FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios

<< INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals

Financial Management MGT201

Lesson 45

FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT.

Outline of 5 Major Areas of FM:

1- Interest Rates

Compounding (money grows with time)

Discrete Annual (FV=PV (1+r) t) vs.

Discrete Multiple / Fractional (FV = PV (1+ (r/m)) mn)

"n" number of years,

"r" is the Discount Rate or Opportunity Cost of Capital or WACC depending on your

perspective

"m" times a year interest is compounded

Discounting (or Reverse-Compounding)

PV = FV / (1+r) t

Annuity and Perpetuity

FV Annuity = CCF [(1+r) n -1] / i. Limited time period.

PV Perpetuity = CCF / r.

Yield Curves and Term Structure

· Normal Yield Curve is Upward Sloping. Interest Rates rise with maturity or life

of Bond.

Geometric Average:

· (1 + 2Yr Bond YTM)

= (1 + 1Yr Bond YTM 1st year) x (1 + 1Yr Bond YTM in 2nd Year).

· Nominal i = Real i + Inflation + Risk Premiums (i.e. Liquidity Risk + Maturity Risk

+ Sovereign Risk)

Financial Statements and Ratios

· Balance Sheet, Profit and Loss Account (Income Statement) and Cash flow

statement

· DuPont = Profit Margin x Asset Turnover x (Assets/Equity),

· Margin = Net Income/Sales

· Turnover = Sales / Assets

· Important ratios: ROA, ROE, EPS, P/E, Plough back Pb, Current ratio,

Debt/Capitalization, TIE

· ROA ( = (NI + Interest) / Total Assets) and ROE (= NI / Equity)

· EPS (= NI / No. of Shares Outstanding) and P/E and Plough back (Pb = g /

ROE where "g" is Dividend growth rate %)

· Current Ratio (=Current Assets / Current Liabilities), Debt/Capitalization or

Leverage Ratio, TIE

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Financial Management MGT201

FM Perspective of Balance Sheet

Own Stock

Issued by

Company to

Raise Cash

Graphical View of

Simple, Discrete Compound, &

Continuous Interest - Important

Future Value (FV)

CONTINUOUS COMPOUNDING

in Rupees

DISCRETE COMPOUNDING

SIMPLE INTEREST

Time (Years)

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Financial Management MGT201

Yield Curve for Bonds

Term Structure of Interest rates

Annualized

Interest Rate %

(Bond Yield)

Time

(Years)

Now

1 Year

5 Years

10 Years

2- Capital Budgeting and Investment Decisions to Rank Projects - Fixed assets Side of Balance

Sheet

Objective of Financial Management: Maximization of Shareholders' (Owners')

Wealth. Maximization of Value of Firm. Maximization of Value of Shares of the Firm.

Cash Flows = CF

=Net After Tax Incremental Cash Flows

= NOI + Depreciation + Cost Savings Extra Taxes + Any Salvage Value

Cash Flow Diagrams / Time Line: Cash Inflows (Upward Arrows)

NPV or DCF (Best Criterion) Highest NPV Project is Best.

NPV uses Discount Rate

= Required ROR or WACC which can be changed for every year and varies depending

on the Investor's Risk Profile.

NPV= PV - Io

= -Io + CF1/ (1+r) + CF2/ (1+r) 2 + CF3/ (1+r) 3 + ...,

For comparison of projects with Unequal Lives use Adjusted NPV

= NPV x EAA where EAA Factor = [i x (1+i) n / (1+i) n -1]

IRR (%) - Higher IRR is better. Fixed throughout life of project,

If Multiple IRR then use (1+MIRR) n = FV Inflows / PV Outflows.

FV = Future Value and PV = Present Value

Capital Rationing Limited Budget, % Budget Utilization

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Financial Management MGT201

NPV IRR Diagram

Combined Use of NPV & IRR

to Compare 2 Projects - Important

NPV (Rs)

PROJECT A: LOWER IRR BUT

HIGHER NPV BECAUSE ACTUAL

"r" IS VERY LOW.

PROJECT B: HIGHER IRR BUT

LOWER NPV

NPV A

NPV FAVORS PROJECT A

SO PROJECT A IS BETTER.

