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For Financial Management course.
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What is Financial Management?
Financial management is concerned with the maintenance and creation and economic
value or wealth. Financial management refers to the efficient and effective
management of money (funds) in such a manner as to accomplish the objectives of the
organization. It also means planning, organizing, directing and controlling the financial
activities of the enterprise.
Role of the Financial Manager – Financial Objectives
1. To raise funds of the company
Financial manager checks his need in short term and in long term and after this he
selects best source of finance. Financial manager also has to the power to change
the capital structure of the company in order to give more benefits to the
company.
2. To take maximum benefits from leverage
Financial manager uses both operating and financial leverage and try to use it for
taking maximum benefit from leverage.
3. To make investment decisions
Financial manager checks the net present value of each investment project before
actual investment is made. Projects with high NPV will be accepted.
4. To manage risks
Financial manager plays important role to find new ways to control risks of the
company. Financial manager estimates all risks, organizes employees who are
responsible to control risk, and calculates risk-adjusted NPV. Financial manager
also meets all risk controlling organizations.
Goal of the Firm/Company
The primary goal of the company is the maximization of stockholders’ wealth, by which
we mean maximization of the price of the existing common stock. Firms should promote
transparent reporting in order to improve their credibility and investors’ confidence in
them. Meanwhile, firms have to ensure good share price. Competitive advantages should
be gained in order to outperform the competitors. Besides, firms should put in their best
effort to ensure the future growth of theirs.
In addition, the firm’s survival in the long term needs to be ensured by having a healthy
balance sheet. A balance sheet is a financial statement that gives us a bird’s-eye view of
our small business at a given point in time. We might prepare one monthly, quarterly, or
annually. The document contains information about our assets, our liability, and our
equity.
Balance sheets are an absolute necessity for our business because they make it possible
for us to evaluate its overall strength and health — something every business should want
to know.
A balance sheet can help us answer many questions, including:
Is it time to expand the business?
Do revenue fluctuations severely impact business operations?
Are cash revenues dangerously low?
Are receivables being collected on time?
Is business slowing down or picking up?
But balance sheets are essential for many other aspects of operating our business.
Along with income statements, they are used by investors, lenders, and vendors to
determine how much credit to grant. So, not only is the balance sheet telling you what’s
going on with your business — it’s telling others too.
What are the Non-Financial Objectives?
1. Employee engagement and satisfaction
Focusing on employee satisfaction allows the creation of a workforce of engaged
and loyal employees. With increased employee morale often comes better
attendance and effort.
2. Environmental protection
All organizations have social responsibility to carry out the protection of the
environment. As people’s awareness about environmental protection is rising, it
has become a social responsibility of organizations. Organizations have to make
sure that things they do are and will not cause major damages to the environment.
3. Consumer benefits
All organizations should take care of the consumers’ benefits by producing high-
quality goods and services at the lowest possible cost. Products and services that
the consumers need and want should be developed.
4. Personal aspiration
Some managers have used the business to promote their own personal
image/status in the society or to obtain personal gain at the expense of the profit
of the company, this has been seen as an unhealthy situation and should be
prevented as far as possible. But some other companies even attempt to help their
employees to achieve their personal status for example by allowing them to obtain
higher education qualification by providing scholarship for their studies etc. This
can be explained by the fact that by having highly qualified staff, the
creditworthiness and operating risk of the company can be preserved at a low
lower.
Type of Claim: Debt or Equity
1. Debt instruments typically have specified payments and a specified maturity.
2. If the debt matures in less than a year, it is a money market security.
3. Equity instruments are a claim upon a residual value. Because stock has no
maturity date, it is a capital market security.
Financial Markets
Financial markets can be classified as:
1. Physical asset markets are those for products such as wheat, real estate, autos,
and computers. Financial asset markets deal with stocks, bonds, notes,
mortgages, and other financial instruments.
2. Spot markets and future markets are markets where assets are being bought
or sold for “on-the-spot” delivery or for delivery at some future dates.
3. Money markets are the markets for short-term, highly liquid debt securities,
while capital markets are the markets for corporate stocks and bonds maturing
more than a year in the future.
4. Primary markets are the markets where companies raise new capital. It is
where new securities are traded. On the other hand, secondary markets are
markets where existing, already outstanding securities are traded among investors.
5. There are two different types of offerings in the primary markets: Initial Public
Offering (IPO) is the first time the company’s stock is sold to the general
public, whereas a seasoned new issue refers to stock offerings by companies
that already have common stock traded in the secondary market.
What is a Financial Intermediary?
A financial intermediary is an entity that acts as the middleman between two parties in a
financial transaction. While a commercial bank is a typical financial intermediary, this
category also includes other financial institutions such as investment banks, insurance
companies, broker-dealers, mutual funds and pension funds. Financial intermediaries
offer a number of benefits to the average consumer including safety, liquidity and
economies of scale.
The 10 Principles that Form the Basics of Financial Management
1. Principle 1: The Risk-Return Trade-Off
We save money to expand our future consumption opportunities. Some people
would rather forgo future consumption opportunities to consume more now.
