Approved CAE - BSA BSMA BSAIS BSIA - ACC 222 - Acdog

UNIVERSITY OF MINDANAO
College of Accounting Education
Program: BSA, BSIA, BSMA, BSAIS
Physically Distanced but Academically Engaged
Self-Instructional Manual (SIM) for

Self-Directed Learning (SDL)
Course/Subject: ACC222 – Financial Management
Name of Teacher: ___________________________
Name of Author: Phoebelyn V. Acdog
THIS SIM/SDL MANUAL IS A DRAFT VERSION ONLY; NOT FOR

REPRODUCTION AND DISTRIBUTION OUTSIDE OF ITS INTENDED
USE. THIS IS INTENDED ONLY FOR THE USE OF THE STUDENTS
WHO ARE OFFICIALLY ENROLLED IN THE COURSE/SUBJECT.
EXPECT REVISIONS OF THE MANUAL.
THIS IS NOT FOR COMMERCIAL USE.

3F, Business & Engineering Building
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Table of Contents
Course Outline: ACC222 – FINANCIAL MANAGEMENT Error! Bookmark not defined.
Course Outline Policy Error! Bookmark not defined.
Course Information Error! Bookmark not defined.
Big Picture 1
Week 1-3: Unit Learning Outcomes (ULO): At the end of the unit, you are expected to 1
ULOa. Discuss the nature and purpose of financial management. Error! Bookmark not defined.
Metalanguage 1
Essential Knowledge 2
Self-Help Error! Bookmark not defined.
Let’s Check 6
Let’s Analyze 8
In a Nutshell 11
Q&A List 12
Keywords Index 12
ULOb. Compare intrinsic value and fair value. Error! Bookmark not defined.
ULOc. Explain the conflicts between stockholders and managers. How can these conflicts be
alleviated? Error! Bookmark not defined.
ULOd. Explain how to maximize shareholders’ wealth. Error! Bookmark not defined.
Metalanguage 13
Let’s Check 17
Let’s Analyze 19
In a Nutshell 28
Q&A List 28
Keywords Index 28
ULOe. Discuss the importance of financial statements in finance decision making. Error!
Bookmark not defined.
ULOf. Discuss the importance of analysis of financial statements in decision making. Error!
ULOg. Analyze horizontal, vertical and ratio analysis Error! Bookmark not defined.
Metalanguage 29
Let’s Check 44
Let’s Analyze 47
In a Nutshell 48
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Phone No.: (082)300-5456 Local 137
Q&A List 49
Keywords Index 49
ULOh. Explain the key factors on which external financing depends, as indicated in the AFN
equation. Error! Bookmark not defined.
ULOi. Apply the different financial management tools for decision making. Error! Bookmark
not defined.
Metalanguage 50
Let’s Check 54
Let’s Analyze 56
In a Nutshell 57
Q&A List 57
Keywords Index 57
COURSE SCHEDULES 58
ULOa. Discuss the elements of interest rates. Error! Bookmark not defined.
Metalanguage 59
Let’s Check 67
Let’s Analyze 68
In a Nutshell 70
Q&A List 70
Keywords Index 70
ULOb. Apply key concepts of bonds and their valuation. Error! Bookmark not defined.
Metalanguage 71
Let’s Check 80
Let’s Analyze 82
In a Nutshell 84
Q&A List 85
Keywords Index 85
ULOc. Explain the nature of risk and rates of return. Error! Bookmark not defined.
ULOd. Compare stand-along risk and portfolio risk. Error! Bookmark not defined.
Metalanguage 86
Let’s Check 92
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Let’s Analyze 92
In a Nutshell 95
Q&A List 96
Keywords Index 96
ULOe. Apply key concepts of stocks and their valuation. Error! Bookmark not defined.
Metalanguage 97
Let’s Check 105
Let’s Analyze 106
In a Nutshell 109
Q&A List 110
Keywords Index 110
COURSE SCHEDULES 111
ULOa. Explain the elements of the cost of capital. Error! Bookmark not defined.
ULOb. Compare CAPM and WACC. Error! Bookmark not defined.
Metalanguage 112
Let’s Check 119
Let’s Analyze 120
In a Nutshell 122
Q&A List 122
Keywords Index 122
ULOc. Discuss the nature and concept of capital budgeting. Error! Bookmark not defined.
ULOd. Explain the different capital budgeting tools for decision making. Error! Bookmark not
defined.
ULOe. Apply key concepts of cost of capital and capital budgeting. Error! Bookmark not
defined.
Metalanguage 123
Let’s Check 131
Let’s Analyze 132
In a Nutshell 133
Q&A List 133
Keywords Index 133
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ULOf. Discuss the importance of capital structure. Error! Bookmark not defined.
ULOg. Explain the essence of leverage in business organization. Error! Bookmark not defined.
ULOh. Apply key concepts of capital structure and leverage for decision making. Error!
Metalanguage 134
Let’s Check 143
Let’s Analyze 144
In a Nutshell 146
Q&A List 147
Keywords Index 147
ULOa. Discuss the nature and concepts of dividends and share repurchase. Error! Bookmark
not defined.
ULOb. Apply key concepts of dividends and share repurchase for decision making. Error!
Metalanguage 149
Let’s Check 153
Let’s Analyze 154
In a Nutshell 156
Q&A List 156
Keywords Index 156
ULOc. Explain the nature and concepts of working capital management. Error! Bookmark not
defined.
ULOd. Compare the different working capital management tools for decision making. Error!
ULOe. Apply key concepts of working capital management for decision making. Error!
Metalanguage 157
Let’s Check 168
Let’s Analyze 169
In a Nutshell 171
Q&A List 171
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Keywords Index 172

Online Code of Conduct 173
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Course Outline: ACC222 – FINANCIAL MANAGEMENT
Course Coordinator: Phoebelyn V. Acdog, CPA

Email: pacdog@umindanao.edu.ph
Student Consultation: By Blackboard LMS Message
Mobile: 0919-2538567
Phone: c/o UM CAE 305-0645
Effectivity Date: May 25, 2020 (Summer/Term)
Mode of Delivery: Blended (On-Line with face to face or virtual sessions)
Time Frame: 54 Hours
Student Workload: Expected Self-Directed Learning
Requisites: Acc212 – Financial Markets
Credit: 3
Course Outline Policy
Areas of Concern Details

Contact and Non-contact This 3-unit course self-instructional manual is designed for
Hours blended learning mode of instructional delivery with scheduled
face to face or virtual sessions. The expected number of hours
will be 54 including the face to face or virtual sessions.
Assessment Task Submission of assessment tasks shall be on 3rd, 5th, 7th and 9th
Submission week of the term. The assessment paper shall be attached
with a cover page indicating the title of the assessment task (if
the task is performance), the name of the course coordinator,
date of submission and name of the student. The document
should be emailed to the course coordinator. It is also
expected that you already paid your tuition and other fees
before the submission of the assessment task.
If the assessment task is done in real time through the features

in the Blackboard Learning Management System, the
schedule shall be arranged ahead of time by the course
coordinator.
Since this course is included in the licensure examination for

accountants, you will be required to take the Multiple- Choice
Question exam inside the University. This should be scheduled
ahead of time by your course coordinator. This is non-
negotiable for all licensure-based programs.
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Turnitin Submission All assessment tasks are required to be submitted through

(if necessary) Turnitin with a maximum similarity index of 30% to ensure
honesty and authenticity. This means that if your paper goes
beyond 30%, the students will either redo her/his paper or
explain in writing addressed to the course coordinator the
reasons for the similarity. In addition, if the paper has reached
more than 30% similarity index, the student may be called for
disciplinary action in accordance with the University's OPM on
Intellectual and Academic Honesty.
Please note that academic dishonesty such as cheating and

commissioning other students or people to complete the task
for you have severe punishments (reprimand, warning,
expulsion).
Penalties for Late The score for an assessment item submitted after the
Assignments/Assessments designated time on the due date, without an approved
extension of time, will be reduced by 5% of the possible
maximum score for that assessment item for each day or part
day that the assessment item is late.
However, if the late submission of assessment paper has a

valid reason, a letter of explanation should be submitted and
approved by the course coordinator. If necessary, you will
also be required to present/attach
evidences.
Return of Assignments/ Assessment tasks will be returned to you two (2) weeks after
Assessments the submission. This will be returned by email or via Blackboard
portal.
For group assessment tasks, the course coordinator will require

some or few of the students for online or virtual sessions to ask
clarificatory questions to validate the originality of the
assessment task submitted and to ensure that all the group
members are involved.
Assignment Resubmission You should request in writing addressed to the course
coordinator his/her intention to resubmit an assessment task.
The resubmission is premised on the student’s failure to comply
with the similarity index and other reasonable grounds such as
academic literacy standards or other reasonable circumstances
e.g. illness, accidents financial constraints.
Re-marking of Assessment You should request in writing addressed to the program
Papers and Appeal coordinator your intention to appeal or contest the score given
to an assessment task. The letter should explicitly explain the
reasons/points to contest the grade. The program coordinator
shall communicate with the students on the approval and
disapproval of the request.
If disapproved by the course coordinator, you can elevate your

case to the program head or the dean with the original letter of
request. The final decision will come from the dean of the
college.
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Phone No.: (082)300-5456 Local 137
Grading System All culled from Black Board sessions and traditional
contact
EXAMINATIONS ……………………………………….. 60%

Exam 1 to Exam 3 (10% each) …………….. 30%
Final Exam (50% MCQ;
50% Performance Task) ………………… 30%
CLASS PARTICIPATIONS ……………………………. 40%

Quizzes ……………………………………….. 10%
Final Requirements ………………………….. 15%
Oral Recitation ……………………………….. 10%
Assignments ………………………………….. 5%
TOTAL ………………………………………………….... 100%
Submission of the final grades shall follow the usual University

system and procedures.
Preferred Referencing Style Harvard Referencing Style
Student Communication You are required to create a umindanao email account which
is a requirement to access the BlackBoard portal. Then, the
course coordinator shall enroll the students to have access to
the materials and resources of the course. All communication
formats: chat, submission of assessment tasks, requests etc.
shall be through the portal and other university recognized
platforms.
You can also meet the course coordinator in person through

the scheduled face to face sessions to raise your issues and
concerns.
For students who have not created their student email,

please contact the course coordinator or program head.
Contact Details of the Dean Lord Eddie I. Aguilar
Email: aguilar_lordeddie@umindanao.edu.ph
Phone: (082) 3050645 local 137
Contact Details of the Mary Grace Sombilon
Assistant Dean and the Assistant Dean
Program Head Email: sombilon_marygrace@umindanao.edu.ph
Phone: (082) 3050645 local 137
Jade Solana
(BSA, BSMA)
Email:
Phone: Phone: (082) 3050645 local 137
Devzon U. Porras
(BSIA, BSAIS, BSAT)
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Email: dporras@umindanao.edu.ph
Phone: (082) 3050645 local 137
Students with Special Students with special needs shall communicate with the course
Needs coordinator about the nature of his or her special needs.
Depending on the nature of the need, the course coordinator
with the approval of the program coordinator may provide
alternative assessment tasks or extension of the deadline of
submission of assessment tasks. However, the alternative
assessment tasks should still be in the service of achieving the
desired course learning outcomes.
Online Tutorial Through LMS or PM Chats
Library and Information Brigida E. Bacani

Center (LIC) Resource Email: library@umindanao.edu.ph
09513766681
For inquiries, you can email at umlic.eresources@gmail.com,

raphael_digal@umindanao.edu.ph or
chat with us here http://library.umindanao.edu.ph/
Facebook page:
https://www.facebook.com/UM-Learning-and-Information-
Center-Davao-City-962331877193048/
Well-Being Welfare Support Ronadora E. Deala
Help Desk Email: Ronadora_deala@umindanao.edu.ph
09212122846
GSTC Facilitator
Zerdszen P. Rañises
Emai: gstcmain@umindanao.edu.ph
09058924090
GSTC Facebook Page:

https://facebook.com/UM-GSTC-Main-CAE-
111901303784349/?modal=admin_todo_tour
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Course Information – see/download course syllabus in the Black Board LMS
CC’s Voice: Hello, future accountants! Welcome to our ACC 222 course – Financial
Management. This is your 2nd finance course in your chosen
profession. Hopefully, by now, you can adjust and see yourself become
an Accountant someday. Meeting with key executives in the company
and helping them in their respective businesses.
CO This course is a continuation of your Acc212 – Financial Markets. This

course provides the synthesis of finance policies into a grand strategy
which integrates organizational purpose and goals. The focus of the
course is on current thinking regarding valuation of the firm, investment
decision processes, financing and dividend policies, asset management
and financial strategies, and portfolio theory. This course also covers
the financial analysis, financial planning and forecasting, interest rates,
bonds and their valuation, risk and rates of returns, stocks and their
valuation, the cost of capital, capital budgeting, capital structure and
leverage, distribution to shareholders, and working capital
management.
Let us begin!
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Phone No.: (082)300-5456 Local 137
Big Picture
Week 1-3: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to
a. Discuss the nature and purpose of financial management;

b. Compare intrinsic value and fair value;
c. Explain the conflicts between stockholders and managers. How can these
conflicts be alleviated?
d. Explain how to maximize shareholders’ wealth;
e. Discuss the importance of financial statement in finance decision making;
f. Discuss the importance of analysis of financial statements in decision making; and
g. Analyze horizontal, vertical and ratio analysis.
h. Explain the key factors on which external financing depends, as indicated in the
AFN equation.
i. Apply the different financial management tools for decision making.
Big Picture in Focus:

ULOa. Discuss the nature and purpose of financial management.
Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOa will be operationally defined to establish a common frame of refence as
to how the texts work in your chosen field or career. You will encounter these terms as we
go through the study of curriculum. Please refer to these definitions in case you will
encounter difficulty in the in understanding the nature and purpose of financial
management.
1. Proprietorship. A form of business organization that is unincorporated and is

owned by one individual.
2. Partnership. A form of business organization that is unincorporated that is owned
by two or more persons.
3. Corporation. A legal entity by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited
liability.
4. Finance. Art and science of managing money.
5. Economics. Provides a structure for decision making in the area of risk analysis;
it also provides a broad picture of the economic environment that affects the
business.
6. Accounting. It is considered as the language of finance because it provides
financial data through financial statements.
7. Financial Management. It refers to capital procurement, funds allocation, capital
restructuring, and profit administration which involves financial planning, analysis
of financial condition and supervision of financial operations.
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8. Treasurer. Responsible for the firm’s financial activities including financial

planning, raising funds, making capital budgeting decisions and managing the
firm’s working capital. It is also known as the Chief Financial Manager.
9. Controller. In-charge of the firm’s accounting activities such as corporate
accounting, tax management, financial accounting, and cost accounting. It is also
known as the Chief Accountant.
10. Stockholder Wealth Maximization. The primary goal for managerial decisions;
considers the risk and timing associated with expected earnings per share in order
to maximize the price of the firm’s common stock.
Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the first three
(3) weeks of the course, you need to fully understand the following essential
knowledge that will be laid down in the succeeding pages. Please note that you are
not limited to exclusively refer to these resources. Thus, you are expected to utilize
other books, research articles and other resources that are available in the university’s
library e.g. ebrary, search.proquest.com etc.
In business, Financial Management problems are inevitable, no matter what the

size of your business is. For example, if you were to start a small business of your
own, you must develop a plan. This plan covers what assets or other resources will
the business require. The purchase of these resources can require substantial funds.
Thus, Financial Management is essential.
1. Finance. It is the art and science of managing money. The field of finance is
closely related to economics and accounting. Thus, a financial manager must
understand both economics and accounting.
1.1 Economics. Provides a structure for decision making in the area of risk
analysis. It also provides a broad picture of the economic environment that
affects the business.
1.2 Accounting. It is considered as the language of finance because it provides
financial data through financial statements.
2. Financial Management. It refers to capital procurement, funds allocation, capital

restructuring, and profit administration which involves financial planning, analysis
of financial condition and supervision of financial operations. Financial
management endeavors to make optimal investment, financing, and
dividend/share repurchase decisions.
2.1 Scope of Financial Management. It covers:
● Working Capital Management
● Investment/Portfolio Analysis
● Capital Investment Analysis
● Capital Structure
2.2 Financial Manager. A financial manager actively handles the financial affairs
of the business firm. His/her tasks involves:
● Financial Planning and Forecasting
● Making Investment and Financing Decisions
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● Risk Management
2.3 Goal of Financial Management. The goal of financial management is more
than just profit maximization. It is value maximization or maximizing
shareholders’ wealth.
3. Forms of Business Organization. The key aspects of financial management are

the same for all businesses, large or small, regardless of how they are organized.
Still, its legal structure does affect some aspects of a firm’s operations and thus
must be recognized. There are three main forms of business organization:
3.1 Sole Proprietorship. It is an unincorporated business owned by an individual.

Going into business as sole proprietor is easy – merely begin business
operations. This form is primarily used for small businesses.
SOLE PROPRIETORSHIP
ADVANTAGES DISADVANTAGES
Proprietors have unlimited personal
liability for the business debts,
Easy and inexpensive to form which can result in losses that
exceed the money they have
invested in the company.
Subject to few government Difficulty for proprietorships to
regulations obtain large sums of capital
The life of a business organized is
Subject to lower income taxes than
limited to the life of the individual
corporations
who created it.
3.2 Partnership. It is a legal arrangement between two or more people who

decide to do business together. They can be established easily and
inexpensively. They are also not subject to corporate income tax.
PARTNERSHIP
Easy and inexpensive to form Unlimited personal liabilitya
Not subject to corporate income Difficulty in raising capital
tax
Limited lives
aUnlimited Personal Liability – Under Partnership Law, each partner is liable for the business’s
debts. Therefore, if any partner is unable to meet his/her pro rata liability and the partnership goes
bankrupt, then the remaining partners are personally responsible for making good on the
unsatisfied claims.
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3.3 Corporation. It is a legal entity created by a state, and it is separate and distinct
from its owners and managers.
CORPORATION
Unlimited life High cost of setup and report filing
Limited liabilityb Subject to double taxationc
It is easier to transfer one’s
ownership interest (stock) in a
corporation than one’s interest in a
nonincorporated business.
It is much easier for corporations to
raise the capital necessary to
operate large businesses.
bLimited Liability - their owners are not subject to losses beyond the amount they have invested in
the business
cDouble Taxation - the earnings of the corporation are taxed at the corporate level, and then, when
after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to
the stockholders.
4. Deciding on a form of organization. Firms must trade off the advantages of

incorporation against a possibly higher tax burden. However, the value of any business
other than a very small one will probably be maximized if it is organized as a corporation
for the following three reasons:
4.1 Limited liability reduces the risks borne by investors, and, other things held constant,
the lower the firm’s risk, the higher its value.
4.2 A firm’s value is dependent on its growth opportunities, which, in turn, are dependent
on its ability to attract capital. Because corporations can attract capital more easily
than can unincorporated businesses, they are better able to take advantage of
growth opportunities.
4.3 The value of an asset also depends on its liquidity, which means the ease of selling
the asset and converting it to cash at a “fair market value.” Because an investment
in the stock of a corporation is much easier to transfer to another investor than are
proprietorship or partnership interests, a corporate investment is more liquid than a
similar investment in a proprietorship or partnership, and this too enhances the value
of a corporation.
5. The finance function. The size and importance of the finance function depends on the
size of the firm.
5.1 The finance function and the size of the firm.
SIZE OF THE FIRM FINANCE FUNCTION
Small Firms Accounting Unit
Bigger Firms Separate Finance Unit
Chief Financial Officer, Treasurer and
Large Corporations
Controller
5.2 Treasurer. He/she is responsible for the firm’s financial activities including financial
planning, raising funds, making capital budgeting decisions, and managing the firm’s
working capital. It is also known as the Chief Financial Manager.
5.3 Controller. He/she is in-charge of the firm’s accounting activities such as corporate
accounting, tax management, financial accounting, and cost accounting. It is also
called as Chief Accountant.
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5.4 Finance within the organization.
5.5 Major decisions in the finance function.

● Investing Decision. It involves provision of capital to proposals whose benefits
are to be realized in the future. Investments in capital projects should provide
expected returns in excess of what financial markets require.
● Financing Decision. It involves determination of the best capital structure.
Capital structure involves determining the best mix of debt, equity, and hybrid
securities to employ.
● Dividend Decision. It involves allocation of cash to be distributed to
shareholders. Excess cash can be distributed to stockholders directly through
dividend.
● Risk Management. It involves determining which risks to accept, which to
neutralize, and which to transfer. The four key processes in risk management
are: Identification, Assessment, Mitigation and Transference.
Self-Help: You can also refer to the sources below to help you further
understand the lesson:
*Brigham, E. and Houston, J. (2007). Fundamentals of Financial Management (11th Edition). USA:
Thomson South-Western
*Broyles, J. (2003). Financial Management and Real Options. England: John Wiley & Sons, Ltd.
*Hill, A. (2008). Strategic Financial Management. Ventus Publishing.
*Drake, P.P. and Fabozzi, F. (2010). The Basics of Finance: An Introduction to Financial Markets,
Business Finance, and Portfolio Management. USA: John Wiley & Sons, Ltd.
*Mcmenamin, J. (2005). Financial Management: An Introduction. USA: Routledg
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Let’s Check
Activity 1 (Adapted. Brigham & Houston. (2015). Fundamentals of Financial
Management). Now that you know the most essential knowledge in the nature and purpose
of financial management, let us try to check your understanding. In the space provided, write
the letter of the correct answer.
1. Which of the following statements is FALSE?

a. In most corporations, the CFO ranks under the CEO.
b. The board of directors is the highest-ranking body in a corporation, and the chairman
of the board is the highest ranking individual. The CEO generally works under the board
and its chairman, and the board generally has the authority to remove the CEO under
certain conditions.
c. Partnerships and proprietorships generally have a tax advantage over corporations.
d. A disadvantage of the corporate form of organization is that corporate stockholders are
more exposed to personal liabilities in the event of bankruptcy than are investors in a
typical partnership.
2. Choose the INCORRECT statement/s.

I. An advantage of the corporate form of organization is that corporations are generally
less highly regulated than proprietorships and partnerships.
II. One advantage of the corporate form of organization is that it avoids double
taxation.
III. It is generally harder to transfer one's ownership interest in a partnership than in a
corporation.
a. Statement I only
b. Statement I and II
c. All statements are correct.
d. None of the statements are correct.
3. Choose the CORRECT statement/s.

