CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT

1-1. What is finance?

Finance is the system that includes the circulation of money, the granting of credit, the making of
investments, and the provision of banking facilities. (Defined by Webster’s Dictionary).
a. Areas of finance – 3 areas:
1. Financial management (Corporate Finance)
- Focus on decisions relating to how much and what types of assets to acquire, how to raise
the capital needed to purchase assets, and how to run the firm to maximize its value.
- Principles apply to both for-profit and non-profit organizations.
2. Capital markets
- Relate to the market where interest rates along with stock and bond prices, the financial
institutions that supply capital to businesses.
- Banks, investment banks, stockbrokers, mutual funds, insurance companies, and “savers”
who have money to invest and businesses, individuals, and other entities that need capital
for various purposes.
- Governmental organizations (the Federal Reserve System regulating banks and controlling
the supply of money, the Securities and Exchange Commission regulating the trading of
stocks and bonds in public markets,…).
3. Investments
- Relate to decisions concerning stocks and bonds, include activities:
o Security analysis: deals with finding the proper values of individual securities. (i.e.
stocks and bonds).
o Portfolio theory: deals with the best way to structure portfolios or “baskets” of stocks
and bonds. Rational investors hold diversified portfolios to limit risks and choosing a
properly balanced portfolio is an important issue for any investor.
o Market analysis: deals with the issue of whether stock and bond markets at any given
time are too high, too low, or about right. It includes behavioural finance – investors'
psychology is examined to determine whether stock prices have been bid up to
unreasonable heights in a speculative bubble or driven down to unreasonable lows in
a fit of irrational pessimism.
b. Finance within an organization (Skimming)
c. Finance vs economics and accounting (Skimming)
1-2. Jobs in Finance (Textbook)
1-3. Forms of Business Organisation (Page 7)
- The following are the classifications of business ownership:
o Sole Proprietorship is a form of business owned by a single individual that can be
easily established since there are fewer government regulations to follow.
o Partnership is an unincorporated business in which two or more people oversee a
business operation where all parties share legal and financial liability.
o Corporation is a business organization created by a state that has rights and liabilities
separate and distinct from its owners and managers.

- Advantages and Disadvantages:

Business ownership Advantages Disadvantages

- It is easy and inexpensive to
Sole Proprietorship
create.
- Financial.
- The owner must have
unlimited liability or full
 - It gives the owner complete
authority over all business
activities.
- It allows the owner to
receive all the profits and the
business also pays no taxes.
- Easy and inexpensive to
create.
Partnership - The partners have complete
control, they can combine
ideas, secure more capital.
Limited liability, the ability
to raise investment money,
Corporation perpetual existence,
employee benefits and tax
advantages.
responsibility for debts and
actions of the business.
- Eventually, the death of the
owner automatically
dissolves unless there is a
will to the contrary.
- different interests, one
partner dies the partnership is
over.
Expensive set up, more
heavily taxed, taxes on
profits.

- The different types of businesses are differentiated as follows:

