FINE2000 MIDTERM EXAM

STUDY PACKAGE

Package Created by: Yifeng Lu & Macy Bacos

Exam-AID Tutor: Alac Kim & Yiran Li

Preface This document was created by the York University chapter of Students Offering Support (York SOS) to accompany our FINE2000 Exam-AID session. It is intended for students enrolled in any section of “FINE2000 – Introduction to Corporate Finance” 2013 course who are looking for an additional resource to assist their studies in preparation for the exam. Please do NOT share this with other students and instead tell them about the session or to contact York SOS to make a donation to get a copy of it. (info@yorksos.com) References Brealey, Richard A. Fundamentals of Corporate Finance. Toronto: McGraw-Hill Ryerson, 2009. Print.

Students Offering Support: Laurier Chapter BU383 2010&2011 Package

Tips for General Midterm Success Use mnemonics to remember concepts better. An example of a mnemonic would be acronyms. Do practice multiple choice questions. Doing these practice questions can assess your understanding of what you have learned and can help you identify areas of weakness. Practice multiple choice questions are found in textbooks, on textbook companion websites, and/or provided by your professor. Read a multiple choice question and try to answer it BEFORE looking at the possible answers. Having an answer in mind before looking at possible answers can reduce the chances of being fooled by wrong answers. Use logic and process of elimination on multiple choice questions. For example, if you know that answer A is wrong, then logically an answer “A and B are correct” in the same question must also be incorrect. When you don‟t know the answer, eliminating wrong answers (as opposed to just random guessing) can increase your chances of getting the question right. Practice writing answers to short answer questions. If you know ahead of time what the questions will be on the short answer section, make a list of essential points you want to include in each answer and practice writing the answer on paper. If you don’t know what questions will be on the short answer section, you could try scanning the material to identify concepts that have enough content to be a possible short answer question. Again, you can make a list of essential points you want to include in each answer and practice writing the answer on paper. Even if the question you thought of doesn’t show up on the short answer section, doing this can help solidify what you learned. Don’t spend too much time on a difficult question. It is better to move onto easier questions to ensure getting those marks than to get hung up on a difficult question, especially when time is limited.

Get adequate sleep the night before your test. Sleeping at night helps consolidate what you learned during the day into memory so that it is better remembered in future. Not only does staying up late the night before a test destroy your concentration during the test the next day, but your brain has not effectively learned the material. What is Students Offering Support? Students Offering Support is a national network of student volunteers working together to raise funds to raise the quality of education and life for those in developing nations through raising marks of our fellow University students. This is accomplished through our Exam-AID initiative where student volunteers run group review sessions prior to a midterm or final exam for a $20 donation. All of the money raised through SOS Exam-AIDs is funneled directly into sustainable educational projects in developing nations. Not only does SOS fund these projects, but SOS volunteers help build the projects on annual volunteer trips coordinated by each University chapter.

Introduction to corporate finance There are various ways that a business can be organized:

• Sole proprietorships – business owned and operated by one individual • Partnerships • Corporation – legally distinct from its owners • Companies need to make good investment and financing decisions made by the

financial manager

What is finance?

• Study of allocation, monitoring and control of scarce resources over time and under conditions of risk and uncertainty

What is financial management? • Acquisition, management, and financing of resources needed by firms by means of money with

due regard for prices in external financial markets Goals of the Corporation

• Shareholders want managers to maximize market value o Delegation to managers o Agency problems

Flow of savings to corporation

1. Cash raised from investors (financing decision) 2. Cash invested in operating assets (capital budgeting decision) 3. Cash generated by operations 4. Cash reinvested (retained earnings/internal financing) 5. Cash returned to investors (interest payments/dividends)

• Stock market – where securities are issued and traded • When companies ‘go public’

o First issue – initial public offering (IPO)

o Issuance after IPO – seasoned equity offers or follow-on offers • Primary market – issue of shares that increases both the amount of cash held by company and

number of shares held by public • Secondary market – transfer of ownership of existing shares between shareholders • Financial intermediaries - organization that raises money from investors and provides financing

for individuals, companies and other organizations o Mutual funds o Private equity fund o Pension fund o Financial Institutions – e.g. banks

• Functions of Financial markets and intermediaries o Transporting cash across time o Offering liquidity o Creating a payment mechanism o Reducing risk

Accounting and Finance

• Shows value of firm’s assets and liabilities at a particular time

The Balance Sheet

• total assets = total liabilities + owners’ equity • Current assets – more liquid – more likely to be turned into cash • Assets are generally shown at historical cost, which are not equal to their market values e.g.

assets can be written down but not up • Asset side is where money is invested in (investment) and right side is where money came from

(capitalization) therefore read balance sheet from right to left

• Shows revenues, expenses and net income of a firm over a period of time

The Income Statement

• Cash and profits are not the same due to o Inclusion of non-cash items – e.g. depreciation o Revenue recognition policies – sale may be included but cash has not received (since

performance is met and no collection risk) o Accrual accounting - Revenue – Expense matching – recognizing expense in periods

other than cash outflow occurs • Cash outflow = Cost of goods sold – change in inventories

