CHAPTER 1

An Overview of Financial
Management
 Career Opportunities
 Issues of the New Millennium
 Forms of Businesses
 Goals of the Corporation
 Agency Relationships
1-1
Career Opportunities in
Finance
 Money and capital markets
 Investments
 Financial management

1-2
Responsibility of the
Financial Staff
 Maximize stock value by:
 Forecasting and planning
 Investment and financing decisions
 Coordination and control
 Transactions in the financial markets
 Managing risk

1-3
 Role of Finance in a Typical
Business Organization
n Board of Directors

n President

n VP: Sales n VP: Finance n VP: Operations

n Treasurer n Controller

n Credit Manager n Cost Accounting

n Inventory Manager n Financial Accounting

n Capital Budgeting Director n Tax Department

1-4
Financial Management
Issues of the New
Millennium
 The effect of
changing
technology
 The
globalization of
business

1-5
Percentage of Revenue and Net
Income from Overseas Operations
for 10 Well-Known Corporations,
2001
Company % of Revenue % of Net Income
from overseas from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & 35.5 51.7
Co.
McDonald’s 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8 1-6
Alternative Forms of
Business Organization
 Sole proprietorship
 Partnership
 Corporation

1-7
Sole proprietorships &
Partnerships
 Advantages
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life

1-8
Corporation
 Advantages
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages
 Double taxation
 Cost of set-up and report filing

1-9
Financial Goals of the
Corporation
 The primary financial goal is
shareholder wealth maximization,
which translates to maximizing
stock price.
 Do firms have any responsibilities to
society at large?
 Is stock price maximization good or
bad for society?
 Should firms behave ethically?
1-10
Is stock price maximization
the same as profit
maximization?
 No, despite a generally high
correlation amongst stock price, EPS,
and cash flow.
 Current stock price relies upon
current earnings, as well as future
earnings and cash flow.
 Some actions may cause an increase
in earnings, yet cause the stock price
to decrease (and vice versa).
1-11
Agency relationships
 An agency relationship exists
whenever a principal hires an
agent to act on their behalf.
 Within a corporation, agency
relationships exist between:
 Shareholders and managers
 Shareholders and creditors
1-12
Shareholders versus
Managers
 Managers are naturally inclined to
act in their own best interests.
 But the following factors affect
managerial behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover

1-13
Shareholders versus
Creditors
 Shareholders (through managers)
could take actions to maximize
stock price that are detrimental to
creditors.
 In the long run, such actions will
raise the cost of debt and
ultimately lower stock price.

1-14
Factors that affect stock
price
 Projected cash
flows to
shareholders
 Timing of the
cash flow stream
 Riskiness of the
cash flows

1-15
 Basic Valuation Model
CF1 CF2 CFn
Value 1
 2
 
(1  k) (1  k) (1  k)n
n
CFt
 t
.
t 1 (1  k)

 To estimate an asset’s value, one estimates the

cash flow for each period t (CFt), the life of the
asset (n), and the appropriate discount rate (k)
 Throughout the course, we discuss how to
estimate the inputs and how financial
management is used to improve them and thus
maximize a firm’s value.
1-16
Factors that Affect the
Level and Riskiness of
Cash Flows
 Decisions made by financial
managers:
 Investment decisions
 Financing decisions (the relative use
of debt financing)
 Dividend policy decisions
 The external environment

1-17
CHAPTER 3
Analysis of Financial
Statements
 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors
1-18
Balance Sheet: Assets
2003E 2002
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
1-19
Balance sheet:
Liabilities and Equity
2003E 2002
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
1-20
Income statement
2003E 2002
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
1-21
Other data
2003E 2002
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

1-22
Why are ratios useful?
 Ratios standardize numbers and
facilitate comparisons.
 Ratios are used to highlight
weaknesses and strengths.

1-23
What are the five major categories
of ratios, and what questions do they
answer?
 Liquidity: Can we make required
payments?
 Asset management: right amount of
assets vs. sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA?
 Market value: Do investors like what they
see as reflected in P/E and M/B ratios?

1-24
 Calculate D’Leon’s forecasted
current ratio for 2003.

Current ratio = Current assets / Current

liabilities
= $2,680 / $1,145
= 2.34x

1-25
Comments on current ratio
2003 2002 2001 Ind.
Current
2.34x 1.20x 2.30x 2.70x
ratio

 Expected to improve but still

below the industry average.
 Liquidity position is weak.

1-26
What is the inventory
turnover vs. the industry
average?
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x

2003 2002 2001 Ind.

Inventory
4.1x 4.70x 4.8x 6.1x
Turnover
1-27
Comments on
Inventory Turnover
 Inventory turnover is below
industry average.
 D’Leon might have old inventory,
or its control might be poor.
 No improvement is currently
forecasted.

1-28
DSO is the average number of days
after making a sale before receiving
cash.

DSO = Receivables / Average sales

per day
= Receivables / Sales/365
= $878 / ($7,036/365)
= 45.6

1-29
Appraisal of DSO
2003 2002 2001 Ind.

DSO 45.6 38.2 37.4 32.0

 D’Leon collects on sales too

slowly, and is getting worse.
 D’Leon has a poor credit policy.

1-30
Fixed asset and total asset
turnover ratios vs. the industry
average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

1-31
Evaluating the FA turnover
and TA turnover ratios
2003 2002 2001 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x
 FA turnover projected to exceed the
industry average.
 TA turnover below the industry
average. Caused by excessive
currents assets (A/R and Inv).
1-32
 Calculate the debt ratio, TIE, and
EBITDA coverage ratios.

Debt ratio = Total debt / Total assets

= ($1,145 + $400) / $3,497 =
44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

1-33
 Calculate the debt ratio, TIE, and
EBITDA coverage ratios.
EBITDA (EBITDA+Lease pmts)
=
coverage Int exp + Lease pmts + Principal pmts

$609.6 + $40
=
$70 + $40 + $0
= 5.9x

1-34
How do the debt management
ratios compare with industry
averages?
2003 2002 2001 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
coverag 5.9x 0.1x 3.0x 8.0x
e
 D/A and TIE are better than the

industry average, but EBITDA coverage

still trails the industry.
1-35
 Profitability ratios:
Profit margin and Basic earning
power

Profit margin = Net income / Sales

= $253.6 / $7,036 =
3.6%

BEP = EBIT / Total assets

= $492.6 / $3,497 =
14.1%
1-36
 Appraising profitability with the
profit margin and basic earning
power
2003 2002 2001 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
 Profit margin was very bad in 2002, but is projected to
exceed the industry average in 2003. Looking good.
 BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
 BEP projected to improve, yet still below the industry
average. There is definitely room for improvement.

1-37
Profitability ratios:
Return on assets and Return on
equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common

equity
= $253.6 / $1,952 = 13.0%

1-38
Appraising profitability with the
return on assets and return on
equity
2003 2002 2001 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
-
ROE 13.0% 13.3% 18.2%
32.5%
 Both ratios rebounded from the previous
year, but are still below the industry
average. More improvement is needed.
 Wide variations in ROE illustrate the effect
that leverage can have on profitability.
1-39
Effects of debt on ROA and
ROE
 ROA is lowered by debt--interest
lowers NI, which also lowers ROA
= NI/Assets.
 But use of debt also lowers
equity, hence debt could raise
ROE = NI/Equity.

1-40
 Problems with ROE
 ROE and shareholder wealth are
correlated, but problems can arise when
ROE is the sole measure of performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital

invested.
 Might encourage managers to make

investment decisions that do not benefit

shareholders.
 ROE focuses only on return. A better
measure is one that considers both risk
and return.
1-41
 Calculate the Price/Earnings,
Price/Cash flow, and Market/Book
ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share

= $12.17 / [($253.6 + $117.0)
÷ 250]
= 8.21x

1-42
 Calculate the Price/Earnings,
Price/Cash flow, and Market/Book
ratios.

