT(PVI FAi,n )

=$100 2.673  $267.30
Table present value of Annuity due =
PVAND0 = PMT  PVI FAi,n(1  i) 
75
 Annuities
r Uses of Annuity Formulas
• Sinking Fund Problems: calculating the annuity payment that must
be received or invested each year to produce a future value.
Ordinary Annuity Annuity Due
FVANn FVANn
PMT= PMT=
FVI FAi,n FVI FAi,n 1  i

Loan Amortization and Capital Recovery Problems:

calculating the payments
PMT=
necessary
PVAN0 to pay off, or
amortize, a loan. PVI FAi,n

76
 Perpetuities
• Financial instrument that pays an equal cash flow per period
into the indefinite future (i.e. to infinity). Example:
dividend stream0on common and3 preferred stock
1

$60
2

$60 $60
4

$60


PMT
PVPER 0   PMT
t 1 (1+i)n
PVPER 0 
i
Example: What is the present value of a $100 perpetuity,
given a discount rate of 8% compounded annually?
PMT $100
PVPER 0   $1, 250.00
i 0.08 77
 More Frequent Compounding
Nominal Interest Rate: the annual percentage interest rate, often referred to as
the Annual Percentage Rate (APR).
Example: 12% compounded semi-annually
12%

0 6% 0.5 6% 1 6% 1.5

-$1,000 $60.00 $63.60 $67.42

Increased interest payment frequency requires future
and present value formulas to be adjusted to account
for the number of compounding
Future Value periods
Present per year (m).
Value
mn FVn
 inom  PV0 
FVn PV0  1    inom 
mn

 m   1+
m 
 78
 More Frequent Compounding
Example: What is a $1,000 mn investment worth in five years if it
earns 8% interest, inom 
 compounded quarterly?
FVn PV0  1  
 m 
(4)(5)
 0.08 
 $1, 000  1  
 4 
 $1, 485.95
Example: How much do you have to invest today in order to
have $10,000 in 20 years, if you
PV0 
can FVearn
n 10% interest,
mn
compounded monthly?  i 
1+ nom  m 

$10,000
 (12)(20)
 $1, 364.62
 0.10 
 1+ 12 
  79
 Impact of Compounding Frequency
$1,000 Invested at Different 10% Nominal Rates for One Year
$1,106
$1,105
$1,104
$1,103
$1,102
$1,101
$1,100
$1,099
$1,098
$1,097
Annual Semi- Quarterly Monthly Daily
Annual

Effective Annual Rate

(EAR)
The annually compounded interest rate that is identical to
m ieff  effective annual rate
some nominal rate,
 compounded
inom  “m” times per year.
ieff   1+
i 1
 nominal interest rate
 nom
 m  m = compounding frequency per year
80
 Effective Annual Rate (EAR)
EAR provides a common basis for comparing investment
alternatives.
Example: Would you  prefer
inom  an investment offering
m
m
6.12%,
ieff   1+or one
compounded quarterly  1
 offering 6.10%, inom 
 compounded
 m  ieff   1+  1
monthly?  m 
4
 0.0612  12
  1+  1  0.061 
 4    1+  1
 12 
 6.262%
 6.273%

81
Cost of Capital
By Kibrysfaw 82
 An Overview
Terms required return, appropriate discount rate, and cost
of capital are more or less interchangeably used.
We take the firm’s financial policy – capital structure as
given that a firm uses both debt and equity capital.
Hence, a firm's cost of capital will reflect both its
• cost of equity capital and
• cost of debt capital.
 We know that the return earned on assets depends on the
risk of those assets
 The return to an investor is the same as the cost to the
company
 Our cost of capital provides us with an indication of how the
market views the risk of our assets 83
 The Cost of Equity
Cost of equity = the return that equity investors require on their
investment in the firm.
There two approaches to determining the over all cost of equity:
1) the dividend growth model approach and
2) the security market line (SML) approach.

