1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The Financial Manager and the Firm Unit Slides by UK Versity

1Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons

CHAPTER 1CHAPTER 1

The Financial The Financial Manager and the Manager and the

FirmFirmUnit Slides byUK Versity


Legal Forms of Business Organizations

Quick LinksQuick Links

The Role of the Financial Manager

Managing the Financial Function

The Goal of the Firm

Agency Conflicts: Separation of Ownership and Control


The role of financial The role of financial managermanagerThe financial manager is responsible for

making decisions that are in the best interests of firm owners or maximize the owner’s wealth.

Stakeholder is someone other than an owners. The managers, employees, suppliers, government, creditors.


The Role of the Financial The Role of the Financial ManagerManager

A firm generates cash flows by selling the goods and services produced by its productive assets and human capital.

The firm can pay the remaining cash, called residual cash flows, to the owners as a cash dividend, or reinvest the cash in the business.

It is all About Cash Flows

The firm is successful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors, and taxes.


Exhibit 1.1: Cash Flow Exhibit 1.1: Cash Flow DiagramDiagram



It is all about cash flows

A firm is unprofitable when it fails to generate sufficient cash flows.

In bankruptcy, the company will either be reorganized, or the company’s assets will be liquidated.

Firms that are unprofitable over time will be forced into bankruptcy by their creditors.


Three Fundamental Decisions in Financial Management

The capital budgeting decision: Which productive assets should the firm buy? A good capital budgeting decision is one

in which the benefits are worth more for the firm than the cost of the assets.


The financing decision: How should the firm finance or pay for assets?


Three Fundamental Decisions in Financial Management

Financing decisions involve trade-offs between advantages and disadvantages of debt and equity financing.

Working capital management decisions: How should day-to-day financial matters be managed?


The mismanagement of working capital can cause the firm to go into bankruptcy even though the firm is profitable.


Exhibit 1.2: How Financial Exhibit 1.2: How Financial ManagerManager’’s Decisions Affect s Decisions Affect the Balance Sheetthe Balance Sheet


Legal Forms of Business Legal Forms of Business OrganizationsOrganizations

Sole Proprietorship

No legal distinction between personal and business income for a sole proprietor.

All business income is taxed as personal income.

A sole proprietorship has unlimited liability for all business debts and other obligations of the firm.


Partnership

Has the same basic advantages and disadvantages as a sole proprietorship.

When a transfer of ownership takes place, the partnership is terminated and a new partnership is formed.

The problem of unlimited liability can be avoided in a limited partnership.



Corporation

In a legal sense, it is a “person” distinct from its owners.

The owners of a corporation are its stockholders, or shareholders.

A major advantage of the corporate form of business is that stockholders have limited liability.



Corporation

The owners of corporations are subject to double taxation first at the corporate level and then at the personal level when dividends are paid to them.

Public corporations can sell their debt or equity in the public securities markets.

Private corporations are held by a small number of investors.



Hybrid Forms of Business Organization

Limited liability partnerships (LLPs) combine the limited liability of a corporation with the tax advantage of a partnership.

Limited liability companies (LLCs)

Professional corporations (PCs)



Managing the Financial Managing the Financial FunctionFunction

Chief Executive Officer (CEO)

Ultimate management responsibility and decision-making power in the firm.

Reports directly to the board of directors, which is accountable to the company’s owners.


Chief Financial Officer (CFO)

Responsible for the best possible financial analysis that is presented to the CEO.

Positions that report to the CFO: The Controller prepares financial

statements, oversees the firm’s cost accounting systems, prepares taxes, and works closely with the firm’s external auditors.



The Treasurer looks after the collection and disbursement of cash, invests excess cash, raises new capital, handles foreign exchange, and oversees the firm’s pension fund managers.

CFO’s Key Financial Reports




The Internal Auditor is responsible for in-depth risk assessments, performing audits of high-risk areas.

CFO’s Key Financial Reports



The Risk Manager manages the firm’s risk exposure in financial markets and the relationships with insurance providers.


External Auditors (big Four)

Provide an independent annual audit of the firm’s financial statements.

Ensure that the financial numbers are reasonably accurate, and accounting principles have been consistently applied.



Audit Committee Approves the external auditor’s fees and

engagement letter. The external auditor cannot be fired or terminated without the audit committee’s approval.


Compliance and Ethics Director Oversees the compliance program, ethics

program, and the compliance hotline and reports directly to the audit committee.


Exhibit 1.3: Simplified Exhibit 1.3: Simplified Corporate Organization ChartCorporate Organization Chart


The Goal of the FirmThe Goal of the Firm

What Should Management Maximize?

Minimizing risk or maximizing profits without regard to the other is not a successful strategy.



What Should Management Maximize?

Profit maximization does not tell us when cash flows are to be received.

Why not maximize profits?

Profit maximization ignores the uncertainty or risk associated with cash flows.



Maximize the Value of the Firm’s Stock Price When analysts and investors determine

the value of a firm’s stock, they consider. The size of the expected cash flows.

The timing of the cash flows.

The riskiness of the cash flows.



Maximize the Value of the Firm’s Stock Price

An appropriate goal for financial management is to maximize the current value of the firm’s stock.

For private corporations and partnerships, the goal is to maximize the current value of owner’s equity.


Exhibit 1.4: Major Factors Exhibit 1.4: Major Factors Affecting Stock PricesAffecting Stock Prices



Can Management Decisions Affect Stock Prices?

YES!!!


Agency Conflicts:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl

Ownership and Control

For large corporations, the ownership of the firm is spread over huge number of shareholders and the firm’s owners may effectively have little control over management .

Management may make decisions that benefit their self-interest rather than those of the stockholders.


Agency Relationships

An agency relationship arises whenever one party, called the principal, hires another party, called the agent.


The relationship between stockholders (principals) and management (agents) is an agency relationship.


Do Managers Really Want to Maximize Stock Price?

Shareholders own the corporation, but managers control the money and have the opportunity to use it for their own benefit.

Agency Costs


The costs of the conflict of interest between the firm’s owners and its management.


Aligning the Interests of Management and Stockholders

Management Compensation A significant portion of management

compensation should be tied to firm performance (e.g. stock price).



