MSU-ILIGAN INSTITUTE OF TECHNOLOGY

FINANCIAL MANAGEMENT

NOTES
ON
FINANCIAL
MANAGEMENT

DR. MARIA CECILIA P. LAGARAS, CPA

Senior Fellow – HEA-UK

TOPICS COVERED

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1 The Scope and Environment of Financial Management

2 Financial Markets and The Investment Banking System
3 Financial Statements and Financial Statement Analysis
4 Time Value of Money
5 Risk and Rate of Return Analysis
6 Bond and Stock Valuation
7 Capital Budgeting - Cash flows
8 Capital Budgeting Techniques
9 Risk And Refinements In Capital Budgeting

TOPIC 1. The Scope and Environment of Financial Management

The major thrust of this chapter is to establish the objectives of financial management and the importance of the
financial manager to the organization. This chapter highlights the importance of stockholder’s wealth maximization as a
goal and briefly relates it to valuation concepts associated with risk and return. In addition, the role and functions of the
financial markets in allocating capital should be emphasized as well as the pressures of institutional investors on
financial managers. It discusses the shortfalls of profit maximization as the ultimate goal of the firm. A short discussion
of social responsibility and its relationship to the financial objectives of the firm can engage students in a discussion of
how wealth maximization and social responsibility can co-exist.

1.1 Corporate Finance

A. What Is Corporate Finance?

Corporate finance addresses several important questions:

1. What long-term investments should the firm take on? (Capital budgeting)
2. Where will we get the long-term financing to pay for the investment? (Capital structure)
3. How will we manage the everyday financial activities of the firm? (Working capital)

B. The Financial Manager

 The Chief Financial Officer (CFO) or Vice-President of Finance coordinates the activities of the
treasurer and the controller.
 The controller handles cost and financial accounting, taxes and information systems.
 The treasurer handles cash management, financial planning and capital expenditures.

C. Financial Management Decisions

The financial manager is concerned with three primary categories of financial decisions.

1. Capital budgeting – process of planning and managing a firm’s investments in fixed assets.
The key concerns are the size, timing and riskiness of future cash flows.

2. Capital structure – mix of debt (borrowing) and equity (ownership interest) used by a firm.
What are the least expensive sources of funds? Is there an optimal mix of debt and equity?
When and where should the firm raise funds?

3. Working capital management – managing short-term assets and liabilities. How much
inventory should the firm carry? What credit policy is best? Where will we get our short-term
loans?

1.2 Nature and Scope of Finance

A. Forms of Organization
The finance function may be carried out within a number of different forms of organizations.

1. Sole proprietorship
a. Single ownership
b. Simplicity of decision making
c. Low organizational and operating costs
d. Unlimited liability
e. Earnings are taxed as personal earnings of the individual owner
2. Partnership
a. Two or more partners
b. Usually formed by articles of partnership agreement
c. Unlimited liability for all partners unless a limited partnership is formed which
provides limited liability for one or more partners. At least one partner must be
a general partner.
d. Earnings are taxed as personal earnings of partners
3. Corporation
a. Most important form of business in terms of revenue and profits
b. Legal entity
c. Formed by articles of incorporation
d. Stockholders (owners) have limited liability

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e. Easy divisibility of ownership

f. Managed by the board of directors
g. Double taxation of earnings: Earnings of the corporation are subject to the /
;P[P[-0Pcorporate income tax; dividends (distributed net income) are
subject to personal taxation
h. Subchapter S corporations, however, avoid the double taxation disadvantage.
S Corporations are limited to 75 shareholders.

1.3 The Goal of the Firm

1. Profit Maximization – this is an imprecise goal. Do we want to maximize long-run or short-run profits?
Do we want to maximize accounting profits or some measure of cash flow? Because of the different
possible interpretations, this should not be the main goal of the firm.

2. Minimizing costs or maximizing market share. Both have potential problems. We can minimize
costs by not purchasing new equipment today, but that may damage the long-run viability of the
firm. Many “dot.com” companies got into trouble in the late ‘90s because their goal was to
maximize market share. They raised substantial amounts of capital in IPOs and then used the
money on advertising to increase the number of “hits” on their site. However, many firms failed to
translate those “hits” into enough revenue to meet expenses and they quickly ran out of capital.
The stockholders of these firms were not happy; stock prices fell dramatically and it became difficult
for these firms to raise additional funds. In fact, many of these companies have gone out of
business.

3. From a stockholder (owner) perspective, the goal of buying the stock is to gain financially.
The goal of financial management in a corporation is to maximize the current value per share of the
existing stock.

4. Maximize the market value of owners’ equity.

Ethical Issues:
Is it ethical to sell a product that is known to be addictive and dangerous to the health of the user
even when used as intended? Is the fact that the product is legal relevant? Do recent court
decisions against the companies matter? What about the way companies choose to market their
product? Are these issues relevant to financial managers?

Sarbanes-Oxley - “Sarbox” or “SOX,” as it is commonly referred to, was designed to reduce the
likelihood of corporate scandals by increasing investor protection by limiting certain actions by
executives and increasing overall reporting requirements. Particularly the latter has increased the
cost of incorporation and has led some firms to either avoid going public or even to “go dark.”

1.4 Critiquing the Agency Theory

The Agency Problem and Control of the Corporation

1. Agency Relationships – The relationship between stockholders and management is called the
agency relationship. This occurs when one party (principal) hires another (agent) to act on their
behalf. The possibility of conflicts of interest between the parties is termed the agency problem.
Agency costs:
1. direct costs – compensation and perquisites for management
2. indirect costs – cost of monitoring and sub-optimal decisions

Ethics:
When shareholders elect a board of directors to oversee the corporation, the election serves as a
control mechanism for management. The board of directors bears legal responsibility for corporate
actions. However, this responsibility is to the corporation itself and not necessarily to the
stockholders. Although it happened several years ago, it still makes for an interesting discussion of
directors’ and managers’ duties:

In 1986, Ronald Perelman engaged in an unsolicited takeover offer for Gillette. Gillette’s
management filed litigation against Perelman and subsequently entered into a standstill agreement
with Perelman. This action eliminated the premium that Perelman offered shareholders for their
stock in Gillette.
A group of shareholders filed litigation against the board of directors in response to its actions. It
was subsequently discovered that Gillette had entered into standstill agreements with ten additional
companies. When questioned regarding the rejection of Perelman’s offer, management responded
that there were projects on the line that could not be discussed (later revealed to be the “Sensor”
razor, which was one of the most profitable new ventures in Gillette’s history up to that time). Thus,
despite appearances, management’s actions may have been in the best interests of the firm, and
this case indicates that management may consider factors other than the bid when considering a
tender offer.

2. Do Managers Act in the Stockholders’ Interests?

Managerial compensation can be used to encourage managers to act in the best interest of
stockholders. One commonly cited tool is stock options. The idea is that if management has an
ownership interest in the firm, they will be more likely to try to maximize owner wealth.

Stockholders technically have control of the firm, and dissatisfied shareholders can oust
management via proxy fights, takeovers, etc. However, this is easier said than done. Staggered

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elections for board members often make it difficult to remove the board that appoints management.
Poison pills and other anti-takeover mechanisms make hostile takeovers difficult to accomplish.

3. Stakeholders

Stakeholders are other groups, besides stockholders, that have a vested interest in the firm and
potentially have claims on the firm’s cash flows. Stakeholders can include creditors, employees and
customers.

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TOPIC 2. FINANCIAL MARKETS & THE INVESTMENT BANKING SYSTEM

Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into
loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In
general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.

Role of Financial Markets and the Corporation in Finance.

A firm issues securities (stocks and bonds) to raise cash for investments (usually in real assets). The operating
cash flows generated from the investment in assets allows for the payment of taxes, reinvestment in new
assets, payment of interest and principal on debt and payment of dividends to stockholders.

Primary versus Secondary Markets

1. Primary market – the market in which securities are sold by the company. Public and private placements
of securities, SEC registration and underwriters are all part of the primary market.
2. Secondary market – the market where securities that have already been issued are traded between
investors. The stock exchanges, such as the New York Stock Exchange, and the over-the-counter market,
such as the NASDAQ, are part of the secondary market.
3. Dealer versus Auction Markets – A dealer market is one where you have several traders that carry an
inventory and provide prices at which they stand ready to buy (bid) and sell (ask) the securities. The
Nasdaq market is an example of a dealer market. An auction market has a physical location where buyers
and sellers are matched, with little dealer activity.

Financial Markets

The money market is created by a financial relationship between suppliers and demanders of short-term funds. Most
money market transactions are made in marketable securities which are short-term debt instruments, such as U.S.
Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial
institutions, respectively. Investors generally consider marketable securities to be among the least risky investments
available

The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. The
key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership).
– Bonds are long-term debt instruments used by businesses and government to raise large sums of
money, generally from a diverse group of lenders.
– Common stock are units of ownership interest or equity in a corporation.
– Preferred stock is a special form of ownership that has features of both a bond and common
stock.

The Ethics of Insider Trading

– Martha Stewart was convicted of conspiracy, obstruction, and making false statements to federal
investigators and served 5 months in jail, 5 months of home confinement, 2 years of probation, and a
P30,000 fine.
– Laws prohibiting insider trading were established in the United States in the 1930s. These laws are
designed to ensure that all investors have access to relevant information on the same terms.
– However, many market participants believe that insider trading should be permitted.
– If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical?
– Does allowing insider trading create an ethical dilemma for insiders?

Minicase: The Desert Enterprise (Case 1)

Mohamad Abdelhamid is the head of Desert Enterprise, a family-owned business located in Bahrain. The company was
founded in 1981, three years after his father emigrated from Iran. Small in the beginning, the company has been
growing steadily ever since Mohamad was entrusted with its leadership. Together with his local partner Ahmed Bin
Talal, he changed the character of the company from a small enterprise importing Iranian carpets and cashew nuts to
Bahrain and Saudi Arabia to a large trading enterprise exporting and importing anything from food items and spices to
heavy machinery within the Gulf region. Contributing to its success, several members of both families invested

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substantial amounts of their personal funds over the years in the company and became actively involved in its
management.

In the fall of 2011, Mohamad sees the company at a crossroads. With regional competition increasing, he is
determined to extend the company's geographic reach to the European Union, the Gulf region's largest trading partner.
The required funds are estimated to be BD20 million (Bahraini Dinar, the equivalent of USP53 million), well beyond the
financial means of the two families. The families are considering taking the company public by issuing 5 million shares
at BD4 which would subsequently be listed at the stock exchange in Manama. Mohamad also realizes that at age 64,
his days as active head of the company are numbered. With the challenges ahead, he would like to hire a team of
managers with the international experience necessary to implement his corporate vision.

QUESTIONS:
1. Discuss the consequences of the proposed change from a partnership to a corporation in terms of advantages and
disadvantages.
2. Describe potential agency conflicts that can arise when hiring a management team and suggest possible solutions.
3. Determine the amount of cash the company would generate from going public. Does it matter to the company
whether the share price rises subsequent to the IPO? Who benefits from an increase in the company's
share price?
4. Do you see a tradeoff between a company's focus on share price maximization and the adherence to social and
ethical standards?

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TOPIC 3. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT ANALYSIS

3.1. Financial Statements

A. The Income Statement

1. The income statement begins with the aggregate amount of sales (revenues) that are
generated within a specific period of time.

2. The various expenses that occur in generating the sales are subtracted in stair-step
fashion to arrive at the net income for the defined period.

3. The separation of the expense categories such as cost of goods sold, selling and
administrative expenses, depreciation, interest and taxes enables the management to
assess the relative importance and appropriateness of the expenditures in producing each
level of sales.

4. The "bottom line" value, net income, is the aggregate amount available to the owners.

5. Net income is converted from an aggregate value to an earnings per share (EPS) value by
dividing net income by the number of shares of outstanding stock.

6. The EPS is a measurement of the return available to providers of equity capital to the firm.
The return to the providers of debt capital, interest, appears earlier in the income
statement as a tax-deductible expense.

7. The statement of retained earnings, a supplement to the income statement, indicates the
disposition of earnings.

8. The earnings per share may be converted to a measure of current value through
application of the price/earnings (P/E) ratio.

9. The P/E ratio is best used as a relative measure of value because the numerator, price, is
based on the future and the denominator, earnings, is a current measure.

10. There are limitations associated with the income statement. For example, the income
statement reflects only income occurring to the individual or business firm from verifiable
transactions as opposed to the economists' definition of income, which reflects changes in
real worth.

B. Balance Sheet

1. Whereas the income statement provides a summary of financial transactions for a period
of time, the balance sheet portrays the cumulative results of transactions at a point in time.
The balance sheet may present the position of the firm as a result of transactions for six
months, twenty-five years, or other periods.

2. The balance sheet is divided into two broad categories. The assets employed in the
operations of the firm compose one category while the other, liabilities and net worth, is
composed of the sources of financing for the employed assets.

3. Within the asset category, the assets are listed in their order of liquidity.

a. Cash (including demand deposits)

b. Marketable securities: investments of temporarily excess cash in highly liquid
securities
c. Accounts receivable
d. Inventory
e. Prepaid expenses: future expense items that have already been paid
f. Investments: investments in securities and other assets for longer than one
operating cycle
g. Plant and equipment adjusted for accumulated depreciation

4. The various sources of financing of a firm are listed in their order of maturity. Those
sources that mature earliest, current liabilities, are listed first. The more permanent debt
and equity sources follow.

a. Accounts payable
b. Notes payable
c. Accrued expenses: an obligation to pay is incurred but payment has not been
made
d. Long-term debt: all or a majority of the principal will be paid beyond the current
period
e. Preferred stock
f. Common stock accounts:

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(1) Common stock (par value)

(2) Capital paid in excess of par
(3) Retained earnings

5. Confusing balance-sheet-related terms

a. Retained earnings is the account used to measure the accumulation of earnings

over the life of the firm. It includes “all the income the firm ever made minus all
the dividends the firm ever paid.” It is not a bucket of money that can be
reinvested, but is one of the sources of funds that make up the present
investment level.
b. Net worth or book value of the firm is composed of the various common equity
accounts and represents the net contributions of the owners to the business
plus the earnings retained by the firm (Retained Earnings – see above).
c. Book value is a historical value and does not necessarily coincide with the
market value of the owner's equity.

6. Limitation of the balance sheet: Values are recorded at cost; replacement cost of some assets,
particularly plant and equipment, may greatly exceed their recorded value.

C. Statement of Cash Flows

1. In November 1987, the accounting profession replaced the statement of changes in

financial position (and the sources and uses of funds statement) with the Statement of
Cash Flows as a required financial statement.
2. The new statement emphasizes the critical nature of cash flow to the operations of the
firm.
3. The three primary sections of the statement of cash flows are:

a. cash flows from operating activities.

b. cash flows from investing activities.
c. cash flows from financing activities.

4. Income from operations may be translated from an accrual basis to a cash basis in two
ways to obtain cash flow from operations.

a. Direct method -- each and every item on the income statement is adjusted from
accrual accounting to cash accounting.
b. Indirect method - a less tedious process than the direct method is usually
preferred. Net income is used as the starting point and adjustments are made to
convert net income to cash flows from operations. Beginning with net income,
(1) Add depreciation for the current period, decreases in individual current
asset accounts (other than cash) and increases in current liabilities;
(2) Subtract increases in current asset accounts (other than cash) and
decreases in current liabilities.

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5. Cash flow from investing is found by summing the changes of investment in securities and
plant and equipment. Increases are uses of funds and decreases are sources of funds.

6. Cash flow from financing activities is found by summing the sale or retirement of corporate
securities and dividends. The sale of securities is a source of funds and the retirement of
securities and payment of dividends are uses of funds.

7. Cash flows from operations, cash flows from investing, and cash flows from financing are
combined to arrive at the statement of cash flows. The net increase or decrease shown in
the statement of cash flows will be equal to the change in the cash balance on the balance
sheet.

Another important concept is that of free cash flow.

From the balance sheet identity, we know that the value of a firm's assets is equal to the value of
its liabilities plus the value of its equity. Similarly, the cash flow from the firm's assets must equal the
sum of the cash flow to creditors and the cash flow to stockholders (or owners)

This is the cash flow identity. It says that the cash flow from the firm's assets is equal to the cash
flow paid to suppliers of capital to the firm. What it reflects is the fact that a firm generates cash
through its various activities, and that cash is either used to pay creditors or paid out to the owners
of the firm.
To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don't
want to include depreciation because it's not a cash outflow, and we don't want to include interest
because it's a financing expense. We do want to include taxes because taxes are (unfortunately)
paid in cash.

Cash flows to creditors and stockholders represent the net payments to creditors and owners during
the year. Their calculation is similar to that of cash flow from assets. Cash flow to creditors is
interest paid less net new borrowing; cash flow to stockholders. Dividends paid out by a firm less
net new equity raised.

D. Depreciation and Funds Flow

A. Depreciation is an attempt to allocate an initial asset cost over its life.

B. Depreciation is an accounting entry and does not involve the movement of funds.
C. As indicated in the statement of cash flows, depreciation is added back to net income to arrive
at cash flow.

E. Income Tax Considerations

A. Personal taxes at varying rates apply to the earnings of proprietors and partners.
B. Corporate earnings are subject to taxation at two levels -- at the corporate level and at the
personal level when received as dividends. The corporate tax rates have been changed by
Congress four times since 1980.
C. The after-tax cost of a tax-deductible business expense can be calculated by taking the
(expense) - (1 - tax rate).

D. Although depreciation is a noncash expense, it does affect cash flow by reducing taxes. Tax
reduction in cash outflow for taxes resulting from depreciation charges may be computed by
multiplying the (depreciation expense) (1-tax rate).

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EXERCISES & PROBLEMS

1. Building a Balance Sheet

Penguin Pucks, Inc., has current assets of P5,100, net fixed assets of P23,800, current liabilities of P4,300, and
long-term debt of P7,400. What is the value of the shareholders' equity account for this firm? How much is net
working capital?

2. Building an Income Statement

Papa Roach Exterminators, Inc., has sales of P586,000, costs of P247,000, depreciation expense of P43,000,
interest expense of P32,000, and a tax rate of 35 percent. What is the net income for this firm?

3. Dividends and Retained Earnings

Suppose the firm in Problem 2 paid out P73,000 in cash dividends. What is the addition to retained earnings?

4. Per-Share Earnings and Dividends

Suppose the firm in Problem 3 had 85,000 shares of common stock outstanding. What is the earnings per share,
or EPS, figure? What is the dividends per share figure?

5. Market Values and Book Values

Klingon Widgets, Inc., purchased new cloaking machinery three years ago for P7 million. The machinery can be
sold to the Romulans today for P4.9 million. Klingon's current balance sheet shows net fixed assets of P3.7 million,
current liabilities of P1.1 million, and net working capital of P380,000. If all the current assets were liquidated today,
the company would receive P1.6 million cash.

What is the book value of Klingon's assets today?

What is the market value?

6. Calculating OCF
So Long, Inc., has sales of P27,500, costs of P13,280, depreciation expense of P2,300, and interest expense of
P1,105. If the tax rate is 35 percent, what is the operating cash flow, or OCF?

7. Calculating Net Capital Spending

Earnhardt Driving School's 2008 balance sheet showed net fixed assets of P3.4 million, and the 2009 balance
sheet showed net fixed assets of P4.2 million. The company's 2009 income statement showed a depreciation
expense of P385,000. What was net capital spending for 2009?

8. Calculating Additions to NWC

The 2008 balance sheet of Saddle Creek, Inc., showed current assets of P2,100 and current liabilities of P1,380.
The 2009 balance sheet showed current assets of P2,250 and current liabilities of P1,710. What was the
company's 2009 change in net working capital, or NWC?

9. Cash Flow to Creditors

The 2008 balance sheet of Maria's Tennis Shop, Inc., showed long-term debt of P2.6 million, and the 2009 balance
sheet showed long-term debt of P2.9 million. The 2009 income statement showed an interest expense of
P170,000. What was the firm's cash flow to creditors during 2009?

10. Cash Flow to Stockholders

The 2008 balance sheet of Maria's Tennis Shop, Inc., showed P740,000 in the common stock account and P5.2
million in the additional paid-in surplus account. The 2009 balance sheet showed P815,000 and P5.5 million in the
same two accounts, respectively. If the company paid out P490,000 in cash dividends during 2009, what was the
cash flow to stockholders for the year?

