Fin 304 notesfdfhwefudvg fdre financial markets and institution

7/27/2019 Fin 304 notesfdfhwefudvg fdre financial markets and institution

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Working Capital Policy and Short Term Financing

Introduction This chapter deals with the management of working capital, which involves decisions

about the optimal overall level of current assets and the optimal mix of short-term fundsused to finance the companys assets.

It also deals with the financing of the current assets that make up the working capital. Working Capital Working capital is the firms total investment in current assets Net working capital equals current assets minus current liabilities Working capital represents assets that flow through the firm

Turned over at a rapid rate Usually recovered during the operating cycle when inventory sells and receivables

collected

Working capital is needed because of the time lag between cash disbursementsand cash receipts

Working Capital Policy Involves many decisions about a firms current assets and current liabilities

What they consist of How they are used How their mix affects the risk-return characteristics of the company

Operating Cycle Operating Cycle Analysis Operating Cycle Analysis Continued Size and Nature of Current Assets Depends on:

Type of product manufactured or distributed


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Length of operating cycle Optimal amount of Inventory Optimal amount of safety stock Credit policies Efficiency of current asset management

Appropriate Level of Working Capital More conservative policies often result in lost sales due to restrictive credit policies. Optimal level of working capital investment is the level which is expected to maximize

shareholder wealth.

Optimal Mix of ST and LT Debt Impact of term structure of interest rates

Long rates usually higher than short rates Thus the interest cost of short-term debt usually cheaper than long-term debt

Borrower incurs higher risk with short term debt Must refinance frequently Short term interest rates are highly volatile

Profitability Versus Risk Need for financing equal to the sum of:

Current assets Fixed assets

Current assets may be: Permanent - Are not affected by seasonal or cyclical demand Fluctuating - Are affected by seasonal or cyclical demand

Financing Strategies Matching


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Match the maturity of all assets & liabilities Reduces liquidity risk Hard to implement in practice

Financing Strategies Conservative Approach

High proportion of long term debt Less profitable, since LT debt usually more expensive

Financing Strategies Aggressive Approach

High proportion of short term debt More profitable (short term debt cheaper) but also more risky

An Optimal Financing Strategy? No one strategy is right for all firms The mix between ST and LT debt must also consider:

Industry norms

Variability of sales Variability of cash flows

Cost of Short Term Credit Sources of Short-Term Financing Trade credit Accrual expenses and deferred income Loans from commercial banks Commercial paper Borrowing against Account Receivables


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Trade Credit Seller provides financing as part of the sales inducement Spontaneous source of financing Cost of trade credit is captured in the purchase price Trade credit is never free. The cost of foregoing a cash discount is: Example: Cost of Foregoing a Discount A vendor offers a discount of 2% if payment is made within ten days. If the discount is

not taken, full payment is due in 30 days. What is the annual cost of not accepting the

2% discount?

Accrued Expenses & Deferred Income Any accrued but unpaid expense is a form of short term financing Stretching payables extends the financing period but can result in a poor credit rating Deferred income consists of payments received for goods & services to be delivered in

the future

Are shown on the Balance Sheet as a liability called Deferred Income Short Term Bank Credit Single loans for specific financial needs Line of credit

Agreement to borrow up to predetermined limit at any time Revolving credit

Legally commits the bank Usually secured Requires a commitment fee

Commercial Paper Short-term unsecured promissory notes


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Issued by large well-known corporations Maturities from a few days to 9 months Sold at a discount Purchasers include corporations, banks, insurance companies, pension funds, etc Accounts Receivable Loans Receivables make excellent collateral:

Fairly liquid Easy to recover in the event of default

Problems with receivables includes: Subject to fraud High administrative costs

Two common forms of receivables lending PledgingFirm retains title FactoringSale of A/R

With recourse

Without recourse Borrowing Against Inventory Inventory may make a good form of collateral, depending on the following

characteristics:

Perishability Identifiability Marketability Price stability

Borrowing Against Inventory


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When lending against inventory, the lender must decide who will hold the collateral(inventory)

If borrower holds inventory, the lender may use: Floating lien: floating charge over all current and future acquired inventory Trust receipt: inventory and sale proceeds are held in trust for the lender A third party holds the inventory in a: Terminal warehouse: inventory is stored in a bonded warehouse Field warehouse: secured inventory is segregated on site and managed by a field

warehouse company

Characteristics of Term Loans Granted by a bank or other lending institution Maturityinitial maturity of 1 to 10 years Less expensive than a public offering Repayment may include:

Equal periodic payments of interest plus principal (amortized) Equal principal payments plus interest on the outstanding balance Periodic payments plus a large [balloon] payment at the maturity date One large payment on the maturity date (bullet payment)

Characteristics of Term Loans Interest rate varies, depending on:

General level of rates in the market Size of the loan Maturity of the loan Borrowers credit rating

Interest may be charged as a:


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Fixed rate Variable rate (Prime plus ___%) Characteristics of Term Loans

Security Provisions Protect the lender in case of borrower default May include:

Assignment of monies due under a contract Assignment of receivables or inventory Floating lien or debenture on firm assets Pledge of marketable securities Mortgage on fixed assets Assignment of the cash surrender value on a life insurance policy

Characteristics of Term Loans Affirmative Covenants

Things the borrower will do Provide periodic Financial statements Carry insurance Maintain minimum net working capital

Negative Covenants Things the borrower will not do

Not to pledge certain assets as security

Not to merge or consolidate Not to make or guarantee loans to others

Sources of Term Loans Banks


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Insurance companies Pension funds Government agencies Equipment suppliers

Conditional sales contracts Chattel mortgages

Major Points Working capital consists of the current assets carried on the Balance Sheet and the

current liabilities used to fund them.

Current assets require an investment, similar to that of a fixed asset. Current assets are low return; therefore the firm wants to carry the minimum amount

necessary.

There are many forms of short-term funding available, but each of them has a costattached.


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Dividend Policy

Introduction This chapter examines the factors that influence a companys choice of dividend policy The pros and cons of dividend policies The mechanics of dividend payments Stock dividends Share repurchase plans Dividends When a company earns a profit, there are only two things it can do with the earnings:

Pay a dividend to the shareholders Retain the earnings in the form of Retained Earnings

The choice as to how to divide firm earnings between Retained Earnings and Dividendsand the implications of the choice made is the subject of this chapter.

Influencing the Value of the Firm Investment Decisions

Determine the level of future earnings and future potential dividends Financing Decisions


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Influence the cost of capital, which can determine the number of acceptableinvestment opportunities

Dividend Decisions Influence the amount of equity in a firms capital structure and the cost of capital

Determinants of Dividend Policy Legal Constraints

A firms capital cannot be used to pay dividends (capital impairment restriction) Dividends can only be paid out of past & present net earnings (net earnings

restriction)

Dividends cannot be paid when a firm is insolvent (insolvency restriction) Restrictive Covenants & Sinking Funds Usually imposed by creditors to prevent excessive withdrawals by owners

Determinants of Dividend Policy Tax considerations

Investment income can be received as a capital gain or as a dividend The marginal tax rate will determine which form of income is preferred by

investors

Liquidity and Cash Flow Considerations Dividends represent an outflow of cash Access to New Equity and Debt Capital A firm may decide to pay dividends and simultaneously issue new equity or

borrow

Determinants of Dividend Policy Variability of Earnings (stable vs. growth)

The more stable the earnings pattern, the greater the percentage of earnings thefirm can safely pay out as a dividend


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Inflation During periods of high inflation, the firm may need to retain more earnings to

fund the replacement of fixed assets

Determinants of Dividend Policy Shareholder Preference

Firms often develop clienteles that are attracted to the firms stated dividendpolicy