Aligning the Interests of Management and Stockholders

Managerial Labor Market Firms with unethical behavior have

difficulty hiring top managers. Executives with poor performance or

criminal convictions can rarely secure good positions in the future.



Aligning the Interests of Management and StockholdersBoard of Directors

Lack of board independence is a key factor in the misalignment between board members’ and stockholders’ interests


Other Managers

Large Stockholders

The Takeover Market

The Legal and Regulatory Environment


CHAPTER 3CHAPTER 3

Financial Statements,Financial Statements,Cash Flows, and TaxesCash Flows, and Taxes



The Income StatementStatement of Retained Earnings

Cash Flows

The Balance Sheet


The Balance SheetThe Balance Sheet

This financial statement identifies all the assets and liabilities of a firm at a point in time.

Left side of the balance shows all assets the firm owns and uses to generate revenues.

Right side represents the liabilities of the firm – money that the firm has borrowed from both creditors and shareholders.

Total assets = Total liabilities+Total stockholders’ equity (3.1)


Balance sheet also lists the capital raised from its shareholders.

Shareholders of the firm’s common equity are listed last. Shareholders will be paid with whatever

remains after paying all other suppliers of funds.

Assets listed in order of their liquidity. Liabilities listed in order in which they must be

paid.



Current Assets and Liabilities

Current assets include all assets likely to be converted to cash within a year (or within an operating cycle).

These include cash and marketable securities, accounts receivables, and inventory.



Current Assets and Liabilities

Current Liabilities include all liabilities that have to be paid within a year. Bank loans and other borrowings with

less than a year’s maturity, accounts payables, accrued wages and taxes


Net working capital= Total current assets - Total current liabilities (3.2)


Net working capital example - Diaz Manufacturing

Total current assets = $1,039.8 millionTotal current liabilities = $377.8 millionNet working capital =?



Inventory Accounting

FIFO (First in first out) refers to practice of recognizing a sale as being made up of inventory purchased earlier.

LIFO (Last in first out) calls for firm to attribute any sale made to the most recently acquired.

Book Example?

Inventory (least liquid of current assets) usually reported in one of two ways on balance sheet.



Inventory Accounting

During rising prices, FIFO reporting leads to higher current asset value and higher net income.

Firms may switch from one to another only under extraordinary circumstances and not frequently.



Long-Term Assets

Intangible assets also listed here. Goodwill, patents, copyrights, etc.

Real assets firm acquires to produce its products and generate cash flows. Land, buildings, plant and equipment.



Long-Term Assets

All long-term real assets that deteriorate with use are depreciated.

Intangible assets are amortized. Depreciating assets allow a firm to lower

taxable income and reduce taxes. Firms are allowed to depreciate assets

using straight line method or accelerated depreciation method allowed by IRS.



Long-Term Liabilities

Long-term debt of the company.

Includes bank loans, mortgages, and bonds with a maturity of one year or longer.



Equity – There are two sources of equity funds

Preferred EquityHas features that make it a combination of a fixed income security and an equity security.

Common EquityCommon equity represents the true ownership of the firm.



More Balance Sheet Accounts Retained earnings

Results from funds the firm has reinvested from its earnings.These funds are not cash–they already have been put to work.

Treasury stockThis account reflects the value of the shares that the firm has repurchased from investors.



The Income StatementThe Income Statement

Measures the profitability of a firm for any reporting period.

Revenues represent value of products and services sold by firm–include both cash and credit sales.

Expenses range from cost of producing goods for sale and asset utilization costs- depreciation or amortization.

Net income = Revenues – Expenses (3.3)

The Income Statement: Overview



Revenues = $1,563.7 millionExpenses = $1,445.2 millionNet Income = ?

Net Income example – Diaz Manufacturing


The cost of any physical asset, such as plant or machinery, is written off over its lifetime. This is called depreciation and is a non-cash expense.

The Income Statement: Depreciation

Firms use one of these for depreciating an asset:

Straight line methodAccelerated depreciation method

Firms allowed to use one for internal purposes and another for tax purposes.



Amortization expenses are related to the writing off of the value of intangible assets, such as: Goodwill, Patents, Licenses, etc.

The Income Statement: Amortization

It is also a non-cash expense like depreciation.



Extraordinary Items

Extraordinary Items refer to income or expenses associated with events that are not expected to happen on a regular basis.



Earnings before interest, taxes, depreciation and amortization (EBITDA) . Earnings generated from operations prior to

payment of expenses not directly connected to production of products.

Bottom Line Accounts

After netting out the expenses related to depreciation and amortization, we arrive at earnings before interest and taxes (EBIT).



Subtracting taxes from EBT yields net income or net income after taxes.

This amount tells us amount available to management to pay dividends, pay off debt, or reinvest in firm.

Bottom Line Accounts

Earnings before taxes (EBT) represents the taxable income for the period.



Statement of Retained Statement of Retained EarningsEarnings

This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared.

This financial statement shows the changes in the retained earnings account from one period to the next.


Exhibit 3.3: Diaz Mfg Exhibit 3.3: Diaz Mfg Statement of Retained Statement of Retained EarningsEarnings


Cash FlowsCash Flows

Net Cash Flow versus Net Income

While accountants focus on net income, shareholders would be more interested in net cash flows.

These two are not the same, because of the presence of non-cash revenues and expenses.



Net Cash Flow versus Net Income

We can estimate the net cash flow from operating activities (NCFOA) as:

NCFOA = Net income + Depreciation and Amortization (3.5)



NCFOA example – Diaz Manufacturing

Net Income = $118.5 millionDepreciation and Amortization = $83.1 millionNCFOA = ?


The Statement of Cash Flows

Helps to measure cash outflows and cash inflows generated during any period.

Indicates cash flows resulting from Operating activities, investing activities,

and financing activities.

Sum of cash flows measures net cash flows of firm during a given period. Net cash flows is the bottom line of this

financial statement.



Organization of the Statement of Cash Flows

Cash inflows result from producing and selling goods and services.

Cash outflows are tied to the purchase of raw materials, inventory, salaries and wages, utilities, rent, interest and other related expenses.


