Presentation on theme: "The Financial Manager and the Firm"— Presentation transcript:
1 The Financial Manager and the Firm CHAPTER 1The Financial Manager and the FirmUnit Slides byUK Versity
2 Legal Forms of Business Organizations Quick LinksThe Role of the Financial ManagerLegal Forms of Business OrganizationsManaging the Financial FunctionThe Goal of the FirmAgency Conflicts: Separation of Ownership and Control
3 The role of financial manager The financial manager is responsible for making decisions that are in the best interests of firm owners or maximize the owner’s wealth.Stakeholder is someone other than an owners. The managers, employees, suppliers, government, creditors.
4 The Role of the Financial Manager It is all About Cash FlowsA firm generates cash flows by selling the goods and services produced by its productive assets and human capital.The firm is successful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors, and taxes.The firm can pay the remaining cash, called residual cash flows, to the owners as a cash dividend, or reinvest the cash in the business.
6 The Role of the Financial Manager It is all about cash flowsA firm is unprofitable when it fails to generate sufficient cash flows.Firms that are unprofitable over time will be forced into bankruptcy by their creditors.In bankruptcy, the company will either be reorganized, or the company’s assets will be liquidated.
7 The Role of the Financial Manager Three Fundamental Decisions in Financial ManagementThe capital budgeting decision: Which productive assets should the firm buy?A good capital budgeting decision is one in which the benefits are worth more for the firm than the cost of the assets.The financing decision: How should the firm finance or pay for assets?
8 The Role of the Financial Manager Three Fundamental Decisions in Financial ManagementFinancing decisions involve trade-offs between advantages and disadvantages of debt and equity financing.Working capital management decisions: How should day-to-day financial matters be managed?The mismanagement of working capital can cause the firm to go into bankruptcy even though the firm is profitable.
9 Exhibit 1.2: How Financial Manager’s Decisions Affect the Balance Sheet
10 Legal Forms of Business Organizations Sole ProprietorshipNo legal distinction between personal and business income for a sole proprietor.All business income is taxed as personal income.A sole proprietorship has unlimited liability for all business debts and other obligations of the firm.
11 Legal Forms of Business Organizations PartnershipHas the same basic advantages and disadvantages as a sole proprietorship.When a transfer of ownership takes place, the partnership is terminated and a new partnership is formed.The problem of unlimited liability can be avoided in a limited partnership.
12 Legal Forms of Business Organizations CorporationIn a legal sense, it is a “person” distinct from its owners.The owners of a corporation are its stockholders, or shareholders.A major advantage of the corporate form of business is that stockholders have limited liability.
13 Legal Forms of Business Organizations CorporationThe owners of corporations are subject to double taxation first at the corporate level and then at the personal level when dividends are paid to them.Public corporations can sell their debt or equity in the public securities markets.Private corporations are held by a small number of investors.
14 Legal Forms of Business Organizations Hybrid Forms of Business OrganizationLimited liability partnerships (LLPs) combine the limited liability of a corporation with the tax advantage of a partnership.Limited liability companies (LLCs)Professional corporations (PCs)
15 Managing the Financial Function Chief Executive Officer (CEO)Ultimate management responsibility and decision-making power in the firm.Reports directly to the board of directors, which is accountable to the company’s owners.
16 Managing the Financial Function Chief Financial Officer (CFO)Responsible for the best possible financial analysis that is presented to the CEO.Positions that report to the CFO:The Controller prepares financial statements, oversees the firm’s cost accounting systems, prepares taxes, and works closely with the firm’s external auditors.
17 Managing the Financial Function Chief Financial Officer (CFO)CFO’s Key Financial ReportsThe Treasurer looks after the collection and disbursement of cash, invests excess cash, raises new capital, handles foreign exchange, and oversees the firm’s pension fund managers.
18 Managing the Financial Function Chief Financial Officer (CFO)CFO’s Key Financial ReportsThe Internal Auditor is responsible for in-depth risk assessments, performing audits of high-risk areas.The Risk Manager manages the firm’s risk exposure in financial markets and the relationships with insurance providers.
19 Managing the Financial Function External Auditors (big Four)Provide an independent annual audit of the firm’s financial statements.Ensure that the financial numbers are reasonably accurate, and accounting principles have been consistently applied.
20 Managing the Financial Function Audit CommitteeApproves the external auditor’s fees and engagement letter. The external auditor cannot be fired or terminated without the audit committee’s approval.Compliance and Ethics DirectorOversees the compliance program, ethics program, and the compliance hotline and reports directly to the audit committee.
22 The Goal of the Firm What Should Management Maximize? Minimizing risk or maximizing profits without regard to the other is not a successful strategy.
23 The Goal of the Firm What Should Management Maximize? Why not maximize profits?Profit maximization does not tell us when cash flows are to be received.Profit maximization ignores the uncertainty or risk associated with cash flows.
24 The Goal of the Firm Maximize the Value of the Firm’s Stock Price When analysts and investors determine the value of a firm’s stock, they consider.The size of the expected cash flows.The timing of the cash flows.The riskiness of the cash flows.
