Business Finance - ACC501 Handouts.pdf

8/14/2019 Business Finance - ACC501 Handouts.pdf

1/194

Business Finance ACC501 VULESSON 1

BUSINESS FINANCE

The Primary textbook for the course is

Essentials of Corporate Finance, by Ross, Westerfield and ordan, fourth edition, !c"ra# $illPublishers, %S&N '(')(1*1'+)()

Reference books #ill be

Introduction to Financeby La#rence "itman and eff !adura, -ddison(Wesley Publishers Foundations of Financial Managementby Stanley & &lock and "eoffrey - $irt, !c"ra# $ill

Publishers

Course Contents

-n o.er.ie# of /inancial En.ironment /inancial Statements, Taxes and 0ash /lo#s Time alue of !oney and 2iscounted 0ash /lo# aluation aluation of Stocks and &onds Net Present alue and other %n.estment 0riteria

0a3ital %n.estment 2ecision Risk and Return 0ost of 0a3ital Le.era4e and 0a3ital Structure Raisin4 0a3ital Workin4 0a3ital !ana4ement 2i.idends

Finance: A Quick ook

/our &asic -reas &usiness /inance

%n.estments /inancial %nstitutions %nternational /inance

Business Finance

-ddresses the follo#in4 three 5uestions6 What lon4(term in.estments should the firm en4a4e in7 $o# can the firm raise the money for the re5uired in.estments7 $o# much short(term cash flo# does a com3any need to 3ay its bills7

In!estments

2eals #ith financial assets such as stocks and bonds %t co.ers the follo#in4 issues Pricin4 /inancial -ssets -ssociated Risks and Re#ards 2eterminin4 best mixture of financial in.estment 0areer o33ortunities in in.estment Stock &rokera4e Portfolio !ana4ement Security -nalysis

8 0o3yri4ht irtual 9ni.ersity of Pakistan 1


2/194

Business Finance ACC501 VU

Financial Institutions

&usinesses dealin4 in financial matters &anks and %nsurance com3anies

International Finance

0o.ers international as3ects of cor3orate finance, in.estment and financial institutions



3/194

Business Finance ACC501 VULESSON *

"#$ S%U&$ FINANCE'

Marketing and Finance

!arketers ha.e to #ork #ith bud4ets Need to 4et 4reatest 3ayoffs from marketin4 ex3enditures and 3ro4rams 0ost and &enefit analysis of 3ro:ects So finance is .ital for

Marketing researc( &esign of marketing and distri)utions c(annels *roduct pricing

Accounting and Finance -ccountants are re5uired to make financial decisions as #ell as understand the im3lications of ne#

financial contracts /inancial analysts make extensi.e use of accountin4 information

Management and Finance &usiness Strate4y is al#ays disastrous if financial 3lannin4 is not adhered to

"(at is Business Finance'

%n order to start any ne# business, the follo#in4 issues become .ital What lon4(term in.estment should be taken on7 /rom #here to 4et the lon4(term financin4 to 3ay for in.estment7 &rin4 in other o#ners or borro#

the money7 $o# to mana4e e.eryday financial acti.ities7

%(e Financial Manager

To create .alue, the financial mana4er should6

Try to make smart in.estment decisions Try to make smart financin4 decisions



4/194

Business Finance ACC501 VU#+pot(etical rgani-ation C(art

Business Finance and Financial Manager

/inancial !ana4ement 2ecisions 0a3ital &ud4etin4 0a3ital Structure Workin4 0a3ital !ana4ement

Financial Management &ecisions

0a3ital &ud4etin4 The 3rocess of 3lannin4 and mana4in4 a firm;s lon4(term in.estments /inancial mana4ers concern #ith ho# much, #hen and ho# likely is cash ex3ected to recei.e E.aluatin4 the si


5/194

89 &e)t ;9E7uit+

Business Finance ACC501 VUFinancial Management &ecisions


%(e Capital Structure &ecision

Capital Structure

The .alue of the firm can be thou4ht of as a 3ie The 4oal of the mana4er is to increase the si


6/194



%(e Net "orking Capital In!estment &ecision

%(e Corporate Firm

The cor3orate form of business is the standard method for sol.in4 the 3roblems encountered inraisin4 lar4e amounts of cash

$o#e.er, businesses can take other forms

Forms of Business rgani-ation

Three ma:or forms Sole 3ro3rietorshi3 Partnershi3

=eneral imited

0or3oration imited lia)ilit+ compan+

Sole *roprietors(ip

8 0o3yri4ht irtual 9ni.ersity of Pakistan

#o< muc( s(ort4termcas( flo< does a compan+need to pa+ its )ills'

Net

"orkingCapital

S(are(olders6 E7uit+

Current ia)ilities

Current Assets

Fi/ed Assets3 %angi)le5 Intangi)le

ong4%erm &e)t

6


7/194

Business Finance ACC501 VUAd!antages

Easiest to start Least re4ulated Sin4le o#ner kee3s all the 3rofits Taxed once as 3ersonal income

&isad!antages

Limited to life of o#ner E5uity ca3ital limited to o#ner;s 3ersonal #ealth 9nlimited liability 2ifficult to sell o#nershi3 interest

*artners(ip

T#o or more o#ners =3artners> "eneral 3artnershi36 all 3artners share in 4ains and losses and all ha.e unlimited liability for all3artnershi3 debts

Limited 3artnershi36 one or more 4eneral 3artners #ill run the business and ha.e unlimited liabilitybut there #ill be one or more limited 3artners #ho do not acti.ely 3artici3ate in the business andtheir liability is limited to their contribution

Ad!antages

T#o or more o#ners !ore ca3ital a.ailable Relati.ely easy to start %ncome taxed once as 3ersonal income

&isad!antages 9nlimited liability

There are t#o ty3es of 3artnershi3 =eneral partners(ip imited partners(ip

Partnershi3 dissol.es #hen one 3artner dies or #ishes to sell 2ifficult to transfer o#nershi3



8/194

Business Finance ACC501 VULESSON ?

%#E C>*>A%E FI>M

The cor3orate form of business is the standard method for sol.in4 the 3roblems encountered in raisin4lar4e amounts of cash $o#e.er, businesses can take other forms

Forms of Business rgani-ation

Three ma:or forms Sole 3ro3rietorshi3 Partnershi3

=eneral imited

0or3oration

imited lia)ilit+ Compan+

Sole *roprietors(ip

Ad!antages

Easiest to start Least re4ulated Sin4le o#ner kee3s all the 3rofits Taxed once as 3ersonal income

&isad!antages

Limited to life of o#ner E5uity ca3ital limited to o#ner;s 3ersonal #ealth 9nlimited liability 2ifficult to sell o#nershi3 interest

*artners(ip

T#o or more o#ners =3artners> "eneral 3artnershi36 all 3artners share in 4ains and losses and all ha.e unlimited liability for all

3artnershi3 debts Limited 3artnershi36 one or more 4eneral 3artners #ill run the business and ha.e unlimited liability

but there #ill be one or more limited 3artners #ho do not acti.ely 3artici3ate in the business andtheir liability is limited to their contribution

Ad!antages

T#o or more o#ners !ore ca3ital a.ailable Relati.ely easy to start

%ncome taxed once as 3ersonal income&isad!antages

9nlimited liability =eneral partners(ip imited partners(ip Partnershi3 dissol.es #hen one 3artner dies or #ishes to sell 2ifficult to transfer o#nershi3

Corporation- business created as a distinct le4al entity o#ned by one or more indi.iduals or entities



9/194


/ormin4 of cor3oration in.ol.es 3re3arin4

C(arterincludin4 cor3oration;s name, intended life, business 3ur3ose and number of shares Set of )+la


10/194


%(e Agenc+ *ro)lem

-4ency relationshi3 Princi3al hires an a4ent to re3resent their interest Stockholders =3rinci3als> hire mana4ers =a4ents> to run the com3any -4ency 3roblem 0onflict of interest bet#een 3rinci3al and a4ent !ana4ement 4oals and a4ency costs

Managerial =oals

!ana4erial 4oals may be different from shareholder 4oals Ex3ensi.e 3er5uisites Sur.i.al %nde3endence %ncreased 4ro#th and si


11/194

Business Finance ACC501 VULESSON A

%#E FI>M AN& %#E FINANCIA MA>?E%S

Financial Markets

*rimar+ Market

When a cor3oration issues securities, cash flo#s from in.estors to the firm 9sually an under#riter is in.ol.ed

Secondar+ Markets

%n.ol.e the sale of BusedC securities from one in.estor to another Securities may be exchan4e traded or trade o.er(the(counter in a dealer market

Financial Markets


Cash flofrom firm

C

Taxes

(D)

Firm

Government

Firm issues securities (A)

Retained cash

flows F

Investsin

assets

Dividends and debtpayments (E)

Currentassets Fixed

Financialmarkets

Short-termdebton!-term debt"#uity shares

Ultimatel+, t(e firm must )e a

cas( generating acti!it+@

%(e cas( flo


12/194

Business Finance ACC501 VU&ealer 2s@ Auction Markets

-uction markets are different from dealer markets in t#o #ays6 Tradin4 in a 4i.en auction exchan4e takes 3lace at a sin4le site on the floor of the exchan4e

Transaction 3rices of shares are communicated almost immediately to the 3ublicListin4

%(e Balance S(eet

-n accountant;s sna3shot of the firm;s accountin4 .alue as of a 3articular date The &alance Sheet %dentity is6 -ssets D Liabilities Stockholder;s E5uity

When analy


13/194


%(e Balance4S(eet Model of t(e Firm

Building t(e Balance S(eet

- firm has current assets of I1'', Net fixed assets of I+'', Short term debt of I)', and Lon4 term debt of I*''

No#J Total -ssets are I1'' +'' H IK'' Total Liabilities are I)' *'' H I*)' Shareholders; e5uity is IK'' *)' H I??'

