Post on 01-Jan-2016
description
1. OBTAIN FINANCING•Short term debt•Long term debt•Stocks
MODEL OF THE FIRM
2. INVEST IN RESOURCES•Current assets•Fixed assets
3. TO RUN OPERATIONS•Revenues•Expenses
1. OBTAIN FINANCING
•Short term debt
MODEL OF THE FIRM
Accounts payableNotes payableAccrued expenses
•Long term debtCorporate bonds
NYSE
•StocksCommon stockPreferred stock
MODEL OF THE FIRM
2. INVEST IN RESOURCES
•Current assetsCashMarketable securitiesAccounts receivableInventories
•Fixed assetsPlant and equipmentAccumulated depreciation
MODEL OF THE FIRM
3. TO RUN OPERATIONS
•Operating profits
Total salesCost of goods soldGross margins
•Net profits
Selling and adminInterest expensesTaxesNet profit margin
WHAT the firm does:
WHY the firm does it:
HOW the firm does it:
MAXIMIZE SHAREHOLDER WEALTH
MINIMIZE RISK / MAXIMIZE RETURNS
MODEL OF THE FIRM1. OBTAIN FINANCING2. INVEST IN RESOURCES3. TO RUN OPERATIONS
BASIC CONCEPTS
•Investment: What assets should the firm acquire and how much money should they spend?
•Financing: What securities should the firm issue and how much should be raised issuing stocks and bonds?
•Dividends: What portion of the firm’s profits should be paid in dividends (payout ratio)?
•Working Capital: Management of current assets and current liabilities.
FINANCIAL RATIOS(using financial statements)
•Balance sheet - Common-sized balance sheet shows assets,liabilities, and equity as a % of total assets.
•Income statement - Common-sized income statement shows income and expense items as a % of sales.
•Statement of cash flows
INCOME STATEMENT(Common Size)
(Each line item as a percent of sales)
($ amount) (% of sales)
Sales $2,311 100.0%COGS 1,344 58.2Depreciation 276 11.9EBIT 691 29.9Interest paid 141 6.1Taxable income 550 23.8Taxes (34%) 187 8.1Net income 363 15.7%
Dividends $121 5.2% Addition to RE 242 10.5
BALANCE SHEET(Common Size)
(Each item as a percent of total assets)
($ amt) (% tot. assets)
Current Assets cash $ 84 2.5% AR 165
4.9Inventory 393 11.7
Total $ 642 19.1Fixed Assets
Net P & E $2,731 80.9
Total assets $3,373 100.0%
FINANCIAL RATIOS(standardized measures)
•Used by managers for planning and evaluation
•Used by credit managers to assess risk
•Used by investors to assess stocks and bonds
•Used to compare with industry and over time
FINANCIAL RATIOSTypes of ratios
Liquidity -ability to meet short term debt Asset management -efficiency in using resources Financial leverage management -level of risk due to debt Profitability -effectiveness in generating profits Market-based -market’s view of the firm
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Liquidity Ratios Current ratio = Current assets
Current liabilities
CR = $50,190 / $25,523
CR = 1.97 vs. 2.4 Ind. Avg.
Quick ratio = Current assets – inventories Current liabilities
QR = ($50,190 - $27,530) / $25,523
QR = .89 vs. .92 Ind. Avg.
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Asset Management Ratios Avg collection period = Accounts receivable
Annual credit sales/365
ACP = $18,320 / ($112,760/365)
ACP = 59.3 days vs. 47 days Ind. Avg.
Inventory turnover = Cost of sales Average inventory
Inv. Turn. = $85,300 / ($27,530 + $26,470)/2
Inv. Turn. = 3.16 vs. 3.9 Ind. Avg.
15
Asset Management Ratios Fixed-asset turnover = Sales
Net fixed assets
FAT = $112,760 / $31,700
FAT = 3.56 vs. 4.6 Ind. Avg.
Total asset turnover = Sales Total assets
TAT = $112,760 / $81,890
TAT = 1.38 vs. 1.82 Ind. Avg.
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Financial Leverage Management Debt ratio = Total debt
Total assets
DR = $47,523 / $81,890
DR = 58% vs. 47% Ind. Avg.
Debt-to-equity ratio = Total debt Total equity
D/E = $47,253 / $34,367
D/E = 138.3% vs. 88.7% Ind. Avg.