25 The Goal of the Firm Maximize the Value of the Firm’s Stock Price An appropriate goal for financial management is to maximize the current value of the firm’s stock.For private corporations and partnerships, the goal is to maximize the current value of owner’s equity.
26 Exhibit 1.4: Major Factors Affecting Stock Prices
27 The Goal of the Firm Can Management Decisions Affect Stock Prices? YES!!!
28 Agency Conflicts: Separation of Ownership and Control For large corporations, the ownership of the firm is spread over huge number of shareholders and the firm’s owners may effectively have little control over management .Management may make decisions that benefit their self-interest rather than those of the stockholders.
29 Agency Conflicts: Separation of Ownership and Control Agency RelationshipsAn agency relationship arises whenever one party, called the principal, hires another party, called the agent.The relationship between stockholders (principals) and management (agents) is an agency relationship.
30 Agency Conflicts: Separation of Ownership and Control Do Managers Really Want to Maximize Stock Price?Shareholders own the corporation, but managers control the money and have the opportunity to use it for their own benefit.Agency CostsThe costs of the conflict of interest between the firm’s owners and its management.
31 Agency Conflicts: Separation of Ownership and Control Aligning the Interests of Management and StockholdersManagement CompensationA significant portion of management compensation should be tied to firm performance (e.g. stock price).
32 Agency Conflicts: Separation of Ownership and Control Aligning the Interests of Management and StockholdersManagerial Labor MarketFirms with unethical behavior have difficulty hiring top managers.Executives with poor performance or criminal convictions can rarely secure good positions in the future.
33 Agency Conflicts: Separation of Ownership and Control Aligning the Interests of Management and StockholdersBoard of DirectorsLack of board independence is a key factor in the misalignment between board members’ and stockholders’ interestsOther ManagersLarge StockholdersThe Takeover MarketThe Legal and Regulatory Environment
34 Financial Statements, Cash Flows, and Taxes CHAPTER 3Financial Statements, Cash Flows, and Taxes
35 Quick Links The Balance Sheet The Income Statement Statement of Retained EarningsCash Flows
36 The Balance SheetThis financial statement identifies all the assets and liabilities of a firm at a point in time.Left side of the balance shows all assets the firm owns and uses to generate revenues.Right side represents the liabilities of the firm – money that the firm has borrowed from both creditors and shareholders.Total assets = Total liabilities+Total stockholders’ equity (3.1)
37 The Balance SheetBalance sheet also lists the capital raised from its shareholders.Assets listed in order of their liquidity.Liabilities listed in order in which they must be paid.Shareholders of the firm’s common equity are listed last.Shareholders will be paid with whatever remains after paying all other suppliers of funds.
38 The Balance Sheet Current Assets and Liabilities Current assets include all assets likely to be converted to cash within a year (or within an operating cycle).These include cash and marketable securities, accounts receivables, and inventory.
39 The Balance Sheet Current Assets and Liabilities Current Liabilities include all liabilities that have to be paid within a year.Bank loans and other borrowings with less than a year’s maturity, accounts payables, accrued wages and taxesNet working capital= Total current assets- Total current liabilities (3.2)
40 The Balance Sheet Net working capital example - Diaz Manufacturing Total current assets = $1,039.8 millionTotal current liabilities = $377.8 millionNet working capital =?
41 The Balance Sheet Inventory Accounting Inventory (least liquid of current assets) usually reported in one of two ways on balance sheet.FIFO (First in first out) refers to practice of recognizing a sale as being made up of inventory purchased earlier.LIFO (Last in first out) calls for firm to attribute any sale made to the most recently acquired.Book Example?
42 The Balance Sheet Inventory Accounting During rising prices, FIFO reporting leads to higher current asset value and higher net income.Firms may switch from one to another only under extraordinary circumstances and not frequently.
43 The Balance Sheet Long-Term Assets Real assets firm acquires to produce its products and generate cash flows.Land, buildings, plant and equipment.Intangible assets also listed here.Goodwill, patents, copyrights, etc.
44 The Balance Sheet Long-Term Assets All long-term real assets that deteriorate with use are depreciated.Intangible assets are amortized.Depreciating assets allow a firm to lower taxable income and reduce taxes.Firms are allowed to depreciate assets using straight line method or accelerated depreciation method allowed by IRS.
45 The Balance Sheet Long-Term Liabilities Long-term debt of the company. Includes bank loans, mortgages, and bonds with a maturity of one year or longer.
46 The Balance Sheet Equity – There are two sources of equity funds Common EquityCommon equity represents the true ownership of the firm.Preferred EquityHas features that make it a combination of a fixed income security and an equity security.
47 The Balance Sheet More Balance Sheet Accounts Retained earnings Results from funds the firm has reinvested from its earnings.These funds are not cash–they already have been put to work.Treasury stockThis account reflects the value of the shares that the firm has repurchased from investors.
48 The Income Statement The Income Statement: Overview Measures the profitability of a firm for any reporting period.Revenues represent value of products and services sold by firm–include both cash and credit sales.Expenses range from cost of producing goods for sale and asset utilization costs- depreciation or amortization.Net income = Revenues – Expenses (3.3)
49 The Income Statement Net Income example – Diaz Manufacturing Revenues = $1,563.7 millionExpenses = $1,445.2 millionNet Income = ?