11. Calculating Total Cash Flows

Given the information for Maria's Tennis Shop, Inc., in Problems 9 and 10, suppose you also know that the firm's
net capital spending for 2009 was P940,000, and that the firm reduced its net working capital investment by
P85,000. What was the firm's 2009 operating cash flow, or OCF?

12. Calculating Total Cash Flows

Jetson Spacecraft Corp. shows the following information on its 2009 income statement: sales = P196,000; costs =
P104,000; other expenses = P6,800; depreciation expense = P9,100; interest expense = P14,800; taxes =
P21,455; dividends = P10,400. In addition, you're told that the firm issued P5,700 in new equity during 2009 and
redeemed P7,300 in outstanding long-term debt.

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a. What is the 2009 operating cash flow?

b. What is the 2009 cash flow to creditors?

c. What is the 2009 cash flow to stockholders?

d. If net fixed assets increased by P27,000 during the year, what was the addition to NWC?

13. Preparing a Balance Sheet.

Prepare a 2009 balance sheet for Bertinelli Corp. based on the following information:

cash = P195,000; patents and copyrights = P780,000;

accounts payable = P405,000; accounts receivable = P137,000;
tangible net fixed assets = P2,800,000; inventory = P264,000;
notes payable = P160,000; accumulated retained earnings = P1,934,000;
long-term debt = P1,195,300.

14. Calculating Cash Flows

Dahlia Industries had the following operating results for 2009: sales = P22,800; cost of goods sold = P16,050;
depreciation expense = P4,050; interest expense = P1,830; dividends paid = P1,300. At the beginning of the
year, net fixed assets were P13,650, current assets were P4,800, and current liabilities were P2,700. At the end
of the year, net fixed assets were P16,800, current assets were P5,930, and current liabilities were P3,150. The
tax rate for 2009 was 34 percent.
a. What is net income for 2009?
b. What is the operating cash flow for 2009?
c. What is the cash flow from assets for 2009? Is this possible? Explain.
d. If no new debt was issued during the year, what is the cash flow to creditors?
e. What is the cash flow to stockholders?
f. Explain and interpret the positive and negative signs of your answers in (a) through (d).

15. Calculating Cash Flows

Consider the following abbreviated financial statements for Parrothead Enterprises:

a. What is owners' equity for 2008 and 2009?

b. What is the change in net working capital for 2009?
c. In 2009, Parrothead Enterprises purchased P1,350 in new fixed assets. How much in fixed assets did Parrothead
Enterprises sell? What is the cash flow from assets for the year? (The tax rate is 35 percent.)
d. During 2009, Parrothead Enterprises raised P270 in new long-term debt.

e. How much long-term debt must Parrothead Enterprises have paid off during the year?
What is the cash flow to creditors?

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Topic 3. Analysis of Financial Statements

2.2. Financial Ratios

 Ratio analysis provides a meaningful comparison of a company to its industry, chief competitors, or to
any other well run firm.
 Ratios can be used to measure profitability, asset utilization, liquidity and debt utilization.
 The Du Pont system of analysis breaks down the return on assets and return on stockholders’ equity
ratios into their respective component parts.
 Trend analysis shows company performance over time.
 Reported income must be further evaluated to identify sources of distortion.

Ratio analysis

A. Uses of ratios:
1. Provide a basis for evaluating the operating performance of a firm.
2. Facilitate comparison with other firms, using data from firms such as Dun & Bradstreet,
Standard & Poor’s, Value Line Investment Survey, etc.

B. Classification and computation

1. Profitability: Measures of returns on sales, total assets and invested capital

a. Profit margin = Net income/Sales
b. Return on assets (investment) = Net income/Total assets
c. Return on equity = Net income/Stockholders' equity
= Return on assets ÷ (1 - Debt/assets)
= ROA x TAT x EM

2. Asset Management, or Assets Utilization: Measures how well the firm is managing its
accounts receivable, inventories, and longer term assets.

a. Receivables turnover = Sales/Receivables

b. Ave. collection period = Acct. receivable/Average daily credit sales*
* Sales/365
c. Inventory turnover = COGS/Inventory
d. Days’ sales in inventory = 365 days/ inventory turn-over
e. Fixed asset turnover = Sales/Fixed assets
f. Total asset turnover = Sales/Total assets
g. Payable turn-over = cost of goods / accounts payable
h. Average payment period = 365 days/payable turn-over
i. NWC turn-over = sales /NWC

3. Liquidity ratios: Measures of the firm's ability to pay off short-term obligations as they
come due
a. Current ratio = Current assets/current liabilities
b. Quick ratio = Current assets minus inventory/Current liabilities
c. Cash Ratio = Cash/Current Liabilities

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d. Net working capital (NWC)= current assets – current liabilities

e. NWC to total assets = Net working capital/total assets
f. Interval measure = current assets/average daily operating costs
average daily operating costs = total costs excluding depreciation and
interests /365 days or = COGS /365 days

4. Debt Utilization Ratios: Measures the prudence of the firm's debt management policies.

a. Total Debt Ratio (Debt to total assets) = Total Debt / Total Assets
b. Debt-Equity Ratio = Total Debts/Total Equity
c. Equity Multiplier = Total Assets / Total Equity
d. Long-term debt ratio = long-term debts /(long-term debts + total equity)
e. Times interest earned = EBIT / Interest Expense
f. Fixed charge coverage
g. Cash coverage ratio = (EBIT + depreciation )/Interest

5. Market Value Measures

a. Earnings per Share = Net Income / Shares outstanding

b. Price - Earnings Ratio = Price per share / EPS
c. PEG Ratio = Price - Earnings Ratio/EPS
d. Price – Sales Ratio = Price per Share /Sales per share
e. Market-to-Book Ratio = Market Value
Book Value per Share

6. Vertical and Horizontal Analysis

Computation of Peso Changes and Percent Changes. Comparing financial statements

over relatively short time periods—two to three years—is often done by analyzing
changes in line items. A change analysis usually includes analyzing absolute peso
amount changes and percent changes. Both analyses are relevant because peso
changes can yield large percent changes inconsistent with their importance. For instance,
a 50% change from a base figure of P100 is less important than the same percent change
from a base amount of P100,000 in the same statement. Reference to peso amounts is
necessary to retain a proper perspective and to assess the importance of changes. We
compute the peso change for a financial statement item as follows:

Analysis period is the point or period of time for the financial statements under analysis,
and base period is the point or period of time for the financial statements used for
comparison purposes. The prior year is commonly used as a base period. We compute
the percent change by dividing the peso change by the base period amount and then
multiplying this quantity by 100 as follows:

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Common-Size Balance Sheets Common-size statements express each item as a percent of

a base amount, which for a common-size balance sheet is usually total assets. The base amount is
assigned a value of 100%. (This implies that the total amount of liabilities plus equity equals 100%
since this amount equals total assets.) We then compute a common-size percent for each asset,
liability, and equity item using total assets as the base amount. When we present a company’s
successive balance sheets in this way, changes in the mixture of assets, liabilities, and equity are
apparent.

Common-Size Comparative Balance Sheets

Common-Size
Comparative Income
Statements

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Common-Size Comparative Income Statements

Analysis also benefits from use of a common-size income statement. Revenue is usually the base amount, which is
assigned a value of 100%. Each common-size income statement item appears as a percent of revenue. If we think of
the 100% revenue amount as representing one sales peso, the remaining items show how each revenue peso is
distributed among costs, expenses, and income.

FINANCIAL RATIOS SUMMARY

Example:

Al Thomas has recently been approached by his brother-in-law, Robert Watson, with a proposal to buy a 20 percent
interest in Watson Leisure Time Sporting Goods. The company manufactures golf clubs, baseball bats, basketball
goals, and other similar items.

Mr. Watson is quick to point out the increase in sales over the last three years as indicated in the income statement,
Exhibit 1. The annual growth rate is 20 percent. A balance sheet for a similar time period is shown in Exhibit 2, and
selected industry ratios are presented in Exhibit 3. Note the industry growth rate in sales is only approximately 10
percent per year.

There was a steady real growth of 2 to 3 percent in gross domestic product during the period under study. The rate of
inflation was in the 3 to 4 percent range.

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The stock in the corporation has become available due to the ill health of a current stockholder, who needs cash. The
issue here is not to determine the exact price for the stock, but rather whether Watson Leisure Time Sporting Goods
represents an attractive investment situation.

Although Mr. Thomas has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has no
fast and firm rules about required return on investment, but rather wishes to analyze the overall condition of the firm.
The firm does not currently pay a cash dividend, and return to the investor must come from selling the stock in the
future. After doing a thorough analysis (including ratios for each year and comparisons to the industry), what comments
and recommendations do you offer to Mr. Thomas?

Exhibit 1

WATSON LEISURE TIME SPORTING GOODS

Income Statement
200X 200Y 200Z
Sales (all on credit) P1,500,000 P1,800,000 P2,160,000
Cost of goods sold 950,000 1,120,000 1,300,000
Gross profit 550,000 680,000 860,000
Selling and administrative expense* 380,000 490,000 590,000
Operating profit 170,000 190,000 270,000
Interest expense 30,000 40,000 85,000
Net income before taxes 140,000 150,000 185,000
Taxes 46,120 48,720 64,850
Net income P 93,880 P 101,280 P 120,150
Shares 40,000 40,000 46,000
Earnings per share P2.35 P2.53 P2.61
*Includes P20,000 in lease payments for each year.

Exhibit 2

WATSON LEISURE TIME SPORTING GOODS

Balance Sheet
200X 200Y 200Z
Assets
Cash P 20,000 P 30,000 P 20,000
Marketable securities 30,000 35,000 50,000
Accounts receivable 150,000 230,000 330,000
Inventory 250,000 285,000 325,000
Total current assets 450,000 580,000 725,000
Net plant and equipment 550,000 720,000 1,169,000
Total assets P1,000,000 P1,300,000 P1,894,000

Liabilities and Stockholders’ Equity

Accounts payable P 100,000 P 225,000 P 200,000
Notes payable (bank) 100,000 100,000 300,000
Total current liabilities 200,000 325,000 500,000
..........................................................................
Long-term liabilities 250,000 331,120 550,740
.................................................................................
Total liabilities 450,000 656,120 1,050,740
..........................................................................
Common stock (P10 par) 400,000 400,000 460,000
.................................................................................
Capital paid in excess of par 50,000 50,000 80,000
.................................................................................
Retained earnings 100,000 193,880 303,260
.................................................................................
Total stockholders’ equity 550,000 643,880 843,260
..........................................................................
Total liabilities and stockholders’ equity P1,000,000 P1,300,000 P1,894,000
.................................................................................

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Exhibit 3
Selected Industry Ratios
200X 200Y 200Z

Growth in sales — 9.98% 10.02%

...........................................................................
Profit margin 5.75% 5.80% 5.81%
...........................................................................
Return on assets (investment) 8.22% 8.24% 8.48%
...........................................................................
Return on equity 13.26% 13.62% 14.16%
...........................................................................
Receivable turnover 10X 9.5X 10.1X
...........................................................................
Average collection period 36 days 37.9 days 35.6 days
...........................................................................
Inventory turnover 5.71X 5.62X 5.84X
...........................................................................
Fixed asset turnover 2.75X 2.66X 2.20X
...........................................................................
Total asset turnover 1.43X 1.42X 1.46X
...........................................................................
Current ratio 2.10X 2.08X 2.15X
...........................................................................
Quick ratio 1.05X 1.02X 1.10X
...........................................................................
Debt to total assets 38% 39.5% 40.1%
...........................................................................
Times interest earned 5.00X 5.20X 5.26X
...........................................................................
Fixed charge coverage 3.85X 3.95X 3.97X
...........................................................................
Growth in EPS — 9.7% 9.8%
...........................................................................

CP 3-1. Solution: Watson Leisure Time Sporting Goods

200X 200Y 200Z

Growth in sales (Company) 20% 20%
(Industry) 9.98% 10.02%
Profit margin (Company) 6.26% 5.63% 5.56%
(Industry) 5.75% 5.80% 5.81%
Return on assets (Company) 9.39% 7.79% 6.34%
(Industry) 8.22% 8.24% 8.48%
Return on equity (Company) 17.07% 15.73% 14.25%
(Industry) 13.26% 13.62% 14.16%
Receivable turnover (Company) 10.0x 7.83x 6.55x
(Industry) 10.0x 9.5x 10.1x
Average collection period (Company) 36 days 46.0 days 55.0 days
(Industry) 36 days 37.9 days 35.6 days
Inventory turnover (Company) 6.0x 6.32x 6.65x
(Industry) 5.71x 5.62x 5.84x
Fixed asset turnover (Company) 2.73x 2.50x 1.85x
(Industry) 2.75x 2.66x 2.20x
Total asset turnover (Company) 1.50x 1.38x 1.14x
(Industry) 1.43x 1.42x 1.44x
Current ratio (Company) 2.25x 1.78x 1.45x
(Industry) 2.10x 2.08x 2.15x

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Quick ratio (Company) 1.00x .91x 0.80x

(Industry) 1.05x 1.02x 1.10x
Debt to total assets (Company) 45.0% 50.47% 55.48%
(Industry) 38.0% 39.50% 40.10%
Times interest earned (Company) 5.67x 4.75x 3.18x
(Industry) 5.0x 5.20x 5.26x
Fixed charge coverage (Company) 3.80x 3.50x 2.76x
(Industry) 3.85x 3.95x 3.97x
Growth in E.P.S. (Company) ---- 7.7% 3.2%
(Industry) ---- 9.7% 9.8%

Discussion of Ratios

While Watson Leisure Time Sporting Goods is expanding its sales much more rapidly than others in the industry, there
are some clear deficiencies in their performance. These can be seen in terms of a trend analysis over time as well as a
comparative analysis with industry data.

Profitability:

In terms of profitability, the profit margin is declining over time. This is surprising in light of the 44 percent increase in
sales over two years (20 percent per year). There obviously are no economies of scale for this firm. Higher selling and
administrative costs and interest expense appear to be causing the problem. The return-on-asset ratio starts out in
200X above the industry average (9.39 percent versus 8.22 percent) and ends up well below it (6.34 percent versus
8.48 percent) in 200Z. The decline of 3.05 percent for return on assets at Watson Sporting Goods is serious, and can
be attributed to the previously mentioned declining profit margin as well as a slowing total asset turnover (going from
1.5X to 1.14X).

Return on equity is higher than the industry ratio, but in a downtrend. It is superior to the industry average for one
reason: the firm has a heavier debt positive than the industry. Lower returns on assets are translated into higher returns
on equity because of the firm’s high debt.

Asset Utilization:

The previously mentioned slower turnover of assets can be analyzed through the turnover ratios. A very real problem
can be found in accounts receivable where turnover has gone from 10X to 6.55X.

This can also be stated in terms of an average collection period that has increased from 36 days to 55 days. While
inventory turnover has been and remains superior to the industry, the same cannot be said for fixed asset turnover. A
decline from 2.73X to 1.85X was caused by an increase in 112.5 percent in fixed assets (representing P619,000).

We can summarize the discussion of the turnover ratios by saying that despite a 44 percent increase in sales, assets
grew even more rapidly causing a decline in total asset turnover from 1.50X to 1.14X.

Liquidity:

The liquidity ratios also are not encouraging. Both the current and quick ratios are falling against a stable industry norm
of approximately two and one respectively.

Debt Utilization:

The debt to total assets ratio is particularly noticeable in regard to industry comparisons. Watson Sporting Goods has
gone from being seven percent over the industry average to 15.38 percent above the norm (55.48 percent versus 40.1
percent). Their heavy debt position is clearly out of line with their competitors. Their downtrend in times interest earned
and fixed charge coverage confirms the heavy debt burden on the company.

Market Value:

Finally, we see that the firm has a slower growth rate in earnings per share than the industry. This is a function of less
rapid growth in earnings as well as an increase in shares outstanding (with the sale of 6,000 shares in 200Z). Once
again, we see that the rapid growth in sales is not being translated down into significant earnings gains. This is true in
spite of the fact that there is a very stable economic environment. It does not appear that this is an attractive investment
opportunity.

Optional Discussion:

Although the student was not specifically asked to address the issue, the instructor may wish to comment on the shares
that were sold in 200Z. Looking at the capital section of the balance sheet, it appears that 6,000 shares were sold for a
total value of P90,000.

P60,000 increase in par value

30,000 increase in capital paid in excess of par
P90,000 total value of 6,000 shares

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The P90,000 proceeds indicates the 6,000 shares were sold at an average price of P15.00 each. The P15.00
represents a fairly low multiplier of 200Z earnings of P2.61. The price/earnings ratio is 5.75X. Book value per share
(including the new shares) is P18.33 (P843,260/46,000), so once again the price of P15 is fairly modest (81.8 percent of
book value).

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FINANCIAL STATEMENTS ANALYSIS

EXERCISES & PROBLEMS

1. Calculating Liquidity Ratios

SDJ, Inc., has net working capital of P1,370, current liabilities of P3,720, and inventory of P1,950. What is the
current ratio? What is the quick ratio?

2. Calculating Profitability Ratios

Wakers, Inc., has sales of P29 million, total assets of P17.5 million, and total debt of P6.3 million. If the profit
margin is 8 percent, what is net income? What is ROA? What is ROE?

3. Calculating the Average Collection Period

Ortiz Lumber Yard has a current accounts receivable balance of P431,287. Credit sales for the year just ended
were P3,943,709. What is the receivables turnover? The days' sales in receivables? How long did it take on
average for credit customers to pay off their accounts during the past year?

4. Calculating Inventory Turnover

The Blue Moon Corporation has ending inventory of P407,534, and cost of goods sold for the year just ended was
P4,105,612. What is the inventory turnover? The days' sales in inventory? How long on average did a unit of
inventory sit on the shelf before it was sold?

5. Calculating Leverage Ratios

Crystal Lake, Inc., has a total debt ratio of .63. What is its debt–equity ratio? What is its equity multiplier?

6. Calculating Market Value Ratios

Bach Corp. had additions to retained earnings for the year just ended of P430,000. The firm paid out P175,000 in
cash dividends, and it has ending total equity of P5.3 million. If the company currently has 210,000 shares of
common stock outstanding, what are earnings per share? Dividends per share? Book value per share? If the stock
currently sells for P63 per share, what is the market-to-book ratio? The price–earnings ratio? If the company had
sales of P4.5 million, what is the price–sales ratio?

7. Du Pont Identity
If Roten Rooters, Inc., has an equity multiplier of 2.80, total asset turnover of 1.15, and a profit margin of 5.5
percent, what is its ROE?

8, Du Pont Identity
Braam Fire Prevention Corp. has a profit margin of 6.80 percent, total asset turnover of 1.95, and ROE of 18.27
percent. What is this firm's debt–equity ratio?

9. Sources and Uses of Cash

Based only on the following information for Bennington Corp., did cash go up or down? By how much? Classify
each event as a source or use of cash.

10. Calculating Average Payables Period

Tortoise, Inc., had a cost of goods sold of P28,834. At the end of the year, the accounts payable balance was
P6,105. How long on average did it take the company to pay off its suppliers during the year? What might a large
value for this ratio imply?

11. Cash Flow and Capital Spending

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For the year just ended, Ypsilanti Yak Yogurt shows an increase in its net fixed assets account of P835. The
company took P148 in depreciation expense for the year. How much did the company spend on new fixed assets?
Is this a source or use of cash?

12. Equity Multiplier and Return on Equity

Organic Chicken Company has a debt–equity ratio of .65. Return on assets is 8.5 percent, and total equity is
P540,000.

What is the equity multiplier?

Return on equity?

Net income?

13. Using the Du Pont Identity

Y3K, Inc., has sales of P5,276, total assets of P3,105, and a debt–equity ratio of 1.40. If its return on equity is 15
percent, what is its net income?

14. Days' Sales in Receivables

A company has net income of P218,000, a profit margin of 8.70 percent, and an accounts receivable balance of
P132,850. Assuming 70 percent of sales are on credit, what is the company's days' sales in receivables?

15. Ratios and Fixed Assets

The Ashwood Company has a long-term debt ratio of .45 and a current ratio of 1.25. Current liabilities are P875,
sales are P5,780, profit margin is 9.5 percent, and ROE is 18.5 percent. What is the amount of the firm's net fixed
assets?