M/B = Mkt price per share / Book value per

share
= $12.17 / ($1,952 / 250) = 1.56x
2003 2002 2001 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x

1-43
Analyzing the market value
ratios
 P/E: How much investors are willing to
pay for $1 of earnings.
 P/CF: How much investors are willing to
pay for $1 of cash flow.
 M/B: How much investors are willing to
pay for $1 of book value equity.
 For each ratio, the higher the number,
the better.
 P/E and M/B are high if ROE is high and
risk is low.
1-44
 Extended DuPont equation:
Breaking down Return on equity

ROE = (Profit margin) x (TA turnover) x (Equity multiplier)

= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
1-45
 The Du Pont system
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
 Focuses on:

 Expense control (PM)

 Asset utilization (TATO)

 Debt utilization (Eq. Mult.)

 Shows how these factors combine to

determine ROE.
1-46
 Trend analysis
 Analyzes a firm’s
financial ratios over
time
 Can be used to
estimate the
likelihood of
improvement or
deterioration in
financial condition.
1-47
An example:
The effects of improving
ratios
A/R 878 Debt 1,545
Other CA 1,802 Equity 1,952
Net FA 817 _____
TA 3,497 Total L&E 3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firm’s DSO to 32

days affect the company?

1-48
Reducing accounts receivable
and the days sales outstanding
 Reducing A/R will have no effect on
sales
Old A/R = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up: $261,180

Initially shows up as addition to cash.

1-49
Effect of reducing receivables
on balance sheet and stock
price
Added cash $261 Debt 1,545
A/R 617 Equity 1,952
Other CA 1,802
Net FA 817 _____
Total Assets 3,497 Total L&E 3,497

What could be done with the new cash?

How might stock price and risk be
affected?
1-50
Potential uses of freed up
cash
 Repurchase stock
 Expand business
 Reduce debt
 All these actions would likely
improve the stock price.

1-51
Potential problems and
limitations of financial ratio
analysis
 Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.
 “Average” performance is not
necessarily good, perhaps the firm
should aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can
make statements and ratios look
better.
1-52
More issues regarding
ratios
 Different operating and accounting
practices can distort comparisons.
 Sometimes it is hard to tell if a
ratio is “good” or “bad”.
 Difficult to tell whether a company
is, on balance, in strong or weak
position.

1-53
Qualitative factors to be
considered when evaluating a
company’s future financial
performance
 Are the firm’s revenues tied to 1 key
customer, product, or supplier?
 What percentage of the firm’s
business is generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment

1-54
CHAPTER 7
Bonds and Their Valuation

 Key features of bonds

 Bond valuation
 Measuring yield
 Assessing risk
1-55
What is a bond?
 A long-term debt instrument in
which a borrower agrees to make
payments of principal and
interest, on specific dates, to the
holders of the bond.

1-56
Bond markets
 Primarily traded in the over-the-counter
(OTC) market.
 Most bonds are owned by and traded
among large financial institutions.
 Full information on bond trades in the
OTC market is not published, but a
representative group of bonds is listed
and traded on the bond division of the
NYSE.
1-57
Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply
by par to get dollar payment of interest.
 Maturity date – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).

1-58
Effect of a call provision
 Allows issuer to refund the bond
issue if rates decline (helps the
issuer, but hurts the investor).
 Borrowers are willing to pay
more, and lenders require more,
for callable bonds.
 Most bonds have a deferred call
and a declining call premium.

1-59
What is a sinking fund?
 Provision to pay off a loan over
its life rather than all at maturity.
 Similar to amortization on a term
loan.
 Reduces risk to investor,
shortens average maturity.
 But not good for investors if
rates decline after issuance.
1-60
How are sinking funds
executed?
 Call x% of the issue at par, for sinking
fund purposes.
 Likely to be used if kd is below the
coupon rate and the bond sells at a
premium.
 Buy bonds in the open market.
 Likely to be used if kd is above the
coupon rate and the bond sells at a
discount.
1-61
 The value of financial
assets
 0  1  2  n
 k
...


 Value  CF1  CF2  CFn

CF1 CF2 CFn

Value 1
 2
 ...  n
(1  k) (1  k) (1  k)

1-62
Other types (features) of
bonds
 Convertible bond – may be exchanged for
common stock of the firm, at the holder’s
option.
 Warrant – long-term option to buy a stated
number of shares of common stock at a
specified price.
 Putable bond – allows holder to sell the bond
back to the company prior to maturity.
 Income bond – pays interest only when
interest is earned by the firm.
 Indexed bond – interest rate paid is based
upon the rate of inflation.
1-63
What is the opportunity cost of
debt capital?
 The discount rate (ki ) is the
opportunity cost of capital, and is
the rate that could be earned on
alternative investments of equal
risk.

ki = k* + IP + MRP + DRP +
LP
1-64
 What is the value of a 10-year,
10% annual coupon bond, if kd =
10%?
 0  1  2  n
 k
...


 VB = ?  100  100  100 + 1,000

$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB $1,000
1-65
 Using a financial calculator to
value a bond
 This bond has a $1,000 lump sum due at t
= 10, and annual $100 coupon payments
beginning at t = 1 and continuing through
t = 10, the price of the bond can be found
by solving for the PV of these cash flows.

 INPUTS
 10  10  100  1000
 N  I/YR  PV  PMT  FV
 OUTPUT -1000


1-66
 An example:
Increasing inflation and kd
 Suppose inflation rises by 3%, causing
kd = 13%. When kd rises above the
coupon rate, the bond’s value falls
below par, and sells at a discount.

 INPUTS
 10  13  100  1000
 N  I/YR  PV  PMT  FV
 OUTPUT -837.21


1-67
 An example:
Decreasing inflation and kd
 Suppose inflation falls by 3%, causing
kd = 7%. When kd falls below the
coupon rate, the bond’s value rises
above par, and sells at a premium.

 INPUTS
 10  7  100  1000
 N  I/YR  PV  PMT  FV
 OUTPUT -1210.71


1-68
 The price path of a bond
 What would happen to the value of this bond if
its required rate of return remained at 10%, or
at 13%, or at 7% until maturity?
VB


 1,372  kd = 7%.
 1,211 kd = 10%.
 1,000
 837 kd = 13%.


 775  Years
to Maturity
 30 25 20 15 10 5 0 1-69
Bond values over time
 At maturity, the value of any bond must
equal its par value.
 If kd remains constant:
 The value of a premium bond would

decrease over time, until it reached

$1,000.
 The value of a discount bond would

increase over time, until it reached

$1,000.
 A value of a par bond stays at $1,000.

1-70
What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value
bond, selling for $887?
 Must find the kd that solves this model.

INT INT M
VB  1
 ...  N
 N
(1  kd ) (1  kd ) (1  kd )
90 90 1,000
$887 1
 ...  10
 10
(1  kd ) (1  kd ) (1  kd )

1-71
 Using a financial calculator
to find YTM
 Solving for I/YR, the YTM of this bond
is 10.91%. This bond sells at a
discount, because YTM > coupon
rate.

 INPUTS
 10  - 887  90  1000
 N  I/YR  PV  PMT  FV
 OUTPUT  10.91

1-72
 Find YTM, if the bond price was
$1,134.20.
 Solving for I/YR, the YTM of this bond
is 7.08%. This bond sells at a
premium, because YTM < coupon
rate.

 INPUTS
 10 -1134.2
  90  1000
 N  I/YR  PV  PMT  FV
 OUTPUT  7.08

1-73
 Definitions
Annual coupon payment
Current yi
eld(CY) 
Currentprice

Changein price
Capitalgainsyield(CGY) 
Beginningprice

 Expected
  Expected

Expectedtotalreturn YTM     
 CY   CGY 
1-74
An example:
Current and capital gains yield
 Find the current yield and the capital
gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and
has a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%

1-75
Calculating capital gains
yield
YTM = Current yield + Capital gains yield

CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year

from now and divide the change in price by the
beginning price, which gives the same answer.

