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Business Finance - ACC501 Handouts PDF
Business Finance - ACC501 Handouts PDF
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LESSON 1
Essentials of Corporate Finance, by Ross, Westerfield and ordan, fourth edition, !c"ra# $ill Publishers, %S&N '(')(1*1'+)()
Reference books #ill be Introduction to Finance by La#rence , "itman and eff !adura, -ddison(Wesley Publishers Foundations of Financial Management by Stanley &, &lock and "eoffrey -, $irt, !c"ra# $ill Publishers
Course Contents -n o.er.ie# of /inancial En.ironment /inancial Statements, Taxes and 0ash /lo#s Time 1alue of !oney and 2iscounted 0ash /lo# 1aluation 1aluation of Stocks and &onds Net Present 1alue and other %n.estment 0riteria 0a3ital %n.estment 2ecision Risk and Return 0ost of 0a3ital Le.era4e and 0a3ital Structure Raisin4 0a3ital Workin4 0a3ital !ana4ement 2i.idends Finance: A Quick ook /our &asic -reas &usiness /inance %n.estments /inancial %nstitutions %nternational /inance Business Finance -ddresses the follo#in4 three 5uestions6 What lon4(term in.estments should the firm en4a4e in7 $o# can the firm raise the money for the re5uired in.estments7 $o# much short(term cash flo# does a com3any need to 3ay its bills7 In!estments 2eals #ith financial assets such as stocks and bonds, %t co.ers the follo#in4 issues Pricin4 /inancial -ssets -ssociated Risks and Re#ards 2eterminin4 best mixture of financial in.estment 0areer o33ortunities in in.estment Stock &rokera4e Portfolio !ana4ement Security -nalysis 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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LESSON *
Marketing researc( &esign of marketing and distri)utions c(annels *roduct pricing Accounting and Finance -ccountants are re5uired to make financial decisions as #ell as understand the im3lications of ne# financial contracts /inancial analysts make extensi.e use of accountin4 information Management and Finance &usiness Strate4y is al#ays disastrous if financial 3lannin4 is not adhered to ,
"(at is Business Finance' %n order to start any ne# business, the follo#in4 issues become .ital What lon4(term in.estment should be taken on7 /rom #here to 4et the lon4(term financin4 to 3ay for in.estment7 &rin4 in other o#ners or borro# the money7 $o# to mana4e e.eryday financial acti.ities7
%(e Financial Manager To create .alue, the financial mana4er should6 Try to make smart in.estment decisions, Try to make smart financin4 decisions,
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%reasurer
Controller
Business Finance and Financial Manager /inancial !ana4ement 2ecisions 0a3ital &ud4etin4 0a3ital Structure Workin4 0a3ital !ana4ement Financial Management &ecisions 0a3ital &ud4etin4 The 3rocess of 3lannin4 and mana4in4 a firm;s lon4(term in.estments /inancial mana4ers concern #ith ho# much, #hen and ho# likely is cash ex3ected to recei.e E.aluatin4 the si<e, timin4 and risk of future cash flo#s is the essence of ca3ital bud4etin4 Financial Management &ecisions %otal 2alue of Assets: Current Assets Fi/ed Assets 34 %angi)le 54Intangi)le %otal Firm 2alue to In!estors: Current ia)ilities ong4%erm &e)t S(are(olders6E7uit+
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Current Assets
#o< can t(e firm raise t(e mone+ for t(e re7uired in!estments'
Capital Structure The .alue of the firm can be thou4ht of as a 3ie, The 4oal of the mana4er is to increase the si<e of the 3ie, The 0a3ital Structure decision can be .ie#ed as ho# best to slice u3 the 3ie, %f ho# you slice the 3ie affects the si<e of the 3ie, then the ca3ital structure decision matters, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Financial Management &ecisions %(e Net "orking Capital In!estment &ecision Current ia)ilities Current Assets Net "orking Capital
ong4%erm &e)t
#o< muc( s(ort4term cas( flo< does a compan+ need to pa+ its )ills'
S(are(olders6 E7uit+
%(e Corporate Firm The cor3orate form of business is the standard method for sol.in4 the 3roblems encountered in raisin4 lar4e amounts of cash, $o#e.er, businesses can take other forms, Forms of Business ,rgani-ation Three ma:or forms Sole 3ro3rietorshi3 Partnershi3 =eneral imited 0or3oration imited lia)ilit+ compan+ Sole *roprietors(ip 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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*artners(ip T#o or more o#ners =3artners> "eneral 3artnershi36 all 3artners share in 4ains and losses and all ha.e unlimited liability for all 3artnershi3 debts Limited 3artnershi36 one or more 4eneral 3artners #ill run the business and ha.e unlimited liability but there #ill be one or more limited 3artners #ho do not acti.ely 3artici3ate in the business and their liability is limited to their contribution,
Ad!antages T#o or more o#ners !ore ca3ital a.ailable Relati.ely easy to start %ncome taxed once as 3ersonal income &isad!antages 9nlimited liability There are t#o ty3es of 3artnershi3 =eneral partners(ip imited partners(ip Partnershi3 dissol.es #hen one 3artner dies or #ishes to sell 2ifficult to transfer o#nershi3
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LESSON ?
The cor3orate form of business is the standard method for sol.in4 the 3roblems encountered in raisin4 lar4e amounts of cash, $o#e.er, businesses can take other forms, Forms of Business ,rgani-ation Three ma:or forms Sole 3ro3rietorshi3 Partnershi3 =eneral imited 0or3oration
Sole *roprietors(ip Ad!antages Easiest to start Least re4ulated Sin4le o#ner kee3s all the 3rofits Taxed once as 3ersonal income &isad!antages Limited to life of o#ner E5uity ca3ital limited to o#ner;s 3ersonal #ealth 9nlimited liability 2ifficult to sell o#nershi3 interest *artners(ip T#o or more o#ners =3artners> "eneral 3artnershi36 all 3artners share in 4ains and losses and all ha.e unlimited liability for all 3artnershi3 debts Limited 3artnershi36 one or more 4eneral 3artners #ill run the business and ha.e unlimited liability but there #ill be one or more limited 3artners #ho do not acti.ely 3artici3ate in the business and their liability is limited to their contribution, Ad!antages T#o or more o#ners !ore ca3ital a.ailable Relati.ely easy to start %ncome taxed once as 3ersonal income &isad!antages 9nlimited liability =eneral partners(ip imited partners(ip Partnershi3 dissol.es #hen one 3artner dies or #ishes to sell 2ifficult to transfer o#nershi3 Corporation - business created as a distinct le4al entity o#ned by one or more indi.iduals or entities, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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/ormin4 of cor3oration in.ol.es 3re3arin4 C(arter includin4 cor3oration;s name, intended life, business 3ur3ose and number of shares Set of )+la<s #hich describes the re4ulations for the business Separation of ,<ners(ip and Control
Board of &irectors
&e)t (olders
Management
S(are (olders
Assets
&e)t E7uit+
Corporation Ad!antages Limited liability 9nlimited life Se3aration of o#nershi3 and mana4ement Transfer of o#nershi3 is easy Easier to raise ca3ital &isad!antages Se3aration of o#nershi3 and mana4ement 2ouble taxation =income taxed at the cor3orate rate and then di.idends taxed at 3ersonal rate> =oal of t(e Corporate Firm The traditional ans#er is that the mana4ers of the cor3oration are obli4ed to make efforts to maximi<e shareholder #ealth, -lternati.ely, the 4oal of the financial mana4er is to maximi<e the current .alue 3er share of the existin4 stock %(e Set4of4Contracts *erspecti!e The firm can be .ie#ed as a set of contracts, One of these contracts is bet#een shareholders and mana4ers,
The mana4ers #ill usually act in the shareholders; interests, The shareholders can de.ise contracts that ali4n the incenti.es of the mana4ers #ith the 4oals of the shareholders, The shareholders can monitor the mana4ers beha.ior, This contractin4 and monitorin4 is costly, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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0ontracts can be carefully constructed to be incentive compatible, There is a market for mana4erial talent@this may 3ro.ide market discipline to the mana4ers@they can be re3laced, %f the mana4ers fail to maximi<e share 3rice, they may be re3laced in a hostile takeo.er,
Managing Managers !ana4erial com3ensation %ncenti.es can be used to ali4n mana4ement and stockholder interests The incenti.es need to be structured carefully to make sure that they achie.e their 4oal 0or3orate control The threat of a takeo.er may result in better mana4ement Other stakeholders
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LESSON A
Firm
Invests in assets (B) Current assets Fixed assets
Firm issues securities (A) Retained cash flows (F) Cash flow from firm (C)
Dividends and debt payments (E)
Financial markets
Short-term debt on!-term debt "#uity shares
Taxes (D)
Government
%(e cas( flo<s from t(e firm must e/ceed t(e cas( flo<s from t(e financial markets@
Financial Markets *rimar+ Market When a cor3oration issues securities, cash flo#s from in.estors to the firm, 9sually an under#riter is in.ol.ed Secondar+ Markets %n.ol.e the sale of BusedC securities from one in.estor to another, Securities may be exchan4e traded or trade o.er(the(counter in a dealer market, Financial Markets
Stocks and &onds Firms !oney -li securities In!estors money Primary !arket Secondary !arket !aria
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Transaction 3rices of shares are communicated almost immediately to the 3ublic, Listin4 %(e Balance S(eet -n accountant;s sna3shot of the firm;s accountin4 .alue as of a 3articular date, The &alance Sheet %dentity is6 -ssets D Liabilities E Stockholder;s E5uity When analy<in4 a balance sheet, the financial mana4er should be a#are of three concerns6 accountin4 li5uidity, debt .ersus e5uity, and .alue .ersus cost,
%(e Balance4S(eet Model of t(e Firm %otal 2alue of Assets Current Assets %otal Firm 2alue to In!estors Current ia)ilities
S(are(olders6 E7uit+
Net "orking Capital Net "orking Capital A Current Assets B Current ia)ilities
NW0 F ' NW0 G ' NW0 H '
0urrent -ssets F 0urrent Liabilities 0urrent -ssets G 0urrent Liabilities 0urrent -ssets H 0urrent Liabilities
NW0 usually 4ro#s #ith the firm for the healthy firms,
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Lon4(Term 2ebt
$o# much short(term cash flo# does a com3any need to 3ay its bills7
Shareholders; E5uity
Building t(e Balance S(eet - firm has current assets of I1'', Net fixed assets of I+'', Short term debt of I)', and Lon4 term debt of I*'' No#J Total -ssets are I1'' E +'' H IK'' Total Liabilities are I)' E *'' H I*)' Shareholders; e5uity is IK'' L *)' H I??' Building t(e Balance S(eet -ssets 0urrent -ssets Net /ixed -ssets Total -ssets I1'' +'' IK'' Liabilities and Shareholders; E5uity 0urrent Liabilities Lon4 Term 2ebt Shareholders; e5uity Total liabilities and Shareholders; e5uity I )' *'' ??' IK''
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&i'ed assets" $1,423 $1,274 +#o e#t!, lant, and equi -ent .ess accu-ulated de #eciation 0550 0460 873 814 $et #o e#t!, lant, and equi -ent 245 221 %ntan/i"le assets and othe# $1,118 $1,035 (otal *i&ed assets
(otal assets
$1,879 $1,742
Stockholder's equit " $39 $39 +#e*e##ed stoc1 55 32 Co--on stoc1 2$1 e# value3 347 327 Ca ital su# lus 390 347 Accu-ulated #etained ea#nin/s .ess t#easu#! stoc1 026 $725 020 $805 (otal equit! (otal liabilities and $1,879 $1,742 stockholder's equit
Balance S(eet Anal+sis When analy<in4 a balance sheet, the financial mana4er should be a#are of three concerns6 -ccountin4 li5uidity 2ebt .ersus e5uity 1alue .ersus cost
Accounting i7uidit+ Refers to the ease and 5uickness #ith #hich assets can be con.erted to cash, 0urrent assets are the most li5uid, Some fixed assets are intan4ible, The more li5uid a firm;s assets, the less likely the firm is to ex3erience 3roblems meetin4 short(term obli4ations, Li5uid assets fre5uently ha.e lo#er rates of return than fixed assets,
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Assets Cu##ent assets4 Cash and equivalents Accounts #eceiva"le %nvento#ies 'the# (otal cu##ent assets
Fi&ed assets4 +#o e#t!, lant, and equi -ent $1,423 $1,274 .ess accu-ulated de #eciation 0550 0460 873 814 $et #o e#t!, lant, and equi -ent 245 221 %ntan/i"le assets and othe# (otal *i&ed assets $1,118 $1,035
$ere #elia"ilities4 see NW0 4ro# to I*)+ million in .on/0te#$117 $104 *'N* )e*e##ed from ta&esI*+* million in *'N1, 471 458 .on/0te#- de"t $588 $562 (otal lon/0te#- lia"ilities
5toc1holde#6s equit!4 $39 $39 I*? million +#e*e##ed stoc1 55 32 Co--on stoc1 2$1 a# value3 347 327 Ca ital su# lus of I*? million is an in.estment This increase 390 347 Accu-ulated #etained ea#nin/s of .ess the t#easu#! firm, stoc1 026 020 $805 $725 (otal equit! (otal lia"ilities and stoc1holde#6s equit! $1,879 $1,742
(otal assets
$1,879
$1,742
&e)t !ersus E7uit+ "enerally, #hen a firm borro#s it 4i.es the bondholders first claim on the firm;s cash flo#, Thus shareholder;s e5uity is the residual difference bet#een assets and liabilities, Shareholders; E5uity H -ssets L Liabilities The 9se of debt in a firm;s ca3ital structure is called B/inancial Le.era4eC The more debt a firm has =as a 3ercenta4e of assets> the 4reater is the de4ree of financial le.era4e 2ebt acts as a le.er in the sense that it ma4nifies both 4ains and losses 2alue !ersus Cost The true .alue of any asset is its market .alue, #hich is sim3ly the amount of cash #e #ould 4et if #e actually sold it, The .alues sho#n on the balance sheet for the firm;s assets are book .alues and 4enerally are not #hat the assets are actual #orth, 9nder the -ccountin4 standards audited financial statements of firms carry assets at historical cost, /or current assets, market .alue and book .alue mi4ht be some#hat similar since they are bou4ht and con.erted into cash o.er a relati.ely short s3an of time, /or fixed assets, its .ery unlikely that the actual market .alue of an asset is e5ual to its book .alue, Exam3le6 Land 3urchased for railroads a century a4o Similarly the o#ner;s e5uity fi4ure on the balance sheet and the true market .alue of the e5uity need not be related, /or /inancial !ana4ers, accountin4 .alue of the e5uity is not a matter of concern rather it is the market .alue of the shares that matters, Market !s@ Book 2alue M 0or3oration has fixed assets #ith a book .alue of I)'' and an a33raised market .alue of I1,''' 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 15
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Net #orkin4 ca3ital is IA'' on the books but a33rox, IK'' #ould be reali<ed if the current accounts #ere li5uidated M has I+'' in lon4(term debt, both book P market .alue What is the book .alue of the e5uity7 What is the market .alue7 ? Corporation Balance S(eet Market 2alue !s@ Book 2alue
Assets Net #orkin4 0a3ital IA'' Net /ixed -ssets )'' Book Market IK'' 1,''' I1,1'' I1,K''
ia)ilities and S(are(olders6 E7uit+ Lon4(term debt Shareholders; e5uity Book I+'' K'' Market I+'' 1,1'' I1,1'' I1,K''
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LESSON +
%f #e think of the balance sheet as a sna3shot then #e can think of income statement as a .ideo recordin4 co.erin4 before and after the 3icture, The income statement measures 3erformance o.er a s3ecific 3eriod of time, The accountin4 definition of income is Re.enue L Ex3enses D %ncome NQR 0or3oration %ncome Statement
C$D C,>*,>A%I,N 0nco%e State%ent 20X2 0in E millions1
The o3erations section of the income statement re3orts the firm;s re.enues and ex3enses from 3rinci3al o3erations
Total o3eratin4 re.enues 0ost of 4oods sold Sellin4, 4eneral, and administrati.e ex3enses 2e3reciation O3eratin4 income Other income Earnin4s before interest and taxes %nterest ex3ense Pretax income Taxes 0urrent6 I)1 2eferred6 I1? Net income Retained earnin4s6 2i.idends6
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C$D Corporation Income Statement C$D C,>*,>A%I,N Income Statement 20X2 0in E millions1 Total o3eratin4 re.enues 0ost of 4oods sold Sellin4, 4eneral, and administrati.e ex3enses 2e3reciation O3eratin4 income Other income Earnin4s before interest and taxes %nterest ex3ense Pretax income Taxes 0urrent6 I)1 2eferred6 I1? Net income Retained earnin4s6 2i.idends6 I*,*K*
0 1,655
( (?*) S'
I1S' *S I*1S ( AS I1)' ( OA
9sually a se3arate section re3orts as a se3arate item the amount of taxes le.ied on income,
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I1) ( OA
0 49
Income Statement Anal+sis There are three thin4s to kee3 in mind #hen analy<in4 an income statement6 "enerally -cce3ted -ccountin4 Princi3les ="--P> Non 0ash %tems Time and 0osts Income Statement Anal+sis "enerally -cce3ted -ccountin4 Princi3les ="--P> BThe Reali<ation 3rinci3leC is to reco4ni<e re.enue #hen the earnin4 3rocess is com3lete, i,e, re.enue is reco4ni<ed at the time of sale, #hich need not be the same as time of collection, BThe matchin4 3rinci3alC of "--P dictates that re.enues be matched #ith ex3enses, Thus, income is re3orted #hen it is earned, e.en thou4h no cash flo# may ha.e occurred, Income Statement Anal+sis Non 0ash %tems The 3rimary reason that accountin4 income differs from cash flo# is that income statement contain non(cash items 2e3reciation is the most a33arent, No firm e.er #rites a check for Bde3reciationC, The de3reciation deduction is sim3ly an a33lication of the matchin4 3rinci3le in accountin4, -nother noncash item is deferred taxes, #hich does not re3resent a cash flo#, Income Statement Anal+sis Time and 0osts %n the short run, certain e5ui3ment, resources, and commitments of the firm are fixed, but the firm can .ary such in3uts as labor and ra# materials, %n the lon4 run, all in3uts of 3roduction =and hence costs> are .ariable, /inancial accountants do not distin4uish bet#een .ariable costs and fixed costs, %nstead, accountin4 costs usually fit into a classification that distin4uishes 3roduct costs from 3eriod costs,
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Income Statement Anal+sis Time and 0osts Product cost include such thin4s as ra# materials, direct labor and manufacturin4 o.erhead and are re3orted on the income statement as the cost of 4oods sold, but they include both fixed and .ariable costs, Period costs include sellin4, 4eneral, and administrati.e ex3enses #hich may be fixed as #ell as .ariable, %a/es One of the lar4est cash outflo#s that a 0or3orate firm ex3eriences, The si<e of tax is determined throu4h the tax schedule issued by the 0entral &oard of Re.enue, Taxes for 3artnershi3s and 3ro3rietorshi3 are com3uted usin4 the 3ersonal income tax schedules, !odel Tax Rates Taxable %ncome Tax Rate , I' ( +',''' 1+T +',''1 ( )+,''' *+ )+,''1 ( 1'',''' ?A 1'',''1 ( ??+,''' ?S ??+,''1 ( 1',''',''' ?A 1',''',''1 ( 1+,''',''' ?+ 1+,''',''1 ( 1O,???,??? ?O 1O,???,??AE ?+ A!erage !s@ Marginal %a/ >ates -.era4e tax rate is tax bill di.ided by the taxable income or the 3ercenta4e of the income that 4oes to 3ay taxes !ar4inal tax rate is the extra tax you #ould 3ay if you earn one more dollar, Su33ose a 0or3oration has a taxable income of I*'',''', So the Tax calculation #ill be6 I +',''' x 1+T H I ),+'' =I )+,''' L +','''> x *+T H K,*+' =I 1'',''' L )+,'''> x ?AT H O,+'' =I *'',''' L 1'','''> x ?ST H ?S,''' I K1,*+' Our total tax is IK1,*+' -.era4e tax rate is IK1,*+' U *'',''' H ?',K*+T !ar4inal rate is ?ST Flat %a/ rate There is only one tax rate and this rate is same for all income le.els, With such a tax, the mar4inal tax rate is al#ays same as the a.era4e tax rate, The model tax rate schedule 3resented earlier re3resents a modified flat(rate tax, #hich becomes a true flat rate for the hi4hest incomes, Lets take another .ie# A!erage !s@ Marginal %a/ >ates Taxable %ncome I A+,''' !ar4inal Tax Rate 1+T *+ ?A Total Tax I K,)+' -.era4e tax Rate 1+,''T 1),OK *1,K?
)',''' S+,'''
1*,+'' *',++'
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A!erage !s@ Marginal %a/ >ates We see that the more a cor3oration makes, the 4rater is the 3ercenta4e of taxable income 3aid in taxes, So the a.era4e tax rate ne.er 4oes do#n, e.en thou4h the mar4inal rate does, %t #ill normally be the mar4inal tax rate that is rele.ant for financial decision makin4, since any ne# cash flo#s #ill be taxed at the mar4inal rate Cost of a %a/ &educti)le E/pense The business3ersons often say that a tax(deductible item, such as interest on loans, tra.el ex3enditures, or salaries, costs substantially less than the amount s3ent on after(tax basis, Lets examine t#o cor3orations ( one 3ays I1'',''' in interest, #hile other has no interest ex3ense, Cost of a %a/ &educti)le E/pense Corporation A Earnin4s before interest and taxes ( %nterest Ex3ense Earnin4 before taxes =taxable income> ( Taxes V?+T Earnin4 after taxes 2ifference in earnin4 after taxes %t can also be com3uted as6 %nterest Ex3ense =1 L Tax rate> HI1'',''' =1 L ?+T> H IK+,''' Cost of a %a/ &educti)le E/pense IA'',''' 1'',''' ?'',''' 1'+,''' I1S+,''' IK+,''' Corporation B IA'',''' ' A'',''' 1A',''' I*K','''
%nterest is deducted from earnin4s before determinin4 taxable income, thus sa.in4 I?+,''' in taxes and costin4 only IK+,''' on a net basis, &ecause a di.idend on common stock is non tax(deductible, #e say it cost 1''T of amount 3aid, /rom a 3urely cor3orate cash flo# 3oint of .ie#, the firm #ould be indifferent bet#een 3ayin4 I1'',''' in interest and IK+,''' in di.idends,
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-lthou4h de3reciation is not a ne# source of funds, it 3ro.ides the im3ortant function of shieldin4 3art of our income from taxes, -4ain, #e take the same t#o cor3orations L one char4es off I1'',''' in de3reciation, other char4es off none, &epreciation as a %a/ S(ield 0or3oration Earnin4s before de3reciation P taxes ( 2e3reciation Earnin4 before taxes =taxable income> ( Taxes V?+T Earnin4 after taxes E 2e3, char4ed #ithout cash outlay 0ash flo# 2ifference %t can also be com3uted as6 2e3reciation x Tax rate I1'',''' x ?+T H I?+,''' &epreciation as a %a/ S(ield 0or3oration - en:oys I?+,''' more in cash flo#, since de3reciation shielded I1'',''' from taxation in 0or3oration - and sa.ed I?+,''' in taxes, #hich e.entually a33eared in cash flo#s, Financial Cas( Flo< %n finance, the most im3ortant item that can be extracted from financial statements is the actual cash flo# of the firm, Since there is no ma4ic in finance, it must be the case that the cash recei.ed from the firm;s assets must e5ual the cash flo#s to the firm;s creditors and stockholders, 0ash /lo#s to creditors 0ash /lo# from -ssets E 0ash flo# to stockholders 0ash /lo# from -ssets 0ash flo# from assets in.ol.es three com3onents O3eratin4 0ash flo# 0a3ital S3endin4 0han4e in Net Workin4 ca3ital IA'',''' 1'',''' ?'',''' 1'+,''' I1S+,''' 1'',''' I*S+,''' I?+,''' 0or3oration & IA'',''' ' A'',''' 1A',''' I*K',''' ' I*K','''
This refers to the cash flo# that results from the firm;s day(to(day acti.ities of 3roducin4 and sellin4, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Ex3enses related to firm;s financin4 of its assets are not included since they are not o3eratin4 ex3enses, To calculate O0/, #e calculate re.enues minus costs =includin4 taxes bein4 3aid in cash>, but don;t include de3reciation since it is not a cash out flo# %nterest because it is a financin4 ex3ense O0/ is .ery si4nificant as it tells #hether or not the firm;s cash inflo#s from its business o3erations are sufficient to co.er its e.eryday cash outflo#s, So, a ne4ati.e o3eratin4 cash flo# is a si4n of trouble, Financial Cas( Flo< of t(e C$D Corporation
X+, &inancial !ash !-./-.A(0-1 2 &lo2 (in ) 0X2 %illions)
Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3endin4 -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total I?K K I*?O =1)?> =*?> IA*
O3eratin4 0ash /lo#6 E&%T I*1S 2e3reciation IS' 0urrent Taxes =I)1> O0/ I*?O
IA*
Capital Spending Some 3ortion of the firm;s cash flo# is rein.ested in the firm, 0a3ital s3endin4 refers to the net s3endin4 on fixed assets =Purchases of fixed assets less sale of fixed assets>, Net 0a3ital S3endin4 could be ne4ati.e if the firm sold off more assets than it 3urchased, 2e3reciation of the res3ecti.e assets is accounted for in this re4ard,
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Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3endin4 -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total C(ange in Net "orking Capital I?K K IA* I*?O =1)?> =*?> IA*
0a3ital S3endin4 Purchase of fixed assets Sales of fixed assets 0a3ital S3endin4
%t is the amount s3ent on Net Workin4 0a3ital, and re3resents the net increase in current assets o.er current liabilities, Financial Cas( Flo< of t(e C$D
X+, !-./-.A(0-1 &inancial !ash &lo2 20X2 (in ) %illions)
Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3endin4 -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total I?K K IA* I*?O =1)?> 2233 IA*
NW0 4re# to I*)+ million in *'N* from I*+* million in *'N1, This increase of I*? million is the addition to NW0,
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Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3enadin4 -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total I?K K
IA*
Cas( Flo< to Creditors 0ash flo# to creditors is calculated as interest 3aid less net ne# borro#in4 Financial Cas( Flo< of t(e C$D C$D C,>*,>A%I,N
&inancial !ash &lo2
Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3endin4 -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total I?K K
Cas( Flo< to Creditors Interest >etirement of de)t 8; &e)t ser!ice *roceeds from ne< de)t sales %otal
IA*
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Cas( Flo< of t(e Firm O3eratin4 cash flo# Ca ital s endin/ -dditions to net #orkin4 ca3ital Total Cas( Flo< of In!estors in t(e Firm 2ebt E5uity Total I?K K I*?O =1)?> =*?> IA*
Cas( Flo< to Stock(olders &i!idends EF; >epurc(ase of stock I Cas( to Stock(olders FG *roceeds from ne< stock issue 0F;1 %otal EI
IA*
!ash &lo2 o3 the &ir% Cas( Flo< of t(e Firm O3eratin4 cash flo# 0a3ital s3endin4 -dditions to net #orkin4 ca3ital (otal Cas( Flo< of In!estors in t(e Firm 2ebt E5uity
%(e cas( from recei!ed from t(e firm6s assets must e7ual t(e cas( flo<s to t(e firm6s creditors and stock(olders:
(otal
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Cas( Flo< Summar+ Cas( Flo< identit+ 0ash flo# from -ssets H 0ash /lo# to creditors E0ash flo# to Stockholders 0ash flo# from -ssets 0ash flo# from assets H O3eratin4 0ash /lo# ( Net 0a3ital S3endin4 ( 0han4e in Net Workin4 0a3ital Where Operating cash flow = Earnings before Interest and taxes + epreciation ! "axes #et $apital %pending = Ending #et &ixed 'ssets ( )eginning #et &ixed 'ssets $hange in #W$ = Ending #W$ ! )eginning #W$ Cas( flo< to creditors 0)ond(olders1 0ash flo# to creditors H %nterest 3aid L Net ne# borro#in4s Cas( flo< to stock(olders 0o<ners1 0ash flo# to stockholders H 2i.idends Paid L Net ne# e5uity raised
+ epreciation
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LESSON )
Assets Current assets: 0ash and e5ui.alents -ccounts recei.able %n.entories Other Total current assets
59C5 59C3
$140 $107 294 270 269 280 58 50 $761 $707
Fi/ed assets: $1,423 $1,274 Pro3erty, 3lant, and e5ui3ment 0460 Less accumulated de3reciation 0550 873 814 Net 3ro3erty, 3lant, and e5ui3ment 245 221 %ntan4ible assets and other $1,118 $1,035 Total fixed assets
$1,879 $1,742
(otal assets
Stockholder's equit " $39 $39 +#e*e##ed stoc1 55 32 Co--on stoc1 2$1 e# value3 347 327 Ca ital su# lus 390 347 Accu-ulated #etained ea#nin/s .ess t#easu#! stoc1 026 $725 020 $805 (otal equit! (otal liabilities and $1,879 $1,742 stockholder's equit
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20X2
To calculate cash flo# from o3erations, start #ith net income, ,perations add back noncash items like Net %ncome de3reciation and ad:ust for chan4es 2e3reciation in current assets and liabilities =other 2eferred Taxes than cash>, 0han4es in -ssets and Liabilities -ccounts Recei.able %n.entories -ccounts Payable -ccrued Ex3enses Notes Payable Other
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0ash flo# from in.estin4 acti.ities in.ol.es chan4es in ca3ital assets6 ac5uisition of fixed assets and sales of -c5uisition of fixed assets fixed assets =i*e* net ca3ital Sales of fixed assets ex3enditures>, %otal Cas( Flo< from In!esting Acti!ities C$D Corporation Cas( Flo< from Financing Acti!ities C$D C,>*,>A%I,N Cas( Flo< from Financing Acti!ities 59C5 0in E millions1 0ash flo#s to and from creditors and o#ners include chan4es in e5uity and debt, Retirement of debt =includes notes> Proceeds from lon4(term debt sales 2i.idends Re3urchase of stock Proceeds from ne# stock issue %otal Cas( Flo< from Financing C$D Corporation Statement of Cas( Flo<s The statement of cash flo#s is the addition of cash flo#s from o3erations, cash flo#s from in.estin4 acti.ities, and cash flo#s from financin4 acti.ities,
I=1SO> *+ I=1)?>
-4erations $et %nco-e )e #eciation )e*e##ed (a&es Chan/es in Assets and .ia"ilities Accounts 7eceiva"le %nvento#ies Accounts +a!a"le Acc#ued 8& enses $otes +a!a"le 'the# (otal !ash &lo2 3ro% -4erations 0n5estin# Acti5ities Acquisition o* *i&ed assets 5ales o* *i&ed assets (otal !ash &lo2 3ro% 0n5estin# Acti5ities &inancin# Acti5ities 7eti#e-ent o* de"t 2includes notes3 +#oceeds *#o- lon/0te#- de"t sales )ividends 7e u#chase o* stoc1 +#oceeds *#o- ne9 stoc1 issue %otal Cas( Flo< from Financing C(ange in Cas( 0on t(e )alance s(eet1
$86 90 13 2243 11 16 18 233 283 $199 $21983 25 $21733 $2733 86 2433 263 43 $7 $33
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- 4ood Workin4 Mno#led4e of financial Statements is desirable sim3ly because these statements are the 3rimary means of communicatin4 financial information both #ithin and outside the firm, E/ternal Uses of Statement Anal+sis
"rade $reditors (( /ocus on the li5uidity of the firm, )ondholders (( /ocus on the lon4(term cash flo# of the firm, %hareholders (( /ocus on the 3rofitability and lon4(term health of the firm,
Internal Uses of Statement Anal+sis +lan (( /ocus on assessin4 the current financial 3osition and e.aluatin4 3otential firm o33ortunities, $ontrol (( /ocus on return on in.estment for .arious assets and asset efficiency, ,nderstand (( /ocus on understandin4 ho# su33liers of funds analy<e the firm,
Significance of Financial Statements The reason, #e rely on accountin4 fi4ures for much of our financial information is that #e are almost al#ays unable to obtain all of market information #e #ant, The only meanin4ful yardstick for e.aluation business decisions is #hether or not they create economic .alue, 0learly, one im3ortant 4oal of the accountant is to re3ort financial information to the user in a form useful for decision makin4, &ut the financial statements don;t come #ith a user;s 4uide, We #ill try to fill u3 this 4a3 throu4h learnin4 a com3rehensi.e analysis of financial statements,
Standardi-ed Financial Statements One ob.ious thin4 #e #ant to do #ith a com3any;s financial statements is to com3are them to those of other, %t is almost im3ossible to directly com3are the financial statements for t#o com3anies because of differences in si<e, So #e #ill try to standardi<e the financial statements,
Common4Si-e Statements One .ery common and useful #ay of standardi<ed com3arison is to #ork #ith 3ercenta4es instead of dollars, So, a standardi<ed financial statement 3resentin4 all items in 3ercenta4es is called a common(si<e statement, &alance sheet items are sho#n as a 3ercenta4e of total assets and income statement items as a 3ercenta4e of sales,
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LESSON O C,MM,N4SIDE S%A%EMEN%S One .ery common and useful #ay of standardi<ed com3arison is to #ork #ith 3ercenta4es instead of dollars, So, a standardi<ed financial statement 3resentin4 all items in 3ercenta4es is called a common(si<e statement, &alance sheet items are sho#n as a 3ercenta4e of total assets and income statement items as a 3ercenta4e of sales, A5D Inc@, Balance S(eet A5D Inc@ Balance S(eet as of &ecem)er ;3 0E in millions1 59C5
Assets 59C3 0urrent -ssets 0ash I OA I SO -ccounts recei.able 1K+ 1OO %n.entory ?S? A** Total I KA* I)'O /ixed assets Net 3lant and e5ui3ment *,)?1 *,OO' Total assets I?,?)? I?,+OO -*R %nc,, &alance Sheet ia)ilities and e7uit+ Current lia)ilities -ccounts 3ayable Notes 3ayable Total Lon4(term debt Stock(olders6 e7uit+ 0ommon stock and 3aid(in sur3lus Retained earnin4s Total Total liabilities and e5uity 59C3
59C5
A5D Inc@, Common4Si-e Balance S(eet Assets Current Assets 0ash -ccounts recei.able %n.entory Total /ixed assets Net 3lant and e5ui3ment Total assets 59C3 *,+T A,S 11,) O',ST O',?T 1'','T 1'','T 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan *,)T 1S,1T +,* 11,O 1S,)T 59C5
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A5D Inc@, Common4Si-e Balance S(eet ia)ilities and e7uit+ Current lia)ilities -ccounts 3ayable Notes 3ayable Total Lon4(term debt Stock(olders6 e7uit+ 0ommon stock and 3aid(in sur3lus Retained earnin4s Total Total liabilities and e5uity A5D Inc@, Common4Si-e Balance S(eet !ore on Standardi<ed Statements Su33ose #e ask6 BWhat ha33ened to -*R;s net 3lant and e5ui3ment =NPPE> o.er the 3eriod7C *'N1 S,*T K,O S,KT *'N*
+,+ 1K,'T 1+,1T 1+,)T 1*,)T 1A,OT 1+,?T +?,? +K,S KO,1 1'','T 1'','T
)*,*
&ased on the *'N1 and *'N* &US, NPPE rose from I*,)?1 to I*,OO', so NPPE rose by I1AS, 2id the firm;s NPPE 4o u3 or do#n7 Ob.iously, it #ent u3, but so did total assets, %n fact, lookin4 at the standardi<ed statements, NPPE #ent from O',ST of total assets to O',?T of total assets,
!ore on Standardi<ed Statements %f #e standardi<ed the *'N* numbers by di.idin4 each by the *'N1 number, #e 4et a common base year statement, %n this case, I*,OO' U I*,)?1 H 1,'+A+, so NPPE rose by +,A+T o.er this 3eriod, %f #e standardi<ed the *'N* common si<e numbers by di.idin4 each by the *'N1 common si<e number, #e 4et a combined common si-e, common base year statement, %n this case, O',?TU O',ST H SS,*KT, so NPPE almost remained the same as a 3ercenta4e of assets, =, ,> *,KT, %n absolute terms, NPPE is u3 by I1AS or +,A+T, but relati.e to total assets, NPPE fell by
!ore on Standardi<ed Statements 0urrent assets rose from 1S,1T in *'N1 to 1S,)T in *'N* 0urrent liabilities declined from 1K,'T to 1+,1T of total liabilities and e5uity o.er the same time, Total e5uity rose from KO,1T of total liabilities and e5uity to )*,*T, O.erall, -*R;s li5uidity as measured by current assets com3ared to current liabilities, increased o.er the year, -lso, -*R;s indebtness diminished as a 3ercenta4e of total assets, So #e may conclude that balance sheet as 4ro#n stron4er A5D Inc@, Income Statement For t(e $ear 59C5 0E in millions1 Net sales I*,?11 0ost of 4oods sold 1,?AA 2e3reciation *)K Earnin4s before interest and taxes I KS1 %nterest 1A1 Taxable income ++' Taxes 1O) 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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-*R %nc,, 0ommon(Si<e %ncome Statement Net sales 0ost of 4oods sold 2e3reciation Earnin4s before interest and taxes *S,S %nterest K,1 Taxable income *?,O Taxes Net income 2i.idends +,*T Retained earnin4s 1',+ A5D Inc@, Common4Si-e Income Statement 1'',' T +O,* 11,S
O,1 1+,) T
This statement tells us #hat ha33ened to each dollar in sales, /or -*R interest ex3ense eats u3 K,1T of sales, #hile taxes take another O,1T of sales fi4ure, /ollo#in4 this, 1+,)T of re.enues from sales flo# do#n to bottom as net incomeW one(third of #hich is 3aid in di.idends and remainder t#o(thirds is taken as retained earnin4s for business, -s far as cost is concerned, +O,*T of re.enues are s3ent on the 4oods sold
Standardi-ed Financial Statements -lthou4h an or4ani<ation;s common(si<e statements 3ro.ide a better analytical insi4ht into the it;s stren4th and standin4, yet it;s 3erformance and efficiency can be better :ud4ed by com3arin4 these #ith those of the firm;s com3etitors, >atio Anal+sis -nother #ay of a.oidin4 the 3roblems in.ol.ed in com3arin4 com3anies of different si<es, is to calculate and com3are financial ratios, One 3roblem #ith ratios is that different 3eo3le and different sources fre5uently don;t com3ute them in exactly the same #ay, While usin4 ratios as a tool for analysis, you should be careful to document ho# you calculate each one, and, if you are com3arin4 your numbers to those of another source, be sure you kno# ho# their numbers are com3uted,
/or each of the ratios #e discuss, se.eral 5uestions come to mind6 $o# is it com3uted7 What is it intended to measure, and #hy mi4ht #e be interested7 What is the unit of measurement7 What mi4ht a hi4h or lo# .alue be tellin47 $o# mi4ht such .alues be misleadin47 $o# could this measure be im3ro.ed7 /inancial ratios are traditionally 4rou3ed into the follo#in4 cate4ories6 S(ort4term sol!enc+, or li7uidit+, ratios -bility to 3ay bills in the short(run ong4term sol!enc+, or financial le!erage, ratios -bility to meet lon4(term obli4ations Asset management, or turno!er, ratios 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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%ntensity and efficiency of asset use *rofita)ilit+ ratios -bility to control ex3enses Market !alue ratios "oin4 beyond financial statements S(ort4%erm Sol!enc+, or i7uidit+ Measures The 3rimary concern to #hich these ratios relate, is the firm;s ability to 3ay its bills o.er the short run #ithout undue stress, So these ratios focus on current assets and current liabilities, Li5uidity ratios are 3articularly interestin4 to short(term creditors, Since financial mana4ers are constantly #orkin4 #ith banks and other short(term lenders, an understandin4 of these ratios is essential Current assets and lia)ilities Their book .alues and market .alues are likely to be similar, They can and do chan4e fairly ra3idly, hence un3redictable 0urrent -ssets 0urrent RatioH (((((((((((((((((((((((( 0urrent Liabilities &ecause current assets and liabilities are con.erted into cash o.er the follo#in4 1* months, the current ratio is a measure of short run li5uidity, The unit of measurement is either dollars or times, Current >atio /or -*R 0or3oration, the *'N* current ratio is I)'O 0urrent RatioH (((((((((( H 1,?1 times I+A' We can say that
-*R has a I1,?1 in current assets for e.ery I1 in current liabilities OR -*R has its current liabilities co.ered 1,?1 times o.er, To a creditor =3articularly a short(term creditor like su33lier>, the hi4her the current ratio, the better To firm, hi4h current ratio indicates li5uidity, but it may also indicate an inefficient use of cash and
other short(term assets,
We #ould ex3ect to see a current ratio of at least 1, because a current ratio of less than 1 #ould mean
that net #orkin4 ca3ital is ne4ati.e
Like any other ratio, current ratio is effected by .arious transactions, %f a firm borro#s o.er lon4(term, %(e s(ort run effect <ould )e an increase in cas( as <ell as in long term lia)ilities@ Current lia)ilities <ould not )e affected, so t(e current ratio <ould rise@ -n a33arently lo# current ratio may not be a bad si4n for a com3any #ith a lar4e reser.e of unlimited
borro#in4 3o#er, Current E!ents 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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0urrent ratio mo.es a#ay from 1, if it is 4reater than 1 it #ill 4et bi44er, &ut if it is less than 1, it #ill 4et
smaller,
Su33ose a firm has IA in current assets and I* in current liabilities for a current ratio of *, and uses I1 in
cash to reduce current liabilities, then ne# current ratio is =IA(*> U =I*(1> H ?
