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1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The Financial Manager and the Firm Unit Slides by UK Versity.

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Presentation on theme: "1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The Financial Manager and the Firm Unit Slides by UK Versity."— Presentation transcript:

1 1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The Financial Manager and the Firm Unit Slides by UK Versity

2 2 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Legal Forms of Business Organizations Quick Links The Role of the Financial Manager Managing the Financial Function The Goal of the Firm Agency Conflicts: Separation of Ownership and Control

3 3 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 4 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Role of the Financial Manager  A firm generates cash flows by selling the goods and services produced by its productive assets and human capital.  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. It is all About Cash Flows  The firm is successful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors, and taxes.

5 5 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 1.1: Cash Flow Diagram

6 6 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Role of the Financial Manager It is all about cash flows  A firm is unprofitable when it fails to generate sufficient cash flows.  In bankruptcy, the company will either be reorganized, or the company’s assets will be liquidated.  Firms that are unprofitable over time will be forced into bankruptcy by their creditors.

7 7 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Three Fundamental Decisions in Financial Management  The 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 Role of the Financial Manager  The financing decision: How should the firm finance or pay for assets?

8 8 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Three Fundamental Decisions in Financial Management  Financing 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 Role of the Financial Manager  The mismanagement of working capital can cause the firm to go into bankruptcy even though the firm is profitable.

9 9 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 1.2: How Financial Manager’s Decisions Affect the Balance Sheet

10 10 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Legal Forms of Business Organizations Sole Proprietorship  No 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 11 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Partnership  Has 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. Legal Forms of Business Organizations

12 12 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Corporation  In 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. Legal Forms of Business Organizations

13 13 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Corporation  The 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. Legal Forms of Business Organizations

14 14 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Hybrid Forms of Business Organization  Limited liability partnerships (LLPs) combine the limited liability of a corporation with the tax advantage of a partnership.  Limited liability companies (LLCs)  Professional corporations (PCs) Legal Forms of Business Organizations

15 15 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 16 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. Managing the Financial Function

17 17 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  The 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.  CFO’s Key Financial Reports Chief Financial Officer (CFO) Managing the Financial Function

18 18 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  The Internal Auditor is responsible for in- depth risk assessments, performing audits of high-risk areas.  CFO’s Key Financial Reports Chief Financial Officer (CFO) Managing the Financial Function  The Risk Manager manages the firm’s risk exposure in financial markets and the relationships with insurance providers.

19 19 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. Managing the Financial Function

20 20 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Audit Committee  Approves the external auditor’s fees and engagement letter. The external auditor cannot be fired or terminated without the audit committee’s approval. Managing the Financial Function Compliance and Ethics Director  Oversees the compliance program, ethics program, and the compliance hotline and reports directly to the audit committee.

21 21 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 1.3: Simplified Corporate Organization Chart

22 22 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 23 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Goal of the Firm What Should Management Maximize?  Profit maximization does not tell us when cash flows are to be received.  Why not maximize profits?  Profit maximization ignores the uncertainty or risk associated with cash flows.

24 24 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 25 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 26 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 1.4: Major Factors Affecting Stock Prices

27 27 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Goal of the Firm Can Management Decisions Affect Stock Prices?  YES!!!

28 28 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Agency Conflicts: Separation of Ownership and Control 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 29 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Agency Relationships  An agency relationship arises whenever one party, called the principal, hires another party, called the agent. Agency Conflicts: Separation of Ownership and Control  The relationship between stockholders (principals) and management (agents) is an agency relationship.

30 30 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 Costs Agency Conflicts: Separation of Ownership and Control  The costs of the conflict of interest between the firm’s owners and its management.