Building t(e Balance S(eet

Liabilities and-ssets Shareholders; E5uity

0urrent -ssets I1'' 0urrent Liabilities I )'Net /ixed -ssets +'' Lon4 Term 2ebt *''

Shareholders; e5uity ??'Total liabilities and

Total -ssets IK'' Shareholders; e5uity IK''


$o# much short(termcash flo# does acom3any need to 3ayits bills7

%(e Net "orking Capital In!estment &ecision

NetWorkin40a3ital

Shareholders; E5uity

0urrent Liabilities

0urrent

-ssets

/ixed -ssets 1 Tan4ible * %ntan4ible

Lon4(Term 2ebt

13


14/194


%(e Balance S(eet of t(e $D Corporation

Balance S(eet Anal+sis

When analy*>A%IN

Liabilities (Debt)Assets 20X2 20X1 and Stockholder's Equit 20X2 20X1

!urrent assets" !urrent Liabilities" Cash and equivalents

$140 $107 Accounts a!a"le

$213 $197

Accounts #eceiva"le294 270 otes a!a"le

50 53

%nvento#ies269 280 Acc#ued e&enses

223 205

'the#58 50 (otal cu##ent lia"ilities

$486 $455

(otal cu##ent assets$761 $707 Lon#$ter% liabilities"

&ied assets"

)e*e##ed ta&es$117 $104

+#oe#t!, lant, and equi-ent$1,423 $1,274

.on/te#- de"t471 458

.ess accu-ulated de#eciation 550 460

(otal lon/te#- lia"ilities$588 $562

et #oe#t!, lant, and equi-ent873 814

%ntan/i"le assets and othe#245 221

Stockholder's equit"

(otal *i&ed assets$1,118 $1,035

+#e*e##ed stoc$39 $39

Co--on stoc $1 e# value55 32

Caital su#lus347 327

Accu-ulated #etained ea#nin/s390 347

.ess t#easu#! stoc 26 20 (otal equit! $805 $725

otal assets$1,879 $1,742 otal liabilities and

stockholder's equit$1,879 $1,742

14


15/194

Business Finance ACC501 VU%(e Balance S(eet of t(e $D Corporation

&e)t !ersus E7uit+

"enerally, #hen a firm borro#s it 4i.es the bondholders first claim on the firm;s cash flo# Thus shareholder;s e5uity is the residual difference bet#een assets and liabilities

Shareholders; E5uity H -ssets Liabilities The 9se of debt in a firm;s ca3ital structure is called B/inancial Le.era4eC

The more debt a firm has =as a 3ercenta4e of assets> the 4reater is the de4ree offinancial le.era4e

2ebt acts as a le.er in the sense that it ma4nifies both 4ains and losses

2alue !ersus Cost

The true .alue of any asset is its market .alue, #hich is sim3ly the amount of cash #e #ould 4et if#e actually sold it

The .alues sho#n on the balance sheet for the firm;s assets are book .alues and 4enerally are not#hat the assets are actual #orth

9nder the -ccountin4 standards audited financial statements of firms carry assets at historical cost /or current assets, market .alue and book .alue mi4ht be some#hat similar since they are bou4ht

and con.erted into cash o.er a relati.ely short s3an of time /or fixed assets, its .ery unlikely that the actual market .alue of an asset is e5ual to its book .alue Exam3le6 Land 3urchased for railroads a century a4o Similarly the o#ner;s e5uity fi4ure on the balance sheet and the true market .alue of the e5uity need

not be related /or /inancial !ana4ers, accountin4 .alue of the e5uity is not a matter of concern rather it is the

market .alue of the shares that matters

Market !s@ Book 2alue

M 0or3oration has fixed assets #ith a book .alue of I)'' and an a33raised market .alue of I1,'''8 0o3yri4ht irtual 9ni.ersity of Pakistan

(in %illions)

20X2 and 20X1

*alance Sheet

X+, !-./-.A-

Liabilities (Debt)

Assets 20X2 20X1 and Stockholder's Equit 20X2 20

Cu##ent assets Cu##ent .ia"ilities

Cash and equivalents$140 $107

Accounts a!a"le$213 $

Accounts #eceiva"le 294 270 otes a!a"le 50 %nvento#ies

269 280 Acc#ued e&enses

223

'the#58 50

(otal cu##ent lia"ilities$486 $

(otal cu##ent assets$761 $707

.on/te#- lia"ilities

Fi&ed assets )e*e##ed ta&es$117 $

+#oe#t!, lant, and equi-ent $1,423 $1,274 .on/te#- de"t471

.ess accu-ulated de#eciation 550 460 (otal lon/te#- lia"ilities$588 $

et #oe#t!, lant, and equi-ent873 814

%ntan/i"le assets and othe#245 221

tocholde#s equit!

(otal *i&ed assets $1,118 $1,035 +#e*e##ed stoc $39

Co--on stoc $1 a# value55

Caital su#lus347

Accu-ulated #etained ea#nin/s390

.ess t#easu#! stoc 26 (otal equit!

$805 $

(otal assets $1,879 $1,742 (otal lia"ilities and stocholde#s equit! $1,879 $1

$ere #e see NW0 4ro# to I*)+ million in*'* from I*+* million in *'1

This increase of I*? million is an in.estmeof the firm

I*? million

I*)+m H I)K1m( IAKm

I*+*m H I)')( IA++

15


16/194


Net #orkin4 ca3ital is IA'' on the books but a33rox IK'' #ould be reali


17/194

Business Finance ACC501 VULESSON +

%#E INCME S%A%EMEN%

%f #e think of the balance sheet as a sna3shot then #e can think of income statement as a .ideorecordin4 co.erin4 before and after the 3icture

The income statement measures 3erformance o.er a s3ecific 3eriod of time The accountin4 definition of income is

Re.enue Ex3enses D %ncome

Q 0or3oration %ncome Statement


0in millions120X2

nco%e State%ent$D C>*>A%IN

Total o3eratin4 re.enues0ost of 4oods soldSellin4, 4eneral, and administrati.e ex3enses2e3reciation

O3eratin4 incomeOther incomeEarnin4s before interest and taxes%nterest ex3ensePretax incomeTaxes 0urrent6 I)1 2eferred6 I1?Net income

Retained earnin4s6 IA? 2i.idends6 IA?

The o3erationssection of the incomestatement re3orts thefirm;s re.enues andex3enses from

3rinci3al o3erations

I*,*K*( 1,K++

( ?*)( '

I1'*

I*1( A

I1)'( A

IK

17


18/194

Business Finance ACC501 VU$D Corporation Income Statement

$D Corporation Income Statement


0in millions1595

nco%e State%ent$D C>*>A%IN

Total o3eratin4 re.enues0ost of 4oods soldSellin4, 4eneral, and administrati.e ex3enses2e3reciationO3eratin4 incomeOther incomeEarnin4s before interest and taxes%nterest ex3ensePretax incomeTaxes 0urrent6 I)1 2eferred6 I1?Net income


The non(o3eratin4section of the income

statement includes allfinancin4 costs, suchas interest ex3ense

I*,*K*( 1,K++

( ?*)( '

I1'*

I*1( A

I1)'( A

IK

0in millions120X2

Income Statement$D C>*>A%IN

Total o3eratin4 re.enues0ost of 4oods soldSellin4, 4eneral, and administrati.e ex3enses2e3reciationO3eratin4 incomeOther incomeEarnin4s before interest and taxes%nterest ex3ensePretax incomeTaxes 0urrent6 I)1 2eferred6 I1?Net income


9sually a se3aratesection re3orts as ase3arate item theamount of taxesle.ied on income

I*,*K*

1,655( ?*)( '

I1'*

I*1( A

I1)'( A

IK

18


19/194


Income Statement Anal+sis

There are three thin4s to kee3 in mind #hen analy Non 0ash %tems Time and 0osts

Income Statement Anal+sis

"enerally -cce3ted -ccountin4 Princi3les ="--P> BThe Reali


20/194

Business Finance ACC501 VUIncome Statement Anal+sis

Time and 0osts Product cost include such thin4s as ra# materials, direct labor and manufacturin4 o.erhead and are

re3orted on the income statement as the cost of 4oods sold, but they include both fixed and.ariable costs

Period costs include sellin4, 4eneral, and administrati.e ex3enses #hich may be fixed as #ell as.ariable

%a/es

One of the lar4est cash outflo#s that a 0or3orate firm ex3eriences The si x ?A H ,+''=I *'',''' 1'','''> x ? H ?,'''

I K1,*+' Our total tax is IK1,*+' -.era4e tax rate is IK1,*+' U *'',''' H ?'K*+ !ar4inal rate is ?

Flat %a/ rate

There is only one tax rate and this rate is same for all income le.els With such a tax, the mar4inal tax rate is al#ays same as the a.era4e tax rate The model tax rate schedule 3resented earlier re3resents a modified flat(rate tax, #hich becomes a

true flat rate for the hi4hest incomes Lets take another .ie#

A!erage !s@ Marginal %a/ >ates

Taxable %ncome !ar4inal Tax Rate Total Tax -.era4e tax Rate

I A+,''' 1+ I K,)+' 1+''

)',''' *+ 1*,+'' 1)K

+,''' ?A *',++' *1K?



21/194

Business Finance ACC501 VU*+',''' ? ',)+' ?*?'

1,''',''' ?A ?A',''' ?A''

1),+'',''' ? K,1'',''' ?AK

+',''',''' ?+ 1),+'',''' ?+''

1'',''',''' ?+ ?+,''',''' ?+''

A!erage !s@ Marginal %a/ >ates

We see that the more a cor3oration makes, the 4rater is the 3ercenta4e of taxable income 3aid intaxes

So the a.era4e tax rate ne.er 4oes do#n, e.en thou4h the mar4inal rate does %t #ill normally be the mar4inal tax rate that is rele.ant for financial decision makin4, since any ne#

cash flo#s #ill be taxed at the mar4inal rateCost of a %a/ &educti)le E/pense

The business3ersons often say that a tax(deductible item, such as interest on loans, tra.elex3enditures, or salaries, costs substantially less than the amount s3ent on after(tax basis

Lets examine t#o cor3orations ( one 3ays I1'',''' in interest, #hile other has no interest ex3ense

Cost of a %a/ &educti)le E/pense

Corporation A Corporation B

Earnin4s before interest and taxes IA'',''' IA'','''

( %nterest Ex3ense 1'',''' '

Earnin4 before taxes =taxable income> ?'',''' A'','''

( Taxes V?+ 1'+,''' 1A','''

Earnin4 after taxes I1+,''' I*K','''

2ifference in earnin4 after taxes IK+,'''

%t can also be com3uted as6 %nterest Ex3ense =1 Tax rate> HI1'',''' =1 ?+>

H IK+,'''

Cost of a %a/ &educti)le E/pense

%nterest is deducted from earnin4s before determinin4 taxable income, thus sa.in4 I?+,''' in taxesand costin4 only IK+,''' on a net basis &ecause a di.idend on common stock is non tax(deductible, #e say it cost 1'' of amount 3aid

/rom a 3urely cor3orate cash flo# 3oint of .ie#, the firm #ould be indifferent bet#een 3ayin4I1'',''' in interest and IK+,''' in di.idends

LESSON K8 0o3yri4ht irtual 9ni.ersity of Pakistan 21


22/194

Business Finance ACC501 VU&E*>ECIA%IN AS A %A S#IE&

-lthou4h de3reciation is not a ne# source of funds, it 3ro.ides the im3ortant function of shieldin4 3artof our income from taxes

-4ain, #e take the same t#o cor3orations one char4es off I1'',''' in de3reciation, other char4esoff none

&epreciation as a %a/ S(ield

0or3oration - 0or3oration &

Earnin4s before de3reciation taxes IA'',''' IA'','''

( 2e3reciation 1'',''' '

Earnin4 before taxes =taxable income> ?'',''' A'','''

( Taxes V?+ 1'+,''' 1A','''

