Presentation1
-
date post
17-Sep-2014 -
Category
Documents
-
view
573 -
download
0
description
Transcript of Presentation1
CORPORATE FINANCE
(Ref:Introduction to Accounting and Finance-Geoff Black)
Do you think ..-you know nothing about accounting Y/N
-accounting needs advanced mathemetical skills Y/N
-accounting requires an IQ of 200 plus Y/N
-accounting is boring Y/N
-accounting is only relevant for some people Y/N
you can only help him find it within himself -'Galileo-an italian professor
you cannot teach a person anything
To learn from each other, because,
Why are we here?
Negative Slab or Positive Boon' Mr. Anchovy, our experts describe you
as a appallingly dull fellow, unimaginative, timid, lacking in
initiative, spineless, easily dominated, no sense of humour, tedious company
and irrepressibly drab and awful.'
And , in most professions these would be considerable drawbacks, in accounting they are a positive boon' -
Monty Python, 'The Lion Tamer Sketch”
Do you really don't know what's accounting?
Consider this snippet of conversation:
“Tan, wrote his car off yesterday. He'd gone into the red to pay for it, but - would you credit it –
the car wasn't insured. There's no accounting for some people. The bottom line is you need to
protect your assets”
: This module will be lead-managed by Mr.Masilamani R He has about 3 decades of working, training & consulting
experience His basic degree is in statistics & economics His MBA is in finance and economics He also has several professional accreditations, including
business performance management & project management
Presenter:
Why accounting Course?Offered to all incoming Masters students at any School of Business.
In particular, this lecture is designed for those who have no previous education or training in accounting.
The intention is for this lecture to teach at the most basic level.
To teach the “alphabet” of accounting so that students can learn to speak in “full sentences” in the accounting (and other) courses.
Students with even minimal background may wish to skim or skip sections of the lecture.
Food for ThoughtWith reference to non-business, performance management occurs in Sun Tzu's The Art of War. Sun Tzu claims that, 'to
succeed in war, one should have full knowledge of one's own strengths and weaknesses as well as those of one's enemies.
Lack of either set of knowledge might result in defeat' Parallels between the challenges in business and those of
war include: * collecting data - both internal and external
* discerning patterns and meaning in the data (analyzing) * responding to the resultant information
Financial and Management Accounting
Accounting has two main divisions:
Financial accounting
Primarily prepared for users external to the company.
Revenues, earnings, assets, etc.
Management accounting
Primarily for internal purposes
Costing, budgeting, net present value, etc.
This lecture will focus mainly on financial accounting for business. Thus it is called 'CORPORATE FINANCE'
Corporate Finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms
Learning Emphasis
In business management program we emphasise more on application of accounting and finance
concepts, skills and practices.
This course focuses on using student awareness of accounting and finance to learn how to apply
in practice
Course AimsThe broad aims of this course are to:
1. Introduce the basic principles and underlying concepts of accounting and finance;
2. Describe profit and loss accounts, balance sheets and cash flows tatements and generally how they are prepared;
3. Explain in detail how these statements may be read and interpreted, including points of weakness and their shortcomings; and
4. Provide basic understanding of how management accounting can assistmanagers in planning, control and decision.
Course OutcomesAt the completion of this course, it is expected that you will be able to:
1. Explain the effect of decision, transactions and events on financial
performance and construct simple sets of accounts;
2. Interpret published financial statements intelligently and translate
financial information accordingly to match the various needs of business
problems;
3. Identify the main uses and limitations of financial information and
administer them effectively for decision-making, planning and control;
4. Apply cash flow statements, cash forecasts and consolidate data for
capital investments, project appraisals and management budget; and
5. Evaluate company performance, estimate its cost of capital and justify
the processes of budgeting.
Corporate Finance
Day OneA. Fundamentals of
Financial
ManagementB. Analysis of Financial
StatementsC. Time Value of
MoneyD. Securities Valuation
Day TwoE. Risk & ReturnF. Capital BudgetingG. The Cost of CapitalH. Dividend Policy
AccountingAccounting can be simply defined as the recording,
summarising and interpretation of financial information
The key aspects of accounting are therefore,
1. Identifying the key financial components of the oganisation e.g. assets, liabilities, capital, revenue and cash flow
2. Measuring the monetary values of key financial components in a way which represents a true and fair view of the organisation
3. Communicating the financial information in ways that are
useful to the users of the organisation
Accrual vs Cash accounting why do some report cash and some accrual?It really depends on the needs of the users.
.