NPV B

Discount

Rate % (r)

ACTUAL

IRR

Required

Project B

Project A

Return or

WACC for

Investor

Non-Normal Cash Flow Diagram

Multiple IRR Example

(1+MIRR)n = (FV Cash Inflows) / (PV Cash Outflows)

CF 1 = +Rs 500

Sign Change #1

Yr 0

Yr 1

Yr 2

Sign Change #2

Io = - Rs 500

Note: More than 1 Sign Change

CF 2 = -Rs 500

in Direction of Cash Flow

Arrows suggests Multiple IRR's

3- Securities Valuation

Fair vs. Market Value - PV Formula gives Fair (Intrinsic)Value

Market Value is determined by Investors in Market and buying /selling of securities.

Bond Pricing and YTM - Bond is Legal Paper representing Debt

· Use PV Formula to Calculate Bond Price:

PV = CF1 / (1+rD) + CF2 / (1+rD) 2 + ... + PAR value / (1+rD) n

· Cash Flows = CF = Coupon

= Coupon Rate (%) x Par Value

· Coupon Rate (fixed) vs. Discount Rate (rD Required Return for

Bond Investor)

· YTM = IRR for Bond. Set PV = 0 and solve for "rD" using Iteration.

· Bond Ratings of FIRMS by Moodys and S&P.

Share Pricing and Yields:

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Financial Management MGT201

Stock is Legal Paper representing Ownership

· Market Price of Share = Po = EPS x P/E

· Gordon's Formula is IMPORTANT: rE = Required Return on Equity for

Shareholders

= (DIV1 / Po) + g = Dividend Yield + Capital Gains Yield.

Note: DIV1 is expected future Dividend NEXT year. Po is price THIS year.

· Earnings Approach: Po = (EPS / rE) + PVGO.

PVGO = NPV1/(rE - g) =[-Io +(C/rE )] / (rE -g)

Io = Value of Reinvestment = Pb x EPS where Pb= Plough back = 1 -

Payout = 1 - (DIV/EPS)

· Shareholders' Required ROR (= rE) vs. ROE (= NI / Equity)

Bond Cash Flow Diagram

Savings Certificate Example

Rs 1,000

Coupon Annuity :

(Monthly)

Time (Months)

01 2

Rs 100,000

Par Receipt :

(at Maturity)

2 Cash Flow

Arrows at

SAME point in

time can be

Combined

added.

Time (Months)

Cash Flow Diagram 0 1 2

4- Risk and Return

Securities

· Single Stock Risk = Standard Deviation

Single Stock Return: measured by Share Price or Capital Gain or

Return (rE)

Single Stock Risk = Standard Deviation = Sq. Root of Variance in the

Expected Return

Total Risk

= Diversifiable (Company Specific) Risk + Market Risk

· Portfolio Theory and CML

Portfolio Return - Weighted Average Formula

Portfolio Risk: Risk Matrix , Covariance of each stock with entire

Market , Correlation Coefficient

Risk Return Graph: Hook-shaped Curve, Efficient Frontier, T-Bill

Portfolio and CML

Portfolio of Stocks Return: Weighted Average Formula.

2-Stock Portfolio's Expected Return

= rP * = xA rA + xB rB

Portfolio Risk: Measured by Sigma P (standard deviation).

2 Stocks:

P = XA2 σ A 2 + XB2 σ B 2 + 2 (XA XB σ A σ B ρ AB).

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Financial Management MGT201

Risk Matrix , Covariance of each stock with entire Market , Correlation

Coefficient

Risk Return Graph for Portfolio of Stocks

Hook-shaped Curve: possible to reduce risk and raise return

together

Efficient Frontier shows all possible efficient portfolios

"Risk Free" T-Bill Portfolio is always available to all investors

CML connects Risk Free Return and Tangent to Efficient

Frontier

3-Stock Portfolio Risk Formula

RISK MATRIX

S to ck A

S to ck B

S to ck C

S to ck X A2 A 2

XA XB

XA XC

X B2

S to ck X B X A B

XB XC

X C2

S to ck X C X A C

XC XB

Portfolio Size vs Risk Graph

Unique or Diversifiable or

Specific or Non-Systematic Risk

Market or Systematic or Non-

Diversifiable or Beta Risk =

Minimum Possible Portfolio Risk

Number of Investments (Stocks) in the Portfolio

Note: About 100% of the Diversifiable Risk (and 50% of the Total

Risk) can be removed by Diversification across 40 stocks. Just 7

carefully chosen Un-Correlated Stocks might be enough to remove

30% of the Total Risk.