o S Corporation is a classification for small businesses that meets certain conditions
and can elect to be taxed as a proprietorship or a partnership rather than as a
corporation.
o Limited Liability Company (LLC) is a popular type of business hybrid entity having
the liability protection of a corporation and the tax pass-through of a partnership. This
limits the personal liability of the owners and their partners or investors.
o Limited Liability Partnership (LLP) is a business structure where the partners have
limited liability depending on the amount that they put into the business. It protects
the personal assets of a partner when the partnership fails, and creditors cannot go after
them.
1-4. Main Financial Goal: Creating Value for Investors
1. Determinants of Value
- A marginal investor is one who determines a stock's price. On the other
hand, equilibrium occurs when the stock's current value is equal to its intrinsic value.
2. Intrinsic Value
- An intrinsic value is a value derived from the expected future cash flows and its risks which
is based on the complete and correct financial data provided by each company while
the market price is the current stock value or price of an asset or service.
- Current market price:
o The market value of a firm is determined by current expectations for its prospective
organizational and financial performance. The market price is the value of a stock
given the information that is assessed by an investor.
o The current stock price is determined by the investor and his perception of risk and
return of the stock. These estimates may be subject to human error and may not be
reliable and can be incorrect.
 Intrinsic value is the stock's true long-run value since it is calculated based on the firm's
realistic risk and returns. Intrinsic value may not be an accurate measure of the firm's worth,
but it is calculated based on the variables that influence the stock's value.
- A stock is in equilibrium when its intrinsic value equals its current price in the market. When
a stock is in equilibrium, there will be no gains and losses when investors sell or buy stocks.
 But investors' decisions are based on their perception of the market. They buy and sell stocks
out of insights or fear. Since different investors have different perceptions, the current stock
price shifts out the stock's intrinsic value.
- The firm's stock price is better if it equals its intrinsic value if it is sloping upwards. In this
scenario, there be no gains and losses to the investors and the firm's value is continuously
increasing.
o From the stockholders, it is better if the stock price is under the intrinsic value.
Because, in the long run, the stock price will equal its intrinsic value which will
increase the current price of the stocks held by the stockholders and this will give them
profits.
o With the CEO, it is better if the current stock price is above the intrinsic value.
When the stock options are exercised, the CEO will receive overvalued stocks that can
be sold immediately and realize profits.
3. Consequences of having a short-run focus
- Corporate Governance is a system that instils a set of rules and practices that help in
balancing the needs of the company.
1-5. Stockholder–Manager Conflicts
- Stockholder wealth maximization happens when the company's stock price increases, the
value of the firm increases, as well as the shareholder's wealth which is usually done by
business managers.
- Stockholder wealth maximization should be a long-term goal.
o To secure a reliable and satisfying long-term return for the investors, a company must
have a plan for the long run, which takes time to assemble.
o The company created long-term value for the stockholders, all while increasing the
average market price.
- Managers’ Response:
o A corporate raider is when investors often buy a huge number of the company's
shares to take control of it.
o Hostile takeover takes place when a company is acquired by another against the
wishes of the target company's management.
- Agency Theory:
o Agency theory is a principle that is used to explain and resolve issues in the
relationship between business principals and their agents. Most commonly, that
relationship is the one between shareholders, as principals, and company executives,
as agents.
o An agency, in broad terms, is any relationship between two parties in which one, the
agent, represents the other, the principal, in day-to-day transactions. The principal or
principals have hired the agent to perform a service on their behalf.
o Principals delegate decision-making authority to agents. Because many decisions that
affect the principal financially are made by the agent, differences of opinion, and even
differences in priorities and interests, can arise. Agency theory assumes that the
interests of a principal and an agent are not always in alignment. This is sometimes
referred to as the principal-agent problem.
o By definition, an agent is using the resources of a principal. The principal has entrusted
money but has little or no day-to-day input. The agent is the decision-maker but is
incurring little or no risk because any losses will be borne by the principal.
o Financial planners and portfolio managers are agents on behalf of their principals and
are given responsibility for the principals' assets. A lessee may be in charge of
 protecting and safeguarding assets that do not belong to them. Even though the lessee
is tasked with the job of taking care of the assets, the lessee has less interest in
protecting the goods than the actual owners.
CHAPTER 2: FINANCIAL MARKETS AND INSTITUTIONS (Skimming)
CHAPTER 3: FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
3-1. Financial Statement and Reports
- 4 financial statements are contained in most annual reports: balance sheet, income statement,
statement of retained earnings, and statement of cash flows.
- Basic users of financial statements are accountants. Accountants translate physical quantities
into numbers when they construct the financial statements. The number shown on balance
sheets generally represents historical costs. When examining a set of financial statements, one
should keep in mind the physical reality that lies behind the numbers, and the fact that the