• shows the firm’s cash inflow and outflow over a period of time

The Statement of Cash Flows

• It has three sections – operating, financing and investing • Operating

o Cash from operations = net income + non-cash expense items (depreciation) – gain (loss) on asset sales + deferred taxes +/- cash provided by (used in) working capital

o Increase in cash: Decrease in current assets Increase in current liabilities

o Decrease in cash Increase in current assets Decrease in current liabilities

o Change in assets is inversely related to change in cash, while liabilities is directly related • Investing

o Increase in cash Sales of fixed assets, investment, and subsidiaries

o Decrease in cash Purchase of PPE

Marketable securities Acquisitions

• Combining the above two = cash flow from assets = cash from operating activities + cash from investment activities

• Financing activities o Increase in cash

New issues of debt, preferred and equity shares o Decrease in cash

Retirements Dividends

• Combining all = change in cash = cash from (used in) operating activities + cash from (used in) investment activities + cash from (used in) financing activities

• Cash can be used to pay off debt (to creditors), to pay dividends (to shareholders) or add to existing cash balance

• Federally:

Taxes

o Interest is treated as ordinary income o Capital gains – 50% is taxable o Dividends is subject to gross-up and tax credit

• Provincially: o Dividends are subject to gross-up and tax credit

• Taxes are calculated according to the Income Tax Act – hence taxable income can be very different from GAAP income

o E.g. company’s depreciation method is usually different from CCA method o Allowed to deduct interest paid to debt holders when calculating taxable income, not

dividends to shareholders

Measuring Performance • Performed against standard benchmarks, compared to industry averages, or drew from

historical data • Three types of analyses –

o common size – on balance sheet express everything as a % of total assets, on income statement express everything as a % of net sales, express everything as a % of total inflow or outflow of cash

o index (common base year) analysis o ratio analysis

Which is most appropriate to use? How to calculate? Compare to industry norms

If discrepancy – why? – solutions? Identify trends in ratios over time If a trend is observed – why?

• Liquidity Ratios - Measure a company’s ability to pay off its short-term financial obligations. Generally, the higher the liquidity ratio is the larger the margin of safety that a company has to cover short-term debt.

o Current Ratio - The amount of assets available to pay off 1 dollar of short-term debt (rule of thumb – good ratio is 3:1)

o Quick/acid test ratio - The amount of liquid assets available to pay off 1 dollar of short-term debt (rule of thumb – 2:1)

o Net working capital to total capital ratio - Expresses net working capital as a percentage of long-term invested capital

o Interval measure – whether liquid assets are large relative to regular outgoings – how long can a firm continue operation if does not make any sales

o Cash ratio – cash + marketable securities – most liquid assets compared to current liabilities. Generally the higher the better but it does not matter if the firm is able to borrow quickly

• Efficiency ratio - how efficiently the firm is using its assets o Inventory Turnover – amount of times inventory is re-stocked over the course of

the year o Day’s inventory – calculates inventor turnover in days o Asset turnover – amount of sales generated for every dollar’s worth in assets – higher

value indicates firm is working near capacity o Average collection period – speed with which customers pay their bills

• Profitability Ratios

o Net profit margin – measures how much out of every dollar of sales a company can actually keep

o Operating profit margin – how much for one dollar sale do shareholders and debt holders earn together

o Return on Assets – profit per dollar of assets o Return on invested capital – return earned on debt, capital leases, and preferred and

common equity o Return on Equity – amount of profit a company generates with the amount invested by

shareholders o Payout ratio – proportion of earnings that is paid out as dividends

• All ratio formulae are provided on page 558 of the textbook

• DuPont Analysis o The DuPont Analysis measures assets at their gross book value rather than at net

book value in order to produce a higher ROE. Financial accounting depreciation methods produce lower ROEs in the initial years that an asset is purchased, thus DuPont uses gross book value to avoid investing in new assets.

o From the identity we can determine which part of the business is underperforming

• Market value added – the difference between the market value of the firm’s equity and its book value

• Residual income – the net profit of a firm or division after deducting the cost of the capital employed – also known as Economic value added (EVA)

o = after-tax operating profit – cost of capital * invested capital o Also = (return on invested capital – cost of capital) * invested capital

Time Value of Money

The idea behind the Time Value of Money (TVM) is that as long as money can accumulate interest (a return), then any amount of money today is worth more than that same amount of money in any given time in the future due to its interest earning capacity. This does not however only apply to money. Capital goods are a prime example of tangible assets that yield services in the present as well as the future. They can appreciate in value so long as they have potential to earn a return (ie. Cars, homes, factories, etc.). This appreciation in value is referred to as the Net Productivity of Investment. For example, buying a home today can potentially double in value over ten years if it is subject to strong economic conditions.

Key concepts of TVM

Interest Rate- Rate of Return An interest rate or rate of return can be thought of as a form of compensation to a lender, paid by the borrower for borrowing a sum of money from the lender over a specified period of time.

