Chapter 1 – Overview of Financial Management

Investment Vehicle Model – Investors provide financing to the firm in exchange for financial securities (bonds and shares), and firm invests these funds in assets. The income generated by the firm is distributed to the investors.

Balance Sheet Model (Accounting Model) – Investment decisions are represented by LHS/Assets and Financing decisions are represented by RHS/Liabilities & Equity on the balance sheet. Total Value of Assets = Total Firm Value to Investors

3 Primary Decision Areas of Corporate FinanceCapital Budgeting Decision

What long term investments (fixed assets) should the firm engage in?

Capital Structure Decision

How can the firm raise money for the required investments? CL, LT Debt and Shareholders’ Equity.

Working Capital Management

How much ST cash flow does a company need to pay its bills (manage liquidity)? NWC = CA-CL

Typical Organisation Chart

Roles and Responsibilities of Financial ManagersController TreasurerSupervising accounting personnel Raising capital, managing cash

and capital expendituresPreparation of financial and managerial accounting information and reports

Supervises relationships with financial institutions, work with investors and potential investors

Analyses accounting information Manages investments and establishes credit policies

Planning and decision making Manages insurance coverage

Advantages of Different Types of BusinessBusiness Advantages Disadvantages

Sole Proprietorship

Easy to start, few regulations

Limited to life of owner

Single owner keeps all the profits

Unlimited liability

Taxed once as personal income

Equity capital is limited to personal wealth

Partnership

More capital available Unlimited liability (may be limited partnership)

Taxed once as personal Income

Dissolves when one partner wishes to sell/dies

More Capital available Difficult to sell/transfer

Corporation Limited Liability Double taxation (not for Singapore

Separation of Separation of

ownership & management

ownership & management

Unlimited Life

Ease of raising capitalEase of transferring ownership

The Primary Goal of Financial Management – is to maximize shareholder wealth (maximize stock price).

1. Maximize the value of the firm2. Maximize the wealth of its owners3. Maximize the price of its stock4. Maximize its contribution to the economy

Shareholder wealth is a cash-flow related concept, maximizing annual profits, market share, sales and minimizing costs may not max wealth.

Concentrating on the long term. Ability to generate cash flows for stockholders determines stock prices Amount, timing, and riskiness of cash flows determine the intrinsic

value of stocks.

Intrinsic Value – estimate of stock’s true value with accurate risk & return informationMarket Price – based on perceived information by the marginal investorReputation – compilation of impressions held by all of the entity’s stakeholders Reputation management involves managing expectations and

perceptions

Agency Problem – Conflict of interest between principal and agent Direct Agency Costs: expenditures benefit management, (monitoring)

audit cost Indirect Agency Costs: lost opportunities that would increase firm value Shareholders and Managers Shareholders and Creditors1. Compensation plans tied to share value2. Monitoring by creditors, analysts and investors3. Threat of being fired4. Awareness of good Corporate Governance

Financial Markets – markets where finances are traded. Act as intermediaries between savers and borrowers. Money Markets – debt securities of less than one year are traded: treasury securities, commercial paper, bills and inter-bank loans. Dealer MarketsCapital Markets – equity & long-term debt claims are traded. Auction Markets

Primary Market – funds raised go to company directly. Government and corporations initially issued securities. Public and private offerings. Secondary Market – funds raised do not go to company directly. Existing financial claims are traded. Dealer Market: OTC markets (NASDAQ) Auction markets: SGX, NYSE. Getting market value of securities is easier

Chapter 2 – Financial Statement Analysis

Balance Sheet – snapshot of a firm’s financial position at one point in time; Income Statement – firm’s revenues and expenses over a given period of time; Statement of RE – how much of the firm’s earnings were retained, rather than paid out as dividends; Statement of Cash Flows – activities on cash flows over a given period of time.

Book Values (historical costs less accumulated depreciation)

Market Values

Determined by GAAP Determined by current trading values in the market

Enterprise Value = Market Value of Equity + Debt – Cash. It assesses the value of the underlying business assets unencumbered by debt and separate from any cash and marketable securities.

