Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management.

Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.
Chapter 1 An Introduction to the Foundations of Financial Management – The Ties that Bind

Foundations of Finance
Chapter Objectives Identify the goal of the firm. Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing. Describe the corporate tax features that affect business decisions. Describe the corporate tax features that affect decisions. Explain the 10 principles that form the foundations of financial management. Explain what has led to the era of the multinational corporation. Foundations of Finance Pearson Prentice Hall

The Goal of the Firm The goal of the firm is maximization of shareholder wealth or Maximization of the price of the existing common stock Foundations of Finance Pearson Prentice Hall

Profit Maximization Stresses the efficient use of capital resources Not specific to time frame for profits to be measured Goals are not precise, allow for misinterpretation Ignores uncertainty and timing Foundations of Finance Pearson Prentice Hall

Benefits of Maximizing Shareholder Wealth
Good decisions are those that create wealth for the shareholder Societal benefits as businesses compete to create wealth Includes effects of all financial decisions Foundations of Finance Pearson Prentice Hall

Legal Forms of Business Organization
Sole Proprietorship Partnership Corporation Foundations of Finance Pearson Prentice Hall

Sole Proprietorship Business owned by an individual Owner maintains title to assets and profits Unlimited liability Termination occurs on owner’s death or by owner’s choice Foundations of Finance Pearson Prentice Hall

Partnerships Two or more owners General Partnership Each partner is fully responsible for liabilities Limited Partnerships Foundations of Finance Pearson Prentice Hall

Partnerships Limited Partnership and Limited Liability Company Allows one or more partners limited liability based on amount of capital invested Must have one general partner with unlimited liability Names of limited partners may not appear in name of firm Limited partners may not participate in management decisions. Foundations of Finance Pearson Prentice Hall

Corporation Legally functions separate and apart from its owners Can sue, be sued, purchase, sell, and own property Owners who dictate direction and policies Elect a board of directors Investors liability is restricted to amount of investment in company Life continues with transfer of ownership Taxed separately Foundations of Finance Pearson Prentice Hall

Comparison of Organizational Forms
Large growing firms choose the corporate form Ease in raising capital Limited liability Transfer of ownership is simple Foundations of Finance Pearson Prentice Hall

Comparison of Organizational Forms
Sole Proprietorship and General Partnership Unlimited liabilities Not as easy to raise capital Limited Partnership Limited liability for partners Practical number of partners restricted Restricted marketability of interest in partnership Foundations of Finance Pearson Prentice Hall

Organizational Form and Taxes
Corporation Double taxation of dividends Tax act of 2003 limited tax rate on dividends to stimulate the economy Ends in 2008 unless Congress takes action Foundations of Finance Pearson Prentice Hall

S-Type Corporations Benefits Limited liability Taxed as partnership Limitations Owners must be people Can’t be used for joint ventures between two corporations Foundations of Finance Pearson Prentice Hall

Limited Liability Corporations Benefits Limited liability Taxed like a partnership Limitations Qualifications vary from state to state Can’t appear like corporation otherwise will be taxed like one Foundations of Finance Pearson Prentice Hall

The Role of the Financial Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION Foundations of Finance Pearson Prentice Hall

Objectives of Income Taxation
Raise revenues for government expenditures Achieve socially desirable goals Economic stabilization Foundations of Finance Pearson Prentice Hall

Types of Taxpayers Individuals employees, self-employed persons, members of partnerships Report income on personal tax return Corporations separate legal entity Report income on corporate tax return Distributed dividends taxed to shareholders Fiduciaries estates and trusts Pay taxes on undistributed income Foundations of Finance Pearson Prentice Hall

Computing Taxable Income
Gross income less tax deductible expenses, plus interest income and dividend income Gross Income Dollar sales from a product or service less cost of production or acquisition Tax Deductible Expenses Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible Foundations of Finance Pearson Prentice Hall

Computing Taxable Income ($000’s)
Sales $50,000 Cost of Goods Sold ,000 Gross Profit $27,000 Operating Expenses Administrative Expenses $4,000 Depreciation Expense ,500 Marketing Expenses 4,500 Total Operating Expenses $10,000 Operating Income $17,000 Other Income Interest Expense ,000 Taxable Income $16,000 Foundations of Finance Pearson Prentice Hall

Corporate Tax Rates Income Rate $ 0 - $50, % $50,001 - $75, % $75,001 - $10,000, % Over $10,000, % Additional surtax: 5% on income between $100,000 and $335,000 3% on income between $15,000,000 and $18,333,333 Foundations of Finance Pearson Prentice Hall

Marginal Tax Rates Rates applicable to next dollar of income Used in financial decision-making Foundations of Finance Pearson Prentice Hall

Other Corporate Tax Considerations
Dividend Exclusion A corporation may typically exclude 70% of any dividend received from another corporation. Depreciation Expense A corporation may expense an asset’s cost over its useful life Capital Gains and Losses Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income. Foundations of Finance Pearson Prentice Hall

Ten Principles That Form The Foundations of Financial Management
“…although it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.”