The interest rate is compensation for the foregone opportunity cost of the lender, had he kept the funds himself and used it for something other than lending. Interest rates are always quoted as an annual nominal figure (APR) which can be compounded in different ways; annually, semi annually, quarterly, monthly, semi-monthly, daily, etc. For example, if you are offered a savings account that pays 5% APR compounded monthly, your monthly rate of return would be 5%/12 = 0.41667% Given any APR, you can determine the Effective Annual Rate (EAR) given the number of compounding periods in a year:

Future Value The future value of money or a capital good is the total value of it that has accumulated over a period of time t at a given rate of return r. Where, PV= Present Value FV= Future Value r = rate of return t = time elapsed It follows that FV = PV * (1+ r)t = PV * FVIFr,t

This introduces the concept of compounding which is defined as the process of leaving your money plus any accumulated interest in an investment for more than one period (hence reinvesting the interest). Present Value However, in many cases investors are faced with the problem of figuring out how much they should invest now (present value) in order to accumulate a certain amount over time (future value). This raises the concept of the Present Value.

Example You would like to save some money in order to buy a $2000 flat screen TV two years from now for your son’s 18th birthday. You found a GIC that offers an annual effective interest rate of 7% compounded annually. How much should you invest today in order to accumulate the $2,000 two years from now?

The Value of Capital Goods Since many capital goods appreciate in value, the price of a capital good is determined by discounting the assets cash flows at its rate of return. This discount rate reflects the opportunity cost of investing the funds. Discounting the future cash flows (DCF) applies to many assets such as stocks, bonds, companies, and projects. Annuities Annuities are financial products that provide a stream of equal cash flows at regular time intervals. These cash flows can be either paid out or received. There are two basic types of annuities that will be focused on in this course; The Annuity Due and the Annuity Immediate. The Annuity Due is a stream of cash flows whereby each payment is made at the BEGINNING of each period whereas The Annuity Immediate is a stream of cash flows whereby each payment is made at the END of each period. The following are timeline illustrations for each annuity type where payments of $X are made for two years:

Future Value of Annuities The future value of an annuity refers to the value of a stream of cash flows at a given time in the future. Each cash flow payment earns a rate of return from the time of payment until the final date. Where, FVt = Future Value of the annuity at the tth payment period P= Value of each payment (all payments being equal) r = rate of return t = number of payments periods

Example You just turned 16 and just got hired for your first part-time job. You would like to save some money for a trip to Europe with your friends immediately after you graduate from university. As such, you decide to save $1000 at the end of every year (starting this year) until the age of 22.You have found a bank that offers you annual compounding at 4.5%. How much will you have saved up right after graduation?

The sum of all of these future values is the total amount of funds accumulated at the end of the six years. The sum is $6,716.90. Alternatively, the formula for the Future Value of The Annuity Immediate can also be used to arrive at the same figure.

Present Value of Annuities The present value of an annuity refers to the value of a stream of payments discounted to time zero with respect to a given rate of return. To make this clearer, consider the following scenario: Your father has just retired today and you would like to provide him with an annual income of $50,000 each year for five years starting at the end of this current year. To do this, you purchase a Payout Annuity from Manulife Financial with just a onetime initial investment this very day at a specified rate of return r. This initial investment amount is also known as the present value of all of the annuity payments discounted all the way back to the initial day of purchase at a rate of return r. Where, PVt= Present Value of the annuity at the tth payment period P= Value of each payment (all payments being equal) r = rate of return t = number of payments periods

Helpful Tips in solving TVM problems i) Draw a detailed timeline indicating all cash inflows, cash outflows, unknown figures (ie what you are solving for on the timeline), any PV or FV figures that are given, and lastly indicate each cash flow (payment) period ii) Determine your equation of value, in other words equate all cash inflows to cash outflows iii) Determine how to calculate the common point(s) in time that you are trying to solve for

Growing Annuities and Perpetuities We have already discussed annuities, so let’s define Perpetuity first. Perpetuity is a series of CF that continues indefinitely. As such, we are only able to find the PV of perpetuity because the FV of any infinite stream of positive CFs would produce a future value of “infinity” The PV of perpetuity that generates payments of amount P at interest rate r is:

Present value of Growing Annuities A growing annuity is a finite stream of payments (n payments) that grow by a rate of g each period and earn a rate of return r. The present value at time t of such a growing annuity can be computed as follows:

Home mortgages A home mortgage is simply a loan that one takes from a financial institution (lender) to purchase a home at time zero. This mortgage can then be paid back by equal installments at equal time intervals over a specified period of time given a certain rate of interest (APR). Think of a home mortgage as an amortized loan, because it’s all it really is however there is ONE KEY DIFFERENCE. In Canada, home mortgages offer APRs that are always compounded semiannually REGARDLESS of your payment frequency (annual, semi-annual, monthly, etc). So, the first step in solving a mortgage problem is always to find the effective interest rate for each of your payment intervals. Given a standard APR on your mortgage, and your payment frequency per year m, your effective interest rate per payment period; i, can be computed as follows:

Example You take out a ten year loan for $100,000 at an APR of 8%. You negotiate with your mortgage specialist to make monthly payments. What is your effective rate per payment period? What are your monthly payment amounts? A ten year loan with monthly payments generates a total of 120 payments over the loan term. The effective rate per monthly period is as follows:

• The general formula for calculating period interest rate: o APR/m = (1 + effective annual rate)t/m -1

• APR vs. EAR o Generally, if the frequency of payment is mentioned, the rate is likely an APR

