Comprehensive Notes - mriazkhan91.files.wordpress.com · Corporate Valuation and Value-Based Management i) ... Value-Based Management iv) Corporate Governance and ... Chapter#1 An

Comprehensive Notes

For Students of BBA, MBA & M.com

Prepared By:

Muhammad Riaz Khan

Government College of Management Sciences Peshawar

Contact: +923139533123 ([email protected])

Financial Management

2Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar) Mob#+923139533123

ACKNOWLEDGEMENT

I am very grateful to Almighty ALLAH who enabled me to complete notes on FINANCIAL MANAGEMENT. I have taken efforts for completion of these Notes. However, it would not have been possible without the kind support and help of many individuals. I would like to extend my sincere thanks to all of them.

I am highly indebted to Sir Mr. Jawad Anwar (Lecturer at PIMS Peshawar) and Sir Imtiaz Ali (Lecturer at GCMS Peshawar) for theirguidance and constant supervision as well as for providing necessary information regarding these notes & also for their support in completing it.

I would like to express my gratitude towards my Parents & Friendsfor their kind co-operation and encouragement which help me in completion of these notes.

My thanks and appreciations also go to my dearest colleagues Mr. Adnan Khan and Tauseef Ullah in preparing such notes who have willingly helped me out with their abilities.

Muhammad Riaz Khan

Comprehensive Notes


COURSE OUTLINE

Part – I

1. An Overview of FinancialManagement

i) Careers in Financeii) How are Companies Organizediii) Finance in the Organizational

Structure of the Firmiv) The Goals of the Corporationv) Business Ethics and Social

Responsibilityvi) Agency Relationships

2. Financial Statement, Cash Flows and Taxes

i) A Brief History of Accounting and Financial Statements

ii) Financial Statements and Reportsiii) The Balance Sheetiv) The Income Statementv) Statement of Retained Earningsvi) Net Cash Flowvii)Statement of Cash Flowsviii) Modifying Accounting Data for

Managerial Decisionsix) MVA and EVAx) Depreciation

3. Analysis of Financial Statementsi) Ratio Analysisii) Liquidity Ratiosiii) Asset Management Ratiosiv) Debt Management Ratiosv) Profitability Ratiosvi) Market Value Ratiosvii)Trend Analysis, Common Size

Analysis, and Percent Change Analysis

viii) Tying the Ratios Togetherix) Comparative Ratios and

“Benchmarking”

x) Uses and Limitations of Ratio Analysis

xi) Problems with ROExii)Looking Beyond the Numbers

4. Financial Planning and Forecasting Financial Statements

i) Strategic Plansii) Operating Plansiii) The Financial Planiv) Computerized Financial Planning

Modelsv) Sales Forecastsvi) Financial Statement Forecasting:

The Percent of Sales Methodvii)The AFN Formulaviii) Forecasting Financial

Requirements When the Balance Sheet Ratios Are Subject to Change

ix) Other Techniques of Forecasting Financial Statements

Part – II

5. The Financial Environmenti) The Financial Marketsii) Financial Institutionsiii) The Stock Marketiv) The Cost of Moneyv) Interest Rate Levelsvi) The Determinants of Market

Interest Ratesvii)The Term Structure of Interest

Ratesviii) What Determines the Shape of

the Yield Curve?ix) Using the Yield Curve to

Estimate Future Interest Ratesx) Investing Overseasxi) Other Factors That Influence

Interest Rate Levelsxii) Interest Rates and Business

Decisions6. Risk and Return

i) Investment Returns



ii) Stand-Alone Riskiii) Risk in Portfolio Contextiv) Calculating Beta Coefficientv) The Relationship between Risk

and Rates of Returnvi) Physical Assets versus Securitiesvii)Some Concerns about Beta and

the CPMviii) Volatility versus Risk

7. Portfolio Theory and Asset PricingModels

i) Measuring Portfolio Riskii) Efficient Portfoliosiii) Choosing the Optimal Portfolioiv) The Capital Asset Pricing Modelv) The Capital Market Line and

Security Market Linevi) Calculating Beta Coefficientvii)Empirical Tests of the CAPMviii) Arbitrage Pricing Theoryix) The Fama-French Three-Factor

Modelx) An Alternative Theory of Risk

and Return: Behavioral FinancePart – III

8. The Cost of Capitali) The Weighted Average Cost of

Capitalii) Cost of Debtiii) Cost of Preferred Stockiv) Cost of Common Stockv) The CAPM Approachvi) Dividend-Yield-plus-Growth

Rate, or DCF Approachvii)Comparison of the CAPM, DCF,

and Bond-Yield-plus-Risk-Premium Methods

viii) Composite, or Weighted Average, Cost of Capital, WACC

ix) Adjusting the Cost of Capital for Risk

x) Estimating Project Riskxi) Using the CAPM to Estimate a

Project’s Risk-Adjusted Cost of Capital

xii)Techniques for Measuring Beta Risk

xiii) Adjusting the Cost of Capital for Flotation Costs

xiv) Some Problem Areas in Cost of Capital

xv) Four Mistakes to Avoid9. Corporate Valuation and Value-

Based Managementi) Overview of Corporate Valuationii) The Corporate Valuation Modeliii) Value-Based Managementiv) Corporate Governance and

Shareholders Wealth10. Capital Structure Decisions

i) The Target Capital Structureii) Business and Financial Riskiii) Determining the Optimal Capital

Structureiv) Capital Structure Theoryv) Checklist for Capital Structure

Decisionsvi) Variations in Capital Structure

11. Distributions to Shareholders:Dividends and Repurchases

i) Dividend versus Capital Gainsii) Dividend Policy Issuesiii) Dividend Stabilityiv) Establishing the Dividend Policy

in Practicev) Dividend Reinvestment Plansvi) Summary of Factors Influencing

Dividend Policyvii)Overview of the Dividend Policy

Decisionviii) Stock Dividends and Stock

Splitsix) Stock RepurchasesPart – IV

12. Initial Public Offerings, Investment Banking, and Financial Restructuring

i) The Financial Life Cycle of a Startup Company



ii) The Decision to Go Public Initial Public Offerings

iii) The Process of Going Publiciv) Equity Carve-Outs: A Special

Type of IPOv) Non-IPO Investment Banking

Activitiesvi) The Decision to Go Privatevii)Managing the Maturity Structure

of Debtviii) Zero (or Very Low) Coupon

Bondsix) Refunding Operationsx) Managing the Risk Structure of

Debt13. Lease Financing

i) The Two Parties to Leasingii) Types of Leasesiii) Tax Effectsiv) Financial Statement Effectsv) Evaluation by the Lesseevi) Evaluation by the Lessorvii)Other Issues in Lease Analysisviii) Other Reasons for Leasing

14. Current Asset Managementi) Working Capital Terminologyii) Alternative Current Asset

Investment Policiesiii) The Cash Conversion Cycleiv) The Concept of Zero Working

Capitalv) Cash Managementvi) The Cash Budgetvii)Cash Management Techniquesviii) Marketable Securities

ix) Inventoryx) Inventory Costsxi) Inventory Control Systemsxii)Receivable Managementxiii) Credit Policyxiv) Setting the Credit Period and

Standardsxv) Setting the Collection Policyxvi) Cash Discountsxvii) Other Factors Influencing

Credit Policy15. Short-Term Financing

i) Alternative Current Asset Financing Policies

ii) Advantages and Disadvantages of Short-Term Financing

iii) Sources of Short-Term Financingiv) Accrualsv) Accounts Payable (Trade Credit)vi) Short-Term Bank Loansvii)The Cost of Bank Loansviii) Choosing a Bankix) Commercial Paperx) Use of Security in Short-Term

Financing

Recommended Text:

1. Brigham, E.F. and Ehrhardt, M.C., (2002 ), Financial Management: Theory and Practice (10th Edition), HarCourt College Publishers



Chapter#1

An Overview of Financial Management

Meaning of Financial Management

Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind.

Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.

Functions of Financial Management

Based on the above definition functions of the financial management can be categorized into three major categories, these are

(A) Investment DecisionsInvestment decisions are concerned with assets. Major decisions regarding investment decisions are explained below.

1 What is the optimal firm size? It means to decide what amount of assets should be purchased in order to keep the operations of business going and also not increasing the size of the business.

2 What specific assets should be acquired? The exact asset required to maintain the operations of the business.

3 What assets (if any) should be reduced or eliminated? Any asset not contributing in the profitability of the firm should be disposed off in order to release the excess capital.

(B) Financing DecisionsDetermine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet). This means to arrange funds for purchasing assets.

1 What is the best type of financing? Means either to use debt or equity.2 What is the best financing mix? A firm normally uses a mix of debt and equity,

financial manager decides the ratio of debt and equity which can increase the profitability and reduce risk.

3 What is the best dividend policy (e.g., dividend-payout ratio)? Refers to the percentage of profit to be distributed among the shareholders.

4 How will the funds be physically acquired? Means either to take loan, issue shares debentures etc.



(C) Asset Management Decisions

1 How do we manage existing assets efficiently? Efficiently means to maximize their productivity and overall contribution to profits.

2 Financial Manager has varying degrees of operating responsibility over assets.3 Greater emphasis is made on current asset management than fixed asset

management.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.2. To ensure adequate returns to the shareholders which will depend upon the earning

capacity, market price of the share, expectations of the shareholders?3. To ensure optimum funds utilization. Once the funds are procured, they should be

utilized in maximum possible way at least cost.4. To ensure safety on investment, i.e., funds should be invested in safe ventures so

that adequate rate of return can be achieved.To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

The Goals of Corporations

Corporate goals are defined as those specific ambitions or quantifiable targets that are set by an organization of which it commits to so as to achieve its corporate mission and objectives. The goals must define a mark that can be specifically measured over a period of time. The Goal of Corporations refers to the maximizing of profits while managing the financial risks of the firm. This refers to the main purpose of a corporation which is to maximize shareholder value in order for the investors to gain from the corporation. This applies in capital finance where capital is raised for creating, developing, growing or acquiring businesses.Several examples of corporate goals can be used for inspiration for your own business.

Profit maximization

Goals reflect general statements about what the business wants to achieve. Improving profitability is a common corporate goal. The goal statement usually includes details about the business and aligns its actions with the company mission and values. For



example, actions might include developing new markets, products or services. Other examples include reducing unnecessary costs, changing suppliers or raising prices. Stated simply, the goal must be clearly understood by all employees. It must also be flexible enough. If market conditions change, the goal can be adjusted.

Efficiency

Corporate goals typically reflect a commitment to improve existing operations. This includes striving for excellence. It also involves producing results through effective teamwork and using technology to innovate. Successful corporate leaders realize that they have to be vigilant about reducing product errors, waste and customer dissatisfaction. Corporate goals may also specify planned methods or strategies. For example, to reduce product errors, a business might set a goal of implementing a Six Sigma initiative, a quality management technique.

Expansion

Increasing market share is common corporate goal. This often involves targeting new audiences, such as younger customers. Reaching out to a new demographic may also involve using new marketing techniques. For example, a small business can promote its products and services using social media technology. A company can expand its market presence by designing, developing and delivering new products.

Satisfaction

Corporate leaders recognize that employee satisfaction contributes to productivity. Corporate goals related to employees typically demonstrate a commitment to the workforce. Programs may include training courses, events and resources. These allow employees to develop professional skills and enhance collaboration. For example, a common goal strives to create a culture based trust and respect for all. This improves employee retention rates, reduces absenteeism and increases employee morale.

Sustainability

Corporate goals usually demonstrate a commitment to the community. A business has a responsibility to be an asset, not a liability. For example, a company may aspire to improve the environmental performance of the tools and technology used in its facilities, by its customers and by its suppliers. Short-term goals address today’s problems and long-term goals prepare for the future.



Business Ethics and Social Responsibility

What is Business Ethics?

The concept has come to mean various things to various people, but generally it's coming to know what it right or wrong in the workplace and doing what's right -- this is in regard to effects of products/services and in relationships with stakeholders.

Business ethics is the behavior that a business adheres to in its daily dealings with the world. The ethics of a particular business can be diverse. They apply not only to how the business interacts with the world at large, but also to their one-on-one dealings with a single customer.

Many businesses have gained a bad reputation just by being in business. To some people, businesses are interested in making money, and that is the bottom line. It could be called capitalism in its purest form. Making money is not wrong in itself. It is the manner in which some businesses conduct themselves that brings up the question of ethical behavior.Good business ethics should be a part of every business. There are many factors to consider. When a company does business with another that is considered unethical, does this make the first company unethical by association? Some people would say yes, the first business has a responsibility and it is now a link in the chain of unethical businesses.

Many global businesses, including most of the major brands that the public use, can be seen not to think too highly of good business ethics. Many major brands have been fined millions for breaking ethical business laws. Money is the major deciding factor

Social Responsibility:Social responsibility and business ethics are often regarding as the same concepts.

However, the social responsibility movement is but one aspect of the overall discipline of business ethics. The social responsibility movement arose particularly during the 1960s with increased public consciousness about the role of business in helping to cultivate and maintain highly ethical practices in society and particularly in the natural environment.

Social responsibility is an ethical theory that an entity, be it an organization or individual, has an obligation to act to benefit society at large. Social responsibility is a duty every individual has to perform so as to maintain a balance between the economy and the ecosystems.