Protection Against Dilution If the firm pays dividends and issues new equity, existing shareholders will be

diluted if they do not purchase a portion of the new equity sold

Dividend Irrelevance Miller & Modigliani (MM) argue that dividends are irrelevant (under certain

assumptions)

MM argue that firm value is determined by the firms investment policy, not dividendpolicy

MMs assumptions for dividend irrelevance

No taxes

No transaction costs No issuance costs (for selling new equity) Existence of a fixed investment policy

Dividend Irrelevance MM recognize that changes in dividend policy affect share prices

They argue this is due to the informational content conveyed by the change, notthe change itself

Changes in dividend policy have a signaling effectit signals management beliefs aboutfuture firm prospects


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The existence of clienteles should not affect share price, since one clientele is as good asanother clientele

Are Dividends Relevant? Are Dividends Relevant? Risk aversion (Bird in the Hand Theory)

Dividends represent a regular, certain return, thereby lowering risk and increasingfirm value

Transaction costs With no transaction costs, investors can sell a portion of their shares to create a

dividend

In reality, transactions costs are real and significant Taxes

Investors care only about their after-tax return Thus taxes affect the preferred form of income

Relevance of Dividends Issuance (Flotation) costs

The existence of issuance costs reduces the attractiveness of paying dividends andissuing equity

Agency costs are reduced when management is subjected to market scrutiny Conclusions Regarding Dividend Policy Empirical evidence is mixed

Some studies found that, due to tax effects, investors require a higher pretaxreturn on high-dividend shares

Other studies found no difference Many practitioners believe that dividends are important due to:

Their informational content


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External equity is expensive Passive Residual Policy Suggests that a firm should retain its earnings as long as it has investment opportunities

that promise higher rates of return than the shareholders required return

Would imply that dividends fluctuate significantly, based on earnings & investmentopportunities

In practice, firms can smooth their dividends payments by using debt and varyingtheir earnings retention policy

Stable Dollar Dividend Policies Firms are reluctant to reduce dividends; shareholders like a stable dividend stream Increases in dividends tend to lag earnings Investors prefer stable dividends because:

Dividend changes convey information Many shareholders depend on dividend income Stability tends to reduce uncertainty, thereby lowering the firms cost of capital Certain institutions can only hold the shares of firms with a record of continuous

and stable dividends

Other Dividend Payment Policies Constant Payout Ratio

Pays a constant percent of earnings as dividends Causes the dividend to fluctuate

Other Dividend Payment Policies Small Regular Dividends Plus Extras

Shareholders can depend on regular payout Accommodates changing earnings and investment requirements

Other Dividend Payment Policies


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Small Firms and Dividends Tend to pay out a smaller percent of earnings Rapid growth requires capital; small firms retain more of their income to fund

growth

Small firms have limited access to capital markets Multinational Firms & Dividends Primary means of transferring funds to parent company Important issues to consider include:

Tax Foreign Exchange Political risk Funds availability Financing needs

Paying Dividends Dividend Reinvestment Plan Cash dividends reinvested automatically into additional shares Purchase new or existing shares

Purchasing new shares raises new equity capital for the firm No brokerage commissions Income tax liability Stock Dividends Stock dividends are similar to stock splits Both increase the number of shares outstanding Accounting transaction


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Transfer pre-dividend market value from retained earnings to other stockholdersequity

Market price of common shares should decline in proportion to the number ofnew shares issued

Reasons for Stock Dividends Broaden the ownership of the firms shares May result in an effective increase in cash dividends, provided the level of cash dividends

per share is not reduced

Reduction in share price may broaden the appeal of the stock to investors Thus may result in a real increase in market value

Share Repurchase By Tender Offer in the open market or by negotiation with large holders Acquired shares may be cancelled or held as Treasury stock Reduces the number of shares outstanding

Increases EPS for the remaining shareholders Stock repurchase programs are usually publicly announced Share Repurchase Advantages

Converts dividend income into capital gains Greater financial flexibility Greater control over timing Signaling effect Disadvantages Company may overpay for the stock Tax avoidance


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Some current shareholders may be unaware Major Points Firm profits are split into Retained Earnings and Dividends. Dividend policy explicitly

states how the firm intends to make this split.

In a perfect world, it would not matter whether the firm paid dividends or not. In the real world, where taxes and transaction costs exist, dividends probably do matter. Dividends can be paid in cash or stock. In both cases, stock price declines on ex-

dividend date

Share repurchases reduce shares outstanding, thereby pushing up the future price of thestock.

Capital Budgeting and Risk

Introduction This chapter considers adjusting a projects risk level when it has more or less risk than

the firms average level of risk

Risk


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Project risk The risk that a project will perform below expectations Some of the risk can be diversified away

Systematic risk Depends on the risk of the project relative to the market portfolio Systematic risk cannot be diversified away Capital Asset Pricing Model Used to estimate risk-adjusted discount rates for capital budgeting

Adjusting for Total Project Risk Net Present Value (NPV) - Payback approach Simulation approach Sensitivity analysis Scenario analysis Risk-adjusted discount rate approach

Certainty equivalent approach

NPV-Payback Approach A project must have a positive net present value and a payback of less than a critical

number of years to be acceptable

Simulation Approach Estimate the probability distribution of each element influencing a projects cash flows. Calculate the NPV using randomly chosen numerical values for the stochastic elements Repeat the process until a probability distribution of the NPV can be estimated Possible stochastic elements:

Number of units sold, market price, net investment, unit production costs, unitselling cost, project life, cost of capital


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Sensitivity Analysis Involves systematically changing relevant variables to identify which variables the

NPV/IRR seems most sensitive to

Useful to make sensitivity curves to show the impact of changes in a variable on theprojects NPV Electronic spreadsheets and financial modeling make sensitivity analysis easy to perform. Scenario Analysis Estimate the expected NPV for each of:

Optimistic Pessimistic Most likely Estimate the Probability of each scenario

Compute the expected NPV Compute the standard deviation (SD) of the NPV Considers the impact of simultaneous changes in key variables on the desirability of an

investment project

Risk-Adjusted Discount Rate Approach An individual project is discounted at a discount rate adjusted to the riskiness of the

project instead of discounting all projects at one rate

ka* = rf+ risk premium Calculate the NPV substituting ka* forkin the six steps of capital budgeting Certainty Equivalent Approach Involves converting expected risky Cash Flows to their certainty equivalents and then

computing the NPV

Risk-free rate (rf) is used as the discount rate rather than the cost of capital (k) The certainty equivalent factor is the ratio of the certainty equivalent Cash Flows to the

risky Cash Flows


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The Certainty-Equivalent NPV Elements of Risk if Investing Abroad Captive fundsinability to repatriate Foreign government expropriates the assets Exchange rate risk

Uncertain tax rates Calculating k: All Equity Case The projects risk-adjusted discount rate is found using the security market line (SML)

equation:

The Equity and Debt Case Betas can be observed for firms in the same investment class as the proposed investment These betas can be used to estimate risk-adjusted discount rates A two-step process is used

Calculate an unleveraged beta Calculate a new leveraged beta to reflect appropriate debt capacity

Step 1: Calculate Unleveraged Beta Convert observed, leveraged beta (l) into an unleveraged, or pure project beta (u) Step 2: Calculate New Leveraged Beta Calculate the new leveraged beta (l)for the proposed capital structure of the new line of

business

Step 2 (Continued) Calculate the required rate of return, ke, based on the new leveraged beta, l: Calculate the risk-adjusted required return, ka*, on the new line of business: Major Points Adjust for project risk using any one of six methods


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Net Present Value (NPV) -Payback approach Simulation approach Sensitivity analysis Scenario analysis Risk-adjusted discount rate approach Certainty equivalent approach