I. It is generally less expensive to form a corporation than a proprietorship because,
with a proprietorship, extensive legal documents are required.
II. The more capital a firm is likely to require, the greater the probability that it will be
organized as a corporation.
III. One disadvantage of forming a corporation rather than a partnership is that this
makes it more difficult for the firm's investors to transfer their ownership interests.
a. Statement I only
b. Statement II only
c. Statement I, II and III
d. All of the statements are incorrect.
4. Choose the INCORRECT statement/s.

I. Organizing as a corporation makes it easier for the firm to raise capital. This is
because corporations' stockholders are not subject to personal liabilities if the firm
goes bankrupt and because it is easier to transfer shares of stock than partnership
interests.
II. Maximizing firm’s profit is not equivalent to maximizing shareholders’ wealth.
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a. Statement I only
b. Statement II only
c. Neither statements are incorrect.
d. Both statements are incorrect.
5. Which of the following statements is CORRECT?
a. One of the disadvantages of incorporating your business is that you could become
subject to the firm’s liabilities in the event of bankruptcy.
b. Having sole proprietorship or partnership as a form of business is advantageous in
terms of taxes in comparison with corporations.
c. Corporations are subject to lesser regulations than sole proprietorship.
d. Partners have equal rights, privileges, and liabilities in all types of partnership.
6. He/she is in-charge of the firm’s accounting activities such as corporate accounting, tax
management, financial accounting, and cost accounting.
a. Controller
b. Treasurer
c. Chief Financial Officer
d. Chairman of the Board
7. He/she is responsible for the firm’s financial activities including financial planning, raising
funds, making capital budgeting decisions, and managing the firm’s working capital.
a. Controller
b. Treasurer
c. Chief Financial Officer
d. Chairman of the Board
8. It involves determination of the best capital structure.

a. Investing Decision
b. Financing Decision
c. Dividend Decision
d. Safekeeping Decision
9. It involves allocation of cash to be distributed to shareholders.

10. It involves provision of capital to proposals whose benefits are to be realized in the future.
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Let’s Analyze
Activity 1. Please explain your answers thoroughly. Kindly observe a minimum of five (5)
sentences per paragraph
1. There are three (3) forms of business organization: Sole Proprietorship, Partnership and
Corporation. If you are to start your own business, which form of business organization
would you choose? Why did you choose this form or business organization? How did you
come up with your answer?
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2. Among the major decisions involved in finance function (investing, financing, dividend and risk
management), which is the most essential? Please expound your answer.
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3. In 1776 Adam Smith described how an “invisible hand” guides companies striving to
maximize profits so that they make decisions that also benefit society. Smith’s insights led
economists to reach two key conclusions: (1) Profit maximization is the proper goal for a
business, and (2) the free enterprise system is best for society. In the current age, given the
various evolvement in business enterprises, do you still regard the “invisible hand” as a
reliable guide? Please expound your answer.
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In a Nutshell
Based from the discussion of the nature and purpose of financial management
and the learning exercises that you have done, please feel free to write what
have you learned below.
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2. ____________________________________________________________
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Q&A List
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Do you have any question for clarification?

Questions/Issues Answers
Keywords Index
Finance Corporation Chief Finance Officer

Stockholder Wealth
Economics Unlimited Personal Liability
Maximization
Accounting Limited Liability Investing Decision
Financial Management Double Taxation Financing Decision
Proprietorship Treasurer Dividend Decision
Partnership Controller Risk Management
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Matina, Davao City
Phone No.: (082)300-5456 Local 137

ULOb. Compare intrinsic value and fair value.
ULOc. Explain the conflicts between stockholders and
managers. How can these conflicts be alleviated?
ULOd. Explain how to maximize shareholders’ wealth.
Metalanguage
For you to demonstrate ULOb, ULOc and ULOd, you will need to have
an operational understanding of the following terms below. Please note that you
will also be required to refer to the previous definitions found in ULOa section.
1. Stockholders’ Wealth Maximization. This is the primary goal for

managerial decisions. To maximize the price of the firm’s common stock,
managers should consider the risk and timing associated with expected
earnings per share. (Brigham & Houston, 2007)
2. Intrinsic Value. This is an estimate of the stock’s “true” value based on
accurate risk and return data. This can be estimated but cannot be
measured precisely. (Brigham & Houston, 2007)
3. Market Price. The stock value based on perceived but possibly incorrect
information as seen by the marginal investor. (Brigham & Houston, 2007)
4. Marginal Investor. An investor whose views determine the actual stock
price. (Brigham & Houston, 2007)
5. Equilibrium. The situation in which actual market price equals the
intrinsic value. Thus, investors are indifferent between buying or selling a
stock. (Brigham & Houston, 2007)
6. Business Ethics. A company’s attitude and conduct toward its
employees, customers, community, and stockholders. (Brigham &
Houston, 2007)
7. Corporate Raider. An individual who targets a corporation for takeover
because it is undervalued. (Brigham & Houston, 2007)
8. Hostile Takeover. The acquisition of a company over the opposition of
its management. (Brigham & Houston, 2007)
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Matina, Davao City
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Essential Knowledge
Before we proceed further with the study of financial management, it is highly important
that we understand its goal which is shareholders’ wealth maximization. To fully comprehend
the concept of shareholders’ wealth maximization, we need to emphasize on the difference
between intrinsic value and fair value. Furthermore, the conflicts between shareholders and
managers and how can these be alleviated should be discussed.
1. The management ‘s primary goal is STOCKHOLDER WEALTH MAXIMIZATION. This

translates into maximizing the price of the firm’s common stock.
2. How to determine the stockholders’ wealth? The stockholders’ wealth is essentially the
firm’s outstanding shares multiplied by its market price per share. (Stockholders’ Wealth
= No. of Shares Outstanding X Market Price Per Share)
2.1. Example:
If Pilipinas Shell Petroleum Corporation has 100,000 outstanding shares and
its price is P53.50, then the firm’s wealth is P5,350,000.00 (100,000 shares X P53.50
= P5,350,000.00). This item should be maximized by the management to achieve its
goals.
2.2. Since the number of shares is if not given, it is easy to find, then the price of stock is
the primary determinant of stockholders’ wealth.
3. Factors beyond management’s control. There are factors that the management cannot
control which affect stock prices. For example, during the COVID-19 pandemic, the prices
of numerous stocks fell, no matter how effective their management.
4. Stock prices are based on expected future cash flows. To achieve stock price
maximization, it requires years of operation observation. However, during the latter part of
the 20th century, managers shifted to short-run focus from long-run. (Brigham & Houston,
2007)
4.1. An example of stockholders’ wealth maximization strategies with short-term focus are
share-based incentives for managers (share options).
5. Stock’s Intrinsic Value vs. Stock’s Market Price (Fair Value).
5.1. Illustration
5.2. Even if the Stock’s Market Price can be more convenient to determine since it is
published in newspapers and numerous websites, please do note that this figure is
only based on perceived but possibly incorrect information as seen by the marginal
investor. Thus, it is more ideal to look for the Stock’s Intrinsic Value since it is based
on accurate risk and return of data. However, the stock’s intrinsic value cannot be
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
precisely measured and is heavily reliant on estimation. (Brigham & Houston, 2007)
5.3. The firm’s managers have the best information about the company’s future
endeavors, thus, they are the ideal estimators for the firm’s intrinsic value as
compared with estimates from outside investors. (Brigham & Houston, 2007)
5.4. Example:
For example, investors at the margin might expect SHLPH’s dividend to be
P2.00 per share in 2018 and to grow at a rate of 6 percent per year thereafter, and on
that basis, they might set a price of P50.00 per share. However, if they had all the
available facts, they might conclude that the best dividend estimate is P2.85 with a 7
percent growth rate, which would lead to a higher price, say, P60.00 per share. In this
example, the actual market price would be P50.00 versus an intrinsic value of
P60.00.
5.5. Market Equilibrium. This is the situation where the stock’s market value is equal to
its intrinsic value. Since there is no fundamental imbalance, there is no pressure for a
stock price change. (Brigham & Houston, 2007)
6. Conflicts Between Stockholders and Management.
6.1. Managers’ Personal Goals. Oftentimes, managers’ personal goals may not be
congruent with stockholders’ wealth maximization. They might be more interested in
maximizing their own wealth than maximizing the stockholders’ wealth.
6.1.1. Example:
A common example of conflict between managers’ personal goals and
stockholders’ wealth maximization is that due to the desire to further their own
wealth, managers pay themselves excessively. Another example is when
managers clash with each other, it can lead to offering excessive severance
pay to assert dominance. Disney paid its former president, Michael Ovitz, $140
million as a severance package after just 14 months on the job because he and
Disney CEO Michael Eisner were having disagreements. Eisner himself was
also handsomely compensated the year Ovitz was fired—a $750,000 base
salary, plus a $9.9 million bonus, plus a $565 million profit from stock options,
for a total of just over $575 million. (Brigham & Houston, 2007)
6.2. Motivational Tools. A good compensation package does not always connote
incongruence of managers’ personal goal and stockholders’ maximization. Good
executive compensation plans can motivate managers to act in their stockholders’
best interests. Useful motivational tools include:
6.2.1. Reasonable Compensation Package. The compensation package
should be sufficient to attract and retain able managers but not go beyond
what is needed. Also, compensation should be structured so that managers
are rewarded on the basis of the stock’s performance over the long run, not
the stock’s price on an option exercise date.
6.2.2. Stockholders can intervene directly with managers. In today’s industry,
majority of companies are owned by institutional investors such as insurance
companies, pension funds, and mutual funds. Since they consist of a large
portion of ownership of the company, these institutional managers exercise
considerable influence over the firm’s operation. Stockholder intervention may
consist of sales improvement suggestions to threatening to fire the
management team. Since most firms are widely distributed in terms of shares,
the threat of overthrowing the management team posed little threat. However,
situation has changed, and it is not impossible to overthrow the current
management team for poor performance.
6.3. What happens if stocks are undervalued? Undervalued stocks pose numerous
threats to the firm, such as:
6.3.1. Corporate Raiders. It is an individual who targets a corporation for takeover
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because it is undervalued. They will take advantage of the bargain and will
attempt to take ownership over the firm thru a hostile takeover. If the raid will
be successful, the current management will likely to be fired.
6.4. Effective Communication Between Managers and Stockholders. Since managers
need to maximize the average stock price over the long run and not on a specific day,
effective communication between managers and stockholders is essential to maintain
close distance between stock price or fair value and its intrinsic value. However,
managers should be wary on divulging information for it not to be used in aid for their
competitors.
Self-Help: You can also refer to the sources below to help you
further understand the lesson:
*Brigham, E. & Houston, J. (2007). Fundamentals of Financial Management, 11th Edition.

Thomson Corporation. United States of America
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Let’s Check
Instructions: Please choose the letter of the best answer.

(Adapted: Brigham & Houston. (2015). Fundamentals of Financial Management)
1. The primary operating goal of a publicly-owned firm interested in serving its
stockholders should be to
a. Maximize its expected total corporate income.
b. Maximize its expected EPS.
c. Minimize the chances of losses.
d. Maximize the stock price per share over the long run, which is the stock’s intrinsic
value.
2. The primary operating goal of a publicly-owned firm trying to best serve its
stockholders should be to
a. Maximize managers' own interests, which are by definition consistent with
maximizing shareholders' wealth.
b. Maximize the firm's expected EPS, which must also maximize the firm's price
per share.
c. Minimize the firm's risks because most stockholders dislike risk. In turn, this will
maximize the firm's stock price.
d. Use a well-structured managerial compensation package to reduce conflicts
that may exist between stockholders and managers.
3. Which of the following actions would be most likely to reduce potential conflicts of
interest between stockholders and managers?
a. Pay managers large cash salaries and give them no stock options.
b. Change the corporation's formal documents to make it easier for outside
investors to acquire a controlling interest in the firm through a hostile takeover.
c. Beef up the restrictive covenants in the firm's debt agreements.
d. Eliminate a requirement that members of the board of directors must hold a
high percentage of their personal wealth in the firm's stock.
4. Which of the following actions would be likely to reduce potential conflicts of interest
between stockholders and managers?
a. A firm's compensation system is changed so that managers receive larger cash
salaries but fewer long-term options to buy stock.
b. The company changes the way executive stock options are handled, with all
options vesting after 2 years rather than having 20% of the options awarded
vest every 2 years over a 10-year period.
c. The company's outside auditing firm is given a lucrative year-by-year consulting
contract with the company.
d. The composition of the board of directors is changed from all inside directors to
all outside directors, and the directors are compensated with stock rather than
cash.
5. Which of the following mechanisms would be most likely to help motivate managers
to act in the best interests of shareholders?
a. Decrease the use of restrictive covenants in bond agreements.
b. Take actions that reduce the possibility of a hostile takeover.
c. Elect a board of directors that allows managers greater freedom of action.
d. Increase the proportion of executive compensation that comes from stock
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options and reduce the proportion that is paid as cash salaries.

6. Which of the following actions would be likely to encourage a firm's managers to
make decisions that are in the best interests of shareholders?
a. The percentage of executive compensation that comes in the form of cash is
increased and the percentage coming from long-term stock options is reduced.
b. The state legislature passes a law that makes it more difficult to successfully
complete a hostile takeover.
c. The percentage of the firm's stock that is held by institutional investors such as
mutual funds, pension funds, and hedge funds rather than by small individual
investors rises from 10% to 80%.
d. The firm's founder, who is also president and chairman of the board, sells 90%
of her shares.
7. Which of the following actions would be most likely to reduce potential conflicts of
interest between stockholders and bondholders?
a. Compensating managers with stock options.
b. Financing risky projects with additional debt.
c. The threat of hostile takeovers.
d. The use of covenants in bond agreements that limit the firm's use of additional
debt and constrain managers' actions.
a. One of the ways in which firms can mitigate or reduce potential conflicts
between bondholders and stockholders is by increasing the amount of debt in
the firm's capital structure.
b. The threat of takeover generally increases potential conflicts between
stockholders and managers.
c. Managerial compensation plans cannot be used to reduce potential conflicts
between stockholders and managers.
d. The threat of takeovers tends to reduce potential conflicts between
stockholders and manager.
a. Well-designed bond covenants are useful for reducing potential conflicts
between stockholders and managers.
b. The bid price in a hostile takeover is generally above the price before the
takeover attempt is announced, because otherwise there would be no incentive
for the stockholders to sell to the hostile bidder and the takeover attempt would
probably fail.
c. Stockholders in general would be better off if managers never disclosed
favorable events and therefore caused the price of the firm's stock to sell at a
price below its intrinsic value.
d. Takeovers are most likely to be attempted if the target firm's stock price is above
its intrinsic value.
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Matina, Davao City
Phone No.: (082)300-5456 Local 137

a. Hostile takeovers are most likely to occur when a firm's stock is selling below
its intrinsic value as a result of poor management.
b. The managers of established, stable companies sometimes attempt to get their
state legislatures to remove rules that make it more difficult for raiders to
succeed with hostile takeovers.
c. In general, it is more in bondholders' interests than stockholders' interests for a
firm to shift its investment focus away from safe, stable investments and into
risky investments, especially those that primarily involve research and
development.
d. Stockholders in general would be better off if managers never disclosed
favorable events and therefore caused the price of the firm's stock to sell at a
price below its intrinsic value.
Let’s Analyze
At this juncture, you will be required to ELABORATE your answers about the following
questions with a minimum of 30 words:
1. What is the difference between a stock’s current market price and the intrinsic
value?
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2. Should the firm’s managers help investors improve their estimates of a firm’s
intrinsic value? Explain.
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3. What are the three techniques stockholders can use to motivate managers to try
to maximize their stock’s long run price? Which one is the most effective for you?
Explain.
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
In a Nutshell
Knowing the importance between the difference of the stock’s fair value and intrinsic
value is essential to achieve the managements goal of maximizing the stockholders’
wealth. In this portion of the unit, you will be required to state your arguments or
synthesis relevant to the topics presented. I will supply the first two items and you will
continue the rest.
1. The goal of financial management is to maximize the stockholders’ wealth.
2. managers should be trying to maximize is not the price on a specific day. Rather, it
is the average price over the long run, which will be maximized if management focuses
on the stock’s intrinsic value.
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5. _________________________________________________________________
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Q&A List

Keywords Index
Stockholders’ Wealth
Market Price Equilibrium Corporate Raider
Maximization
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Intrinsic Value Marginal Investor Business Ethics Hostile Takeover

ULOe. Discuss the importance of financial statements
in finance decision making.
ULOf. Discuss the importance of analysis of financial
statements in decision making.
ULOg. Analyze horizontal, vertical and ratio analysis
Metalanguage
Below are the essential terms that you are going to encounter in the pursuit of
ULOe, ULOf and ULOg. Again, you are advised to frequently refer to these definitions
to help you understand the succeeding topics. I would like to highly recommend that
you refresh your knowledge about ULOa, ULOb, ULOc and ULOd to further
understand this section.
1. Annual Report. A report issued annually by a corporation to its stockholders. It contains

basic financial statements as well as management’s analysis of the firm’s past operations and
future prospects.
2. Statement of Financial Position. It is also known as balance sheet. It is a
statement of the firm’s financial position at a specific point in time.
3. Statement of Comprehensive Income. A report summarizing the firm’s revenues
and expenses during an accounting period.
4. Statement of Changes in Owners’ Equity. It portrays changes in the capital
balance of a business over a reporting period.
5. Statement of Cash Flows. A statement reporting the impact of a firm’s operating,
investing, and financing activities on cash flows over an accounting period.
6. Notes to Financial Statements. It is also referred as footnotes. These provide
additional information pertaining to a company’s operations and financial position. It
consists of relevant accounting policies and explanatory notes.
7. Liquid Assets. These are assets that can be converted to cash quickly without
having to reduce the asset’s price very much.
8. Financial Leverage. The use of debt financing.
9. Benchmarking. The process of comparing a particular company with a group of
“benchmark” companies.
Matina, Davao City
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Essential Knowledge
This section discusses the basic financial statements, how they are used and what
kinds of financial information users need. Please note that this section only covers the basic
discussion regarding financial statements and its impact to financial decision making. The
detailed discussion of financial statements and its components will be tackled in your
financial accounting subjects.
1. Annual Report. This is the most essential report that firms issue to its stockholders. It
contains two types of information:
1.1. Verbal Section. It usually contains a letter from the chairman or CEO that describes
the firm’s operating results during the period covered by the report. In addition, it also
includes discussion regarding new developments or prospective projects of the firm
and how can it affect future operations.
1.2. Financial Statements. These statements give an accounting picture of the firm’s
operations and financial position. It consists of five components: Statement of
Financial Position, Statement of Comprehensive Income, Statement of Changes in
Stockholders’ Equity, Statement of Cash Flows and the Notes to Financial
Statements. Some companies also issue Statement of Retained Earnings.
2. Financial Statements. Financial Statements report what has actually happened to
assets, earnings, dividends and other items over the past few years. Most of companies
present financial statements in comparative presentation where at least two years figures
are placed side by side. For large companies, they present financial statements figures
for five years.
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FINANCIAL
DESCRIPTION COMPONENTS NOTES
STATEMENT
● A potential
stockholder might
want to know whether
the company actually
earned the funds
reported in its equity
● Assets (Current account or whether
● It is also known as they came mainly
and Non-Current)
Balanced Sheet from selling stock.
Statement of ● Liabilities (Current
● It represents a “snapshot” ● A potential creditor, on
Financial Position and Non-Current)
of the firm’s position at a the other hand, would
● Shareholders’
specific point in time. be primarily interested
Equity
in the total equity
provided by the firm’s
owners and not with
its source.
● Items are listed in
order of their liquidity.
● Revenues
● It is also known as Income ● Costs and Other
● Earnings and
Statement. Expenses
Statement of dividends per share
● A report summarizing the ● Net Income/Loss
Comprehensive are given at the
firm’s revenues and ● Earnings Per
Income bottom of the income
expenses during an Share (EPS)
statement.
accounting period. ● Dividends Per
Share (DPS)
● It details the change in ● Profit/Loss ● It helps users of
stockholders’ equity over an ● Changes in share financial statement to
Statement of accounting period by capital reserves identify the factors
Changes in presenting the movement in ● Dividend that cause a change
Stockholders’ Equity reserves comprising the payments in the equity over the
shareholders’ equity. ● Prior period errors accounting period.
correction
● This information is
useful for both
● Operating managers and
● Summarizes the changes Activities investors.
Statement of Cash
in a company’s cash ● Investing Activities ● Together with the
Flows
position. ● Financing cash budget, it is used
Activities to help forecast a
company’s cash
position.
● It is also referred as footnotes.
● It is an integral part of financial ● Relevant
● This is required by the
Notes to Financial statements that provides Accounting
additional information
full disclosure
Statements Policies
pertaining to a firm’s operations principle
● Explanatory Notes
and financial position.
Matina, Davao City
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3. Financial Statement Analysis. It involves careful selection of data from financial

statements in order to assess and evaluate the firm’s past performance, its
present condition, and future business potentials.
● It provides information about the

financial position (risks) and
performance (returns) of the firm
that will be useful in determining the
amount, certainty, and timing of
future cash flows.
WHAT is Financial ● Financial analysis involves:
Statement Analysis? o Comparing the firm’s
performance to other firms,
especially those in the same
industry, and
o Evaluating trends in the firm’s
financial position over time.
WHEN do managers At least once a year or as needed.
perform Financial
Statement Analysis?
Since the managers’ goal is to
maximize the stockholders’ wealth, it is
important to analyze the operational
outputs of the firm, which are the
financial statements, to aid for decision
making. FS Analysis aims to look into
the firm’s:
WHY do managers need ● Profitability of Business Firm
to perform Financial ● Firm’s Ability to Meet
Statement Analysis? Obligations (Liquidity)
● Safety of the Investment in the
Business Firm (Stability)
● Effectiveness of the
Management in Running the
Firm (Asset Utilization and Debt
Utilization)
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● Investors – They look at the risk

and performance of their
investments and the possibility of
growth in the future.
● Creditors – They are interested in
the liquidity of the company to
ascertain if they will be paid on
WHO are the users of time.
Financial Statement ● Banks/Bond Holders – They are
Analysis? interested in the performance and
solvency of the company for lending
purposes.
● Managers/Employees – They look
at how the company is performing
and its stability in providing job
security and additional benefits.
● Establish the objective of the
financial analysis.
● Gather complete information about
the firm and study the industry
HOW to perform Financial which the firm operates.
Statement Analysis? ● Perform mathematical analysis
using applicable tools.
● Make conclusions relative to the
established objectives.
3.1. Limitations of Financial Statement Analysis

● It does not consider changes and inconsistencies in accounting principles,
policies and procedures of different firms in the same industry.
● It does not consider changes in purchasing power.
● The analysis becomes less reliable as financial statements gets older.
● If financial statements are fraudulent, the analysis may mislead managers
that are used for decision making.
Matina, Davao City
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4. Tools and Techniques for Financial Statement Analysis.

