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# ManagerialFinanceI FRL300

CSU Pomona

GPA 3.91

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This 208 page Class Notes was uploaded by Dominic Erdman on Saturday October 3, 2015. The Class Notes belongs to FRL300 at California State Polytechnic University taught by AhmadSohrabian in Fall. Since its upload, it has received 11 views. For similar materials see /class/218184/frl300-california-state-polytechnic-university in Finance,Real Estate&Law at California State Polytechnic University.

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Date Created: 10/03/15

Chapter 8 Stock Valuation Chapter Outline Common Stock Valuation Some Features of Common and Preferred Stocks The Stock Markets 81 Key Concepts and Skills Understand how stock prices depend on future dividends and dividend growth Be able to compute stock prices using the dividend growth model Understand how corporate directors are elected Understand how stock markets work Understand how stock prices are quoted 82 Cash Flows for Stockholders If you buy a share of stock you can receive cash in two ways The company pays dividends You sell your shares either to another investor in the market or back to the Company As with bonds the price of the stock is the present value of these expected cash flows 83 OnePeriod Example Suppose you are thinking of purchasing the stock of Moore Oil Inc You expect it to pay a 2 dividend in one year and you believe that you can sell the stock for 14 at that time If you require a return of 20 on investments of this risk what is the maximum you would be willing to pay Compute the PV of the expected cash flows Price 14 2 12 1333 Or FV 16 lY 20 N 1 CPT PV 1333 84 TwoPeriod Example Now what if you decide to hold the stock for two years In addition to the dividend in one year you expect a dividend of 210 in two years and a stock price of 1470 at the end of year 2 Now how much would you be willing to pay PV 2 12 210 1470 122 1333 85 ThreePeriod Example Finally what if you decide to hold the stock for three years In addition to the dividends at the end of years 1 and 2 you expect to receive a dividend of 2205 at the end of year 3 and the stock price is expected to be 15435 Now how much would you be willing to pay PV 2 12 210122 2205 15435 123 1333 86 Developing The Model You could continue to push back the year in which you will sell the stock You would find that the price of the stock is really just the present value of all expected future dividends So how can we estimate all future dividend payments 87 Estimating Dividends Special Cases Constant dividend The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula Constant dividend growth The firm will increase the dividend by a constant percent every period The price is computed using the growing perpetuity model Supernormal growth Dividend growth is not consistent initially but settles down to constant growth eventually The price is computed using a multistage model 88 Zero Growth lf dividends are expected at regular intervals forever then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula P0 D R Suppose stock is expected to pay a 050 dividend every quarter and the required return is 10 with quarterly compounding What is the pnce PO5O1420 89 Dividend Growth Model Dividends are expected to grow at a constant percent per period P0 D11R 02 1R2 03 1R3 Po Do1g1R Do1g21R2 D01g31R3 With a little algebra and some series work this reduces to D01g D1 PO R g Rg DGM Example 1 Suppose Big D nc just paid a dividend of 050 per share It is expected to increase its dividend by 2 per year Ifthe market requires a return of 15 on assets of this risk how much should the stock be selling for P0 50102 15 02 392 DGM Example 2 Suppose TB Pirates Inc is expected to pay a 2 dividend in one year If the dividend is expected to grow at 5 per year and the required return is 20 what is the price P0 2 2 05 1333 Why isn t the 2 in the numerator multiplied by 105 in this example Stock Price Sensitivity to Dividend Growth 9 N O O N O O 150 Stock Price H O O O O O D1 2 R 20 0 005 01 015 Growth Rate 02 Stock Price Sensitivity to Required Return R Stock Price i K i K N N U D U D U D O O O O O D12g5 015 02 Growth Rate 005 01 025 03 Example 83 Gordon Growth Company l Gordon Growth Company is expected to pay a dividend of 4 next period and dividends are expected to grow at 6 per year The required return is 16 What is the current price PO 416 06 40 Remember that we already have the