WEEK 1 – CAPITAL BUDGETING
operating costs or savings, or incremental
Capital budgeting
 Planning significant investments in projects
that have long-term implications
 Decisions that concern the commitment of
money to resources or assets that generate
future returns or benefits
Capital budgeting decisions – involve an outlay
NOW in order to obtain a FUTURE return
 Cost reduction decisions
 Expansion decisions
 Equipment selection decisions
 Lease or buy decisions
 Equipment replacement decisions
Categories of capital budgeting decisions:
1. Screening decisions – relate to whether a
proposed project is acceptable (whether it
passes a preset hurdle)
2. Preference decisions – relate to selecting from
among several acceptable alternatives
Types of cash flows in capital budgeting:
1. Cash inflows (future)
 Savings in operating costs, or incremental
revenue less incremental expenses
 Depreciation tax shield (DTS) – savings due
to depreciation
 Salvage value of new at the end of asset’s
life
 Release of working capital at the end of
asset’s life – not a taxable inflow
2. Cash outflows (now)
 Initial investment (including installation costs
and other capitalizable costs)
 Working capital required
Annual cash inflow after tax (ACIAT) – Approach 1:
Annual cash inflow (ACI) before tax
Less: Depreciation
Annual net income (ANI) before tax
Less: Income tax = (ANI) X (tax rate)
Annual net income after tax (ANIAT)
Add back: Depreciation
Annual cash inflow after tax (ACIAT)
Annual cash inflow after tax (ACIAT) – Approach 2:
ACI net of tax = (ACI before tax) X (1-tax rate)
Add: Depreciation tax shield = (Depreciation) X (tax
rate)
Annual cash inflow after tax (ACIAT)
 Cash inflows may be in the form of differential
contribution margin (selling price minus variable
cost)
 Deduct fixed cost from contribution margin to
get ACI
 If there is no tax rate given, there is no
depreciation tax shield
Time value of money
 A peso (or any currency) received today is
more valuable than a peso received in the
future, so cash flows received at different
times must be valued differently
 Projects that promise earlier returns are
preferable than those that promise later
returns
Basic terms regarding time value of money
 Annuity – a series of identical cash flows
 Compound interest – process of paying
interest on interest in an investment
 Discount rate – rate of return that is used to
find the present value of a future cash flow
 Discounting – process of finding the present
value of a future cash flow
 Present value – value now of an amount
that will be received in some future period
(PV factor is used if cash flows are uneven
or occur only once, while PVA factor is used
if cash flows are uniform or even per year)
Methods that CONSIDER the time value of money:
1. Net present value (NPV)
2. Internal rate of return (IRR)
3. Profitability index (PI) – for preference decisions
Methods that IGNORE the time value of money:
1. Payback period
2. Simple or accounting or book value or
unadjusted rate of return
Minimum required rate of return
 A company’s cost of capital is usually
regarded as the minimum required rate of
return
 Cost of capital is the average rate of return
the company must pay to its long-term
creditors and shareholders for the use of
their funds
Screening decisions (cost of capital used as a
screening tool):
1. Net present value – PV of net cash inflows less
PV of net cash outflows
 The cost of capital is used as the
DISCOUNT RATE when computing NPV of
a project
 If NPV is positive, the project is acceptable
 If NPV is zero, the project is acceptable
 If NPV is negative, the project is not
acceptable
2. Internal rate of return – rate of return that
equates PV of net cash inflows and PV of net
cash outflows, resulting in a zero NPV
 The cost of capital is used as the HURDLE
RATE that a project must clear for
acceptance
 Any project whose IRR is less than the cost
of capital is rejected
NET PRESENT VALUE:
PV of net cash inflows
Less: PV of net cash outflows
Net present value
PV of net cash inflows:
(ACIAT) X (PVA factor)
Add: (Working capital released) X (PV factor)
Add: (Salvage value of new) X (1-tax rate) X (PV
factor)
Less: (Cost of major repairs or overhauling in the
future) X (1-tax rate) X (PV factor)
PV of cash inflows, net
PV of net cash outflows:
(Cost of investment) X 1.0
Add: (Working capital required) X 1.0
Total investment
Less: (Salvage value of old)* X 1.0
Less: (Cost of major repairs or overhauling needed
now) X (1-tax rate) X 1.0
PV of cash outflows, net
*Salvage value of old:
Salvage value of old – unadjusted
Less: Book value (cost less accumulated
depreciation)
Gain/loss on sale
Multiplied by: Tax rate
Tax on gain/loss
Salvage value of old – unadjusted
Less: Tax on gain
Salvage value of old – adjusted
Salvage value of old – unadjusted
Add: Tax on loss
Salvage value of old – adjusted
 When life of the asset for tax purposes is
different from its useful life for depreciation
purposes, ACI net of tax and DTS will use
different PVA factors (not combined or added
as one to be multiplied by the same PVA factor
in getting ACIAT)
 If problem does not state “ignore salvage value”
or “without any reduction in salvage value”, SV
is deducted first from cost of asset to get the
depreciable amount
 For replacement decisions, only incremental
cash flows are considered, e.g. DTS is always
based on differential depreciation (new vs. old)
 For even cash flows, the higher the discount
rate, the lower the PV factor, thus the lower the
NPV
 For uneven cash flows, PV is greater if cash
flows are decreasing rather than increasing
 The discount rate in the NPV method is usually
based on a minimum required rate of return,
such as a company’s cost of capital
 NPV is the best single measure, as it tells us
how much value each project contributes to
shareholder wealth; NPV should be given the
greatest weight in capital budgeting decisions
INTERNAL RATE OF RETURN:
Internal rate of return = (PV of net cash outflows) /
(ACIAT)
Locate IRR factor in annuity table; use the
whole number percentage closest to it
Preference or rationing or ranking decisions –
ranking of investment projects; limited investment
funds must be rationed among many competing
alternatives
Preference decisions:
1. Net present value
 The NPV of one project cannot be directly
compared to the NPV of another project
unless initial investments are equal
 There is a need to use the profitability index;
the higher it is, the more desirable the
project
2. Internal rate of return
 The higher the IRR, the more desirable the
project

