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Transcript of 1 Chapter 1 – The Financial Manager and the FirmCopyright 2008 John Wiley & Sons CHAPTER 1 The...
1Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
CHAPTER 1CHAPTER 1
The Financial The Financial Manager and the Manager and the
FirmFirmUnit Slides byUK Versity
2Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Legal Forms of Business Organizations
Quick LinksQuick Links
The Role of the Financial Manager
Managing the Financial Function
The Goal of the Firm
Agency Conflicts: Separation of Ownership and Control
3Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The role of financial The role of financial managermanagerThe 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.
4Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Role of the Financial The Role of the Financial ManagerManager
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.
5Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 1.1: Cash Flow Exhibit 1.1: Cash Flow DiagramDiagram
6Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Role of the Financial The Role of the Financial ManagerManager
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.
7Chapter 1 – The Financial Manager and the Firm Copyright 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 The Role of the Financial ManagerManager
The financing decision: How should the firm finance or pay for assets?
8Chapter 1 – The Financial Manager and the Firm Copyright 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 The Role of the Financial ManagerManager
The mismanagement of working capital can cause the firm to go into bankruptcy even though the firm is profitable.
9Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 1.2: How Financial Exhibit 1.2: How Financial ManagerManager’’s Decisions Affect s Decisions Affect the Balance Sheetthe Balance Sheet
10Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Legal Forms of Business Legal Forms of Business OrganizationsOrganizations
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.
11Chapter 1 – The Financial Manager and the Firm Copyright 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 Legal Forms of Business OrganizationsOrganizations
12Chapter 1 – The Financial Manager and the Firm Copyright 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 Legal Forms of Business OrganizationsOrganizations
13Chapter 1 – The Financial Manager and the Firm Copyright 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 Legal Forms of Business OrganizationsOrganizations
14Chapter 1 – The Financial Manager and the Firm Copyright 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 Legal Forms of Business OrganizationsOrganizations
15Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Managing the Financial Managing the Financial FunctionFunction
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.
16Chapter 1 – The Financial Manager and the Firm Copyright 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 Managing the Financial FunctionFunction
17Chapter 1 – The Financial Manager and the Firm Copyright 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 Managing the Financial FunctionFunction
18Chapter 1 – The Financial Manager and the Firm Copyright 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 Managing the Financial FunctionFunction
The Risk Manager manages the firm’s risk exposure in financial markets and the relationships with insurance providers.
19Chapter 1 – The Financial Manager and the Firm Copyright 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 Managing the Financial FunctionFunction
20Chapter 1 – The Financial Manager and the Firm Copyright 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 Managing the Financial FunctionFunction
Compliance and Ethics Director Oversees the compliance program, ethics
program, and the compliance hotline and reports directly to the audit committee.
21Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 1.3: Simplified Exhibit 1.3: Simplified Corporate Organization ChartCorporate Organization Chart
22Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Goal of the FirmThe Goal of the Firm
What Should Management Maximize?
Minimizing risk or maximizing profits without regard to the other is not a successful strategy.
23Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Goal of the FirmThe 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.
24Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Goal of the FirmThe 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.
25Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Goal of the FirmThe 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.
26Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 1.4: Major Factors Exhibit 1.4: Major Factors Affecting Stock PricesAffecting Stock Prices
27Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Goal of the FirmThe Goal of the Firm
Can Management Decisions Affect Stock Prices?
YES!!!
28Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Agency Conflicts:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
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.
29Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Agency Relationships
An agency relationship arises whenever one party, called the principal, hires another party, called the agent.
Agency Conflicts:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
The relationship between stockholders (principals) and management (agents) is an agency relationship.
30Chapter 1 – The Financial Manager and the Firm Copyright 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:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
The costs of the conflict of interest between the firm’s owners and its management.