When deciding where to invest money in, investors demand a minimum return
that must be greater than the anticipated rate of inflation. If they didn’t receive
enough to compensate for the inflation, they would rather purchase something
else or invest in assets that were subject to inflation and earn the rate of inflation
on the assets. Investors sometimes choose to put their money in risky investments
because these investments offer higher expected returns.
2. Principle 2: The Time Value of Money
A dollar received today is worth more than a dollar received in the future because
we can earn interest on money received today. Thus, it is better to receive money
as early as possible.
3. Principle 3: Cash is King
In measuring wealth or value, we use cash flows but not account profits as the
measuring tool. It is the cash flows that are actually received by the firm and can
be reinvested.
4. Principle 4: Incremental Cash Flows
It’s only what changes that counts. The incremental cash flow is the difference
between the cash flows if the project is taken on versus what they will be if the
project is not taken on. Only incremental cash flow should be considered in the
evaluation process.
5. Principle 5: The Curse of Competitive Markets
If an industry is generating large profits, new entrants will be attracted. The
additional competition and added capacity can result in profits being driven down
to the required rate of return. Conversely, if an industry is returning profits lower
than the required rate of return, then some participants in the market drop out,
reducing capacity and competition. In turn, prices are driven back up.
6. Principle 6: Efficient Capital Markets
An efficient market is a market in which the values and all assets and securities at
any instant in time fully reflect all the publicly available information. An efficient
market is characterized by a large number of profit-driven individuals who act
independently. New information regarding the securities arrives in the market at a
random manner. Given this setting, investors react to the new information by
buying and selling the security until they feel that the market price correctly
reflects the new information. Under the efficient market hypothesis (EMH),
information is reflected in security prices with such speed that there are no
opportunities for investors to profit from the publicly available information. First
implication of efficient market for us is that prices are right. Stock prices reflect
all publicly available information regarding the value of the company. This means
that we can focus on the effect each decision should have on the stock price if
everything else were held constant. Secondly, earnings manipulations through
accounting changes will not result in price changes. Stock splits and other
changes in accounting methods that do not affect cash flows are not reflected in
prices.
7. Principle 7: The Agency Problem
Agency problem is the problem caused by the conflicts of interests between the
managers and the stockholders.
8. Principle 8: Taxes Bias Business Decisions
According to Principle 4, only incremental cash flows should be considered in the
evaluation process. More specifically, the cash flows we will consider will be
after-tax incremental cash flows to the firm as a whole. When the companies are
analyzing the possible acquisition of a plant or equipment, the returns from the
investment should be measured on an after-tax basis. The government also
realizes taxes can bias business decisions and uses taxes to encourage spending in
certain ways.
9. Principle 9: All Risk is Not Equal
Some risks can be diversified away, some cannot.
10. Principle 10: Ethical Behavior is Doing the Right Thing, and Ethical Dilemmas are everywhere in Finance
Comparison Table of Profit Maximization and Shareholders’ Wealth Maximization
Profit Maximization Shareholders’ Wealth MaximizationProfit is the amount of revenue remaining after deducting all costs and expenses. These expenses include non-cash items such as depreciation and amortization of fixed assets. In order to maximize profit, the firm has to increase either sales units or sales price and reduce costs. The firm can achieve maximum profit without achieving maximum shareholders’ wealth.
Shareholders’ wealth refers to the market value of common stock held in the company. Shareholders’ wealth would be maximized as the common stock price is maximized. In order to maximize shareholders’ wealth, the firm has to maximize its profits first.
Profit maximization can be achieved in the short term. It can be achieved by manipulating sales and costs by either increasing or decreasing the variables involved. But doing so may worsen the situation in the long run.
To achieve shareholders’ wealth maximization, the firm has to accomplish all the short-term targets such as growth in earnings and dividends, increase in profitability and maintaining its financial stability. Only after having achieved all that, will the firm be more attractive to potential investors. This will result in an increase in the demand for the firm’s shares which would be followed by an increase in the stock price.
Profit maximization emphasizes the amount of profits received and not when the profits are received. Hence, it does not consider the timing of the returns. It does not matter how late the profits are received as long as the amounts are huge.
Shareholders’ wealth maximization applies the principle of time value of money. According to the time value of money, a dollar received today is worth more than if it is to be received in for example, in 10 years’ time. The earlier the cash is received the better, for the money can be invested in another project so as to increase earnings. This will lead to an overall increases in the company’s earnings.
Profit maximization ignores risk or uncertainty that comes with the project. Risk is an important factor because it would affect the firm’s existence. Rather, profit maximization only emphasizes the significance of getting higher profit.
In achieving shareholders’ wealth maximization, decisions are made after taking into account the uncertainty or risk factor. If the firm wants a higher return, it should be willing to assume a higher risk. If the firm’s manager is a risk-averse person, he would only be willing to accept a certain degree of risk when it is compensated with the same level of return.
Increase in profits does not mean an increase in cash flows. This is because the computation of profit includes non-cash items such as depreciation and amortization.
Increase in shareholders’ wealth is related to an increase in cash flows. Only when cash flows increase, can dividends be paid, payment for expansion be made, and so on.
Agency Problem
A firm consists of various interest groups. Each group will have their own objectives.