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Financial Leverage Management
Times interest earned = EBIT Interest charge
Coverage Ratio = $11,520 / $3,160
Coverage Ratio = 3.65 vs. 6.7 Ind. Avg.
Equity multiplier = Total assets Total equity
EM = $81,890 / $34,367
EM = 2.38 vs. 1.89 Ind. Avg.
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Profitability Ratios Gross profit margin = Sales - Cost of sales
Sales
GPM = ($112,760 - $85,300) / $112,760
GPM = 24.4% vs. 25.6% Ind. Avg.
Net profit margin = EAT Sales
NPM = $5,016 / $112,760
NPM = 4.45% vs. 5.1% Ind. Avg.
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Profitability Ratios ROI = EAT
Total Assets
ROI = $5,016 / $81,890
ROI = 6.13% vs. 9.28% Ind. Avg.
ROE = EAT Stockholders equity
ROE = $5,016 / $34,367
ROE = 14.6% vs. 17.54% Ind. Avg.
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Market-Based Ratios
P/E ratio = Market price per share Current earnings per share
Market to book ratio= Market price per share Book value per share
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Dividend Policy Ratios Payout ratio = Dividends per share
EPS
Dividend yield = Expected dividends per share Stock price
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Financial Ratio Analysis Trend analysis 2000 01 02
XYZ current ratio 1.9 2.2 2.3
Cross-sectional analysis 2002
XYZ current ratio 2.3 Industry averages 2.5
Both simultaneously 2000 01 02
XYZ current ratio 1.9 2.2 2.3 Industry averages 2.5 2.4 2.5
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Relationships Among Ratios
This is the Dupont formula:
ROE = Net profit Total Assets Equity margin turnover multiplier
or ROE = NPM TAT EM
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Dupont Formula
Example of the Dupont formula:
ROE = NPM TAT EM
Company: 14.6% = 4.45% 1.38 2.38
Industry average: 17.5% = 5.10% 1.82 1.89
TIME VALUE OF MONEY (PV-present value, FV-future value)
A. Rate of return (interest/discount rate)
B. Single Amount – PV / FV (PV Princ. #1)
C. Annuities:• FV: Sinking Fund (saving for college)• PV: Capital Recovery (car payment)
D. Cash Flows (PV Principle #2)
E. Bond valuation/Stock valuation
F. Perpetuities
Interest Rates
Simple Interest Interest paid on the principal sum only
Compound Interest Interest paid on the principal and on prior interest
that has not been paid or withdrawn. Note: this is referred to as a discount rate when computing the PV of a FV sum of money.
Real Interest Rate Real rate = nominal rate – inflation
What’s the FV of an initial $100 after 3 years if i = 10%?
FV = ?$133.10
0 1 2 310%
Finding FVs (moving to the righton a time line) is called compounding.
PV100
PV/FV Single Amount
10%
What’s the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting, and it’s the reverse of compounding.
FV100
0 1 2 3
PV = ?$75.13
PV/FV Single Amount
PV/FV Single Amount
A. PV Principle # 1 There is an inverse relationship between
interest rate and PV (present value).
How much is $1000 received one year from now worth today-using 5% and 15% discount rate?
FV Rate PV (n = 1)$1,000 5% $952$1,000 15% $870
What’s the FV of a 3-year ordinary annuity of $100 at 10%?
PMT=100 100100
0 1 2 310%
110 121FV = 331
FV: Sinking Fund (saving for college)
What’s the PV of this ordinary annuity?
PMT=100 100100
0 1 2 310%
90.91
82.64
75.13248.69 = PV
PV: Capital Recovery (car payment)
TIME VALUE OF MONEY (PV-present value, FV-future value)
Cash Flows (PV Principle #2):
Cash flows closer in time have more value than cash flows received later (“bird in the hand” principle).
year CF1 CF2 1 $100 $300 2 300 300 3 300 100 4 50 50 total $750 $750 PV $598 $630
What is the PV of this uneven cashflow stream?
0
100
1
300
2
300
310%
50
4
90.91247.93225.39 34.15
598.38 = PV
Cash Flows (PV Principle #2)
Option #1: total cash=$750
What is the PV of this uneven cashflow stream?