Earnin4 after taxes I1+,''' I*K','''

2e3 char4ed #ithout cash outlay 1'',''' '

0ash flo# I*+,''' I*K','''

2ifference I?+,'''

%t can also be com3uted as6 2e3reciation x Tax rate I1'',''' x ?+

H I?+,'''&epreciation as a %a/ S(ield

0or3oration - en:oys I?+,''' more in cash flo#, since de3reciation shielded I1'',''' from taxation in0or3oration - and sa.ed I?+,''' in taxes, #hich e.entually a33eared in cash flo#s

Financial Cas( Flo


23/194


Ex3enses related to firm;s financin4 of its assets are not included since they are not o3eratin4ex3enses

To calculate O0/, #e calculate re.enues minus costs =includin4 taxes bein4 3aid in cash>, but don;tinclude

de3reciation since it is not a cash out flo# %nterest because it is a financin4 ex3ense O0/ is .ery si4nificant as it tells #hether or not the firm;s cash inflo#s from its business

o3erations are sufficient to co.er its e.eryday cash outflo#s So, a ne4ati.e o3eratin4 cash flo# is a si4n of trouble

Financial Cas( Flo< of t(e $D Corporation

Capital Spending

Some 3ortion of the firm;s cash flo# is rein.ested in the firm 0a3ital s3endin4 refers to the nets3endin4 on fixed assets =Purchases of fixed assets less sale of fixed assets>

Net 0a3ital S3endin4 could be ne4ati.e if the firm sold off more assets than it 3urchased 2e3reciation of the res3ecti.e assets is accounted for in this re4ard


(in 2

&inancial !ashX+,

Cas( Flo< of t(e Firm

O3eratin4 cash flo# I*?

0a3ital s3endin4=1)?>

-dditions to net #orkin4 ca3ital =*?>

Total IA*

Cas( Flo< of In!estors in t(e Firm

2ebt I?K

E5uity K

Total IA*

O3eratin4 0ash /lo#6E&%T I*12e3reciation I'0urrent Taxes =I)1>O0/ I*?

23


24/194

Business Finance ACC501 VUFinancial Cas( Flo< of t(e $D

C(ange in Net "orking Capital

%t is the amount s3ent on Net Workin4 0a3ital, and re3resents the net increase in current assets o.ercurrent liabilities

Financial Cas( Flo< of t(e $D


0in millions1595

&inancial !ash &lo$D C>*>A%IN

0a3ital S3endin4Purchase of fixed assets I1

Sales of fixed assets =*+>0a3ital S3endin4 I1)?



0a3ital s3endin4 =1)?>


Total IA*


2ebt I?K

E5uity K

Total IA*

(in %illions)20X2

&inancial !ash &loX+, !-./-.A-

NW0 4re# to I*)+ million in*'* from I*+* million in *'1This increase of I*? million is theaddition to NW0

Cas( Flo< of t(e FirmO3eratin4 cash flo# I*?

0a3ital s3endin4 =1)?>

-dditions to net #orkin4 ca3ital 23

Total IA*


2ebt I?K

E5uityK

Total IA*

24


25/194



Cas( Flo< to Creditors

0ash flo# to creditors is calculated as interest 3aid less net ne# borro#in4



0in millions120X2



O3eratin4 cash flo#I*?

0a3ital s3enadin4173


Total IA*


2ebt I?K

E5uity K

Total IA*

0in millions1595


Cas( Flo< to CreditorsInterest G>etirement of de)t

8;&e)t ser!ice 355*roceeds fromne< de)t sales 0H1%otal ;



0a3ital s3endin4=1)?>

-dditions to net #orkin4 ca3ital 23

Total IA*


2ebt I?K

E5uity K

Total IA*

25


26/194


Cas( Flo< to Stock(olders

0ash flo# to stockholders is calculated as di.idends 3aid less net ne# e5uity raised




(in %illions)20X2

&inancial !ash &loX+, !-./-.A-

Cas( Flo< to Stock(olders&i!idends ;>epurc(ase of stock

Cas( to Stock(olders G*roceeds from ne< stock issue

0;1%otal



Caital sendin/ =1)?>


Total IA*


2ebt I?K

E5uity K

Total IA*

0in millions1

20X2&inancial !ash &lo

$D C>*>A%IN

!ash &lo o3 the &ir%

rsStockholdeCFCreditorsCF

AssetsCF

+

%(e cas( from recei!ed from t(efirm6s assets must e7ual t(e cas(flo


(otal IA*


2ebt I?K

E5uity K

(otal IA*

26


27/194


Cas( Flo< Summar+

Cas( Flo< identit+

0ash flo# from -ssets H 0ash /lo# to creditors

0ash flo# to Stockholders

0ash flo# from -ssets0ash flo# from assets H O3eratin4 0ash /lo#

( Net 0a3ital S3endin4 ( 0han4e in Net Workin4 0a3ital Where

Operating cash flow = Earnings before Interest and taxes + epreciation ! "axes

#et $apital %pending = Ending #et &ixed 'ssets( )eginning #et &ixed 'ssets + epreciation

$hange in #W$ = Ending #W$ ! )eginning #W$

Cas( flo< to creditors 0)ond(olders10ash flo# to creditors H %nterest 3aid Net ne# borro#in4s

Cas( flo< to stock(olders 0o


28/194

Business Finance ACC501 VULESSON )

%#E S%A%EMEN% F CAS# F"S

There is an official accountin4 statement called the statement of cash flo#s This hel3s ex3lain the chan4e in accountin4 cash, The three com3onents of the statement of cash flo#s are 0ash flo# from o3eratin4 acti.ities 0ash flo# from in.estin4 acti.ities 0ash flo# from financin4 acti.ities




(in %illions)20X2 and 20X1*alance Sheet

X+, !-./-.A-

Assets 595 593Current assets: 0ash and e5ui.alents $140 $107

-ccounts recei.able 294 270

%n.entories 269 280

Other 58 50 Total current assets $761 $707

Fi/ed assets: Pro3erty, 3lant, and e5ui3ment $1,423 $1,274

Less accumulated de3reciation 550 460 Net 3ro3erty, 3lant, and e5ui3ment873 814

%ntan4ible assets and other 245 221

Total fixed assets $1,118 $1,035

otal assets$1,879 $1,742

(in %illions)20X2 and 20X1*alance Sheet

X+, !-./-.A-

Liabilities (Debt)and Stockholder's Equit 20X2 20X1

!urrent Liabilities" Accounts a!a"le

$213 $197

otes a!a"le50 53

Acc#ued e&enses223 205

(otal cu##ent lia"ilities$486 $455

Lon#$ter% liabilities" )e*e##ed ta&es

$117 $104

.on/te#- de"t 471 458 (otal lon/te#- lia"ilities

$588 $562

Stockholder's equit" +#e*e##ed stoc

$39 $39

Co--on stoc $1 e# value55 32

Caital su#lus347 327

Accu-ulated #etained ea#nin/s390 347

.ess t#easu#! stoc 26 20 (otal equit!

$805 $725

otal liabilities and

stockholder's equit$1,879 $1,742

28


29/194


$D Corporation Cas( Flo< from perating Acti!ities


0in millions120X2

Income Statement$D C>*>A%IN

Total o3eratin4 re.enues

0ost of 4oods soldSellin4, 4eneral, and administrati.e ex3enses

2e3reciation

O3eratin4 income

Other income

Earnin4s before interest and taxes

%nterest ex3ense

Pretax income

Taxes

0urrent6 I)1 2eferred6 I1?

Net income

Retained earnin4s6 IA?

2i.idends6 IA?

I*,*K*

( 1,K++( ?*)( '

I1'

*

I*1( A

I1)'( A

IK

0in millions1

595!ash &lo 3ro% -4eratin# Acti5ities

$D C>*>A%IN

To calculate cash flo# fromo3erations, start #ith net income,add back noncash items likede3reciation and ad:ust for chan4esin current assets and liabilities =otherthan cash>

perationsNet %ncome2e3reciation2eferred Taxes0han4es in -ssets and Liabilities

-ccounts Recei.able%n.entories-ccounts Payable-ccrued Ex3ensesNotes Payable

Other

%otal Cas( Flo< from perations

IK'1?

=*A>111K1=?>

I1

=>

29


30/194

Business Finance ACC501 VU$D Corporation Cas( Flo< from In!esting Acti!ities

$D Corporation Cas( Flo< from Financing Acti!ities

$D Corporation Statement of Cas( Flo*>A%IN

0ash flo# from in.estin4 acti.itiesin.ol.es chan4es in ca3ital assets6ac5uisition of fixed assets and sales offixed assets =i*e*net ca3italex3enditures>

-c5uisition of fixed assets

Sales of fixed assets%otal Cas( Flo< from In!esting Acti!ities

I=1>

*+I=1)?>

0in millions1595

Cas( Flo< from Financing Acti!ities$D C>*>A%IN

0ash flo#s to and fromcreditors and o#ners

include chan4es in e5uityand debt

Retirement of debt =includes notes>

Proceeds from lon4(term debt sales2i.idendsRe3urchase of stockProceeds from ne# stock issue

%otal Cas( Flo< from Financing

I=)?>

K=A?>

A?

I)

=K>

The statement of cash flo#s is theaddition of cash flo#s from

o3erations, cash flo#s fromin.estin4 acti.ities, and cash flo#sfrom financin4 acti.ities

-4erationset %nco-e)e#eciation

)e*e##ed (a&esChan/es in Assets and .ia"ilities

Accounts eceiva"le%nvento#iesAccounts +a!a"leAcc#ued &ensesotes +a!a"le'the#

otal !ash &lo 3ro% -4erations

$869013

24111618

3

$1998

Acquisition o* *i&ed assetsales o* *i&ed assets

otal !ash &lo 3ro% n5estin# Acti5ities

$19825

$173

n5estin# Acti5ities

&inancin# Acti5itieseti#e-ent o* de"t includes notes+#oceeds *#o- lon/te#- de"t sales)ividendseu#chase o* stoc+#oceeds *#o- ne stoc issue

%otal Cas( Flo< from Financing

$7386

43

43$7

6

C(ange in Cas( 0on t(e )alance s(eet1 $33

30


31/194

Business Finance ACC501 VUSignificance of Financial Statements

- 4ood Workin4 Mno#led4e of financial Statements is desirable sim3ly because these statements are the3rimary means of communicatin4 financial information both #ithin and outside the firm

E/ternal Uses of Statement Anal+sis

"rade $reditors"rade $reditors (( /ocus on the li5uidity of the firm )ondholders)ondholders (( /ocus on the lon4(term cash flo# of the firm %hareholders%hareholders (( /ocus on the 3rofitability and lon4(term health of the firm

Internal Uses of Statement Anal+sis

lanlan (( /ocus on assessin4 the current financial 3osition and e.aluatin4 3otential firm o33ortunities $ontrol$ontrol (( /ocus on return on in.estment for .arious assets and asset efficiency ,nderstand,nderstand (( /ocus on understandin4 ho# su33liers of funds analy