Capital Budgeting: Decision Criteria and Real Options

Introduction This chapter looks at capital budgeting decision models It discusses and illustrates their relative strengths and weaknesses It examines project review and post-audit procedures, and traces a sample project through

the capital budgeting process


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Types of Capital Budgeting Criteria Net present value (NPV) Profitability index (PI) Internal rate of return (IRR) Payback period (PB) Net Present Value Present value of the stream of future cash flows derived from a project minus the

projects net investment

Characteristics of Net Present Value Considers the time value of money Absolute measure of wealth

Positive NPVs increase owners wealth Negative NPVs decrease owners wealth NPV not easily understood

Assumes that cash flows over the projects life can be reinvested at the cost of capital, k Does not consider the value of real options Profitability Index Ratio of the present value of future cash flows over the life of the project to the net

investment

Profitability Index Characteristics Relative measure showing wealth increase per dollar of investment Accept when PI > 1; reject when PI 1. Considers the time value of money Assumes cash flows are reinvested at k If NPV and PI criteria disagree, with no capital rationing, NPV is preferred


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PI is preferred to NPV under capital rationing Internal Rate of Return Rate of discount (k) that equates the present value of a projects net cash flows with the

present value of the net investment

IRR Characteristics If IRR > k, then the project is acceptable Considers the time value of money Unusual cash flow pattern can result in multiple IRRs If NPV and IRR disagree, NPV is preferred. If NPV > 0, IRR > k; if NPV < 0, IRR < k Assumes cash flows are reinvested at IRR. Does not consider the value of real options Payback Period Number of years for the cumulative net cash flows from a project to equal the initial cash

outlay

Payback Period Characteristics Simple to use and easy to understand Provides a measure of project liquidity Provides a measure of project risk Not a true measure of profitability Ignores cash flows after the payback period Ignores the time value of money May lead to decisions that do not maximize shareholder wealth Capital Budgeting Under Capital Rationing Calculate the profitability index for projects


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Order the projects from the highest to the lowest profitability index Accept the projects with the highest profitability index until the entire capital budget is

spent

Next Acceptable Project is too Large Search for another combination of projects that increases the NPV Attempt to relax the funds constraint When Excess Funds Exist Invest in short-term securities Reduce outstanding debt Pay a dividend Post-Auditing Implemented Projects Find systematic biases or errors relating to projected cash flows Decide whether to abandon or continue projects that have done poorly Inflation and the Capital Budget Make sure the cost of capital takes account of inflationary expectations Make sure that future cash flow estimates include expected price and cost increases Real Options in Capital Projects Investment timing option

Abandonment option Shutdown options Growth options Design-in options

Applying Real Options Concepts Foundation level of use of real options concept

Increase awareness of value


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Options can be created or destroyed Think about risk and uncertainty Value of acquiring additional information Real options as an analytical tool Option pricing models

Value the option characteristics of projects Analyze various project opportunities

International Capital Budgeting Find the present value of the foreign cash flows denominated in the foreign currency and

discounted at the foreign countrys cost of capital.

Convert the present value of the cash flows to the home countrys currency using thecurrent spot exchange rate.

Subtract the parent companys net investment from the present value of the net cashflows to obtain the NPV.

Amount and Timing of Foreign CFs Differential tax rates in different countries Legal and political constraints on repatriating cash flows Government-subsidized loans may affect the WACC or discount rate Small Firms Principles are the same as for large firms Discrepancies

Lack experience to implement procedures

Expertise stretched too thin Cash shortages often require emphasis on payback period

Major Points


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Four types of capital budgeting decision criteria: NPV Profitability Index IRR Payback Period NPV is the preferred decision criteria when capital is not constrained

Remember to think about real options

The Cost of Capital


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Introduction This chapter discusses:

The cost of capital What is it How is it measured What is the Weighted Average Cost of Capital (WACC)

Risk vs. required return trade-off Cost of Capital The return required by investors to hold a companys securities Determined in the capital markets Depends on the risk associated with the firms activities Determines what the firm must pay to acquire new capital (sell new securities) Firms must earn more than their cost of capital or they destroy shareholder wealth Concept of Capital Structure A firms capital structure consists of the mix of debt and equity securities that have been

issued to finance the firms activities.

Forms of financing include: Common stock Preferred stock Bonds (secured debt) Debentures (Unsecured debt) Each different type of security has different risk characteristics and therefore will

earn a different return in the market.

Weighted Ave. Cost of Capital (WACC) Discount rate used when computing the net present value of a project of average risk.


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Calculated by weighting the cost of each form of security issued (Common stock,preferred stock, bonds, debentures).

Weights equal to the proportion of each of the components in the capital structure. Weighted Average Cost of Capital Weighted Average Cost of Capital

Example: A firms capital structure includes $3 Million in bonds, $6 Million in equity, and $1

Million in preferred stock (market values). The firms cost of equity is 15%, the cost of debt is

8% and the cost of preferreds is 10%. If the firms marginal tax rate is 50%, what is its WACC?

Required Rate of Return Risk-free Rate of Return + Risk Premium Risk-free Rate of Return:

real rate of return (compensation for deferring consumption) plus compensationfor expected inflation

Risk Premium: additional reward required for bearing the risk of an investment Composed of business risk, financial risk, marketability risk, interest rate risk and

seniority risk.

Risk-Return Trade-Offs

Cost of Debt The firms after-tax cost of debt (ki) is found by multiplying the firms pre-tax cost of

debt (kd) by 1 minus the firms marginal tax rate (T).

Debt is the firms lowest cost source of funds, since interest is a tax-deductible expense. As the amount of debt issued increases, the risk of default rises and so does the cost. Cost of Preferreds The firms after-tax cost of preferreds (kp) is equal to the pre-tax cost (Dp/Pnet), since

dividends are not tax deductible (dividends are paid out of after-tax cash flow).

Cost of Internal Equity Capital The firms cost of internal equity is the return demanded by the existing shareholder.


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The CAPM defines this return as: Cost of External Equity Capital The cost of external equity is greater than the cost of internal equity due to the existence

of

Issue costs New issue discounts from market price

Issue Costs & Discounts Issue (flotation) costs are the costs associated with making a new issue of equity to the

public.

To sell a new issue of shares, the sale price may have to be set below the current marketprice.

Current market price represents an equilibrium between supply & demand Without new demand being created, the new supply will push down the market

price

Growth Rate Information Institutional Brokers Estimate System

www.firstcall.com/ Zacks Earnings Estimates

www.zacks.com/ Thomson Financial First Call Service

www.firstcall.com/index.html Dividend growth model

www.finplan.com/invest/divgrowmod.htm CAPM Check out this Web site to see how the CAPM is used to calculate a firms cost of equity:

http://www.ibbotson.com/
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Divisional Costs of Capital Some divisions of a company have higher or lower systematic risk. Discount rates for divisions are higher or lower than the discount rate for the firm as a

whole.

Each division could have its own beta and discount rate. Should reflect both the differential risks and the differential normal debt ratios for each

division.

Depreciation A major source of funds Equal to the firms weighted cost of capital based on retained earnings and the lowest

cost of debt

Availability of funds from depreciation shifts the marginal cost of capital (MCC) to theright by the amount of depreciation

Cost of Capital: Case Study Major Foods Corporation is developing its cost of capital. The firms current & target

capital structure is:

40% debt

10% preferred shares 50% common equity The firm can raise the following funds Debtup to $5 Million at 9% Debtover $5 Million at 10% Preferred shares10% The firms marginal tax rate is 40%

Cost of Capital: Case Study (Contd) Equity and internally generated funds


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The firm will generate $10 Million of retained earnings this year Current dividend is $2 per share Current share price is $25 New common shares can be sold at $24 Earnings and dividends growing at 7% per year

Payout ratio expected to remain constant Cost of Capital: Case Study Solution

Step #1: Calculate the cost of capital for each component of financing Cost of debt (up to $5 Million of new debt) Cost of debt (over $5 Million of new debt) Cost of Capital: Case Study Solution Step #1: Calculate the cost of capital for each component of financing

Cost of Preferreds

Cost of Equity (internal) Cost of Capital: Case Study Solution Step #1: Calculate the cost of capital for each component of financing Cost of Equity (external) Cost of Capital: Case Study Solution Step #2: Compute the weighted average cost of capital for each increment of capital raised.