16. Profit Margin

In response to complaints about high prices, a grocery chain runs the
following advertising campaign: “If you pay your child P3 to go buy P50
worth of groceries, then your child makes twice as much on the trip as we
do.” You've collected the following information from the grocery chain's
financial statements:

Evaluate the grocery chain's claim. What is the basis for the statement? Is
this claim misleading? Why or why not?

17. Return on Equity

Firm A and firm B have debt–total asset ratios of 35% and 30% and returns on total assets of 12% and 11%,
respectively. Which firm has a greater return on equity?

18. Calculating the Cash Coverage Ratio

Sherwood Inc.'s net income for the most recent year was P13,168. The tax rate was 34 percent. The firm paid
P3,605 in total interest expense and deducted P2,382 in depreciation expense. What was the cash coverage ratio
for the year?

19. Cost of Goods Sold

Holliman Corp. has current liabilities of P365,000, a quick ratio of .85, inventory turnover of 5.8, and a current ratio
of 1.4. What is the cost of goods sold for the company?

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20. Ratios and Foreign Companies

Prince Albert Canning PLC had a net loss of £13,482 on sales of £138,793 (both in thousands of pounds). What
was the company's profit margin? Does the fact that these figures are quoted in a foreign currency make any
difference? Why? In pesos, sales were P274,213,000. What was the net loss in pesos?

Minicase: Just Dew It Corporation ( Case 2)

Just Dew It Corporation reports the following balance sheet information for 2008 and 2009.

a. Preparing Standardized Financial Statements

Prepare the 2008 and 2009 common-size balance sheets for Just Dew It.

b. Preparing Standardized Financial Statements

Prepare the 2009 common–base year balance sheet for Just Dew It.

c. Preparing Standardized Financial Statements

Prepare the 2009 combined common-size, common–base year balance sheet for Just Dew It.
d. Sources and Uses of Cash
For each account on this company's balance sheet, show the change in the account during 2009 and note whether this
change was a source or use of cash. Do your numbers add up and make sense? Explain your answer for total
assets as compared to your answer for total liabilities and owners' equity.

e. Calculating Financial Ratios

Calculate the following financial ratios for each year:
a. Current ratio.

b. Quick ratio.

c. Cash ratio.

d. NWC to total assets ratio.

e. Debt–equity ratio and equity multiplier.

f. Total debt ratio and long-term debt ratio.

g. Du Pont Identity

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Minicase: Smolira Golf Corp (Case 3)

Some recent financial statements for Smolira Golf Corp. follow.

26. Calculating Financial Ratios

Find the following financial ratios for Smolira Golf Corp. (use year-end figures rather than average values where
appropriate):

27. Du Pont Identity

Construct the Du Pont identity for Smolira Golf Corp.

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28. Statement of Cash Flows

Prepare the 2009 statement of cash flows for Smolira Golf Corp.

29. Market Value Ratios

Smolira Golf Corp. has 25,000 shares of common stock outstanding, and the market price for a share of stock at the
end of 2009 was P43.

What is the price–earnings ratio?

What are the dividends per share?

What is the market-to-book ratio at the end of 2009?

If the company's growth rate is 9 percent, what is the PEG ratio?

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PART 3 – WORKING CAPITAL MANAGEMENT

Learning Outcome:

3. Student will be able to assess the intricacies of managing and financing the working capital requirements of a firm
by:
3.1. illustrating the creation of cash budgets and potential need for financing
3.2. examining the systems used by firms to handle cash inflows and outflows
3.3. evaluating firm’s credit policy and implementation; and,
3.4. analyzing firm’s inventory policy and implementation.

-----------------------------------------------------------------------------------------------------------
3.1. Financial Planning (Chapter 4 & 18)

Tracing Cash and Net Working Capital

Net working capital + Fixed assets = Long-term debt + Equity

Net working capital = Cash + Other current assets – Current liabilities
Substituting NWC into the first equation and rearranging;
Cash = Long-term debt + Equity + Current Liabilities–Other current assets – Fixed assets

Sources of Cash (Activities that increase cash)

 Increase in long-term debt account (borrowed money)

 Increase in equity accounts (sold stock)
 Increase in current liability accounts (borrowed money)
 Decrease in current asset accounts, other than cash (sold current assets)
 Decrease in fixed assets (sold fixed assets)

Uses of Cash (Activities that decrease cash)

 Decrease in long-term debt account (repaid loans)

 Decrease in equity accounts (repurchased stock or paid dividends)
 Decrease in current liability accounts (repaid suppliers or short-term creditors)
 Increase in current asset accounts, other than cash Increase in fixed assets (purchased fixed
assets)

A. The Cash Budget

Cash budget: A summary of expected cash receipts and disbursements for a specific period of time. It
requires sales forecasts for a series of periods. The other cash flows in the cash budget are generally
based on the sales estimates. We also need to know the average collection period on receivables to
determine when the cash inflow from sales actually occurs. Common cash outflows:
 Accounts payable – what is the accounts payables period?
 Wages, taxes and other expenses – usually expressed as a percent of sales (implies that they
are variable costs)
 Fixed expenses, when applicable
 Capital expenditures – determined by the capital budget
 Long-term financing expenses – interest expense, dividends, sinking fund payments, etc.
 Short-term borrowing – determined based on the other information

Steps in making Cash Budget:

1. Estimate cash sales and collection timing of credit sales
2. Forecast cash payments (a. Payments for materials purchase according to credit terms,
Wages, Capital expenditures, Principal payments, Interest payments, Taxes, Dividends)
3. Determine monthly cash flow (receipts minus payments)
4. Construct cash budget
Total receipts (for each month, week, etc.)
- Total payments (for each month, week, etc.)
Net cash flow (for the period)
+ Beginning cash balance
Cumulative cash balance

Note: The beginning cash balance for each period of the cash budget is equal to the
cumulative cash balance of the previous period in the absence of borrowing or investing
of cash balances.

5. Determine cash excess or need for borrowing

Cumulative cash balance (at end of period)
Loan required or cash excess (desired cash balance
- cumulative cash balance)
Ending cash balance

B. Short-Term Borrowing

1. Unsecured Loans
a. Line of credit – formal or informal prearranged short-term loans

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b. Commitment fee – charge to secure a committed line of credit

c. Compensating balance – deposit in a low (or no) interest account as part of a loan agreement
Cost of a compensating balance – if the compensating balance requirement is on the used
portion, less money than what is borrowed is actually available for use. If it is on the unused
portion, the requirement becomes a commitment fee.

Example: Consider a P50,000 line of credit with a 5% compensating balance requirement. The
quoted rate on the line is prime + 5%, and the prime rate is currently 8%. Suppose the firm
wants to borrow P28,500. How much do they have to borrow? What is the effective annual rate
(EAR)?
Loan Amount: 28,500 = (1 - .05) L = 28,500 / .95 = 30,000
Effective rate: Interest paid = 30,000(.13) = 3,900.
Effective rate = 3,900/28,500 = .1368 = 13.68%

2. Secured Loans
1. Accounts Receivable Financing
a. Assigning receivables – receivables are security for a loan, but the borrower retains the risk
of uncollected receivables
b. Factoring – receivables are sold at a discount
Last year your company had average accounts receivable of P2 million. Credit sales were P24
million. You factor receivables by discounting them 2%. What is the effective rate of interest?
• Receivables turnover = 24/2 = 12 times
• APR = 12(.02/.98) = .2449 or 24.49%
• EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%

2. Inventory Loans
1. Blanket inventory lien – all inventory acts as security for the loan
2. Trust receipt – borrower holds specific inventory in trust for the lender (e.g., automobile dealer
financing)
3. Field warehouse financing – public warehouse acts as a control agent to supervise inventory
for the lender
3. Other Sources
1. Commercial paper – short-term publicly traded loans
2. Trade credit – accounts payable

3.2 Short-Term Financial Plan

 Financial forecasting is essential to the strategic growth of the firm.

 The three financial statements for forecasting are the pro forma income statement, the cash budget
and the pro forma balance sheet.
 The percent-of-sales method may also be used for forecasting on a less precise basis.
 The various methods of forecasting enable the firm to determine the amount of new funds required
in advance.
 The process of forecasting forces the firm to consider seasonal and other effects on cash flow.

The most comprehensive means for doing financial planning is through the development of pro
forma financial statements; namely the pro forma income statement, the cash budget, and the pro
forma balance sheet.

Pro Forma Income Statement: A projection of how much profit a firm will make over a specific time
period
1. Establish a sales projection
a. Forecast economic conditions
b. Survey sales personnel
2. Determine production needs, cost of goods sold, and gross profits based on the sales
forecast
a. Determine units to be produced
Projected unit sales
Desired ending inventory
- Beginning inventory
Production requirements
b. Determine the cost of producing the units
(1) Unit cost = materials + labor + overhead
(2) Total costs = number of units to be produced  unit cost
c. Compute cost of goods sold
(1) Estimate unit sales
(2) Cost of goods sold = unit sales X unit cost (FIFO/ LIFO)
d. Compute gross profit
3. Compute other expenses
a. General and administrative
b. Interest expense
4. Finally construct the pro forma income statement
Sales revenue
-Cost of goods sold
Gross profit
-General and administrative expenses

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Operating profit
-Interest expense
Earnings before taxes
-Taxes
Earnings after taxes
-Common stock dividends
Increase in retained earnings

Pro Forma Balance Sheet: An integrated projection of the firm's financial position based on its
existing position, forecasted profitability (from pro forma income statement), anticipated cash flows
(cash budget), asset requirements and required financing

1. Construction of pro forma balance sheet

a. Assets (source of information)
(1) Cash - (cash budget)
(2) Marketable securities - (previous balance sheet and cash budget)
(3) Accounts receivable - (sales forecast, cash budget)
(4) Inventory - (COGS computation for pro forma income statement)
(5) Plant and equipment - (previous balance sheet + purchases -
depreciation)
b. Liabilities and Net Worth
(1) Accounts payable - (cash budget work sheet)
(2) Notes payable - (previous balance sheet and cash budget)
(3) Long-term debt - (previous balance sheet plus new issues)
(4) Common stock - (previous balance sheet plus new issues)
(5) Retained earnings - (previous balance sheet plus projected addition
from pro forma income statement)

Percent-of-Sales Method:

A. Assume balance sheet accounts maintain a given relationship to sales

Assets/ Current Sales = __% of sales ____
_
B. Project asset levels on basis of forecasted sales (percent of sales of each asset x forecasted
sales)

C. Project spontaneous financing: Some financing is provided spontaneously when asset levels
increase; for example, accounts payable increase when a firm buys additional inventory on
credit.

D. Project internal financing from profit = profit margin  forecasted sales

E. Determine external financing = required new assets to support sales - spontaneous financing
- retained earnings. The relationship is expressed
as follows:
A L
Required new funds = ( ΔS) - ( ΔS )- PS2 (1-D)
S S
Where:
A/S = percentage relationship of variable assets to sales
S = change in sales
L/S = percentage relationships of variable liabilities to sales
P = profit margin
S2 = new sales level
D = payout ratio.

It is important to stress that “A” (in the formula above) does not represent Assets. It is only the
assets that are subject to increase. The same thing applies to “L”. “L” does not represent liabilities.
It is only those spontaneous liabilities that will change in relation to sales.

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Demonstration Problem:

Pet Treats, Inc. specializes in gourmet pet treats and receives all income from sales

Data:
Sales estimates Q1 Q2 Q3 Q4
Sales 200 300 250 400

Accounts receivable
Beginning receivables = P120
Average collection period = 30 days credit term: n/45

Accounts payable
Purchases = 50% of next quarter’s sales
Beginning payables = 125
Accounts payable period = 45 days
Other expenses
Wages, taxes, and other expense are 30% of sales

Interest payment is P20. Loan can be granted when the company needs it with an interest of 12%.

A major capital expenditure of P100 is expected in the second quarter

The initial cash balance is P20, and the company maintains a minimum balance of P10.

Projected Cash Collection

QI Q2 Q3 Q4
Beginning receivables 120 100 150 125
Add: sales 200 300 250 400
Collections (220) (250) (275) (325)
Ending Receivables 100 150 125 200
Cash Collection = Beginning Accounts Receivable + 45 days/90 days x sales

Q1 Q2 Q3 Q4
Sales
Days 1-45 46-90 1-45 1-45 46-90 46-90 1-45 46-90
Q1-1 Q1-2 Q2-1 Q2-2 Q3-1 Q3-2 Q4-1 Q4-2
Sales (200/qtr) 100 100 150 150 125 125 200 200
Collection from what 100 100 150 150 125 125 200
period Q1-1 Q1-2 Q2-1 Q2-2 Q3-1 Q3-2 Q4-1
Total Collection 100 250 275 325

The effect of accounts receivable period on TOTAL COLLECTION and CREDIT MANAGEMENT– the less number of
days the better because it will improve the cash flow. In this case, credit term is n/45, meaning, the firm can collect the
receivables within 45 days. If average collection period of 30 days, which is less than the credit term of 45 days, then
collection is efficient.

If average collection period is more than the credit term (n/45), then collection is not efficient. However, if collection is
too tight, then creditors (buyers) may shy away. Detailed discussion on credit management is in 3.3 (Chapter 20).

Payment of Accounts Payable

Accounts payable
Purchases = 50% of next quarter’s sales Sales for Q1(Year 2) - 500
Beginning payables = 45
Accounts payable period = 45 days

Q1 Q2 Q3 Q4
Sales 200 300 250 400
Purchases 300 x 50% 150 125 200 250
Payment Schedule Q1-1 Q1-2 Q2-1 Q2-2 Q3-1 Q3-2 Q4-1 Q4-2
Purchases 75 75 62.5 62.5 100 100 125 125
Payment of Purchases 75 75 62.5 62.5 100 100 125
75 137.5 162.5 225

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Accounts Payable
Q1 Q2 Q3 Q4
Accounts Payable, beg. 125.00 75.00 62.50 100.00
Purchases (+) 150.00 125.00 200.00 250.00
Payment ( - ) (200.00)* (137.50) (162.50) (225.00)
Accounts Payable, end 75.00 62.50 100.00 125.00
Beg A/P : 125 + 75 = 200

Projected Cash Disbursements

Payment of Accounts Payable 200 138* 163* 225*
Wages, Taxes & Other Expenses 60 90 75 120
(30% of sales)
Capital Expenditures 100
Interest Expenses 20 20 20 20
Total Cash Disbursement 280 348 258 365

 - round-up

Assumptions:
o Interest payment is P20.
o Loan can be granted when the company needs it with an interest of 12%.
o A major capital expenditure of P100 is expected in the second quarter.
o The initial cash balance is P20, and the company maintains a minimum balance of P10.

Projected Cash Budget

Q1 Q2 Q3 Q4
Total Cash Collection 220 250 275 325
Less: Total Cash Disbursements 280 348 258 365
Net Cash flow (60) (98) 17 (40)
Plus: Beginning Cash Balance 20 (40) (138) (121)
Ending Cash Balance (40) (138) (121) (161)
Minimum Cash Balance 10 10 10 10
Required Funds (50) (148) (131) (171)

QUARTERLY EFN (NCF + INTEREST): 50 ( 98 + 1.5) 0 (40 + 4.11)

Revised Cash Budget to meet the required minimum cash balance

Q1 Q2 Q3 Q4
Net Cash flow (60.00) (98.00) 17.00 (40.00)
Less: payment of loan (13.00)
Interest (1.50) (4.50) (4.11)
Total (60.00) (99.50) 0.50 (44.11)
Add: borrowings 50.00 100.00 0 45
Total Cash (10.00) 0.50 0.50 0.89
Add: beginning 20.00 10.00 10.50 10.00
Ending Cash Balance 10.00 10.50 10.00 10.89
Minimum Cash Balance 10.00 10.00 10.00 10.00
Cumulative surplus (deficit) 0 0.50 0 0.89

Interest Payment
Q1 Q2 Q3 Q4
Cumulative Loan Balance 50 150 137 182
Interest is 12% annually ; 3% qtrly 1.5 4.50 4.11 5.46
Loan Payment 0 0 13 0

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3.2 The Operating Cycle and the Cash Cycle

The operating cycle is the average time required to acquire inventory, sell it and collect for it.

Operating cycle = inventory period + accounts receivable period

The inventory period is the time to acquire and sell inventory.

Inventory turnover = Cost of goods sold

average inventory

Inventory period = 365/ inventory turnover

The accounts receivable period (average collection period) is the time to collect on the sale.
Receivables turnover = credit sales / average receivables

Accounts receivable period = 365 / receivables turnover

The cash cycle is the average time between cash disbursement for purchases and cash received from
collections.

Cash cycle = operating cycle – accounts payable period

The accounts payable period is the time between receipt of inventory and payment for it.
Payables turnover = Cost of goods sold / average payables
Payables period = 365 / payables turnover

Calculating the Operating and Cash Cycles

Item Beginning Ending Average

Inventory 200,000 300,000 250,000
Accounts Receivable 160,000 200,000 180,000
Accounts Payable 75,000 100,000 87,500

Net sales = 1,150,000; COGS = P820,000

Finding inventory period:
Inventory turnover = 820,000 / 250,000 = 3.28 times
Inventory period = 365 / 3.28 = 111 days

Finding accounts receivables period:

Receivables turnover = 1,150,000 / 180,000 = 6.39 times
Accounts receivables period = 365 / 6.39 = 57 days

Operating cycle = 111 + 57 = 168 days

Finding accounts payables period:
Payables turnover = 820,000 / 87,500 = 9.37 times
Accounts payables period = 365 / 9.37 = 39 days

Cash cycle = 168 – 39 = 129 days

Interpreting the Cash Cycle

A positive cash cycle means that inventory is paid for before it is sold and the cash from the sale is collected.
In this situation, a firm must finance the current assets until the cash is collected.

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The Size of the Firm’s Investment in Current Assets

If cash was collected from sales when the bills had to be paid, then cash balances and net working capital
could be zero. The greater the mismatch between collections and payment, and the uncertainty surrounding
collections, the greater the need to maintain some cash balances and to have positive net working capital.

Flexible (conservative) policy – high levels of current assets relative to sales, relatively more long-term
financing

-Keep large cash and securities balances (lower return, but cash available for emergencies and
unexpected opportunities)

-Keep large amounts of inventory (higher carrying costs, but lower shortage costs including lost
customers due to stock-outs)

-Liberal credit terms, resulting in large receivables (greater probability of default from customers and
usually a longer receivables period, but leading to an increase in sales)

Restrictive (aggressive) policy – low levels of current assets relative to sales, relatively more short-term
financing

-Keep low cash and securities balances (may be short of cash in emergencies or unable to take
advantage of unexpected opportunities, but higher return on long-term assets)
-Keep low levels of inventory (high shortage costs, particularly bad in industries where there are plenty of
close substitutes that customers can turn to, lower carrying costs)

-Strict credit policies, or no credit sales (may substantially cut sales level, reduce cash cycle and need
for financing)

Carrying costs – costs that increase with investment in current assets

-Opportunity cost of investing in (and financing) low-yield assets
-Cost associated with storing inventory

Shortage costs – costs that decrease with investment in current assets

-Trading and order costs – commissions, set-up and paperwork
-Stock-out costs – lost sales, business disruptions and alienated customers

The just-in-time inventory system is designed to reduce the inventory period. In essence, companies pay their
suppliers to carry the inventory for them. Reducing the inventory period reduces the operating cycle and thus
the cash cycle. This reduces the need for financing. Ask the students to consider what type of cost is being
minimized and what costs are likely to increase. JIT inventory policies are appropriate for all industries? It
makes sense for industries that have substantial carrying costs with relatively low shortage costs, but not for
industries where shortage costs outweigh carrying costs.

Which Financing Policy is Best?

1. Cash reserves – more important when a firm has unexpected opportunities on a regular basis or where
financial distress is a strong possibility, zero NPV at best, and may hurt firm’s overall return

2. Maturity hedging – match liabilities to assets as closely as possible, avoid financing long-term assets
with short-term liabilities (risky due to possibility of increase in rates and the risk of not being able to
refinance)

3. Relative interest rates – short-term interest rates are usually lower than the long term rates. This implies
that it is, on average, more costly to rely on long-term borrowings as compared to short-term borrowing.