Inflation and TVM

• Inflation is the overall rise in price • Distinguish between real price – which reflects purchasing power – and nominal price • Quoting an interest rate (usually a nominal rate) today only indicates the amount of

money to be received in the future but does not reflect how much that money is going to be worth

• Real interest rate calculated by: 1 + rate interest rate = (1 + nominal interest rate) / (1 + inflation rate)

• Real interest rate = nominal interest rate – inflation rate • Current dollar CF must be discounted by the nominal interest rate, real cash flow must

be discounted by the real interest rate

Valuing Bond Bonds A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Usually, attached to a bond certificate is a specification of the issuer, principal, holder, maturity and coupons. The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range. Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range. Companies (and rarely governments) always carry some sort of probability of defaulting on their credit. In other words, since bonds are a form of raising capital by means of debt, any holder of a bond can potentially default on their payments to their bond issuers. Therefore, there are institution that rate every corporation’s probability of default and assign a rating in order to inform investors of the risk associated with these potential bondholders. The two most commonly used rating companies are S&P and Moody’s. Under the S&P standard, any corporations with a rating of BBB and above are considered companies that have very little likelihood of credit default of credit default and almost considered as “risk free” (be careful with this judgment though!) Anything with a rating of BB/B+ or below is considered risky and is often referred to as a Junk Bond. Zero Coupon Bond A Zero coupon bond is an investment in which an issuer lends the holder a sum of money P and receives a face value F after a time period n which has accumulated interest at an APR i. The price (present value) of a zero coupon bond is computed as follows:

Basic Bond Pricing Besides zero coupon bonds, there are bonds that offer actual coupons at regular intervals. These bonds are very similar to annuities in the sense that they generate a steady sequence of cash flows (coupons) for each coupon period for a specified amount of periods. The following is an illustration of a life of a bond where P is the purchase price of the bond, C is the coupon payment for the n periods, and F is the Face value received by the investor at the end. So, the Price of a bond with C coupon payments and Face value for n coupon periods is just all of the coupon payments discounted back to time zero at the investor’s prospective yield rate, plus the Face value discounted back to time zero at the investor’s prospective yield rate j. The following is the basic pricing formula for bonds:

Example Suppose you are interested in purchasing a ten year bond that pays 5% annual coupons and a face value of $2000 at the end of the ten years. Also, you are hoping to earn an 8% yield on your investment, what is the fair price of the bond today?

Note: When the coupon rate is lower than the investor’s yield rate, the bond sells at a discount (P<F) because a lower rate is being discounted by a higher one. When the coupon rate is higher than the investor’s yield rate, the bond sells at a premium (P>F) because a larger rate is being discounted by a smaller one. Lastly, when the coupon rate is equal to the investor’s yield rate the bond sells at par value (P=F) because the coupon rate is being discounted by itself. Discount - Coupon rate < yield P<F Premium - Coupon rate > yield P>F Par - Coupon rate = yield P=F

Bond rates of return Rate of return = (coupon income + price change) / investment After-tax rate of return = (after-tax coupon income + after tax capital gain)/investment After-tax coupon income = coupon income – tax on coupon income After tax capital gain = capital gain – personal tax rate*0.5*capital gain Interest Rates and Inflation - The Fischer Effect The Fischer Formula allows you to determine your nominal rate R of return at a point in time given your real rate of return and the inflation rate: 1 + nominal interest rate = (1 + real interest rate) * (1 + expected inflation rate) Other:

• Distinguish the below: o Stripped bonds o Floating rate bonds o Convertible bonds o Callable bonds

Valuing Stock A company can raise capital by issuing either debt or equity, this chapter will focus on the equity offerings issued by corporation. Stocks are issued to the public through Capital Markets by a process called the Initial Public Offering (IPO). These shares are bought by the investor at a specified price in exchange for a proportion of ownership of the company. As such, methods are used to calculate the theoretical values of companies and their stock. The idea behind Stock Valuation is to predict theoretical prices of stock, and strategically profit from their price movements. Value investors function on the core belief that the market will correct itself overtime and as such, stocks that have current prices lower than their theoretical future price are bought whereas stocks that have current prices higher than their theoretical future price are sold or sold short. Common Shares Common stock is a type of equity ownership within a corporation. In the event of bankruptcy, Common Shareholders receive their dividend payments after all other creditors, bondholders and preferred shareholders. As a result of the higher assumed risk factor, common shareholders expect higher returns on their investment positions.