Agency problem results from conflicts between the manager and the shareholders. It is
the problem in which the managers act in their best interest instead of in the best interest
of the shareholders. Examples of principal and agent relationships are:
1. Managers are agents of shareholders
2. Employees are agents of managers
3. Managers and shareholders are agents of long-term and short-term creditors.
In order to prevent the managers to abuse their position and power and protect their interests, the
shareholders may use several different mechanisms. In the text that follows, the measures are
divided into two groups first and then analyzed as such:
a. Internal measures
i. Internal audit
To secure the continuity and the development of the company, the internal
audit is of the great importance to be made. It helps to evaluate the
efficiency of the company, to detect and stop the eventually inefficient
operations as well as to protect the assets and the capital.
ii. Change in the salaries and payments of the managers
One of the measures that can be taken to overcome this problem is the way
of financial rewarding of the managers. The best way is to calculate their
bonuses as a percentage of the realized profit of the company. Why is this
rewarding method beneficial? The answer to this question can be
illustrated by a simple example of a situation when we ask an agent to help
us sell our computer. At the beginning we can arrange with the agent a
certain amount that he/she would get for his/her engagement for selling
the computer. In this case, the agent will not be interested to ask and get a
better price for the computer from the potential buyer and he/she will only
be interested in just selling the computer as quick as possible in order to
get his/her money arranged previously. Even we, as sellers, will be in a
better position if we offer 10% of the reached value of the computer to the
agent. This agreement makes the agent more motivated to reach and sell
the computer at a higher price, which makes his/her commission bigger.
Accordingly, the same will happen with the top managers if their
rewarding depends on the profit of the company. This type of calculated
rewarding will motivate the mangers to make decisions and take activities
that lead toward the better company profit-the goal that the shareholders
strive to as their main interest. Another established practice is to offer the
managers to buy shares and become owners themselves. This is the way of
aligning the interests of the managers and the shareholders-long-term
development, continuity and increasing the value of the shares.
iii. Concentrate ownership
Concentrated ownership is an effective way to prevent the agency
problem. According to them, managerial ownership share increases, their
interest aligned with the shareholders interest, so they will act in a way
that will increase the shareholder value.
b. External measures
i. External audit
One of the measures taken to control the work of the company and prevent
the agency problem is an effective external control of the work of the
managers. The most effective way in this situation is to engage external
audits who would periodically value the reality and objectivity of the
company’s financial reports. Precise financial reporting is critical to
ascertaining that the results are stated fairly and the management has not
manipulated results for personal gain. The audit reports are delivered to
the shareholders, the managers, the employees, and to the ones who are
involved at the market in order to use them as a part of the valuation of the
company
ii. Market of capital
Market price of the shares of a company, according to which the company
is valuated, is a signal of a successful work of the company. If the
company is governed by a manager whose decisions make the company
less efficient, it can lead to a situation when the shareholders would sell
their shares. As big the offer of shares is, as lower the price gets, which
should be a signal enough for the members of the board of directors that
some changes within the managerial department have to be made.
Nevertheless, it is very important to point out that in situation like the
previously mentioned one, firstly some analysis should be made, meaning
whether the lower price comes as a result of bad managing or as a result of
the change of some external factors.
The consequences of improper financial management
1. Consumers and investors will lose their trust and confidence in the firm.
2. There will be lack of proper audit practices.
3. Misuse of company funds.
4. There will be no growth and direction in the firm.
5. Overstaffing.
6. Poor procurement process.
7. Poor cost control.
Efficient-Market Hypothesis (EMH)
An efficient market is a market in which the values and all assets and securities at any
instant in time fully reflect all the publicly available information. An efficient market is
characterized by a large number of profit-driven individuals who act independently. New
information regarding the securities arrives in the market at a random manner. Given this
setting, investors react to the new information by buying and selling the security until
they feel that the market price correctly reflects the new information. Under the efficient
market hypothesis (EMH), information is reflected in security prices with such speed that
there are no opportunities for investors to profit from the publicly available information.
First implication of efficient market for us is that prices are right. Stock prices reflect all
publicly available information regarding the value of the company. This means that we
can focus on the effect each decision should have on the stock price if everything else
were held constant. Secondly, earnings manipulations through accounting changes will
not result in price changes. Stock splits and other changes in accounting methods that do
not affect cash flows are not reflected in prices.
EMH classifies market information into:
a. Weak form
If an investor predicts the share price movement based only on past information,
such a prediction is not likely to be accurate and he is said to be in the weak form
of market.
b. Semi-strong form
If an investor can predict share price based on past information but immediately
be updated with currently published information, the prediction may be accurate
depending on how fast he can update the current information and he is said to be
in the semi-strong market if he possesses currently published information.
c. Strong form
If an investor can predict share price based on past, present, future, published and
unpublished information, the prediction will be very accurate and he is said to be
in a strong form of market but such a market will not exist because people possess
unpublished information (insider) are not allowed to deal in securities on a
recognized exchange and therefore super-normal profit cannot be earned by him.
Assumptions of EMH
1. All investors are rational utility maximizer.
2. There are many investors. Therefore, no individual dominates the market and can
affect the prices.
3. The market is efficient, that is all relevant information is freely available to all
buyers and sellers. This is made possible with the advent of information
technology.
