Corporate Finance Fin622 Short Note
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Transcript of Corporate Finance Fin622 Short Note
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Lesson 1st
Corporate finance is the study of planning,evaluating and drawing decisions in the courseof business.
(1)SWOT analysis is also very helpful in capital budgeting process.SWOT stands for:
Strengths
Weaknesses Opportunities
Threats
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(2)Broadly speaking there are two potential sources for makinginvestments
The first sourcesemerge from the contributions of sponsors or directors
who commence the business. This portion of investment is called Capital or
Equity contribution.
The other sourceof investment is from loans and various financial
instruments and markets. Banks provide long term and short loans to the
business world and this has been the most important source of business
finance and is being used widely.
Other source of external financing is issuance of bonds and securities in
primary and secondary markets. This process is known as Capital Structure
(3) There are basically three financial statements that every businessentity runs periodically. It includes:
Balance Sheet
Income Statement
Cash Flow
Balance SheetThis is a statement of resources controlled by and obligations to settle by an
entity as on a specified date.
The format of Financial Statements is governed by International Financial
Reporting Standard in Pakistan.
Assets (both fixed and current) are placed in balance sheet in the order of
less liquid or illiquid to liquid.
This means that current assets are more liquid than fixed assets.
What is a liquid asset?
Answer: An asset that can be converted to cash quickly and without loss of
value is liquid asset
Example
Prize bond or gold highly liquid asset
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Current Assets and Current Liabilitieswhen clubbed together, give birth
to another concept known as working capital.
Current assetsare those that form part of the circulating capital of a
business. The most common current assets are stocks, trade debtors, and
cash.
Current liabilitiesare those short-term liabilities which are intended to be
constantly replaced in the normal course of trading activity.
Current liabilities typically comprise: trade creditors, accruals and bankoverdrafts.
There is another concept of Cash Cycle associatedwith working
capital
ExampleYou were still able to use money for 5 days before paying to creditors. This
means the operating cycle is positive.
Corporate Finance
Lesson 2
Types of analysis
(1) vertical analysis
(2) horizontal analysis
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Vertical AnalysisCommon Size analysis is also known as Vertical Analysis
Horizontal AnalysisBase year analysis is another tool of comparing performance
and is also known as Horizontal Analysis.
Ratio analysis
Ratio analysisis another widely acknowledged and used comparison
tool for financial managers
Question :A ratio is a relationship between ------------- or more line
items expressed in ---------------------------- of times?
Five, %age or numbers
Two, %age or numbersThree, %age or number
One, %age or number
Question :Financial ratios are useful indicators of a firms performance
and --------------------?
Financial changes
Financial situation
Financial requirementFinancial needs
Question:ratio analysis can predict future?
Profit
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Rations
Bankruptcy
Values
Financial ratioscan be used to analyze trendsand to compare the firms
financials to those of other firms.
Different ratios
Current ratio = current assets / current liabilities
Note: current ratio is a measure of short term liquidity. This is short
term solvency or liquidity measurement
Current assets inventory
Quick (or acid test) ratio =____________________________
Current liabilities
Note: using cash to buy inventory does not affect the current ratio, but
It reduces the quick ratio. This is short term solvency or liquidity
measurement
Total assets Total equity
Total debt ratio = ------------------------------------------
Total assets
Or
Total debt
--------------------
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Total assets
Note: Total debt equity ratio take into all debts of all maturities to all
creditors. This is long term solvency measurement.
Total debt
Debt-equity ratio=-----------------
Total equity
Note: This is long term solvency measurement.
EBT
Time Interest Earned ratio = -------------
Interest
Interest coverage ratio = EBIT / interest
Note: This is long term solvency measurement.
Cost of goods sold
Inventory turnover ratio= ----------------------------------
Avg. Inventory
Days sale in inventory = 365 days / inventory turnover
Note: They are intended to describe is how efficiently, or intensively, a
firm uses its assets to generate sales. This is assets management or
turnover measure.
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Sales
Account receivable turnover = -----------------------
Account receivable
Average collection period or days sales in receivables=
365 days / receivables turnover
Cost of goods sold
Payable turnover = -----------------------------------Trade credits
Average payment period = 365 days / payable turnover
Net income
Net profit or Profit margin ratio = ----------------------- * 100
Sales
Note: All other things being equal, a relatively high profit margin is
obviously. This situation corresponds to low expense ratio relative tosales. How ever, we hasten to add that other things are often not equal.