Re.ersin4 the situation to I* in current assets and IA in current liabilities, the chan4e #ill cause current
ratio to fall to 1U? from 1U* Su33ose a firm buys some in.entory, What #ould ha33en in this case7
Nothin4 ha33ens to current ratio, &ecause in this scenario, one current asset =cash> 4oes do#n #hile
another current asset =in.entory> 4oes u3, Total current assets are unaffected, "(at (appens if a firm sells some merc(andise'
0urrent
ratio #ould usually rise because in.entory is sho#n at cost and sale #ould normally be at somethin4 4reater than cost =difference is marku3>,
So, the increase in either cash or recei.ables is 4reater This increases current assets and current ratio rises,
Quick 0or Acid4%est1 >atio %n.entory is often the least li5uid current asset, -nd its book .alues are least reliable as measures of market .alue since the 5uality of in.entory isn;t considered, Some of the in.entory may turn out to be dama4ed, obsolete or lost, Relati.ely lar4e in.entories are often a si4n of short(term trouble, The firm may ha.e o.erestimated sales and o.erbou4ht or o.er3roduced as a result, hence tied u3 a substantial 3ortion of its li5uidity in slo# mo.in4 in.entory %t is com3uted :ust like current ratio, exce3t in.entory is omitted, 0urrent -ssets L %n.entory Xuick RatioH (((((((((((((((((((((((((((((((((((( 0urrent Liabilities /or -*R, this ratio in *'N* #as I)'O L A** Xuick RatioH ((((((((((((((((( H ',+? times I+A' The 5uick ratio here tells a some#hat different story than the current ratio, because in.entory accounts for more than half of -*R;s current assets %f the same fi4ure is for an aircraft manufacturin4 cor3oration, then this #ould certainly be a cause for a &%" concern,
Cas( >atio - .ery short(term creditor may be interested in the cash ratio 0ash 0ash RatioH ((((((((((((((((((((((( 0urrent Liabilities 0urrent ratio for -*R in *'N* #as ',1O
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LESSON S >A%I, ANA $SIS A5D Inc@, Balance S(eet A5D Inc@ Balance S(eet as of &ecem)er ;3 0E in millions1 59C5
Assets 59C3 Current Assets 0ash I OA I SO -ccounts recei.able 1K+ 1OO %n.entory ?S? A** Total I KA* I)'O /ixed assets Net 3lant and e5ui3ment *,)?1 *,OO' Total assets I?,?)? I?,+OO A5D Inc@, Balance S(eet ia)ilities and e7uit+ *'N1 *'N* Current lia)ilities -ccounts 3ayable I ?1* I ?AA Notes 3ayable *?1 1SK Total I +A? I +A' Lon4(term debt +?1 A+) Stock(olders6 e7uit+ 0ommon stock and 3aid(in sur3lus +'' ++' Retained earnin4s 1,)SS *,'A1 Total I*,*SS I*,+S1 Total liabilities and e5uity I?,?)? I?,+OO
Net sales 0ost of 4oods sold 2e3reciation Earnin4s before interest and taxes %nterest Taxable income Taxes Net income 2i.idends Retained earnin4s Current >atio Current E!ents
A5D Inc@, Income Statement For t(e $ear 59C5 0E in millions1 I*,?11 1,?AA *)K I KS1 1A1 ++' 1O) I ?K? I1*1 *A*
Su33ose a firm buys some in.entory, What #ould ha33en in this case7
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Nothin4 ha33ens to current ratio, &ecause in this scenario, one current asset =cash> 4oes do#n #hile 0urrent
ratio #ould usually rise because in.entory is sho#n at cost and sale #ould normally be at somethin4 4reater than cost =difference is marku3>,
So, the increase in either cash or recei.ables is 4reater This increases current assets and current ratio rises,
Current >atio
- firm #ants to 3ayoff some of its su33liers and creditors, What #ould ha33en to current ratio7
0urrent ratio mo.es a#ay from 1, if it is 4reater than 1 it #ill 4et bi44er, &ut if it is less than 1, it #ill 4et
smaller,
Su33ose a firm has IA in current assets and I* in current liabilities for a current ratio of *, and uses I1 in
cash to reduce current liabilities, then ne# current ratio is =IA(1> U =I*(1> H ?
Re.ersin4 the situation to I* in current assets and IA in current liabilities, the chan4e #ill cause current
ratio to fall to 1U? from 1U* ong %erm Sol!enc+ Measures These ratios are intended to address the firm;s lon4(run ability to meet its obli4ations, or its financial le.era4e,
%otal &e)t >atio This ratio takes into account all debts of all maturities to all creditors, %t is com3uted as Total -ssets L Total E5uity Total 2ebt RatioH (((((((((((((((((((((((((((((((((((( Total -ssets For A5D Corporation I?,+OO L *,+S1 Total 2ebt RatioH (((((((((((((((((((((( H ',*O times I?,+OO So -*R uses *OT debt, Whether this is hi4h or lo#, or #hether it e.en makes any difference de3ends on #hether or not ca3ital structure matters, -*R has *OT debt a4ainst total assets, thus there is )*T e5uity a4ainst total assets, $ere #e dra# t#o .ariations out of total debt ratio
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-lso kno#n as Times %nterest Earned =T%E> ratio, refers to the ability of the firm to co.er is interest obli4ations,
Earnin4 before %nterest P Taxes %nterest 0o.era4e ratio H ((((((((((((((((((((((((((((((((((((((((( %nterest /or -*R cor3oration6 H IKS1 U I1A1 H A,S times Cas( Co!erage >atio - 3roblem #ith %nterest 0o.era4e Ratio is that it is based on Earnin4s before %nterest and Taxes =E&%T> #hich is not really a measure of cash a.ailable to 3ay interest, The reason is that de3reciation, a non(cash ex3ense has been deducted out, So #e use6 E&%T E 2e3reciation 0ash 0o.era4e ratio H ((((((((((((((((((((((((((((((((((((((((( %nterest H IKS1 E *)K H ISK) H I@G times I1A1 I1A1 Asset Management or %urno!er Measures The measures in this section are sometimes called -sset 9tili<ation Ratios, These are intended to describe ho# efficiently or intensi.ely a firm uses its assets to 4enerate sales, In!entor+ %urno!er >atio %n.entory turno.er can be calculated as6 0ost of 4oods Sold %n.entory Turno.er ratio H (((((((((((((((((((((((((((((((( %n.entory /or -*R, %TR #ould be6 I1,?AA H (((((((((((((((( H ;@5 times IA** So -*R sold off or turned o.er the entire in.entory ?,* times, -s lon4 as stock(out and fore4oin4 sales situation doesn;t arise, the hi4her this ratio is, the more efficiently in.entory is bein4 mana4ed &a+s6 Sales in In!entor+ %f #e kno# sales #ere turned o.er ?,* times durin4 the year, #e can calculate easily ho# lon4 it took to turno.er on a.era4e, ?K+ days 2ays; Sales in %n.entory H (((((((((((((((((((((((((((((((( %n.entory Turno.er /or -*R6 ?K+ H ((((((((((( H 11A days ?,* So in.entory stays for :ust less than A months before bein4 sold or it #ould take 11A days to sell off current in.entory, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 39
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I*,?11 H (((((((((( H 1*,? times I1OO So -*R collected its outstandin4 credit accounts and reloaned the money 1*,? times durin4 the year, .'ssuming all the sales are credit sales* If not/ we use only credit sales for this ratio0 &a+s6 Sales in >ecei!a)les ?K+ days 2ays; Sales in Recei.ables H ((((((((((((((((((((((((((((((( Recei.ables Turno.er
/or -*R6 ?K+ H ((((((((((( H ?' days 1*,? So -*R collects on its credit sales in a month, or the firm has ?' days; #orth of sales uncollected, This ratio is also called A!erage Collection *eriod A 2ariation: *a+a)les %urno!er %t describes a ho# lon4 does the firm take to 3ay its bills, and is com3uted as6 0ost of "oods Sold Payables Turno.er H ((((((((((((((((((((((((((((((( -ccounts 3ayables I1,?AA H (((((((((((( H ?,S times I?AA So days it took to turno.er the 3ayables are6 ?K+ H ((((((((((( H SA days ?,S This fi4ure is .ery si4nificant to the current as #ell as 3otential creditors of -*R,
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LESSON 1'
Assets Current Assets 0ash -ccounts recei.able %n.entory Total Fi/ed assets Net 3lant and e5ui3ment Total assets
A5D Inc@, Balance S(eet ia)ilities and e7uit+ Current lia)ilities -ccounts 3ayable Notes 3ayable Total Lon4(term debt Stock(olders6 e7uit+ 0ommon stock and 3aid(in sur3lus Retained earnin4s Total Total liabilities and e5uity A5D Inc@, Income Statement For t(e +ear 59C5 0E in millions1 Net sales 0ost of 4oods sold 2e3reciation Earnin4s before interest and taxes %nterest Taxable income Taxes Net income 2i.idends Retained earnin4s %otal Asset turno!er Sales Total -ssets Turno.er H (((((((((((((((((((( Total -ssets I*,?11 H (((((((((((( H ',KA times I?,++O 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 59C3 59C5
I ?1* I ?AA *?1 1SK I +A? I +A' +?1 A+) +'' ++' 1,)SS *,'A1 I*,*SS I*,+S1 I?,?)? I?,+OO
I*,?11 1,?AA *)K I KS1 1A1 ++' 1O) I ?K? I1*1 *A*
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%n other #ords, for e.ery dollar in assets, -*R 4enerated I',KA in sales, Capital Intensit+ >atio %t is sim3ly the reci3rocal of total assets turno.er, or6 Total -ssets 0a3ital %ntensity Ratio H (((((((((((((((((((( Sales %t is inter3reted as the dollar in.estment in assets needed to 4enerate I1 in sales, $i4her .alues re3resent ca3ital intensi.e industries, /or -*R, this ratio is com3uted to be 1,+K, i,e, -*< has to in.est I1,+K in assets to 4et I1 in sales, *rofita)ilit+ Measures %n one form or the other, these ratios are intended to measure ho# efficiently the firm uses its assets and ho# efficiently the firm mana4es its o3erations, The focus in this 4rou3 is on the bottom line L net income, *rofit Margin E.ery com3any, bi4 or small, 3ays .ery close attention to their 3rofit mar4in Net income Profit !ar4inH (((((((((((((((((((( Sales /or -*R com3any the 3rofit mar4in #ill be6 I ?K? H (((((((((((( H 1+,)T I*,?11 So in accountin4 sense, -*R 4enerates a little less than 1K cents in 3rofit for e.ery dollar in sales, Other Thin4s bein4 e5ual, a relati.ely hi4h 3rofit mar4in is ob.iously desirable, corres3ondin4 to lo# ex3enses .s, sales, &ut Other Thin4s are not al#ays e5ual Y /or exam3le, lo#erin4 the sales 3rice #ill usually increase unit sales but #ill normally cause 3rofit mar4in to shrink, Total Profit of o3eratin4 cash flo# may 4o u3 or do#n, >eturn on Assets Return on -ssets =RO-> is a measure of 3rofit 3er dollar of assets6 Net income Return on -ssets H (((((((((((((((((((( Total -ssets /or -*R6 I ?K? RO- H (((((((((( H 1',1*T I?,+OO >eturn on E7uit+ Return on e5uity =ROE> is a measure of ho# the stockholders fared durin4 the year, Since benefitin4 the shareholders is the 4oal of cor3oration, ROE is a true bottom line measure of 3erformance, Net income Return on E5uity H (((((((((((((((((((( Total E5uity /or -*R ROE fi4ure is6 I ?K? ROE H (((((((((( H 1AT I*,+S1 Therefore, for e.ery dollar in e5uity, -*R 4enerated 1A cents in 3rofit, &ut this is correct in accountin4 terms only,
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>,A and >,E &ecause RO- and ROE are most #idely used and commonly cited numbers, so it should be ke3t in mind that these are accountin4 rates of return, That is #hy these are called return on book assets and return on book e5uity ROE is sometimes called return on Net Worth Market 2alue Measures This 4rou3 of measures is based, in 3art, on information not necessarily contained in financial Statements, like market 3rice 3er share, These measures can be calculated directly only for 3ublicly traded com3anies, Earnings *er S(are -ssumin4,
-*Rhas ?? million shares outstandin4 and stock sold for IOO 3er share at the end of year,
So the Earnin4s 3er Share =EPS> #ill be6 Net income I?K? EPS H ((((((((((((((((((((((((((( H ((((((((( H I11 Shares Outstandin4 ?? *rice4Earning >atio Price(earnin4s or PE ratio is defined as6 Price 3er share PE ratio H (((((((((((((((((((((((((( Earnin4s 3er share /or -*R, I OO PE ratio H ((((((((( H O times I11 So -*R shares sell for ei4ht times earnin4s or it carries a PE multi3le of O, Since PE ratio measures ho# much in.estors are #illin4 to 3ay 3er dollar of current earnin4s, hi4her PEs are often taken to mean that the firm has si4nificant 3ros3ects for future 4ro#th, %f a firm had no or almost no earnin4s, its PE #ould 3robably be 5uite lar4eW so careful inter3retation is re5uired, Book 2alue per s(are &ook 1alue is calculated as6 Total e5uity &ook 1alue H (((((((((((((((((((((((((((((((((((( No, of shares outstandin4 I *,+S1 &ook 1alue H ((((((((((((( H I)O,+ ?? Since book .alue 3er share is an accountin4 number, it reflects historical costs, Market4to4Book ratio %t is defined as6 !arket .alue 3er share !ark(to(&ook ratio H (((((((((((((((((((((((((((((((((((( &ook .alue 3er share 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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I OO H ((((((((( H 1,1* times I)O,+ The market(to(&ook ratio com3ares the market .alue of the firm;s in.estment to their costs, - .alue less than 1 could mean that the firm has not been successful o.erall in creatin4 .alue for its stockholders,
%(e &u *ont Identit+ The difference bet#een the t#o 3rofitability measures, RO- and ROE, is the use of debt financin4 , or financial le.era4e, The relationshi3 bet#een these measure can be illustrated by decom3osin4 ROE into its com3onent 3arts, Recall, Net %ncome ROE H (((((((((((((((((((( Total E5uity !ulti3lyin4 it by -ssets U -ssets =#ithout chan4in4 anythin4> Net %ncome Net %ncome -ssets ROE H (((((((((((((((((((( H (((((((((((((((( x ((((((((((( Total E5uity Total E5uity -ssets Net %ncome -ssets H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity Net %ncome -ssets ROE H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity So, #e ha.e ex3ressed ROE as a 3roduct of t#o other ratios L RO- and the e5uity multi3lier ROE H RO- x E5uity multi3lier H RO- x =1 E 2ebt(E5uity ratio>
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LESSON 11
The difference bet#een the t#o 3rofitability measures, RO- and ROE, is the use of debt financin4 , or financial le.era4e, The relationshi3 bet#een these measure can be illustrated by decom3osin4 ROE into its com3onent 3arts, Net %ncome ROE H (((((((((((((((((((( Total E5uity
Recall,
!ulti3lyin4 it by -ssets U -ssets =#ithout chan4in4 anythin4> Net %ncome Net %ncome -ssets ROE H (((((((((((((((((((( H (((((((((((((((( x ((((((((((( Total E5uity Total E5uity -ssets Net %ncome -ssets H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity Net %ncome -ssets ROE H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity So, #e ha.e ex3ressed ROE as a 3roduct of t#o other ratios L RO- and the e5uity multi3lier ROE H RO- x E5uity multi3lier H RO- x =1 E 2ebt(E5uity ratio>
Lookin4 back at -*R6 2ebt(E5uity Ratio H ',?S RO- H 1',1*T #hile ROE calculated 3re.iously H 1AT No#, usin4 the decom3osition method6
ROE H 1',1*T x 1,?S H 1AT We can further decom3ose ROE by multi3lyin4 the to3 and bottom by total sale6 Sales Net %ncome -ssets ROE H (((((((( x (((((((((((((((( x (((((((((((((((( Sales -ssets Total E5uity Rearran4in4 a bit, Net %ncome Sales -ssets ROE H ((((((((((((((( x ((((((((((( x (((((((((((((((( Sales -ssets Total E5uity
>eturn on Assets
!ar4in
ROE
Profit Turno.er
H H
E5uity
Profit
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This last Ex3ression is called 2u Pont identity after the 2u Pont 0or3oration, #hich 3o3ulari<ed its use, No# for -*R6 ROE H 1+,)T x ',KA x 1,?S H 1AT The 2u Pont identity tells us that ROE is affected by three thin4s6 O3eratin4 efficiency =as measured by 3rofit mar4in> -sset use efficiency =as measured by total assets turno.er> /inancial Le.era4e =as measured by e5uity multi3lier>
0onsiderin4 the 2u Pont identity, it a33ears that a firm could le.era4e u3 its ROE by increasin4 its amount of debt this #ill only ha33en if RO- exceeds interest rate on debt, The decom3osition of ROE is a con.enient #ay of systematically a33roachin4 the financial statements analysis, %f ROE is unsatisfactory by some measure, then 2u Pont identity tells you #here to start lookin4 for the reasons, &i!idend *a+out We ha.e seen earlier that the net income is di.ided into t#o 3ieces, The first 3iece is cash di.idend 3aid to stockholders Lefto.er amount is the addition to retained earnin4s -*R;s Net %ncome #as I?K?, of #hich I1*1 #as 3aid out in di.idends, -s a 3ercenta4e6 0ash 2i.idends 2i.idend Payout ratio H ((((((((((((((((((((((( Net %ncome I1*1 H ((((((((( H ??1U?T I?K? >etention >atio -nythin4 -*R does not 3ay out in form of di.idends must be retained in the firm, So retention ratio is6 Retained Earnin4s Retention ratio H ((((((((((((((((((((((( Net %ncome I*A* H (((((((((( H KK*U?T I?K? So -*R retains t#o(thirds of its net income, The retention ratio is also kno#n as the 3lo#back ratio, as this is the amount #hich is 3lo#ed back into the business *a+out and >etention X6 L!N cor3oration 3ays out A'T of net income in form of di.idends, What is its retention ratio7 -6 %f 3ayout ratio is A'T, retention ratio is 1 L A'T H K'T X6 -6 %f net income of L!N is IO'', ho# much did stockholders actually recei.e7 2i.idends are IO'' x A'T H I?*'
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/irm;s Return on -ssets and Return on E5uity are fre5uently used to calculate t#o additional numbers, both of #hich ha.e to do #ith the firms ability to 4ro#, %n.estors and others are fre5uently interested in kno#in4 ho# ra3idly a firm;s sales can 4ro#, &ut the im3ortant thin4 to reco4ni<e is that if sales are to 4ro#, assets ha.e to 4ro# as #ell, at least o.er the lon4 run, /urther if assets are to 4ro#, then the firm must someho# obtain money to 3ay for the 3urchases, So, the 4ro#th has to be financed, -nd more so, a firm;s ability to 4ro# de3ends on its financin4 3olicies, - firm has t#o broad sources of financin46
%nternal financin4 sim3ly refers to #hat the firm earns and subse5uently 3lo#s back into the business, External financin4 refers to funds raised by either borro#in4 money or sellin4 stock, Internal =ro<t( >ate - firm ha.in4 a 3olicy of internal financin4, #on;t borro# funds and #on;t sell any ne# stock, %nternal 4ro#th rate re3resents ho# ra3idly the firm 4ro#, RO- x b %nternal "ro#th rate H (((((((((((((((((( =1 L RO-> x b #here RO- is return on assets and b is the retention ratio /or -*R this rate is ',1'1* x *U? H ((((((((((((((((((((((( =1 L ',1'1*> x *U? H ),*?T Relyin4 solely on internal financin4, -*R can 4ro# at a maximum rate of ),*?T 3er year Sustaina)le =ro<t( >ate %f a firm only relies on the internal financin4 , then throu4h time, its total debt ratio #ill decline, because assets #ill 4ro# but total debt #ill remain the same =or e.en fall if some is 3aid off>, /re5uently, firms ha.e a 3articular total debt ratio or e5uity multi3lier that they .ie# as o3timal, With this in mind #e no# consider ho# ra3idly a firm can 4ro# if it #ishes to maintain a 3articular total debt ratioW and it is un#illin4 to sell ne# stock "i.en these assum3tions, the maximum 4ro#th rate that can be achie.ed is called the Sustainable "ro#th Rate6 ROE x b Sustainable "ro#th rate H (((((((((((((((((( =1 L ROE> x b /or -*R this rate is ',1A x *U? H (((((((((((((((((((( =1 L ',1A> x *U? H 1',*ST The reason for Sustainable "ro#th rate =1',*ST> bein4 lar4er than internal 4ro#th rate =),*?T> is that, as the firm 4ro#s, it #ill ha.e to borro# additional funds if it has to maintain a constant debt ratio, This ne# borro#in4 is an extra source of financin4 in addition to internally 4enerated funds, so -*R can ex3and more, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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&eterminants of =ro<t( 9sin4 2u Pont identity, #e sa# that ROE can be decom3osed into its .arious com3onents Since ROE a33ears so 3rominently in determination of Sustainable 4ro#th rate, the factors determinin4 ROE are also im3ortant determinants of 4ro#th, We kno# that6
ROE
E5uity multi3lier
-nythin4 that increases ROE #ill increase the Sustainable 4ro#th rate, %ncreasin4 the retention ratio #ill ha.e the same effect, So 3uttin4 it all to4ether, the firm;s ability to sustain 4ro#th de3ends ex3licitly on the four factors6
-n increase in 3rofit mar4in #ill increase the firm;s ability to 4enerate funds internally and thereby increase its sustainable 4ro#th, %otal Assets %urno!er -n increase in firm;s total assets turno.er increases the sales 4ro# and thereby increases the sustainable 4ro#th rate, %ncreasin4 total assets turno.er is the same thin4 as decreasin4 ca3ital intensity, Financial *olic+ -n increase in the debt(e5uity ratio increases the firm;s financial le.era4e, Since this makes additional debt financin4 a.ailable, it increases the sustainable 4ro#th rate, &i!idend *olic+ - decrease in the 3ercenta4e of net income 3aid out as di.idends #ill increase the retention ratio, This increases internally 4enerated e5uity and thus increases internal and sustainable 4ro#th, The sustainable 4ro#th rate illustrates the ex3licit relationshi3 bet#een the firm;s four ma:or areas of concern6 O3eratin4 efficiency =as measured by 3rofit mar4in> -sset use efficiency =as measured by total assets turno.er> /inancial 3olicy =as measured by the debt(e5uity ratio> 2i.idend 3olicy =as measured by the retention ratio> %f sales are to 4ro# at a rate hi4her than the sustainable 4ro#th rate, the firm must increase 3rofit mar4ins, increase total assets turno.er, increase financial le.era4e, increase earnin4s retention, or Sell ne# shares
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"(+ E!aluate Financial Statements Primary reason for lookin4 at the accountin4 information is that #e don;t ha.e and cant ex3ect to 4et market .alue information, &ut if #e ha.e such information, #e #ill use it instead of accountin4 data, %f there is a conflict bet#een accountin4 and market data, market data #ould be 3referred, /inancial statements analysis is an a33lication of mana4ement by exce3tion and boils do#n to com3arin4 ratios for one business #ith some a.era4e or re3resentati.e ratios, The ratios differin4 considerably from a.era4es are studied further, Internal Uses Performance E.aluation Profit mar4in and return on e5uity 0om3arin4 the 3erformance of different di.isions Plannin4 for the future $istorical information used for 4eneratin4 3ro:ections 0heckin4 the realism of assum3tions for the 3ro:ections E/ternal Uses Customers: To e.aluate the credit standin4 of a ne# customer Lar4e customers #ould eye on the sustainability of the firm Su33liers6 E.aluate the financial #orth of the su33lier Su33liers #ould be concerned about the credit#orthiness of the firm Competitors Potential stren4th of the com3etitors in case of a ne# 3roduct launched by a firm -c5uisition of ne# firms %dentification of 3otential tar4ets What to offer, C(oosing a Benc(mark &enchmarkin4 is to establish a standard to follo# for com3arison, Some methods of benchmarkin4 are6 Time(Trend analysis Peer "rou3 -nalysis
%ime4%rend Anal+sis &ased on the historical data of the firm %f the current ratio of a firm is *,A for the recent financial statements, #e may com3are it #ith the current ratios for last 1' years, We may find that current ratio has declined o.er the years because of !ore efficient usa4e of current assets 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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*eer =roup Anal+sis %dentifyin4 the firms com3etin4 in the same markets, $a.in4 similar assets, O3erate in similar #ays &enchmarkin46 a.era4es for this 4rou3 of firms OR the to3 firms amon4 the 4rou3 *ro)lems <it( Financial Statements Anal+sis No underlyin4 theory to hel3 identify the items or ratios to look at or to 4uide in establishin4 benchmark 1ery little hel3 on .alue and risk Which ratios matter the most7 What a hi4h or lo# .alue mi4ht be7
/irms #ith many di.ersified businesses 2ifferent accountin4 standards and 3rocedures in different 3arts of the #orld
%ime 2alue of Mone+
%t refers to the fact that a dollar in hand today is #orth more than a dollar 3romised at some time in future, The trade(off bet#een money today and money later de3ends on, amon4 other thin4s, the rate one can
earn by in.estin4 the money today for some interest income, Simple Interest !s@ Compound Interest %ts most basic form, interest is calculated by multi3lyin4 principal =amount in.ested> by rate =T of interest> multi3lied by time =number of 3eriods the interest is calculated>, This is called simple interest, %HPxrxt Where P HF 3rinci3al amount r HF interest rate t HF time 3eriods =years> % HF sim3le interest $o#e.er, if interest is left in the account to accumulate for a lon4er 3eriod =usually lon4er than one year>, common 3ractice re5uires that after interest is earned and credited for a 4i.en 3eriod, the ne# sum of 3rinci3al E interest must no# earn interest for the next 3eriod, etc, This is compound interest, % H P x rt Future 2alue
%t refers to the amount of money an in.estment #ill 4ro# to o.er some 3eriod of time at some 4i.en
interest rate,
-lternati.ely, future .ale is the cash .alue of an in.estment at some time in future,
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Sim3le %nterest is calculated as6 %HPxrxt - I1,''' de3osit at OT 3er year for ? yearsZ sim3le interest6 % H 1''' x ,'O x ? H *A' - I1''' de3osit at OT sim3le interest for three years earns I*A' interest, The future !alue 0F21 of a sim3le interest calculation is deri.ed by addin4 the ori4inal 3rinci3al back to the interest earned, I1,''' E I*A' H I1,*A' Ex3ressed as a formula6 /1 H P=1 E rt> /1 H 1'''E=1''' x ,'O x ?> H 1,*A' %n the one(3eriod case, the formula for &1 can be #ritten as6 &1 H $'[=1 E r> Where $' is cash flo# today =time <ero> and r is the a33ro3riate interest rate, Future 2alue for a ump Sum %f I1'' are in.ested at 1'T interest rate, the future .alue of this I1'' in each 3roceedin4 year #ould be6
1, *, ?,
I11' I1*1
I1??,1' H I1*1 x =1 E ,1'> H I1'' x 1,1' x 1,1' x ,1' H I1'' x =1,1'>? The !ulti3eriod 0ase6 /uture 1alue "enerali<in4 the future .alue of an in.estment o.er many 3eriods6 &1 H $'[=1 E r>t Where $' is cash flo# at date ', r is the a33ro3riate interest rate, and t is the number of 3eriods o.er #hich the cash is in.ested, The ex3ression =1 E r>t is the future value interest factor* The !ulti3eriod 0ase6/uture 1alue Qear &e4innin4 -mount %nterest Earned
Endin4 -mount
1 * ? A
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Futu#e :alue 2$3 160 150 140 130 120 110 100 (i-e 2<ea#s3 $110 $121 $133;10 $146;41 $161;05 Futu#e :alue, 5i- le inte#est, and co- ound inte#est
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1 2 3 4 5 6 7 8 9 10 (i-e 2
Future 2alue and Compounding
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LESSON 1? FU%U>E 2A UE
9sually sim3le interest is used in financial institutions for interest 3eriods of less than one year, %f the rate is ex3ressed as an annual rate =normal 3ractice>, then the time 3eriod =t> must be a fraction of a year, &y in.estin4 I1',''' in an OT, S'(day certificate of de3osit, total 3roceeds at the end of the 02 3eriod #ill be6 /1 H =1','''>E=1','''x,'OxS'U?K+> H I1',1S),*K
%f you #ere to in.est I1',''' at +(3ercent interest for one year, your in.estment #ould 4ro# to I1',+'' I+'' #ould be interest =I1',''' [ ,'+> I1',''' is the 3rinci3al re3ayment =I1',''' [1> I1',+'' is the total due, %t can be calculated as6 I1',+'' H I1','''[=1,'+>, I1',''' today is #orth I1',+'' in one year, 4i.en that interest rate is +T %t refers to the current .alue of the future cash flo# discounted at the a33ro3riate discount rate, %n other #ords, the amount one #ould need to in.est today at some 3re(determined interest rate to 4et some desired amount in future is the 3resent .alue of the desired money,
*resent 2alue