translation from physical assets to numbers is far from precise.
- Financial statements are based on generally accepted accounting principles (GAAP) and
audited by CPA firms. Investors need to worry about the validity of those statements. Since
companies are required to follow GAAP, managers still have quite discretion in deciding how
and when to report certain transactions. Consequently, two firms in exactly the same operating
situation may report financial statements that convey different impressions about their
financial strength. Some variations may stem from legitimate differences of opinion about the
correct way to record transactions. In other cases, managers may choose to report numbers in
a way that helps them present either higher earnings or more stable earnings over time.
3-2. The Balance Sheet
3-3. The Income Statement
3-4. Statement of Cash Flows
1. Net cash flow
- Net cash flow is the actual net cash that a firm generates during some specified period. The
value of an asset (or firm) is determined by the cash flows generated. The emphasis in finance
is on net cash flow.
- Cash is necessary to purchase assets to continue operations and to pay dividends.
- Thus, financial managers should strive to maximize cash flows available to investors over the
long run.
- A business’ net cash flow generally differs from net income because some of the expenses
and revenues listed on the income statement are not paid out or received in cash during the
year.
- Primary examples of non-cash charges are depreciation and amortization. These items reduce
net income but are not paid out in cash, they are added back to net income when calculating
cash flow. Likewise, some revenues may not be collected in cash during the year, these must
be subtracted from net income when calculating net cash flow.
- D&A represents the largest non-cash items, in many cases, the other non-cash items roughly
net to zero. Therefore, many analysts assume that net cash flow equals net income + D&A.
2. Free cash flow
- Free Cash Flow (FCF) is the cash flow actually available for distribution to investors after
the company has made all the investments in fixed-assets, new products, and operating
working capital necessary to sustain ongoing operations.
- FCF is defined as net operating profit after taxes (NOPAT) minus the amount of net
investment in operating working capital and fixed assets necessary to sustain the business.
 - FCF is the most important measure of cash flows because it shows the exact amount
available to all investors (stockholders and debtholders). The value of a company’s
operations depends on expected future FCF.
- Managers make their companies more valuable by increasing their FCF. Therefore,
investors ought to focus on cash flow rather than accounting profit.
- Negative cash flow is not necessarily bad. It depends on why the FCF was negative. If FCF
was negative because NOPAT was negative, this is definitely bad, meaning that the
company is experiencing operation problems. However, many high-growth companies have
positive NOPAT but negative FCF because they must invest heavily in operating assets to
support rapid growth. There is nothing wrong with a negative cash flow if it results from
profitable growth.
3. Operating cash flow
- Operating cash flow arises from normal, ongoing operations, whereas net cash flow reflects
both operating and financing decisions. Thus, operating cash flow is defined the difference
between sales revenue and operating expenses paid, after taxes on operating income.
4. NOPAT
- NOPAT is the profit a company would generate if it had no debt and held only operating
assets. Net income is the profit available to common stockholders. Thus, both interest and
taxes have been deducted.
- NOPAT is a better measure of the performance of a company’s operations than net income,
because debt lowers income. To get a true reflection of a company’s operating performance,
one would want to take out debt to get a clearer picture of the situation.
3-5. Statement of Stockholders’ Equity
3-6. Uses and Limitations of Financial Statement
3-7. MVA and EVA
- The management’s actions are incorporated in EVA and MVA such that where the higher the
EVA and MVA means that there is efficiency and the management is doing well inhandling
the business which is better for the stockholders.
- EVA and MVA are interconnected because both of which become higher when
themanagement is progressive when handling the business. This means that the better that
management is handling the business, the higher both EVA and MVA will be. To elaborate,
EVA is the excess of net operating profit after tax of a company over its capital costs which
ishandled by the management and the MVA is the excess of market value equity over
bookvalue which is also handled by the management driving to have a high
equity value. Basically, both are dependent on how well the management is handled.
3-8. Income Taxes
a. Individual Taxes
b. Corporate Taxes
- “Our tax rates are progressive” means the higher the income, the larger is the percentage paid
in taxes. The rationale behind this is based on the taxpayer’s ability to pay. There is an imposed
lower tax rate on low-income earners than those with higher income.
- Double taxation is what transpires in most corporations’ earnings. This means that the
corporations’ earnings are taxed, and then when its after-tax earnings are paid out as
dividends, those earnings are taxed again as personal income to the stockholders.
- Corporations that receive dividend income can exclude some of the dividends from their
taxable income. Because when a corporation receives dividends and then pays out its own
after-tax income as dividends to its stockholders, the dividends are then subject to triple
taxation. This minimizes the amount of triple taxation that would occur otherwise.
 - Most companies can choose either the use of debt or equity to finance operations. In debt
financing, it includes interest which is tax-deductible. On the other hand, equity
financing is not tax deductible but rather has taxes that need to be paid on dividends.
Therefore, taking the use of debt to finance operations is more favorable to most companies
because of tax breaks associated with interest payments.

CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENTS

- Financial ratio analysis is conducted by three main groups of analysts: credit analysts,
stock analysts, and managers.
- Primary emphasis of each group is by no means uniform nor should it be.
o Management is interested in all types of ratios, because:
 The ratios point out weaknesses that should be strengthened;
 Management recognizes that the other parties are interested in all theratios and
that financial appearances must be kept up if the firm is to be regarded highly
by creditors and equity investors.
o Equity investors (stockholders) are interested primarily in profitability, but they
examine the other ratios to get information on the riskiness of equity commitments.
o Long-term creditors are more interested in the debt, TIE, and EBITDA coverage ratios,
as well as the profitability ratios.
o Short-term creditors emphasize liquidity and look most carefully at the current ratio.
- The inventory turnover ratio is more important for someone analyzing a grocey store chain
than an insurance company because of the much larger inventory required, and some of
inventories is perishable. An insurance company would have no inventory to speak of since
its line of business is selling insurance policies or other similar financial products – contracts
written on paper and entered into between the company and the insured.
- Inflation distort ratio analysis comparisons for one company over time (trend analysis) and
for different companies that are being compared. Inflation will cause earnings to increase,
even if there is no increase in sales volume. The book value of the assets that produced the
sales and the annual depreciation expense remain at historic values and do not reflect the
actual cost of replacing those assets. Thus, ratios that compare current flows with historic
values become distorted over time. For example, ROA will increase eventhrough those assets
are generating the same sales volume.
- When comparing different companies, the age of the assets will greatly affect the ratios.
Companies with assets that were purchased earlier will reflect lower asset values than those
thatpurchased assets later at inflated prices. Two firms with similar physical assets and sales
could havesignificantly different ROAs. Under inflation, ratios will also reflect differences in
the way firms treat inventories. As can be seen, inflation affects both income statement and
balance sheet items.
- ROE, using the extended Du Pont equation, is the return on assets multiplied by the
equity multiplier. The equity multiplier, defined as total assets divided by common equity,
is a measure of debtutilization; the more debt a firm uses, the lower its equity, and the higher
the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a
higher ROE.
- Sometimes, there is misleading to compare a company’s financial ratios with those of other
firms that operate in the same industry because firms within the same industry may employ
different accounting techniques that make it difficult to compare financial ratios. More
fundamentally, comparisons may be misleading if firms in the same industry differ in their
other investments.
 - The three components of the extended Du Pont equation are profit margin, assets
turnover, and the equity multiplier. One would not expect the three components of the
discount merchandiser and high-end merchandiser to be the same eventhrough their ROEs are
identical. The discount merchandiser’profit margin would be lower than the high-end
merchandiser, while the assets turnover would be higher for the discount merchandiser than
for the high-end merchandiser.