PROFITABILITY INDEX:
Approach 1
Profitability index = (NPV) / (PV of net cash
outflows)
Approach 2
Profitability index = (PV of net cash inflows) / (PV of
net cash outflows)
 If NPV is positive, PI is positive (Approach 1) or
PI is more than 100% (Approach 2); if NPV is
negative, PI is negative (Approach 1) or PI is
less than 100% (Approach 2)
Payback period
 The length of time it takes for a project to
recover its initial cost from the net cash
inflows it generates
 The time it takes for an investment to pay
for itself
 The more quickly the cost of an investment
can be recovered, the more desirable the
investment is
TRADITIONAL PAYBACK PERIOD:
If cash inflows are uniform,
Traditional payback period = (PV of net cash
outflows) / (ACIAT)
If cash flows are not uniform,
Traditional payback period = (Number of years
where respective cash flows are fully recovered) +
(Fractional part of year where investment can be
recovered by a portion of that year’s inflow)*
*Fractional part = (Balance of investment not yet
recovered) / (Cash flow for that year)
DISCOUNTED PAYBACK PERIOD:
Same procedure as traditional payback period is
applied, except that ACIAT is multiplied by PV
factor
 Discounted payback period is always longer
than traditional payback period because cash
flows are discounted (smaller)
 Payback period method is not a true measure of
profitability of an investment because it does
not consider the time value of money (a cash
inflow to be received several years in the future
is weighed the same as a cash inflow received
right now)
Simple rate of return
 Focuses on accounting net operating
income rather than cash flows
SIMPLE RATE OF RETURN:
Simple rate of return = (ANIAT) / (PV of net cash
outflows OR average investment)*
*Average investment = (Original investment +
Salvage value at the end) / 2
 If problem does not indicate “average”
investment, use PV of net cash outflows as the
denominator
INCREASE OR DECREASE IN UNITS in order to
earn a return equal to IRR (with a given NPV):
Net present value (positive)
Divide by: PVA factor
Divide by: (1-tax rate)
Divide by: Contribution margin per unit
Decrease in units (excess)
Net present value (negative)
Divide by: PVA factor
Divide by: (1-tax rate)
Divide by: Contribution margin per unit
Increase in units (deficiency)
 If NPV is positive, the number of excess units
represent the number of units which, if not
produced, would cause NPV to be zero (inflows
and outflows are equal)
 If NPV is negative, the number of deficient units
represent the number of units which, if
produced, would cause NPV to be zero (inflows
and outflows are equal)
Determining relevant cash flows
 Opportunity costs are included as relevant
cash flows
 Sunk costs are not included as relevant
cash flows because they are not affected by
accepting or rejecting the project (e.g.
purchase cost of old PPE)