Often, if a bank or other financial institution loans a sum for a short term, the lender #ill 3refer to calculate the interest u3 front and loan out the discounted 3rinci3al, or 3rinci3al minus interest to be earned, The interest to be 3aid u3 front on a loan is called discount and the discounted 3rinci3al, or the actual amount loaned is called the present value =P1> P1 H /1 =1Ert>
Re3eatin4 the discount basic formula =sim3le interest>6 P1 H /1 =1Ert> Exam3le6 %f the bank loans out I1',''' for S' days at OT sim3le interest, the P1 is6 P1 H 1'''' U \1 E =,'O>=S'U?K+>] H 1''''U 1,'1S)*K H IS,O'K,+K
*resent 2alue Su33ose you need IA'' to buy textbooks next year, Qou can earn )T on your money, $o# much do you ha.e to 3ut u3 today7 No#, ((((((((((( Present .alue x 1,') H IA'', Sol.in4 for 3resent .alue6
+#esent value =
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%f you #ere to be 3romised I1',''' due in one year #hen interest rates are at +(3ercent, your in.estment be #orth IS,+*?,O1 in today;s dollars,
$9,523;81 =
$10,000 1;05
So, the amount that a borro#er #ould need to set aside today to, be able to meet the 3romised 3ayment of I1',''' in one year is called the +resent 1alue =+1> of I1',''',Note that ((((((( I1',''' H IS,+*?,O1[=1,'+> %n the one(3eriod case, the formula for +1 can be #ritten as6
Where $1 is cash flo# at date 1 and r is the a33ro3riate interest rate or discount rate,
PV =
*resent 2alue for Multiple *eriods
C1 1+ r
0alculatin4 3resent .alue for multi3le 3eriods is 5uite similar in nature as #as in case of future .alue, "eneral formula for calculatin4 3resent .alue of $ cash flo# in t 3eriods time is6
PV = C
1 21 + r 3 t
1 U=1 E r0t is used to discount a future cash flo#, so it is called the discount factor Or present !alue interest factor 0*2IF r,t1,
0alculatin4 the 3resent .alue of a future cash flo# to determine its #orth today is commonly called discounted cas( flo< 0&CF1 !aluation *resent 2alue Interest Factors 0*2IF1 %nterest Rates Number Periods 1 * ? of+T ',S+*A ',S')' ',OK?O 1'T ',S'S1 ',O*KA ',)+1? 1+T ',OKSK ',)+K1 ',K+)+ *'T ',O??? ',KSAA ',+)O)
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*resent 2alue for Multiple *eriods 2o you #ant to be a millionaire7 No 3roblemY Su33ose you are currently *1 years old, and can earn 1' 3ercent on your money,
$o# much you must in.est today in order to accumulate I1 million by the time you reach a4e K+7
Set this u3 as a future .alue e5uation and sol.e for the 3resent .alue6 I1 million H P1 x =1,1'>AA P1 H I1 millionU=1,1'>AA H I1+,'S1, Of course, #e;.e i4nored taxes and other com3lications, but stay tuned ( ri4ht no# you need to fi4ure out #here to 4et I1+,'''Y *resent 2alue of E3 for &ifferent *eriods and >ates Present of I1 =I> .alue
r $ %&
(2%% 21% 20% 2/% 2.% 2'% 2-% 2,% 2)% 2(% ( ) , ' . / 0 1 (%
r $ '&
*resent 2alue $o# much #ould an in.estor ha.e to set aside today in order to ha.e I*',''' fi.e years from no# if the current rate is 1+T7 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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PV
0 1 2 3 4
$20,000 $9,943;53 = 21;153 5
$20,000
5
*resent 2alue !s@ Future 2alue What #e called the 3resent .alue factor is :ust the reci3rocal of the future .alue factor,
%f #e let /1t stand for the future .alue after t 3eriods, then the relationshi3 bet#een the future .alue and the 3resent .alue is6 P1 x =1 E r>t H /1t P1 H /1t U =1 E r>t H /1t x \1U =1 E r>t] This is also kno#n as basic 3resent .alue e5uation,
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LESSON 1A
- com3any is considerin4 the 3urchase of an asset for I??+, #hich may be sold for IA'' in three years, %f the discountin4 factor is 1'T, is this a 4ood in.estment7 Since the com3any can in.est I??+ else#here at 1'T, in three years, it #ould 4ro# to6 I??+ x =1 E r>t H I??+ x 1,1? H I??+ x 1,??1 H IAA+,OS
Since the 3ro3osed 3urchase of asset 3ays out only IA'', it is not as 4ood as other in.estment alternati.es -nother #ay of lookin4 at it is to calculate the 3resent .alue of IA'' in three years at 1'T6
IA'' x \1U=1Er>t] H IA'' U 1,1? H IA'' U 1,??1 H I?'',+? This tells us that #e only ha.e to in.est about I?'' to 4et IA'' in three years, not I??+ "(at >ate Is Enoug(' -ssume the total cost of a colle4e education #ill be I+',''' #hen a child enters colle4e in 1* years, The Parents ha.e I+,''' to in.est today, What rate of interest must you earn on your in.estment to co.er the cost of your child;s education7
FV = C0 21 + r 3
21 + r 312 =
$50,000 = 10 $5,000
21 + r 3 = 101 12
-bout *1,1+T
/or Pennsyl.ania, the future .alue is I * million and the 3resent .alue is I 1,''', There are *'' years in.ol.ed, so #e need to sol.e for r in the follo#in46 I 1,''' H I * millionU=1 E r >*'' 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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=1 E r >*'' H *,''','' Sol.in4 for r, the Pennsyl.ania money 4re# at about ?,O)T 3er year, The !assachusetts money did betterW check that the rate of return in this case #as A,?T, Small differences can add u3Y Finding t(e Num)er of *eriods %f #e de3osit I+,''' today in an account 3ayin4 1'T, ho# lon4 does it take to 4ro# to I1','''7 t 0
FV = C 21 + r 3
21;103 t =
$10,000 = 2 $5,000
ln21;103t = ln 2
t=
Finding t(e Num)er of *eriods: >ule of 85 /or reasonable rates of return, the time it takes to double the money, is 4i.en a33roximately by o t H )* U rT 0ontinuin4 #ith the exam3le, #e ha.e discount rate of 1'T, so6 o t H )* U 1' H ),* years This rule is fairly a33licable to discount rates in +T to *'T ran4e, Finding t(e Num)er of *eriods: An E/ample - com3any has been sa.in4 u3 to 3urchase an asset, Total cost #ill be I1' million, The com3any has currently about I*,? millions, $o# lon4 it #ill ha.e to #ait, if it can earn +T on the money7, if it can earn 1KT on the money7
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I2@ %(e )asic present !alue e7uation gi!ing t(e relations(ip )et<een present and future !alue is: P1 H /1tU=1 E r>t 2aluation of Multiple Cas( Flo<s So far #e ha.e restricted our attention to either future .alue of a lum3(sum 3resent amount or the 3resent .alue of some sin4le future cash flo#s, No# on#ards #e #ill focus on .aluation of multi3le cash flo#s
%f you de3osit I1'' today in an account at OT and de3osit another I1'' in one year, $o# much #ill you
ha.e in t#o years7 -t the end of first year, you #ill ha.e I1'O 3lus the second I1'' you de3osit, amountin4 to I*'O, &y de3ositin4 this amount at OT, #hat you #ill 4et at the end of *nd year is6 I*'O x 1,'O H I**A,KA
3(%%
) Time *year
(2%0
3))-2.-
-n alternate #ay to calculate the future .alue is to calculate the future .alue of each cash flo# se3arately, The future .alue of first I1'' in * years at OT is6
The *nd I1'' is de3osited for one year, thus6 /1 H I1'' x 1,'O H I1'O -ddin4 u3 both the future .alues #e 4et the total future .alue6 I11K,KA E I1'O H I**A,KA
/uture .alue calculated by com3oundin4 for#ard one 3eriod at a time 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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3% % 3% x (2(
% )5%%% 3)5%%%
x (2(
x (2(
3)5%% %
3)5%% % x (2(,
x (2()
3)5%% x (2( %
x (2(-
$12,210.20
Su33ose, #e had an in.estment that #as 4oin4 to 3ay I1,''' at the end of e.ery year for next fi.e years,
The discount rate is assumed as KT,
Present .alue of all these cash inflo#s can be calculated by6 2iscountin4 each cash flo#s se3arately OR 2iscountin4 back one 3eriod at a time,
Present .alue calculated by discountin4 each cash flo# se3arately
% ( ) , '
3(5%%% x (6(2%.)
3(5%%% x (6(2%.,
Time *years+
3(5%%% 3(5%%%
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Time (years)
Qou are offered an in.estment that #ill 3ay you I*'' in one year, IA'' the next year, IK'' in ?
at the end of A year,
th
rd
and IO''
%f you can earn 1*T on .ery similar in.estments, #hat is the most you should 3ay for this one7 0alculatin4 the 3resent .alue of each cash flo# at 1*T6
I*'' x 1U1,1*1 H I*'' U 1,1*'' H I1)O,+) IA'' x 1U1,1** H IA'' U 1,*+AA H ?1O,OO IK'' x 1U1,1*? H IK'' U 1,A'AS H A*),') IO'' x 1U1,1*A H IO'' U 1,+)?+ H +'O,A1 Total Present 1alueHI1,A?*,S?
%f you can earn 1*T on your money then you can du3licate this in.estment;s cash flo#s for I1,A?*,S?, So
this is the most you should be #ilin4 to 3ay, Annuities and *erpetuities
We #ill fre5uently encounter situations #here #e ha.e multi3le cash flo#s that are all the same amount, Series of e5ual installments for a loan(re3ayment - series of constant, or le.el, cash flo#s that occur at the end of each 3eriod for some fixed number of
3eriods is called an ordinary Annuit+@ *resent 2alue for Annuit+ cas( flo<s
/or annuity calculation, #e use a .ariation of 3resent .alue e5uation, The 3resent .alue of an annuity of $ dollars 3er 3eriod for t 3eriods #hen interest rate is r is6
P1H0 ^ =1 ( Present .alue factor>Ur H 0 ^ \1 ( 1U=1 E r>t ]Ur Where 0 H Periodic 3ayment or annuity r H rate of interest t H number of 3eriods The term in the 3arenthesis is called 3resent .alue interest factor of an annuity =P1%/-r,t>,
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LESSON 1+
We #ill fre5uently encounter situations #here #e ha.e multi3le cash flo#s that are all the same amount, Series of e5ual installments for a loan(re3ayment - series of constant, or le.el, cash flo#s that occur at the end of each 3eriod for some fixed number of 3eriods is called an ordinary Annuit+@
/or annuity calculation, #e use a .ariation of 3resent .alue e5uation, The 3resent .alue of an annuity of $ dollars 3er 3eriod for t 3eriods #hen interest rate is r is6
P1H0 ^ =1 ( Present .alue factor>Ur H 0 ^ \1 ( 1U=1 E r>t ]Ur Where 0 H Periodic 3ayment or annuity r H rate of interest t H number of 3eriods The term in the 3arenthesis is called 3resent .alue interest factor of an annuity =P1%/-r,t>, *resent 2alue Interest Factor of an Annuit+ 0*2IFA1 %nterest Rates Number Periods 1 * ? A + of+T ',S+*A 1,O+SA *,)*?* ?,+AK' A,?*+S 1'T ',S'S1 1,)*++ *,AOKS ?,1KSS ?,)S'O 1+T ',OKSK 1,K*+) *,*O?* *,O++' ?,?+** *'T ',O??? 1,+*)O *,1'K+ *,+OO) *,SS'K
&y lookin4 at your bud4et you kno# you can 3ay IK?* for a ne# car, bank is offerin4 you a loan for AO
months at 1T 3er month, $o# much should you borro#7 P1%/- H =1 L Present .alue factor>Ur H \1 ( =1U1,'1AO >]U','1 H =1 L ',K*'?>U','1 H ?),S)A'
So, Present .alue H IK?* x ?),S)A' H I *A,''' Therefore, you can afford to borro# I*A,'''
Finding t(e *a+ment
%f you #ant to buy a ne# car costin4 I*?,''', With a 1'T do#n 3ayment, the bank #ill loan you the rest
at ST 3er year =,)+T 3er month> for K' months, $o# much #ill each monthly 3ayment be7
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I*',)'', This is the amount today, so it;s the P1, The rate is ,'SU1* H ,'')+, and there are K' 3eriods6 I*',)'' H 0 x \= 1 ( 1U=1,'')+>K']U,'')+ H 0 x AO,1)?A 0 H I*',)''UAO,1)?A 0 H IA*S,)' 3er month Finding t(e num)er of pa+ments
To re3ay a loan of I1,''', !r, N can only afford to 3ay I*' 3er month, %nterest rate is 1,+T 3er month,
$o# lon4 #ill it take to re3ay the loan7
-n
insurance com3any offers to 3ay you I1,''' 3er year if you 3ay IK,)1' u3 front, What rate is a33licable in this 1'(year annuity7
$ere
0 H I1,''', P1 H IK,)1' and t H 1', r H 7 IK,)1' H I1,''' x =1 L P1/> U r K,)1 H _1( \1 U=1 E r>1']` U r Lookin4 at the P1%/- table for 1' 3eriods, K,)1'1 is the .alue for OT, So insurance com3any is offerin4 OT Annuit+ Future 2alue /1t H 0 ^ =/uture .alue factor ( 1>Ur H 0 ^ \=1 E r>t ( 1]Ur Future 2alue for Annuities
could accumulate I1 million by a4e K+ by in.estin4 I1+,'S1 today and lettin4 it earn interest =at 1'T com3ounded annually> for AA years,
No#, rather than 3lunkin4 do#n I1+,'S1 in one chunk, su33ose she #ould rather in.est smaller amounts %f the first de3osit is made in one year, and de3osits #ill continue throu4h a4e K+, ho# lar4e must they be7 Set this u3 as a /1 3roblem6
I1,''',''' H 0 x \=1,1'>AA ( 1] U ',1' 0 H I1,''','''UK+*,KA'O H I1,+?*,*A &ecomin4 a millionaire :ust 4ot easierY
9nfortunately, most 3eo3le don;t start sa.in4 for retirement that early in life, =!any don;t start at allY> Su33ose a A'(year old 3erson has decided it;s time to 4et serious about sa.in4, -ssumin4 that he #ishes to
accumulate I1 million by a4e K+, he can earn 1'T com3ounded annually, and #ill be4in makin4 e5ual annual de3osits in one year, ho# much must each de3osit be7
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!oral of the story6 Puttin4 off sa.in4 for retirement makes it a lot more difficultY
Annuities &ue
So far, #e ha.e discussed only ordinary annuities, #here cash flo#s occur at the end of each 3eriod, e,4,
loan re3ayments
$o#e.er,
#hen you lease an asset, the first lease 3ayment is usually due immediately, second at the be4innin4 of second 3eriod and so on,
-n -nnuity due is an annuity for #hich cash flo#s occur at the be4innin4 of each 3eriod, The time line for -nnuity due, ha.in4 + 3ayments of IA'' each, #ould be like6
% ( ) , ' Time *year
$400
$400
$400
$400
$400
Present .alue of a four year IA'' ordinary annuity at 1'T is I1,*K),S+ -ddin4 on the extra IA'', #e 4et I1,KK),S+, the 3resent .alue of this annuity due, The relationshi3 bet#een an annuity due and an ordinary annuity is :ust6
o -nnuity due .alue H Ordinary annuity .alue x =1 E r>
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LESSON 1K
Su33ose #e ex3ect to recei.e I1''' at the end of each of the next + years, Our o33ortunity rate is KT, What is the .alue today of this set of cash flo#s7
P1
H H H
No# su33ose the cash flo# #ill be I1''' 3er year forever, makin4 it a perpetuity, %n this case, the P1 is easy to calculate6 P1 H 0Ur H I1'''U,'K H I1K,KKK,K)
Summar+ of Annuit+ and *erpetuit+ %, Symbols P1 H Present .alue, #hat future cash flo#s brin4 today /1t H /uture .alue, #hat cash flo#s are #orth in the future r H %nterest rate, rate of return, or discount rate 3er 3eriod t H Number of time 3eriods 0 H 0ash amount %%, /1 of 0 3er 3eriod for t 3eriods at r 3ercent 3er 3eriod6 /1t H 0 ^ \=1 E r>t ( 1] U r %%%, P1 of 0 3er 3eriod for t 3eriods at r 3ercent 3er 3eriod6 P1 H 0 ^=1 ( \1U=1 E r>t]> U r %1, P1 of a 3er3etuity of 0 3er 3eriod6 P1 H 0 U r Effecti!e Annual >ates %f a rate is 5uoted as 1'T com3ounded semiannually, then #hat this means is that the in.estment actually 3ays +T e.ery six months, %s +T e.ery six months the same thin4 as 1'T 3er year7 I1 x 1,1' H I1,1' I1 x 1,'+* H I1,1'*+ 1'T com3ounded semiannually is e5ui.alent to 1',*+T com3ounded annually, 1',*+T is called effecti.e annual rate =E-R> Su33ose three banks offer you the follo#in4 rates for a sa.in4s account6 &ank -6 1+T, com3ounded daily &ank &6 1+,+T, com3ounded 5uarterly &ank 06 1KT, com3ounded annually Which one #ould you o3t for6 &ank 0 is offerin4 1KT 3er year, since there is no com3oundin4 durin4 the year, this is effecti.e rate &ank & actually 3ayin4 ',1++UA H ','?O)+ or ?,O)+T 3er 5uarter, -n in.estment of I1 at this rate for 1 year #ould 4ro# to6 I1 x 1,'?O)+A H I1,1KA* So, E-R is 1K,A*T, /or sa.in4, it is 4ood, /or borro#in4 it is #orse &ank - is com3oundin4 daily, so the daily interest rate is actually ',1+ U ?K+ H ','''A11 or ','A11T, -n %n.estment of I1 at this rate for ?K+ days #ould 4ro# to6 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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I1 x 1,'''A11
?K+
H I1,1K1O
So, E-R is 1K,1OT This is not as 4ood as &ank &;s 1K,A*T for a sa.er, and not as 4ood as &ank 0;s 1KT for a borro#er T#o Lessons6 The hi4hest 5uoted rate is not necessarily the best rate 0om3oundin4 durin4 the year can lead to a si4nificant difference bet#een the 5uoted rate and the effecti.e rate E-R is com3uted in three ste3s 2i.ide the 5uoted rate by the number of times the interest is com3ounded -dd 1 and raise it to the 3o#er of number of times the interest is com3ounded, Subtract 1 E-R H =1 E Xuoted rate U m>m L 1 where m is the number of times the interest is compounded
So
The E-Rof 1*T com3ounded monthly is6 E-R H =1 E Xuoted rate U m>m L 1 H =1 E ',1*U1*>1* L 1 H =1,'1>1* L 1 H 1,1*KO+ L 1 H 1*,KO*+T Compounding Num)er of times period compounded Effecti!e annual rate 1','''''T 1',?O1*S 1',A)1?1 1',+'KAO 1',+1++O 1',+1)'? 1',+1)'S
- bank is offerin4 1*T com3ounded 5uarterly, %f you 3ut I1'' in an account ho# much you #ill earn at the end of one year7 #hat is the E-R7 ho# much #ill you ha.e at the end of t#o years7 The bank is offerin4 1*TUA H ?T e.ery 5uarterW in.estin4 I1'' for A 3eriods at ?T 3er 3eriod, the future
.alue is The E-R is 1*,++T /1 H I1'' x 1,'?A H I11*,++
We can calculate the yield of t#o years in t#o #ays Reco4ni<e t#o years as ei4ht 5uarters6
I1'' x 1,'?O H I1*K,KO
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-nytime #e do a 3resent .alue or future .alue calculation, the rate #e use must be an actual or effecti.e
rate, Annual *ercentage >ates
-nnual 3ercenta4e rate =-PR> is the interest rate char4ed 3er 3eriod multi3lied by the number of 3eriods
3er year,
La#s in some countries re5uire that the lenders disclose an -PR on .irtually all the consumer loans in a
3rominent and un(ambi4uous #ay,
- ty3ical credit card a4reement 5uotes an interest rate of 1OT -PR, !onthly 3ayments are re5uired, What
is the actual interest rate you 3ay on such a credit card 7
-PR of 1OT #ith monthly 3ayments is really ',1O U 1* H ','1+ or 1,+T 3er month, So,
E-R H =1 E ',1OU1*>1* L 1 H 1',1+1* L 1 H 1S,+KT oans
Whene.er a lender extends a loan, some 3ro.ision #ill be made for re3ayment of the 3rinci3al amount,
$ere #e discuss three forms of re3ayment of 3rinci3le and interest 3atterns,
The borro#er recei.es money today and re3ays a sin4le lum3 sum at some time in the future, - borro#er is able to re3ay I*+,''' in + years, "i.en a discount rate of 1*T, #hat amount of money the
lender should lend,7 Present .alue H I*+,''' U 1,1*+ H I1A,1OK Interest4,nl+ oans
0alls for the borro#er to 3ay interest each 3eriod and to re3ay the entire 3rinci3al at some time in the
future,
With a ?(year, 1'T, interest(only loan of I1,''', the borro#er #ould 3ay I1,''' x ',1' H I1'' in interest
at the end of first and second years,
-t the end of third year, he #ould return I1''' 3lus the I1'' in interest for that year,
Amorti-ed oans
-morti<ed loan re5uires the borro#er to re3ay 3arts of the loan amount o.er time, The 3rocess of 3ayin4 off a loan by makin4 re4ular 3rinci3al deductions is called amorti<in4 the loan, loan can be amorti<ed in t#o #ays6
&orro#er 3ays the interest each 3eriod 3lus some fixed amount, e,4, medium(term business loans &orro#er makes a sin4le fixed 3ayment e.ery 3eriod, car loans and mort4a4es
Amorti-ation Sc(edule 4 Fi/ed *rincipal - I+''' loan at an interest rate of ST for + years 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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-4ain takin4 a I+''' loan at an interest rate of ST for + yearsW #e first need to determine the 3ayment, Since this loan;s cash flo#s are in the form of an ordinary annuity, So, sol.in4 for 3ayments6
I+''' H 0 x =1 L 1U','S+> U ','S H 0 x =1 L ',KASS> U ','S
0 H I+''' U ?,OOS)
H I1,*O+,AK Amorti-ation Sc(edule 4 Fi/ed *a+ments Beginning %otal Interest *rincipal Ending $ear Balance *a+ment *aid *aid Balance 1 I+,''','' I1,*O+,AK IA+','' IO?+,AK IA,1KA,+A * A,1KA,+A1, *O+,AK ?)A,O1 S1',K+ ?,*+?,OO ? ?,*+?,OO 1, *O+,AK *S*,O+ SS*,K1 *,*K1,*) A *,*K1,*) 1, *O+,AK *'?,+1 1,'O1,S+ 1,1)S,?* + 1,1)S,?*1, *O+,AK 1'K,1A 1,1)S,?* ','' Totals IK,A*),?' I1,A*),?1 I+,''',''
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LESSON 1)
B,N&S -n e.idence of debt issued by a cor3oration or a 4o.ernmental body, When a cor3oration =or 4o.ernment> #ishes to borro# from 3ublic on a lon4 term basis, it does so by issuin4 or sellin4 debt securities 4enerally called bonds - bond re3resents a loan made by in.estors to the issuer* %n return for hisUher money, the in.estor recei.es a le4al claim on future cash flo#s of the borro#er, The issuer 3romises to6 !ake re4ular cou3on 3ayments e.ery 3eriod until the bond matures, and Pay the faceU3arUmaturity .alue of the bond #hen it matures, 2efault ( since the abo.ementioned 3romises are contractual obligations, an issuer #ho fails to kee3 them is sub:ect to le4al action on behalf of the lenders =bondholders>, & 0or3oration Wants to borro# I1,''' for ?' years at 1* T interest rate Will 3ay ',1* x I1,''' H I1*' in interest e.ery year for ?' years, Will re3ay I1,''' at the end of ?' years & 0or3oration I1*' re4ular interest 3ayments are the bond;s cou3ons I1,''' is the 3ar .alue or face .alue of the bond -nnual cou3on di.ided by the 3ar .alue =I1*'UI1''' H 1*T> is the cou3on rate ?' years is the maturity time
Bond 2alues and $ields The .alue of bonds may fluctuate as the interest rates chan4e by time in the market 3lace, thou4h the cash flo#s from a bond remains the same, When interest rates rise, the 3resent .alue of the bond;s remainin4 cash flo#s decline and the bond is #orth less When the interest rates fall, the bond is #orth more To determine the .alue of bond at a 3articular 3oint in time, #e need to kno# No, of 3eriods remainin4 till maturity, The face .alue, The cou3on rate, and The market interest rate for similar bonds The interest rate re5uired in the market on bonds is called the bond;s Qield to !aturity The N 0or3oration %ssues a bond #ith 1' years to maturity ha.in4 annual cou3on of IO', similar bonds ha.e a yield to maturity of OT, N bond;s cash flo#s ha.e t#o com3onents6 an annuit+ component 0coupons1 and a lump sum 0face !alue paid at maturit+1 The N 0or3oration -t the 4oin4 interest rate of OT the 3resent .alue of I1,''' 3aid in 1' years is6 P1 H I1,''' U 1,'O1' H I1,''' U *,1+OS H IAK?,1S Present .alue of the annuity of O'I 3er year for 1' years is6 P1 H IO' x =1 L 1U1,'O1'> U ','O P1 H IO' x K,)1'1 H I+?K,O1 The N 0or3oration
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This means that the bond sells for exactly its face .alue,
-lternati.ely
7ear s
'
'
(%
30%
30%
30%
30%
30%
30%
30%
30%
30%
0%
30%
30%
30%
30%
30%
30%
30%
30%
30%
3(%%% 3(%0%
%nterest rate chan4e %nterest rate risen to 1'T after one years =S years to maturity> No< t(e present !alue of E3,999 paid in nine +ears at 39: is
I1,''' U 1,1'S H I1,'''U*,?+)S H IA*A,1'
-nother #ay to see #hy bond is discounted by I11+ is to note that the IO' cou3on is I*' belo# the cou3on on a ne#ly issued 3ar .alue bond, So the in.estor #ho buys and kee3s the bond 4i.es u3 I*' e.ery year for S years, -t 1' T this annuity is #orth6 I*' x =1 L 1U1,1'S>U',1' H I*' x +,)+S' H I11+,1O ust as rise of interest rates reflected a decline in the 3rice of the bond, a dro3 of *T in interest rates #ould result in the bond bein4 sold for more than I1''', Such a bond is said to sell at a 3remium or is called a 3remium bond,
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LESSON 1O
2aluing a Bond : A &iscount Bond -ssume you ha.e the follo#in4 information, &!N, %nc, bonds ha.e a I1''' face .alue The 3romised annual cou3on is I1'' The bonds mature in *' years The market;s re5uired return on similar bonds is 1*T
Present .alue of the face .alue o H I1''' x \1U1,1**' ] H I1''' x ,1'?KK H I1'?,KK
Present .alue of the cou3on 3ayments o H I1'' x \1 ( =1U1,1'*'>]U,1' H I1'' x ),AKSA H I)AK,SA
1alue of each bond H I1'?,KK E )AK,SA H IO+',K' -ssume you ha.e the follo#in4 information,
&!N, %nc, bonds ha.e a I1''' face .alue The 3romised annual cou3on is I1'' The bonds mature in *' years The market;s re5uired return on similar bonds is OT Present .alue of the face .alue H I1''' x \1U1,'O*' ] H I1''' x ,*1A++ H I*1A,++
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3(50%% 3(5.%% 3(5-%% 3(5)%% 3(5%%% 3 0%% 3 .%% -& .& 0& (%& ()& (-& (.& 7ields to maturity5 7T9
2aluing Bonds &ased on our exam3les #e can #rite a 4eneral ex3ression for the .alue of a bond, %f a bond has
a face .alue of / 3aid at maturity a cou3on of 0 3aid 3er 3eriod t 3eriods to maturity a yield of r 3er 3eriod
%ts .alue is &ond .alue H 0 x \1 L 1U=1Er>t]Ur E /U =1Er>t &ond .alue H 0 x \1 L 1U=1Er>t]Ur E /U =1Er>t H Present .alue E Present .alue of cou3ons of face amount Semiannual Coupons &ond yields are 5uoted like -PRs, the 5uoted rate is e5ual to the actual rate 3er 3eriod multi3lied by the number of 3eriods in a year, When the 3ayments of cou3ons are made on semiannually, each 3ayment of half of the annual cou3on, it is referred to as semiannual cou3on bond %f an ordinary bond has a cou3on rate of 1AT then the o#ner 4ets I1A' 3er year but in t#o installments each of I)', in this case, the Qield to maturity is 1KT So #ith a 1KT 5uoted yield, the true yield is OT 3er 3eriod, No# if the bond has se.en years to maturity What #ould be the bond;s 3rice7 What is the effecti.e annual yield on this bond7 The bond should sell at a discount because it has a cou3on rate of )T 3er six months #hen the market re5uires a re5uires OT e.ery six months, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Total Present .alue tells that the bond should sell for6 I?A',AK E +)),1' H IS1),+K To calculate the effecti.e annual yield on this bond, note that OT e.ery six months is e5ui.alent to E-R H =1 E ','O>* L 1 H 1K,KAT Interest >ate >isk The risk that arises for bond o#ners from fluctuatin4 interest rates is called interest rate risk, The risk on a bond de3ends on ho# sensiti.e its 3rice is to interest rate chan4es The sensiti.ity directly de3ends on Time to maturity 0ou3on rate While lookin4 at a bond follo#in4 should be ke3t in mind -ll other thin4s bein4 e5ual, the lon4er time to maturity, the 4rater the interest rate risk -ll other thin4s bein4 e5ual, the lo#er the cou3on rate, the 4reater the interest rate risk We can illustrate these characteristics 4ra3hically Interest >ate >isk %ime to Maturit+
(5%%%
31(.2./
'%%
3'%)2((
'
(%
('
)%
2alue of a Bond <it( a 39: Coupon >ate for &ifferent Interest >ates and Maturities 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The slo3e of the line connectin4 the 3rices is much stee3er for ?'(year maturity than it is for 1(year maturity The stee3ness tells that a relati.ely small chan4e in interest rate #ill lead to a substantial chan4e in the bond;s .alue, %n com3arison, one year bond is relati.ely less sensiti.e to interest rate chan4es The reason for lon4er term bonds ha.in4 4reater interest rate sensiti.ity is that a lar4e 3ro3ortion of the bond;s .alue comes from the I1''' face amount, The 3resent .alue of this amount is not affected by small chan4e in interest rate if amount is to be recei.ed in an year While, e.en a small chan4e in interest rate #hen com3ounded for ?' years, #ill ha.e a si4nificant effect on the 3resent .alue, %nterest rate risk increases at a decreasin4 rate, %f #e com3ared a 1'(year bond #ith a 1(year bond, ob.iously, 1' year bond has much 4reater risk &ut if #e com3are a *' year bond to a ?' year bond, the ?' year bond #ill ha.e a some#hat 4reater interest rate risk but the difference is fairly small, The bonds #ith lo#er cou3ons ha.e 4reater interest rate risk %f t#o bonds #ith different cou3on rates ha.e same maturity, the .alue of the one #ith the lo#er cou3on is 3ro3ortionately more de3endent on the face amount to be recei.ed, So its .alue #ill fluctuate more as interest rate chan4es %n other #ords, bond #ith hi4her cou3on has a lar4er cash flo# early in its life, so its .alue is less sensiti.e to chan4es in discount rate