CHAPTER 5: TIME VALUE OF MONEY (TINH TOAN)

- Opportunity cost is the rate of interest one could earn on an alternative investment with a
risk equal to the value of I in TVM of the investment. It is shown on the top of a timeline,
between the first and second tick marks. It is not a single rate – the opportunity cost rate varies
depending on the riskiness and maturity of an investment, and it also varies from year to year,
depending on inflationary expectations.
- To find the present value of an uneven series of cash flows, you must find the PVs of the
individual cash flows and then sum them. Annuity procedures can never be of use, even
when some of the cash flows constitute an annuity, because the entire series is not an
annuity. True or false? Explain.
 False. Because one can find the PV of an embedded annuity and add this PV to the PVs of the
other individual cash flows to determine the present value of cash flow stream.
- The annual percentage rate (APR) is the periodic rate times the number of periods per year.
It is also called the nominal, or stated, rate. With the "Truth in Lending" law, Congress
required that financial institutions disclose the APR so the rate charged would be more
"transparent" to consumers. The APR is equal to the effective annual rate only when
compounding occurs annually. If more frequent compounding occurs, the effective rate is
always greater than the annual percentage rate. Nominal rates can be compared with one
another, but only if the instruments being compared use the same number of compounding
periods per year. If this is not the case, then the instruments being compared should be put on
an effective annual rate basis for comparisons.
- Loan amortization schedule is a table showing precisely how a loan will be repaid. It gives
the required payment on each payment date and the breakdown of the payment, showing how
much is interest and how much is repayment of principal. These schedules can be used for
any loans that are paid off in installments over time such as automobile loans, home mortgage
loans, student loans, and many business loans.

CHAPTER 6: INTEREST RATES

- Short-term interest rates are more volatile, because:
o The Fed operates mainly in the short-term sector, hence Federal Reserve intervention
has its major effect here
o Long-term interest rates reflect the average expected inflation rate over the next 20 to
30 years, this average does not change as radically as year-to-year expectations.
- Interest rates will fall as the recession takes hold because:
o Business borrowings will decrease
o The Fed will increase the money supply to stimulate the economy.
 If the economy is just entering a recession, it would be better to borrow on a short-term basis
at that time, and then convert to long-term since rates have reached a cyclical low. This
requires interest rate forecasting, which is extremely difficult to do with better than 50%
accuracy.
- If the interest rates rise after a bond issue, the price of the bond will fall and its YTM
will rise if interest rates rise. If the bond still has a long term to maturity, its YTM will
 reflect long-term rates. Of course, the bond's price will be less affected by a change in
interest rates if it has been outstanding a long time and matures soon. While this is true, it
should be noted that the YTM will increase only for buyers who purchase the bond after the
change in interest rates and not for buyers who purchased previous to the change. If the bond
is purchased and held to maturity, the bondholder's YTM will not change, regardless of what
happens to interest rates.
- The YTM can be viewed as the bond's promised rate of return, which is the return that
investors will receive if all of the promised payments are made. However, the YTM equals
the expected rate of return only when:
o The probability of default is zero
o The bond cannot be called.
If there is some default risk or the bond may be called, there is some chance that the
promised payments to maturity will not be received, in which case the calculated YTM
will exceed the expected return.
- If the bond’s price increases, its YTM decreases.
- If the bond is downgraded by the rating agencies, its YTM increases.
- If a change in the bankruptcy code makes it more difficult for bondholders to receive
- payments in the event the firm declares bankruptcy, the bond’s YTM would increase.
- If the economy seems to be shifting from a boom to a recession, the possibility of a firm
defaulting on its bond would increase, consequently, its YTM would increase.
- If investors learn that the bonds are subordinated to another debt issue, the bond’s YTM would
increase.
- Call provision advatageous to a bond issuer. If a company sold bonds when interest rates
were relatively high and the issue is callable, then the company could sell a new issue of low-
yielding securities if and when interest rates drop. The proceeds of the new issue would be
used to retire the high-rate issue, and thus reduce its interest expense. The call privilege is
valuable to the firm but detrimental to long-term investors, who will be forced to reinvest the
amount they receive at the new and lower rates.
- Treasury bonds, along with all other bonds, are available to investors as an alternative
investment to common stocks. An increase in the return on Treasury bonds would increase
the appeal of these bonds relative to common stocks, and some investors would sell their
stocks to buy T-bonds. This would cause stock prices, in general, to fall.
- Trade deficit occurs when a country buys more than it sells. In other words, a trade deficit
occurs when the U.S. imports more than it exports. When trade deficits occur, they must be
financed, and the main source of financing is debt. Therefore, the larger the U.S. trade deficit,
the more the U.S. must borrow, and as the U.S. increases its borrowing, this drives up interest
rates.