Agency Relationships in Financial Management

Management acts as an agent for the owners (shareholders) of the firm. An agent is an individual authorized by another person, called the principal, to act

in the latter’s behalf.



Agency Theory is a branch of economics relating to the behavior of principals and their agents.

Principals must provide incentives so that management acts in the principals’ best interests and then monitor results.

Incentives include stock options, perquisites, and bonuses.Shareholders and managers have divergent goals. The Shareholders goal is to maximize shareholder value while the manager's goals are Job security, Power, status, and compensation etc. Thus, managers may have the incentive to take actions that are not in the best interest of the shareholders. Because managers usually own only a small interest in most large corporations, potential agency conflicts are significant

Managerial compensation:

The compensation package should be designed to meet two objectives: one is to attract and retain capable managers; two is to align managers' actions with the interest of shareholders.

Performance shares: Management receives a certain number of shares if the company achieves predefined performance benchmarks.

Executive stock options: Management is granted an option to buy stock at a stated price within a specified time period.

Agency Problems: Shareholders (Through Managers) Vs. Creditors:Managers are the agent of both shareholders and creditors. Shareholders

empower managers to manage the firm. Creditors empower managers to use the loan. Though employed by shareholders managers work in the best interest of shareholders,They deprive creditors in two different ways,

By investing in riskier projects they maximize the profits which on turn is received by the shareholders and creditors bear only risk for them

By increasing dent the company increases leverage and in turn the risk of insolvency is increased but creditors get nothing as risk premium.

To protect themselves against shareholders, creditors often include restrictive covenants in debt agreements. In the long-run, a firm that deals unfairly with creditors may impair the shareholders' interest because the firm may

lose access to the debt markets or Be saddled with high interest rates and restrictive covenants.

*End of Chapter*



Chapter#2

Financial Statements, Cash Flow and Taxes

Financial Statements Definition:Summary report that shows how a firm has used the funds entrusted to it by

its stockholders (shareholders) and lenders, and what is its current financial position. The three basic are the (1) balance sheet, which shows firm's assets, liabilities, and net worth on a stated date; (2) income statement (also called profit & loss account), which shows how the net income of the firm is arrived at over a stated period, and (3) cash flow statement, which shows the inflows and outflows of cash caused by the firm's activities during a stated period.

Basic Financial StatementsA business is a financial entity separate from its owners. Each business must keep

financial records. Financial statements have generally agreed-upon formats and follow the same rules of disclosure. This puts everyone on the same level playing field, and makes it possible to compare different companies with each other, or to evaluate different year's performance within the same company. There are three main financial statements:

Income Statement Balance Sheet Statement of Cash FlowsEach financial statement tells its own story. Together they form a comprehensive

financial picture of the company, the results of its operations, its financial condition, and the sources and uses of its money. Evaluating past performance helps managers identify successful strategies, eliminate wasteful spending and budget appropriately for the future. Armed with this information they will be able to make necessary business decisions in a timely manner

There are 5 types of Accounts.

Assets Liabilities Owners' Equity (Stockholders' Equity for a corporation)



Revenues ExpensesAll the accounts in an accounting system are listed in a Chart of Accounts. They are

listed in the order shown above. This helps us prepare financial statements, by conveniently organizing accounts in the same order they will be used in the financial statements.

Financial StatementsThe Balance Sheet lists the balances in all Assets, Liability and Owners' Equity

accounts.

The Income Statement lists the balances in all Revenue and Expense accounts.

The Balance Sheet and Income Statement must accompany each other in order to comply with GAAP. Financial statements presented separately do not comply with GAAP. This is necessary so financial statement users get a true and complete financial picture of the company.

All accounts are used in one or the other statement, but not both. All accounts are used once, and only once, in the financial statements. The Balance Sheet shows account balances at a particular date. The Income Statement shows the accumulation in the Revenue and Expense accounts, for a given period of time, generally one year. The Income Statement can be prepared for any span of time, and companies often prepare them monthly or quarterly.

It is common for companies to prepare a Statement of Retained Earnings or a Statement of Owners' Equity, but one of these statements is not required by GAAP. These statements provide a link between the Income Statement and the Balance Sheet. They also reconcile the Owners' Equity or Retained Earnings account from the start to the end of the year.



The Statement of Cash Flows is the third financial statement required by GAAP, for full disclosure. The Cash Flow statement shows the inflows and outflows of Cash over a period of time, usually one year. The time period will coincide with the Income Statement. In fact, account balances are not used in the Cash Flow statement. The accounts are analyzed to determine the Sources (inflows) and Uses (outflows) of cash over a period of time.

There are 3 types of cash flow (CF):Operating - CF generated by normal business operations

Investing - CF from buying/selling assets: buildings, real estate, investment portfolios, equipment.

Financing - CF from investors or long-term creditors

The SEC (Securities and Exchange Commission) requires companies to follow GAAP in their financial statements. That doesn't mean companies do what they are supposed to do. Enron executives had millions of reasons ($$) to falsify financial information for their own personal gain. Auditors are independent CPAs hired by companies to determine whether the rules of GAAP and full disclosure are being followed in their financial statements. In the case of Enron and Arthur Andersen, auditors sometimes fail to find problems that exist, and in some cases might have also failed in their responsibilities as accounting professionals.

Retained EarningsThe Retained Earnings (RE) account has a special purpose. It is used to

accumulate the company's earnings, and to pay out dividends to the company's stockholders. Let's look at the first part of that for a moment.

At the end of the fiscal year, all Revenue and Expense accounts are closed to Income Summary, and that account is closed to Retained Earnings. Profits increase RE; losses will decrease RE. So the RE account might go up or down from year to year, depending on whether the company had a profit or loss that year.

The changes in the RE accounts are called "Changes in Retained Earnings" and are presented in the financial statements. This information can be included in the Income Statement, in the Balance Sheet, or in a separate statement called the Statement of Changes in Retained Earnings. Each company can decide how to present the information, but it must be presented in one of those three places.

Most financial statements today include a Statement of Retained Earnings. Some companies prepare a Statement of Stockholders' Equity to give a more comprehensive picture of their financial events. This statement includes information about how many



shares of stock were outstanding over the year, and provides other valuable information for large companies with a complex capital structure. The changes in RE are included in the Stockholders' Equity statement.

Net Cash Flow:Net cash flow refers to the difference between a company's cash inflows and

outflows in a given period. In the strictest sense, net cash flow refers to the change in a company's cash balance as detailed on its cash flow statement.

How it works/Example:Net cash flow is also known as the "change in cash and cash equivalents." It is

very important to note that net cash flow is not the same as net income, free cash flow, or EBITDA.

You can approximate a company's net cash flow by looking at the period-over-period change in cash on the balance sheet. However, the statement of cash flows is a more insightful place to look. Net cash flow is the sum of cash flow from operations (CFO), cash flow from investing (CFI), and cash flow from financing (CFF).

Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as presented by Yahoo! Finance. At the bottom of the cash flow statement, we see that the change in cash and cash equivalents is calculated to be $632 million. This means that when the cash flow from operations, cash flow from investing, and cash flow from financing is added up, Wal-Mart added $632 million to its cash balance in 2010.



Dividends

Dividends are payments companies make to their stockholders. These must be made from earnings. Since we record accumulated earnings in the RE account, all dividends must come out of that account. There are several types of dividends, but they all must come from Retained Earnings. In order to pay dividends, the RE account MUST have a positive, or Credit, balance.

If the RE account has a Debit balance, we would call that a Deficit, and the company would not be able to pay dividends to its stockholders. Deficits arise from successive years of posting losses in excess of profits.

Market Value Added (MVA) Market value added represents the difference in the total value of the firm and the

total capital supplied by the investors. MVA measures the performance of the managers from the creation of the

company till current year, because it compares the par value of share with the current market value means the total increase in the firm share till date.

Share holders wealth is maximized by maximizing the difference in market value of the stock and the amount of wealth supplied by the shareholders.

MVA = Market value of stock – Equity capital supplied by shareholders.Or = (Shares outstanding) (Stock Price – Total Common Equity

Or MVA = Total Market value – Total investor supplied capital

Greater the market value more efficiency and more profitable the firm is

Economic Value Added (EVA) Economic value added is the difference between after tax profits of the firm and

the total dollar cost of capital. EVA is the value created by the management due to profitable operations of the business.

Economic value added measures the firm efficiency in the current year only that how much the firm earned more than its cost of capital

EVA = NOPAT – Cost of capital required for operations

EVA = (Operating capital) (ROIC – WACC)

Where ROIC is Return on invested capital and WACC is the weighted average cost of capital

And NOPAT is net operating profit after tax

Positive EVA means firm is generating more profit than its cost and additional investment will increase the value of the firm



The EVA shows the true economic profit of the business greater the value more profitable the firm is.

Free Cash flows Free cash flow is the amount of cash remaining after the company makes

investment in assets that are necessary for the firms operations, or the cash which is left over from the investment in assets.

In other words free cash flow is the amount of cash available for distribution to all investors that is shareholders and debt holders.

So the value of the company is directly related to the amount of free cash flow generated

Uses of free cash flowFollowing are the uses of free cash flows

1. To pay interest to debt holders2. To repay or redeem bonds3. Pay dividend to shareholders4. To repurchase some of its stock5. Buy short term investments

Calculating free cash flowsFree cash flows can be calculated using the following equations

FCF = NOPAT – Net investment in operating assetsWhere net investment in operating assets means net increase in both current and fixed assets

Or FCF = Operating cash flow – Gross investment in operating capitalWhere Operating cash flow = NOPAT + DepreciationAnd Gross investment in operating capital = Net investment in operating assets + DepreciationWhat Is Depreciation?

Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources - such as minerals, timber and oil reserves - its called depletion.

End of Chapter



Chapter#3

Financial Statement Analysis

Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports.

Reasons for AnalysisFinancial statements analysis may be carried out by either internal or external users.

What do internal users use it for?Internal users (Management) analyze financial statements for the following reasons.

• Evaluating the financial statements• Planning according to the past performance.• And controlling company operations

What do external users use it for?

• To check long term solvency for Investment decisions• Creditors to check the liquidity for Credit decisions• Investors for Valuation for investment decisions.• Government for regulations and tax purposes.

Advantages of financial statement analysis

The different advantages of financial statement analysis are listed below:

The most important benefit if financial statement analysis is that it provides an idea to the investors about deciding on investing their funds in a particular company.

Another advantage of financial statement analysis is that regulatory authorities like IASB can ensure the company following the required accounting standards.

Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm.

Above all, the company is able to analyze its own performance over a specific time period.



Ratio AnalysisQuantitative analysis of information contained in a company’s financial

statements. Ratio analysis is based on line items in financial statements like the balance sheet, income statement and cash flow statement; the ratios of one item – or a combination of items - to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.Ratio analysis can be made by

• Comparing one company to another• Comparing one year with another year of the same company• Comparing one company with the industry

Following are the different categories of financial ratios.

(A)Liquidity: Can we make required payments as they fall due?(B) Asset management: Do we have the right amount of assets for the level of

sales?(C)Debt management: Do we have the right mix of debt and equity?(D)Profitability: Do sales prices exceed unit costs, and are sales high enough as

reflected in PM, ROE, and ROA?(E) Market value: Do investors like what they see as reflected in P/E and M/B

ratios?These ratios are now explained below

(A) Liquidity Ratios.• Liquidity ratios measure the ability of the company that whether it can pay its

short term obligations or not. • This is done by comparing a company's most liquid assets (or, those that can be

easily converted to cash), its short-term liabilities.• In general, the greater the coverage of liquid assets to short-term liabilities the

better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations.

• Short term creditors and suppliers are more interested in these ratios.Liquidity ratios can be measured using two ratios these are

1 Current ratio2 Quick/ liquid. Acid test ratio

Current Ratio

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position)by deriving the proportion of current assets available to cover current liabilities.



The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes).

In theory, the higher the current ratio, the better. the company liquidity is

Formula

Shows that the company has 2.6 of current assets to pay off 1 re of current liability.Quick ratio

• Quick ratio compares quick assets with current liabilities. • It further refines the current ratio by measuring the amount of the

most liquid current assets there are to cover current liabilities.• The quick ratio is more conservative than the current ratio because it excludes

inventory and other current assets, which are more difficult to turn into cash.• Therefore, a higher ratio means a more liquid current position.

Formula

Quick Ratio = Quick Asset/ Current Liabilities

Or

It shows that company have 1.3 of quick assets to pay current liabilities of Re 1

(B) Asset Management RatiosAsset Management Ratios attempt to measure the firm's success in managing its assets to generate sales. These ratios shows that how efficiently a company is using their assets

Following are the asset management ratios.



Inventory Turnover Ratio

• The Inventory Turnover and Days' Inventory Ratios measure the firm's management of its Inventory.

• Inventory turnover means the speed through which old inventory is replaced with new one.

• In general, a higher Inventory Turnover Ratio is indicative of better performance since this indicates that the firm's inventories are being sold more quickly.

Formula Sales/ inventory

300000/50000 = 6 times

Which shows that we the company’s old inventory is replaced 6 times annually

Receivable management ratio- The days of sales outstanding Ratio

• Days of sales outstanding also called the average collection period refers to the days in which account receivables are collected.