Operating Activities



Cash inflows and outflows arise out of the acquisition and selling of long-term assets necessary to operate the business. investing activities.

Also result from Buying and selling financial assets

(bonds, stocks). Making and collecting loans. Selling and settling insurance contracts.


Investing Activities


Cash Inflows–when a firm issues debt or equity securities, or borrows money from banks or other lenders.

Cash Outflows–if they pay interest or dividends on the investor’s funds, pay off debt, or purchase treasury stock.



Financing Activities


Exhibit 3.5: Interrelations Exhibit 3.5: Interrelations among the Financial among the Financial StatementsStatements


In-class discussionIn-class discussion

End of chapter questionsGroup selection


CHAPTER 4CHAPTER 4

Analyzing Financial StatementsAnalyzing Financial Statements


Ratio Analysis


Financial Statement Analysis

The DuPont System, ROA, ROE

Benchmarks

Limitations of Ratio Analysis


Perspectives on Financial Perspectives on Financial Statement AnalysisStatement Analysis

A firm’s financial statements can be analyzed from the perspective of different stakeholders.

Important perspectives:

Creditor

Manager

Stockholder


Stockholders’ perspective

Centers on value of stock held.

Allows determination of firm’s profitability, return for that period, and likely dividends.

Interest in the financial statement is to gauge cash flows firm will generate from operations.



Manager’s perspective Interest in firm’s financial statement is similar to

stockholders’.

Manager’s job security depends on firm’s performance.

Management gets feedback on investing, financing, and working capital decisions by identifying trends in various accounts reported in financial statements.



Creditors’ perspective

A firm’s creditors closely monitor Amount of debt firm has.

Ability to meet short-term obligations.

Ability to generate sufficient cash flows to meet all legal obligations, debt repayment, and interest payments.

Focus on getting loans repaid and receiving interest payments on time.



Main Concern

Guidelines for Financial Guidelines for Financial Statement Analysis Statement Analysis

From whose perspective firm analysis is done. Management, shareholder or creditor.

Use only audited financial statements if possible.

Perform analysis over 3-5 year period–time-trend analysis.


Main Concern (cont.)

Compare firm’s performance to direct competitors’ performance.

Example?

Perform a benchmark analysis comparing it to most relevant competitors – Vietnam Airlines to Indochina or Jetstar

Guidelines for Financial Guidelines for Financial Statement Analysis Statement Analysis


Common-Size Balance Sheets

Common-Size Financial Common-Size Financial Statements Statements

Each asset and liability item on balance sheet is standardized by dividing by total assets.

Accounts are then represented as percentages of total assets.


Exhibit 4.1: Common-Size Exhibit 4.1: Common-Size Balance SheetsBalance Sheets


Common-Size Income Statement

Each income statement item standardized by dividing it by dollar amount of net sales.

Each income statement item now indicated as percent of sales.

Common-Size Financial Common-Size Financial Statements Statements


Exhibit 4.2: Common-Size Exhibit 4.2: Common-Size Income StatementsIncome Statements


Measures ability of firm to meet short-term obligations with short-term assets, without endangering the firm.

Liquidity RatiosLiquidity Ratios

Current ratio

Quick ratio

Two commonly used ratios to measure liquidity


Current ratio is calculated by dividing current assets by current liabilities.

2.75 $377.8

$1,039.8

(4.1) liabilites Currentassets Current

ratio Current

Amount of current assets firm has per dollar of current liabilities.

Higher number = more liquidity



Quick (acid-test) ratio calculated by dividing most liquid current assets by current liabilities.

Amount of liquid assets firm has per dollar of current liabilities.

Higher number = more liquidity


Inventory subtracted from total current assets determines most liquid assets.


Quick ratios typically smaller than current ratios for manufacturing firms

1.63 $377.8

$423.8 - $1,039.8

(4.2) sliabilitie Current

Inventory - assets Currentratio Quick


Service firms see no different between current and quick ration


Measure how efficiently firm’s management uses assets to generate sales.

Efficiency RatiosEfficiency Ratios

Sometimes called asset turnover ratios.


Used by management to identify areas of inefficiency.

Efficiency ratios focus on inventory, receivables and use of fixed and total assets.

Used by creditors to determine speed of converting inventory to receivables. Receivables convert to cash to help firm meet debt

obligations.



Inventory turnover ratio–measures how many times inventory turned over into saleable products.

2.55 $423.8

$1,081.1

(4.3) Inventory

sold goods of Costratio turnoverInventory

In general, more often a firm can turn over inventory, the better. Too high or too low a turnover could be warning sign.



Days’ sales in inventory ratio also builds on inventory turnover ratio.

days 143.14 2.55

days 365

(4.4) turnoverInventory

days 365inventory in sales Days’

Measures number of days firm takes to turn over inventory.

The smaller the number, the faster the firm turns over inventory, more efficient it is.



Accounts receivable turnover ratio measures how quickly firm collects on its credit sales.

5.11 $306.2

$1,563.7

(4.5) receivable Accounts

sales Netturnover receivable Accounts

The higher the frequency of turnover, the faster it converts credit sales into cash flows



Days Sales Outstanding (DSO) measures number of days firm takes to convert receivables into cash.

days 71.43 5.11

days 365

(4.6) turnover receivable Accounts

days 365DSO

The fewer the days, the more efficient the firm.

Note: an overzealous credit department may offend firm’s customers.



Total asset turnover ratio measures level of sales firm generates per dollar of total assets.

0.83

$1,889.2

$1,563.7

(4.7) assets Total

sales Netturnover asset Total

Asset Turnover RatiosAsset Turnover Ratios

The higher the turnover, the more efficiently management is using total assets.

More relevant for service industry firms.


Fixed asset turnover ratio measures level of sales firm generates per dollar of fixed assets.

Higher the fixed asset turnover, the more efficiently management uses plant and equipment.

More relevant for equipment intensive firms (e.g. mfg).

Asset Turnover RatiosAsset Turnover Ratios

Net salesFixed asset turnover = (4.8)

Net fixed assets$1,563.7

= $399.4

= 3.92


Leverage ratios reflect ability of firm and owners to use equity to generate borrowed funds.