3.3 Credit and Receivables (Chapter 20)

Components of Credit Policy

 Terms of sale – define credit period and any available discounts
 Credit analysis – estimate probability of default for individual customers to determine who receives credit
and at what terms
 Collection policy –steps that will be taken to collect on receivables, particularly when customers are late
with their payment
The Investment in Receivables depends upon the average collection period and the level of average
daily credit sales.

 Accounts receivable = average daily sales * average collection period (ACP)

The amount of investment in accounts receivables is the daily sales times ACP, since “sales” contains cost
plus profit, but the out-of-pocket investment required would be the cost of the receivables, excluding the profit
reflected in the receivables balance. Point out that the analysis refers to the funds committed to this balance.
If the receivables balance could be reduced by ten days, these ten days’ receivables would be immediately
freed up. Therefore, the investment in receivables should be viewed in terms of the funds that are tied up.

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Terms of the Sale

 Credit period – amount of time allowed for payment
 Cash discount and discount period – percent of discount allowed if payment is made during the
discount period
 Type of credit instrument

The Basic form

The terms 2/10 net 60 mean you receive a 2% discount if you pay in 10 days, with the total amount due
in 60 days if the discount is not taken. In this example, the 60 days is the credit period, the 10 days is
the discount period and the 2% is the cash discount amount.

The invoice date is the date for which the credit period starts. This is normally the shipping date, but
some companies may post date the invoice to encourage customers to order early.

The Credit Period

Credit Period – the length of time before the borrower is supposed to pay
Two components: net credit period and discount period

Invoice date – begins the credit period, usually the shipping or billing date
 ROG – receipt of goods
 EOM – end-of-month (invoice date is the end of the month)
 Seasonal dating – invoice date corresponds to the “season” of the goods

Length of the credit period depends on:

 Buyer’s inventory and credit cycle Perishability and collateral value
 Consumer demand Credit risk
 Cost, profitability and standardization Size of the account
 Competition Customer type

Cash discounts
Offered by sellers to induce early payment. Not taking the discount involves a cost of credit for the
purchaser.
Cost of credit – the cost of not taking discounts offered (this is a benefit to the company granting credit)
Periodic rate = (discount %) / (100 – discount %)
Number of periods per year = m = 365 / (net period – discount period)
APR = m(periodic rate) EAR = (1 + periodic rate)m – 1

Example: Consider terms of 1/15, net 45 (assume payment is made on time in 45 days when the
discount is forgone)
Periodic rate = 1/99 = .0101
Number of periods per year = m = 365 / (45 – 15) = 12.17
APR = 12.17(.0101) = 12.29% EAR = (1.0101)12.17 – 1 = 13.%

When a company does not take advantage of discount terms, such as those given above, it is effectively
borrowing the invoice amount at 1% for 30 days. The company is only borrowing the money at the
discount rate for the period between the end of the discount period and the net period.

Offering discounts generally reduces the average collection period and thus the cash cycle. This reduces
the amount of financing required, but the company loses sales in the amount of the discount taken.
Consequently, the firm needs to look at the size and timing of the expected cash flows to determine
what, if any, discount should be offered.

Credit instruments

 Evidence of indebtedness
 Open account – invoice only
 Promissory note – basic IOU, may be used when the order is large or the purchasing firm has
a history of late payments
 Commercial draft – request for funds sent directly to the purchaser’s bank
 Sight draft – payable immediately
 Time draft – payment required by some future date
 Trade acceptance – buyer accepts draft with agreement to pay in the future
 Bankers’ acceptance – bank accepts draft and guarantees payment

Various investments have been developed to shift the risk of non-payment of receivables in international
transactions from the seller to a financial institution. For example, the banker’s acceptance is an
irrevocable letter of credit issued by a bank guaranteeing payment of the face amount. A letter of credit
is simply a promise from the buyer’s bank to make payment upon receipt of the goods by the buyer. The
guarantee arrangements add to the cost of doing business, their existence greatly facilitates international
trade.

Credit Policy Effects

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 Revenue effects – price and quantity sold may be increased

 Cost effects – the cost of running a credit plan and collecting receivables
 Cost of debt – firm must finance receivables
 Probability of nonpayment – always get paid if you sell for cash
 Cash discount – affects payment patterns and amounts

Evaluating a Proposed Credit Policy

The process for determining the NPV of a credit policy switch is the same as the process for
determining the NPV of a capital asset replacement (or “switch”). The analysis involves a comparison of
the marginal costs with the marginal benefits to be realized from the switch. If a company liberalizes
credit terms, the present value of the marginal profit is compared to the immediate investment in a higher
receivables balance. If a company tightens credit, lower sales should be expected. The present value of
the reduction in profit is compared to the cash realized from the lower amount invested in receivables.

Define:
P = price per unit Q = current quantity sold per period
v = variable cost per unit Q = new quantity expected to be sold
R = periodic required return (corresponds to the ACP)

Benefit of switching is the change in cash flow:

(P – v)Q - (P – v)Q = (P – v)(Q - Q)

Periodic benefit is the gross profit * change in quantity.

The PV of switching is: PV = [(P – v)(Q - Q)] / R

The cost of switching is the amount uncollected for the period + additional variable costs of production:
Cost = PQ + v(Q - Q)

NPV of the switch is: NPV = -[PQ + v(Q - Q)] + (P – v)(Q - Q)/R

A break-even application – what change in quantity would produce a P0 NPV?

Q - Q = PQ/[(P-v)/R - v]

Optimal Credit Policy

An optimal credit policy is one in which the incremental cash flows from sales are equal to the
incremental costs of carrying the increased investment in accounts receivable.

The Total Credit Cost Curve

Credit policy represents the trade-off between two kinds of costs:

Carrying costs: the required return on receivables, the losses from bad debts
and the costs of managing credit and collections

Opportunity costs: -potential profit from credit sales lost

Organizing the Credit Function

 Credit operations may be outsourced due to the cost of managing such operations.
 Those that manage credit operations internally either self-insure against bad debts or purchase credit
insurance.
 A final alternative is to set up a subsidiary that handles the credit operations.

When Should Credit Be Granted?

One-Time Sale
Let  be the percentage of new customers who default
NPV = -v + (1 - )P / (1 + R)
The firm risks –v to gain P a period later.

Repeat Business
NPV = -v + (1 - )(P – v)/R

Credit information:
-Financial statements, -Credit reports (i.e., Dun and Bradstreet)
-Banks -Customer’s payment history

Credit Evaluation and Scoring

Credit evaluation – trying to estimate the probability of default

Five Cs of Credit
1. Character – evidence of willingness to pay

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2. Capacity – ability to pay out of operating income

3. Capital – financial reserves
4. Collateral – assets that can be pledged as security
5. Conditions – economic conditions that may affect the firm’s ability to pay

Credit scoring – assigning a numerical rating to customers based on credit history

Collection Policy
Monitoring receivables - Keeping track of payments to try to spot potential problems (chronic late-
payers and possible defaults) to reduce losses.
Aging schedule – a break-down of receivables accounts by age

Collection Effort - the sequence of steps taken in collecting overdue accounts

Typical steps:
-Send delinquency letter, -call customer, employ collection agency
and initiate legal proceedings

Discounts and Default Risk

Define:
 = percentage of credit sales that go uncollected
d = percentage discount allowed for cash customers
P = credit price (no discount)
P = cash price = P(1 – d)

Assuming no change in Q, then:

Net incremental cash flow = [(1 - )P - v]Q – (P – v)Q = PQ(d - )

NPV = -PQ + PQ(d - )/R

A break-even application:
 = d – R(1 – d) is the break-even default rate.

3.4 Inventory Management

The Financial Manager and Inventory Policy

Many people, not just those in the finance function, influence the level of inventory. Nonetheless,
financial managers see the results of inventory decisions in many places – ROA, inventory turnover and
Days’ Sales in Inventory ratios, to name a few.
Dell has one of the best inventory management systems in place. There have been numerous articles
written in the financial press concerning their policies. The management at Dell believes that by carrying
low levels of inventory on hand, they are able to pass the savings along to customers when component
prices drop, which happens regularly. They are also able to stay on top of the new technology and offer it
to customers as soon as it becomes available instead of trying to get rid of out-dated equipment. In fact,
Dell is so effective at managing its inventory and receivables, that it has historically had a negative cash
cycle, meaning that the firm is selling and collecting on inventory before it is paying for it!

Inventory Types

For a manufacturer, inventory is classified into one of three categories:

(1) Raw materials, (2) Work-in-progress, (3) Finished goods

Classification into one of these categories depends on the firm’s business; what are raw materials for
one firm may be finished goods for another. Inventory types have different levels of liquidity. Demand
for raw materials and work-in-progress depends on the demand for finished goods.

Inventory Costs
There are two basic types of costs associated with current assets in general and inventory in particular –
carrying costs and shortage costs.

: Boeing Corporation is one of the largest manufacturers of military aircraft in the world. For many years,
the firm has employed hundreds of subcontractors not only to produce aircraft components, but also to
maintain stocks of raw materials inventory for the firm. Inventory managers have found that it is often
less costly to pay someone to maintain these inventories.

Inventory Management Techniques

The ABC Approach

Inventory is subdivided into three (or more) groups, and the groups are analyzed to determine the
relationship between inventory value and quantity represented in each group.

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The Economic Order Quantity Model

EOQ – the restocking quantity that minimizes total inventory costs based on the assumption that
inventory is depleted at a steady pace.

Total carrying costs = (average inventory)(carrying cost per unit)

= (Q/2)(CC)

Total restocking costs = (fixed cost per order)(number of orders)

= F(T/Q)

Total costs = carrying costs + restocking costs

= (Q/2)(CC) + F(T/Q)

EOQ=
√ 2 TF
CC
The EOQ is the point where the total carrying costs just equal the total restocking costs.
Q T
TC= CC+F
2 Q
∂TC CC −FT
= + 2 =0
∂Q 2 Q
CC FT
= 2
2 Q
2 2 FT
Q=
CC
Q=
√ 2 FT
CC
The EOQ model assumes that the firm’s inventory is depleted at a constant rate until it hits zero. Firms
with seasonal demand may not be able to use the EOQ model without some adjustments. One way to
adjust the equation is to compute “T” based on the high sales level and use that number to compute the
EOQ during periods of high sales. Conversely, during periods of low sales, compute “T” based on the
low sales figures and use that number to compute EOQ. What will happen is that the “optimal” order
quantity will change depending on the seasonality in sales. Another option is to develop a cost formula
that accounts for the seasonality and then use calculus to minimize the new cost function.

Extensions to the EOQ Model

Safety stocks – minimum level of inventory that must be kept on hand; inventory won’t actually reach
zero; will increase the carrying cost component above what is predicted by the EOQ model
Reorder points – place orders before inventory reaches a critical level. Designed to account for delivery
time

Managing Derived-Demand Inventories

Materials Requirements Planning – computer based systems that manage the manufacturing process
to make sure that inventory will be available when it is required
Just-in-Time Inventory – order inventory so that it will arrive when needed. Reduces the cost of storing
inventory.

The primary advantage of JIT systems is the reduction in inventory carrying costs that, for a large
manufacturer, can be substantial. As with every financial decision, however, there is no increase in
return without an increase in risk. In this instance, the risk is that an interruption in the supply of
inventory items will require the user to shut down production virtually immediately. As part of a larger
program to reduce costs, GM adopted a variant of the JIT system, but found it necessary to temporarily
halt production of some models in early 1994 as a result of labor strikes at a supplier’s plants.

Leverage in a Business: The use of fixed charge obligations with the intent of magnifying the
potential return to the firm.

A. Fixed operating costs: Those operating costs that remain relatively constant regardless of the
volume of operations such as rent, depreciation, property taxes, and executive salaries.

B. Fixed financial costs: The interest costs arising from debt financing that must be paid regardless of
the level of sales or profits.

Operating Leverage
A. Break-even analysis: A numerical and graphical technique used to determine at what point
the firm will break even.
1. Break-even point: the unit sales where total revenue = total costs
2. Contribution Margin per unit is sales price (per unit) minus variable costs per unit.
3. Formula for break-even point in units:

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FixedCosts
BE=
Contribution Margin per Unit
B. The risk factor in using financial leverage depends on the firm’s operations relative to its
breakeven point and it operating leverage. Management’s willingness to take risk is also a
function of its view of future economic conditions.

C. Cash break-even analysis

1. Deducting non-cash fixed expenses such as depreciation in the break-even
analysis enables one to determine the break-even point on a cash basis.

2. Cash break-even point formula:

Fixed Costs - (Non-cash Fixed Costs )

Cash BE =
Contribution Margin per Unit
3. Although cash break-even analysis provides additional insight, the emphasis in
the chapter is on the more traditional accounting-data related break-even
analysis.

D. Operating leverage: A reflection of the extent fixed assets and fixed costs are utilized in
the business firm. The employment of operating leverage causes operating profit to
be more sensitive to changes in sales.

1. The use of operating leverage increases the potential return but it also increases
potential losses.
2. The amount of leverage employed depends on anticipated economic conditions,
nature of the business (cyclical or noncyclical), and the risk aversion of
management.
3. The sensitivity of a firm's operating profit to a change in sales as a result of the
employment of operating leverage is reflected in its degree of operating
leverage.
4. Degree of operating leverage (DOL) is defined as the ratio of percentage
change in operating income in response to percentage change in volume.

DOL = % change in operating income

% change in volume

5. The DOL may also be computed using the formula:

Q (P - VC) CM
DOL =
Q(P - VC) - FC EBIT
where:
Q = quantity at which DOL is computed
P = price per unit
VC = variable cost per unit
FC = fixed costs
CM = Contribution Margin
EBIT= Earnings Before Interest and Taxes

6. DOL and other measures of leverage always apply to the starting point for the
range used in the computation.

7. The normal assumption in doing break-even analysis is that a linear function

exists for revenue and costs as volume changes. This is probably reasonable
over a reasonable range. However, for more extreme levels of operations,
there may be revenue weakness and cost overruns. Some non-linearity may
exist.

3.5. Financial Leverage: A measure of the amount of debt used in the capital structure of the firm.

A. Two firms may have the same operating income but greatly different net incomes due to the
magnification effect of financial leverage. The higher the financial leverage, the greater the profits
or losses at high or low levels of operating profit, respectively.

B. While operating leverage primarily pertains to the left-hand side of the balance sheet (assets and
associated costs), financial leverage deals with the right-hand side of the balance sheet (liabilities
and net worth).

C. Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a higher rate
of return than the interest rate on the borrowed amount. The extent of a firm's use of financial
leverage may be measured by computing its degree of financial leverage (DFL). The DFL is the
ratio of the percentage change in net income (or earnings per share) in response to a percentage
change in EBIT.

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D. The DFL may also be computed utilizing the following formula:

Where:

EBIT =
% change in EPS EBIT
DFL = DFL =
% change in EBIT EBT
Earnings Before Interest and Taxes
EBT = Earnings Before Taxes

E. The DFL is associated with a specific level of EBIT and changes as EBIT changes.

F. The purpose of employing financial leverage is to increase return to the owners but its use also
increases their risk.

G. The use of financial leverage is not unlimited.

1. Interest rates that a firm must pay for debt-financing rise as it becomes more highly
leveraged.
2. As the risk to the stockholders increases with leverage, their required rate of return
increases and stock prices may decline.

4.2. Combining Operating and Financial Leverage

A. Combining operating and financial leverage provides maximum magnification of returns-it also
magnifies the risk.
B. The combined leverage effect can be illustrated through the income statement.

C. The degree of combined leverage (DCL) is a measure of the effect on net income as a result of a
change in sales. The DCL is computed similar to DOL or DFL
% change in EPS
DCL =
D. The DCL may also be computed as follows: % change in sales
Q(P - VC) CM
DCL =
Q(P - VC) - FC - I EBT

EXERCISES AND PROBLEMS

1. Changes in the Cash Account

Indicate the impact of the following corporate actions on cash, using the letter I for an increase, D for a decrease,
or N when no change occurs:
a. A dividend is paid with funds received from a sale of debt.
b. Real estate is purchased and paid for with short-term debt.
c. Inventory is bought on credit.
d. A short-term bank loan is repaid.
e. Next year's taxes are prepaid.
f. Preferred stock is redeemed.
g. Sales are made on credit.
h. Interest on long-term debt is paid.
i. Payments for previous sales are collected.
j. The accounts payable balance is reduced.
k. A dividend is paid.
l. Production supplies are purchased and paid for with a short-term note.
m. Utility bills are paid.
n. Cash is paid for raw materials purchased for inventory.
o. Marketable securities are sold.

2. Cash Equation
Rocco Corp. has a book net worth of P10,380. Long-term debt is P7,500. Net working capital, other than cash, is
P2,105. Fixed assets are P15,190. How much cash does the company have? If current liabilities are P1,450, what
are current assets?

3. Changes in the Operating Cycle

Indicate the effect that the following will have on the operating cycle. Use the letter I to indicate an increase, the
letter D for a decrease, and the letter N for no change:
a. Average receivables goes up.
b. Credit repayment times for customers are increased.
c. Inventory turnover goes from 3 times to 6 times.
d. Payables turnover goes from 6 times to 11 times.
e. Receivables turnover goes from 7 times to 9 times.
f. Payments to suppliers are accelerated.

4. Changes in Cycles
Indicate the impact of the following on the cash and operating cycles, respectively. Use the letter I to indicate an
increase, the letter D for a decrease, and the letter N for no change:

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a. The terms of cash discounts offered to customers are made less favorable.
b. The cash discounts offered by suppliers are decreased; thus, payments are made earlier.
c. An increased number of customers begin to pay in cash instead of with credit.
d. Fewer raw materials than usual are purchased.
e. A greater percentage of raw material purchases are paid for with credit.
f. More finished goods are produced for inventory instead of for order.

5. Calculating Cash Collections

The Morning Jolt Coffee Company has projected the following quarterly sales amounts for the coming year:

a. Accounts receivable at the beginning of the year are P360. Morning Jolt has a 45-day collection period.
Calculate cash collections in each of the four quarters by completing the following:

b. Rework (a) assuming a collection period of 60 days.

c. Rework (a) assuming a collection period of 30 days.

6. Calculating Cycles
Consider the following financial statement information for the Mediate Corporation:

Calculate the operating and cash cycles. How do you interpret your answer?

7. Factoring Receivables.
Your firm has an average collection period of 32 days. Current practice is to factor all receivables immediately at a
1.5 percent discount. What is the effective cost of borrowing in this case? Assume that default is extremely
unlikely.

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8. Calculating Payments
Iron Man Products has projected the following sales for the coming year:

Sales is projected to be 15 percent greater in each quarter.

a. Calculate payments to suppliers assuming that Iron Man places orders during each quarter equal to 30
percent of projected sales for the next quarter. Assume that Iron Man pays immediately. What is the payables
period in this case?

Last year Q1 Q2 Q3 Q4
Q4

Sales 820 860 930 990

Purchases

Payments of
Accounts

b. Rework (a) assuming a 90-day payables period.

Last year Last year Last year Q1 Q2 Q3 Q4

Q2 Q3 Q4

Sales 820 860 930 990

Purchases

Payments of
Accounts

c. Rework (a) assuming a 60-day payables period.

Last year Last year Last year Q1 Q2 Q3 Q4

Q2 Q3 Q4

Sales 820 860 930 990

Purchases

Payments of
Accounts

9. Calculating Payments
The Torrey Pine Corporation's purchases from suppliers in a quarter are equal to 75 percent of the next quarter's
forecast sales. The payables period is 60 days. Wages, taxes, and other expenses are 20 percent of sales, and
interest and dividends are P90 per quarter. No capital expenditures are planned. Projected quarterly sales are
shown here:

Sales for the first quarter of the following year are projected at P1,090. Calculate the company's cash outlays by
completing the following:

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10. Calculating Cash Collections

The following is the sales budget for Trickle, Inc., for the first quarter of 2009:

Credit sales are collected as follows:

65 percent in the month of the sale

20 percent in the month after the sale
15 percent in the second month after the sale

The accounts receivable balance at the end of the previous quarter was P173,000 (P136,000 of which was
uncollected December sales).

a. Compute the sales for November

b. Compute the sales for December.

c. Compute the cash collections from sales for each month from January through March.