The firm wants to retain its target capital structure


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The firm should always raise its cheapest source of funds first. These are: Retained earnings (internal equity) Preferred shares Debt up to $5 Million

Cost of Capital: Case Study Solution Increment #1: Calculate total financing that can be acquired using 9% debt while

retaining the target capital structure with 40% debt.

Cost of Capital: Case Study Solution The WACC for increment #1 is: Cost of Capital: Case Study Solution Increment #2: Calculate total financing that can be acquired using internally generated

equity (retained earnings) while retaining the target capital structure with 50% equity.

Cost of Capital: Case Study Solution The WACC for increment #2 (total new funding between $12.5 Million & $20 Million is: Cost of Capital: Case Study Solution Increment #3: Financing in excess of $20 Million will require both high-cost debt and

issuing new common stock. The WACC for Increment #3 is:

Cost of Capital: Case Study Solution Small Firms Have a difficult time attracting capital Issuance costs are high (> 20% of issue)

Often issue two classes of stock

One class sold to outsiders paying a higher dividend Second class held by founders with greater voting power Limited sources of debt

Major Points


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The Weighted Average Cost of Capital (WACC) is a weighted average cost of funding. Equity is the most expensive form of funding; debt is the cheapest. Debt has a tax advantage due to the tax-deductibility of interest

Analysis of Risk and Return

Introduction This chapter develops the risk-return relationship for both individual projects

(investments) and portfolios of projects

Risk and Return Risk is usually defined as the actual or potential variability of returns from a project or

portfolio

Risk-free returns are known with certainty Federal Government Treasury Bills are often considered the risk-free security. The risk-free rate of return sets a floor under all other returns in the market.

Holding Period Return Return for holding an investment for one period (i.e. period of days, months, years, etc.) When there is no cash flow during the holding period, then: Holding Period Return When there is a cash flow in addition to the ending price (such as the payment of a

dividend), the Holding Period Return formula is:

Holding Period Return: Example

You bought a stock one year ago for $10. Today, it is worth $12. Yesterday, youreceived a $1 dividend. What is your holding period return?

Returns Ex Post Returns (After the fact)


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Return that an investor actually realizes Ex Ante Returns (Before the fact) Return that an investor expects to earn

Analyzing Return Expected Return ( ):

When returns are not known with certainty, there will often exist a probabilitydistribution of possible returns with an associated probability of occurrence.

Expected return is a weighted average of the individual possible returns (rj), withweights being the probability of occurrence (pj).

Expected Return: Example Expected Return: Solution Analyzing Risk Standard Deviation ( ): a statistical measure of the dispersion, or variability, of

outcomes around the mean or expected value ( ).

Low standard deviation means that returns are tightly clustered around the mean High standard deviation means that returns are widely dispersed around the mean

Calculating Standard Deviation Three common ways of calculating standard deviation:

Returns are known with certainty Standard deviation of a population Standard deviation of a sample

Returns are not known with certainty

Standard Deviation of a Population Standard Deviation of a Sample Standard Deviation: Example


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You have been given the following sample of stock returns, for which you would like tocalculate the standard deviation:

{12%, -4%, 0%, 22%, 5%}

Standard Deviation: Example

You have been given the following sample of stock returns, for which you would like tocalculate the standard deviation:

{12%, -4%, 0%, 22%, 5%}

Step 1: Calculate Arithmetic Return Standard Deviation: Example You have been given the following sample of stock returns, for which you would like to

calculate the standard deviation:

{12%, -4%, 0%, 22%, 5%}

Step 2: Calculate Variance Standard Deviation: Example You have been given the following sample of stock returns, for which you would like to

calculate the standard deviation:

{12%, -4%, 0%, 22%, 5%}

Step 3: Calculate Standard Deviation Standard DeviationReturns Not Certain Standard Deviation: Example You have been provided with the following possible returns and their associated

probabilities. Calculate the expected return and the standard deviation of return.

Standard Deviation: Solution Step #1: Calculate the Expected Return Standard Deviation: Solution Step #2: Calculate the Variance


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Standard Deviation: Solution Step #3: Calculate the Standard Deviation Normal Probability Distribution A symmetrical, bell-like curve where 50% of possible outcomes are greater than the

expected value and 50% are less than the expected value.

A normal distribution is fully described by just two statistics: Mean Standard deviation

Normal Probability Distribution Normal Distribution Example Standard Normal Probability Problem: Standard deviation is correlated with size of the mean Solution: To allow for easy comparison among distributions with different means,

standardize using a Z score

Z score measures the number of standard deviations ( ) a particular rate of return (r) isfrom the mean or expected value ( ).

Standard Normal: Example What is the probability of a loss on an investment with an expected return of 20% and a

standard deviation of 17%?

Step #1: Calculate the Z Score for the number of standard deviations from the mean for a0% return

Standard Normal: Example What is the probability of a loss on an investment with an expected return of 20% and a

standard deviation of 17%?

Step #2: Consult Table V on Page 712. Find the row with 1.10 in the left hand column.Then find the column with 0.08 in the top row. The cell where the row & column


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intersect is the probability of obtaining a value less than 1.18 standard deviations from

the mean. The answer is 0.1190 or 11.90%

Probability of Earning Less then 0%

Concept of Efficient Portfolios Has the highest possible expected return for a given level of risk (or standard deviation) Has the lowest possible level of risk for a given expected return Coefficient of Variation (v) The ratio of the standard deviation ( ) to the expected value ( ). Tells us the risk per unit of return. An appropriate measure of total risk when comparing two investment projects of different

size.

Coefficient of Variation: Example You are asked to rank the following set of investments according to their risk per unit of

return.

Coefficient of Variation: Solution Relationship Between Risk and Return Required Rate of Return

Discount rate used to present value a stream of expected cash flows from an asset. Risk-Return Relationship The riskier, or the more variable, the expected cash flow stream, the higher the

required rate of return.

Relationship Between Risk and Return Required Rate of Return =

Risk-free Rate of Return + Risk Premium

Risk-free Rate: rate of return on securities that are free of default risk, such as T-bills.


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Risk Premium: expected reward the investor expects to earn for assuming risk Risk-Free Rate of Return Risk-free Rate of Return (rf) =

Real Rate of Return + Exp. Inflation Premium

Real Rate of Return: the reward for deferring consumption Expected Inflation Premium: compensates investors for the loss of purchasing power due

to inflation

Types of Risk Premiums Maturity risk premium Default risk premium Seniority risk premium Marketability risk premium Business risk Financial risk Term Structure of Interest Rates Term structure is a plot of the yield on securities with similar risk but different maturities Term structure is used to explain the maturity risk premium (why long securities tend to

have higher yields than short maturity securities)

Three theories of the Term Structure: Expectations theory Liquidity premium theory Market segmentation theory

Expectations Theory The long interest rate is the geometric average of expected future short interest rates.


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If the term structure is sloping up, future short interest rates are expected to be higherthan current short interest rates.

If the term structure is sloping down, future short interest rates are expected to be lowerthan current short interest rates.