Principle 1: The Risk-Return Trade-off
We won’t take on additional risk unless we expect to be compensated with additional return. Investment alternatives have different amounts of risk and expected returns. The more risk an investment has, the higher its expected return will be. Foundations of Finance Pearson Prentice Hall

Principle 2: The Time Value of Money
A dollar received today is worth more than a dollar received in the future. Because we can earn interest on money received today, it is better to receive money earlier rather than later. Foundations of Finance Pearson Prentice Hall

Principle 3: Cash—Not Profits—Is King
Cash Flow, not accounting profit, is used as our measurement tool. Cash flows, not profits, are actually received by the firm and can be reinvested. Foundations of Finance Pearson Prentice Hall

Principle 4: Incremental Cash Flows
It is only what changes that counts The incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected. Foundations of Finance Pearson Prentice Hall

Principle 5: The Curse of Competitive Markets
It is hard to find exceptionally profitable projects If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return. Product Differentiation, Service and Quality can insulate products from competition Foundations of Finance Pearson Prentice Hall

Principle 6: Efficient Capital Markets
The markets are quick and the prices are right. The values of all assets and securities at any instant in time fully reflect all available information. Foundations of Finance Pearson Prentice Hall

Principle 7: The Agency Problem
Managers won’t work for the owners unless it is in their best interest The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not in line with the goal of maximization of shareholder wealth. Foundations of Finance Pearson Prentice Hall

Principle 8: Taxes Bias Business Decisions
The cash flows we consider are the after-tax incremental cash flows to the firm as a whole. Foundations of Finance Pearson Prentice Hall

Principle 9: All Risk is Not Equal
Some risk can be diversified away, and some cannot The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult. Foundations of Finance Pearson Prentice Hall

Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing Foundations of Finance Pearson Prentice Hall

Finance and the Multinational Firm
U.S. corporations are looking to international expansion Collapse of communism Acceptance of free market system developing in the Third World countries PC’s and the internet Freer access to international markets Foundations of Finance Pearson Prentice Hall

Chapter 2 The Financial Markets and Interest Rates
Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 2 The Financial Markets and Interest Rates

Chapter Objectives Understanding the historical relationship between internally generated and externally generated sources of funds. Understand the financing mix that tends to be used by the firms raising long-term capital. Explain why the financial markets exist in a developed country. Explain the financing process by which savings are supplied and raised by major sectors in the economy. Foundations of Finance Pearson Prentice Hall

Chapter Objectives Describe key components of the U.S. financial market system. Understand the role of the investment-banking business in the context of raising corporate capital. Distinguish between privately placed securities and publicly offered securities. Be acquainted with securities floatation costs and securities markets regulations. Foundations of Finance Pearson Prentice Hall

Chapter Objectives Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets. Be acquainted with recent interest rate levels and the fundamentals of interest rate determination. Explain the popular theories of the term structure of interest rates. Understand the relationships among the multinational firm, efficient financial markets, and the inter-country risk. Foundations of Finance Pearson Prentice Hall

Principles Used in this Chapter
Principle 1: The Risk-Return Tradeoff - We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. Principle 6: Efficient Capital Markets - The Markets are Quick and the Prices Are Right. Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance. Foundations of Finance Pearson Prentice Hall

Federal Funds Rate Short-term market rate of interest Serves as a sensitivity indicator of the direction of future changes in interest rates Foundations of Finance Pearson Prentice Hall

Objectives of the Fed Maximum sustainable employment Price stability Foundations of Finance Pearson Prentice Hall

Recent Interest Rate Cycles
Early 1994 & 1997 Inflation Raise interest Rates Fall 1998 International Pressures Lower interest rates Summer 1999 Tight labor markets, aggregate real growth, inflation Raise interest rates Early 2001 Contracting manufacturing output, slower business capital spending, equity market sell-off, recession Summer 2004 Firming Labor market, stronger retail sales, improving industrial production, hot housing market, increases in energy prices, all suggesting unacceptable future rates of inflation. Foundations of Finance Pearson Prentice Hall

Nonfinancial Corporate Business Sources of Funds, 1981-2000
Changes in market conditions influence the way corporate funds are raised Example: High interest costs discourage the use of debt. Foundations of Finance Pearson Prentice Hall

Corporate Securities Offered for Cash
Nonfinancial Corporations- 3yr. Cash Weighted Average, Total Volume($M) $1,288,515 Source:Statistical Supplement to the Federal Reserve Bulletin, Table 1.46, October 2004, A29. Foundations of Finance Pearson Prentice Hall