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LESSON 1S
The follo#in4 statements about bond 3ricin4 are always true, 1, &ond 3rices and market interest rates mo.e in o33osite directions, *, When a bond;s cou3on rate is =4reater than U e5ual to U less than> the market;s re5uired return, the bond;s market .alue #ill be =4reater than U e5ual to U less than> its 3ar .alue,
The follo#in4 statements about bond 3ricin4 are always true, ?, "i.en t#o bonds identical but for maturity, the 3rice of the lon4er(term bond #ill chan4e more than that of the shorter(term bond, for a 4i.en chan4e in market interest rates, A, "i.en t#o bonds identical but for cou3on, the 3rice of the lo#er(cou3on bond #ill chan4e more than that of the hi4her(cou3on bond, for a 4i.en chan4e in market interest rates,
Finding t(e $ield to Maturit+ We ha.e seen that the 3rice of a bond can be #ritten as the sum of its annuity and lum3 sum com3onents, Mno#in4 that there is an IO' cou3on rate for K years and a I1''' face .alue, the 3rice of the bond is6 o ISS+,1A H IO' x \1 L 1U=1 E r>K]Ur E 1''' U =1 E r>K r is the unkno#n discount rate or the yield to maturity To sol.e the abo.e e5uation for r #e #ill ha.e to use trial and error method, as #e can not ex3licitly calculate r We can s3eed u3 the trial and error 3rocess by usin4 our kno#led4e about 3rices and yields Since the bond is sellin4 at a discount, #e kno# that the yield is 4reater than OT, %f #e com3ute the 3rice at 1'T, 3rice is IS1*,OS #hich is lo#er than the actual 3rice, so 1'T is too hi4h, Rather it should be bet#een OT and 1'T 0om3utin4 at ST re.eals that this is in fact the bond;s yield to maturity Summar+ of Bond 2aluation %, /indin4 the .alue of a bond &ond .alue H 0 x \1 ( 1U=1 E r>t]Ur E /U=1 E r>t #here6 0 H the 3romised cou3on 3ayment / H the 3romised face .alue t H number of 3eriods until the bond matures r H the market;s re5uired return, QT! %%, /indin4 the yield on a bond "i.en a bond .alue, cou3on, time to maturity, and face .alue, it is 3ossible to find the im3licit discount rate, or yield to maturity, by trial and error only, To do this, try different discount rates until the calculated bond .alue e5uals the 4i.en bond .alue, Remember that increasin4 the rate decreases the bond .alue, &e)t !s@ E7uit+ Securities issued by the cor3orations may be classified rou4hly as E5uity Securities 2ebt Securities When cor3orations borro#, they 4enerally 3romise to !ake re4ular scheduled interest 3ayments, and Re3ay the ori4inal amount borro#ed =3rinci3al> The main differences bet#een debt and e5uity are the follo#in4 2ebt is not an o#nershi3 interest in the firm, 0reditors 4enerally do not ha.e .otin4 3o#er, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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0or3oration;s 3ayment of interest on debt is considered as a cost of doin4 business and is fully tax deductible, While di.idends 3aid to stockholders are not tax deductible, The main differences bet#een debt and e5uity are the follo#in4 9n3aid debt is a liability of the firm, %f it is not 3aid, the creditors can le4ally claim the assets of the firm, resultin4 in bankru3tcy or financial failure, This 3ossibility does not arise #hen e5uity is issued,
ong %erm &e)t Lon4 term debt securities are 3romises made by the issuin4 firm to 3ay 3rinci3al #hen due and to make timely interest 3ayments on the un3aid balance, - number of features that distin4uish the securities from one another !aturity is the len4th of time debt remains outstandin4 #ith some un3aid balance, Short(term debt =ha.in4 maturity of one year or less> is sometimes referred to as unfunded debt - number of features that distin4uish the securities from one another 2ebt securities are ty3ically called notes, debentures or bonds
Strictly s3eakin4 a bond is a secured debt, but the #ord bond refers to all kinds of secure and unsecured debt, Public(issue bonds offered to 4eneral 3ublic Pri.ately 3laced bonds 3laced #ith a 3ri.ate lender and not offered to 4eneral 3ublic Features of a Super Stores Bond
%erm -mount of issue I1*+ million 2ate of issue !aturity /ace 1alue -nnual cou3on *U*OUOK ?U1U1K I1,''' S,*+
E/planation
Offer 3rice 1''' face .alue 3er bond, 0ou3on 3ayment ?U1, SU1 Security Sinkin4 fund None -nnual, be4innin4
The com3any #ill issue I1*+ million #orth of bonds, The bonds #ere sold on *U*OUOK, The 3rinci3al #ill be 3aid in ?' years, The denomination of the bonds is I1,''', Each bondholder #ill recei.e IS*,+' 3er bond 3er year =S,*+T of the face .alue>, The offer 3rice #ill be 1''T of the I1,''' 0ou3ons of IS*,+'U* H IAK,*+ #ill be dates 3aid on these dates, The bonds are debentures, The firm #ill make annual 3ayments to#ard the sinkin4 fund,
?U1US) Not callable The bonds ha.e a deferred call feature before *U*OUS? 1'K,AO initially, -fter *U*OUS?, the com3any declinin4 to 1'' can buyback the a -* This is a hi4her ratin4, The bonds ha.e a lo# 3robability of default,
The bond indenture is a contract bet#een the bond issuer and the bondholders, 9sually, a trustee =3erha3s a bank> is hired by the issuer to 3rotect the bondholders; interests, The trust com3any must 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 78
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%erms of a Bond 0or3orate bonds usually ha.e a face .alue of I1''', called 3rinci3al .alue and is stated on the bond certificate, The 3ar .alue =initial accountin4 .alue> of a bond is almost al#ays same as the face .alue, and terms are used interchan4eably, The cor3orate bonds are usually in re4istered form The com3any kee3s a re4ister recordin4 the o#nershi3 of each bond and any chan4es thereof, The com3any #ill 3ay the interest and 3rinci3al by che5ue mailed directly to the address of the o#ner of record, The bond may be registered and (a!e attac(ed coupons, To obtain the interest 3ayment, the o#ner must se3arate a cou3on from the bond certificate and send it to com3any re4istrar -lternati.ely, the bond could be in )earer form, in #hich case, the certificate is the e.idence of o#nershi3 and the com3any #ill 3ay the bearer, O#nershi3 is not recorded, and the holder of the bond certificate detaches cou3ons and sends to com3any to recei.e 3ayments, &earer bonds are difficult to reco.er if lost or stolen 0om3any ha.in4 no record of o#nershi3 can not notify the bondholders of im3ortant e.ents
Securit+ 2ebt securities are classified as collateral and mort4a4es used to 3rotect the bondholders 0ollateral means securities =bonds, stocks> or any asset 3led4ed as security for 3ayment of debt, !ort4a4e securities are secured by a mort4a4e on the real 3ro3erty of the borro#er, in.ol.in4 usually real estate, 2ebenture is an unsecured bond for #hich no s3ecific 3led4e of 3ro3erty is made The term note is used for such instruments if the maturity of the bonds is less than 1' years #hen issued Seniorit+ Seniority indicates 3reference in 3osition o.er lenders, and debts are sometimes labeled as senior or :unior to indicate seniority, %n the e.ent of default, the holders of subordinated debt must 4i.e 3reference to other s3ecified creditors, $o#e.er, debt cannot be subordinated to e5uity >epa+ment &onds can be re3aid at maturity or they may be re3aid in 3art or in entirety before maturity, Earlier re3ayment is handled throu4h a sinkin4 fund, - sinkin4 fund is an account mana4ed by the bond trustee for the 3ur3ose of re3ayment of bonds, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The com3any makes annual 3ayment to trustee #ho uses the funds to retire a 3ortion of the debt, by either buyin4 u3 some of the bonds in the market or, callin4 in a fraction of outstandin4 bonds Some ty3es of sinkin4 fund arran4ements are6 Some sinkin4 funds start about 1' years after initial issuance Some sinkin4 funds establish e5ual 3ayments o.er the life of bond Some sinkin4 funds are insufficient to redeem the entire issue of hi4h(5uality bonds, creatin4 a 3ossibility of a lar4e Bballoon 3aymentC at maturity
Call *ro!ision - call 3ro.ision allo#s the com3any to re3urchase, or BcallC 3art or all of the bond issue at stated 3rices o.er a s3ecific 3eriod, "enerally, the call 3rice is abo.e the bond;s stated .alue =3ar .alue> The difference bet#een the call 3rice and the stated .alue is the call 3remium, The amount of 3remium, initially set e5ual to the annual cou3on 3ayment, becomes smaller o.er time and declines to <ero as call date mo.es closer to time of maturity, 0all 3ro.isions are not usually o3erati.e durin4 the first 3art of a bond;s life, makin4 it less of a #orry for bondholders, /or exam3le, a com3any may be 3rohibited from callin4 its bonds for the first 1' years, makin4 the bond call protecti!e@ This is called a deferred call 3ro.isions,
*rotecti!e Co!enants - 3rotecti.e co.enant is that 3art of the indenture or loan a4reement that limits certain actions a com3any mi4ht #ish to take durin4 the term of the loan, These co.enants can be classified into t#o ty3es Ne4ati.e co.enants Positi.e co.enants - ne4ati.e co.enant limits or 3rohibits actions that com3any mi4ht take, /or exam3le Limitation on the amount of di.idend accordin4 to some formula Restrict 3led4in4 assets to other lenders &arrin4 mer4er #ith another firm Restrictin4 sellin4 or leasin4 assets &arrin4 issuance of additional lon4(term debt, - 3ositi.e co.enant s3ecifies an action that the com3any a4rees to take or a condition the com3any must abide by, /or exam3le6 The firm must maintain its #orkin4 ca3ital at or abo.e some s3ecified minimum le.el The firm must 3eriodically furnish audited financial statements to the lender The firm must maintain any collateral or security in 4ood condition,
Bond >atings The bond ratin4s are an assessment of the credit#orthiness of the cor3orate issuer, The definitions of credit#orthiness used by the ratin4 a4encies are based on ho# likely the issuer firm is to default and the 3rotection creditors ha.e in the e.ent of a default, These ratin4s are concerned only #ith the 3ossibility of the default, Since they do not address the issue of interest rate risk, the 3rice of a hi4hly rated bond may be 5uite .olatile, Lon4 Term Ratin4s by P-0RAAA: #ig(est credit 7ualit+@ a---; ratin4s denote the lo#est ex3ectation of credit risk, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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AA: 2er+ (ig( credit 7ualit+@ a--; ratin4s denote a .ery lo# ex3ectation of credit risk, A: #ig( credit 7ualit+@ a-; ratin4s denote a lo# ex3ectation of credit risk,
BBB: =ood credit 7ualit+@ a&&&; ratin4s indicate that there is currently a lo# ex3ectation of credit risk, Lon4 Term Ratin4s by P-0RS3eculati.e "rades6 BB: Speculati!e@ a&&; ratin4s indicate that there is a 3ossibility of credit risk de.elo3in4, B: #ig(l+ speculati!e@ a&; ratin4s indicate that si4nificant credit risk is 3resent, but a limited mar4in of safety remains, CCC, CC, C: #ig( default risk, 2efault is a real 3ossibility, Short Term Ratin4s by P-0R-
A3L: A3:,
hi4hest stron4
ca3acity ca3acity
for for
timely timely
re3ayment, re3ayment,
A5: satisfactory ca3acity for timely re3ayment, may be susce3tible to ad.erse economic conditions, A;: an ade5uate ca3acity for timely re3ayment, more susce3tible to ad.erse economic conditions, Short Term Ratin4s by P-0RB: timely re3ayment is susce3tible to ad.erse chan4es in business, economic, or financial conditions, C: an inade5uate ca3acity to ensure timely re3ayment,
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LESSON *'
The bond indenture is a contract bet#een the bond issuer and the bondholders, 9sually, a trustee =3erha3s a
bank> is hired by the issuer to 3rotect the bondholders; interests,
The trust com3any must !ake sure the terms of indenture are obeyed !ana4e the sinkin4 fund Re3resent the bondholders in default The indenture includes The basic terms of the bond issue The total amount of bonds issued - descri3tion of the security The re3ayment arran4ements The call 3ro.isions 2etails of the 3rotecti.e co.enants
%erms of a Bond
0or3orate bonds usually ha.e a face .alue of I1''', called 3rinci3al .alue and is stated on the bond
certificate,
The 3ar .alue =initial accountin4 .alue> of a bond is almost al#ays same as the face .alue, and terms are
used interchan4eably,
The cor3orate bonds are usually in re4istered form The com3any kee3s a re4ister recordin4 the o#nershi3 of each bond and any chan4es thereof, The com3any #ill 3ay the interest and 3rinci3al by che5ue mailed directly to the address of the o#ner of
record,
The bond may be registered and (a!e attac(ed coupons, To obtain the interest 3ayment, the o#ner
must se3arate a cou3on from the bond certificate and send it to com3any re4istrar
-lternati.ely, the bond could be in )earer form, in #hich case, the certificate is the e.idence of o#nershi3
and the com3any #ill 3ay the bearer, O#nershi3 is not recorded, and the holder of the bond certificate detaches cou3ons and sends to com3any to recei.e 3ayments,
&earer bonds are difficult to reco.er if lost or stolen 0om3any ha.in4 no record of o#nershi3 can not notify the bondholders of im3ortant e.ents
Securit+
2ebt securities are classified as collateral and mort4a4es used to 3rotect the bondholders 0ollateral means securities =bonds, stocks> or any asset 3led4ed as security for 3ayment of debt, !ort4a4e securities are secured by a mort4a4e on the real 3ro3erty of the borro#er, in.ol.in4 usually
real estate,
2ebenture is an unsecured bond for #hich no s3ecific 3led4e of 3ro3erty is made The term note is used for such instruments if the maturity of the bonds is less than 1' years #hen
issued 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Seniority indicates 3reference in 3osition o.er lenders, and debts are sometimes labeled as senior or :unior
to indicate seniority,
%n the e.ent of default, the holders of subordinated debt must 4i.e 3reference to other s3ecified creditors,
$o#e.er, debt cannot be subordinated to e5uity >epa+ment
&onds can be re3aid at maturity or they may be re3aid in 3art or in entirety before maturity, Earlier
re3ayment is handled throu4h a sinkin4 fund,
- sinkin4 fund is an account mana4ed by the bond trustee for the 3ur3ose of re3ayment of bonds, The com3any makes annual 3ayment to trustee #ho uses the funds to retire a 3ortion of the debt, by
either buyin4 u3 some of the bonds in the market or, callin4 in a fraction of outstandin4 bonds
Some ty3es of sinkin4 fund arran4ements are6 Some sinkin4 funds start about 1' years after initial issuance Some sinkin4 funds establish e5ual 3ayments o.er the life of bond Some sinkin4 funds are insufficient to redeem the entire issue of hi4h(5uality bonds, creatin4 a
3ossibility of a lar4e Bballoon 3aymentC at maturity Call *ro!ision
- call 3ro.ision allo#s the com3any to re3urchase, or BcallC 3art or all of the bond issue
o.er a s3ecific 3eriod,
at stated 3rices
"enerally, the call 3rice is abo.e the bond;s stated .alue =3ar .alue> The difference bet#een the call 3rice and the stated .alue is the call 3remium, The amount of 3remium,
initially set e5ual to the annual cou3on 3ayment, becomes smaller o.er time and declines to <ero as call date mo.es closer to time of maturity,
0all 3ro.isions are not usually o3erati.e durin4 the first 3art of a bond;s life, makin4 it less of a #orry for
bondholders,
/or exam3le, a com3any may be 3rohibited from callin4 its bonds for the first 1' years, makin4 the bond
call protecti!e@ This is called a deferred call 3ro.isions, *rotecti!e Co!enants
- 3rotecti.e co.enant is that 3art of the indenture or loan a4reement that limits certain actions a com3any
mi4ht #ish to take durin4 the term of the loan,
These co.enants can be classified into t#o ty3es Ne4ati.e co.enants Positi.e co.enants - ne4ati.e co.enant limits or 3rohibits actions that com3any mi4ht take, /or exam3le Limitation on the amount of di.idend accordin4 to some formula Restrict 3led4in4 assets to other lenders &arrin4 mer4er #ith another firm
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Restrictin4 sellin4 or leasin4 assets &arrin4 issuance of additional lon4(term debt, - 3ositi.e co.enant s3ecifies an action that the com3any a4rees to take or a condition the com3any must
abide by, /or exam3le6
The firm must maintain its #orkin4 ca3ital at or abo.e some s3ecified minimum le.el The firm must 3eriodically furnish audited financial statements to the lender The firm must maintain any collateral or security in 4ood condition,
Bond >atings
The bond ratin4s are an assessment of the credit#orthiness of the cor3orate issuer, The definitions of credit#orthiness used by the ratin4 a4encies are based on ho# likely the issuer firm is to
default and the 3rotection creditors ha.e in the e.ent of a default,
These ratin4s are concerned only #ith the 3ossibility of the default, Since they do not address the issue of
interest rate risk, the 3rice of a hi4hly rated bond may be 5uite .olatile,
Lon4 Term Ratin4s by P-0RAAA: #ig(est credit 7ualit+@ a---; ratin4s denote the lo#est ex3ectation of credit risk, AA: 2er+ (ig( credit 7ualit+@ a--; ratin4s denote a .ery lo# ex3ectation of credit risk, A: #ig( credit 7ualit+@ a-; ratin4s denote a lo# ex3ectation of credit risk, BBB: =ood credit 7ualit+@ a&&&; ratin4s indicate that there is currently a lo# ex3ectation of credit
risk,
Short Term Ratin4s by P-0RB: timely re3ayment is susce3tible to ad.erse chan4es in business, economic, or financial conditions,
C: an inade5uate ca3acity to ensure timely re3ayment, &6 hi4h risk of default or #hich are currently in default,
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LESSON *1
=o!ernment Bonds When the 4o.ernment #ishes to borro# money for more than one year, it sells #hat are kno#n as treasury notes and bonds =mostly in the form of ordinary cou3on bond> to the 3ublic, "o.t, treasury issues ha.e no default risk These issues are exem3ted from income taxes
Dero Coupon Bonds - bond that 3ays no cou3on at all and are offered at a 3rice that is much lo#er than its stated .alue, Su33ose N com3any issues a I1''' face .alue, + year <ero cou3on bond, %nitial 3rice is set at IAS), yieldin4 1+T to maturity Total interest 3aid o.er the life of the bond is I1''' L AS) H I+'? /or tax 3ur3oses, the issuer of a <ero cou3on bond deducts interest e.ery year e.en thou4h no interest is actually 3aid, &ecause of the tax break, the yields are lo#er than the yields on taxable bonds
&ifferent %+pes of Bonds Dero Coupon Bonds Qear &e4innin4 1alue 1 * ? A + %otal IAS) +)* K+O )+K O)'
Floating >ate Bonds %n case of floatin4 rate bonds, the cou3on 3ayments are ad:ustable #ith res3ect to an interest rate index such as treasury bill interest rate, The .alue of a floatin4 rate bond de3ends on this ad:ustment and its definition, %n most cases, the cou3on ad:usts #ith a la4 to some base rate, The ma:ority of the floatin4 rate bonds ha.e the follo#in4 features #older (as t(e rig(t to redeem t(e note at par on t(e coupon pa+ment date after some specified period of time@ %(is is called a put pro!ision 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 85
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Coupon rate (as a floor and a ceiling i@e@ coupon is su)Jected to a minimum and a ma/imum@ %(us coupon rate is ca33ed and upper and lo<er rates are t(e called t(e collar -n interestin4 ty3e of floatin4 rate bonds is an Inflation4linked bond, Such bonds ha.e cou3ons that are ad:usted accordin4 to the rate of inflation =the 3rinci3al amount may be ad:usted as #ell>,
Income )onds ha.e cou3on 3ayments de3endent on com3any income sufficient enou4h to su33ort such 3ayment Con!erti)le )onds can be s#a33ed for a fixed number of shares at anytime before maturity at the holder;s o3tion, *ut )onds allo#s the holder to force the issuer to buy the bond back at a stated 3rice,
Inflation and Interest >ates Real .ersus Nominal Rates Real rates are interest rates or rates of returns that ha.e been ad:usted for inflation Nominal rates are not ad:usted for inflation Su33ose rate of inflation is +T -n in.estment costin4 I1'' today #ill be #orth I11+,+' in one year, 4i.in4 a rate of return of 1+,+T, &ut this 1+,+T does not consider the effect of inflation, so this is nominal return No# su33ose a 3en costs I+ a 3iece at the be4innin4 of the year, 4i.in4 *' 3ens for I1'' With inflation rate of +T, 3ens #ill cost I+,*+ at the end of the year, $o# many 3ens can be bou4ht7 What is rate of return7 I11+,+' from the in.estment #ill buy us I11+,+'U+,*+ H ** 3ens This is u3 from *' 3ens, so 3en rate of return is 1'T With nominal return of 1+,+T, our buyin4 3o#er 4oes u3 by only 1'T, because of inflation, So real rate of return is 1'T, -lternati.ely, #ith +T inflation, each of the 11+,+' nominal dollars #e 4et is #orth +T less in real terms,
Real .alue of our in.estment in an year is I11+,+'U1,'+ H I11' 4i.in4 a real rate of return of 1'T Real .ersus nominal returns6 Qour nominal return is the 3ercenta4e chan4e in the amount of money you ha.e, Qour real return is the 3ercenta4e chan4e in the amount of stuff you can actually buy,
%(e Fis(er Effect The relationshi3 bet#een real and nominal returns is described by the /isher Effect, Let6 2 H the nominal return r H the real return h H the inflation rate -ccordin4 to the /isher Effect6 1 E R H =1 E r> ^ =1 E h> /rom the exam3leW the nominal rate is 1+,+T, and the inflation rate is +T so real rate is 1 E ',1++ H =1 E r> x =1 E ','+> =1 E r> H 1,1++U1,'+ H 1,1' 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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r H 1'T Rearran4in4 the fisher effect 1 E R H =1 E r> ^ =1 E h> RHrEhErxh %t tells that nominal rate has three com3onents Real rate on in.estment r 0om3ensation for the decrease in .alue of ori4inal in.estment because of inflation h 0om3ensation for the decrease in .alue of income earned on in.estment due to inflation 2ro33in4 the third com3onent =bein4 .ery small>, nominal rate 4i.es us then a33roximately e5ual to6 o RbrEh
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LESSON **
These are pure interest rates because they in.ol.e no risk of default and a sin4le, lum3(sum future 3ayment When lon4 term rates are hi4her than short term rates #e say term structure is u3#ard slo3in4 and .ice .ersa,
&eterminants of %erm Structure Real Rate of %nterest Ex3ected %nflation %nterest Rate Risk
>eal >ate of Interest When real rate is hi4h, all interest rates #ill tend to be hi4her and .ice .ersa, Thus real rate does not really determine the sha3e of the term structure rather it influences the o.er all le.el of interest rates
*rospect for Future inflation %t .ery stron4ly influences the sha3e of the term structure 1alue of dollar returns on in.estment for .arious 3eriods of time may be eroded by future inflation So in.estors demand a com3ensations for this loss in the form of Inflation premium =hi4her interest rates> Ex3ectation of a hi4her inflation rate #ill 3ush lon4 term interest rates hi4her than short term rates reflected by an u3#ard term structure,
Interest >ate >isk Lon4 term bonds ha.e much 4reater risk of loss resultin4 from chan4es in interest rates than do short(term bonds, %n.estors reco4ni<e this risk and demand extra com3ensation in the form of hi4her rates for bearin4 it, This extra com3ensation is called the interest rate risk premium The lon4er the term to maturity, the 4reater is the interest rate risk and the interest rate risk 3remium, %nterest rate risk 3remium increases at a decreasin4 rate in line #ith the interest rate risk
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Inflation premium
Inflation premium
Bond $ields and t(e $ield Cur!e We kno# that yields on treasury notes and bonds of different maturities are not the same, Plottin4 the treasury yields relati.e to maturity 4i.es us a treasury yield cur.e =or :ust yield cur.e,> &ond Qields and the Qield 0ur.e
/2 ' / 7ields as at close of a particular day 7esterday ( week a!o - weeks a!o
.2 ' .
The sha3e of yield cur.e is a reflection of the term structure of the interest rates makin4 these almost the same thin4, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The only difference is that the term structure is based on 3ure discount bonds #hereas the yield cur.e is based on cou3on bond yields Treasury notes and bonds ha.e three im3ortant features6 they are 2efault free Taxable $i4hly li5uid 0redit risk is the 3ossibility of default, %n.estors demand a hi4her yield as a com3ensation to the risk of 3ossible default, This extra 3remium is called default risk 3remium We kno# that 4o.ernment bonds are free from most taxes, and ha.e much lo#er yield than taxable bonds, %n.estors demand extra yield on a taxable bond as a com3ensation for the unfa.orable tax treatment, kno#n as ta/a)ilit+ premium &onds ha.e .aryin4 de4rees of li5uidity, 2ue to a lar4e number of bonds issued, you may not 4et as mush 4ood 3rice if you #ant to sell 5uickly, %n.estor demand a li5uidity 3remium for the com3ensation
Common Stock 2aluation 1aluation of a share of common stock is difficult due to 6 Not e.en 3romised cash flo#s are kno#n in ad.anced Life of in.estment is fore.er, since common stock has no maturity !arket rate of return is not easily obser.ed Cas( Flo<s Su33ose you buy a share of stock today, #ith a 3lan to sell it in a year, ho3in4 that its #orth #ill be I)' at that time, alon4 #ith a di.idend 3ayment of I1' 3er share, %f you re5uire a *+T return on your in.estment, #hat is the most #ould you 3ay for the stock7 -lternati.ely, #hat is the 3resent .alue of the I1' di.idend alon4 #ith the I)' endin4 .alue at *+T7 The 3resent .alue of the in.estment is Present .alue H =I1' E I)'>U1,*+ H IKA So, IKA is the .alue you #ould assi4n to the stock today, "enerali<in4 this .aluation, let
P' HF current 3rice of stock P1 HF 3rice in one 3eriod 21 HF 2i.idend 3aid at the end of the 3eriod So P' H =21 E P1>U=1 E R> Where R is the market rate of return &ut this 3ossible only if #e kno# P1, makin4 the 3roblem more com3licated So, if #e #ant to kno# the 3rice in one year i,e, P 1 and #e someho# kno# the 3rice in t#o years P* #ith 2* di.idend ex3ected in t#o years, then
No# substitutin4 this ex3ression for P1 into our 3re.ious ex3ression for P' , #e #ould ha.e the follo#in4 e5uation6 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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21 =1 E R>
*
2* =1 E R>?
2? c =1 E R>A
2A c J
- share of common stock in a com3any #ith a constant di.idend is termed as <ero 4ro#th ty3e of stocks, Which im3lies6 21 H 2* H 2? H 2 H constant So the .alue of the stock is6 2 2 2 c 2 cJ =1 E R>1 =1 E R>* =1 E R>? =1 E R>A Since di.idend is al#ays the same, the stock can be .ie#ed as an ordinary 3er3etuity #ith a cash flo# e5ual to 2 e.ery 3eriod, So the 3er share .alue is P' H 2UR #here R is the re5uired rate of return 01P cor3oration has a 3olicy of 3ayin4 a I1' 3er share di.idend e.ery year, %f this 3olicy is to continue indefinitely, #hat is the .alue of a share of stock if the re5uired rate of return is *'T7 Since the stock amounts to be a 3er3etuity, .alue of the share is I1'U',*' H I+' 3er share
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LESSON *?