CAPM and SML -Efficient Markets, Beta, Non-diversifiable Market Risk,

Risk Premium, Required ROR on Equity

(rE = rRF + (rM rRF)Beta)

· CV (Coefficient of Variation) = Risk / Return

Criterion combines BOTH Risk and return in deciding which is the Best Investment

(Capital Budgeting)

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Financial Management MGT201

Portfolio Efficient Frontier & CML -

Important

P Efficient Frontier for

rP* = rRF + [ (rM - rRF) / M ]

rP*

3-Stock Portfolio

Lin

30%

rke

Stock C

"The Parachute"

pit

Stock A

20%

Optimal Portfolio Mix

(50%A, 30% B, 20%C) if

10%=

Stock B

rRF

Risk Free T-Bill ROR = 10%

40%

20%

2.5%

Portfolio with Negative

Portfolio Risk

3.4%

or Zero Correlation

Coefficient

Security Market Line (SML)

ALL Efficient Stocks in Efficient Markets

Important

Required

rA = rRF + (rM - rRF )

. IMPORTANT

Return (r*)

rA= 30%

et L

ty M

rM= 20%

Market Risk

uri

Sec

Premium for

Risky Stock A's

Avg Stock = 10%

rRF= 10%

Total Risk

Premium =

30-10 = 20%

A =+ 2.0

M =+ 1.0

Beta Risk (

)

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Financial Management MGT201

Combined Risk & Return

Graphical Comparison of

Investments

T-Bill B: Low Risk

& Low Return

Project C: High

Risk B

Risk & High Return

Risk C

Exp Return C

Exp Return B

Rate of Return ( r ) %

Entire Firm

· Return - ROA = (NI + Interest) / (D+E) or ROE = NI / E

· Risk - Standard Deviation in ROE (stand alone), FIRM BETAS (market Risk)

· Firm's Overall Level of Risk = Business Risk + Financial Risk

Business Risk caused by changes in price and cost of raw materials and

products and Operating Leverage

Business Risk and Operating Leverage

(OL = Fixed Costs / Total Cost). OL can be good if Sales > Breakeven

Point

Financial Risk, Financial Leverage:

Financial Risk caused by Financial Leverage or Debt

(FL = Debt / Total Assets = D / (D+E)). FL can be good if EBIT / Total

Assets > Cost of Debt

Probability Distribution

Many Possibilities for Forecasted Returns of

Single Stock Uncertainty & Risk

"BELL"

0.45

Curve

0.4

0.35

0.3

Possible

0.25

Outcomes

0.2

0.15

"Expected ROR"

0.1

or Most Likely

0.05

or Mean ROR =

10%

-20

Rate of Return After 1 Year < r >

5- Capital Structure and Corporate Financing - Long Term LIABILITIES Side of Balance Sheet

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Financial Management MGT201

Maturity Matching or Hedging Principle

of Financing Important

Value (Rs)

Spontaneous

Financing ie.

A/c Receivables

Spontaneous Current

Short Term

Assets

Loans

Temporary Current Assets

Permanent Financing

ie. Equity & Long Term

Loans / Bonds

Fixed or Permanent Assets :

Life / usage more than 1 Yr

Time

Buy Permanent Fixed Assets with Permanent Financing. IMPORTANT

Objective: To maintain best balance of Debt & Equity Capital

Cost vs. Required Return- Net Proceeds, After-Tax Cost of Debt , Source of Equity

· Compute Cost using Net Proceeds: NP = Market Price (Po) Issuance Costs

· After-Tax Cost of Debt: rD (1-Tc)

· Source of Equity: Retained Earnings cheaper than Fresh Stock Issuance in

Stock Market

WACC (%) - Use MARKET VALUES of Debt and Equity,

FIRMS TRY TO MINIMIZE THEIR COST OF CAPITAL

· WACC = rDxD + rExE. IMPORTANT FORMULA

rD and rE are "Costs" of Debt & Equity respectively. INTEREST is the

cost paid by Firm to Investors who hold Firm's Debt. DIVIDEND is

cost paid by Firm to Investors who hold Firm's Equity.