50 The Income Statement The Income Statement: Depreciation The cost of any physical asset, such as plant or machinery, is written off over its lifetime. This is called depreciation and is a non-cash expense.Firms use one of these for depreciating an asset:Straight line methodAccelerated depreciation methodFirms allowed to use one for internal purposes and another for tax purposes.
51 The Income Statement The Income Statement: Amortization Amortization expenses are related to the writing off of the value of intangible assets, such as:Goodwill, Patents, Licenses, etc.It is also a non-cash expense like depreciation.
52 The Income Statement Extraordinary Items Extraordinary Items refer to income or expenses associated with events that are not expected to happen on a regular basis.
53 The Income Statement Bottom Line Accounts Earnings before interest, taxes, depreciation and amortization (EBITDA) .Earnings generated from operations prior to payment of expenses not directly connected to production of products.After netting out the expenses related to depreciation and amortization, we arrive at earnings before interest and taxes (EBIT).
54 The Income Statement Bottom Line Accounts Earnings before taxes (EBT) represents the taxable income for the period.Subtracting taxes from EBT yields net income or net income after taxes.This amount tells us amount available to management to pay dividends, pay off debt, or reinvest in firm.
55 Statement of Retained Earnings This financial statement shows the changes in the retained earnings account from one period to the next.This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared.
56 Exhibit 3.3: Diaz Mfg Statement of Retained Earnings
57 Cash Flows Net Cash Flow versus Net Income While accountants focus on net income, shareholders would be more interested in net cash flows.These two are not the same, because of the presence of non-cash revenues and expenses.
58 Cash Flows Net Cash Flow versus Net Income We can estimate the net cash flow from operating activities (NCFOA) as:NCFOA = Net income + Depreciation and Amortization (3.5)
59 Cash Flows NCFOA example – Diaz Manufacturing Net Income = $118.5 millionDepreciation and Amortization = $83.1 millionNCFOA = ?
60 Cash Flows The Statement of Cash Flows Helps to measure cash outflows and cash inflows generated during any period.Indicates cash flows resulting fromOperating activities, investing activities, and financing activities.Sum of cash flows measures net cash flows of firm during a given period.Net cash flows is the bottom line of this financial statement.
61 Cash Flows Organization of the Statement of Cash Flows Operating ActivitiesCash inflows result from producing and selling goods and services.Cash outflows are tied to the purchase of raw materials, inventory, salaries and wages, utilities, rent, interest and other related expenses.
62 Cash Flows Organization of the Statement of Cash Flows Investing ActivitiesCash inflows and outflows arise out of the acquisition and selling of long-term assets necessary to operate the business. investing activities.Also result fromBuying and selling financial assets (bonds, stocks).Making and collecting loans.Selling and settling insurance contracts.
63 Cash Flows Organization of the Statement of Cash Flows Financing ActivitiesCash Inflows–when a firm issues debt or equity securities, or borrows money from banks or other lenders.Cash Outflows–if they pay interest or dividends on the investor’s funds, pay off debt, or purchase treasury stock.
64 Exhibit 3.5: Interrelations among the Financial Statements
65 In-class discussionEnd of chapter questionsGroup selection
67 Quick Links Ratio Analysis Financial Statement Analysis The DuPont System, ROA, ROEBenchmarksLimitations of Ratio Analysis
68 Perspectives on Financial Statement Analysis A firm’s financial statements can be analyzed from the perspective of different stakeholders.Important perspectives:StockholderManagerCreditor
69 Perspectives on Financial Statement Analysis Stockholders’ perspectiveCenters on value of stock held.Interest in the financial statement is to gauge cash flows firm will generate from operations.Allows determination of firm’s profitability, return for that period, and likely dividends.
70 Perspectives on Financial Statement Analysis Manager’s perspectiveInterest in firm’s financial statement is similar to stockholders’.Manager’s job security depends on firm’s performance.Management gets feedback on investing, financing, and working capital decisions by identifying trends in various accounts reported in financial statements.
71 Perspectives on Financial Statement Analysis Creditors’ perspectiveFocus on getting loans repaid and receiving interest payments on time.A firm’s creditors closely monitorAmount of debt firm has.Ability to meet short-term obligations.Ability to generate sufficient cash flows to meet all legal obligations, debt repayment, and interest payments.
72 Guidelines for Financial Statement Analysis Main ConcernFrom whose perspective firm analysis is done.Management, shareholder or creditor.Use only audited financial statements if possible.Perform analysis over 3-5 year period–time-trend analysis.
73 Guidelines for Financial Statement Analysis Main Concern (cont.)Compare firm’s performance to direct competitors’ performance.Example?Perform a benchmark analysis comparing it to most relevant competitors – Vietnam Airlines to Indochina or Jetstar
74 Common-Size Financial Statements Common-Size Balance SheetsEach asset and liability item on balance sheet is standardized by dividing by total assets.Accounts are then represented as percentages of total assets.
76 Common-Size Financial Statements Common-Size Income StatementEach income statement item standardized by dividing it by dollar amount of net sales.Each income statement item now indicated as percent of sales.