Preferred Shares Preferred Shares are a class of ownership that has preference over common shares in terms of dividend payments. The dividends must be paid at regular time frames and are typically fixed (stated as a percentage of Face Value). Intrinsic Value and Market Price As mentioned earlier, Value investors try to determine the theoretical price of a company’s stock. The value at which investors believe the stock is actually worth (the fair market price) is often referred to as the Intrinsic Value (IV). However, markets are inefficient and prices fluctuate constantly and as such, a stock’s current market price (MP) will not always be equal to that of its theoretical Intrinsic Value. When faced with this problem, investors generally perceive the following trading signals: IV > MP => BUY IV < MP => SELL/ SELL SHORT IV = MP => HOLD

Return A return R on a commodity of some sort is the total amount that it has appreciated in value from time t to time t+1. To clarify this, suppose that you purchased a stock one year ago at $15 and by the end of today it has appreciated in value to $27. Your total return throughout the year is ($27- $15) / $15 = 80% Furthermore, suppose that you purchased a common share one year ago for $15 which pays annual dividends of $1, and it also appreciated to $27 by the end of today. Your total return throughout the year is ($27+$1-$15)/$15 = 86.67% It follows that the total return R (from time t to time t+1) on a commodity purchased at time t at price P with a dividend payment D can be computed as follows: r = (DIV1 + Pt+1 – Pt)/Pt Dividend Discount Model As mentioned in previous chapters, the fair value of a given security is the present value of all future cash flows generated by the security discounted back to the time zero at a given rate of return. To visualize this better, consider the following timeline that indicates a preferred share that pays annual dividends of amount D forever (perpetuity)

The Fair Market Price of a share at time zero can therefore be calculated using the following formula:

Now, suppose a share offers annual dividends that grow at a constant rate of g forever. The first initial payment can be denoted by Do whereas the next dividend payment D1 is the equivalent of D0(1+g). It follows that any dividend payment at time t, or Dt can be denoted as Do(1+g)t Using previous knowledge of TVM, the following formula can be used to calculate the fair market price of a share that generates a sequence of growing dividend payments:

For a one period investor, evaluation is simple Po = (DIV1 + P1)/(1+r) Two period investor, evaluation is Po = DIV1/(1+r) + (DIV2+P2)/(+r)2

...

For nth period, the generalized formula is: Po = DIV1/(1+r) + DIV2/(1+r)2+…+(DIVn+Pn)/(1+r)t Estimating expected rates of return r = DIV1/Po + g When growth is non-constant, add up total present value of dividends plus ending stock price discounted back to PV. Growth stocks and income stocks

When a corporation generates a positive Net Income, it uses a portion of those earnings to pay dividends to its shareholders and uses the remaining portion to reinvest back into the company with the intent to expand its operations (grow). The percentage of earnings that are paid out as dividends is referred to as the Payout Ratio, and the remaining percentage that is reinvested is referred to as the Retention Ratio.

Estimating g

To estimate g, we need the retention ratio and Return on Equity (ROE) where;

Retention Ratio = (Net income – Dividend) / Net income

ROE= Net income/Owner’s equity So, g can be calculated as follows: g = (retention ratio)*ROE = (1-payout ratio)*ROE

Total value = value of assets in place + Present value of growth opportunities

NPV and Other Investment Criteria The following are ways firms determine how to evaluate investment opportunities: 1. NPV Formula: NPV = PV – Required Investment (C0) Take into consideration the opportunity cost of capital, as it is the return you give up by investing in the project. 2. IRR IRR is the rate of return that makes the NPV equal to 0 Formula: NPV = PV of Anticipated Cash Flows – Cost of Asset = 0 • You can determine IRR by trial and error followed by a graph. • You can determine IRR by using finance calculator. 3. Payback Period Rule Payback period is the time needed to recover the initial investment. 4. Discounted Payback Discounted payback is the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project. 5. Book Rate of Return Book rate of return equals the company’s accounting income divided by its assets. Formula: Book rate of return = Book Income/Book Assets 6. Profitability Index Pick the projects that generate the highest NPV per dollar of investment. Formula: NPV/Initial Investment (C0) Some points to note: • NPV has proven to be the only reliable measure of a project’s acceptability • The NPV rule can be adapted to deal with the following situations: o Mutually exclusive projects o The investment timing decision o Long vs. short-lived equipment (unequal lives) o Replacing an old machine • Rules for project selection: a firm maximizes its value by accepting all positive NPV projects. With capital rationing, you need to select a group of projects which: o Is within the company’s resources o Gives the highest NPV o When capital rationing is in place, NPV by itself cannot lead you to the correct decision - you must combine NPV with the Profitability Index.

SOS: FINE 2000 Alac Kim & Yiran Li February 6th & 7th, 2013

Structure

1. Chapter Overview

2. Q&A about Concepts

3. Questions:

1. Basic (few)

2. Intermediate (more)

3. Advanced (few)

4. Sample Midterms

INTRO TO FINANCE

Chapter 1:

Chapter 1: Overview

Separation of

– Investment decision: Risk vs. Reward

– Financing decision: Capital Structure

In Canada, over 80% of corporations are privately held

Corp Sole-Pro Partner

Ownership Shareholder Individual 2+

Liability Limited Unlimited Either

Tax “Double” Income Individual

Legal Fee High Low Medium

Advantage Liquidity

Premium

Low set-up cost Strategic Gains

Disadvantage Agency Problem Investor Attraction Decision Making

FINANCIAL MARKET

Chapter 2:

Chapter 2: Financial Market

Financial Market:

– Equity Market (Primary vs. Secondary)

– Fixed Income

– Capital Market

– Money Market

– FOREX

– Commodities

– Options & Derivatives

ETF vs. Mutual Funds

Advantages of ETF Disadvantages

Little management fees No professional advice is given to

investors that buy an ETF

Income is taxed when you sell Some ETFs are not liquid

history of outperformance

Can go long or short

Chapter 2: Financial Intermediary

Different Financial Intermediaries:

– Investment Bank

– Hedge Fund

– Private Equity

– Pension Fund

Functions of Financial Markets & Intermediaries

– Transport cash across time

– Risk transfer & diversification

– Liquidity

– Payment mechanism

– Information provided

Chapter 2: Cost of Capital

Opportunity Cost of Capital:

– Theory: minimum acceptable rate of return on an investment

– In practice: “discount rate”

How do we obtain this rate?