Sources of Cash (bring in cash)

Uses of Cash (cash outflow)

Decreases in assets other than cash

Increases in assets other than cash

Increases in equity and liability Decreases in equity and liabilities

Operating – net income and changes in most current accounts (AP, AR, Invent); Investment – changes in fixed assets; Financing – changes in notes payable, LT debt, equity accounts and dividends.

∆Cash = ∆Retained Earnings (Net Income) + ∆CL - ∆CA other than cash -∆Net fixed assets + ∆Long Term Debt + ∆Common Stock

∆Cash = Operating Activities: Net Income + depreciation + ∆non-interest bearing current liabilities - ∆current assets other than cash. Investment activities: - (∆net fixed assets + depreciation) Financing Activities: +∆interest bearing current liabilities ∆long-term debt +∆common stock - dividends

Accounts Payables do not bear interest

Common-size Balance Sheet – as a percent of total assets; Common-size Income Statements – all line items as a percent of sales.

Liquidity Ratios: measure ability to pay liabilities in the short run (ability to convert assets to cash quickly without a significant loss in value) Current Ratio: Current Assets/Current Liabilities Quick Ratio: Current Assets – Inventory / Current Liabilities Cash Ratio: Cash / Current Liabilities NWC to Total Assets Ratio: Net Working Capital / Total Assets

Ways to handle the agency problem

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Interval Measure: Current Assets / Average daily operating costs - (how many days of operations can the current assets fund)

Long Term Solvency Ratios (Financial Leverage): extent of relying on debt financing rather than equity. More debt means more likely to default Total Debt Ratio: Total Debt / Total Assets Debt Equity Ratio = Total Debt / Total Equity Equity Multiplier Ratio = Total Assets / Total Equity = DE-ratio +1 Long Term Debt Ratio = Long Term Debt/Long Term Debt + Total

Equity Times Interest Earned Ratio = EBIT / Interest (given what I earn,

how much can it cover my interests payable) Cash Coverage Ratio = EBIT + Depreciation / Interest

Asset Management Ratios: measure how effectively assets are managed Inventory Turnover: COGS/Inventory Days Sales in Inventory: 365/Inventory Turnover =

365XInventory/COGS (no. of days taken to sell that ‘set’ of inventory) Receivables Turnover: Sales/Receivables Days Sales Outstanding: AR/Avg Daily Sales = 365/Receivables

turnover (number of days after making sales before receiving cash) Fixed Asset Turnover: Sales/Net Fixed Assets (for every $ of fixed

asset, how much sales can it generate) Total Asset Turnover: Sales/Total Assets

Profitability Ratios: measures how successful a business is in earning returns on its investments. Combined effects of liquidity asset management and debts. Profit Margin = Net Income/Sales Basic Earning Power = EBIT/Total Assets ROA = Net Income / Total Assets ROE = Net Income (-preferred dividends) / Total Common Equityo ROA is lowered by debt – interest expense lowers net income which also

lowers ROAo ROE increases with debto ROE does not consider risk and amount of capital invested

Market Value Ratios: relate firms stock price to earnings, cash flow & book values P/E Ratio: Price/Earnings how much investors are willing to pay for $1

of earnings M/B Ratio: Market Price per share/Book Value per share how much

investors are willing to pay for $1 of book value equity

Dupont IdentityROE = ROA X EM = PM X TA TO X EM = NI/SALES x SALES/TA x TA/TE

Profit Margin: measure of firm’s operating efficiency – how well does it control costs

Total Asset Turnover: measure of firm’s asset use efficiency – how well does it manage its assets.

Equity Multiplier: measure of the firm’s financial leverage.

Chapter 3 – Time Value of Money

Lost Earnings: Interest Revenue earned on investing the money

Loss of Purchasing Power: Due to Inflation. Real value is less than nominal value

Ordinary Annuity: Payments are made at the end of the period.Annuity Due: Payments are made at the beginning of the periodPerpetuity: Infinite series of equal payments. PV = payment/interest rate.Growing Perpetuity: set of payments which grow at a constant rate each period and continue forever. PV = payment/(interest rate – growth rate)

FV=PV (1+r )t=PV (1+ i)n

FV interest factor =(1+r )tPV=FV /(1+r)t

PV factor = ( 11+ i

)n

Effective Annual Rate (EAR): the actual rate paid (or received) after taking into consideration any compounding that may occur during the year.Annual Percentage Rate (APR): annual rate that is quoted by law. Period rate = APR / number of periods per year.