Leverage RatiosLeverage Ratios

Financial leverage refers to use of debt in firm’s capital structure.


Use of debt increases shareholders’ returns; tax benefits from interest payments on debt.

Two sets of ratios can analyze leverage:Debt ratios quantify use of debt in capital structure;Coverage ratios measure firm’s ability to meet debt obligations.



The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.


Total debtTotal debt ratio = (4.9)

Total assets$951.8

= $1,889.2

= 0.50

Total debt ratio is calculated using short-term and long-term debt.


Debt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity.


Total debtTotal equity

Debt-to-equity ratio = (4.10)

$951.8 =

$937.4 = 1.01


Equity multiplier or leverage multiplier reveals amount of assets firm has for every dollar of equity.


Total assetsEquity multiplier = (4.11)

Total equity

$1,889.2 =

$937.4 = 2.02

Best measure of firm’s ability to leverage shareholders’ equity with borrowed funds.


Equity multiplier = 1 + Debt to equity ratio

Other Leverage RelationshipsOther Leverage Relationships


Times interest earned measures number of dollars in operating earnings firm generates per dollar of interest expense.

Coverage RatiosCoverage Ratios

EBITTimes interest earned = (4.12)

Interest expense

$168.4 =

$5.6 =30.07


Cash coverage ratio measures amount of cash firm has to meet its interest payments.

Coverage RatiosCoverage Ratios

EBITDACash coverage = (4.13)

Interest expense

$251.5 =

$5.6 = 44.91


Gross profit margin measures amount of gross profit generated per dollar of net sales.

Profitability RatiosProfitability Ratios

Net sales - Cost of Goods SoldNet sales

Gross profit margin = (4.14)

$1,563.7 - $1,081.1 =

$1,563.7

= 30.86%


Operating profit margin measures the amount of operating profit generated by firm for each dollar of net sales.


EBITOperating profit margin = (4.15)

Net sales$168.4

= $1,563.7

= 10.77%


Net profit margin measures amount of net income after taxes generated by firm for each dollar of net sales.


Net IncomeNet profit margin = (4.16)

Net sales$118.5

= $1,563.7

= 7.58%

In each case, the higher the ratio, the more profitable the firm.

Management and creditors likely to focus on these profitability measures; shareholders likely to concentrate on two others.


Return on assets (ROA) ratio measures amount of net income per dollar of total assets. There are two approaches to calculate the return on assets.


EBITEROA = (4.17)

Total assets$168.4

= $1,889.2

= 8.91%

This ratio reveals how efficiently management utilized assets under their command.


Some analysts calculate return on assets as:


Net incomeROA = (4.18)

Total assets$118.5

= $1,889.2

= 6.27%


Return on equity (ROE) ratio measures dollar amount of net income per dollar of shareholders’ equity.

For firm with no debt, ROA = ROE For firm with debt, ROE >ROA


Net incomeReturn on equity = (4.19)

Total equity

$118.5 =

$937.4 = 12.64%


The following ratios reveal how market views company’s liquidity, efficiency, leverage, profitability.

Market Value RatiosMarket Value Ratios

Net incomeEarnings per share = (4.20)

Shares outstanding

$118,500,000 =

$54,566,054

= 2.17 per share

Earnings per share (EPS) ratio measures income after taxes generated by firm for each share outstanding.


Price-earnings (P/E) ratio ties firm’s earnings per share to price per share.

P/E ratio reflects investors’ expectations of firm’s future earnings growth.

Market Value RatiosMarket Value Ratios

Price per sharePrice-earnings ratio = (4.21)

Earnings per share

$48.61 =

$2.17 = 22.4


Set of related ratios that links balance sheet and income statement.

The DuPont SystemThe DuPont System

Diagnostic tool for evaluating firm’s financial health.

Used by management and shareholders to understand factors that drove firm’s ROE.

Based on two equations that relate firm’s ROA and ROE.

Diagnostic Tool


Return on assets (net income/total assets) can be broken down into two components:

Profit margin and total assets turnover ratio

(4.22) turnover assets Totalmargin Profitassets Totalsales Net

sales Netincome NetROA

The ROA EquationThe ROA Equation

Net profit margin measures management’s ability to generate sales & manage operating expenses.


Total asset turnover reveals how efficiently management uses assets under its command; how much output can be generated with a given asset base. Thus, asset turnover measures asset use efficiency.

The ROA equation says if management wants to increase firm’s ROA, it can increase profit margin, asset turnover, or both.

Management can examine a poor ROA and determine whether the problem is operating efficiency or asset use efficiency.



This equation is simply a restatement of equation 4.19.

(4.23) multiplierEquity ROA

equity Totalassets Total

assets Totalincome Net

equity Totalincome NetROE


ROE is determined by firm’s ROA and its use of leverage.

Firm with small ROA can increase ROE by using higher leverage.


Shows that a firm’s ROE is determined by three factors:

The DuPont EquationThe DuPont Equation

Net profit margin, which measures firm’s operating efficiency.

Total asset turnover, which measures firm’s asset use efficiency.

The equity multiplier, which measures firm’s financial leverage.

ROE = Net profit margin Total asset turnover

Equity multiplier (4.24)

Net income Net sales Total assetsROE =

Net sales Total assets Total e

(4.25)quity


Exhibit 4.5: Relations in the Exhibit 4.5: Relations in the DuPont System of AnalysisDuPont System of Analysis


A ratio analysis becomes relevant only when compared against a benchmark.

Financial managers can create a benchmark for comparison in three ways:

Selecting a BenchmarkSelecting a Benchmark

1. Time-trend

2. Industry average

3. Peer group


Time-trend analysis

Based on firm’s historical performance.

Allows management to examine each ratio over time, determine whether trend is good or bad for firm.



Industry average analysis

Another way of developing benchmark.

Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios.

Example



Peer group analysis

Instead of selecting an entire industry, management may select firms similar in size or sales, or who compete in same market.

Average ratios of this peer group would then be used as benchmark.

Peer groups can be only 3 or 4 firms, depending on industry.



Ratio analysis depends on accounting data based on historical costs.