dividend expected next year so we don t multiply the dividend by 1g Example 83 Gordon Growth Company What is the price expected to be in year 4 P4 D41gRg D5R g P4 41064 16 06 5050 What is the implied return given the change in price during the four year period 5050 4O1return4 return 6 PV 40 FV 5050 N 4 CPT IN 6 The price is assumed to grow at the same rate as the dividends Nonconstant Growth Problem Statement Suppose a firm is expected to increase dividends by 20 in one year and by 15 in two years After that dividends will increase at a rate of 5 per year indefinitely Ifthe last dividend was 1 and the required return is 20 what is the price of the stock Remember that we have to find the PV of al expected future dividends Nonconstant Growth Example Solution Compute the dividends until growth levels off D1112120 D2 120115 138 D3 138105 1449 Find the expected future price P2 D3R g14492 05 966 Find the present value of the expected future cash flows P0 120 12 138 966 122 867 Quick Quiz Part What is the value of a stock that is expected to pay a constant dividend of 2 per year if the required return is 15 What if the company starts increasing dividends by 3 per year beginning with the next dividend The required return stays at 15 Using the DGM to Find R Start With the DGM D01g 2 D1 P0 R g Rg D P0 P0 Finding the Required Return Example Suppose a firm s stock is selling for 1050 Itjust paid a 1 dividend and dividends are expected to grow at 5 per year What is the required return R 11051050 05 15 What is the dividend yield 11051o5o 10 What is the capital gains yield g 5 Table 81 Stock Valuation Summary 11 a share agsxucu In sneak m p we Dian um um imam mama i DI 1 n P n my n HP 0 var AnthemH 5 he Walled mum u mummu grows a a many mg man m Was an a wn en a F a 5g Tm lasul mm umdmum gmwllv model I 39T I u 39 39 x 11 me AIM grew signaUy lkerl puma men 3n prhgeg ya man as A y unr Wm umr um v a whale unduly Thnrlqmyod mum a can u Mm as has sum ullwa mm H Dunn y Wham 12m g ms dwkan ylald and v is mm mm yainsyvcld wmch vs quotm mm mm as m gmwln m in uwmm lnr me marl gmwm ass Features of Common Stock Voting Rights Proxy voting Classes of stock Other Rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right first shot at new stock issue to maintain proportional ownership if desked Dividend Characteristics Dividends are not a liability of the firm until a dividend has been declared by the Board Consequently a firm cannot go bankrupt for not declaring dividends Dividends and Taxes Dividend payments are not considered a business expense therefore they are not tax deductible The taxation of dividends received by individuals depends on the holding period Dividends received by corporations have a minimum 70 exclusion from taxable income Features of Preferred Stock Dividends Stated dividend that must be paid before dividends can be paid to common stockholders Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely Most preferred dividends are cumulative any missed preferred dividends have to be paid before common dividends can be paid Preferred stock generally does not carry voting rights Stock Market Dealers vs Brokers New York Stock Exchange NYSE Largest stock market in the world License holders 1366 Commission brokers Specialists Floor brokers Floortraders Operations Floor activity NASDAQ Not a physical exchange computerbased quotation system Multiple market makers Electronic Communications Networks Three levels of information Level 1 median quotes registered representatives Level 2 view quotes brokers amp dealers Level 3 view and update quotes dealers only Large portion of technology stocks Work the Web Example Electronic Communications Networks provide trading in NASDAQ securities Click on the web surfer and visit Instinet 3 Reading Stock Quotes Sample Quote usr 294133 2mm EWahaai 75 um ReaHime 7331 U71 1i113PM Er LastTrzde 7323 Daystnge mums 73 Trade Time 21an 5 5m Range mum Change M i Mn Vuiume mama W cm 7w Avg Vui tam 4929 56n n Marketh 31755 am 1327mm HM 2753 7mm EPS 1mm 255 WWE EEL my mm mm a maintainvnmgnse 0 What information is provided in the stock quote 0 Click on the web surfer to go to Bloomberg for current stock quotes Quick Quiz Part II You observe a stock price of 1875 You expect a dividend growth rate of 5 and the most recent dividend was 150 What is the required return What are some of the major characteristics of common stock What are some of the major characteristics of preferred stock Ethics Issues The status of pension funding ie