• Assumption: Dividend Growth Model Approach

• The firm’s dividend will
grow at a constant rate, g, Where,
D0 is the dividend just paid
• The price per share of the D1 is the next period’s projected
stock, P0, can be written dividend
as: RE (the E stands for equity) for
, the required return on the stock
84
 The Cost of Equity
• Dividend Growth Model Approach
• Rearrange to solve for RE as:RE = + g
• Because RE is the return that the shareholders require on the
stock, it can be interpreted as the firm’s cost of equity capital.
• EX.1: Suppose GS Co., a large public utility, paid a dividend of br 4 per
share last year. The stock currently sells for br 60 per share. It is
estimated that the dividend will grow steadily at a rate of 6% per year
into the indefinite future. What is the cost of equity capital for GS?
• 0.06 = 0.13 =13%

EX.2: ABC Co. is expected to pay an annual dividend of br 0.80 a

share next year. The market price of the stock is expected to be
br 22.40 and the
• 0.05 growth=8.6%
= 0.086 rate is 5%. What is the firm's cost of
equity? 85
 The Cost of Equity
• Advantages and Disadvantages of Dividend Growth Model:
• Advantage – easy to understand and use
• Disadvantages:
• Only applicable to companies currently paying dividends
• Not applicable if dividends are not growing at a reasonably
constant rate
• Extremely sensitive to the estimated growth rate – an increase in
g of 1% increases the cost of equity by 1%
• Does not explicitly consider risk.
The SML Approach/Model:
The notion here is that required/expected return on a risky
investment depends on three things:
1) The risk-free rate, Rf
2) The market risk premium, E(RM) - Rf 86
 The Cost of Equity
Using the SML, we can write the expected return on the
company’s equity, E(RE), as:

• Ex1: Suppose your company has an equity beta of 0.58, and

the current risk-free rate is 6.1%. If the expected market risk
premium is 8.6%, what is your cost of equity capital?
• Given: Rf = 6.1%, E = 0.58, RM-Rf = 8.6%
• RE = Rf + β (RM – Rf)
• RE = 6.1% + 0.58(8.6%) = 0.11088 = 11.1%

87
 The Cost of Equity
• Advantages and Disadvantages of SML
• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can
estimate beta, 
• Disadvantages
• Have to estimate the expected market risk premium,
which does vary over time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is
not always reliable
88
 The Cost of Debt
• Cost of debt measures the current cost to the firm of borrowing funds to finance
projects, such as
interest expense, transaction cost, bond printing cost, taxes
• It is measured by the effective interest rate or yield paid to bondholders.
• i.e., before tax cost of debt is equal to the yield to maturity on
bond issue.
• If the debt is publically issued, floatation cost incurred.
• But required return to debt holders is not equal to the firm’s
cost of debt b/c interest payments are deductible, which
means the government in effect pays part of the total cost.
• after-tax cost of debt is

89
90
 The Cost of Debt
• Ex1: assume that ABC’s tax rate is 40%, the cost of new, or marginal, debt is 9%,
then its after-tax cost of debt is
• Soln: after-tax cost of debt is

• EX2:

91
 Cost of Preferred Stock
• Cost of preferred stock is quite straightforward b/c:
• Preferred stock generally pays a constant dividend each
period
• Dividends are expected to be paid every period forever
• Preferred stock is a perpetuity, so cost of preferred stock, RP,
• RP = D / P0
• Ex1: Your company has preferred stock that has an annual
dividend of br 3. If the current price is br 25, what is the cost
of preferred stock?
• RP = 3/25 = 12%

92
Cost of Preferred Stock

93
The Weighted Average Cost of Capital
• We can use the individual costs of capital that we have
computed to get our “average” cost of capital for the firm.
• This “average” is the required return on the firm’s assets,
based on the market’s perception of the risk of those assets.
• The weights are determined by how much of each type of
•financing
WACC: is used.
• After calculating individual CC, now can combine them  WACC.
• WACC = cost of equity + cost of debt + cost of preferred stock