Debt/Equity Mix U.S. tax system favors debt as means of raising capital Interest expense is deductible Dividends paid are not deductible Foundations of Finance Pearson Prentice Hall

Financial Markets Financial markets are institutions and procedures that facilitate transactions in all types of financial claims Financial markets exist in order to allocate the supply of savings in the economy to the demanders of those savings. Foundations of Finance Pearson Prentice Hall

Financial Markets Real assets are tangible assets such as houses, equipment, and inventories. Financial assets represent claims for future payments in other economic units. Foundations of Finance Pearson Prentice Hall

Financial Markets Underwriting — the purchase of financial claims of borrowing units and reselling them at a higher price to other investors. Secondary Markets — trading in already existing financial claims Financial Intermediaries — major financial institutions i.e. commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc. Foundations of Finance Pearson Prentice Hall

Financial Markets Indirect Securities – financial claims offered by financial intermediaries to economic units with excess savings Direct Securities – financial claims purchased by financial intermediaries with proceeds from the sale of indirect securities Foundations of Finance Pearson Prentice Hall

The Financing Process Sector Funds Raised ($) Funds Supplied ($) Net Funds Supplied ($) Households 447.4 397.1 (50.3) Nonfinancial Corporate Business 447.5 383.8 (63.7) U.S. Gov’t 73.9 62.9 (11.0) State and Local Gov’ts 56.4 48.4 ( 8.0) Foreign 320.2 561.7 241.5 Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1 (Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000). Foundations of Finance Pearson Prentice Hall

Movement of Savings Direct Transfer of Funds Indirect Transfer of Funds Using an Investment Banker Indirect Transfer of Funds Using the Financial Intermediary Foundations of Finance Pearson Prentice Hall

Three Ways to Transfer Financial Capital in the Economy
Foundations of Finance Pearson Prentice Hall

Public Offerings and Private Placements
Public Offering – both individuals and institutional investors have the opportunity to purchase securities Private Placement (direct placement) – the securities are offered and sold to a limited number of investors Foundations of Finance Pearson Prentice Hall

Primary and Secondary Markets
Primary Markets – Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy. Secondary Markets – Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy. Foundations of Finance Pearson Prentice Hall

Money Market and Capital Market
Money Market: all institutions and procedures that provide for transactions in short-term debt instruments Capital Market: all institutions and procedures that provide for transactions in long-term financial instruments Foundations of Finance Pearson Prentice Hall

Organized Security Exchanges and Over-the-Counter Markets
Organized Security Exchanges—Tangible entities; physically operate space, where financial instruments are traded on the premises National and regional exchanges New York Stock Exchange American Stock Exchange Chicago Stock Exchange Over-The-Counter Markets—All security markets except the organized exchanges Money Market Foundations of Finance Pearson Prentice Hall

Stock Exchange Benefits
Provides a continuous market Establishes and publicizes fair security prices Helps businesses raise new capital Foundations of Finance Pearson Prentice Hall

Listing Requirements Listing criteria varies from exchange to exchange. General requirements include: *Profitability *Market Value *Public Ownership Foundations of Finance Pearson Prentice Hall

Investment Banker A financial specialist involved as an intermediary in the merchandising of securities; facilitates flow of savings from economic units that want to invest in those units that want to raise funds. Foundations of Finance Pearson Prentice Hall

Functions of an Investment Banker
Underwriting Distributing Advising Foundations of Finance Pearson Prentice Hall

Distribution Methods Negotiated Purchase Competitive Bid Purchase Commission or Best Efforts Basis Privileged Subscription Direct Sales Foundations of Finance Pearson Prentice Hall

Private Placements Advantages Speed Reduced Flotation Costs Financing Flexibility Disadvantages Interest Costs Restrictive Covenants Possible Future SEC Registration Foundations of Finance Pearson Prentice Hall

Market Regulation Securities Act of 1933 — Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered. Securities Exchange Act of 1934 — Created SEC to enforce federal securities laws Securities Acts Amendments of 1975 —Created a national market system Foundations of Finance Pearson Prentice Hall

Securities Exchange Act of 1934
Major security exchanges must register with the SEC Insider trading is regulated Prohibits manipulative trading SEC control over proxy procedures Gives Board of Governors of Federal Reserve System responsibility for setting margin requirements Foundations of Finance Pearson Prentice Hall

Sarbanes-Oxley Act of 2002 Congress passed in July 2002 the Public Accounting and Reform and Investor Protection Act The Act contains 11 titles which tighten significantly the latitude given corporate advisors who have access to or influence company decisions. Foundations of Finance Pearson Prentice Hall

Sarbanes-Oxley Act of 2002 Key Elements
Public Company Accounting Oversight Board Auditor Independence Corporate Responsibility Enhanced Financial Decisions Analysts Conflicts of Interest Commission Resources and Authority Studies and Reports Corporate and Criminal Fraud Accountability White-Collar Crime Penalty Enhancements Corporate Tax Returns Corporate Fraud and Accountability Foundations of Finance Pearson Prentice Hall

