1. 3-0 Week 2 Lecture 2 Ross, Westerfield and Jordan 7e Chapter 3 Financial Statements, Taxes and Cash Flows Chapter 5 Introduction to Valuation: The Time Value for Money

2. 3-1 Last Week.. Main areas of Corporate Finance Capital Budgeting Capital Structure Working Capital Management Financial Management Goal = Maximise shareholder’s value Market Value vs Book Value Cash Flows matter in Valuation

3. 3-2 Chapter 3 Outline Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The DuPont Identity Using Financial Statement Information

4. 3-3 Sample Balance Sheet 2003200220032002 Cash69658A/P307303 A/R956992N/P26119 Inventory301361Other CL1,6621,353 Other CA303264Total CL1,9951,775 Total CA2,2561,675LT Debt8431,091 Net FA3,1383,358Equity2,5562,167 Total Assets 5,3945,033Total Liab. & Equity 5,3945,033 Numbers in millions

5. 3-4 Sample Income Statement Revenues5,000 Cost of Goods Sold2,006 Expenses1,740 Depreciation116 EBIT1,138 Interest Expense7 Taxable Income1,131 Taxes 442 Net Income689 EPS3.61 Dividends per share1.08 (190.9 mil. Shares) Numbers in millions, except EPS & DPS

6. 3-5 Sources and Uses Sources Cash inflow – occurs when we “sell” something Decrease in asset account (Sample B/S)Sample B/S Accounts receivable, inventory, and net fixed assets Increase in liability or equity account Accounts payable, other current liabilities, and common stock Uses Cash outflow – occurs when we “buy” something Increase in asset account Accounts receivable, and other current assets Decrease in liability or equity account Notes payable and long-term debt

7. 3-6 Statement of Cash Flows Statement that summarizes the sources and uses of cash Changes divided into three major categories Operating Activity – includes net income and changes in most current accounts Investment Activity – includes changes in fixed assets Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends

8. 3-7 Sample Statement of Cash Flows Cash, beginning of year58Financing Activity Operating Activity Decrease in Notes Payable (u)-93 Net Income689 Decrease in LT Debt (u)-248 Plus: Depreciation116 Decrease in Eq (minus RE) (u)-94 Decrease in A/R (s)36 Dividends Paid (u)-206 Decrease in Inventory (s)60 Net Cash from Financing-641 Increase in A/P (s)4Net Increase in Cash (1175+104-641)638 Increase in Other CL (s)309Cash End of Year (58+638)696 Less: Increase in CA (u)-39 Net Cash from Operations1,175 Investment Activity Change in RE 689 – 206 = 483 Sale of Fixed Assets (s)104 Decrease in Equity 2556-2167-483= -94 Net Cash from Investments104 Numbers in millions Sale of FA: 3138-3358+116= -104

9. 3-8 Standardized Financial Statements Common-Size Balance Sheets - Table 3.5 Compute all accounts as a percent of total assets Common-Size Income Statements - Table 3.6 Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry

10. 3-9 Ratio Analysis Ratios also allow for better comparison through time or between companies Ratios are used both internally and externally Be aware! There is a large number of possible ratios Different people compute ratios in different ways

11. 3-10 Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

12. 3-11 Computing Liquidity Ratios Current Ratio = CA / CL 2256 / 1995 = 1.13 times Quick Ratio = (CA – Inventory) / CL (2256 – 301) / 1995 =.98 times Cash Ratio = Cash / CL 696 / 1995 =.35 times NWC to Total Assets = NWC / TA (2256 – 1995) / 5394 =.05 Interval Measure = CA / average daily operating costs 2256 / ((2006 + 1740)/365) = 219.8 days

13. 3-12 Computing Long-term Solvency Ratios (Financial Leverage Ratios) Total Debt Ratio = (TA – TE) / TA = TD/TA (5394 – 2556) / 5394 = 52.61% Debt/Equity = TD / TE = D/E (5394 – 2556) / 2556 = 1.11 times Equity Multiplier = TA / TE = A/E = 1 + D/E 5394 / 2556 = 2.11 1 + 1.11 = 2.11 Long-term debt ratio = LTD / (LTD + TE) 843 / (843 + 2556) = 24.80%

14. 3-13 Computing Coverage Ratios part of Long Term Solvency Ratios Times Interest Earned = EBIT / Interest 1138 / 7 = 162.57 times Cash Coverage = (EBIT + Depreciation) / Interest (1138 + 116) / 7 = 179.14 times

15. 3-14 Computing Inventory Ratios part of Asset Management Ratios Inventory Turnover = Cost of Goods Sold / Inventory 2006 / 301 = 6.66 times Days’ Sales in Inventory = 365 / Inventory Turnover 365 / 6.66 = 55 days