• This ratio measures the ability of an organization that how efficiently company is their credit sales and receivables

• it shows the days during which money is tied up due to credit sales• More quickly the debts are recovered more fund will be available for the

organization and hence will show efficiencyFormula

DSO (in times) = Sales/receivables

DSO (in days) = receivables/ average daily sales

Or = receivables * 365/ annual sales

= 20000 * 365/ 200000

= 36.5 days

Shows that it takes 36.5 days for an average debtor to be collected

Fixed assets turnover Ratio• This ratio shows that how efficiently the firm uses their fixed assets. • Greater the fixed assets turnover greater is their efficiency.

Formula Sales/Net fixed Assets



Total Assets Turnover ratio• Shows the turnover of total assets with respect of sales.• Shows the efficiency of total assets, that how much of revenue is generated by

total assets• Greater turnover shows that assets produce greater sales with respect to their

value.

FormulaSales/ Total Assets

(C) Debt Management Ratio• Debt management ratios show how the firm is financed and how better the firm

van pay their long term debt and interest payment.• Investors, creditors and banks are often interested in calculating these ratios• Three important debt management ratios are

Total Liabilities to total assets ratio• This ratio compares total liabilities of the firm with total assets• Shows the percentage of assets purchased by taking liabilities• Higher the ratio greater will be the leverage, which shows that most of the assets

are financed through debt.• If most assets are financed through debt solvency risk will be high and will be less

attractive for investors and long term creditors.

FormulaTotal liabilities/ Total assets

= 150,000/250,000

= 0.6 or 60%

Which means that 60% of the assets are financed through liabilities?

Times Interest earned Ratio• Shows the firm’s ability that whether the firm can pay their fixed interest charges

or not? In other words it compares the firm’s profits with fixed interest charges,• Banks and other financial institutes which grant loan to the organization are

interested in this ratio. • This ratio shows that what amount of profit is available for payment of one dollar

of interest, greater the ratio more profit is available, better is the ability to service debt

Formula



= 200000/10000 =20

Which means that the company has 20 Rs of profit to pay I Re of interest?

Earnings before interest tax depreciation and amortization (EBITDA) Ratio Interest coverage ratio does not fully explain the firm’s ability to service debt

because interest is not the only payment which a company makes but it also has to pay some portion of its loan and also lease payment

Similarly EBIT is not the total cash available for all these payments EBITDA is used to find the amount of free cash flow available for payment of

interest, repayment of principle amount and also lease installment. Greater the ratio means more free cash is available for payment of the above

payments.

Formula:NPBITDA + Lease payments/Interest expense Principle Payment Lease payment

(D) Profitability ratios These ratios, much like the operational performance ratios, give users a good

understanding of how well the company utilized its resources in generating profit and shareholder value.

The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders.

Profit margin to sales Profit margin to sales compares net profit available to shareholders for

distribution with sales. Net profit available for shareholders is the absolute profit from which all types of

expenses, taxes and preference dividend has been deducted To a large degree, it is the quality, and growth, of a company's earnings that drive

its stock price. Theatrically greater the profit margin ratio greater will be the performance of the

business, or more profitable the business is.

Formulas:

Net profit margin ratio = Profit available for shareholders/ sales

Basic Earning Power Ratio This ratio shows the basic or raw earning capacity of the assets of the business



This ratio is calculated by taking EBIT (earnings before interest and tax), which shows that tax effects and interest is not taken into consideration.

FormulaBasic Earning power = EBIT/ Total Assets

Return on Total Assets Return on total assets is calculated by comparing Net profit available for

shareholders with total assets This ratio shows the final earning power and final earning capacity of the business Greater the ratio more profitable the business is and more efficiently the business

is utilizing its resourcesFormula

Return on Total assets = Net profit available for shareholders/ Total asset

Return on Equity:

This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity.

The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company.

The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.

Formula:

(E) Market Value RatiosMarket Value Ratios relate an observable market value, the stock price, to book values obtained from the firm's financial statements.

Price-Earnings Ratio (P/E Ratio)

The Price-Earnings Ratio is calculated by dividing the current market price per share of the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net income by the number of shares outstanding.)

The P/E Ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are willing to pay a high price for a dollar of current earnings obviously expect high earnings in the future.)



In this manner, the P/E Ratio also indicates how expensive a particular stock is. This ratio is not meaningful, however, if the firm has very little or negative earnings.

Where

Market-to-Book Ratio The Market-to-Book Ratio relates the firm's market value per share to its book value per

share. This shows the amount of money an investor is willing to pay to get 1 rupee ownership in

that company Since a firm's book value reflects historical cost accounting, this ratio indicates

management's success in creating value for its stockholders. Greater the ratio more interested the investors are in your company and will show greater

growth in the shares.

Where

Book value per share = Total equity/ total outstandding shares,

Retention Ratio:

The proportion of earnings kept back in the business as retained earnings. The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of earnings paid out to shareholders as dividends.

On a per-share basis, the retention ratio can be expressed as (1 – Dividends per share / EPS).



The retention ratio is 100% for companies that do not pay dividends, and is zero for companies that pay out their entire net income as dividends.

Also known as “plowback ratio.”

Trend Analysis, Common Size Analysis and Percent Change Analysis

Trend Analysis

Trend analysis Is one of the tools for the analysis of the company’s monetary statements for the investment purposes. Investors use this analysis tool a lot in order to determine the financial position of the business. In a trend analysis, the financial statements of the company are compared with each other for the several years after converting them in the percentage. In the trend analysis, the sales of each year from the 2008 to 2011 will be converted into percentage form in order to compare them with each other. In order to convert the figures into percentages for the comparison purposes, the percentages are calculated in the following way:Trend analysis percentage = (figure of the previous period – figure of the current period)/total of both figures

The percentage can be found this way and if the current-year percentages were greater than previous year percentage, this would mean that current-year result is better than the previous year result.

Common‐Size AnalysisCommon‐size analysis (also called vertical analysis) expresses each line item on a single year's financial statement as a percent of one line item, which is referred to as a base amount. The base amount for the balance sheet is usually total assets (which is the same number as total liabilities plus stockholders' equity), and for the income statement it is usually net sales or revenues. By comparing two or more years of common‐size statements, changes in the mixture of assets, liabilities, and equity become evident. On the income statement, changes in the mix of revenues and in the spending for different types of expenses can be identified.

Percentage Change AnalysisA percent change analysis shows how two items changed as a percentage from one period to another period. Used on a balance sheet, a percent change analysis shows how a balance sheet account changes from year to year, or quarter to quarter. The balance sheet accounts are assets,



liabilities and stockholders' equity. Percent change analysis is important for managers and investors to see how a company is growing or retracting from year-to-year.

DuPont Analysis:

DuPont analysis is an extended analysis of a company's return on equity. It concludes that a company can earn a high return on equity if:

1. It earns a high net profit margin;2. It uses its assets effectively to generate more sales; and/or3. It has a high financial leverage

Formula

According to DuPont analysis:

Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage

Return on Equity =Net Income

×Sales

×Total Assets

Sales Total Assets Total Equity

Analysis

DuPont equation provides a broader picture of the return the company is earning on its equity. It tells where a company's strength lies and where there is a room for improvement.

DuPont equation could be further extended by breaking up net profit margin into EBIT margin, tax burden and interest burden. This five-factor analysis provides an even deeper insight.

ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage

Return on Equity =EBIT

×EBT

×Net Income

×Sales

×Total Assets

Sales EBIT EBT Total Assets Total Equity

*End of Chapter*



Chapter#4

Financial Planning and Forecasting Financial Statements

Financial Planning - Definition, Objectives and Importance

Definition of Financial Planning

Financial Planning is the process of estimating the capital required and determining its competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.

b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term.

c. Framing financial policies with regards to cash control, lending, borrowings, etc.d. A finance manager ensures that the scarce financial resources are maximally

utilized in the best possible manner at least cost in order to get maximum returns on investment.

Importance of Financial PlanningFinancial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as-

1. Adequate funds have to be ensured.2. Financial Planning helps in ensuring a reasonable balance between outflow and

inflow of funds so that stability is maintained.3. Financial Planning ensures that the suppliers of funds are easily investing in

companies which exercise financial planning.4. Financial Planning helps in making growth and expansion programmes which

helps in long-run survival of the company.



5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds.

6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability and profitability in concern.

Forecasting Financial Statements

Introduction:

Financial Forecasting describes the process by which firms think about and prepare for the future. The forecasting process provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assists the firm in identifying the asset requirements and needs for external financing.

For example, the principal driver of the forecasting process is generally the sales forecast. Since most Balance Sheet and Income Statement accounts are related to sales, the forecasting process can help the firm assess the increase in Current and Fixed Assets which will be needed to support the forecasted sales level. Similarly, the external financing which will be needed to pay for the forecasted increase in assets can be determined.

Strategic Planning:

Strategic planning provides the vision, direction and goals for the business. Strategic planning is an organization's process of defining its strategy, or direction, and making decisions about allocating resources to pursue this strategy. In order to determine the direction of the organization, it is necessary to understand its current position and the possible avenues through which it can pursue a particular course of action. A financial forecast is an estimate of future financial outcomes for a company. Using historical internal accounting and sales data, in addition to external market and economic indicators, a financial forecast is an economist's best guess of what will happen to a company in financial terms over a given time period—which is usually one year.

Operating Plans:

Operational planning is a subset of strategic work planning which describes short-term ways of achieving milestones and explains how. The strategic plan will be put into operation during a given operational period. An operational plan draws directly from agency and program strategic plans to describe agency and program missions and goals, program objectives, and program activities.

Like a strategic plan, an operational plan addresses four questions:

Where are we now? Where do we want to be?



How do we get there? How do we measure our progress?

The Financial Plans:

Financial planning is the process of meeting your life goals through the proper

management of your finances. Life goals can include buying a home, saving for your

child’s education or planning for retirement. The financial planning process involves the

following steps:

Gathering relevant financial information Setting life goals Examining your current financial status Coming up with a financial strategy or plan for how you can meet your goals Implementing the financial plan Monitoring the success of the financial plan, adjusting it if necessary

Using these steps, you can determine where you are now and what you may need in the future in order to reach your goals.

Financial planning is a systematic approach whereby the financial planner helps the customer to maximize his existing financial resources by utilizing financial tools to achieve his financial goals. Financial planning is simple mathematics. There are 3 major components:

Financial Resources (FR) Financial Tools (FT) Financial Goals (FG)

When you want to maximize your existing financial resources by using various financial tools to achieve your financial goals, which is financial planning.

Financial Planning: FR + FT = FG

Computerized Financial Planning Model:The financial plan describes the practice's financial strategy, projects the strategy's

future effect on the practice, and establishes goals by which the practice's manager can measure subsequent performance. The act of putting together a financial plan is called the financial planning process. It is a process that consists of analyzing the practice; projecting future outcomes of decisions that have to be made regarding finances, investments, and day to day operations; deciding which alternatives to undertake; and measuring performance against goals that are established in the financial plan.

Computer financial planning models can aid the practice manager in projecting future outcomes of various financial, investment, and operational decisions. These models can be created inexpensively by non-computer programmers with the aid of computer software on the market today. The financial planning process for a hypothetical



practice was summarized, and the financial model used to test out various alternatives available to the practice was described

Sales Forecasts:

Sales forecasting is estimating what a company's future sales are likely to be based on sales records as well as market research. The information used in them must be well organized and may include information on the competition and statistics that affect the businesses' customer base. Companies try to forecast sales in hopes of identifying patterns so that revenue and cash flow can be maximized.

Before the forecasting process begins, marketing, sales, or other managers should determine how far ahead the estimate should be done. Short-term forecasting is a maximum of three months and is often effective for analyzing budgets and markets. Intermediate forecasting is between a period of three months and two years and may be used for schedules, inventory and production. Long-term forecasting is for a minimum of two years and is good for dealing with growth into new markets or new products. Sales forecasts should be conducted regularly and all results need to be measured so that future methods can be adjusted if necessary.

Basically, sales forecasting is analyzing all parts of a business from total inventory to the strengths and weaknesses of salespeople. Managers must think about changes in customer sales or other changes that could affect the estimated figures. They must be competitive when assessing the competition and how they can surpass others in the marketplace to better meet the needs of the target market.

Financial Statement Forecasting MethodsTo forecast financial data, corporate leadership and department heads rely on

various methods and tools. These include appraisal methodologies, such as vertical and horizontal analyses, as well as financial ratios, such as net profit margin and return on equity. Forecasted financial information is also known as pro forma or projected accounting information.

Following are some methods of forecasting Financial Statements

Statistical Forecasting

Statistical forecasting enables department heads to project financial statements based on assumptions and internally derived factors. For example, supervisors may review the state of the economy and take government-published GDP metrics to estimate how much the company might grow sales in the future -- say, in one, two or 10 years. Gross domestic product, or GDP, is the total market value of goods and services produced within a nation's borders during a given period.



Ratio Method

In ratio analysis, a company uses previously calculated metrics to forecast financial statement data. Financial ratios indicate everything from efficiency and profitability to solvency and liquidity. Examples include net profit margin, asset-turnover ratio and return on equity, or ROE. A company may, for example, forecast income data for each of the next five years by multiplying current-year sales by the current-year ROE. The firm then may adjust the final number by including material cost and labor expense projections.

Vertical Method

Vertical analysis means a company sets a financial statement item as a numerical standard and compares other items with the benchmark. For example, a company may set total sales as the benchmark for income statement forecasts. The business then may calculate that material costs amounted to a certain percentage -- say, 50 percent -- of total sales over the last 12 months. Using this proportion, accountants may extrapolate by setting material costs at 50 percent of total sales for the next five years.