xD and xE based on MARKET VALUES of Debt and Equity,

Firm Value = Value = Debt + Equity

= Share Price x Number of Shares Outstanding

Two ways to compute:

NI (or EBIT) Approach (E = NI / rE

V = E+D) and Tax Shield (or NOI) Approach (VL =

VU + Tc D EL rE

WACC)

VL is Value of Levered Firm. VU is Value of Un levered Firm. Tc is Corporate Tax %. D is

Debt.

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Financial Management MGT201

SML WACC Graph

Important

Required

FEASIBLE REGION (where

SML Line

ROR rCE (%)

IRR of investment or project

(EXTERNAL

is more than SML and

MARKET

WACC)

criterion)

IRR < SML

WACC

Firm's own

WACC

IRR < WACC

(INTERNAL

rRF = T-

IRR <WACC < SML

Bill rate

criterion)

Beta Risk

Visualizing Operating Leverage (OL)

Impact on Breakeven Point & Capital Budgeting

Revenues &

Sales REVENUE Line

Total COST Line

Costs (Rupees)

Company A:

OL = Fixed Cost /Total Cost

Higher OL So

Higher Breakeven

Total COST Line

Company B

Breakeven A is Higher.

A is More Risky. As

Fixed Costs A

long as Sales >

Breakeven, OL is Good.

Fixed Costs B

Sales Quantity

(# of Units)

QB*

QA*

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Financial Management MGT201

Visualizing Financial Leverage (FL)

Impact on ROE & Capital Structure

LEVERED (Debt

ROE (%)

& Equity) Firm:

77%

Higher Slope.

FL IS GOOD IF EBIT /

ROE more

ASSETS > COST OF

sensitive to

42% DEBT.

changes in EBIT

35% = <ROE>L

UN-LEVERED

(100% Equity)

21% = <ROE>UL

Firm. Safer

Capital Structure

3.5%

at Low EBIT's

EBIT (Rs)

Tradeoff Theory Graph

LeveSlahgeeve&geOiptiImeaTaxCapital Structure

rig tly L ra d F rm: nter st l

Shield Benefit. Total Return to Investors

Excessively Leveraged Firm:

Rises so Stock Value Rises. Total Return

Threat of Bankruptcy has Real

= Net Income (paid to Shareholders) +

Value of

Costs. Less Investor

Interest (paid to Debt Holders)

Firm or

Confidence and Lower Share

Price.

Price of

Stock

Firm Remains 100%

Equity (Un-Levered)

Financial Leverage =

OPTIMAL Capital

Debt / Assets =

Structure - MAXIMUM

D/(D+E)

VALUE & MINIMUM

WACC

Capital Structure Theories:

Tradeoff Theory: Little Debt reduces WACC. High Debt Bankruptcy Risk

Signaling Theory: Raising New Debt carries Positive signal to market. Fresh Equity

carries Negative Signal

Agency Theory: Managers' Personal Motives clash with Shareholders' (Owners')

Interest

Capital Structure Models

Miller Modigliani

(Without Taxes: rE = WACCU + (D/E (WACCU -rE),

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Financial Management MGT201

Pure MM Theory - Ideal Markets

WAFinancialGraph - Important

CC Risk.

Cost of

rE = Cost of Equity

Higher Required

Capital

Return on Equity.

=WACC+D/E (WACC-rD)

Higher rE

(%)

WACC =

rDxD + rExE

rD = Cost

of Debt

Debt / Equity = A

Measure of Leverage =

100%

D/E = xD / ( 1- xD )

Equity

Firm

Market Value of Firm = V = EBIT / WACC. As Debt Increases, Risk Increases so rD and rE and

WACC should increase. BUT Debt is cheaper than equity (recall Risk Theory) so as Debt

Increases, WACC should decrease! Net Effect is No Change in WACC and No Change in

Value. CAPITAL BUDEGTING is Independent of Corporate Finance / Capital Structure.

DEBT HAS NO BEARNING ON A FIRM'S VALUE!