Limitations of Ratio AnalysisLimitations of Ratio Analysis

No theoretical backing in making judgments based on financial statement and ratio analysis.

When doing industry or peer group analysis, one often encounters large, diversified firms that do not fit into any financial statement.

Example comparing Apple to Apple, Vinashin example


Time trend analysis could be distorted by financial statements affected by inflation.

Multinational firms deal with many accounting standards. (GAAP, IFRS) Difficult to compare financial reports.

Even among domestic firms, differences in accounting practices make comparisons difficult. FIFO versus LIFO

Limitations of Ratio AnalysisLimitations of Ratio Analysis


CHAPTER 5CHAPTER 5

The Time Value of MoneyThe Time Value of Money


Time Value of MoneyTime Value of Money

Time Value of Money

Future Value and Compounding

Present Value and Discounting

Finding the Interest Rate

Rule of 72

Compound Growth Rates


TVM is based on the belief that people prefer to consume goods today rather than wait to consume similar goods tomorrow. People have a positive time preference.


Consuming Today or Tomorrow

Money has a time value because a dollar today is worth more than a dollar tomorrow.


Today’s dollar can be invested to earn interest or spent.

Value of a dollar invested (positive interest rate) grows over time.

Rate of interest determines trade-off between spending today versus saving.

Example: Inflation 18%, saving 14%, which is better, spend now or save now, spend later?


Consuming Today or Tomorrow



Timelines as Aids to Problem Solving

Timelines are an easy way to visualize cash flows.

Cash outflows as negative values.

Cash inflows as positive values.


Exhibit 5.1: Five-year Exhibit 5.1: Five-year Timeline for $10,000 Timeline for $10,000 InvestmentInvestment



Future Value versus Present Value

Future value measures what one or more cash flows are worth at the end of a specified period.

Present value measures what one or more cash flows that are to be received in the future will be worth today (at t=0).

Financial decisions are evaluated either on a future value basis or present value basis.



Discounting is the process of converting future cash flows to their present values.

Discounting rate

Compounding is the process of earning interest over time.

Future Value versus Present Value


Exhibit 5.2: Future Value & Exhibit 5.2: Future Value & Present Value ComparedPresent Value Compared


Future Value and Future Value and Compounding Compounding

Single Period Investment

We can determine the value of an investment at the end of one period if we know the interest rate to be earned by the investment.

If you invest for one period at an interest rate of i, your investment, or principle, will grow by (1 + i) per dollar invested.

The term (1+ i) is the future value interest factor, often called simply the future value factor.



Two-Period Investing

After the first period, interest accrues on original investment (principle) and interest earned in preceding periods.

A two-period investment is simply two single-period investments back-to-back.


The principal is the amount of money on which interest is paid.

Simple interest is the amount of interest paid on the original principal amount only.

Compounding interest consists of both simple interest and interest-on-interest.


Two-Period Investing



General equation to find the future value after any number of periods.

The Future Value Equation

We can use financial calculators or future value tables to find the future value factor at different interest rates and maturity periods.

The term (1 + i)n is the future value factor.


where:

FVn = future value of investment at the end of period n

PV = original principle (P0) or present value

i = the rate of interest per period, which is often a year

n = the number of periods

(5.1) n

i1PVFV )( n

The general equation to find the future value is:



You leave your $100 invested in the bank savings account at 10 percent interest for five years. How much would you have in the bank at the end of five years?

Future value example


55

5

FV $100 (1 0.10)

= $100 (1.10)

= $100 1.6105

= $161.05


Exhibit 5.4: How Compound Exhibit 5.4: How Compound Interest GrowsInterest Grows


Compounding More Frequently Than Once a Year

The more frequently the interest payments are compounded, the larger the future value of $1 for a given time period.

where: m = number of compounding periods in a year


m×nnFV =PV×(1+i/m) (5.2)


Non-annual compounding example


2 22

4

FV $100 (1+0.05 / 2)

= $100 (1+0.025)

= $100 (11038)

= $110.38

You invest $100 in a bank account that pays a 5 percent interest rate semiannually for two years. How much would you have in the bank at the end of two years?


When interest is compounded on a continuous basis, we can use the equation below.

where: e = exponential function which is about 2.71828


FV PV (5.3)i ne


Continuous compounding example


0.05 5

0.25

FV = $10,000

= $10,000 2.71828

= $10,000 1.284025

= $12,840.25

e

Your grandmother wants to put $10,000 in a savings account at a bank. How much money would she have at the end of five years if the bank paid 5 percent annual interest compounded continuously?


Using Excel: Time Value of Using Excel: Time Value of MoneyMoney


Using Excel: Time Value of Using Excel: Time Value of MoneyMoney

Excel also has the following functions for time value of money problems.

PV: PV(RATE, NPER, PMT, FV)

FV: FV(RATE, NPER, PMT, PV)

Discount Rate: RATE(NPER, PMT, PV, FV)

Payment: PMT(RATE, NPER, PV, FV)

Number of Periods: NPER(RATE, PMT, PV, FV)


Present Value and Present Value and Discounting Discounting

Present value calculations state the current value of a dollar in the future.

This process is called discounting, and the interest rate i is known as the discount rate.

The present value (PV) is often called the discounted value of future cash payments.

The present value factor is more commonly called the discount factor.


The equation below gives us the general equation to find the present value after any number of periods.

(5.4) ni)(1nFV

PV



Suppose you are interested in buying a new BMW 330 Sports Coupe a year from now. You estimate that the car will cost $40,000. If your local bank pays 5 percent interest on savings deposits, how much will you need to save to buy the car?

Present value example


$40,000PV =

1+0.05 = $38,095.24



The further in the future a dollar will be received, the less it is worth today.

The higher the discount rate, the lower the present value of a dollar.

Show formula


Finding the Interest RateFinding the Interest Rate

A number of situations will require you to determine the interest rate (or discount rate) for a given stream of future cash flows.

to determine the interest rate on a loan.

to determine a growth rate.

to determine the return on an investment.

For an individual investor or a firm, it may be necessary.


ExamplesExamples

Buy government bond price $90 each, in next 20 years, you receive $1000 value each bond. What is interest rate?


The Rule of 72The Rule of 72

Rule of 72 is used to determine the amount of time it takes to double an investment.