31 31 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Aligning the Interests of Management and Stockholders  Management Compensation  A significant portion of management compensation should be tied to firm performance (e.g. stock price). Agency Conflicts: Separation of Ownership and Control

32 32 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Aligning the Interests of Management and Stockholders  Managerial Labor Market  Firms with unethical behavior have difficulty hiring top managers.  Executives with poor performance or criminal convictions can rarely secure good positions in the future. Agency Conflicts: Separation of Ownership and Control

33 33 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Aligning the Interests of Management and Stockholders Board of Directors  Lack of board independence is a key factor in the misalignment between board members’ and stockholders’ interests Agency Conflicts: Separation of Ownership and Control Other Managers Large Stockholders The Takeover Market The Legal and Regulatory Environment

34 34 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 3 Financial Statements, Cash Flows, and Taxes

35 35 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quick Links The Income Statement Statement of Retained Earnings Cash Flows The Balance Sheet

36 36 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Balance Sheet This 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 37 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Balance sheet also lists the capital raised from its shareholders.  Shareholders of the firm’s common equity are listed last.  Shareholders will be paid with whatever remains after paying all other suppliers of funds.  Assets listed in order of their liquidity.  Liabilities listed in order in which they must be paid. The Balance Sheet

38 38 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. The Balance Sheet

39 39 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 taxes The Balance Sheet Net working capital= Total current assets - Total current liabilities (3.2)

40 40 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Net working capital example - Diaz Manufacturing Total current assets = $1,039.8 million Total current liabilities = $377.8 million Net working capital =? The Balance Sheet

41 41 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Inventory Accounting  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?  Inventory (least liquid of current assets) usually reported in one of two ways on balance sheet. The Balance Sheet

42 42 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. The Balance Sheet

43 43 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Long-Term Assets  Intangible assets also listed here.  Goodwill, patents, copyrights, etc.  Real assets firm acquires to produce its products and generate cash flows.  Land, buildings, plant and equipment. The Balance Sheet

44 44 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. The Balance Sheet

45 45 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Long-Term Liabilities  Long-term debt of the company.  Includes bank loans, mortgages, and bonds with a maturity of one year or longer. The Balance Sheet

46 46 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Equity – There are two sources of equity funds  Preferred Equity  Has features that make it a combination of a fixed income security and an equity security.  Common Equity  Common equity represents the true ownership of the firm. The Balance Sheet

47 47 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 stock  This account reflects the value of the shares that the firm has repurchased from investors. The Balance Sheet

48 48 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Income Statement  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) The Income Statement: Overview

49 49 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Income Statement Revenues = $1,563.7 million Expenses = $1,445.2 million Net Income = ? Net Income example – Diaz Manufacturing

50 50 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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. The Income Statement: Depreciation  Firms use one of these for depreciating an asset:  Straight line method  Accelerated depreciation method  Firms allowed to use one for internal purposes and another for tax purposes. The Income Statement

51 51 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Amortization expenses are related to the writing off of the value of intangible assets, such as:  Goodwill, Patents, Licenses, etc. The Income Statement: Amortization  It is also a non-cash expense like depreciation. The Income Statement

52 52 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Extraordinary Items  Extraordinary Items refer to income or expenses associated with events that are not expected to happen on a regular basis. The Income Statement

53 53 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Earnings before interest, taxes, depreciation and amortization (EBITDA).  Earnings generated from operations prior to payment of expenses not directly connected to production of products. Bottom Line Accounts  After netting out the expenses related to depreciation and amortization, we arrive at earnings before interest and taxes (EBIT). The Income Statement

54 54 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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. Bottom Line Accounts  Earnings before taxes (EBT) represents the taxable income for the period. The Income Statement

55 55 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Statement of Retained Earnings  This account will show changes whenever a firm reports a loss or profit and when a cash dividend is declared.  This financial statement shows the changes in the retained earnings account from one period to the next.

56 56 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 3.3: Diaz Mfg Statement of Retained Earnings

57 57 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 58 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 59 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Cash Flows NCFOA example – Diaz Manufacturing Net Income = $118.5 million Depreciation and Amortization = $83.1 million NCFOA = ?

60 60 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Statement of Cash Flows  Helps to measure cash outflows and cash inflows generated during any period.  Indicates cash flows resulting from  Operating 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. Cash Flows

61 61 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Organization of the Statement of Cash Flows  Cash 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. Cash Flows Operating Activities

62 62 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Organization of the Statement of Cash Flows  Cash inflows and outflows arise out of the acquisition and selling of long-term assets necessary to operate the business. investing activities.  Also result from  Buying and selling financial assets (bonds, stocks).  Making and collecting loans.  Selling and settling insurance contracts. Cash Flows Investing Activities

63 63 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Cash 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. Organization of the Statement of Cash Flows Cash Flows Financing Activities