78 Liquidity RatiosMeasures ability of firm to meet short-term obligations with short-term assets, without endangering the firm.Two commonly used ratios to measure liquidityCurrent ratioQuick ratio
79 Liquidity RatiosCurrent ratio is calculated by dividing current assets by current liabilities.Amount of current assets firm has per dollar of current liabilities.Higher number = more liquidity
80 Liquidity RatiosQuick (acid-test) ratio calculated by dividing most liquid current assets by current liabilities.Inventory subtracted from total current assets determines most liquid assets.Amount of liquid assets firm has per dollar of current liabilities.Higher number = more liquidity
81 Liquidity RatiosQuick ratios typically smaller than current ratios for manufacturing firmsService firms see no different between current and quick ration
82 Efficiency RatiosSometimes called asset turnover ratios.Measure how efficiently firm’s management uses assets to generate sales.
83 Efficiency RatiosUsed by management to identify areas of inefficiency.Used by creditors to determine speed of converting inventory to receivables.Receivables convert to cash to help firm meet debt obligations.Efficiency ratios focus on inventory, receivables and use of fixed and total assets.
84 Efficiency RatiosInventory turnover ratio–measures how many times inventory turned over into saleable products.In general, more often a firm can turn over inventory, the better. Too high or too low a turnover could be warning sign.
85 Efficiency RatiosDays’ sales in inventory ratio also builds on inventory turnover ratio.Measures number of days firm takes to turn over inventory.The smaller the number, the faster the firm turns over inventory, more efficient it is.
86 Efficiency RatiosAccounts receivable turnover ratio measures how quickly firm collects on its credit sales.The higher the frequency of turnover, the faster it converts credit sales into cash flows
87 Efficiency RatiosDays Sales Outstanding (DSO) measures number of days firm takes to convert receivables into cash.The fewer the days, the more efficient the firm.Note: an overzealous credit department may offend firm’s customers.
88 Asset Turnover RatiosTotal asset turnover ratio measures level of sales firm generates per dollar of total assets.The higher the turnover, the more efficiently management is using total assets.More relevant for service industry firms.
89 Asset Turnover RatiosFixed asset turnover ratio measures level of sales firm generates per dollar of fixed assets.Higher the fixed asset turnover, the more efficiently management uses plant and equipment.More relevant for equipment intensive firms (e.g. mfg).
90 Leverage RatiosLeverage ratios reflect ability of firm and owners to use equity to generate borrowed funds.Financial leverage refers to use of debt in firm’s capital structure.
91 Leverage RatiosUse of debt increases shareholders’ returns; tax benefits from interest payments on debt.Two sets of ratios can analyze leverage:Debt ratios quantify use of debt in capital structure;Coverage ratios measure firm’s ability to meet debt obligations.
92 Leverage RatiosTotal debt ratio is calculated using short-term and long-term debt.The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.
93 Leverage RatiosDebt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity.
94 Leverage RatiosEquity multiplier or leverage multiplier reveals amount of assets firm has for every dollar of equity.Best measure of firm’s ability to leverage shareholders’ equity with borrowed funds.
95 Other Leverage Relationships Equity multiplier = 1 + Debt to equity ratio
96 Coverage RatiosTimes interest earned measures number of dollars in operating earnings firm generates per dollar of interest expense.
97 Coverage RatiosCash coverage ratio measures amount of cash firm has to meet its interest payments.
98 Profitability RatiosGross profit margin measures amount of gross profit generated per dollar of net sales.
99 Profitability RatiosOperating profit margin measures the amount of operating profit generated by firm for each dollar of net sales.
100 Profitability RatiosNet profit margin measures amount of net income after taxes generated by firm for each dollar of net sales.In each case, the higher the ratio, the more profitable the firm.Management and creditors likely to focus on these profitability measures; shareholders likely to concentrate on two others.
101 Profitability RatiosReturn on assets (ROA) ratio measures amount of net income per dollar of total assets. There are two approaches to calculate the return on assets.This ratio reveals how efficiently management utilized assets under their command.
102 Profitability RatiosSome analysts calculate return on assets as:
103 Profitability RatiosReturn on equity (ROE) ratio measures dollar amount of net income per dollar of shareholders’ equity.For firm with no debt, ROA = ROEFor firm with debt, ROE >ROA
104 Market Value RatiosThe following ratios reveal how market views company’s liquidity, efficiency, leverage, profitability.Earnings per share (EPS) ratio measures income after taxes generated by firm for each share outstanding.
105 Market Value RatiosPrice-earnings (P/E) ratio ties firm’s earnings per share to price per share.P/E ratio reflects investors’ expectations of firm’s future earnings growth.
106 The DuPont SystemDiagnostic ToolSet of related ratios that links balance sheet and income statement.Diagnostic tool for evaluating firm’s financial health.Used by management and shareholders to understand factors that drove firm’s ROE.Based on two equations that relate firm’s ROA and ROE.
107 The ROA EquationReturn on assets (net income/total assets) can be broken down into two components:Profit margin and total assets turnover ratioNet profit margin measures management’s ability togenerate sales & manage operating expenses.