Net income
Return on assets = ------------------------*100
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Total assets
Note:measure of profit per dollar of assets.
Net income
Return on equity =------------------ * 100
Total equity
Note:
ROE is a measure how the shareholder fared during the year. Since
befitting shareholder our goal, ROE in accounting sense, the true
bottom-line measure of performance.
Net income
Earning per share =---------------------------
Total share (o/s)
BASIC OVERVIEW OF
RATIOS
Short Term Solvency Or Working Capital Ratios
(1) CURRENT RATIO(2) QUICK RATIO
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(3) CASH RATIOLong Term Solvency Or Financial Leverage Ratios
(1) TOTAL DEBT RATIO(2) DEBT EQUITY RATIO(3) EQUITY MULTIPLIER(4) TIME INTEREST EARNED RATIO(5) CASH COVERAGE RATIO
Assets Management Or Asset Utilization Turnover Ratios
(1) INVENTORY TURNOVER AND INV. DAYS(2) RECEIVABLE TURNOVER AND AVERAGE
COLLECTON PERIOD
(3) PAYALE TURNOVER AND AVERAGEPAYMENT PERIOD
(4) TOTAL ASSETS TURNOVER(5)
CAPITAL INTENSITY
PROFITABILITY RATIOS
(1) NET PROFIT OR PROFIT MARGIN(2) RETURN ON ASSETS(3) RETURN ON EQUITY
MARKET VALUES RATIOS
(1) PRICE-EARNING SHARE OR PE RATIO
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(2) MARKET-TO-BOOK RATIO(3) EPS
Ratios are subject to the limitations of accounting
methods. Different accounting choices may result in
significantly different ratio values.
Corporate finance
Lesson 3rd
Time Value of Moneyis based on the concept that a dollar that you have
today is worth more than the promise or expectation that you will
receive a dollar in the future.
Time value of money divided into following
topics
(1)present value
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(2)
Future value
(3)Annuities
(4)perpetuity
Present value
The present value of a future cash flow is the nominal amountof money
to change hands at some future date, discounted to account for the timevalue of money
Discount factor = 1/1+r
PV = 1 / 1+r. C1
Future value
Future value measures what money is worth at a specified time in thefuture assuming a certain interest rate.
Determine the future value
without compounding
Fv=pv(1+rt)
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Determine the future value
with compounding
Fv=pv(1+i)n
AnnuitiesEqual annual series of cash flow
Annuities may be
(1) equal annual deposit
(2) equal annual withdrawal
(3) equal annual payments
(4) equal annual receipts
Annuities is key of equal annual cash flow
Present value of annuity = c [1/r-1/r (1+r)t]
= c {1-[1/ (1+r) t]
/ r}
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Future value of annuity = [(1+r)t 1] / r
Annuity
A level stream of cash flows for a fixed period of time.
Ordinary annuity
Cash flow that occurs at the end of each period for some fixed
number of period is called an ordinary annuity.
Annuity due
Cash flow occurs at the beginning of each period.
PerpetuityAn annuity in which the cash flow continue forever.
OrPerpetuity is a cash flow without a fixed time horizon.
Consol
Also called perpetuity and type of perpetuity
Present value of perpetuity= C/r
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Lesson 4Discounting cash flow & Effective annual interest
Effective Annual Rate EARInterest rate that is annualized using compound interest
FormulaEAR = [1 + i/n) n 1
BOND VALUATION
A bond is a financial instrument or a debt securityissued by a company
to raise money. It is offered to general public or to institutions.
Equity & Debt (Bonds)
Equity represents ownershipand is a residual claim
Lesson 5
BondBondContract between investor and issuer
It is debt instrument.
Use to raise capital and return pay interest to investor
Bonds are redeemable
Coupon interest
Interest payment per period
Coupon rate
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Interest payment stated is annualized term
Or
The rate at which issuer pays interest to investor is know
as coupon rate
Current yield = annual coupon payment / bond price
Maturity date
The date on which company return the principle amount
back to investor
Discount bond
Bond sells less than the face or par value so the return on
a bond is greater than the current yield, in this case capital
gain at maturity.
Premium bond
Bond sells more than the face or par value so return on a
bond less than the current yield. In this case capital loss at
maturity.
Interest rate risk & bond
The risk arising from fluctuating interest rate is known as interest raterisk.Two things to change sensitivity to change interest rate
(1)time to maturity
(2)coupon rate
Small changes in interest rate will have greater impact on yield to
maturity and bond.
