Chapters 1-5 Exam Training

Chapter 1
Introduction to Corporate Finance
The firm as a balance sheet
3 Questions:
Which assets to buy? (Capital Budgeting)

How to raise cash? (Capital Structure)
How to manage short term cash flows? (Net working capital)
Finance Crash Course 2012
The firm as a pie (Capital Structure)
We think of the firm as a pie. It shows us how the firm is

sliced up between debt- and equity holders.
In Essence: V=B+S (which is BS), better V=D+E
Value creation
Note: Accounting profits and cash flows are fundamentally

different!
Goal of Finance: Maximize share price of the company
Basic principles of Finance

Again: 100 today is worth more than 100 in a year.
Why?
Three main reasons
Interest is forgone: Your money has earnings potential.You

could invest it at 5% p.a. today and have 105 in one years
time
Inflation:Your 100 will very likely be worth less in one year,
because inflation decreases its buying power. (Note: nominally,
youll still have 100)
Risk: How can you know, that you will actually receive 100 in
one year? Even with the best contract, you might have to fight
for it in court.
Quiz
Should you pay SEK100,000 every month for one year or

pay SEK1,200,000 at the end of the year?
Intuitively: Time value of money!

Nominally the same (12x100,000=1,200,000)
However, paying SEK100,000 every month means, cash
will leave your firm more quickly than if you would pay
SEK1,200,000 in one year! You forgo the earnings
potential of SEK100,000 every month with the first plan.
The later you pay the better!
Solution: Pay SEK1,200,000 at the end of the year!
Quiz
End of
Month
Total PV
Annuity [SEK]
PV
Lump Sum [SEK]
PV
1
100.000 /(1+0.01)1
99009,90
2
100.000 /(1+0.01)2
98029,60
3
100.000 /(1+0.01)3
97059,01
4
100.000 /(1+0.01)4
96098,03
5
100.000 /(1+0.01)5
95146,57
6
100.000 /(1+0.01)6
94204,52
7
100.000 /(1+0.01)7
93271,81
8
100.000 /(1+0.01)8
92348,32
9
100.000 /(1+0.01)9
91433,98
10
100.000 /(1+0.01)10
90528,70
11
100.000 /(1+0.01)11
89632,37
12
100.000 /(1+0.01)12
88744,92
1.200.000 /(1+0.01)12 1064939,07
1125507,75
1064939,07
Quiz
Quiz: What if you had to pay SEK1,400,000 at the end of
the year?
We dont know, unless we have the discount rate.
If the discount rate is very high->pay at the end of the year

If it is low-> better to pay earlier, but nominally less
Chapter 2
Corporate Governance
Business Forms
Sole Proprietorship
Owned by one person

Pays no corporate taxes
Unlimited Liability, Limited Lifespan
Partnership
10
Limited and General partners

Pays no corporate taxes
Controlled by general partners
Business Forms
Corporation
11
Legal entity: Limited Liability for investors

Owned by shareholders
Potentially eternal lifespan
Private or public
Double taxation
Requires articles of incorporation to form
Corporate Governance for Corporations
Agency relationship between managers and shareholders:

How to ensure that managers act in the best interest of
shareholders?
Agency costs:
Perquisites
Shirking
Pet projects Most expensive of them all!
Monitoring through boards (one-tier or two-tier)

Monitoring through large shareholders: banks, institutional
investors (bank vs. market-based financial system)
Bonding: Share options
12
Quiz
What are the advantages and disadvantages of a

corporation over a sole proprietorship?
Advantages:
Easy access to financing

Limited Liability
Legal Entity
Disadvantages
13
Double taxation
Agency problems
Quiz
In case of bankruptcy who gets paid last?

Share holders are the residual claimants. They get
whatever is left.
14
Chapter 3
Financial Statement Analysis
The Balance sheet
Assets
Liabilities
Current: Inventories, Trade receivables, Cash

Non-Current: Property, plant and equipment, Intangible assets
Current: Trade payables
Non-Current: Long term debt
Equity: issued share capital, share premium, retained

earnings
Generally: Assets=Equity+Liabilities
16
Definitions
Assets
Liabilities
Controlled by the firm

Provide future benefit
Can be tangible and intangible
Present obligations
Expected outflow of benefits
Equity
17
Residual claim after deduction of liabilities
Income Statement
Revenue Cost of goods sold=Gross profit

Gross profit Operating and administrative
expenses=EBIT
EBIT interest payments=EBT
EBT taxes=Net income
18
Definitions
Expenses
Decrease in assets or liabilities that result in decrease of equity