Horizontal Method

In horizontal analysis, the goal is to review financial data year over year, giving analytical prominence to the study of historical information. For example, a business may analyze its sales data over a five-year period and determine that the average revenue-growth rate is 11 percent. The organization then may use the same number to forecast that sales will grow 11 percent for each of the next five or 10 years.

*End of Chapter*



Chapter#5

Financial Environment

Introduction:

Financial environment is the outcome of a range of functions of the economy on all financial outcomes of an area or a country. It includes forex markets, bond markets, stock markets and commodity markets.

Financial Markets A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to

borrow funds/capital are brought together with those having a surplus of funds.

Types of Financial markets:Some Financial markets are as follows

1-Real/tangible/Physical assets Markets and Financial Asset Market Real assets are tangible assets that determine the productive capacity of an

economy, that is, the goods and services its members can create. These include land, buildings, machines, and knowledge that can be used to produce goods and services. Other common examples of investments in Real Assets are paintings, antiques, precious metals and stones, classic cars etc.

While Financial Asset Market refers to that market where financial assets are dealt. Financial Assets, (Assets in the form of paper) or more commonly known as Securities, include stocks, bonds, unit trusts etc. In essence, financial assets or securities represent legal claim on future financial benefits.

2-Spot Markets and Future Markets:The spot market is where securities (e.g. shares, bonds, funds, warrants and

structured products) and goods (e.g. commodities) are traded. In spot market goods are delivered on the same day or within a few days In other words, the transaction takes place immediately or within a short period of time (T+3; transactions are usually settled three working days after they take place).

Future market transactions are transactions in which the price, number and delivery date of the traded securities are agreed when the transaction is concluded but



delivery and payment take place at a future time. Usually, the term "forward transaction" is used if the time period is three days or more.

3-Money Market and Capital MarketThe money market is a segment of the financial market in which financial

instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year.

A capital market is one in which individuals and institutions trade those securities and instruments whose maturity is more than one year.

4-Primary Market and Secondary marketThe primary market is where securities are created. It's in this market that firms

sell new stocks and bonds to the public for the first time. Or the market in which new shares are issued

The secondary market is that market in which second hand shares and bonds are traded. Stock exchange is the market in which one investor buys 3nd hand shares from another investor

5-Private and Public Markets:A private market, also known as the private market sector, is the part of a nation's

economy that is not controlled by the government. It is operated by individuals and firms with the aim of making profits. It is the complete opposite of a public sector which is operated by the government with the aim of providing goods and services.

Financial InstitutionsFinancial institutions are the organizations that are involved in providing various

types of financial services to their customers. Examples of financial institutions include; Banks, Credit Unions, Asset Management Firms, Insurance companies and pension funds among others.

Following are some financial institutions:

1-Commercial BanksThis is a financial institution providing services for businesses, organizations and

individuals. Services include offering current, deposit and saving accounts as well as giving out loans to businesses. Commercial banks are defined as a bank whose main business is deposit-taking and making loans.

2-Savings and Loan Associations



A savings and loan association (S&L) is a financial institution that specializes in savings deposits and mortgage loans, and has become one of theprimary sources of mortgage loans for homebuyers today. It offers mortgage services to people from the savings and deposits received from private investors.

3-Mutual Savings Bank:A Mutual Savings Bank is a financial establishment which is licensed through a

centralized or state government and provides individuals with a secure place to invest in mortgages, credit, stocks and other securities. It is owned and operated by the depositors.

4-Credit union:This is a mutual financial organization formed and managed by a group of people

with a common affiliation, such as employees of a company or a trade union. When you deposit money into a credit union, you become a member and a partial owner.

5-Insurance Companies:These are corporate entities that insure people against loss. The client pays a fee,

known as a premium, in exchange for the promise of the company to protect the client financially in the event of certain potential misfortunes. The different t types of insurance include life, Vehicle, health, liability and homeowners.

6-Investment Banks:Unlike commercial banks, investment banks do not take deposits. Their focus is

assisting individuals, corporations, and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions.

7-Mutual Fund Companies:Sometimes called investment companies, these are companies that pool money

from many investors to purchase securities. Each fund invests in a different group of securities for the investors. They serve the general public.

The Stock Exchange or Stock Market“Stock exchanges are privately organized markets which are used to facilitate

trading in securities.”

Stock Exchange (also called Stock Market or Share Market) is one important constituent of capital market Stock Exchange is an organized market for the purchase and



sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations.

It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country. Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange and bonds and debentures issued by government, public corporations and municipal and port trust bodies.

Over-the-counter (OTC)A decentralized market, without a central physical location, where market

participants trade with one another through various communication modes such as the telephone, email and proprietary electronic trading systems. An over-the-counter (OTC) market and an exchange market are the two basic ways of organizing financial markets. In an OTC market, dealers act as market makers by quoting prices at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges and are also subject to fewer regulations.

What are the Bid-ask spread? The amount by which the ask price exceeds the bid. This is essentially the

difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.

For example, if the bid price is $20 and the ask price is $21 then the "bid-ask spread" is $1.

The Cost of Money:

Concept of the Cost of MoneyThe cost of money refers to the price paid for using the money, whether borrowed

or owned. In other words the cost of money is the expectation of investor from investing or lending money every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of



money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below:

Factors Affecting the Cost of Money

1. Production OpportunitiesProduction opportunities refer to the profitable opportunities for investment in

productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money.

2. Time Preference for ConsumptionTime preference for consumption refers to the preference of consumers for

current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer to consume in current period or in future period. If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa.

3. RiskRisk refers to the chance of loss. In the context of financial markets, risk means

the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase.

4. InflationInflation refers to the tendency of prices to increase over periods. The expected

future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increase in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation.

Interest Rate Levels

What is interest rate?Interest rate is the rate of interest charged for the amount of money borrowed.

Banks or lending institutions usually have general guidelines for the rate they intend to charge. Money borrowed by the bank on short term basis (such as overdraft facility) or long term basis (debentures, mortgages or bank loans) has different interest rate.



These are factors that influence the level of market interest rates:

Expected levels of inflation:Over time, as the cost of products and services increase, the value of money

decreases. Consumer will therefore have to spend more money for the same products or services which had cost less in the previous year. As for finance lending sector, borrowers may find it is attractive to borrow now but less attractive for lender. The value of money now has fallen as compared to the time when they lent their money. In order to compensate this loss, lenders have to increase the interest rate.

Demand and supply of money:Demand and supply of money can affect interest rates. In United States, The

Federal Reserve Bank has taken a step to manipulate money supply through an open market operation, by purchasing large volumes of government security to increase money supply, thus reduce the interest rates, or sell large volumes of government security to reduce money supply which will subsequently increase interest rates.

On the other hand, liquidity preference theory is linked to demand of money. Developed by John Keynes, this theory explains how demand and supply for money influence interest rates. It states that demand for liquidity is determined by transaction, precaution and speculation motives.

Monetary policy and intervention by the government:One of the government’s strategies to control the flow of money within its

consumers is by monetary policy. People will avoid borrowing money when the interest rates are high. This in turn will reduce the money outflow and affect the country’s revenue as consumers will not be spending unless it is necessary. In order to stimulate growth, government may offer lower interest rates on borrowing which subsequently attracts consumer to spend more borrowing. As a result, when the growth rate increases rapidly to the extent that economy may face overheat problem, the government then have to curb this by imposing higher interest rates.

General economic conditions:Economic condition may face series its booms and slumps. The world economy

has been on the slump side since the past five years with many business closures. Banks are unable to provide loan at lower rate as they have to cover their cost.

Apart from the above, other factors such as political and financial stability and investors’ demand for debt securities also affect interest rates. While increase in interest rates helps consumer to save more, it is not good news for lenders and business as they lose their revenue. Globally, this also adversely affects the world economy.



Determinants of market interest ratesThe explanation of these determinants of interest rates is given as under:

Risk Free Interest Rate (kRF=k*+IP)Risk free rate is one of the determinants of the interest rate. Risk free rate means

the rate of interest received if no risk is taken. Factually speaking, there is no such thing as a risk-free rate of return because no investment can be entirely risk-free. All the investments and securities include a certain amount of risk. A company may go bankrupt or close down. However, if we talk about the relevant risk involved in different securities, the government-issued securities are considered as risk-free, since the chances of default of a government are minimal. These government issued securities provide a benchmark for the determination of interest rates. Internationally the US T-Bills are considered as risk free rate of return.

In Pakistan, Government of Pakistan T-Bills can be used as a proxy for risk free rate of return, however, since Pakistan faces some sovereign risk, the T-bills would not be considered entirely risk-free in the true sense.

Inflation (g): The expected average inflation over the life of the investment or security is

usually inculcated in the nominal interest rate by the issuer of security to cover the inflation risk. For instance, consider a bond with a maturity of 5 years. If the inflation rate in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the investors would not be willing to invest in the bond since the gains from the interest rate would be exactly offset by the inflate ion rate which is actually eroding the wealth of the investor. To secure the investor against inflation the issuers, while quoting nominal interest rates, add the rate of inflation to the real interest rate.

Default Risk Premium (DR): Default risk refers to the risk that the company might go bankrupt or close down

& bonds, or shares issued by the company may collapse. Default Risk Premium is charged by the investor, as compensation, against the risk that the company might goes bankrupt. Companies may also default on interest payments, something not very unusual in the corporate world. In USA, rating agencies like

Moody’s and S&P grade securities (debt and equity instruments) according to their financial health and thus identify those companies which have a good ability to pay off their principal lending and interest charges and those which might default on the payments.



Maturity Risk Premium (MRP): The maturity risk premium is linked to the life of that security. For example, if

you purchase the long term Federal Investment Bonds issued by the government of Pakistan, you are assuming certain risk, because changes in the rates of inflation or interest rates would depreciate the value of your investment. These changes are more likely in the long term and less likely in the short term. Maturity risk Premium is linked to life of the investment. The longer the maturity period, the higher the maturity risk premium.

Sovereign Risk Premium (SR): Sovereign Risk refers to the risk of government default on debt because of

political or economic turmoil, war, prolonged budget and trade deficits. This risk is also linked to foreign exchange (F/x), depreciation, and devaluation. Now-a-days the individuals as well as institutions are investing billions of rupees globally. If a bank wants to invest in Pakistan, it will have to take view of Pakistan’s political, economic, and financial environment. If the bank sees some risk involved it would be willing to lend at a higher interest rate. The interest rate would be high since the bank would add sovereign risk premium to the interest rate. Here it may be clarified that Pakistan is not considered as risky as many other countries of Africa and South America.

Liquidity Preference (LP):Investor psychology is such that they prefer easily encashable securities.

Moreover, they charge the borrower for forgoing their liquidity. A higher liquidity preference would always push the interest rates upwards.

So summing up Quoted interest rate=k=k*+IP+DRP+LP+MRPThe above relation includes all the above factors.

The Term Structure of Interest RatesThe relationship between interest rates or bond yields and different terms or

maturities. The term structure of interest rates is also known as a yield curve and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.



In general terms, yields increase in line with maturity, giving rise to an upward sloping yield curve or a "normal yield curve." One basic explanation for this phenomenon is that lenders demand higher interest rates for longer-term loans as compensation for the greater risk associated with them, in comparison to short-term loans. Occasionally, long-term yields may fall below short-term yields, creating an "inverted yield curve" that is generally regarded as a harbinger of recession.

What determines the shape of the yield curve?The yield curve, also known as the "term structure of interest rates," is a graph

that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. (Note that the chart does not plot coupon rates against a range of maturities -- that's called a spot curve.)

How it works/Example:The yield curve shows the various yields that are currently being offered

on bonds of different maturities. It enables investors at a quick glance to compare the yields offered by short-term, medium-term and long-term bonds.The yield curve can take three primary shapes. If short-term yields are lower than long-term yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve. Below you'll find an example of a normal yield curve:

If short-term yields are higher than long-term yields (the line is sloping downwards), then the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an example of an inverted yield curve:



Finally, a flat yield curve exists when there is little or no difference between short- and long-term yields. Below you'll find an example of a flat yield curve:

It is important that only bonds of similar risk are plotted on the same yield curve. The most common type of yield curve plots Treasury securities because they are considered risk-free and are thus a benchmark for determining the yield on other types of debt.The shape of the yield curve changes over time. Investors who are able to predict how the yield curve will change can invest accordingly and take advantage of the corresponding change in bond prices.Yield curves are calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions.

*End of Chapter*



Chapter # 06

Risk and ReturnWhat is Risk?

The probability or threat of quantifiable damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.

In Finance: The probability that an actual return on an investment will be lower than the expected return. Financial risk can be divided into the following categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk, Political risk, Refinancing risk, risk, Settlement, Sovereign risk, and Underwriting risk.

What Are the Different Types of Risk?

*Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk.

*Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect you from unsystematic risk.

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds.

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios.

Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country.

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency.



Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.

Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the day-to-day fluctuation in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces.

Investment Return:A performance measure used to evaluate the efficiency of an investment or to

compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

The rate of return on an investment can be calculated as follows:

In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.Return on investment, or ROI, is the most common profitability ratio. There are several ways to determine ROI, but the most frequently used method is to divide net profit by total assets. So if your net profit is $100,000 and your total assets are $300,000, your ROI would be .33 or 33 percent.