108 The ROA EquationTotal asset turnover reveals how efficiently management uses assets under its command; how much output can be generated with a given asset base. Thus, asset turnover measures asset use efficiency.The ROA equation says if management wants to increase firm’s ROA, it can increase profit margin, asset turnover, or both.Management can examine a poor ROA and determine whether the problem is operating efficiency or asset use efficiency.
109 The ROA EquationThis equation is simply a restatement of equation 4.19.ROE is determined by firm’s ROA and its use of leverage.Firm with small ROA can increase ROE by using higher leverage.
110 The DuPont EquationShows that a firm’s ROE is determined by three factors:Net profit margin, which measures firm’s operating efficiency.Total asset turnover, which measures firm’s asset use efficiency.The equity multiplier, which measures firm’s financial leverage.
111 Exhibit 4.5: Relations in the DuPont System of Analysis
112 Selecting a BenchmarkA ratio analysis becomes relevant only when compared against a benchmark.Financial managers can create a benchmark for comparison in three ways:1. Time-trend2. Industry average3. Peer group
113 Selecting a Benchmark Time-trend analysis Based on firm’s historical performance.Allows management to examine each ratio over time, determine whether trend is good or bad for firm.
114 Selecting a Benchmark Industry average analysis Another way of developing benchmark.Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios.Example
115 Selecting a Benchmark Peer group analysis Instead of selecting an entire industry, management may select firms similar in size or sales, or who compete in same market.Average ratios of this peer group would then be used as benchmark.Peer groups can be only 3 or 4 firms, depending on industry.
116 Limitations of Ratio Analysis Ratio analysis depends on accounting data based on historical costs.No theoretical backing in making judgments based on financial statement and ratio analysis.When doing industry or peer group analysis, one often encounters large, diversified firms that do not fit into any financial statement.Example comparing Apple to Apple, Vinashin example
117 Limitations of Ratio Analysis Time trend analysis could be distorted by financial statements affected by inflation.Multinational firms deal with many accounting standards. (GAAP, IFRS)Difficult to compare financial reports.Even among domestic firms, differences in accounting practices make comparisons difficult.FIFO versus LIFO
119 Time Value of MoneyTime Value of Money Future Value and Compounding Present Value and Discounting Finding the Interest Rate Rule of 72 Compound Growth Rates
120 The Time Value of Money Consuming Today or Tomorrow TVM is based on the belief that people prefer to consume goods today rather than wait to consume similar goods tomorrow.People have a positive time preference.Money has a time value because a dollar today is worth more than a dollar tomorrow.
121 The Time Value of Money Consuming Today or Tomorrow Today’s dollar can be invested to earn interest or spent.Value of a dollar invested (positive interest rate) grows over time.Rate of interest determines trade-off between spending today versus saving.Example: Inflation 18%, saving 14%, which is better, spend now or save now, spend later?
122 The Time Value of Money Timelines as Aids to Problem Solving Timelines are an easy way to visualize cash flows.Cash outflows as negative values.Cash inflows as positive values.
123 Exhibit 5.1: Five-year Timeline for $10,000 Investment
124 The Time Value of Money Future Value versus Present Value Financial decisions are evaluated either on a future value basis or present value basis.Future value measures what one or more cash flows are worth at the end of a specified period.Present value measures what one or more cash flows that are to be received in the future will be worth today (at t=0).
125 The Time Value of Money Future Value versus Present Value Compounding is the process of earning interest over time.Discounting is the process of converting future cash flows to their present values.Discounting rate
126 Exhibit 5.2: Future Value & Present Value Compared
127 Future Value and Compounding Single Period InvestmentWe can determine the value of an investment at the end of one period if we know the interest rate to be earned by the investment.If you invest for one period at an interest rate of i, your investment, or principle, will grow by (1 + i) per dollar invested.The term (1+ i) is the future value interest factor, often called simply the future value factor.
128 Future Value and Compounding Two-Period InvestingA two-period investment is simply two single-period investments back-to-back.After the first period, interest accrues on original investment (principle) and interest earned in preceding periods.
129 Future Value and Compounding Two-Period InvestingThe principal is the amount of money on which interest is paid.Simple interest is the amount of interest paid on the original principal amount only.Compounding interest consists of both simple interest and interest-on-interest.
130 Future Value and Compounding The Future Value EquationGeneral equation to find the future value after any number of periods.The term (1 + i)n is the future value factor.We can use financial calculators or future value tables to find the future value factor at different interest rates and maturity periods.
131 Future Value and Compounding The general equation to find the future value is:where:FVn = future value of investment at the end of period nPV = original principle (P0) or present valuei = the rate of interest per period, which is often a yearn = the number of periods
132 Future Value and Compounding Future value exampleYou leave your $100 invested in the bank savings account at 10 percent interest for five years. How much would you have in the bank at the end of five years?
134 Future Value and Compounding Compounding More Frequently Than Once a YearThe more frequently the interest payments are compounded, the larger the future value of $1 for a given time period.where: m = number of compounding periods in a year
135 Future Value and Compounding Non-annual compounding exampleYou invest $100 in a bank account that pays a 5 percent interest rate semiannually for two years. How much would you have in the bank at the end of two years?