WEEK 2 – COST OF CAPITAL
Capital component – one of the types of capital
(e.g. debt, preferred stock, common equity) used by
firms to raise funds
Component cost – cost of each component
 It is cost on the part of the issuing corporation,
and return on the part of the investor
Cost of debt
 Before-tax cost of debt is the interest rate a
firm must pay on its new debt
 After-tax cost of debt is the interest rate on
new debt less tax savings that result,
because interest is tax deductible; this
should be used to calculate the weighted
average cost of capital
Yield to maturity – rate of return earned on a bond if
it is held to maturity
COST OF DEBT (after tax):
After-tax cost of debt = (Interest rate)* X (1-tax rate)
*Yield to maturity (YTM):
Interest payment + [(Face value - Present value or
price) / (No. of years to maturity)]
Divided by:
(Face value + Present value or price) / 2
 Cost of debt is the interest rate on new debt, not
on already outstanding debt
 If yield to maturity on bonds is not given, use
coupon rate as before-tax interest rate
 Only debt has a tax adjustment factor
Cost of preferred stock
 The rate of return investors require on the
firm’s preferred stock
 The formula used is merely the formula for
dividend yield, without applying the
expected growth rate
 The cost of preferred stock is automatically
the fixed dividend per share (as a fixed
percentage of the par value)
COST OF PREFERRED STOCK:
Dividend yield = (Dividend per share)* / (Current
price of share)
*Dividend per share = (Earnings per share) X
(Dividend payout ratio)
 If problem requires cost of preferred stock, and
growth rate is given, ignore growth rate (do not
apply to current dividend per share) because
dividends for preferred stock are fixed and do
not change throughout the years; growth rate is
relevant only for common equity
 Flotation costs in issuing preferred stock are
also deducted from current price of share, in the
denominator
Cost of common equity
 The rate of return investors require on the
firm’s common stock
 Raised in two ways: (1) retaining some of
the current year’s earnings, and (2) issuing
new common stock
 Equity raised by issuing common stock has
a higher cost than equity from retained
earnings due to flotation costs required to
sell new common stock
Models in computing cost of common equity:
1. Capital asset pricing model (CAPM) – to
compute required rate of return
2. Dividend-yield-plus-growth-rate or discounted
cash flow (DCF) model – to compute expected
rate of return
 The required and expected rates of return are
equal if the market is in equilibrium
Beta coefficient b
 A measure of an asset’s systematic risk
 A measure of a stock’s volatility relative to
the overall stock market
 A measure of the sensitivity of a stock’s
returns to the returns on some market index
 A beta greater than 1 indicates greater
volatility (price movements) than the market,
while a beta less than 1 would mean lesser
volatility
REQUIRED RATE OF RETURN AS COST OF
COMMON EQUITY (CAPM approach):
Required rate of return = (Risk-free rate) + [(Risk
premium)* X (Beta coefficient b)]
*Risk premium = (Required return on average
stock) - (Risk-free rate)
Cost of retained earnings (internal)
 No direct costs are associated with retained
earnings
 The cost of retained earnings pertains to
opportunity cost; the firm needs to earn at
least as much on any earnings retained as
the stockholders could earn on alternative
investments of comparable risk
Cost of new common stock (external)
 The total cost of capital raised is the
investors’ required rate of return plus
flotation costs
 Flotation costs are bankers’ fees for helping
the company structure terms, set prices for
issue, and sell stocks to investors; the
percentage cost of issuing new common
stock
 Capital gain in problems relating to cost of
common equity, is the growth rate
EXPECTED RATE OF RETURN AS COST OF
RETAINED EARNINGS (DCF approach):
Cost of retained earnings = [(Dividend per share)* /
(Current price of share)] + (Expected growth rate)**
EXPECTED RATE OF RETURN AS COST OF
NEW COMMON STOCK (DCF approach):
Cost of new common stock = [(Dividend per share)*
/ (Current price of share X 1-flotation cost)] +
(Expected growth rate)**
*Dividend per share = (Last dividend per share) X
(1+growth rate)
**Expected growth rate = (Return on equity)*** X
(Retention ratio)****
***Return on equity (ROE) = (Net income) / (Equity)
****Retention or plowback ratio = (1-dividend
payout ratio)
 Since it is the cost of common equity that is
being computed and not the cost of preferred
stock, apply growth rate to current dividend per
share because dividends for common stock are
not fixed and change throughout the years;
growth rate is relevant only for common equity
 Use the next or expected dividend per share,
not the last or current dividend per share
 If growth rate is not explicitly given in problem, it
is computed based on historical data of
dividends paid in previous years
 Aside from flotation costs, price reductions are
also considered (underpricing necessary in the
competitive capital market)
 If CAPM approach is used, internal and external
financing of common equity is taken as one; if
DCF approach is used, they are taken not as
one (there is distinction between cost of
retained earnings and cost of new common
stock)
Composite or weighted average cost of capital
(WACC) – weighted average of component costs of
debt, preferred stock, and common equity
 D0 = last or current dividend per share
 D1 = next or expected dividend per share
 rd = rate of return; after-tax cost of debt
 rs = rate of return; cost of retained earnings
 re = rate of return; cost of new common
stock
WEIGHTED AVERAGE COST OF CAPITAL:
Weighted average cost of capital = (Capital
structure of component) X (Cost of capital)
After multiplying the respective capital structures
and costs of capital of each capital component,
they are added to get WACC
 In terms of determining the capital structure
based on the company’s financing needs or
projected capital expansion, the portion for
common equity is allocated to both internal
(retained earnings) and external (new common
stock) equity financing by exhausting such
portion first for the given amount of retained
earnings
 The WACC computed as marginal cost of
capital for any projected capital expansion (in
excess of given budget, where retained
earnings are already exhausted) is greater than
the WACC initially computed based on given
budget
 Capital structure is based on market value of
securities, not book value
 Capital structure of debt securities does not
include short-term or spontaneous liabilities
Factors that affect WACC:
1. Factors the firm can control
 Change in capital structure
 Change in dividend payout ratio
 Alteration of capital budget decision rules to
accept projects with more or less risk than
projects previously undertaken
2. Factors the firm cannot control
 Interest rates in the economy
 General level of stock prices
 Tax rates
COST OF EQUITY (bond-yield-plus-risk-premium
approach):
Cost of equity = (Bond yield or return on bonds) +
(Risk premium)
 If there is equal confidence in all approaches,
get the average of their costs of capital
TERMINAL VALUE:
Terminal value = (Equilibrium market price) X
(1+required rate of return)
Dividend payout ratio – ratio of dividend per share
to earnings per share (percentage or portion of
earnings per share paid out as dividends)
DIVIDEND PAYOUT RATIO:
Dividend payout ratio = (Dividend per share) /
(Earnings per share)
Price-earnings ratio – ratio of market price to
earnings per share
PRICE-EARNINGS RATIO:
Price-earnings ratio = (Market price per share, or
“close”) / (Earnings per share)*
*Earnings per share = (Dividend per share) /
(Dividend payout ratio)
 The most recent or current market price per
share (“as of” price) is also known as the close
of trading
WEEK 3 – RISK AND RATES OF RETURN
Risk – chance that some unfavorable event will
occur
 Investors like returns and dislike risk
 To entice investors to take on more risk,
higher expected returns should be provided
(fundamental trade-off between risk and
return)
 The slope of the risk-return line (on the part
of the investor) and the slope of the cost of
capital line (on the part of the issuing
corporation) is steeper when more risk
averse, and flatter when comfortable
bearing risk
 If the project’s return exceeds the cost of
capital, it is a good investment, and if does
not, it is a bad investment
 A stock’s risk can be considered on a stand-
alone or single-stock basis, or in a portfolio
context
Stand-alone risk – risk an investor would face if
only one asset is held