In most cases, you can choose which method to use. Learn how they work and the advantages and disadvantages of each so you can choose the better one for your business.
In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts
What is accrual accounting?
Revenue and expenses reported for an accounting period are the revenue earned and expenses matched to or incurred in generating that income – regardless of whether the income has actually been received or cash paid for the expenditure
.
For ExampleWhere we have performed some work for a client and invoiced this client,
we would include this revenue in our reporting for the period, regardless of whether we have actually received payment or not. On the expense side, we
would include expenses such as electricity and gas consumed during the period even if the bill is not due for payment until the following period
What is Cash Accounting The cash method is the more commonly used method of accounting in small business. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.
Example Your computer installation business finishes a job in November,
and doesn't get paid until three months later in January.Under the cash method, you would record the payment in January. Under
the accrual method, you would record the income in your November books
The Accounting FormulaHas 3 Major Components to reflect the
organisation value:
a)Assets-the value of the resources of the organisation
b)Capital-the value of the owner's interest in the organisation
c)Liabilities-the value of others' claim on the organisation
ASSETS - LIABILITIES=CAPITAL
The Basic Accounting Statements1.The Balance Sheet-A financial summary showing the assets, liabilities and capital of the organisation at a particular date2.The Income statement-A financial summary showing revenue and expenses for the financial period3.The Cash flow Statement is a summary of cash and bank balances over a defined past period
A. Fundamentals of Financial Management
1.Definition of Financial Management
The management of the finances of a business / organization
in order to achieve financial objectives.
1.Key Objectives of Financial Management
Create wealth for the business.
Generate cash.
Provide adequate return on investment
A. Fundamentals of Financial Management
1. Key elements of the process of financial
management
a) Financial Planning Ensure enough funding is available at the right
time.
b) Financial Control Ensure that the business is meeting its
objectives.
c) Financial Decision Making Key aspects – investment, financing and
dividends.
Financial Statement Analysis
Comparative Analysis
B. Analysis of Financial Statements
Ratio Analysis
Horizontal Analysis
Vertical Analysis
1. Profitability Ratio
2. Liquidity Ratio
3. Activity Ratio
4. Gearing Ratio
5. Other Ratios
B. Analysis of Financial Statements
1. Comparative Analysis
Comparative Analysis involves the comparison against the
company’s past performance, against another company’s
performance or against the industry average. Comparison
against a benchmark will enable users to make an informed
and better decision.
a) Horizontal Analysis Involves the comparison of items in the financial
statements over a two year period or more. Comparison can be made against last year’s
performance or against few years.
B. Analysis of Financial Statements
1. Comparative Analysis
a) Vertical Analysis As not all companies are of the same size, and
comparing the absolute results of different businesses
of dissimilar sizes will not provide an adequate
picture. By turning the absolute figures into percentage, we
could make a more meaningful interpretation of the
data. We will compare percentages rather than the absolute
figure (overcome the problems of companies with
different sizes).
28
B. Analysis of Financial Statements
1. Financial Ratio Analysis Shows the relationship between an item in the income
statement or balance sheet with another item. Provide a meaningful data and will enable users to understand
the financial statement.
a) Profitability Ratios Measure the ability of a business entity to earn profits. Used as an indicator of how efficient and effective a
company is in achieving its profit.
29
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios
1) Gross Profit Margin (Ratio) Measures the gross profit earned for every
Ringgit sales. Higher gross profit ratio indicates strong
performance as the company has more profit to
pay for its sales & administrative expenses.
Gross Profit Ratio = ( Gross Profit / Net Sales) x 100
30
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios
1) Net Profit Margin (Ratio) Measures the net profit earned for every Ringgit sales. Higher net profit ratio indicates strong performance as
the company has more profit to pay dividends to
shareholders.
Net Profit Ratio = ( Net Profit / Net Sales) x 100
31
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios
1) Earnings Per Share (EPS) Measures the earning that is earned by each
ordinary share after paying for tax and preference
shares dividend. The higher the earning per share the better it is.
EPS = ( Earning after Tax – Div for PS) / Total OS
PS – Preference Share, OS – Ordinary Share
32
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Liquidity Ratios
Liquidity refers to the ability to generate or raise cash.
Measure the ability of a company to meet short term
obligations or debts that might be unexpectedly
demanded to be paid before its maturity dates.
If a company fails to pay its debts, it could mean an end
to the business.
33
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Liquidity Ratios
1) Current Ratio Measures the ability of a business entity to pay up
current liabilities. A current ratio of 2:1 indicates strong ability to
meet short term debts. The higher the current ratio, the more liquid the
company is said to be.