For illustration purposes, please refer to the sample financial statements of Lucky
Company for the year 2018 and 2019:
LUCKY COMPANY
STATEMENT OF COMPREHENSIVE INCOME
2019 2018
Sales 6,540,000 5,830,000

Less: Expenses
Cost of Sales 4,200,000 3,800,000
Selling Expenses 740,000 680,000
Administrative Expenses 400,000 430,000
Total Expenses 5,340,000 4,910,000
Operating Income 1,200,000 920,000
Less: Interest Expense 200,000 200,000
Income Before Tax 1,000,000 720,000
Less: Income Tax – 30% 300,000 216,000
NET INCOME 700,000 504,000
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LUCKY COMPANY
STATEMENT OF FINANCIAL POSITION
2019 2018
ASSETS
Current Assets
Cash and Cash Equivalents 30,000 40,000
Trade and Other Receivables 454,000 552,000
Inventory 1,208,000 952,000
Prepaid Expenses 40,000 30,000
Total Current Assets 1,732,000 1,574,000
Non-Current Assets
Property, Plant & Equipment 6,000,000 4,450,000
Investment in Stocks 2,000,000 2,000,000
Total Non-Current Assets 8,000,000 6,450,000
TOTAL ASSETS 9,732,000 8,024,000
LIABILITIES AND STOCKHOLDERS’ EQUITY

Current Liabilities
Trade and Other Payables 474,000 418,000
Other Current Liabilities 200,000 170,000
Total Current Liabilities 674,000 588,000
Non-Current Liabilities
Bonds Payable – 10% 2,000,000 2,000,000
Total Liabilities 2,674,000 2,588,000
Stockholders’ Equity
Share Capital, P200 par 5,000,000 4,000,000
Reserve 1,000,000 1,000,000
Retained Earnings 1,058,000 436,000
Total Stockholders’ Equity 7,058,000 5,436,000
TOTAL LIABILITIES AND
9,732,000 8,024,000
STOCKHOLDERS’ EQUITY
Matina, Davao City
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4.1. Vertical Analysis or Common Size Financial Statement. It covers one year’s
operating results and expresses each component as a percentage total. The
balances of the different accounts will be expressed as a percentage of the groups
called BASE AMOUNT. This can be compared to competitors or other
responsibility centers.
4.1.1. Base Amount. Generally, there are three common base amounts: TOTAL
ASSETS for the Asset Group, TOTAL LIABILITIES AND EQUITY for the
Liabilities and Equity group and NET SALES/REVENUE for the Income
Statement Group.
4.1.2. Example. Please refer to the sample financial statements of Lucky

Company on the previous pages.
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4.2. Horizontal Analysis or Trend Analysis. It is a financial statement analysis

technique that shows changes in the amounts of corresponding financial
statement items over a period of time. This is undertaken to determine the
behavioral patterns of the different account balances.
4.2.1. Base Year. Trend analysis are computed using the figures of the base year.
It is usually the earliest period or year as divisors.
4.2.2. Importance of Horizontal Analysis. It helps to compare data to locate
fraudulent activities and any areas that may need changes or
improvements.
4.2.3. Horizontal Analysis Methods. There are two methods regarding horizontal
analysis:
● Absolute Comparison. Comparing the absolute currency amounts of some
items over the period of time.
● Percentage Comparison. Percentage differences in certain items are

compared over a period of time. The absolute currency amounts are
converted into the percentages for the purpose of comparison.
4.2.4. Example. Please refer to the sample financial statements of Lucky

Company on the previous pages.
Matina, Davao City
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Matina, Davao City
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4.3. Financial Ratio Analysis. It shows significant relationships between items

in the financial statements (in total or per responsibility center) expressed in
mathematical form. They are used to determine possible areas of
weaknesses and strengths of an organization.
4.3.1. Standards For Comparison. Ratios alone tell little about the financial
well-being of a company. Therefore, these should be compared with
a standard for a meaningful analysis. The two types of standards for
comparison are the following:
● Past History. Values are compared over time. This standard allows
trends to be assessed. For example, ratios measuring liquidity may
be dropping over time, signaling a deteriorating ﬁnancial condition.
The company’s management can use this information to take
corrective action. Investors and creditors, on the other hand, may
use this information to decide whether or not to invest money in the
company.
● Industrial Averages. Ratios are compared with ratios of
companies in the same industry. These data can be accessed via
annual publications such as Dun and Bradstreet which reports the
median, upper quartile, and lower quartile for 14 commonly used
ratios for more than 900 lines of business. Industrial ratios can also
be accessed in various websites such as www.investing.com.
However, these industrial averages should be used with care since
companies in the same industry may use different accounting
policies. Lastly, industrial averages should not be taken as absolute
but rather as general guidelines for purposes of decision-making.
4.3.2. Classification of Ratios. There are three classifications of financial
ratios: Profitability Ratios, Liquidity Ratios and Stability Ratios.
Please refer to the sample Financial Statements of Lucky Company
in the previous pages.
Additional Information:
● Lucky Company belongs to the Construction Industry.
● Industry Average are taken from www.investing.com
● Additional data:
Market Price Per Dividend Per
YEAR
Share Share
2019 250.00 3.12
2018 235.00 3.50
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*For clearer view of the table, this excel file will be uploaded in LMS.
Matina, Davao City
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
*Brigham, E. & Houston, J. (2007). Fundamentals of Financial Management, 11th
Edition. Thomson Corporation. United States of America.
*Melicher, R. & Norton, E. (2017). Introduction to Finance: Markets, Investments
and Financial Management, 16th Edition. John Wiley & Sons, Inc. United
States of America.
Matina, Davao City
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Let’s Check
To test your learnings in financial statements and its analysis, below is the published
financial statement of Pilipinas Shell Petroleum Corporation as of December 31, 2018. This
is retrieved from the financial reports section of their website
(https://pilipinas.shell.com.ph/investors/financial-reports.html). If information given is
incomplete, please visit the company’s website.
PDF File will also be uploaded in LMS.
Matina, Davao City
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Matina, Davao City
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Please supply the following:

1. Vertical Analysis
1.1. 2018
1.2. 2017
1.3. 2016
2. Horizontal Analysis (2017 & 2018)
2.1. Absolute Comparison
2.2. Percentage Comparison
3. Financial Ratios
FINANCIAL RATIOS 2018 2017

PROFITABILITY RATIOS
Gross Profit Ratio
Operating Profit Ratio
Net Profit Ratio
Return on Assets
Return on Equity
Earnings Per Share
Price/Earnings Ratio
Dividend Payout Ratio
Dividend Yield Ratio
LIQUIDITY RATIOS
Current Ratio
Quick Ratio
Accounts Receivable
Turnover
Average Collection Period
Inventory Turnover
Average Sales Period
Operating Cycle
STABILITY RATIOS
Debt Ratio
Debt-to-Equity Ratio
Times-Interest-Earned Ratio
Let’s Analyze
Based on your answers in Let’s Check, kindly provide interpretations of your
Matina, Davao City
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answers. (Minimum of 30 words)
1. Horizontal Analysis
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2. Vertical Analysis
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3. What can you say about the profitability of Pilipinas Shell Petroleum
Corporation?
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
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4. What can you say about the liquidity of Pilipinas Shell Petroleum Corporation?
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5. What can you say about the stability of Pilipinas Shell Petroleum Corporation?
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In a Nutshell
Part of being a good manager is managing assets well. Successful financial

analysis and planning require an understanding of a firm’s external and internal
environments. In this activity, you will be required to write your lessons learned
about financial statements and its analysis. I will supply the first item and you will
continue the rest.
1. Financial Statement Analysis are just tools for guidance in decision-making and
should not be taken as absolute.
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3. ___________________________________________________________________
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4. ___________________________________________________________________
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Q&A List

Matina, Davao City
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Keywords Index
Statement of Changes in
Annual Report Liquid Assets
Owners’ Equity
Statement of Financial
Statement of Cash Flows Financial Leverage
Position
Statement of Notes to Financial
Benchmarking
Comprehensive Income Statements
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ULOh. Explain the key factors on which external financing
depends, as indicated in the AFN equation.
ULOi. Apply the different financial management tools for
decision making.
Metalanguage
The most essential terms below are operationally defined for you to have
a better understanding of this section in the course.
1. AFN. Additional Funds Needed. It is the amount of external capital that

will be needed to acquire the needed assets.
2. Capital Intensity Ratio. The amount of assets required per peso of
sales.
Essential Knowledge
Forecasting is essential for a good decision making. If analysts forecast
earnings properly, then the risk of having “negative surprises”, which leads to stock
prices to plummet, will decrease.
1. Pro-forma or Projected Financial Statements. Managers make pro-forma or

projected financial statements for the following purposes:
a. To help estimate the effect of proposed operating changes.
b. To help managers provide better guidance to security analysts and thus
reduce price volatility.
c. To help top management to establish reasonable targets.
d. To anticipate the firm’s future financing needs.
e. The results can be analyzed which leads to establishment of corrective
actions.
2. Strategic Planning. These are the elements of strategic plan:
a. Mission Statement.
b. Statement of the Firm’s Corporate Scope. This contains the lines of
business it plans to pursue and geographic areas in which it will operate.
c. Statement of Corporate Objectives. This sets forth the specific goals that
operating managers are expected to meet.
d. Corporate Strategies. It contains how the firm plans to achieve its goals.
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e. Operating Plan. This consists of detailed implementation guidance on how

to achieve its corporate objectives. This should be based on the corporate
strategies.
f. Financial Plan. This shows the projected results based on the operating
plan. The heart of the financial plan is the set of projected financial
statements.
3. Sales Forecast. Part of financial planning is forecasting and analyzing a set of
financial statements. The forecast starts with the sales forecast. It starts by
reviewing the sales during the past 5 to 10 years. Forecasts should be made for
every divisions, both in the aggregate and on an individual product basis. The
individual product basis forecast should be summed up and compared to the
aggregate amounts, and reconcile differences, if any. Analysts should be careful
in creating sales forecast since any mistake can lead to serious consequences. If
the forecast is too conservative, then the company may not be able to meet the
demand. On the other hand, if the forecast is too optimistic, it could end up with
excess plant, equipment and inventory.
4. The AFN Equation. In order to increase sales, the company must acquire
additional assets. These assets must be financed and there is a possibility that not
all funds will be obtained to adhere to the business plan. Thus, an essential element
to financial forecasting is to determine the external financing requirements. To
achieve the most accurate computation, you need to develop a detailed future
financial statement forecast. However, the AFN Equation can be used to get an
approximation of the funds needed.
4.1. Example: Allied Foods Corporation (Brigham & Houston, 2007)

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To increase sales by $300 million, Allied must increase assets by

$200 million, where $20 million will come from spontaneous increases in
payables and accruals, while another $66 million will come from
retained earnings. The remaining $114 million must be raised from
external sources.
5. Key Determinants of External Funds Requirements.
5.1. Sales Growth. As your company grows, the requirement of assets
also increases.
5.2. Capital Intensity (A*/S0). It has a major effect on capital
requirements. Companies with high assets-to-sales ratios require
more assets for its increasing sales, thus, have a greater need for
external financing.
5.3. Spontaneous Liabilities-to-Sales Ratio (L*/S0). A company that
generates huge portion of funds from accounts payable and accruals
have a lesser need for external financing.
5.4. Profit Margin (M). The higher the profit margin, the larger the net
income to support increase in assets. These companies have lower
need for external financing.
5.5. Retention Ratio (RR). Companies that retain a high percentage of
their earnings rather than paying them out as dividends generate
more retained earnings and thus need less external financing.
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States of America.
Let’s Check
(Adapted. Brigham & Houston. (2015). Fundamentals of Financial
Management).
Choose the letter of the best answer.
1. Which of the following is NOT a key element of strategic planning as it is

described in the text?
a. The mission statement
b. The statement of the corporation’s scope
c. The statement of cash flows
d. The statement of corporate objectives
2. ABC Company has developed a forecasting model to estimate its AFN for
the upcoming year. All else being equal, which of the following factors is
most likely to lead to an increase of the additional funds needed (AFN)?
a. A sharp increase in its forecasted sales.
b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company switches its materials purchases to a supplier that
sells on terms of 1/5, net 90, from a supplier whose terms are 3/15,
net 35.
3. The term "additional funds needed (AFN)" is generally defined as follows:
a. Funds that are obtained automatically from routine business
transactions.
b. Funds that a firm must raise externally from non-spontaneous
sources, i.e., by borrowing or by selling new stock, to support
operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the
amount of cash needed to acquire the new assets needed to
support growth.
4. The capital intensity ratio is generally defined as follows:
a. The percentage of liabilities that increase spontaneously as a
percentage of sales.
b. The ratio of sales to current assets.
c. The ratio of current assets to sales.
d. The amount of assets required per dollar of sales, or A0*/S0.
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5. Spontaneously generated funds are generally defined as follows:

a. Assets required per dollar of sales.
b. A forecasting approach in which the forecasted percentage of
sales for each item is held constant.
c. Funds that a firm must raise externally through borrowing or by
selling new common or preferred stock.
d. Funds that arise out of normal business operations from its
suppliers, employees, and the government, and they include
spontaneous increases in accounts payable and accruals.
6. XYZ Corporation's CFO uses this equation, which was developed by
regressing inventories on sales over the past 5 years, to forecast
inventory requirements: Inventories = P22.0 + 0.125(Sales). The company
expects sales of P400 million during the current year, and it expects sales
to grow by 30% next year. What is the inventory forecast for next year? All
pesos are in millions.
a. P74.6
b. P78.5
c. P82.7
d. P87.0
7. Frail Landscaping Supply expects P600 million of sales this year, and it
forecasts a 15% increase for next year. The CFO uses this equation to
forecast inventory requirements at different levels of sales: Inventories =
P30.2 + 0.25(Sales). All pesos are in millions. What is the projected
inventory turnover ratio for the coming year?
a. 3.40
b. 3.57
c. 3.75
d. 3.94
8. Clockers Industries is planning its operations for next year. Randell
Clokers, the CEO, wants you to forecast the firm's additional funds
needed (AFN). Data for use in your forecast are shown below. Based on
the AFN equation, what is the AFN for the coming year? Pesos are in
millions:
a. P102.8
b. P108.2
c. P113.9
d. P119.9
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9. Wong, Lim & Chan Inc. is planning its operations for next year, and the
CEO wants you to forecast the firm's additional funds needed (AFN). Data
for use in your forecast are shown below. Based on the AFN equation,
what is the AFN for the coming year?
a. −P14,440
b. −P15,200
c. −P16,000
d. −P16,800
10. To determine the amount of additional funds needed (AFN), you may
subtract the expected increase in liabilities, which represents a source of
funds, from the sum of the expected increases in retained earnings and
assets, both of which are uses of funds.
a. True
b. False
Let’s Analyze
In 50 words, kindly explain the importance of financial planning and
forecasting and what are the tools and techniques to arrive at the best
forecast?
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Matina, Davao City
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In a Nutshell
A successful business always stems from good financial planning and

forecasting. In this part, you will be required to draw conclusions, perspectives,
arguments and ideas from the unit lesson. I will supply the first item and you will
continue the rest.
1. Financial planning should be done within the context of a well-articulated strategic

plan that contains a number of elements.
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3. _______________________________________________________________
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4. _______________________________________________________________
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5. _______________________________________________________________
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Q&A List

Keywords Index
AFN Strategic Planning

Pro-forma Financial Statements Financial Planning
Forecast Capital intensity
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COURSE SCHEDULES
This section calendars all the activities and exercises, including readings and lectures, as well as time
for making assignments and doing other requirements.
WHERE TO
ACTIVITY DATE
SUBMIT/PERFORM
Big Picture ULOa:
Blackboard LMS
Let’s Check
Big Picture ULOa:
Blackboard LMS
Let’s Analyze
Big Picture ULOa:
Blackboard LMS
In a Nutshell
Big Picture ULOb, ULOc &
Blackboard LMS
ULOd: Let’s Check
Blackboard LMS
ULOd: Let’s Analyze
Blackboard LMS
ULOd: In a Nutshell
Big Picture ULOe, ULOf &
Blackboard LMS
ULOg: Let’s Check
Blackboard LMS
ULOg: Let’s Analyze
Blackboard LMS
ULOg: In a Nutshell
Big Picture ULOh & ULOi:
Blackboard LMS
Let’s Check
Blackboard LMS
Let’s Analyze
Blackboard LMS
In a Nutshell
1st Examination January 29, 2021 Blackboard LMS
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Big Picture
Week 4-5: Unit Learning Outcomes (ULO): At the end of the unit, you
are expected to
a. Discuss the elements of interest rates.

b. Apply key concepts of bonds and their valuation.
c. Explain the nature of risk and rates of return.
d. Compare stand-along risk and portfolio risk.
e. Apply key concepts of stocks and their valuation.

ULOa. Discuss the elements of interest rates.
Metalanguage
demonstrate ULOa will be operationally defined to establish a common frame of refence as
to how the texts work in your chosen field or career. You will encounter these terms as we
go through the study of curriculum. Please refer to these definitions in case you will
encounter difficulty in the in understanding interest rates.
1. Production Opportunities. The investment opportunities in productive assets.

2. Time Preferences for Consumption. The preferences of consumers for current
consumption as opposed to saving for future consumption.
3. Risk. In a financial market context, the chance that an investment will provide a low or
negative return.
4. Inflation. The amount by which prices increase over time.
5. Nominal (Quoted) Risk-Free Rate, rRF. The rate of interest on a security that is free
of all risk. (r* + IP)
6. Inflation Premium (IP). A premium equal to expected inflation that investors add to
the real risk-free rate of return.
7. Default Risk Premium (DRP). The difference between the interest rate on a Treasury
Bond and a Corporate Bond of equal maturity and marketability.
8. Liquidity Premium (LP). A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
fair market value.
9. Interest Rate Risk. The risk of capital losses to which investors are exposed because
of changing interest rates.
10. Maturity Risk Premium (MRP). A premium that reflects interest rate risk.
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11. Reinvestment Rate Risk. The risk that a decline in interest rates will lead to lower
income when bonds mature and funds are reinvested.
12. Yield Curve. A graph showing the relationship between bond yields and maturities.
13. Normal Yield Curve. An upward-sloping yield curve.
14. Inverted Yield Curve. A downward-sloping yield curve.
15. Pure Expectations Theory. A theory that states that the shape of the yield curve
depends on investors’ expectations about future interest rates.
16. Foreign Trade Deficit. The situation that exists when a country imports more than it
exports.
Essential Knowledge
Companies raise capital in two main forms: debt and equity. As a future finance
professional, students should understand interest rates and its determinants.
1. Factors That Affect Levels of Interest Rates. These are the four most fundamental
factors affecting the cost of money:
1.1 Production Opportunities. These are investment opportunities in productive (cash-
generating) assets.
1.2 Time Preferences for consumption. The preferences of consumers for current
consumption as opposed to saving for future consumption.
1.3 Risk. In a financial market context, the chance that an investment will provide a low or
negative return.
1.4 Inflation. The amount by which prices increase over time.
2. Determinants of Interest Rates. In general, the quoted (or nominal) interest rate on a
debt security, r, is composed of a real risk-free rate of interest, r*, plus several premiums
that reflect inflation, the security’s risk, and its marketability (or liquidity). This relationship
can be expressed as follows:
2.1 Quoted or Nominal Rate (r). This is the required return on a debt security.
2.2 Real Risk-Free Rate (r*). It is pronounced as “r-star”, and it is the rate that would exist
on a riskless security in a world with no inflation. The real risk-free rate is not static
since it changes over time depending on economic conditions like the corporate rate
of return and other borrowers’ expectations on productive assets, and on people’s time
preferences for current versus future consumption. The best estimate of r* is the rate
of return on indexed Treasury bonds.
2.3 Risk-Free Rate (rRF). It is the quoted rate on a risk-free security such as government
bills, which are mostly very liquid and free of most types of risk. It is the real risk-free
rate added with inflation premium (r* + IP).
2.4 Inflation Premium (IP). It is equal to the average expected inflation rate over the life
of the security. The expected future inflation rate is not necessarily equal to the current
inflation rate. It has a major impact on interest rates since it erodes the purchasing
power and lowers real investment returns.
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2.5 Default Risk Premium (DRP). The risk that a borrower will default, which means not
make scheduled interest or principal payments. It has a direct relationship with the
interest rates. The greater the risk of default, the higher the interest rate. Treasury
securities have no default risk.
2.6 Liquidity Premium (LP). A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
fair market value. Generally, real assets are less liquid than financial assets.
2.7 Maturity Risk Premium (MRP). It is the premium that reflects interest rate risk. it
varies somewhat over time, rising when interest rates are more volatile and uncertain,
then falling when interest rates are more stable. The effect of maturity risk premiums
is to raise interest rates on long-term bonds relative to those on short-term bonds.
• Interest Rate Risk. The risk of capital losses to which investors are exposed
because of changing interest rates. The more interest rate risk, the longer the
maturity of the security.
• Reinvestment Rate Risk. The risk that a decline in interest rates will lead to lower
income when bonds mature and funds are reinvested. Short-term securities are
heavily exposed to reinvestment rate risk.
3. Premiums Added to r* for Different Types of Debt.
4. The Term Structure of Interest Rates. It describes the relationship between long and
short-term rates. The term structure is important both to corporate treasurers deciding
whether to borrow by issuing long- or short-term debt and to investors who are deciding
whether to buy long- or short-term bonds. Therefore, both borrowers and lenders should
understand how long and short-term rates relate to each other and what causes shifts in
their relative levels.
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4.1 Illustration. U.S. Treasury Bond Interest Rates on Different Dates: (Brigham &
Houston, 2007)
• Normal Yield Curve. It is an upward-sloping curve. In the illustration

above, the rates on February 2005 is considered a Normal Yield
Curve.
• Abnormal Yield Curve. It is sometimes called “Inverted Yield
Curve”. This is a downward-sloping yield curve. In the illustration
above, the rates on March 1980 is considered an Abnormal Yield
Curve.
• Humped Yield Curve. A yield curve where interest rates on
medium-term maturities are higher than rates on both short and
long-term maturities. In the illustration above, the rates on February
2000 is considered a humped yield curve.
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5. Constructing the Yield Curve