It says that the time to double your money (TDM) approximately equals 72/i, where i is expressed as a percentage.

Rule of 72 is fairly accurate for interest rates between 5% and 20%.


Compound Growth RatesCompound Growth Rates

Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate).

(5.6) n

g)(1PVnFV

Examples include population growth, earnings growth.


Compound Growth RatesCompound Growth Rates

Compound growth rate example

Because of an advertising campaign, a firm’s sales increased from $20 million in 2007 to more than $35 million three years later. What has been the average annual growth rate in sales?

3

3

13

35 = 20 (1+g)

1.75 = (1+g)

g = (1.75) 1 = 1.2051-1 = 0.2051 or 20.51%


CHAPTER 6CHAPTER 6

Discounted Cash Flows and ValuationDiscounted Cash Flows and Valuation

149


Level Cash Flows: Annuities and Perpetuities


Multiple Cash Flows

Cash Flows That Grow at a Constant Rate

The Effective Annual Interest Rate

150


Future Value of Multiple Cash Flows

Solving future value problems with multiple cash flows.

1. Draw timeline to ascertain each cash flow is placed in correct time period.

2. Calculate future value of each cash flow for its time period.

3. Add up the future values.

Multiple Cash FlowsMultiple Cash Flows

151


Exhibit 6.1: Future Value of Exhibit 6.1: Future Value of Two Cash FlowsTwo Cash Flows

152


Exhibit 6.2: Future Value of Exhibit 6.2: Future Value of Three Cash FlowsThree Cash Flows

153



Many business situations call for computing present value of a series of expected future cash flows. Determining market value of security. Deciding whether to make capital investment

Process similar to determining future value of multiple cash flows.

Present Value of Multiple Cash Flows

154


Next, calculate present value of each cash flow using equation 5.4 from the previous chapter.

Present Value of Multiple Cash Flows

Finally, add up all present values.

Sum of present values of stream of future cash flows is their current market price, or value.

First, prepare timeline to identify magnitude and timing of cash flows.

155



Exhibit 6.3: Present Value of Exhibit 6.3: Present Value of Three Cash FlowsThree Cash Flows

156


The Value of a Gift to the The Value of a Gift to the UniversityUniversitySuppose that you made a gift to your

university, pledging $1,000 per year for four years and $3,000 for the fifth year, for a total of $7,000. After making the first three payments, you decide to pay off the final two payments of your pledge because your financial situation has improved. How much should you pay to the university if the interest rate is 6 percent?

157


Buying a Used CarBuying a Used CarFor a student—or anyone else—buying a used car

can be a harrowing experience. Once you fi nd the car you want, the next diffi cult decision is choosing how to pay for it—cash or a loan. Suppose the cash price you have negotiated for the car is $5,600, but that amount will stretch your budget for the year. The dealer says, “No problem. The car is yours for $4,000 down and payments of $1,000 per year for the next two years. Or you can put $2,000 down and pay $2,000 per year for two years. The choice is yours.” Which offer is the best deal? The interest rate you can earn on your money is 8 percent.

158


The Investment DecisionThe Investment Decision You are thinking of buying a business, and your investment adviser

presents you with two possibilities. Both businesses are priced at $60,000, and you have only $60,000 to invest. She has provided you with the following annual and total cash flows for each business, along with the present value of the cash flows discounted at 10 percent:

Cash flow ($ thousands)

Business 1 2 3 Total

A $50 $30 $ 20 $100

B $ 5 $ 5 $100 $110

Which business should you acquire?

159


Annuities and Perpetuities

Individual investors may make constant payments on home or car loans, or invest fixed amount year after year saving for retirement.

Many situations exist where businesses and individuals would face either receiving or paying constant amount for a length of period.

Level Cash FlowsLevel Cash Flows

160


Annuity: any financial contract calling for equally spaced level cash flows over finite number of periods.

Annuities and Perpetuities

Perpetuity: contract calling for level cash flow payments to continue forever.

Ordinary annuities: constant cash flows occurring at end of each period.

161



Present Value of an Annuity Can calculate present value of annuity same way

present value of multiple cash flows is calculated.

Instead, simplify equation 5.4 in chapter 5 to obtain annuity factor. Results in equation 6.1 that can be used to

calculate the annuity’s present value.

162



Exhibit 6.3: Present Value of Exhibit 6.3: Present Value of Three Cash FlowsThree Cash Flows

163


(6.1) i

i)(1

11

CF

i

factor) value Present(1CF

annuity an for factor value PresentCFPVA

n

n

164



165


A financial contract pays $2,000 at the end of each year for three years and the appropriate discount rate is 8% percent? What is the present value of these cash flows?

Present Value of Annuity example

n 3

3

1 1Present value factor = = = 0.7938

(1+i) (1+0.08)

1 - Present value factor 1 - 0.7938PV annuity factor = = = 2.577

i 0.08PVA = CF PV annuity factor = $2,000 2.577 = $5,154.00


Finding Monthly or Yearly Payments Example

166


You have just purchased a $450,000 condominium. You were able to put $50,000 down and obtain a 30-year fixed rate mortgage at 6.125 percent for the balance. What are your monthly payments?

n 360

Monthly interest rate = 6.125 % / 12 months = 0.51042 %

1 1Present value factor = 0.1599589

(1+i) (1.0051042)

1 - Present value factorPV annuity factor =

i1 - 0.1599589

=

= 164.578400.0051042


Preparing a Loan Amortization Schedule

Amortization: the way the borrowed amount (principal) is paid down over life of loan.

Monthly loan payment is structured so each month portion of principal is paid off; at time loan matures, it is entirely paid off.

167



Exhibit 6.5: Amortization Exhibit 6.5: Amortization Table for a 5-Yr, $10K LoanTable for a 5-Yr, $10K Loan

168


Amortized loan: each loan payment contains some payment of principal and an interest payment.

Preparing a Loan Amortization Schedule

Loan amortization schedule is a table showing: loan balance at beginning and end of each

period. payment made during that period. how much of payment represents interest. how much represents repayment of principal.

169



Future Value of an Annuity

Future value annuity calculations usually involve finding what a savings or investment activity is worth at some future point.