Bond valuation
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Bond valuation is the process of determining the fair price of abond.
The fair value of a bond is the present value of the stream of cash flows itis expected to generate.
(1)general relationship
(2)bond pricing
General Relationships
o Present value relationship
Coupon yield
Current yield Yield to maturity
Present value relationship
C F
Po = ----------- + ------------
(1+r)t (1+r)
T
There is inverse relationship between price and discount rate. Thehigher the interest rate the lower the price of a bond
Coupon yield
Coupon yield are called nominal yield
Coupon yield = C/F
C: is coupon payment
F: is percentage of face value
Current yield
Current yield = coupon payment / bond price
YTM
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C F
Market price = -------------- + --------------
(1+YTM)t (1+YTM)
T
If YTM increases, the rate of return will be less than yield.If the YTM decreases, the rate of return will be greater than yield.
Bond pricing
Relative price approach
Arbitrage free price approach
Arbitrage free price approach
C F
Po = ------------ + ------------(1+r t)t
(1+rT)T
Lesson 6
Term structure & interest rate
Term structure
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Relationship between long term
&short term rates
(1)When long term rate is greater than
short term ratethan the term
structure is upward sloping
(2)when short term rate is greater
than long term ratethen termstructure will be downward
sloping
Q: the term structure of interest rate,
also know as ----------?
Coupon rate
Coupon yield
Yield curve
Current yield
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Q: there are ----------- main patterns
created by the term structure of
interest rate?
Two
Three
Five
Eight
Market interest rate
In market interest rate
ultimately includesmoney market,
bond market, stock market, andcurrency market as well as retail
financial institutions like bank.
Risk free cost of capital
Real interest on risk free loan,while no loan is ever entirely risk-free
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Rate of incorporates the deferred
consumption and alternative
investment is element of interest.
Inflationary expectations
In = ir+pe
In: nominal interest rate
Ir: real interest rate
Pe: inflationary expectations
Risk
The level of risk in investment is
taken into consideration.
Risk premium
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The extra interest charged on
risky investment is called risk
premiumLonger-term investment carries a
maturity risk premium, because long
term loan are more exposed to more
risk of default during this duration.
Liquidity preferenceCash is on hand to be spent immediately if the need arises,
but some investments require time or effort to transfer into
spending able form. This is known as liquidity preference
Lesson # 7
DIVIDEND DISCOUNT MODELDividend discount model states that todays price is equal tothe present value of all future dividends.
After One year
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P0 = Div + P1 / (1 + r)
After 2 years the value of stock is:=div1/ (1+r) + div2+P2/ (1+r) 2
After 3 years the value of stock is:=div1/(1+r) + div2/(1+r)2 + div3+P3/(1+r)3
PV of stock depends only on future dividends
.DIVIDEND GROWTH MODELS:If the value of stock is the PV of all future dividend then
PV = DIV / r
When company pay out everything as dividend then earningsand dividend will be equal and PV can be calculated as:PV = EPS / r
CONSTANT GROWHT MODEL:
P0 = D1 x (1+g) / (r g)This is known as Constant-growth Dividend Discount Model orGordon Growth Model
Gordon model is valid as long as g < r
Lesson 8
Fundamental Analysis
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Three step process:In large organizations fundamental analysis is usually performed in three steps:
Analysis of the macroeconomic situation, usually including bothinternational and national economic indicators, such as GDP growth rates,inflation, interest rates, exchange rates, productivity, and energy prices.
Industry analysis of total sales, price levels, the effects of competingproducts, foreign competition, and entry or exit from the industry.
Individual firm analysisof unit sales, prices, new products, earnings, andthe possibilities of new debt or equity issues
Often the procedure stresses the effects of the overall economic situation onindustry and firm analysis and is known as top down analysis.
If instead the procedure stresses firm analysis and uses it to build its industryanalysis, which it uses to build its macroeconomic analysis, it is known as
bottom up analysis.
Capital budgetingCapital Budgeting is the planning process used to determine afirm's long term investments such as new machinery,replacement machinery, new plants, new products, andresearch and development projects.Capital budgeting process is carried out for projects involvingheavy initial upfront cost.
classification of investment projects
BY PROJECT SIZE
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BY TYPE OF BENEFIT TO THE FIRM
BY DEGREE OF DEPENDANCE
BY DEGREE OF STATISTICAL DEPENDANCE
BY TYPE OF CASH FLOW
Relevant Costs:These are costs that are relevant with respect to a particulardecision. A relevant cost for a particular decision is one thatchanges if an alternative course of action is taken. Relevantcosts are also called differential costs.