Current Ratio = Current Assets / Current Liabilities
34
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Liquidity Ratios
1) Quick Ratio Also known as acid test ratio. Measures how many quick assets there are to
cover quick liabilities. Comprises of cash, receivables and market
securities and exclude inventory.
Current Ratio = [CA – (Inventory + Prepaid)] / CL
CA – Current Asset, CL – Current Liabilities
35
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
Measure the effectiveness and ability of a company in
its resources.
It can indicate how effective a company’s inventory
is being used to generate sales or how efficient is the
collection of debts by a company.
36
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
1) Accounts Receivable Turnover (ART) Measures how fast accounts receivable is
collected. Indicates the effectiveness of a business entity
in managing its accounts receivables.
ART = Net Credit Sales / *Ave Account
Receivable
*Ave Acc Rec = (Opening Acc Rec + Closing Acc Rec)/2
37
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
1) Inventory Turnover Measures the ability of a business entity to sell its
inventory. Indicates the number of times inventory is sold.
Inventory Turnover = COGS / *Ave Inventory
COGS – Cost of Good Sold
*Ave Inventory = (Opening Inventory + Closing Inventory)/2
38
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
1) Total Assets Turnover (TAT)
Measure the relationship between sales levels
against the average total sales.
Measures the effectiveness of total assets which
are used in generating sales.
TAT = Net Sales / Average Total Assets
39
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
Measure how much the assets of a company is
financed by creditor rather than the owners.
High proportion of shareholders fund indicates
financial strength.
Heavy reliance on borrowing indicates the risk to the
investors as debts require repayments of loan
principal amount and the interest expenses.
40
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Equity Ratios
Measure the financial structure of a company.
Higher equity ratios indicate stability.
Equity Ratio = (*Total OS Fund / Total Assets) x 100
* Total Ordinary Shareholder Fund include retained earnings
and reserves but exclude preference shares
41
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Debts Ratios
Measures the financial structure of a company.
Higher debt ratios indicate that a company face a
higher risk in its ability to settle its debts.
Debt Ratio = *Total Debts / Total Assets) x 100
* Total debts = Total Liabilities + Preference S/holders Fund
42
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Debts to Equity Ratios (DER) Measures how much of total debts are covered by
equity. The lower the ratio the better it is as it indicates
the amount owned by equity is more than
liabilities.
DER = *Total Debts / Total Shareholder Equity
* Total debts = Total Liabilities + Preference S/holders Fund
Activity No. Category Financial ratios 2005 2004
1 Profitability
Gross Profit Margin
Net Profit Margin
Earning Per Share
2 Liquidity Current Ratio
Quick Ratio
3 Activity Accounts receivable turnover
Inventory turnover
B. Analysis of Financial Statements1.Financial Ratios Analysis – Practical Example
No. Category Financial ratios 2005 2004
3 Activity Total Asset Turnover
4 Gearing Equity Ratios
Debt Ratio
Debt to Equity ratio
5 Other ratios
Any additional covering ratios
the above under the respective
category
e.g. interest cover, dividend cover,
dividend yeild, debt collection
B. Analysis of Financial Statements1.Financial Ratios Analysis – Practical Example
C. Time Value of Money
TVM
Interest Future Value Present Value
Simple
Compound
Amortization
Annuity
C. Time Value of Money
1. The Interest Rate
Which would you prefer -- $10,000 today or
$10,000 in 5 years?
Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!
C. Time Value of Money
1. The Interest Rate
TIME allows you the opportunity to postpone consumption and earn INTEREST.
Why is TIME such an important element in your decision?
C. Time Value of Money
1. The Interest Rate
a) Simple Interest Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
b) Compound Interest Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
C. Time Value of Money1. The Interest Rate
Simple Interest - Formula
SI = P0(i)(n)
Where SI = Simple Interest
P0 = Deposit Today (t=0)
i = Interest Rate Per Period
n = Number of Time Periods
C. Time Value of Money
1. The Interest Rate
Simple Interest - Example
Assume that you deposit RM1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?
SI = P0(i)(n) = RM1,000(.07)(2) = RM140
C. Time Value of Money
1. The Interest Rate
a) Compound Interest
When interest paid on an investment during
the first period is added to the principal.
During the second period, interest is earned
on the new sum.