over vs underfunded depends heavily on the choice of a discount rate When actuaries are choosing the appropriate rate should they give greater priority to future pension recipients management or shareholders How has the increasing availability and use of the internet impacted the ability of stock traders to act unethically Comprehensive Problem XYZ stock currently sells for 50 per share The next expected annual dividend is 2 and the growth rate is 6 What is the expected rate of return on this stock If the required rate of return on this stock were 12 what would the stock price be and what would the dividend yield be Chapter 6 Time Value of Money Chapter Outline Future and Present Values of Multiple Cash Flows Valuing Level Cash Flows Annuities and Perpetuities Comparing Rates The Effect of Compounding Loan Types and Loan Amortization Key Concepts and Skills Be able to compute the future value of multiple cash flows Be able to compute the present value of multiple cash flows Be able to compute loan payments Be able to find the interest rate on a loan Understand how interest rates are quoted Understand how loans are amortized or paid off Multiple Cash Flows Future Value Example 61 Find the value at year 3 of each cash flow and add them together Today s year 0 CF 3 N 8 IN 7000 PV CPT FV 881798 Year 1 CF 2 N 8 IN 4000 PV CPT FV 466560 Year 2 CF 1 N 8 IN 4000 PV CPT FV 4320 Year 3 CF value 4000 Total value in 3 years 881798 466560 4320 4000 2180358 Value at year 4 1 N 8 IN 2180358 PV CPT FV 2354787 Multiple Cash Flows FV Example 2 Suppose you invest 500 in a mutual fund today and 600 in one year Ifthe fund pays 9 annually how much will you have in two years Year 0 CF 2 N 500 PV 9 IN CPT FV 59405 Year 1 CF 1 N 600 PV 9 IN CPT FV 65400 Total FV 59405 65400 124805 Multiple Cash Flows Example 2 Continued How much will you have in 5 years if you make no further deposits First way Year 0 CF 5 N 500 PV 9 IN CPT FV 76931 Year 1 CF 4 N 600 PV 9 IN CPT FV 84695 Total FV 76931 84695 161626 Second way use value at year 2 3 N 124805 PV 9 IN CPT FV 161626 Multiple Cash Flows FV Example 3 Suppose you plan to deposit 100 into an account in one year and 300 into the account in three years How much will be in the account in five years if the interest rate is 8 Year 1 CF 4 N 100 PV 8 IN CPT FV 13605 Year 3 CF 2 N 300 PV 8 IN CPT FV 34992 Total FV 13605 34992 48597 Multiple Cash Flows Present Value Example 63 Find the PV of each cash flow and add them Year1 CF N 1 Y 12 FV 200 CPT PV 17857 Year 2 CF N 2 IN 12 FV 400 CPT PV 31888 Year 3 CF N 3 IN 12 FV 600 CPT PV 42707 Year4 CF N 4 IN 12 FV 800 CPT PV 50841 Total PV 17857 31888 42707 50841 143293 Example 63 Timeline O 1 2 3 4 17857 2OO 400 600 800 31888 42707 M 143293 Multiple Cash Flows Using a Spreadsheet You can use the PV or FV functions in Excel to find the present value or future value of a set of cash flows Setting the data up is half the battle if it is set up properly then you can just copy the formulas Click on the Excel icon for an example 609 Multiple Cash Flows PV Another Example You are considering an investment that will pay you 1000 in one year 2000 in two years and 3000 in three years If you want to earn 10 on your money how much would you be willing to pay N 1 lY 10 FV 1000 CPT PV 90909 N 2 IN 10 FV 2000 CPT PV 165289 N 3 IN 10 FV 3000 CPT PV 225394 PV 90909 165289 225394 481593 6C1O Multiple Uneven Cash Flows Using the Calculator Another way to use the financial calculator for uneven cash flows is to use the cash flow keys Press CF and enter the cash flows beginning with year 0 You have to press the Enter key for each cash flow Use the down arrow key to move to the next cash flow The F is the number of times a given cash flow occurs in consecutive periods Use the NPV key to compute the present value by entering the interest rate for l pressing the down arrow and then computing the answer Clear the cash flow worksheet by pressing CF and then 2nOI CLR Work 6C1 1 Decisions Decisions Your broker calls you and tells you that he has this great investment opportunity If you invest 100 today you will receive 40 in one year and 75 in two years If you require a 15 return on investments of this risk should you take the investment Use the CF keys to compute the value of the investment CF CFO 0C01 40 F01 1 C02 75 F02 1 NPV l 15 CPT NPV 9149 No the broker is charging more than you would be willing to pay 6C12 Saving For Retirement You are offered the opportunity to put some money away for retirement You will