Month/Sales Nov Dec January February March

Budget 235,000 260,000 295,000
November
December
January
February
March

11. Calculating the Cash Budget

Here are some important figures from the budget of Nashville Nougats, Inc., for the second quarter of 2009:

The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its sales will be
collected in the month of the sale, and the remaining 60 percent will be collected in the following month. Credit
purchases will be paid in the month following the purchase.

In March 2009, credit sales were P245,000, and credit purchases were P168,000. Using this information,
complete the following cash budget:

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12. Applying Percentage of Sales

The balance sheet for the Heir Jordan Corporation follows. Based on this information and the income statement in
the previous problem, supply the missing information using the percentage of sales approach. Assume that
accounts payable vary with sales, whereas notes payable do not. Put “n/a” where needed.

EFN and Sales

Prepare a pro forma balance sheet showing EFN, assuming a 15 percent increase in sales, no new external debt
or equity financing, and a constant payout ratio.

13. Internal Growth

If the Baseball Shoppe has an 8 percent ROA and a 20 percent payout ratio, what is its internal growth rate?

14. Sustainable Growth

If the Garnett Corp. has a 15 percent ROE and a 25 percent payout ratio, what is its sustainable growth rate?

15. Sustainable Growth

Based on the following information, calculate the sustainable growth rate for Kaleb's Kickboxing:

16. Sources and Uses

Below are the most recent balance sheets for Country Kettles, Inc. Excluding accumulated depreciation,
determine whether each item is a source or a use of cash, and the amount:

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17. Costs of Borrowing

You've worked out a line of credit arrangement that allows you to borrow up to P50 million at any time. The
interest rate is .64 percent per month. In addition, 5 percent of the amount that you borrow must be deposited in a
non-interest-bearing account. Assume that your bank uses compound interest on its line of credit loans.
a. What is the effective annual interest rate on this lending arrangement?

b. Suppose you need P15 million today and you repay it in six months. How much interest will you pay?

18. Costs of Borrowing

A bank offers your firm a revolving credit arrangement for up to P70 million at an interest rate of 2.3 percent per
quarter. The bank also requires you to maintain a compensating balance of 4 percent against the unused portion of
the credit line, to be deposited in a non-interest-bearing account. Assume you have a short-term investment
account at the bank that pays 1.20 percent per quarter, and assume that the bank uses compound interest on its
revolving credit loans.
a. What is your effective annual interest rate (an opportunity cost) on the revolving credit arrangement if your firm
does not use it during the year?

b. What is your effective annual interest rate on the lending arrangement if you borrow P45 million immediately
and repay it in one year?

c. What is your effective annual interest rate if you borrow P70 million immediately and repay it in one year?

Minicase: Wildcat, Inc., (Case 4)

Calculating the Cash Budget

Wildcat, Inc., has estimated sales (in millions) for the next four quarters as follows:

Sales for the first quarter of the year after this one are projected at P240 million. Accounts receivable at the
beginning of the year were P68 million. Wildcat has a 45-day collection period.

Wildcat's purchases from suppliers in a quarter are equal to 45 percent of the next quarter's forecast sales, and
suppliers are normally paid in 36 days. Wages, taxes, and other expenses run about 25 percent of sales. Interest
and dividends are P12 million per quarter.

Wildcat plans a major capital outlay in the second quarter of P80 million. Finally, the company started the year
with a P64 million cash balance and wishes to maintain a P30 million minimum balance.

a. Complete a cash budget for Wildcat by filling in the following:

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b. Assume that Wildcat can borrow any needed funds on a short-term basis at a rate of 3 percent per quarter and can
invest any excess funds in short-term marketable securities at a rate of 2 percent per quarter. Prepare a short-term
financial plan by filling in the following schedule. What is the net cash cost (total interest paid minus total
investment income earned) for the year?

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Cash Management Policy :

Rework Problem 20 assuming:

a. Wildcat maintains a minimum cash balance of P50 million.

b. Wildcat maintains a minimum cash balance of P10 million.

Based on your answers in (a) and (b), do you think the firm can boost its profit by changing its cash management
policy? Are there other factors that must be considered as well? Explain.

Costs of Borrowing

In exchange for a P400 million fixed commitment line of credit, your firm has agreed to do the following:
1. Pay 1.9 percent per quarter on any funds actually borrowed.

2. Maintain a 4 percent compensating balance on any funds actually borrowed.

3. Pay an up-front commitment fee of .140 percent of the amount of the line.

Based on this information, answer the following:

a. Ignoring the commitment fee, what is the effective annual interest rate on this line of credit?

b. Suppose your firm immediately uses P130 million of the line and pays it off in one year. What is the effective
annual interest rate on this P130 million loan?

c. Assuming Come and Go Bank offers your firm a 10 percent discount interest loan for up to P25 million, and
in addition requires you to maintain a 5 percent compensating balance against the amount borrowed. What
is the effective annual interest rate on this lending arrangement?

PART 4. CASH FLOW VALUATION

Learning Outcome:

4. The student will be able to determine the value of future cash flows using by:
4.1 computing the future value of an investment made today, present value of cash to be received at a future date,
the return on investment; how long it takes for an investment to reach a desired value; the effective annual
rate of return for a given cash flow stream;
4.2 discounting the value of cash flows; and
4.3 valuing the bonds and stocks.

4.1 Time Value of Money (Ch 05 - Time Value of Money)

 Money has a time value associated with it and therefore a peso received today is worth more than a peso
received in the future.
 The future value is based on the number of periods over which the funds are to be compounded at a given
interest rate.
 The present value is based on the current value of funds to be received.
 Not only can future value and present value be computed, but other factors such as yield (rate of return) can
be determined as well.
 Compounding or discounting may take place on a less than annual basis such as semiannually or monthly.

A. Investing for a single period

In determining future value, we measure the value of an amount that is allowed to grow at a give interest rate
over a period of time.

FV = PV (1+i)n
The relationship may be expressed by the following formula:

FV = PV x FV IF
The formula may be restated as: The FVIF term is found in Table 1

If you invest PX today at an interest rate of r, you will have PX + PX(r) = PX(1 + r) in one period.

Example: P100 at 10% interest gives P100(1.1) = P110

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Table 1. Future Value of P1

B. Investing for more than one period

Reinvesting the interest, we earn interest on interest, i.e., compounding

FV = PX(1 + r)(1 + r) = PX(1 + r)2

Example: P100 at 10% for 2 periods gives P100(1.1)(1.1) = P100(1.1)2 = P121

In general, for t periods, FV = PX(1 + r)t, where (1 + r)t is the future value interest factor, FVIF(r,t)

Example: P100 at 10% for 10 periods gives P100(1.1)10 = P259.37

The interest rate is really just the “growth” rate of money, and the future value formula can be used more
generally to find the future amount of anything that is expected to grow at a constant rate over a set number of
periods.

C. Present Value and Discounting

1. The Single-Period Case

The present value of a future sum is the amount invested today, at a given interest rate that will
equal the future sum at a specified point in time.
The relationship may be expressed in the following formula:

1
PV = FV
(1+i )n

or PV = FV (1 + r)-n

Example: P110 in 1 period with an interest rate of 10% has a

PV = 110 / (1.1) = P100

Discounting – the process of finding the present value.

Table 2. Present Value of P1(PVIF)

2. Present Values for Multiple Periods

PV of future amount in t periods at r is:

PV = FV [1 / (1 + r)t],
where [1 / (1 + r)t] is the discount factor, or the present value interest factor,
PVIF(r,t)
Example: If you have P259.37 in 10 periods and the interest rate was 10%, how much did you
deposit initially? PV = 259.37 [1/(1.1)10] = 259.37(.3855) = P100

Discounted Cash Flow (DCF) – the process of valuation by finding the present value

3. Determining the Discount Rate

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FV = PV(1 + r)t
r = (FV / PV)1/t – 1

Example: What interest rate makes a PV of P100 become a FV of P150 in 6 periods? r = (150 /
100)1/6 – 1 = 7%

4. Finding the Number of Periods

FV = PV(1 + r)t – rearrange and solve for t. Remember your logs!

t = ln(FV / PV) / ln(1 + r)

Example: How many periods before P100 today grows to P150 at 7%?
t = ln(150 / 100) / ln(1.07) = 6 periods

Rule of 72 – the time to double your money,

(FV / PV) = 2.00, is approximately (72 / r%) periods.

The rate needed to double your money is approximately (72/t)%.

Example: To double your money at 10% takes approximately (72/10) = 7.2 periods.

EXERCISES & PROBLEMS

1. Simple Interest versus Compound Interest

First City Bank pays 8 percent simple interest on its savings account balances, whereas Second City Bank pays 8
percent interest compounded annually. If you made a P5,000 deposit in each bank, how much more money would
you earn from your Second City Bank account at the end of 10 years?

2. Calculating Future Values

For each of the following, compute the future value:

3. Calculating Present Values

For each of the following, compute the present value:

4. Calculating Interest Rates

Solve for the unknown interest rate in each of the following:

5. Calculating the Number of Periods

Solve for the unknown number of years in each of the following:

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6. Calculating Interest Rates

Assume the total cost of a college education will be P290,000 when your child enters college in 18 years. You
presently have P55,000 to invest. What annual rate of interest must you earn on your investment to cover the
cost of your child's college education?

7. Calculating the Number of Periods

At 7 percent interest, how long does it take to double your money? To quadruple it?

8. Calculating Interest Rates

In January 2007, the average house price in the United States was P314,600. In January 2000, the average price
was P200,300. What was the annual increase in selling price?

9. Calculating the Number of Periods

You're trying to save to buy a new P170,000 Ferrari. You have P40,000 today that can be invested at your bank.
The bank pays 5.3 percent annual interest on its accounts. How long will it be before you have enough to buy the
car?

10. Calculating Present Values

Imprudential, Inc. has an unfunded pension liability of P650 million that must be paid in 20 years. To assess the
value of the firm's stock, financial analysts want to discount this liability back to the present. If the relevant
discount rate is 7.4 percent, what is the present value of this liability?

11. Calculating Present Values

You have just received notification that you have won the P1 million first prize in the Centennial Lottery.
However, the prize will be awarded on your 100th birthday (assuming you're around to collect), 80 years from
now. What is the present value of your windfall if the appropriate discount rate is 10 percent?

12. Calculating Future Values

Your coin collection contains fifty 1952 silver pesos. If your grandparents purchased them for their face value
when they were new, how much will your collection be worth when you retire in 2057, assuming they appreciate
at a 4.5 percent annual rate?

13. Calculating Interest Rates and Future Values

In 1895, the first U.S. Open Golf Championship was held. The winner's prize money was P150. In 2007, the
winner's check was P1,260,000. What was the percentage increase per year in the winner's check over this
period? If the winner's prize increases at the same rate, what will it be in 2040?

14. Calculating Interest Rates

In 2008, a gold Morgan peso minted in 1895 sold for P43,125. For this to have been true, what rate of return did
this coin return for the lucky numismatist?

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4.2. DISCOUNTED CASH FLOW ( Ch 06 - Discounted Cash Flow)

A. Future and Present Values of Multiple Cash Flows

Future Value with Multiple Cash Flows

There are two ways to calculate future value of multiple cash flows: compound the accumulated
balance forward one period at a time or calculate the future value of each cash flow and add them
at the ending period (i.e., net future cash flow).

Present Value with Multiple Cash Flows

Assume a contract involving payments of different amounts
each year for a three-year period. To determine the present
value, each payment is discounted to the present and then
totaled at 8% discount rate

Cash Flow Timing

In general, we assume that cash flows occur at the end of each time period. This assumption is
implicit in the ordinary annuity formulas presented.

B. Valuing Level Cash Flows: Annuities and Perpetuities

1. Present Value for Annuity Cash Flows

The present value of an annuity represents the sum of the present value of the individual flows.
The formula for the present value of an annuity is:

1−( 1+r ) -n
PV =C ( ) or PVA = C x PVIFA
r
The terms in the formula for the present value of an annuity are transformed to find C.
PV A
C =
PV IFA

The Table 3. Present Value of Annuity ( PVIFA)

The annuity value equal to a present value is often associated with withdrawal of funds from an
initial deposit or the repayment of a loan.

Example: If you are willing to make 36 monthly payments of P100 at 1.5% per month, what size
loan can you obtain?
PV = 100[1 – 1/(1.015)36] / .015 = 100(27.6607) = 2766.07

The interest paid in any year is equal to the sum of the payments made during the year minus the
change in principal. After 228 months (19 years), the outstanding loan balance is P97,161.79.
The change in principal is 97,161.79 – 91,334.41 = 5,827.38.

Total interest paid in year 20 = 12(1096.11) – 5,827.38 = P7,325.94.

C = PV {r / [1 – 1/(1 + r)t]}

Example: If you borrow P400, promising to repay in 4 monthly installments at 1% per month, how
much are your payments?
C = 400 {.01 / [1 – 1/(1.01)4]} = 400(.2563) = 102.51

Finding the number of payments given PV, C and r:

PV = C [1 – 1/(1 + r)t] / r
t = ln[1 / (1 – rPV/C)] / ln(1 + r)

Example: How many P100 payments will pay off a P5,000 loan at 1% per period?
t = ln[(1 / 1 - .01(5,000)/100)] / ln(1.01) = 69.66 periods

Finding the rate given PV, C and t:

Trial and error requires you to choose a discount rate, find the PV and compare to the actual PV. If
the computed PV is too high, then choose a higher discount rate and repeat the process. If the

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computed PV is too low, then choose a lower discount rate and repeat the process.

2. Future Value for Annuities

FV = C[(1 + r)t – 1] / r

Example: Assuming, A = P1,000, n = 4, and i = 10%

FVa = 1,000 x 4.641 = 4,641

3. Present value of deferred annuity.

Two step solution process

Single step solution

PVIFA for total period
-PVIFA for initial period
PVIFA for deferred period x annuity

Table 4. Future value of an annuity (FVIFA)

Summary
Formula Table
Future value of a single amount FV = PV x FVIF 1
Present value of a single amount PV = FV x PVIF 2
Present value of an annuity PVA = A x PFIFA 3
Future value of an annuity FVA = A x FVIFA 4
Annuity equaling a future value A = FVA ÷ FVIFA 4
Annuity equaling a present value A = PVA ÷ PVIFA 3

4. Perpetuities

Perpetuity – series of level cash flows forever : PV = C / r

Preferred stock is a good example of a perpetuity.

Growing Annuities and Perpetuities

Growing annuity: a growing stream of cash flows with a fixed maturity

C1
[ ( )]
T
1+g
1−
PV =
r−g 1+r
Growing perpetuity: a stream of cash flows that grows at a constant rate forever
PV = C1 / (r-g)

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5. Comparing Rates: The Effect of Compounding

1. Effective Annual Rates and Compounding

Stated or quoted interest rate – rate before considering any compounding effects, such as
10% compounded quarterly

Effective annual interest rate – rate on an annual basis that reflects compounding effects,
e.g. 10% compounded quarterly has an effective rate of 10.38%.

2. Calculating and Comparing Effective Annual Rates (EAR)

EAR = [1 + (quoted rate)/m]m – 1, where m is the number of periods per year

Example: 18% compounded monthly is [1 + (.18/12)]12 – 1 = 19.56%

Annual percentage rate (APR) = period rate times the number of compounding periods
per year

3. Yield -- Present value of an annuity

a. The rate equating C to PV must be found.

PV A
PV IFA =
C
b. The first step is to determine PVIFA.
c. The next step is to find this value in Table 4 so the yield may be identified.
d. Interpolation may be used to find a more exacting answer.

6. Loan Types and Loan Amortization

1. Pure Discount Loans

Borrower pays a single lump sum (principal and interest) at maturity. Treasury bills are a
common example of pure discount loans.

2. Interest-Only Loans

Borrower pays interest only each period and the entire principal at maturity. Corporate
bonds are a common example of interest-only loans.

3. Amortized Loans

Borrower repays part or all of the principal over the life of the loan. Two methods are (1)
fixed amount of principal to be repaid each period, which results in uneven payments; and
(2) fixed payments, which results in uneven principal reduction. Traditional auto and
mortgage loans are examples of the second type of amortized loans.

Notice that in each year, the interest paid is given by the beginning balance multiplied by
the interest rate. Also notice that the beginning balance is given by the ending balance
from the previous year. Probably the most common way of amortizing a loan is to have
the borrower make a single, fixed payment every period. Almost all consumer loans (such
as car loans) and mortgages work this way. For example, suppose our five-year, 9
percent, P5,000 loan was amortized this way. How would the amortization schedule look?

Determine first the payment.

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The borrower will therefore make five equal payments of P1,285.46.

In the first year, the interest is P450, as we calculated before. Because the total payment
is P1,285.46, the principal
paid in the first year must be:

The interest in the second

year is P4,164.54 × .09 =
P374.81, and the loan
balance declines by P1,285.46 − 374.81 = P910.65. We can summarize all of the relevant
calculations in the following schedule:

Because the loan balance declines to zero, the five equal payments do pay off the loan.
Notice that the interest paid declines each period. This isn't surprising because the loan
balance is going down. Given that the total payment is fixed, the principal paid must be
rising each period.

If you compare the two loan amortizations in this section, you will see that the total
interest is greater for the equal total payment case: P1,427.31 versus P1,350. The reason
for this is that the loan is repaid more slowly early on, so the interest is somewhat higher.
This doesn't mean that one loan is better than the other; it simply means that one is
effectively paid off faster than the other. For example, the principal reduction in the first
year is P835.46 in the equal total payment case as compared to P1,000 in the first case.

Exercises & Problems

1. Present Value and Multiple Cash Flows

Seaborn Co. has identified an investment project with the following
cash flows. If the discount rate is 10 percent, what is the present
value of these cash flows? What is the present value at 18
percent? At 24 percent?

2. Present Value and Multiple Cash Flows

Investment X offers to pay you P6,000 per year for nine years, whereas Investment Y offers to pay you P8,000
per year for six years. Which of these cash flow streams has the higher present value if the discount rate is 5
percent? If the discount rate is 15 percent?

3. Future Value and Multiple Cash Flows

Paradise, Inc., has identified an investment project with the following
cash flows. If the discount rate is 8 percent, what is the future value of
these cash flows in year 4? What is the future value at a discount rate of 11 percent? At 24 percent?

4. Calculating Annuity Present Value

An investment offers P5,300 per year for 15 years, with the first payment occurring one year from now. If the
required return is 7 percent, what is the value of the investment? What would the value be if the payments
occurred for 40 years? For 75 years? Forever?

5. Calculating Annuity Cash Flows

If you put up P34,000 today in exchange for a 7.65 percent, 15-year annuity, what will the annual cash flow be?

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6. Calculating Annuity Values

Your company will generate P73,000 in annual revenue each year for the next eight years from a new
information database. If the appropriate interest rate is 8.5 percent, what is the present value of the savings?

7. Calculating Annuity Values

If you deposit P4,000 at the end of each of the next 20 years into an account paying 11.2 percent interest, how
much money will you have in the account in 20 years? How much will you have if you make deposits for 40
years?

8. Calculating Annuity Values

You want to have P90,000 in your savings account 10 years from now, and you're prepared to make equal
annual deposits into the account at the end of each year. If the account pays 6.8 percent interest, what amount
must you deposit each year?

9. Calculating Annuity Values

Dinero Bank offers you a P50,000, seven-year term loan at 7.5 percent annual interest. What will your annual
loan payment be?

10. Calculating Perpetuity Values

The Maybe Pay Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs
P25,000 per year forever. If the required return on this investment is 7.2 percent, how much will you pay for the
policy?

11. Calculating Perpetuity Values

In the previous problem, suppose a sales associate told you the policy costs P375,000. At what interest rate
would this be a fair deal?

12. Calculating EAR

Find the EAR in each of the following cases:

13. Calculating APR

Find the APR, or stated rate, in each of the following cases:

14. Calculating EAR

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First National Bank charges 14.2 percent compounded monthly on its business loans. First United Bank charges
14.5 percent compounded semiannually. As a potential borrower, which bank would you go to for a new loan?

15. Calculating APR

Barcain Credit Corp. wants to earn an effective annual return on its consumer loans of 16 percent per year. The
bank uses daily compounding on its loans. What interest rate is the bank required by law to report to potential
borrowers? Explain why this rate is misleading to an uninformed borrower.