1-76
 What is interest rate (or price)
risk?
 Interest rate risk is the concern that rising
kd will cause the value of a bond to fall.

% change 1 yr kd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to

interest rate changes, and hence has more
interest rate risk.
1-77
What is reinvestment rate
risk?
 Reinvestment rate risk is the concern
that kd will fall, and future CFs will have
to be reinvested at lower rates, hence
reducing income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You
intend to invest the money and
live off the interest.
1-78
 Reinvestment rate risk
example
 You may invest in either a 10-year bond or
a series of ten 1-year bonds. Both 10-year
and 1-year bonds currently yield 10%.
 If you choose the 1-year bond strategy:
 After Year 1, you receive $50,000 in

income and have $500,000 to reinvest.

But, if 1-year rates fall to 3%, your
annual income would fall to $15,000.
 If you choose the 10-year bond strategy:
 You can lock in a 10% interest rate, and

$50,000 annual income.

1-79
 Conclusions about interest rate
and reinvestment rate risk
Short-term Long-term
AND/OR High AND/OR Low
coupon bonds coupon bonds
Interest
Low High
rate risk
Reinvestme
High Low
nt rate risk
 CONCLUSION: Nothing is riskless!

1-80
 Semiannual bonds
1. Multiply years by 2 : number of periods = 2n.
2. Divide nominal rate by 2 : periodic rate (I/YR)
= kd / 2.
3. Divide annual coupon by 2 : PMT = ann cpn /
2.

 INPUTS
 2n  kd / 2  OK  cpn / 2  OK
 N  I/YR  PV  PMT  FV
 OUTPUT

1-81
 What is the value of a 10-year, 10%
semiannual coupon bond, if kd =
13%?

1. Multiply years by 2 : N = 2 * 10 = 20.

2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 =
50.

 INPUTS
 20  6.5  50  1000
 N  I/YR  PV  PMT  FV
 OUTPUT  - 834.72

1-82
Would you prefer to buy a 10-year,
10% annual coupon bond or a 10-
year, 10% semiannual coupon bond,
all else equal?

The semiannual bond’s effective rate

is: m 2
 iNom   0.10
EFF%  1    1  1    1 10.25%
 m  2 

10.25% > 10% (the annual bond’s

effective rate), so you would prefer
the semiannual bond.
1-83
 If the proper price for this semiannual
bond is $1,000, what would be the
proper price for the annual coupon
bond?
 The semiannual coupon bond has an
effective rate of 10.25%, and the annual
coupon bond should earn the same EAR.
At these prices, the annual and
semiannual coupon bonds are in
equilibrium, as they earn the same
effective return.
 INPUTS
 10  10.25  100  1000
 N  I/YR  PV  PMT  FV
 OUTPUT  - 984.80
1-84
 A 10-year, 10% semiannual coupon
bond selling for $1,135.90 can be called
in 4 years for $1,050, what is its yield to
call (YTC)?

 The bond’s yield to maturity can be

determined to be 8%. Solving for the YTC
is identical to solving for YTM, except the
time to call is used for N and the call
premium is FV.

 INPUTS
 8 - 1135.90
  50  1050
 N  I/YR  PV  PMT  FV
 OUTPUT 3.568


1-85
Yield to call
 3.568% represents the periodic
semiannual yield to call.
 YTCNOM = kNOM = 3.568% x 2 =
7.137% is the rate that a broker
would quote.
 The effective yield to call can be
calculated
 YTCEFF = (1.03568)2 – 1 = 7.26%
1-86
If you bought these callable bonds,
would you be more likely to earn the
YTM or YTC?

 The coupon rate = 10% compared to

YTC = 7.137%. The firm could raise
money by selling new bonds which
pay 7.137%.
 Could replace bonds paying $100 per
year with bonds paying only $71.37
per year.
 Investors should expect a call, and to
earn the YTC of 7.137%, rather than
the YTM of 8%.
1-87
When is a call more likely to
occur?
 In general, if a bond sells at a
premium, then (1) coupon > kd, so
(2) a call is more likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

1-88
Default risk
 If an issuer defaults, investors
receive less than the promised
return. Therefore, the expected
return on corporate and
municipal bonds is less than the
promised return.
 Influenced by the issuer’s
financial strength and the terms
of the bond contract.
1-89
Types of bonds
 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds
 Junk bonds

1-90
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds
Moody’ Aaa Aa A Baa Ba B Caa C
s
S&P AAA AA A BBB BB B CCC
D
 Bond ratings are designed to reflect
the probability of a bond issue going
into default.

1-91
Factors affecting default risk and
bond ratings
 Financial performance
 Debt ratio
 TIE ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity
1-92
Other factors affecting default
risk
 Earnings stability
 Regulatory environment
 Potential antitrust or product
liabilities
 Pension liabilities
 Potential labor problems
 Accounting policies
1-93
Bankruptcy
 Two main chapters of the Federal
Bankruptcy Act:
 Chapter 11, Reorganization
 Chapter 7, Liquidation
 Typically, a company wants Chapter
11, while creditors may prefer
Chapter 7.

1-94
 Chapter 11 Bankruptcy
 If company can’t meet its obligations …
 It files under Chapter 11 to stop creditors from
foreclosing, taking assets, and closing the
business.
 Has 120 days to file a reorganization plan.
 Court appoints a “trustee” to supervise
reorganization.
 Management usually stays in control.
 Company must demonstrate in its
reorganization plan that it is “worth
more alive than dead”.
 If not, judge will order liquidation under Chapter 7.

1-95
Priority of claims in
liquidation
1. Secured creditors from sales of
secured assets.
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
1-96
Reorganization
 In a liquidation, unsecured creditors
generally get zero. This makes them
more willing to participate in
reorganization even though their claims
are greatly scaled back.
 Various groups of creditors vote on the
reorganization plan. If both the majority
of the creditors and the judge approve,
company “emerges” from bankruptcy
with lower debts, reduced interest
charges, and a chance for success.
1-97
CHAPTER 2
Financial Statements,
Cash Flow, and Taxes
 Balance sheet
 Income statement
 Statement of cash flows
 Accounting income vs. cash
flow
 MVA and EVA
1-98
 Federal tax system
The Annual Report
 Balance sheet – provides a snapshot of a
firm’s financial position at one point in time.
 Income statement – summarizes a firm’s
revenues and expenses over a given period
of time.
 Statement of retained earnings – shows
how much of the firm’s earnings were
retained, rather than paid out as dividends.
 Statement of cash flows – reports the
impact of a firm’s activities on cash flows
over a given period of time.
1-99
Balance Sheet: Assets
2002 2001
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800
1-100
Balance sheet:
Liabilities and Equity
2002 2001
Accts payable 524,160 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total CL 1,650,568 481,600
Long-term debt 723,432 323,432
Common stock 460,000 460,000
Retained earnings 32,592 203,768
Total Equity 492,592 663,768
Total L & E 2,866,592 1,468,800
1-101
Income statement
2002 2001
Sales 6,034,000 3,432,000
COGS 5,528,000 2,864,000
Other expenses 519,988 358,672
EBITDA (13,988) 209,328
Depr. & Amort. 116,960 18,900
EBIT (130,948) 190,428
Interest Exp. 136,012 43,828
EBT (266,960) 146,600
Taxes (106,784) 58,640
Net income (160,176) 87,960
1-102
Other data
2002 2001
No. of shares 100,000 100,000
EPS -$1.602 $0.88
DPS $0.11 $0.22
Stock price $2.25 $8.50
Lease pmts $40,000 $40,000

1-103
Statement of Retained
Earnings (2002)
Balance of retained
earnings, 12/31/01 $203,768
(160,176)
Add: Net income,
2002 (11,000)