Return on investment isn't necessarily the same as profit. ROI deals with the money you invest in the company and the return you realize on that money based on the net profit of the business. Profit, on the other hand, measures the performance of the business. Don't confuse ROI with the return on the owner's equity. This is an entirely different item as well. Only in sole proprietorships does equity equal the total investment or assets of the business.

Stand Alone RiskStandalone risk describes the danger associated with investing in a particular

instrument or investing in a particular division of a company. A typical investment portfolio contains a wide array of instruments in which case investors are exposed to a



large number of risks and potential rewards. In contrast, a standalone risk is one that can easily be distinguished from these other types of risk.

When an investor only invests in one type of stock, then his or her entire investment returns depend on the performance of that security. If the company that issued the stock performs well then the stock will grow in value but if the firm becomes insolvent then the stock may become worthless. Therefore, such an investor is exposed to standalone risk because that individual's entire investment could be lost due to the poor performance of a single asset.

Additionally, someone who invests in a wide array of securities is also exposed to standalone risk if that individual holds each type of instrument in a separate brokerage account. In such situations, the investor would not lose everything if one asset dropped in value, but each holding account would expose the investor to a different standalone risk since each account would only hold one type of security.

Probability DistributionA statistical function that describes all the possible values and likelihoods that a

random variable can take within a given range. This range will be between the minimum and maximum statistically possible values, but where the possible value is likely to be plotted on the probability distribution depends on a number of factors, including the distributions mean, standard deviation, skewness and kurtosis. Academics and fund managers alike may determine a particular stock's probability distribution to determine the possible returns that the stock may yield in the future. The stock's history of returns, which can be measured on any time interval, will likely be comprised of only a fraction of the stock's returns, which will subject the analysis to sampling error. By increasing the sample size, this error can be dramatically reduced.

There are many different classifications of probability distributions, including the chi square and normal and binomial distributions.

Expected Rate of Return:Expected return is calculated as the weighted average of the likely profits of the

assets in the portfolio, weighted by the likely profits of each asset class. Expected return is calculated by using the following formula:



Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnRn

Example: Expected ReturnFor a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect the stock fund to return 10% and the bond fund to return 6% and our allocation is 50% to each asset class, we have the following:

Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%

Expected return is by no means a guaranteed rate of return. However, it can be used to forecast the future value of a portfolio, and it also provides a guide from which to measure actual returns.

Standard DeviationStandard deviation can be defined in two ways:

1. A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.

2. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as volatility and is used by investors as a gauge for the amount of expected volatility.

Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while a stable blue chip stock will have a lower standard deviation. A large dispersion tells us how much the fund's return is deviating from the expected normal returns.

Example: Standard DeviationStandard deviation (σ) is found by taking the square root of variance:

(165)1/2 = 12.85%.

We used a two-asset portfolio to illustrate this principle, but most portfolios contain far more than two assets. The formula for variance becomes more complicated for multi-asset portfolios. All terms in a covariance matrix need to be added to the calculation.

Risk aversion

Risk aversion is a concept in economics and finance, based on the behavior of humans (especially consumers and investors) while exposed to uncertainty to attempt to reduce that uncertainty.



Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.Example:

A person is given the choice between two scenarios, one with a guaranteed payoff and one without. In the guaranteed scenario, the person receives $50. In the uncertain scenario, a coin is flipped to decide whether the person receives $100 or nothing. The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble. However, individuals may have different risk attitudes.

Risk in a Portfolio ContextPortfolio

A collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices.

A group of investments such as stocks, bonds and cash equivalents, mutual funds, exchange-traded funds, and closed-end funds that are selected on the basis of an investor's short-term or long-term investment goals. Portfolios are held directly by investors and/or managed by financial professionals.

Portfolio ReturnThe monetary return experienced by a holder of a portfolio. Portfolio returns can

be calculated on a daily or long-term basis to serve as a method of assessing a particular investment strategy. Dividends and capital appreciation are the main components of portfolio returns.

Portfolio returns can be calculated through various methodologies such as a time-weighted and money-weighted return. However, the overall return must be compared to the required benchmarks and risk of the portfolio as well.

Calculation Portfolio Return: To determine the expected return on a portfolio, the weighted average expected return of the assets that comprise the portfolio is taken.

Formula 17.4

E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn

Example: Assume an investment manager has created a portfolio with the Stock A and Stock B.



Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the portfolio?

Answer: E(R) = (0.30) (20%) + (0.70) (15%) = 6% + 10.5% = 16.5%The expected return of the portfolio is 16.5%

Portfolio RiskPortfolio risk is the possibility that an investment portfolio may not achieve its

objectives. There are a number of factors that contribute to portfolio risk, and while you are able to minimize them, you will never be able to fully eliminate them.

Portfolio risk refers to the combined risk attached to all of the securities within the investment portfolio of an individual. This risk is generally unavoidable because there is a modicum of risk involved in any type of investment, even if it is extremely small. Investors often try to minimize portfolio risk through diversification, which involves purchasing many securities with different characteristics in terms of potential risk and reward. There are some risks which cannot be solved through diversification, and these risks, known as market risks, can only be lessened by hedging with contrasting investments.

Calculating Beta CoefficientA measure of the volatility, or systematic risk, of a security or a portfolio in

comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.Also known as "beta coefficient."

Beta coefficient is a measure of sensitivity of a share price to movement in the market price. It measures systematic risk which is the risk inherent in the whole financial system. Beta coefficient is an important input in capital asset pricing model to calculate required rate of return on a stock. It is the slope of the security market line.

FormulaBeta coefficient is calculated as covariance of a stock's return with market returns

divided by variance of market return. A slight modification helps in building another key relationship which tells that beta coefficient equals correlation coefficient multiplied by standard deviation of stock returns divided by standard deviation of market returns. Beta coefficient is given by the following formulas:

β =Covariance of Market Return with Stock ReturnVariance of Market Return

β = Correlation Coefficient ×Standard Deviation of Stock Returns

Between Market and Stock Standard Deviation of Market Returns



The Relationship between Risk and Rate of ReturnThere are two primary concerns for all investors: the rate of return they can expect

on their investments and the risk involved with that investment. While investors would love to have an investment that is both low risk and high return, the general rule is that there is a more or less direct trade-off between financial risk and financial return. This does not suggest that there is some perfect linear relationship between risk and return, but merely that the investments that promise the greatest returns are generally the riskiest.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

Physical assets verses securitiesAn item of economic, commercial or exchange value that has a tangible or

material existence. For most businesses, physical assets usually refer to cash, equipment, inventory and properties owned by the business. Physical assets are the opposite of intangible assets, which are non-physical assets such as leases, computer programs or agreements.

A financial instrument that represents: an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer.

Securities are typically divided into debt securities and equities. A debt security is a type of security that represents money that is borrowed that must be repaid, with terms that define the amount borrowed, interest rate and maturity/renewal date. Debt securities



include government and corporate bonds, certificates of deposit (CDs), preferred stock and collateralized securities (such as CDOs and CMOs).

Capital Asset Pricing Model (CAPM)A model that describes the relationship between risk and expected return and that

is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two

ways: time value of money and risk. The time value of money is represented by the risk-

free (rf) rate in the formula and compensates the investors for placing money in any

investment over a period of time. The other half of the formula represents risk and

calculates the amount of compensation the investor needs for taking on additional risk.

This is calculated by taking a risk measure (beta) that compares the returns of the asset to

the market over a period of time and to the market premium (Rm-rf).

Risk and the Capital Asset Pricing Model Formula

The formula for CAPM is as follows:

In this formula, Ri represents the return on a risky security i, Rf represents the risk

free rate, βi represents the beta of security i, and Rm represents the market return.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. For example, if Security A has an expected return of 5%, but based on the CAPM the expected return should be 6%, then you should not buy Security A because for the same level of risk you can find other investments with an expected return of 6%.

Using the CAPM model and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock



is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Security market line (SML):

The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta.

The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line.

Figure:Security Market Line

Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium required by investors was to change, the slope of the SML would change as well.The formula for the Security Market Line is:

Required Return = Risk Free Rate + ( Beta x [Market Return - Risk Free Rate])

The Capital Market Line (CML):

A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.Figure 12.1 below shows why it is called the security market line:

Figure 12.1



Figure 12.1 illustrates: How a static, risk-free investment should yield the RFR, How an investment that varies constantly in direct proportion to the market (and

thus has a covariance equal to the variance of the market) should yield the market rate, and

How one particular investment that moves with greater volatility than the market (and thus has a higher covariance) ought to yield a higher return?

What is Beta?In finance, the beta (β) of an investment is a measure of the risk arising from

exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. An example of the first is a treasury bill; the price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of gold does go up and down a lot, but not in the same direction or at the same time as the market.

A measure of a security's or portfolio's volatility. A beta of 1 means that the security or portfolio is neither more nor less volatile or risky than the wider market. A beta of more than 1 indicates greater volatility and a beta of less than 1 indicates less. Beta is an important component of the Capital Asset Pricing Model, which attempts to use volatility and risk to estimate expected returns

Volatility Verses RiskRisk:-Risk exposure to the chance of injury or loss; a hazard or dangerous chance. The degree of probability of such loss.-If you are worried about the “risk level” of a certain investment, you are worried about the potential permanent loss of your money.-Risk is based on the actual fundamentals of a company or country

Volatility:Tending to fluctuate sharply and regularly.-The volatility of a stock or bond does not necessarily have to equate with its risk.



-The more volatile stock goes up and down much more violently. But it makes billions of dollars every year, and has billions of dollars of cash on hand to weather hard economic times.-If the less volatile stock has never made a profit, has declining sales and will be forced to take on more debt to pay its short term liabilities, is it really “Less risky” as the volatility implies?-Volatility simply refers to the price action. Usually this is expressed in terms of a stock’s Beta -A security’s volatility matters if the money is needed immediately because you may be forced to sell and take a loss when the security has only temporarily declined.

Conclusion-There is an important difference between an investment’s volatility and its risk.-An investment’s volatility should be a concern to investors if the money is needed in the immediate future. But just because an investment is more volatile does not necessarily mean it is more risky in the long term. As an investment’s time horizon gets longer, the effect of volatility is reduced greatly.-The stock market as a whole is much more volatile than a bank CD, but that does not mean savers should bypass any investment in the stock market altogether. Instead, it means that investors should know the potential for short term volatility to affect the value of their investments and plan accordingly.

End of Chapter



Chapter #08

COST OF CAPITAL

IntroductionAssets of the firm re financed by three major fixed sources of funds, these fixed

sources of finance are called capital of the firm. These are

1. Debt2. Preferred stock3. Common stock

The investors who have provided these funds demand some return on these funds. This required return is basically the cost of capital for that company. This return depends on the riskiness of the security. The cost of these different capitals and also the combine weighted average cost of capital (WACC) are now discussed in detail.

Cost of DebtDebt is the major source of finance for a company. Company normally acquires

debt by issuing bonds, and pay interest on bonds they issue. The first step for calculating the cost of debt is to determine what rate of return bond holders demand (rd), which is basically the interest rate on that bond. Here we will use the current market rate of interest instead of coupon rate of interest. For example market rate of interest is 12%.If there are no taxes on a company we can say that this rd is the cost of debt. But this interest paid on debt is a deductable expense from profits so this interest reduces the profits and hence reduces the tax liability as well. Hence the real cost of debt is not the interest but it is lesser than the interest expense up to the saving in taxes. So the actual cost of debt is the interest rate less tax savings.

Mathematically After tax cost of debt = Interest – Tax savings= rd - rdT (Where T is the corporate tax rate)= rd (1-T)

For example if rd = 12% and Tax rate is 40% thenAfter tax cost of debt = 12 %( 1- .4)

= 7.2%So after tax cost of capital is 7.2%

Cost of Preferred stockPreferred stock is that which are preferred in payment of dividend. Some

preferred stock is issued without stated maturity, but most of the preferred stock has a



finite maturity. It should be noted that preferred stock dividend is not a deductible expense and hence the issuer bears the full cost of dividend without any tax adjustment.The component cost of preferred stock rps is the cost used for calculating the weighted average cost of capital. For proffered stock having stated maturity the method used is same as used for bonds, but without considering the effect of taxes. For bonds having no specific maturity eps so calculated as

rps = Dps/Pps(1-f)Where D is the dividend per share, P is the price per share and f is the floatation cost. Floatation cost is recorded in percentage of the amount realized on issue of preference shares and it is basically the cost incurred on issuing these preference shares. For example if dividend per share is 12, and price per share is 90 and floatation cost is 4%of the amount realized. By putting the values in the above equation we find that.

rps =12/90(1-04)=12/86.4=13.89%

Cost of Common equityA firm can raise common stock by either issuing new shares or retaining the

profits and reinventing them the in the business. For issuing new shares the company must incur floatation cost in shape of brokerage and commission etc. Here in this part of discussion we will ignore floatation cost by assuming rising of equity by retaining the profit.

The cost of capital is the expectation of share holders from the investment they have made in a specific company. Their expectations are based on several aspects of the company. In which the most important is the amount of risk they are taking in investing in that company. Besides risk the cost of equity also depends on the market risk premium, the annual dividend they are announcing, the annual growth of the company. Overall market situation etcThere are three different methods for calculating the cost of capital. These are as following.