CHAPTER 7: BONDS AND THEIR VALUATION

- A sinking fund can be set up in one of two ways:
o The corporation makes annual payments to the trustee, who invests the proceeds in
securities (frequently government bonds) and uses the accumulated total to retire the
bond issue at maturity.
o The trustee uses the annual payments to retire a portion of the issue each year, calling
a given percentage of the issue by a lottery and paying a specified price per bond or
buying bonds on the open market, whichever is cheaper.
- A sinking fund provision facilitates the orderly retirement of the bond issue. Although
sinking funds are designed to protect investors by ensuring that the bonds are retired in an
 orderly fashion, sinking funds can work to the detriment of bondholders. On balance,
however, bonds that have a sinking fund are regarded as being safer than those without
such a provision, so at the time they are issued sinking fund bonds have lower coupon rates
than otherwise similar bonds without sinking funds.
- The difference between a call for a sinking fund purposes and a refunding call is:
o A call for sinking fund purposes is quite different from a refunding call. A sinking
fund call requires no call premium, and only a small percentage of the issue is normally
callable in a given year.
o A refunding call gives the issuer the right to call all the bond issue for redemption. The
call provision generally states that the issuer must pay the bondholders an amount
greater than the par value if they are called.
- From the corporation's viewpoint, one important factor in establishing a sinking fund is that
its own bonds generally have a higher yield than do government bonds; hence, the company
saves more interest by retiring its own bonds than it could earn by buying government bonds.
This factor causes firms to favor the second procedure. Investors also would prefer the annual
retirement procedure if they thought that interest rates were more likely to rise than to fall, but
they would prefer the government bond purchase program if they thought rates were likely to
fall. In addition, bondholders recognize that, under the government bond purchase scheme,
each bondholder would be entitled to a given amount of cash from the liquidation of the
sinking fund if the firm should go into default, whereas under the annual retirement plan, some
of the holders would receive a cash benefit while others would benefit only indirectly from
the fact that there would be fewer bonds outstanding.
- On balance, investors seem to have little reason for choosing one method over the other, while
the annual retirement method is clearly more beneficial to the firm. The consequence has been
a pronounced trend toward annual retirement and away from the accumulation scheme.
- Short-term bond prices are less sensitive than long-term bond prices to interest rate changes
because funds invested in short-term bonds can be reinvested at the new interest rate sooner
than funds tied up in long-term bonds.
- Convertibles and bonds with warrants are typically offered with lower coupons than
similarly rated straight bonds. Because both offer investors the chance for capital gains as
compensation for the lower coupon rate:
o Convertible bonds are exchangeable into shares of common stock, at a fixed price, at
the option of the bondholder.
o Bonds issued with warrants are options that permit the holder to buy stock for a stated
price, thereby providing a capital gain if the stock's price rises.
- The yield spread between a corporate bond over a Treasury bond with the same maturity
reflects both investors' risk aversion and their optimism or pessimism regarding the economy
and corporate profits. If the economy appeared to be heading into a recession, the spread
should widen. The change in spread would be even wider if a firm's credit strength weakened.
- A bond’s expected return is sometimes estimated by its YTM and sometimes by its YTC.
Assuming a bond issue is callable, the YTC is a better estimate of a bond's expected return
when interest rates are below an outstanding bond's coupon rate. The YTM is a better estimate
of a bond's expected return when interest rates are equal or above an outstanding bond's
coupon rate.