Traditionalist Theory - Real Markets

WACC Graph - Important

Bankruptcy Risk &

Cost of

Costs. Higher

Capital

Required Return on

rE,L = Cost of Equity =

Equity. Steeper Rise.

(%)

WACCU + xD(WACCU -rD) (1-TC)

WACCL = rD(1-Tc)xD + rExE

rD = Cost of Debt

Interest Tax Shield

Advantage

Debt / Equity = A

100%

Optimal Capital

Measure of

Structure = Minimum

Equity

Leverage = D/E = xD

WACC and

Firm

Maximum Value

/ ( 1- xD )

Note: xD = D / (D+E)

Traditionalists Formulas (WACCL = rD (1-Tc) xD + rExE)

FIRM'S VALUE = EBIT / COST OF CAPITAL. MORE LEVERAGE (OR DEBT)

MEANS MORE RISK WHICH MEANS HIGHER COST OF CAPITAL AND

THEREFORE LOWER VALUE

Traditionalist View is based on Practical Reality. Leverage provides Interest Tax

Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to

Bankruptcy Risk. Increases in Risk will Change Value of Firm and WACC.

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Financial Management MGT201

Practical Capital Structure Management- Target Ratios i.e. TIE of 2.5. TIE and Debt /

Capitalization

Dividend Policy Theories - MM, Signaling, and Agency,

DIV1 = DIVo (1+g) , g = Pb x ROE , If ROE < rE then better to give Dividends than to

Retain Earnings

MM: Dividend Policy and Debt are Irrelevant to a Firm's Value. What matters

is the Cash Flows from Underlying Assets and NOT how you divide or split up

the Cash Outflows i.e. Dividends. IMPORTANT.

Signaling Theory: Issuing New Debt (or taking new loan) gives positive signal

to Investors. Issuing Fresh Stock / Equity in Stock Market gives negative signal.

Agency Theory: Management's Personal Motives often clash with Owner /

Shareholders Objectives

Impact of Dividend Announcement and Ex-Dividend Date on Share Price

Dividend Payout restricted by Capital Expenditure Requirement, Target Debt Ratio, and

restrictions placed by Debt Contracts

DIV1 = Future Dividend

If ROE < rE then better to pay out Dividends rather than keep cash as Retained Earnings

because company is unable to generate an ROE high enough to satisfy the

Shareholder's Required Return (rE).

Global Investing Makes the Efficient Frontier and

the CML (Capital Market Line) Rise Up

Higher Return for Same Level of Risk

Efficient Frontier (for

)

rP*

nts

Global Investments)

stm

l In

ent

stm

(fo

Inv

ntr

Efficient Frontier

ing

(for Investment in

(fo

rRF

Single Country)

Risk

Outline of 4 Minor Areas of FM:

1- Working Capital and Short Term Financing

Current Assets Management: Cash, Marketable Securities, Inventory.

· Current Assets necessary for safe liquidity but earn no / little return on cash,

inventory

· Fat Cat vs. Lean Mean , C/F Synchronization and Cheques Float ,

Current Liabilities and Short Term Financing: Accounts Payable and Short Term Loans.

"Spontaneous" and unpredictable source of financing.

Types of Financing

· Permanent (Equity & Long Term Loan) vs. Temporary (Short-Term Loan)

vs. Spontaneous Financing (Current Liabilities). IMPORTANT.

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Financial Management MGT201

Hedging Principle or Self-Liquidating Debt or Maturity Matching:

Buy

Permanent Assets with Permanent Financing. IMPORTANT.

2- Lease Financing

Financing Lease, Operating Lease, Sale & Lease Back

Ownership vs. Control

Valuation of Lease Finance: NAL (modified NPV) and IRR (%)

3- Mergers and Acquisitions (M&A) and Valuation of Firms

Mergers, Acquisitions, LBO's

Merger Valuation using DCF (NPV) or MMA Short-cut Formulas

Impact of Merger on Share Price and Value of Firm

4- International Finance

Impact on Major Areas of FM: Capital Structure and Corporate Financing, Financial

Accounting, Capital Budgeting

Foreign Exchange (F/x)

· Markets: Spot, Forward, Futures, Options

· Relationships: PPP, Fischer Effect, IRP

· European Convention & Cross Rates

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