Pure Discount Loans: Like zero-coupon bonds, pure discount bonds, principal (and all interest) paid at maturity, no periodic interest payment, issued at discountInterest Only Loans: Interest paid throughout loan period, principal at maturityLoans with Fixed Principal Payments: Interest and fixed principal payments over lifeAmortized Loan: Equal payments cover interest expense and reduce principal

Chapter 4 – Risk and Return I

Dividend Yield (%) = Dividend/Initial Share Price Capital Gain Yield (%) = Capital Gain/Initial Share PricePercentage return = dividend yield + capital gains yield

Impact of Inflation:

1+Real Rate of Return=1+nominal Rateof Return1+ Inflation Rate

Expected Returns take into account uncertainties that are present in diff scenarios.

r̂=∑i=1

n

riP i OR r̂=¿

Risk is the uncertainty associated with future possible outcomes. Investment risk is the potential for investment return to fluctuate up and down

σ=√∑i=1

n

(r i−r̂ )2Pi

Standard deviation measures stand-alone risk of an investmentUsing Historical Data: Ravg = Arithmetic mean (avg annual return) Rt = realized ROR

σ=√∑t=1n

(rt−r Avg)2

n−1

Coefficient of Variation CV=Standard DeviaionExpected Return

=σr̂

CV

better measure of risk

Financial Markets allow companies, government and individuals to increase utility Savers can invest in fin assets & earn compensation for deferred

consumption Borrowers have more access to capital to invest in productive assets Provide information about returns required for various levels of risk

Expected Portfolio Return: Weighted average of E(R) on individual stocks

r̂ p=∑i=1

n

w i r̂ i

Expected Portfolio σ: Find σ, treating portfolio as 1 stock (or below). CVp samePortfolio Risk Premium based on market risk.

SD of a 2 stock portfolio:

Correlation Coefficient/Covariance: -1.0 ≤ ρ ≤ 1.0

Cov (r1 , r2 )σ1σ2

=ρ12=∑i=1

n

pi(r1 , i−r1)(r2 ,i−r 2)

If ρ=-1.0, 2 stocks can form a riskless portfolioIf ρ=+1.0, there is no reduction of risk for the 2 stock portfolio

Total Risk = Company-specific (Unsystematic Risk) + Market (Systematic) RiskUnsystematic Risk: caused by random events specific to firm. Can be diversifiedSystematic Risk: affects most if not all firms. Cannot be diversified away.

β measures stock’s market/systematic risk, shows volatility relative to market, indicating how risky a stock is if held in a well-diversified portfolio. Market β is 1.

β i=σ i

σM

ρℑ=Cov ¿¿

Geometric mean: what you actually earn per year on average compounded annually. Also known as mean holding period return or average compound return earned per year over a multi-year period.Arithmetic mean: what you earned in a typical year.

Chapter 5 – Risk and Return II

Risk-Return Trade-off for a portfolio is measured by portfolio’s expected return and standard deviation (volatility of the portfolio)

Diversification involves investing in different asset classes and sectors. It reduces variability of returns without equivalent reduction in expected returns.

Well Diversified Portfolios have very little unsystematic risk. Risk = systematic riskPortfolio’s Beta, βp is the weighted average of the assets betas.

Systematic Risk Principle: There is a reward for bearing risk but there is no reward for bearing risk unnecessarily. Expected return on a risky asset depends only on β.

β>1 implies that the asset has more systematic risk than the overall market

Risk Premium = (RM – RF)β = Expected Return – Risk Free RateMarket Risk Premium = RM – RF (since market beta is always 1) also risk-reward ratioSecurity Market Line: Graphical representation of the CAPM, and market equilibrium Assets below SML are overpriced and assets above SML are

underpriced

Capital Asset Pricing Model: equation describing SML. Appropriate return for risk

Capital Market Line: the tangential line joining the Risk Free Rate to the efficient frontier of all possible portfolios in the market

Security Market Line Capital Market LineGraphical representation of market’s risk and return at a given time

Shows rate of return, which depend on risk free rate and levels of risk of a specific portfolio

Beta x-axis Standard deviation x-axisBoth nonefficient and efficient portfolios

Only efficient portfolios

Where market portfolios and risk free assets are determined by CML, security factors are determined by SML. CML is superior to SML in measuring risk factors.