16. 3-15 Computing Receivables Ratios part of Asset Management Ratios Receivables Turnover = Sales / Accounts Receivable 5000 / 956 = 5.23 times Days’ Sales in Receivables = 365 / Receivables Turnover 365 / 5.23 = 70 days

17. 3-16 Computing Total Asset Turnover part of Asset Management Ratios Total Asset Turnover = Sales / Total Assets 5000 / 5394 =.9269 It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets NWC Turnover = Sales / NWC 5000 / (2256 – 1995) = 19.16 times Fixed Asset Turnover = Sales / NFA 5000 / 3138 = 1.59 times

18. 3-17 Computing Profitability Measures Profit Margin = Net Income / Sales 689 / 5000 = 13.78% Return on Assets (ROA) = Net Income / Total Assets 689 / 5394 = 12.77% Return on Equity (ROE) = Net Income / Total Equity 689 / 2556 = 26.96%

19. 3-18 Computing Market Value Measures Market Price = $87.65 per share Shares outstanding = 190.9 million PE Ratio = Price per share / Earnings per share 87.65 / 3.61 = 24.28 times Market-to-book ratio = market value per share / book value per share 87.65 / (2556 / 190.9) = 6.56 times

20. 3-19 Deriving the DuPont Identity ROE = Net Income/ Total Equity Multiply top and bottom by Total Assets and then rearrange ROE = (NI/ TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM Multiply ROA by Sales and then rearrange ROE = (Sales / Sales) (NI / TA) (TA / TE) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

21. 3-20 Using the DuPont Identity ROE = PM * TAT * EM PM - Profit margin is a measure of the firm’s operating efficiency – how well does it control costs TAT - Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets EM - Equity multiplier is a measure of the firm’s financial leverage

22. 3-21 DuPont Example Calculated previously: ROE = Net Income/ Total Equity = 26.96% Using DuPont Identity: ROE = PM * TAT * EM ROE = 13.78% * 0.9269 * 2.11 = 26.96%

23. 3-22 Why Evaluate Financial Statements? Internal uses Performance evaluation – compensation and comparison between divisions Planning for the future – guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders

24. 3-23 Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm’s performance is changing through time Peer Group Analysis Compare to similar companies or with the industry

25. 3-24 Potential Problems There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events

26. 3-25 End of Chapter 3

27. 3-26 Week 2 Lecture 2 Ross, Westerfield and Jordan 7e Chapter 5 Introduction to Valuation: The Time Value for Money

28. 3-27 Chapter 5 Outline Future Value and Compounding Present Value and Discounting More on Present and Future Values Determine the return on an investment Calculate the number of periods Use excel to solve problems

29. 3-28 Future Values Suppose you invest $1000 for one year at 5% per year. What is the future value in one year? Interest = 1000(.05) = 50 Value in one year = principal + interest = 1000 + 50 = 1050 Future Value (FV) = 1000 +1000(.05) = 1000 (1+.05) = 1050 Suppose you leave the money in for another year. How much will you have two years from now? FV = 1000(1.05)(1.05) = 1000(1.05) 2 = 1102.50

30. 3-29 Future Values: General Formula FV = PV(1 + r) t FV = future value PV = present value r = period interest rate, expressed as a decimal t = number of periods Future value interest factor = (1 + r) t “r” also known as: Discount rate Cost of capital Required return

31. 3-30 Simple vs Compound Interest Simple interest interest earned each period only on the principal Compound interest Interest is reinvested each period – interest on interest Consider the previous example FV with simple interest = 1000 + 50 + 50 = 1100 1000+1000(.05)+1000(.05) FV with compound interest=1000 + 50 + 52.50 = 1102.5 1000+1000(.05)+1050(.05) The extra 2.50 comes from the interest of.05(50) = 2.50 earned on the first interest payment

32. 3-31 Future Values – Example 2 Suppose you invest the $1000 from the previous example at 5% per year, for 5 years. How much would you have at the end of 5 years? FV = 1000(1.05) 5 = 1276.28 The effect of compounding is small for a small number of periods, but increases as the number of periods increases. What would be the future value using simple interest ?

33. 3-32 Future Values – Example 3 Suppose you had a relative deposit $10 at 5.5% pa interest 200 years ago. How much would the investment be worth today? FV = 10(1.055) 200 = 447,189.84 What is the effect of compounding? Simple interest = 10 + 200(10)(.055) = 120.00 Compounding added $447,069.84 to the value of the investment

34. 3-33 Quick Quiz – Part I What is the difference between simple interest and compound interest? Suppose you have $500 to invest and you believe that you can earn 8% per year over the next 15 years. How much would you have at the end of 15 years using compound interest? How much would you have using simple interest?