Means of predicting the market
1. Technical Analysis (short term)
Price movements have important bearing on future prices. A study of trend and
pattern.
2. Fundamental Analysis (long term)
The organization’s performance, earnings, dividend policy are the important
determinant of future share prices. Fundamentalist believes that shares have
intrinsic value even though market prices may fluctuate above and below this
value from time to time. The fluctuations are due to changes in demand and
supply.
Factors to Consider when Sourcing for Finance
1. The type of business
A sole trader will be limited to the capital the owner can put into the business plus
any money he or she is able to borrow. A limited company will be able to raise
share capital. In order to become a plc it will need to share capital of £50,000+
and a track record of success. This will make borrowing easier.
2. The state of the economy
When the economy is booming, business confidence will be high. It will be easy
to raise finance both from borrowing and from investors. It will be more difficult
for businesses to find investors when interest rates are high. They will invest their
money in more secure accounts such as building societies. Higher interest rates
will also put up the cost of borrowing. This will make it more expensive for the
business to borrow.
3. The stage of development of the business
A new business will find it much harder to raise finance than an established firm.
As the business develops it is easier to persuade outsiders to invest in the
business. It is also easier to obtain loans as the firm has assets to offer as security.
4. Repayment terms
Consider how long the financing arrangement is structured to last. Longer loans
can build up a significant amount of interest over time, but loans with shorter
terms can require larger periodic payments. Consider the amount of the periodic
payment and how often you are required to pay. Also take into account the
allocation of each payment to principal and interest; look for loans with a higher
allocation to principal to minimize the total long-term cost.
5. Interest and Fee Structures
Add up all of the costs associated with each financing method before making a
decision. Common costs for loans include interest rates, origination fees and
brokers' fees. Financing through investment can carry much different costs.
Money from venture capitalists, for example, may not require repayment for
years, at which time the investor may expect to be repaid at a steep premium all at
once. Financing through stock offerings can lead to a change in management and
a shifting in strategic focus.
6. Financial Strength and Stability of Operations
The financial strength of a business also serves as a key determinant. While
making the choice of source of funds, business should be financially sound so that
the company is able to repay the principal amount and interest on the borrowed
amount. When the income/financial position of the organization is not stable,
fixed charged funds like preference shares and debentures should be carefully
selected as these add to the financial burden of the company.
Sources of long-term Finance
1. Shares
2. Debentures
3. Public deposits
4. Retained earnings
5. Term loans from banks
6. Loan from financial institutions
7. Long term financing products
Sources of short-term Finance
1. Bank overdraft
2. Trade credit
3. Lease
4. Short term bank loans
5. Commercial paper
6. Factoring
Financial Forecasting
A financial forecast is simply a financial plan or budget for your business. It is an
estimate of two essential future financial outcomes for a business – your projected
income and expenses. Create a cash flow forecast by adding income and expenses as they
are due. You will then know exactly how much you need to make every month for a
profitable business.
A financial forecast is the best guess of what will happen to your business financially
over a period of time. Usually, financial forecasts are an estimate of future income and
expenses for a business over the next year and are used to develop the projections
of profit and loss statements, balance sheets and, most critically, the cash flow forecast.
Predicting the financial future of your business is not easy, especially if you are starting a
business and do not have a trading history. Initially, your financial forecasts will be
inexact and inaccurate. However, frequent forecasting with adjustments as required will
promote more accurate forecasting.
The financial forecast is critical to your business plan, especially if it is for the purpose of
getting a bank loan. More importantly, you are an investor in your own business and you
must have confidence in the validity of your business concept. Use a financial forecast to
prove to yourself that your business will generate your desired profit and when it will
start to make that profit.
A financial forecast is a vital tool in the financial management of your business and, like
your business plan, requires regular review and amendment to be effective. Once the
period for which you prepared the budget is over, be sure to compare the actual results
against your budget forecasts. Examine why variations have occurred, take any remedial
action necessary to correct the problem, or plan for them accordingly in your next budget.
Advantages of an effective financial forecast:
Demonstrates the financial viability of a new business venture. Allows you to
construct a model of how your business might perform financially if certain
strategies, events and plans are carried out.
Allows you to measure the actual financial operation of the business against the
forecast financial plan and make adjustments where necessary.
Allows you to guide your business in the right direction and take control of your cash
flow.
Provides a benchmark against which to measure future performance.
Identifies potential risks and cash shortfalls to keep the business out of financial
trouble.
Provides an estimate of future cash needs and whether additional private equity or
borrowing is necessary.
Assists you to secure a bank loan or other funding. Lenders and investors require
financial forecasts to show your capacity to repay the loan.