Less: Dividends
paid $32,592

Balance of retained
earnings, 12/31/02
1-104
Statement of Cash Flows
(2002)
OPERATING ACTIVITIES
Net income (160,176)
Add (Sources of cash):
Depreciation 116,960
Increase in A/P 378,560
Increase in accruals 353,600
Subtract (Uses of cash):
Increase in A/R (280,960)
Increase in inventories (572,160)
Net cash provided by ops.
(164,176)
1-105
Statement of Cash Flows
(2002)
L-T INVESTING ACTIVITIES
Investment in fixed assets (711,950)
FINANCING ACTIVITIES
Increase in notes payable 436,808
Increase in long-term debt 400,000
Payment of cash dividend (11,000)
Net cash from financing 825,808
NET CHANGE IN CASH (50,318)
Plus: Cash at beginning of 57,600
year
Cash at end of year 7,282
1-106
What can you conclude about
D’Leon’s financial condition
from its statement of CFs?
 Net cash from operations = -
$164,176, mainly because of
negative NI.
 The firm borrowed $825,808 to
meet its cash requirements.
 Even after borrowing, the cash
account fell by $50,318.
1-107
Did the expansion create
additional net operating after
taxes (NOPAT)?
NOPAT = EBIT (1 – Tax rate)

NOPAT02 = -$130,948(1 – 0.4)

= -$130,948(0.6)
= -$78,569

NOPAT01 = $114,257

1-108
What effect did the expansion
have on net operating working
capital?
NOWC = Current - Non-interest
assets bearing CL

NOWC02 = ($7,282 + $632,160 + $1,287,360)

– ( $524,160 + $489,600)
= $913,042

NOWC01 = $842,400

1-109
What effect did the expansion
have on operating capital?
Operating capital = NOWC + Net Fixed
Assets

Operating Capital02 = $913,042 +

$939,790
= $1,852,832

Operating Capital01 = $1,187,200

1-110
What is your assessment of
the expansion’s effect on
operations?
2002 2001
Sales $6,034,000 $3,432,000
NOPAT -$78,569 $114,257
NOWC $913,042 $842,400
Operating $1,187,200
$1,852,832
capital $87,960
-$160,176
Net Income

1-111
What effect did the expansion have
on net cash flow and operating cash
flow?
NCF02 = NI + Dep = ($160,176) + $116,960
= -$43,216
NCF01 = $87,960 + $18,900 = $106,860
OCF02 = NOPAT + Dep
= ($78,569) + $116,960
= $38,391
OCF01 = $114,257 + $18,900
= $133,157
1-112
What was the free cash
flow (FCF) for 2002?
FCF = OCF – Gross capital investment
- OR -
FCF02 = NOPAT – Net capital investment
= -$78,569 – ($1,852,832 -
$1,187,200)
= -$744,201

Is negative free cash flow always a bad sign?

1-113
Economic Value Added
(EVA)
EVA = After-tax __ After-tax
Operating Income Capital costs

= Funds Available __ Cost of

to Investors Capital Used

= NOPAT – After-tax Cost of Capital

1-114
EVA Concepts
 In order to generate positive EVA,
a firm has to more than just cover
operating costs. It must also
provide a return to those who have
provided the firm with capital.
 EVA takes into account the total
cost of capital, which includes the
cost of equity.
1-115
What is the firm’s EVA? Assume the
firm’s after-tax percentage cost of
capital was 10% in 2000 and 13% in
2001.
EVA02 = NOPAT – (A-T cost of capital) (Capital)
= -$78,569 – (0.13)($1,852,832)
= -$78,569 - $240,868
= -$319,437

EVA01 = $114,257 – (0.10)($1,187,200)

= $114,257 - $118,720
= -$4,463

1-116
Did the expansion
increase or decrease MVA?
MVA = Market value __ Equity
capital
of equity supplied

During the last year, the stock price

has decreased 73%. As a
consequence, the market value of
equity has declined, and therefore
MVA has declined, as well.
1-117
Does D’Leon pay its
suppliers on time?
 Probably not.
 A/P increased 260%, over the
past year, while sales increased
by only 76%.
 If this continues, suppliers may
cut off D’Leon’s trade credit.

1-118
Does it appear that D’Leon’s
sales price exceeds its cost per
unit sold?
 NO, the negative NOPAT and
decline in cash position shows
that D’Leon is spending more on
its operations than it is taking in.

1-119
 What if D’Leon’s sales manager
decided to offer 60-day credit terms
to customers, rather than 30-day
credit terms?
 If competitors match terms, and sales remain
constant …
 A/R would 

 Cash would 

 If competitors don’t match, and sales double …

 Short-run: Inventory and fixed assets  to

meet increased sales. A/R , Cash .

Company may have to seek additional
financing.
 Long-run: Collections increase and the

company’s cash position would improve.

1-120
How did D’Leon finance its
expansion?
 D’Leon financed its expansion with
external capital.
 D’Leon issued long-term debt
which reduced its financial
strength and flexibility.

1-121
Would D’Leon have required
external capital if they had broken
even in 2001 (Net Income = 0)?
 YES, the company would still have
to finance its increase in assets.
Looking to the Statement of Cash
Flows, we see that the firm made
an investment of $711,950 in net
fixed assets. Therefore, they
would have needed to raise
additional funds.
1-122
What happens if D’Leon
depreciates fixed assets over 7
years (as opposed to the current 10
years)?
 No effect on physical
assets.
 Fixed assets on the
balance sheet would
decline.
 Net income would
decline.
 Tax payments would
decline.
 Cash position would
improve.

1-123
Federal Income Tax
System

1-124
 Corporate and Personal
Taxes
 Both have a progressive structure (the higher the
income, the higher the marginal tax rate).
 Corporations
 Rates begin at 15% and rise to 35% for

corporations with income over $10 million.

 Also subject to state tax (around 5%).

 Individuals
 Rates begin at 10% and rise to 38.6% for

individuals with income over $307,050.

 May be subject to state tax.

1-125
Tax treatment of various
uses and sources of funds
 Interest paid – tax deductible for corporations
(paid out of pre-tax income), but usually not for
individuals (interest on home loans being the
exception).
 Interest earned – usually fully taxable (an
exception being interest from a (muni”).
 Dividends paid – paid out of after-tax income.
 Dividends received – taxed as ordinary income
for individuals (“double taxation”). A portion of
dividends received by corporations is tax
excludable, in order to avoid “triple taxation”.

1-126
More tax issues
 Tax Loss Carry-Back and Carry-Forward – since
corporate incomes can fluctuate widely, the
tax code allows firms to carry losses back to
offset profits in previous years or forward to
offset profits in the future.
 Capital gains – defined as the profits from the
sale of assets not normally transacted in the
normal course of business, capital gains for
individuals are generally taxed as ordinary
income if held for less than a year, and at the
capital gains rate if held for more than a year.
Corporations face somewhat different rules.

1-127
CHAPTER 6
Time Value of Money
 Future value
 Present value
 Annuities
 Rates of return
 Amortization
1-128
 Time lines
 0  1  2  3
i%

 CF0  CF1  CF2  CF3

 Show the timing of cash flows.

 Tick marks occur at the end of periods,
so Time 0 is today; Time 1 is the end
of the first period (year, month, etc.)
or the beginning of the second period.
1-129
 Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity
 $100 lump sum due in 2
years
 0 1  2
i%


 100
3 year $100 ordinary
annuity
0 1  2  3
i%

 100  100  100

1-130
 Uneven cash flow stream; CF0 = -
$50,
CF1 = $100, CF2 = $75, and CF3 =
$50

 Uneven cash flow stream

 0  1  2  3
i%


 -50  100  75  50

1-131
 What is the future value (FV) of an
initial $100 after 3 years, if I/YR =
10%?
 Finding the FV of a cash flow or series
of cash flows when compound interest
is applied is called compounding.
 FV can be solved by using the
arithmetic, financial calculator, and
spreadsheet methods.
 0  1  2  3
10%


 100  FV = ?
1-132
Solving for FV:
The arithmetic method
 After 1 year:

FV1 = PV ( 1 + i ) = $100 (1.10)
= $110.00
 After 2 years:

FV2 = PV ( 1 + i )2 = $100 (1.10)2
=$121.00
 After 3 years:

FV3 = PV ( 1 + i )3 = $100 (1.10)3
=$133.10
 After n years (general case):

FVn = PV ( 1 + i )n
1-133
 Solving for FV:
The calculator method
 Solves the general FV equation.
 Requires 4 inputs into calculator, and
will solve for the fifth. (Set to P/YR =
1 and END mode.)