Liquidity Premium Theory Investors prefer liquidity (the ability to convert to cash at or near face value) Long securities are less liquid than short securities Therefore, to induce investors to hold long securities, must pay a liquidity premium Market Segmentation Theory The yield in each segment of the yield curve is determined by the supply and demand for

funds in that maturity zone

Supply & demand driven by firms which deal primarily in a specific maturity zone Chartered banksshort maturities Trust companiesmedium maturities Pension fundslong maturities

Modern Portfolio Theory Expected Return The expected return on a portfolio is the weighted average of the returns of each asset

within the portfolio

Example: A portfolio is comprised of three securities with the following returns:

Expected Return The expected return of the portfolio is the weighted average: Portfolio Risk: Two Risky Assets Standard deviation of a two-asset portfolio is calculated as follows: Portfolio Risk: Two Risky Assets


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Correlation Correlation is a measure of the linear relationship between two assets Correlation varies between perfect negative (-1) to perfect positive (+1) Perfect negative correlation: when the return on asset A rises, the return on Asset B falls

and vice versa

Perfect positive correlation: the returns on asset A and Asset B move in perfect unison Correlation & Risk Reduction Moving Toward Many Risky Assets When the portfolio consists of many risky assets, they form a plot similar to a broken egg

shell shape

Each dot within the broken egg shell shape represents the risk/return profile for a singlerisky asset or portfolio of risky assets

To maximize return per unit of risk assumed, an investor would always choose an asset orportfolio that plots along the efficient frontier

Portfolios: Many Risky Assets Choosing a Portfolio: So Far The investor first decides how much risk to assume The investor then chooses the portfolio that plots along the efficient frontier with that

amount of risk

Introducing the Risk Free Security When a risk-free asset (Treasury Bill) is introduced into the set of risky assets, a new

efficient frontier emerges

This new efficient frontier is known as the Capital Market Line (CML) The CML represents all possible portfolios comprised of Treasury Bills and the Market

Portfolio

Adding the Risk-Free Asset Capital Market Line (CML)


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To maximize return for an amount of risk, investors should hold a portion of their assetsin T-bills and a portion in the market portfolio.

Linear relationship between risk and return To earn an expected return greater than the return on the market portfolio, invest morethan 100% of ones own wealth in the market portfolio. What are we Missing? We know:

Investors should split their assets between Treasury bills and the market portfolio To reduce risk, invest a greater proportion of assets in Treasury bills To enhance expected return, invest a greater proportion of assets in the market

portfolio

We do not know how to calculate the expected return (and hence the price) for a singlerisky asset

The Capital Asset Pricing Model is needed The Missing Link We need to measure the Market risk that cannot be diversified away The Missing Link CAPM: Systematic Risk is Relevant Systematic, or non-diversifiable, risk is caused by factors affecting the entire market

interest rate changes changes in purchasing power change in business outlook Unsystematic, or diversifiable, risk is caused by factors unique to the firm strikes regulations managements capabilities


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Portfolio Diversification When assets are put into a well-diversified portfolio, some of the unique or nonsystematic

risk is diversified away

The number of assets required to diversify away most of the unique risk varies with thecorrelation between the assets Canadas capital markets are more highly correlated with the natural resource

sector than are the US capital markets

Require more securities in Canada to diversify away most of the unique risk Diversifying Unique Risk Systematic Risk is Measured by Beta Beta is a measure of the volatility of a securitys return compared to the volatility of the

return on the Market Portfolio

Concept of Beta Security Market Line (SML) Shows the relationship between required rate of return and beta (). Required Rate of Return The required return for any securityj may be defined in terms of systematic risk, j, the

expected market return, rm, and the expected risk free rate, rf.

SML: Example A security has a Beta of 1.25. If the yield on Treasury Bills is 5% and the return on the

market portfolio is 11%, what is the expected return for holding the security?

Market Risk Premium The reward for bearing risk

Equal to (rmrf) Equal to the slope of security market line (SML)

Will increase or decrease with uncertainties about the future economic outlook


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the degree of risk aversion of investors Security Market Line (Again) CAPM Assumptions Investors hold well-diversified portfolios Competitive markets Borrow and lend at the risk-free rate Investors are risk averse No taxes Investors are influenced by systematic risk Freely available information Investors have homogeneous expectations No brokerage charges CAPM Drawbacks Estimating expected future market returns on historic returns.

Determining an appropriate rf

Determining the best estimate of Investors dont totally ignore unsystematic risk Betas are frequently unstable over time Required returns are determined by macroeconomic factors Market Efficiency Capital markets are efficient if prices adjust fully and instantaneously to new information

affecting a securitys prospective return.

Three Degrees of Market Efficiency Weak form Semi-strong form


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Strong form Weak Form Market Efficiency Security prices capture all of the information contained in the record of past prices and

volumes

Implication: No investor can earn excess returns using historical price or volumeinformation. Technical analysis should have no marginal value.

Semi-Strong Form Market Efficiency Security prices capture all of the information contained in the public domain. Implication: No investor can earn excess returns using publicly available information.

Fundamental analysis should have no marginal value.

Strong Form Market Efficiency Security prices capture all information, both public and private. Markets are quite efficient (but it is illegal to use private information for personal gain,

when trading securities)!

Common Shares: Characteristics and Valuation

Introduction This chapter describes:

the characteristics of common shares common share valuation models

Common Shares Common shares are evidence of ownership. Common shareholders own the firm. Common shares are a form of long-term financing for a firm.


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Common shares are often called a residual security as their value represents whateverassets are left after all prior claims against the assets have been settled.

Common shareholders elect the Board of Directors. Balance Sheet Accounts Par Value of Common Shares (can ignore for all practical purposes) Contributed Capital in Excess of Par

Additional paid in capital Capital surplus Retained earnings

Book Value per Share The book value of a companys assets attributable to each share of common stock

Example: ZBC Corporation reports a common share account balance of $10M and a retained

earnings of $5M with 100M shares outstanding. The book value per share is $0.15.

Common Shareholder Rights Right to vote at shareholder meetings. Right to share in the profits of an organization (paid either as a dividend or as reinvested

profits).

Right to share in the residual assets of an organization after all other stakeholder (i.e.governments, creditors, employees) claims are satisfied.

Voting for the Board of Directors Majority voting

Each share carries one vote Requires more than 50% of the votes to elect a Director

Cumulative voting Each share carries as many votes as there are Directors to be elected Shareholders may cast all votes for one candidate


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Voting by Proxy Shareholders may elect to assign their voting rights to someone else. Management actively solicits proxies. A dissent shareholder group may attempt to solicit proxies to wrest control away from

management.

Common Share Features Certificate of ownership Classes

Voting vs. non-voting Amount shareholder invests in common shares is the maximum capital at risk

(shares are said to be fully paid and non-assessable).

Common shares are marketable securities that can be transferred from one investor toanother.

Common Share Features Advantages

Flexible Reduces financial risk Disadvantages Dilute Earnings Per Share Most expensive form of financing

Common Share Transactions Cash Dividend

Firm pays a portion of retained earnings in cash to shareholders based uponnumber of shares owned (i.e. $0.60/share)

Stock Dividend Funds transferred from retained earnings to the common share account.


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Shareholders receive certificate for additional shares. Common Share Transactions Stock Split

Firm increases the number of shares outstanding by issuing a specific number ofnew shares for every old shares outstanding

Example: stock splits 3 for 1. Reverse Stock Split Firm decreases the number of shares outstanding by consolidating a specific

number of old shares into one share.

Example: stock reverse split of 1 for 3 Common Share Transactions Stock Repurchases

Disposition of excess cash Repurchased shares are often cancelled Earnings power of remaining shares is increased Financial restructuring Future corporate needs (stock option plans) Reduction of takeover risk

Valuation of Common Shares Cash flows attributable to a common stock accrue from:

Dividend stream (while owning the stock) Sale price (the future dividends that would have been received from sale date to

perpetuity)

Dividend Valuation Models Zero growth model


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Constant growth model Nonconstant growth model Dividend Valuation Models Zero Growth Model

The cash flow (dividend) is expected to remain the same over time. Identical to model applied to preferred shares Zero Growth: Example

Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain thesame into the foreseeable future. If shareholders require a return of 20% to hold the

stock, what is each share worth in the market?