31Chapter 1 – The Financial Manager and the Firm Copyright 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:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
32Chapter 1 – The Financial Manager and the Firm Copyright 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:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
33Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Aligning the Interests of Management and StockholdersBoard of Directors
Lack of board independence is a key factor in the misalignment between board members’ and stockholders’ interests
Agency Conflicts:Agency Conflicts:Separation of Ownership and Separation of Ownership and ControlControl
Other Managers
Large Stockholders
The Takeover Market
The Legal and Regulatory Environment
34Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
CHAPTER 3CHAPTER 3
Financial Statements,Financial Statements,Cash Flows, and TaxesCash Flows, and Taxes
35Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quick LinksQuick Links
The Income StatementStatement of Retained Earnings
Cash Flows
The Balance Sheet
36Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Balance SheetThe 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)
37Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
38Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
39Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
Net working capital= Total current assets - Total current liabilities (3.2)
40Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Net working capital example - Diaz Manufacturing
Total current assets = $1,039.8 millionTotal current liabilities = $377.8 millionNet working capital =?
The Balance SheetThe Balance Sheet
41Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
42Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
43Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
44Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
45Chapter 1 – The Financial Manager and the Firm Copyright 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 SheetThe Balance Sheet
46Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Equity – There are two sources of equity funds
Preferred EquityHas features that make it a combination of a fixed income security and an equity security.
Common EquityCommon equity represents the true ownership of the firm.
The Balance SheetThe Balance Sheet
47Chapter 1 – The Financial Manager and the Firm Copyright 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 stockThis account reflects the value of the shares that the firm has repurchased from investors.
The Balance SheetThe Balance Sheet
48Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Income StatementThe 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
49Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Income StatementThe Income Statement
Revenues = $1,563.7 millionExpenses = $1,445.2 millionNet Income = ?
Net Income example – Diaz Manufacturing
50Chapter 1 – The Financial Manager and the Firm Copyright 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 methodAccelerated depreciation method
Firms allowed to use one for internal purposes and another for tax purposes.
The Income StatementThe Income Statement
51Chapter 1 – The Financial Manager and the Firm Copyright 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 StatementThe Income Statement
52Chapter 1 – The Financial Manager and the Firm Copyright 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 StatementThe Income Statement
53Chapter 1 – The Financial Manager and the Firm Copyright 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 StatementThe Income Statement
54Chapter 1 – The Financial Manager and the Firm Copyright 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 StatementThe Income Statement
55Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Statement of Retained Statement of Retained EarningsEarnings
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.
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Exhibit 3.3: Diaz Mfg Exhibit 3.3: Diaz Mfg Statement of Retained Statement of Retained EarningsEarnings
57Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Cash FlowsCash 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.
58Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Cash FlowsCash 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)
59Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Cash FlowsCash Flows
NCFOA example – Diaz Manufacturing
Net Income = $118.5 millionDepreciation and Amortization = $83.1 millionNCFOA = ?
60Chapter 1 – The Financial Manager and the Firm Copyright 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 FlowsCash Flows
61Chapter 1 – The Financial Manager and the Firm Copyright 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 FlowsCash Flows
Operating Activities
62Chapter 1 – The Financial Manager and the Firm Copyright 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 FlowsCash Flows
Investing Activities
63Chapter 1 – The Financial Manager and the Firm Copyright 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 FlowsCash Flows
Financing Activities
64Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 3.5: Interrelations Exhibit 3.5: Interrelations among the Financial among the Financial StatementsStatements
65Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
In-class discussionIn-class discussion
End of chapter questionsGroup selection
66Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
CHAPTER 4CHAPTER 4
Analyzing Financial StatementsAnalyzing Financial Statements
67Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Ratio Analysis
Quick LinksQuick Links
Financial Statement Analysis
The DuPont System, ROA, ROE
Benchmarks
Limitations of Ratio Analysis
68Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Perspectives on Financial Perspectives on Financial Statement AnalysisStatement Analysis
A firm’s financial statements can be analyzed from the perspective of different stakeholders.
Important perspectives:
Creditor
Manager
Stockholder
69Chapter 1 – The Financial Manager and the Firm Copyright 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 Perspectives on Financial Statement AnalysisStatement Analysis
70Chapter 1 – The Financial Manager and the Firm Copyright 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 Perspectives on Financial Statement AnalysisStatement Analysis
71Chapter 1 – The Financial Manager and the Firm Copyright 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 Perspectives on Financial Statement AnalysisStatement Analysis
72Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Main Concern
Guidelines for Financial Guidelines for Financial Statement Analysis 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.