16. Calculating Future Values

What is the future value of P2,100 in 17 years assuming an interest rate of 8.4 percent compounded
semiannually?

17. Calculating Future Values

Gold Door Credit Bank is offering 9.3 percent compounded daily on its savings accounts. If you deposit P4,500
today, how much will you have in the account in 5 years? In 10 years? In 20 years?

18. Calculating Present Values

An investment will pay you P58,000 in seven years. If the appropriate discount rate is 10 percent compounded
daily, what is the present value?

19. EAR versus APR

Big Dom's Pawn Shop charges an interest rate of 30 percent per month on loans to its customers. Like all
lenders, Big Dom must report an APR to consumers. What rate should the shop report? What is the effective
annual rate?

20. Calculating Loan Payments

You want to buy a new sports coupe for P68,500, and the finance office at the dealership has quoted you a 6.9
percent APR loan for 60 months to buy the car. What will your monthly payments be? What is the effective
annual rate on this loan?

21. Calculating Number of Periods

One of your customers is delinquent on his accounts payable balance. You've mutually agreed to a repayment
schedule of P500 per month. You will charge 1.3 percent per month interest on the overdue balance. If the
current balance is P18,000, how long will it take for the account to be paid off?

22. Calculating EAR

Friendly's Quick Loans, Inc., offers you “three for four or 1 knock on your door.” This means you get P3 today
and repay P4 when you get your paycheck in one week (or else). What's the effective annual return Friendly's
earns on this lending business? If you were brave enough to ask, what APR would Friendly's say you were
paying?

23. Valuing Perpetuities

Live Forever Life Insurance Co. is selling a perpetuity contract that pays P1,800 monthly. The contract currently
sells for P95,000. What is the monthly return on this investment vehicle? What is the APR? The effective annual
return?

24. Calculating Annuity Future Values

You are planning to make monthly deposits of P300 into a retirement account that pays 10 percent interest
compounded monthly. If your first deposit will be made one month from now, how large will your retirement
account be in 30 years?

25. Calculating Annuity Future Values

In the previous problem, suppose you make P3,600 annual deposits into the same

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retirement account. How large will your account balance be in 30 years?

26. Calculating Annuity Present Values

Beginning three months from now, you want to be able to withdraw P2,300 each quarter from your bank account
to cover college expenses over the next four years. If the account pays .65 percent interest per quarter, how
much do you need to have in your bank account today to meet your expense needs over the next four years?

27. Discounted Cash Flow Analysis

If the appropriate discount rate for the following cash flows is 11 percent
compounded quarterly, what is the present value of the cash flows?

28. Discounted Cash Flow Analysis

If the appropriate discount rate for the following cash flows is 8.45
percent per year, what is the present value of the cash flows?

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MINICASE: HOUSE IN DUBAI – CASE 5

Ahmed Al Sadeq is about to make his dream of a house of his own come true. For years he has been saving for this
moment and now, after months of searching for a suitable house for his family of four, he found a spacious three-
bedroom detached house with a little garden in the popular Springs neighborhood in Dubai and is about to sign the
purchase contract. He feels comfortable with the financing arrangement he has made. Requiring a 10 percent down
payment on the Dh1,500 million house, Ahmed's bank grants him a 30-year loan (mortgage) with fixed monthly
payments at an annual percentage rate (APR) of 9 percent. He knows that interest will be compounded monthly. Ahmed
brought you along to answer some of his last-minute questions. In particular, Ahmed would like to know:

QUESTIONS

1. The size of the monthly payment required to pay off the loan over the 30-year period;

2. The total payments he is required to make over the life of the loan;

3. How much of the loan would still be outstanding after 20 years of payments;

4. The portion of the monthly payment that goes towards principal reduction versus interest coverage (use the
first payment, the payment at the end of year 10, the payment at the end of year 20, and the very last
payment as an example); and

5. How much interest he would have to pay in a given year (use the first and the last year as an example).

4.3 Bonds and Bond Valuation (Interest Rates and Bond Valuation)

A. Bond Features and Prices

Bonds – long-term IOUs, usually interest-only loans (interest is paid by the borrower every
period with the principal repaid at the end of the loan).

Coupons – the regular interest payments (if fixed amount – level coupon).

Face or par value – principal, amount repaid at the end of the loan

Coupon rate – coupon quoted as a percent of face value

Maturity – time until face value is paid, usually given in years

B. Bond Values and Yields

The cash flows from a bond are the coupons and the face value. The value of a bond
(market price) is the present value of the expected cash flows discounted at the market
rate of interest.

Yield to maturity (YTM) – the required market rate or return, or rate that makes the
discounted cash flows from a bond equal to the bond’s market price.

Example: Suppose Wilhite, Co. issues P1,000 par bonds with 20 years to maturity. The
annual coupon is P110. Similar bonds have a yield to maturity of 11%.

Bond value = PV of coupons + PV of face value

Bond value = 110[1 – 1/(1.11)20] / .11 + 1,000 / (1.11)20
Bond value = 875.97 + 124.03 = P1,000

or N = 20; I/Y = 11; PMT = 110; FV = 1,000; CPT PV = -1,000

Since the coupon rate and the yield are the same, the price should equal face value.

Discount bond – a bond that sells for less than its par value. This is the case when the
YTM is greater than the coupon rate.

Example: Suppose the YTM on bonds similar to that of Wilhite Co. is 13% instead of 11%.
What is the bond price?

Bond price = 110[1 – (1.13) - 20] / .13 + 1,000/(1.13)20

Bond price = 772.72 + 86.78 = 859.50

Premium bond – a bond that sells for more than its par value. This is the case when the
YTM is less than the coupon rate.

Example:

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Consider the Wilhite bond in the previous examples. Suppose that the yield on bonds of
similar risk and maturity is 9% instead of 11%. What will the bonds sell for?

Bond value = 110[1 – (1.09)-20] / .09 + 1,000(1.09)-20

Bond value = 1,004.14 + 178.43 = P1,182.57

General Expression for the value of a bond:

Bond value = present value of coupons + present value of par

Bond value = C[1 – (1+r) -t] / r + FV (1+r)-t

Semiannual coupons – coupons are paid twice a year. Everything is quoted on an annual
basis so you divide the annual coupon and the yield by two and multiply the number of
years by 2.

Example: A P1,000 bond with an 8% coupon rate, with coupons paid semiannually, is
maturing in 10 years. If the quoted YTM is 10%, what is the bond price?

Bond value = 40[1 – (1.05)-20] / .05 + 1,000 (1.05)-20

Bond value = 498.49 + 376.89 = P875.38

C. Interest Rate Risk

Interest rate risk – changes in bond prices due to fluctuating interest rates.

All else equal, the longer the time to maturity, the greater the interest rate risk.

All else equal, the lower the coupon rate, the greater the interest rate risk.

D. Finding the Yield to Maturity: More Trial and Error

It is a trial and error process to find the YTM via the general formula above. Knowing if a
bond sells at a discount (YTM > coupon rate) or premium (YTM < coupon rate) is a help,
but using a financial calculator is by far the quickest, easiest and most accurate method.

E. Bond Features

Is It Debt or Equity?

In general, debt securities are characterized by the following attributes:

-Creditors (or lenders or bondholders) generally have no voting rights.
-Payment of interest on debt is a tax-deductible business expense.
-Unpaid debt is a liability, so default subjects the firm to legal action by its creditors.
It is sometimes difficult to tell whether a hybrid security is debt or equity.
The distinction is important for many reasons, not the least of which is that
(a) the IRS takes a keen interest in the firm’s financing expenses in order to be sure
that nondeductible expenses are not deducted and
(b) investors are concerned with the strength of their claims on firm cash flows.

F. Long-Term Debt: The Basics

Major forms are public and private placement.

Long-term debt – loosely, bonds with a maturity of one year or more.

Short-term debt – less than a year to maturity, also called unfunded debt.
Bond – strictly speaking, secured debt; but used to describe all long-term debt.

G. The Indenture

Indenture – written agreement between issuer and creditors detailing terms of borrowing.
(Also, deed of trust.) The indenture includes the following provisions:

-Bond terms
-The total face amount of bonds issued
-A description of any property used as security
-The repayment arrangements
-Any call provisions
-Any protective covenants

Terms of a bond – face value, par value, and form

Registered form – ownership is recorded, payment made directly to owner
Bearer form – payment is made to holder (bearer) of bond

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Security – debt classified by collateral and mortgage

Collateral – strictly speaking, pledged securities
Mortgage securities – secured by mortgage on real property
Debenture – an unsecured debt with 10 or more years to maturity
Note – a debenture with 10 years or less maturity

Seniority – order of precedence of claims

Subordinated debenture – of lower priority than senior debt

Repayment – early repayment in some form is typical

Sinking fund – an account managed by the bond trustee for early redemption

Call provision – allows company to “call” or repurchase part or all of an issue

Call premium – amount by which the call price exceeds the par value
Deferred call – firm cannot call bonds for a designated period
Call protected – the description of a bond during the period it can’t be called

Protective covenants – indenture conditions that limit the actions of firms

Negative covenant – “thou shalt not” sell major assets, etc.
Positive covenant – “thou shalt” keep working capital at or above PX, etc.

H. Some Different Types of Bonds

1. Government Bonds

Long-term debt instruments issued by a governmental entity. Treasury bonds are bonds
issued by a federal government; a state or local government issues municipal bonds. In
the U.S., Treasuries are exempt from state taxation and “munis” are exempt from federal
taxation.

2. Zero-Coupon Bonds

Zero-coupon bonds are bonds that are offered at deep discounts because there are no
periodic coupon payments. Although no cash interest is paid, firms deduct the implicit
interest on these “original issue discount bonds,” while holders report it as income.
Interest expense equals the periodic change in the amortized value of the bond.

3. Floating-Rate Bonds

Floating-rate bonds – coupon payments adjust periodically according to an index.

put provision - holder can sell back to issuer at par
collar - coupon rate has a floor and a ceiling

4. Other Types of Bonds

Income bonds – coupon is paid if income is sufficient

Convertible bonds – can be traded for a fixed number of shares of stock
Put bonds – shareholders can redeem for par at their discretion

I. Bond Markets

How Bonds are Bought and Sold. Most transactions are OTC (over-the-counter). The
OTC market is not transparent. Daily bond trading volume (in pesos) exceeds stock
trading volume, but trading in individual issues tends to be very thin

J. Inflation and Interest Rates

Real versus Nominal Rates

Nominal rates – rates that have not been adjusted for inflation
Real rates – rates that have been adjusted for inflation

The Fisher Effect

The Fisher Effect is a theoretical relationship between nominal returns, real returns, and
the expected inflation rate. Let R be the nominal rate, r the real rate, and h the expected
inflation rate; then,

(1 + R) = (1 + r)(1 + h)

A reasonable approximation, when expected inflation is relatively low, is R = r + h.

A definition whereby the real rate can be found by deflating the nominal rate by the
inflation rate: r = [(1 + R) / (1 + h)] – 1.

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K. Inflation and Present Values

Discount nominal cash flows at a nominal rate, or real cash flows at a real rate. If you are
consistent, the same answer results.

L. Determinants of Bond Yields

The bond yields that we observe are influenced by six factors:
(1) the real rate of interest, (2) expected future inflation,
(3) interest rate risk, (4) default risk (5) taxability, and
(6) liquidity.

a. Term structure of interest rates –relationship between nominal interest rates on

default-free, pure discount bonds and maturity

b. Inflation premium – portion of the nominal rate that is compensation for expected
inflation

c. Interest rate risk premium – reward for bearing interest rate risk

d. Default risk premium – the portion of a nominal rate that represents compensation for
the possibility of default

e. Taxability premium – the portion of a nominal rate that represents compensation for
unfavorable tax status

f. Liquidity premium – the portion of a nominal rate that represents compensation for
lack of liquidity

N. Valuation Concepts

A. The value of an asset is the present value of the expected cash flows associated with the
asset. In order to compute the present value of an asset, an investor must know or
estimate the amount of expected cash flows, the timing of expected cash flows and the
risk characteristics of the expected flows.

B. Actually, the price (present value) of an asset will be based on the collective assessment
of the asset's cash flow characteristics by the many capital market participants.

Valuation of Bonds

A. The value of a bond is derived from cash flows composed of periodic interest payments
and a principal payment at maturity.
B. The present value (price) of a bond is equal to the present value of the interest payments
plus the present value of the principal (Face Value or Par Value) payment.
n

Pb =
∑ t=1
¿
It Pn
( 1+ r )t ( 1+ r )n
¿

where:
Pb = the market price of the bond
It = the periodic interest payments
Pn = the principal payment at maturity
t = the period from 1 to n
n = the total number of periods
r = the yield to maturity (required rate of return)

C. The present value tables may be used to compute the price of a bond.
1. The stream of periodic interest payments constitutes an annuity. The present value of the
stream of interest payments may be computed by multiplying the periodic interest
payment by the present value of an annuity interest factor.
2. The present value of the principal payment may be computed by applying the present

PV A = C x PVIFA
value of a P1 formula.

PV = FV x PV IF
3. The present value (price) of the bond will be the sum of the present value of the interest
payments plus the present value of the principal.

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D. Concept of Yield to Maturity

1. 3 factors influence an investor's required rate of return on a bond.

a. The required real rate of return-the rate of return demanded for giving up current use of
funds on a non-inflation adjusted basis.
b. An inflation premium-a premium to compensate the investor for the effect of inflation on
the value of the peso.
c. Risk premium: all financial decisions are made within a risk-return framework. An astute
investor will require compensation for risk exposure. There are two types of risk of
concern in determining the required rate of return (yield to maturity) on a bond:
(1) Business risk is the possibility of a firm not being able to sustain its competitive
position and growth in earnings.
(2) Financial risk is the possibility that a firm will be unable to meet its debt
obligations as they come due.

2. Bond prices are inversely related to required rates of return. A change in the required rate
of return will cause a change in the bond price in the opposite direction.

3. The impact of the

change in required rate of return on the bond price is dependent upon the remaining time
to maturity. The impact will be greater as the time to maturity increases.

E. Determining Yield to Maturity from the Bond Price

1. If the bond price, coupon rate, and number of years to maturity are known, the yield to
maturity (market determined required rate of return) can be computed.
a. Trial and error process. This process requires one to "guess" various yields until
the yield to maturity that will cause the present value of the stream of interest

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payments plus the present value of principal payment to equal the bond price is
determined. The initial "guess" is not completely blind, however, since the
relationship between the coupon rate, yield to maturity (market rate), and the bond
price is known.
b. Often, a close approximation of the yield to maturity is sufficient. Using the
approximate yield to maturity approach:
c. An exact calculation of the yield to maturity can be made using a good calculator.
F. Often interest payments are made more frequently than once a year. Semiannual interest

Principal payment - Price of the bond

Annual inter e st payment
Approximate Yield Number of years to maturity
to Maturity . 6 (Price of the bond ) + . 4 (Principal payment )

payments are common. To compute the price of such a bond, we divide the annual
amount of interest and the yield to maturity by two and multiply the number of years to
maturity by two.

EXERCISES & PROBLEMS

1. Interpreting Bond Yields

Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon
rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the
same bond is 8 percent. What is the coupon rate on the bond then? The YTM?

2. Interpreting Bond Yields

Suppose you buy a 7 percent coupon, 20-year bond today when it's first issued. If interest rates suddenly rise to
15 percent, what happens to the value of your bond? Why?

3. Bond prices
Stained, Inc., has 7.5 percent coupon bonds on the market that have 10 years left to maturity. The bonds make
annual payments. If the YTM on these bonds is 8.75 percent, what is the current bond price?

4. Bond Yields
Ackerman Co. has 9 percent coupon bonds on the market with nine years left to maturity. The bonds make
annual payments. If the bond currently sells for P934, what is its YTM?

5. Coupon Rates
Kiss the Sky Enterprises has bonds on the market making annual payments, with 13 years to maturity, and selling
for P1,045. At this price, the bonds yield 7.5 percent. What must the coupon rate be on the bonds?

6. Bond prices
Grohl Co. issued 11-year bonds a year ago at a coupon rate of 6.9 percent. The bonds make semiannual
payments. If the YTM on these bonds is 7.4 percent, what is the current bond price?

7. Bond Yields
Ngata Corp. issued 12-year bonds 2 years ago at a coupon rate of 8.4 percent. The bonds make semiannual
payments. If these bonds currently sell for 105 percent of par value, what is the YTM?

8. Coupon Rates
Ashes Divide Corporation has bonds on the market with 14.5 years to maturity, a YTM of 6.8 percent, and a
current price of P924. The bonds make semiannual payments. What must the coupon rate be on these bonds?

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9. Calculating Real Rates of Return

If Treasury bills are currently paying 7 percent and the inflation rate is 3.8 percent, what is the approximate real
rate of interest? The exact real rate?

10. Inflation and Nominal Returns

Suppose the real rate is 3 percent and the inflation rate is 4.7 percent. What rate would you expect to see on a
Treasury bill?

11. Nominal and Real Returns

An investment offers a 14 percent total return over the coming year. Bill Bernanke thinks the total real return on
this investment will be only 9 percent. What does Bill believe the inflation rate will be over the next year?

12. Nominal versus Real Returns

Say you own an asset that had a total return last year of 11.4 percent. If the inflation rate last year was 4.8
percent, what was your real return?

MINICASE: Real Cash flows – Case 6

Real Cash flows

You are planning to save for retirement over the next 30 years. To save for retirement, you will invest P900 a month in a
stock account in real pesos and P450 a month in a bond account in real pesos. The effective annual return of the stock
account is expected to be 11 percent, and the bond account will earn 7 percent. When you retire, you will combine your
money into an account with a 9 percent effective return. The inflation rate over this period is expected to be 4 percent.

a. How much can you withdraw each month from your account in real terms assuming a 25-year withdrawal
period?

b. What is the nominal peso amount of your last withdrawal?

TOPIC 5 – CAPITAL BUDGETING (Chapter 9)

The student will be able to distinguish feasible investments or projects by:

1. calculating and analyzing the Net Present Value, internal rate of return, payback, discounted payback,
accounting rate of return, break-even analysis;
2. comparing and interpreting the results of the measured values; and
3. deciding what feasible investment should the firm undertake.

I. Characteristics of Capital Budgeting Decisions

A. Capital expenditures are outlays for projects with lives extending beyond one year and perhaps for
many years.
B. Intensive planning is required.
C. Capital expenditures usually require initial cash flows, often large, with the expectation of future
cash inflows. The differing time periods of inflows and outflows require present-value analysis.
D. The longer the time horizon associated with a capital expenditure, the greater the uncertainty.
Areas of uncertainty are:
1. Annual costs and inflows.
2. Product life.
3. Interest rates.
4. Economic conditions.
5. Technological change.

II. Administrative Considerations

A. Search and discovery of investment opportunities
B. Collection of data
C. Evaluation and decision making
D. Reevaluation and adjustment

III. Accounting Flows versus Cash Flows

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A. The capital budgeting process focuses on cash flows rather than income. Income figures do not
reflect the cash available to a firm due to the deduction of noncash expenditures such as
depreciation.
B. Accounting flows are not totally disregarded in the capital budgeting process.
1. Investors' emphasis on earnings per share may, under certain conditions, require use of
income rather than cash as the decision criterion.
2. Top management may elect to glean the short-term personal benefits of an income effect
rather than the long-run cash-flow effects which are more beneficial, from the owner's
viewpoint.

IV. Methods for Ranking Investment Proposals

A. Payback Method
1. The payback period is the length of time necessary for the sum of the expected annual cash
inflows to equal the cash investment. A cutoff period is established for comparison. Capital
proposals with a payback in excess of the cutoff are rejected.

2. Deficiencies of the method

a. Inflows after the cutoff period are ignored.
b. The pattern of cash flows is ignored, therefore, time value of money is not considered.

3. Though not conceptually sound, the payback method is frequently used.

a. Easy to use
b. Emphasizes liquidity
c. Quick return is important to firms in industries characterized by rapid technological
development.

B. Internal Rate of Return (IRR)

1. The IRR method requires calculation of the rate that equates the cash investment with the
cash inflows.
2. The calculation procedure is the same as the yield computation.
a. If the inflows constitute an annuity, the IRR may be computed directly.