Dividend Valuation Models Constant Growth Model

The cash flow (dividend) is expected to increase at a constant rate over time Constant Growth: Example Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share. The dividend is

expected to grow at a rate of 5% per year for the foreseeable future. If the shareholders

require a 15% return to hold Tinkerbell shares, what is each share worth in the market?

Dividend Valuation Models Nonconstant Growth Model

Many firms grow rapidly for period of time. However, eventually, growth slowsto a long-run sustainable constant rate

To deal with the nonconstant growth example, we simply present value alldividends back to time period zero

Nonconstant Growth: Example Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for 3 years. From

then on, growth is expected to be 10% per year. The firm paid a dividend of $1.00

yesterday. The dividend is expected to grow at the same rate as the firms growth rate. If


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the shareholders require a 15% return to hold the common stock, what is each share

worth in the market?

Nonconstant Growth: Solution

Draw a time line showing the expected cash flows. Each dividend must be calculated,using the growth rate for the period.

Nonconstant Growth: Solution Nonconstant Growth: Solution Nonconstant Growth: Helpful Hints Draw a timeline Calculate each dividend on the timeline During the period of nonconstant growth, present value dividends back to time zero Once growth has stabilized:

Calculate the present value of all dividends from that point forward out to infinity. Calculated value must be brought back to time zero. Example: Dividend4, multiply by:

Sources of Growth Rate Forecasts Value Line Investment Survey

www.valueline.com Thompson Financial/First Call

www.tfn.com Zacks Earnings Estimates

www.zacks.com Major Points Common shares are a form of long-term financing for a firm. The value of a common share is equal to the present value of its future cash flows.


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The value of a common share is determined using: Zero growth model (preferred shares) Constant growth model (blue chip stocks) Nonconstant growth model (growth stocks)

Time Value of Money

Introduction This chapter introduces the concepts and skills necessary to understand the time value of

money and its applications.


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Payment of Interest Interest is the cost of money Interest may be calculated as:

Simple interest Compound interest

Simple Interest Interest paid only on the initial principal

Example: $1,000 is invested to earn 6% per year, simple interest.

Compound Interest Interest paid on both the initial principal and on interest that has been paid & reinvested.

Example: $1,000 invested to earn 6% per year, compounded annually.

Future Value The value of an investment at a point in the future, given some rate of return.

Future Value: Simple InterestExample: You invest $1,000 for three years at 6%simple interest per year.

Future Value: Compound InterestExample: You invest $1,000 for three years at 6%, compoundedannually.

Future Value: Compound Interest Future values can be calculated using a table method, whereby future value interest

factors (FVIF) are provided.

See Table 4.1 (page 135)


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Future Value: Compound InterestExample: You invest $1,000 for three years at 6% compoundedannually.

Present Value What a future sum of money is worth today, given a particular interest (or discount) rate. Present Value Present Value Present Value

Example: What is the present value of $1,000 to be received in three years, given a discount

rate of 6%?

A Note of Caution Note that the algebraic solution to the present value problem gave an answer of 839.62 The table method gave an answer of $840.

Annuities The payment or receipt of an equal cash flow per period, for a specified number of

periods.

Examples: mortgages, car leases, retirement income.

Annuities Ordinary annuity: cash flows occur at the end of each period

Example: 3-year, $100 ordinary annuity

Annuities Annuity Due: cash flows occur at the beginning of each period

Example: 3-year, $100 annuity due

Difference Between Annuity Types


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Annuities: Future Value Annuities: Future ValueAlgebra Future value of an ordinary annuity Annuities: Future Value

Example: What is the future value of a three year ordinary annuity with a cash flow of $100

per year, earning 6%?

Annuities: Future ValueAlgebraExample: What is the future value of a three year annuity due with a cash flow of $100 per

year, earning 6%?

Annuities: Future ValueTable Ordinary Annuity: Future Value Annuity Due: Future Value Annuity Due: Future Value Annuities: Present Value

Annuities: Present ValueAlgebraExample: What is the present value of a three year, $100 ordinary annuity, given a discount

rate of 6%?

Annuities: Present ValueAlgebra

Annuities: Present ValueAlgebraExample: What is the present value of a three year, $100 annuity due, given a discount rate of

6%?

Annuities: Present ValueTable


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Annuities: Present ValueTable Annuities: Present ValueTable Annuities: Present ValueTable Other Uses of Annuity Formulas Sinking Fund Problems: calculating the annuity payment that must be received or

invested each year to produce a future value.

Other Uses of Annuity Formulas Loan Amortization and Capital Recovery Problems: calculating the payments necessary

to pay off, or amortize, a loan.

Perpetuities Financial instrument that pays an equal cash flow per period into the indefinite future (i.e.

to infinity).

Example: dividend stream on common and preferred stock

Perpetuities Present value of a perpetuity equals the sum of the present values of each cash flow. Equal to a simple function of the cash flow (PMT) and interest rate (i). Perpetuities

Example: What is the present value of a $100 perpetuity, given a discount rate of 8%

compounded annually?

More Frequent Compounding Nominal Interest Rate: the annual percentage interest rate, often referred to as the

Annual Percentage Rate (APR).

Example: 12% compounded semi-annually

More Frequent Compounding Increased interest payment frequency requires future and present value formulas to be

adjusted to account for the number of compounding periods per year (m).

More Frequent Compounding


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Example: What is a $1,000 investment worth in five years if it earns 8% interest, compounded

quarterly?

More Frequent CompoundingExample: How much do you have to invest today in order to have $10,000 in 20 years, if youcan earn 10% interest, compounded monthly?

Impact of Compounding Frequency Effective Annual Rate (EAR) The annually compounded interest rate that is identical to some nominal rate,

compounded m times per year.

Effective Annual Rate (EAR) EAR provides a common basis for comparing investment alternatives.

Example: Would you prefer an investment offering 6.12%, compounded quarterly or one

offering 6.10%, compounded monthly?

Major Points The time value of money underlies the valuation of almost all real & financial assets Present valuewhat something is worth today

Future valuethe dollar value of something in the future

Investors should be indifferent between: Receiving a present value today Receiving a future value tomorrow A lump sum today or in the future An annuity

The Role and Objective of Financial Management


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Introduction This chapter introduces the financial management process. It looks at the financial

manager, the field of finance, financial decisions and their implications, and the daily

questions faced by the firms financial management.

Questions Faced in Finance How is finance related to other fields of study? What are financial managers goals and objectives? How has the finance field evolved? How is the finance field changing today? Forms of Business Organizations Sole proprietorship Partnership Corporation Sole Proprietorship Owned by one person Represent 75% of all businesses, but accounts for less than 5% of dollar volume. Small Business Not the dominant firm in the industry Tend to grow more rapidly Lack management resources Have a high failure rate Shares not publicly traded Poorly diversified Owner/manager frequently the same Partnership


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Owned by two or more persons Classified as general or limited Liability of Partners General Partner

Has unlimited liability for all obligations of the business

Limited PartnerLiability limited to the partnership agreement

Limited Partnerships Must have at least one general partner who:

Has unlimited liability Performs all management functions Can have many limited partners who: Have limited liability Cannot participate in management

Corporation

A distinct, legal entity of its own Board of Directors Shareholders elect a Board of Directors Board of Directors appoints the officers of the company:

Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO)


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Vice president Treasurer Secretary

Who Manages?