5.1 Step 1: Find the Average Expected Inflation Rate (IP) Over Years 1 to N.
The firm must earn these IPs to break even vs. inflation since these IPs would
permit you to earn r* before taxes.
5.2 Step 2: Find the Appropriate Maturity Risk Premium (MRP). For this example, the
following equation will be used to find a security’s appropriate maturity risk premium.
Please note that since the equation is linear, the maturity risk premium is increasing
as the time to maturity increases. The longer the maturity, the higher the rates.
5.3 Step 3: Adding the Premiums to r*. This is to get the appropriate nominal
rates.
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5.4 Hypothetical Yield Curve. Now, we construct the yield curve based on the
illustration above.
6. Relationship Between Treasury Yield Curve and Yield Curves for Corporate
Issues. Corporate Yield Curves are higher than that of Treasury securities due to
the presence of Default Risk and Liquidity Premiums.
6.1 Illustration. (Brigham & Houston, 2007)
Corporate bonds’ default and liquidity risks are affected by their maturities. Established
corporations’ short-term bonds have very small default risk premium since it has almost
no chance to go bankrupt. However, long-term bonds have higher probability of default
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risk than on its short-term ones. Longer-term corporate bonds are also less liquid than
shorter-term bonds.
7. Pure Expectations Theory. The pure expectations theory contends that the
shape of the yield curve depends on investors’ expectations about future interest
rates.
7.1 Assumptions of Pure Expectations.
• Assumes that the maturity risk premium for Treasury securities is
zero.
• Long-term rates are an average of current and future short-term rates.
• If the pure expectations theory is correct, you can use the yield curve
to “back out” expected future interest rates.
7.2 Illustration.
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7.3 Conclusions About Pure Expectations. Some would argue that the MRP is not
zero, hence, the pure expectations theory is incorrect. Most evidence supports the
general view that lenders prefer short-term securities, and view long-term securities
are riskier. Thus, investors demand a premium to persuade them to hold long-term
securities.
8. Macroeconomic Factors That Influence Interest Rate Levels.
8.1 Federal Reserve Policy
8.2 Federal Budget Deficits or Surpluses
8.3 International Factors
8.4 Level of Business Activity
*Brigham, E. and Houston, J. (2015). Fundamentals of Financial Management (11th
Edition). USA: Thomson South-Western
*Broyles, J. (2003). Financial Management and Real Options. England: John Wiley & Sons,
Ltd.
*Hill, A. (2008). Strategic Financial Management. Ventus Publishing.
*Drake, P.P. and Fabozzi, F. (2010). The Basics of Finance: An Introduction to Financial
Markets, Business Finance, and Portfolio Management. USA: John Wiley & Sons,
Ltd.
*Mcmenamin, J. (2005). Financial Management: An Introduction. USA: Routledge

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Let’s Check
Management). Now that you know the most essential knowledge in interest
rates, let us try to check your understanding. Write True if the answer is correct
and False if not.
1. One of the four most fundamental factors that affect the cost of money is the
current state of the weather. If the weather is dark and stormy, the cost of
money will be higher than if it is bright and sunny, other things held constant.
2. One of the four most fundamental factors that affect the cost of money as
discussed in the text is the expected rate of inflation. If inflation is expected
to be relatively high, then interest rates will tend to be relatively low, other
things held constant.
discussed in the text is the risk inherent in a given security. The higher the
risk, the higher the security's required return, other things held constant.
discussed in the text is the time preference for consumption. The higher the
time preference, the lower the cost of money, other things held constant.
5. The four most fundamental factors that affect the cost of money are (1)
production opportunities, (2) time preferences for consumption, (3) risk, and
(4) inflation.
6. If the demand curve for funds increased but the supply curve remained
constant, we would expect to see the total amount of funds supplied and
demanded increase and interest rates in general also increase.
7. During periods when inflation is increasing, interest rates tend to increase,
while interest rates tend to fall when inflation is declining.
8. If investors expect a zero rate of inflation, then the nominal rate of return on
a very short-term U.S. Treasury bond should be equal to the real risk-free
rate, r*.
9. The risk that interest rates will increase, and that increase will lead to a
decline in the prices of outstanding bonds, is called "interest rate risk," or
"price risk."
10. Because the maturity risk premium is normally positive, the yield curve is
normally upward sloping.
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Let’s Analyze
Activity 1. (Adapted. Brigham & Houston. (2015). Fundamentals of Financial
Management) Choose the letter of the correct answer.
1. Assume that inflation is expected to decline in the future, but that the real risk-free rate,
r*, will remain constant. Which of the following statements is CORRECT, other things
held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward
sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward
sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward
sloping.
d. If inflation is expected to decline, there can be no maturity risk premium.
2. Which of the following factors would be most likely to lead to an increase in nominal
interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the internet has just been introduced, and it increases
investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
3. Which of the following statements is CORRECT, other things held constant?
a. If companies have fewer good investment opportunities, interest rates are likely to
increase.
b. If individuals increase their savings rate, interest rates are likely to increase.
c. If expected inflation increases, interest rates are likely to increase.
d. Interest rates on all debt securities.
4. In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at
3%, inflation is expected to steadily increase, and the maturity risk premium is
expected to be 0.1(t − 1)%, where t is the number of years until the bond matures.
Given this information, which of the following statements is CORRECT?
a. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury
securities.
b. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate
bonds.
c. The yield curve must be humped.
d. The yield curve must be upward sloping.
5. If the Treasury yield curve is downward sloping, how should the yield to maturity on a
10-year Treasury coupon bond compare to that on a 1-year T-bill?
a. The yield on a 10-year bond would be less than that on a 1-year bill.
b. The yield on a 10-year bond would have to be higher than that on a 1-year bill
because of the maturity risk premium.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two securities would be equal.
6. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected
to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard
any cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 3.80%
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b. 3.99%
c. 4.19%
d. 4.40%
7. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to
be constant at 2.20%. What rate of return would you expect on a 1-year Treasury
security, assuming the pure expectations theory is valid? Disregard cross-product
terms, i.e., if averaging is required, use the arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
8. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to
be constant at 4.10%. What rate of return would you expect on a 5-year Treasury
security, assuming the pure expectations theory is valid? Disregard cross-product
terms, i.e., if averaging is required, use the arithmetic average.
a. 5.38%
b. 5.66%
c. 5.96%
d. 6.60%
9. Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year
Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP
on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity
premium is required on any T-bond. Given this information, what is the expected rate
of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is
required, use the arithmetic average.
a. 1.81%
b. 1.90%
c. 2.00%
d. 2.10%
10. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield
6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity
premium for T-bonds, and the maturity risk premium on both Treasury and corporate
10-year bonds is 1.15%. What is the default risk premium on corporate bonds?
a. 1.08%
b. 1.20%
c. 1.32%
d. 1.45%
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In a Nutshell
Based from the discussion of interest rates and the learning exercises that you
have done, please feel free to write what have you learned below.
1. ____________________________________________________________
___
____________________________________________________________
___
2. ____________________________________________________________
___
____________________________________________________________
___
3. ____________________________________________________________
___
____________________________________________________________
___
4. ____________________________________________________________
___
____________________________________________________________
___
5. ____________________________________________________________
___
____________________________________________________________
___
Q&A List

Keywords Index
Production Nominal Risk-Free Interest Rate
Risk Normal Yield Curve
Opportunities Rate
Time Preferences for Inflation Premium Maturity Risk Inverted Yield Curve
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Consumption Premium
Default Risk Premium Reinvestment Pure Expectations
Risk
Rate Risk Theory
Inflation Liquidity Premium Yield Curve Foreign Trade Deficit
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ULOb. Apply key concepts of bonds and their valuation.
Metalanguage
demonstrate ULOf and ULOg will be operationally defined to establish a common frame of
refence as to how the texts work in your chosen field or career. You will encounter these terms
as we go through the study of curriculum. Please refer to these definitions in case you will
encounter difficulty in the understanding bonds and their valuation.
1. Bond. A long-term debt instrument in which a borrower agrees to make payments of

principal and interest, on specific dates, to the holders of the bond.
2. Treasury Bonds. Bonds issued by the federal government, sometimes referred to as
government bonds.
3. Corporate Bonds. Bonds issued by corporations.
4. Municipal Bonds. Bonds issued by state and local government.
5. Foreign Bonds. Bonds issued by either foreign government or foreign corporations.
6. Par Value. The face value of a bond.
7. Coupon Payment. The specified number of peso of interest paid each year.
8. Coupon Interest Rate. The stated annual interest rate on a bond.
9. Floating-Rate Bond. A bond whose interest rate fluctuates with shifts in the general
level of interest rates.
10. Zero-Coupon Bond. A bond that pays no annual interest but is sold at a discount
below par, thus providing compensation to investors in the form of capital appreciation.
11. Original Issue Discount (OID) Bond. Any bond originally offered at a price below its
par value.
12. Maturity Date. A specified date on which the par value of a bond must be repaid.
13. Call Provision. A provision in a bond contract that gives the issuer the right to redeem
the bonds under specified terms prior to the normal maturity date.
14. Sinking Fund Provision. A provision in a bond contract that requires the issuer to
retire a portion of the bond issue each year.
15. Convertible Bond. A bond that is exchangeable, at the option of the holder, for the
issuing firm’s common stock.
16. Warrant. A long-term option to buy a stated number of shares of common stock at a
specified price.
17. Putable Bond. A bond with provisions that allow its investors to sell it back to the
company prior to maturity at a pre-arranged price.
18. Income Bond. A bond that pays interest only if it is earned.
19. Indexed (Purchasing Power) Bond. A bond that has interest payments based on an
inflation index so as to protect the holder from inflation.
20. Discount Bond. A bond that sells below its par value. It occurs whenever the growing
rate of interest is above the coupon rate.
21. Premium Bond. A bond that sells above its par value. It occurs whenever the going
rate of interest is below the coupon rate.
22. Yield to Maturity (YTM). The rate of return earned on a bond if it is held to maturity.
23. Yield to Call (YTC). The rate of return earned on a bond if it is called before its maturity
date.
24. Current Yield. The annual interest payment on a bond divided by the bond’s current
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price.
25. Mortgage Bond. A bond backed by fixed assets.
26. Indenture. A formal agreement between the issuer and the bondholders.
27. Debenture. A long-term bond that is not secured by a mortgage on specific property.
28. Investment-Grade Bonds. Bonds rated triple-B or higher.
29. Junk Bond. A high-risk, high-yield bond.
Essential Knowledge
Companies raise capital in two main forms: debt and equity. As a future finance
professional, students should understand interest rates and its determinants.
1. Bond. A long-term debt instrument which a borrower agrees to make payments of principal
and interest, on specific dates, to the holders of the bond.
1.1. Who issues bonds?
2. Bond Markets. Bonds are primarily traded in the over-the-counter market. Most
bonds are owned by and traded among large financial institutions.
3. Key Features of a Bond.
3.1. Par Value. It is the face amount of the bond, which is paid at maturity.
3.2. Coupon Interest Rate. This is the stated interest rate (generally fixed) paid by
the issuer. It is multiplied by the par value to get interest payment. (Int. Pmt. =
Par Value x Coupon Interest Rate)
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3.3. Maturity Date. This is the years until the bond must be repaid.
3.4. Issue Date. The date when the bond was issued.
3.5. Yield to Maturity (YTM). This is the rate of return earned on a bond held until
maturity. It is also called the promised yield.
3.6. Call Provisions. A provision in a bond contract that gives the issuer the right
to redeem the bonds under specified terms prior to the normal maturity date. It
allows issuer to refund the bond issue if rates decline. It helps the issuer but
hurts the investor. Bond investors require higher yields on callable bonds. In
many cases, callable bonds include a deferred call provision and a declining
call premium
3.7. Sinking Funds. It is a provision to pay off a loan over its life rather than all at
maturity. It reduces the risk to investor and shortens the average maturity.
However, it is not good for investors if rates decline after issuance.
3.7.1. Calling issues at par for sinking fund purposes. Likely to be used if
cost of debt is below the coupon rate and the bond sells at a premium.
3.7.2. Buying bonds in the open market. Likely to be used if cost of debt is
above the coupon rate and the bond sells at a discount.
4. Bond Valuation. The value of any financial asset, including bonds, is simply the
present value of the cash flows the asset is expected to produce.
4.1. Opportunity Cost of Debt Capital. The discount rate (ri) is the opportunity
cost of capital and is the rate that could be earned on alternative investments
of equal risk.
4.2. Illustration 1. What is the value of a 10-year, P1,000 10% annual coupon
bond, if rd = 10%?
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Or
4.3. Illustration 2. In relation with the previous illustration, what is the value of a
10-year, P1,000 bond outstanding with the same risk but a 13% annual coupon
rate?
4.4. Illustration 3. In relation with the previous illustrations, what is the value of a
10-year bond outstanding with the same risk but a 7% annual coupon rate?
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5. Calculating the Yield to Maturity (YTM) of bonds. These are the alternatives for finding
the YTM of bonds:
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5.1. Illustration 1. Compute the YTM of a 10-year, 9% annual coupon, P1,000 par value
bond that is selling for P887.
5.2. Illustration 2. Compute the YTM of a 10-year, 9% annual coupon, P1,000 par value
bond that is selling for P1,134.20.
6. Current Yield and Capital Gains Yield

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6.1. Illustration. Find the current yield and the capital gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and has a face value of $1,000.
7. Price Risk. It is the concern that rising rd will cause the value of a bond to fall.
7.1. Illustration. Which bond have more price risk, a 1-year or 10-years P1,000 bond with
10% annual coupon rate?
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8. Reinvestment Risk. It is the concern that rd will fall, and future cash flows will have to be
reinvested at lower rates, hence reducing income.
8.1. Illustration. You have P500,000 and you may invest it in either a 10-year bond or a
series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%.
8.1.1. 1-Year Bond Strategy.
After Year 1, you will receive P50,000 in income and have P500,000 to
reinvest. But, if 1-year rates fall to 3%, your annual income would fall to
P15,000.
8.1.2. 10-Year Bond Strategy.
You can lock in a 10% interest rate, and P50,000 annual income for 10 years,
assuming that the bond is not callable.
9. Conclusions about Price Risk and Reinvestment Risk.
10. Semiannual Bonds.

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10.1. Illustration. What is the value of a 10-year, P1,000 par, 10% semiannual coupon
bond, if rd = 13%?
11. Yield to Call (YTC). The rate of return earned on a bond if it is called before its maturity
date. The computation of YTC is similar with the formula of YTM, except the time to
call is used for N and the call premium is your Face Value (F).
11.1.Illustration. A 10-year, P1,000 par, 10% semiannual coupon bond selling for
P1,135.90 can be called in 4 years for P1,050. What is its yield to call (YTC)?
11.2.When is a call more likely to occur? In general, if a bond sells at a premium,

then coupon rate > rd. Thus, a call is more likely. You should expect to earn YTC
on premium bonds and YTM on par and discount bonds.
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States of America.
Let’s Check
Management). Now that you know the most essential knowledge in bonds and their valuation,
let us try to check your understanding. Choose the letter of the best answer.
1. If a firm raises capital by selling new bonds, it could be called the "issuing firm," and the coupon
rate is generally set equal to the required rate on bonds of equal risk.
a. True
b. False
2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond.
Typically, companies call bonds if interest rates rise and do not call them if interest rates
decline.
a. True
b. False
3. Sinking funds are provisions included in bond indentures that require companies to retire
bonds on a scheduled basis prior to their final maturity. Many indentures allow the company
to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market
at the going market price or (2) selecting the bonds to be called by a lottery administered by
the trustee, in which case the price paid is the bond's face value.
a. True
b. False
4. A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par.
These bonds provide compensation to investors in the form of capital appreciation.
a. True
b. False
5. The market value of any real or financial asset, including stocks, bonds, or art work purchased
in hope of selling it at a profit, may be estimated by determining future cash flows and then
discounting them back to the present.
a. True
b. False
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a. You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays
a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the
market rate rises from its current level, the zero coupon bond will experience the
larger percentage decline.
b. The time to maturity does not affect the change in the value of a bond in response
to a given change in interest rates.
c. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-
year bond that pays a 6% annual coupon. The same market rate, 6%, applies to
both bonds. If the market rate rises from the current level, the zero coupon bond
will experience the smaller percentage decline.
d. The shorter the time to maturity, the greater the change in the value of a bond in
response to a given change in interest rates, other things held constant.
7. Which of the following events would make it more likely that a company would call its
outstanding callable bonds?
a. The company's bonds are downgraded.
b. Market interest rates rise sharply.
c. Market interest rates decline sharply.
d. The company's financial situation deteriorates significantly.
8. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all
of which are noncallable, are as follows:
The differences in rates among these issues were most probably caused primarily by:
a. Real risk-free rate differences.
b. Tax effects.
c. Default and liquidity risk differences.
d. Maturity risk differences.
9. Under normal conditions, which of the following would be most likely to increase the coupon
rate required for a bond to be issued at par?
a. Adding additional restrictive covenants that limit management's actions.
b. Adding a call provision.
c. The rating agencies change the bond's rating from Baa to Aaa.
d. Making the bond a first mortgage bond rather than a debenture.
10. Three $1,000 face value, 10-year, noncallable, bonds have the same amount of risk, hence
their YTMs are equal. Bond 8 has an 8% annual coupon, Bond 10 has a 10% annual coupon,
and Bond 12 has a 12% annual coupon. Bond 10 sells at par. Assuming that interest rates
remain constant for the next 10 years, which of the following statements is CORRECT?
a. Bond 8's current yield will increase each year.
b. Since the bonds have the same YTM, they should all have the same price, and
since interest rates are not expected to change, their prices should all remain at
their current levels until maturity.
c. Bond 12 sells at a premium (its price is greater than par), and its price is expected
to increase over the next year.
d. Bond 8 sells at a discount (its price is less than par), and its price is expected to
increase over the next year.
Let’s Analyze
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1. Assume that all interest rates in the economy decline from 10% to 9%. Which of the
following bonds would have the largest percentage increase in price?
a. An 8-year bond with a 9% coupon.
b. A 1-year bond with a 15% coupon.
c. A 3-year bond with a 10% coupon.
d. A 10-year zero coupon bond.
a. All else equal, high-coupon bonds have less reinvestment risk than low-
coupon bonds.
b. All else equal, long-term bonds have less price risk than short-term bonds.
c. All else equal, low-coupon bonds have less price risk than high-coupon
bonds.
d. All else equal, long-term bonds have less reinvestment risk than short-term
bonds.
3. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of
the following statements is CORRECT?
a. The bond sells at a price below par.
b. The bond has a current yield greater than 8%.
c. The bond sells at a discount.
d. If the yield to maturity remains constant, the price of the bond will decline
over time.
4. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z
has a 12% annual coupon. Each of the bonds is noncallable, has a maturity of 10
years, and has a yield to maturity of 10%. Which of the following statements is
CORRECT?
a. If the bonds' market interest rate remains at 10%, Bond Z's price will be lower
one year from now than it is today.
b. Bond X has the greatest reinvestment risk.
c. If market interest rates decline, the prices of all three bonds will increase,
but Z's price will have the largest percentage increase.
d. If market interest rates remain at 10%, Bond Z's price will be 10% higher one
year from today.
a. A bond is likely to be called if its coupon rate is below its YTM.
b. A bond is likely to be called if its market price is below its par value.
c. Even if a bond's YTC exceeds its YTM, an investor with an investment
horizon longer than the bond's maturity would be worse off if the bond were
called.
d. A bond is likely to be called if its market price is equal to its par value.
6. Ringgo Company's bonds mature in 8 years, have a par value of P1,000, and make
an annual coupon interest payment of P65. The market requires an interest rate of
8.2% on these bonds. What is the bond's price?
a. P903.04
b. P925.62
c. P948.76
d. P972.48
7. Randy Inc. recently issued noncallable bonds that mature in 15 years. They have a
par value of P1,000 and an annual coupon of 5.7%. If the current market interest
rate is 7.0%, at what price should the bonds sell?
a. P817.12
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b. P838.07
c. P859.56
d. P881.60
8. Greatpenny Corporation issued 20-year, noncallable, 7.5% annual coupon bonds
at their par value of P1,000 one year ago. Today, the market interest rate on these
bonds is 5.5%. What is the current price of the bonds, given that they now have 19
years to maturity?
a. P1,113.48
b. P1,171.32
c. P1,201.35
d. P1,232.15
9. Jolly Inc.'s bonds currently sell for P1,250. They pay a P90 annual coupon, have a
25-year maturity, and a P1,000 par value, but they can be called in 5 years at
P1,050. Assume that no costs other than the call premium would be incurred to call
and refund the bonds, and also assume that the yield curve is horizontal, with rates
expected to remain at current levels on into the future. What is the difference
between this bond's YTM and its YTC? (Subtract the YTC from the YTM; it is
possible to get a negative answer.)
a. 2.62%
b. 2.88%
c. 3.17%
d. 3.48%
10. Keanu Industries has a bond outstanding with 15 years to maturity, an 8.25%
nominal coupon, semiannual payments, and a P1,000 par value. The bond has a
6.50% nominal yield to maturity, but it can be called in 6 years at a price of P1,120.
What is the bond's nominal yield to call?
a. 6.20%
b. 6.53%
c. 6.85%
d. 7.20%
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In a Nutshell
Based from the discussion of bonds and their valuation and the learning
exercises that you have done, please feel free to write what have you learned
below.
1. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
2. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
3. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
4. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
5. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Q&A List

Keywords Index
Coupon Mortgage
Bond Call Provision Indexed Bond
Payment Bond
Coupon Interest Sinking Fund
Treasury Bonds Discount Bond Indenture
Rate Provision
Floating-Rate Convertible
Corporate Bonds Premium Bond Debenture
Bond Bond
Zero-Coupon Investment-
Municipal Bonds Warrant Yield to Maturity
Bond Grade Bonds
Original Issue
Foreign Bonds Putable Bond Yield to Call Junk Bond
Discount Bond
Par Value Maturity Date Income Bond Current Yield
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ULOc. Explain the nature of risk and rates of return.
ULOd. Compare stand-along risk and portfolio risk.
Metalanguage
Below are the essential terms that you are going to encounter in the pursuit of ULOc
and ULOd. Again, you are advised to frequently refer to these definitions to help you
understand the succeeding topics.
1. Risk. The chance that some unfavorable event will occur.