Rates of Return in Financial Markets
Opportunity Cost — Rate of return on next best investment alternative to the investor Standard Deviation — Dispersion or variability around the mean, or average of the rate of return in the financial markets Maturity Premium — Additional return required by investors in long-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes Foundations of Finance Pearson Prentice Hall

Rates of Return in Financial Markets Liquidity Premium — Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price. Real Return — Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate) Real Rate of Interest — Rate of increase in actual purchasing power—after adjusting for inflation Foundations of Finance Pearson Prentice Hall

Term Structure of Interest Rates
The relationship between a debt security’s rate of return and the length of time until the debt matures. Also called “Yield to Maturity” Foundations of Finance Pearson Prentice Hall

Term Structure of Interest Rates
Explained by: Unbiased Expectations Theory Liquidity Preference Theory Market Segmentation Theory Foundations of Finance Pearson Prentice Hall

Unbiased Expectations Theory
Term Structure is determined by an Investor’s expectations about future interest rates. Foundations of Finance Pearson Prentice Hall

Liquidity Preference Theory
Investors require maturity premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates Foundations of Finance Pearson Prentice Hall

Market Segmentation Theory
Legal restrictions and personal preferences limit choices for investors to certain ranges of maturities Foundations of Finance Pearson Prentice Hall

Financial Markets and Intercountry Risk
Financial System Risk Political System Risk Exchange Rate Risk Foundations of Finance Pearson Prentice Hall

Chapter 3 Understanding Financial Statements and Cash Flows
Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 3 Understanding Financial Statements and Cash Flows

Chapter Objectives Compute a company’s profits as reflected by an income statement. Determine a firm’s accounting book value, as presented in a balance sheet. Measure a company’s free cash flows. Foundations of Finance Pearson Prentice Hall

Principle 3: Cash-Not Profits-Is King Principle 7: Managers Won’t Work for the Owners Unless It’s in Their Best Interest Foundations of Finance Pearson Prentice Hall

Basic Financial Statements
Income Statement Balance Sheet Statement of Cash Flows Foundations of Finance Pearson Prentice Hall

Income Statement Profit/Loss Statement Indicates the amount of profits generated by a firm over a given period of time Sales – Expenses = Profit Foundations of Finance Pearson Prentice Hall

Income Statement Terminology
Revenue (Sales) Money derived from selling the company’s product or service Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services to be sold Operating Expenses Expenses related to marketing and distributing the product or service and administering the business Financing Costs The interest paid to creditors and the dividends paid to preferred stockholders Tax Expenses Amount of taxes owed, based upon taxable income Foundations of Finance Pearson Prentice Hall

Income Statement Sales Less cost of goods sold = Gross profit Less operating expenses = Operating income Less interest expense = Earnings before taxes Less corporate taxes = Earnings before preferred dividends Less preferred stock dividends = Net income available to common stockholders Foundations of Finance Pearson Prentice Hall

Starbucks Corporation Income Statement 2003 ($M)
Sales $4,076 Cost of Goods Sold ,207 Gross Profit $ 869 Operating Expenses Marketing expenses and general and Administrative expenses $227 Depreciation Expense Total Operating Expenses $ 433 Operating Profits $ 436 Interest Expense Earnings before taxes $ 433 Income taxes Net income $ 268 Foundations of Finance Pearson Prentice Hall

Balance Sheet Provides a firm’s financial position at a specific point in time Assets are resources owned by the firm Liabilities and owner’s equity indicate how those resources are financed Total Assets = Liabilities (debt) + Shareholder’s Equity Or…A= L+OE Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology
Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include: Cash Accounts Receivable payments due from customers who buy on credit Inventory raw materials, work in process, and finished goods held for eventual sale Other expenses Prepaid expenses are those items paid for in advance Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology Fixed Assets – Assets held for more than one year. Typically Include: Machinery and equipment Buildings Land Other Assets – Assets that are not current assets or fixed assets Patents Copyrights Goodwill Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology Debt (Liabilities) Money that has been borrowed and must be repaid at some predetermined date Debt Capital financing provided by a creditor Current or short-term debt and long-term debt Current or short-term must be repaid within the next 12 months Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology Current Liabilities: Accounts payable Credit extended by suppliers to a firm when it purchases inventories Accrued expenses Short term liabilities incurred in the firm’s operations but not yet paid for Short-term notes Borrowings from a bank or lending institution due and payable within 12 months Long-Term Debt Loans from banks or other institutions for longer than 12 months Foundations of Finance Pearson Prentice Hall

Balance Sheet Terminology Equity Includes the shareholder’s investment Preferred stock Common stock Treasury Stock stock that was once outstanding and has been re-purchased by the company Retained Earnings cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years Foundations of Finance Pearson Prentice Hall