Within the ordinary course of business
Expenses or losses
Income
19
Increase in assets or liabilities that result in increase of equity

Within the ordinary course of business
Revenue or gains
Cash Flow statement
Cash provided by:
20
operating activities: principal revenue generating activities in

the firm (providing service, selling good)
Investing activities: increase or decrease in non-current assets
(PPE, intangible assets, other companies), generate future
income
Financing activities: cash to and from equity and debt holders
(issuing shares, dividends, borrowing)
Quiz
Which of these is an asset?
21
A new manager hired to increase sales

A patent
A plant the firm rents to serve excess demand
Cash on the bank account
A new floor waxing machine in the HR department
Quiz
Asset definition:
Controlled by the firm

Provide future benefit
Can be tangible and intangible
Manager: Not controlled

Patent: asset
Rented plant: Expense, because not controlled
Cash: by definition an asset (albeit short-term)
Waxing machine: definitely asset
22
Taxes
Average tax rate for a firm:
The tax bill divided by taxable income

Actual percentage of taxes paid
Marginal tax rate:
23
Tax charge on last earned Euro
Quiz
Aerosol BV earned 452,000 of taxable income last

year. The average industry tax rate is 22.5%.The
applicable tax regime looks as follows:
Bracket
Applicable Tax rate
0-70,000
18%
70,001-220,000
19.5%
220,001-500,000
23%
>500,000
25%
What is the marginal tax rate for Aerosol BV?
24
Quiz
Bracket
Applicable Tax rate
0-70,000
18%
70,001-220,000
19.5%
220,001-500,000
23%
>500,000
25%
Marginal tax rate is the rate paid on the last earned Euro!
In this case: 23%
What would be the average tax rate?
25
Quiz
For the average tax rate, we calculate:

Taxable Income
Applicable Tax
Rate
Tax Paid
70,000
18%
12,600
220,000-70,000
19.5%
29,250
452,000-220,000 23%
53,360
SUM
95,210
We then divide the paid taxes by our earnings to find the

average tax rate:
95,210/452,000=21.06%
26
Financial Ratios
Liquidity (short term solvency):
27
Current ratio: Current asset/Current Liabilities

Should be at least 1, measures ability to pay the bills
Quick ratio: (CA-Inventory)/CL
Inventory often least liquid current asset
Cash ratio: Cash/CL
Quiz
Which one is usually largest, Current, Quick or Cash

ratio?
Current ratio, because the numerator includes all current

assets
What happens to the Current ratio, if I use cash to pay off

short term debt? What if I buy Inventory with Cash?
28
In the first case: It moves away from 1 (If >1 it becomes larger,
if <1 it becomes smaller)
Second case: Nothing happens: Cash decreases, Inventory
increases, so Current Assets dont change
Financial Ratios
Long Term Solvency
Total debt ratio: Total debt/Total assets= D/(E+D)

Debt-Equity Ratio: Total debt/Total Equity=D/E
Equity multiplier: Total assets/Total equity =(D+E)/E or 1+D/E
They are all related! If you know one, you can calculate
the others!
29
Quiz
What is the Total debt ratio, when the Equity multiplier is

2.1?
30
We know that the equity multiplier is the inverse of the ratio

of equity to assets:
Ratio
Definition
Equity Multiplier
(D+E)/E
Equity to Assets
E/(D+E)
We can thus take the inverse 1/2.1=47.62% and subtract it

from 1 to arrive at
D/(D+E)=1-47,62%=52.38%
Quiz
Alternatively we know that the Equity multiplier is 1 plus

the debt equity ratio, so the debt equity ratio is 2.11=1.1.
Since D/E=1.1/1 we know that D/(D+E)=1.1/2.1=52.38%
31
Financial Ratios
Long Term Solvency
32
Total debt ratio: Total debt/Total assets= D/(E+D)

Debt-Equity Ratio: Total debt/Total Equity=D/E
Equity multiplier: Total assets/Total equity =(D+E)/E or 1+D/E
Times interest earned ratio: EBIT/Interest
Interest Coverage
Cash Coverage: (EBIT+Depreciation)/Interest
Depreciation added back because its not a cash outflow
Financial Ratios
Asset Management or Turnover
33
Inventory turnover: COGS/Inventory

Times inventory is turned over per year
Days sales in inventory: 365/Inventory Turnover
How many days between a turnover
Receivables turnover: Sales/Trade receivables
Times trade receivables are collected per year
Days sales in inventory: 365/Receivables Turnover
Also Average Collection Period
Total Asset Turnover: Sales/Total Assets
How much sales for every euro in assets
Financial Ratios
Profitability
Profit Margin (PM): Net income/Sales