CHAPTER 8: THE RISK AND RATES OF RETURN

- It is possible to contract a portfolio of real-word stocks that has a required return equal
to the risk-free rate if the portfolio's beta is equal to zero. In practice, however, it may be
impossible to find individual stocks that have a non-positive beta. In this case it would also
 be impossible to have a stock portfolio with a zero beta. Even if such a portfolio could be
constructed, investors would probably be better off just purchasing Treasury bills, or other
zero beta investments.
- If investors’ aversion to risk increased, the risk premium on a high-beta stock would increase
by more than on a low-beta stock.
- If a company’s beta were to double, its required return would not also double. Because
according to the Security Market Line (SML) equation, an increase in beta will increase a
company's expected return by an amount equal to the market risk premium times the change
in beta. For example, assume that the risk-free rate is 6%, and the market risk premium is 5%.
If the company's beta doubles from 0.8 to 1.6 its expected return increases from 10% to 14%.

CHAPTER 9: STOCKS AND THEIR VALUATION

1. Common Stock
- Three key features of common stock:
o Residual Claim, the common stock shareholder is entitled to all assets and cash flow
of the company after the liabilities have been satisfied.
o No Maturity Date, the stock never pays out a principal at maturity and is considered
permanent financing.
o Vote, shares allow owners to vote on activities, charter changes, board members, etc.
- Common stock’s dividends are set by the board and will change over time.
- Role of the investment banker in the primary sale of common stock: The investment
banker is the partner to the company in the sale of common stock in the primary market. The
investment banker serves as the distributor of information to potential buyers, the expert to
the company on pricing and timing of the sale, and the marketer of the shares.
- If you bought a share of common stock, you would probably expect to receive dividends plus
an eventual capital gain. The distribution between the dividend yield and the capital gains
yield will be influenced by the firm’s decision to pay more dividends rather than to retain and
reinvest more of its earnings. Because if a company decides to increase its payout ratio, then
the dividend yield component will rise, but the expected long-term capital gains yield will
decline.
2. Preferred Stock
- Preferred stock is a form of financing where the owner receives a pre-set dividend based on
the par value of the preferred stock.
- Preferred stock must receive its dividends prior to dividends sent to common stock holders.
Hence, preferred stock represents a preferential claim on dividends.
3. Preemptive right
It is frequently stated that the one purpose of the preemptive right is to allow individuals to
maintain their proportionate share of the ownership and control of a corporation.
- The preemptive right is more important to the stockholders of closely held (private) firms
whose owners are interested in maintaining their relative control positions.
The discounted dividend and the corporate valuation models comparison:
- The discounted dividend:
o Uses the firm's cost of equity as the discount rate to discount future dividends per share
an investor expects to receive starting at t = 1 to calculate the firm's intrinsic value.
o The discounted dividend can not be used to value divisions and firms that do not pay
dividends.
- The corporate valuation models:
o Uses the firm's weighted average cost of capital as the discount rate to discount the
firm's future FCF starting at t = 1 to arrive at the firm's corporate value.
 o The corporate valuation model can be used to value divisions and firms that do not
pay dividends.
- The P/E multiple: can be used as a starting point in stock valuation. If a stock's P/E ratio is
well above its industry average and if the stock's growth potential and risk are similar to other
firms in the industry, the stock's price may be too high. To estimate a ball-park value, multiply
the firm's EPS by the industry-average P/E ratio.
- EVA (Economic Value Added): Companies increase their EVA by investing in projects that
provide shareholders with returns greater than the cost of capital. When purchasing a firm's
stock, buyers receive more than just the book value of equity, they also receive a claim on all
future value that is created by the firm's managers. So, it follows that a company's market
value of equity = book value plus the present value of all future EVAs. This value is then
divided by the number of shares outstanding to arrive at an estimate of the stock's intrinsic
value.