receive five annual payments of 25000 each beginning in 40 years How much would you be willing to invest today if you desire an interest rate of 12 Use cash flow keys CF CFO 0 CO1 0 F01 39 C02 25000 F02 5 NPV 12 CPT NPV 108471 6C13 Saving For Retirement Timeline 0 1 2 39 40 41 42 43 44 l l l l l l l l l 0 0 0 0 25K 25K 25K 25K 25K Notice that the year 0 cash ow 0 CF0 0 The cash ows in years 1 39 are 0 C01 0 F01 39 The cash ows in years 40 44 are 25000 C02 25000 F02 5 6C14 Quick Quiz Part Suppose you are looking at the following possible cash flows Year 1 CF 100 Years 2 and 3 CFs 200 Years 4 and 5 CFs 300 The required discount rate is 7 What is the value of the cash flows at year 5 What is the value of the cash flows today What is the value of the cash flows at year 3 6C15 Annuities and Perpetuities De ned Annuity finite series of equal payments that occur at regular intervals If the first payment occurs at the end of the period it is called an ordinary annuity If the first payment occurs at the beginning of the period it is called an annuity due Perpetuity infinite series of equal payments 6C16 Annuities and Perpetuities Basic Formulas Perpetuity PV C r Annuities 1 1rt r FVZC 1r 1 I 6C17 Annuities and the Calculator You can use the PMT key on the calculator for the equal payment The sign convention still holds Ordinary annuity versus annuity due You can switch your calculator between the two types by using the 2ncl BGN 2ncl Set on the TI BAll Plus If you see BGN or Begin in the display of your calculator you have it set for an annuity due Most problems are ordinary annuities 6C18 Annuity Example 65 You borrow money TODAY so you need to compute the present value 48 N 1 IN 632 PMT CPT PV 2399954 24000 Formula 1 1 101 8 1 PV 2 632 2 2399954 6C19 Annuity Sweepstakes Example Suppose you win the Publishers Clearinghouse 10 million sweepstakes The money is paid in equal annual endof year installments of 33333333 over 30 years If the appropriate discount rate is 5 how much is the sweepstakes actually worth today 30 N 5 IN 33333333 PMT CPT PV 512415029 6C20 Buying a House You are ready to buy a house and you have 20000 for a down payment and closing costs Closing costs are estimated to be 4 of the loan value You have an annual salary of 36000 and the bank is willing to allow your monthly mortgage payment to be equal to 28 of your monthly income The interest rate on the loan is 6 per year with monthly compounding 5 per month for a 30year fixed rate loan How much money will the bank loan you How much can you offer for the house 6C21 Buying a House Continued Bank loan Monthly income 36000 12 3000 Maximum payment 283000 840 3012 360 N 5 W 840 PMT CPT PV 140105 Total Price Closing costs 04140105 5604 Down payment 20000 5604 14396 Total Price 140105 14396 154501 6C22 Annuities on the Spreadsheet Example The present value and future value formulas in a spreadsheet include a place for annuity payments Click on the Excel icon to see an example 6023 Quick Quiz Part II You know the payment amount for a loan and you want to know how much was borrowed Do you compute a present value or a future value You want to receive 5000 per month in retirement If you can earn 075 per month and you expect to need the income for 25 years how much do you need to have in your account at retirement 6C24 Finding the Payment Suppose you want to borrow 20000 for a new car You can borrow at 8 per year compounded monthly 812 66667 per month If you take a 4year loan what is your monthly payment 412 48 N 20000 PV 66667 IN CPT PMT 48826 6C25 Finding the Payment on a Spreadsheet Another WM formula that can be found in a spreadsheet is the payment formula PMTratenperpvfv The same sign convention holds as for the PV and FV formulas Click on the Excel icon for an example 6026 Finding the Number of Payments Example 66 The sign convention matters 15 Y 1000 PV 20 PMT CPT N 93111 MONTHS 775 years And this is only if you don t charge anything more on the card 6C27 Finding the Number of Payments Another Example Suppose you borrow 2000 at 5 and you are going to make annual payments of 73442 How long before you pay off theloan Sign convention matters 5 IN 2000 PV 73442 PMT CPT N 3 years 6C28 Finding the Rate Suppose you borrow 10000 from your parents to buy a car You agree to pay 20758 per month for 60 months What is the monthly interest rate Sign convention matters 60 N 10000 PV 20758 PMT CPT IN 75 6C29 Annuity Finding the Rate Without a Financial Calculator Trial and Error Process Choose an