Investment
Annuity = IFpva

The IF may then be found in the present value of an annuity table and its correspondent
interest rate (IRR).
b. If the cash inflows do not constitute an annuity, determination of IRR is a trial-and error
process.
c. Interpolation may be used to find a more exacting answer.

3. An investment option that exceeds the minimum return on investment (usually the firm's cost of
capital or some variation of that measure) is a candidate for approval.

C. Net Present Value (NPV)

1. In this method, the cash inflows are discounted at the firm's cost of capital or some variation
of that measure.
2. If the present value of the cash inflows equals or exceeds the present value of the cash
investment, the capital proposal is acceptable.

V. Selection Strategy
A. All non-mutually exclusive projects having an NPV>= 0
(which also means IRR >= cost of capital) should be accepted under normal conditions.
B. The NPV method and the IRR method always agree on the accept-reject decision on a capital
proposal.
C. A disagreement may arise between the NPV and IRR methods when a choice must be made from
mutually exclusive proposals or all acceptable proposals cannot be taken due to capital rationing.
1. The primary cause of disagreement is the differing reinvestment assumptions. The NPV
method inherently assumes reinvestment of cash inflows at the cost of capital. The IRR
method assumes reinvestment of cash inflows at the internal rate of return.
2. The more conservative net present-value technique is usually the recommended
approach when a conflict in ranking arises.

D Modified Internal Rate of Return is an alternative calculation to the IRR and NPV methods.
1. All cash outflows are discounted to the present at the firms cost of capital.
2. All cash inflows are converted to a terminal value by compounding them at the firm’s cost
of capital out to the end of the project.
3. Determine the PV IF factor that equates the present value of the outflows to the future
value of the inflows.

PV
PV IF =
FV
4. Look up the factor for the year that represents the life of the project in the PV table to

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determine the discount rate.

VI. Capital Rationing

A. Management may implement capital rationing by artificially constraining the amount of investment
expenditures.
B. Under capital rationing, some acceptable projects may be declined due to management's fear of
growth or hesitancy to use external financing.
C. Under capital rationing, projects are ranked by NPV and accepted until the rationed amount of
capital is exhausted.

VII. Net Present Value Profile

A. The characteristics of an investment may be summarized by the use of the net present value profile.
B. The NPV profile provides a graphical representation of an investment at various discount rates.
C. Three characteristics of an investment are needed to apply the net present value profile:
1. The net present value at a zero discount rate.
2. The net present value of the project at the normal discount rate (cost of capital).
3. The internal rate of return for the investment.

D. The NPV profile is particularly useful in comparing projects when they are mutually exclusive or
under conditions of capital rationing.

EXERCISES & PROBLEMS

1. Calculating Payback
What is the payback period for the following set of cash flows?

2. Calculating Payback
An investment project provides cash inflows of P765 per year for eight years. What is the project payback period
if the initial cost is P2,400? What if the initial cost is P3,600? What if it is P6,500?

3. Calculating Payback
Buy Coastal, Inc., imposes a payback cutoff of three years for its international investment projects. If the company
has the following two projects available, should it accept either of them?

4. Calculating Discounted
An investment project has annual cash inflows of P4,200, P5,300, P6,100, and P7,400, and a discount rate of 14
percent. What is the discounted payback period for these cash flows if the initial cost is P7,000? What if the initial
cost is P10,000? What if it is P13,000?

5. Calculating Discounted Payback

An investment project costs P15,000 and has annual cash flows of P4,300 for six years. What is the discounted
payback period if the discount rate is zero percent? What if the discount rate is 5 percent? If it is 19 percent?

6. Calculating AAR
You're trying to determine whether to expand your business by building a new manufacturing plant. The plant has
an installation cost of P15 million, which will be depreciated straight-line to zero over its four-year life. If the plant
has projected net income of P1,938,200, P2,201,600, P1,876,000, and P1,329,500 over these four years, what is
the project's average accounting return (AAR)?

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7. Calculating IRR
A firm evaluates all of its projects by applying the IRR rule. If the required return is 16 percent, should the firm
accept the following project?

8. Calculating NPV
For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of
11 percent, should the firm accept this project? What if the required return was 30 percent?

9. Calculating NPV and IRR

A project that provides annual cash flows of P28,500 for nine years costs P138,000 today. Is this a good project if
the required return is 8 percent? What if it's 20 percent? At what discount rate would you be indifferent between
accepting the project and rejecting it?

10. Calculating NPV

For the cash flows in the previous problem, what is the NPV at a discount rate of zero percent? What if the
discount rate is 10 percent? If it is 20 percent? If it is 30 percent?

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Minicase. Sun Star Hotel – Case 7

Said Al Hamli and his friend Khaled Al Masri are the owners of a small hotel, the Sun Star, in the Red Sea town of
Hurghada. Close to Cairo, the resort town has grown from a fishing village to one of Egypt's famous vacation spots.
Hurghada is the gateway to many small islands and offshore reefs favored by recreational snorkelers and divers and
many tourists combine their stay with excursions to the Nile Valley, the Great Pyramids and Luxor. To take advantage
of the growing numbers of tourists, particularly from Europe and the Middle East, Said and Khaled are planning to
double the room capacity of their hotel by adding a second building to the already existing structure. Fortunately, Said
recognized the great potential of Hurghada ten years ago, well before the town became a hub for recreational tourism,
and bought the land adjacent to the hotel for relatively little money when it was still under construction. Now, Said and
Khaled are studying the new layout and trying to determine if the expected revenues justify the substantial initial
investment of EGP 70 million (P11.8 million). According to their
calculations, operating cost would rise by EGP 23.8 million (P4
million) in the first year, which would include hiring and training of
new personnel, maintenance of facilities and equipment etc., and
likely increase by about 5 percent per year thereafter. With an
aggressive marketing strategy, Said and Khaled believe that a
revenue enhancement of EGP 20.8 million in the first year is
realistic and that a subsequent annual increase of about 15 percent
for eight to nine years, with revenues leveling off thereafter, can be
achieved. Ideally, Khaled would like to retire in ten years. Seeking
advice from you, a knowledgeable friend, they share their detailed
cost and revenue projections with you.

QUESTIONS
1. Determine the resulting net cash flow for each year and compute:
a. the net present value,
b. the internal rate of return,
c. the modified internal rate of return,
d. the simple payback period,
e. the discounted payback period,
f. the profitability index.

2. Interpret each result in terms of the project's expected profitability and Khaled's ten-year investment horizon.

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COST OF CAPITAL & RISK AND RETURN

Chapter 08 – Stock Valuation

Chapter 14 – Cost of Capital
Chapter 13 – Risk and Return

Learning Outcomes:

6. The student will be able to determine the firm’s overall cost of capital and its relationship to the required return on
an investment by:
6.1. assessing the primary determinant of the cost of capital for an investment;
6.2. computing a firm’s cost of capital, cost of debt and its overall cost of capital; and
6.3. analyzing their relationship to an investment.

Why Cost of Capital Is Important

A good estimate is required for
 good capital budgeting decisions – neither the NPV rule nor the IRR rule can be implemented without
knowledge of the appropriate discount rate
 financing decisions – the optimal/target capital structure minimizes the cost of capital
 operating decisions – cost of capital is used by regulatory agencies in order to determine the “fair” return
in some regulated industries (e.g. utilities)

I. Cost of Debt

The basic cost of debt to the firm is the effective yield to maturity. The yield to maturity is a market
determined rate and can be found by examining the relationships of security price, periodic interest payments,
maturity value, and length of time to maturity. The yield to maturity for a corporate bond may be found by
solving for Y' in the following equation:
Where:

Pn - Pb
It +
' n
Y =
0. 6 ( Pb ) + 0. 4 (P n )
Y'= the approximate yield to maturity
Pb= the market price of the bond
It = the periodic interest payments
Pn= the principal at maturity
t = the period from 1 to n
n= the total number of periods

Since interest is tax deductible, the actual cost of debt to the firm is less than the yield to maturity.
Assuming: 10% is the cost of debt and tax is 34%

K d = . 10 (1 - . 34 ) = . 066
The after-tax cost of debt is:
The after-tax cost to a firm of bonds issued at par paying P100 annually in interest would be 6.6
percent if the firm's marginal tax rate were 34 percent.

II. Cost of Preferred Stock

Preferred stock is similar to debt in that the preferred dividend is fixed but dissimilar in that dividends are not
tax deductible.

The cost of preferred stock to a firm may be determined by examining the relationship of its annual (usually
fixed) dividend and its market determined price. Preferred stock, unlike debt, has no maturity and therefore
the dividends are expected to be perpetual.

The cost of preferred stock Kp is computed by dividing the annual dividend payment by the net proceeds
received by the firm in the sale of preferred stock.

D
K p=
( P-F)

where:
Kp = cost of preferred stock
D = preferred stock dividend
F = flotation costs per share
P = market price of preferred stock

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Valuation of Preferred/Preference Stock

Preferred stock is usually valued as a perpetual stream of fixed dividend payments.

Dp Dp Dp Dp
Pp = + + +. . .. +
(1+K p )1 (1+K p )2 (1+ K p )3 (1+K )n

where:
Pp = the price of preferred stock
Dp = the annual dividend for preferred stock
Kp = the required rate of return (discount rate) applied to preferred stock dividends

Since the dividend stream is a perpetuity, the preferred stock valuation formula can be reduced to a more
usable form

Dp
Pp =
Kp
If Kp changes after preferred stock is issued, Pp will change in an inverse fashion. Since preferred stock
theoretically has a perpetual life, it is highly sensitive to changes in the required rate of return (Kp).

If the market price of preferred stock and the annual dividend are known, the market determined required rate
of return may be computed by using the valuation equation and solving for Kp.

Dp Po =
D1
Pp = ( K e - g)
Kp

III. Cost of Common Equity

A. The value of a share of common stock is the present value of an expected stream of dividends.
D1 D2 D3 Dn
P0 = + + + .. . . +
( 1+ K e ) ( 1+ K e )2
( 1+ K e )3
( 1+ K e )n
where:
Po = price of the stock at time zero (today)
D = dividend for each year
Ke = the required rate of return for common stock

B. Unlike dividends on most preferred stock, common stock dividends may vary. The valuation
formula may be applied, with modification, to three different circumstances: no growth in dividends,
constant growth in dividends, and variable growth in dividends.
1. No Growth in Dividends. Common stock with constant (no growth) dividends is valued in
the same manner as preferred stock.
Do
Po =
Ke
where:
Po = price of common stock
Do = current annual dividend on common stock = D1
(Expected to remain the same in the future)
Ke = required rate of return for common stock

2. Constant Growth in Dividends. The price of common stock with constant growth in
dividends is the present value of an infinite stream of growing dividends. Fortunately, in
this circumstance the basic valuation equation can be reduced to the more usable form
below if the discount rate (Ke) is assumed to be greater than the growth rate.
where:
D1 = dividend expected at the end of the first year =
Do (1+g)

D1
Po =
( K e -g )
g = constant growth rate in dividends
Po = price of common stock
Ke = required rate of return for common stock

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a. The above formula, which is labeled 10-9 in the text, can also be thought to
represent the present value of dividends for a period of time (such as n = 3) plus the
present value of the stock price after a period of time (such as P3). Since P3
represents the present value of dividends from D4 through Dn, Po will still represent
the present value of all future dividends.

b. The value of Po is quite sensitive to any change in Ke (required rate of return) and g
(the growth rate).

3. Rearrangement of the constant growth equation allows the calculation of the required
rate of return, Ke, when Po, D1, and g are given.
The first term represents the dividend yield that the stockholder expects to receive and the

D1
Ke = +g
Po
second term represents the anticipated growth in dividends, earnings and stock price.

4. The Price Earnings Ratio Concept and Valuation. Stock valuation may also be linked
to the concept of price-earnings ratios. Although this is a less theoretical, more
pragmatic approach than the dividend valuation models, the end results may be similar
because of the common emphasis on risk and growth under either approach.

5. Variable Growth in Dividends. The most likely variable growth case is one of
supernormal growth followed by constant growth.

a. Value can be found through taking the present value of the dividends during the
supernormal growth period plus the price of the stock at end of the supernormal
growth period. Since growth is then constant, Formula 10-9 can be used.

b. Another type of variable growth is where the firm is assumed to pay no dividends
for a period of time and then begins paying dividends. In this case, the present
value of deferred dividends can be computed as a representation of value.

c. If no dividends are ever intended, then valuation may rest solely on the present
value of future earnings and the present value of a future stock price.

IV. Optimal Capital Structure - Weighing Costs

A. The firm should seek to minimize its cost of capital by employing the optimal mix of capital
financing.

B. Although debt is the cheapest source of capital, there are limits to the amount of debt capital that
lenders will provide. The cost of both debt and equity financing rise as debt becomes a larger
portion of the capital structure.

C. Traditional financial theory maintains that the weighted average cost of capital declines as lower
costing debt is added to the capital structure. The optimum mix of debt and equity corresponds to
the minimum point on the average cost of capital curve.

D. The optimal debt-to-equity mix varies among industries. The more cyclical the business, the lower
the D/E ratio is required to be.

E. The weights applied in computing the weighted average cost should be market value weights.

V. Capital Acquisition and Investment Decision Making

A. The discount rate used in evaluating capital projects should be the weighted average cost of capital.

B. If the cost of capital is earned on all projects, the residual claimants of the earnings stream, the
owners, will receive their required rate of return. If the overall return of the firm is less than the cost
of capital, the owners will receive less than their desired rate of return because providers of debt
capital must be paid.

C. For most firms, the cost of capital is fairly constant within a reasonable range of debt-equity mixes.
Changes in money and capital market conditions (supply and demand for money), however, cause
the cost of capital for all firms to vary upward and downward over time.

D. Cost of Capital in the Capital Budgeting Decision

1. It is the current cost of each source of funds that is important.

2. The cost of each source of capital will vary with the amount of capital derived from that source.

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3. The required rate of return or discount rate for capital budgeting decisions will be the weighted
average cost of capital.

VI. Marginal Cost of Capital

The marginal cost of debt (the cost of the last amount of debt financing) will rise as more debt financing is
used. The marginal cost of equity also rises when the shift from retained earnings to external (common stock)
equity financing is necessary.

VII. Cost of Capital and the Capital Asset Pricing Model

A. The Capital Asset Pricing Model (CAPM) relates the risk-return tradeoffs of individual assets to
market returns.
B. The CAPM encompasses all types of assets but is most often applied to common stock.
C. The basic form of the CAPM is a linear relationship between returns on individual stocks and the

K j = α + βKm + e
market over time. Using least squares regression analysis, the return on an individual stock Kj is:
where: Kj = Return on individual common stock of company
α = Alpha, the intercept on the y-axis
β = Beta, the coefficient
Km = Return on the stock market (an index of stock returns is used, usually
the Standard & Poor's 500 Index)
e = Error term of the regression equation

D. Using historical data, the beta coefficient is computed. The beta coefficient is a measurement of the
return performance of a given stock relative to the return performance of the market.

e. The CAPM evolved into a risk premium model.

1. Investors expect higher returns if higher risks are taken.
2. The minimum return expected by investors will never be less than can be obtained from a
riskless asset (usually considered to be U.S. Treasury bills). The relationship is
expressed as follows:

K j = R f + β( K m - R f )
where:
Rf = Risk-free rate of return
β = Beta coefficient from Formula 11A-1
Km = Return on the market index
K m - Rf = Premium or excess return of the market versus the risk-free rate
(since the market is riskier than Rf, the assumption is that the
expected Km will be greater than Rf)
β(Km - Rf) = Expected return above the risk-free rate for the stock of Company j,
given the level of risk

3. Beta measures the sensitivity of an individual security's return relative to the market.

a. By definition, the market beta = 1.

b. A security with a beta = 1, is expected to have returns equal to and as volatile
as the market. One with a beta of 2 is twice as volatile (up or down).

4. Beta measures the impact of an asset on an individual's portfolio of assets.

G. A risk-return graph can be derived from the risk premium model. The graphed relationship between
risk (measured by beta) and required rates of return is called the Security Market Line (SML).

H. Cost of capital considerations

1. If required returns rise, prices of securities fall to adjust to the new equilibrium return level
and as required returns fall, prices rise.
2. A change in required rates of return is represented by a shift in the SML.

a. The new SML will be parallel to the previous one if investors attempt to maintain the
same risk premium over the risk-free rate.
b. If investors attempt to maintain purchasing power in an inflationary economy, the
slope of the new SML may be greater than before due to an inflation premium.
c. An investor's required rate of return and thus a firm's cost of capital will also change
if investors risk preferences change. The slope of the SML would change even if the
risk-free rate remained the same.

EXERCISES – CHAPTER 8

1. Stock Values
The Jackson–Timberlake Wardrobe Co. just paid a dividend of P1.95 per share on its stock. The dividends are
expected to grow at a constant rate of 6 percent per year indefinitely. If investors require an 11 percent return on

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The Jackson–Timberlake Wardrobe Co. stock, what is the current price? What will the price be in three years? In
15 years?

2. Stock Values
The next dividend payment by Hot Wings, Inc., will be P2.10 per share. The dividends are anticipated to maintain
a 5 percent growth rate forever. If the stock currently sells for P48 per share, what is the required return?

3. Stock Values
For the company in the previous problem, what is the dividend yield? What is the expected capital gains yield?

4. Stock Values
Metroplex Corporation will pay a P3.04 per share dividend next year. The company pledges to increase its
dividend by 3.8 percent per year indefinitely. If you require an 11 percent return on your investment, how much
will you pay for the company's stock today?

5. Stock Valuation
Keenan Co. is expected to maintain a constant 5.2 percent growth rate in its dividends indefinitely. If the
company has a dividend yield of 6.3 percent, what is the required return on the company's stock?

6. Stock Valuation
Apocalyptica Corp. pays a constant P9.75 dividend on its stock. The company will maintain this dividend for the
next 11 years and will then cease paying dividends forever. If the required return on this stock is 10 percent, what
is the current share price?

7. Stock Valuation and Required Return

Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of P2.35 next year. The growth rate in
dividends for all three companies is 5 percent. The required return for each company's stock is 8 percent, 11
percent, and 14 percent, respectively. What is the stock price for each company? What do you conclude about
the relationship between the required return and the stock price?

Chapter 13 - Return, Risk and Security Market Line

The student will be able to determine the impact on the overall value and risk of the company by;
1. calculating and interpreting the geometric return, expected rate of return, variance and standard deviation of
returns for both stand-alone assets and portfolios.
2. assessing the impact of systematic and unsystematic risks; and
3. using the SML equation.

I. Return

A. Peso Returns

 Income component – direct cash payments such as dividends or interest

 Price change – loosely, capital gain or loss
 Total peso return = income component + capital gain (loss)
The return is unaffected by the decision to sell or hold securities.

Percentage Returns
Percentage return = peso return / initial investment
= dividend yield + capital gains yield

Dividend yield = Dt+1 / Pt

Capital gains yield = (Pt+1 – Pt) / Pt

Calculating Average Returns

The arithmetic average return equals the sum of the observed returns, divided by the number of
observations. Note that over long periods of time, even the worst period still has a positive average
annual return.

B. Calculating Geometric Average Returns

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Arithmetic average – return earned in an average year over multiple years. It is used to computing:
add the returns for each period and divide by the number of periods.

εR
Arithmetic average =
n

Geometric average – average compound return earned per year over multiple years
Geometric average = [(1+R1)*(1+R2)*…*(1+RT)]1/T – 1

Geometric means will always be smaller than arithmetic means unless all the returns are equal.

C. Expected Return & Variance

Let n denote the total number of states of the economy; Ri the return in state i; and pi the probability
of state i. Then the expected return, E(R), is given by:

n
E( R )=∑ pi Ri
i=1

Example:

State of economy Probability Return Product

(%)
+1% change in GDP .25 -5 -1.25
+2% change in GDP .50 15 7.5
+3% change in GDP .25 35 8.75
Sums 1.00 E(R) = 15%

Projected risk premium = expected return minus the risk-free rate = E(R) – Rf

Calculating the Variance

n
Var (R )=σ 2 =∑ pi ( Ri − E( R ))2
i=1
Variance measures the dispersion of points around the mean of a distribution. In this context, we
are attempting to characterize the variability of possible future security returns around the expected
return. In other words, we are trying to quantify risk and return. Variance measures the total risk of
the possible returns.