 No investment should be undertaken unless
the expected rate of return is high enough to
compensate for the perceived risk
Statistical measures of stand-alone risk:
1. Probability distribution
2. Expected rate of return (“r hat”)
3. Historical or past realized rate of return (“r bar”)
4. Standard deviation (sigma, σ)
5. Coefficient of variation (CV)
Probability distribution – a listing of possible
outcomes or events with a probability (chance of
occurrence) assigned to each outcome
  The tighter the probability distribution of
expected future returns, the smaller the risk
of a given investment
Expected rate of return (“r hat”) – rate of return
expected to be realized from an investment;
weighted average of probability distribution of
possible results (in a portfolio)
 If investors (on average) think a stock’s
expected return is too low to compensate
for its risk, they will start selling it, driving
down its price, and boosting its expected
return; and vice versa
 The stock will be in equilibrium, with neither
buying nor selling pressure, when its
expected return is exactly sufficient to
compensate for its risk
Historical or past realized rate of return (“r bar”) –
return that was actually earned during some past
period
 The actual return usually turns out to be
different from the expected return, except
for riskless assets
Standard deviation (sigma, σ) – statistical measure
of the variability of a set of observations; a measure
of how far the actual return is likely to deviate from
the expected return
STANDARD DEVIATION:
Standard deviation = √Squared sigma*
*Squared sigma:
Multiply (a) probability of each demand occurring,
by (b) rate of return if each demand occurs, to get
(c) stock’s expected return for each demand
Add all expected returns of each demand in (c) to
get total expected return of stock [sum of (c)]
Get difference between rate of return of each
demand in (b) and total expected return [sum of (c)]
to get (d) deviation of each demand
Square deviation of each demand in (d) to get (e)
squared deviation of each demand
Multiply probability of each demand occurring in (a)
by squared deviation of each demand in (e) to get
(f) squared sigma of each demand
Add all squared sigmas in (f) to get total squared
sigma [sum of (f)]
Coefficient of variation – standardized measure of
the risk per unit of return; provides a more
meaningful risk measure when the expected
returns on two alternatives are not the same
COEFFICIENT OF VARIATION:
Coefficient of variation = (Standard deviation) /
(Expected return)
Risk aversion
 Risk-averse investors dislike risk and
require higher rates of return as an
inducement to buy riskier securities
 Other things held constant, the higher a
security’s risk, the higher its required return
 If this situation does not hold, prices will
change to bring about the required condition
Market risk premium – difference between
expected rate of return on a given risky asset and
that on a less risky asset
 It is the additional return over the risk-free
rate needed to compensate investors for
assuming an average amount of risk
 In a market dominated by risk-averse
investors, riskier securities compared to less
risky securities must have higher expected
returns as estimated by the marginal
investor
 If this situation does not exist, buying and
selling will occur until it does exist
Risk in a portfolio context – a number of stocks are
combined, and their consolidated cash flows are
analyzed
Expected portfolio returns
 The risk and return on an individual stock
should be analyzed in terms of how the
security affects the risk and return of the
portfolio in which it is held
 The expected return on a portfolio is the
weighted average of the expected returns
(not weighted average of the standard
deviation) on its individual stocks
Market portfolio – a portfolio consisting of all stocks
Portfolio risk – generally smaller than the average
of the stocks’ standard deviations because
diversification lowers the portfolio’s risk (portfolio
risk declines as the number of stocks in a portfolio
increases, but at a decreasing rate)
Capital asset pricing model (CAPM) – based on the
proposition that any stock’s required rate of return
is equal to the risk-free rate of return plus risk
premium that reflects only the risk remaining after
diversification
Components of a stock’s risk:
1. Diversifiable or company-specific or
unsystematic risk
 It is the part of a security’s risk associated
with random events unique to the firm
 It can be diversified away or eliminated by
proper diversification (“bad” events will be
offset by “good” events)
 It is of little concern to diversified investors
2. Market or non-diversifiable or systematic or
beta risk
 It reflects the risk of a general stock market
decline caused by macro factors
 It is the risk that remains in a portfolio after
diversification has eliminated all company-
specific risk
 It cannot be eliminated by diversification
 It does not concern investors
 Only market risk is relevant to rational investors
because diversifiable risk can and will be
eliminated
Security market line (SML) equation – equation that
shows the relationship between risk as measured
by beta and the required rates of return on
individual securities
REQUIRED RATE OF RETURN (CAPM or SML
equation):
Required rate of return = (Risk-free rate) + [(Risk
premium)* X (Beta coefficient b)]
*Risk premium = (Required return on average
stock) - (Risk-free rate)
 The fractional part of each investment in a
portfolio is determined
 The required rate of return of the portfolio may
be computed by adding all the individually
computed rates of return, or by computing it as
one through the consolidated beta coefficient
 The inflation rate is added to the risk-free rate to
get an adjusted risk-free rate
Beta coefficient – metric that shows the extent to
which a given stock’s returns move up and down
with the stock market
 It measures a given stock’s volatility relative
to the market
 A greater beta coefficient means there is
greater risk
 An average stock’s beta is equal to 1.0
(beta of overall stock market)
 The consolidated beta coefficient of the
portfolio is determined by multiplying the
fractional parts of the investments by their
respective beta coefficients, then adding
them all together
Relevant risk
 The risk that remains once a stock is in a
diversified portfolio, is its contribution to the
portfolio’s market risk
 It is measured by the extent to which the
stock moves up or down with the market
Correlation – tendency of two variables to move
together
 When stocks are perfectly positively
correlated, diversification is completely
useless for reducing risk; when stocks are
perfectly negatively correlated, all risk can
be diversified away
 The returns on two perfectly positively
correlated stocks with the same expected
returns would move up and down together,
and a portfolio consisting of these two
stocks would be exactly as risky as the
individual stocks
Correlation coefficient – a measure of the degree of
relationship between two variables
 Perfect positive correlation is p = +1.0
 Perfect negative correlation is p = -1.0
 No correlation or independent is p = 0
WEEK 4 – STOCKS AND THEIR VALUATION
 Unlike bonds and preferred stock dividends
which are set by contract (fixed), common stock
 dividends are not contractual because they
depend on the firm’s earnings, which in turn
depend on many random factors
Models in estimating stock’s intrinsic or true value:
1. Discounted dividend model
2. Corporate valuation model
 A stock should be bought if its price is less than
its estimated intrinsic value, and sold if its price
is more than its estimated intrinsic value
Marginal investor – a representative investor whose
actions reflect the beliefs of those people who are
currently trading a stock; the marginal investor who
determines a stock’s price
Market price – price at which a stock sells in the
market
Growth rate – expected rate of growth in dividends
per share
Required rate of return – minimum rate of return on
a common stock that a stockholder considers
acceptable
Expected rate of return – rate of return on a
common stock that a stockholder expects to
receive in the future
Actual (realized) rate of return – rate of return on a
common stock actually received by stockholders in
some past period; may be greater than or less than
expected and/or required rate of return
Constant growth (Gordon) model – used to find the
value of a constant growth stock
 D0 = last or current dividend per share
 D1 = next or expected dividend per share
 rs = rate of return
EXPECTED DIVIDEND YIELD:
Expected dividend yield = (Expected or next year’s