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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 Guidelines for Financial Statement Analysis Statement Analysis
74Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Common-Size Balance Sheets
Common-Size Financial Common-Size Financial Statements 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.
75Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 4.1: Common-Size Exhibit 4.1: Common-Size Balance SheetsBalance Sheets
76Chapter 1 – The Financial Manager and the Firm Copyright 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 Common-Size Financial Statements Statements
77Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 4.2: Common-Size Exhibit 4.2: Common-Size Income StatementsIncome Statements
78Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Measures ability of firm to meet short-term obligations with short-term assets, without endangering the firm.
Liquidity RatiosLiquidity Ratios
Current ratio
Quick ratio
Two commonly used ratios to measure liquidity
79Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Current ratio is calculated by dividing current assets by current liabilities.
2.75 $377.8
$1,039.8
(4.1) liabilites Currentassets Current
ratio Current
Amount of current assets firm has per dollar of current liabilities.
Higher number = more liquidity
Liquidity RatiosLiquidity Ratios
80Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosLiquidity Ratios
Inventory subtracted from total current assets determines most liquid assets.
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Quick ratios typically smaller than current ratios for manufacturing firms
1.63 $377.8
$423.8 - $1,039.8
(4.2) sliabilitie Current
Inventory - assets Currentratio Quick
Liquidity RatiosLiquidity Ratios
Service firms see no different between current and quick ration
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Measure how efficiently firm’s management uses assets to generate sales.
Efficiency RatiosEfficiency Ratios
Sometimes called asset turnover ratios.
83Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosEfficiency Ratios
84Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Inventory turnover ratio–measures how many times inventory turned over into saleable products.
2.55 $423.8
$1,081.1
(4.3) Inventory
sold goods of Costratio turnoverInventory
In general, more often a firm can turn over inventory, the better. Too high or too low a turnover could be warning sign.
Efficiency RatiosEfficiency Ratios
85Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Days’ sales in inventory ratio also builds on inventory turnover ratio.
days 143.14 2.55
days 365
(4.4) turnoverInventory
days 365inventory in sales Days’
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 RatiosEfficiency Ratios
86Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Accounts receivable turnover ratio measures how quickly firm collects on its credit sales.
5.11 $306.2
$1,563.7
(4.5) receivable Accounts
sales Netturnover receivable Accounts
The higher the frequency of turnover, the faster it converts credit sales into cash flows
Efficiency RatiosEfficiency Ratios
87Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Days Sales Outstanding (DSO) measures number of days firm takes to convert receivables into cash.
days 71.43 5.11
days 365
(4.6) turnover receivable Accounts
days 365DSO
The fewer the days, the more efficient the firm.
Note: an overzealous credit department may offend firm’s customers.
Efficiency RatiosEfficiency Ratios
88Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Total asset turnover ratio measures level of sales firm generates per dollar of total assets.
0.83
$1,889.2
$1,563.7
(4.7) assets Total
sales Netturnover asset Total
Asset Turnover RatiosAsset Turnover Ratios
The higher the turnover, the more efficiently management is using total assets.
More relevant for service industry firms.
89Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosAsset Turnover Ratios
Net salesFixed asset turnover = (4.8)
Net fixed assets$1,563.7
= $399.4
= 3.92
90Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Leverage ratios reflect ability of firm and owners to use equity to generate borrowed funds.
Leverage RatiosLeverage Ratios
Financial leverage refers to use of debt in firm’s capital structure.
91Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosLeverage Ratios
92Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.
Leverage RatiosLeverage Ratios
Total debtTotal debt ratio = (4.9)
Total assets$951.8
= $1,889.2
= 0.50
Total debt ratio is calculated using short-term and long-term debt.
93Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Debt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity.
Leverage RatiosLeverage Ratios
Total debtTotal equity
Debt-to-equity ratio = (4.10)
$951.8 =
$937.4 = 1.01
94Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Equity multiplier or leverage multiplier reveals amount of assets firm has for every dollar of equity.