C. Time Value of Money
1. The Interest Rate
a) Compound Interest - Formula
CI = P(1 + i)n
Where CI = Compound Interest
P = Deposit Today
i = Interest Rate Per Period
n = Number of Time Periods
C. Time Value of Money
1. The Interest Rate
a) Compound Interest – Example
David deposited RM100 into his saving account
in Maybank for 5 years with interest of 5% per
annum. What is the return that he is expected to
receive at the end of 5th year?
C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding – Formula (future value)
FVn= PV0(1 + [i/m])mn
Where n = Compounding Period per year
i = Annual Interest Rate
FVn,m= FV at the end of Year n
PV0= PV of the Cash Flow today
C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding - Example
Suppose you deposit $1,000 in an account that
pays 12% interest, compounded quarterly. How
much will be in the account after eight years if
there are no withdrawals?
C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding - Question
John deposit $1,000 in an account that pays 12%
interest, compounded monthly. How much will be
in the account after one year if there are no
withdrawals?
C. Time Value of Money
1. Future Value - Formula
FV = PV (1+i)n
Where FV = Future Value
PV = Present Value
i = Rate of interest per compounding period
n = Number of Compounding Periods
C. Time Value of Money
1. Future Value - Example
If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?
0 1 2
$2,000
FV
6%
C. Time Value of Money
1. Present Value - Question
John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.
0 1 2 3 4 5
$5,000
FV5
8%
C. Time Value of Money
1. Present Value - Formula
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Where FV = Future Value
PV = Present Value
i = Rate of interest per compounding period
n = Number of Compounding Periods
C. Time Value of Money
1. Present Value - Example
Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?
0 5 10
$4,000
6%
PV0
C. Time Value of Money
1. Present Value - Question
Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.
0 1 2 3 4 5
$2,500
PV0
4%
C. Time Value of Money
1. Annuities An Annuity represents a series of equal payments
(or receipts) occurring over a specified number of
equidistant periods.
Examples of Annuities Include:
- Car Loan Payments
- Insurance Premiums
- Mortgage Payments
C. Time Value of Money
1. Annuities
a) Annuities Future Value - Formula
FVAn = R(1+i)n-1 + R(1+i)n-2 + ... + R(1+i)1 + R(1+i)0
R R R
0 1 2 n n+1
FVAn
R = Periodic Cash Flow
Cash flows occur at the end of the period
i% . . .
C. Time Value of Money
1. Annuities
a) Annuities Future Value - Question
If one saves $1,000 a year at the end of every
year for three years in an account earning 7%
interest, compounded annually, how much will
one have at the end of the third year?
C. Time Value of Money
1. Annuities
a) Annuities Present Value - Formula
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
R R R
0 1 2 n n+1
PVAn
R = Periodic Cash Flow
i% . . .
Cash flows occur at the end of the period
C. Time Value of Money
1. Annuities
a) Annuities Present Value - Question
If one agrees to repay a loan by paying $1,000
a year at the end of every year for three years
and the discount rate is 7%, how much could
one borrow today?
C. Time Value of Money
1. Amortization - Example
Julie Miller is borrowing $10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years.
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Ending Balance
End of Year
Payment Interest Principal
$10,000 0 --- --- ---
8,426 1 $2,774 $1,200 $1,574
6,663 2 2,774 1,011 1,763
4,689 3 2,774 800 1,974
2,478 4 2,774 563 2,211
0 5 2,775 297 2,478
$13,871 $3,871 10,000
C. Time Value of Money
1. Amortization – Example (Table)
[Last Payment Slightly Higher Due to Rounding]
C. Time Value of Money
1. Amortization – Question
Suppose you borrow $6,655 to make repairs to
your house, and the loan is considered a
second mortgage. The terms of the loan
require you to make payments every three
months, i.e. quarterly, for the next two years
and the simple interest rate is 6 percent p.a.
What is the amount that must be paid every
three months?
D. Securities Valuation
Securities Valuation
Stock Bonds
Common Stock
Preferred Stock
1. Mortgage Bond2. Eurobonds3. Zero Coupon Bonds4. Junk Bond
Stock market
Securities Valuation
D. Securities Valuation-Investment Appraisal
1. Preferred Stock Preferred Stock is often referred to as a hybrid
security because it has many characteristics of both common stocks and bonds.
Like common stocks- No fixed maturity date.- Failure to pay dividends does not bring on bankruptcy.
Like bonds
- Dividends are for a limited time.