E.g. saving periodically for vacation, car, house, or retirement.

We can derive the future value annuity equation from the present value annuity equation (equation 6.1). This results in equation 6.2.

170



Future Value of an Annuity Equation

(6.2) i

1i)(1CF

i

1- factor value FutureCF

annuity an for factor value FutureCFFVA

n

n

171



Exhibit 6.6: Future Value of Exhibit 6.6: Future Value of 4-Yr Annuity4-Yr Annuity

172


Level Cash Flows: Annuities and Level Cash Flows: Annuities and PerpetuitiesPerpetuitiesFinding the Interest Rate

◦The present value of an annuity equation can be used to find the interest rate or discount rate for an annuity

◦To determine the rate-of-return for an annuity, solve the equation for i

◦Using a calculator is easier than a trial-and-error approach


Perpetuities A perpetuity is constant stream of cash flows that

goes on for infinite period.

In stock markets, preferred stock issues are considered to be perpetuities, with issuer paying a constant dividend to holders.

Equation for present value of a perpetuity can be derived from present value of an annuity equation with n tending to infinity.

174



Perpetuities

(6.3) i

CF

i0)(1

CFi

i)(1

11

CF

annuity an for factor value PresentCFPVA

175



Perpetuities - Example

176


Suppose you decided to endow a chair in finance. The goal of the chair is to provide the chair holder with $100,000 of additional financial support per year forever. If the rate of interest is 8 percent, how much money will you have to give the university foundation to provide the desired level of support?

PVA CF $100,000 = = = $1,250,000

i 0.08


Exhibit 6.7: Ordinary Exhibit 6.7: Ordinary Annuity versus Annuity DueAnnuity versus Annuity Due

177


Annuity DueAnnuity transformation method shows relationship

between ordinary annuity and annuity due.

Each period’s cash flow thus earns extra period of interest compared to ordinary annuity. Present or future value of annuity due is

always higher than that of ordinary annuity.

178


Annuity due = Ordinary annuity value (1+i) (6.4)


Annuity Due Example

The value of the annuity due shown in Exhibit 6.7B is:

179


Annuity due = $3,312 (1.08) = $3,577


In addition to constant cash flow streams, one may have to deal with cash flows that grow at a constant rate over time.

These cash-flow streams called growing annuities or growing perpetuities.

Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant Rate

180


Growing Annuity

Business may need to compute value of multiyear product or service contracts with cash flows that increase each year at constant rate.

These are called growing annuities.

Example of growing annuity: valuation of growing business whose cash flows increase every year at constant rate.

181



Growing Annuity

Use this equation to value the present value of growing annuity (equation 6.5) when the growth rate is less than discount rate.

(6.5) i1

g11

g-i

CFPVA

n1

n

182



Growing Annuity Example

183


A coffee shop will be in business for 50-years. It produced $300,000 this year and the discount rate used by similar businesses is 15 percent. The cash flows will grow at 2.5 percent per year. What is the estimated value of the coffee shop? 1

50

50

CF = $300,000 (1 0.025) = $307,500

$307,500 1.025PVA = 1

0.15 0.025 1.15

= $2,460,000 0.9968 = $2,452,128


Growing PerpetuityWhen cash flow stream features constant growing

annuity forever.

Can be derived from equation 6.5 when n tends to infinity and results in the following equation:

184


1CFPVA = (6.6)

i - g


Growing Perpetuity Example

185


01 CF ×(1+g)CFPVA = =

i - g i - g

$450,000 (1+0.05) = = $3,634,615

0.18 0.05

Your account reports that a firm’s cash flow last year was $450,000 and the appropriate discount rate for the club is 18 percent. You expect the firm’s cash flows to increase by 5 percent per year and that the business will have no fixed life. What is the value of the firm?


Interest rates can be quoted in financial markets in variety of ways.

Most common quote, especially for a loan, is annual percentage rate (APR).

APR represents simple interest accrued on loan or investment in a single period; annualized over a year by multiplying it by appropriate number of periods in a year.

Effective Annual Interest RateEffective Annual Interest Rate

186


Calculating the Effective Annual Rate (EAR)Correct way to compute annualized rate is to

reflect compounding that occurs; involves calculating effective annual rate (EAR).

Effective annual interest rate (EAR) is defined as annual growth rate that takes compounding into account.

187



Calculating the Effective Annual Rate (EAR)

EAR = (1 + Quoted rate/m)m – 1 (6.7)

m is the # of compounding periods during a year.

EAR conversion formula accounts for number of compounding periods, thus effectively adjusts annualized interest rate for time value of money.

EAR is the true cost of borrowing and lending.

188



Effective Annual Rate (EAR) Example

189


Your credit card has an APR of 12 percent (1 percent per month). What is the effective annual interest rate?

EAR = (1 + 0.12/12)12 – 1 = (1.01)12 – 1 = 1.1268 – 1 = 0.1286 or 12.68%


Examples: Calculating EARExamples: Calculating EAR

Lender A: 10.40% compound monthlyLender B: 10.90% compound annuallyLender C: 10.50% compound quarterly

Who will you chose to borrow?

190


CHAPTER 7CHAPTER 7

Risk and ReturnRisk and Return


Risk and ReturnRisk and Return

The greater the risk, the larger the return investors require as compensation for bearing that risk.

Future Value vs. Present Value

Higher risk means less certainty.


Quantitative Measures of Quantitative Measures of ReturnReturn

Total holding period return consists of two components: 1) capital appreciation and 2) income.

Holding Period Returns

R

CA=

CapitalAppreciationInitialPrice

P

1-P

0

P0

PP

0

Capital appreciation component of a return, :CAR



Total holding period return is simply

R

I=

Cash FlowInitialPrice

CF

1

P0

Income component of a return RI:

Holding Period Returns

1 1T CA I

0 0 0

CF P CFPR R R (7.1)

P P P



Holding Period Returns Example

One year ago today, you purchased a share of Dell Inc. stock for $26.50. Today it is worth $29.00. Dell paid no dividend on its stock. What total return did you earn on this stock over the past year?1 0 1

T CA I0

P - P + CFR = R + R =

P

$29.00 - $26.50 + $0.00 =

$26.50 = 0.0943 = 9.43%



Expected Returns ExampleYou estimate that there is 30 percent chance that your total return on your Dell stock investment will be -3.45 percent, a 30 percent chance that it will be 5.17 percent , a 30 percent chance that it will be 12.07 percent and a 10 percent chance that it will be 24.14 percent. Calculate your expected return.