Types of Forecasting Models
1. Qualitative models
i. Delphi Methods
Delphi method is a forecasting method based on the results of
questionnaires sent to a panel of experts. Several rounds of questionnaires
are sent out, and the anonymous responses are aggregated and shared with
the group after each round. The experts are allowed to adjust their answers
in subsequent rounds. Because multiple rounds of questions are asked and
because each member of the panel is told what the group thinks as a
whole, the Delphi Method seeks to reach the "correct" response through
consensus. The Delphi Method seeks to aggregate opinions from a diverse
set of experts, and can be done without having to bring everyone together
for a physical meeting. Because the responses of the participants are
anonymous, individual panelists don't have to worry about repercussions
for their opinions. Consensus can be reached over time as opinions are
swayed. There are three different types of participants, which are the
decision makers, staff personnel, and respondents.
ii. Jury of Executive Opinion
Jury of executive opinion is a method of forecasting using a composite
forecast prepared by a number of individual experts. The experts form
their own opinions initially from the data given, and revise their opinions
according to the others' opinions. Finally, the individuals' final opinions
are combined. This technique is part of a set of techniques that are useful
in situations where past data do not exist, causal relationships have not
been identified, or some major change has occurred in the forecasting
context which is not accounted for by other techniques (such as a Gulf
War, trade agreement, etc.). Evidence as to the validity of using these
methods by themselves is mixed, although using them correctly can
provide very good forecasts, especially in uncertain environments. The
objective of these techniques is to provide logical, unbiased, and
systematic quantitative estimates. In the jury of executive opinion method,
appropriate managers within the organization assemble to discuss their
opinions on what will happen to sales in the future. Since these discussion
sessions usually resolve around hunches or experienced guesses, the
resulting forecast is a blend of informed opinions.
iii. Sales Force Composite
It is a forecasting method used to forecast the sales by adding up
individual sales agents forecasts for sales in their respective sales
territories. It is a bottom-up approach which companies use to forecast
more accurately. Sales agents have the most direct interaction with the
customers and provide many valuable insights which help the companies
boost their sales.
Using the sales force composite forecast the company not only forecasts
for the market as a whole but it also has numbers for individual areas and
territories.
Flipside of using this technique is that the company forecast will only rely
on sales agents who may use too optimistic or too pessimistic approach
based on their latest experience. Thus the company can end up forecasting
taking only microeconomic factors and neglect the macroeconomic
environment. Hence the companies usually combine the sales force
composite forecast with the top-down forecast and then finalize the actual
forecast.
Another drawback of this technique is that some agents may give a lower
forecast than the actual potential of sales to easily achieve their target and
get the money bonus from the company on the extra sales generated.
Nowadays many companies use scripting software which takes into
account the response of the agents and gives a cumulated forecast based
on the programming from the historical data and previous forecasts.
2. Quantitative models
i. Historical data forecasts
Naïve methods
A naïve forecast is not a specific forecasting model, although it is
sometimes defined as simply the last period’s demand. However,
naïve forecast can be several models. It can be simply the sales
from the last period, a moving average, or for seasonal items, what
was sold last year in the same period.
Moving averages
Essentially, moving averages try to estimate the next period’s
value by averaging the value of the last couple of periods
immediately prior. The number of periods you use in your moving
average forecasts are arbitrary; you may use only two-periods, or
five or six periods – whatever you desire – to generate your
forecasts. The approach above is a simple moving average.
Sometimes, more recent months’ sales may be stronger influencers
of the coming month’s sales, so you want to give those nearer
months more weight in your forecast model. This is a weighted
moving average. And just like the number of periods, the weights
you assign are purely arbitrary.
Trend Analysis
Trend Analysis is the practice of collecting information and
attempting to spot a pattern, or trend, in the information. Uses
linear and nonlinear regression with time as the explanatory
variable, it is used where pattern over time have a long-term trend.
Unlike most time-series forecasting techniques, the Trend Analysis
does not assume the condition of equally spaced time series.
ii. Associative (causal) forecasts
Simple Regression
Multiple Regression
Percent of Sales Forecasting MethodFormulas to be remembered for this method are:
1. Increase∈assets= AS
( g ) (s )
2. Increase∈liabilities=LS
( g ) ( s)
3. Increase∈retained earnings=P (1+g ) ( s)−D
A indicates total assets, L indicates total liabilities, g indicates forecast growth in
sales (percentage), s indicates current sales, P indicates net profit margin on sales, D
indicates cash dividends to be paid
Methods of Capital Budgeting
1. Accounting Rate of Return (ARR) Accounting rate of return is calculated using the following formula:
ARR= Average Accounting Profit∨Average Net IncomeAverageinitial investment
Accept the project only if its ARR is equal to or greater than the required
accounting rate of return. In case of mutually exclusive projects, accept the one
with highest ARR.
Example 1
Lea Gea Corporation is considering a ridiculous long term capital investment
project called Old Trafford. The project will require an investment of $100000
and it will have a useful life of 5 years. Depreciation is computed by the straight
line method with no salvage value. The company’s cost of capital is 10%. Annual
net income is expected to be:
Year Net Income
1 $10000
2 $15000
3 $8000
4 $12000
5 $14000
Solution to Example 1
Average accounting income ¿$ (10000+15000+8000+12000+14000 )
5
¿ $11800
Accounting rate of income ¿ $ 11800
( $ 100000+02 )
¿0.236
2. Payback Period The payback period is the number of years needed to recover the initial cash
outlay of the capital budgeting project. As this criterion measures how quickly the
project will return its original investment, it deals with free cash flows, which
measure the true timing of the benefits, rather than accounting profits. A project
will be accepted as long as the payback period is less than the firm’s maximum
desired payback period. What happens after the payback period is not important.