D. Securities Valuation
1. Preferred Stock – Features
a) Multiple series of Preferred Stock
b) Preferred Stock’s claim on asset & income
c) Cumulative dividends
d) Protective provisions
e) Convertibility
f) Retirement features
g) Callable
D. Securities Valuation
1. Preferred Stock – Features
a) Multiple series of Preferred Stock If a company desires, it can issue more than
one series of preferred stock, and each series
can have different characteristics.- Convertible- Protective provisions
D. Securities Valuation
1. Preferred Stock – Features
a) Claims on Assets and Income Preferred stock has priority over Common
Stock with regard to claim on assets in the
case of bankruptcy. Honored before common stockholders, but
after bonds. Must pay dividends to preferred stockholders
before it pays common stockholder dividends.
D. Securities Valuation
1. Preferred Stock – Features
a) Cumulative Dividends Cumulative features requires that all past,
unpaid preferred stock dividends be paid
before any common stock dividends are
declared.
b) Protective Provisions Protective provisions generally allow for
voting rights in the event of non payment of
dividends.
D. Securities Valuation
1. Preferred Stock – Features
a) Convertibility Convertible preferred stock can, at the
discretion of the holder, be converted into a
predetermined number of shares of common
stock. Almost one third of preferred stock issued
today is convertible. Reduces the cost of the preferred stock to the
issue
D. Securities Valuation
1. Preferred Stock – Features
a) Retirement Features Although preferred stock has no set maturity
associated with it, issuing firms generally
provide for some method of retiring the stock.
b) Callable A call provision entitles a company to
repurchase its preferred stock from their
holders at stated prices over a given time
period.
D. Securities Valuation
1. Preferred Stock
a) Valuing Preferred Stock
Where Vps= The value of preferred stock
D = The preferred dividend
kps= The required rate of return
Example : Xerox’s Series C preferred stock pays an annual dividend of RM6.25 and the investors required rate of return is 5%
Vps =
D
kps
D. Securities Valuation
1. Common Stock Common stock is a certificate that indicates
ownership in a corporation. Has no maturity date. Dividend payments will normally divided into
Interim & Final Dividend In the event of bankruptcy, common stockholders
will not receive any payment until the creditors,
including the bondholders and preferred
stockholders, have been satisfied.
D. Securities Valuation
1. Common Stock – Features
a) Claim on income
b) Claim on assets
c) Voting rights
d) Preemptive rights
e) Limited liability
D. Securities Valuation
1. Common Stock – Features
a) Claim on income
Common shareholders have the right to
residual income after bondholders and
preferred stockholders have been paid
Can be in the form of dividends or retained
earnings.
D. Securities Valuation
1. Common Stock – Features
a) Claim on assets
Common stock has a residual claim on assets
after claims of debt holders and preferred
stockholders.
If bankruptcy occurs, claims of the common
shareholders generally go unsatisfied.
D. Securities Valuation
1. Common Stock – Features
a) Voting Rights Common shareholders are entitled to elect the
board of directors. Most often are the only security holders with
a vote. A proxy gives a designated party the
temporary power of attorney to vote for the
signee at the corporation’s annual general
meeting.
D. Securities Valuation
1. Common Stock – Features
a) Preemptive Rights Preemptive right entitles the common
shareholder to maintain a proportionate share
of ownership in the corporation.
Rights – certificates issued to the shareholders
giving them an option to purchase a stated
number of shares of stock at a specified price
during a two to ten week period.
D. Securities Valuation
1. Common Stock – Features
a) Limited Liability Liability of the shareholder is limited to the
amount of their investment.
Limited liability feature aids the firm in
raising funds.
D. Securities Valuation
1. Common Stock
a) Valuing Common Stock
Where Vcs= The value of common stock
D0 = The preferred dividend
g= Growth rate
kcs= The required rate of return
gk
gDV
C SC S
10
D. Securities Valuation
1.Common Stock
a) Valuing Common Stock – Example
Consider the valuation of a common stock that paid
RM2.00 dividend at the end of the last year and is
expected to pay a cash dividend in the future.
Dividends are expected to grow at 10% and the
investors required rate of return is 15%
D. Securities Valuation
1. Bond – type of debt or long term promissory note,
issued by a borrower, promising to its holder a
predetermined and fixed amount of interest per
year.
a) Types of Bonds
i. Debentures Any unsecured long term debt.
Viewed as more risky than secured
bonds and provide a higher yield than
secured bonds.
D. Securities Valuation
1. Bond
a) Types of Bonds
i. Mortgage Bonds A bond secured by a lien on real property. Typically, the value of the real property is
greater than that of the bonds issued.
ii. Eurobonds Securities (bonds) issued in a country
different from the one in whose currency
the bond is denominated.