0
300
1
300
2
100
310%
50
4
272.73247.93 75.13 34.15
629.94 = PV
Cash Flows (PV Principle #2)
Option #2: total cash = $750
Key Features of a Bond
1. Par value: Face amount; paid at maturity. Assume $1,000.
2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest.
Generally fixed.(More…)
3. Maturity: Years until bondmust be repaid. Declines.
4. Issue date: Date when bondwas issued.
5. Default risk: Risk that issuer will not make interest or principal payments.
How does adding a call provision affect a bond?
Issuer can refund if rates decline. That helps the issuer but hurts the investor.
Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.
Most bonds have a deferred call and a declining call premium.
(Note: convertible bonds would have lower yields.)
What’s a sinking fund?
Provision to pay off a loan over its life rather than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after issuance.
1. Call x% at par per year for sinking fund purposes.
2. Buy bonds on open market.
Company would call if rd is below the coupon rate and bond sells at a premium. Use open market purchase if rd is above coupon rate and bond sells at a discount.
Sinking funds are generally handledin 2 ways
What’s the value of a 10-year, 10% coupon bond if rd = 10%?
V
rB
d
$100 $1,000
11 10 10 . . . +
$100
1+ r d
100 100
0 1 2 1010%
100 + 1,000V = ?
...
= $90.91 + . . . + $38.55 + $385.54= $1,000.
+++1 r+ d
What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value
bond that sells for $887?
90 90 90
0 1 9 10rd=?
1,000PV1 . . .PV10
PVM
887 Find rd that “works”!r = 10.91%
...
What’s interest rate (or price) risk? Does a 1-year or 10-year 10% bond
have more risk?
rd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%
15% 956 4.4% 749 25.1%
Interest rate risk: Rising rd causes bond’s price to fall.
What is reinvestment rate risk?
The risk that CFs will have to be reinvested in the future at lower rates, reducing income.
Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.
Year 1 income = $50,000. At year-end get back $500,000 to reinvest.
If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.
Long-term bonds: High interest rate risk, low reinvestment rate risk.
Short-term bonds: Low interest rate risk, high reinvestment rate risk.
Nothing is riskless!
Bond Risk
What factors affect default risk and bond ratings?
Financial performance Debt ratio Coverage ratios, such as
interest coverage ratio or EBITDA coverage ratio
Current ratios
(More…)
Provisions in the bond contract Secured versus unsecured debt Senior versus subordinated debt Sinking fund provisions Debt maturity
Other factors Earnings stability Regulatory environment Potential product liability Accounting policies
What factors affect default risk and bond ratings?
Stocks and Their Valuation
Features of common stock Determining common stock
values Efficient markets Preferred stock
Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of
shareholders, their goal should be: Maximize stock price.
Common Stock: Owners, Directors, and Managers
Dividend growth model Using the multiples of comparable
firms (P/E) Free cash flow method
Different Approaches for Valuing Common Stock
ssss r
D
r
D
r
D
r
DP
1. . .
111ˆ
33
22
11
0
One whose dividends are expected togrow forever at a constant rate, g.
Stock Value = PV of Dividends
What is a constant growth stock?
P0 = D1/(r-g) Preferred stock: P = D/r
What’s the Efficient MarketHypothesis (EMH)?
Securities are normally in equilibrium (S/D) and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.
1. Weak-form EMH:
Can’t profit by looking at past trends, support for weak-form but “technical analysis” is still used.
2. Semistrong-form EMH:All publicly available information is reflected in stock
3. Strong-form EMH:All information, even inside information, is embedded in stock prices.
Perpetuities and Their Valuation
Key features of perpetuities: Fixed income No maturity date
Valuation: Perpetual Bond: P = I / k Preferred Stock: P = D / k
Capital Budgeting(Capital Investment)
A.Methods of evaluation:1.NPV: Net Present Value = PV(cash flows) –
Net investment2.IRR: Internal rate of return = true yield on
investment3.PB: payback = number of years to get back
your investment.4.PI: profitability index = PV(cf’s) / Net Invest
B. Discount rate: WACC = weighted average cost of capital
Capital Budgeting(Capital Investment)
Discount rate: WACC = weighted average cost of capital (hurdle rate)
Type of funding Rate Proportion ProdShort term debt 8% .15 8%x.15=1.2Long term debt 10% .35 10%x.35=3.5Stocks 20% .50
20%X.50=10.0WACC=
14.7%
WACC = weighted average cost of capital