dividend per share)* / (Current or market price of
share)
*Expected or next year’s dividend per share = (Next
year’s earnings per share)** X (Dividend payout
ratio)
**Next year’s earnings per share = (Prior earnings)
+ [(Return on equity) X (Retained earnings)]
CAPITAL GAINS YIELD OR EXPECTED
GROWTH RATE:
Capital gains yield = (Capital gain during the year) /
(Beginning price)
Growth rate = (Return on equity) X (1-dividend
payout ratio)
EXPECTED RATE OF RETURN (constant growth
model):
Expected rate of return = (Expected dividend yield)
+ (Capital gains yield)
Expected dividends as the basis for stock values –
the value of a share of a stock must be established
as the present value of the stock’s expected
dividend stream
 A higher value for dividend yield increases a
stock’s price; however, a higher growth rate
also increases the stock’s price
 Dividends are paid out of earnings; therefore,
growth in dividends requires growth in earnings
 Earnings growth in the long run occurs primarily
because firms retain earnings and reinvest
them in the business; therefore, the higher the
percentage of earnings retained, the higher the
growth rate
Corporate valuation model – used as an alternative
to the discounted dividend model to determine a
firm’s value, especially one with no history of
dividends, or the value of a division of a larger firm
Free cash flows (FCF)
 It is the amount of cash that could be
withdrawn without harming a firm’s ability to
operate and to produce future cash flows
 They are cash flows actually available for
payments to all investors (stockholders and
debt/bondholders) after company has made
investments in fixed assets, new products,
and working capital required to sustain
ongoing operations
 A positive FCF indicates that the firm is
generating more than enough cash to
finance its current investments in fixed
assets and working capital
 A negative FCF indicates the opposite; it
means that the firm will have to raise new
money in capital markets in order to pay for
the investments
 A negative FCF is not always bad (e.g.
startup companies launching new product
lines, high-growth companies having large
 investments in capital that cause low current
FCF, but will increase future FCF)
Horizontal value – free cash flows when firm is at
constant growth rate
FIRM VALUE OR MARKET VALUE OF
COMPANY:
Total firm value = [(Free cash flows)* X (PV or PVA
factor)] + [(Horizontal value)** X (PV factor)]
Market price per share = (Market value of equity)***
/ (Number of shares outstanding)
*Free cash flows:
Earnings before interest and after tax (earnings
before interest and taxes or EBIT X 1-tax rate)
Add: Depreciation
Add: Amortization
Less: Capital expenditures
Less: Changes in net operating working capital
Free cash flows
*Free cash flows = (Net operating profit after taxes,
or NOPAT) - (Net investment in operating capital)
**Horizontal value = (Free cash flows) / [(WACC) -
(Growth rate)]
***Market value of equity = (Total firm value) -
(Market value of debt and preferred stock)
 In computing the firm value as the present value
of future free cash flows, the discount rate used
is the WACC
 To compute the market price per share, deduct
market value of company’s debt and preferred
stock from total firm value first (to get firm value
applicable to common equity only) before
dividing firm value by number of shares
outstanding
 The discounted dividend model is useful for
mature, stable companies, and it is easier to
use
 The corporate valuation model is more flexible
and better for use with companies that do not
pay dividends or whose dividends would be
especially hard to predict
EFFECTIVE ANNUAL RATE OF RETURN:
Effective annual rate of return = (1+periodic interest
rate)x – 1.00
Let x = number of periods (e.g. quarters)
WEEK 5 – CAPITAL STRUCTURE AND
LEVERAGE
Optimal capital structure – capital structure that
would maximize stock price of firm
 It generally calls for a debt ratio that is lower
than the one that maximizes expected
earnings per share (EPS)
 It is generally treated by financial executives
as a range, rather than a precise point
Target capital structure – mix of debt, preferred
stock, and common equity the firm wants to have
 If actual debt ratio is significantly below
target level, management will raise capital
by issuing debt; if debt ratio is above target
level, equity will be used
Trade-off between risk and return
 Using more debt raises the risk borne by
stockholders, but generally increases the
expected return on equity
 Firms should find the capital structure that
strikes a balance between risk and return so as
to maximize stock price
Primary factors that influence capital structure
decisions:
1. Business risk
 It is the risk inherent in the firm’s operations
if it used no debt
 If the company has no debt, its return on
equity (ROE) is equal to its return on assets
(ROA)
 It depends on a number of factors (e.g.
demand variability, sales price variability,
input cost variability, ability to adjust output
prices for changes in input costs, ability to
develop new products in a timely and cost-
effective manner, foreign risk exposure, and
operating leverage)
2. The firm’s tax position
 A major reason for using debt is that interest
is tax deductible, which lowers the effective
cost of debt
3. Financial flexibility
 It is the ability to raise capital on reasonable
terms even under adverse market
conditions
4. Managerial conservatism or aggressiveness
  Aggressive managers are more willing to
use debt in an effort to boost profits
Operating leverage – extent to which costs are
fixed
 If a high percentage of its costs are fixed
(and hence do not decline when demand
falls), the firm will be exposed to a relatively
high degree of business risk
 A high degree of operating leverage, other
factors held constant, implies that a
relatively small change in sales results in a
large change in profit and ROE
 Degree of operating leverage (DOL) acts as
a multiplier for any percentage change in
sales, to get the percentage change in profit
DEGREE OF OPERATING LEVERAGE (DOL):
Degree of operating leverage = (Contribution
margin)* / (EBIT)**
Sales
Less: Variable costs
*Contribution margin
Less: Fixed costs
**Earnings before interest and tax (EBIT)
Financial risk
 It is an increase in stockholder’s risk, over
and above the firm’s basic business risk,
resulting from the use of financial leverage
 It is the additional risk placed on common
stockholders as a result of the decision to
finance with debt
Financial leverage – extent to which fixed-income
securities (debt and preferred stock) are used in a
firm’s capital structure
 Using leverage has both positive and
negative effects: higher leverage increases
expected EPS, but it also increases risk
DEGREE OF FINANCIAL LEVERAGE (DFL):
Degree of financial leverage = (EBIT) / [EBIT -
Interest expense - (Preferred dividends / 1-tax
rate)]
DEGREE OF TOTAL LEVERAGE (DTL):
Degree of total leverage = (DOL) X (DFL)
Degree of total leverage = (CM) / [EBIT - Interest
expense - (Preferred dividends / 1-tax rate)]
 If the company does not have preferred stock,
DTL decreases in proportion to decrease in
DFL
Unlevered beta – firm’s beta coefficient if it has no
debt
UNLEVERED BETA (Hamada equation):
Unlevered beta = (Beta coefficient) / [1+ (1-tax rate)
X (Debt / Equity)]
 When there is a change in capital structure,
determine unlevered beta first before computing
for beta under new capital structure
 If debt is increased, debt-to-equity ratio
increases, so beta under new capital structure
increases; now that beta is greater, risk
increases, so required rate of return also
increases as a result
RETURN ON EQUITY (ROE):
ROE = (Net income after tax) / (Equity)
 If there is preferred stock, preferred dividends
should be deducted from net income after tax in
numerator of ROE formula, because the
numerator should represent earnings available
to ordinary shareholders
 As leverage increases, ROE increases up to a
point; as risk increases with increased leverage,
cost of debt (interest expense) also increases;
thus, ROE will reach a maximum level, then it
will inevitably decline
 As leverage increases, the measures of risk
(standard deviation and coefficient of variation)
increase with each increase in leverage
Recapitalization – change in capital structure (e.g.
using proceeds from funds borrowed as debt, to
repurchase stocks)
 To compute for the net income after tax (NIAT)
after recapitalization, where proceeds from
funds borrowed as debt are used to repurchase
stocks, gross up NIAT to get EBIT, then deduct
interest (before-tax cost of debt of the new loan)
and income tax from EBIT