• Where W = Weights
• Firm should accept any project with a return which is more than
WACC.
• In other words, it’s the minimum return for a project must be at
least equal to WACC. 94
 Capital Structure Weights
• Notation
• E = market value of equity = # of outstanding shares times
price per share
• D = market value of debt = # of outstanding bonds times
bond price
• V = market value of the firm = D + E
• CS Weights
• wE = E/V
• Suppose you=have
percent financed
a market with
value of equity
equity equal to $520,000
and
• wDa=market
D/V =value of debt
percent equal
financed to $480,000.
with debt
• What are the capital structure weights?
• V = $520,000 + $480,000 = $1,000,000
• wE = E/V = 520,000 / 1,000,000 = 0.52 = 52%
• wD = D/V = 480,000/ 1,000,000 = 0.48 = 48% 95
 Taxes and the WACC
• We are concerned with after-tax cash flows, so we also need
to consider the effect of taxes on the various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• After-tax cost of debt = RD(1-T)
• Dividends are not tax deductible, so there is no tax impact
on the cost of equity
• WACC = wERE + wDRD(1-T)

96
 WACC - Example
Suppose a firm has following capital structure which it
considers optimal: Debt – 30%, Preferred shares – 18%,
Share Capital (Common shares) – 52%. The firm paid a
dividend of $2/share last year and its stock currently sells at
$80/share. Tax rate is 35% and investors expect earnings
and dividend to grow at a constant rate of 12% in the future.
New Common stocks have a flotation cost of 12%. New
Preferred stock would be sold at $100/share with a dividend
of $9. Flotation is $6/share. For debt, it’s a 9% irredeemable
• Cost of debt: Cost of
$1,000 debt with a current value ofPreferred
$1,100. Stock:
Annual interest
• RD = $90/$1,100
payment = 8.18%
has just been made.
 9%*$100 = $90
• What is the weighted average after-tax costs of capital of
• RDT = 8.18%*(1 – 35%)
the firm?
• RDT = 8.18%*(1 – 35%)
• RDT = 5.32% 97
 WACC – Solution…

• What is the weighted average after-tax costs of

capital of the firm?
• Cost of Common Stock:

• WACC:

98
 Check your understanding!
• Question:
• The market values of common stock and debts of a company are
$150 million and $35 million respectively, in which the required
return for common stock is 17% whilst 7% for debts. The book
value of common stock and debts are $100 million and $20
million respectively.
• Calculate the WACC for this company if they are subject to a 40%
tax rate.

99
 Thanks!
End of the Chapter,

100
 long term By
investment Kibrysfaw
G
Investment Decisions – An Overview
• Investment Decision is concerned with the selection of assets in which funds
will be invested by a firm.

• Where to Invest the MONEY?

• The investment of funds has to be made after CAREFUL ASSESSMENT of
various projects through CAPITAL BUDGETING [CB].
• CB is the PROCESS of making decision regarding capital investment in fixed
assets such as machinery, land, building, etc.
Investment Decisions – An Overview…

• PROCESS of Capital Budgeting:

Selection
• One/more projects
Implementation
• More/most profitable • Control
Planning Evaluation
• Review
• Estimation of CFs
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• Possible Alternatives? Evaluation Techniques
CB Evaluation Techniques
•

CB Evaluation Techniques

Non-Discounting
Net
Discounted
Intern
Modifi
ed
Profita
al Rate Intern
Payback Period Average Rate of Presen bility
of al Rate
[PP] Return [ARR] t Value Index
Return of
[NPV] [PI]
1. Payback Period (PBP)
• Payback Period (PBP):
• How long does it take to get back our MONEY back?
• How soon can we get our CASH back?
• Answer: the number of YEARS required to recover a project’s cost (initial cost).
• The Cash Flows maybe take the form of:
• Annuity (Uniform) CFs:
• returns from capital investment paid back in a series of regular payments