The Capital Asset Pricing Model ApproachThe Capital Asset Pricing Model (CAPM) is a model which describes the

relationship between risk and required rates of return. The main concept behind CAPM is an investor’s required rate of return greatly depends on the risk he is taking by holding that security along with the risk free rate. The overall model of CAPM is as under.

rs = rRF + (RPm)bOr rs = rRF + (rm-rRF)b

(Where re is required rate of return on equity, rRF is the risk free rate; RPm is the market risk premium)



To understand the required return on equity using CAPM individual elements of this model are now discussed

1 the first step for calculating cost of equity is to calculate the risk free rate. Risk

free rate is that rate of return which is earned on such type of securities which have relatively zero risk. Practically there are no such securities which are completely freefrom risk. But here we will take the rate of treasury securities s the risk free rate. We will take the rate of return on T-bonds instead of T-bills because T-bonds are long term securities and have relatively no fluctuation in their interest rates. So the risk free rate will be the rate of interest on T-bonds.

2 The 2nd is to calculate the market risk premium. It is calculated by subtracting

the risk free return from the market return. Market risk premium is the excess return over the risk free return, which an investor can earn on an average security. Market return can be calculated using the average return of the historical data, or can also be calculated by forward looking approach using the discounted cash flow model.

3 Third step for calculating return on equity is to calculate beta. Beta measures the

relevant risk of an individual security compared to the market portfolio. More risky a business greater will be its beta and it will increase the market risk premium accordingly. The above discussion can be summarized that the cost of equity (rs) under the CAPM approach depends on three main factors, risk free rate, market risk premium and beta. Greater these items are greater will be the cost of equity.

Dividend Yield Plus Growth Rate, or Discounted Cash Flow approach

Cost of equity can also be calculated using the dividend yield plus growth approach. Under this method return on equity (rs) is calculating by discounting the future dividends. Equation is derived by rearranging the equation of calculating the price per share. The basic equation is

Po = Di/ (rs - g)By rearranging the above equation for re we get

rs = (Di / po )+ gWhere Di is the dividend per share, po is the market price per share and g is the growth rate of the expected dividend, or the capital gain on securities.Dividend per share and price per share are simple and normally they are known. We will have to find the expected growth on shares. There are three methods for calculating growth on shares these are discussed below.

1 Using historical growth data. The future growth for an individual security can be

calculated by finding the growth pattern of the previous years. For this purpose an



average is calculated for all the growth rates of previous years with an expectation that dividend will grow at the same rate for the coming year as well

2 2nd approaches for calculating growth are from the retention ratio. Normally if a

company retains their profits it increases the book value of the shares of the firm, which causes the market value of shares to rise and hence a company earns capital. So we can predict growth of the company using the retention ratio.

Mathematically g = (Retention rate) (ROE) g = (1 - payout rate) (ROE) g = (1 – 0.65) (15%) = 5.25%.

3 3rd approaches for calculating growth are the analyst’s forecast.

Bond Yield plus Risk Premium ApproachSome analyst estimates the cost of equity by subjective procedure. They add a

specific judgmental risk premium with the interest rate of the firm own long term debt. This interest premium ranges from 3 to 5 percent based on judgment of the analyst.

Mathematically rs = Bond yield + Bond risk premiumThis method is very subjective but still it gives near to accurate answer

Adjusting the Cost of debt for floatation CostFloatation cost is the cost of incurred for issuing new shares. These costs may be

brokerage commission taxes etc. in previous methods of calculating cost of equity it was assumed that equity is raised by reinvesting the profits of the company, hence no floatation cost was taken into consideration. But if we issue new shares floatation cost must be taken into consideration. And rs will become re and the equation will become as

re = [Di / Po(1-F)] + gWhere F is the percentage floatation cost

Weighted Average Cost of CapitalWeighted average cost of capital is the combine or composite cost of the total

capital of the firm. Which include debt, preferred stock and common stock it is the weighted average of all the costs of individual capitals? Weight is the percentage proportion of any component of the capital. Greater the amount of an individual capital, greater weight will be assigned to that capital component. These percentage proportions of capital (weights) are based on the target or optimal capital of the management. Optimum capital is that mix of debt, preferred stock and common stock which causes the company stock prices to be maximized by earning more income and taking low risk.

WACC = (Cost of debt) (Weight of debt) + (Cost of of preferred stock)(Weight of preferred stock) + (Cost of equity)(weight of equity)



WACC = wdrd(1 - T) + wpsrps + wcers

Suppose the stock price is $150 million of common stock, $25 million of preferred stock, and $75 million of debt. Hence the total capital of the firm is 250 millionFirst we calculate the individual weights of the components of the capital, as following

wce = $150/$250 = 0.6wps = $25/$250 = 0.1wd = $75/$250 = 0.3

Then calculate the individual cost of capital and put them in the equation of WACCWACC = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)WACC = 1.8% + 0.9% + 8.4% = 11.1%.

Factors effecting WACCWACC is affected by a number of factors some of them can be controlled by the

firm and some cannot be controlled by the firm.

Factors the firm cannot controlThree most important factors which are beyond the control of the firm re

The level of interest rates affects the overall cost of capital directly. An increase in interest rate also increases the cost of capital. It affects cost of debt directly as a company must issue new bonds at higher rate if there is increase in market rate of interest. it also increases cost of equity because of increase in risk free rate.

Market risk premium higher market risk premium rises the cost of equity, and hence the overall WACC

Tax rate If tax rates increases it will decrease the cost of debt. As interest is a deductable expense and reduces the tax liability. So there is an inverse relationship between tax rates and WACC.

Factors the firm can control

Capital structure policy Every component of the capital has different cost, and if their ratio is changed it will automatically change the overall cost of capital (WACC)

Dividend Policy If a company retains greater portion of its profits and reinvest it in the same business, it will keep increasing its equity and hence will change its capital structure and automatically WACC



Investment policy if a company invest the new capital in similar assets having the same risk the risk premium and beta will not change hence the cost of capital will not change but if the firm changes its investment policy and invest in different assets the risk level will change and the required rate of return will also change accordingly. And hence WACC will change

*End Of Chapter*



Chapter #09

Corporate Valuation and value based Management

Corporate Valuation an Overview:Valuation means the process of determining the value of an asset or company.

Corporate valuation is the process of determining the worth of a firm. In order to evaluate new projects, consider mergers and acquisitions, or make strategic decisions, the financial analyst must understand the factors that drive corporate value. Since public companies are valued in the context of the broader stock market, it will be necessary to examine both internal and external factors that determine prices in the context of the global economy.Business Valuation:

The process of determining the economic value of a business or company. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and divorce proceedings. Often times, owners will turn to professional business valuators for an objective estimate of the business value.

In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such asstocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Business Valuation MethodsOR

The Corporate Valuation Model

Following methods are used for the Valuation of Business

Asset Based approachesThe asset, or cost, approach considers the value of a business to be equivalent to

the sum of its parts; or the replacement costs for this business. This is an objective view of a business. It can be effective in quantifying the fair market value of an entity's tangible assets, as it adjusts for the replacement costs of existing, potentially deteriorating, assets.

Income Based approaches



The income approach identifies the fair market value of a business by measuring the current value of projected future cash flows generated by the business in question. It is derived by multiplying cash flow of the company times an appropriate discount rate.In contrast the asset based approaches, which are very objective; the income based approaches require the valuator to make subjective decisions about discount rates or capitalization. Many considerations and variables are measured to account for the specific contribution of primary value drivers in a business that result in influencing cash flow: revenue drivers, expense drivers, capital investment, etc. This method, which comes in several approaches, is useful as it identifies fundamental factors driving the value of a business.

Market Comparison Based approachesThe Market Comparison approach to a business valuation is based upon current

conditions amongst active business buyers, recent buy-sell transactions, and other fairly comparable business entities. Financial attributes of these comparable companies and the prices at which they have transferred can serve as strong indicators of fair market value of the subject company

Value Based ManagementValue based management is a structured approach to measure the performance of

a firm's section managers or products in terms of the total advantage they provide to shareholders. This is usually the utilization of shareholder value added metrics.

Value based management focusing on creating wealth for shareholders. (VBM) can help managers make decisions in the context of the financial objectives of the company and the expectations of the shareholders. Managers need to have an understanding of their key value drivers, which can be intangible assets, the financial structure, asset turns and working capital. Each requires a different type of focus and management attention.

SAS software can be used to enhance the effectiveness of a VBM implementation by providing better analysis and predictive capabilities and aiding communication within the company and with external parties. SAS software can be used to implement VBM in the following ways:

Strategy mapping: business drivers that affect shareholder value can be mapped to show the links between each and what can be done to improve them.

Alignment: ensure the goals cascaded throughout the organization are in line with the overall corporate objectives, and that there is top to bottom alignment of activities.

Internal communication: the strategic vision and long term corporate goals can be shared with all employees through the Web. Performance reporting can be updated automatically and delivered to the desktop.



Measurements: measures can be summed and amalgamated, target and actual data can be collected and reported automatically, and early indicators of variance can be displayed. Appropriate VBM drivers can be linked to each metric.

Investor communication: disclosure of relevant information, the goal being to avoid unnecessary surprises and minimize the uncertainty. Top level views can give management an overall view of VBM performance.Continuous improvement: highlight key areas that need improvement through drill down and analysis, correlation of drivers with outcomes and personalized information portals.

Corporate Governance and shareholders wealth

Corporate Governance is "the system by which an organization is directed and controlled." In particular, corporate governance is concerned with the potential abuse of power and the need for openness, integrity and accountability in corporate decision making. The main objective of the firm is always to maximize shareholders wealth. The major decisions that have an influence on shareholder wealth maximization are investment, financing and dividend decisions. This study was carried out to clearly show the extent to which corporate governance contributes to shareholder wealth maximization. It delineates the role, duties and obligations of all Board of Directors and therefore helps avoid agency conflicts. The researcher looked at the various variables of corporate governance i.e. the Board composition, Number of Board meetings, attributes of board members and directors' remuneration strategy and showed the extent to which they contribute towards shareholder wealth maximization.

End of Chapter



Chapter #10

Capital Structure Decisions

Capital Structure

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such asworking capital requirements is also considered to be part of the capital structure.Target or optimal Capital Structure

The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this target (optimal) capital structure.

The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its value. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firm’s cost of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of its tax deductibility. However, it is seldom the optimal structure for as debt increases, it increases the company’s risk.There are numerous ways in which a company’s optimal capital structure can be estimated. The most commonly used ones are:Method 1One method of estimating a company’s optimal capital structure is utilizing the average or median capital structure of the principle companies engaged in the market approach. This approach is helpful as the appraiser is well aware about which companies are included in the analysis and the degree to which they are related to the subject company. However, this method features a limitation that fluctuations in market prices and the spread out nature of debt offerings and retirements might cause the actual capital structure of a principle company to be significantly different from the target capital structure.Method 2

This method is applied if the risk of a company did not change because of the nature of its capital structure, and a company would wish as much debt as possible, as the interest payments are tax deductible and debt financing is always cheaper than equity financing. The main objective of this method is determining the debt level at which the benefits of increased debt does not overshadow the increased risks and potential costs associated with an economically distressed company.



Business and Financial Risk

1-Business RiskA company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:

Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.

Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.2-Financial Risk:A company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high -meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Capital Structure Theory-The Modigliani-Miller ModelsThe Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is a

theorem on capital structure, debatably forming the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

Assumptions Required for Modigliani-Miller Theorems1. Control aspects of shares ignored.2. Shareholders can lend and borrow at the same interest rate as Örms.3. No bankruptcy.4. Tax ignored



Checklist for Capital Structure Decisions: Debt ratios of other firms in the industry. Lender and rating agency attitudes

(impact on bond ratings). Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible and hence suitable as collateral? Tax rates.

End Of Chapter



Chapter #11

Distribution to Shareholders: Dividends and Repurchase

Dividend vs. Capital GainCapital gains and dividends are both financial gains available to investors of

stock. Capital gains can be obtained, not just by selling shares, but also through the sale of other capital assets such as property, plant, equipment, machinery that is held for a longer period of time. Dividends, however, are only obtained by investing in stock and are paid to shareholders at different intervals depending on the amount of revenue generated and the types of shares held by shareholders. The tax rate for capital gains will be higher than tax applied for dividends.

Dividends Versus Capital Gains: What Do Investors Prefer?When deciding how much cash to distribute to stockholders, financial managers

must keep in mind that the firm’s objective is to maximize shareholder value. Consequently, the target payout ratio-defined as the percentage of net income to be paid out as cash dividends –should be based in large part on investors, preferences for dividends versus capital gains: do investors prefer (1) to have the firm distribute income as cash dividends or (2) to have it either repurchase stock or else plow the earnings back into the business, both of which should result in capital gains? This preference can be considered in terms of the constant growth stock valuation model:

D1

P0 = ------------- Ks - g

If the company increases the payout ratio, it raises D1. This increase in the numerator, taken alone, would cause the stock price to rise. However, if D1 is raised, then less money will be available for reinvestment, that will cause the expected growth rate to decline, and that would tend to lower the stock’s price. Thus any change in payout policy will have two opposing effects. Therefore, the firm’s optimal dividend policy must strike a balance between current dividends and future growth so as to maximize the stock price.

Dividends are irrelevantIn Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.

- The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.

- If an investor wants cash flow, he/she could sell some shares.- If an investor wants more risk, he/she could borrow to invest. - An investor is indifferent about a share repurchase or a dividend.