- share of common stock in a com3any #ith a constant di.idend is termed as <ero 4ro#th ty3e of stocks, Which im3lies6 21 H 2* H 2? H 2 H constant So the .alue of the stock is6 P' H 2 2 =1 E R>1 =1 E R>* =1 E R>? 2 c =1 E R>A 2 cJ
Since di.idend is al#ays the same, the stock can be .ie#ed as an ordinary 3er3etuity #ith a cash flo# e5ual
to 2 e.ery 3eriod,
01P cor3oration has a 3olicy of 3ayin4 a I1' 3er share di.idend e.ery year, %f this 3olicy is to continue indefinitely, #hat is the .alue of a share of stock if the re5uired rate of return is
*'T7
Stocks, the di.idend for #hich 4ro# at a steady rate termed as 4ro#th rate 4, %f #e let 2 be the di.idend :ust 3aid, then the next di.idend, 2 is
' 1
21 H 2' x =1 E 4>
-n asset #ith cash flo#s that 4ro# at a constant rate fore.er is called a 4ro#in4 3er3etuity The reason for the constant 4ro#th of di.idend lies in the fact that the com3anies ha.e this as3ect as an
ex3licit 4oal,
The $ com3any has :ust 3aid a di.idend of I? 3er share, The di.idend of this com3any 4ro#s at a steady
rate of OT 3er year,
&ased on this information, #hat #ill be the di.idend in + years7 The future amount is
I? x 1,'O+ H I? x 1,AKS? H IA,A1
The di.idend #ill therefore 4ro# by I1,A1 o.er the comin4 years %f di.idend 4ro# at a steady rate, #e ha.e re3laced the 3roblem of forecastin4 an infinite number of future
di.idends #ith the 3roblem of comin4 u3 #ith a sin4le 4ro#th rate,
So if #e take 2
' to be the di.idend :ust 3aid and 4 to be the constant 4ro#th rate, the .alue of a share of stock can be #ritten as6
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21 2* 2? c J =1 E R>1 =1 E R>* =1 E R>? 2'=1 E 4>1 2'=1 E 4>* 2'=1 E 4>? J 1 * =1 E R> =1 E R> =1 E R>? -s lon4 as the 4ro#th rate, 4, is less than the discount rate, R, the 3resent .alue of cash flo#s can be #ritten as P' H 2'=1 E 4> R(4 21 c RL4
This is commonly kno#n as di.idend 4ro#th model Su33ose 2 is I*,?', R is 1?T and 4 is +T, The 3rice 3er share in this case is6
'
P' H 2' x =1 E 4>U=R L 4> H I*,?' x 1,'+U=',1? L ','+> H I*,A1+ U ','O H I?',1S
We can use the di.idend 4ro#th model to 4et the stock 3rice at any 3oint in time, The 3rice of the stock as of time t is
P' H2t=1 E 4> R(4 H 2t E1 c RL4
+
/rom the di.idend 4ro#th model, #e 4et the 3rice of the stock in + years
P+ H 2+=1 E 4> R(4 H I*,S?+ x 1,'+ ',1? L ','+ H I?,'O** ','O
"" 0om3any The next di.idend of the com3any #ill be IA 3er share, %n.estors re5uire a 1KT return on the similar
stocks, The com3any;s di.idend 4ro#s by KT e.ery year,
The only tricky thin4 is that the next di.idend is IA, so #e #on;t multi3ly this by =1 E 4>, With this in mind
the 3rice 3er share is 4i.en by6 P' H 21 U =R ( 4> H IA U =',1K L ','K> H IA U ',1' H IA'
Since #e already ha.e di.idend in one year, #e kno# that the di.idend in four years is e5ual to
21 x =1 E 4>? H IA x 1,'K? H IA,)KA
Notice that
PA H P' x =1 E 4>A PA H I+',+' H IA' x 1,'KA 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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$o#e.er, 2
is :ust e5ual to 21 x =1 E 4>A, so #e can #rite PA as6 PA H 21 x =1 E 4>AU=R ( 4> H \21 U=R ( 4>] x =1 E 4>A H P' x =1 E 4>A This exam3le illustrates that the di.idend 4ro#th model makes the im3licit assum3tion that the stock 3rice #ill 4ro# at the same constant rate as the di.idend, What it tells us is that if the cash flo#s on an in.estment 4ro# at a constant rate throu4h time, so does the .alue of that in.estment, %f the 4ro#th rate, 4 is bi44er than discount rate, R, then the 3resent .alue of the di.idends kee3s on 4ettin4 bi44er and bi44er, So the stock 3rice is infinitely lar4e, The same is true if 4ro#th rate and discount rate are e5ual, The ex3ression #e came u3 #ith for the constant 4ro#th case #ill #ork for any 4ro#in4 3er3etuity, not :ust di.idends on common stock,
+
%f 01 is the next cash flo# on a 4ro#in4 3er3etuity, then the 3resent .alue of the cash flo#s is 4i.en by6 P1 H 01 U =R L 4> H 0'=1 E 4> U =R L 4>
Non4Constant =ro<t( Stocks 0onsider the case of a com3any that is currently not 3ayin4 any di.idends, Qou 3redict that in + years, the com3any #ill 3ay a di.idend for the first time, say I',+', Qou ex3ect that this di.idend #ill 4ro# at a rate of 1'T 3er year indefinitely, The re5uired rate of return on similar com3anies is *'T, What is the 3rice of the stock today7 /irst #e calculate #hat it #ill be #orth once di.idends are 3aid, We can then calculate the 3resent .alue of that future 3rice to 4et today;s 3rice,
1st di.idend #ill be 3aid in + years and it #ill 4ro# steadily then on#ards, So the 3rice in A years #ill be PA H 2A x =1 E 4> U =R ( 4> H 2+ U =R ( 4> H I',+'U =',*' L ',1'> H I+
No# #e can calculate the current .alue by discountin4 this 3rice back four years at *'T
P' H I+ U 1,*'A H I+ U *,')?K H I*,A1
The 3roblem of non(constant 4ro#th is sli4htly com3licated if the di.idends are not <ero for the first time, /or exam3le consider the follo#in4 di.idend forecasts for next three years,
Qear 1 * ? Ex3ected 2i.idend I1,'' I*,'' I?,''
-fter ?rd year, di.idend #ill 4ro# at a constant rate of +T 3er year The re5uired return is 1'T, What is the .alue of the stock today7 - time line can be 5uite hel3ful in dealin4 #ith such a 3roblem of non(constant 4ro#th,
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We can no# calculate the total .alue of the stock as the 3resent .alue of the first ? di.idends 3lus the 3resent .ale of the 3rice at time ?, P? P' H 2* 2? c P? c =1 E R>1 =1 E R>* =1 E R>? =1 E R>? I1 * *,+' c +*,+* c 1,1'1 1,1' * 1,1'? 1,1'? H I',S1 E 1,K+ E 1,OO E ?S,AA H IA?,OO 21
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LESSON *A
0R %nc,6 - 0ase of Su3ernormal "ro#th The com3any has been 4ro#in4 at a 3henomenal rate of ?'T 3er year, Qou ex3ect that this 4ro#th rate to last for ? more years and the rate #ill then dro3 to 1'T 3er year, %otal di!idends Just paid <ere EK million, and re7uired return is 59: If t(e gro<t( rate t(en remains at 39: indefinitel+, <(at is t(e total !alue of t(e stock' %t is unlikely that a ?'T su3ernormal 4ro#th rate can be sustained for any extended len4th of time, To .alue the e5uity in this com3any, #e first need to calculate the total di.idend o.er the su3ernormal 4ro#th 3eriod6 Qear 1 * ? Total 2i.idend =in millions> I+,'' x 1,? H I K,+'' IK,+' x 1,? H O,A+' IO,A+ x 1,? H 1',SO+
The 3rice at time ? can be calculated as6 P? H 2? x =1 E 4> U=R ( 4> #here 4 is the lon4(run 4ro#th rate, So #e ha.e6 P? H I1',SO+x1,1'U=',*' L ',1'> H I1*',O?+ Non(0onstant "ro#th Stocks To determine the .alue today, #e need the 3resent .alue of this amount 3lus the 3resent .alue of the total di.idends6 P 'H 2* 2? c P? c =1 E R>1 =1 E R>* =1 E R>? =1 E R>? IK,+' O,A+ 1',SO+ 1*',O?+c 1,1'1 1,1' * 1,1'? 1,1'? H I+,A* E +,O) E K,?K E KS,S? H IO),+O =mill,> 21
The 3er share .alue #ill be IO),+O U *' H IA,?O 3er share Components of >e7uired >eturn Let;s examine the im3lications of the di.idend 4ro#th model for the re5uired return of 2iscount rate R, We calculated P' as P' H 21 U =R ( 4> Rearran4in4 it to sol.e for R, #e 4et R L 4 H 21UP' R H 21UP' E 4 This tells us that the total return, R, has t#o com3onents 21UP' is called the &i!idend $ield, &ecause this is calculated as the ex3ected cash di.idend by the current 3rice, it is conce3tually similar to the current yield on a bond "ro#th rate, 4, is also the rate at #hich the stock 3rice 4ro#s, So it can be inter3reted as capital gains +ield Su33ose a stock is sellin4 for I*' 3er share, The next di.idend is I1 3er share and it is ex3ected to 4ro# by 1'T more or less indefinitely, What return does this stock offer you if this is correct7 The di.idend 4ro#th model calculates the total return as 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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R H 21UP' E 4 o H I1U*' E 1'T H +T E 1'T H 1+T We can .erify this ans#er by calculatin4 the 3rice in one year, P1, usin4 1+T as the re5uired return, &ased on the di.idend 4ro#th model, the 3rice is6 P1 H 21 x =1 E 4> U=R ( 4> H I1 x 1,1' U =',1+ L ',1'> H I1,1' U','+ H I** This I** is e5ual to I*' x 1,1', so the stock 3rice has 4ro#n by 1'T %f you 3ay I*' for the stock today, you #ill 4et a I1 di.idend at the end of the year, and you #ill ha.e a I** L *' H I* 4ain Qour di.idend yield is thus I1U*' H +T, #hile your ca3ital 4ains yield is I*U*' H 1'T So total return #ould be +T E 1'T H 1+T
The 3rice today of a share of stock, P', is the 3resent .alue of all its future di.idends, 21, 2*, 2?J P' H 21 2* 2? c
=1 E R>1 =1 E R>* =1 E R>? #here R is the re5uired return 0onstant "ro#th rate %f the di.idend is constant and e5ual to 2, then the 3rice is6 P' H 2UR %f the di.idend 4ro#s at a steady rate, 4, then the 3rice #ill be6
P' H
21 c RL4
This is called di.idend 4ro#th model Non(constant "ro#th rate The re5uired return can be #ritten as the sum of t#o thin4s
R H 21UP' E 4
#here 21UP' is the di.idend yield and 4 is the ca3ital 4ains yield
Common Stock Features Stocks ha.in4 no s3ecial 3reference either in 3ayin4 di.idend or in bankru3tcy Shareholder Ri4hts Proxy 1otin4 0lasses of Stock Other Ri4hts 2i.idends S(are(older >ig(ts
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Shareholders control the or4ani<ation by electin4 the directors #ho, in turn, hire mana4ement to carry out their ob:ecti.es, 2irectors are elected usually each year at an annual meetin4 throu4h a 4olden rule of Bone share L one .ote,C Either of t#o 3rocedures is follo#ed 0umulati.e .otin4 Strai4ht .otin4 0umulati.e .otin4 -do3ted to 3ermit minority 3artici3ation The total number of .otes that each shareholder may cast is determined first by multi3lyin4 the number of shares #ith the number of directors to be elected, The to3 .ote 4etters are all elected at once, %ndi.idual shareholders can distribute .otes ho#e.er they #ish, Cumulati!e !oting /or exam3le, a cor3oration has t#o shareholdersW Sami #ith *' shares and unaid #ith O' shares, &oth #ant to be a elected as one of the four director, &ut unaid does not #an Sami, Smith #ill cast *' x A H O' .otes and unaid #ill cast O' x A H ?*' .otes, 0umulati.e .otin4 %f Sami 4i.es all his .otes to himself, he is assured of a directorshi3, &ecause unaid can not di.ide ?*' .otes amon4 four candidates in such a #ay as to 4i.e all of them more than O' .otes, So Sami #ill finish fourth at #orst, "enerally, \1U=NE1> T of stocks E 1] shares #ill 4uarantee you a seat,
Straig(t 2oting 2irectors are elected one at a time in this style, -33lyin4 to our exam3le, Sami can cast *' .otes and unaid can cast O', So unaid #ill elect all the candidates, The only #ay to 4uarantee a seat is to o#n +' T 3lus one shares, also 4uaranteein4 #in o.er e.ery seat, makin4 it Ball or nothin4,C
Staggering Only a fraction of the directorshi3 are u3 for election at a 3articular time, So if only t#o directors are u3 for election at any one time, it #ill take 1U=* E 1> H ??,??T of the stocks 3lus one share to 4uarantee seat Sta44erin4 %t makes more difficult for a minority to elect a director #hen there is a cumulati.e .otin4 because there are fe#er directors to b elected at one time %t makes takeo.er attem3ts less likely to be successful since it makes it more difficult to .ote in a ma:ority of ne# directors,
*ro/+ 2oting - 3roxy is a 4rant of authority by a shareholder to someone else to .ote the shareholder;s shares, This is a routine 3ractice in lar4e cor3orations, since they ha.e hundreds of thousands or e.en millions of shareholders, Ob.iously mana4ement #ould like to 4et as many 3roxies as 3ossible transferred to it, $o#e.er, an outside 4rou3 may try to obtain .otes .ia 3roxy if shareholders are dissatisfied #ith mana4ement, This may result in a 3roxy fi4ht to retain or re3lace mana4ement by electin4 enou4h directors, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan 98
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Some firms ha.e more than one class of common stocks #ith une5ual .otin4 ri4hts %n 3rinci3le, stock exchan4e does not allo# such classification, The 3rimary reason for such stocks concerns #ith the control of the firm, as the firms can raise e5uity by issuin4 non(.otin4 or limited(.otin4 stocks #hile maintainin4 control,
,t(er >ig(ts Some additional ri4hts are6 Ri4ht to share 3ro3ortionately in di.idends 3aid Ri4ht to share 3ro3ortionately in assets remainin4 after liabilities ha.e been 3aid in a li5uidation Ri4ht to .ote on matters of 4reat im3ortance, such as mer4er =usually done at annual 4eneral meetin4 or s3ecial meetin4> !oreo.er, shareholders sometimes ha.e the ri4ht to share 3ro3ortionately in any ne# stock sold, This is called the 3reem3ti.e ri4ht %t means that a com3any that #ishes to sell stock must first offer it to the exitin4 shareholders before offerin4 it to 4eneral 3ublic, so that they can 3rotect their 3ro3ortionate o#nershi3 in the firm, &i!idends 2i.idends 3aid to the shareholders re3resent a return on the ca3ital directly or indirectly contributed to the cor3oration by the shareholders, The 3ayment of the di.idend is at the discretion of the board of directors, Some im3ortant characteristics 9nless a di.idend is declared by the board of the directors of a cor3oration, it is not a liability of the cor3oration, The amount of the di.idend and #hether it is 3aid are decisions based on business :ud4ment of the board of directors Payment of di.idend is not a business ex3ense and is not deductible for tax, 2i.idends recei.ed by indi.iduals are considered ordinary income by tax authorities and are fully tax deductible, $o#e.er, cor3oration o#nin4 stocks in other cor3orations are 3ermitted to exclude certain 3ercenta4e of di.idend amount they recei.e and are taxed only on the remainin4 3ortion,
*referred Stock Features Stock #ith di.idend 3riority o.er common stock, normally #ith a fixed di.idend rate, sometimes #ithout .otin4 ri4hts, Preference means only that the holders of the 3referred shares must recei.e a di.idend before holders if common shares are entitled to anythin4,
Stated 2alue Preferred shares ha.e stated li5uidatin4 .alue 0ash di.idend is described in terms of dollars 3er share,
Accumulation of &i!idend - 3referred di.idend is not like interest on a bond, The directors may decide not to 3ay the di.idends on 3referred stock irres3ecti.e of the net income of com3any, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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2i.idends on 3referred stock may be either cumulati.e or non(cumulati.eW most are cumulati.e %f 3referred stocks are cumulati.e and are not 3aid a 3articular year, they #ill be carried for#ard as an arreara4e, 9n3aid 3referred di.idends are not debts of the firm, 2irectors can defer the 3referred di.idend indefinitely, $o#e.er, in this scenario, common stockholders must also fore4o di.idends, Sometimes these delayed 3ayments are com3ensated by .otin4 ri4hts,
Is *referred Stock &e)t' Preferred shareholders are only entitled to recei.e a stated di.idend and they are only entitled to the stated .alue of their shares Preferred stocks hold credit ratin4s much like bonds These are sometimes con.ertible into common stock and are often callable,
%(e Stock Market We kno# that the shares of stocks are bou4ht and sold at stock exchan4es, Stock market consists of6 Primary market Secondary !arket *rimar+ Market The market in #hich ne# securities are ori4inally sold to the in.estors 0om3anies sell securities to raise money
Secondar+ Market The market in #hich 3re.iously issued securities are traded amon4 in.estors &ealer -n a4ent #ho buys and sells securities from a maintained in.entory %t stands ready to buy securities from in.estors #ishin4 to sell them and sells securities to in.estors #ishin4 to buy them The 3rice that the dealer #ishes to 3ay is the bid 3rice and the 3rice at #hich the dealer sells the securities is called the strike 3rice, The difference bet#een the bid and ask 3rice is called the s3read
Broker -n a4ent #ho arran4es security transactions amon4 in.estors, matchin4 in.estors #ishin4 to buy securities #ith in.estors #ishin4 to sell securities They do not buy or sell securities for their o#n accounts, /acilitatin4 trades others is their business
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LESSON *+
*>EFE>>E& S%,C? FEA%U>ES Stock #ith di.idend 3riority o.er common stock, normally #ith a fixed di.idend rate, sometimes #ithout .otin4 ri4hts, Preference means only that the holders of the 3referred shares must recei.e a di.idend before holders if common shares are entitled to anythin4,
Stated 2alue Preferred shares ha.e stated li5uidatin4 .alue 0ash di.idend is described in terms of dollars 3er share,
Accumulation of &i!idend - 3referred di.idend is not like interest on a bond, The directors may decide not to 3ay the di.idends on 3referred stock irres3ecti.e of the net income of com3any, 2i.idends on 3referred stock may be either cumulati.e or non(cumulati.eW most are cumulati.e %f 3referred stocks are cumulati.e and are not 3aid in a 3articular year, they #ill be carried for#ard as an arreara4e, 9n3aid 3referred di.idends are not debts of the firm, 2irectors can defer the 3referred di.idend indefinitely, $o#e.er, in this scenario, common stockholders must also fore4o di.idends, Sometimes these delayed 3ayments are com3ensated by .otin4 ri4hts,
Is *referred Stock &e)t or E7uit+' Preferred shareholders are only entitled to recei.e a stated di.idend and they are only entitled to the stated .alue of their shares Preferred stocks hold credit ratin4s much like bonds These are sometimes con.ertible into common stock and are often callable,
%(e Stock Market We kno# that the shares of stocks are bou4ht and sold at stock exchan4es, Stock market consists of6 Primary !arket Secondary !arket *rimar+ Market The market in #hich ne# securities are ori4inally sold to the in.estors 0om3anies sell securities to raise money
Secondar+ Market The market in #hich 3re.iously issued securities are traded amon4 in.estors &ealer -n a4ent #ho buys and sells securities from a maintained in.entory %t stands ready to buy securities from in.estors #ishin4 to sell them and sells securities to in.estors #ishin4 to buy them 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The 3rice that the dealer #ishes to 3ay is the bid 3rice and the 3rice at #hich the dealer sells the securities is called the ask 3rice,
The difference bet#een the bid and ask 3rice is called the s3read
Broker -n a4ent #ho arran4es security transactions amon4 in.estors, matchin4 in.estors #ishin4 to buy securities #ith in.estors #ishin4 to sell securities They do not buy or sell securities for their o#n accounts, /acilitatin4 trade bet#een others is their business
Capital Budgeting What lon4(term in.estment should the firm take on7 Net *resent 2alue -n in.estment is #orth undertakin4 if it creates .alue for its o#ners characteri<ed by #orth in market3lace bein4 more than #hat it costs to ac5uire, /or exam3le, you buy a run(do#n house for I*+,''' and s3end another I*+,''' on 3ainters, 3lumbers and so on to 4et it fixed u3, So your total in.estment is I+',''', When the #ork is com3leted, you 3lace the house on the market and find that it is #orth IK',''', The market .alue =IK','''> exceeds the cost =I+','''> by I1',''', %f you consider yourself as mana4er and ha.e brou4ht to4ether some fixed assets, labor and material etc,, you ha.e created I1',''' in .alue, No# #hat you as a mana4er has to do is to identify the feasibility of in.estin4 I+',''' ahead of time, %n other #ords you are tryin4 to determine #hether a 3ro3osed in.estment or 3ro:ect #ill be #orth more than it costs once it is in 3lace, a to3ic #e call 0a3ital &ud4etin4 The difference bet#een an in.estment;s market .alue and its cost is called the net 3resent .alue of the in.estment =NP1>, -lternati.ely, NP1 is a measure of ho# much .alue is created or added today by undertakin4 an in.estment, "i.en our 4oal of creatin4 .alue for our shareholders, the ca3ital bud4etin4 3rocess can be .ie#ed as a search for in.estment #ith 3ositi.e net 3resent .alues, %n.estment decisions are 4reatly sim3lified #hen there is a market for assets similar to the in.estment #e are considerin4, 0a3ital bud4etin4 becomes more difficult #hen #e cant determine the market 3rice for com3arable in.estment, The reason is that #e are then faced #ith 3roblem of estimatin4 the .alue of an in.estment usin4 only indirect market information
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7ears % ( ) , ' .
*3%%%+
/ 0
3)% - (3 .
3)% - (3 .
3)% - (3 .
3)% - (3 .
3)% - (3 .
3)% - (3 .
3)% - (3 .
3)% - (3 . )
3 .
3 .
3 .
3 .
3 .
3 .
3 0
%f #e #ant to estimate the .alue of a ne# business, say fertili<er, #e #ill Try to estimate the future cash flo#s #e ex3ect the ne# business to 3roduce -33ly discounted cash flo# 3rocedure to estimate the 3resent .alue of the cash flo#s Estimate the difference bet#een the 3resent .alue of the future cash flo#s and the cost of in.estment,
This is kno# as discounted cash flo# =20/> .aluation, Su33ose the cash re.enues from our fertili<er business #ill be I*',''' 3er year, 0ash costs =includin4 taxes> #ill be I1A,''' 3er year The business #ill be #ound u3 in O years The 3lant, 3ro3erty and e5ui3ment #ill #orth I*,''' as sal.a4e .alue at that time, The 3ro:ect costs I?',''' to launch 2iscount rate on similar 3ro:ects is 1+T %s this a 4ood in.estment7 What #ill be the effect on 3rice 3er share of 1,''' shares from takin4 the in.estment7 0alculatin4 the 3resent .alue of the future cash flo#s6 P1 H IK,''' x =1 L 1U1,1+O>U',1+ E *,''' U 1,1+O H IK,''' x A,AO)? E *,'''U?,'+S' H I*K,S*A E K+A H I*),+)O NP1 H (I?',''' E *),+)O H (I*,A**
0om3arin4 this .alue #ith the I?',''' estimated cost, the NP1 isW Therefore this is not a 4ood in.estment, as it #ould decrease the total .alue of stock by I*,A**, With 1,''' shares outstandin4, best estimate of im3act of takin4 u3 this 3ro:ect is a loss of .alue of
I*,A**U1,''' H I*,A** 3er share
/orm this exam3le #e notice that if NP1 is ne4ati.e, the effect on share .alue #ill be unfa.orable, %f NP1
#ere 3ositi.e, the effect #ould be fa.orable, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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"i.en that the 4oal of financial mana4ement is to increase the share .alue, this discussion leads to the net
3resent .alue rule OAn in!estment s(ould )e accepted if t(e net present !alue is positi!e and reJected if it is negati!e@P %n the unlikely e.ent that NP1 is turned out to be <ero, #e #ould be indifferent bet#een takin4 and not takin4 the in.estment T#o comments The task of comin4 u3 #ith cash flo#s and the discount rate is much more im3ortant than the 3rocess of discountin4 itself, The 3rocess of discountin4 cash flo#s #ould only 4i.e us an estimated fi4ure of NP1, The true NP1 can be found by 3uttin4 the in.estment for sale and see #hat #e 4ot for it,
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LESSON *K
"i.en that the 4oal of financial mana4ement is to increase the share .alue, #e ha.e the net 3resent .alue rule OAn in!estment s(ould )e accepted if t(e net present !alue is positi!e and reJected if it is negati!e@P %n the unlikely e.ent that NP1 is turned out to be <ero, #e #ould be indifferent bet#een takin4 and not takin4 the in.estment T#o comments The task of comin4 u3 #ith cash flo#s and the discount rate is much more im3ortant than the 3rocess of discountin4 itself, The 3rocess of discountin4 cash flo#s #ould only 4i.e us an estimated fi4ure of NP1, The true NP1 can be found by 3uttin4 the in.estment for sale and see #hat #e 4ot for it, Su33ose #e are asked to decide #hether or not a ne# 3roduct be launched, &ased on 3ro:ected costs and sales, #e ex3ect that the cash flo#s o.er the +(year life of the 3ro:ect #ill be I*,''' in first t#o years, IA,''' in the next t#o and I+,''' in the last year, %t #ould cost about I1',''' to be4in 3roduction, "i.en a 1'T discount rate, #hat should #e do7 The total .alue of the 3roduct by discountin4 its cash flo# to 3resent6 +,'''U1,1+
P1 H I*,'''U1,1 E *,'''U1,1* E A,'''U1,1? E A,'''U1,1A E H I1,O1O E 1,K+? E ?,''+ E *,)?* E ?,1'+ H I1*,?1?
The 3resent .alue of the ex3ected cash flo#s is I1*,?1?, but the cost of 4ettin4 those cash flo#s is I1',''' so the NP1 is I1*,?1? L 1',''' H I*,?1? So based on the NP1 rule #e should take on the 3ro:ect,
%(e *a+)ack >ule The 3ayback 3eriod is the amount of time re5uired for an in.estment to 4enerate cash flo#s sufficient to reco.er its initial cost,
$ear
4EK9,999
E;9,999
E59,999
E39,999
EK,999
This in.estment 3ays for itself back in exactly t#o year OR 3ayback 3eriod is t#o years, OAn in!estment is accepta)le if its calculated pa+)ack period is less t(an some specified num)er of +ears@P Su33ose the initial in.estment is IK',''', and the cash flo#s are I*',''' in the first year and IS',''' in the second, The cash flo#s o.er the first t#o years are I11',''', so the 3ro:ect 3ays back sometime in the second year, -fter the first year, the 3ro:ect has 3aid back I*',''', lea.in4 IA',''' to be reco.ered Note that this IA',''' is IA','''US',''' H AUS of the second year;s cash flo#s, S3readin4 this ratio o.er ?K+ days6 AUS x ?K+ H 1K* days =a33rox,> 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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$ear 9 3 5 ; F
The 3ro:ect costs I+'', #hat is the 3ayback 3eriod for this in.estment7 -fter the first * years, the cash flo#s total I?'', -fter the ?rd year, the total cash flo# is IO'', so the 3ro:ect 3ays back sometimes bet#een the end of year * and end of year ?, Out of I+'' cash flo#s for ?rd year, #e need to co.er I*'', so #e #ill ha.e to #ait I*''U+'' H ',A' years to do this, The 3ayback 3eriod is *,A years or about t#o years and fi.e months, &ased on this method of calculatin4 3ayback, #e can make decisions on in.estments, 2ecide on the cutoff time, say t#o years, for the in.estment -cce3t all the 3ro:ects ha.in4 3ayback of t#o years or less and re:ect all those ha.in4 3ayback more than t#o years A (I1'' ?' A' +' K' B (I*'' A' *' 1' C (I*'' A' *' 1' 1?' & (I*'' 1'' 1'' ( *'' *'' E (I +' 1'' ( +',''','''
Payback 3eriod of Pro:ect - is *,K years, Pro:ect & ne.er 3ays back Pro:ect 0 has a 3ayback 3eriod of A years Pro:ect 2 has t#o 3ayback 3eriodsW * and A years =both correct>, Pro:ect E is unrealistic but it 3ays back in K months, thereby illustratin4 that a ra3id 3ayback does not
4uarantee a 4ood in.estment
0om3ared to NP1, 3ayback 3eriod rule has some shortcomin4s, Time .alue of money is i4nored %t fails to consider risk differences %t doesn;t 3ro.ide an ob:ecti.e basis for a 3articular number for the cutoff 3eriod Primary shortcomin4s of 3ayback 3eriod rule6 &y i4norin4 time .alue, #e may be led to take in.estments that are #orth less than they cost &y i4norin4 cash flo#s beyond cutoff, #e may be led to re:ect 3rofitable lon4 term in.estments
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"enerally, it tends to bias us to#ards shorter term in.estments Xualities of 3ayback 3eriod rule6 Sim3le and easy to calculate, useful for lar4e number of small in.estment decisions by cor3oration %ts biasness to#ards short term 3ro:ects, em3hasi<es on li5uidity, i,e, 5uickly freein4 u3 cash for other uses %t ad:usts for more uncertain cash flo#s ex3ected in later 3art of a 3ro:ect;s life =thou4h by i4norin4 them
alto4ether>
With a cutoff of t#o years, short is acce3ted and lon4 is not %s 3ayback 3eriod rule 4i.in4 us the ri4ht decisions7 Su33ose, #e re5uire a 1+T return on this kind of in.estmentW NP1 for the t#o in.estments is6
NP1 =Short> H NP1 =Lon4> H (I*+' E1''U1,1+ E *''U1,1+* H (I11,O1 (I*+' E 1'' x =1 L 1U1,1+A>U,1+ H I?+,+
We can see that the NP1 of shorter term in.estment is ne4ati.e, #hich #ould diminish the .alue of
shareholders; e5uity,
- break(e.en measureW in accountin4 sense but not in economic sense 2oes not focus on ri4ht issue of im3act of in.estment on .alue of stock Sim3licity hel3ful for decisions on minor in.estments
Ad!antages
Easy to understand -d:usts for uncertainty of later cash flo#s &iased to#ards li5uidity
&isad!antages
%4nores the time .alue of money Re5uires an arbitrary cutoff 3oint %4nores cash flo#s beyond the cutoff date &iased a4ainst lon4 term 3ro:ects, such as research and de.elo3ment and ne# 3ro:ects
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LESSON *)
The re5uired in.estment in im3ro.ements is I+'',''' The store has a +(years life, as e.erythin4 re.erts to the o#ners of the sho33in4 center after that time, The re5uired in.estment #ould be 1''T de3reciated o.er + years, i,e,
I+'',''' U + H I1'',''' 3er year
-.era4e book .alue H =I+'',''' E '> U * H I*+',''' The a.era4e accountin4 return is6
-.era4e net income H I+',''' -.era4e book .alue *+',''' OA proJect is accepta)le if its a!erage accounting return e/ceeds a target a!erage accounting returnP
2ra#backs of --R %t is not a rate of return in any meanin4ful economic sense, as it i4nores time .alue of money %t lacks an ob:ecti.e or tar4et --R to be com3ared #ith %t focuses on net income and book .alue rather than cash flo# and market .alue -d.anta4es Easy to calculate
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With %RR, #e try to find a sin4le rate of return that summari<es the merits of a 3ro:ect We #ant this rate to be an BinternalC rate in the sense that it only de3ends on the cash flo#s of a 3articular
in.estment, not on rates offered else#here
0onsider a 3ro:ect that costs I1'' today and 3ays I11' in one year, Ob.iously it 3ays a return of 1'T, since it 3ays I1,1' for e.ery dollar #e 3ut in, This 1'T is in fact the internal rate of return
I>> >ule OBased on I>> rule an in!estment is accepta)le if t(e I>> e/ceeds t(e re7uired return@ It s(ould )e reJected ot(er<iseP
No# for our exam3le, NP1 for the in.estment at discount rate R is6
NP1 H (I1'' E 11'U=1 E R>
No# if #e don;t kno# the discount rate, it re3resents a 3roblem, &ut still #e could ask, ho# hi4h the
discount rate #ould ha.e to be before this 3ro:ect #as unacce3table,
The in.estment is economically a break(e.en 3ro3osition #hen the NP1 is <ero because the .alue is
neither created nor destroyed,
To find the break(e.en discount rate, #e set NP1 e5ual to <ero and sol.e for R
NP1 H ' H (I1'' E 11'U=1 E R>] I1'' H I11'U=1 E R> 1 E R H I11'U1'' H 1,1' R H 1'T
This 1'T is #hat #e already ha.e called the return on this in.estment,
Ot(e I>> on an in!estment is t(e re7uired return t(at results in a -ero N*2 <(en it is used as t(e discount rateP
The fact that the %RR is sim3ly the discount rate that makes the NP1 e5ual to <ero is im3ortant because it
tells us ho# to calculate the return on more com3licated in.estments
Su33ose you are lookin4 at an in.estment #ith the cash flo#s IK' 3er year for t#o years With our understandin4 on calculatin4 %RR by e5uatin4 NP1 to <ero6
NP1 H ' H (I1'' E K'U=1 E %RR> E K'U=1 E %RR>*
The only #ay to find %RR in 4eneral is by trial and error method %f #e start #ith a 'T rate, then
NP1 H I1*' L 1'' H I*'
We are 4ettin4 closerY These and other 3ossibilities are summari<ed in the follo#in4 table
2iscount Rate 'T + 1' NP1 I*','' 11,+K A,1? 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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NP1 a33ears to be <ero bet#een 1'T and 1+T, so %RR is some#here in that ran4e With a little effort #e can find that the %RR is about 1?,1T So if our re5uired return is less than 1?,1T #e #ould take this in.estment, other#ise re:ect it
>@A *3+ -n NP1 Profile 20 15 10 5 0 %5 %10 5 10 15 20 25 30
>@A B %
IRR $ (,2(&
R *&+
>@A C %
- 3ro:ect has total u3(front cost of IA?+,AA, the cash flo#s are I1'' in 1
in ? year
rd
st
What is the %RR7 -t 1OT re5uired return, should #e take this in.estment7 NP1 calculated at different discount rates is as belo#6
2iscount Rate 'T + 1' 1+ *' NP1 I1KA,+K 1'',?K AK,1+ ,'' (?S,K1
-t 1OT re5uired rate, #e should not take this in.estment %RR and NP1 rules al#ays lead to identical decisions as lon4 as Pro:ect;s cash flo#s are con.entional i,e, first cash flo# =initial in.estment> is ne4ati.e and rest are 3ositi.e Pro:ects are inde3endent i,e, decision to acce3t or re:ect one 3ro:ect does not affect the decision to acce3t
or re:ect any other *ro)lems <it( I>>
Problems #ith %RR come about #hen cash flo#s are not con.entional or
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#hen #e are tryin4 to com3are t#o or more in.estments Non(con.entional 0ash /lo#s Su33ose #e ha.e a minin4 3ro:ect that re5uires a IK' in.estment, Our cash flo#s in the 1
I1++, in the second year the mine is de3leted, but #e ha.e to s3end I1'' to restore the terrain
st
year #ill be
and ?rd year cash flo#s are ne4ati.e, Problems #ith %RR
st
Non(con.entional 0ash /lo#s To find %RR, the NP1 at different rates are
2iscount Rate 'T 1' *' ?' A' Problems #ith %RR NP1 ( I+,'' ( 1,)A ( ',*O ,'K ( ',?1
>@A *3+
IRR $ )'&
2 1 0 %1 %2 %3 %4 %5
IRR $ ,,2(6,&
R *&+ 10 20 30 40 50
The %RR of both *+T and ??1U?T are correct, makin4 it a !ulti3le rates of return 3roblem %n this exam3le %RR rule breaks do#n com3letely
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Should #e take this in.estment on 1'T re5uired rate7 &y %RR rule #e should, &ut since NP1 is ne4ati.e at any discount rate less than *+T, so this is not a 4ood in.estment NP is 3ositi.e only if the re5uired return is bet#een *+T and ??1U?T !oral of the Story 0ash flo#s are not con.entional So the ob.ious 5uestion BWhat is the rate of return7C may not be ans#ered, althou4h NP1 #orks :ust fine !utually Exclusi.e %n.estments %f t#o in.estments N and Q are mutually exclusi.e, then takin4 one of them means that #e cant take the
other one
T#o 3ro:ects that are not mutually exclusi.e are said to be inde3endent
e@g@ <e can )uild a gas station ,> an apartment )uilding on a corner plot )ut not )ot(
%RR for - is *AT and %RR for & is *1T NP1 for the in.estments for different re5uired returns
2iscount rate 'T + 1' 1+ *' *+ NP1 =-> IK','' A?,1? *S,'K 1),1O ),'K ( 1,K? NP1 =&> I)','' A),OO *S,)S 1A,O* *,?1 ( O,**
%RR for - =*AT> is lar4er than that for & =*1T>, $o#e.er in.estment ha.in4 hi4her NP1 de3ends on
re5uired return
& has 4reater total cash flo# but it 3ays back more slo#ly than -, So it has hi4her NP1 at lo#er discount
rates 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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%f our re5uired return is 1'T, & has hi4her NP1 and is better of the t#o e.en thou4h - has hi4her returns
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>@A *3+
70 60 50 40 30
26.34
Crossover point
.nvestment /
20 0
114
.22/ # 24$
VU
>@A *3+
70 60 50 40 30
26.34
Crossover point
.nvestment /
20 10
115
2025
.22/ # 24$
VU
-t any discount rate less than 11,1T, NP1 for & is hi4her, so & benefits more than -, e.en thou4h -;s
%RR is hi4her
-t any rate 4reater than 11,1T, in.estment - has 4reater NP1 !oral of the story Whene.er #e ha.e mutually exclusi.e in.estments, #e shouldnZt rank them based on their returns %n other #ords, %RR can be misleadin4 in determinin4 the best in.estment %nstead #e should look at their relati.e NP1s to a.oid 3ossibility of choosin4 incorrectly
Qualities of I>>
!ost #idely used Easily communicated and understood We can estimate %RR e.en if #e don;t kno# the discount rate
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LESSON *O
-lso defined as benefit cost ratio, this index is defined as the 3resent .alue of the future cash flo#s di.ided
by the initial in.estment,
So if a 3ro:ect cost I*'' and the 3resent .alue of its future cash flo#s is I**', then the 3rofitability index
#ould be P% H I**' U*'' H 1,1'
-lso, the NP1 for this in.estment is I*', so this a desirable in.estment, The 3rofitability index for a 3ositi.e NP1 in.estment #ould be bi44er than 1,'' and less than 1,'' for a
ne4ati.e NP1 in.estment
The P% of 1,1' tells us that 3er dollar in.ested, I1,1' in .alue or I',1' in NP1 results, So it measures .alue
created 3er dollar in.ested,
%t is often 3ro3osed as a measure of 3erformance of 4o.ernment or other non(3rofit in.estments, When ca3ital is scarce, it is sensible a33roach to allocate it to those 3ro:ects #ith hi4hest P% 0onsider an in.estment #hich costs I+ and has a I1' 3resent .alue and an in.estment costin4 I1'' #ith a
I1+' 3resent .alue,
The first of these in.estments has an NP1 of I+ and a P% of *, #hile the second one has an NP1 of I+'
and a P% of 1,+',
%f theses are mutually exclusi.e in.estments, then the second one is 3referred e.en thou4h it has a lo#er
P%
This rankin4 3roblem is .ery similar to %RR rankin4 3roblem -d.anta4es 0losely related to NP1, 4enerally leadin4 to identical decisions Easy to understand and communicate !ay be useful #hen a.ailable in.estment funds are limited 2isad.anta4es !ay lead to incorrect decisions in com3arisons of mutually exclusi.e in.estments
Capital Budgeting *ractice
Why alternati.e 3rocedures used if NP1 seems to tell us directly #hat #e #ant to kno#7 We are tryin4 to make an in.estment decision #hile o3eratin4 under considerable uncertainty We can only estimate the NP1 of an in.estment in this case but the true NP1 mi4ht be 5uite different, Since the true NP1 is unkno#n, the financial mana4er seeks clues to assess the reliability of the estimated
NP1,
/or this 3ur3ose firms often use multi3le criteria for e.aluatin4 a 3ro3osal, Su33ose, #e ha.e an in.estment #ith 3ositi.e NP1, #ith a short 3ayback and a .ery hi4h --R, %n this case all different indicators 4i.e a 4reen si4nal, %n other #ords, 3ayback and --R are consistent
#ith the conclusion that NP1 is 3ositi.e
No# su33ose, #e ha.e a 3ositi.e estimated NP1, a lon4 3ayback and a lo# --R, This could be 4ood
in.estment but #e should be much more careful in makin4 the decision since #e are 4ettin4 conflictin4 si4nals 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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%f the estimated NP1 is based on 3ro:ections in #hich #e ha.e little confidence then further analysis is - $istorical 0om3arison of Primary 9se of 1arious 0a3ital &ud4etin4 Techni5ues
3GKG Payback 3eriod -.era4e -ccountin4 Return %nternal Rate of Return Net Present 1alue %RR or NP1 ?AT ?A 1S ((( 1S 3GIF *AT ?' ?O ((( ?O 3G89 1*T *K +) ((( +) 3G8K 1+T 1' ?) *K K? 3G88 ST *+ +A 1' KA 3G8G 1'T 1A K' 1A )A 3GH3 +,'T 1',) K+,? 1K,+ O1,O
Net *resent 2alue 0N*21 The NP1 of an in.estment is the difference bet#een its market .alue and its cost, The NP1 rule is to take a 3ro:ect if its NP1 is 3ositi.e, %t is estimated by calculatin4 the 3resent .alue of the future cash flo#s and then subtractin4 the cost 2iscounted 0ash /lo# 0riteria Internal >ate of >eturn %RR is the discount rate that makes the estimated NP1 of an in.estment e5ual to <ero %RR rule is to take a 3ro:ect #hen its %RR exceeds the re5uired return, %t leads to the same decision as NP1 for con.entional, inde3endent 3ro:ects /or mutually exclusi.e and non(con.entional 3ro:ects, %RR may be misleadin4 2iscounted 0ash /lo# 0riteria *rofita)ilit+ Inde/
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P% is the ratio of 3resent .alue to cost, %t measures the 3resent .alue of an in.estment 3er dollar in.ested P% rule is to take an in.estment if the index exceeds 1 %t is sometimes use to rank 3ro:ects #hen a firm has more 3ositi.e NP1 in.estments than it can currently
finance
-ccountin4 0riteria A!erage Accounting >eturn --R is a measure of accountin4 3rofit relati.e to book .alue --R rule is to take an in.estment if its --R exceeds a benchmark --R Payback 0riteria *a+)ack *eriod %t is the len4th of time until the sum of an in.estment;s cash flo#s e5uals its costs Payback 3eriod rule is to take a 3ro:ect if its 3ayback is less than some cutoff %t i4nores risk, time .alue of money and cash flo#s beyond cutoff 3oint,
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LESSON *S
We shall no# s3read the numbers for a 3ro3osed in.estment or 3ro:ect and, based on those numbers
make an initial assessment about #hether or not the 3ro:ect should be undertaken,
We #ill focus on a the 3rocess of settin4 u3 a discounted cash flo# analysis, While e.aluatin4 a 3ro3osed in.estment, s3ecial attention is 3aid to the rele.ance
a.ailable for decision makin4 *roJect Cas( Flo<s
of the information
To e.aluate a 3ro3osed in.estment, #e must consider the chan4es in the firm;s cash flo#s and then decide
#hether or not they add .alue to the firm
The first ste3 is, thus, to decide #hich cash flo#s are rele.ant and #hich are not
>ele!ant Cas( Flo<s
- rele.ant cash flo# for a 3ro:ect is a chan4e in the firm;s o.erall future cash flo# that comes about as
direct conse5uence of the decision to take the in.estment
Since the rele.ant cash flo#s are defined in terms of chan4es in, or increments to, the firm;s existin4 cash
flo#, they are called the incremental cash flo#s associated #ith the 3ro:ect Incremental Cas( Flo<s
The incremental cash flo#s for 3ro:ect e.aluation consist of any and all chan4es in the firm;s future cash
flo#s that are a direct conse5uence of takin4 the 3ro:ect,
%(e Stand4Alone *rinciple The assum3tion that e.aluation of a 3ro:ect may be based on the 3ro:ect;s incremental cash flo#s -nalysis of the 3ro:ect as a BminifirmC #ith its o#n future re.enues and costs, its o#n assets and its o#n
cash flo#s Incremental Cas( Flo<s
%t seems easy enou4h to decide #hether a cash flo# is incremental or not, E.en so there are situations
#here mistakes are easy to make,
Sunk 0osts O33ortunity 0osts Side Effects Net Workin4 0a3ital /inancin4 0osts Other %ssues
Sunk Costs
- cost that has already been incurred and cannot be recou3ed and therefore should not be considered in
an in.estment decision e@g@ a consultant6s fee for e!aluating t(e option of launc(ing a ne< product 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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,pportunit+ Costs The most .aluable alternati.e that is 4i.en u3 if a 3articular in.estment is undertaken
e@g@ option of selling a piece of land 0)oug(t +ears ago1 at market rates instead of esta)lis(ing a
sc(ool upon it #o< muc( s(ould )e c(arged to sc(ool proJect in terms of opportunit+ costsQ amount at <(ic( <e )oug(t t(e piece of land or its current market price'
Side Effects %t is not unusual for a 3ro:ect to ha.e side or s3illo.er effects both 4ood and bad
e@g@ sales of a ne< car )+ a certain compan+ mig(t come at t(e e/pense of t(e ot(er cars of t(e
same compan+ %(is p(enomenon is called erosion, pirac+ or canni)alism
So cash flo#s from the ne# 3roduct line should be ad:usted do#n#ard to reflect lost 3rofits on other lines Net "orking Capital Normally a 3ro:ect re5uires in.estments in net #orkin4 ca3ital in addition to lon4 term assets,
e@g@ cas( in (and, in!entories . accounts recei!a)les as <ell as accounts pa+a)lesQ t(e )alance
)eing t(e net <orking capital
-s the 3ro:ect #inds do#n, net #orkin4 ca3ital 4ets freed(u3, So in.estment in NW0 resembles a loan as
firm 3ro.ides NW0 at the be4innin4 and reco.ers it to#ards the end
Financing Costs We don;t include interest 3aid or any other financin4 costs like di.idend or 3rinci3le 3aid #hile analy<in4 a
3ro3osed in.estment, as #e are interested in the cash flo# 4enerated by the assets of the 3ro:ect
The mixture of debt and e5uity a firm actually chooses to use in financin4 a 3ro:ect is a mana4erial .ariable
and does not form 3art of the 3ro:ect e.aluation 3rocess
,t(er Issues We are only concerned in measurin4 cash flo#s and #hen it actually occurs rather than #hen it occurs in
accountin4 sense
We are interested in after(tax cash flo#s as in fact incremental cash flo#s means after(tax incremental cash
flo#s *ro Forma Financial Statements
Pro forma financial statements 3ro:ect future years; o3erations in a summari<ed format, To 3re3are these statements, #e need estimates of 5uantities like 9nit sales Sellin4 3rice 3er unit 1ariable cost 3er unit Total fixed cost Su33ose #e #ant to 3re3are a set of 3ro forma financial statements for a 3ro:ect for N2 Enter3rises, %n
order to do so, #e must ha.e some back4round information, %n this case, assume6 1, Sales of 1',''' unitsUyear V I+Uunit, *, 1ariable costUunit is I?, /ixed costs are I+,'''Uyear, Pro:ect has no sal.a4e .alue, Pro:ect life is ? years, ?, Pro:ect cost is I*1,''', 2e3reciation is I),'''Uyear, A, %n.estment in net #orkin4 ca3ital is I1',''', +,The firm;s re5uired return is *'T, The tax rate is ?AT, *ro Forma Financial Statements 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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*roJect Cas( Flo<s We kno# that Pro:ect 0ash /lo# H Pro:ect o3eratin4 cash flo# L Pro:ect chan4e in net #orkin4 ca3ital L Pro:ect ca3ital s3endin4 We also kno# that O3eratin4 0ash flo#s H Earnin4s before interest and taxes E 2e3reciation L Taxes Let;s use the information from the 3re.ious exam3le to do a ca3ital bud4etin4 analysis, Pro:ect o3eratin4 cash flo# =O0/>6 E&%T I O,''' 2e3reciation E),''' Taxes (*,)*' O3eratin4 0ash /lo# I1*,*O' Pro:ect 0ash /lo#s ' O3eratin4 0ash /lo# 0han4e in NW0 0a3ital S3endin4 Total I1*,*O' (I1',''' (*1,''' (I?1,''' I1*,*O' 1 * I1*,*O' I1*,*O' 1',''' , I1*,*O' I**,*O' ?