Return on Assets (ROA): Net income/Total Assets
Return on Equity (ROE): Net income/Total Equity
The Du Pont Identity:
34
ROE = ROA * (1+ debt-equity ratio)

ROA=PM*Total asset turnover
ROE=PM*Total asset turnover*(1+debt-equity ratio)
Quiz
You have the following information:
Profit=120,000
Assets=500,000
Receivables turnover=7.1
Trade receivables=50,000
40% debt in the capital structure
What is the ROE?
35
Quiz
Redundant information! We dont need to find sales,

because we can calculate ROA directly:
ROA=120,000/500,000=24%
Now we need the equity multiplier. We know that there
is 40% debt, so equity must be 60%. Since the equity
multiplier is the inverse of the equity percentage:
EM=1/0.60=1.67
Through the Du Pont Identity we find:
ROE=0.24*1.67=0.4
Actually, we could have done this even more quickly.
How?
36
Long-Term Financial Planning
How much additional money do we need to finance

growth?
Percentage of Sales approach assumptions:
37
Assets grow at the same rate as sales

Spontaneous (current) liabilities grow at the same rate as sales
Equity grows by retained earnings
We can then calculate EFN as
3.23 External Funds Needed
Lets try to understand the formula

Assets
(
) * Sales
The increase in assets due to the growth in
Sales
sales
Spont.Liabilitie s
(
) * Sales
The spontaneous increase in debt financing
Sales
(decreases the need for External Funds)
Retained Earnings, part of the
profit that is not paid out as dividend ( PM * ExpectedSa les ) * (1 d )
(d is the payout ratio of dividends)
38
Internal growth rate:

ROA*b/(1-ROA*b) where b is the retention ratio
This is the growth rate achievable with internal financing
only (retained earnings)
Sustainable growth rate:
ROE*b/(1-ROE*b)
The growth rate achievable without increasing financial
leverage (D/E ratio)
39
Quiz
Where is the internal growth rate here?
IGR
40
Determinants of Growth
Profit Margin: Increases the ability to generate funds

internally and thus the growth rate
Dividend Policy: Increasing the retention ratio also
increases growth rate
Financial Policy: More debt makes additional debt available
Total Asset Turnover: The more efficiently the assets are
used, the fewer I need to generate sales
41
Chapter 4
Discounted Cash Flow Valuation
Present Value
How much must I invest today at a given rate to achieve a

certain outcome in the future?
For Example: Keith wants to have 11,424 in one year. If
he can invest at a yearly rate of 12%, how much must he
invest today?
Answer: PV*1.12= 11,424. Solving for PV, we get PV=
11,424/1.12= 10,200
So at 12% yearly rate, 11,424 in one year is worth
10,200 today
43
Present and Future Value
For a single cash flow in the future, we generally get :

t=0
t=T
P
V
FV
This also work the other way around:

t=0
P
V
44
t=T
FV
Compounding Periods
I could also have multiple period in one term (e.g. months

in a year)
If only the nominal yearly rate is given, we can adjust for
this:
As soon as we switch from discrete to continuous
compounding, we get:
45
Compounding Periods
The more periods, the stronger the compounding effect
46
Quiz
What is the effective annual rate of interest (EAR) if we

receive 6% nominal annual rate compounded quarterly?
What if we compound continuously?
47
Discounting
What if we have more than one cash flow?

If we have similar cash flows in equal intervals forever, we
use a perpetuity
t=0
t=1
t=2
P
V
t=3
C
t=4
t=5
t=6
Note that discounting formulas work on period back!

Youll get the value of the cash flows that start in t=1 in
t=0.
48
Discounting
To find the present value of a series of equal cash flows,

that is constrained to a certain number of periods (say T),
we have the annuity formula.
49
t=0
t=1
t=2
P
V
t=3
t=4
t=5
t=6
t=T
Discounting
How can we adjust this formula for multiple

compounding periods?
There is also a version for Future Values:
50
Quiz
What is the present value of an investment that pays

5,000 per year in semi-annual installments for 10 years if
the discount rate is 8%?
Here we also have to adjust the cash flow, because we
receive semi-annual payments, so 2,500. We then use the
formula:
51
Discounting
What if either a perpetuity or and annuity gives us cash

flows that grow at a constant rate (say g)?
52
t=0
t=1
PV
t=2
t=3
C (1+g) C (1+g)
Discounting
Finally, what if one of the cash flows is already due today

(annuity due)?
t=0
t=1
t=2
PV+C
t=3
C
t=4
t=5
t=T
Note: WE DONT SIMPLY INCREASE T BY 1!
53
Quiz
How do we find the present value today of a series of

cash flows that starts in 4 years and keeps paying them
forever after?
t=0
PV0
t=1
t=2
t=3
PV3
t=4
t=5
t=6
First we use a perpetuity to find PV in t=3!