• Mixed Stream (Fluctuating) CFs:

• CFs paid back are not equal/irregular payments.
 1. Payback Period (PBP) – Examples
Ex. 1: Suppose the project requires an initial investment of Br 500,000 and the
annual after-tax cash flows of Br 150,000 for eight years.
Determine Payback Period for this project.
PBP= Initial 𝟓𝟎𝟎 , 𝟎𝟎𝟎
= 3.33 years or
investment 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 =
After tax 𝟏𝟓𝟎 , 𝟎𝟎𝟎
3 years & 4 months
cash flow
Ex. 2: Suppose the project requires an initial investment of Birr 500,000 and the
annual after-tax cash flows of Br 180,000; Br 240,000; Br 320,000; Br 600,000and
Br 150,000 for years 1 – 5 respectively.
Determine Payback Period for this project.
 yea After Cummulati
r tax CF ve CF
PBP = 2+ 80/320 =
1 180,000 180,000
2.25 Years or 2 years
2 240,000 420,000
and 3 months
3 320,000 740,000 Cut-off - a designated
4 600,000 time limit by
5
• Based on150,000
the PBP and MANAGEMENT management Cut-off:
during
• Payback Period < Cut-off  Accept
which the project
• Payback Period > Cut-off  Reject
initial investment will
Assume in the previous examples, be ifrecovered.
the senior management
had set a cut-off period of 3 years for the projects, what would
be your decision?
• Types of projects?
• Independent projects – Accept all projects which fulfill the
bench mark .
1. Payback Period (PBP) – Strengths & Weaknesses
• Strengths:
Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
• Weaknesses:
Ignores the time value of money.
Ignores the CFs after the payback period.
Does not consider any required rate of return.
Cut-offs are subjective.
 2. Average Rate of Return (ARR)
• ARR also called Accounting Rate of Return.
• This technique considers the EARNINGS from the
investment over its WHOLE LIFE.

• Where,

• WC
 3. Average Rate of Return (ARR) – Example
• Suppose the project with initial investment of Br. 70,000, Salvage
value of Br 6,000, tax rate of 40% & no working capital. If the firm
applies straight line method of depreciation, determine ARR given
the ff CFs:
Years 1 2 3 4
CFs, before tax 40,000 42,000 36,000 50,000