32/194


LESSON CMMN4SIDE S%A%EMEN%S

One .ery common and useful #ay of standardi


33/194


A5D Inc@, Common4Si-e Balance S(eet

ia)ilities and e7uit+ *'1 *'*Current lia)ilities-ccounts 3ayable * K

Notes 3ayable K ++Total 1K' 1+1Lon4(term debt 1+) 1*)Stock(olders6 e7uit+0ommon stock and 3aid(in sur3lus 1A 1+?Retained earnin4s +?? +K

Total K1 )**Total liabilities and e5uity 1''' 1'''

A5D Inc@, Common4Si-e Balance S(eet

!ore on Standardi o.er the 3eriod7C

&ased on the *'1 and *'* &US, NPE rose from I*,)?1 to I*,', so NPE rose by I1A 2id the firm;s NPE 4o u3 or do#n7 Ob.iously, it #ent u3, but so did totalassets %n fact, lookin4

at the standardi


34/194

Business Finance ACC501 VUNet income I ?K?2i.idends I1*1Retained earnin4s *A*

-* %nc, 0ommon(Si


35/194


%ntensity and efficiency of asset use *rofita)ilit+ ratios -bility to control ex3enses Market !alue ratios "oin4 beyond financial statements

S(ort4%erm Sol!enc+, or i7uidit+ Measures

The 3rimary concern to #hich these ratios relate, is the firm;s ability to 3ay its bills o.er the shortrun #ithout undue stress So these ratios focus on current assets and current liabilities

Li5uidity ratios are 3articularly interestin4 to short(term creditors Since financial mana4ers areconstantly #orkin4 #ith banks and other short(term lenders, an understandin4 of these ratios isessential

Current assets and lia)ilities

Their book .alues and market .alues are likely to be similar They can and do chan4e fairly ra3idly, hence un3redictable

0urrent -ssets0urrent RatioH ((((((((((((((((((((((((

0urrent Liabilities

&ecause current assets and liabilities are con.erted into cash o.er the follo#in4 1* months, thecurrent ratio is a measure of short run li5uidity

The unit of measurement is either dollars or timesCurrent >atio

/or -* 0or3oration, the *'* current ratio is

I)'0urrent RatioH (((((((((( H 1?1 times

I+A'We can say that

-* has a I1?1 in current assets for e.ery I1 in current liabilities OR-* has its current liabilities co.ered 1?1 times o.er

To a creditor =3articularly a short(term creditor like su33lier>, the hi4her the current ratio, the betterTo firm, hi4h current ratio indicates li5uidity, but it may also indicate an inefficient use of cash andother short(term assets

We #ould ex3ect to see a current ratio of at least 1, because a current ratio of less than 1 #ould meanthat net #orkin4 ca3ital is ne4ati.e

Like any other ratio, current ratio is effected by .arious transactions

%f a firm borro#s o.er lon4(term,%(e s(ort run effect


36/194

Business Finance ACC501 VU- firm #ants to 3ayoff some of its su33liers and creditors What #ould ha33en to current ratio7

0urrent ratio mo.es a#ay from 1 if it is 4reater than 1 it #ill 4et bi44er &ut if it is less than 1, it #ill 4etsmaller

Su33ose a firm has IA in current assets and I* in current liabilities for a current ratio of * and uses I1 incash to reduce current liabilities, then ne# current ratio is =IA(*> U =I*(1> H ?

Re.ersin4 the situation to I* in current assets and IA in current liabilities, the chan4e #ill cause currentratio to fall to 1U? from 1U*

Su33ose a firm buys some in.entory What #ould ha33en in this case7

Nothin4 ha33ens to current ratio &ecause in this scenario, one current asset =cash> 4oes do#n #hileanother current asset =in.entory> 4oes u3 Total current assets are unaffected

"(at (appens if a firm sells some merc(andise'

0urrent ratio #ould usually rise because in.entory is sho#n at cost and sale #ould normally be atsomethin4 4reater than cost =difference is marku3>

So, the increase in either cash or recei.ables is 4reater than the decrease in in.entoryThis increases current assets and current ratio rises

Quick 0or Acid4%est1 >atio

%n.entory is often the least li5uid current asset -nd its book .alues are least reliable as measures ofmarket .alue since the 5uality of in.entory isn;t considered Some of the in.entory may turn out to bedama4ed, obsolete or lost

Relati.ely lar4e in.entories are often a si4n of short(term trouble The firm may ha.e o.erestimated sales and o.erbou4ht or o.er3roduced as a result, hence tied u3 a

substantial 3ortion of its li5uidity in slo# mo.in4 in.entory

%t is com3uted :ust like current ratio, exce3t in.entory is omitted

0urrent -ssets %n.entory

Xuick RatioH ((((((((((((((((((((((((((((((((((((0urrent Liabilities/or -*, this ratio in *'* #as

I)' A**Xuick RatioH ((((((((((((((((( H '+? times

I+A'

The 5uick ratio here tells a some#hat different story than the current ratio, because in.entory accountsfor more than half of -*;s current assets

%f the same fi4ure is for an aircraft manufacturin4 cor3oration, then this #ould certainly be a cause for a&%" concern

Cas( >atio- .ery short(term creditor may be interested in the cash ratio

0ash0ash RatioH ((((((((((((((((((((((( 0urrent Liabilities

0urrent ratio for -* in *'* #as '1



37/194


LESSON

>A%I ANA$SIS

A5D Inc@, Balance S(eetA5D Inc@

Balance S(eet as of &ecem)er ;30 in millions1

Assets 593 595Current Assets0ash I A I -ccounts recei.able 1K+ 1%n.entory ?? A**

Total I KA* I)'/ixed assetsNet 3lant and e5ui3ment*,)?1 *,'Total assets I?,?)? I?,+A5D Inc@, Balance S(eetia)ilities and e7uit+ *'1 *'*Current lia)ilities-ccounts 3ayable I ?1* I ?AANotes 3ayable *?1 1K

Total I +A? I +A'Lon4(term debt +?1 A+)Stock(olders6 e7uit+0ommon stock and 3aid(in sur3lus +'' ++'Retained earnin4s 1,) *,'A1

Total I*,* I*,+1Total liabilities and e5uity I?,?)? I?,+

A5D Inc@, Income StatementFor t(e $ear 595

0 in millions1Net sales I*,?110ost of 4oods sold 1,?AA2e3reciation *)KEarnin4s before interest and taxes I K1%nterest 1A1Taxable income ++'

Taxes 1)Net income I ?K?2i.idends I1*1Retained earnin4s *A*

Current >atio

Current E!ents

Su33ose a firm buys some in.entory What #ould ha33en in this case7



38/194


Nothin4 ha33ens to current ratio &ecause in this scenario, one current asset =cash> 4oes do#n #hileanother current asset =in.entory> 4oes u3 Total current assets are unaffected

"(at (appens if a firm sells some merc(andise'

0urrent ratio #ould usually rise because in.entory is sho#n at cost and sale #ould normally be atsomethin4 4reater than cost =difference is marku3>

So, the increase in either cash or recei.ables is 4reater than the decrease in in.entory

This increases current assets and current ratio rises

Current >atio

- firm #ants to 3ayoff some of its su33liers and creditors What #ould ha33en to current ratio7

0urrent ratio mo.es a#ay from 1 if it is 4reater than 1 it #ill 4et bi44er &ut if it is less than 1, it #ill 4etsmaller

Su33ose a firm has IA in current assets and I* in current liabilities for a current ratio of * and uses I1 incash to reduce current liabilities, then ne# current ratio is =IA(1> U =I*(1> H ?

Re.ersin4 the situation to I* in current assets and IA in current liabilities, the chan4e #ill cause current

ratio to fall to 1U? from 1U*

ong %erm Sol!enc+ Measures

These ratios are intended to address the firm;s lon4(run ability to meet its obli4ations, or its financialle.era4e

%otal &e)t >atioThis ratio takes into account all debts of all maturities to all creditors %t is com3uted as

Total -ssets Total E5uityTotal 2ebt RatioH ((((((((((((((((((((((((((((((((((((

Total -ssetsFor A5D Corporation

I?,+ *,+1Total 2ebt RatioH (((((((((((((((((((((( H '* times

I?,+ So -* uses * debt Whether this is hi4h or lo#, or #hether it e.en makes any difference de3ends

on #hether or not ca3ital structure matters -* has * debt a4ainst total assets, thus there is )* e5uity a4ainst total assets $ere #e dra# t#o .ariations out of total debt ratio

2ebt(e5uity ratio

E5uity multi3lier

2ebtE5uity ratio H Total 2ebt U Total E5uity H * U )* H '? times

E5uity !ulti3lier H Total -ssets U Total E5uity H 1'' U )* H 1? times

OR H 1 2ebt(E5uity ratio H 1? times

Interest Co!erage >atio



39/194


-lso kno#n as Times %nterest Earned =T%E> ratio, refers to the ability of the firm to co.er is interestobli4ations

Earnin4 before %nterest Taxes%nterest 0o.era4e ratio H (((((((((((((((((((((((((((((((((((((((((

%nterest/or -* cor3oration6

H IK1 U I1A1 H A times

Cas( Co!erage >atio

- 3roblem #ith %nterest 0o.era4e Ratio is that it is based on Earnin4s before %nterest and Taxes=E&%T> #hich is not really a measure of cash a.ailable to 3ay interest

The reason is that de3reciation, a non(cash ex3ense has been deducted out So #e use6

E&%T 2e3reciation0ash 0o.era4e ratio H (((((((((((((((((((((((((((((((((((((((((

%nterest

H IK1 *)K H IK) H @G times I1A1 I1A1

Asset Management or %urno!er Measures

The measures in this section are sometimes called -sset 9tiliatio

%n.entory turno.er can be calculated as6

0ost of 4oods Sold%n.entory Turno.er ratio H (((((((((((((((((((((((((((((((( %n.entory

/or -*, %TR #ould be6 I1,?AAH (((((((((((((((( H ;@5 times IA**

So -* sold off or turned o.er the entire in.entory ?* times -s lon4 as stock(out and fore4oin4 salessituation doesn;t arise, the hi4her this ratio is, the more efficiently in.entory is bein4 mana4ed

&a+s6 Sales in In!entor+

%f #e kno# sales #ere turned o.er ?* times durin4 the year, #e can calculate easily ho# lon4 it took toturno.er on a.era4e

?K+ days2ays; Sales in %n.entory H ((((((((((((((((((((((((((((((((

%n.entory Turno.er/or -*6

?K+H ((((((((((( H 11A days ?*

So in.entory stays for :ust less than A months before bein4 sold or it #ould take 11A days to sell off currentin.entory



40/194


>ecei!a)les %urno!er

No# #e take a look on ho# fast #e collect on the sales of in.entorySales

Recei.ables Turno.er H (((((((((((((((((((((((((((((((-ccounts Recei.ables

/or -*6

I*,?11

H (((((((((( H 1*? times I1

So -* collected its outstandin4 credit accounts and reloaned the money 1*? times durin4 the year.'ssuming all the sales are credit sales* If not/ we use only credit sales for this ratio0

&a+s6 Sales in >ecei!a)les?K+ days

2ays; Sales in Recei.ables H (((((((((((((((((((((((((((((((Recei.ables Turno.er

/or -*6 ?K+H ((((((((((( H ?' days 1*?