136 Future Value and Compounding When interest is compounded on a continuous basis,we can use the equation below.where: e = exponential function which is about
137 Future Value and Compounding Continuous compounding exampleYour grandmother wants to put $10,000 in a savings account at a bank. How much money would she have at the end of five years if the bank paid 5 percent annual interest compounded continuously?
139 Using Excel: Time Value of Money Excel also has the following functions for time value of money problems.PV: PV(RATE, NPER, PMT, FV)FV: FV(RATE, NPER, PMT, PV)Discount Rate: RATE(NPER, PMT, PV, FV)Payment: PMT(RATE, NPER, PV, FV)Number of Periods: NPER(RATE, PMT, PV, FV)
140 Present Value and Discounting Present value calculations state the current value of a dollar in the future.This process is called discounting, and the interest rate i is known as the discount rate.The present value (PV) is often called the discounted value of future cash payments.The present value factor is more commonly called the discount factor.
141 Present Value and Discounting The equation below gives us the general equation to find the present value after any number of periods.
142 Present Value and Discounting Present value exampleSuppose you are interested in buying a new BMW 330 Sports Coupe a year from now. You estimate that the car will cost $40,000. If your local bank pays 5 percent interest on savings deposits, how much will you need to save to buy the car?
143 Present Value and Discounting The further in the future a dollar will be received, the less it is worth today.The higher the discount rate, the lower the present value of a dollar.Show formula
144 Finding the Interest Rate A number of situations will require you to determine the interest rate (or discount rate) for a given stream of future cash flows.For an individual investor or a firm, it may be necessary.to determine the return on an investment.to determine the interest rate on a loan.to determine a growth rate.
145 ExamplesBuy government bond price $90 each, in next 20 years, you receive $1000 value each bond. What is interest rate?
146 The Rule of 72Rule of 72 is used to determine the amount of time it takes to double an investment.It says that the time to double your money (TDM) approximately equals 72/i, where i is expressed as a percentage.Rule of 72 is fairly accurate for interest rates between 5% and 20%.
147 Compound Growth RatesCompound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate).Examples include population growth, earnings growth.
148 Compound Growth Rates Compound growth rate example Because of an advertising campaign, a firm’s sales increased from $20 million in 2007 to more than $35 million three years later. What has been the average annual growth rate in sales?
149 Discounted Cash Flows and Valuation CHAPTER 6Discounted Cash Flows and Valuation
150 Level Cash Flows: Annuities and Perpetuities Quick LinksMultiple Cash FlowsLevel Cash Flows: Annuities and PerpetuitiesCash Flows That Grow at a Constant RateThe Effective Annual Interest Rate
151 Future Value of Multiple Cash Flows Solving future value problems with multiple cash flows.1. Draw timeline to ascertain each cash flow is placed in correct time period.2. Calculate future value of each cash flow for its time period.3. Add up the future values.
154 Multiple Cash Flows Present Value of Multiple Cash Flows Many business situations call for computing present value of a series of expected future cash flows.Determining market value of security.Deciding whether to make capital investmentProcess similar to determining future value of multiple cash flows.
155 Multiple Cash Flows Present Value of Multiple Cash Flows First, prepare timeline to identify magnitude and timing of cash flows.Next, calculate present value of each cash flow using equation 5.4 from the previous chapter.Finally, add up all present values.Sum of present values of stream of future cash flows is their current market price, or value.
156 Exhibit 6.3: Present Value of Three Cash Flows
157 The Value of a Gift to the University Suppose that you made a gift to your university, pledging $1,000 per year for four years and $3,000 for the fifth year, for a total of $7,000. After making the first three payments, you decide to pay off the final two payments of your pledge because your financial situation has improved. How much should you pay to the university if the interest rate is 6 percent?
158 Buying a Used CarFor a student—or anyone else—buying a used car can be a harrowing experience. Once you fi nd the car you want, the next diffi cult decision is choosing how to pay for it—cash or a loan. Suppose the cash price you have negotiated for the car is $5,600, but that amount will stretch your budget for the year. The dealer says, “No problem. The car is yours for $4,000 down and payments of $1,000 per year for the next two years. Or you can put $2,000 down and pay $2,000 per year for two years. The choice is yours.” Which offer is the best deal? The interest rate you can earn on your money is 8 percent.
159 The Investment Decision You are thinking of buying a business, and your investment adviser presents you with two possibilities. Both businesses are priced at $60,000, and you have only $60,000 to invest. She has provided you with the following annual and total cash flows for each business, along with the present value of the cash flows discounted at 10 percent:Cash flow ($ thousands)Business TotalA $50 $30 $ 20 $100B $ 5 $ 5 $100 $110Which business should you acquire?
160 Annuities and Perpetuities Level Cash FlowsAnnuities and PerpetuitiesMany situations exist where businesses and individuals would face either receiving or paying constant amount for a length of period.Individual investors may make constant payments on home or car loans, or invest fixed amount year after year saving for retirement.
161 Level Cash Flows Annuities and Perpetuities Annuity: any financial contract calling for equally spaced level cash flows over finite number of periods.Perpetuity: contract calling for level cash flow payments to continue forever.Ordinary annuities: constant cash flows occurring at end of each period.