Leverage RatiosLeverage Ratios
Total assetsEquity multiplier = (4.11)
Total equity
$1,889.2 =
$937.4 = 2.02
Best measure of firm’s ability to leverage shareholders’ equity with borrowed funds.
95Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Equity multiplier = 1 + Debt to equity ratio
Other Leverage RelationshipsOther Leverage Relationships
96Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Times interest earned measures number of dollars in operating earnings firm generates per dollar of interest expense.
Coverage RatiosCoverage Ratios
EBITTimes interest earned = (4.12)
Interest expense
$168.4 =
$5.6 =30.07
97Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Cash coverage ratio measures amount of cash firm has to meet its interest payments.
Coverage RatiosCoverage Ratios
EBITDACash coverage = (4.13)
Interest expense
$251.5 =
$5.6 = 44.91
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Gross profit margin measures amount of gross profit generated per dollar of net sales.
Profitability RatiosProfitability Ratios
Net sales - Cost of Goods SoldNet sales
Gross profit margin = (4.14)
$1,563.7 - $1,081.1 =
$1,563.7
= 30.86%
99Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Operating profit margin measures the amount of operating profit generated by firm for each dollar of net sales.
Profitability RatiosProfitability Ratios
EBITOperating profit margin = (4.15)
Net sales$168.4
= $1,563.7
= 10.77%
100Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Net profit margin measures amount of net income after taxes generated by firm for each dollar of net sales.
Profitability RatiosProfitability Ratios
Net IncomeNet profit margin = (4.16)
Net sales$118.5
= $1,563.7
= 7.58%
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.
101Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosProfitability Ratios
EBITEROA = (4.17)
Total assets$168.4
= $1,889.2
= 8.91%
This ratio reveals how efficiently management utilized assets under their command.
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Some analysts calculate return on assets as:
Profitability RatiosProfitability Ratios
Net incomeROA = (4.18)
Total assets$118.5
= $1,889.2
= 6.27%
103Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosProfitability Ratios
Net incomeReturn on equity = (4.19)
Total equity
$118.5 =
$937.4 = 12.64%
104Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The following ratios reveal how market views company’s liquidity, efficiency, leverage, profitability.
Market Value RatiosMarket Value Ratios
Net incomeEarnings per share = (4.20)
Shares outstanding
$118,500,000 =
$54,566,054
= 2.17 per share
Earnings per share (EPS) ratio measures income after taxes generated by firm for each share outstanding.
105Chapter 1 – The Financial Manager and the Firm Copyright 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 RatiosMarket Value Ratios
Price per sharePrice-earnings ratio = (4.21)
Earnings per share
$48.61 =
$2.17 = 22.4
106Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Set of related ratios that links balance sheet and income statement.
The DuPont SystemThe 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
107Chapter 1 – The Financial Manager and the Firm Copyright 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
(4.22) turnover assets Totalmargin Profitassets Totalsales Net
sales Netincome NetROA
The ROA EquationThe ROA Equation
Net profit margin measures management’s ability to generate sales & manage operating expenses.
108Chapter 1 – The Financial Manager and the Firm Copyright 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 EquationThe ROA Equation
109Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
This equation is simply a restatement of equation 4.19.
(4.23) multiplierEquity ROA
equity Totalassets Total
assets Totalincome Net
equity Totalincome NetROE
The ROA EquationThe 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.
110Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Shows that a firm’s ROE is determined by three factors:
The DuPont EquationThe 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.
ROE = Net profit margin Total asset turnover
Equity multiplier (4.24)
Net income Net sales Total assetsROE =
Net sales Total assets Total e
(4.25)quity
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Exhibit 4.5: Relations in the Exhibit 4.5: Relations in the DuPont System of AnalysisDuPont System of Analysis
112Chapter 1 – The Financial Manager and the Firm Copyright 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 BenchmarkSelecting a Benchmark
1. Time-trend
2. Industry average
3. Peer group
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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 BenchmarkSelecting a Benchmark
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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 BenchmarkSelecting a Benchmark
115Chapter 1 – The Financial Manager and the Firm Copyright 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 BenchmarkSelecting a Benchmark
116Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Ratio analysis depends on accounting data based on historical costs.