No# #e kno# that firm must s3end I*1,''' u3 front for fixed assets and in.est an additional I1',''' in
net #orkin4 ca3ital, So the immediate outflo# is I?1,'''
The reco.ery of I1',''' tied u3 in NW0 in the last year #ill lead to a cash inflo# of the same amount, 0a3ital &ud4etin4 E.aluation6
NP1 H (I?1,''' E I1*,*O'U1,*'1 I1*,*O'U1,*' * E I**,*O'U1,*' ? H IK++ %RR H *1T E
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LESSON ?'
Su33ose #e #ant to 3re3are a set of 3ro forma financial statements for a 3ro:ect for N2 Enter3rises, %n order to do so, #e must ha.e some back4round information, %n this case, assume6 1, Sales of 1',''' unitsUyear V I+Uunit, *, 1ariable costUunit is I?, /ixed costs are I+,'''Uyear,Pro:ect has no sal.a4e .alue, Pro:ect life is ? years, ?, Pro:ect cost is I*1,''', 2e3reciation is I),'''Uyear, A, %n.estment in net #orkin4 ca3ital is I1',''', +,The firm;s re5uired return is *'T, The tax rate is ?AT, *ro Forma Financial Statements *roJected Income Statements Sales =1',''' unitsUyear V I+Uunit> 1ar, costs =I?Uunit> "ross Profit /ixed costs 2e3reciation E&%T Taxes =?AT> Net income Pro:ected &alance Sheets ' Net Workin4 0a3ital Net /ixed -ssets Total *roJect Cas( Flo<s Let;s use the information from the 3re.ious exam3le to do a ca3ital bud4etin4 analysis, Pro:ect o3eratin4 cash flo# =O0/>6 E&%T I O,''' 2e3reciation E),''' Taxes (*,)*' O3eratin4 0ash /lo# I1*,*O' Pro:ect 0ash /lo#s ' O3eratin4 0ash /lo# 0han4e in NW0 0a3ital S3endin4 Total I1*,*O' (I1',''' (*1,''' (I?1,''' I1*,*O' 1 I1*,*O' I1*,*O' * I1*,*O' 1',''' cccccc, I**,*O' ? I1',''' *1,''' I?1,''' I1',''' 1A,''' I*A,''' 1 I1',''' ),''' I1),''' * I1',''' ' I1',''' ? I+',''' ?',''' I*',''' +,''' ),''' IO,''' *,)*' I+,*O'
No# #e kno# that firm must s3end I*1,''' u3 front for fixed assets and in.est an additional I1',''' in
net #orkin4 ca3ital, So the immediate outflo# is I?1,'''
The reco.ery of I1',''' tied u3 in NW0 in the last year #ill lead to a cash inflo# of the same amount, 0a3ital &ud4etin4 E.aluation6
NP1 H (I?1,''' E I1*,*O'U1,*'1 EI1*,*O'U1,*' * E I**,*O'U1,*' ? H IK++ 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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These are not bi4 3roblems until #e don;t for4et to include additions to net #orkin4 ca3ital in our analysis Su33ose #e had the follo#in4 income statement durin4 an year of a 3ro:ect
Sales 0osts Net income I+'' ?1' I1S'
0e4innin4 o) year +n5 o) year 67an4e $880 $910 9$30 550 605 9 55 $330 $305 %$25
O3eratin4 cash flo# in this exam3le is the same as E&%T as there are not taxes or de3reciation NW0 declined by I*+, there #as no ca3ital s3endin4 durin4 the year, So Total cash flo# H O3eratin4 cash flo# L chan4e in NW0 L 0a3ital s3endin4 H I1S' L =(*+> L ' H I*1+ No# #e need to kno# 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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3What #ere cash re.enues for the year7 3What #ere cash costs7
We had sales of I+'', #hile accounts recei.able rose by I?' o.er the year, so cash inflo# is I+'' L ?' H
IA)'
We sho# costs of I?1' on our income statement but accounts 3ayable increase by I++ durin4 the year, So
the cash costs for the year are I?1' L ++ H I*++
0ash inflo#s less cash outflo#s is IA)' L *++ H I*1+ =matchin4 our 3re.ious result> 0ash flo# H cash inflo# L cash outflo#
H =I+'' ( ?'> L =?1' ( ++> H =I+'' ( ?1'> L =?' ( ++> H O0/ L 0han4e in NW0 H I1S' L =(*+> H I*1+ %(e *encil Compan+ /or the year :ust com3leted, sales #ere ISSO and costs I)?A, follo#in4 are the be4innin4 and endin4 balance sheets &e4innin4 End -ccounts recei.able I1'' I11' %n.entory 1'' O' -ccounts Payable 1'' )' Net Workin4 0a3ital I1'' I1*'
Sales #ere ISSO but recei.ables rose by only I1', So cash re.enues #ere ISSO L 1' H ISOO 0osts #ere I)?A but in.entories fell by I*' and 3ayables by I?', Thus cash costs #ere
H I)AA
-ccountin4 de3reciation is a non(cash deduction, -s a result de3reciation has cash flo# conse5uences
only because it influences the tax bill,
So the #ay the de3reciation is com3uted becomes rele.ant for ca3ital in.estment decisions, !odified -0RS 2e3reciation
3The basic idea is that e.ery asset is assi4ned to a 3articular class, The class establishes asset;s life for tax
3ur3oses 3We com3ute the de3reciation for each year by multi3lyin4 the cost of the asset by a fixed 3ercenta4e, 3The ex3ected sal.a4e .alue and the actual ex3ected economic life are not ex3licitly considered in calculation of de3reciation 3!-0RS Pro3erty 0lasses Class ?(year +(year )(year E/amples E5ui3ment used in research -utos, 0om3uters !ost industrial e5ui3ment c
<ea#
1 * ? A
Pro3erty 0lass ?(year +(year )(year ??,??T *',''T 1A,*ST AA,AA ?*,'' *A,AS 1A,O* 1S,*' 1),AS ),A1 11,+* 1*,AS 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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&ook 1alue .ersus !arket 1alue Qear &e4innin4 &ook 1alue 1 I1*,''','' * S,K'','' ? +,)K','' A ?,A+K,'' + *,')?,K' K KS1,*'
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LESSON ?1
Su33ose #e #ant to sell the car after + years, &ased on historical a.era4es, it #ill be #orth, say *+T of the
3urchase 3rice, i,e, ',*+ x 1*,''' H I?,'''
%f sold on this 3rice #e #ould ha.e to 3ay taxes on the difference bet#een the 3rice of I?,''' and the
book .alue of IKS1,*',
The
reason for tax 3ayment is that the difference bet#een the market and book .alue is the excess de3reciation that must be reca3tured #hen the asset is sold,
This is not a tax on ca3ital 4ain, because a ca3ital 4ain occurs if the market 3rice exceeds the ori4inal cost, %f the book .alue exceeds the market .alue, then the difference is treated as a loss for tax 3ur3oses
%(e SS Compan+
The com3any :ust 3urchased a ne# %T system #ith an installed cost of I1K',''', the com3uter is treated
as +(year 3ro3erty under !-0RS,
What are the yearly de3reciation allo#ances7 The system #ill ha.e an estimated #orth of only I1',''', if sold in A years, What are the tax conse5uences of the sale7 What is the total after tax cash flo# from sale
Qear 1 * ? A + K !-0RS Percenta4e *',''T ?*,'' 1S,*' 11,+* 11,+* +,)K 2e3reciation I?*,''' +1,*'' ?',)*' 1O,A?* 1O,A?* S,*1K Endin4 &ook 1alue I1*O,''' )K,O'' AK,'O' *),KAO S,*1K '
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The book .alue at the end of year A is I*),KAO, if #e sell the system for I1',''' at that time, #e #ill ha.e a We 4et I1',''' from buyer We sa.e ',?A x I1),KAO H IK,''' in taxes, So the total after tax cash flo# from the sale is a I1K,''' cash
inflo# %(e M Inc@
of a ne# line of 3roduct, &ased on the market research, it 9nit Sales ?,''' +,''' K,''' K,+'' K,''' +,''' A,''' ?,'''
The ne# 3roduct #ill be 3riced to sell at I1*' 3er unit to start, $o#e.er the com3etitions may effect the The 3ro:ect #ill re5uire I*',''' in net #orkin4 ca3ital at the start, Subse5uently, total NW0 at the end of
each year #ill be 1+T of sales for that year,
The .ariable cost 3er unit is IK' and total fixed costs are I*+,''' 3er year, %t #ill cost about IO'',''' to buy the e5ui3ment necessary to be4in the 3roduction, This e5ui3ment
comes under )(year !-0RS 3ro3erty,
The e5ui3ment #ill be #orth *'T of its cost in O years, or ',*' x IO'',''' H I1K',''', Tax rate is ?AT
and re5uired return is 1+T
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Net #orkin4 0a3ital starts out at I*',''' and then rises to 1+T of sales, /or first year, net #orkin4 ca3ital 4ro#s from I*',''' to ',1+ x ?K',''' H I+A,''' The increase is thus I+A,''' L *',''' H I?A,''' Rest of the fi4ures are 4i.en in the next table
Qear ' 1 * ? A + K ) O Re.enues I?K',''' K'',''' )*',''' )1+,''' KK',''' ++',''' AA',''' ??',''' Net Workin4 0a3ital I *',''' +A,''' S',''' 1'O,''' 1'),*+' SS,''' O*,+'' KK,''' AS,+'' 0ash /lo# (I*',''' ( ?A,''' ( ?K,''' ( 1O,''' )+' O,*+' 1K,+'' 1K,+'' 1K,+''
Capital Spending
%n.ested IO'',''' at year ', #hich by assum3tion #ill be #orth I1K',''' at the end of the 3ro:ect, %t #ill
ha.e a book .alue of <ero at that time,
This I1K',''' excess of market .alue o.er book .alue is taxable, So after tax 3roceeds #ill be I1K',''' x
=1 L ',?A> H I1'+,K'' Pro:ect Total 0ash /lo#s Qear O3eratin4 0/ NW0 0han4es 0a3, S3endin4 Total 3ro:ect 0/ 0umulati.e 0/ 2iscounted 0/ V1+T ' (I *',''' ( O'',''' (IO*',''' (IO*',''' ( O*',''' 1 I1A1,1KS ( ?A,''' c I1'),1KS (I)1*,O?1 S?,1S' + I *'+,)S' O,*+' c I *1A,'A' I 1SK,)1O * I*AO,11? ( ?K,''' c I*1*,11? (I+'',)1O 1K',?OO ? I*KO,11? ( 1O,''' c *+',K)? (I*+','A+ 1KA,O*1 O ISA,'KA KK,''' 1'+,K'' I*KK,*'A IO'O,+'*
*roJect %otal Cas( Flo<s Qear A O0/ I*?1,S)? 0NW0 )+' 0a3, S3 c Total 3ro:ect 0/ I*?*,)*? 0umulati.e 0/ (I 1),?**
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Net Present 1alue at 1+T is calculated to be IK+,AOO, indicatin4 that the 3ro:ect is acce3table %nternal rate of return is 4reater than 1+T since NP1 is 3ositi.e, and is calculated to be I1),*AT, a4ain
indicatin4 the acce3tance of the 3ro:ect
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LESSON ?*
One of the res3onsibilities of the financial mana4er is to assess the .alue of the 3ro3osed in.estment, %n doin4 this, it is im3ortant that #e first look at #hat financial in.estments ha.e to offer, -t a minimum, the return #e re5uire from a 3ro3osed non(financial in.estment must be at least as lar4e as
#hat #e can 4et from buyin4 financial assets of similar risk,
Lessons from market history There is a re#ard for bearin4 risk The 4reater the 3otential re#ard, the 4reater the risk, %f you buy an asset of any sort, your 4ain =or loss>
in.estment,
This return, usually termed as dollar returns, has normally t#o com3onents6 %ncome earned =2i.idend> 0a3ital 4ain -lternati.ely, dollar returns are the sum of the cash recei.ed and the chan4e in dollar .alue of the asset,
2i.idends
Time
%nitial in.estment
Su33ose you bou4ht 1'' shares of a cor3oration one year a4o at I*+, O.er the last year, you recei.ed I*' =H *' cents 3er share R 1'' shares> in di.idends, -t the end of the year, the stock sells for I?', $o# did you do7 Qou in.ested I*+ R 1'' H I*,+'', -t the end of the year, you ha.e stock #orth I?,''' and cash di.idends of I*', Qour dollar 4ain #as I+*' H I*' E =I?,''' L I*,+''>,
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I?,'''
Time
(I*,+''
%f you don;t sell the stocks of the com3any, rather hold it Qou should still consider the ca3ital 4ain as 3art of your return %t is not :ust a 3a3er 4ain
Percenta4e Returns
%t is more con.enient to summari<e the information about returns in 3ercenta4e terms, as in this #ay, your
return does not de3end on ho# much you actually in.est,
&i!idend +ield H 2i.idend U be4innin4 3rice Capital gains +ield H =endin4 3rice L be4innin4 3rice> U be4innin4 3rice %otal percentage return H di.idend yield E ca3ital 4ains yield
Percenta4e return
= = =
dollar
return
be4innin4 market .alue di.idend + 0han4e in !arket .alue &e4innin4 market .alue 2i.idend yield + 0a3ital 4ain yield
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H *'T
0a3ital 4ains yieldH =I?,''' L *,+''> U *,+'' Percenta4e returns H *'T E ',O H *',OT
I*'
I?,'''
Time
1
Percenta4e Return6 I+*'
(I*,+''
*',OT H I*,+''
Su33ose you buy some stock for I*+ 3er share, -t the end of the year, the 3rice is I?+ 3er share, 2urin4
the year, you 4et a I* di.idend 3er share
What is the di.idend yield7 ca3ital 4ains yield7 3ercenta4e return7 %f your total in.estment #as I1,''' ho# much do you ha.e at the end of the year7
%nflo#s I* I?) 2i.idend
I?+
Time
Outflo#s (I*+
2i.idend yield H I*U*+ H ','O H OT 0a3ital 4ains yield H =I?+ ( *+>U*+ H A'T
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Percenta4e Return H OT E A'T H AOT So, if you had in.ested I1,''', you #ould ha.e had I1,AO' at the end of the year
2aria)ilit+ of >eturns
!easurin4 this .ariability is the key factor in examinin4 the to3ic of risk, /irst #e dra# a fre5uency distribution for the common stock returns to count u3 the number of times the
annual return on lar4e stock 3ortfolios falls #ithin a certain 3ercenta4e ran4e /re5uency 2istribution of Returns on 0ommon Stocks for )* years
(0 (. (()
>umber of 7ears (( 0 . , ) ( ( Return *&+ (, (( (.
(% 0 . ) % -'' --' -,' -)' -(' -' ' (' )' ,' -' ''
/or exam3le, if the returns on small stock in a 3articular year #as 1),?T, #e need to kno# ho# far the
actual return de.iate from this a.era4e, or #e need a measure of the .olatility of returns,
The
most commonly used measures for this 3ur3ose are .ariance and its s5uare root, the standard de.iation
1ariance measure the a.era4e s5uared differences bet#een the actual returns and the a.era4e return, The
bi44est the number is the more the actual returns tend to differ from the a.era4e return,
The lar4er the .ariance or standard de.iation is the more s3read out the returns #ill be, Su33ose, a 3articular in.estment had returns of 1'T, 1*T, ?T and (ST o.er the last four years, -.era4e return is =',1' E ',1* E ','? L ','S>UA H AT To com3ute the .ariance, #e take de.iations of the actual returns from this a.era4e return, take s5uares of
these de.iations and the a.era4e of the s5uared de.iations #ill be our .ariance, $ear Actual A!erage &e!iation from t(eS7uared &e!iation >eturn >eturn Mean 1 ,1' ,'A ,'K ,''?K * ,1* ,'A ,'O ,''KA ? ,'? ,'A (,'1 ,'''1 A (,'S ,'A (,1? ,'1KS Totals ,1K ,'' ,'*)' 1ariance H ,'*)' U =A(1> H ,''S Standard 2e.iation H ,''S H ,'SAO) or S,AO)T 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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LESSON ?? 2A>IABI I%$ ,F >E%U>NS %n 4eneral, the .ariance for T historical returns is 6 1ar=R> H \=R1 ( R>* EJJE=RT ( R>*] U =T (1>
What are the a.era4e returns7 .ariances7 Standard de.iations7 Which in.estment #as more .olatile
No# #e calculate .ariance for 0om3any N $ear Actual A!erage &e!iation from t(eS7uared &e!iation >eturn >eturn Mean *''' (,*' ,1)+ (,?)+ ,1A'K*+ *''1 ,+' ,1)+ ,?*+ ,1'+K*+ *''* ,?' ,1)+ ,1*+ ,'1+K*+ *''? ,1' ,1)+ (,')+ ,''+K*+ Totals ,)' ,''' ,*K)+'' Summari<in4 the calculations6
1ariance =d*> Standard 2e.iation =d> ,'OS* H ,*SO) ,'1)K H ,1?*) ? Standard de.iation for com3any N, *S,O)T more than t#ice 0om3any Q;s 1?,*)T, This indicates that com3any N is more .olatile in.estment, E/pected >eturn 0om3any N ,*K)+U? H ,'OS* 0om3any Q ,'+*SU? H ,'1)K
0onsider a sin4le 3eriod of time, say a year, We ha.e t#o stocks, L and 9, and they are ex3ected to ha.e a
return of *+T and *'T res3ecti.ely in the comin4 year
return may actually 3erform abnormally, %t could 4o u3 to )'T in economic boom or may slide to (*'T in recession,
While stock 9 may earn ?'T in recession and 1'T durin4 a boom, %f the 3robabilities of occurrin4 a boom and a recession are ',+ each then the ex3ected return for both the
stocks can be calculated as6 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The difference bet#een the return on a risky in.estment and that on a risk(free in.estment, Su33ose, risk(free in.estments are currently offerin4 O 3ercent, %n other #ords, risk(free rate =R > is OT, 9sin4 this information, #e can calculate the 3ro:ected risk 3remia on stocks 9 and L, Risk Premium =9> H ex3ected return L Risk(free rate
f
To calculate the .ariances of the returns 2etermine the s5uared de.iations from the ex3ected return !ulti3ly each 3ossible s5uared de.iation by its 3robability -dd u3 all the 3roducts
State of Economy Stock L Recession &oom Stock 9 Recession &oom P ',+ ',+ 1,' S5uared Return Return 2e., /rom ER /rom ER (,*' ( ,*+ H (,A+ ,)' ( ,*+ H ,A+ d*L H ',*'*+ (',A+* H ',*'*+ ',A+* H ',*'*+ 2e., Product ',1'1*+ ',1'1*+ ',''+'' ',''+'' Stock 9 *'T ','1'' 1'T *
',+ ,?' ( ,*' H ,1' ',1'* H ','1 ',+ ,1' ( ,*' H (,1' ( ',1'* H ','1 1,' d*9 H ','1'' Summari<in4 the ex3ected return and .ariability information6 Stock L Ex3ected return, E=R> *+T 1ariance, d* ',*'*+ Standard 2e.iation, d A+T 0oefficient of .ariation, 01 H E=R> U d ',++ 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Stock L has a hi4her ex3ected return, but 9 has less risk, Qou could 4et )'T return on your in.estment in L but you could also lose *'T -n in.estment in 9 #ill al#ays 3ay at least 1'T Which of these stocks should you buy7 /or the economy conditions #ith une5ual 3robabilities, #e ha.e summari<ed the com3utations in the
follo#in4 table6 State of Economy Stock L Recession &oom Stock 9 Recession &oom P ',O ',* 3@9 ',O ',* 3@9 Return 2e., /rom ER (,*' L =(,'*> H (,1O ,)' ( =(,'*> H ,)* ,?' ( ,*K H ,'A ,1' ( ,*K H (,1K S5uared Return /rom ER ','?*A ',+1OA ',''1K ','*+K 2e., Product
Portfolio is the 4rou3 of assets such as stocks and bonds held by an in.estor Portfolio #ei4hts are the 3ercenta4es of the total 3ortfolio;s .alue that are in.ested in each 3ortfolio asset, %f #e ha.e I+' in one asset and I1+' in another, then our total 3ortfolio is #orth I*'', The 3ercenta4e of first asset in 3ortfolio is I+'U*'' H ',*+, #hile the same for the second asset is
I1+'U*'' H ',)+
So, the 3ortfolio #ei4hts are ',*+ and ',)+ Lets return to our stocks L and 9, #here you 3ay half your money in each, i,e, 3ortfolio #ei4hts are ',+'
and ',+', State of Econom+ * Recession ',+ &oom ',+ 1,' *ortfolio returns if state occurs ',+ x (*'T E ',+ x ?'T H +T ',+ x )'T E ',+ x 1'T H A'T E=RP> H ',**+ *roduct ','*+ ',*''
Su33ose #e had n assets in our 3ortfolio, #here n is any number, and let x
money in asset i, then the ex3ected return is6 E=RP> H x4 x E=R1> E x5 x E=R*> EJJ,E xn x E=Rn>
1ariance on a 3ortfolio is not 4enerally a sim3le combination of the .ariances of the assets in the 3ortfolio
State of* *ortfolio returnsS7uared >eturn &e!@ From E> 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan *roduct
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*U11 =about 1OT> in stock L and other SU11 =about O*T> in stock
The returns are the same, sho#in4 <ero .ariance, $ence, combinin4 assets into 3ortfolios can substantially alter the risks faced by the in.estor Su33ose #e ha.e the follo#in4 3ro:ections on three stocks
5tate 8cono-!
&oom &ust
o*
What #ould be the ex3ected return on a 3ortfolio #ith e5ual amounts in.ested in each of the assets7 #ith half in.estment in -, remainder di.ided bet#een & an 07
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LESSON ?A
#ith e5ual amounts in.ested in each of the assets7 #ith half in.estment in -, remainder di.ided e5ually bet#een & and 07
The ex3ected returns on indi.idual stocks are calculated as
%f a 3ortfolio has e5ual in.estment in each asset, the 3ortfolio #ei4hts are all the same, 1U? each in this case, So 3ortfolio ex3ected return is6
E=R > H 1U? x O,OT E 1U? x O,AT E 1U? x O,'T H O,AT %n case of Stock - ha.in4 half the in.estment =1U* #ei4ht> and remainder di.ided e5ually =1UA each>
P
E=R > H 1U* x O,OT E 1UA x O,AT E 1UA x O,'T H O,+T Portfolio returns 3attern for the case #here - has +'T #ei4hts and & and 0 ha.e *+T each are6
P
5tate 8cono-!