interest rate and compute the PV of the payments based on this rate Compare the computed PV with the actual loan amount If the computed PV gt loan amount then the interest rate is too low If the computed PV lt loan amount then the interest rate is too high Adjust the rate and repeat the process until the computed PV and the loan amount are equal 6C3O Quick Quiz Part III You want to receive 5000 per month for the next 5 years How much would you need to deposit today if you can earn 075 per month What monthly rate would you need to earn if you only have 200000 to deposit Suppose you have 200000 to deposit and can earn 075 per month How many months could you receive the 5000 payment How much could you receive every month for 5 years 6C31 Future Values for Annuities Suppose you begin saving for your retirement by depositing 2000 per year in an IRA Ifthe interest rate is 75 how much will you have in 40 years Remember the sign convention 40 N 75 IY 2000 PMT CPT FV 45451304 6C32 Annuity Due You are saving for a new house and you put 10000 per year in an account paying 8 The first payment is made today How much will you have at the end of 3 years 2nOI BGN 2nOI Set you should see BGN in the display 3 N 10000 PMT 8 IN CPT FV 3506112 2nOI BGN 2nOI Set be sure to Change it back to an ordinary annuity 6C33 Annuity Due Timeline 10000 10000 10000 32464 3501612 Perpetuity Example 67 Perpetuity formula PV C r Current required return 40 1 r r 025 or 25 per quarter Dividend for new preferred 100 C 025 C 250 per quarter 6C35 Quick Quiz Part IV You want to have 1 million to use for retirement in 35 years If you can earn 1 per month how much do you need to deposit on a monthly basis if the first payment is made in one month What if the first payment is made today You are considering preferred stock that pays a quarterly dividend of 1 50 If your desired return is 3 per quarter how much would you be willing to pay 6C36 Work the Web Example Another online financial calculator can be found at MoneyChimp Click on the web surfer and work the following example Choose calculator and then annuity You just inherited 5 million If you can earn 6 on your money how much can you withdraw each year for the next 40 years Money chimp assumes annuity due Payment 31349781 6C37 Table 62 w Pmmwuu whm alum um um me warm mm mqu vnhm whuccuh ownam Wm m mum0v mm m ul mum nr m swum ma parplliud Iyuically but mums v m Mummy 039 pu uda Vypknuy m m man m m1me nl yum ash nmmm u nunJ m dupLWEI L nn ILw acEI a mannaMum Melanin 1 u my 011 rvo m I V Nmmgvult manlu mnihjhwrww v hv 5c m Growing Annuity A growing stream of cash flows with a fixed maturity Growing Annuity Example A definedbenefit retirement plan offers to pay 20000 per year for 40 years and increase the annual payment by threepercent each year What is the present value at retirement if the discount rate is 10 percent PV 120000 1103 4o 265512157 10 03 110 60 40 Growing Perpetuity A growing stream of cash flows that lasts forever 60 41 Growing Perpetuity Example The expected dividend next year is 130 and dividends are expected to grow at 5 forever If the discount rate is 10 what is the value of this promised dividend stream 60 42 Effective Annual Rate EAR This is the actual rate paid or received after accounting for compounding that occurs during the year If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison 6C43 Annual Percentage Rate This is the annual rate that is quoted by law By definition APR period rate times the number of periods per year Consequently to get the period rate we rearrange the APR equation Period rate APR number of periods per year You should NEVER divide the effective rate by the number of periods per year it will NOT give you the period rate 6C44 Computing APRs What is the APR if the monthly rate is 5 512 6 What is the APR if the semiannual rate is 5 52 1 What is the monthly rate if the APR is 12 with monthly compounding 12 12 1 6C45 Things to Remember You ALWAYS need to make sure that the interest rate and the time period match If you are looking at annual periods you need an annual rate If you are looking at monthly periods you need a monthly rate If you have an APR based on monthly compounding you have to use monthly periods for lump sums or adjust the interest rate appropriately if you have payments other than monthly 6C46 Computing EARS Example Suppose you can earn 1 per month on 1 invested today What is the APR 112 12 How much are you effectiver earning FV110112 11268 Rate 11268 1 1 1268 1268 Suppose