Shareholder Rights Right to share in company profits (or losses) Right to vote

Some shares may be non-voting Some shares may carry multiple votes

Right to share in the residual assets at dissolution Right to acquire new common stock (preemptive right) Priority of Corporate Securities

Type of Organization Influenced by

Cost Complexity Liability Continuity Need for capital Decision making Tax considerations Shareholder Wealth Maximization Core objective of financial managers.


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Considers the timing and risk of the benefits from stock ownership Determines that a good decision increases the price of the firms common stock (C/S) Is an impersonal objective Is concerned for social responsibility Social Responsibility Ethical issues will constantly confront financial managers as they strive to achieve the

goal of Shareholder Wealth Maximization

Managers must: Avoid personal conflicts of interest Maintain confidentiality Be objective Act fairly

Agency Relationships/Problems Job Security Managements decisions may be based on retaining management, rather than Shareholder

Wealth Maximization

Example:

A decision is made to retain an existing supplier rather than select a new supplierproviding higher quality and/or lower cost

Why? If a change is made management will be scrutinized, but if no change ismade, the issue will be ignored.

Agency Costs Costs incurred by shareholders to minimize agency problems

Examples:

Management incentives Monitor performance


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Owners protection Complex organization structures

Recent Trend: flatter organizational structures have emerged to reduce costs. Another Agency Problem Examples of Protective Covenants Limitations on

Dividends Capital expenditures Asset divestitures Incurring additional debt Poison pills

SWM and Profit Maximization Shareholder Wealth Maximization is not the same as Profit Maximization

Reasons:

Profit maximization has no time dimension

Profit is an accounting concept with many different interpretations Profit maximization ignores risk

Maximizing Shareholder Wealth To maximize shareholder wealth, the financial manager must maximize the market value

of the firms common stock

Three factors determine the market value of common stock: Size of the firms cash flow Timing of the firms cash flow Risk of the firms cash flow stream

Conditions Affecting Market Value


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Cash Flow Cash flows, not accounting profits, are critical to most financial analysis Important cash flow concepts:

Timing of cash inflows versus cash outflows Cash flow is not equal to operating profit.

Concept of Net Present Value The net present value (NPV) of an investment represents the contribution of the

investment to the value of the firm

To maximize shareholder wealth, reject all projects with a negative NPV NPV = PV of cash inflows - PV of cash outflows NPV Example A firm is analyzing a new investment opportunity. It can invest $1 million today to

generate free cash flows of $400,000 per year for the next three years. After three years,

the project is worthless. The firms shareholders require a 20% return. Should they

proceed?

NPV Example: Intuition NPV Example: Solution Major Points Businesses may be established as proprietorships, partnerships or corporations. Shareholders are entitled to a number of rights as owners of a corporation. The separation between shareholders, managers and creditors give rise to agency

problems which detract from a firms goal of shareholder wealth maximization.

Positive NPV projects enhance shareholder wealth.


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Managing Current Assets

Alternative working capital policies Cash management Inventory management Accounts receivable management Working capital terminology Gross working capitaltotal current assets. Net working capitalcurrent assets minus non-interest bearing current liabilities. Working capital policydeciding the level of each type of current asset to hold, and how

to finance current assets.

Working capital managementcontrolling cash, inventories, and A/R, plus short-termliability management.

Selected ratios for SKI Inc.SKI Ind. Avg.

Current 1.75x 2.25x

Debt/Assets 58.76% 50.00%

Turnover of cash & securities 16.67x 22.22x

DSO (days) 45.63 32.00

Inv. turnover 4.82x 7.00x

F. A. turnover 11.35x 12.00x

T. A. turnover 2.08x 3.00x


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Profit margin 2.07% 3.50%

ROE 10.45% 21.00%

How does SKIs working capital policy compare with its industry? SKI appears to have large amounts of working capital given its level of sales. Working capital policy is reflected in current ratio, turnover of cash and securities,

inventory turnover, and DSO.

These ratios indicate SKI has large amounts of working capital relative to its level ofsales. SKI is either very conservative or inefficient.

Is SKI inefficient or just conservative? A conservative (relaxed) policy may be appropriate if it leads to greater profitability. However, SKI is not as profitable as the average firm in the industry. This suggests the

company has excessive working capital.

Cash conversion cycle The cash conversion model focuses on the length of time between when a company

makes payments to its creditors and when a company receives payments from its

customers.

Cash conversion cycle Cash doesnt earn a profit, so why hold it?1. Transactionsmust have some cash to operate.2. Precautionsafety stock. Reduced by line of credit and marketable securities.3. Compensating balancesfor loans and/or services provided.4. Speculationto take advantage of bargains and to take discounts. Reduced by credit

lines and marketable securities.

What is the goal of cash management? To meet above objectives, especially to have cash for transactions, yet not have any

excess cash.

To minimize transactions balances in particular, and also needs for cash to meet otherobjectives.


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Ways to minimize cash holdings Use a lockbox. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account. Increase forecast accuracy to reduce need for safety stock of cash. Hold marketable securities (also reduces need for safety stock). Negotiate a line of credit (also reduces need for safety stock). What is float, and how is it affected by the firms cash manager? Float is the difference between cash as shown on the firms books and on its banks

books.

If SKI collects checks in 2 days but those to whom SKI writes checks dont process themfor 6 days, then SKI will have 4 days of net float.

If a firm with 4 days of net float writes and receives $1 million of checks per day, itwould be able to operate with $4 million less capital than if it had zero net float.

Cash budget:The primary cash management tool

Purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loansneeded or funds available to invest.

Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly forannual planning, daily for actual cash management.

SKIs cash budget:For January and February

Net Cash Inflows

Jan Feb

Collections $67,651.95 $62,755.40

Purchases 44,603.75 36,472.65

Wages 6,690.56 5,470.90


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Rent 2,500.00 2,500.00

Total payments $53,794.31 $44,443.55

Net CF $13,857.64 $18,311.85

SKIs cash budgetNet Cash Inflows

Jan Feb

Cash at start if

no borrowing $ 3,000.00 $16,857.64

Net CF 13,857.64 18,311.85

Cumulative cash 16,857.64 35,169.49

Less: target cash 1,500.00 1,500.00

Surplus $15,357.64 $33,669.49

Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash

budget.

However, depreciation does affect taxes, which appear in the cash budget. What are some other potential cash inflows besides collections? Proceeds from the sale of fixed assets. Proceeds from stock and bond sales. Interest earned. Court settlements. How could bad debts be worked into the cash budget? Collections would be reduced by the amount of the bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of

sales.

Lower collections would lead to higher borrowing requirements.


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Analyze SKIs forecasted cash budget Cash holdings will exceed the target balance for each month, except for October and

November.

Cash budget indicates the company is holding too much cash.

SKI could improve its EVA by either investing cash in more productive assets, or byreturning cash to its shareholders.

Why might SKI want to maintain a relatively high amount of cash? If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its

sales forecast, or if it is very conservative.

The cash may be used, in part, to fund future investments. Types of inventory costs Carrying costsstorage and handling costs, insurance, property taxes, depreciation, and

obsolescence.

Ordering costscost of placing orders, shipping, and handling costs. Costs of running shortloss of sales or customer goodwill, and the disruption of

production schedules.

Reducing the average amount of inventory generally reduces carrying costs, increases

ordering costs, and may increase the costs of running short.

Is SKI holding too much inventory? SKIs inventory turnover (4.82) is considerably lower than the industry average (7.00).

The firm is carrying a lot of inventory per dollar of sales.

By holding excessive inventory, the firm is increasing its costs, which reduces its ROE.Moreover, this additional working capital must be financed, so EVA is also lowered.

If SKI reduces its inventory, without adversely affecting sales, what effect will this haveon the cash position?

Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to take steps to reduce its cash holdings and increase its

EVA.