64 64 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 3.5: Interrelations among the Financial Statements

65 65 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons In-class discussion End of chapter questions Group selection

66 66 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 4 Analyzing Financial Statements

67 67 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Ratio Analysis Quick Links Financial Statement Analysis The DuPont System, ROA, ROE Benchmarks Limitations of Ratio Analysis

68 68 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Perspectives on Financial Statement Analysis  A firm’s financial statements can be analyzed from the perspective of different stakeholders.  Important perspectives:  Creditor  Manager  Stockholder

69 69 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Stockholders’ perspective  Centers on value of stock held.  Allows determination of firm’s profitability, return for that period, and likely dividends.  Interest in the financial statement is to gauge cash flows firm will generate from operations. Perspectives on Financial Statement Analysis

70 70 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Manager’s perspective  Interest 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. Perspectives on Financial Statement Analysis

71 71 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Creditors’ perspective  A firm’s creditors closely monitor  Amount 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.  Focus on getting loans repaid and receiving interest payments on time. Perspectives on Financial Statement Analysis

72 72 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Main Concern Guidelines for Financial Statement Analysis  From 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 73 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 Guidelines for Financial Statement Analysis

74 74 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Common-Size Balance Sheets Common-Size Financial Statements  Each asset and liability item on balance sheet is standardized by dividing by total assets.  Accounts are then represented as percentages of total assets.

75 75 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 4.1: Common-Size Balance Sheets

76 76 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Common-Size Income Statement  Each income statement item standardized by dividing it by dollar amount of net sales.  Each income statement item now indicated as percent of sales. Common-Size Financial Statements

77 77 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 4.2: Common-Size Income Statements

78 78 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Measures ability of firm to meet short-term obligations with short-term assets, without endangering the firm. Liquidity Ratios  Current ratio  Quick ratio Two commonly used ratios to measure liquidity

79 79 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Current 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 Liquidity Ratios

80 80 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quick (acid-test) ratio calculated by dividing most liquid current assets by current liabilities.  Amount of liquid assets firm has per dollar of current liabilities.  Higher number = more liquidity Liquidity Ratios  Inventory subtracted from total current assets determines most liquid assets.

81 81 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Quick ratios typically smaller than current ratios for manufacturing firms Liquidity Ratios  Service firms see no different between current and quick ration

82 82 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Measure how efficiently firm’s management uses assets to generate sales. Efficiency Ratios  Sometimes called asset turnover ratios.

83 83 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Used by management to identify areas of inefficiency.  Efficiency ratios focus on inventory, receivables and use of fixed and total assets.  Used by creditors to determine speed of converting inventory to receivables.  Receivables convert to cash to help firm meet debt obligations. Efficiency Ratios

84 84 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Inventory 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. Efficiency Ratios

85 85 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Days’ 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. Efficiency Ratios

86 86 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Accounts 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 Efficiency Ratios

87 87 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Days 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. Efficiency Ratios

88 88 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Total asset turnover ratio measures level of sales firm generates per dollar of total assets. Asset Turnover Ratios  The higher the turnover, the more efficiently management is using total assets.  More relevant for service industry firms.

89 89 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Fixed 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). Asset Turnover Ratios

90 90 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Leverage ratios reflect ability of firm and owners to use equity to generate borrowed funds. Leverage Ratios  Financial leverage refers to use of debt in firm’s capital structure.

91 91 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Use 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. Leverage Ratios

92 92 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The higher the amount of debt, the higher the firm’s leverage, and the more risky it is. Leverage Ratios Total debt ratio is calculated using short-term and long-term debt.

93 93 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Debt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity. Leverage Ratios

94 94 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Equity multiplier or leverage multiplier reveals amount of assets firm has for every dollar of equity. Leverage Ratios Best measure of firm’s ability to leverage shareholders’ equity with borrowed funds.

95 95 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Equity multiplier = 1 + Debt to equity ratio Other Leverage Relationships

96 96 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Times interest earned measures number of dollars in operating earnings firm generates per dollar of interest expense. Coverage Ratios

97 97 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Cash coverage ratio measures amount of cash firm has to meet its interest payments. Coverage Ratios

98 98 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Gross profit margin measures amount of gross profit generated per dollar of net sales. Profitability Ratios

99 99 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Operating profit margin measures the amount of operating profit generated by firm for each dollar of net sales. Profitability Ratios

100 100 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Net profit margin measures amount of net income after taxes generated by firm for each dollar of net sales. Profitability Ratios 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.