CHAPTER 10: THE COST OF CAPITAL

The risk-free rate is the rate of return a risk-free asset generates on average. According to the capital
asset pricing, a higher risk-free rate will also raise the expected return on a stock, holding other
factors constant.
The increase in the risk free rate with the market risk premium remains constant will not affect
the cost of existing debt. But it could increase the cost of debt through new issuance.
Weighted Average Cost of Capital (WACC) is the rate at which a company will pay for raising
finances. Company raises money issuance of new shares, issuance of note or bonds(debts). The
WACC is also the same as Cost of Capital.
The capital structure weights used to calculate the WACC are determined:
- The stock market falls drastically, and the firm’s stock price falls along with the rest. The
target proportions of debt, preferred stock, and common equity, along with the costs of those
components, are used to calculate the firm’s weighted average cost of capital, WACC.
- To determine the weights to be used in the computation of WACC of a company, a manager
should ideally use the proportion of each source of capital which will be used.
- The market value weights are appropriate compared to book value weights. Hence, historical
market value weights should be used for calculation of WACC out of the three options –
marginal weights, historical book value weights, and historical market value weights.
The WACC would be different if the equity for the coming year came solely in the form of
retained earnings versus some equity from the sale of new common stock:
- WACC will be lower if the equity came solely from retained earnings.
 WACC are going to be different if the equity for the approaching year came solely from
retained earnings. WACC are going to be lower if equity comes solely from retained earnings
because the price of retained earnings is zero or smaller than if new equity is issued.
- WACC depends on the size of the capital budget.
 WACC does rely on the dimensions of the capital budget. If usage of retained earnings is
above new equity, WACC will decrease and vice-versa.
- Dividend policy affects WACC.
 Dividend policy affects WACC. If a firm’s dividend payout is high, there will be smaller
addition to retained earnings and this will make the WACC to increase and vice-versa.

CHAPTER 11: THE BASICS OF CAPITAL BUDGETING

1. Capital budgeting analysis pay attention only to cash flows.
 Because finance theory argues that cash flows are the underlying determinant of the financial
value of a company. By examining cash flows, capital budgeting analysis measures the
 exchange of value between a proposed project's projected cash outflows and projected cash
inflows to test whether the benefits exceed the costs, if so, the company's financial value
should increase.
2. Sunk cost
- A sunk cost is a cost that has already taken place.
- It is ignored in capital budgeting because it cannot be changed by the decision under
consideration, hence it is irrelevant to the potential change in the company's financial value
that would come from accepting the proposed capital budgeting project.
3. NPV and IRR
a. NPV – Net Present Value
- The NPV of a proposed investment project is the anticipated increase (if positive or decrease
if negative) in the financial worth of an organization from investing in that project.
b. IRR – Internal rate of return
- The IRR of a proposed investment project is the anticipated interest rate an organization would
earn on the money invested in that project. (Analytically, a proposed project's IRR is the
discount rate that makes NPV=0.)
c. Comparisons
- They are the same in that they both begin with the projected cash flows from the investment.
- They differ in the way they match the cash flows against the organization's cost of capital.
o NPV incorporates the cost of capital directly in the analysis as a result, an NPV number
is valid only for an organization with that specific cost of capital.
o IRR first analyzes the investment's projected cash flows without regard to a cost of
capital, making the IRR number valid for any organization with the same cash flow
estimates. Cost of capital enters in a second step to test whether the IRR issufficiently
high to add financial value.
- Calculating an NPV involves obtaining the present values of future cash flows. These future
flows are greater than the project's initial outflow the IRR describes this difference. If the IRR
is used as the discount rate in the NPV analysis, its effect is to exactly remove the greater
value in the future cash flows. The present value of these flows becomes equal to the
project's initial outlay, and NPV calculates as equal to zero.
- Not all capital budgeting projects are of the same risk or time horizon. The Fisher model of
interest rates tells us that investor's required rates of return depend on forecasted inflation (a
function of time horizon) and risk. As a result, each capital budgeting project has its own
hurdle rate, a cost of capital appropriate for its particular combination of time and risk.
Applying one cost of capital to all proposed projects runs the risk of making poor
decisions: rejecting value-adding low-risk projects and accepting nonvalue-adding high
risk projects.