Limitations of Ratio AnalysisLimitations 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
117Chapter 1 – The Financial Manager and the Firm Copyright 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 AnalysisLimitations of Ratio Analysis
118Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
CHAPTER 5CHAPTER 5
The Time Value of MoneyThe Time Value of Money
119Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Time Value of MoneyTime Value of Money
Time Value of Money
Future Value and Compounding
Present Value and Discounting
Finding the Interest Rate
Rule of 72
Compound Growth Rates
120Chapter 1 – The Financial Manager and the Firm Copyright 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 MoneyThe Time Value of Money
Consuming Today or Tomorrow
Money has a time value because a dollar today is worth more than a dollar tomorrow.
121Chapter 1 – The Financial Manager and the Firm Copyright 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 MoneyThe Time Value of Money
Consuming Today or Tomorrow
122Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Time Value of MoneyThe 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.
123Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 5.1: Five-year Exhibit 5.1: Five-year Timeline for $10,000 Timeline for $10,000 InvestmentInvestment
124Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Time Value of MoneyThe 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.
125Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Time Value of MoneyThe 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
126Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 5.2: Future Value & Exhibit 5.2: Future Value & Present Value ComparedPresent Value Compared
127Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Future Value and Future Value and Compounding 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.
128Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Future Value and Future Value and Compounding 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.
129Chapter 1 – The Financial Manager and the Firm Copyright 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 Future Value and Compounding Compounding
Two-Period Investing
130Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Future Value and Future Value and Compounding 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.
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where:
FVn = future value of investment at the end of period n
PV = original principle (P0) or present value
i = the rate of interest per period, which is often a year
n = the number of periods
(5.1) n
i1PVFV )( n
The general equation to find the future value is:
Future Value and Future Value and Compounding Compounding
132Chapter 1 – The Financial Manager and the Firm Copyright 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 Future Value and Compounding Compounding
55
5
FV $100 (1 0.10)
= $100 (1.10)
= $100 1.6105
= $161.05
133Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Exhibit 5.4: How Compound Exhibit 5.4: How Compound Interest GrowsInterest Grows
134Chapter 1 – The Financial Manager and the Firm Copyright 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 Future Value and Compounding Compounding
m×nnFV =PV×(1+i/m) (5.2)
135Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Non-annual compounding example
Future Value and Future Value and Compounding Compounding
2 22
4
FV $100 (1+0.05 / 2)
= $100 (1+0.025)
= $100 (11038)
= $110.38
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?
136Chapter 1 – The Financial Manager and the Firm Copyright 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 2.71828
Future Value and Future Value and Compounding Compounding
FV PV (5.3)i ne
137Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Continuous compounding example
Future Value and Future Value and Compounding Compounding
0.05 5
0.25
FV = $10,000
= $10,000 2.71828
= $10,000 1.284025
= $12,840.25
e
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?
138Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Using Excel: Time Value of Using Excel: Time Value of MoneyMoney
139Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Using Excel: Time Value of Using Excel: Time Value of MoneyMoney
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)
140Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Present Value and Present Value and Discounting 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.
141Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The equation below gives us the general equation to find the present value after any number of periods.
(5.4) ni)(1nFV
PV
Present Value and Present Value and Discounting Discounting
142Chapter 1 – The Financial Manager and the Firm Copyright 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 Present Value and Discounting Discounting
$40,000PV =
1+0.05 = $38,095.24
143Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Present Value and Present Value and Discounting 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
144Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Finding the Interest RateFinding 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.
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ExamplesExamples
Buy government bond price $90 each, in next 20 years, you receive $1000 value each bond. What is interest rate?
146Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
The Rule of 72The 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%.
147Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Compound Growth RatesCompound Growth Rates
Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate).
(5.6) n
g)(1PVnFV
Examples include population growth, earnings growth.
148Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Compound Growth RatesCompound 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?