Balance Sheet ASSETS Current Assets Fixed Assets Total Assets LIABILITIES Current Liabilities Long-Term Liabilities Total Liabilities OWNER’S EQUITY Preferred Stock Common Stock Retained earnings Total Owner’s Equity Total liabilities + OE Foundations of Finance Pearson Prentice Hall

Terms Net Working Capital Current assets – current liabilities Debt Ratio Percentage of debt a firm uses to finance its assets Accrual Basis Accounting Recording revenues when earned and expenses when incurred, rather than when cash is exchanged Free Cash Flows Cash flow that is free and available to be distributed to the firm’s investors. Foundations of Finance Pearson Prentice Hall

Free Cash Flows Free cash flows: (After-tax cashflows from operations) Less (Increase or decrease in net working capital) (Increase or decrease in gross fixed assets) Foundations of Finance Pearson Prentice Hall

Traditional Statement of Cash Flows
Three sections: Cash flows from Operating Activities Cash flows from Investing Activities Cash flows from Financing Activities Foundations of Finance Pearson Prentice Hall

After-Tax Cash Flows From Operations
Operating Income (EBIT) + Depreciation - Income tax expense = After-tax cash flows from operations Foundations of Finance Pearson Prentice Hall

Change in Operating Working Capital
(change in current assets) - (change in current liabilities) Foundations of Finance Pearson Prentice Hall

Compute the Change in Fixed Assets
The final step involves computing the change in Gross Fixed Assets (not net Fixed Assets) Foundations of Finance Pearson Prentice Hall

Starbucks Free Cash Flows ($M)
After-tax cash flows from operations $477 Less 2003 investments in: Investments in net working capital $ 4 Investments in Long Term Assets Total investments $ 570 Free cash flows $ (93) Foundations of Finance Pearson Prentice Hall

Financing Cash Flows A firm can either receive money from or distribute money to its investors. The firm can: Pay interest to lenders Pay dividends to stockholders Increase or decrease in long-term debt Issue stock to new shareholders or repurchase stock from current shareholders Foundations of Finance Pearson Prentice Hall

Chapter 4 Evaluating a Firm’s Financial Performance
Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 4 Evaluating a Firm’s Financial Performance

Learning Objectives After reading this chapter, you should be able to: Explain the purpose and importance of financial analysis. Calculate and use a comprehensive set of measurements to evaluate a company’s performance. Describe the limitations of financial ratio analysis. Foundations of Finance Pearson Prentice Hall

Principle 7: Managers Won’t Work the Owners Unless it is their best Interest. Principle 5: The Curse of Competitive Markets – Why It’s Hard to Find Exceptionally Profitable Markets. Principle 1: The Risk Return Trade-Off – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. Foundations of Finance Pearson Prentice Hall

Financial Ratios Ratios give us two ways of making meaningful comparisons of a firm’s financial data: Trends across time Comparisons with other firms’ ratios Foundations of Finance Pearson Prentice Hall

Uses of Financial Ratios within the Firm
Identify deficiencies in a firm’s performance and take corrective actions. Evaluate employees’ performance and determine incentive compensation. Compare the financial performance of different divisions within the firm Foundations of Finance Pearson Prentice Hall

Uses of Financial Ratios within the Firm
Prepare financial projections, both at the firm and division levels. Understand the financial performance of competitors Evaluate the financial condition of a major supplier. Foundations of Finance Pearson Prentice Hall

Uses of Financial Ratios Outside the Firm
Lenders in deciding whether or not to make a loan to a company. Credit-rating agencies in determining a firm’s credit worthiness. Investors in deciding whether or not to invest in a company. Major suppliers in deciding to sell and grant credit terms to a company. Foundations of Finance Pearson Prentice Hall

Measuring Key Financial Relationships
How liquid is the firm? Is management generating adequate operating profits on the firm’s assets? How is the firm financing its assets? Is management providing a good return on the capital provided by the shareholders? Is the management team creating shareholder value? Foundations of Finance Pearson Prentice Hall

How Liquid Is a Firm? Liquidity is the ability to have cash available when needed to meet its financial obligations Measured by two approaches: Comparing the firm’s assets that are relatively liquid Examines the firm’s ability to convert accounts receivables and inventory into cash in a timely basis Foundations of Finance Pearson Prentice Hall

Measuring Liquidity: Approach 1
Compare a firm’s current assets with current liabilities Current Ratio Acid Test or Quick Ratio Foundations of Finance Pearson Prentice Hall

Current Ratio Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year Current assets/Current liabilities Starbucks Example: Current ratio= $922M / $591M = 1.67 Foundations of Finance Pearson Prentice Hall

Acid Test or Quick Ratio
Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year. Cash and accounts receivable/Current liabilities Starbucks Example Quick Ratio= ($350M + $114M) / $591M =1.05 Foundations of Finance Pearson Prentice Hall