DellE(R ) = (0.3 × -0.0345) + (0.3 × 0.0517)

+ (0.3 × 0.1207) + (0.1 × 0.2414)

= - 0.01035 + 0.01551 + 0.03621 + 0.02414

= 0.0655 = 6.55%



Expected value represents the sum of products of possible outcomes, and probabilities that those outcomes will be realized.

Expected Returns

Expected return, E(RAsset), is an average of possible returns from an investment, where each of these returns is weighted by the probability that it will occur:

nAsset i i 1 1 2 2 n n

i 1E(R ) (p ×R )=(p ×R )+(p ×R )+...+(p ×R ) (7.2)



Expected Returns

E R

Asset R

i i1

n

n

R

1+R

2+...+R

n

n

If each of the possible outcomes is equally likely (that is, p1 = p2 = p3 = … = pn = p = 1/n), the expected return formula reduces to:


Variance and Standard Variance and Standard DeviationDeviationas Measures of Riskas Measures of Risk

Calculating the Variance and Standard Deviation The variance (2) squares the difference between

each possible occurrence and the mean (squaring the differences makes all the numbers positive), and multiplies each difference by its associated probability before summing them up:

n 22i iR i=1

Var(R) = = p × R -E(R) (7.3)

Take the square root of the variance to get the standard deviation ().



Calculating the Variance and Standard Deviation

R2

Ri E(R)

2

i1

n

n

If all possible outcomes are equally likely, the formula becomes:


= > σ = 0.0838 or 8.38%

Profit (Ri) Probability (Pi) (Ri)(Pi) [Ri - E(R)](Pi)-0,10 0,05 -0,0050 (-0,10 - 0,09)2(0,05)-0,02 0,10 -0,0020 (-0,02 - 0,09)2(0,10)0,04 0,20 0,0080 (0,04 - 0,09)2(0,20)0,09 0,30 0,0270 (0,09 - 0,09)2(0,30)0,14 0,20 0,0280 (0,14 - 0,09)2(0,20)0,20 0,10 0,0200 (0,20 - 0,09)2(0,10)0,28 0,05 0,0140 (0,28 - 0,09)2(0,05)

Total = 1,00 E(R) = 0,090 σ2= 0,00703



Normal distribution is a symmetric frequency distribution that is completely described by its mean (average) and standard deviation.

Interpreting the Variance and Standard Deviation

Normal distribution’s left and right sides are mirror images of each other. The mean falls directly in center of distribution. Probability that an outcome is a particular distance from the mean is the same, whether the outcome is on the left or the right side of the distribution.


Risk and DiversificationRisk and Diversification

By investing in two or more assets whose values do not always move in same direction at same time, investors can reduce risk of investments or portfolio.

The concept of diversification



Returns for individual stocks from one day to next are largely independent of each other and approximately normally distributed.

Single-Asset Portfolios

A first pass at comparing risk and return for individual stocks is coefficient of variation, CV.

iRi

iCV (7.4)

E(R )


Stock A Stock B

E(R) 0,08 0,24

σ 0,06 0,08

CV 0,75 0,33



Coefficient of variation has a critical shortcoming not quite evident when only a single asset is considered.

Portfolios with More than One Asset

E(R

Portfolio) x

1E(R

1) x

2E(R

2)

Expected return of portfolio made up of two assets:




Expected return of portfolio made up of multiple assets:

1

1 1 2 2 n

( ) ( ) (7.5)

= x ( ) x ( ) ... x ( )

nPortfolio i i

i

n

E R x E R

E R E R E R



Expected return of Portfolio Example

You invested $100,000 in Treasury bills that yield 4.5 percent; $150,000 in Proctor and Gamble stock, which has an expected return of 7.5 percent; and $150,000 in Exxon Mobil Corporation stock, which has an expected return of 9.0 percent. What is the expected return of this $400,000 portfolio?

&

$100,0000.25

$400,000

$150,0000.375

$400,000

TB

P G EMC

x

x x



Expected return of Portfolio Example -continued

( ) (0.25 0.045) (0.375 0.075)

(0.375 0.090)

=0.0731 or 7.31%

PortfolioE R



Expected return of each asset must be found before applying either of the two above formulas; fraction of portfolio invested in each asset must also be known.


Prices of two stocks in a portfolio will rarely change by the same amount and in the same direction at same time.



When stock prices move in opposite directions, the change in price of one stock offsets at least some of the change in price of other stock.


Level of risk for portfolio of two stocks is less than average of risks associated with individual shares. The risk can be calculated with the variance equation below:

1,22 Asset portfolio 1 2

2 2 2 2 21 2 R1 2R R Rσ =x σ +x σ +2x x σ (7.6)



Portfolio Variance Example

The variance of the annual returns of CSX and Wal-Mart stocks in Exhibit 7.6 are 0.03949 and 0.02584 respectively. The covariance between the annual returns of these stocks is 0.00782. Calculate the variance of the portfolio that consists of 50 percent CSX stock and 50 percent Wal-Mart stock.

2 Portfolio

2 2 2Rσ = (0.5) (0.03949) + (0.5) (0.02584)

+ 2(0.5)(0.5)(0.00782)

= 0.02024




In order to ease interpretation of covariance, we divide it by the product of the standard deviations of returns for the two assets. This gives the correlation coefficient between the returns on the two assets:

1,2

1 1

(7.8)R

R R



Correlation Coefficient Example

Find the correlation coefficient between the annual returns of CSX and Wal-Mart in Exhibit 7.6. 1

2CSX

12

Wal-Mart

1,2

1 1

=

=

(0.03949) =0.199

(0.02584) =0.161

0.00782= = =0.244

0.199×0.161

R

R R

Documents

1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The Financial Manager and the Firm Unit Slides by UK Versity