3
3
13
35 = 20 (1+g)
1.75 = (1+g)
g = (1.75) 1 = 1.2051-1 = 0.2051 or 20.51%
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CHAPTER 6CHAPTER 6
Discounted Cash Flows and ValuationDiscounted Cash Flows and Valuation
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Level Cash Flows: Annuities and Perpetuities
Quick LinksQuick Links
Multiple Cash Flows
Cash Flows That Grow at a Constant Rate
The Effective Annual Interest Rate
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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 FlowsMultiple Cash Flows
151
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Exhibit 6.1: Future Value of Exhibit 6.1: Future Value of Two Cash FlowsTwo Cash Flows
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Exhibit 6.2: Future Value of Exhibit 6.2: Future Value of Three Cash FlowsThree Cash Flows
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Multiple Cash FlowsMultiple 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
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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 FlowsMultiple Cash Flows
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Exhibit 6.3: Present Value of Exhibit 6.3: Present Value of Three Cash FlowsThree Cash Flows
156
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The Value of a Gift to the The Value of a Gift to the UniversityUniversitySuppose 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?
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Buying a Used CarBuying a Used CarFor a student—or anyone else—buying a used car
can be a harrowing experience. Once you fi nd the car you want, the next diffi cult decision is choosing how to pay for it—cash or a loan. Suppose the cash price you have negotiated for the car is $5,600, but that amount will stretch your budget for the year. The dealer says, “No problem. The car is yours for $4,000 down and payments of $1,000 per year for the next two years. Or you can put $2,000 down and pay $2,000 per year for two years. The choice is yours.” Which offer is the best deal? The interest rate you can earn on your money is 8 percent.
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The Investment DecisionThe 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 1 2 3 Total
A $50 $30 $ 20 $100
B $ 5 $ 5 $100 $110
Which business should you acquire?
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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 FlowsLevel Cash Flows
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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.
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Level Cash FlowsLevel Cash Flows
162Chapter 1 – The Financial Manager and the Firm Copyright 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 FlowsLevel Cash Flows
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Exhibit 6.3: Present Value of Exhibit 6.3: Present Value of Three Cash FlowsThree Cash Flows
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(6.1) i
i)(1
11
CF
i
factor) value Present(1CF
annuity an for factor value PresentCFPVA
n
n
164
Level Cash FlowsLevel Cash Flows
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165
Level Cash FlowsLevel 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
n 3
3
1 1Present value factor = = = 0.7938
(1+i) (1+0.08)
1 - Present value factor 1 - 0.7938PV annuity factor = = = 2.577
i 0.08PVA = CF PV annuity factor = $2,000 2.577 = $5,154.00
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Finding Monthly or Yearly Payments Example
166
Level Cash FlowsLevel 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 6.125 percent for the balance. What are your monthly payments?
n 360
Monthly interest rate = 6.125 % / 12 months = 0.51042 %
1 1Present value factor = 0.1599589
(1+i) (1.0051042)
1 - Present value factorPV annuity factor =
i1 - 0.1599589
=
= 164.578400.0051042
167Chapter 1 – The Financial Manager and the Firm Copyright 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.
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Level Cash FlowsLevel Cash Flows
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Exhibit 6.5: Amortization Exhibit 6.5: Amortization Table for a 5-Yr, $10K LoanTable for a 5-Yr, $10K Loan
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169Chapter 1 – The Financial Manager and the Firm Copyright 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.
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Level Cash FlowsLevel Cash Flows
170Chapter 1 – The Financial Manager and the Firm Copyright 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 6.2.
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Level Cash FlowsLevel Cash Flows
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Future Value of an Annuity Equation
(6.2) i
1i)(1CF
i
1- factor value FutureCF
annuity an for factor value FutureCFFVA
n
n
171
Level Cash FlowsLevel Cash Flows
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Exhibit 6.6: Future Value of Exhibit 6.6: Future Value of 4-Yr Annuity4-Yr Annuity
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Level Cash Flows: Annuities and Level Cash Flows: Annuities and PerpetuitiesPerpetuitiesFinding 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
174Chapter 1 – The Financial Manager and the Firm Copyright 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.
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Level Cash FlowsLevel Cash Flows
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Perpetuities
(6.3) i
CF
i0)(1
CFi
i)(1
11
CF
annuity an for factor value PresentCFPVA
175
Level Cash FlowsLevel Cash Flows
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Perpetuities - Example
176
Level Cash FlowsLevel 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?