Example 1
Lea Gea Corporation is considering a ridiculous long term capital investment
project called Old Trafford. The project will require an investment of $100000
and it will have a useful life of 5 years. Depreciation is computed by the straight
line method with no salvage value. The company’s cost of capital is 10%. Annual
net income is expected to be:
Year Net Income
1 $10000
2 $15000
3 $8000
4 $12000
5 $14000
Solution to Example 1
Annual depreciation¿Initial investment−salvage value
Useful life∈ years
¿$ 100000−$ 0
5
¿ $20000
Cash flow from project ¿ annual net income +¿ annual depreciation
Thus, the adjusted annual cash flow will become
Year Net Income
1 $ 10000+$20000=$ 30000
2 $ 15000+$20000=$ 35000
3 $ 8000+$ 20000=$28000
4 $ 12000+$20000=$ 32000
5 $ 14000+$20000=$ 34000
From year 1 to year 3, the net income will be $93000, indicating that $7000 extra
is needed to recapture the initial cash outlay of $100000. Therefore, the payback
period for this project is 3+ $ 7000$ 32000
years.
3. Discounted payback period As the time value of money is ignored in regular payback period, discounted
payback period is invented to deal with the problem. The discounted payback
period method is similar to the traditional payback period except that it uses
discounted free cash flows rather than actual undiscounted free cash flows in
calculating the payback period. The discounted payback period is defined as the
number of years needed to recover the initial cash outlay from the discounted free
cash flows. The accept-reject criterion then becomes whether the project’s
discounted payback period is less than or equal to the firm’s maximum desired
discounted payback period.
Example 1
Lea Gea Corporation is considering a ridiculous long term capital investment
project called Old Trafford. The project will require an investment of $100000
and it will have a useful life of 5 years. Depreciation is computed by the straight
line method with no salvage value. The company’s cost of capital is 10%. Annual
net income is expected to be:
Year Net Income
1 $10000
2 $15000
3 $8000
4 $12000
5 $14000
Solution to Example 1Project A
Annual depreciation¿Initial investment−salvage value
Useful life∈ years
¿$ 100000−$ 0
5
¿ $20000
Cash flow from project ¿ annual net income +¿ annual depreciation
Thus, the adjusted annual cash flow will become
Year Net Income
1 $ 10000+$20000=$ 30000
2 $ 15000+$20000=$ 35000
3 $ 8000+$ 20000=$28000
4 $ 12000+$20000=$ 32000
5 $ 14000+$20000=$ 34000
YearUndiscounted free cash flows
1
(1+ i )n , i=0.10
Discounted free cash
flows
Cumulative discounted free cash
flows0 -$100000 1.000 -$100000 -$1000001 30000 0.909 27270 -727302 35000 0.826 28910 -438203 28000 0.751 21028 -227924 32000 0.683 21856 -9365 34000 0.621 21114 20178
The discounted payback period of project A (4+ $ 936$ 21114 ) years.
4. Net Present Value (NPV) The net present value can be expressed as follows:
NPV =∑t=1
n FCF t
(1+k )t−InitialOutlay
Where FCF t = the annual free cash flow in time period t (this can take on either
positive or negative values)
k = the appropriate discount rate; that is, the required rate of return or cost of
capital
n = the project’s expected life
The accept-reject criterion can be stated as:
NPV ≥ 0.00 ; Accept
NPV <0.00 ;Reject
Example 1
Solution to Example 1
5. Probability Index (PI)
The profitability index (PI), or benefit/cost ratio, is the ratio of the present value
of the future free cash flows to the initial outlay. The probability index can be
expressed as follows:
PI=∑t=1
n FCF t
(1+k )t
Initial cashoutlay
Where FCF t = the annual free cash flow in time period t (this can take on either
positive or negative values)
k = the appropriate discount rate; that is, the required rate of return or cost of
capital
n = the project’s expected life
The decision criterion is like this: Accept the project if the PI is greater than or
equal to 1.00, and reject the project if the PI is less than 1.00.
Example 1
Solution to Example 1
6. Internal Rate of Return (IRR) For computational purposes, the internal rate of return is defined as the discount
rate that equates the present value of the project's future net cash flows with the
project's initial cash outlay. Mathematically, the internal rate of return is defined
as the value of IRR in the following equation:
Initial cash outlay=∑t=1
n FCF t
(1+ IRR )t
Where FCF t = the annual free cash flow in time period t (this can take on either
positive or negative values)
n = the project’s expected life
IRR = the project’s internal rate of return
This accept-reject criterion can be stated as:
IRR>required rate of return : Accept
IRR<required rate of return : Reject
Bonds ValuationTo find the price of a bond, the following formula is to be used.
V b=(Coupon× PV annuity )+PV of the par value of the bond
¿(Coupon×
1−1
(1+i )n
i )+ par value
(1+i )n
¿ Sometimes the coupon can be paid semiannually or quarterly or monthly. For example,
the value of a bond with par value of $1000, coupon rate of 9%, interest rate of 8%,
maturing in 10 years, which is paid quarterly will be
V b=($ 22.50 ×
1− 1
1.0240
0.02 )+ $ 1000(1.02 )40
Yield ¿maturity of bonds=total expected rate of return of bonds
¿current yield+capital gain yield
¿coupon
current price+ selling price−buying price
buying price
Yield ¿maturity of bonds=total expected rate of return of bonds
¿cost of debt before tax
¿coupon+par value− (current price−flotationcost )
years ¿maturity ¿
par value+ (current price−flotationcost )2
Common Stock ValuationThere are 3 types of common stock. Each of them has different calculation for the value.