 INPUTS
 3  10  -100  0
 N  I/YR  PV  PMT  FV
 OUTPUT 133.10


1-134
 What is the present value (PV) of
$100 due in 3 years, if I/YR = 10%?
 Finding the PV of a cash flow or series
of cash flows when compound interest
is applied is called discounting (the
reverse of compounding).
 The PV shows the value of cash flows
in terms of today’s purchasing power.
 0  1  2  3
10%

 PV = ?  100
1-135
Solving for PV:
The arithmetic method
 Solve the general FV equation for
PV:
 PV = FVn / ( 1 + i )n

 PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

1-136
 Solving for PV:
The calculator method
 Solves the general FV equation for PV.
 Exactly like solving for FV, except we
have different input information and
are solving for a different variable.

 INPUTS
 3  10  0  100
 N  I/YR  PV  PMT  FV
 OUTPUT -75.13


1-137
 Solving for N:
If sales grow at 20% per year, how
long before sales double?
 Solves the general FV equation for N.
 Same as previous problems, but now
solving for N.

 INPUTS
 20  -1  0  2
 N  I/YR  PV  PMT  FV
 OUTPUT  3.8

1-138
 What is the difference between
an ordinary annuity and an
annuity due?
 Ordinary Annuity
 0  1  2  3
i%


 PMT  PMT  PMT

 Annuity Due
 0  1  2  3
i%


 PMT  PMT  PMT

1-139
 Solving for FV:
3-year ordinary annuity of $100 at
10%
 $100 payments occur at the end
of each period, but there is no PV.

 INPUTS
 3  10  0  -100
 N  I/YR  PV  PMT  FV
 OUTPUT  331

1-140
 Solving for PV:
3-year ordinary annuity of $100 at
10%
 $100 payments still occur at the
end of each period, but now there
is no FV.

 INPUTS
 3  10  100  0
 N  I/YR  PV  PMT  FV
 OUTPUT -248.69


1-141
 Solving for FV:
3-year annuity due of $100 at 10%
 Now, $100 payments occur at the
beginning of each period.
 Set calculator to “BEGIN” mode.

 INPUTS
 3  10  0  -100
 N  I/YR  PV  PMT  FV
 OUTPUT 364.10


1-142
 Solving for PV:
3 year annuity due of $100 at 10%
 Again, $100 payments occur at the
beginning of each period.
 Set calculator to “BEGIN” mode.

 INPUTS
 3  10  100  0
 N  I/YR  PV  PMT  FV
 OUTPUT -273.55


1-143
 What is the PV of this uneven
cash flow stream?
0 1 2
  3  4
 10%
100 300
 300
 -50

 90.91
247.93

225.39

 -34.15
530.08 = PV

1-144
Solving for PV:
Uneven cash flow stream
 Input cash flows in the calculator’s
“CFLO” register:

CF0 = 0

CF1 = 100

CF2 = 300

CF3 = 300

CF4 = -50
 Enter I/YR = 10, press NPV button to get
NPV = $530.09. (Here NPV = PV.)
1-145
 Solving for I:
What interest rate would cause $100
to grow to $125.97 in 3 years?
 Solves the general FV equation for I.

 INPUTS
 3  -100  0 125.97


 N  I/YR  PV  PMT  FV
 OUTPUT  8

1-146
The Power of Compound
Interest
A 20-year-old student wants to start saving for
retirement. She plans to save $3 a day.
Every day, she puts $3 in her drawer. At the
end of the year, she invests the accumulated
savings ($1,095) in an online stock account.
The stock account has an expected annual
return of 12%.

How much money will she have when she is

65 years old?
1-147
 Solving for FV:
Savings problem
 If she begins saving today, and
sticks to her plan, she will have
$1,487,261.89 when she is 65.

 INPUTS
 45  12  0  -1095
 N  I/YR  PV  PMT  FV
 OUTPUT 1,487,262


1-148
 Solving for FV:
Savings problem, if you wait until
you are 40 years old to start
 If a 40-year-old investor begins saving
today, and sticks to the plan, he or she will
have $146,000.59 at age 65. This is $1.3
million less than if starting at age 20.
 Lesson: It pays to start saving early.

 INPUTS
 25  12  0  -1095
 N  I/YR  PV  PMT  FV
 OUTPUT 146,001


1-149
 Solving for PMT:
How much must the 40-year old
deposit annually to catch the 20-
year old?
 To find the required annual
contribution, enter the number of
years until retirement and the final
goal of $1,487,261.89, and solve for
PMT.
 INPUTS
 25  12  0 1,487,262


 N  I/YR  PV  PMT  FV
 OUTPUT -11,154.42


1-150
 Will the FV of a lump sum be larger
or smaller if compounded more
often, holding the stated I%
constant?
 LARGER, as the more frequently
compounding occurs, interest is earned on
0
interest more
1 often. 2 3
 10%

 100  133.10
 Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5
 6
5%


100
  134.01
 Semiannually: FV6 = $100(1.05) = $134.01
6

1-151
 Classifications of interest
rates
 Nominal rate (iNOM) – also called the quoted or
state rate. An annual rate that ignores
compounding effects.

iNOM is stated in contracts. Periods must also
be given, e.g. 8% Quarterly or 8% Daily
interest.
 Periodic rate (iPER) – amount of interest
charged each period, e.g. monthly or
quarterly.

iPER = iNOM / m, where m is the number of
compounding periods per year. m = 4 for
quarterly and m = 12 for monthly 1-152
Classifications of interest
rates
 Effective (or equivalent) annual rate (EAR
= EFF%) – the annual rate of interest
actually being earned, taking into account
compounding.

EFF% for 10% semiannual investment
EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 – 1 =
10.25%

An investor would be indifferent
between an investment offering a
10.25% annual return and one offering
a 10% annual return, compounded
semiannually. 1-153
Why is it important to consider
effective rates of return?
 An investment with monthly payments is
different from one with quarterly payments.
Must put each return on an EFF% basis to
compare rates of return. Must use EFF% for
comparisons. See following values of EFF%
rates at various compounding levels.

EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
1-154
Can the effective rate ever
be equal to the nominal rate?
 Yes, but only if annual
compounding is used, i.e., if m =
1.
 If m > 1, EFF% will always be
greater than the nominal rate.

1-155
When is each rate used?
 iNOM written into contracts, quoted by
banks and brokers. Not used in
calculations or shown on time lines.
 iPER Used in calculations and shown
on time lines. If m = 1, iNOM = iPER =
EAR.
 EAR Used to compare returns on
investments with different payments
per year. Used in calculations when
annuity payments don’t match
compounding periods. 1-156
What is the FV of $100 after 3 years
under 10% semiannual
compounding? Quarterly
compounding?
iNOM mn
FVn PV ( 1  )
m

0.10 23
FV3S $100( 1  )
2
6
FV3S $100(1.05) $134.01
12
FV3Q $100(1.025) $134.49
1-157
 What’s the FV of a 3-year $100
annuity, if the quoted interest
rate is 10%, compounded
semiannually?
1 2 3
 0  1 2  3 4  5 6

5%


 100  100  100

 Payments occur annually, but
compounding occurs every 6 months.
 Cannot use normal annuity valuation
techniques.