D. Securities Valuation
1. Bond
a) Types of Bonds
i. Zero Coupon Bonds Issued at a substantial discount from the
RM1,000 face value with a zero coupon
rate. Return comes from appreciation of the
bonds. Advantages – cash outflows don’t occur
with zero coupon bonds.
D. Securities Valuation
1. Bond
a) Types of Bonds
i. Junk Bonds (High Yield Bonds)
High risk debt with ratings of BB or below
by Moody’s and Standard & Poor’s.
High yield – typically pay 3% ~ 5% more
than AAA grade long term bonds.
D. Securities Valuation
1. Bond
a) Terminologyi. Claims on assets and income
In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock.
ii. Par Value Face value of the bond, returned to the
bondholder at maturity. Corporate bonds are issued at
denomination of RM1,000
D. Securities Valuation
1. Bond
a) Terminologyi. Coupon Interest Rate
The percentage of the par value of the bond that will be paid out annually in the form of interest.
ii. Maturity The length of time until the bond issuer
returns the par value to the bondholder and terminates or redeem the bonds.
D. Securities Valuation
1. Bond
a) Terminologyi. Convertibility
May allow the investor to exchange the bond for a predetermined number of the firm’s shares of common stock.
ii. Indenture The legal agreement between the firm
issuing the bond and the trustee who represents the bondholders.
D. Securities Valuation
1. Bonda) Terminology
i. Call Provision A provision such that if the prevailing
interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.
Issuer must pay the bondholder at premium.
There is also call protection period where the firm can’t call for a specified period.
D. Securities Valuation
1. Bonda) Valuation
Assigning a value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate.
The value of a bond is combination of:-- the amount and timing of cash flows to be
received by investors.- the time to maturity of the loan.- the investor’s required rate of return.
D. Securities Valuation
1. Bonda) Valuation - Formula
)1()1(1 bn
bt
n
tb
k
M
k
IV
Where Vb= Intrinsic value
I = Interest to be received
n = Number of period to maturity
kb= Required rate of return for bondholder
M = Par value of the bond at maturity
D. Securities Valuation
1. Bonda) Valuation - Formula
Vb= I(PVIFAkb,n) + M(PVIFkb,n)
Where Vb= Intrinsic value
I = Interest to be received
n = Number of period to maturity
kb= Required rate of return for bondholder
M = Par value of the bond at maturity
D. Securities Valuation
1. Bonda) Valuation – Example
Consider a bond issued by Toyota with a
maturity date of 2008 and a stated coupon of
5.5%. In December 2004, with 4 years left to
maturity, Investors owning the bonds are
requiring a 4% rate of return. Calculate the price
of Toyota Bond.
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
First Relationships The value of a bond is inversely related to
changes in investor’s present required rate of
return (interest rate). As interested rate increases (decreases), the
value of the bond decreases (increases).
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
Second Relationship The market value of a bond will be less than
the par value if the investor’s required rate of
return is above the coupon interest rate. However, it will be valued above par value if
the investor’s required rate of return is below
the coupon interest rate.
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
Third Relationship Long term bonds have greater interest rate
risk than the short term bonds.
E. Risk & Return
Risk & Return
Risk & Return?
Market RiskSummary
Diversification
E. Risk & Return
1. Risk & Returna) What is Risk?
The possibility that an actual return will differ from our expected return.
Uncertainty in the distribution of possible outcomes.
b) What is Return? Expected Return - the return that an investor
expects to earn on an asset, given its price, growth potential, etc.
Required Return - the return that an investor requires on an asset given its risk.
E. Risk & Return
1. Expected Return - Example
State of Economy
Probability Return
(P) Company A Company B
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30% k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
E. Risk & Return
1. How do we Measure Risk?
A more scientific approach is to examine the
stock’s STANDARD DEVIATION of returns.
Standard deviation is a measure of the dispersion
of possible outcomes.
The greater the standard deviation, the greater
the uncertainty, and therefore , the greater the
RISK.
E. Risk & Return
1. How do we Measure Risk?
a) Formula for Standard Deviation
Where n = The number of possible outcomes
ki= The value of ith possible rate of return
P(ki) = Probability that ith return will occur
k = Expected value of the rate of return
)()(2
1ii kPkk
n
t
E. Risk & Return
1. How do we Measure Risk? - Example
Company A Company B
Recession (4% -10%)2 (.2) = 7.2 (-10% -14%)2(.2) = 115.2
Normal (10% - 10%)2 (.5) = 0 (14% - 14%)2 (.5) = 0
Boom (14% -10%)2 (.3) = 4.8 (30% - 14%)2 (.3) = 76.8
Variance 12 192
Std Deviation 3.46% 13.86%
E. Risk & Return
1. How do we Measure Risk? - Summary
Company A Company B
Expected Return 10% 14%
Standard Deviation 3.46% 13.86%
Which stock would you prefer? How would you decide?