2. Stand-Alone Risk. The risk an investor would face if he or she held only one asset.
3. Probability Distribution. A listing of all possible outcomes, or events, with a
probability assigned to each outcome.
4. Expected Rate of Return, r. The rate of return expected to be realized from an
investment, the weighted average of the probability distribution of possible results.
5. Standard Deviation. A statistical measure of the variability of a set of observations.
6. Variance. The square of the standard deviation.
7. Coefficient of Variation. Standardized measure of the risk per unit of return;
calculated as the standard deviation divided by the expected return.
8. Risk Aversion. Risk-averse investors dislike risk and require higher rates of return as
an inducement to buy riskier securities.
9. Risk Premium. The difference between the expected rate of return on a given risky
asset and that on a less risky asset.
10. Expected Return on a Portfolio. The weighted average of the expected returns on
the assets held in the portfolio.
11. Realized Rate of Return. The 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.
12. Correlation. The tendency of two variables to move together.
13. Correlation Coefficient. A measure of the degree of relationship between two
variables.
14. Market Portfolio. A portfolio consisting of all stocks.
15. Diversifiable Risk. That part of a security’s risk associated with random events; it can
be eliminated by proper diversification.
16. Market Risk. That part of a security’s risk that cannot be eliminated by diversification.
17. Capital Asset Pricing Model (CAPM). A model based on the proposition that any
stock’s required rate of return is equal to the risk-free rate of return plus a risk premium
that reflects only the risk remaining after diversification.
18. Relevant Risk. The risk of a security that cannot be diversified away. This is the risk
that affects portfolio risk, and this is relevant to a rational investor.
19. Beta Coefficient. A metric that shows the extent to which a given stock’s returns move
up and down with the stock market. Beta measures market risk.
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20. Market Risk Premium. The additional return over the risk-free rate needed to
compensate investors for assuming an average amount of risk.
21. Security Market Line (SML) Equation. An equation that shows the relationship
between risk as measured by beta and the required rates of return on individual
securities.
Essential Knowledge
This section discusses the risk and rates of return. Furthermore, it differentiates stand-
alone and portfolio risks.
1. Investment Risk. Related to the probability of earning a low or negative actual return. The
greater the chance of lower than expected, or negative returns, the riskier the investment.
1.1. Types of Investment Risk.
1.1.1. Stand-alone Risk
1.1.2. Portfolio Risk
2. Probability Distributions. A listing of all possible outcomes, and the probability of each
occurrence. It can be shown graphically.
3. Illustration – Investment Alternatives.
Legend:
*T-Bills: Treasury Bills
*HT: High Tech
*Coll: Collection
*USR: US Rubber
*MP: Market
3.1. T-Bill Returns. They are independent of the economy. T-bills do not provide a
completely risk-free return, as they are still exposed to inflation. Although, unexpected
inflation is not likely to occur over such a short period of time. T-bills also have high
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reinvestment risk. However, it is free from default risk.

3.2. HT Returns. Moves with the economy and has a positive correlation. This is typical.
3.3. Collections. It has a negative correlation with the economy. This is not the usual
case.
3.4. Calculating for the Expected Return.
3.4.1. HT.
3.4.2. Summary of Expected Returns. Follow the formula in HT:
High Tech has the highest expected return and the best investment alternative
based on the computation. However, we must not forget to take account its risk.
3.5. Calculating Standard Deviation. It measures the total or stand-alone risk. The larger
the standard deviation is, the lower the probability that actual returns will be close to
expected returns.
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3.6. Comparing Risk and Return.
3.7. Coefficient of Variation. A standardized measure of dispersion about the

expected value, that shows the risk per unit of return.
Collections has the highest degree of risk per unit of return.
4. Risk Aversion. Assumes investors dislike risk and require higher rates of return to
encourage them to hold riskier securities.
5. Risk Premium. The difference between the return on a risky asset and a riskless
asset, which serves as compensation for investors to hold riskier securities.
6. Sources of Stand-Alone Risk.
6.1. Market Risk. A portion of a security’s stand-alone risk that cannot be eliminated
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through diversification. It is measured by beta.

6.2. Diversifiable Risk. A portion of a security’s stand-alone risk that can be
eliminated through proper diversification.
7. Failure to Diversify. The investor will not be compensated for the extra risk they
bear if they don’t diversify.
8. Capital Asset Pricing Model (CAPM). Model linking risk and required returns.
CAPM suggests that there is a Security Market Line that states that a stock’s
required return equals the risk-free return plus a risk premium that reflects the
stock’s risk after diversification.
8.1. Beta. Measures stock’s market risk and shows a stock’s volatility relative to the
market. It indicates how risky a stock is if the stock is held in a well-diversified
portfolio.
8.1.1. Beta = 1.0. The security is just as risky as the average stock.
8.1.2. Beta > 1.0. The security is riskier than average.
8.1.3. Beta < 1.0. The security is less risky than average.
8.2. Illustration.
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8.3. Security Market Line (SML): Calculating Required Rates of Return.
8.4. Market Risk Premium. Additional return over the risk-free rate needed to
compensate investors for assuming an average amount of risk. Its size
depends on the perceived risk of the stock market and investors’ degree of risk
aversion.
8.5. Expected Return vs. Required Return

States of America.
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Let’s Check
Management). Now that you know the essential knowledge in risk and rates of return, let us
try to check your understanding. Write TRUE if the statement is correct and FALSE if
otherwise.
1. The tighter the probability distribution of its expected future returns, the greater the risk of
a given investment as measured by its standard deviation.
2. The coefficient of variation, calculated as the standard deviation of expected returns
divided by the expected return, is a standardized measure of the risk per unit of expected
return.
3. The standard deviation is a better measure of risk than the coefficient of variation if the
expected returns of the securities being compared differ significantly.
4. Risk-averse investors require higher rates of return on investments whose returns are
highly uncertain, and most investors are risk averse.
5. When adding a randomly chosen new stock to an existing portfolio, the higher (or more
positive) the degree of correlation between the new stock and stocks already in the
portfolio, the less the additional stock will reduce the portfolio's risk.
6. Diversification will normally reduce the riskiness of a portfolio of stocks.
7. In portfolio analysis, we often use ex post (historical) returns and standard deviations,
despite the fact that we are really interested in ex ante (future) data.
8. The realized return on a stock portfolio is the weighted average of the expected returns on
the stocks in the portfolio.
9. Market risk refers to the tendency of a stock to move with the general stock market. A
stock with above-average market risk will tend to be more volatile than an average stock,
and its beta will be greater than 1.0.
10. An individual stock's diversifiable risk, which is measured by its beta, can be lowered by
adding more stocks to the portfolio in which the stock is held.
Let’s Analyze
1. You have the following data on three stocks:

Stock A Standard Deviation Beta
A 20% 0.59
B 10% 0.61
C 12% 1.29
If you are a strict risk minimizer, you would choose Stock ____ if it is to be held
in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
a. A;A
b. A;B
c. B;A
d. C;A
e. C;B
2. Which is the best measure of risk for a single asset held in isolation, and which
is the best measure for an asset held in a diversified portfolio?
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a. Variance; correlation coefficient.

b. Standard deviation; correlation coefficient.
c. Beta; variance.
d. Coefficient of variation; beta.
e. Beta; beta.
3. A highly risk-averse investor is considering adding one additional stock to a 3-
stock portfolio, to form a 4-stock portfolio. The three stocks currently held all
have b = 1.0, and they are perfectly positively correlated with the market.
Potential new Stocks A and B both have expected returns of 15%, are in
equilibrium, and are equally correlated with the market, with r = 0.75. However,
Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which
stock should this investor add to his or her portfolio, or does the choice not
matter?
a. Either A or B, i.e., the investor should be indifferent between the two.
b. Stock A.
c. Stock B.
d. Neither A nor B, as neither has a return sufficient to compensate for risk.
e. Add A, since its beta must be lower.
4. Which of the following is NOT a potential problem when estimating and using
betas, i.e., which statement is FALSE?
a. The fact that a security or project may not have a past history that can
be used as the basis for calculating beta.
b. Sometimes, during a period when the company is undergoing a change
such as toward more leverage or riskier assets, the calculated beta will
be drastically different from the "true" or "expected future" beta.
c. The beta of an "average stock," or "the market," can change over time,
sometimes drastically.
d. Sometimes the past data used to calculate beta do not reflect the likely
risk of the firm for the future because conditions have changed.
e. The beta coefficient of a stock is normally found by regressing past
returns on a stock against past market returns. This calculated historical
beta may differ from the beta that exists in the future.
a. The beta of a portfolio of stocks is always smaller than the betas of any
of the individual stocks.
b. If you found a stock with a zero historical beta and held it as the only
stock in your portfolio, you would by definition have a riskless portfolio.
c. The beta coefficient of a stock is normally found by regressing past
returns on a stock against past market returns. One could also construct
a scatter diagram of returns on the stock versus those on the market,
estimate the slope of the line of best fit, and use it as beta. However, this
historical beta may differ from the beta that exists in the future.
d. The beta of a portfolio of stocks is always larger than the betas of any of
the individual stocks.
e. It is theoretically possible for a stock to have a beta of 1.0. If a stock did
have a beta of 1.0, then, at least in theory, its required rate of return
would be equal to the risk-free (default-free) rate of return, rRF.
6. Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance
of producing a 10% return, and a 20% chance of producing a −28% return. What
is the firm's expected rate of return?
a. 9.41%
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b. 9.65%
c. 9.90%
d. 10.15%
e. 10.40%
7. Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance
of producing a 12% return, and a 25% chance of producing a −18% return. What
is the firm's expected rate of return?
a. 7.72%
b. 8.12%
c. 8.55%
d. 9.00%
e. 9.50%
8. Cheng Inc. is considering a capital budgeting project that has an expected return
of 25% and a standard deviation of 30%. What is the project's coefficient of
variation?
a. 1.20
b. 1.26
c. 1.32
d. 1.39
e. 1.46
9. Bae Inc. is considering an investment that has an expected return of 15% and a
standard deviation of 10%. What is the investment's coefficient of variation?
a. 0.67
b. 0.73
c. 0.81
d. 0.89
e. 0.98
10. Bill Dukes has $100,000 invested in a 2-stock portfolio. $35,000 is invested in
Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta
is 0.70. What is the portfolio's beta?
a. 0.65
b. 0.72
c. 0.80
d. 0.89
e. 0.98
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In a Nutshell
Based from the discussion of risk and rates of return and the learning exercises
that you have done, please feel free to write what have you learned below.
1. ____________________________________________________________
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2. ____________________________________________________________
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____________________________________________________________
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3. ____________________________________________________________
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4. ____________________________________________________________
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5. ____________________________________________________________
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____________________________________________________________
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____________________________________________________________
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Q&A List

Keywords Index
Realized Rate of
Risk Variance Market Risk
Return
Coefficient of Capital Asset Pricing
Stand-Alone Risk Correlation
Variation Model
Correlation
Probability Distribution Risk Aversion Relevant Risk
Coefficient
Expected Rate of
Risk Premium Market Portfolio Beta Coefficient
Return
Expected Return on
Standard Deviation Diversifiable Risk Market Risk Premium
Portfolio
Matina, Davao City
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ULOe. Apply key concepts of stocks and their valuation.
Metalanguage
Below are the essential terms that you are going to encounter in the pursuit of
ULOe. Again, you are advised to frequently refer to these definitions to help you
1. Proxy. A document giving one person the authority to act for another, typically the power
to vote shares of common stock.
2. Proxy Fight. An attempt by a person or group to gain control of a firm by getting its
stockholders to grant that person or group the authority to vote their shares to replace the
current management.
3. Takeover. An action whereby a person or group succeeds in ousting a firm’s management
and taking control of the company.
4. Preemptive Right. A provision in the corporate charter or bylaws that gives common
stockholders the right to purchase on a pro rata basis new issues of common stock or
convertible securities.
5. Classified Stock. Common stock that is given a special designation (Class A, Class B,
etc.) to meet special needs of the company.
6. Founders’ Shares. Stock owned by the firm’s founders that has sole voting rights but
restricted dividends for a specified number of years.
7. Market Price (P0). The price at which a stock sells in the market.
8. Intrinsic Value ( ). The value of an asset that, in the mind of a particular investor, is
justified by the facts. This might be different from the asset’s current market price.
9. Growth Rate (g). The expected rate of growth in dividends per share.
10. Required Rate of Return (rs). The minimum rate of return on a common stock that a
stockholder considers acceptable.
11. Expected Rate of Return. The rate of return on a common stock that a stockholder
expects to receive in the future.
12. Actual Realized Rate of Return. The rate of return on a common stock actually received
by stockholders in some past period.
13. Dividend Yield. The expected dividend divided by the current price of a share of stock.
14. Capital Gains Yield. The capital gain during a given year divided by the beginning price.
15. Expected Total Return. The sum of the expected dividend yield and the expected capital
gains yield.
16. Constant Growth (Gordon) Model. Used to find the value of a constant growth stock.
17. Zero Growth Stock. A common stock whose future dividends are not expected to grow
at all. (g=0)
18. Supernormal (Nonconstant) Growth. The part of the firm’s life cycle in which it grows
much faster than the economy as a whole.
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19. Terminal Date (Horizon Date). The date when the growth rate becomes constant. At
this date, it is no longer necessary to forecast the individual dividends.
20. Horizon (Terminal) Value. The value at the horizon date of all dividends expected
thereafter.
21. Total Company or Corporate Valuation Model. A valuation model used as an
alternative to the dividend growth model to determine the value of a firm, especially one
with no history of dividends or a division of a larger firm. This model first calculates the
firm’s free cash flows and then finds their present value to determine the firm’s value.
22. Marginal Investor. A representative investor whose actions reflect the beliefs of those
people who are currently trading a stock. It is the marginal investor who determines a
stock’s price.
23. Equilibrium. A condition under which the expected return on a security is just equal to
its required return and the price is stable.
Essential Knowledge
This section discusses the common and preferred stocks. While it is generally
easy to predict the cash flows received from bonds, forecasting the cash flows on
common stocks is much more difficult.
1. Facts About Common Stock.

1.1. Represents ownership
1.2. Ownership implies control
1.3. Stockholders elect directors
1.4. Directors elect management
1.5. Management’s Goal: Maximize stock price
2. Types of Common Stock. Most of the firms have only one type of common
stock. However, some firms have:
2.1. Classified Stock. Common stock that is given a special designation, such
as Class A, Class B, etc., to meet special needs of the company.
2.2. Founders’ Shares. Stock owned by the firm’s founders that has sole
voting rights but restricted dividends for a specified number of years.
3. Intrinsic Value and Stock Price. Outside investors, corporate insiders and
analysts use a variety of approaches to estimate a stock’s intrinsic value (P 0).
3.1. Equilibrium. In equilibrium, we assume that a stock’s price equals its
intrinsic value. Outsiders estimate intrinsic value to help determine which
stocks are attractive to buy and/or sell.
3.1.1. Undervalued Stocks. Stock Price < Intrinsic Value
3.1.2. Overvalued Stocks. Stock Price > Intrinsic Value
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3.2. Determinants of Intrinsic Value and Stock Prices.
4. Different Approaches for Estimating the Intrinsic Value of a Common

Stock.
4.1. Discounted Dividend Model. Value of a stock is the present value of
the future dividends expected to be generated by the stock.
4.1.1. Constant Growth Stock. A stock whose dividends are expected

to grow forever at a constant rate, g.
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● Illustration. If rRF = 7%, rM = 12%, b=1.2, D0 = P2.00 and g is a

constant 6% what is the stock’s intrinsic value?
4.1.2. Zero Growth Stock.

● Illustration. What would be the expected price today if the
stock’s expected return is 13%, D0 = 2.00 and no growth?
4.1.3. Supernormal Growth.

stock’s expected return is 13%, D0 = 2.00 and growth is 30% for
3 years before achieving long-run growth of 6%?
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4.1.4. Zero-Growth at the Beginning Before Achieving Long-Run

Growth.
stock’s expected return is 13%, D0 = 2.00 and growth is 0% for
3 years before achieving long-run growth of 6%?
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4.1.5. Negative Growth.

stock’s expected return is 13%, D0 = 2.00 and growth is -6%?
4.2. Corporate Valuation Model. It is called the free cash flow method. It suggests the value
of the entire firm equals the present value of the firm’s free cash flows. Free Cash Flow
is the firm’s after-tax operating income less the net capital investment.
4.2.1. Market Value of the Firm.

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4.2.2. Issues Regarding the Corporate Valuation Model.
4.2.3. Illustration 1. Calculate the intrinsic value of a stock that has WACC of 10% and
a long-run growth of 6% after 3-years with this FCF:
4.2.4. Illustration 2. What is the firm’s intrinsic value per share if the firm has $40 million
total in debt and preferred stock and has 10 million shares of common stock?
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4.3. Firm Multiples Method. Analysts often use the following multiples to value stocks:
4.3.1. Example. Based on comparable firms, estimate the appropriate P/E. Multiply
this by expected earnings to back out an estimate of the stock price.
4.4. EVA Approach. Economic Value-Added Approach.
5. Preferred Stocks. These are hybrid securities. Like bonds, preferred stockholders receive
a fixed dividend that must be paid before dividends are paid to common stockholders.
However, companies can omit preferred dividend payments without fear of pushing the
firm into bankruptcy.
5.1. Illustration. If preferred stock with an annual dividend of $5 sells for $50, what is the
preferred stock’s expected return?
States of America.
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Let’s Check
Management). Now that you know the most essential knowledge in stocks and their valuation,
let us try to check your understanding. Choose the letter of the best answer.
1. A proxy is a document giving one party the authority to act for another party, including the
power to vote shares of common stock. Proxies can be important tools relating to control
of firms.
a. True
b. False
2. The preemptive right gives current stockholders the right to purchase, on a pro rata basis,
any new shares issued by the firm. This right helps protect current stockholders against
both dilution of control and dilution of value.
a. True
b. False
3. Classified stock differentiates various classes of common stock, and using it is one way
companies can meet special needs such as when owners of a start-up firm need additional
equity capital but don't want to relinquish voting control.
a. True
b. False
4. Founders' shares are a type of classified stock where the shares are owned by the firm's
founders, and they generally have more votes per share than the other classes of common
stock.
a. True
b. False
5. The total return on a share of stock refers to the dividend yield less any commissions paid
when the stock is purchased and sold.
a. True
b. False
6. The cash flows associated with common stock are more difficult to estimate than those
related to bonds because stock has a residual claim against the company versus a
contractual obligation for a bond.
a. True
b. False
7. When a new issue of stock is brought to market, it is the marginal investor who determines
the price at which the stock will trade.
a. True
b. False
8. According to the nonconstant growth model discussed, the discount rate used to find the
present value of the expected cash flows during the initial growth period is the same as
the discount rate used to find the PVs of cash flows during the subsequent constant growth
period.
a. True
b. False
9. The corporate valuation model can be used only when a company doesn't pay dividends.
a. True
b. False
10. Preferred stock is a hybrid—a sort of cross between a common stock and a bond—in the
sense that it pays dividends that normally increase annually like a stock but its payments
are contractually guaranteed like interest on a bond.
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a. True
b. False
Let’s Analyze

a. The constant growth model is often appropriate for evaluating start-up companies
that do not have a stable history of growth but are expected to reach stable growth
within the next few years.
b. If a stock has a required rate of return rs = 12% and its dividend is expected to
grow at a constant rate of 5%, this implies that the stock's dividend yield is also
5%.
c. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose
dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.
d. The price of a stock is the present value of all expected future dividends,
discounted at the dividend growth rate.
e. The constant growth model cannot be used for a zero growth stock, where the
dividend is expected to remain constant over time.
2. An increase in a firm's expected growth rate would cause its required rate of return to
a. increase.
b. decrease.
c. fluctuate less than before.
d. fluctuate more than before.
e. possibly increase, possibly decrease, or possibly remain constant.
3. If in the opinion of a given investor a stock's expected return exceeds its required return,
this suggests that the investor thinks
a. the stock is experiencing supernormal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.
4. If markets are in equilibrium, which of the following conditions will exist?
a. Each stock's expected return should equal its realized return as seen by the
marginal investor.
b. Each stock's expected return should equal its required return as seen by the
marginal investor.
c. All stocks should have the same expected return as seen by the marginal investor.
d. The expected and required returns on stocks and bonds should be equal.
e. All stocks should have the same realized return during the coming year.
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5. Stocks A and B have the following data. Assuming the stock market is efficient and the
stocks are in equilibrium, which of the following statements is CORRECT?
a. These two stocks should have the same price.

b. These two stocks must have the same dividend yield.
c. These two stocks should have the same expected return.
d. These two stocks must have the same expected capital gains yield.
e. These two stocks must have the same expected year-end dividend.
6. Stocks A and B have the following data. Assuming the stock market is efficient and the
stocks are in equilibrium, which of the following statements is CORRECT?
a. The two stocks should have the same expected dividend.

b. The two stocks could not be in equilibrium with the numbers given in the
question.
c. A's expected dividend is $0.50.
d. B's expected dividend is $0.75.
e. A's expected dividend is $0.75 and B's expected dividend is $1.20.
7. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher
required rate of return. Which of the following statements is CORRECT?
a. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield
must be higher than Stock B's.
b. Stock B must have a higher dividend yield than Stock A.
c. Stock A must have a higher dividend yield than Stock B.
d. If Stock A has a higher dividend yield than Stock B, its expected capital gains
yield must be lower than Stock B's.
e. Stock A must have both a higher dividend yield and a higher capital gains yield
than Stock B.
8. Two constant growth stocks are in equilibrium, have the same price, and have the same
required rate of return. Which of the following statements is CORRECT?
a. The two stocks must have the same dividend per share.
b. If one stock has a higher dividend yield, it must also have a lower dividend growth
rate.
c. If one stock has a higher dividend yield, it must also have a higher dividend
growth rate.
d. The two stocks must have the same dividend growth rate.
e. The two stocks must have the same dividend yield.
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9. Yong Company's last dividend was P1.25. The dividend growth rate is expected to be
constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6%
forever. If the firm's required return (rs) is 11%, what is its current stock price?
a. P30.57
b. P31.52
c. P32.49
d. P33.50
e. P34.50
10. William's preferred stock pays a dividend of P1.00 per quarter. If the price of the stock is
P45.00, what is its nominal (not effective) annual rate of return?
a. 8.03%
b. 8.24%
c. 8.45%
d. 8.67%
e. 8.89%
11. Based on the corporate valuation model, Chase Inc.'s total corporate value is P300
million. The balance sheet shows P90 million of notes payable, P30 million of long-term
debt, P40 million of preferred stock, and P100 million of common equity. The company
has 10 million shares of stock outstanding. What is the best estimate of the stock's price
per share?
a. P12.00
b. P12.64
c. P13.30
d. P14.00
e. P14.70
12. Sunnier Corp.'s expected year-end dividend is D1 = P1.60, its required return is rs =
11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the
future. What is Sorenson's expected stock price in 7 years?
a. P37.52
b. P39.40
c. P41.37
d. P43.44
e. P45.61
13. Baker Inc.'s stock has a required rate of return of 10.25%, and it sells for P57.50 per
share. The dividend is expected to grow at a constant rate of 6.00% per year. What is
the expected year-end dividend, D1?
a. P2.20
b. P2.44
c. P2.69
d. P2.96
e. P3.25
14. Better Inc.'s stock has a required rate of return of 11.50%, and it sells for P25.00 per
share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the
last dividend, D0?
a. P0.95
b. P1.05
c. P1.16
d. P1.27
e. P1.40
15. Senheiser Corporation just paid a dividend of D0 = P0.75 per share, and that dividend is
expected to grow at a constant rate of 6.50% per year in the future. The company's beta
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is 1.25, the required return on the market is 10.50%, and the risk-free rate is 4.50%.
What is the company's current stock price?
a. P14.52
b. P14.89
c. P15.26
d. P15.64
e. P16.03
In a Nutshell
Based from the discussion of stocks and their valuation and the learning
below.
1. ____________________________________________________________
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____________________________________________________________
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____________________________________________________________
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2. ____________________________________________________________
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____________________________________________________________
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____________________________________________________________
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3. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
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4. ____________________________________________________________
___
____________________________________________________________
___
____________________________________________________________
___
5. ____________________________________________________________
Matina, Davao City
Phone No.: (082)300-5456 Local 137
___
____________________________________________________________
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____________________________________________________________
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Matina, Davao City
Phone No.: (082)300-5456 Local 137
Q&A List

Keywords Index
Proxy Market Price Dividend Yield Terminal Date

Capital Gains
Proxy Fight Intrinsic Value Horizon Value
Yield
Total Company or
Expected Total
Takeover Growth Rate Corporate Valuation
Return
Model
Required Rate of Constant Growth
Preemptive Right Marginal Investor
Return Model
Expected Rate of Zero Growth
Classified Stock Equilibrium
Return Stock
Actual Realized Rate Supernormal
Founders’ Shares
of Return Growth
Matina, Davao City
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COURSE SCHEDULES
WHERE TO
ACTIVITY DATE
SUBMIT/PERFORM
Big Picture ULOa:
Blackboard LMS
Let’s Check
Big Picture ULOa:
Blackboard LMS
Let’s Analyze
Big Picture ULOa:
Blackboard LMS
In a Nutshell
Big Picture ULOb:
Blackboard LMS
Let’s Check
Big Picture ULOb:
Blackboard LMS
Let’s Analyze
Big Picture ULOb:
Blackboard LMS
In a Nutshell
Big Picture ULOc & ULOd:
Blackboard LMS
Let’s Check
Blackboard LMS
Let’s Analyze
Blackboard LMS
In a Nutshell
Big Picture ULOe:
Blackboard LMS
Let’s Check
Big Picture ULOe:
Blackboard LMS
Let’s Analyze
Big Picture ULOe:
Blackboard LMS
In a Nutshell
2nd Examination February 12, 2021 Blackboard LMS
Matina, Davao City
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Big Picture
are expected to
a. Explain the elements of the cost of capital.

b. Compare CAPM and WACC.
c. Discuss the nature and concept of capital budgeting.
d. Explain the different capital budgeting tools for decision making.
e. Apply key concepts of cost of capital and capital budgeting.
f. Discuss the importance of capital structure.
g. Explain the essence of leverage in business organization.
h. Apply key concepts of capital structure and leverage for decision
making.