1-158
 Method 1:
Compound each cash flow
1 2 3
 0  1 2  3 4  5 6

5%


 100  100 100

110.25

121.55

331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100

FV3 = $331.80
1-159
 Method 2:
Financial calculator
 Find the EAR and treat as an
annuity.
 EAR = ( 1 + 0.10 / 2 )2 – 1 =
10.25%.
 INPUTS
 3  10.25  0  -100
 N  I/YR  PV  PMT  FV
 OUTPUT 331.80


1-160
 Find the PV of this 3-year
ordinary annuity.
 Could solve by discounting each
cash flow, or …
 Use the EAR and treat as an
annuity to solve for PV.
 INPUTS
 3  10.25  100  0
 N  I/YR  PV  PMT  FV
 OUTPUT -247.59


1-161
Loan amortization
 Amortization tables are widely used
for home mortgages, auto loans,
business loans, retirement plans, etc.
 Financial calculators and
spreadsheets are great for setting up
amortization tables.

 EXAMPLE: Construct an amortization

schedule for a $1,000, 10% annual
rate loan with 3 equal payments.
1-162
 Step 1:
Find the required annual
payment
 All input information is already given,
just remember that the FV = 0 because
the reason for amortizing the loan and
making payments is to retire the loan.

 INPUTS
 3  10 -1000
  0

 N  I/YR  PV  PMT  FV
 OUTPUT 402.11


1-163
Step 2:
Find the interest paid in Year
1
 The borrower will owe interest upon
the initial balance at the end of the
first year. Interest to be paid in the
first year can be found by multiplying
the beginning balance by the interest
rate.

INTt = Beg balt (i)

INT1 = $1,000 (0.10) = $100
1-164
Step 3:
Find the principal repaid in
Year 1
 If a payment of $402.11 was made
at the end of the first year and $100
was paid toward interest, the
remaining value must represent the
amount of principal repaid.

PRIN = PMT – INT

= $402.11 - $100 =
$302.11
1-165
Step 4:
Find the ending balance after
Year 1
 To find the balance at the end of
the period, subtract the amount
paid toward principal from the
beginning balance.

END BAL = BEG BAL – PRIN

= $1,000 - $302.11
= $697.89
1-166
table:
Repeat steps 1 – 4 until end of
loan
Year BEG PMT INT PRIN END
BAL BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTA 1,206.3 206.34 1,000 -
L 4
 Interest paid declines with each
payment as the balance declines. What
are the tax implications of this?
1-167
 Illustrating an amortized
payment:
Where does the money go?
 $
402.11


Interest


302.11


Principal Payments

 0  1  2  3
 Constant payments.
 Declining interest payments.
 Declining balance.
1-168
Partial amortization
 Bank agrees to lend a home buyer
$220,000 to buy a $250,000 home,
requiring a $30,000 down payment.
 The home buyer only has $7,500 in cash,
so the seller agrees to take a note with
the following terms:
 Face value = $22,500
 7.5% nominal interest rate
 Payments made at the end of the year,
based upon a 20-year amortization
schedule.
 Loan matures at the end of the 10 th year.
1-169
 Calculating annual loan
payments
 Based upon the loan information,
the home buyer must make annual
payments of $2,207.07 on the
loan.

 INPUTS
 20  7.5 -22500
  0

 N  I/YR  PV  PMT  FV
 OUTPUT 2207.07


1-170
Determining the balloon
payment
 Using an amortization table
(spreadsheet or calculator), it can
be found that at the end of the
10th year, the remaining balance
on the loan will be $15,149.54.
 Therefore,
 Balloon payment = $15,149.54

 Final payment = $17,356.61

1-171
CHAPTER 5
Risk and Rates of Return

 Stand-alone risk
 Portfolio risk
 Risk & return: CAPM / SML

1-172
 Investment returns
The rate of return on an investment can be
calculated as follows:
(Amount received – Amount invested)
________________________
Return =
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for
this investment is:
($1,100 - $1,000) / $1,000 = 10%.
1-173
What is investment risk?
 Two types of investment risk
 Stand-alone risk
 Portfolio risk
 Investment risk is related to the
probability of earning a low or
negative actual return.
 The greater the chance of lower than
expected or negative returns, the
riskier the investment.
1-174
Probability distributions
 A listing of all possible outcomes, and the
probability of each occurrence.
 Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

1-175
 Selected Realized Returns,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002),
28.

1-176
 Investment alternatives

Economy Prob. T-Bill HT Coll USR MP

Recessio 0.1 8.0% - 28.0% 10.0% -
n 22.0% 13.0%

Below 0.2 8.0% -2.0% 14.7% - 1.0%

avg 10.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above 0.2 8.0% 35.0% - 45.0% 29.0%

avg 10.0%

Boom 0.1 8.0% 50.0% - 30.0% 43.0%

20.0%
1-177
 Why is the T-bill return
independent of the economy? Do
T-bills promise a completely risk-
free return?
 T-bills will return the promised 8%,
regardless of the economy.
 No, T-bills do not provide a risk-free return,
as they are still exposed to inflation.
Although, very little unexpected inflation is
likely to occur over such a short period of
time.
 T-bills are also risky in terms of
reinvestment rate risk.
 T-bills are risk-free in the default sense of
the word.
1-178
How do the returns of HT and
Coll. behave in relation to the
market?
 HT – Moves with the economy, and
has a positive correlation. This is
typical.
 Coll. – Is countercyclical with the
economy, and has a negative
correlation. This is unusual.

1-179
Return: Calculating the expected
return for each alternative
^
k expectedrateof return
^ n
k  ki Pi
i1

^
kHT (-22.%) (0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1) 17.4%

1-180
 Summary of expected
returns for all alternatives
Exp return
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%

HT has the highest expected return, and

appears to be the best investment
alternative, but is it really? Have we failed to
account for risk?
1-181
Risk: Calculating the standard
deviation for each alternative

 Standarddeviation

  Variance 2
n
  (k  k̂) P
i1
i
2
i

1-182
Standard deviation
calculation
n ^
  
i1
(ki  k)2 Pi

1
2 2
 (8.0 - 8.0) (0.1)  (8.0 - 8.0) (0.2)  2

 T  bills    (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 

2
  (8.0 - 8.0) (0.1) 

 T  bills 0.0%  Coll 13.4%

 HT 20.0%  USR 18.8%
 M 15.3%
1-183
Comparing standard
deviations
Prob.
T-
bill
USR

HT

0 8 13.8 17.4 Rate of Return (%)

1-184
Comments on standard
deviation as a measure of
risk
 Standard deviation (σi) measures total, or
stand-alone, risk.
 The larger σi is, the lower the probability
that actual returns will be closer to
expected returns.
 Larger σi is associated with a wider
probability distribution of returns.
 Difficult to compare standard deviations,
because return has not been accounted
for.
1-185
Comparing risk and return
Security Expected Risk, σ
return
T-bills 8.0% 0.0%
HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place.

1-186
Coefficient of Variation
(CV)
A standardized measure of dispersion
about the expected value, that shows
the risk per unit of return.

Stddev 
CV  ^
Mean k

1-187
 Risk rankings,
by coefficient of variation
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
 Collections has the highest degree of risk
per unit of return.
 HT, despite having the highest standard
deviation of returns, has a relatively
average CV. 1-188
 Illustrating the CV as a
measure of relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by σ) for less returns.

1-189
Investor attitude towards
risk
 Risk aversion – assumes investors
dislike risk and require higher
rates of return to encourage them
to hold riskier securities.
 Risk premium – the difference
between the return on a risky
asset and less risky asset, which
serves as compensation for
investors to hold riskier securities.
1-190
 Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
 Expected return of a portfolio is a
weighted average of each of the
component assets of the portfolio.
 Standard deviation is a little more
tricky and requires that a new
probability distribution for the
portfolio returns be devised.
1-191
Calculating portfolio expected
return
^
kp is a weightedaverage:

^ n ^
kp  wi ki
i1

^
kp 0.5(17.4%) 0.5(1.7%) 9.6%

1-192
An alternative method for
determining portfolio expected
return

Economy Prob HT Coll Port.