Required rate of returnof common stock
¿Cost of equity
¿Capital Asset Pricing Model
¿ risk free rate+(risk premium× beta)
¿ r f +(r m−r f )(β)
Common stock with constant growthTo find the price of common stock with constant growth, the following formula is to be
used.
Pn=Dn+1
r−g
Where Pn = price of the common stock at year n
Dn+1 = dividend paid by the common stock at the year after year n
r = required rate of interest
g = growth rate
For example, if we want to find the price of a common stock at year 0, the price would be
P0=D1
r−g
¿D0 (1+g )
r−g
If we want to find the price of a common stock at year 3, the price would be
P3=D4
r−g
¿D0 (1+g )4
r−g
Expected rate of return of commonstocks withconstant growth
¿Gordon growthmodel
¿ Expected dividend yield+expected growth rate
¿D1
P0−flotationcost+g
Common stock with non-constant growthTo find the price of common stock with non-constant growth, the following formula is to
be
P0=PV annuity of future dividendsuntil the last year of having constant growth rate+PV of the price of the commonstock at thelast year of having constant growth rate
For example, if a common stock is said to have a required rate of return of i%, growth
rate of g% from year 0 until year 4, dividend of D0 at year 0, and growth rate of k% from
year 5 onwards. The price of the common stock will be
P0=D0 (1+g )
1+i+
D0 (1+g )2
(1+i )2+
D0 (1+g )3
(1+i )3+
D0 (1+g )4
(1+i )4+
D0 (1+g )5
r−g(1+ i) 4
Common stock with zero growth
To find the price of common stock with zero growth, the following formula is to be
P= Dr
Where P = price of the common stock
D = dividend
r = required rate of return
Preferred Stock Valuation
To find the price of preferred stock, the following formula is to be used.
P= Dr
Where P = price of the common stock
D = dividend
r = required rate of return
Cost of preferred stock= DividendPrice of preferred stock− flotationcost
What is a Weighted Average Cost of Capital (WACC)?
Broadly speaking, a company's assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how much
interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for cash
flows with risk that is similar to that of the overall firm.
To calculate the WACC, the following formula is to be used.
WACC=( KE× WE )+( KP ×℘)+( KD after tax ×WD )
Where KE = cost of equity, which is also r f +(rm−r f )(β) or D1
P0−flotationcost+g
KP = cost of preferred stock, which is also
DividendPrice of preferred stock−flotationcost
KD after tax = cost of debt after tax, which is also
coupon+par value−(current price−flotationcost )
years ¿maturity ¿
par value+ (current price−flotationcost )2
× (1−tax margin )
During the calculation of WACC, it’s important to remember that the WE ,℘ ,∧WD are
calculated by using the market value instead of book value/nominal value. For
KE , KP ,∧KD, using nominal value will do. The example of calculation of market value
of securities is as follow.
Example 1
(000’s)Common stock of $0.60 each $1200
12% Preferred stock of $1.00 each $30008% Bonds, $1000 face value $10000
The company has just paid a common stock dividend of $0.12 per stock and the current
price of each common stock is $2.50. Dividends are expected to grow at a rate of 7% per
annum. The preferred stocks are quoted at $0.80 per stock. The market price of the 8 year
bond is $880. The flotation costs of this bond is $30 per bond. The corporation tax rate is
30%.
Calculate
a) The market value of the bonds
b) The market value of the common stocks
c) The market value of the preferred stocks
d) The cost of equity
e) The after-tax cost of debt
f) The cost of preferred stocks
Solution to Example 1
a) Market value of the bonds= $ 880$ 1000
× $ 10
¿ $8.8
b) Market value of the common stocks=$ 2.50$ 0.60
×$ 1.20
¿ $5
c) Market value of the preferred stocks=$ 0.80$ 1
× $ 3
¿ $2.4
d) KE=D1
P0
+g
¿$ 0.12×1.07
$ 2.50+0.07
¿0.12136
e) After−tax cost of debt=$ 80+
$1000−($ 880−$30 )8
$ 1000+ ($ 880−$ 30 )2
×0.7
¿0.07473
f) Cost of preferred stocks=$ 0.12$ 0.8
¿0.15
g) WE= 58.8+5+2.4
,℘= 2.48.8+5+2.4
,WD= 8.88.8+5+2.4
h) WACC=( 58.8+5+2.4
× 0.12136)+( 2.48.8+5+2.4
× 0.15)+( 8.88.8+5+2.4
× 0.07473) ¿ (0.3086 × 0.12136 )+(0.148 × 0.12 )+ (0.543× 0.07473 )
¿0.03745+0.0222+0.0406
¿0.10025
Risk and Diversification
Risk is the variability of anticipated return as measured by the standard deviation. Total
risk of portfolio can be divided into two types of risk:
a) Firm-specific risk / company-unique risk
Company-unique risk is also known as diversifiable risk or unsystematic risk.