Every decision involves a choice between at least two
alternatives.
To identify which costs are relevant in a particularsituation, take this three step approach:1. Eliminate sunk costs and committed costs2. Eliminate costs and benefits that do not differ betweenalternatives
3. Compare the remaining costs and benefits that do differbetween alternatives to make the proper decision.4. Take care of opportunity cost
Lesson 9Net present value (NPV)Two aspects of NPV method of project evaluation
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(1) initial investment or upfront cost
(2) benefit (cash flow) emerging from the
project
The present value of future cash flow is calculated using adiscount rate. And if this PV of future cash flow is greater thanthe initial investment, the NPV is stated as positive. If the PVof future cash flow is less than initial investment, then it isbetter to scrap the project.NPV = PV required investment
Formula net present value
NPV = Co +C1 / 1+r
Co = the cash flow at time o or investment and therefore cashoutflowr = the discount rate/the required minimum rate of return oninvestment
The discount factor r can be calculated using:
Q (t, i) = 1/ (1+i)tWeighted Average Cost of Capital
All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.Multiply the cost of each capital component by its proportional weight and thesumming
FormulaWACC = E / V * Re + D / V * Rd * ( 1 Tc )
Re = cost of equityRd = cost of debtE = market value of the firm's equityD = market value of the firm's debt
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V = E + DE/V = percentage of financing that is equityD/V = percentage of financing that is debt
Tc = corporate tax rate
Opportunity CostThe cost of an alternative that must be forgone in order to pursue acertain action is called opportunity cost.
Lesson 10The Internal Rate of Return (IRR)
The IRR is the discount rate at which the NPV for a project equals zero.This rate means that the present value of the cash inflows for the projectwould equal the present value of its outflows.
(1)The IRR is the break-even discount rate.(2)The IRR is found by trial and error.
IRR OF AN ANNUITY
Q (n, r) = Io / C
Q (n, r) is the discount factorIo
is the initial outlayC is the uniform annual receipt (C1 = C2 =....= Cn).
Net present value vs. Internal rate of returnNPV and IRR methods are closely related because:i) Both are time-adjusted measures of profitability, andii) Their mathematical formulas are almost identical.
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NPV vs. IRR: Independent projects
Independent project: Selecting one project does not preclude the
choosing of the other. With conventional cash flows (-|+|+) noconflict in decision arises; in this case both NPV and IRR lead to thesame accept/reject decisions.
NPV vs. IRR: Dependent projects
NPV clashes with IRR where mutually exclusive projects exist.
Advantage of NPV:It ensures that the firm reaches an optimal scale of investment
Lesson 11THE PAYBACK PERIOD (PP)
The time it takes the cash inflows from a capital investment project toequal the cash outflows, usually expressed in years'. When decidingbetween two or more competing projects, the usual decision is to acceptthe one with the shortest payback.Payback is often used as a "first screening method".
For a project with equal annual receipts: PP = Io / Ct
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DISADVANTAGES OF PAYBACK
(1) It Ignore The Timing Of Cash Flow Within ThePayback Period, The Cash Flow After The EndOf Payback Period And Therefore The TotalProject Return
(2) It ignore the time value of money(3) Unable to distinguish between projects within
the same payback period.
(4) It may lead to excessive investment in short-term
projects
Advantages of the payback method
Payback can be important: long payback means capital tiedup and high investment risk.The method also has theadvantage that it involves a quick, simple calculationand aneasily understood concept
DISCOUNTED PAYBACK PERIOD
Length of timerequired to recover the initial cash
outflowfrom the discounted future cash inflows. This is the
approach where the present values of cash inflows are
cumulated until they equal the initial investment.
THE ACCOUNTING RATE OF RETURN
ARR method also called return on capital
employed(ROCE) or return on investment (ROI)
Formula
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ARR on total investment = net annual profit / investment outlay
Or
= [Rt+ c-d / Io]
Note the net annual profit excludes depreciation
Profitability indexThis is also known as benefit-cost ratio. It is a relationship between thePV of all the future cash flows and the initial investment.
This is a variant of the NPV method
PI= PV / Io