Measuring Liquidity: Approach 2
Measures a firm’s ability to convert accounts receivable and inventory into cash Average Collection Period Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle Foundations of Finance Pearson Prentice Hall

Average Collection Period
How long it takes to collect the firm’s receivables Accounts receivable/(Annual credit sales/365) Starbucks Example: Avg. Collection Period = $114M / $1.68M= 68.1 days Foundations of Finance Pearson Prentice Hall

Accounts Receivable Turnover
How many times accounts receivable are “rolled over” during a year Credit sales/Accounts receivable Starbucks Example Accounts Receivable Turnover = $611M / $114M = 5.36X Foundations of Finance Pearson Prentice Hall

Inventory Turnover How many times is inventory rolled over during the year? Cost of goods sold/Inventory Starbucks Example Inventory Turnover= $3,207M / $342M = 9.38X Foundations of Finance Pearson Prentice Hall

Starbucks vs. Peer Group
Ratio Starbucks Peers Current 1.67 2.02 Quick 1.05 1.54 Avg. Collection Period 68.1 days 93 days Accounts Receivable Turnover 5.36X 3.90X Inventory Turnover 9.38X 8.5X Foundations of Finance Pearson Prentice Hall

Is Management Generating Adequate Operating Profits on the Firm’s Assets? Operating Return on Assets (OROA) Operating Profit Margin Total Asset Turnover Fixed Asset Turnover Foundations of Finance Pearson Prentice Hall

Operating Return on Assets
Level of profits relative to total assets Operating return/Total assets Starbucks Example Operating Return On Assets = $436M / $2,672M = .163 or 16.3% Foundations of Finance Pearson Prentice Hall

Operating Profit Margin
Examines how effective the company is managing its operations Operating profit/Sales Starbucks Example Operating Profit Margin = $436M / $4,067M = .107 or 10.7% Foundations of Finance Pearson Prentice Hall

Total Asset Turnover How efficiently a firm is using its assets in generating sales Sales/Total assets Starbucks Example Total Asset Turnover = $4,076M / $2,672M = 1.53X Foundations of Finance Pearson Prentice Hall

Fixed Asset Turnover Examines investment in fixed assets for sales being produced Sales/Fixed assets Starbucks Example Fixed Asset Turnover = $4,076M / $1,750M = 2.33X Foundations of Finance Pearson Prentice Hall

Ratio Starbucks Peers Operating Return on Assets 16.3% 14.9% Operating Profit Margin 10.7% 11.8% Total Asset Turnover 1.53X 1.26X Fixed Asset Turnover 2.33X 2.75X Foundations of Finance Pearson Prentice Hall

How Is the Firm Financing Its Assets?
Does the firm finance assets more by debt of equity? Debt Ratio Times Interest Earned Foundations of Finance Pearson Prentice Hall

Debt Ratio What percentage of the firm’s assets are financed by debt? Total debt/Total assets Starbucks Example Debt ratio = $591M / $2,672M = .221 or 22.1% Foundations of Finance Pearson Prentice Hall

Times Interest Earned Examines the amount of operating income available to service interest payments Operating income/Interest Starbucks Example Times Interest Earned = $436M / $3M = 145.3X Foundations of Finance Pearson Prentice Hall

Ratio Starbucks Peers Debt Ratio 22.1% 25% Times Interest Earned 145.3X 46.0X Foundations of Finance Pearson Prentice Hall

Is Management Providing a Good Return on the Capital Provided by the Shareholders? Are the earnings available to shareholders attractive Return on equity Net income/Common equity Starbucks Example Return on Equity = $268M / $208M = .129 or 12.9% Foundations of Finance Pearson Prentice Hall

Ratio Starbucks Peers Return on Equity 12.9% 12.0% Foundations of Finance Pearson Prentice Hall

How Is Management Doing Creating Shareholder Value?
These ratios indicate what investors think of management’s past performance and future prospects. Two approaches: Price/Earnings ratio Price/Book ratio Foundations of Finance Pearson Prentice Hall

Price/Earnings Ratio Measures how much investors are willing to pay for $1 of reported earnings Price per share/Earnings per share Starbucks Example Price/Earnings Ratio = $35.00 / $0.69 = 51X Foundations of Finance Pearson Prentice Hall

Price/Book Ratio Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet Price per share/Equity book value per share Starbucks Example Price/Book Ratio = $35.00 / $5.32= 6.58X Foundations of Finance Pearson Prentice Hall

Starbucks vs. S&P Index Price
Ratio Starbucks S&P Price/Earnings 51X 24X Price/Book Ratio 6.58X 3X Foundations of Finance Pearson Prentice Hall