ULOa. Explain the elements of the cost of capital.
ULOb. Compare CAPM and WACC.
Metalanguage
Below are the essential terms that you are going to encounter in
the pursuit of ULOa and ULOb. Again, you are advised to frequently refer
to these definitions to help you understand the succeeding topics.
1. Capital Component. One of the types of capital used by firms to raise funds.
2. Target (Optimal) Capital Structure. The percentages of debt, preferred stock,
and common equity that will maximize the firm’s stock price.
3. Weighted Average Cost of Capital (WACC). A weighted average of the
component costs of debt, preferred stock, and common equity.
4. After-Tax Cost of Debt, rd(1-T). The relevant cost of new debt, considering the
tax deductibility of interest. It is used to calculate the WACC.
5. Cost of Preferred Stock, rp. The rate of return investors requires on the firm’s
preferred stock.
6. Cost of Retained Earnings, rs. The rate of return required by stockholders on a
firm’s common stock.
7. Cost of New Common Stock, rs. The cost of external equity. It is based on the
cost of retained earnings but increased for flotation costs.
8. Flotation Cost, F. The percentage cost of issuing new common stock.
9. Retained Earnings Breakpoint. The amount of capital raised beyond which new
common stock must be issued.
Essential Knowledge
In the previous topics, we know that debt and equity comprise the firm’s capital.
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This section discusses the cost of capital.
1. Sources of Capital.
2. Optimal Capital Structure. Each firm has an optimal capital structure. It is defined as the
mix of debt, preferred and common equity that causes its stock prices to be maximize. A
value-maximizing firm will estimate its optimal capital structure and use it as target to raise
new capital in a manner designed to keep the actual capital structure target over time.
3. Weighted Average Cost of Capital. A weighted average of the component costs of debt,
preferred stock, and common equity.
3.1. Should we use before-tax or after-tax capital costs? Stockholders focus on

after-tax cash flows. Therefore, we should focus on after-tax capital costs. Only
the cost of debt is affected since interest is tax deductible.
3.2. Should our analysis focus on historical (embedded) costs or new (marginal)
costs? The cost of capital is used primarily to make decisions that involve raising
new capital. So, we focus more on today’s marginal costs.
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4. Computation of WACC. For illustration purposes, please refer to the following data of
Coleman Technologies, Inc.:
Review of Coleman’s Capital Structure:
4.1. Cost of Debt.

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Based on the illustration, the company has a 15-year, 12% semiannual

coupon bond that sells for P1,153.72. Let us calculate the cost of debt or
YTM:
Since this computation is in semi-annual terms, the annual YTM that we

should consider in the calculation for our WACC is 10%
The cost of debt component should be an after-tax figure.
4.2. Cost of Preferred Stock, rp. It is the marginal cost of preferred stock, which
is the return investors require on a firm’s preferred stock. Preferred
dividends are not tax-deductible, so no tax adjustments are necessary. Our
calculation ignores possible flotation costs.
According to our illustration, the firm has 10%, P100 par value, quarterly
dividend, perpetual preferred stock that sells for P111.10.
The cost of preferred stock is:

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4.2.1. Which is riskier to investors? Preferred stocks or debt? Preferred

stocks are riskier since the company is not required to pay preferred
dividend. However, firms try to pay preferred dividend otherwise, they
cannot pay common dividends, it is difficult to raise additional funds and
preferred stockholders may gain control of firm.
4.3. Cost of Retained Earnings, rs. It is the marginal cost of common equity using
retained earnings. There is a cost for retained earnings because earnings can be
reinvested or paid out as dividends and investors could buy other securities and
earn a return. If earnings are retained, there is an opportunity cost.
4.3.1. Three Ways to Determine the Cost of Retained Earnings, rs.
Please refer to the illustration above.
CAPM Approach:
DCF Approach:
Bond-Yield-Plus-Risk-Premium Approach:
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We have three different answers for each method. We should use the
MIDPOINT of the range as our cost of retained earnings.
The cost of retained earnings (rs) is 14%.
4.3.2. Cost of New Common Stock, re. The cost of external equity based on
the cost of retained earnings but increased for flotation costs. The cost
of retained earnings is cheaper than the cost of issuing new common
stock because when a company issues new common stock, they also
must pay flotation costs to the underwriter. Issuing new common stock
may send a negative signal to the capital markets, which may depress
the stock price.
A flotation cost should be included as part of the project’s upfront cost.

This reduces the project’s estimated return. This cost should serve as
an adjustment to the cost of capital in the DCF Model.
Suppose that the company issued new commons tocks and it incurs a
flotation cost of 15% of the proceeds. What is the cost of new common
stock? Please refer to the previous illustration.
Flotation costs depend on the firm’s risk and the type of capital raised.
These are highest for common equity. However, since most firms issue
equity infrequently, the per-project cost is fairly small.
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4.4. What is the firm’s WACC (ignoring flotation costs)?
5. Factors that influence a company’s composite WACC.

5.1. Factors the firm cannot control.
5.1.1. Market Conditions. Interest rates and tax rates.
5.2. Factors the firm can control.
5.2.1. Firm’s Capital Structure
5.2.2. Firm’s Dividend Policy
5.2.3. Firm’s Investment Policy. Firms with riskier projects generally have a
higher WACC.
States of America.
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Let’s Check
Management). Now that you know the most essential knowledge in the cost of
capital, let us try to check your understanding. Write True if the answer is correct
and False if not.
1. The cost of capital used in capital budgeting should reflect the average cost of the
various sources of investor-supplied funds a firm uses to acquire assets.
2. Suppose you are the president of a small, publicly-traded corporation. Since you
believe that your firm's stock price is temporarily depressed, all additional capital
funds required during the current year will be raised using debt. In this case, the
appropriate marginal cost of capital for use in capital budgeting during the current
year is the after-tax cost of debt.
3. The component costs of capital are market-determined variables in the sense that
they are based on investors' required returns.
4. The before-tax cost of debt, which is lower than the after-tax cost, is used as the
component cost of debt for purposes of developing the firm's WACC.
5. The cost of debt is equal to one minus the marginal tax rate multiplied by the
average coupon rate on all outstanding debt.
6. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest
rate on new debt.
7. The cost of preferred stock to a firm must be adjusted to an after-tax figure because
70% of dividends received by a corporation may be excluded from the receiving
corporation's taxable income.
8. The cost of perpetual preferred stock is found as the preferred's annual dividend
divided by the market price of the preferred stock. No adjustment is needed for taxes
because preferred dividends, unlike interest on debt, are not deductible by the
issuing firm.
9. The cost of common equity obtained by retaining earnings is the rate of return the
marginal stockholder requires on the firm's common stock.
10. Funds acquired by the firm through retaining earnings have no cost because there
are no dividend or interest payments associated with them, and no flotation costs
are required to raise them, but capital raised by selling new stock or bonds does
have a cost.
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Let’s Analyze
Management) Choose letter of the correct answer.

a. When calculating the cost of debt, a company needs to adjust for taxes,
because interest payments are deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for
taxes, because dividends paid on preferred stock are deductible by the
paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater
effect on the after-tax cost of debt than on the cost of common stock as
measured by the CAPM.
d. If a company's beta increases, this will increase the cost of equity used to
calculate the WACC, but only if the company does not have enough retained
earnings to take care of its equity financing and hence must issue new stock.
a. In the WACC calculation, we must adjust the cost of preferred stock (the
market yield) to reflect the fact that 70% of the dividends received by
corporate investors are excluded from their taxable income.
b. We should use historical measures of the component costs from prior
financings that are still outstanding when estimating a company's WACC for
capital budgeting purposes.
c. The cost of new equity (re) could possibly be lower than the cost of retained
earnings (rs) if the market risk premium, risk-free rate, and the company's
beta all decline by a sufficiently large amount.
d. Its cost of retained earnings is the rate of return stockholders require on a
firm's common stock.
a. The WACC as used in capital budgeting is an estimate of a company's
before-tax cost of capital.
b. The percentage flotation cost associated with issuing new common equity is
typically smaller than the flotation cost for new debt.
c. The WACC as used in capital budgeting is an estimate of the cost of all the
capital a company has raised to acquire its assets.
d. There is an "opportunity cost" associated with using retained earnings,
hence they are not "free."
a. A change in a company's target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the
individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce
the WACC.
d. If a company's tax rate increases, then, all else equal, its weighted average
cost of capital will decline.
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a. The after-tax cost of debt usually exceeds the after-tax cost of equity.
b. For a given firm, the after-tax cost of debt is always more expensive than
the after-tax cost of non-convertible preferred stock.
c. Retained earnings that were generated in the past and are reported on the
firm's balance sheet are available to finance the firm's capital budget during
the coming year.
d. The WACC that should be used in capital budgeting is the firm's marginal,
after-tax cost of capital.
6. Bosio Inc.'s perpetual preferred stock sells for P97.50 per share, and it pays an
P8.50 annual dividend. If the company were to sell a new preferred issue, it would
incur a flotation cost of 4.00% of the price paid by investors. What is the company's
cost of preferred stock for use in calculating the WACC?
a. 8.72%
b. 9.08%
c. 9.44%
d. 9.82%
7. Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.
You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and
b = 1.30. Based on the CAPM approach, what is the cost of equity from retained
earnings?
a. 9.97%
b. 10.28%
c. 10.60%
d. 10.93%
8. Assume that you are a consultant to Broske Inc., and you have been provided with
the following data: D1 = P0.67; P0 = P27.50; and g = 8.00% (constant). What is the
cost of equity from retained earnings based on the DCF approach?
a. 9.42%
b. 9.91%
c. 10.44%
d. 10.96%
9. A. Butcher Timber Company hired your consulting firm to help them estimate the
cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists
believe that the cost of equity can be estimated using a risk premium of 3.85% over
a firm's own cost of debt. What is an estimate of the firm's cost of equity from
retained earnings?
a. 12.60%
b. 13.10%
c. 13.63%
d. 14.17%
10. You were hired as a consultant to Giambono Company, whose target capital
structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost
of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings
is 12.75%. The firm will not be issuing any new stock. What is its WACC?
a. 8.98%
b. 9.26%
c. 9.54%
d. 9.83%
In a Nutshell
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Explain the steps on how to calculate the following components of WACC (10 pts each)
1. Cost of Debt
2. Cost of Preferred Stock
3. Cost of Retained Earnings
4. Cost of New Common Stocks
Q&A List

Keywords Index
Capital Component After-Tax Cost of Debt Cost of New Common Stock
Target (Optimal) Capital
Cost of Preferred Stock Flotation Cost
Structure
Weighted Average Cost of Retained Earnings
Cost of Retained Earnings
Capital Breakpoint
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ULOc. Discuss the nature and concept of capital budgeting.
ULOd. Explain the different capital budgeting tools for decision
making.
ULOe. Apply key concepts of cost of capital and capital
budgeting.
Metalanguage
the pursuit of ULOc, ULOd and ULOe. Again, you are advised to frequently
refer to these definitions to help you understand the succeeding topics.
1. Capital Budgeting. The process of planning expenditures on assets whose cash

flows are expected to extend beyond one year.
2. Strategic Business Plan. A long-run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years.
3. Net Present Value (NPV) Method. A method of ranking investment proposals
using the NPV, which is equal to the present value of future net cash flows,
discounted at the cost of capital.
4. Mutually Exclusive Projects. A set of projects where only one can be accepted.
5. Independent Projects. Projects whose cash flows are not affected by the
acceptance of nonacceptance of other projects.
6. Internal Rate of Return (IRR). The discount rate that forces a project’s NPV to
equal zero.
7. Net Present Value Profile. A graph showing the relationship between a project’s
NPV and the firm’s cost of capital.
8. Crossover Rate. The cost of capital at which the NPV profile of two projects
cross, and, thus, at which the projects’ NPVs are equal.
9. Reinvestment Rate Assumption. The assumption that cash flows from a
project can be reinvestment at the cost of capital (if using the NPV method) or at
the internal rate of return (if using the IRR method).
10. Multiple IRRs. The situation where a project has two or more IRRs.
11. Modified IRR (MIRR). The discount rate at which the present value of a project’s
cost is equal to the present value of its terminal value, where the terminal value
is found as the sum of the future values of the cash inflows, compounded at the
firm’s cost of capital.
12. Payback Method. The length of time required for an investment’s net revenues
to cover its cost.
13. Post-Audit. A comparison of actual versus expected results for a given capital
project.
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Essential Knowledge
This section discusses capital budgeting and evaluation of projects using capital
budgeting. Please note that this section only covers the basic discussion regarding capital
budgeting. A further discussion will be held in your advanced finance subjects.
1. Capital Budgeting. The process of planning expenditures on assets whose

cash flows are expected to extend beyond one year. It involves investment
decisions involving fixed assets.
1.1. Capital. Long-term assets used in production.
1.2. Budget. A plan that details projected expenditures during some future
period.
1.3. Capital Budget. An outline of planned investments in long-term assets.
1.4. Strategic Business Plan. A long-run plan that outlines in broad terms the
firm’s basic strategy for the next 5 to 10 years.
1.5. Capital Budgeting in a Nutshell.
1.6. Steps to Capital Budgeting.

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2. Project Classifications. The analysis of capital expenditures incurs costs. For

certain project type, a certain detailed analysis is needed. For simpler projects,
non-complex procedures should be used. Here are some project categories:
3. Independent Projects vs. Mutually Exclusive Projects.
4. Normal Cash Flow Stream vs. Non-normal Cash Flow Stream.
5. Net Present Value Method (NPV). It estimates how much a potential project
will contribute to shareholder wealth. It is the primary capital budgeting decision
criterion. It is found as follows:
5.1. Illustration. (Brigham & Houston, 2015)

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*Project S stands for short-term project.

*Project L stands for long-term project.
*Cost of Capital is 10%.
Project S:
Project L:
5.1.1. Decision-Making.
● Mutually Exclusive Projects. The higher NPV should be
accepted and the other rejected. In the illustration, Project L should
be accepted and reject Project S.
● Independent Projects. Accept projects that have positive NPV. In
the illustration, both projects should be accepted.
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6. Internal Rate of Return (IRR). It is the discount rate that forces the project’s NPV to equal
zero.
The project’s IRR is similar to a bond’s YTM. Think of a bond as a project. The YTM
on the bond would be the IRR of the “bond” project.
6.1. Ways to Calculate IRR. Financial Calculator, MS Excel and Trial and Error (to get
NPV=0)
6.2. Illustration. Based on the above illustration, the IRR for the Project S and Project L
are:
6.3. Rationale for the IRR Method.
7. Comparison of the NPV and IRR Methods. In many respects the NPV method is better
than IRR. However, the IRR method is familiar to may corporate executives. the NPV and
IRR methods can provide conflicting recommendations when used to evaluate mutually
exclusive projects. Therefore, it is important that you understand the IRR method, know
how it is related to the NPV, and know why it is sometimes better to choose a project with
a relatively low IRR over a mutually exclusive alternative with a higher IRR.
8. Multiple IRRs. If a project has non-normal cash flows, it can have two or more IRRs.
8.1. Normal Cash Flows. It has one or more cash outflows followed by a series of cash
inflows.
8.2. Non-Normal Cash Flows. A cash outflow occurs sometime after the inflows have
commenced. There is more than one sign changes in the cash flows.
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9. Reinvestment Rate Assumptions.
10. Modified Internal Rate of Return. It is the discount rate that causes the present
value (PV) of a project’s terminal value (TV) to equal the PV of costs. Terminal Value
is found by compounding inflows at WACC.
10.1.Illustration. A project has the following cash flows with 10% as its WACC:
10.2.Why use MIRR vs IRR? MIRR assumes reinvestment at opportunity cost

(WACC). MIRR also avoids the multiple IRR problem. Managers like rate of
return comparisons, and MIRR is better for this than IRR.
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11. Payback Period. The earliest selection criterion of capital budgeting. It is defined
as the number of years required to recover a project’s cost from operating cash
flows. The shorter the payback, the better.
11.1.Illustration. Assume that Project L has the following cash flow stream:
Or
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11.2.Discounted Payback Method. It uses discounted cash flows rather than raw
cash flows.
11.3.Advantages and Disadvantages of Payback Period.
States of America.
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Let’s Check
Management). Now that you know the most essential knowledge in capital
budgeting, let us try to check your understanding. Write True if the answer is
correct and False if not.
1. A firm should never accept a project if its acceptance would lead to an

increase in the firm's cost of capital (its WACC).
2. Because "present value" refers to the value of cash flows that occur at
different points in time, a series of present values of cash flows should not be
summed to determine the value of a capital budgeting project.
3. Assuming that their NPVs based on the firm's cost of capital are equal, the
NPV of a project whose cash flows accrue relatively rapidly will be more
sensitive to changes in the discount rate than the NPV of a project whose
cash flows come in later in its life.
4. Conflicts between two mutually exclusive projects occasionally occur, where
the NPV method ranks one project higher but the IRR method puts the other
one first. In theory, such conflicts should be resolved in favor of the project
with the higher NPV.
5. Conflicts between two mutually exclusive projects occasionally occur, where
the NPV method ranks one project higher but the IRR method puts the other
one first. In theory, such conflicts should be resolved in favor of the project
with the higher IRR.
6. The internal rate of return is that discount rate that equates the present value
of the cash outflows (or costs) with the present value of the cash inflows.
7. Other things held constant, an increase in the cost of capital will result in a
decrease in a project's IRR.
8. Under certain conditions, a project may have more than one IRR. One such
condition is when, in addition to the initial investment at time = 0, a negative
cash flow (or cost) occurs at the end of the project's life.
9. The phenomenon called "multiple internal rates of return" arises when two or
more mutually exclusive projects that have different lives are being
compared.
10. The primary reason that the NPV method is conceptually superior to the IRR
method for evaluating mutually exclusive investments is that multiple IRRs
may exist, and when that happens, we don't know which IRR is relevant.
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Let’s Analyze
Management) Write the correct answer. Please show your solution. (All answers should be
in 2 decimal places)
1. Anderson Systems is considering a project that has the following cash flow and WACC
data. What is the project's NPV? Note that if a project's projected NPV is negative, it should
be rejected.
WACC: 9%
2. Tuttle Enterprises is considering a project that has the following cash flow and WACC data.
What is the project's NPV? Note that if a project's projected NPV is negative, it should be
rejected.
3. Harry's Inc. is considering a project that has the following cash flow and WACC data. What
is the project's NPV? Note that if a project's projected NPV is negative, it should be
rejected.
4. Taggart Inc. is considering a project that has the following cash flow data. What is the
project's payback?
5. Resnick Inc. is considering a project that has the following cash flow data. What is the
project's payback?
6. Susmel Inc. is considering a project that has the following cash flow data. What is the
project's payback?
7. Mansi Inc. is considering a project that has the following cash flow data. What is the
project's payback?
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8. Cornell Enterprises is considering a project that has the following cash flow and WACC
data. What is the project's NPV? Note that a project's projected NPV can be negative, in
which case it will be rejected.
9. Ehrmann Data Systems is considering a project that has the following cash flow and
WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less
than the WACC (and even negative), in which case it will be rejected.
10. Ingram Electric Products is considering a project that has the following cash flow and
WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less
than the WACC (and even negative), in which case it will be rejected.
In a Nutshell
Explain the following topics in no less than 30 words.
1. Importance of Capital Budgeting (10pts)