PVA CF $100,000 = = = $1,250,000
i 0.08
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Exhibit 6.7: Ordinary Exhibit 6.7: Ordinary Annuity versus Annuity DueAnnuity versus Annuity Due
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Annuity DueAnnuity 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 FlowsLevel Cash Flows
Annuity due = Ordinary annuity value (1+i) (6.4)
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Annuity Due Example
The value of the annuity due shown in Exhibit 6.7B is:
179
Level Cash FlowsLevel Cash Flows
Annuity due = $3,312 (1.08) = $3,577
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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 Cash Flows That Grow at a Constant RateConstant Rate
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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.
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Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant Rate
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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.
(6.5) i1
g11
g-i
CFPVA
n1
n
182
Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant Rate
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Growing Annuity Example
183
Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant 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? 1
50
50
CF = $300,000 (1 0.025) = $307,500
$307,500 1.025PVA = 1
0.15 0.025 1.15
= $2,460,000 0.9968 = $2,452,128
184Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Growing PerpetuityWhen cash flow stream features constant growing
annuity forever.
Can be derived from equation 6.5 when n tends to infinity and results in the following equation:
184
Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant Rate
1CFPVA = (6.6)
i - g
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Growing Perpetuity Example
185
Cash Flows That Grow at a Cash Flows That Grow at a Constant RateConstant Rate
01 CF ×(1+g)CFPVA = =
i - g i - g
$450,000 (1+0.05) = = $3,634,615
0.18 0.05
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?
186Chapter 1 – The Financial Manager and the Firm Copyright 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 RateEffective Annual Interest Rate
186
187Chapter 1 – The Financial Manager and the Firm Copyright 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 RateEffective Annual Interest Rate
188Chapter 1 – The Financial Manager and the Firm Copyright 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 RateEffective Annual Interest Rate
189Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Effective Annual Rate (EAR) Example
189
Effective Annual Interest RateEffective Annual Interest Rate
Your credit card has an APR of 12 percent (1 percent per month). What is the effective annual interest rate?
EAR = (1 + 0.12/12)12 – 1 = (1.01)12 – 1 = 1.1268 – 1 = 0.1286 or 12.68%
190Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Examples: Calculating EARExamples: Calculating EAR
Lender A: 10.40% compound monthlyLender B: 10.90% compound annuallyLender C: 10.50% compound quarterly
Who will you chose to borrow?
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191Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
CHAPTER 7CHAPTER 7
Risk and ReturnRisk and Return
192Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and ReturnRisk 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.
193Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Total holding period return consists of two components: 1) capital appreciation and 2) income.
Holding Period Returns
R
CA=
CapitalAppreciationInitialPrice
P
1-P
0
P0
PP
0
Capital appreciation component of a return, :CAR
194Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Total holding period return is simply
R
I=
Cash FlowInitialPrice
CF
1
P0
Income component of a return RI:
Holding Period Returns
1 1T CA I
0 0 0
CF P CFPR R R (7.1)
P P P
195Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Holding Period Returns Example
One year ago today, you purchased a share of Dell Inc. stock for $26.50. Today it is worth $29.00. Dell paid no dividend on its stock. What total return did you earn on this stock over the past year?1 0 1
T CA I0
P - P + CFR = R + R =
P
$29.00 - $26.50 + $0.00 =
$26.50 = 0.0943 = 9.43%
196Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Expected Returns ExampleYou estimate that there is 30 percent chance that your total return on your Dell stock investment will be -3.45 percent, a 30 percent chance that it will be 5.17 percent , a 30 percent chance that it will be 12.07 percent and a 10 percent chance that it will be 24.14 percent. Calculate your expected return.
DellE(R ) = (0.3 × -0.0345) + (0.3 × 0.0517)
+ (0.3 × 0.1207) + (0.1 × 0.2414)
= - 0.01035 + 0.01551 + 0.03621 + 0.02414
= 0.0655 = 6.55%
197Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Expected value represents the sum of products of possible outcomes, and probabilities that those outcomes will be realized.