Economic Value Added (EVA)
Measures a firm’s economic profit, rather than accounting profit Recognizes a cost of equity and a cost of debt EVA = (r-k) X C where: r = Operating return on assets k = Total cost of capital C = Amount of capital (Total Assets) invested in the firm Foundations of Finance Pearson Prentice Hall

Limitations of Ratio Analysis
Difficulty in identifying industry categories or finding peers Published peer group or industry averages are only approximations Accounting practices differ among firms Financial ratios can be too high or too low Industry averages may not provide a desirable target ratio or norm Use of average account balances to offset effects of seasonality Foundations of Finance Pearson Prentice Hall

Chapter 5 The Time Value of Money
Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 5 The Time Value of Money

Learning Objectives Explain the mechanics of compounding, which is how money grows over a time when it is invested. Be able to move money through time using time value of money tables, financial calculators, and spreadsheets. Discuss the relationship between compounding and bringing money back to present. Foundations of Finance Pearson Prentice Hall

Learning Objectives Define an ordinary annuity and calculate its compound or future value. Differentiate between an ordinary annuity and an annuity due and determine the future and present value of an annuity due. Determine the future or present value of a sum when there are nonannual compounding periods. Foundations of Finance Pearson Prentice Hall

Learning Objectives Determine the present value of an uneven stream of payments Determine the present value of a perpetuity. Explain how the international setting complicates the time value of money. Foundations of Finance Pearson Prentice Hall

Principle 2: The Time Value of Money – A Dollar Received Today Is Worth More Than a Dollar Received in The Future. Foundations of Finance Pearson Prentice Hall

Simple Interest Interest is earned on principal $100 invested at 6% per year 1st year interest is $6.00 2nd year interest is $6.00 3rd year interest is $6.00 Total interest earned: $18.00 Foundations of Finance Pearson Prentice Hall

Compound Interest When interest paid on an investment during the first period is added to the principal; then, during the second period, interest is earned on the new sum. Foundations of Finance Pearson Prentice Hall

Compound Interest Interest is earned on previously earned interest $100 invested at 6% with annual compounding 1st year interest is $6.00 Principal is $106.00 2nd year interest is $6.36 Principal is $112.36 3rd year interest is $6.74 Principal is $119.11 Total interest earned: $19.11 Foundations of Finance Pearson Prentice Hall

Future Value - The amount a sum will grow in a certain number of years when compounded at a specific rate. Foundations of Finance Pearson Prentice Hall

Future Value FV1 = PV (1 + i) Where FV1 = the future of the investment at the end of one year i= the annual interest (or discount) rate PV = the present value, or original amount invested at the beginning of the first year Foundations of Finance Pearson Prentice Hall

Future Value What will an investment be worth in 2 years? $100 invested at 6% FV2= PV(1+i)2 = $100 (1+.06)2 $100 (1.06)2 = $112.36 Foundations of Finance Pearson Prentice Hall

Future Value Future Value can be increased by: Increasing number of years of compounding Increasing the interest or discount rate Foundations of Finance Pearson Prentice Hall

Future Value Using Tables
FVn = PV (FVIFi,n) Where FVn = the future of the investment at the end of n year PV = the present value, or original amount invested at the beginning of the first year FVIF = Future value interest factor or the compound sum of $1 i= the interest rate n= number of compounding periods Foundations of Finance Pearson Prentice Hall

Future Value What is the future value of $500 invested at 8% for 7 years? (Assume annual compounding) Using the tables, look at 8% column, 7 time periods. What is the factor? FVn= PV (FVIF8%,7yr) = $500 (1.714) = $857 Foundations of Finance Pearson Prentice Hall

Future Value Using Calculators
Using any four inputs you will find the 5th. Set to P/YR = 1 and END mode. INPUTS OUTPUT N 10 I/YR 6 -100 PV PMT FV 179.10 Foundations of Finance Pearson Prentice Hall

Future Value Using Spreadsheets
Foundations of Finance Pearson Prentice Hall

Present Value The current value of a future payment PV = FVn {1/(1+i)n} Where FVn = the future of the investment at the end of n years n= number of years until payment is received i= the interest rate PV = the present value of the future sum of money Foundations of Finance Pearson Prentice Hall

Present Value What will be the present value of $500 to be received 10 years from today if the discount rate is 6%? PV = $500 {1/(1+.06)10} = $500 (1/1.791) = $500 (.558) = $279 Foundations of Finance Pearson Prentice Hall

Present Value Using Tables
PVn = FV (PVIFi,n) Where PVn = the present value of a future sum of money FV = the future value of an investment at the end of an investment period PVIF = Present Value interest factor of $1 i= the interest rate n= number of compounding periods Foundations of Finance Pearson Prentice Hall

Present Value What is the present value of $100 to be received in 10 years if the discount rate is 6%? PVn = FV (PVIF6%,10yrs.) = $100 (.558) = $55.80 Foundations of Finance Pearson Prentice Hall