&oom &ust
o*Probability of stateReturns
=P> ',A' ',K'
Stock 1'T O
1ariance is thus6
d* H ,A' x =,1?)+ ( ,'O+>* E ,K' x =,'+ ( ,'O+>* H ,''1O?)+
Standard 2e.iation is calculated to be A,?T /or e5ually #ei4hted 3ortfolio, standard de.iation is about +,AT
>isk
The true risk of an in.estment is the unantici3ated or sur3risin4 3art of the return, %f #e al#ays recei.e exactly #hat #e ex3ect then the in.estment #ill be risk(free, Systematic Risk - risk that influences a lar4e number of assets, %t is also called market risk
8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Interest rate Inflation Affects <ages, cost of supplies, !alues of t(e assets o<ned )+ compan+ and selling price 9nsystematic Risk - risk that affects a sin4le or at most a small number of assets, &ecause these risks are uni5ue to indi.idual
com3anies or assets, they are also called uni5ue or asset s3ecific risks, %(e oil strike call in a compan+ <ill affect t(at compan+ and per(aps, its primar+ competitors and suppliers@ But it <ill (a!e little effect on <orld oil markets and companies not in t(e oil )usiness
We kno# till no# that the actual return, R can be broken do#n into its ex3ected and sur3rise com3onents6
R H E=R> E 9 #here 9 is the sur3rise com3onent
Since the sur3rise com3onent has a systematic and an unsystematic com3onent, so6
R H E=R> E Systematic 3ortion =m> E 9nsystematic 3ortion =f>
Thus
R H E=R> E m E f &i!ersification and *ortfolio >isk
Su33ose if the standard de.iation of annual return on a 3ortfolio of +'' lar4e common stocks is, say *'T,
does that mean that the standard de.iation of annual returns of a certain stock in that 3ortfolio is *'T7
No, Why7
&i!ersification and *ortfolio >isk =*> = ?> =1> -.era4e Standard Ratio of Portfolio Standard 2e.iation Number of Stocks 2e.iation of -nnual to Standard 2e.iation of a in Portfolio Portfolio Returns Sin4le Stock 1 AS,*AT 1,'' 1' *?,S? ',AS +' *',*' ',A1 1'' 1S,KS ',A' ?'' 1S,?A ',?S +'' 1S,*) ',?S 1,''' 1S,*1 ',?S SourceW !eir Statman, B$o# !any Stocks !ake a 2i.ersified Portfolio7C 6ournal of &inancial and 7uantitative 'nalysis ** =Se3, 1SO)>, 33, ?+?LKA,
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*'T>
&y the time #e ha.e 1'' randomly chosen stocks, the 3ortfolio;s standard de.iation has declined by about
A!erage annual standard de!iation *&+
12)
) ,21 ( 12)
&i!ersifia)le risk
Nondi!ersifia)le risk
( %
) %
, %
( %%%
*rinciple of &i!ersification
&enefit in terms of risk reduction from addin4 securities dro3s off as #e add more and more securities, With 1' securities most of the effect is already utili<ed, and #ith ?', there is .ery little remainin4 benefit,
T#o key 3oints6
Some of the riskiness associated #ith indi.idual assets can be eliminated by formin4 3ortfolios, %(e process of spreading an in!estment across assets 0and forming portfolio1
di!ersification
is called
%(e
principle of di!ersification tells us t(at spreading an in!estment across man+ assets <ill eliminate some of t(e risk@
There is a minimum le.el of risk that cannot be eliminated sim3ly by di.ersifyin4, This minimum le.el is
called nondi.ersifiable risk, %f #e hold a sin4le stock the .alue of our in.estment #ould fluctuate because of com3any(s3ecific e.ents,
%f #e hold a lar4e 3ortfolio, some of the stocks in the 3ortfolio #ill 4o u3 and other may 4o do#n because
of res3ecti.e com3any(s3ecific e.ents,
Net effect on the o.erall .alue of the 3ortfolio #ill be relati.ely small,
OUns+stematic risk is essentiall+ eliminated )+ di!ersification, so a relati!el+ large portfolio (as almost no uns+stematic risk@P
Systematic risk can not be eliminated by di.ersification, as it affects almost all assets to some de4ree, So the si<e or ty3e of 3ortfolio #ill ha.e little effect on systematic risk makin4 it nondi.ersifiable risk,
Summari<in4 ( Total risk H Systematic risk E 9nsystematic risk ( Systematic risk is also called nondi.ersifiable risk or market risk 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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LESSON ?+
When #e say that the re5uired return on an in.estment is, say, 1'T #e mean that the in.estment #ill ha.e
a 3ositi.e NP1 only if its return exceeds 1'T,
-lternati.ely, the firm must earn 1'T on the in.estment :ust to com3ensate its in.estors for the use of the
ca3ital needed to finance the 3ro:ect,
Thus, 1'T is the cost of ca3ital associated #ith the in.estment, While e.aluatin4 a risk(free 3ro:ect, #e look at the ca3ital markets and obser.e the current rate offered by risk(free in.estments, 9se this rate to discount the 3ro:ect;s cash flo#s So the cost of ca3ital here is the risk(free rate, %f the 3ro:ect is risky, then re5uired return is ob.iously hi4her %n other #ords, the cost of ca3ital for a risky 3ro:ect is 4reater than the risk free rate, and the a33ro3riate
discount rate #ould exceed the risk free rate,
So #e can use the terms re8uired return, appropriate discount rate and cost of capital interchan4eably, The cost of the ca3ital associated #ith an in.estment de3ends on the risk of that in.estment, Thus, it is the use of mone+, not the source of money that matters, We kno# that a firm;s o.erall cost of ca3ital #ill reflect the re5uired return on the firm;s assets as a #hole, "i.en that a firms uses both debt and e5uity ca3ital, this o.erall cost of ca3ital #ill be a mixture of the
returns needed to com3ensate its creditors and stockholders,
0ost of ca3ital #ill reflect 0ost of e5uity ca3ital 0ost of debt ca3ital
0ost of E5uity
Recall that under the assum3tion that the firm;s di.idend #ill 4ro# at a constant rate 4, the 3rice 3er share
of the stock, P', is6 2' x =1 E 4> 21 P' H (((((((((((((((( H (((((((((( RE L 4 RE L 4
Where 2 is the di.idend :ust 3aid 2 is the next 3eriod;s 3ro:ected di.idend R is the re5uired return on the stock We can rearran4e this to sol.e for R as6
' 1 E E
R E H 21 U P ' E 4
'
estimated
Su33ose, "SS com3any 3aid a di.idend of IA 3er share last year, The stock;s current 3rice is IK' 3er
share, -ssumin4 that the di.idends are estimated to 4ro# steadily at KT 3er year, #hat is the cost of the ca3ital for "SS7
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Estimatin4 4
To estimate the di.idend 4ro#th rate, #e can use the di.idend obser.ations for 3re.ious years, -lternati.ely #e can use analysts; forecasts of future 4ro#th rates Su33ose a com3any has the follo#in4 di.idend 3attern in the 3ast years6
Qear 1SSS *''' *''1 *''* *''? 2i.idend I1,1' 1,*' 1,?+ 1,A' 1,++ 2ollar 0han4e ( I',1' ',1+ ','+ ',1+ Percenta4e 0han4e ( S,'ST 1*,*' ?,)' 1',)1
0ost of debt is the return that firm;s creditors demand on the ne# borro#in4s, This cost of debt can be obser.ed directly or indirectly usin4 the interest rates in the financial markets, -lternati.ely, #e can use the firm;s bond ratin4s to estimate the interest rates on ne#ly issued bonds of
same ratin4,
0ou3on rate on the firm;s outstandin4 debt is irrele.ant as it relates the firm;s cost of debt #hen the
bonds #ere issued not the cost of debt today,
Su33ose, the "enTech com3any issued a ?'(year, )T bond O years a4o, The bond is currently sellin4 for
SKT of it;s face .alue, i,e, ISK', What is "enTech;s 0ost of debt7
9sin4 our kno#led4e of bond .aluation, #e can calculate that yield to maturity is about ),?)T, So the
"enTech;s 0ost of debt, R2 is ),?)T Cost of *referred Stock
Preferred stock has a fixed di.idend 3aid e.ery 3eriod fore.er makin4 it a 3er3etuity, 0ost of 3referred stock, R is6
P
RP H 2U P' #here 2 is fixed di.idend P' is the current 3rice 3er share of 3referred stock
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One issue of the 3referred stocks of 0" inc, 3aid I1,)O annually and sold for I*+,?+ 3er share, The other 9sin4 the first issue, cost of 3referred stock #as
RP H 2U P' H I1,)OU*+,?+ H ),'*T
So the 0" inc,;s cost of 3referred stock a33ears to ha.e been in bet#een K,S to )T
Capital Structure "eig(ts
We can calculate the market .alue of the firm;s e5uity, E by multi3lyin4 the number of shares outstandin4
by the 3rice 3er share,
!arket .alue of firm;s debt 2 can be calculated by multi3lyin4 the market 3rice of a sin4le bond by the
number of bonds outstandin4,
/or multi3le bond issues, #e re3eat this calculation for each and then add u3 the results, /or the debt not 3ublicly traded, #e obser.e the yield on similar 3ublicly traded debt and estimate the
market .alue of 3ri.ately held debt usin4 this yield as discount rate,
/or short term debt #e use the book .alues as estimate of the market .alue as both should be similar, No# the combined market .alue of debt and e5uity, 1 is
1HEE2
2i.idin4 both sides by 1, #e 4et the 3ercenta4es of the total ca3ital re3resented by debt and e5uity
1''T H EU1 E 2U1
These 3ercenta4es are called ca3ital structure #ei4hts /or exam3le, if the total market .alue of a com3any;s stocks #ere calculated as I*'' million and the total
market .alue of the com3any;s debt #ere calculated as I+' million, then combined .alue #ould be I*+' million,
No# EU1 H I*''U*+' H O'T, So O'T of the firm;s financin4 #ould be e5uity and remainin4 *'T #ould
be debt, %(e %a/ Effect
%nterest 3aid by cor3oration is tax deductible but 3ayments to stockholders, such as di.idends are not tax
deductible,
This means that the 4o.ernment 3ays some of the interest, So #e need to distin4uish bet#een the 3retax and after(tax Su33ose a firms borro#s a I1 million at ST, Tax rate is ?AT The total interest bill #ill be IS',''' 3er year, This amount is tax deductible, so the IS',''' reduces the
tax bill by ',?A x IS',''' H I?',K''
The after(tax interest bill is thus IS',''' ( ?',K'' H I+S,A'' The after(tax interest rate is I+S,A''U1 million H +,SAT -lternati.ely, if T stands for cor3orate tax rate, then the after tax rate that #e use for the cost of debt can
0
be #ritten as
R2 x =1 L T0>,
So
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LESSON ?K
To calculate the firm;s o.erall cost of ca3ital, #e multi3ly the ca3ital structures #ith the associated costs
and add u3 the 3ieces, The result is called the Wei4hted -.era4e 0ost of 0a3ital =W-00> o "ACC S 0ET21 / >E L 0&T21 / >& / 03 B %C1
The W-00 is the o.erall return the firm must earn on its existin4 assets to maintain the .alue of the
stock,
%t is also the re5uired return on any in.estments by the firm that ha.e the same risks as exitin4 o3erations,
So for e.aluatin4 the cash flo#s a 3ro3osed ex3ansion 3ro:ect, this is the discount rate to be used,
/or the firm usin4 3referred stocks in its ca3ital structure, the W-00 #ould be6
W-00 H =EU1> x RE E =PU1> x RP E =2U1> x R2 x =1 L T0>
Su33ose a com3any #ants to reno.ate its #arehouse distribution system, The 3lan #ill cost I+' million
and is ex3ected to sa.e I1* million 3er year after the taxes o.er next six years,
The com3any has a tar4et debt(e5uity ratio of 1U? =i,e, EU1 is ',)+ and 2U1 is ',*+>, The com3any has a cost of debt of 1'T and a cost of e5uity of *'T, -ssumin4 a tax rate of ?AT, should the com3any 4o for the 3ro:ect7 The Wei4hted -.era4e 0ost of 0a3ital is6
W-00 H =EU1> x RE E =2U1> x R2 x =1 L T0> H ,)+ x *'T E ,*+ x 1'T x =1 L ,?A> H 1K,K+T
Since the cash flo#s are in the form of an ordinary annuity, #e can calculate this NP1 usin4 1K,K+T as the
discount rate as follo#in46 1 L \1U=1 E ',1KK+>K] NP1 H (I+' E 1* x ((((((((((((((((((((((((((((( ',1KK+ H (I+' E 1* x ?,K*** H (IK,+? million
The ne4ati.e NP1 means that the financial market offers su3erior 3ro:ects in the same risk class, so the
3ro:ect should be re:ected, EMN Corporation
E!N 0or3oration has )),? million shares of stock outstandin4, The book .alue 3er share is I1),K*, but
the stock actually sells for IA+,A1,
The total e5uity is about I1,?K billion on a book .alue basis but is closer to I?,+1billion on a market .alue
basis,
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E!N
3aid I1,)K 3er share in di.idends last year and analysts estimate this di.idend to 4ro# by )T throu4h next + years,
E!N has four lon4 term bond issues that account for essentially all of its lon4 term debt, To calculate the
cost of debt, #e #ill ha.e to combine these four issues by com3utin4 a #ei4hted a.era4e,
To calculate the #ei4hted a.era4e cost of debt, #e take the 3ercenta4e of the total debt re3resented by
each issue and multi3ly by the yield on the issue
We then add to 4et the o.erall #ei4hted a.era4e cost of debt, /or com3arison 3ur3ose, #e use both book
and market .alues, &ook 1alue !arket 1alue =/ace .alue inT of T ofQield to&ook !arket 0ou3on rate millions> Total =in millions> Total !aturity 1alues 1alues K,?)+T IASK ',?? I+'),O ',?? A,O+) 1,K*T 1,K'T ),*+ ASK ',?? +'K,' ',?? ),'K) *,?+ *,?* ),K*+ *'' ',1? **K,1 ',1+ K,+'* ',O) ',S+ ),K' *S) ',*' ?'',' ',1S ),+'S 1,+' 1,AK %otal E3,FHG 3@99 E3,K;G@H 3@99 I@;F: I@;F: -s these calculations sho# for E!N, #hether market .alues or book .alues are used, cost of debt remains K,?AT,
This is because !arket .alues and book .alues are similar E!N has no 3referred stock No# to calculate the W-00 for E!N on book .alue basis, #e ha.e the follo#in4 information E!N;s e5uity is #orth I1,?K* billion E!N;s debt is #orth I1,AOS billion Total .alue is I*,O+1 billion So EU1 H I1,?K*bU *,O+1b H ',AO, and 2U1 H I1,AOSbU *,O+1b H ',+* -ssumin4 a tax rate of ?AT, E!N;s W-00 #ill is6
W-00 H =EU1> x RE E =2U1> x R2 x =1 L T0> H ',AO x 11,1+T E ',+* x K,?AT x =1 ( ',?A> H ),+?T
No# to calculate the W-00 for E!N on market .alue basis, #e ha.e the follo#in4 information E!N;s e5uity is #orth I?,+1' billion
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EU1 H I ?,+1'bU +,'+'b H ',)', and 2U1 H I 1,+A'bU +,'+'b H ',?' -ssumin4 a tax rate of ?AT, E!N;s W-00 #ill is6
W-00 H =EU1> x RE E =2U1> x R2 x =1 L T0> H ',)' x 11,1+T E ',?' x K,?AT x =1 ( ',?A> H S,'KT
Thus, usin4 market .alue #ei4hts, #e 4et S,'KT for E!N;s W-00 #hich is much hi4her than ),+?T
W-00 #e 4et usin4 book .alue,
So usin4 book .alues can lead to trouble 3articularly if e5uity book .alues are used, E!N;s market(to(book ratio is about *,K, so book .alues si4nificantly o.erstate the 3ercenta4e of E!N;s
financin4 that comes from debt Summar+ of Capital Cost
RE H 21UP' E 4 #here 21 is the ex3ected di.idend in one 3eriod, 4 is the di.idend 4ro#th rate, and P' is the current stock 3rice,
The 0ost of debt, R /or a firm #ith 3ublicly held debt, the cost of debt can be measured as the yield to maturity on the
2
%f the firm has no 3ublicly traded debt, then the cost of debt can be measured as the yield to maturity on
similarly rated bonds
The Wei4hted -.era4e 0ost of 0a3ital, W-00 The firm;s W-00 is the o.erall re5uired return on the firm as a #hole, %t is the a33ro3riate discount rate
to use for cash flo#s similar in risk to the o.erall firm
T is the cor3orate tax rate, E is the market .alue of the firm;s e5uity, 2 is the market .alue of the firm;s debt 1 H E E 2, EU1 is the 3ercenta4e of the firm;s financin4 that is e5uity 2U1 is the 3ercenta4e that is debt,
0
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LESSON ?)
The
firm,
4uidin4 3rinci3le in choosin4 the debt(e5uity ratio, is a4ain to choose a course of action that maximi<es the .alue of a share of stock,
When it comes to ca3ital structure decisions, this is the same thin4 as maximi<in4 the .alue of the #hole Recall, W-00 tells us that the firm;s o.erall cost of ca3ital is the #ei4hted a.era4e of the costs of .arious
com3onents of the firm;s ca3ital structure,
9sually, #hile describin4 W-00, #e take the ca3ital structure of the firm as 4i.en, &ut #hat ha33ens to
the cost of ca3ital #hen #e .ary the amount of debt financin4, or 2ebt(e5uity ratio7
Recall that the W-00 is the discount rate a33ro3riate for the firm;s o.erall cash flo#s, Since the .alues and discount rates mo.e in the o33osite directions, #e can say that the .alue of the firm;s
cash flo#s =or the .alue of the firm> is maximi<ed #hen the W-00 is minimi<ed,
So #e can safely say that one ca3ital structure is better than the other if it results in a lo#er #ei4hted
a.era4e cost of ca3ital
/urther, a 3articular debt(e5uity ratio re3resents the o3timal ca3ital structure if it results in the lo#est
3ossible W-00,
This o3timal ca3ital structure is also called firm;s tar4et ca3ital structure,
Financial e!erage
/inancial le.era4e refers to the extent to #hich a firm relies on the debt, The more debt financin4 a firm
uses in ca3ital structure, the more financial le.era4e it em3loys,
/inancial le.era4e can dramatically alter the 3ayoffs to the shareholders in the firm, but it may not affect
the o.erall cost of ca3ital,
While illustratin4 ho# financial le.era4e #orks, #e shall i4nore taxes here, and describe the im3act of
le.era4e in terms of its effect on earnin4s 3er share, EPS and return on e5uity, ROE,
/or meanin4ful analysis, #e shall use cash flo#s instead of these accountin4 fi4ures, but results #ill be the
same
The
T- 0or3oration currently has no debt in its ca3ital structure, The com3any is considerin4 a restructurin4 that #ould in.ol.e issuin4 debt and usin4 3roceeds to buy back some of the outstandin4 e5uity,
The follo#in4 table 3resents both current and 3ro3osed ca3ital structures,
-ssets 2ebt E5uity 2ebtUE5uity ratio Share 3rice Shares outstandin4 %nterest rate
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The im3act of le.era4e is e.ident in the abo.e fi4ures, #hen #e examine the restructurin4 effect on EPS
and ROE,
Particularly, the .ariability in both EPS and ROE is much lar4er under the 3ro3osed ca3ital structure,
illustratin4 ho# financial le.era4e acts to ma4nify 4ains and losses to shareholders, E*S 0E1 Ad!antage to de)t Break4e!en point F ; 5 3 9 B3 B5 No de)t "it( de)t
A'','''
O'','''
1,*'','''
&isad!antage to de)t 0alculatin4 Point -, &reak(E.en With no debt6 EPS H E&%TUA'',''' &, With IA,''',''' in debt at 1'T6 EPS H =E&%T ( IA'','''>U*'',''' 0alculatin4 &reak(E.en Point 0, Sol.e for the break(e.en E&%T&E6 E&%T&EUA'',''' H =E&%T&E ( IA'','''>U*'',''' 2, With a little al4ebra6 E&%T&E H IO'',''' -nd EPS&E H I*,''Ushare
The !P2 0or3oration currently uses no(debt financin4 and it has decided to 4o for ca3ital restructurin4
#hich #ould incor3orate I1 million debt at ST debt, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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le.el for E&%T that !P2;s
!P2 has *'',''' shares outstandin4 and the 3rice 3er share is I*', %f the restructurin4 is ex3ected to increase EPS, #hat is the minimum
mana4ement must be ex3ectin47
To ans#er #e ha.e to calculate the &reak(e.en E&%T 9nder the old ca3ital structure,
EPS H E&%TU*'','''
9nder the ne# ca3ital structure, interest ex3ense #ill be I1 million x ','S H IS',''' With I1 million 3roceeds !P2 #ill re3urchase I1millionU*' H +',''' shares of stock, lea.in4 1+','''
outstandin4,
While EPS is I1,O' and mana4ement of !P2 ex3ects this fi4ure to exceed /rom the abo.e discussion, the follo#in4 conclusions can be dra#n 6 The effect of financial le.era4e de3ends on the com3any;s E&%T, When E&%T is relati.ely hi4h, le.era4e is
beneficial,
9nder the unex3ected scenario, le.era4e increases the returns to the shareholders, as measured by ROE
and EPS,
/rom the abo.e discussion, the follo#in4 conclusions can be dra#n Shareholders are ex3osed to more risk under the 3ro3osed ca3ital structure since the EPS and ROE are
much more sensiti.e to chan4es in E&%T in this case,
&ecause of im3act that financial le.era4e has on both the ex3ected return to stockholders and the riskiness
of the stock, ca3ital structure is an im3ortant consideration #omemade e!erage
The last conclusion is not necessarily correct because the shareholders can ad:ust the amount of financial
le.era4e by borro#in4 and lendin4 on their o#n,
The use of 3ersonal borro#in4 to alter the de4ree of financial le.era4e is called homemade le.era4e, Returnin4 to our discussion of T- cor3oration, #e #ill no# illustrate that it makes no difference #hether
or not T- uses the 3ro3osed ca3ital structure,
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The 3ro3osed ca3ital structure results in a debt(e5uity ratio of 1 To re3licate this ca3ital structure at the 3ersonal le.el, the stockholder must borro# enou4h to create this
same debt(e5uity ratio of 1, Unle!ering
No#,
under the condition that T- mana4ement ado3ted the 3ro3osed ca3ital structure, su33ose, an in.estor #ho o#ned 1'' shares 3referred the ori4inal ca3ital structure
To create le.era4e, in.estors borro# on their o#n, #hile to unle.er in.estors must loan out the money, %n T-, the cor3oration borro#ed an amount e5ual to half it s .alue, The in.estor can unle.er the stock by
sim3ly sol.in4 loanin4 out the money in the same 3ro3ortion
The in.estor sells +' shares for I1,''' total and then loans out I1,''' at 1'T,
EPS =Pro3osed structure> Earnin4s for +' shares 3lus interest on I1,''' at 1'T Total Payoff Recession Ex3ected Ex3ansion I',+' I?,'' I+,+' *+,'' 1+','' *)+,'' 1'','' 1'','' 1'','' I1*+,'' I*+','' I?)+,''
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LESSON ?O
We ha.e seen that cor3orate borro#in4 is relati.ely less si4nificant #hen it comes to cor3orate structure,
because in.estors can borro# or lend on their o#n,
So, in our T- cor3oration, the stock 3rice remains almost the same #hiche.er ca3ital structure com3any
chooses,
This result is based u3on a famous ar4ument by t#o noble laureates, /ranco !odi4liani and !erton !iller
=commonly kno#n as !P!>,
We shall discuss the t#o 3ro3ositions 3resented by !P!, The 1 3ro3osition states that it is com3letely irrele.ant ho# a firm chooses to arran4e its finances, %ma4ine t#o firms ha.in4 identical assets and o3erations de3icted on the left hand side of the balance
st
sheet,
&ut the ri4ht hand side is different because the t#o firms finance their o3erations differently, %n this case #e can .ie# the ca3ital structure 5uestion in terms of a 3ie model,
70$ <e8t
30$ +="ity
"he si-e of the pie does not depend on how it is sliced -lthou4h chan4in4 the ca3ital structure may not chan4e the firm;s total .alue, it does cause im3ortant
chan4es in the firm;s debt and e5uity,
No# #e examine the firm #hich chan4es its debt(e5uity ratioW and for sim3lification #e i4nore taxes here, We kno# that
W-00 H =EU1> x RE E =2U1> x R2 #here 1 H E E 2
We also kno# that W-00 can be inter3reted as the re5uired return on the firm;s o.erall assets =R >, Thus
-
R- H =EU1> x RE E =2U1> x R2
Rearran4in4
RE H R- E=R- L R2> x =2UE>
This * 3ro3osition tells us that the cost of e5uity de3ends on three thin4s The re5uired return on firm;s assets R The firm;s cost of debt R , and
nd 2
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debt(e5uity ratio 2UE
The
Cost of Capital *&+
firm;s
R"
-s the firm raises its debt(e5uity ratio, the increase in le.era4e raises the risk of the e5uity and therefore
the re5uired return or cost of e5uity =RE>
W-00 remains the same, su33ortin4 !P! 3ro3osition 1 R02 cor3oration has a W-00 of 1*T =i4norin4 taxes>, %t can borro# at OT, -ssumin4 that R02 has a tar4et ca3ital structure of O'T e5uity and *'T debt, #hat is its cost of e5uity7 What is the cost of e5uity if the tar4et ca3ital structure is +'T e5uity7 0alculate W-00 in both cases to .erify it remains the same, -ccordin4 to !P! 3ro3osition *, the cost of e5uity, R , is6
E
%n the 1
case, debt(e5uity ratio is ,*U,O H ,*+, so the cost of e5uity is RE H 1*T E =1*T ( OT> x ',*+ H 1?T
st
%n the second case, debt(e5uity comes out to be 1,', so the cost of e5uity is 1KT No# assumin4 e5uity financin4 is O'T, the cost of e5uity is 1?T and tax rate is <ero, W-00 is
W-00 H =EU1> x RE E =2U1> x R2 H ',O' x 1?T E ',*' x OT H 1*T
%n the second case, e5uity financin4 is +'T, the cost of e5uity is 1KT, W-00 is
W-00 H =EU1> x RE E =2U1> x R2 H ',+' x 1KT E ',+' x OT H 1*T
!P! 3ro3osition * sho#s that the firm;s cost of e5uity can be broken into t#o com3onents The re5uired return on firm;s assets, R de3ends on the nature of the firm;s o3eratin4 acti.ities
-
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The risk inherent in the firm;s o3erations is called the )usiness risk, and #e kno# that this business risk !P! 3ro3osition * sho#s that the firm;s cost of e5uity can be broken into t#o com3onents =R L R > x =2UE> is determined by the firm;s financial structure, /or an all e5uity firm, this com3onent is <ero, The increase in debt financin4 raises the re5uired return on e5uity because the risk born by the in.estors
2
increases,
2ebt features interest 3aid on debt is tax deductibleW a benefit for the firm /ailure to meet debt financin4 may lead to bankru3tcyW a cost of debt financin4 To examine the effect of cor3orate taxes, #e consider t#o firms =/irm 9 P /irm L>, identical on left side
of balance sheet, So their assets and o3erations are the same,
-ssumin4 E&%T to be I1,''' e.ery year for both firms, the difference is that /irm L has issued I1,'''
#orth of 3er3etual bonds at OT interest e.ery year, /irm 9 E&%T %nterest Taxable %ncome Taxes =?'T> Net %ncome I1,''' ' I1,''' ?'' I )'' I1,''' O' I S*' *)K I KAA /irm L
To sim3lify, #e assume 2e3reciation is <ero 0a3ital s3endin4 is <ero There are no additions to Net Workin4 0a3ital Thus cash flo# from assets is sim3ly e5ual to E&%T L Taxes,
Cas( Flo< from Assets /irm 9 E&%T I1,''' ( Taxes ?'' Total I )'' /irm L I1,''' *)K I )*A
Total cash flo# to /irm L is I*A more, as its tax bill is I*A less, %nterest bein4 tax deductible has 4enerated a tax sa.in4 e5ual to interest 3ayment multi3lied by tax rate, i,e,
IO' x ',?' H I*A 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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This tax sa.in4 is called the %nterest Tax Shield Since debt is 3er3etual, the same I*A shield #ill be 4enerated e.ery year fore.er, Since /irm L;s cash flo# is al#ays I*A 4reater, its #orth is more than /irm 9 by the .alue of this I*A
3er3etuity,
&ecause the tax shied is 4enerated by 3ayin4 interest, it has the same risk as the debt, and OT is therefore
the a33ro3riate discount rate,
We may conclude here that the .alue of /irm L, 1 , exceeds the .alue of the firm 9, 1 , by the 3resent
L 9
$ TC
A=
A=
Pro3osition 16 the .alue of the firm le.ered =1 > is e5ual to the firm unle.ered =1 >6
L 9
1L H 1 9
%m3lications of 3ro3osition 16
A Firm6s capital structure is irrele!ant A firms "ACC is t(e same no matter <(at mi/ture of de)t and e7uit+ is used to finance t(e firm
%(e no4ta/ case Pro3osition *6 The cost of e5uity, RE is6 RE H R- E =R- L R2> x 2UE #here R- is the W-00, R2 is the cost
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Pro3osition 1 #ith taxes6 the .alue of the firm le.ered =1 > is e5ual to the .ale of the firm unle.ered =1 >
L 9
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LESSON ?S
The costs that are directly associated #ith bankru3tcy, such as le4al and administrati.e ex3enses
Indirect Bankruptc+ Costs
The direct and indirect costs associated #ith 4oin4 bankru3t or ex3eriencin4 financial distress
Static %(eor+ of Capital Structure
- firm borro#s u3 to the 3oint #here tax benefit from an extra dollar in debt is exactly e5ual to the cost
that comes from the increased 3robability of financial distress 2alue of t(e Firm, 2 *2 of ta/ s(ield on de)t Ma/@ Firm 2alue 2 U Financial distress costs 2 S 2 U L %C / & S !alue of firm <it( de)t
Actual Firm !alue 2U S !alue of firm <it( no de)t %otal de)t 0&1
A=
The maximum .alue of the firm, 1 g is reached at a debt le.el of 2g, so this is the o3timal amount of
L
borro#in4
-lternati.ely, the firm;s ca3ital structure is com3osed of 2gU 1 g in debt and =1 ( 2gU 1 g> in e5uity, The difference bet#een the .alue of firm in static theory and the !P! .alue of the firm #ith taxes is the
L L
The difference bet#een the static theory .alue of the firm and the !P! .alue #ith no taxes is the 4ain
from le.era4e, net of distress costs,
We kno# that the ca3ital structure that maximi<es the .alue of the firm is also the one that minimi<es the
cost of ca3ital,
With no taxes and bankru3tcy costs, the .alue of the firm and its #ei4hted a.era4e cost of ca3ital =W-00>
are not affected by ca3ital structure 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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A=
With cor3orate taxes and no bankru3tcy costs the .alue of the firm increases and the W-00 decreases as
the amount of debt 4oes u3,
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A=
"ACC 0:1
With cor3orate taxes and bankru3tcy costs, the .alue of the firm, 1 , reaches a maximum at 2g, the
L
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AE
A=
DE
"ACC 0:1
D<CCE
Case 3 M.M 0no ta/es1 Case ; Static t(eor+ Case 5 M.M 0<it( ta/es1
DE 6 "E
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Tax benefits from le.era4in4 is only im3ortant to the firms that are in a tax(3ayin4 3osition, /irms #ith
substantial losses #ill 4et little .alue from the interest tax shield,
/irms that ha.e substantial tax shields from other sources, such as de3reciation, #ill 4et less benefit from
le.era4e,
/irms #ith a 4reater risk of ex3eriencin4 financial distress #ill borro# less than the firms #ith a lo#er risk, The cost of financial distress de3ends 3rimarily on the firm;s assets and it #ill be determined by ho# easily
the o#nershi3 of those assets can be transferred
Net #orkin4 ca3ital =NW0> is the difference bet#een the current assets and the current liabilities, Often
the short(term financin4 is called net #orkin4 ca3ital mana4ement,
The difference bet#een short( and lon4( term financin4 is the timin4 of the cash flo#s, The 5uestions to address under short(term financin4 are What is the reasonable le.el of cash to kee3 on hand to 3ay bills7 $o# much the firm should borro# in short term7 $o# much credit should be extended to the customers7 0urrent assets 0ash and other assets that are ex3ected to con.ert to cash #ithin one year Presented on balance sheet in order of their li5uidity
Cas( . e7ui!alents Marketa)le securities Accounts recei!a)les In!entories
0urrent liabilities Obli4ations that are ex3ected to re5uires cash 3ayment #ithin one year
Accounts pa+a)le E/penses pa+a)le 0including accrued <ages and ta/es1 Notes pa+a)le
The basic balance sheet identity can be #ritten as NW0 E /ixed assets H Lon4 term debt E E5uity #hile NW0 H =0ash E other current assets> ( 0urrent liabilities So 0ash H Lon4(term debt E E5uity E 0urrent liabilities ( 0urrent assets other than cash ( /ixed assets
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%ncreasin4 lon4(term debt %ncreasin4 e5uity %ncreasin4 current liabilities 2ecreasin4 current assets other than cash 2ecreasin4 fixed assets -cti.ities that decrease cash =uses of cash> 2ecreasin4 lon4 term debt 2ecreasin4 e5uity 2ecreasin4 current liabilities %ncreasin4 current assets other than cash %ncreasin4 fixed assets Sources of cash al#ays in.ol.e increasin4 a liability =or e5uity> account or decreasin4 an asset account 9ses of cash in.ol.e decreasin4 a liability or increasin4 assets, %s it a source or use7 %f accounts 3ayable 4o u3 by I1'' %f accounts recei.able u3 by I1''
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LESSON A'
/or a ty3ical manufacturin4 firm, short run acti.ities mi4ht consist of the follo#in4 se5uence of e.ents and decisions6 E.ents 2ecisions 1, &uyin4 ra# materials 1, $o# much in.entory to order7 *, Payin4 cash *, Whether to borro# or dra# do#n cash balances7 ?, !anufacturin4 the 3roduct ?, What choice of 3roduction technolo4y to use7
/or a ty3ical manufacturin4 firm, short run acti.ities mi4ht consist of the follo#in4 se5uence of e.ents and decisions6 E.ents 2ecisions A, Sellin4 the 3roduct A, Whether credit should be extended to a 3articular customer7 +, 0ollectin4 cash +, $o# to collect7 These acti.ities are
Uns+nc(roni-ed because 3ayment for 3urchases may not ha33en at the same time as the recei3ts of sales Uncertain because future sales and costs cannot be 3recisely 3redicted, 0onsider the follo#in4
chronolo4ical e.ents 2ay -cti.ity ' -c5uire in.entory on credit ?' Pay for in.entory K' Sell in.entory on credit 1'+ 0ollect on sale ,perating c+cle 0ash Effect None (I1,''' None EI1,A''
The time 3eriod bet#een the ac5uisition of in.entory and the collection of cash from recei.ables, =in our
exam3le, it is 1'+ days> In!entor+ period
The time it takes to ac5uire and sell in.entory, =in our exam3le, it is K' days>
Accounts recei!a)le period
The time bet#een sale of in.entory and collection of recei.able, =here, it is A+ days> So #e can describe the o3eratin4 cycle as6
O3eratin4 cycle H %n.entory 3eriod E -ccounts recei.able 3eriod 1'+ days H K' days E A+ days -n o3eratin4 cycle describes ho# a 3roduct mo.es throu4h the current asset accounts
%t be4ins life as in.entory 0on.erted to a recei.able #hen it is sold 0on.erted to cash #hen #e collect from the sale
Accounts pa+a)le period 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The
time bet#een recei3t of in.entory and 3ayment for it, =%n our exam3le #e 3ay for in.entory 3urchased after ?' days,> Cas( c+cle
The time bet#een cash disbursement and cash collection, =We s3end cash on day ?', but donZt collect until
day 1'+, so #e ha.e to arran4e finances I1,''' for 1'+ L ?' H )+ days>
Cas( paid for in!entor+ ,perating C+cle li5uidity reser.e in the form of cash or marketable securities,
Cas( recei!ed
The 4a3 bet#een the short(term inflo#s and outflo#s can be filled either by borro#in4 or by holdin4 a -lternati.ely, the 4a3 can be shortened by chan4in4 the in.entory, recei.able and 3ayable 3eriods
Managing ,perating C+cle Title of !ana4er 2uties Relatin4 Short(Term /inancial-ssetsULiabilities influenced !ana4ement 0ash !ana4er 0ollection, concentration, disbursementW short(0ash, marketable securities, short( term in.estmentW short(term borro#in4W bankterm loans relations 0redit !ana4er !onitorin4 and control of accounts recei.ableW-ccounts recei.able credit 3olicy decisions !arketin4 0redit 3olicy decisions -ccounts recei.able !ana4er Title of !ana4er 2uties Relatin4 Short(Term /inancial-ssetsULiabilities influenced !ana4ement Purchase !ana4er 2ecisions on 3urchases, su33liesW may ne4otiate%n.entory, accounts 3ayable 3ayment terms Production Settin4 3roduction schedules and materials%n.entory, accounts 3ayable !ana4er re5uirements Payables !ana4er 2ecisions on 3ayment 3olicies and on #hetheraccounts 3ayable to take discounts 0ontroller -ccountin4 info, on cash flo#sW reconciliation-ccounts recei.able, accounts of -U0 recei.ableW a33lication of 3ayments to3ayable -U0 recei.able Calculating ,perating and Cas( C+cle 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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-lso the most recent income statement 4i.es the follo#in4 =in thousands> Net Sales 0ost of 4oods sold %n.entory turno.er H 0ost of 4oods sold -.era4e %n.entory H IO,* million *,+ million H ?,*O times %n.entory 3eriod H ?K+ days %n.entory Turno.er H ?K+ H 111,? days ?,*O I11,+'' O,*''