2. Difference between NPV and IRR (10pts)
3. Which is better to use, NPV or IRR? (10pts)
Q&A List

Keywords Index
Reinvestment Rate
Capital Budgeting Independent Projects
Assumption
Strategic Business Plan Internal Rate of Return Multiple IRRs
Modified Internal Rate of
Net Present Value Net Present Value Profile
Return
Mutually Exclusive Projects Crossover Rate Payback Method
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ULOf. Discuss the importance of capital structure.
ULOg. Explain the essence of leverage in business organization.
ULOh. Apply key concepts of capital structure and leverage for
decision making.
Metalanguage
demonstrate ULOf, ULOg and ULOh will be operationally defined to establish a common
frame of refence as to how the texts work in your chosen field or career. You will encounter
these terms as we go through the study of curriculum. Please refer to these definitions in
case you will encounter difficulty in the understanding capital structure and leverage.
1. Business Risk. The riskiness inherent in the firm’s operations if it uses no debt.
2. Operating Leverage. The extent to which fixed costs are used in a firm’s operations.
3. Operating Breakeven. The output quantity at which EBIT is zero.
4. Financial Risk. An increase in stockholders’ risk over and above the firm’s business
risk resulting from the use of financial leverage.
5. Financial Leverage. The extent to which fixed income securities (debt and preferred
stock) are used in a firm’s capital structure.
6. Unlevered Beta, bU. The firm’s beta coefficient if it has no debt.
7. Trade-Off Theory. The capital structure theory that states firms trade off the tax
benefits of debt financing against problems caused by potential bankruptcy.
8. Symmetric Information. The situation in which investors and managers have identical
information about firm’s prospects.
9. Asymmetric Information. The situation in which managers have different information
about firm’s prospects than do investors.
10. Signal. An action taken by a firm’s management that provides clues to investors about
how management views the firm’s prospects.
11. Reserve Borrowing Capacity. The ability to borrow money at a reasonable cost when
good investment opportunities arise. Firms often use less debt than specified by the
MM optimal capital structure in normal times to ensure that they can obtain debt capital
later, if necessary.
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Essential Knowledge
The target capital structure may change over time, such a change will affect the risk
and cost of each type of capital, and all this can change the WACC. Moreover, a change in
the WACC can affect capital budgeting decisions and, ultimately, the firm’s stock price.
1. Optimal Capital Structure. The structure that would maximize its stock price. It is useful
to analyze the situation and seek to determine the optimal structure, but in practice it is
difficult to estimate it with much confidence. We seek to find the capital structure that
strikes a balance between risk and return so as to maximize the stock price.
2. Target Capital Structure. The mix of debt, preferred stock and common equity with which
the firm plans to raise capital. Setting the capital structure involves a trade-off between risk
and return. Using more debt will raise the risk borne by stockholders. However, using more
debt generally increases the expected return on equity.
3. Factors that Influence Capital Structure Decisions.
3.1. Business Risk. The riskiness inherent in the firm’s operations if it uses no debt. A
commonly used measure of business risk is ROIC. These are the determinants of
business risk:
3.2. Firm’s Tax Position. A major reason for using debt is that interest is tax deductible,
which lowers the effective cost of debt.
3.3. Financial Flexibility. The ability to raise capital on reasonable terms under adverse
conditions.
3.4. Managerial Conservatism or Aggressiveness. This factor does not affect the true
optimal, or value-maximizing, capital structure, but it does influence the firm’s target
capital structure
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4. Operating Leverage. It is the use of fixed costs rather than variable costs. More
operating leverage leads to more business risk. A small sales decline causes a
big profit decline.
Firms can use operating leverage to get higher return on invested capital, but
risk also increases.
5. Return on Invested Capital (ROIC). It measures the after-tax return that the
company provides for all its investors. ROIC doesn’t vary with changes in capital
structure.
6. Financial Leverage. It is the use of debt and preferred stock. Financial risk is
the additional risk concentrated on common stockholders as a result of financial
leverage. Financial risk depends only on the types of securities issued. More
debt = more financial risk.
6.1. Illustration. Two firms with the same operating leverage, business risk, and
probability of distribution of EBIT. They only differ with respect to their use
of debt (capital structure).
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6.2. Effect of Leverage on Profitability and Debt Coverage. For leverage to

raise expected ROE, firm must have ROIC > After-Tax Cost of Debt. If ROIC
is lesser than the after-tax cost of debt, the leverage will depress income.
As debt increases, TIE decreases because EBIT is unaffected by debt, but
interest expense increases.
6.3. Conclusions.
6.3.1. ROIC is unaffected by financial leverage.
6.3.2. Leveraged companies have higher ROE because ROIC > After-
Tax Cost of Debt
6.3.3. Leveraged companies have much wider ROE (and EPS) swings
because of fixed interest charges. Its higher expected return is
accompanied by higher risk.
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7. Recapitalization. These are the sequence of events in a recapitalization.
7.1. Illustration. Please refer to this example:
*Market Price = P25

EBIT = P400,000
Tax Rate = 40%
Analyze the recapitalization at various debt levels and determine the EPS
and TIE at each level.
7.1.1. D = P250,000 and rd = 8%
7.1.2. D = P500,000 and rd = 9%

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7.1.3. D = P750,000 and rd = 11.5%
7.1.4. D = P1,000,000 and rd = 14%.

Matina, Davao City
Phone No.: (082)300-5456 Local 137
8. Effects of more debt on the firm’s cost of equity.
9. Hamada Equation. It attempts to quantify the increased cost of equity due to

financial leverage. It uses the firm’s unlevered beta, which represents the firm’s
business risk as if it had no debt.
9.1. Illustration. Suppose the risk-free rate is 6%, as is the market risk
premium. The unlevered beta of the firm is 1.0.
10. Finding the Optimal Capital Structure. To find the optimal capital structure,
firms must compute the structure that:
● Minimizes WACC
● Maximizes the Stock Price
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Calculate the WACC for each structure:
Calculate the Stock Price for each structure:
The company’s optimal capital structure is P500,000 in debt and P1,500,000 in

equity since it both minimizes the WACC and maximizes the stock price.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
States of America.
Let’s Check
Management). Now that you know the most essential knowledge in capital
structure and leverage, let us try to check your understanding. Write True if the
statement is correct and False if otherwise.
1. A firm's business risk is largely determined by the financial characteristics of

its industry, especially by the amount of debt the average firm in the industry
uses.
2. Financial risk refers to the extra risk borne by stockholders as a result of a
firm's use of debt as compared with their risk if the firm had used no debt.
3. A firm's capital structure does not affect its free cash flows as discussed in
the text, because FCF reflects only operating cash flows, which are available
to service debt, to pay dividends to stockholders, and for other purposes.
4. If a firm borrows money, it is using financial leverage.
5. Other things held constant, an increase in financial leverage will increase a
firm's market (or systematic) risk as measured by its beta coefficient.
6. Different borrowers have different risks of bankruptcy, and if a borrower goes
bankrupt, its lenders will probably not get back the full amount of funds that
they loaned. Therefore, lenders charge higher rates to borrowers judged to
be more likely to go bankrupt.
7. If two firms have the same expected earnings per share (EPS) and the same
standard deviation of expected EPS, then they must have the same amount
of business risk.
8. Other things held constant, firms with more stable and predictable sales tend
to use more debt than firms with less stable sales.
9. Other things held constant, the lower a firm's tax rate, the more logical it is
for the firm to use debt.
10. A firm's treasurer likes to be in a position to raise funds to support operations
whenever such funds are needed, even in "bad times." This is called
"financial flexibility," and the lower the firm's debt ratio, the greater its financial
flexibility, other things held constant.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Let’s Analyze
1. An increase in the debt ratio will generally have no effect on which of these items?
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
2. Business risk is affected by a firm's operations. Which of the following is NOT directly
associated with (or does not directly contribute to) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm's debt fluctuate.
a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will
always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a company's debt ratio
will always reduce its WACC.
c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt
and equity financing. However, this action still may raise the company's WACC.
d. Increasing a company's debt ratio will typically increase the marginal costs of both debt
and equity financing. However, this action still may lower the company's WACC.
a. The capital structure that maximizes expected EPS also maximizes the price per share
of common stock.
b. The capital structure that minimizes the interest rate on debt also maximizes the
expected EPS.
c. The capital structure that minimizes the required return on equity also maximizes the
stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of
common stock.
5. Which of the following statements best describes the optimal capital structure?
a. The optimal capital structure is the mix of debt, equity, and preferred stock that
maximizes the company's earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that
maximizes the company's stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that
minimizes the company's cost of equity.
d. The optimal capital structure is the mix of debt, equity, and preferred stock that
minimizes the company's cost of debt.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
6. Your company, which is financed entirely with common equity, plans to manufacture a new
product, a cell phone that can be worn like a wristwatch. Two robotic machines are
available to make the phone, Machine A and Machine B. The price per phone will be
P250.00 regardless of which machine is used to make it. The fixed and variable costs
associated with the two machines are shown below, along with the capital (all equity) that
must be invested to purchase each machine. The expected sales level is 25,000 units.
Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life
of the project, so T = 0. How much higher or lower will the project's ROE be if you select
the machine that produces the higher ROE, i.e., what is ROEB − ROEA? (Hint: Since the
firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)
a. 6.00%
b. 6.67%
c. 7.00%
d. 7.35%
7. You work for the CEO of a new company that plans to manufacture and sell a new product,
a watch that has an embedded TV set and a magnifying glass crystal. The issue now is
how to finance the company, with only equity or with a mix of debt and equity. Expected
operating income is P400,000. Other data for the firm are shown below. How much higher
or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e.,
what is ROEL − ROEU?
a. 5.85%
b. 6.14%
c. 6.45%
d. 6.77%
8. Confu Inc. expects to have the following data during the coming year. What is the firm's
expected ROE?
a. 12.51%
b. 13.14%
c. 13.80%
d. 14.49%
9. El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%,
and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's
beta be if it used no debt, i.e., what is its unlevered beta, bU?
a. 0.75
Matina, Davao City
Phone No.: (082)300-5456 Local 137
b. 0.79
c. 0.83
d. 0.87
10. Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and
additional firm data are shown below. Now the company is considering using some debt,
moving to the new capital structure indicated below. The money raised would be used to
repurchase stock at the current price. It is estimated that the increase in risk resulting from
the additional leverage would cause the required rate of return on equity to rise somewhat,
as indicated below. If this plan were carried out, by how much would the WACC change,
i.e., what is WACCOld − WACCNew?
a. 2.74%
b. 3.01%
c. 3.32%
d. 3.65%
In a Nutshell
Based from the discussion of capital structure and leverage and the learning
below.
1. ____________________________________________________________
___
____________________________________________________________
___
2. ____________________________________________________________
___
____________________________________________________________
___
3. ____________________________________________________________
___
____________________________________________________________
___
4. ____________________________________________________________
___
____________________________________________________________
___
5. ____________________________________________________________
___
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Q&A List

Keywords Index
Asymmetric
Business Risk Financial Leverage
Information
Operating Leverage Unlevered Beta Signal
Reserve Borrowing
Operating Breakeven Trade-Off Theory
Capacity
Financial Risk Symmetric Information
Matina, Davao City
Phone No.: (082)300-5456 Local 137
COURSE SCHEDULES
WHERE TO
ACTIVITY DATE
SUBMIT/PERFORM
Big Picture ULOa & ULOb:
Blackboard LMS
Let’s Check
Blackboard LMS
Let’s Analyze
Blackboard LMS
In a Nutshell
Big Picture ULOc, ULOd &
Blackboard LMS
ULOe: Let’s Check
Blackboard LMS
ULOe: Let’s Analyze
Blackboard LMS
ULOe: In a Nutshell
Big Picture ULOf, ULOg &
Blackboard LMS
ULOh: Let’s Check
Blackboard LMS
ULOh: Let’s Analyze
Blackboard LMS
ULOh: In a Nutshell
3rd Examination February 26, 2021 Blackboard LMS
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Big Picture
are expected to
a. Discuss the nature and concepts of dividends and share repurchase.

b. Apply key concepts of dividends and share repurchase for decision making.
c. Explain the nature and concepts of working capital management.
d. Compare the different working capital management tools for decision making.
e. Apply key concepts of working capital management for decision making.

ULOa. Discuss the nature and concepts of dividends and share
repurchase.
ULOb. Apply key concepts of dividends and share repurchase for
decision making.
Metalanguage
Below are the essential terms that you are going to encounter in the pursuit of ULOa
and ULOb. Again, you are advised to frequently refer to these definitions to help you
1. Target Payout Ratio. The target percentage of net income paid out as cash dividends.
2. Optimal Dividend Policy. The dividend policy that strikes a balance between current
dividends and future growth and maximizes the firm’s stock price.
3. Dividend Irrelevance Theory. The theory advanced by Professors Merton Miller and
Franco Modigliani which stated that a firm’s dividend policy has no effect on either its value
or its cost of capital.
4. Bird-in-the-Hand Theory. MM’s name for the theory that a firm’s value will be maximized
by setting a high dividend payout.
5. Signal. An action taken by a firm’s management that provides clues to investors about
how management views the firm’s prospects.
6. Information Content (Signaling) Hypothesis. The theory that investors regard dividend
changes as signals of management’s earnings forecasts.
7. Clienteles. Different groups of stockholders who prefer different dividend payout policies.
8. Clientele Effect. The tendency of a firm to attract a set of investors who like its dividend
policy.
9. Residual Dividend Model. A model in which the dividend paid is set equal to net income
minus the amount of retained earnings necessary to finance the firm’s optimal capital
budget.
10. Low-Regular-Dividend-Plus-Express. The policy of announcing low, regular dividend
that can be maintained no matter what and then, when times are good, playing a
designated extra dividend.
11. Declaration Date. The date on which a firm’s directors issue a statement declaring a
dividend.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Holder-of-Record Date. If the company lists the stockholder as an owner on this date, then
the stockholder receives the dividend.
12. Ex-Dividend Date. The date on which the right to the current dividend no longer
accompanies the stock.
13. Payment Date. The date on which a firm actually mails dividend checks.
14. Dividend Reinvestment Plan (DRIP). A plan that enables a stockholder to automatically
reinvest dividends received back into the stock of the paying firm.
15. Stock Split. An action taken by a firm to increases the number of shares outstanding,
such as doubling the number of shares outstanding by giving each stockholder two new
shares for each one formerly held.
16. Stock Dividend. A dividend paid in the form of additional shares of stock rather than in
cash.
17. Stock Repurchase. A transaction in which a firm buys back shares of its own stock,
thereby decreasing shares outstanding, increasing EPS, and, often, increasing the stock
price.
Essential Knowledge
Firm’s income can be used to be reinvested I operating assets, to extinguish debts, or
to be distributed to stockholders. In distributing the income to shareholders, these questions
should be addressed: (1) How much should be distributed? (2) Should the distribution be in
the form of dividends or should the cash be passed on to shareholders by buying back stock?
(3) How stable should the distribution be?
1. Dividend Policy. The decision to pay out earnings versus retaining and reinvesting them.
1.1. High or low dividend payout?
1.2. Stable or irregular dividends?
1.3. Frequency of dividend payment
1.4. Announcement of policy
2. Dividend Irrelevance Theory. Investors are indifferent between dividends and retention-
generated capital gains. It is proposed by Modigliani and Miller and is based on unrealistic
assumptions that there are no taxes or brokerage cost. Thus, this may not be true.
According to this theory, investors can create their own dividend policy such as selling of
stock if they want cash or use dividends to buy stock if they do not want cash.
3. Investors’ Preferences.
3.1. Investors Might Prefer Dividends. Investors may think dividends are less risky than
potential future capital gains. This, investors would value high-payout firms since a
high payout would result in a high stock price.
3.2. Investors Might Prefer Capital Gains. They may want to avoid transaction costs.
4. Clientele Effect. Since different groups of investors prefer different dividend policies, firms
should determine its current clientele of investors. Clientele effects impede changing
dividend policy. Taxes and brokerage cost hurt investors who have to switch companies.
5. Catering Theory. A theory that suggests that investors’ preference for dividends varies
over time and that corporations adapt their dividend policy to cater to the current desire of
investors.
6. Residual Dividend Model. The dividends to be distributed is only the leftover earnings
after deducting the funds needed for capital investments. This policy minimizes flotation
and equity signaling costs, hence minimizes the WACC.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
6.1. Illustration.
Information:
Capital Budget P800,000
Target Capital Structure 40% debt; 60% equity
Forecasted Net Income P600,000
How much of the forecasted net income should be paid out as dividends?
Dividends = P600,000 – (0.6 x P800,000)

Dividends = P600,000 – P480,000
Dividends = P120,000
Dividend Payout Ratio = 120,000/600,000

Dividend Payout Ratio = 20%
6.2. Change in Investment Opportunities.

6.2.1. Fewer Good Investments. Smaller capital budget and higher dividend payout.
6.2.2. More Good Investments. Lower dividend payout.
6.3. Advantages and Disadvantages of Residual Dividend Policy.
7. Setting Dividend Policy.

7.1. Forecast Capital Needs. Long-term over a planning horizon (often 5 years).
7.2. Set a Target Capital Structure.
7.3. Estimate Annual Equity Needs.
7.4. Set Target Payout. Set target payout based on the residual model.
8. Dividend Reinvestment Plan (DRIP). Shareholders can automatically reinvest their
dividends in shares of the company’s common stock. There are two types of plans: Open
Market and New Stock.
8.1. Open Market Purchase Plan. Reinvestments are turned over to trustee who buys
shares on the open market. Brokerage costs are reduced by volume purchases. This
is convenient, easy way to invest and useful for investors.
8.2. New Stock Plan. Firm issues new stock to DRIP enrollees then use the kept money
to buy assets. Firms that need new equity capital use new stock plans. Firms with no
need for new equity capital use open market purchase plans.
9. Stock Dividends. Firm issues new shares in lieu of paying a cash dividend. If stock
dividend is 10%, the investor can get 10 shares for each 100 shares owned. The number
of shares outstanding is increased, and the stock price decreased. This may get the firm
to an optimal price range.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
10. Stock Split. Firm increases the number of shares outstanding. The number of shares
outstanding is increased, and the stock price decreased. This may get the firm to an
optimal price range. It generally occurs when management is confident. So, this is
regarded as a positive signal. On average, stock tend to outperform the market in the year
following a split.
11. Stock Repurchases. Buying own stock back from stockholders. There are many reasons
for repurchases such as an alternative to distributing cash as dividends, to make a large
capital structure change and to obtain stock for use when options are exercised.
11.1. Advantages of Repurchases.
11.2. Disadvantages of Repurchases.
States of America.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Let’s Check
Management). Now that you know the essential knowledge in the dividend
distribution and stock repurchases, let us try to check your understanding. Write
True if the answer is correct and False if not.
1. The optimal distribution policy strikes that balance between current dividends
and capital gains that maximizes the firm's stock price.
2. Other things held constant, the higher a firm's target payout ratio, the higher
its expected growth rate should be.
3. Miller and Modigliani's dividend irrelevance theory says that the percentage
of its earnings a firm pays out in dividends has no effect on either its cost of
capital or its stock price.
4. Miller and Modigliani's dividend irrelevance theory says that the percentage
of its earnings a firm pays out in dividends has no effect on its cost of capital,
but it does affect its stock price.
5. If investors prefer firms that retain most of their earnings, then a firm that
wants to maximize its stock price should set a low payout ratio.
6. A 100% stock dividend and a 2:1 stock split should, at least conceptually,
have the same effect on the firm's stock price.
7. A "reverse split" reduces the number of shares outstanding.
8. The announcement of an increase in the cash dividend should, according to
MM, lead to an increase in the price of the firm's stock, other things held
constant.
9. The federal government sometimes taxes dividends and capital gains at
different rates. Other things held constant, an increase in the tax rate on
dividends relative to that on capital gains would logically lead to an increase
in dividend payout ratios.
10. The federal government sometimes taxes dividends and capital gains at
different rates. Other things held constant, if the tax rate on dividends is high
relative to that on capital gains, then individuals with low taxable incomes
should favor stocks with low payouts and high-income individuals should
favor high-payout companies.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Let’s Analyze
1. In the real world, dividend

a. are usually more stable than earnings.
b. fluctuate more widely than earnings.
c. tend to be a lower percentage of earnings for mature firms.
d. are usually changed every year to reflect earnings changes, and these changes are
randomly higher to lower, depending on whether earnings increased or decreased.
e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS
= P2.00, then DPS would equal P0.80. Once the percentage is set, then dividend policy
is on "automatic pilot" and the dividend actually paid depends strictly on earnings.
2. You own 100 shares of Troll Brothers' stock, which currently sells for P120 a share.
The company is about to declare a 2-for-1 stock split. Which of the following best
describes your likely position after the split?
a. You will have 200 shares of stock, and the stock will trade at or near P120 a share.
b. You will have 200 shares of stock, and the stock will trade at or near P60 a share.
c. You will have 100 shares of stock, and the stock will trade at or near P60 a share.
d. You will have 50 shares of stock, and the stock will trade at or near P120 a share.
e. You will have 50 shares of stock, and the stock will trade at or near P600 a share.
3. Myron Gordon and John Lintner believe that the required return on equity increases
as the dividend payout ratio is lowered. Their argument is based on the assumption
that
a. investors are indifferent between dividends and capital gains.
b. investors require that the dividend yield plus the capital gains yield equal a constant.
c. capital gains are taxed at a higher rate than dividends.
d. investors view dividends as being less risky than potential future capital gains.
e. investors prefer a dollar of expected capital gains to a dollar of expected dividends
because of the lower tax rate on capital gains.
4. If a firm adheres strictly to the residual dividend policy, and if its optimal capital
budget requires the use of all earnings for a given year (along with new debt
according to the optimal debt/assets ratio), then the firm should pay
a. the same dividend as it paid the prior year.
b. no dividends to common stockholders.
c. dividends only out of funds raised by the sale of new common stock.
d. dividends only out of funds raised by borrowing money (i.e., issuing debt).
e. dividends only out of funds raised by selling off fixed assets.
5. If a firm adheres strictly to the residual dividend model, the issuance of new common
stock would suggest that
a. the dividend payout ratio has remained constant.
b. the dividend payout ratio is increasing.
c. no dividends will be paid during the year.
d. the dividend payout ratio is decreasing.
e. the dollar amount of capital investments had decreased.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
6. Portland Plastics Inc. has the following data. If it follows the residual dividend model,
what is its forecasted dividend payout ratio?
a. 25.36%
b. 28.17%
c. 31.30%
d. 34.78%
e. 38.26%
7. Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock
sold for P80 per share. If the firm's total market value is unchanged by the split,
what will the stock price be following the split?
a. P36.10
b. P38.00
c. P40.00
d. P42.00
e. P44.10
8. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its
stock sold for P90 per share. The firm's total market value was unchanged by the
split. Other things held constant, what is the best estimate of the stock's post-split
price?
a. P30.00
b. P31.50
c. P33.08
d. P34.73
e. P36.47
9. Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the
stock sold for P80 per share. If the firm's total market value is unchanged by the
split, what will the stock price be following the split?
a. P20.63
b. P21.71
c. P22.86
d. P24.00
e. P25.20
10. Fauver Industries plans to have a capital budget of P650,000. It wants to maintain
a target capital structure of 40% debt and 60% equity, and it also wants to pay a
dividend of P225,000. If the company follows the residual dividend model, how
much net income must it earn to meet its investment requirements, pay the dividend,
and keep the capital structure in balance?
a. P584,250
b. P615,000
c. P645,750
d. P678,038
e. P711,939
Matina, Davao City
Phone No.: (082)300-5456 Local 137
In a Nutshell
Based from the discussion of distribution to shareholders, and the learning
below.
1. ____________________________________________________________
___
____________________________________________________________
___
2. ____________________________________________________________
___
____________________________________________________________
___
3. ____________________________________________________________
___
____________________________________________________________
___
4. ____________________________________________________________
___
____________________________________________________________
___
5. ____________________________________________________________
___
____________________________________________________________
___
Q&A List