WEEK 6 – WORKING CAPITAL MANAGEMENT
Working capital management
 It involves finding the optimal levels for
cash, marketable securities, accounts
receivable, and inventory, and then
financing that working capital at the least
cost
 Effective working capital management can
generate considerable amounts of cash
 Prepaid expenses are classified as current
assets, but they are not part of working capital
management because they are not convertible
to cash
Net working capital
 Current assets are often called working
capital because these assets “turn over”
Current asset investment policies:
1. Relaxed – large amounts of cash, marketable
securities, and inventories are carried; a liberal
credit policy results in a higher level of
receivables
2. Restricted – holdings of cash, marketable
securities, inventories, and receivables are
constrained
3. Moderate – between the relaxed and restricted
policies
RETURN ON EQUITY (DuPont equation):
Return on equity = (Profit margin)* X (Asset
turnover)** X (Leverage factor or equity
multiplier)***
*Profit margin = (Net income) / (Net sales)
**Asset turnover = (Net sales) / (Average total
assets)
***Leverage factor or equity multiplier = (Average
total assets) / (Average total equity)
 In ratio analysis, balance sheet items are
averaged if ratio involves income statement
item and balance sheet item; they are not
averaged if ratio involves two income statement
items, or two balance sheet items (except for
leverage factor or equity multiplier)
 If there are no beginning and ending balances
given for an asset item, it is assumed that there
is no change in the balances, so the ending
balance is already the average
RETURN ON ASSETS (ROA):
Return on assets = [(Net income after tax) +
(Interest expense, net of tax)] / (Average total
assets)
 Interest expense, net of tax is added back
because the numerator of ROA is the earnings
of the company where it is assumed that there
was no borrowing made
 Financial leverage is positive when ROA is
greater than the average of the after-tax cost of
debt, and the cost of preferred stock, if there is
any; a positive financial leverage explains why
ROE is greater than ROA
Cash conversion cycle (CCC)
 It is the length of time where funds are tied
up in working capital
 It is the length of time between paying for
working capital and collecting cash from the
sale of the working capital
CASH CONVERSION CYCLE:
Cash conversion cycle = (Inventory conversion
period) + (Average collection period) - (Payables
deferral period)
 The number of days in a year is 365 days,
unless the problem requires the use of 360
days
 To compute for the amount of cash freed up or
the amount of working capital released, get the
improvements (differences) of the old and new
ICP, ACP, and PDP, and multiply them by their
respective denominators (income statement
items expressed on a daily basis)
 To compute for the increase or decrease in
pretax profits related to working capital
management, the amount of cash freed up is
multiplied by the finance charge or cost of funds
Inventory conversion period (ICP) – average time
required to convert raw materials into finished
goods, and then sell them (in the case of a
manufacturing concern)
INVENTORY CONVERSION PERIOD:
Inventory conversion period = (Average inventory) /
(Cost of goods sold per day)
Inventory conversion period = (365) / (Inventory
turnover)*
*Inventory turnover = (Cost of goods sold) /
(Average inventory)
Average collection period (ACP) or days sales
outstanding (DSO) or average days in receivables
– average length of time required to convert the
firm’s receivables into cash, that is, to collect cash
following a sale on account
AVERAGE COLLECTION PERIOD:
Average collection period = (Average trade
receivables) / (Net credit sales per day)
Average collection period = (365) / (Receivables
turnover)*
*Receivables turnover = (Net credit sales) /
(Average trade receivables)
 Average trade receivables include accounts
receivable and trade notes receivable
 If notes receivable is silent on whether it is trade
or nontrade, do not include it as part of trade
receivables because, in general, they are
nontrade
 Net credit sales is computed by deducting sales
discounts, returns, and allowances from gross
sales
 If sales is silent on whether it is for cash or on
credit, it is assumed that all sales are on credit
Payables deferral period (PDP) – average length of
time between the purchase of materials and labor
on account, and the payment of cash for them (in
the case of a manufacturing concern)
PAYABLES DEFERRAL PERIOD:
Payables deferral period = (Average trade
payables) / (Cost of goods sold or net credit
purchases per day)
Payables deferral period = (365) / (Payables
turnover)*
*Payables turnover = (Net credit purchases) /
(Average trade payables)
 In payables deferral period, the assumption is
that if inventory did not change (beginning and
ending balances are the same), cost of goods
sold is equal to purchases
 Average trade payables include accounts
payable and trade notes payable
 If notes payable is silent on whether it is trade
or nontrade, do not include it as part of trade
payables because, they are nontrade in general
 Net credit purchases is computed by deducting
purchase discounts, returns, and allowances
from gross purchases
 If purchases is silent on whether it is for cash or
on credit, it is assumed that all purchases are
on credit
Techniques used to optimize demand deposit
holdings (cash management):
1. Hold marketable securities rather than demand
deposits to provide liquidity
2. Borrow on short notice
3. Forecast payments and receipts better (through
cash budgets)
4. Speed up payments (through a lockbox system)
 Lockbox is a post office box operated by a
bank or any collection agency to which
payments are sent; it is used to speed up
effective receipt of cash
5. Use credit cards, debit cards, wire transfers,
and direct deposits
6. Synchronize cash flows
Variables of credit policy (accounts receivable
management):
1. Credit period – length of time customers have to
pay for purchases
2. Discounts – price reductions given for early
payment
3. Credit standards – financial strength customers
must exhibit to qualify for credit
4. Collection policy – degree of toughness in
enforcing credit terms
INVESTMENT IN ACCOUNTS RECEIVABLE:
Accounts receivable = (Sales per day) X (Length of
collection period or days sales outstanding)
Accounts payable
 When a firm buys inventory on credit, its
suppliers, in effect, lend it the money used
to finance the inventory
 The firm could have borrowed from its bank
or sold stock to obtain the money, but it
received the funds from its suppliers
 These loans are “accounts payable”, and
they are typically “free” because they do not
bear interest
Trade credit
 It is furnished by a firm’s suppliers
 It is often the largest source of short-term
credit, especially for small firms
 It is spontaneous, easy to get, but its cost
(implicit cost) can be high
Types of trade credit:
1. Free
 It is the credit received during the discount
period
 It is obtained without a cost, and it consists
of all trade credit that is available without
giving up discounts
2. Costly
 It is the credit taken in excess of free trade
credit, whose cost is equal to the discount
lost
 It is any trade credit over and above the free
trade credit
ANNUAL NOMINAL COST (ANC) OF TRADE
CREDIT:
Nominal annual cost of trade credit = (Periodic
rate)* X (Periods per year)**
*Periodic rate = (Discount rate) / (1-discount rate)
**Periods per year = (365) / [(Number of days credit
is outstanding) – (Discount period)]
EFFECTIVE COST OF TRADE CREDIT:
Effective cost of trade credit = (1+periodic rate)n – 1
 Firms should avail of the discount if the cost of
bank loan is lower than the cost of additional
trade credit, thus, cash payment is made to the
supplier within the discount period, and cash
funds for other projects are financed by the
bank loan at a lower rate
 Firms should always use the free component,
but they should use the costly component if
they cannot obtain funds at a lower cost from
another source
WEEK 7 – CASH, RECEIVABLES AND
INVENTORY MANAGEMENT
Cash management
 It involves the maintenance of the
appropriate levels of cash and investment in
marketable securities to meet the firm’s
cash requirements and to maximize income
on idle funds
 An objective is to invest excess cash for a
return while retaining sufficient liquidity to
satisfy future needs
 Another objective is to provide the cash
balance required to meet the firm’s liquidity
requirements at the lowest possible cost of
maintaining liquidity
Reasons for holding cash:
1. Transaction purposes – to conduct ordinary
transactions
2. Compensating balance requirements – certain
amount of cash that a firm must leave in its
checking account at all times as part of a loan
agreement
3. Precautionary reserves – to handle unexpected
problems or contingencies due to the uncertain
pattern of cash inflows and outflows
 Cost of maintaining liquidity – income
foregone on cash balance; giving up
earning a higher income when cash is
maintained instead of invested
4. Potential investment opportunities – in
anticipation of a future investment opportunity,
such as a major capital expenditure project
5. Speculation – to take advantage of possible
changes in prices of materials, equipment, and
securities, as well as changes in currency
exchange rates
Float – difference between the bank balance for a
firm’s account and the balance that the firm shows
on its own books (expressed in peso amounts)
Aspects of float:
1. The time it takes a company to process its
checks internally
2. The time consumed in clearing the check
through the banking system
Types of float:
1. Negative float (availability or collection float) –
book balance exceeds bank balance, which
means that there is more cash tied up in the
collection cycle, and it earns a 0% rate of return
 Mail float – mailed by customer, but not yet
received by the seller
 Processing float – received by seller, but not
yet deposited
 Clearing float – deposited, but not yet
cleared
2. Positive float (disbursement or payment float) –
bank balance exceeds book balance (e.g.
checks written or issued by firm, but not yet
cleared)
 Good cash management dictates that negative
float must be minimized, if not eliminated;
management should increase positive float
 To compute for the net float, deduct negative
float from positive float
Cash flow management – preparing cash budgets,
preparing the cash break-even chart, determining
the optimal cash balance using the Baumol Cash
Management Model
Cash break-even chart
 It shows the cash break-even point (amount
of sales in pesos, or number of units to be
sold so that total cash inflows is equal to
total cash outflows)
 It shows the amount of cash deficiency
when sales is below cash break-even point,
or the amount of excess cash when sales is
above cash break-even point
Baumol Cash Management Model
 It is an EOQ-type model which can be used
to determine the optimal cash balance,
where the costs of maintaining and
obtaining cash are at the minimum
 Such costs are the costs of securities
transactions or obtaining loans, and
opportunity costs of holding cash, which
includes the return forgone by not investing
in marketable securities (cost of borrowing
cash)
OPTIMAL CASH BALANCE (using the Baumol
Cash Management Model):
Optimal cash balance = [√(2 X Annual cash
disbursements X Fixed cost per transaction) /
(Opportunity cost of holding cash]
 To compute for the average cash balance,
deduct the optimal cash balance by 2
 To compute for the net benefit or loss of having
an improvement or change in cash
management, deduct cost from benefit
Receivables management
 It is the process of ensuring that customers
pay their dues on time
 It helps businesses prevent themselves
from running out of working capital at any
point of time
 It prevents overdue payments or non-
payments of pending amounts of customers
 The main objective is to minimize day sales
outstanding (DSO) and processing costs
while maintaining good customer relations
DAY SALES OUTSTANDING (DSO):
Day sales outstanding = (365) / (Receivables
turnover)
INVESTMENT IN RECEIVABLES:
Investment in receivables = (Average daily sales) X
(DSO)
COST OF CARRYING RECEIVABLES:
(Investment in receivables) X (Cost of funds)
 Tightening or relaxing the credit policy has an
effect on total sales, percentage of credit sales
to total sales, percentage of bad debts,
collection costs, and cost of carrying
receivables
ACCOUNTS RECEIVABLE-RELATED PROFIT:
Sales
Less: Variable costs
Contribution margin
Less: AR-related costs*
AR-related profit before tax
Less: Income tax
AR-related profit after tax
*AR-related costs = (Cost of carrying receivables) +
(Bad debts expense) + (Collection costs)
Inventory management
 It is the process of efficiently monitoring the
constant flow of units (materials or goods)
into receipts, and out as issuances of an
existing inventory
  It usually involves controlling the inflow of *Lead time usage = (Daily usage)** X (Lead time or
units in order to prevent the inventory from delivery time in working days)
becoming too high or too low (stockouts)
 A component of supply chain management, **Daily usage or average daily usage = (Annual
it supervises the flow of goods from usage) / (Number of working days)
manufacturers to warehouses, and from
these facilities to the point of sale Reorder point = (Daily usage) X (Maximum lead
 A key function is to keep a detailed record time in working days)
of each new or returned product as it enters
or leave a warehouse or point of sale
 Inventory control is the area that is
concerned with minimizing the total cost of
inventory, while maximizing the ability to
provide customers with products in a timely
manner