Chapter 6 – Bond Valuation

Bonds are long term debt instruments sold to raise money. Bonds are fixed-income investments, and this regular income is what makes bonds less volatile than stocks.Bond owners are creditors of the company and not owners (unlike stockholders)

Coupon: A bond’s interest (payment)

Coupon= CouponRate ×ParValueNo.of CouponPayments per year

Coupon Rate: Annual coupon divided by the par value of the bond (annual)Par: Face value of a bond (principal amount) that will be repaid at maturity.

Callability: the issuer can redeem the bond before it expiresSeniority: Preference in position over other creditors. Subordinated debt is juniorDebenture: Bond backed by issuer’s general credit/ability to repay and not assetsBasis Points: measures of differences in yields. 1 basis point = 0.01%Convertibility: option of exchanging bond for stock Protective Covenant: part of indenture that limits certain actions a company may choose to take during the term of the bond. Sinking Fund Provision: pay off loan over its life like an amortized loan. Reduced risk to investor and shortens average maturity. Not good if rates decline after issuance.Bond Indenture: Bond contract specifying principal, coupon, maturity, amt of bonds, backing assets/securities, sinking fund, call provisions & protective covenants

Coupon Rate/YTM on a bond depends on risk characteristics when issued

Higher

Unsecured Subordinated

No Sinking Fund

Callable

Lower Secured Senior Sinking Fund Non callable

Yield To Maturity – rate earned if bond is held to maturity. Rate at which cash flows are discounted to the present value. Interest rate required on a bond in the market. When YTM > Coupon Rate, bond sells below par value - Discount BondInterest Rate rises, YTM increase, Bond prices decreaseWhen YTM < Coupon Rate, bond sells above par value - Premium BondInterest rate falls, YTM decreases, Bond prices increaseHolding a bond till maturity ensures repayment of principal as long as no defaultBuying or Selling bonds before maturity can result in gains or losses outside couponBonds of similar risk & maturity will be priced similarly regardless of coupon

Premium Bonds: YTM < Current Yield < Coupon RateDiscount Bonds: YTM > Current Yield > Coupon RatePar Value: YTM = Current Yield = Coupon Rate

Price VsYTM

Factors Affecting Default Risk & Bond RatingsFinancial Performance Bond Contract Provisions

Debt Ratio Secured/Unsecured DebtTIE Ratio Senior/Subordinated DebtCurrent Ratio Guarantee & sinking fund

provisionDebt maturity

Effect of Time on Bond Prices

Pure Discount Bonds: 0-coupon bonds, sold at discount (YTM comes from difference between PV and principal sum) cannot sell more than par value. T billsFloating Rate Bonds: coupon rate float depending on index such as inflation. Less price risk. Coupon floats and unlikely to differ from YTM. Collar controlling rateDisaster bonds: issued by property and casualty companies. Pay interest and principal as usual unless claims reach a certain threshold for a single disaster. At that point, bondholders may lose all remaining payments Higher required return.Income bonds – coupon payments depend on level of corporate income. If earnings are not enough to cover the interest payment, it is not owed. Higher required return.Convertible bonds – bonds can be converted into shares of common stock at the bondholders discretion Lower required returnPut bond – bondholder can force the company to buy the bond back prior to maturity Lower required return

Structure of Interest Rates: r/s of time to maturity and yields ceteris paribusDoes not include effects of default risk, different coupons

Normal: LT yields are more than ST

Inverted: LT yields are less than ST

Factors that affect Bond Yields: 1. Real Rate of Interest2. Expected Future Inflation3. Interest Rate Risk4. Default Risk5. Taxability6. Liquidity Risk

LECTURE 4: Risks & Returns I

Fischer Effect: 1+Nominal Rate = (1+real rate)(1+inflation)

Approximation: Nominal Rate = Real Rate + Inflation