35. 3-34 Present Values How much do I have to invest today to have some amount in the future? FV = PV(1 + r) t Rearrange to solve for PV = FV / (1 + r) t PVIF = 1/(1+r) t When we talk about discounting, we mean finding the present value of some future amount. PV = the current value of future cash flows discounted at the appropriate discount rate

36. 3-35 Present Value – Examples Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today? PV = 10,000 / (1.07) 1 = 9345.79 You want to begin saving for your child’s education and you estimate that the cost will be $150,000 in 17 years. You feel confident that you can earn 8% per year, how much do you need to invest today? PV = 150,000 / (1.08) 17 = 40,540.34

37. 3-36 Present Value – Important Relationships For a given interest rate – the longer the time period, the lower the present value What is the present value of $500 to be received in 5 years? 10 years? The discount rate is 10% 5 years: PV = 500 / (1.1) 5 = 310.46 10 years: PV = 500 / (1.1) 10 = 192.77 For a given time period – the higher the interest rate, the smaller the present value What is the present value of $500 received in 5 years if the interest rate is 10%? 15%? Rate = 10%: PV = 500 / (1.1) 5 = 310.46 Rate = 15%; PV = 500 / (1.15) 5 = 248.59

38. 3-37 Quick Quiz – Part II What is the mathematical relationship between present value and future value? Suppose you need $15,000 in 3 years. If you can earn 6% annually, how much do you need to invest today? If you could invest the money at 8%, would you have to invest more or less than at 6%? How much?

39. 3-38 Future and Present Values FV = PV (1+r) t PV = FV / (1 + r) t = FV(1+r) -t There are four parts to these equations PV, FV, r and t If we know any three, we can solve for the fourth To find r FV = PV(1 + r) t (FV/PV) = (1+r) t 1+r = (FV/PV) 1/t r = (FV/PV) 1/t – 1 To find t FV = PV(1 + r) t (FV/PV) = (1 + r) t LN(FV/PV) = t x LN(1+r) t = LN(FV/PV)/LN(1 + r)

40. 3-39 Finding the Rate r – Example 1 You are looking at an investment that will pay $1200 in 5 years if you invest $1000 today. What is the implied rate of interest? FV = PV(1+r) t 1200 = 1000(1+r) 5 1200/1000 = (1+r) 5 (1200/1000) 1/5 = 1+r r = (1200 / 1000) 1/5 – 1 = (1.2) 1/5 – 1= 1.03714 -1 =.03714 = 3.714%

41. 3-40 Finding r – More Examples Suppose you are offered an investment that will allow you to double your money in 6 years. You have $10,000 to invest. What is the implied rate of interest? r = (20,000 / 10,000) 1/6 – 1 =.122462 = 12.25% Suppose you have a 1-year old son and you want to provide $75,000 in 17 years towards his college education. You currently have $5000 to invest. What interest rate must you earn to have the $75,000 when you need it? r = (75,000 / 5,000) 1/17 – 1 =.172688 = 17.27%

42. 3-41 Finding the Number of Periods t – Example 1 You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car? FV = PV(1 + r) t 20000 = 15000(1+.1) t 20000/15000 = (1.1) t LN(20,000 / 15,000) = t x LN(1.1) t = LN(20,000 / 15,000) / LN(1.1) t = LN(1.3333)/ LN(1.1) = 0.2876 / 0.0953 = 3.02 years

43. 3-42 Number of Periods – Example 2 Suppose you want to buy a new house. You currently have $15,000 and you figure you need to have a 10% deposit plus an additional 5% of the loan amount for loan fees. Assume the type of house you want will cost about $150,000 and you can earn 7.5% per year, how long will it be before you have enough money for the deposit and fees?

44. 3-43 Number of Periods – Example 2 Continued How much do you need to have in the future? Deposit =.1(150,000) = 15,000 Loan becomes = 150000-15000 = 135000 Fees =.05(135000) = 6,750 Total needed = 15,000 + 6,750 = 21,750 Compute the number of periods PV = 15,00021,750 = 15,000(1+0.075) t FV = 21,75021,750/15,000 = (1.075) t r = 7.5% Solving for the number of periods: t = LN(21,750 / 15,000) / LN(1.075) = 5.14 years

45. 3-44 Spreadsheet Example Use the following formulas for calculations FV(rate,nper,pmt,pv) PV(rate,nper,pmt,fv) RATE(nper,pmt,pv,fv) NPER(rate,pmt,pv,fv)

46. 3-45 Work the Web Example Many financial calculators are available online Go to Investopedia’s web site and work the following example: You need $50,000 in 10 years. If you can earn 6% interest, how much do you need to invest today? You should get $27,919.74 www.investopedia.com/calculator

47. 3-46 Table 5.4

48. 3-47 End of Lecture 2