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Do SKIs customers pay more or less promptly than those of its competitors? SKIs DSO (45.6 days) is well above the industry average (32 days). SKIs customers are paying less promptly. SKI should consider tightening its credit policy in order to reduce its DSO. Elements of credit policy1. Credit PeriodHow long to pay? Shorter period reduces DSO and average A/R, but it

may discourage sales.

2. Cash DiscountsLowers price. Attracts new customers and reduces DSO.3. Credit StandardsTighter standards tend to reduce sales, but reduce bad debt expense.

Fewer bad debts reduce DSO.

4. Collection PolicyHow tough? Tougher policy will reduce DSO but may damagecustomer relationships.

Does SKI face any risk if it tightens its credit policy? Yes, a tighter credit policy may discourage sales. Some customers may choose to go

elsewhere if they are pressured to pay their bills sooner.

If SKI succeeds in reducing DSO without adversely affecting sales, what effect wouldthis have on its cash position?

Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive

assets, or pay it out to shareholders. Both of these actions would increase EVA.


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The cost of capital is used primarily to make decisions that involve raising new capital.So, focus on todays marginal costs (for WACC).

How are the weights determined?WACC = wdkd(1-T) + wpkp + wcks

Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? Component cost of debt

WACC = wdkd(1-T) + wpkp + wcks

kd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of kd. Why tax-adjust, i.e. why kd(1-T)? A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt

(kd)?

Remember, the bond pays a semiannual coupon, so kd = 5.0% x 2 = 10%. Component cost of debt Interest is tax deductible, so

A-T kd = B-T kd (1-T)

= 10% (1 - 0.40) = 6%

Use nominal rate. Flotation costs are small, so ignore them. Component cost of preferred stock


kp is the marginal cost of preferred stock. The rate of return investors require on the firms preferred stock. What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula:


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kp = Dp / Pp

= $10 / $111.10

= 9%

Component cost of preferred stock Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use kp. Nominal kp is used. Our calculation ignores possible flotation costs. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common

dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain

control of firm.

Why is the yield on preferred stock lower than debt? Corporations own most preferred stock, because 70% of preferred dividends are

nontaxable to corporations.

Therefore, preferred stock often has a lower B-T yield than the B-T yield on debt. The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock

than on debt. Consistent with higher risk of preferred stock.

Illustrating the differences between A-T costs of debt and preferred stockRecall, that the firms tax rate is 40%, and its before-tax costs of debt and preferred stock are kd

= 10% and kp = 9%, respectively.

A-T kp = kpkp (10.7)(T)

= 9% - 9% (0.3)(0.4) = 7.92%

A-T kd = 10% - 10% (0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

Component cost of equity


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ks is the marginal cost of common equity using retained earnings. The rate of return investors require on the firms common equity using new equity is ke. Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity cost (the return that stockholders could

earn on alternative investments of equal risk).

Investors could buy similar stocks and earn ks. Firm could repurchase its own stock and earn ks. Therefore, ks is the cost of retained earnings.

Three ways to determine the cost of common equity, ks CAPM: ks = kRF + (kMkRF) DCF: ks = D1 / P0 + g Own-Bond-Yield-Plus-Risk Premium:

ks = kd + RP

If the kRF = 7%, RPM = 6%, and the firms beta is 1.2, whats the cost of common equitybased upon the CAPM?

ks = kRF + (kMkRF)

= 7.0% + (6.0%)1.2 = 14.2%

If D0 = $4.19, P0= $50, and g = 5%, whats the cost of common equity based upon theDCF approach?

D1 = D0 (1+g)

D1 = $4.19 (1 + .05)

D1 = $4.3995

ks = D1 / P0 + g


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= $4.3995 / $50 + 0.05

= 13.8%

What is the expected future growth rate? The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings

(dividend payout = 65%). This situation is expected to continue.

g = ( 1Payout ) (ROE)

= (0.35) (15%)

= 5.25%

Very close to the g that was given before. Can DCF methodology be applied if growth is not constant? Yes, nonconstant growth stocks are expected to attain constant growth at some point,

generally in 5 to 10 years.

May be complicated to compute. If kd = 10% and RP = 4%, what is ks using the own-bond-yield-plus-risk-premium

method?

This RP is not the same as the CAPM RPM. This method produces a ballpark estimate of ks, and can serve as a useful check.

ks = kd + RP

ks = 10.0% + 4.0% = 14.0%

What is a reasonable final estimate of ks?Method Estimate

CAPM 14.2%

DCF 13.8%

kd + RP 14.0%

Average 14.0%

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?


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When a company issues new common stock they also have to pay flotation costs to theunderwriter.

Issuing new common stock may send a negative signal to the capital markets, which maydepress the stock price.

If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke? Flotation costs Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue

equity infrequently, the per-project cost is fairly small.

We will frequently ignore flotation costs when calculating the WACC. Ignoring floatation costs, what is the firms WACC?


= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4%

= 11.1%

What factors influence a companys composite WACC? Market conditions. The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher

WACC.

Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the

firm. Therefore, the WACC only represents the hurdle rate for a typical project with

average risk.

Different projects have different risks. The projects WACC should be adjusted to reflectthe projects risk.

Risk and the Cost of Capital What are the three types of project risk?


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Stand-alone risk Corporate risk Market risk How is each type of risk used? Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate

risk.

Therefore, corporate risk is also relevant. Problem areas in cost of capital Depreciation-generated funds Privately owned firms Measurement problems Adjusting costs of capital for different risk Capital structure weights How are risk-adjusted costs of capital determined for specific projects or divisions? Subjective adjustments to the firms composite WACC. Attempt to estimate what the cost of capital would be if the project/division were a stand-

alone firm. This requires estimating the projects beta.

Finding a divisional cost of capital:Using similar stand-alone firms to estimate a projects cost of capital

Comparison firms have the following characteristics: Target capital structure consists of 40% debt and 60% equity. kd = 12% kRF = 7% RPM = 6% DIV = 1.7


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Tax rate = 40% Calculating a divisional cost of capital Divisions required return on equity

ks = kRF + (kMkRF)= 7% + (6%)1.7 = 17.2%

Divisions weighted average cost of capital WACC = wd kd ( 1T ) + wc ks

= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%

Typical projects in this division are acceptable if their returns exceed 13.2%.

Risk and Rates of Return

Stand-alone risk Portfolio risk Risk & return: CAPM / SML Investment returns

The rate of return on an investment can be calculated as follows:


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(Amount receivedAmount invested)

Return = ________________________

Amount invested

For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this

investment is:

($1,100 - $1,000) / $1,000 = 10%.

What is investment risk? Two types of investment risk

Stand-alone risk Portfolio risk

Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the

investment.

Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Selected Realized Returns,

19262001

Average Standard

Return Deviation

Small-company stocks 17.3% 33.2%

Large-company stocks 12.7 20.2

L-T corporate bonds 6.1 8.6

L-T government bonds 5.7 9.4

U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002

Yearbook(Chicago: Ibbotson Associates, 2002), 28.


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Investment alternatives Why is the T-bill return independent of the economy? Do T-bills promise a completely

risk-free return?

How do the returns of HT and Coll. behave in relation to the market?

HTMoves with the economy, and has a positive correlation. This is typical. Coll.Is countercyclical with the economy, and has a negative correlation. This is

unusual.

Return: Calculating the expected return for each alternative Summary of expected returns for all alternatives

Exp return

HT 17.4%

Market 15.0%

USR 13.8%

T-bill 8.0%

Coll. 1.7%

HT has the highest expected return, and appears to be the best investment alternative, but is it

really? Have we failed to account for risk?

Risk: Calculating the standard deviation for each alternative Standard deviation calculation Comparing standard deviations Comments on standard deviation as a measure of risk Standard deviation (i) measures total, or stand-alone, risk. The largeri is, the lower the probability that actual returns will be closer to expected

returns.

Largeri is associated with a wider probability distribution of re

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