So -* collects on its credit sales in a month, or the firm has ?' days; #orth of sales uncollected This ratiois also calledA!erage Collection *eriod

A 2ariation: *a+a)les %urno!er

%t describes a ho# lon4 does the firm take to 3ay its bills, and is com3uted as60ost of "oods Sold

Payables Turno.er H (((((((((((((((((((((((((((((((-ccounts 3ayables

I1,?AA H (((((((((((( H ? times

I?AASo days it took to turno.er the 3ayables are6

?K+H ((((((((((( H A days

?

This fi4ure is .ery si4nificant to the current as #ell as 3otential creditors of -*



41/194

Business Finance ACC501 VULESSON 1'

>A%I ANA$SIS

A5D Inc@, Balance S(eetA5D Inc@

Balance S(eet as of &ecem)er ;30 in millions1

Assets 593 595

Current Assets0ash I A I -ccounts recei.able 1K+ 1%n.entory ?? A**

Total I KA* I)'Fi/ed assetsNet 3lant and e5ui3ment *,)?1 *,'Total assets I?,?)? I?,+

A5D Inc@, Balance S(eet

ia)ilities and e7uit+ 593 595Current lia)ilities-ccounts 3ayable I ?1* I ?AANotes 3ayable *?1 1K

Total I +A? I +A'Lon4(term debt +?1 A+)Stock(olders6 e7uit+0ommon stock and 3aid(in sur3lus +'' ++'Retained earnin4s 1,) *,'A1Total I*,* I*,+1Total liabilities and e5uity I?,?)? I?,+

A5D Inc@, Income Statement

For t(e +ear 5950 in millions1Net sales I*,?110ost of 4oods sold 1,?AA2e3reciation *)KEarnin4s before interest and taxes I K1%nterest 1A1Taxable income ++'Taxes 1)Net income I ?K?2i.idends I1*1Retained earnin4s *A*

%otal Asset turno!er

SalesTotal -ssets Turno.er H ((((((((((((((((((((

Total -ssets

I*,?11 H (((((((((((( H 'KA times

I?,++



42/194

Business Finance ACC501 VU%n other #ords, for e.ery dollar in assets, -* 4enerated I'KA in salesCapital Intensit+ >atio%t is sim3ly the reci3rocal of total assets turno.er, or6

Total -ssets0a3ital %ntensity Ratio H ((((((((((((((((((((

Sales %t is inter3reted as the dollar in.estment in assets needed to 4enerate I1 in sales $i4her .alues

re3resent ca3ital intensi.e industries

/or -*, this ratio is com3uted to be 1+K, ie -*< has to in.est I1+K in assets to 4et I1 in sales*rofita)ilit+ Measures %n one form or the other, these ratios are intended to measure ho# efficiently the firm uses its assets

and ho# efficiently the firm mana4es its o3erations The focus in this 4rou3 is on the bottom line net income*rofit MarginE.ery com3any, bi4 or small, 3ays .ery close attention to their 3rofit mar4in

Net income Profit !ar4inH ((((((((((((((((((((

Sales/or -* com3any the 3rofit mar4in #ill be6

I ?K?

H (((((((((((( H 1+) I*,?11 So in accountin4 sense, -* 4enerates a little less than 1K cents in 3rofit for e.ery dollar in sales Other Thin4s bein4 e5ual, a relati.ely hi4h 3rofit mar4in is ob.iously desirable, corres3ondin4 to lo#

ex3enses .s sales &ut Other Thin4s are not al#ays e5ual Y /or exam3le, lo#erin4 the sales 3rice #ill usually increase unit sales but #ill normally cause 3rofit

mar4in to shrink Total Profit of o3eratin4 cash flo# may 4o u3 or do#n>eturn on AssetsReturn on -ssets =RO-> is a measure of 3rofit 3er dollar of assets6

Net income Return on -ssets H ((((((((((((((((((((

Total -ssets/or -*6 I ?K?

RO- H (((((((((( H 1'1* I?,+

>eturn on E7uit+

Return on e5uity =ROE> is a measure of ho# the stockholders fared durin4 the year Since benefitin4 the shareholders is the 4oal of cor3oration, ROE is a true bottom line measure of

3erformance Net income

Return on E5uity H ((((((((((((((((((((

Total E5uity/or -* ROE fi4ure is6 I ?K?

ROE H (((((((((( H 1A I*,+1

Therefore, for e.ery dollar in e5uity, -* 4enerated 1A cents in 3rofit &ut this is correct in accountin4terms only



43/194


>A and >E

&ecause RO- and ROE are most #idely used and commonly cited numbers, so it should be ke3t inmind that these are accountin4 rates of return

That is #hy these are called return on book assets and return on book e5uity ROE is sometimes called return on Net Worth

Market 2alue Measures

This 4rou3 of measures is based, in 3art, on information not necessarily contained in financialStatements, like market 3rice 3er share

These measures can be calculated directly only for 3ublicly traded com3anies

Earnings *er S(are-ssumin4,

-*has ?? million shares outstandin4 andstock sold for I 3er share at the end of yearSo the Earnin4s 3er Share =EPS> #ill be6

Net income I?K?

EPS H ((((((((((((((((((((((((((( H ((((((((( H I11Shares Outstandin4 ??

*rice4Earning >atioPrice(earnin4s or PE ratio is defined as6

Price 3er share PE ratio H ((((((((((((((((((((((((((

Earnin4s 3er share/or -*,

I PE ratio H ((((((((( H times

I11

So -* shares sell for ei4ht times earnin4s or it carries a PE multi3le of Since PE ratio measures ho# much in.estors are #illin4 to 3ay 3er dollar of current earnin4s, hi4herPEs are often taken to mean that the firm has si4nificant 3ros3ects for future 4ro#th

%f a firm had no or almost no earnin4s, its PE #ould 3robably be 5uite lar4e so careful inter3retation isre5uired

Book 2alue per s(are&ook alue is calculated as6

Total e5uity &ook alue H ((((((((((((((((((((((((((((((((((((

No of shares outstandin4

I *,+1

&ook alue H ((((((((((((( H I)+ ??Since book .alue 3er share is an accountin4 number, it reflects historical costs

Market4to4Book ratio%t is defined as6

!arket .alue 3er share!ark(to(&ook ratio H ((((((((((((((((((((((((((((((((((((

&ook .alue 3er share



44/194


/or -*, I H ((((((((( H 11* times

I)+ The market(to(&ook ratio com3ares the market .alue of the firm;s in.estment to their costs - .alue less than 1 could mean that the firm has not been successful o.erall in creatin4 .alue for its

stockholders

%(e &u *ont Identit+

The difference bet#een the t#o 3rofitability measures, RO- and ROE, is the use of debt financin4 , orfinancial le.era4e

The relationshi3 bet#een these measure can be illustrated by decom3osin4 ROE into its com3onent3arts

Recall, Net %ncome

ROE H ((((((((((((((((((((Total E5uity

!ulti3lyin4 it by -ssets U -ssets =#ithout chan4in4 anythin4>

Net %ncome Net %ncome -ssets ROE H (((((((((((((((((((( H (((((((((((((((( x (((((((((((

Total E5uity Total E5uity -ssets

Net %ncome -ssets H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity

Net %ncome -ssets ROE H (((((((((((((((( x (((((((((((((((( -ssets Total E5uity

So, #e ha.e ex3ressed ROE as a 3roduct of t#o other ratios RO- and the e5uity multi3lier

ROE H RO- x E5uity multi3lierH RO- x =1 2ebt(E5uity ratio>



45/194


%#E &U *N% I&EN%I%$

The difference bet#een the t#o 3rofitability measures, RO- and ROE, is the use of debt financin4 , orfinancial le.era4e

The relationshi3 bet#een these measure can be illustrated by decom3osin4 ROE into its com3onent3arts

Recall, Net %ncome ROE H ((((((((((((((((((((

Total E5uity

!ulti3lyin4 it by -ssets U -ssets =#ithout chan4in4 anythin4> Net %ncome Net %ncome -ssets

ROE H (((((((((((((((((((( H (((((((((((((((( x ((((((((((( Total E5uity Total E5uity -ssets

Net %ncome -ssets H (((((((((((((((( x ((((((((((((((((

-ssets Total E5uity

Net %ncome -ssets ROE H (((((((((((((((( x ((((((((((((((((

-ssets Total E5uity

So, #e ha.e ex3ressed ROE as a 3roduct of t#o other ratios RO- and the e5uity multi3lier

ROE H RO- x E5uity multi3lierH RO- x =1 2ebt(E5uity ratio>

Lookin4 back at -*62ebt(E5uity Ratio H '?RO- H 1'1*#hile ROE calculated 3re.iously H 1A

No#, usin4 the decom3osition method6ROE H 1'1* x 1? H 1A

We can further decom3ose ROE by multi3lyin4 the to3 and bottom by total sale6 Sales Net %ncome -ssets

ROE H (((((((( x (((((((((((((((( x ((((((((((((((((

Sales -ssets Total E5uity Rearran4in4 a bit,

Net %ncome Sales -ssets ROE H ((((((((((((((( x ((((((((((( x ((((((((((((((((

Sales -ssets Total E5uity>eturn on Assets

HProfit / Total -ssets / E5uity!ar4in Turno.er !ulti3lier

ROE H Profit /Total -ssets / E5uity8 0o3yri4ht irtual 9ni.ersity of Pakistan 45


46/194

Business Finance ACC501 VU!ar4in Turno.er !ulti3lier

This last Ex3ression is called 2u Pont identity after the 2u Pont 0or3oration, #hich 3o3ulari


47/194


/irm;s Return on -ssets and Return on E5uity are fre5uently used to calculate t#o additionalnumbers, both of #hich ha.e to do #ith the firms ability to 4ro#

%n.estors and others are fre5uently interested in kno#in4 ho# ra3idly a firm;s sales can 4ro# &ut the im3ortant thin4 to reco4ni x b

/or -* this rate is '1A x *U? H ((((((((((((((((((((

=1 '1A> x *U?