• =  Br 168,000 – Br 64,000 – Br 41,600 = Br 62,400

• Average Profit = Br 62,400/4 yrs = Br 15,600
• Average Investment = [Br 70,000 + Br 6,000]/2 = Br 38,000
• ARR = Br 15,600/Br 38,000 = 0.41 = 41%
• For Br 1 invested in the project, there is an average return of 41
cents in the form of net profit per year over the entire life of the
project.
 3. Discounted Payback Period (DPBP)
• Discounted Payback Period (DPBP):
• This technique is the same with PBP except that it adds one more
factor – discount rate (simply interest rate = WACC). Accordingly
Then DPBP is calculated using discounted net CFs.
• Similar to PBP, DPBP focuses on investment liquidity.
• DPBP is still not perfect (problems of DPBP):
• Still does not examine all CFs & Cut-offs are still subjective.
Initial Cost After-Tax, End-of-Year Cash Inflows, [CFt ]
Year Total
0 1 2 3 4 Inflows
Project S – $10,000 $5000 $4,000 $3,000 $1,000 $13,000
Project L – $10,000 $1000 $3000 $4000 $6750 $14,750
 For both projects risk-adjusted cost of capital,
WACC = r = 10%.
 Determine DPBP for Projects S&L.
yea After Discounting Discounte ACCUM
r tax CF Factor d CF CF
1 5,000 0.909 4,545 4,545
2 4,000 0.826 3,304 7,849
3 3,000 0.751 2,253 10,102
4 1, 000 0.683 683
PBP = 2+ 2,151/2,253
= 2.955 Years or 2 years
yea After tax and 11 months
Discounte
Discounte
r CF (L) d CFL d CFL
1 1,000 909 909
2 3,000 2,478 3,396
3 4,000 3,004 6,400
4 6, 750 4,610 11,010
PBP = 3+ 3,600/4,600 = 3.783 Years or 3
 4. Net Present Value (NPV)
 Is the difference between the present values of future cash
inflows and the present value of cash outflows, discounted at
the given cost of capital, or opportunity cost of capital.
NPVN= PVCF - II
• NPV considers TVM in evaluating capital investments.
•  + + ……… - II
• Where,
• CF0 = Initial Investment,
• CFt = Net CFs at year, t;
• n = life of the project (in years)
• i = cost of capital = r = WACC
 Initial Cost After-Tax, End-of-Year Cash Inflows, [CFt ]
Year Total
0 1 2 3 4 Inflows
Project S – $10,000 $5000 $4000 $3000 $1000 $13,000
Project L – $10,000 $1000 $3000 $4000 $6750 $14,750
risk-adjusted cost of capital,
WACC = r = 10%.
yea After tax After tax Discounting DiscounteDiscounte
r CF (S) CF (L) Factor d CFs d CFL
1 5,000 1,000 0.909 4,545 909
2 4,000 3,000 0.826 3,304 2,478
3 3,000 4,000 0.751 2,253 3,004
4 1, 000 6, 750 0.683 683
PV CF s= 4,610
PV CFL =
NPVs= PVCF- II=
10,785 11,101
10,785- 10,000 = 785
NPVL= PVCF- II=
11,101- 10,000 = 1,101
 4. Net Present Value (NPV) – Decision Rule
•  Accept Reject
• Types of projects?
• Independent projects – Accept all NPV+ projects.
• Mutually exclusive projects – Select the highest NPV+
projects.
• If no project has a positive NPV, reject them all.

Strengths:
 Consistent with Weaknesses:
shareholders wealth Many users find it difficult to
maximization. work with a birr [dollar] return
 Consider both magnitude & than a percentage return.
timing of CFs. Hard to determine the
 Indicates whether a discount rate as it changes
proposed project will yield over the life.
 5. Profitability Index (PI) (Cost benefit
ratio)
Profitability index is the ratio of the present value of the
expected net cash flow of the project and its initial investment
outlay.
PI = PVCF /II
Profitability index provides or measure of profitability in a more
readily understandable terms. It simply converts the NPV
PI s = ( 10,785)/ PI (L) = ( 11,101)/ 10,00
criterion into a relative measure.
10,00 = 1.078 = 1.11
If NPV is +VE If NPV is -VE
PI >1 PI <1
6. Internal Rate of Return (IRR)
• Internal Rate of Return (IRR):
• IRR is discount rate that equates the PV of net CFs of a project to its CF0.
• IRR is a discount rate to obtain NPV of zero.

• IRR is the return on the firm’s invested capital or

• IRR is the rate of return that the firm earns on its CB projects.
• To determine IRR one of the three procedures can be used:
• Trial and error – iterative process solution
• Excel solution
• Financial Calculator solution
6. Internal Rate of Return (IRR) – Decision Rule

•  Accept
•  Reject
• Types of projects?
• Independent projects:
• If IRR exceeds the project’s WACC, accept the project.
• If IRR is less than the project’s WACC, reject it.
• Mutually exclusive projects:
• Accept the project with the highest IRR, provided that IRR is greater than WACC.
• Reject all projects if the best IRR does not exceed WACC.
Summary on CB Evaluation Techniques
• Mathematically, the NPV, IRR, MIRR, and PI methods will
always lead to the same ACCEPT/REJECT decisions for,
independent projects.
• If a project’s NPV is positive, its IRR and MIRR will always
exceed WACC and its PI will always be greater than 1.
• But, these methods can give conflicting rankings for
mutually exclusive projects if the projects differ in size or in
the timing of cash flows.
• If the PI ranking conflicts with the NPV, then the NPV
ranking should be used.
Thank you !