Unsystematic risk can be reduced by diversification. By diversifying our
investments, we can indeed lower risk without sacrificing expected return, or we
can increase expected return without having to assume more risk. An example of
a diversifiable risk is the risk that a particular company will lose market share. It
will not have any impact on other companies in a diversified portfolio, so the only
loss to an investor holding shares in the company will be the decline in that one
share.
b) Market-related risk
Market-related risk is also known as nondiversifiable risk or systematic risk.
Systematic risk is the risk inherent to the entire market or an entire market
segment. It affects the overall market, not just a particular stock or industry. This
type of risk is both unpredictable and impossible to completely avoid. It cannot be
mitigated through diversification, only through hedging or by using the right asset
allocation strategy.
For portfolio involving probability,
Expected return on portoflio
¿∑n=1
x
( Probability of individual investmentn × expected return onindividual investment n )
Portfolio beta
¿∑n=1
x
( Probability of individual investmentn ×beta of individual investmentn )
Risk∨standard deviationσ
¿√∑n=1
x
[ Probability of individual investmentn × ( expected return onindividual investment n−expected returnon portfolio )n ]
For portfolio involving weightage,
Expected return on portoflio
¿∑n=1
x
(Weightage of individual investment n× expected returnon individual investmentn )
Portfolio beta
¿∑n=1
x
(Weightage of individual investment n× beta of individual investment n )
Risk∨standard deviationσ
¿√∑n=1
x
( expected return on individual investmentn−expected return on portfolion )2
total number of n
Given two portfolios A and B,
a. When both have same return but A has lower risk, people go for A.
b. When both have same risk but A has lower return, people go for B.
c. When both have same return and same risk, covariance is needed to be calculated
in order to make a decision between these two portfolios.
To calculate the covariance of portfolios, the following formula is to be used.
CVar ( A )=σ A
X A
Where σ A=¿ the standard deviation/risk of portfolio A
X A=¿ the expected return on portfolio A
Portfolio with lower covariance will be selected. Covariance represents the risk
per unit of return on portfolios.
Assumptions with WACC
The WACC can very well work as a hurdle rate in evaluating the new projects provided
the following two underlying assumptions are true for those new projects.
a) No change in capital structure
The capital mix or structure of the new project investment should be same as the
company’s existing structure. It means that if the company has 70:30 ratio of debt
to equity in their current balance sheet, inclusion of the new project will maintain
the same.
b) No change in risk of new projects
The risk associated with the new project will be like the existing projects. For
example, a textile manufacturer expands and increases the no. of looms from 60
to 100. Since the industry and business is same, there will be almost no change in
the risk profile of current business and the new expansion.
Problems with WACC
Some problems with WACC are
a) Difficulty in maintaining the capital structure
The impractical assumptions of ‘No Change in Capital Structure’ has rare
possibilities of prevailing all the time. Remedy to this problem is that the target
capital structure should be taken into consideration and not the existing. Therefore
the calculation of WACC should be adjusted accordingly.
b) Accepting bad projects and rejecting good projects
The impractical assumptions of ‘No Change in Risk Profile of New Projects again
has its inbuilt drawbacks. Risk is a very wide term and is affected by a big list of
factors. Under that situation, assuming no change in risk profile of new projects
would be very unrealistic. Remedy to this problem is that the WACC should be
adjusted to take effect of the change in risk.
c) Difficulty in acquiring current market cost of capital
The WACC used for evaluation of new projects require consideration of present
day cost of capital and knowing such costs is difficult. The WACC considers
mainly equity, debt and preferred stocks. The interest cost of debt keeps changing
in the market depending on the economic changes. The expected dividend of the
preferred stocks also keeps changing with the market sentiments and the most
fluctuating is the expected cost of equity.
d) Important sources of capital avoided
While making WACC calculations, only equity, debt and preferred stocks are
considered for the sake of simplicity assuming that they cover major portion of
the capital. In support of absolutely correct approach towards discounting rate, if
we include convertible or callable preferred stocks, debt, or stock market linked
bonds, or puttable or extendable bonds, warrants, etc also which are also a
claimant to the profits of the company like equity, debt and preference shares, it
will make the calculations very complex. Too much complexity is a probable
reason for mistakes. On the similar grounds, the short term borrowings and the
cost of trade credit is also not taken into consideration. Factors like such if
introduced, will definitely change the WACC. We will not go into the magnitude
of difference these things will have on the calculations of the WACC but the
impact is there.
Working Capital Management
Working capital refers to short term assets and liabilities including inventories, account
receivables, and account payables of a company. It is the capital a company uses to invest
in current assets as well as to undertake daily business activities. Business cannot survive
without working capital (short-term funds). A company must have a source of short-term
financing to enable it to invest in current assets. These funding requirements come partly
from accounts payable and accruals. The four main components of working capital are
cash, marketable securities, inventories, and account receivables. The more working
capital a company has, the lower its operating risk will be; however, holding working
capital can be costly. Thus, working capital management is needed to coordinate delivery
of goods cheaply and quickly. Companies need to decide on the best working capital
policy to adopt which involves decision on
a) The target proportion of each category of current assets to carry
b) The financing of these current assets