H 1'*The reason for Sustainable "ro#th rate =1'*> bein4 lar4er than internal 4ro#th rate =)*?> is that, asthe firm 4ro#s, it #ill ha.e to borro# additional funds if it has to maintain a constant debt ratioThis ne# borro#in4 is an extra source of financin4 in addition to internally 4enerated funds, so -* canex3and more



48/194


49/194


No# #e take a look at some 3ractical as3ects of the financial statements analysis Reasons for doin4 financial statements analysis &enchmarkin4 the information Problems arisin4 in the 3rocess

"(+ E!aluate Financial Statements

Primary reason for lookin4 at the accountin4 information is that #e don;t ha.e and cant ex3ect to4et market .alue information &ut if #e ha.e such information, #e #ill use it instead of accountin4data

%f there is a conflict bet#een accountin4 and market data, market data #ould be 3referred /inancial statements analysis is an a33lication of mana4ement by exce3tion and boils do#n to

com3arin4 ratios for one business #ith some a.era4e or re3resentati.e ratios The ratios differin4 considerably from a.era4es are studied further

Internal UsesPerformance E.aluation

Profit mar4in and return on e5uity 0om3arin4 the 3erformance of different di.isions

Plannin4 for the future $istorical information used for 4eneratin4 3ro:ections 0heckin4 the realism of assum3tions for the 3ro:ections

E/ternal Uses

Customers:

To e.aluate the credit standin4 of a ne# customer Lar4e customers #ould eye on the sustainability of the firm Su33liers6 E.aluate the financial #orth of the su33lier Su33liers #ould be concerned about the credit#orthiness of the firm

Competitors

Potential stren4th of the com3etitors in case of a ne# 3roduct launched by a firm -c5uisition of ne# firms %dentification of 3otential tar4ets What to offer

C(oosing a Benc(mark

&enchmarkin4 is to establish a standard to follo# for com3arison Some methods of benchmarkin4 are6

Time(Trend analysis Peer "rou3 -nalysis

%ime4%rend Anal+sis

&ased on the historical data of the firm %f the current ratio of a firm is *A for the recent financial statements, #e may com3are it #ith the

current ratios for last 1' years We may find that current ratio has declined o.er the years because of !ore efficient usa4e of current assets



50/194


0han4e in the nature of business of the firm 0han4e in business 3ractices of the firm

*eer =roup Anal+sis

%dentifyin4 the firms com3etin4 in the same markets, $a.in4 similar assets,

O3erate in similar #ays

&enchmarkin46 a.era4es for this 4rou3 of firms OR the to3 firms amon4 the 4rou3

*ro)lems by rate= of interest>multi3lied by time=number of 3eriods the interest is calculated> This is called simple interest

% H P x r x tWhere

P HF 3rinci3al amountr HF interest ratet HF time 3eriods =years>% HF sim3le interest

$o#e.er, if interest is left in the account to accumulate for a lon4er 3eriod =usually lon4er than one year>,common 3ractice re5uires that after interest is earned and credited for a 4i.en 3eriod, the ne# sum of3rinci3al interest must no# earn interest for the next 3eriod, etc This is compound interest% H P x rt

Future 2alue

%t refers to the amount of money an in.estment #ill 4ro# to o.er some 3eriod of time at some 4i.eninterest rate

-lternati.ely, future .ale is the cash .alue of an in.estment at some time in future8 0o3yri4ht irtual 9ni.ersity of Pakistan 50


51/194

Business Finance ACC501 VUSim3le %nterest is calculated as6

% H P x r x t- I1,''' de3osit at 3er year for ? yearsZ sim3le interest6% H 1''' x ' x ? H *A'- I1''' de3osit at sim3le interest for three years earns I*A' interestThe future !alue0F21of a sim3le interest calculation is deri.ed by addin4 the ori4inal 3rinci3al back to theinterest earnedI1,''' I*A' H I1,*A'

Ex3ressed as a formula6/ H P=1 rt>/ H 1'''=1''' x ' x ?> H 1,*A'%n the one(3eriod case, the formula for &1can be #ritten as6&1H $'[=1 r>

Where $'is cash flo# today =time andr is the a33ro3riate interest rate

Future 2alue for a ump Sum%f I1'' are in.ested at 1' interest rate, the future .alue of this I1'' in each 3roceedin4 year #ould be6

1 I11' H I1'' x =1 1'>

* I1*1 H I11' x =1 1'> H I1'' x 11' x 11'H I1'' x 11'*

? I1??1' H I1*1 x =1 1'> H I1'' x 11' x 11' x 1'H I1'' x =11'>?

The !ulti3eriod0ase6/uture alue"enerali


52/194

Business Finance ACC501 VU+ 1AKA1 1AKA 1K1'+

Total %nterest K1'+

The !ulti3eriod 0ase6/uture alue


Futu#e :alue,i-le inte#est,and co-ound

inte#est

$110

$121

$133;10

$146;41

$161;05

100

110

120

130

140

150

160

1 2 3 4 5

Futu#e

:alue $

(i-e


53/194


Future 2alue and Compounding


Future 2alue *roJections

1 2 3 4 5

6

7 8 9 10

1

2

3

4

5

6

7

Futu#e valueo* $1 $

0=

5

1

1

20

0 1 2 3 4 5

10;1$

340;110;1$

02;3$

40;110;1$

54;1$

240;110;1$

16;2$

540;110;1$

92;5$

4

40;110;1$

23;4$

Futu#e values o* $1;10 at 40= #ate o* inte#est

53


54/194


Future 2alue Interest Factors 0F2IF1

Numbe

r of

Periods

%nterest Rates

+ 1' 1+ *'

1 1'+'' 11''' 11+'' 1*'''

* 11'*+ 1*1'' 1?**+ 1AA''

? 11+)K 1??1' 1+*' 1)*'

A 1*1++ 1AKA1 1)A' *')?K

+ 1*)K? 1K1'+ *'11A *A?



55/194


LESSON 1?FU%U>E 2AUE

9sually sim3le interest is used in financial institutions for interest 3eriods of less than one year %f the rate is ex3ressed as an annual rate =normal 3ractice>, then the time 3eriod =t> must be a

fraction of a year

&y in.estin4 I1',''' in an , '(day certificate of de3osit, total 3roceeds at the end of the 023eriod #ill be6

/ H =1','''>=1','''x'x'U?K+> H I1',1)*K

%f you #ere to in.est I1',''' at +(3ercent interest for one year, your in.estment #ould 4ro# to I1',+''

I+'' #ould be interest =I1',''' [ '+>I1',''' is the 3rinci3al re3ayment =I1',''' [1>I1',+'' is the total due %t can be calculated as6

I1',+'' H I1','''[=1'+>

I1',''' today is #orth I1',+'' in one year, 4i.en that interest rate is +

%t refers to the current .alue of the future cash flo# discounted at the a33ro3riate discount rate %n other #ords, the amount one #ould need to in.est today at some 3re(determined interest rate to

4et some desired amount in future is the 3resent .alue of the desired money

*resent 2alue

Often, if a bank or other financial institution loans a sum for a short term, the lender #ill 3refer tocalculate the interest u3 front and loan out the discounted3rinci3al, or 3rinci3al minus interest to beearned

The interest to be 3aid u3 front on a loan is called discountand the discounted 3rinci3al, or theactual amount loaned is called thepresent value=P>

P H / =1rt>

Re3eatin4 the discount basic formula =sim3le interest>6P H /

=1rt>

Exam3le6 %f the bank loans out I1',''' for ' days at sim3le interest, the P is6

P H 1'''' U \1 ='>='U?K+>]H 1''''U 1'1)*KH I,'K+K

*resent 2alue

Su33ose you need IA'' to buy textbooks next year, Qou can earn ) on your money $o# much do youha.e to 3ut u3 today7 No#, ((((((((((( Present .alue x 1') H IA'' Sol.in4 for 3resent .alue6


83;373$07;1

400$lue+#esent va ==


56/194


So in.estin4 I?)?? =present value> at ) #ill result in ha.in4 IA'' =future value> in one year

%f you #ere to be 3romised I1',''' due in one year #hen interest rates are at +(3ercent, your in.estment be#orth I,+*?1 in today;s dollars

So, the amount that a borro#er #ould need to set aside today to, be able to meet the 3romised 3ayment ofI1',''' in one year is called the resent 1alue=1> of I1','''Note that ((((((( I1',''' H I,+*?1[=1'+>

%n the one(3eriod case, the formula for 1can be #ritten as6

Where $1 is cash flo# at date 1 and r is the a33ro3riate interest rate or discount rate

*resent 2alue for Multiple *eriods

0alculatin4 3resent .alue for multi3le 3eriods is 5uite similar in nature as #as in case of future.alue

"eneral formula for calculatin4 3resent .alue of $ cash flo# in t3eriods time is6

1 U=1 r0t is used to discount a future cash flo#, so it is called the discount factorOr present!alue interest factor 0*2IF r,t1,

0alculatin4 the 3resent .alue of a future cash flo# to determine its #orth today is commonly calleddiscountedcas( flo< 0&CF1 !aluation

*resent 2alue Interest Factors 0*2IF1

Number ofPeriods

%nterest Rates

+ 1' 1+ *'

1 '+*A ''1 'KK '???

* '')' '*KA ')+K1 'KAA

? 'K? ')+1? 'K+)+ '+))


05;1000,10$81;523,9$ =

r

C

PV+

= 11

tr

CPV

1

1

+

=


57/194

Business Finance ACC501 VUA '**) 'K?' '+)1 'A*?

+ ')?+ 'K*' 'A)* 'A'1

*resent 2alue for Multiple *eriods

2o you #ant to be a millionaire7 No 3roblemY

Su33ose you are currently *1 years old, and can earn 1' 3ercent on your money $o# much you must in.est today in order to accumulate I1 million by the time you reach a4e K+7

/irst define the .ariables6

/ H I1 million r H 1' 3ercentt H K+ ( *1 H AA years P H 7

Set this u3 as a future .alue e5uation and sol.e for the 3resent .alue6I1 million H P x =11'>AAP H I1 millionU=11'>AA H I1+,'1

Of course, #e;.e i4nored taxes and other com3lications, but stay tuned ( ri4ht no# you need to fi4ure out#here to 4et I1+,'''Y

*resent 2alue of 3 for &ifferent *eriods and >atesPresent .alueof I1 =I>

*resent 2alue

$o# much #ould an in.estor ha.e to set aside today in order to ha.e I*',''' fi.e years from no# if thecurrent rate is 1+7


r$ %&

$

r$ (%&

r$ ('&

r$ )%

Time*years+

(2%%

21%

20%

2/%

2.%

2'%

2%

2,%

2)%

2(%

57


58/194


*resent 2alue !s@ Future 2alue

What #e called the 3resent .alue factor is :ust the reci3rocal of the future .alue factor

/uture .alue factor H =1 r> t Present .alue factor H 1U=1 r>t

%f #e let /tstand for the future .alue after t 3eriods, then the relationshi3 bet#een the future .alue andthe 3resent .alue is6

P x =1 r>tH /tP H /tU =1 r> tH /tx \1U =1 r>t]

This is also kno#n as basic 3resent .alue e5uation


0 1 2 3 4 5

$20,000PV

5

15;1

000,20$53;943,9$ =

58


59/194

t

rCFV 3120 +=121000,5$000,50$ r+=

10000,5$

000,50$31 12 ==+ r

121101 =+ r

2115;12115;1110 121 ===r

Business Finance ACC501 VULESSON 1A

E2AUA%IN= IN2ES%MEN%S

- com3any is considerin4 the 3urchase of an asset for I??+, #hich may be sold for IA'' in threeyears %f the discountin4 factor is 1', is this a 4ood in.estment7

Since the com3any can in.est I??+ else#here at 1', in three years, it #ould 4ro# to6

I??+ x =1 r>tH I??+ x 11?H I??+ x 1??1H IAA+

Since the 3ro3osed 3urchase of asset 3ays out only IA'', it is not as 4ood as other in.estment alternati.es-nother #ay of lookin4 at it is to calculate the 3resent .alue of IA'' in three years at 1'6

IA'' x \1U=1r>t] H IA'' U 11?H IA'' U 1??1H I?''+?