State of Economy Probability Return (%) Squared Product

Deviation
+1% change in GDP .25 -5 400 100
+2% change in GDP .50 15 0 0
+3% change in GDP .25 35 400 100
Total 1.00 E(R) = 15 2 = 200
Standard deviation = square root of variance = 14.14%

2. Portfolio

A. Portfolio
A portfolio is a collection of assets, such as stocks and bonds, held by an investor.

Portfolios can be described by the percentage investment in each asset, and these percentages are
called portfolio weights.

Example:
If two securities in a portfolio have a combined value of P10,000 with P6000 invested in IBM and
P4000 invested in GM, then the weight in IBM = 6/10 = .6 and the weight in GM = 4/10 = .4.

Each individual has their own level of risk tolerance. Some people are just naturally more inclined to
take risk, and they will not require the same level of compensation as others for doing so. Our risk
preferences also change through time. We may be willing to take more risk when we are young and
without a spouse or kids. But, once we start a family, our risk tolerance may drop.

B. Portfolio Expected Returns

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The expected return on a portfolio is the sum of the product of the expected returns on the individual
securities and their portfolio weights. Let wj be the portfolio weight for asset j and m be the total
number of assets in the portfolio; then

m
E( R )= ∑ w j E( R j )
j=1

This formula also works if you drop the expectations and just compute the portfolio return in each
state of the economy. This is necessary for the calculation of the portfolio variance in the next
section.

C. Portfolio Variance

Unlike expected return, the variance of a portfolio is NOT the weighted sum of the individual security
variances. Combining securities into portfolios can reduce the total variability of returns.

Example: Consider a portfolio with equal amounts invested in three stocks:

State of Economy Probabi- Return on Return on B Return on C Return on

lity A (%) (%) (%) Portfolio
(%)
+1% change in GDP .25 -5 0 20 5
+2% change in GDP .50 15 10 10 11.7
+3% change in GDP .25 35 20 0 18.3
Expected Return 15 10 10 11.7

Variances and standard deviations:

Var(A) = .25(-5-15)2 + .5(15-15)2 + .25(35-15)2 = 200 Std. Dev.(A) = 14.14

Var(B) = .25(0 - 10)2 + .5(10 - 10)2 + .25(20 - 10)2 = 50 Std. Dev.(B) = 7.07
Var(C) = .25(20 - 10)2 + .5(10-10)2 + .25(0-10)2 = 50 Std. Dev.(C) = 7.07
Var(portfolio) = .25(5-11.7)2 + .5(11.7-11.7)2 + .25(18.3-11.7)2 = 22.1125
Std. Dev.(portfolio) = 4.70

Notice that the portfolio variance is less than any of the individual variances. The general concept of
the correlation coefficient (and hopefully the covariance) that the correlation coefficient is bounded
by –1 and 1.

Specifically, for a two-asset portfolio, the portfolio variance is equal to:

w 21 σ 21 + w22 σ 22 + 2w1 w 2 σ 1 σ 2 ρ1,2

or w21 σ 21 + w22 σ 22 + 2w1 w2 σ 1,2
Where: 1,2 is the correlation coefficient 1,2 is the covariance.

When you expand the equation to more assets, you will have a variance term for each asset and a
covariance term for each pair of assets. As you increase the number of assets, it is easy to see that
the correlation (covariance) between assets is much more important in determining the portfolio
variance than the individual variances.
The following co-variances can be computed:
cov(A,B) = 100 cov(A,C) = -100 cov(B,C) = -50

Using the co-variances and extending the formula above to three assets, you can compute a
portfolio variance and standard deviation:
portfolio variance =
(1/3)2(200) + (1/3)2(50) + (1/3)2(50) + 2(1/3)(1/3)(100) + 2(1/3)(1/3)(-100) + 2(1/3)(1/3)(-50) =
22.22 standard deviation = 4.71%

This is just as we computed earlier, with a slight difference due to rounding portfolio returns.

D. Expected and Unexpected Returns

Total return = expected return + unexpected return

Total return differs from expected return because of surprises, or “news.” This is one of the reasons
that realized returns differ from expected returns.

E. Announcements and News

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Announcement – the release of information not previously available. Announcements have two
parts: the expected part and the surprise part.

The expected part is “discounted” information used by the market to estimate the expected return,
while the surprise is news that influences the unexpected return.

Discounted information is information that is already included in the expected return (and the price).
The tie-in to efficient markets is obvious. The assumption here is that markets are semi-strong
efficient.

F. Systematic and Unsystematic Risk

Risk consists of surprises. There are two kinds of surprises:

Systematic risk is a surprise that affects a large number of assets, although at varying degrees. It is
sometimes called market risk.

Unsystematic risk is a surprise that affects a small number of assets (or one). It is sometimes called
unique or asset-specific risk.

Example: Changes in GDP, interest rates and inflation are examples of systematic risk. Strikes,
accidents and takeovers are examples of unsystematic risk.

Total return = expected return + unexpected return

Total return = expected return + systematic portion + unsystematic portion

3. The Efficient Markets Hypothesis

Efficient capital market – market in which current market prices fully reflect available information. In
such a market, it is not possible to devise trading rules that consistently “beat the market” after
taking risk into account.
Efficient markets hypothesis (EMH) – An important implication of the EMH is that the expected
return on securities equals their risk-adjusted required return.

Key insight – competition among investors and traders makes a market efficient.

Some Common Misconceptions about the EMH

Market efficiency does NOT imply that it doesn’t make a difference how you invest, since the
risk/return trade-off still applies, but rather that you can’t expect to consistently earn excess returns
using costless trading strategies.

Stock price fluctuations are evidence that the market is efficient since new information is constantly
arriving – prices that don’t change are evidence of inefficiency.

The EMH doesn’t say prices are random. Rather, the influence of previously unknown information
causes randomness in price changes. As a result, price changes can’t be predicted before they
happen.

The Forms of Market Efficiency

Strong form efficiency – All information, both public and private, is already incorporated in the price.
Empirical evidence indicates that this form of efficiency does NOT hold.

Semi-strong form efficiency – All public information is already incorporated in the price. It says that
you cannot consistently earn excess returns using available information to do fundamental analysis.
Evidence is mixed, but suggests that it holds for widely held firms.

Weak form efficiency – All market information, including prices and volume, is included in the price.
It says that you cannot consistently earn excess returns by looking for patterns in past price and
volume information, such as is done by technical analysts. Evidence suggests that markets are
weak form efficient based on the trading rules that we have been able to test.

4. Diversification and Portfolio Risk

Portfolio variability can be quite different from the variability of individual securities.

A typical single stock on the NYSE has a standard deviation of annual returns around 50%, while
the typical large portfolio of NYSE stocks has a standard deviation of around 20%.

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The Principle of Diversification

Principle of Diversification – principle stating that combining imperfectly correlated assets can
produce a portfolio with less variability than the typical individual asset.

The portion of variability present in a single security that is not present in a portfolio of securities is
called diversifiable risk. The level of variance that is present in collections of assets is
nondiversifiable risk.

Common sense suggests that, to the extent that national economies are less than perfectly
positively correlated, there may be diversification benefits to be had by investing in foreign
securities. As a result, the potential for risk reduction is greater when you include international
stocks in your portfolio.

Diversification and Unsystematic Risk

When securities are combined into portfolios, their unique or unsystematic risks tend to cancel out,
leaving only the variability that affects all securities to some degree. Thus, diversifiable risk is
synonymous with unsystematic risk. Large portfolios have little or no unsystematic risk.

Diversification and Systematic Risk

Systematic risk cannot be eliminated by diversification since it represents the variability due to
influences that affect all securities to some degree. Therefore, systematic risk and nondiversifiable
risk are the same.

Total risk = nondiversifiable risk + diversifiable risk = systematic risk + unsystematic risk

The Systematic Risk Principle

The principle – The reward for bearing risk depends only on the systematic risk of the investment.

The implication – The expected return on an asset depends only on that asset’s systematic risk.

A corollary – No matter how much total risk an asset has, its expected return depends only on its
systematic risk.

Exchange Traded Funds (ETFs) are essentially mutual funds that can be traded through a broker
just like stock. Currently, ETFs are traded on a wide variety of indexes, including domestic stock,
international stock, corporate bond, government bond, energy, and many others. One major
advantage of ETFs over traditional index mutual funds is that they trade like stock throughout the
day, whereas mutual funds take orders during the day, but the fund trades at the closing value of
the assets. ETFs have become a popular way for investors to manage their asset allocation and
achieve diversification.

Measuring Systematic Risk

Beta coefficient – measures how much systematic risk an asset has relative to an asset of average
risk.

The average beta for all stocks must be 1.0, the range of possible values for any given beta is from
- to +.

The point that “the market does not reward risks that are borne unnecessarily,” should be strongly
emphasized. Many investment companies offer investors a choice between income-oriented mutual
funds, containing both bonds and stocks in established companies with higher dividend payouts,
and growth-oriented funds that are typically composed of stocks of smaller companies that retain
most of their earnings for reinvestment in the firm. Investors that desire growth-oriented funds
typically assume a much greater degree of systematic risk and expect higher returns. However,
both types of funds eliminate the unsystematic portion of risk through diversification.

Portfolio Betas are a weighted average of the individual asset betas.

Example (different from both the book and the PowerPoint slides):
Stock Amount Portfolio Weight Beta Product
Invested
IBM 6000 50.00% 1.586 .793
GM 4000 33.33% 1.139 .380
Wal-Mart 2000 16.67% .674 .112
Portfolio 10,000 100.00% 1.285

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The cost of equity depends on both the firm’s business risk and its financial risk. So, all else equal, borrowing money
will increase a firm’s equity beta because it increases the volatility of earnings. Robert Hamada derived the following
equation to reflect the relationship between levered and unlevered betas (excluding tax effects):

L = U(1 + D/E)

where: L = equity beta of a levered firm;

U = equity beta of an unlevered firm;
D/E = debt-to-equity ratio

5. The Security Market Line

A riskless asset has a beta of 0.When a risky asset with >0 is combined with a riskless asset, the
resulting expected return is the weighted sum of the expected returns, and the portfolio beta is the
weighted sum of the betas. By varying the amount invested in each asset, we can get an idea of the
relation between portfolio expected returns and betas.
y = mx + b
where: y = expected return
x = beta
m = slope
b = y-intercept = risk-free rate

The Reward-to-Risk Ratio is the expected return per unit of systematic risk. In other words, it is the
ratio of risk premium to systematic risk. The basic argument is that since systematic risk is all that
matters in determining expected return, the reward-to-risk ratio must be the same for all assets. If it
were not, people would buy the asset with the higher reward-to-risk ratio (driving the price up and
the return down).

The fundamental result is that in a competitive market where only systematic risk affects E(R), the
reward-to-risk ratio must be the same for all assets in the market. Consequently, the expected
returns and betas of all assets much plot on the same straight line.

The line that gives the expected return/systematic risk combinations of assets in a well functioning,
active financial market is called the security market line.

Market Portfolios: Consider a portfolio of all the assets in the market and call it the market portfolio.
This portfolio, by definition, has “average” systematic risk with a beta of 1. Since all assets must lie
on the SML when appropriately priced, the market portfolio must also lie on the SML.

Let the expected return on the market portfolio = E(RM).

Then, the slope of the SML = reward-to-risk ratio
= [E(RM) – Rf] / M = [E(RM) – Rf] / 1 = E(RM) – Rf

The Capital Asset Pricing Model: Go back to the discussion of the equation of a line:
E(Rj) = Rf + slope(j) E(Rj) = Rf + (E(RM) – Rf)(j)

The CAPM states that the expected return for an asset depends on:
-The time value of money, as measured by Rf
-The reward per unit risk, as measured by E(RM) - Rf
-The asset’s systematic risk, as measured by 

CHAPTER 13 – RISK AND RETURN

1. Determining Portfolio Weights

What are the portfolio weights for a portfolio that has 180 shares of Stock A that sell for P45 per share and 140
shares of Stock B that sell for P27 per share?

2. Portfolio Expected Return

You own a portfolio that has P2,950 invested in Stock A and P3,700 invested in Stock B. If the expected returns
on these stocks are 11 percent and 15 percent, respectively, what is the expected return on the portfolio?

3. Portfolio Expected Return

You own a portfolio that is 60 percent invested in Stock X, 25 percent in Stock Y, and 15 percent in Stock Z. The
expected returns on these three stocks are 9 percent, 17 percent, and 13 percent, respectively. What is the
expected return on the portfolio?

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4. Portfolio Expected Return

You have P10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 14 percent
and Stock Y with an expected return of 10.5 percent. If your goal is to create a portfolio with an expected return of
12.4 percent, how much money will you invest in Stock X? In Stock Y?

5. Calculating Expected Return

Based on the following information, calculate the expected return:

6. Calculating Expected Return

Based on the following information, calculate the expected return:

7. Calculating Returns and Standard Deviations

Based on the following information, calculate the expected return and standard deviation for the two stocks:

8. Calculating Expected Returns

A portfolio is invested 25 percent in Stock G, 55 percent in Stock J, and 20 percent in Stock K. The expected
returns on these stocks are 8 percent, 15 percent, and 24 percent, respectively. What is the portfolio's expected
return? How do you interpret your answer?

9. Returns and Variances

Consider the following information:

a. What is the expected return on an equally weighted portfolio of these three stocks?

b. What is the variance of a portfolio invested 20 percent each in A and B and 60 percent in C?

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10. Returns and Standard Deviations

Consider the following information:

a. Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected return of the
portfolio?

b. What is the variance of this portfolio? The standard deviation?

11. Calculating Portfolio Betas

You own a stock portfolio invested 25 percent in Stock Q, 20 percent in Stock R, 15 percent in Stock S, and 40
percent in Stock T. The betas for these four stocks are .84, 1.17, 1.11, and 1.36, respectively. What is the
portfolio beta?

12. Calculating Portfolio Betas

You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.38
and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio?

13. Using CAPM

A stock has a beta of 1.05, the expected return on the market is 11 percent, and the risk-free rate is 5.2 percent.
What must the expected return on this stock be?

14. Using CAPM

A stock has an expected return of 10.2 percent, the risk-free rate is 4.5 percent, and the market risk premium is
8.5 percent. What must the beta of this stock be?

15. Using CAPM

A stock has an expected return of 13.5 percent, its beta is 1.17, and the risk-free rate is 5.5 percent. What must
the expected return on the market be?

16. Using CAPM

A stock has an expected return of 14 percent, its beta is 1.45, and the expected return on the market is 11.5
percent. What must the risk-free rate be?

EXERCISES & PROBLEMS ( CHAPTER 14)

1. Calculating Cost of Equity

The Down and Out Co. just issued a dividend of P2.40 per share on its common stock. The company is
expected to maintain a constant 5.5 percent growth rate in its dividends indefinitely. If the stock sells for P52 a
share, what is the company's cost of equity?

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2. Calculating Cost of Equity

The Up and Coming Corporation's common stock has a beta of 1.05. If the risk-free rate is 5.3 percent and the
expected return on the market is 12 percent, what is the company's cost of equity capital?

3. Calculating Cost of Equity

Stock in Country Road Industries has a beta of .85. The market risk premium is 8 percent, and T-bills are
currently yielding 5 percent. The company's most recent dividend was P1.60 per share, and dividends are
expected to grow at a 6 percent annual rate indefinitely. If the stock sells for P37 per share, what is your best
estimate of the company's cost of equity?

4. Estimating the DCF Growth Rate

Suppose In a Found Ltd. just issued a dividend of P1.43 per share on its common stock. The company paid
dividends of P1.05, P1.12, P1.19, and P1.30 per share in the last four years. If the stock currently sells for P45,
what is your best estimate of the company's cost of equity capital using the arithmetic average growth rate in
dividends? What if you use the geometric average growth rate?

5. Calculating Cost of Preferred Stock

Holdup Bank has an issue of preferred stock with a P6 stated dividend that just sold for P96 per share. What is
the bank's cost of preferred stock?

6. Calculating Cost of Debt

Waller, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 15 years to
maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has an
embedded cost of 7 percent annually. What is the company's pretax cost of debt? If the tax rate is 35 percent,
what is the aftertax cost of debt?

7. Calculating Cost of Debt

Jiminy's Cricket Farm issued a 30-year, 8 percent semiannual bond 7 years ago. The bond currently sells for 95
percent of its face value. The company's tax rate is 35 percent.
a. What is the pretax cost of debt?
b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

8. Calculating Cost of Debt

For the firm in Problem 7, suppose the book value of the debt issue is P80 million. In addition, the company has
a second debt issue on the market, a zero coupon bond with seven years left to maturity; the book value of this
issue is P35 million, and the bonds sell for 61 percent of par. What is the company's total book value of debt?
The total market value? What is your best estimate of the aftertax cost of debt now?

9. Calculating WACC
Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock,
and 35 percent debt. Its cost of equity is 14 percent, the cost of preferred stock is 6 percent, and the cost of debt
is 8 percent. The relevant tax rate is 35 percent.
a. What is Mullineaux's WACC?
b. The company president has approached you about Mullineaux's capital structure. He wants to know
why the company doesn't use more preferred stock financing because it costs less than debt. What
would you tell the president?

10. Taxes and WACC

Sixx AM Manufacturing has a target debt—equity ratio of .65. Its cost of equity is 15 percent, and its cost of debt
is 9 percent. If the tax rate is 35 percent, what is the company's WACC?

11. Finding the Target Capital Structure

Fama's Llamas has a weighted average cost of capital of 8.9 percent. The company's cost of equity is 12
percent, and its pretax cost of debt is 7.9 percent. The tax rate is 35 percent. What is the company's target debt
—equity ratio?

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12. Book Value versus Market Value

Filer Manufacturing has 11 million shares of common stock outstanding. The current share price is P68, and the
book value per share is P6. Filer Manufacturing also has two bond issues outstanding. The first bond issue has
a face value of P70 million, has a 7 percent coupon, and sells for 93 percent of par. The second issue has a face
value of P55 million, has an 8 percent coupon, and sells for 104 percent of par. The first issue matures in 21
years, the second in 6 years.
a. What are Filer's capital structure weights on a book value basis?

b. What are Filer's capital structure weights on a market value basis?

c. Which are more relevant, the book or market value weights? Why?

13. Calculating the WACC

In Problem 12, suppose the most recent dividend was P4.10 and the dividend growth rate is 6 percent. Assume
that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both
bonds make semiannual payments. The tax rate is 35 percent. What is the company's WACC?

14. WACC
Jungle, Inc., has a target debt—equity ratio of 1.05. Its WACC is 9.4 percent, and the tax rate is 35 percent.
a. If Jungle's cost of equity is 14 percent, what is its pretax cost of debt?

b. If instead you know that the aftertax cost of debt is 6.8 percent, what is the cost of equity?

15. Finding the WACC

Given the following information for Evenflow Power Co., find the WACC. Assume the company's tax rate is 35
percent.
Debt: 8,000, 6.5 percent coupon bonds outstanding, P1,000 par value, 20 years to maturity,
selling for 92 percent of par; the bonds make semiannual payments.
Common stock: 250,000 shares outstanding, selling for P57 per share; the beta is 1.05.
Preferred stock: 15,000 shares of 5 percent preferred stock outstanding, currently selling for P93 per share.
Market: 8 percent market risk premium and 4.5 percent risk-free rate.

Minicase - Titan Mining Corporation ( Case 8)

Titan Mining Corporation has 9 million shares of common stock outstanding, 250,000 shares of 6 percent
preferred stock outstanding, and 105,000 7.5 percent semiannual bonds outstanding, par value P1,000 each.
The common stock currently sells for P34 per share and has a beta of 1.25, the preferred stock currently sells
for P91 per share, and the bonds have 15 years to maturity and sell for 93 percent of par. The market risk
premium is 8.5 percent, T-bills are yielding 5 percent, and Titan Mining's tax rate is 35 percent.

a. What is the firm's market value capital structure?

b. If Titan Mining is evaluating a new investment project that has the same risk as the firm's typical project,
what rate should the firm use to discount the project's cash flows?

c. Assuming Titan is considering the following projects:

The T-bill rate is 5 percent, and the expected return on the market is 11 percent.
c.1 Which projects have a higher expected return than the firm's 11 percent cost of capital?

c. 2 Which projects should be accepted?

c.3 Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were
used as a hurdle rate?

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