%t means in.entory sat for 111 days before it #as sold No#, assumin4 that all sales #ere credit sales, the recei.ables turno.er is Recei.ables turno.er H 0redit Sales c
-.4, -U0 recei.able H I11,+ million 1,O million H K,A times
Recei.ables 3eriod H
The recei.able 3eriod is also called days; sales in recei.ables or a.era4e collection 3eriod, %t tells that our customers took an a.era4e +) days to 3ay, The o3eratin4 cycle is the sum of the in.entory and recei.able 3eriods
O3eratin4 cycle H %n.entory 3eriod E Recei.able 3eriod H 111 E +) H 1KO days
So on a.era4e, 1KO days ela3se bet#een the time #e ac5uire in.entory and ha.in4 sold it, collect for sale, Payables turno.er H 0ost of 4oods sold
-.era4e 3ayables H IO,* million H S,A times ,O)+ million
Payables 3eriod H
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0ash cycle is the difference bet#een the o3eratin4 cycle and the 3ayables 3eriod6
0ash 0ycle H O3eratin4 0ycle L -U0 Payables Period H 1KO L ?S H 1*S days
So on a.era4e, there is a 1*S(day delay from the time #e 3ay for merchandise to the time #e collect on the
sales,
SP 0om3any has the follo#in4 accountin4 fi4ures6 %tem &e4innin4 Endin4 %n.entory I+,''' I),''' -ccounts recei.able *,)'' *,A'' -ccounts 3ayable )+' A,O'' 0redit sales for the year #ere I+',''' and cost of 4oods sold #as I?',''' 0alculatin4 the three turno.ers6 %n.entory turno.er H I?','''UK,''' H + times Recei.able turno.er H I+','''U*,''' H *+ times Payable turno.er H I?','''U?,)+' H O times No# usin4 these to 4et the .arious 3eriods6 %n.entory 3eriod H ?K+U+ H )? days Recei.able 3eriod H ?K+U*+ H 1A,K days Payable 3eriod H ?K+UO H A+,K days O3eratin4 cycle H )? E 1A,K H O),K days 0ash cycle H O),K L A+,K H A* days
Interpreting Cas( C+cle
These calculations re.eal that cash cycle de3end on the in.entory, recei.able and 3ayables turno.er %ncreases if in.entory and recei.ables 3eriods 4et lon4er 2ecreases if 3ayable 3eriod is len4thened !ost firms ha.e a 3ositi.e cash cycle and they re5uire more financin4 for in.entories and recei.ables for
lon4er cash cycle
The
link bet#een the firm;s cash cycle and its 3rofitability is 3ro.ided by Total =SalesUTotal assets>, =ROE>,
-ssets Turno.er
The hi4her this ratio is, the 4reater are the firm;s accountin4 return on assets =RO-> and return on e5uity So, the shorter the cash cycle is, the lo#er is the firm;s in.estment in in.entories and recei.ables, Thus, the firm;s total assets and lo#er and total turno.er is hi4her,
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LESSON A1
/lexible 3olicy maintain a (ig( ratio of current assets to sales Restricti.e 3olicy maintain a lo< ratio of current assets to sales
/inancin4 of current assets
/lexible 3olicy less s(ort4term de)t and more long4term de)t Restricti.e 3olicy more s(ort4term de)t and less long4term de)t
%f 3olicies are flexible #ith re4ard to current assets
Mee3 lar4er cashUmarketable securities balances Lar4er in.estments in in.entory !ore liberal credit terms, thus hi4her accounts recei.able
%f 3olicies are restricti.e #ith re4ard to current assets
Mee3 lo#er cashUmarketable securities balances !ake smaller in.estments in in.entory Ti4ht or no credit sales, minimal accts, recei.able The o3timum le.el of in.estment in short term assets de3ends on a trade off bet#een the costs of a
restricti.e 3olicy a4ainst the costs of a flexible one
0urrent assets holdin4s are hi4hest #ith a flexible short term financial 3olicy and lo#est #ith a restricti.e
one,
So flexible 3olicies are costly as they re5uire 4reater in.estment in current assets, $o#e.er ex3ected future
cash(flo#s are hi4her too,
- restricti.e short(term financial 3olicy reduces future sales le.el than under flexible 3olicy, !ana4in4 short(term assets in.ol.es a trade(off bet#een carryin4 costs and shorta4e costs
Carr+ing costs
%ncrease #ith increased le.els of current assets are the costs to store and finance the assets, are the o33ortunity costs associated #ith current assets =in.entories .s, short term in.estments>
S(ortage costs
decrease #ith increased le.els of current assets are the costs to re3lenish assets Tradin4 or order costs =a.oidin4 stock(outs or cash(outs throu4h more fre5uent orders, etc,> 0osts related to lack of safety reser.es, i,e,, lost sales and customers and 3roduction sto33a4es
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Minimum point
Carr+ing costs
CAU CAU represents t(e o3timal amount of current assets, $oldin4 this amount minimi<es total costs,
A@ Fle/i)le polic+
Dollars
9inimum point
%otal cost
- flexible 3olicy is most a33ro3riate #hen carryin4 costs are lo# relati.e to shorta4e costs,
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S(ortagae
C<E
- restricti.e 3olicy is most a33ro3riate #hen carryin4 costs are hi4h relati.e to shorta4e costs, Alternati!e Financing *olicies /ocusin4 on the financin4 side of the 3icture, the total asset re5uirements for a 4ro#in4 firm may exhibit chan4e o.er time for many reasons
- 4eneral 4ro#th trend Seasonal .ariation around the trend 9n3redictable day(to(day and month(to(month fluctuations
%emporar+ current assets
Sales or re5uired in.entory build(u3 are often seasonal The additional current assets carried durin4 the B3eakC time The le.el of current assets #ill decrease as sales occur
*ermanent current assets
/irms 4enerally need to carry a minimum le.el of current assets at all times These assets are considered B3ermanentC because the le.el is constant, not because the assets aren;t sold
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Seasonal !ariations
Fixed assets
Time
%ime Policy / al#ays im3lies a short(term cash sur3lus and a lar4e in.estment in cash and marketable securities,
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%otal asset re7uirement
S(ort4term financing
ong4term financing
on!-term financin! Time
%ime Policy R uses lon4(term financin4 for 3ermanent asset re5uirements only and short(term borro#in4 for seasonal .ariations, "(ic( is t(e Best *olic+' Cas( >eser!es
3Pros L firms #ill be less likely to ex3erience financial distress and are better able to handle emer4encies or
take ad.anta4e of unex3ected o33ortunities
30ons L cash and marketable securities earn a lo#er return and are <ero NP1 in.estments
Maturit+ #edging
3Try to match financin4 maturities #ith asset maturities 3/inance tem3orary current assets #ith short(term debt 3/inance 3ermanent current assets and fixed assets #ith lon4(term debt and e5uity
Interest >ates
3Short(term rates are normally lo#er than lon4(term rates, so it may be chea3er to finance #ith short(term
debt
3/irms can 4et into trouble if rates increase 5uickly or if it be4ins to ha.e difficulty makin4 3ayments L may
not be able to refinance the short(term loans
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Marketa)le securities
With a com3romise 3olicy, the firm kee3s a reser.e of li5uidity #hich it uses to initially finance seasonal .ariations in current asset needs, Short(term borro#in4 is used #hen the reser.e is exhausted, Cas( Budget
/orecast of cash inflo#s and outflo#s o.er the next short(term 3lannin4 3eriod Primary tool in short(term financial 3lannin4 $el3s determine #hen the firm should ex3erience cash sur3luses and #hen it #ill need to borro# to co.er
#orkin4(ca3ital costs
-llo#s a com3any to 3lan ahead and be4in the search for financin4 before the money is actually needed Records the estimates of cash recei3ts =cash in> and disbursements =cash out>, PT %nc, s3eciali<es in toys and recei.es all income from sales Sales estimates =in millions> X1 H +''W X* H K''W X? H K+'W XA H O''W X1 next year H ++' -ccounts recei.able &e4innin4 recei.ables H I*+' -.era4e collection 3eriod H ?' days -ccounts 3ayable Purchases H +'T of next 5uarter;s sales &e4innin4 3ayables H 1*+ -ccounts 3ayable 3eriod is A+ days Other ex3enses Wa4es, taxes and other ex3ense are *+T of sales
8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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%nterest and di.idend 3ayments are I+' - ma:or ca3ital ex3enditure of I*'' is ex3ected in the second 5uarter The initial cash balance is I1'' and the com3any maintains a minimum balance of I+' -.era4e 0ollection Period H ?' days, this im3lies that *U? of sales are collected in the 5uarter made and
the remainin4 1U? are collected the follo#in4 5uarter
Payables 3eriod is A+ days, so half of the 3urchases #ill be 3aid for each 5uarter and the remainin4 #ill be
3aid the follo#in4 5uarter
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LESSON A*
Line of credit 0ommitted .s, Non committed 0ommitted bein4 formal arran4ements in.ol.in4 a commitment fee Non committed bein4 an informal channel in.ol.in4 lesser 3a3er #ork Re.ol.in4 credit arran4ement O3en for t#o or more years Letter of credit
Secured oans
-ccounts recei.able financin4 Assigning &orro#er is res3onsible e.en if recei.ables are not collected Factoring Recei.able is discounted and sold to lender =factor> #ho then bears the risk of default Maturit+ Factoring /actor for#ards the money on an a4reed(u3on future date Secured Loans %n.entory loans Blanket in!entor+ lien "i.es a lien a4ainst all the in.entories %rust receipt &orro#er holds s3ecific in.entory in BtrustC for the lenderW also called floor 3lannin4 Field <are(ouse financing -n inde3endent com3any s3eciali<ed in in.entory mana4ement acts as control a4ent Other Sources 0ommercial Pa3er
S(ort term notes issued )+ large and (ig(l+ rated firms
Trade 0redit
Increase t(e accounts pa+a)le period, dela+ing t(e pa+ments
A S(ort4%erm Financial *lan
PT %nc, arran4es to borro# any needed funds on short term basis, The interest rate is *'T -PR, calculated on 5uarterly basis =*'TUA H +T> There is no startin4 short term debt
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Cas( Balance Q3 &e4innin4 0ash &alance Net cash inflo# Endin4 cash balance !inimum cash balance 0umulati.e sur3lus =deficit> I*' A' IK' (1' I+' Q3 &e4innin4 cash balance Net cash inflo# Ne# short(term borro#in4 %nterest on short(term borro#in4 =+T> Short(term borro#in4 re3aid Endin4 cash balance !inimum cash balance 0umulati.e sur3lus =deficit> &e4innin4 short(term debt 0han4e in short(term debt Endin4 short(term debt the year, I? E ,A H I?,A, for a total of I*?,A Q5 IK' (11' (I+' (1' (IK' Q5 Q; (I+' ++ I+ (1' (I+ Q; QF I+ (1+ (I1' (1' (I*' %n !illion QF I1',' (1+,' 1+,A ',A ((((( I 1' 0 1' I',' O,' 1+,A I*?,A
I*' IK' A' (11' ((((( K' ((((( ((((( ((((( ((((( I K' I1' 0 1' 0 1' I +' ' ' ' ' K' I ' IK'
Endin4 short(term debt is e5ual to cumulati.e deficit for the entire year, I*' mill,, 3lus interest 3aid durin4 %n this 3lan, #e i4nored the tax deductibility of interest 3aid %nterest earnin4s on cash sur3lus This 3lan illustrates that financin4 the firm;s short term needs #ill cost about I?,A million in interest
before taxes for the year, Float and Cas( Management
The basic ob:ecti.e in cash mana4ement is to kee3 the in.estment in cash as lo# as 3ossible #hile still
o3eratin4 the firm;s acti.ities efficiently and effecti.ely,
0ollect early and 3ay late, /irm must in.est tem3orarily idle cash in short term marketable securities, ha.in4 lo#er default risk and
most are hi4hly li5uid
Reasons of holdin4 0ash Speculati!e Moti!e ( the need to hold cash to take ad.anta4e of additional in.estment o33ortunities,
such as bar4ain 3urchases, attracti.e interest rates and fa.orable exchan4e rater fluctuations,
Reser.e borro#in4 utility and !arketable securities %ransaction Moti!e ( the need to hold cash to satisfy normal disbursement
associated #ith a firm;s on4oin4 o3erations,
*recautionar+ Moti!e ( the need to hold cash as a safety mar4in to act as a financial reser.e
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The o33ortunity cost of excessi.e cash is the interest income that could be earned in the next best use The firm holds excessi.e cash to 3ro.ide li5uidity necessary for transaction needs, %ncase of cash(out
situation, the firm may ha.e to raise cash on a short(term basis by borro#in4 or sellin4 current assets,
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LESSON A?
The difference bet#een bank cash and book cash, re3resentin4 the net effect of che5ues in the 3rocess of
clearin4 is called float,
0he5ues #ritten by a firm 4enerate dis)ursement float, causin4 a decrease in the firm;s book balance but
no chan4e in its a.ailable balance,
"m %nc, has I1'',''' on de3osit #ith its bank, On une O, it buys some ra# material and 3ays #ith a che5ue for I1'',''', reducin4 the book balance by
I1'',''' immediately,
"!;s bank is una#are of this acti.ity until the che5ue is 3resented, say
balance is 4reater than it;s book balance by I1'',''',
&efore /orm
une O, the "!;s float is <ero6 /loat H /irm;s a.ailable balance L /irm;s book balance H I1'',''' L 1'',''' H' une O to une 1A, the 3osition is6 2isbursement /loat H /irm;s a.ailable balance L /irm;s book balance H I1'',''' L ' H 1'','''
0he5ues
collected by the firm create collection float, #hich increases book balances but does not immediately chan4e a.ailable balance,
%n 4eneral, the firm;s 3ayment acti.ities 4enerate disbursement float and its collection acti.ities 4enerate
collection float,
The net effect, the sum of both floats is the net float, e5ual to the o.erall difference bet#een the firm;s
a.ailable balance and its book balance,
%f net float is 3ositi.e, then the firm;s disbursement float exceeds its collection float and its a.ailable
balance exceeds its book balance, and .ice .ersa,
Su33ose you ha.e I+,''' on de3osit, One day, you #rite a che5ue for I1,''' and de3osit I*,''', What are your disbursement, collection and net floats7 -fter #ritin4 the che5ue, you sho# a balance of IA,''' on your books, but bank sho#s I+,''' #hile the
che5ue is clearin4, So you ha.e a disbursement float of I1,'''
2e3ositin4 I*,''' increases the book balance to IK,''', but the a.ailable balance remains the same until
the che5ue clears, So collection float is (I*,''',
Net float H I1''' E =(*,'''> H (I1,''' Cas( Collection S3eed u3 collection Reduce la4 bet#een the time customers 3ay their bills and time cash becomes a.ailable, Cas( &is)ursement 0ontrol 3ayments !inimi<e firm;s costs associated #ith makin4 3ayments
Total collection or disbursement time can be broken into three 3arts 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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Mailing time L the 3art of collection and disbursement 3rocess durin4 #hich che5ues are tra33ed in the *rocessing dela+ L the time it takes the recei.er of a che5ue to 3rocess the 3ayment and de3osit in a
bank for collection
A!aila)ilit+ dela+ L the time re5uired to clear a che5ue throu4h the bankin4 system
Electronic &ata Interc(ange 0E&I1
Electronically transfer financial information and funds bet#een 3arties, thereby eliminatin4 3a3er in.oices,
3a3er che5ues, mailin4 and handlin4
Len4th of time re5uired to initiate and com3lete a business transaction is shortened considerably, and float
is shar3ly reduced or eliminated, 0ash 0ollection
0ash recei.ed
Processin4 delay
0learin4 delay
!ail float
Processin4 float
0learin4 float
0ollection for 3ayments throu4h che5ues $a.in4 mailed all che5ues to one location $a.e different collection 3oints to reduce mailin4 time Outsource the collection 3rocess Preauthori<ed 3ayment system Lockboxes
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Local bank collects funds from PO &oxes En.elo3es o3enedW se3aration of checks and recei3ts
ock)o/ *rocessing
Cas( Concentration
0ash collections of firm ha.in4 many collection 3oints may end u3 in different banks and bank accounts,
The 3rocess of mo.in4 these amounts to main account is called cash concentration
&y routinely 3oolin4 its cash, the firm reduces the number of accounts that must be tracked, Normally, firms use concentration banks for this 3ur3ose,
Customer payments Firm sales office Local bank deposits Customer payments Statements are sent by mail to firm for receivables processing Post office lockbox receipts
Funds are transferred to concentration bank Concentration bank Firm cash manager Maintenance of cash reserves
Cash manager analyzes bank balance and deposit information and makes cash allocation revision.
Disbursements activity
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The 4oal in mana4in4 disbursement float is to slo# do#n the disbursements as much as 3ossible, The firm may ado3t some strate4ies to increase mail float, 3rocessin4 float and a.ailability float on the
che5ues it #rites, These strate4ies may include
Write check on a distant bank, $old 3ayment for se.eral days after 3ostmarked in office, 0all su33lier firm to .erify statement accuracy for lar4e amounts, !ail from distant 3ost office, !ail from 3ost office that re5uires a 4reat deal of handlin4
/irm 3re3ares check to su33lier
The
financial mana4ers must al#ays #ork #ith collected com3any cash balances and not #ith the com3any;s book balance, #hich reflects checks that ha.e been de3osited but not collected,
%f you are borro#in4 the bank;s money #ithout their kno#led4e, you are raisin4 serious ethical and le4al
5uestions,
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- disbursement account in #hich the firm maintains a <ero balance transferrin4 funds in from a master
account only as needed to co.er che5ues 3resented for 3ayment, >o Fero-balance accounts %<o -ero4)alance accounts
@ayroll account Supplier account 9aster account
@ayroll account
Supplier account
- disbursement account to #hich the firm transfers an amount that is sufficient to co.er demands for
3ayment, In!esting Idle Cas( - firm #ith sur3lus cash can 3ark it in the money market,
!ost lar4e firms mana4e their o#n short(term financial assets, transactin4 throu4h banks and dealers, Some lar4e firms and many small ones use money market mutual funds =funds that in.est in short term
financial assets for some fee>,
/irms ha.e sur3lus cash mostly for t#o reasons6 Seasonal or 0yclical -cti.ities Planned Ex3enditures
&ollars Marketa)le securities Bank loans S(ort4term financing %otal financing needs
ong4term financing
%
%ime
%ime 07uarters1
3: - sur3lus cash 3osition exists, Seasonal demand for current assets is lo#, The sur3lus is in.ested in short(term marketable securities, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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5: deficit cash flo# exists, Seasonal demand for assets is hi4h, The financial deficit is financed by the sellin4 of marketable securities and bank borro#in4, Credits and >ecei!a)les
The ob.ious reason for 4rantin4 credit to the customers is to stimulate sales, The costs associated #ith 4rantin4 assets are not tri.ial 0hance that customer #ill not 3ay 0ost of carryin4 the recei.ables 0redit 3olicy decisions in.ol.e a trade(off bet#een the benefits of increased sales and costs of 4rantin4
credit 0ustomer mails check &ank credits firm;s account
Terms of sale
0onditions under #hich a firm sells its 4oods and ser.ices for cash or credit,
0redit -nalysis
The 3rocess of determinin4 the 3robability that customers #ill or #ill not 3ay,
0ollection Policy
Procedures follo#ed by a firm in collectin4 accounts recei.able The terms of sale of com3osed of
- buyer 3laces an order for I1,''' under the terms *U1', net K', $e has the o3tion of 3ayin4 I1,''' x =1 ( ,'*> H ISO' in 1' days, or 3ayin4 the full I1,''' in K' days, %n 4eneral, the credit terms are inter3reted as6
=take this discount off the in.oice 3rice>U=if you 3ay in this many days >, =else 3ay the full amount in this many days> 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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LESSON AA
The basic len4th of time for #hich the credit is 4ranted, %f a cash discount is offered, then credit 3eriod has t#o com3onents Net credit period B len4th of time customer has to 3ay Cas( discount period B time durin4 #hich discount is a.ailable %n.oice date is the shi33in4 date or billin4 date of in.oice, a #ritten account of merchandise shi33ed to
the buyer,
T#o
most im3ortant factors influencin4 the len4th of credit 3eriod are buyer;s in.entory 3eriod and o3eratin4 cycle, The shorter these are, the shorter the credit 3eriod #ill be
We kno# that o3eratin4 cycle has t#o com3onents %n.entory 3eriod Recei.ables 3eriod &y extendin4 credit #e finance a 3ortion of our buyer;s o3eratin4 cycle and shorten the buyer;s cash cycle %f our credit 3eriod exceeds the buyer;s in.entory 3eriod, #e are not only financin4 buyer;s in.entory
3urchases but 3art of the buyer;s recei.ables as #ell
%f
our credit 3eriod exceeds buyer;s o3eratin4 cycle, then #e are 3ro.idin4 financin4 for customer;s business beyond the immediate 3urchase and sale of our merchandise
&uyer has a loan from us e.en after the merchandise is resold - number of other factors #hich influence the credit 3eriod are6 Perish ability and collateral .alue
*eris(a)le items (a!e rapid turno!er and lo< collateral !alueQ t(us credit periods for t(ese goods
are s(orter
0onsumer demand
"ell esta)lis(ed products (a!e rapid turno!er@ "(ile ne<er or slo< mo!ing products <ill re7uire
longer credit periods@
0redit risk
#ig(er credit risk of t(e )u+er <ill lead to s(orter credit period
0ustomer ty3e
,n case4to4case )asis
0ash discounts - discount 4i.en to induce 3rom3t 3ayment, %t is also called sales discount
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This #ill ha.e the effect of reducin4 the amount of credit offered, and firm must trade this off a4ainst cash &uyer only credit after the discount ex3ires This is a #ay to char4in4 hi4her 3rices on credit sales -n exam3le #ould be B?U1' net ?'C The customer can take a ?T discount if he 3ays #ithin 1' days, %n any e.ent, he must 3ay #ithin ?' days, - firm offerin4 credit terms of ?U1' net ?' is essentially offerin4 their customers a *'(day loan, To see this, consider a firm that makes a I1,''' sale on day ' Some customers #ill 3ay on day 1' and take the discount,
)780 0 10 60
Other customers #ill 3ay on day ?' and for4o the discount
)19000 0
interest6
10
60
- customer that for4oes the ?T discount to 3ay on day ?' is borro#in4 IS)' for *' days and 3ayin4 I?'
:)780 0 10 ;)19000 60
$
r
S)'
I 1
*' ?K+ =1 + r 3
I 1
'''
=1 + r >
365
I S)'
I 1, ''' 20 =a 1 I S)'
' ; )A?+ a
= )A ; ?+ T
Credit instrument
%t is a basic e.idence of indebtness !ost credit is offered on open account @ the in.oice is the only credit instrument, *romissor+ notes are %O9s that are si4ned after the deli.ery of 4oods Commercial drafts call for a customer to 3ay a s3ecific amount by a s3ecific date, The draft is sent to the
customer;s bank, #hen the customer si4ns the draft, the 4oods are sent,
Banker6s acceptances allo# a bank to substitute its credit#orthiness for the customer, for a fee, 0onditional sales contracts let the seller retain le4al o#nershi3 of the 4oods until the customer
com3leted 3ayment, 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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The o3timal amount is determined by the 3oint at #hich the incremental cash flo#s from increased sales
are exactly e5ual to the incremental costs of carryin4 the increased in.estment in accounts recei.able,
The carryin4 costs associated #ith 4rantin4 credit are of three ty3es The re5uired return on recei.ables The losses from bad debts The cost of mana4in4 credit and credit collection L ex3ense associated #ith runnin4 the credit de3artment, /or a restricti.e credit 3olicy, all abo.e costs #ill be lo#, Shorta4e of credit #ill be an o33ortunity cost of extra 3otential 3rofit from credit sales that is lo# because
credit is refused,
This for4one benefit comes from %ncrease in 5uantity sold $i4her 3rices $arrying costs are the cash flo#s that must be incurred #hen credit is 4ranted, They are 3ositi.ely related to
the amount of credit extended,
Opportunity costs are the lost sales from refusin4 credit, These costs 4o do#n #hen credit is 4ranted, The sum of carryin4 costs and o33ortunity costs is called the credit cost cur.e
Cost 0E1 ,ptimal amount of credit %otal costs
CE
(#ade C#edit is -o#e li1el! to "e /#anted i*4
The sellin4 firm has a cost ad.anta4e o.er other lenders, The sellin4 firm can en4a4e in 3rice discrimination, The sellin4 firm can obtain fa.orable tax treatment, The sellin4 firm has no established re3utation for 5uality 3roducts or ser.ices, The sellin4 firm 3ercei.es a lon4(term strate4ic relationshi3, The o3timal credit 3olicy de3ends on the characteristics of 3articular firms, Excess ca3acity
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0redit analysis refers to the 3rocess of decidin4 #hether or not to extend credit to a 3articular customer "ather rele.ant information 2etermine credit#orthiness 0redit %nformation /inancial statements 0redit re3orts on customer;s 3ayment
history #ith other firms
&anks 0ustomer;s 3ayment history #ith the firm 0redit E.aluation6 The traditional + 0;s of credit 0haracter ( Willin4ness to 3ay 0a3acity ( -bility to 3ay 0a3ital ( /inancial reser.es 0ollateral ( Pled4ed assets 0onditions ( Rele.ant economic conditions 0redit scorin4 refers to the 3rocess of calculatin4 a numerical ratin4 for a customer based on information
collectedW credit is then 4ranted or refused based on the result, Collection *olic+
$ollection refers to obtainin4 3ayment on 3ast(due accounts, 0ollection Policy is com3osed of The firm;s #illin4ness to extend credit as reflected in the firm;s in.estment in recei.ables, 0ollection Effort To kee3 track of the 3ayments by the customers, the firm focuses on its -.era4e 0ollection Period =-0P> -lternati.ely, -4in4 Schedule can also be used to monitor the recei.ables, #hich classifies credit accounts
by a4e,
Su33ose a firm has I1'',''' in recei.ables, Some of the accounts are only a fe# days old, but others ha.e
been outstandin4 for 5uite sometime,
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%f this firm has a credit 3eriod of K' days, then *+T of its accounts are late,
The seriousness of the case de3ends on the nature of firm;s collections and customers, The lon4er an account has been un3aid, the less likely it is to be 3aid, Percenta4es on a4in4 schedule kee3 chan4in4 for the firms #ith seasonal sales, 0ollection Effort !ost firms follo# a 3rotocol for customers that are 3ast due6 Send a delin5uency letter, !ake a tele3hone call to the customer, Em3loy a collection a4ency, Take le4al action a4ainst the customer, /irm may refuse to 4rant additional credit to customers until arreara4es are cleared u3,
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LESSON A+
We kno# that firm;s o3eratin4 cycle is made u3 of its in.entory 3eriod and its recei.ables 3eriod, &oth credit 3olicy and in.entory 3olicy are used to deri.e sales, and thus must be coordinated to ensure
the 3rocess of ac5uirin4 P sellin4 in.entory and collectin4 on sale 3roceeds smoothly,
%n.entory Ty3es Ra# !aterial L startin4 3oint in 3roduction 3rocess Work(in(Pro4ress L si<e of this in.entory de3ends on the len4th of 3roduction 3rocess /inished "oods One com3any;s ra# material can be another;s finished 4ood, Steel Sheets and -utomobile !anufacturin4 1arious ty3es of in.entory can be 5uite different in terms of their li5uidity 0ommodity(like or standardi<ed ra# materials are easily con.erted to cash Work(in(3ro4ress can be 5uite illi5uid 2emand of an in.entory item that becomes a 3art of another item is termed as 2eri.ed or 2e3endant
2emand
The firm;s demand for finished 4oods not deri.ed from demand for other in.entory items %n.entory 0osts 0arryin4 costs include all direct and o33ortunity costs of kee3in4 in.entory on hand Stora4e and trackin4 costs %nsurance and taxes Losses due to obsolescence, deterioration, or theft O33ortunity cost of ca3ital for the in.ested amount %n.entory 0osts Shorta4e costs are associated #ith ha.in4 inade5uate in.entory on hand >estocking costs B costs of 3lacin4 an order #ith su33liers or the cost of settin4 u3 a 3roduction run Safet+ reser!e costs B o33ortunity losses from ha.in4 inade5uate in.entory e,4, lost sales and 4ood#ill - trade(off 0arryin4 costs increase #ith in.entory le.els and shorta4e or restockin4 costs decline #ith in.entory le.els The 4oal of in.entory mana4ement is to minimi<e the sum of these t#o costs
ABC Approac(
&asic
4rou3s, .alue,
idea in this a33roach of in.entory mana4ement is to di.ide the in.entory into three =or more>
- small 3ortion of in.entory in terms of 5uantity mi4ht re3resent a lar4e 3ortion in terms of in.entory - 3roduction 3rocess in.ol.in4 ex3ensi.e, hi4h(tech com3onents as #ell as relati.ely inex3ensi.e basic
materials
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Economic ,rder Quantit+ Model Economic order 5uantity =EOX> model is the best kno#n a33roach to ex3licitly establish an o3timal in.entory le.el Cost of (olding in!entor+ 0E1 %otal costs of (olding in!entor+ Carr+ing costs
-ctual cost of in.entory is not included as the total amount of in.entory the firm needs in a 4i.en year is
dictated by sales
$ere #e are tryin4 to determine the order si<e the firm should use #hen it restocks its in.entory -ssumin4 that the firm;s in.entory is sold off at a steady rate until it hits <ero, -t that 3oint firm restocks
back to some o3timal le.el
Su33ose a firm starts off today #ith ?,K'' units of a 3articular item in in.entory, -nnual sales of this item
are AK,O'' units =about S'' 3er #eek>,
With this 3ace of #eekly sales, all the a.ailable in.entory #ill be sold after four #eeks, and the firms #ill
restock by orderin4 =or manufacturin4> another ?,K'' units and start o.er,
This sellin4 and restockin4 3rocess 3roduces a sa#tooth 3attern for in.entory holdin4s6
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Q T 5 H 3,H99
A!erage in!entor+
Ending in!entor+: 9
"eeks 9 3 5 ; F K I 8 H
We ha.e seen that carryin4 costs are assumed to be directly 3ro3ortional to in.entory le.els, %f #e let 00 be the carryin4 cost 3er unit 3er year, the firm;s total carryin4 costs #ill be6
Total carryin4 costs H -.4, N carryin4 in.entory costs 3er unit H =XU*> N 00
/or carryin4 costs of I',)+ 3er unit 3er year total carryin4 costs #ill be 1,O'' N ',)+ H I1,?+' 3er year %n case of shorta4e costs #e #ill focus only on restockin4 costs, assumin4 that firm ne.er runs short of
in.entory,
Restockin4 costs are normally assumed to be fixed, No#, let T be the firm;s total unit sales 3er year, %f firm orders 5 units each time, it #ill need to 3lace a
total of TUX orders,
%n our exam3le this number #ould be AK,O'' U ?,K'' H 1? orders 3er year %f fixed cost 3er order is /, then total restockin4 costs for the year #ill be6
Total restockin4 costs H /ixed costs N Number of 3er order orders H / N =TUX>
%n our exam3le order costs mi4ht be I+' 3er order, so total restockin4 costs for 1? orders #ill be I+' N 1?
H IK+' 3er year, Total costs H carryin4 costs E restockin4 costs H =XU*> N 00 E / N =TUX>
To find the .alue of X, the restockin4 5uantity, that minimi<es this cost, #e calculate the total costs for
some different .alues of X,
We had carryin4 costs =00> of I',)+ 3er unit 3er year, fixed costs =/> of I+' 3er order and total unit sales
=T> of AK,O'' units, Restockin4 XuantityTotal carryin4 costsRestockin4 0osts =X> =XU* N 00> =/ N TUX> Total 0osts +'' I 1O),+ IA,KO',' IA,OK),+ 1,''' ?)+,' *,?A',' *,)1+,' 1,+'' +K*,+ 1,+K',' *,1**,+ *,''' )+',' 1,1)',' 1,S*',' 8 0o3yri4ht 1irtual 9ni.ersity of Pakistan
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To find the 3recise cost(minimi<ation 5uantity #e take a look at the basic EOX !odel dia4ram,
Cost of (olding in!entor+ 0E1 %otal costs of (olding in!entor+ Carr+ing costs
@e can *ind the -ini-u- oint Aust "! equatin/ ca##!in/ and #estoc1in/ costs and solvin/ *o# BC
0arryin4 costs H Restockin4 0osts =XgU*> x 00 H / N =TUXg>
Rearran4in4
=Xg>* H *T x / U 00
Or
Xg H =*T x / U 00>1U*
This reorder 5uantity #hich minimi<es the total in.entory cost is called the Economic order 5uantity
=EOX>,
Carr+ing Costs R Shoes be4ins each 3eriod #ith 1'' 3airs of hikin4 boots in stock, #hich is de3leted each 3eriod and
reordered, %f carryin4 cost 3er 3air of boots 3er year is I?, #hat are the total carryin4 costs for hikin4 boots7
-.era4e in.entory is 1'' U * H +' items, -t an annual cost of I? 3er item, total carryin4 costs are I1+' >estocking Costs Su33ose R Shoes sells a total of K'' 3airs a year, $o# many times 3er year does the com3any restocks7 %f the restockin4 cost is I*' 3er order, #hat are total restockin4 costs7 R Shoes restocks K'' U 1'' H K times 3er year or about e.ery t#o months The restockin4 costs #ill be K orders x I*' 3er order H I1*'
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What si<e orders shout R Shoes 3lace to minimi<e costs7 $o# often #ill the com3any restock7 What are $ere T H K'', / H I*', 00 H I?, so EOX for R shoes is
EOX H =*T x / U 00>1U* H \=* x K''> x I*' U ?] h OS,AA units H
Since R shoes, sells K'' 3airs 3er year, it #ill stock U OS,AA H K,)1 times The total restockin4 costs #ill be I*' x K,)1 H I1?A,1K, -.era4e in.entory #ill be OS,AA U * H AA,)* The carryin4 costs #ill be I? x AA,)* I1?A,1K, the same as restockin4 costs Total costs are thus I*KO,?? %n reality, firms #ish to reorder before its in.entory runs do#n to <ero /irms minimi<e the risk of stock(out /irm co.ers the lead time bet#een order and deli.ery Safety stock The minimum le.el of in.entory that a firm kee3s on hand, in.entories
in.entory falls to the safety stock le.el In!entor+ 0units1
These are the times at #hich the firm #ill actually 3lace its in.entory orders e.en before reachin4 critical
le.el
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&eli!er+ time
>eorder point
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