.
Recessio 0.1 - 28.0% 3.0%
n 22.0%
Below 0.2 -2.0% 14.7% 6.4%
avg
Average 0.4 20.0% 0.0% 10.0%
^Above 0.2 35.0% - 12.5%
kavg
p 0.10(3.0%)  0.20(6.4%)  0.40(10.0%)
10.0%
Boom 0.20(12.5%)  0.10(15.0%)
0.1 50.0% - 9.6%
15.0%
20.0% 1-193
Calculating portfolio standard
deviation and CV
1
2
 0.10(3.0 - 9.6)  2

  0.20(6.4 - 9.6)2 
 2

 p    0.40(10.0- 9.6)  3.3%
  0.20(12.5- 9.6)2 
 2

  0.10(15.0 - 9.6) 

3.3%
CVp  0.34
9.6%
1-194
Comments on portfolio risk
measures
 σp = 3.3% is much lower than the σi of
either stock (σHT = 20.0%; σColl. =
13.4%).
 σp = 3.3% is lower than the weighted
average of HT and Coll.’s σ (16.7%).
 Portfolio provides average return of
component stocks, but lower than
average risk.
 Why? Negative correlation between
stocks. 1-195
General comments about
risk
 Most stocks are positively
correlated with the market (ρk,m
 0.65).
 σ  35% for an average stock.
 Combining stocks in a portfolio
generally lowers risk.

1-196
 Returns distribution for two
perfectly negatively correlated
stocks (ρ = -1.0)

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

1-197
 Returns distribution for two
perfectly positively correlated
stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

1-198
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
 σp decreases as stocks added, because
they would not be perfectly correlated
with the existing portfolio.
 Expected return of the portfolio would
remain relatively constant.
 Eventually the diversification benefits of
adding more stocks dissipates (after
about 10 stocks), and for large stock
portfolios, σp tends to converge to  20%.

1-199
 Illustrating diversification
effects of a stock portfolio
p (%)
Company-Specific Risk
35
Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
1-200
 Breaking down sources of
risk
Stand-alone risk = Market risk + Firm-specific
risk

 Market risk – portion of a security’s stand-

alone risk that cannot be eliminated
through diversification. Measured by beta.
 Firm-specific risk – portion of a security’s
stand-alone risk that can be eliminated
through proper diversification.
1-201
 Failure to diversify
 If an investor chooses to hold a one-stock
portfolio (exposed to more risk than a
diversified investor), would the investor be
compensated for the risk they bear?
 NO!
 Stand-alone risk is not important to a well-
diversified investor.
 Rational, risk-averse investors are concerned
with σp, which is based upon market risk.
 There can be only one price (the market
return) for a given security.
 No compensation should be earned for
holding unnecessary, diversifiable risk.
1-202
Capital Asset Pricing Model
(CAPM)
 Model based upon concept that a
stock’s required rate of return is equal
to the risk-free rate of return plus a risk
premium that reflects the riskiness of
the stock after diversification.
 Primary conclusion: The relevant
riskiness of a stock is its contribution to
the riskiness of a well-diversified
portfolio.
1-203
Beta
 Measures a stock’s market risk,
and shows a stock’s volatility
relative to the market.
 Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.

1-204
Calculating betas
 Run a regression of past returns of
a security against past returns on
the market.
 The slope of the regression line
(sometimes called the security’s
characteristic line) is defined as
the beta coefficient for the
security.
1-205
 Illustrating the calculation of
beta
_
ki
. Year kM ki
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
kM
-5 Regression line:
. -10
^
ki = -2.59 + 1.44 ^
kM
1-206
Comments on beta
 If beta = 1.0, the security is just as risky
as the average stock.
 If beta > 1.0, the security is riskier than
average.
 If beta < 1.0, the security is less risky
than average.
 Most stocks have betas in the range of
0.5 to 1.5.

1-207
Can the beta of a security be
negative?
 Yes, if the correlation between Stock
i and the market is negative (i.e., ρi,m
< 0).
 If the correlation is negative, the
regression line would slope
downward, and the beta would be
negative.
 However, a negative beta is highly
unlikely.
1-208
 Beta coefficients for
HT, Coll, and T-Bills
_
ki HT: β =
40 1.30

20

T-bills: β =
0 _
-20 0 20 40 kM

Coll: β = -
0.87
-20
1-209
Comparing expected return
and beta coefficients
Security Exp. Ret. Beta
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87

Riskier securities have higher returns, so

the rank order is OK.

1-210
The Security Market Line (SML):
Calculating required rates of
return

SML: ki = kRF + (kM – kRF) βi

 Assume kRF = 8% and kM = 15%.

 The market (or equity) risk
premium is RPM = kM – kRF = 15% –
8% = 7%.
1-211
What is the market risk
premium?
 Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
 Its size depends on the perceived risk
of the stock market and investors’
degree of risk aversion.
 Varies from year to year, but most
estimates suggest that it ranges
between 4% and 8% per year.

1-212
Calculating required rates of
return
 kHT = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
 kM = 8.0% + (7.0%)(1.00) = 15.00%
 kUSR = 8.0% + (7.0%)(0.89) = 14.23%
 kT-bill = 8.0% + (7.0%)(0.00) = 8.00%
 kColl = 8.0% + (7.0%)(-0.87)= 1.91%

1-213
 Expected vs. Required
returns
^
k k
^
HT 17.4% 17.1% Undervalue
d (k  k)
^
Market 15.0 15.0 Fairly valued(k k)
^
USR 13.8 14.2 Overvalued
(k  k)
^
T - bills 8.0 8.0 Fairly valued(k k)
^
Coll. 1.7 1.9 Overvalued
(k  k)

1-214
 Illustrating the
Security Market Line
SML: ki = 8% + (15% – 8%) βi
ki (%) SML

HT
.. .
kM = 15

.
kRF = 8 T-bills USR

-1
. 0 1 2 Risk, βi
Coll.
1-215
An example:
Equally-weighted two-stock
portfolio
 Create a portfolio with 50% invested
in HT and 50% invested in Collections.
 The beta of a portfolio is the weighted
average of each of the stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215

1-216
Calculating portfolio required
returns
 The required return of a portfolio is the
weighted average of each of the stock’s
required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

 Or, using the portfolio’s beta, CAPM can be

used to solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215) 1-217
 Factors that change the
SML
 What if investors raise inflation expectations
by 3%, what would happen to the SML?

ki (%)
 I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 1-218
 Factors that change the
SML
 What if investors’ risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?

ki (%) SML2
 RPM = 3%
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 1-219
Verifying the CAPM
empirically
 The CAPM has not been verified
completely.
 Statistical tests have problems that
make verification almost impossible.
 Some argue that there are
additional risk factors, other than
the market risk premium, that must
be considered.
1-220
More thoughts on the
CAPM
 Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate of
ki.
ki = kRF + (kM – kRF) βi + ???
 CAPM/SML concepts are based upon
expectations, but betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
1-221
CHAPTER 8
Stocks and Their Valuation

 Features of common stock

 Determining common stock
values
 Efficient markets
 Preferred stock
1-222
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the
stock price

1-223
Social/Ethical Question
 Should management be equally
concerned about employees,
customers, suppliers, and “the
public,” or just the stockholders?
 In an enterprise economy,
management should work for
stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
1-224
Types of stock market
transactions
 Secondary market
 Primary market
 Initial public offering market
(IPO) (“going public”)
 Secondary offering

1-225
Different approaches for
valuing common stock
 Dividend growth model
 Corporate value model
 Using the multiples of
comparable firms
 Lucky 10/300 = 0.033
 DGKC 8 = 240

1-226
 Dividend growth model
 Value of a stock is the present value of
the future dividends expected to be
generated by the stock.