ECONOMIC ORDER QUANTITY (EOQ):

Economic order quantity = [√(2 X Annual usage or
demand in units X Cost per order) / (Carrying cost
per unit]

 At EOQ, the total carrying cost is equal to the

total ordering cost, if there is no safety stock

 Other terms for EOQ are standard order size,

optimal order size, and optimal production run

 In a manufacturing concern, setup cost is also

known as ordering cost, and number of
production runs is also known as number of
orders

TOTAL CARRYING COST:

Total carrying cost = [(Average inventory)* +
(Safety stock)] X (Carrying cost per unit)

*Average inventory = (EOQ) / 2

 Carrying costs include storage costs, insurance

costs, and annual interest foregone from
alternative investment of funds

TOTAL ORDERING COST:

Total ordering cost = (Number of orders)* X (Cost
per order)

*Number of orders = (Annual demand) / (EOQ)

TOTAL INVENTORY COST:

Total inventory cost = (Total carrying cost) + (Total
ordering cost)

REORDER POINT:
Reorder point = (Lead time usage)* + (Safety stock)
WEEK 8 – FINANCIAL PLANNING AND
FORECASTING
Financial planning and forecasting
 Additional funds needed (AFN)
 Projected income statement and projected
dividend growth rate
 Projected increase in fixed assets
 Forecasted year-end receivables and
inventory level using simple linear
regression analysis
 Both investors and corporations use forecasting
techniques to help value a company’s stock,
estimate the benefits of potential projects, and
estimate how changes in capital structure,
dividend policy, and working capital policy
influence shareholder value
 If the projected operating results are
unsatisfactory, management can “go back to
the drawing board”, reformulate its plans, and
develop more reasonable targets for the coming
year
 The funds required to meet the sales forecast
simply may not be obtainable; if not, it is
obviously better to know this in advance and to
scale back projected operations than to
suddenly run out of cash and have operations
grind to an abrupt halt
Key factors in determining the need for external
financing:
1. Sales growth
 Rapidly growing companies require large
increases in assets
2. Capital intensity
 Companies with high assets-to-sales ratio
require more assets for a given increase in
sales; hence, have a greater need for
external financing
3. Spontaneous liabilities-to-sales ratio
 Companies that spontaneously generate a
large amount of funds from accounts
payable and accrued liabilities have a
reduced need for external financing
4. Profit margin
 The higher the profit margin, the larger the
net income available to support increases in
assets; hence, the lower the need for
external financing
5. Retention ratio
 Companies that retain a high percentage of
earnings rather than paying them out as
dividends generate more retained earnings;
thus, there is less external financing
ADDITIONAL FUNDS NEEDED (AFN) or
EXTERNAL FINANCING NEEDED (EFN):
Projected increase in assets*
Less: Projected increase in spontaneous liabilities**
Less: Projected increase in retained earnings***
Additional funds needed
*Projected increase in assets = [(CY assets) / (CY
sales)] X (Peso change in sales)
**Projected increase in spontaneous liabilities =
[(CY spontaneous liabilities) / (CY sales)] X (Peso
change in sales)
***Projected increase in retained earnings =
[(Projected sales) X (Forecasted profit margin)] X
(1-payout ratio)
Capital intensity ratio = (A0) / (S0)
CY = current year
A0 = CY assets
S0 = CY sales
 In computing AFN, current year assets and
current year liabilities are the ending balances
of the period; they are not averaged
 Spontaneous liabilities are liabilities that grow in
proportion to projected sales; not all liabilities
are spontaneous
 If the historical profit margin is given instead of
the forecasted profit margin, use the historical
profit margin (the assumption is that the profit
margin is maintained)
 The computed AFN will be supplied by debt and
equity financing, depending on the company’s
capital structure
Sustainable growth rate – maximum achievable
growth rate without the firm having to raise external
funds
 AFN or EFN is zero when the firm only has
a sustainable growth rate
FULL CAPACITY SALES:
Full capacity sales = (Actual sales) / (% of capacity
at which fixed assets are operated)
TARGET FIXED ASSETS TO SALES RATIO:
Target FA to sales ratio = (Actual FA) / (Full
capacity sales)
REQUIRED LEVEL OF FIXED ASSETS:
Required level of FA = (Projected sales) X (Target
FA to sales ratio)
PROJECTED INCREASE IN FIXED ASSETS:
Projected increase in FA = [(Projected sales) - (Full
capacity sales)] X (Target FA to sales ratio)
Regression analysis – a statistical technique that
fits a line to observed data points, so that the
resulting equation can be used to forecast other
data points; used to forecast year-end receivables
based on its relationship with sales, and year-end
inventory level based on its relationship with cost of
goods sold
FORECASTED YEAR-END RECEIVABLES (using
simple linear regression):
Forecasted year-end receivables = (Fixed
component) + [(Variable component) X (Forecasted
sales)]
FORECASTED YEAR-END INVENTORY LEVEL
(using simple linear regression):
Forecasted year-end inventory level = (Fixed
component) + [(Variable component) X (Forecasted
cost of goods sold)]
WEEK 9 – SHORT TERM FINANCING
Sources of short-term credit:
1. Spontaneous sources
a. Trade credit (accounts payable)
b. Accruals (accrued expenses)
c. Deferred income
2. Negotiated sources
a. Commercial bank loans
b. Commercial papers
Trade credit (accounts payable)
 It is considered as a spontaneous or
continuous source of financing because it is
automatically obtained when a firm
purchases goods or services on credit from
a supplier
 It is more readily available than other
negotiated sources of short-term credit
Cost of trade credit
 It usually bears no interest, but it is not
costless
 Its cost is implicit in the terms of credit
agreed upon (discount policy and credit
period)
Cost of trade credit:
1. No trade discount (no cash discount)
 Purchases on credit without trade discount
are usually priced higher than cash
purchases
 The difference between the selling prices is
the implicit cost of credit
2. With trade discount (with cash discount)
  If a supplier allows a trade discount for
prompt payment, an implicit cost is incurred
if the discount is not availed of
COST OF TRADE CREDIT:
Cost of trade credit or annual rate = [(Interest cost
per period, or discount rate) / (Usable loan
amount)*] X [(Number of days in a year) / (Number
of days funds are used)**]
*Usable loan amount = (1-discount rate)
**Number of days funds are used = (Net period) -
(Discount period)
Accruals (accrued expenses)
 It is another form of spontaneous financing
which represents liabilities for services that
have been provided to the company, but
have not yet been paid for
 Typical examples are accrued wages,
salaries, rent, taxes, and interest
 There is no cost of accruals, whether
implicit or explicit
Deferred income
 These are customers’ advance payments or
deposits for goods or services that will be
delivered at some future date
 There is no cost of deferred income
Commercial bank loans
 These are short-term business credits
provided by commercial banks, requiring the
borrower to sign a promissory note to
acknowledge the amount of debt, maturity
and interest
 They can be though line of credit, or through
transaction loan (single payment loan)
Line of credit – the bank agrees to lend up to a
maximum amount of credits to a firm; applicable to
firms that need frequent funding in varying amounts
Revolving credit agreement – the bank makes a
formal, contractual commitment to provide the
maximum amount to a firm; the firm pay a minimal
commitment fee per year on the average unused
portion of the commitment
Transaction loan (single payment loan) – short-term
credit for a specific purpose
Compensating balance – a certain percentage of
the face amount of the loan that must be
maintained by a borrower on his or her account
REGULAR INTEREST RATE (loan is not a
discount loan):
Regular interest rate = (Interest) / (Usable loan
amount)*
*Usable loan amount = (Loan amount) -
(Compensating balance)
EFFECTIVE INTEREST RATE (loan is a discount
loan):
Effective interest rate = (Interest) / (Usable loan
amount)*
*Usable loan amount = (Loan amount) - (Interest) -
(Compensating balance)
 If the loan is a discount loan, always deduct
interest in the denominator
 Interest expense in the numerator should be net
of any interest income
 Compensating balance in the denominator
should be net of any transactional balance
DISCOUNTED INTEREST RATE:
Discounted interest rate = (Interest) / [(Loan
amount) - (Interest)]
COST OF ADD-ON INTEREST LOAN:
Effective interest rate = (Interest) / [(Loan amount) /
2]
Commercial papers
 These are short-term, unsecured
promissory notes (IOUs) issued by large
firms with great financial strength and high
credit rating to other companies and
institutional investors, such as trust funds,
banks, and insurance companies
 These entail lower cost than bank financing
(the interest rate is usually lower than the
prime rate)
 Its disadvantage is limited access and
availability
 Only the largest firms with the greatest
financial strength can issue commercial
papers
 The amount of funds available is limited to
the excess liquidity of big corporations
Prime interest rate – rate charged by commercial
banks to their best business clients; usually the
lowest rate charged by banks
EFFECTIVE INTEREST RATE OF COMMERCIAL
PAPER:
Effective annual interest rate = [(Interest plus
transaction cost) / (Usable loan amount)*] X
[(Number of days in a year) / (Number of days
funds are borrowed)]