Bottom line: Dividend policy does not affect a firm’s value



Dividend Policy Issues Clientele Effect: Investors needing current income will be drawn to firms with

high payout ratios. Investors preferring to avoid taxes will be drawn to firms with lower payout ratios. (i.e., firms draw a given clientele, given their stated dividend policy). Therefore, firms should avoid making drastic changes in their dividend policy.

Information Content: Changes in dividend policy may be signals concerning the firm’s financial condition. A dividend increase may signal good future earnings. A dividend decrease may signal poor future earnings.

Bird-in-the-hand TheoryBird-in-the-hand Theory is one of the major theories concerning dividend policy

in an enterprise. This theory was developed by Myron Gordon and John Lintner as a response to Modigliani and Miller's dividend irrelevance theory.Gordon and Lintner claimed that MM made a mistake assuming lack of impact of dividend policy on firm's cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The authors indicated that the higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk. In other words, Gordon and Lintner claimed that one percent drop in dividend payout has to be offset by more than one percent of additional growth.

Bird-in-the-hand theory was criticized by Modigliani and Miller who claimed that dividend policy does not affect the firm's cost of capital and that investors are totally indifferent if they receive more dividend or capital gains. They called Gordon and Lintner's theory a bird-in-the-hand fallacy indicating that most investors will reinvest the dividend in the similar or even the same company and that company's riskiness is only affected by its cash-flows from operating assets.Tax preference theoryTax preference theory is one of the major theories concerning dividend policy in an enterprise. It was first developed by Litzenberger and Ramaswamy. This theory claims that investors prefer lower payout companies for tax reasons.Litzenberger and Ramaswamy based this theory on observation of American stock market. They presented three major reasons why investors might prefer lower payout companies.Firstly, unlike dividend, long-term capital gains allow the investor to differ tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future.Secondly, up until 1986 all dividend and only 40 percent of capital gains were taxed. At a taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on long-term capital gains. Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but deferral issue still remains.Finally, if a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them on the death day at their base costs and avoid capital gains tax payment.



Dividend Stability:

According to this policy, the percentage of earnings paid out as dividends remain constant irrespective of the level of earnings. Thus, as earnings of a company fluctuate, dividends paid by it also fluctuate accordingly. The following figure shows the behavior of dividends in case this policy is adopted–

Most of the firms follow stable dividends or gradually increasing dividends due to following reasons –

Many investors consider dividends as a part of regular income to meet their expenses. Hence, they prefer a predictable pattern of dividends rather fluctuating pattern. A fall in the dividend income may lead to sale of some shares, on the other hand when the dividend income increases, an investor may invest some of the proceeds as reinvestment in shares. Both the cases involve transaction cost and inconvenience for investor. They prefer regular dividends.

The dividend policy of firms conveys a lot to the investors. Increasing dividends mean better prospects of the company. On the contrary, decreasing dividends suggest bad earnings expectations. In addition, stable dividends are signs of stable earnings of the company. On the other hand, varying dividends lead to uncertainty in the mind of shareholders.

Certain investors mainly institutional consider the stability of dividends as an important criterion before they decide on the investment in that particular firm.

Establishing a dividend policy in Practice:Dividend policy refers to the policy which is used as a guide when a firm

makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.



Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

Factors which affect dividend policyThere are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints - this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negativesignal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positivesignal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.



Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

Dividend reinvestment plan (DRIP):

Dividend Reinvestment Plans (Also known as Dividend Reinvestment Programs or DRIPs) are a great tool for long-term investors. The compounding interest of DRIPs allows investors to purchase additional shares of stock at no cost -- simply reinvest the dividends, and when enough money is accrued, additional shares are automatically purchased.

How dividend reinvestment plans does (DRIPs) work?

When an investor enrolls in a dividend reinvestment plan, he will no longer receive dividends in the mail or directly deposited into his brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend.

What are the benefits of dividend reinvestment plans?

Enrolling in a DRIP is fairly easy. Cash dividends paid by the company are automatically reinvested into additional shares. Once the investor has enrolled in a DRIP, the process becomes entirely automated and usually requires minimal attention or monitoring.

Many dividend reinvestment plans are often part of a direct stock purchase plan. If the investor holds at least one of his shares directly, he can have his checking or savings account automatically debited on a regular basis to purchase additional shares of stock, usually at no cost to the buyer.

The Fee to purchase through dividend reinvestment programs is normally small, if any. Dividend reinvestment plans also allow the investor to purchase fractional shares. Over decades, this can result in significantly more wealth in the investor's hands.

Stock Dividends and Stock Splits

Like cash dividends, stock dividends and stock splits also have effects on a company's stock price. Stock DividendsStock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. For example, suppose New.co decides to issue a 10% stock dividend. Each current stockholder will thus have 10% more shares after the dividend is issued.Stock Splits



Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.

Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company's stock.

Stock Repurchase:

A program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. Share repurchase is usually an indication that the company's management thinks the shares are undervalued. The company can buy shares directly from the market or offer its shareholder the option to tender their shares directly to the company at a fixed price.

Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it will usually say something along the lines of, "We find no better investment than our own company."

End of Chapter



Chapter #12

Initial Public Offering, Investment Banking and Financial Restructuring

What is Initial Public Offering – IPO?The first sale of stock by a private company to the public. IPOs are often issued

by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market.

IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, which are subject to additional uncertainty regarding their future values.

Financing Life Cycle of a Startup CompanyFinancial Life Cycle A life cycle is a series of stages in which an individual passes

during his or her lifetime.

In the first stage, a new company's external financing needs (EFN) are high, since it needs money to develop its idea but lacks retained earnings. They are usually financed through debt, but may find investors who are willing to take on risk if projected growth is high.

In the growth stage, a firm's initial EFN is high relative to its current value; it needs significant funds for growth. It can be financed through venture capital or issuing equity.

Growth eventually slows and the firm enters the mature stage. These firms can be financed by equity or debt. If they have no new projects, EFN is relatively low.

The firm may go into decline as their product becomes obsolete or a competitor outperforms them. In this case, they have very low external financing needs.

The decision to Go PublicThe decision to take a company public is one of the most important that a CFO is

involved in. Some companies are founded on the assumption that they will go public as soon as possible. It is important to ensure that the decision to go public is made after full consideration of the challenges involved. The more consideration that goes into the decision, the better prepared the company will be to deal with the rigors of the goingpublic process itself and the responsibilities of life as a public company. It is therefore vital that the CFO, in consultation with the CEO, the board, and other major stakeholders



such as owners and investors, has addressed the following questions when making the decision to go public:

What factors must be considered in making the decision to go public?

What must the company have in place prior to going public?

What will life be like as a public company?

Advantages of Going Public:Going public and offering stock in an initial public offering represents a milestone for most privately owned companies. A large number of reasons exist for a company to decide to go public, such as obtaining financing outside of the banking system or reducing debt.Furthermore, taking a company public reduces the overall cost of capital and gives the company a more solid standing when negotiating interest rates with banks. This would reduce interest costs on existing debt the company might have.The main reason companies decide to go public, however, is to raise money — a lot of money — and spread the risk of ownership among a large group of shareholders. Spreading the risk of ownership is especially important when a company grows, with the original shareholders wanting to cash in some of their profits while still retaining a percentage of the company.

Being able to raise additional funds through the issuance of more stock Companies can offer securities in the acquisition of other companies Stock and stock options programs can be offered to potential employees, making

the company attractive to top talent Companies have additional leverage when obtaining loans from financial

institutions Market exposure – having a company’s stock listed on an exchange could attract

the attention of mutual and hedge funds, market makers and institutional traders Indirect advertising – the filing and registration fee for most major exchanges

includes a form of complimentary advertising. The company’s stock will be associated with the exchange their stock is traded on

Brand equity – having a listing on a stock exchange also affords the company increased credibility with the public, having the company indirectly endorsed through having their stock traded on the exchange.

Disadvantages of Going Public:While going public allows the corporation to raise large amounts of money from stock market investors, it also involves a number of disadvantages that makes the decision one of the most important choices a private corporation can make.

ExpenseGoing public is an expensive, time-consuming process. A corporation must put its affairs in order and prepare reports and disclosures to comply with Securities and Exchange Commission. You will have to hire specialists to take the company through the process, including attorneys, accountants and underwriters.



Equity DilutionGoing public is the process of selling ownership of a part of your company to strangers. Every bit of ownership that you sell comes out of a current owner's equity position. It is not always possible to raise the amount of money that you may need to operate a public corporation and still keep at least 51 percent of the company's ownership in your own hands.

Loss of Management ControlOnce your corporation goes public, management becomes more complicated. You can no longer make decisions autonomously. Even if you are a majority shareholder, the minority shareholders have a say in how the company is managed. Also, you will no longer have total control over the composition of the board of directors, as federal law places restrictions on board composition to ensure the independence of the board from insider influence.

Increased LiabilityTaking your company public increases the potential liability of the company and its officers and directors for mismanagement. By law, a public corporation has an obligation to its shareholders to maximize shareholder profits and disclose operational information.

Increased Regulatory OversightGoing public places your company under the supervision of the SEC or state regulatory agencies that regulate public corporations, as well as the stock exchange that has agreed to list the company's stock. This increase in regulatory oversight significantly changes the way you can manage the business.

Enhanced Reporting RequirementsA private corporation can keep its internal business information private. A public corporation, however, must make extensive quarterly and annual disclosures about business operations, financial condition, compensation of directors and officers and other internal matters. It loses most privacy rights as a consequence of allowing the public to invest in its stock.

The Process of Going PublicTaking a company public, also called an initial public offering (IPO), is the sale of

stock that allows the general buying public to own equity in a company. The decision to take a company public involves more than the agreement of the board members of a corporation. It also requires filing extensive paperwork with the Securities and Exchange Commission (SEC) to make the transition from private to public legal. The decision to take a company public has its pros and cons and involves taking on new responsibilities.

Decide if going public is right for your company. Consider the benefits to your company's overall health. Going public can help

your company raise funding and improve your brand and visibility.



If raising funding is the primary motivation for taking your company public, consider alternative funds such as loans or seeking out investors. Taking a company public requires that you report to shareholders, which can slow down the pace of decision-making in your business. Public companies also have more financial reporting requirements than private companies. Private companies can keep innovative and proprietary information private.

Hire an underwriter. An investment bank serves as an underwriter for a company that is going public.

An underwriter is the link between your company and the public to whom you will be offering your stock. The underwriter will work with you to negotiate how the funds you need to raise to go public will be accumulated. Some underwriting agreements involve the investment bank guaranteeing a price for your shares, purchasing them and then reselling them to the public. In other agreements a primary underwriter will bring in other banks or firms (called syndicates) to distribute the risk involved with raising funds by selling your company's stock.

Begin the registration process. The SEC requires a company that's going public to complete an extensive

registration process. The underwriter will work with members of your company on compiling materials for the registration process. The registration process includes submitting a prospectus and a registration form. A prospectus is a compilation of pertinent information about your company, often presented in book form, that includes operations, finances, your competitors, board of directors and their annual pay, any legal issues the company is involved in, and how the company will distribute the stock as well as how the company plans to use the profits from the sale of the stock.

File the registration statement with the SEC. If the SEC determines that your registration materials are complete and accurate,

approval of your application will be provided in writing. The next step is to begin selling your company's stock. If the SEC does not approve your application, you will receive a letter with comments on the incomplete or inaccurate information in your prospectus. Your company should respond to the SEC's comments in writing with amendments to your registration that explain or otherwise address these comments.

Begin your road show. Distribute your prospectus with information about the amount of stock to be

released and the preliminary price in meetings with potential investors. This is called a road show. A road show typically lasts around 2 weeks and it involves managers having multiple meetings in many cities.

Decide on the final price for your stock on the last day of your road show.



Make the initial public offering of your company's stock on the stock market at the end of your road show.

To list your stock with the New York Stock Exchange (NYSE) your company must meet the basic criteria for listing your stock: earnings of $40 million or greater; shares priced at a minimum of $4.

Complete the application and accompanying documents for listing your stock. You can download these forms from the NYSE website.

Pay the listing and annual fees. Information on the NYSE website offers details about how to calculate fees.

On the 4th day after the initial offering, underwriters are allowed to purchase their agreed upon number of shares at a discounted rate as "payment" for their service in taking your company public.

*End of Chapter*



Chapter #13

LEASE FINANCING

Definition of Lease:

A legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid.

Leases are the contracts that lay out the details of rental agreements in the real estate market. For example, if you want to rent an apartment, the lease will describe how much the monthly rent is, when it is due, what will happen if you don't pay, how much of a security deposit is required, the duration of the lease, whether you are allowed to have pets, how many occupants may live in the unit and any other essential information. The landlord will require you to sign the lease before you can occupy the property as a tenant.

Parties of the lease

The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent.

Types of Leases:

The most common types of leases are as follows

Operating Lease:

Operating leases, also called service leases, are agreements between two parties in which one provides rent to the other for using an asset. In an operating lease, the borrower uses an asset for only a fixed portion of the assets life. After expiry of the period the leased asset must be returned back to the owner.

The owner of the asset is responsible for all maintenance costs and other operating costs associated with the leased asset.

The lessee has the right to cancel the lease during the lease period.