– Expected rate of return that investors can achieve in the financial market, at the same risk

– Specific example: CAPM & MRP (will be discussed later)

Why is this useful?

– Basis of risk vs. reward

– Determine NPV of projects

– Separate financing vs. investment decision

ACCOUNTING & FINANCE

Chapter 3:

Chapter 3: Accounting Review

Fundamental Equation: Assets = Liabilities + Equity

Components of Liabilities:

– Bank debt

– Mezzanine debt

– Debenture

– Subordinated debt vs. Senior debt

Components of Equity:

– Shareholder’s equity

– Retained Earnings

– Additional Paid-in Capital

– Other items (ex// Accumulated OCI)

Chapter 3: Cash Flow

How the three statements connect:

Income Statement Statement of Cash Flow Balance Sheet

Examples:

– $10 increase in depreciation

– $100 Investment in equipment

Statement of Cash Flow:

– CFO + CFF + CFI = Net Change in Cash

– Cash Flow from Assets = Free Cash Flow = CFO + CFI

Free Cash Flow (Unlevered)

1. EBIT (1-t) + Depreciation – CapEx – Changes in NWC

2. Net Income + Non-Cash Charges + After-tax Interest Expense - CapEx – Changes in NWC

3. CFO – CapEx

Chapter 3: Free Cash Flow (Advanced)

Why do we care about Free Cash Flow?

– Cash available to both debt & equity investors

– Better metric than EBITDA in valuation (tax consideration, changes in NWC, cash revenue-based)

Advanced concept: Levered Free Cash Flow

– Cash available to only equity investors

– (EBIT – Interest Expense)*(1 – tax rate) + CCA – CapEx – Changes in NWC – Mandatory Debt

Repayment

– In valuation: use Cost of Equity (instead of WACC)

INTRO TO VALUATION

Chapter 4:

Chapter 4: Enterprise Value

Market Capitalization (Equity Value) vs. Book Value

Enterprise Value

– Represents total value of the firm

– = Equity Value + Debt + Prefs + NCI – Investment in Associates – Cash & Cash Equivalents

Why Add NCI?

Why subtract Investment in Associates?

Advanced concepts: Other Adjustments:

– Capital Lease vs. Operating Lease

– NOL

– Etc.

Chapter 4: EVA

Economic Value Added (EVA) = Residual Income

Better measure than accounting profits

Formula: EBIAT – Cost of Capital * Capital Invested

In essence: measures “pure” profit considering invested capital

Chapter 4: Ratios

Leverage Ratios

Debt Ratio

Debt-Equity Ratio

Times Interest Earned

Total Debt Ratio

Liquidity Ratios

Current Ratio

Quick Ratio

Efficiency Ratios

Asset Turnover

Average Collection Period

Inventory Turnover

Chapter 4: Ratios

Profitability Ratios

Gross Profit Margin

Net Profit Margin

Operating Profit Margin

Return on Invested Capital

ROE

Payout Ratio (KEY in DDM)

Dupont System:

ROA = Asset Turnover * Net Profit Margin

– Separates: Ability to generate revenue vs. Ability to retain revenue

– Better identifies the company’s value driver

ROE = Leverage Ratio * Asset T.O. * Net Profit Margin

TIME VALUE OF MONEY

Chapter 5:

Chapter 5: Time Value of Money

Why use TVM?

– Money today is worth more than money tomorrow! (Why?)

Two important concepts:

– Future value: FV of current cash flow of $1

– Present value: PV of future cash flow of $1

When do we use either?

– Depends! (Will look at questions later on) But, you can actually use either method

Formulas:

Future Value = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 ∗ 1 +𝑟

𝑛

𝑡𝑛

Present Value = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

1+𝑟

𝑛

𝑡𝑛

Chapter 5: Perpetuity & Annuity

Perpetuity:

Infinite stream of cash flows

PV = 𝑐

𝑟

Annuities:

Equally spaced & level stream of cash flows (finite)

PV of t-year annuity = 𝐶 ∗1

𝑟 −

1

𝑟 1+𝑟 𝑡

– “Receive” some cash flow at the end of every term (finite)

– Annuity Factor = PVA (r, t)

– Therefore, PV = PMT * PVA (r,t)

FV of annuity = 1

𝑟 −

1

𝑟 1+𝑟 𝑡 ∗ 1 + 𝑟 𝑡 =1+r t−1

r

– “Save” certain amount at the end of every term (finite)

– FV = PMT * FVA (r,t)

Chapter 5: Annuities Due

Annuities Due

Level stream of cash flows starting immediately

PV Annuity Due = 1 + 𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑡 − 1 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

= 1 +1

𝑟−

1

𝑟 1+𝑟 𝑡−1

Annuity:

Begins

Annuity Due:

Begins

Chapter 5: Growth

Growing Perpetuity:

Infinite stream of growing cash flows

PV = 𝑐

𝑟 −𝑔

Growing Annuity:

PV = 𝐶

𝑟−𝑔 ∗ 1 −

1+𝑔

1+𝑟

𝑡

Chapter 5: Inflation

Real Value of Cash Payments

1 + 𝑟 =1+𝑖

1+ 𝜋

– Approximately: 𝑟 = 𝑖 − 𝜋

Recall: 𝑃𝑉

𝑖 ∴

𝑅𝑒𝑎𝑙 𝑃𝑉

𝑅𝑒𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒=

𝑃𝑉/𝜋

𝑟

EAR vs. APR

When compounding period is annual, EAR = APR

However, when an investment / saving compounds more than once a year,

𝐸𝐴𝑅 ≠ 𝐴𝑃𝑅 (since interest accrues interest)

1 + 𝐸𝐴𝑅 = 1 +𝐴𝑃𝑅

𝑚

𝑚

∴ 𝑃𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒: 𝐴𝑃𝑅

𝑚= 1 + 𝐸𝐴𝑅

1

𝑚 − 1

BONDS

Chapter 6:

Chapter 6: Basics

Governments and corporations raise funds for long term by issuing bonds

Typical structure: interest-only loan

Interest payments = coupons

Principle (paid at the maturity date) = par value

– Usually bonds are traded in units of $1,000 of face or par value

The date when the loan is paid off = maturity date

Investors look at other similar bonds to determine “discount rate”

Price of a bond = PV of all the payments (interests + principle)

Chapter 6: Coupon & Discount Rate

Coupon rate = Interest payment (coupon) / face value of bond

Coupon = coupon rate * face value

Required rate / discount rate / interest rate:

the rate that makes PV of all payments = price of the bond

Accrued interest = (days left until the next coupon / days between consecutive

coupon payments) * coupon

Chapter 6: Example

Example: A bond with a 6.5% annual coupon has three years to maturity. If

investors require a 5.1% return, what is the price of the bond? Assume the bond is

issued at par.

Coupon = 6.5% * 1000 = 65

Discount rate = 5.1%

Price of bond = PV of coupons + PV of principle

Chapter 6: Premiums vs. Discounts

Par: Coupon rate = Discount rate

Discount: Coupon rate < Discount rate

Premium: Coupon rate > Discount rate

All else held equal,

the price of a premium bond falls over time

the price of par bond stays constant over time

the price of a discount bond rises over time

Chapter 6: Bond Yield

3 methods of measuring return an investor would receive on bond investment:

Current yield

Yield to Maturity (YTM or yield)

Rate of Return

Current yield = annual coupon payment / bond price

Yield To Maturity: discount rate for which the present value of the bond’s

payments equal the price.

Chapter 6: Example

Suppose you buy the bond and sell it after one year, and interest rates have not

changed. The price of the bond will be

P = 100/(1+r) + 100/(1+r)^2 + 1,000/(1+r)^2 =1,092.97

Your return is = 100 +1,092.97 −1,136.36 = 5% = ytm 1,136.16

what if interest rates rise or fall?

Instead if you hold it till maturity, reinvesting coupons, and interest rates do not

change, your return is

=[100 (1.05)^2 +100(1.05)+1100 - 1,136.36]/1136.16 =15.7625%

or, on an annualized basis, your return is =(1.157625)^(1/3) −1=5%=ytm

If interest rates rise (i.e., future bond prices fall), then your return is higher than the

YTM implied by current prices, for a holding period till maturity. Vice versa if

interest rates fall.

Exception: zero-coupon bonds, for which YTM = return till maturity regardless of

interest rate movements.

Chapter 6: Interest Rate Risk & Yield Curve

All else equal, a longer maturity bond has higher interest rate risk.

All else equal, a lower coupon bond has higher interest rate risk.

The principal measure of interest risk of a bond is called its duration

The yield curve, at any point in time, plots the yield to maturity of otherwise

identical bonds that differ only in their time to maturity.

Since longer maturity bonds have higher interest rate risk, all else equal, investors

would require a higher rate of return on longer maturity bonds, or else they would

not be willing to hold these bonds.

Chapter 6: Managing Risk

A bond issuer faces the risk that interest rates may fall, but he is locked into paying a fixed coupon.

One option is to make the bond callable, the issuer reserves the right to retire the bond before maturity at a pre- specified call price. all else equal, a callable bond should trade at a lower price than an otherwise identical non-callable

bond.

Similarly, to protect investors, bonds may be puttable the buyer/holder reserves the right to demand repayment before maturity all else equal, a puttable bond should trade at a higher price than an otherwise identical non-puttable

bond.

Most government bonds and many corporate bonds are callable.

Floating rate bonds: coupon rate = reference benchmark + spread

Chapter 6: Credit Risk & Default Risk

Corporate bonds yield = similar government bonds yield + Spread

– Primarily due to: Default risk

Look at ratings to determine the proper yield (risks), if available

STOCKS

Chapter 7:

Chapter 7: Basics

A common stock is an ownership share in a corporation

Like bonds, shares are periodically issued and publicly traded

Unlike bonds, there are no pre-specified promised stream of income for a stock

and no maturity date.