101 101 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Return on assets (ROA) ratio measures amount of net income per dollar of total assets. There are two approaches to calculate the return on assets. Profitability Ratios  This ratio reveals how efficiently management utilized assets under their command.

102 102 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Some analysts calculate return on assets as: Profitability Ratios

103 103 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Return on equity (ROE) ratio measures dollar amount of net income per dollar of shareholders’ equity.  For firm with no debt, ROA = ROE  For firm with debt, ROE >ROA Profitability Ratios

104 104 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  The following ratios reveal how market views company’s liquidity, efficiency, leverage, profitability. Market Value Ratios  Earnings per share (EPS) ratio measures income after taxes generated by firm for each share outstanding.

105 105 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Price-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. Market Value Ratios

106 106 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Set of related ratios that links balance sheet and income statement. The DuPont System  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. Diagnostic Tool

107 107 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Return on assets (net income/total assets) can be broken down into two components:  Profit margin and total assets turnover ratio The ROA Equation Net profit margin measures management’s ability to generate sales & manage operating expenses.

108 108 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Total 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. The ROA Equation

109 109 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons This equation is simply a restatement of equation The ROA Equation  ROE is determined by firm’s ROA and its use of leverage.  Firm with small ROA can increase ROE by using higher leverage.

110 110 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Shows that a firm’s ROE is determined by three factors: The DuPont Equation  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.

111 111 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 4.5: Relations in the DuPont System of Analysis

112 112 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons A ratio analysis becomes relevant only when compared against a benchmark. Financial managers can create a benchmark for comparison in three ways: Selecting a Benchmark 1. Time-trend 2. Industry average 3. Peer group

113 113 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. Selecting a Benchmark

114 114 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Industry average analysis  Another way of developing benchmark.  Firms in same industry grouped by size, sales, and product lines, to establish benchmark ratios.  Example Selecting a Benchmark

115 115 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. Selecting a Benchmark

116 116 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Ratio analysis depends on accounting data based on historical costs. Limitations of Ratio Analysis  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

117 117 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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 Limitations of Ratio Analysis

118 118 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 5 The Time Value of Money

119 119 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Time Value of Money Future Value and Compounding Present Value and Discounting Finding the Interest Rate Rule of 72 Compound Growth Rates

120 120 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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. The Time Value of Money Consuming Today or Tomorrow  Money has a time value because a dollar today is worth more than a dollar tomorrow.

121 121 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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? The Time Value of Money Consuming Today or Tomorrow

122 122 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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.

123 123 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 5.1: Five-year Timeline for $10,000 Investment

124 124 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Time Value of Money Future Value versus Present Value  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).  Financial decisions are evaluated either on a future value basis or present value basis.

125 125 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Time Value of Money  Discounting is the process of converting future cash flows to their present values.  Discounting rate  Compounding is the process of earning interest over time. Future Value versus Present Value

126 126 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 5.2: Future Value & Present Value Compared

127 127 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Future Value and Compounding Single Period Investment  We 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.

128 128 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Future Value and Compounding Two-Period Investing  After the first period, interest accrues on original investment (principle) and interest earned in preceding periods.  A two-period investment is simply two single- period investments back-to-back.

129 129 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  The 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. Future Value and Compounding Two-Period Investing

130 130 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Future Value and Compounding  General equation to find the future value after any number of periods. The Future Value Equation  We can use financial calculators or future value tables to find the future value factor at different interest rates and maturity periods.  The term (1 + i) n is the future value factor.

131 131 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons where: FV n = future value of investment at the end of period n PV = original principle (P 0 ) or present value i = the rate of interest per period, which is often a year n = the number of periods The general equation to find the future value is: Future Value and Compounding

132 132 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons You 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? Future value example Future Value and Compounding

133 133 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 5.4: How Compound Interest Grows

134 134 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Compounding More Frequently Than Once a Year The 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 Future Value and Compounding

135 135 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Non-annual compounding example Future Value and Compounding You 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?