Matina, Davao City
Phone No.: (082)300-5456 Local 137
Keywords Index
Residual Dividend
Target Payout Ratio Signal Ex-Dividend Date Stock Dividend
Model
Low-Regular-
Optimal Dividend Information Content
Dividend-Plus- Payment Date Stock Repurchase
Policy Hypothesis
Express
Dividend
Dividend Irrelevance
Clienteles Declaration Date Reinvestment Plan
Theory
(DRIP)
Bird-in-the-Hand Holder-of-Record
Clientele Effect Stock Split
Theory Date

ULOc. Explain the nature and concepts of working capital
management.
ULOd. Compare the different working capital management tools
for decision making.
ULOe. Apply key concepts of working capital management for
decision making.
Metalanguage
the pursuit of ULOc, ULOd and ULOe. Again, you are advised to frequently
refer to these definitions to help you understand the succeeding topics.
1. Working Capital. All short-term assets. (eg. Cash, marketable Securities,

Inventories and Accounts Receivable).
2. Net Working Capital. Current assets minus all current liabilities.
3. Net Operating Working Capital. Current assets minus non-interest-bearing
current liabilities.
4. Cash Conversion Cycle. The length of time funds are tied up in working capital,
or the length of time between paying for working capital and collecting cash from
the sale of the working capital.
5. Inventory Conversion Period. The average time required to convert raw
materials into finished goods and then to sell them.
6. Average Collection Period (ACP). The average length of time required to
convert the firm’s receivables into cash.
7. Payables Deferral Period. The average length of time between the purchase of
materials and labor and the payment of cash for them.
8. Relaxed Current Asset Investment Policy. Relatively large amount of cash,
marketable securities, and inventories are carried, and a liberal credit policy
results in a high level of receivables.
9. Restricted Current Asset Policy. Holdings of cash, marketable securities,
inventories, and receivables are constrained.
10. Moderate Current Asset Policy. Between the relaxed and restricted policies.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
11. Permanent Current Assets. Current assets that a firm must carry even at the
trough of its cycles.
12. Temporary Current Assets. Current assets that fluctuate with seasonal or
cyclical variations in sales.
13. Current Asset Financing Policy. The way current assets are financed.
14. Maturity Matching or Self-Liquidating Approach. A financing policy that
matches asset and liability maturities. This is a moderate policy.
15. Cash Budget. A table that shows cash receipts, disbursements, and balances
over some period.
16. Target Cash Balance. The desired cash balance that a firm plans to maintain in
order to conduct business.
17. Lockbox. A post office box operated by a bank to which payments are sent.
Used to speed up effective receipt of cash.
18. Account Receivable. A balance due from a customer.
19. Credit Policy. A set of rules that include the firm’s credit period, discounts, credit
standards, and collection procedures offered.
20. Credit Period. The length of time customers must pay for purchases.
21. Discounts. Price reductions given for early payment.
22. Credit Standards. The financial strength customers must exhibit to qualify for
credit.
23. Collection Policy. Degree of toughness in enforcing the credit terms.
24. Credit Score. A numerical score from 1 to 10 that indicates the likelihood that a
person or business will pay on time.
25. Aging Schedule. A report showing how long accounts receivable have been
outstanding.
26. Trade Credit. Debt arising from credit sales and recorded as an accounts
receivable by the seller and as an accounts payable by the buyer.
27. Free Trade Credit. Credit received during the discount period.
28. Costly Trade Credit. Credit taken in excess of free trade credit; whose cost is
equal to the discount lost.
29. Stretching Accounts Payable. The practice of deliberately paying late.
30. Promissory Note. A document specifying the terms and conditions of a loan,
including the amount, interest rate, and repayment schedule.
31. Line of Credit. An arrangement in which a bank agrees to lend up to a specified
maximum amount of funds during a designated period.
32. Revolving Credit Agreement. A formal, committed line of credit, extended by a
bank or other lending institution.
33. Prime Rate. A published interest rate charged by commercial banks to large,
strong borrowers.
34. Regular or Simple Interest. The situation when interest only is paid monthly.
35. Add-on Interest. Interest that is calculated and added to funds received to
determine the face amount of an installment loan.
36. Commercial Paper. Unsecured, short-term promissory notes of large firms
having an interest rate somewhat below the prime rate.
37. Accruals. Continually recurring short-term liabilities, especially accrued wages
and accrued taxes.
38. Spontaneous Funds. Funds that are generated spontaneously as the firm
expands.
39. Secured Loan. A loan backed by collateral, often inventories or accounts
receivables.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
ssential Knowledge
Working capital policy involves two basic questions: (1) What is the optimal amount of each
type of current asset for the firm to carry and (2) how should current asset holdings be
financed? This section addresses these issues.
1. Working Capital Management. It comprises of controlling cash, inventories, and

accounts receivables, including the short-term liability management.
1.1. Current Assets Investment Policy. Deciding the level of each type of current
asset to hold, and how to finance these current assets.
1.2. Illustration. Shown below are the selected financial ratios of SKI Inc. and its
industry’s average:
How does SKI’s current asset investment policy compare with its industry?
Is SKI inefficient or conservative?
2. Working Capital Financing Policies. These are the three working capital financing
Matina, Davao City
Phone No.: (082)300-5456 Local 137
policies:
2.1. Moderate. It matches the maturity of the assets with the maturity of the
financing.
2.2. Aggressive. Use short-term financing to finance permanent assets.

2.3. Conservative. Use permanent capital for permanent assets and temporary assets.
3. Cash Conversion Cycle (CCC). It is also known as working capital cycle. This is the
process of purchasing or producing an inventory, hold it for a time, and eventually sell it
and receive cash.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
3.1. Example 1. ABC Company is just starting in business, buying ladies golf outfits from
a manufacturer in China and selling them through pro shops at high-end golf clubs.
Its business plan calls for it to purchase P100,000 of merchandise at the start of each
month and have it sold after 60 days. The company will have 40 days to pay its
suppliers, and it will give its customers 60 days to pay for their purchases. ABC also
expects monthly sales of P100,000, which means that it will just break even during its
first few years. Any funds required to support operations will be obtained from the
bank, and those loans must be repaid as soon as cash is available.
Note that if ABC could sell goods faster, collect receivables faster, or defer its
payables longer without hurting sales or increasing operating costs, then its CCC
would decline, its interest charges would be reduced, and its profits and stock price
would be improved.
The following data were taken from its latest financial statements of ABC Company:
Thus, it takes ABC an average of 90 days to sell its merchandise, not the 60 days
called for in the business plan. Note also that inventory is carried at cost, so the
denominator of the equation should be the cost of goods sold, not sales.
Thus, it takes ABC 90 days after a sale to receive cash, not the 60 days called for in
the business plan. Because receivables are recorded at the sales price, we use sales
rather than the cost of goods sold in the denominator.
ABC is supposed to pay its suppliers after 40 days, but it is actually a slow
payer, delaying payment until Day 54.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
ABC’s actual 126-day CCC is quite different from the planned 80 days. It takes longer
than planned to sell merchandise, customers don’t pay as fast as they should, and
ABC itself pays suppliers slower than it should. The end result is a CCC of 126 days
versus the planned 80 days.
If the planned 80-day CCC is “reasonable,” then the actual 126 days is way too high.
The CFO should push the sales and credit personnel to speed up sales and
collections. Also, the purchasing department should seek longer payment terms. If
ABC could take these steps without hurting sales and operating costs, this would help
its profits and the stock price.
4. Minimizing Cash Holdings. These are the methods that can minimize the cash holdings:
5. Cash Budget. It forecasts cash inflows, outflows, and ending cash balances. It is used to
plan loans needed or funds available to invest. It can be daily, weekly, or monthly
forecasts.
5.1. Monthly Forecasts. This is used for annual planning.
5.2. Daily Forecasts. This is used for actual cash management.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
5.3. Illustration. Please see financial information of Allied Food Corporation

(Adapted. Brigham & Houston. (2015). Fundamentals of Financial
Management)
6. Inventory Management.
6.1. Types of Inventory Costs.
6.2. Reducing inventory levels generally reduces carrying costs, increases ordering
costs, and may increase the costs of running short.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Illustration. Please refer to the information above pertaining to SKI Inc.
If SKI reduces its inventory without adversely affecting sales, what effect will
this have on the cash position?
Do SKI’s customers pay more or less promptly than those of its competitors?
Matina, Davao City
Phone No.: (082)300-5456 Local 137
7. Credit Policy. A set of riles that include the firm’s credit period, discounts, credit
standards, and collection procedures offered.
7.1. Elements of Credit Policy.
7.2. Illustration. Please refer to the information above regarding SKI Inc.
Does SKI face any risk if it restricts its credit policy?
If SKI reduces its Days Sales Outstanding (DSO) without adversely affecting
sales, how would this affect its cash position?
Matina, Davao City
Phone No.: (082)300-5456 Local 137
8. Trade Credit. Trade credit is the credit furnished by a firm’s suppliers. It is often the
largest source of short-term credit, especially for small firms. This is spontaneous,
easy to get credits butt the cost can be high.
8.1. Illustration. A firm buys inventory worth P3,000,000 net (P3,030,303 gross) on
terms of 1/10, net 30.
If the firm can forego discounts and pay on Day 40, without penalty, then
Analysis:
8.2. Nominal Cost of Trade Credit.
Or
Matina, Davao City
Phone No.: (082)300-5456 Local 137
8.3. Effective Cost of Trade Credit.
9. Bank Loans.
9.1. Illustration. The firm can borrow P100,000 for 1 year at an 8% nominal rate.
Interest may be set under one of the following scenarios:
9.1.1. Simple Annual Interest.
9.1.2. Installment Loan, Add-on Interest, 12 months.

Matina, Davao City
Phone No.: (082)300-5456 Local 137
States of America.
Let’s Check
Management). Now that you know the essential knowledge in the working capital
management, let us try to check your understanding. Write True if the answer is
correct and False if not.
1. Net operating working capital, defined as current assets minus the difference
between current liabilities and notes payable, is equal to the current ratio minus the
quick ratio.
2. Net working capital is defined as current assets divided by current liabilities.
3. A conservative financing approach to working capital will result in permanent current
assets and some seasonal current assets being financed using long-term securities.
4. If a firm takes actions that reduce its days sales outstanding (DSO), then, other
things held constant, this will lengthen its cash conversion cycle (CCC) and cause
a deterioration in its cash position.
5. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts
payable, this will lengthen its cash conversion cycle (CCC).
6. Shorter-term cash budgets (such as a daily cash budget for the next month) are
generally used for actual cash control while longer-term cash budgets (such as a
monthly cash budgets for the next year) are generally used for planning purposes.
7. Setting up a lockbox arrangement is one way for a firm to speed up the collection of
payments from its customers.
8. Inventory management is largely self-contained in the sense that very little
coordination among the sales, purchasing, and production personnel is required for
successful inventory management.
9. The average accounts receivables balance is a function of both the volume of credit
sales and the days sales outstanding.
10. The four primary elements in a firm's credit policy are (1) credit standards, (2)
discounts offered, (3) credit period, and (4) collection policy.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Let’s Analyze
1. Other things held constant, which of the following will cause an increase in net
working capital?
a. Cash is used to buy marketable securities.
b. A cash dividend is declared and paid.
c. Merchandise is sold at a profit, but the sale is on credit.
d. Long-term bonds are retired with the proceeds of a preferred stock issue.
2. Firms generally choose to finance temporary current assets with short-term debt
because
a. matching the maturities of assets and liabilities reduces risk under some
circumstances, and also because short-term debt is often less expensive
than long-term capital.
b. short-term interest rates have traditionally been more stable than long-term
interest rates.
c. a firm that borrows heavily on a long-term basis is more apt to be unable to
repay the debt than a firm that borrows short term.
d. the yield curve is normally downward sloping.
3. Helena Furnishings wants to reduce its cash conversion cycle. Which of the
following actions should it take?
a. Increases average inventory without increasing sales.
b. Take steps to reduce the DSO.
c. Start paying its bills sooner, which would reduce the average accounts
payable but not affect sales.
d. Sell common stock to retire long-term bonds.
4. A lockbox plan is
a. used to protect cash, i.e., to keep it from being stolen.
b. used to identify inventory safety stocks.
c. used to slow down the collection of checks our firm writes.
d. used to speed up the collection of checks received.
a. Net working capital is defined as current assets minus the difference
between current liabilities and notes payable, and any increase in the current
ratio automatically indicates that net working capital has increased.
b. Although short-term interest rates have historically averaged less than long-
term rates, the heavy use of short-term debt is considered to be an
aggressive strategy because of the inherent risks associated with using
short-term financing.
c. If a company follows a policy of "matching maturities," this means that it
matches its use of common stock with its use of long-term debt as opposed
to short-term debt.
d. Net working capital is defined as current assets minus the difference
between current liabilities and notes payable, and any decrease in the
current ratio automatically indicates that net working capital has decreased.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
6. SwimSuits Unlimited is in a highly seasonal business, and the following summary

balance sheet data show its assets and liabilities at peak and off-peak seasons (in
thousands of dollars):
a. SwimSuits' current asset financing policy calls for exactly matching asset
and liability maturities.
b. SwimSuits' current asset financing policy is relatively aggressive; that is, the
company finances some of its permanent assets with short-term
discretionary debt.
c. SwimSuits follows a relatively conservative approach to current asset
financing; that is, some of its short-term needs are met by permanent capital.
d. Without income statement data, we cannot determine the aggressiveness
or conservatism of the company's current asset financing policy.
7. Halka Company is a no-growth firm. Its sales fluctuate seasonally, causing total
assets to vary from P320,000 to P410,000, but fixed assets remain constant at
P260,000. If the firm follows a maturity matching (or moderate) working capital
financing policy, what is the most likely total of long-term debt plus equity capital?
a. P274,360
b. P288,800
c. P304,000
d. P320,000
8. Cass & Company has the following data. What is the firm's cash conversion cycle?
a. 31 days
b. 34 days
c. 38 days
d. 42 days
9. Singal Inc. is preparing its cash budget. It expects to have sales of P30,000 in
January, P35,000 in February, and P35,000 in March. If 20% of sales are for cash,
40% are credit sales paid in the month after the sale, and another 40% are credit
sales paid 2 months after the sale, what are the expected cash receipts for March?
a. P24,057
b. P26,730
c. P29,700
d. P33,000
Matina, Davao City
Phone No.: (082)300-5456 Local 137
10. Edwards Enterprises follows a moderate current asset investment policy, but it is
now considering a change, perhaps to a restricted or maybe to a relaxed policy. The
firm's annual sales are P400,000; its fixed assets are P100,000; its target capital
structure calls for 50% debt and 50% equity; its EBIT is P35,000; the interest rate
on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets
will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is
the difference in the projected ROEs between the restricted and relaxed policies?
a. 4.25%
b. 4.73%
c. 5.25%
d. 5.78%
In a Nutshell
Based from the discussion of working capital management, and the learning
below.
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2. ____________________________________________________________
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3. ____________________________________________________________
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4. ____________________________________________________________
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5. ____________________________________________________________
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Q&A List
Matina, Davao City
Phone No.: (082)300-5456 Local 137

Matina, Davao City
Phone No.: (082)300-5456 Local 137
Keywords Index
Restricted Current
Working Capital Lockbox Aging Schedule Prime Rate
Asset Policy
Moderate Current Regular or Simple
Net Working Capital Accounts Receivable Trade Credit
Asset Policy Interest
Net Operating Permanent Current
Credit Policy Free Trade Credit Add-on Interest
Working Capital Assets
Cash Conversion Temporary Current
Credit Period Costly Trade Credit Commercial Paper
Cycle Assets
Inventory Current Asset Stretching Accounts
Discounts Accruals
Conversion Period Financing Policy Payable
Average Collection Maturity Matching
Credit Standards Promissory Note Spontaneous Funds
Period Approach
Payables Deferral Revolving Credit
Cash Budget Collection Policy Secured Loan
Period Agreement
Relaxed Current
Asset Investment Target Cash Balance Credit Score Line of Credit
Policy
COURSE SCHEDULES
WHERE TO
ACTIVITY DATE
SUBMIT/PERFORM
Blackboard LMS
Let’s Check
Blackboard LMS
Let’s Analyze
Blackboard LMS
In a Nutshell
Blackboard LMS
ULOe: Let’s Check
Blackboard LMS
ULOe: Let’s Analyze
Blackboard LMS
ULOe: In a Nutshell
Final Examination March 10-11, 2021 Blackboard LMS
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Online Code of Conduct

1. Students are expected to abide by and honor code of conduct, and thus everyone and all are
exhorted to exercise self-management and self-regulation.
2. All students are guided by professional conduct as learners in attending On-Line Blended Delivery
(OBD) course. Any breach and violation shall be dealt with properly under existing guidelines,
specifically in Section 7 (Student Discipline) in the Student Handbook.
3. Professional conduct refers to the embodiment and exercise of the University’s Core Values,
specifically in the adherence to intellectual honesty and integrity; academic excellence by giving
due diligence in virtual class participation in all lectures and activities, as well as fidelity in doing
and submitting performance tasks and assignments; personal discipline in complying with all
deadlines; and observance of data privacy.
4. Plagiarism is a serious intellectual crime and shall be dealt with accordingly. The University shall
institute monitoring mechanisms online to detect and penalize plagiarism.
5. Students shall independently and honestly take examinations and do assignments, unless
collaboration is clearly required or permitted. Students shall not resort to dishonesty to improve
the result of their assessments (e.g. examinations, assignments).
6. Students shall not allow anyone else to access their personal LMS account. Students shall not
post or share their answers, assignment or examinations to others to further academic
fraudulence online.
7. By enrolling in OBD course, students agree and abide by all the provisions of the Online Code of
Conduct, as well as all the requirements and protocols in handling online courses.
Matina, Davao City
Phone No.: (082)300-5456 Local 137
Course prepared by:
PHOEBELYN V. ACDOG
Author
Course reviewed by:
JADE D. SOLANA DEVZON U. PORRAS

Program Head – BSA & BSMA Program Head – BSAT, BSAIS &
BSIA
MARY GRACE S. SOMBILON

Assistant Dean
Approved by:
LORD EDDIE I. AGUILAR

Dean

Approved CAE - BSA BSMA BSAIS BSIA - ACC 222 - Acdog

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UNIVERSITY OF MINDANAO

College of Accounting Education

Program: BSA, BSIA, BSMA, BSAIS

Physically Distanced but Academically Engaged

Self-Instructional Manual (SIM) for

Course/Subject: ACC222 – Financial Management

Name of Teacher: ___________________________

Name of Author: Phoebelyn V. Acdog

THIS SIM/SDL MANUAL IS A DRAFT VERSION ONLY; NOT FOR

THIS IS NOT FOR COMMERCIAL USE.

Keywords Index 172

Course Outline: ACC222 – FINANCIAL MANAGEMENT

Course Coordinator: Phoebelyn V. Acdog, CPA

Course Outline Policy

Areas of Concern Details

If the assessment task is done in real time through the features

Since this course is included in the licensure examination for

Turnitin Submission All assessment tasks are required to be submitted through

Please note that academic dishonesty such as cheating and

However, if the late submission of assessment paper has a

For group assessment tasks, the course coordinator will require

If disapproved by the course coordinator, you can elevate your

EXAMINATIONS ……………………………………….. 60%

CLASS PARTICIPATIONS ……………………………. 40%

TOTAL ………………………………………………….... 100%

Submission of the final grades shall follow the usual University

You can also meet the course coordinator in person through

For students who have not created their student email,

Library and Information Brigida E. Bacani

For inquiries, you can email at umlic.eresources@gmail.com,

GSTC Facebook Page:

Course Information – see/download course syllabus in the Black Board LMS

CO This course is a continuation of your Acc212 – Financial Markets. This

a. Discuss the nature and purpose of financial management;

Big Picture in Focus:

1. Proprietorship. A form of business organization that is unincorporated and is

8. Treasurer. Responsible for the firm’s financial activities including financial

In business, Financial Management problems are inevitable, no matter what the

2. Financial Management. It refers to capital procurement, funds allocation, capital

3. Forms of Business Organization. The key aspects of financial management are

3.1 Sole Proprietorship. It is an unincorporated business owned by an individual.

3.2 Partnership. It is a legal arrangement between two or more people who

4. Deciding on a form of organization. Firms must trade off the advantages of

5.4 Finance within the organization.

5.5 Major decisions in the finance function.

*Hill, A. (2008). Strategic Financial Management. Ventus Publishing.

*Mcmenamin, J. (2005). Financial Management: An Introduction. USA: Routledg

1. Which of the following statements is FALSE?

2. Choose the INCORRECT statement/s.

3. Choose the CORRECT statement/s.

4. Choose the INCORRECT statement/s.

8. It involves determination of the best capital structure.

9. It involves allocation of cash to be distributed to shareholders.

Do you have any question for clarification?

Finance Corporation Chief Finance Officer

Financial Management Double Taxation Financing Decision

Proprietorship Treasurer Dividend Decision

Partnership Controller Risk Management

Big Picture in Focus:

1. Stockholders’ Wealth Maximization. This is the primary goal for

1. The management ‘s primary goal is STOCKHOLDER WEALTH MAXIMIZATION. This

*Brigham, E. & Houston, J. (2007). Fundamentals of Financial Management, 11th Edition.

Instructions: Please choose the letter of the best answer.