Then we bring this value back 3 years to t=0.
54
Valuing Investments
Net present value: Discounted future cash flows minus

investment today:
Invest only if positive
55
Chapter 5
How to value Bonds and Shares
Types of Bonds
Three common types of bonds
Most typical: Level coupon bond
57
Level coupon bonds
Pays a percentage of the face value as coupon (coupon

rate)
Repays the face value at maturity
What is the relationship between interest rate and the
coupon rate?
If interest rate < coupon rate: Bond sells at a premium

If interest rate > coupon rate: Bond sells at a discount
If interest rate = coupon rate: Bond sells at par!
Value of a coupon bond:
58
Quiz
How would we value a pure discount bond and a consol?

Pure discount bond is only one cash flow in the future:
Consols are a perpetuity:
59
Level coupon bonds
The Required Return on a bond is also called Yield to

Maturity or simply Yield
The Yield is the Rate of Return that equates the bonds
market price and the PV of its cash flows.
60
Valuing shares
Value of a firms equity is equal to the PV of all future

dividends
We also call this the Dividend Growth Model

61
Quiz
A firm will pay 12 dividend per share next year and

promises that the dividends will grow constantly at 5%
each year. If the discount rate is 8%, what is the share
price?
We use the Dividend Growth Model
We get
62
Growth rate and Return
Where does g come from?
Growth is fueled by retaining earnings and by ROE

(remember the sustainable growth rate?)
What about R?
The return is split into Dividend yield and capital gains

yield (growth of the investment)
63
NPVGO model
Alternatively we can value shares like this
We assume the firm acts as a cash cow and pays out all
earnings as dividends
Valid under the condition that EPS is known and stable
In order to create value, the NPVGO must be positive
64
P/E Ratio
The NPVGO model can be rewritten into a P/E ratio:
The P/E ratio is a reflection of the equities risk (1/R) and

its growth opportunities
Thats why high growth industries like semiconductors
have higher P/E ratios than for example utilities
65

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Chapter 1

Introduction to Corporate Finance

The firm as a balance sheet

Which assets to buy? (Capital Budgeting)

The firm as a pie (Capital Structure)

We think of the firm as a pie. It shows us how the firm is

Finance Crash Course 2012

Note: Accounting profits and cash flows are fundamentally

Finance Crash Course 2012

Basic principles of Finance

Interest is forgone: Your money has earnings potential.You

Should you pay SEK100,000 every month for one year or

Intuitively: Time value of money!

Finance Crash Course 2012

Finance Crash Course 2012

If the discount rate is very high->pay at the end of the year

Finance Crash Course 2012

Owned by one person

Limited and General partners

Finance Crash Course 2012

Legal entity: Limited Liability for investors

Finance Crash Course 2012

Corporate Governance for Corporations

Agency relationship between managers and shareholders:

Monitoring through boards (one-tier or two-tier)

Finance Crash Course 2012

What are the advantages and disadvantages of a

Easy access to financing

Finance Crash Course 2012

In case of bankruptcy who gets paid last?

Finance Crash Course 2012

The Balance sheet

Current: Inventories, Trade receivables, Cash

Equity: issued share capital, share premium, retained

Finance Crash Course 2012

Controlled by the firm

Residual claim after deduction of liabilities

Finance Crash Course 2012

Revenue Cost of goods sold=Gross profit

Finance Crash Course 2012

Decrease in assets or liabilities that result in decrease of equity

Increase in assets or liabilities that result in increase of equity

Finance Crash Course 2012

Cash Flow statement

Cash provided by:

operating activities: principal revenue generating activities in

Finance Crash Course 2012

Which of these is an asset?

A new manager hired to increase sales

Finance Crash Course 2012

Controlled by the firm

Manager: Not controlled

Finance Crash Course 2012

Average tax rate for a firm:

The tax bill divided by taxable income

Marginal tax rate:

Tax charge on last earned Euro

Finance Crash Course 2012

Aerosol BV earned 452,000 of taxable income last

Applicable Tax rate

What is the marginal tax rate for Aerosol BV?

Finance Crash Course 2012

Applicable Tax rate