Chapter 7: Valuing Stocks

The intrinsic value of a stock is the PV of all future (uncertain) dividends, at a

suitable discount rate.

Intrinsic value refers to forward looking, market determined, going concern value.

- not book value or liquidation value.

Chapter 7: Dividend Discount Model

Intrinsic value = PV of all future dividends

The discount rate r is the expected return on the stock given its (non-

diversifiable) risk

Very difficult to predict future dividends = practical?

Chapter 7: Dividend Yield & Capital Gain

Assuming intrinsic value equal to market price, we may re-write the valuation

formula as

Constant Growth:

Chapter 7: Growth

Return on equity or ROE = earnings per share/ book equity per share.

Let b = plowback ratio, i.e., proportion of earnings retained

And 1 – b = payout ratio, i.e., proportion of earnings paid as dividends.

With such a policy, dividends = (1-b)EPS

And growth rate g = b*ROE

Therefore:

Chapter 7: P/E Ratio

Can back out the portion of price coming from asset and from growth

Chapter 7: Preferred Stocks

Companies often issue securities called preferred stock.

Paid before common equity, but after debt

the preferred dividends are not tax-deductible and the dividends may not be paid if

the company has unusually poor earnings, although they may be cumulative.

Preferred may also be convertible to common.

Chapter 7: Non-constant Growth

Remember the rule: price = PV of all future payments

Figure out the dividends of each period and discount them to present value.

Other method of Equity Valuation:

– Discounted Cash Flows (DCF)

– Trading Comps

– Precedent Transactions

– Leveraged Buyout

– M&A Premium Analysis

– Future Share Price Analysis

– Sum of the Parts Analysis

Chapter 7: Market Efficiency

In theory, if markets are efficient, stock prices should follow a “random walk”

i.e. it is difficult to systematically predict the future movements of prices.

Weak form efficiency: it is impossible to predict future prices from the analysis of

past prices

technical analysis cannot earn “excess” returns

Semi-strong efficiency: it is impossible to predict future prices from the analysis of

past prices, and publicly available information.

fundamental analysis cannot earn “excess” returns

Strong form efficiency: it is impossible to predict future prices from privately

available (or inside) information

insider trading is illegal

NET PRESENT VALUE

Chapter 8:

Chapter 8: NPV Basics

Why NPV?

Present value is the only feasible price!

Net Present Value

Discount the expected future payoffs by cost of capital

– Recall: Cost of Capital = opportunity cost = rate of return of comparable investment alternative

∴ 𝑁𝑃𝑉 = 𝑃𝑉 𝑜𝑓 𝐶𝐹 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Risk vs. Reward

Since future CF is only a forecast, safe dollar > risky dollar

Therefore, riskier projects get higher cost of capital (investors want to be

compensated for higher level of risk)

Quick Check: Highest-to-lowest required rate of return (cost of capital)?

Debt, Common share, Debenture, Subordinated Debt, Preferred Stock

Chapter 8: Payback & Discounted Payback Period

Payback Period

Time until CF recovers initial investment

Project should only be accepted if payback period < specified cut-off period

Limit: if majority of CF is to be realized after arbitrary cut-off period, not a

meaningful measure

Discounted Payback Period

Same idea as payback period, but discounts the CF to PV

Example:

∴ 𝐷𝑃𝐵 =264

7513+ 2 𝑦𝑒𝑎𝑟𝑠 = 2.04 𝑦𝑒𝑎𝑟𝑠

Year CF DCF @ 10% Cumulative

0 - 2000 - 2000 - 2000

1 + 1000 + 909 - 1091

2 +1000 + 827 - 264

3 +10000 + 7513 + 7249

Chapter 8: Internal Rate of Return (IRR)

IRR

Discount rate for which NPV = 0

Invest in a project if:

1. NPV > 0

2. Cost of Capital < IRR (will result in positive NPV)

Calculating Rate of Return:

=𝑃𝑟𝑜𝑓𝑖𝑡

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡=

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Be careful! 𝐼𝑅𝑅 ≠ 𝑂𝐶𝐶

IRR = internal profitability

OCC = return offered by equivalent-risk investment

Chapter 8: Mutually Exclusive Projects

Rule of Thumb: Invest in highest NPV!

Other considerations:

1. Investment timing (choose the investment date that gives highest NPV)

2. Long vs. Short-lived Assets

3. Replacement

Long vs. Short-lived Assets:

Calculate Equivalent Annual Cost =𝑃𝑉 𝑜𝑓 𝐶𝑜𝑠𝑡

𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑎𝑐𝑡𝑜𝑟

Select asset purchase with lowest equivalent annual cost

Replacement:

1. Calculate equivalent annual costs

2. If operating cost < equivalent annual cost of new asset, do not replace

Chapter 8: Capital Rationing

Soft-Rationing:

Capital rationing is not imposed by investors

Prioritization in investment opportunities

Hard-Rationing:

Cannot raise required funds

May be forced to pass up positive NPV projects

Prioritization through Profitability Index:

=𝑁𝑃𝑉

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

PRACTICE MIDTERM