On termination of lease period the asset is returned back to the lessor



Finance or Capital Lease: Capital leases, also called finance leases, are those in which the borrower has full

control over the use of the asset(s) during its lease period In Financial lease the asset is fully transferred to lessee after the expiry of the

period of lease, means the ownership of the leased property is transferred to lessee The lessee pays not only the rent of the leased property but also the fyll price of

the asset during the period. The lessee is responsible for all maintenance and other associated costs and is

directly affected by its associated advantages and disadvantages.

Sale and Leaseback Arrangement:A sale and leaseback arrangement is a type of lease in which one party purchases

property, equipment or land from another party and immediately leases it to the selling party under specific terms.Third type arrangement matches with the mortgage loan because the lessee who is the seller of the leased asset gets funds by selling his own asset and then gets it back by taking it on rent.

The seller could be an individual investor, a limited partnership, an industrial firm, a leasing company, a commercial bank or an insurance company.A sale and leaseback arrangement is a type of capital lease, with the only difference being that a buyer purchases a used asset instead of a brand new one (as is common in capital leases).

Combination Lease:Combination leases combine aspects of both capital and operating leases.

Combination lease is formed by the mutual arrangement of the parties they may include their desired clauses in the combination lease as per their agreement from either operating or financial lease.

An example of a combination lease is a capital lease that incorporates a cancellation clause, typically associated with an operating lease.Financial statement Effect

Impact of Leasing on the Income StatementThrough leasing, companies can avoid expenses that decrease their bottom line.

Depreciation expensesDepreciation is a major consideration for companies when deciding between

buying and leasing. For assets that suffer from significant depreciation, either as a result of regular wear and tear or through becoming obsolete upon the release of newer versions of the same materials (particularly applicable in the case of technology) leasing can prevent a significant loss of value. In business, there exists a basic rule of thumb: "If it appreciates, buy it. If it depreciates, lease it. “Leasing could permit the use of the equipment while it is new. Upon the completion of the lease, it can be easy to upgrade by virtue of a new lease. In case of a purchase, however, an individual may be "stuck" with an obsolete asset with no means of recouping the cost of its acquisition.



Maintenance expensesThere are no maintenance expenses on the income statement as a result of leasing.

This is because in the case of a lease the ultimate ownership is retained by the lessor; and, it is in their best interest to maintain the asset in its best working order. Therefore, lessees can often benefit from comprehensive maintenance programs offered by lessors while still paying a discounted premium due to the fact that the asset is being leased, not purchased.

Other related costsThe costs of leases on the income statement depend on the duration and type of

lease. In the event of a purchase, the full value of the asset must be paid to the seller. In the event of a lease, however, only a portion of the full value is assessed, typically around 50%; the figure varies depending on the duration and type of lease. As a consequence, a lessor can gain the use of a much needed asset for a fraction of the full price of ownership. In many instances, this can better serve the lessee that an outright purchase would. As a corollary, a lessor could be granted the use of an asset that could otherwise be cost prohibitive.

EBITDALeases will also influence the ratios on income statement. For instance, the

EBITDA coverage ratio will improve if using operating leases. The EBITDA coverage ratio shows if earnings are able to satisfy all financial obligations including leases and principal payments. (EBITDA is short for earnings before interest, taxes, depreciation, and amortization.)Impact of Leasing on the Balance Sheet:

Capitalized leases have significant effects on the balance sheet, while operating leases don't show up there at all.Entries

When you capitalize a lease, the asset appears on your balance sheet the same as if you had bought it. Say you're leasing a truck for three years. The truck goes on the balance sheet as a fixed asset -- property, plant and equipment.Adjustment

The leased asset gets depreciated just like any asset the company actually owns. If your company uses straight-line depreciation for assets, then you would use it for the truck, as well. The book value of the asset thus declines over time. On the liabilities side, you treat the lease obligation like debt, reducing it over time as you pay off the lease.Effect:

A capitalized lease increases the total value of the assets on your balance sheet. That affects a number of ratios that creditors, potential investors and others use to evaluate your company's profitability and efficiency. It will reduce your company's return on assets (essentially, the profit it generates for each $1 worth of assets) and its asset turnover (the sales generated for every $1 worth of assets). And since the lease also appears as a liability, it affects measures of financial leverage, such as your liabilities-to-equity ratio. In short, a capitalized lease can make your company's performance look



worse, so businesses often structure leases in such a way so they can report them as operating leases.

Short Notes

Credit Policy

Definition: Guidelines that spell out how to decide which customers are sold on open account, the exact payment terms, the limits set on outstanding balances and how to deal with delinquent accounts.

Credit Policy considers the link between credit and sales. Easy credit terms can be an excellent way to boost sales, but they can also increase losses if customers default. A typical credit policy will address the following points:

Credit limits. You'll establish dollar figures for the amount of credit you're willing to extend and define the parameters or circumstances.

Credit terms. If you agree to bill a customer, you need to decide when the payment will be due. Your terms may also include early-payment discounts and late-payment penalties.

Deposits. You may require customers to pay a portion of the amount due in advance.

Credit cards and personal checks. Your bank is a good resource for credit card merchant status and for setting policies regarding the acceptance of personal checks.

Customer information. This section should outline what you want to know about a customer before making a credit decision. Typical points include years in business, length of time at present location, financial data, credit rating with other vendors and credit reporting agencies, information about the individual principals of the company, and how much they expect to purchase from you.

Documentation. This includes credit applications, sales agreements, contracts, purchase orders, bills of lading, delivery receipts, invoices, correspondence, and so on.

Inventory 1. A company's merchandise, raw materials, and finished and

unfinished products which have not yet been sold. These are considered liquidassets, since they can be converted into cash quite easily. There are various means of valuing these assets, but to be conservative the lowest value is usually used in financial.

2. The securities bought by a broker or dealer in order to resell them. For the period that the broker or dealer holds the securities in inventory, he/she is bearing the risk related to the securities, which may change in price.


80Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar)

Inventory Conversion PerInventory conversion period reports us about the average time to convert our total

inventory into sales. It is relationship between total days in year andratio. In other words, it measures the length of time on average between the acquisition and sale of merchandise. We can calculate it with following formula.

For example, inventory turnover ratio is 10 times of average stock at cost. Its inventoryconversion period will be

= 365/ 10 = 37 days. It means, the inventory has been disposed off or sold on an average in 37 days.

Interpretation of Inventory Conversion Period

1. Less inventory conversion period is better because more fastly, we will coinventory into sales, there will be less chance of obsolescence and paying of overstocking cost.

2. Inventory conversion period is the part ofhigh, it will increase the time to complete the cash conversion cycle. It means, there will be more liquidity risk in that level of inventory.

3. After adding average collection periodtake good decision relating to inventory level. Following example will explain its importance in simple way.

Receivable collection periodReceivable collection period indicates how

receivables are collected during a year (sales divided by the average of accounts receivables). A popular variant of the receivables turnover ratio is to convert it into an Average collection periodDays Sales Outstanding (DSO)) is the number of days, on average, that it takes a company to collect its accounts receivables, i.e. the average number of days required to convert receivables into cash.An accounting measure used to quantify a firm's effectiveness in extending credit as well as collecting debts.Calculation (formula)Receivables turnover ratio = Net receivable sales/ Average accounts receivablesAccounts Receivable outstanding in days:

Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar) Mob#+923139533123

Inventory Conversion PeriodInventory conversion period reports us about the average time to convert our total

inventory into sales. It is relationship between total days in year and inventory turnover. In other words, it measures the length of time on average between the

and sale of merchandise. We can calculate it with following formula.

For example, inventory turnover ratio is 10 times of average stock at cost. Its inventory

= 365/ 10 = 37 days. It means, the inventory has been disposed off or sold on an average

Interpretation of Inventory Conversion Period

1. Less inventory conversion period is better because more fastly, we will coinventory into sales, there will be less chance of obsolescence and paying of over

2. Inventory conversion period is the part of cash conversion cycle. If this perihigh, it will increase the time to complete the cash conversion cycle. It means, there will be more liquidity risk in that level of inventory.

average collection period and deducting average payment period, we can take good decision relating to inventory level. Following example will explain its

Receivable collection periodReceivable collection period indicates how many times, on average, account

receivables are collected during a year (sales divided by the average of accounts receivables). A popular variant of the receivables turnover ratio is to convert it into

Average collection period in terms of days. The average collection period (also called Days Sales Outstanding (DSO)) is the number of days, on average, that it takes a company to collect its accounts receivables, i.e. the average number of days required to convert receivables into cash.

ure used to quantify a firm's effectiveness in extending credit as well

Receivables turnover ratio = Net receivable sales/ Average accounts receivablesAccounts Receivable outstanding in days:

Mob#+923139533123

Inventory conversion period reports us about the average time to convert our total inventory turnover

and sale of merchandise. We can calculate it with following formula.

For example, inventory turnover ratio is 10 times of average stock at cost. Its inventory

= 365/ 10 = 37 days. It means, the inventory has been disposed off or sold on an average

1. Less inventory conversion period is better because more fastly, we will convert our inventory into sales, there will be less chance of obsolescence and paying of over-

. If this period is very high, it will increase the time to complete the cash conversion cycle. It means, there will

and deducting average payment period, we can take good decision relating to inventory level. Following example will explain its

many times, on average, account receivables are collected during a year (sales divided by the average of accounts receivables). A popular variant of the receivables turnover ratio is to convert it into

erage collection period (also called Days Sales Outstanding (DSO)) is the number of days, on average, that it takes a company to collect its accounts receivables, i.e. the average number of days required to

ure used to quantify a firm's effectiveness in extending credit as well

Receivables turnover ratio = Net receivable sales/ Average accounts receivables



Average collection period (Days sales outstanding) = 365 / Receivables Turnover Ratio

The cash conversion cycleThe cash conversion cycle, also called the net operating cycle, is the number of

days it takes a company to generate revenues with assets.How it works/Example:Analysts can determine the length of the cycle using the following formula:Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding + Days Payables OutstandingNote that DPO is a negative number.

The cash conversion cycle involves determining how long it takes to create inventory, sell inventory and collect on invoices to customers. For example, let's say Company XYZ makes widgets, which typically sit in the warehouse for 10 days. Let's also assume that it typically takes 15 days to collect on the sale of each widget, and that it takes 14 days to pay invoices to Company XYZ's vendors. Using the formula above, Company XYZ's cash conversion cycle is:

Cash Conversion Cycle = 10 + 15 + -14 = 11 daysThis means that Company XYZ generates cash from its assets within 11 days.

What is a cash discount?A cash discount is a deduction allowed by the seller of goods or by the provider

of services in order to motivate the customer to pay within a specified time. The seller or provider often refers to the cash discount as a sales discount. The buyer often refers to the same discount as a purchase discount. The cash discount is also known as an earlypayment discount.

Not all sellers offer cash discounts, but a common cash discount is 1/10, net 30 and it will appear on the sales invoice. If the invoice is $1,000 and the buyer returns $100 the net amount due to the seller is $900 if paid within 30 days. However, the buyer can deduct $9 (1% of $900) if the buyer pays the seller $891 within 10 days of the invoice date. The seller often records the $9 cash discount as Sales Discounts. The buyer will record the $9 savings as Purchase Discounts or as a reduction to the cost recorded in inventory.

Commercial PaperThis is an unsecured promissory note with a fixed maturity of 1 to 364 days in the

global money market. It is issued by large corporations to get financing to meet short-term debt obligations. It is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price.Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. ABCP is typically a short-term instrument that matures between 1 and 180 days from issuance and is typically issued by a bank or other financial institution.



Short-Term FinancingAs is obvious in the name, short term debt financing is a form of financing

involving financial obligations that must be fulfilled usually within a year to two at most. It is more often used for working capital requirements, or day-to-day operations of thebusiness. By the same token, businesses with cyclical operating conditions (for e.g. retailers) or those engaged in international trade will usually obtain financing through short-term debt.

Sources of short-term debt financing:There are 4 main sources of short-term debt financing

OverdraftOverdraft is an instant extension of credit from a lending institution. When a

company has an overdraft arrangement with a bank, it can draw down or transmit cash from its account beyond the available balance. It is also revolving in nature; does not have a fixed repayment period. The amount of credit will depend on the overdraft limit negotiated with the bank. (The advantage of an overdraft arrangement is that the company does not have to ensure that sufficient cash is always available for operating activities such as stock turnover or payment to creditors in the short term).

Letter of CreditLetter of Credit is a letter from a bank guaranteeing a buyer's payment to a seller,

that a seller will receive the amount within the credit period. The advantage of having such an arrangement with a bank is that it enables a company to negotiate better credit terms (E.g. longer credit period) with suppliers.

Short-Term LoanShort-term loan is, as the name suggests, a loan that must be repaid within a year

or less, with interest. It is not revolving in nature; has a fixed repayment period. Companies will usually find this form of debt financing useful if liquidity is a concern, in particular short-term working capital requirements (For e.g., to purchase stocks or to pay creditors).

Bill of exchangeBill of exchange is a document that binds one party to pay a fixed sum of money

to another party at a specified future date. It is often used in international trade. An exporter can grant credit to an importer for goods shipped, by drawing a bill of exchangeto the same amount and credit period.

End of Chapter


83Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar)

! Also Available

Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar) Mob#+923139533123

Also Available !

Mob#+923139533123

Documents

Comprehensive Notes - mriazkhan91.files.wordpress.com · Corporate Valuation and Value-Based Management i) ... Value-Based Management iv) Corporate Governance and ... Chapter#1 An