Present Value Using Calculators
Using any four inputs you will find the 5th. Set to P/YR = 1 and END mode. INPUTS OUTPUT N 10 PV -55.84 I/YR 6 PMT FV 100.00 Foundations of Finance Pearson Prentice Hall

Annuity Series of equal dollar payments for a specified number of years. Ordinary annuity payments occur at the end of each period Foundations of Finance Pearson Prentice Hall

Compound Annuity Depositing or investing an equal sum of money at the end of each year for a certain number of years and allowing it to grow. Foundations of Finance Pearson Prentice Hall

Compound Annuity FV5 = $500 (1+.06)4 + $500 (1+.06)3 +$500(1+.06)2 + $500 (1+.06) + $500 = $500 (1.262) + $500 (1.191) $500 (1.124) + $500 (1.090) $500 = $ $ $ $ $500 = $2,818.50 Foundations of Finance Pearson Prentice Hall

Illustration of a 5yr $500 Annuity Compounded at 6%
1 2 3 4 5 6% 500 500 500 500 500 Foundations of Finance Pearson Prentice Hall

Future Value of an Annuity
FV = PMT {(FVIFi,n-1)/ i } Where FV n= the future of an annuity at the end of the nth years FVIFi,n= future-value interest factor or sum of annuity of $1 for n years PMT= the annuity payment deposited or received at the end of each year i= the annual interest (or discount) rate n = the number of years for which the annuity will last Foundations of Finance Pearson Prentice Hall

Compounding Annuity What will $500 deposited in the bank every year for 5 years at 10% be worth? FV = PMT {(FVIFi,n-1)/ i } Simplified this equation is: FV5 = PMT(FVIFAi,n) = $500(5.637) = $2,818.50 Foundations of Finance Pearson Prentice Hall

Future Value of an Annuity Using Calculators
Using any four inputs you will find the 5th. Set to P/YR = 1 and END mode. INPUTS OUTPUT N 5 FV -2,818.55 PV I/YR 6 PMT 500 Foundations of Finance Pearson Prentice Hall

Present Value of an Annuity
Pensions, insurance obligations, and interest received from bonds are all annuities. These items all have a present value. Calculate the present value of an annuity using the present value of annuity table. Foundations of Finance Pearson Prentice Hall

Present Value of an Annuity
Calculate the present value of a $500 annuity received at the end of the year annually for five years when the discount rate is 6%. PV = PMT(PVIFAi,n) = $500(4.212) = $2,106 Foundations of Finance Pearson Prentice Hall

Annuities Due Ordinary annuities in which all payments have been shifted forward by one time period. Foundations of Finance Pearson Prentice Hall

Amortized Loans Loans paid off in equal installments over time Typically Home Mortgages Auto Loans Foundations of Finance Pearson Prentice Hall

Payments and Annuities
If you want to finance a new machinery with a purchase price of $6,000 at an interest rate of 15% over 4 years, what will your payments be? Foundations of Finance Pearson Prentice Hall

Future Value Using Calculators
Using any four inputs you will find the 5th. Set to P/YR = 1 and END mode. INPUTS OUTPUT N 4 PMT -2,101.59 PV 6,000 I/YR 15 FV Foundations of Finance Pearson Prentice Hall

Amortization of a Loan Reducing the balance of a loan via annuity payments is called amortizing. A typical amortization schedule looks at payment, interest, principal payment and balance. Foundations of Finance Pearson Prentice Hall

Amortization Schedule
Yr. Annuity Interest Principal Balance 1 $2,101.58 $900.00 $1,201.58 $4,798.42 2 719.76 1,381.82 3,416.60 3 512.49 1,589.09 1,827.51 4 274.07 Foundations of Finance Pearson Prentice Hall

Compounding Interest with Non-annual periods
If using the tables, divide the percentage by the number of compounding periods in a year, and multiply the time periods by the number of compounding periods in a year. Example: 8% a year, with semiannual compounding for 5 years. 8% / 2 = 4% column on the tables N = 5 years, with semiannual compounding or 10 Use 10 for number of periods, 4% each Foundations of Finance Pearson Prentice Hall

Perpetuity An annuity that continues forever is called perpetuity The present value of a perpetuity is PV = PP/i PV = present value of the perpetuity PP = constant dollar amount provided by the of perpetuity i = annuity interest (or discount rate) Foundations of Finance Pearson Prentice Hall

The Multinational Firm
Principle 1- The Risk Return Tradeoff – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return The discount rate is reflected in the rate of inflation. Inflation rate outside US difficult to predict Inflation rate in Argentina in 1989 was 4,924%, in 1990 dropped to 1,344%, and in 1991 it was only 84%. Foundations of Finance Pearson Prentice Hall

Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management.

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Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management.

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Presentation on theme: "Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management."— Presentation transcript:

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