162 Level Cash Flows Present Value of an Annuity Can calculate present value of annuity same way present value of multiple cash flows is calculated.Instead, simplify equation 5.4 in chapter 5 to obtain annuity factor.Results in equation 6.1 that can be used to calculate the annuity’s present value.
163 Exhibit 6.3: Present Value of Three Cash Flows
165 Level Cash Flows Present Value of Annuity example A financial contract pays $2,000 at the end of each year for three years and the appropriate discount rate is 8% percent? What is the present value of these cash flows?
166 Level Cash Flows Finding Monthly or Yearly Payments Example You have just purchased a $450,000 condominium. You were able to put $50,000 down and obtain a 30-year fixed rate mortgage at percent for the balance. What are your monthly payments?
167 Level Cash Flows Preparing a Loan Amortization Schedule Amortization: the way the borrowed amount (principal) is paid down over life of loan.Monthly loan payment is structured so each month portion of principal is paid off; at time loan matures, it is entirely paid off.
168 Exhibit 6.5: Amortization Table for a 5-Yr, $10K Loan
169 Level Cash Flows Preparing a Loan Amortization Schedule Amortized loan: each loan payment contains some payment of principal and an interest payment.Loan amortization schedule is a table showing:loan balance at beginning and end of each period.payment made during that period.how much of payment represents interest.how much represents repayment of principal.
170 Level Cash Flows Future Value of an Annuity Future value annuity calculations usually involve finding what a savings or investment activity is worth at some future point.E.g. saving periodically for vacation, car, house, or retirement.We can derive the future value annuity equation from the present value annuity equation (equation 6.1). This results in equation 6.2.
171 Level Cash FlowsFuture Value of an Annuity Equation
173 Level Cash Flows: Annuities and Perpetuities Finding the Interest RateThe present value of an annuity equation can be used to find the interest rate or discount rate for an annuityTo determine the rate-of-return for an annuity, solve the equation for iUsing a calculator is easier than a trial-and- error approach
174 Level Cash Flows Perpetuities A perpetuity is constant stream of cash flows that goes on for infinite period.In stock markets, preferred stock issues are considered to be perpetuities, with issuer paying a constant dividend to holders.Equation for present value of a perpetuity can be derived from present value of an annuity equation with n tending to infinity.
176 Level Cash Flows Perpetuities - Example Suppose you decided to endow a chair in finance. The goal of the chair is to provide the chair holder with $100,000 of additional financial support per year forever. If the rate of interest is 8 percent, how much money will you have to give the university foundation to provide the desired level of support?
177 Exhibit 6.7: Ordinary Annuity versus Annuity Due
178 Level Cash Flows Annuity Due Annuity transformation method shows relationship between ordinary annuity and annuity due.Annuity due = Ordinary annuity value (1+i) (6.4)Each period’s cash flow thus earns extra period of interest compared to ordinary annuity.Present or future value of annuity due is always higher than that of ordinary annuity.
179 Level Cash Flows Annuity Due Example The value of the annuity due shown in Exhibit 6.7B is:Annuity due = $3,312 (1.08) = $3,577
180 Cash Flows That Grow at a Constant Rate In addition to constant cash flow streams, one may have to deal with cash flows that grow at a constant rate over time.These cash-flow streams called growing annuities or growing perpetuities.
181 Cash Flows That Grow at a Constant Rate Growing AnnuityBusiness may need to compute value of multiyear product or service contracts with cash flows that increase each year at constant rate.These are called growing annuities.Example of growing annuity: valuation of growing business whose cash flows increase every year at constant rate.
182 Cash Flows That Grow at a Constant Rate Growing AnnuityUse this equation to value the present value of growing annuity (equation 6.5) when the growth rate is less than discount rate.
183 Growing Annuity Example Cash Flows That Grow at a Constant RateGrowing Annuity ExampleA coffee shop will be in business for 50-years. It produced $300,000 this year and the discount rate used by similar businesses is 15 percent. The cash flows will grow at 2.5 percent per year. What is the estimated value of the coffee shop?
184 Cash Flows That Grow at a Constant Rate Growing PerpetuityWhen cash flow stream features constant growing annuity forever.Can be derived from equation 6.5 when n tends to infinity and results in the following equation:
185 Growing Perpetuity Example Cash Flows That Grow at a Constant RateGrowing Perpetuity ExampleYour account reports that a firm’s cash flow last year was $450,000 and the appropriate discount rate for the club is 18 percent. You expect the firm’s cash flows to increase by 5 percent per year and that the business will have no fixed life. What is the value of the firm?
186 Effective Annual Interest Rate Interest rates can be quoted in financial markets in variety of ways.Most common quote, especially for a loan, is annual percentage rate (APR).APR represents simple interest accrued on loan or investment in a single period; annualized over a year by multiplying it by appropriate number of periods in a year.
187 Calculating the Effective Annual Rate (EAR) Effective Annual Interest RateCalculating the Effective Annual Rate (EAR)Correct way to compute annualized rate is to reflect compounding that occurs; involves calculating effective annual rate (EAR).Effective annual interest rate (EAR) is defined as annual growth rate that takes compounding into account.