*Usable loan amount = (Loan amount) - (Interest) -

(Transaction cost)

 Interest expense of commercial paper is the

difference between the face value and the
proceeds

Treasury bill – issued by BSP (negotiated source of

funds)

CURRENT PRICE OF TREASURY BILL:

Current price of TB = (Face value) - (Discount)

Factoring of accounts receivable – sale of accounts

receivable, the proceeds from which will be used as
funds (other source of funds)

COST OF FACTORING OF ACCOUNTS

RECEIVABLE:
Cost of factoring of AR = (Interest)* + (Annual
fee)** - (Savings in collection expenses)

*Interest = (Proceeds advanced by bank) X

(Interest rate)

**Annual fee = (Total amount of receivables) X

(Annual fee rate)

 To express in terms of percentage or rate, the

cost of factoring of AR is divided by the
proceeds advanced by bank, not the total
amount of receivables

PROCEEDS FROM FACTORING OF AR:

Face amount of AR
Less: Factor’s holdback or receivable from factor
Less: Commission
Proceeds before interest
Less: Interest charge
Proceeds from factoring of AR

 The interest charge is based on the proceeds

before interest, not the face amount of AR

WEEK 10 – DISTRIBUTION TO
SHAREHOLDERS: DIVIDENDS AND STOCK
REPURCHASE
 Once a company becomes profitable and liquid,
it must decide what to do with the cash it
generates: (a) retain cash and use it to
purchase additional operating assets, to repay
outstanding debts, or to acquire other
companies; or (b) return cash to shareholders
 Every peso that management chooses to retain
is a peso that shareholders could have received
and invested elsewhere, thus, managers should
retain earnings if and only if they can invest the
money within the firm, and earn more than
stockholders can earn outside the firm
 High growth companies with many good
projects or investment opportunities tend to
retain a high percentage of their earnings,
whereas mature companies with a great deal of
cash but limited investment opportunities tend
to have generous cash distribution policies
Optimal dividend policy – strikes a balance
between current dividends and future growth, and
maximizes the firm’s stock price
Residual dividend model – dividend paid is set
equal to net income minus the amount of retained
earnings necessary to finance the firm’s optimal
capital budget
 Under this model, dividends and payout
ratio would vary with investment
opportunities
 Dividend variations would also occur if
earnings fluctuated
 Because investment opportunities and
earnings vary from year to year, adherence
to this policy would result in unstable
dividends
DIVIDENDS (residual dividend model):
Dividends = (Net income) - (Retained earnings
required to help finance new investments)*
*Retained earnings required = (Total capital
budget) X (Target equity ratio)
Equity required = (Investment or total capital
budget) X (Target equity ratio)
 The total capital budget or investment does not
include projects which are not acceptable
(projects whose IRR is less than the cost of
capital)
 The equity required can be financed through
retained earnings (internal) or the issuance of
common stock (external)
DIVIDEND PAYOUT RATIO:
Dividend payout ratio = (Dividends) / (Net income)
DIVIDEND PER SHARE (DPS):
Dividend per share = (Dividends) / (Number of
shares of common stock outstanding)
Stock repurchase – transaction in which a firm buys
back shares of its own stock, thereby decreasing
shares outstanding, increasing EPS, and often,
increasing stock price
EARNINGS PER SHARE (EPS):
Current EPS = (Net income) / (Number of shares of
common stock outstanding)
EPS after stock repurchase = (Net income) /
(Number of shares of common stock outstanding
after stock repurchase)
PRICE-EARNINGS RATIO:
Current price-earnings ratio = (Market price per
share) / (Current EPS)
Price-earnings ratio after stock repurchase =
(Market price per share) / (EPS after stock
repurchase)