Expected Returns
Expected return, E(RAsset), is an average of possible returns from an investment, where each of these returns is weighted by the probability that it will occur:
nAsset i i 1 1 2 2 n n
i 1E(R ) (p ×R )=(p ×R )+(p ×R )+...+(p ×R ) (7.2)
198Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Quantitative Measures of Quantitative Measures of ReturnReturn
Expected Returns
E R
Asset R
i i1
n
n
R
1+R
2+...+R
n
n
If each of the possible outcomes is equally likely (that is, p1 = p2 = p3 = … = pn = p = 1/n), the expected return formula reduces to:
199Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Variance and Standard Variance and Standard DeviationDeviationas Measures of Riskas 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:
n 22i iR i=1
Var(R) = = p × R -E(R) (7.3)
Take the square root of the variance to get the standard deviation ().
200Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Variance and Standard Variance and Standard DeviationDeviationas Measures of Riskas Measures of Risk
Calculating the Variance and Standard Deviation
R2
Ri E(R)
2
i1
n
n
If all possible outcomes are equally likely, the formula becomes:
201Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
= > σ = 0.0838 or 8.38%
Profit (Ri) Probability (Pi) (Ri)(Pi) [Ri - E(R)](Pi)-0,10 0,05 -0,0050 (-0,10 - 0,09)2(0,05)-0,02 0,10 -0,0020 (-0,02 - 0,09)2(0,10)0,04 0,20 0,0080 (0,04 - 0,09)2(0,20)0,09 0,30 0,0270 (0,09 - 0,09)2(0,30)0,14 0,20 0,0280 (0,14 - 0,09)2(0,20)0,20 0,10 0,0200 (0,20 - 0,09)2(0,10)0,28 0,05 0,0140 (0,28 - 0,09)2(0,05)
Total = 1,00 E(R) = 0,090 σ2= 0,00703
202Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Variance and Standard Variance and Standard DeviationDeviationas Measures of Riskas 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.
203Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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
204Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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.
iRi
iCV (7.4)
E(R )
205Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Stock A Stock B
E(R) 0,08 0,24
σ 0,06 0,08
CV 0,75 0,33
206Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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
E(R
Portfolio) x
1E(R
1) x
2E(R
2)
Expected return of portfolio made up of two assets:
207Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk and Diversification
Portfolios with More than One Asset
Expected return of portfolio made up of multiple assets:
1
1 1 2 2 n
( ) ( ) (7.5)
= x ( ) x ( ) ... x ( )
nPortfolio i i
i
n
E R x E R
E R E R E R
208Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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?
&
$100,0000.25
$400,000
$150,0000.375
$400,000
TB
P G EMC
x
x x
209Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk and Diversification
Expected return of Portfolio Example -continued
( ) (0.25 0.045) (0.375 0.075)
(0.375 0.090)
=0.0731 or 7.31%
PortfolioE R
210Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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.
211Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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:
1,22 Asset portfolio 1 2
2 2 2 2 21 2 R1 2R R Rσ =x σ +x σ +2x x σ (7.6)
212Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk and Diversification
Portfolio Variance Example
The variance of the annual returns of CSX and Wal-Mart stocks in Exhibit 7.6 are 0.03949 and 0.02584 respectively. The covariance between the annual returns of these stocks is 0.00782. Calculate the variance of the portfolio that consists of 50 percent CSX stock and 50 percent Wal-Mart stock.
2 Portfolio
2 2 2Rσ = (0.5) (0.03949) + (0.5) (0.02584)
+ 2(0.5)(0.5)(0.00782)
= 0.02024
213Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk 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:
1,2
1 1
(7.8)R
R R
214Chapter 1 – The Financial Manager and the Firm Copyright 2008 John Wiley & Sons
Risk and DiversificationRisk and Diversification
Correlation Coefficient Example
Find the correlation coefficient between the annual returns of CSX and Wal-Mart in Exhibit 7.6. 1
2CSX
12
Wal-Mart
1,2
1 1
=
=
(0.03949) =0.199
(0.02584) =0.161
0.00782= = =0.244
0.199×0.161
R
R R