188 Calculating the Effective Annual Rate (EAR) Effective Annual Interest RateCalculating the Effective Annual Rate (EAR)EAR = (1 + Quoted rate/m)m – (6.7)m is the # of compounding periods during a year.EAR conversion formula accounts for number of compounding periods, thus effectively adjusts annualized interest rate for time value of money.EAR is the true cost of borrowing and lending.
189 Effective Annual Rate (EAR) Example Effective Annual Interest RateEffective Annual Rate (EAR) ExampleYour credit card has an APR of 12 percent (1 percent per month). What is the effective annual interest rate?EAR = ( /12)12 – 1= (1.01)12 – 1= – 1= or 12.68%
190 Examples: Calculating EAR Lender A: 10.40% compound monthlyLender B: 10.90% compound annuallyLender C: 10.50% compound quarterlyWho will you chose to borrow?
192 Risk and Return Future Value vs. Present Value The greater the risk, the larger the return investors require as compensation for bearing that risk.Higher risk means less certainty.
193 Quantitative Measures of Return Holding Period ReturnsTotal holding period return consists of two components: 1) capital appreciation and 2) income.Capital appreciation component of a return, :
194 Quantitative Measures of Return Holding Period ReturnsIncome component of a return RI:Total holding period return is simply
195 Quantitative Measures of Return Holding Period Returns ExampleOne year ago today, you purchased a share of Dell Inc. stock for $ Today it is worth $ Dell paid no dividend on its stock. What total return did you earn on this stock over the past year?
196 Quantitative Measures of Return Expected Returns ExampleYou estimate that there is 30 percent chance that your total return on your Dell stock investment will be percent, a 30 percent chance that it will be percent , a 30 percent chance that it will be percent and a 10 percent chance that it will be percent. Calculate your expected return.
197 Quantitative Measures of Return Expected ReturnsExpected value represents the sum of products of possible outcomes, and probabilities that those outcomes will be realized.Expected return, E(RAsset), is an average of possible returns from an investment, where each of these returns is weighted by the probability that it will occur:
198 Quantitative Measures of Return Expected ReturnsIf each of the possible outcomes is equally likely (that is, p1 = p2 = p3 = … = pn = p = 1/n), the expected return formula reduces to:
199 Variance and Standard Deviation as Measures of Risk Calculating the Variance and Standard DeviationThe variance (2) squares the difference between each possible occurrence and the mean (squaring the differences makes all the numbers positive), and multiplies each difference by its associated probability before summing them up:Take the square root of the variance to get the standard deviation ().
200 Variance and Standard Deviation as Measures of Risk Calculating the Variance and Standard DeviationIf all possible outcomes are equally likely, the formula becomes:
202 Variance and Standard Deviation as Measures of Risk Interpreting the Variance and Standard DeviationNormal distribution is a symmetric frequency distribution that is completely described by its mean (average) and standard deviation.Normal distribution’s left and right sides are mirror images of each other. The mean falls directly in center of distribution. Probability that an outcome is a particular distance from the mean is the same, whether the outcome is on the left or the right side of the distribution.
203 Risk and Diversification The concept of diversificationBy investing in two or more assets whose values do not always move in same direction at same time, investors can reduce risk of investments or portfolio.
204 Risk and Diversification Single-Asset PortfoliosReturns for individual stocks from one day to next are largely independent of each other and approximately normally distributed.A first pass at comparing risk and return for individual stocks is coefficient of variation, CV.
206 Risk and Diversification Portfolios with More than One AssetCoefficient of variation has a critical shortcoming not quite evident when only a single asset is considered.Expected return of portfolio made up of two assets:
207 Risk and Diversification Portfolios with More than One AssetExpected return of portfolio made up of multiple assets:
208 Risk and Diversification Expected return of Portfolio ExampleYou invested $100,000 in Treasury bills that yield 4.5 percent; $150,000 in Proctor and Gamble stock, which has an expected return of 7.5 percent; and $150,000 in Exxon Mobil Corporation stock, which has an expected return of 9.0 percent. What is the expected return of this $400,000 portfolio?
209 Risk and Diversification Expected return of Portfolio Example -continued
210 Risk and Diversification Portfolios with More than One AssetExpected return of each asset must be found before applying either of the two above formulas; fraction of portfolio invested in each asset must also be known.Prices of two stocks in a portfolio will rarely change by the same amount and in the same direction at same time.
211 Risk and Diversification Portfolios with More than One AssetWhen stock prices move in opposite directions, the change in price of one stock offsets at least some of the change in price of other stock.Level of risk for portfolio of two stocks is less than average of risks associated with individual shares. The risk can be calculated with the variance equation below:
212 Risk and Diversification Portfolio Variance ExampleThe variance of the annual returns of CSX and Wal- Mart stocks in Exhibit 7.6 are and respectively. The covariance between the annual returns of these stocks is Calculate the variance of the portfolio that consists of 50 percent CSX stock and 50 percent Wal-Mart stock.
213 Risk and Diversification Portfolios with More than One AssetIn order to ease interpretation of covariance, we divide it by the product of the standard deviations of returns for the two assets. This gives the correlation coefficient between the returns on the two assets:
214 Risk and Diversification Correlation Coefficient ExampleFind the correlation coefficient between the annual returns of CSX and Wal-Mart in Exhibit 7.6.