136 136 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons When interest is compounded on a continuous basis, we can use the equation below. where: e = exponential function which is about Future Value and Compounding

137 137 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Continuous compounding example Future Value and Compounding Your 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?

138 138 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Using Excel: Time Value of Money

139 139 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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)

140 140 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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.

141 141 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The equation below gives us the general equation to find the present value after any number of periods. Present Value and Discounting

142 142 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Suppose 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? Present value example Present Value and Discounting

143 143 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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

144 144 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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.  to determine the interest rate on a loan.  to determine a growth rate.  to determine the return on an investment. For an individual investor or a firm, it may be necessary.

145 145 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Examples Buy government bond price $90 each, in next 20 years, you receive $1000 value each bond. What is interest rate?

146 146 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons The Rule of 72  Rule 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%.

147 147 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Compound Growth Rates Compound 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.

148 148 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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?

149 149 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 6 Discounted Cash Flows and Valuation 149

150 150 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Level Cash Flows: Annuities and Perpetuities Quick Links Multiple Cash Flows Cash Flows That Grow at a Constant Rate The Effective Annual Interest Rate 150

151 151 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. Multiple Cash Flows 151

152 152 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.1: Future Value of Two Cash Flows 152

153 153 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.2: Future Value of Three Cash Flows 153

154 154 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 investment  Process similar to determining future value of multiple cash flows. Present Value of Multiple Cash Flows 154

155 155 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Next, calculate present value of each cash flow using equation 5.4 from the previous chapter. Present Value of Multiple Cash Flows  Finally, add up all present values.  Sum of present values of stream of future cash flows is their current market price, or value.  First, prepare timeline to identify magnitude and timing of cash flows. 155 Multiple Cash Flows

156 156 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.3: Present Value of Three Cash Flows 156

157 157 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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? 157

158 158 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Buying a Used Car For 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. 158

159 159 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 Total A $50 $30 $ 20 $100 B $ 5 $ 5 $100 $110 Which business should you acquire? 159

160 160 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Annuities and Perpetuities  Individual investors may make constant payments on home or car loans, or invest fixed amount year after year saving for retirement.  Many situations exist where businesses and individuals would face either receiving or paying constant amount for a length of period. Level Cash Flows 160

161 161 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Annuity: any financial contract calling for equally spaced level cash flows over finite number of periods. Annuities and Perpetuities  Perpetuity: contract calling for level cash flow payments to continue forever.  Ordinary annuities: constant cash flows occurring at end of each period. 161 Level Cash Flows

162 162 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. 162 Level Cash Flows

163 163 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.3: Present Value of Three Cash Flows 163

164 164 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 164 Level Cash Flows

165 165 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 165 Level Cash Flows 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? Present Value of Annuity example

166 166 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Finding Monthly or Yearly Payments Example 166 Level Cash Flows 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?

167 167 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. 167 Level Cash Flows

168 168 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.5: Amortization Table for a 5-Yr, $10K Loan 168

169 169 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  Amortized loan: each loan payment contains some payment of principal and an interest payment. Preparing a Loan Amortization Schedule  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. 169 Level Cash Flows

170 170 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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 Level Cash Flows

171 171 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Future Value of an Annuity Equation 171 Level Cash Flows

172 172 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.6: Future Value of 4-Yr Annuity 172

173 173 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Level Cash Flows: Annuities and Perpetuities Finding the Interest Rate ◦ The present value of an annuity equation can be used to find the interest rate or discount rate for an annuity ◦ To determine the rate-of-return for an annuity, solve the equation for i ◦ Using a calculator is easier than a trial-and- error approach

174 174 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons 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. 174 Level Cash Flows

175 175 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Perpetuities 175 Level Cash Flows

176 176 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Perpetuities - Example 176 Level Cash Flows 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?