This tells us that #e only ha.e to in.est about I?'' to 4et IA'' in three years, not I??+

"(at >ate Is Enoug('

-ssume the total cost of a colle4e education #ill be I+',''' #hen a child enters colle4e in 1* yearsThe Parents ha.e I+,''' to in.est today

What rate of interest must you earn on your in.estment to co.er the cost of your child;s education7

-bout *11+

BenJaminFranklin: A Case Stud+

&en:amin /ranklin died on -3ril 1), 1)' %n his #ill, he 4a.e 1,''' 3ounds sterlin4 to!assachusetts and the city of &oston $e 4a.e a like amount to Pennsyl.ania and the city ofPhiladel3hia

The money #as 3aid to /ranklin #hen he held 3olitical office, but he belie.ed that 3oliticiansshould not be 3aid for their ser.ice=Y>

/ranklin ori4inally s3ecified that the money should be 3aid out 1'' years after his death and used totrain youn4 3eo3le

Later, ho#e.er, after some le4al #ran4lin4, it #as a4reed that the money #ould be 3aid out *''years after /ranklin;s death in 1'

&y that time, the Pennsyl.ania be5uest had 4ro#n to about I* million the !assachusetts be5uesthad 4ro#n to IA+ million The money #as used to fund the /ranklin %nstitutes in &oston andPhiladel3hia

-ssumin4 that 1,''' 3ounds sterlin4 #as e5ui.alent to 1,''' dollars, #hat rate did the t#o statesearn7 =Note6 the dollar didn;t become the official 9S currency until 1)*>

/or Pennsyl.ania, the future .alue is I * million and the 3resent .alue is I 1,''' There are *''years in.ol.ed, so #e need to sol.e for rin the follo#in46

I 1,''' H I * millionU=1 r>*''



60/194

Business Finance ACC501 VU=1 r>*''H *,'''''

Sol.in4 for r, the Pennsyl.ania money 4re# at about ?) 3er year The!assachusetts money did better check that the rate of return in this case #as A? Small differences canadd u3Y

Finding t(e Num)er of *eriods

%f #e de3osit I+,''' today in an account 3ayin4 1', ho# lon4 does it take to 4ro# to I1','''7

Finding t(e Num)er of *eriods: >ule of 85

/or reasonable rates of return, the time it takes to double the money, is 4i.en a33roximately byo t H )* U r

0ontinuin4 #ith the exam3le, #e ha.e discount rate of 1', so6o t H )* U 1' H )* years

This rule is fairly a33licable to discount rates in + to *' ran4e

Finding t(e Num)er of *eriods: An E/ample

- com3any has been sa.in4 u3 to 3urchase an asset Total cost #ill be I1' million The com3any

has currently about I*? millions $o# lon4 it #ill ha.e to #ait, if it can earn + on the money7, if it can earn 1K on the money7

-t + the com3any #ill ha.e to #ait for a lon4 time6I*? H I1' U 1'+t

1'+tH A?+ t H ?' years

-t 1K , it #ill make it in 1' years

Summari-ing %ime 2alue CalculationsI@ S+m)ols:

P H Present .alue, #hat future cash flo#s are #orth today/tH /uture .alue, #hat cash flo#s are #orth in the futurer H %nterest rate, rate of return, or discount rate 3er 3eriodt H number of 3eriods0 H cash amount

II@ Future !alue of C dollars in!ested at rpercent per period for tperiods:/tH 0 ^ =1 r>t

The term =1 r>tis called the future .alue factor


trCFV 310 += t310;1000,5$000,10$ =

2000,5$

000,10$10;1 ==t

2ln10;1ln =t

!ea#s27;70953;0

6931;0

10;1ln

2ln===t

60


61/194

Business Finance ACC501 VUIII@ *resent !alue of C to )e recei!ed in t periods at r percent per period:

P H 0U=1 r>t

The term 1U=1 r>tis called thepresent value factor

I2@ %(e )asic present !alue e7uation gi!ing t(e relations(ip )ett

2aluation of Multiple Cas( Flo


62/194


*resent 2alue


63/194

Business Finance ACC501 VUPresent .alue calculated by discountin4 back one 3eriod at a time

#o< muc( is it t]UrWhere

0 H Periodic 3ayment or annuityr H rate of interestt H number of 3eriodsThe term in the 3arenthesis is called 3resent .alue interest factor of an annuity =P%/-r,t>


1

$4,212.370.00

$4,212.37

$3,465.111,000.00

$4,465.11

$2,673.011,000.00

$3,673.01

$1,833.401,000.00

$2,833.40

$ 943.40,000.00

$1,943.40

$ 0.001,000.00$1,000.0

0

Time (years)

Tota !resent va"e # $4,212.37

r# 6

63


64/194


65/194


Qou #ill borro# '' x I*?,''' H I*',)'' This is the amount today, so it;s the P The rate is 'U1* H'')+, and there are K' 3eriods6I*',)'' H 0 x \= 1 ( 1U=1'')+>K']U'')+ H 0 x A1)?A 0 H I*',)''UA1)?A 0 H IA*)' 3er month

Finding t(e num)er of pa+ments

To re3ay a loan of I1,''', !r can only afford to 3ay I*' 3er month %nterest rate is 1+ 3er month$o# lon4 #ill it take to re3ay the loan7

$ere, P H I1,''', 0 H I*' , r H 1+ 3er monthI1''' H I*' x =1 P/>U''1+

=I1,'''U*'> x ''1+ H 1 P/P/ H '*+ H 1U =1 r>t

1'1+tH 1U'*+ H A

So ho# lon4 #ill it take to 5uadru3le the money71'1+xH A? month or ))+ years

Finding t(e rate

-n insurance com3any offers to 3ay you I1,''' 3er year if you 3ay IK,)1' u3 front What rate isa33licable in this 1'(year annuity7

$ere0 H I1,''', P H IK,)1' and t H 1', r H 7

IK,)1' H I1,''' x =1 P/> U rK)1 H _1( \1 U=1 r>1']` U r

Lookin4 at the P%/- table for 1' 3eriods, K)1'1 is the .alue for So insurance com3any is offerin4Annuit+ Future 2alue

/tH 0 ^ =/uture .alue factor ( 1>UrH 0 ^ \=1 r>t( 1]Ur

Future 2alue for Annuities

Pre.iously #e determined that a *1(year old could accumulate I1 million by a4e K+ by in.estin4 I1+,'1today and lettin4 it earn interest =at 1' com3ounded annually> for AA years

No#, rather than 3lunkin4 do#n I1+,'1 in one chunk, su33ose she #ould rather in.est smaller amountsannually to accumulate the million

%f the first de3osit is made in one year, and de3osits #ill continue throu4h a4e K+, ho# lar4e must they be7

Set this u3 as a / 3roblem6I1,''',''' H 0 x \=11'>AA ( 1] U '1'0 H I1,''','''UK+*KA' H I1,+?**A

&ecomin4 a millionaire :ust 4ot easierY

9nfortunately, most 3eo3le don;t start sa.in4 for retirement that early in life =!any don;t start at allY>Su33ose a A'(year old 3erson has decided it;s time to 4et serious about sa.in4 -ssumin4 that he #ishes toaccumulate I1 million by a4e K+, he can earn 1' com3ounded annually, and #ill be4in makin4 e5ualannual de3osits in one year, ho# much must each de3osit be7

Set this u3 as a / 3roblem68 0o3yri4ht irtual 9ni.ersity of Pakistan 65


66/194

Business Finance ACC501 VUr H 1't H K+ ( A' H *+/ H I1,''','''

Then6I1,''',''' H 0 x \=11'>*+ ( 1] U '1'0 H I1,''','''U?A)1 H I1',1K')

!oral of the story6 Puttin4 off sa.in4 for retirement makes it a lot more difficultY

Annuities &ue

So far, #e ha.e discussed only ordinary annuities, #here cash flo#s occur at the end of each 3eriod, e4loan re3ayments

$o#e.er, #hen you lease an asset, the first lease 3ayment is usually due immediately, second at thebe4innin4 of second 3eriod and so on

-n -nnuity due is an annuity for #hich cash flo#s occur at the be4innin4 of each 3eriodThe time line for -nnuity due, ha.in4 + 3ayments of IA'' each, #ould be like6

Present .alue of a four year IA'' ordinary annuity at 1' is I1,*K)+-ddin4 on the extra IA'', #e 4et I1,KK)+, the 3resent .alue of this annuity dueThe relationshi3 bet#een an annuity due and an ordinary annuity is :ust6o -nnuity due .alue H Ordinary annuity .alue x =1 r>


Timeear

$400

$400 $400 $400 $400

66


67/194

Business Finance ACC501 VULESSON 1K

*E>*E%UI%IES

- s3ecial case of annuity, #here the stream of cash flo#s continue fore.er The 3resent .alue of a 3er3etuity is

Per3etuity P H 0 U r

Su33ose #e ex3ect to recei.e I1''' at the end of each of the next + years Our o33ortunity rate isK What is the .alue todayof this set of cash flo#s7

P H I1''' x =1 ( \1U1'K+]> U ''K H I1''' x A*1*?KA H IA*1*?KA

No# su33ose the cash flo# #ill be I1''' 3er yearforever, makin4 it aperpetuity %n this case, the Pis easy to calculate6

P H 0Ur H I1'''U'K H I1K,KKKK)

Summar+ of Annuit+ and *erpetuit+% Symbols

P H Present .alue, #hat future cash flo#s brin4 today/t H /uture .alue, #hat cash flo#s are #orth in the future

r H %nterest rate, rate of return, or discount rate 3er 3eriodt H Number of time 3eriods0 H 0ash amount

%% / of 0 3er 3eriod for t 3eriods at r 3ercent 3er 3eriod6/tH 0 ^ \=1 r> t( 1] U r