^ D1 D2 D3 D
P0  1
 2
 3
 ...  
(1 ks ) (1 ks ) (1 ks ) (1 ks )

1-227
Constant growth stock
 A stock whose dividends are expected
to grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

 If g is constant, the dividend growth

formula converges to:
^ D0 (1  g) D1
P0  
ks - g ks - g
1-228
 Future dividends and their
present values
 $ Dt D0 ( 1  g ) t

0.25 Dt
PVDt 

t
(1 k )

P0  PVDt
 0  Years (t)
1-229
What happens if g > ks?
 If g > ks, the constant growth
formula leads to a negative stock
price, which does not make sense.
 The constant growth model can
only be used if:
 ks > g
 g is expected to be constant forever

1-230
If kRF = 7%, kM = 12%, and β = 1.2,
what is the required rate of return
on the firm’s stock?
 Use the SML to calculate the
required rate of return (ks):

ks = kRF + (kM – kRF)β

= 7% + (12% - 7%)1.2
= 13%

1-231
 If D0 = $2 and g is a constant 6%,
find the expected dividend
stream for the next 3 years, and
their PVs.

 0  1  2  3
g = 6%


 D0 = 2.00
 2.12  2.247  2.382
1.8761
 ks = 13%
 1.7599
 1.6509

1-232
What is the stock’s market
value?
 Using the constant growth model:

D1 $2.12
P0  
ks - g 0.13- 0.06
$2.12

0.07
$30.29

1-233
What is the expected market
price of the stock, one year
from now?
 D1 will have been paid out already.
So, P1 is the present value (as of
year 1) of D2, D3, D4, etc.
^
D2 $2.247
P1  
ks - g 0.13- 0.06
$32.10

 Could also
^
find expected P1 as:
P1 P0 (1.06)$32.10
1-234
What is the expected dividend
yield, capital gains yield, and total
return during the first year?
 Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
 Total return (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
1-235
 What would the expected
price today be, if g = 0?
 The dividend stream would be a
perpetuity.
 0  1  2  3
ks = 13%

 ...
 2.00  2.00  2.00
^PMT $2.00
P0   $15.38
k 0.13

1-236
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
 Can no longer use just the constant
growth model to find stock value.
 However, the growth does become
constant after 3 years.

1-237
 Valuing common stock with
nonconstant growth
 0 k = 13% 1  2  3  4
s  ...
g = 30% g = 30%
 g = 30%
 g = 6%


 D0 = 2.00 2.600 3.380 4.394 4.65

8
 2.301
 2.647
 3.045
 4.658
 46.114

   
P    $66.54
3
 ^  0.13  0.06
 54.107 = P0
1-238
Find expected dividend and capital
gains yields during the first and
fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
 During non-constant growth, dividend
yield and capital gains yield are not
constant, and capital gains yield ≠ g.
 After t = 3, the stock has constant
growth and dividend yield = 7%, while
capital gains yield = 6%.
1-239
 Nonconstant growth:
What if g = 0% for 3 years before
long-run growth of 6%?

 0 k = 13% 1  2  3  4
s  ...
g = 0% g = 0%
 g = 0%
 g = 6%


 D0 = 2.00 2.00 2.00 2.00 2.1

2
 1.77
 1.57
 1.39
 2.12
 20.99

   
P    $30.29
3
^  0.13  0.06
 25.72 = P0
1-240
Find expected dividend and capital
gains yields during the first and
fourth years.
 Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
 After t = 3, the stock has
constant growth and dividend
yield = 7%, while capital gains
yield = 6%.
1-241
If the stock was expected to have
negative growth (g = -6%), would
anyone buy the stock, and what is its
value?
 The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

^ D1 D0 ( 1  g )
P0  
ks - g ks - g
$2.00(0.94) $1.88
  $9.89
0.13- (-0.06) 0.19

1-242
Find expected annual dividend
and capital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing

constant growth, dividend yield and
capital gains yield are constant.
Dividend yield is sufficiently large
(19%) to offset a negative capital
gains. 1-243
Corporate value model
 Also called the free cash flow
method. Suggests the value of the
entire firm equals the present
value of the firm’s free cash flows.
 Remember, free cash flow is the
firm’s after-tax operating income
less the net capital investment
 FCF = NOPAT – Net capital investment
1-244
 Applying the corporate value
model
 Find the market value (MV) of the firm.
 Find PV of firm’s future FCFs
 Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
 MV of = MV of – MV of debt and
common stock firm preferred
 Divide MV of common stock by the number
of shares outstanding to get intrinsic stock
price (value).

P0 = MV of common stock / # of shares
1-245
Issues regarding the
corporate value model
 Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to dividend growth model, assumes
at some point free cash flow will grow at a
constant rate.
 Terminal value (TVn) represents value of
firm at the point that growth becomes
constant.
1-246
 Given the long-run gFCF = 6%, and
WACC of 10%, use the corporate
value model to find the firm’s
intrinsic value.

 0 k = 10%  1  2  3  4
 ...
g = 6%

 -5 10 20 21.2
-4.545 0
8.264
15.026 21.2

398.197 530 = 0 = TV3

0.10  0.06
416.942 -

1-247
If the firm has $40 million in debt
and has 10 million shares of stock,
what is the firm’s intrinsic value per
share?
 MV of equity = MV of firm – MV of debt
= $416.94m - $40m
= $376.94 million
 Value per share = MV of equity / # of
shares
= $376.94m / 10m
= $37.69

1-248
Firm multiples method
 Analysts often use the following
multiples to value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply
this by expected earnings to back out
an estimate of the stock price.
1-249
What is market
equilibrium?
 In equilibrium, stock prices are stable
and there is no general tendency for
people to buy versus to sell.
 In equilibrium, expected returns must
equal required returns.
^
D1
ks   g  ks kRF  (kM  kRF )
P0

1-250
Market equilibrium
 Expected returns are obtained by
estimating dividends and expected
capital gains.
 Required returns are obtained by
estimating risk and applying the
CAPM.

1-251
How is market equilibrium
established?
 If expected return exceeds
required return …

The current price (P0) is “too low”
and offers a bargain.
 Buy orders will be greater than sell
orders.

P0 will be bid up until expected
return equals required return
1-252
Factors that affect stock
price
 Required return (ks) could change
 Changing inflation could cause kRF to
change
 Market risk premium or exposure to
market risk (β) could change
 Growth rate (g) could change
 Due to economic (market) conditions

Due to firm conditions
1-253
What is the Efficient Market
Hypothesis (EMH)?
 Securities are normally in
equilibrium and are “fairly priced.”
 Investors cannot “beat the
market” except through good luck
or better information.
 Levels of market efficiency
 Weak-form efficiency
 Semi-strong-form efficiency
 Strong-form efficiency
1-254
Weak-form efficiency
 Can’t profit by looking at past
trends. A recent decline is no
reason to think stocks will go up
(or down) in the future.
 Evidence supports weak-form
EMH, but “technical analysis” is
still used.

1-255
Semistrong-form efficiency
 All publicly available information
is reflected in stock prices, so it
doesn’t pay to over analyze
annual reports looking for
undervalued stocks.
 Largely true, but superior
analysts can still profit by finding
and using new information
1-256
Strong-form efficiency
 All information, even inside
information, is embedded in
stock prices.
 Not true--insiders can gain by
trading on the basis of insider
information, but that’s illegal.

1-257
 Is the stock market
efficient?
 Empirical studies have been conducted
to test the three forms of efficiency. Most
of which suggest the stock market was:
 Highly efficient in the weak form.
 Reasonably efficient in the semi-strong form.
 Not efficient in the strong form. Insiders
could and did make abnormal (and
sometimes illegal) profits.
 Behavioral finance – incorporates
elements of cognitive psychology to
better understand how individuals and
markets respond to different situations.
1-258
Preferred stock
 Hybrid security
 Like bonds, preferred stockholders
receive a fixed dividend that must
be paid before dividends are paid
to common stockholders.
 However, companies can omit
preferred dividend payments
without fear of pushing the firm
into bankruptcy.
1-259
If preferred stock with an annual
dividend of $5 sells for $50, what is
the preferred stock’s expected
return?

Vp = D / kp
$50 = $5 / kp

kp = $5 / $50
= 0.10 = 10%

1-260