177 177 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Exhibit 6.7: Ordinary Annuity versus Annuity Due 177

178 178 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Annuity Due  Annuity transformation method shows relationship between ordinary annuity and annuity due.  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. 178 Level Cash Flows Annuity due = Ordinary annuity value  (1+i) (6.4)

179 179 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Annuity Due Example The value of the annuity due shown in Exhibit 6.7B is: 179 Level Cash Flows Annuity due = $3,312  (1.08) = $3,577

180 180 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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. Cash Flows That Grow at a Constant Rate 180

181 181 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Growing Annuity  Business 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. 181 Cash Flows That Grow at a Constant Rate

182 182 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Growing Annuity  Use this equation to value the present value of growing annuity (equation 6.5) when the growth rate is less than discount rate. 182 Cash Flows That Grow at a Constant Rate

183 183 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Growing Annuity Example 183 Cash Flows That Grow at a Constant Rate A 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?

184 184 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Growing Perpetuity  When 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: 184 Cash Flows That Grow at a Constant Rate

185 185 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Growing Perpetuity Example 185 Cash Flows That Grow at a Constant Rate Your 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?

186 186 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons  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. Effective Annual Interest Rate 186

187 187 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Calculating 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. 187 Effective Annual Interest Rate

188 188 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Calculating the Effective Annual Rate (EAR) EAR = (1 + Quoted rate/m) m – 1 (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. 188 Effective Annual Interest Rate

189 189 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Effective Annual Rate (EAR) Example 189 Effective Annual Interest Rate Your 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%

190 190 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Examples: Calculating EAR Lender A: 10.40% compound monthly Lender B: 10.90% compound annually Lender C: 10.50% compound quarterly Who will you chose to borrow? 190

191 191 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 7 Risk and Return

192 192 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Return  The greater the risk, the larger the return investors require as compensation for bearing that risk. Future Value vs. Present Value  Higher risk means less certainty.

193 193 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return  Total holding period return consists of two components: 1) capital appreciation and 2) income. Holding Period Returns  Capital appreciation component of a return, :

194 194 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return  Total holding period return is simply  Income component of a return R I : Holding Period Returns

195 195 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return Holding Period Returns Example One 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?

196 196 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return Expected Returns Example You 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 5.17 percent, a 30 percent chance that it will be percent and a 10 percent chance that it will be percent. Calculate your expected return.

197 197 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return  Expected value represents the sum of products of possible outcomes, and probabilities that those outcomes will be realized. Expected Returns  Expected return, E(R Asset ), is an average of possible returns from an investment, where each of these returns is weighted by the probability that it will occur:

198 198 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Quantitative Measures of Return Expected Returns  If each of the possible outcomes is equally likely (that is, p 1 = p 2 = p 3 = … = p n = p = 1/n), the expected return formula reduces to:

199 199 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Variance and Standard Deviation as Measures of Risk Calculating the Variance and Standard Deviation  The 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 (  ).

200 200 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Variance and Standard Deviation as Measures of Risk Calculating the Variance and Standard Deviation  If all possible outcomes are equally likely, the formula becomes:

201 201 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons = > σ = or 8.38%

202 202 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Variance and Standard Deviation as Measures of Risk  Normal distribution is a symmetric frequency distribution that is completely described by its mean (average) and standard deviation. Interpreting the Variance 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.

203 203 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification  By 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. The concept of diversification

204 204 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification  Returns for individual stocks from one day to next are largely independent of each other and approximately normally distributed. Single-Asset Portfolios  A first pass at comparing risk and return for individual stocks is coefficient of variation, CV.

205 205 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Stock AStock B E(R)0,080,24 σ0,060,08 CV0,750,33

206 206 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification  Coefficient of variation has a critical shortcoming not quite evident when only a single asset is considered. Portfolios with More than One Asset  Expected return of portfolio made up of two assets:

207 207 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Portfolios with More than One Asset  Expected return of portfolio made up of multiple assets:

208 208 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Expected return of Portfolio Example You 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?

209 209 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Expected return of Portfolio Example -continued

210 210 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification  Expected 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. Portfolios with More than One Asset  Prices of two stocks in a portfolio will rarely change by the same amount and in the same direction at same time.

211 211 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification  When 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. Portfolios with More than One Asset  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:

212 212 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Portfolio Variance Example The 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.

213 213 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Portfolios with More than One Asset  In 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:

214 214 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons Risk and Diversification Correlation Coefficient Example Find the correlation coefficient between the annual returns of CSX and Wal-Mart in Exhibit 7.6.


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