It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return.
E. Risk & Return
1. Diversification Investing in more than one security to reduce risk.
If two stocks are perfectly positively correlated,
diversification has no effect on risk.
If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.
If you owned a share of every stock traded on the
BSKL and Mesdaq, would you be diversified? YES!
Would you have eliminated all of your risk? NO!
Common Stock portfolios still have risk.
E. Risk & Return
1. Diversification Some risk can be diversified away and some can
not.a) Market Risk is also called Non - diversifiable
risk. This type of risk can not be diversified away.
Unexpected changes in interest rates. Unexpected changes in cash flows due to
tax rate changes, foreign competition, and the overall business cycle.
E. Risk & Return
1. Diversificationa) Firm-Specific risk is also called diversifiable
risk. This type of risk can be reduced through diversification.
A company’s labor force goes on strike.
A company’s top management dies in a plane crash.
A huge oil tank bursts and floods a company’s production area.
E. Risk & Return
1. Market Risk As we know, the market compensates investors for
accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. So - we need to be able to measure market risk.
Beta: a measure of market risk. Specifically, it is a measure of how an individual
stock’s returns vary with market returns. It’s a measure of the “sensitivity” of an individual
stock’s returns to changes in the market.
E. Risk & Return
1. Market Risk
A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.
A firm with a beta > 1 is more volatile than the market (ex: computer firms).
A firm with a beta < 1 is less volatile than the market (ex: utilities).
E. Risk & Return
1. Summary of Risk & Return
We know how to measure risk, using standard deviation for overall risk and beta for market risk.
We know how to reduce overall risk through diversification.
We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
F. Capital Budgeting
Methodology
Payback Period
Net Present Value
Internal Rate Of Return
F. Capital Budgeting
1. Importance of Capital Budgeting
Capital budgeting is the process of evaluating
proposed large, long-term investment projects.
capital budgeting ensures that proposed
investment will add value to the firm.
Effective capital budgeting can improve both the
timing of asset acquisitions and the quality of
assets purchased.
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Payback Period (PBP)
PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflows.
Formula for PBP :-
PBP = Year b4 full recovery + Unrecovered cost at start of yr
Cash flow during year
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
The present value of an investment project’s
net cash flows minus the project’s initial cash
outflow.
Formula for NPV :-
)1(0 k
CFNPV t
n
t
t
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
NPV’s values:- NPV = 0, the firm’s overall value will not
change if the new project is adopted.
NPV > 0, the firm’s overall value will
increase.
NPV < 0, the firm’s overall value will be
decrease.
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
NPV’s Decision Rules:- For independent projects : accept all
independent projects having NPVs greater
than or equal to 0.
For mutually exclusive projects : projects
having highest positive NPV will be
ranked first.
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Internal Rate of Return (IRR)
IRR is the estimated rate of return for a
proposed project, given the project’s
incremental cash flows.
Formula for IRR :-
)1(0
0 IRR
CFt
n
t
t
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Internal Rate of Return (IRR)
IRR Decision Rules:-
For independent project – accept projects
having IRRs greater than the hurdle rate.
For mutually exclusive projects – projects
are ranked from highest to lowest IRR.
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Conflicting ranking between NPV & IRR
For Independent Projects Both the NPV and IRR methods will
produce the same accept / reject indication. Accept projects having NPV > 0, IRR >
the hurdle rate. For mutually exclusive projects
Project having a higher NPV should be
chosen instead of a higher IRR.
F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Conflicting ranking between NPV & IRR For mutually exclusive projects
Reason for higher choosing higher NPVi. NPV method makes maximizing the
firm value.ii. NPV method assumes that a project’s
cash flows can be reinvested at the cost of capital.
iii. Whereas, IRR method’s assumption on cash flows reinvestment is the IRR.
G. The Cost of Capital
WACC
Cost of PS
Cost of Equity
Cost of Debt
G. The Cost of Capital
When we say a firm has a “cost of capital” of, for
example, 12%, we are saying:-
The firm can only have a positive NPV on a
project if return exceeds 12%.