%%% P of 0 3er 3eriod for t 3eriods at r 3ercent 3er 3eriod6P H 0 ^=1 ( \1U=1 r> t]> U r

% P of a 3er3etuity of 0 3er 3eriod6P H 0 U r

Effecti!e Annual >ates

%f a rate is 5uoted as 1' com3ounded semiannually, then #hat this means is that the in.estmentactually 3ays + e.ery six months

%s + e.ery six months the same thin4 as 1' 3er year7 I1 x 11' H I11'

I1 x 1'+*H I11'*+ 1' com3ounded semiannually is e5ui.alent to 1'*+ com3ounded annually 1'*+ is called effecti.e annual rate =E-R> Su33ose three banks offer you the follo#in4 rates for a sa.in4s account6 &ank -6 1+, com3ounded daily &ank &6 1++, com3ounded 5uarterly &ank 06 1K, com3ounded annually

Which one #ould you o3t for6 &ank 0 is offerin4 1K 3er year, since there is no com3oundin4 durin4 the year, this is effecti.erate

&ank & actually 3ayin4 '1++UA H ''?)+ or ?)+ 3er 5uarter -n in.estment of I1 at this ratefor 1 year #ould 4ro# to6

I1 x 1'?)+AH I11KA*So, E-R is 1KA*

/or sa.in4, it is 4ood /or borro#in4 it is #orse &ank - is com3oundin4 daily, so the daily interest rate is actually '1+ U ?K+ H ''''A11 or

''A11 -n %n.estment of I1 at this rate for ?K+ days #ould 4ro# to6



68/194


I1 x 1'''A11?K+H I11K1 So, E-R is 1K1 This is not as 4ood as &ank &;s 1KA* for a sa.er, and not as 4ood as &ank 0;s 1K for a

borro#er T#o Lessons6 The hi4hest 5uoted rate is not necessarily the best rate 0om3oundin4 durin4 the year can lead to a si4nificant difference bet#een the 5uoted rate and the

effecti.e rate E-R is com3uted in three ste3s 2i.ide the 5uoted rate by the number of times the interest is com3ounded -dd 1 and raise it to the 3o#er of number of times the interest is com3ounded Subtract 1

SoE-R H =1 Xuoted rate U m>m 1

where m is the number of times the interest is compounded

The E-Rof 1* com3ounded monthly is6

E-R H =1 Xuoted rate U m>m 1H =1 '1*U1*>1* 1H =1'1>1* 1H 11*K+ 1H 1*K*+

Compounding Num)er of times Effecti!e period compounded annual rate

Qear 1 1'''''' Xuarter A 1'?1* !onth 1* 1'A)1?1 Week +* 1'+'KA

2ay ?K+ 1'+1++ $our ,)K' 1'+1)'? !inute +*+,K'' 1'+1)'

- bank is offerin4 1* com3ounded 5uarterly %f you 3ut I1'' in an accountho# much you #ill earn at the end of one year7#hat is the E-R7ho# much #ill you ha.e at the end of t#o years7

The bank is offerin4 1*UA H ? e.ery 5uarter in.estin4 I1'' for A 3eriods at ? 3er 3eriod, the future.alue is/ H I1'' x 1'?AH I11*++

The E-R is 1*++

We can calculate the yield of t#o years in t#o #aysReco4ni


69/194

Business Finance ACC501 VUI1'' x 11*++*H I1*KK

-nytime #e do a 3resent .alue or future .alue calculation, the rate #e use must be an actual or effecti.erate

Annual *ercentage >ates

-nnual 3ercenta4e rate =-PR> is the interest rate char4ed 3er 3eriod multi3lied by the number of 3eriods3er year

La#s in some countries re5uire that the lenders disclose an -PR on .irtually all the consumer loans in a3rominent and un(ambi4uous #ay- ty3ical credit card a4reement 5uotes an interest rate of 1 -PR !onthly 3ayments are re5uired Whatis the actual interest rate you 3ay on such a credit card 7

-PR of 1 #ith monthly 3ayments is really '1 U 1* H ''1+ or 1+ 3er monthSo,

E-R H =1 '1U1*>1* 1 H 1'1+1* 1 H 1+K

oans

Whene.er a lender extends a loan, some 3ro.ision #ill be made for re3ayment of the 3rinci3al amount

$ere #e discuss three forms of re3ayment of 3rinci3le and interest 3atternsPure 2iscount Loans%nterest(only Loans-morti


70/194

Business Finance ACC501 VUQear &e4innin4 &alance Total Payment %nterest Paid Princi3al

PaidEndin4&alance

1 I +,''' I1,A+' I A+' I1,''' IA,'''

* A,''' 1,?K' ?K' 1,''' ?,'''

? ?,''' 1,*)' *)' 1,''' *,'''

A *,''' 1,1' 1' 1,''' 1,'''

+ 1,''' 1,'' ' 1,''' '

Totals IK,?+' I1,?+' I+,'''

Amorti-ation Sc(edule Fi/ed pa+ments

-4ain takin4 a I+''' loan at an interest rate of for + years #e first need to determine the 3aymentSince this loan;s cash flo#s are in the form of an ordinary annuity So, sol.in4 for 3ayments6I+''' H 0 x =1 1U''+> U ''H 0 x =1 'KA> U ''

0 H I+''' U ?) H I1,*+AK

Amorti-ation Sc(edule 4 Fi/ed *a+ments

Beginning %otal Interest *rincipal Ending$ear Balance *a+ment *aid *aid Balance 1 I+,''''' I1,*+AK IA+''' I?+AK IA,1KA+A * A,1KA+A1, *+AK ?)A1 1'K+ ?,*+? ? ?,*+? 1, *+AK **+ *K1 *,*K1*) A *,*K1*) 1, *+AK *'?+1 1,'1+ 1,1)?* + 1,1)?* 1, *+AK 1'K1A 1,1)?* '''Totals IK,A*)?' I1,A*)?1 I+,'''''



71/194

Business Finance ACC501 VULESSON 1)

BN&S

-n e.idence of debt issued by a cor3oration or a 4o.ernmental body When a cor3oration =or 4o.ernment> #ishes to borro# from 3ublic on a lon4 term basis, it does so

by issuin4 or sellin4 debt securities 4enerally called bonds

- bond re3resents a loanmade by in.estors to the issuer*%n return for hisUher money, the in.estorrecei.es a le4al claim on future cash flo#s of the borro#er

The issuer 3romises to6 !ake re4ular cou3on 3ayments e.ery 3eriod until the bond matures, and Pay the faceU3arUmaturity .alue of the bond #hen it matures

2efault ( since the abo.ementioned 3romises are contractual obligations, an issuer #ho fails to kee3them is sub:ect to le4al action on behalf of the lenders =bondholders>

& 0or3oration Wants to borro# I1,''' for ?' years at 1* interest rate

Will 3ay '1* x I1,''' H I1*' in interest e.ery year for ?' years Will re3ay I1,''' at the end of ?' years & 0or3oration I1*' re4ular interest 3ayments are the bond;s cou3ons

I1,''' is the 3ar .alue or face .alue of the bond -nnual cou3on di.ided by the 3ar .alue =I1*'UI1''' H 1*> is the cou3on rate ?' years is the maturity time

Bond 2alues and $ields

The .alue of bonds may fluctuate as the interest rates chan4e by time in the market 3lace, thou4hthe cash flo#s from a bond remains the same

When interest rates rise, the 3resent .alue of the bond;s remainin4 cash flo#s decline and the bondis #orth less

When the interest rates fall, the bond is #orth more To determine the .alue of bond at a 3articular 3oint in time, #e need to kno#

No of 3eriods remainin4 till maturity, The face .alue, The cou3on rate, and The market interest rate for similar bonds The interest rate re5uired in the market on bonds is called the bond;s Qield to !aturity The 0or3oration %ssues a bond #ith 1' years to maturity ha.in4 annual cou3on of I' similar bonds ha.e a yield to

maturity of bond;s cash flo#s ha.e t#o com3onents6 an annuit+ component 0coupons1 and a lump sum 0face !alue paid at maturit+1

The 0or3oration -t the 4oin4 interest rate of the 3resent .alue of I1,''' 3aid in 1' years is6 P H I1,''' U 1'1'H I1,''' U *1+ H IAK?1

Present .alue of the annuity of 'I 3er year for 1' years is6 P H I' x =1 1U1'1'> U '' P H I' x K)1'1

H I+?K1The 0or3oration

To 4et the bonds .alue #e add u3 both 3arts



72/194

Business Finance ACC501 VUTotal bond .alue H IAK?1 I+?K1

H I1,'''

This means that the bond sells for exactly its face .alue-lternati.ely

%nterest rate chan4e%nterest rate risen to 1' after one years = years to maturity>No< t(e present !alue of 3,999 paid in nine +ears at 39 is

I1,''' U 11'H I1,'''U*?+) H IA*A1'

And present !alue of H9 annuit+ for G +ears at 39 isI' x =1 1U11'>U'1' H I' x +)+' H IAK')*

-ddin4 both 3arts6 Total bond .alue is IA*A1' AK')* H IA* Therefore, the bond should sell for about I+ &ecause the bond sells for less than the 4oin4 rate, in.estors are #ilin4 to lend somethin4 less than

I1,''' &ecause the bond sells for less than face .alue, it is said to be a discount bond The in.estor #ho 3urchased and ke3t bond #ould 4et I' 3er year and #ould ha.e a I11+ 4ain at

maturity as #ell This 4ain com3ensates the lender for belo#(market cou3on rate

-nother #ay to see #hy bond is discounted by I11+ is to note that the I' cou3on is I*' belo# the cou3onon a ne#ly issued 3ar .alue bond So the in.estor #ho buys and kee3s the bond 4i.es u3 I*' e.ery year for years -t 1' this annuity is #orth6

I*' x =1 1U11'

>U'1' H I*' x +)+' H I11+1

ust as rise of interest rates reflected a decline in the 3rice of the bond, a dro3 of * in interest rates #ouldresult in the bond bein4 sold for more than I1''' Such a bond is said to sell at a 3remium or is called a3remium bond


% ( ) , ' ' / 0 1 (%7ears

CouponFace value

30% 30% 30% 30% 30% 30% 30% 30% 30% 3 0%

30% 30% 30% 30% 30% 30% 30% 30% 30% 3(%0%

3(%%%

72


73/194


2AUIN= A BN&

-ssume you ha.e the follo#in4 information &!N, %nc bonds ha.e a I1''' face .alue The 3romised annual cou3on is I1'' The bonds mature in *' years The market;s re5uired return on similar bonds is 1'

Present .alue of the face .alueo H I1''' x \1U11'*'] H I1''' x 1AKA

H I1AKA

Present .alue of the cou3on 3aymentso H I1'' x \1 ( =1U11'*'>]U1' H I1'' x +1?K

H I+1?K The .alue of each bond H I1AKA +1?K

H I1'''

2alui

Documents

Business Finance - ACC501 Handouts.pdf