The firm must earn 12% just to compensate
investors for the use of their capital in a project.
The use of capital in a project must earn 12% or
more, not that it will necessarily cost 12% to
borrow funds for the project.
G. The Cost of Capital
1. Cost of Debt (Kd)
We use the after tax cost of debt because interest payments are tax deductible for the firm.
Formula for Cost of DebtKd after taxes = Kd (1 – tax rate)
Example : If the cost of debt for ABC Sdn Bhd is
10% and its tax rate is 40% then :- Cost of debt
is?
G. The Cost of Capital
1. Cost of Preferred Stock (Kps)
Preferred Stock has a higher return bonds, but is less costly than common stock. WHY?
In case of default, preferred stockholders get paid
before common stockholders. However, in case of bankruptcy, the holders of
preferred stock get paid only after short and long
term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend
and usually cannot vote on the firm’s affairs.
G. The Cost of Capital
1. Cost of Preferred Stock (Kps)
Formula for Cost of Preferred Stock
kps =D
Vps
Example : If ABC Sdn Bhd is issuing preferred stock at $100 per share, with a stated dividend of $12, then the cost of preferred stock :-
G. The Cost of Capital
1. Cost of Equity (Kcs)
The cost of equity is the rate of return that
investors require to make an equity investment in
a firm.
CAPM (Capital Asset Pricing Model)
- The CAPM is one of the most commonly used
ways to determine the cost of common stock.
G. The Cost of Capital
1. Cost of Equity (Kcs)
Formula for Cost of Equity
kcs= krf + ß (km – krf)
Where krf= The risk free rate
ß = The firm’s beta
km= The return on the market
Example : ABC Sdn Bhd has a ß = 1.6. The risk free on T-bills is currently 4% and the market return has averaged 15%:-
G. The Cost of Capital
1. Weighted Average Cost of Capital (WACC)
Formula for WACC
WACC = wd (Cost of Debt) + wcs (Cost of Equity) + wps (Cost of PS)
Example : ABC Sdn Bhd maintains a mix of 40% debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is :-
H. Dividend Policy
Dividend Policy
Types
Impact
Alternatives
Chronology
H. Dividend Policy
1. Types of Dividend Policy
a) Constant Payout Ratio
b) Constant Nominal Dividend (Regular)
c) Special Dividend Payout
d) Cash Dividend Payment
2. Chronology of Date of Dividend Payment
a) Declaration Date
b) Ex Dividend Date
c) Record Date
d) Payment Date
H. Dividend Policy
1. Impact of Dividend Policy – Firm Value
a) Arguments for Irrelevancy Theory
Signaling Effect
Clientele Effect
b) Arguments against Irrelevancy Theory
Bird in the Hand Theory
Taxes
Floatation Costs
H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Dividend
Firms sometimes tend to distribute additional
shares in the form of dividends to a firm’s
shareholders rather than giving cash
dividends, which are kept in the firm for
investment.
H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Dividend – Example
A firm has 10 million shares outstanding.
Currently the market value of the firm is RM20
million. Therefore, price per share is to be
RM2.00. Assume that the firm is to issue
another 1 million shares as a stock dividend. The
total number of shares outstanding will be 11
million. Hence, given the market value of the
firm, the new price per share will be?
H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Split
Stock Split involve issuing of additional
shares to firm’s stockholders.
The investors’ percentage ownership in the
firm remain unchanged.
The investor is neither better nor worse off
before the stock split.
H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Split – Example
YTM Bhd. Is planning a two for one stock split.
You own 5,000 shares of YTM Bhd’s stock that
is currently selling for RM12.00 per share. What
is the value of your YTM Bhd. Stock now, and
what will it be after the split?
H. Dividend PolicyH. Dividend Policy
1. Alternative Dividend Policy
a) Stock Repurchase
It is a common practice for developed and
developing markets for a firm to buy back
stock from its shareholders.
Reasons for repurchase :-
- an effective substitute for dividends.
- the price of stocks are undervalued.
- Provide internal investment opportunity.
H. Dividend PolicyH. Dividend Policy
1. Alternative Dividend Policy
a) Stock Repurchase – ExampleUEB Bhd. Has RM0.8 million in cash for its next
dividend. However, it is considering a repurchase of its own shares instead of paying dividends. The firm has 10 million shares outstanding, currently selling at RM2.00 per share. The P/E is 10 times and the firm’s EPS is RM0.20. What will be the firm’s dividend per share? If stock is repurchased, how many shares will be remain outstanding and what will the new EPS be?