you put it in another account and earn 3 per quarter What is the APR 34 12 How much are you effectiver earning FV11034 11255 Rate 11255 1 1 1255 1255 6C47 EAR Formula Remember that the APR is the quoted rate and m is the number of compounding periods per year 60 48 Decisions Decisions You are looking at two savings accounts One pays 525 with daily compounding The other pays 53 with semiannual compounding Which account should you use First account EAR 1 0525365365 1 539 Second account EAR 1 05322 1 537 Which account should you choose and why 6C49 Decisions Decisions Continued Let s verify the choice Suppose you invest 100 in each account How much will you have in each account in one year First Account o 365 N 525 365 014383562 W 100 PV CPT FV 10539 Second Account o 2 N 532 255 W 100 PV CPT FV 10537 You have more money in the first account 6C5O Computing APRs from EARS If you have an effective rate how can you compute the APR Rearrange the EAR equation and you get 60 51 APR Example Suppose you want to earn an effective rate of 12 and you are looking at an account that compounds on a monthly basis What APR must they pay 60 52 Computing Payments with APRs Suppose you want to buy a new computer system and the store is willing to allow you to make monthly payments The entire computer system costs 3500 The loan period is for 2 years and the interest rate is 169 with monthly compounding What is your monthly payment 212 24 N 169 12 1408333333Y 3500 PV CPT PMT 17288 6C53 Future Values with Monthly Compounding Suppose you deposit 50 a month into an account that has an APR of 9 based on monthly compounding How much will you have in the account in 35 years 3512 420 N 9 12 75 IN 5O PMT CPT FV 14708922 6C54 Present Value with Daily Compounding You need 15000 in 3 years for a new car If you can deposit money into an account that pays an APR of 55 based on daily compounding how much would you need to deposit 3365 1095 N 55 365 015068493 lY 15000 FV CPT PV 1271856 6C55 Continuous Compounding Sometimes investments or loans are figured based on continuous compounding EAR eq 1 The e is a special function on the calculator normally denoted by eX Example What is the effective annual rate of 7 compounded continuously EAR e07 1 0725 or 725 6C56 Quick Quiz Part V What is the definition of an APR What is the effective annual rate Which rate should you use to compare alternative investments or loans Which rate do you need to use in the time value of money calculations 6C57 Pure Discount Loans Example 612 Treasury bills are excellent examples of pure discount loans The principal amount is repaid at some future date without any periodic interest payments lfa Tbill promises to repay 10000 in 12 months and the market interest rate is 7 percent how much will the bill sell for in the market 1 N 10000 FV 7 IN CPT PV 934579 6C58 InterestOnly Loan Example Consider a 5year interestonly loan with a 7 interest rate The principal amount is 10000 Interest is paid annually What would the stream of cash flows be Years 1 4 Interest payments of 0710000 700 Year 5 Interest principal 10700 This cash flow stream is similar to the cash flows on corporate bonds and we will talk about them in greater detail later 6C59 Amortized Loan with Fixed Principal Payment Example Consider a 50000 10 year loan at 8 interest The loan agreement requires the firm to pay 5000 in principal each year plus interest for that year Click on the Excel icon to see the amortization table 6060 Amortized Loan with Fixed Payment Example Each payment covers the interest expense plus reduces principal Consider a 4 year loan with annual payments The interest rate is 8 and the principal amount is 5000 What is the annual payment 4 N 8 W 5000 PV CPT PMT 450960 Click on the Excel icon to see the amortization table 60 61 Work the Web Example There are web sites available that can easily prepare amortization tables Click on the web surfer to check out the Bankratecom site and work the following example You have a loan of 25000 and will repay the loan over 5 years at 8 interest What is your loan payment What does the amortization schedule look like 6C62 Quick Quiz Part VI What is a pure discount loan What is a good example of a pure discount loan What is an interestonly loan What is a good example of an interestonly loan What is an amortized loan What is a good example of an amortized loan 6C63 Ethics Issues Suppose you are in a hurry to get your income tax refund If you mail your tax return you will receive your refund in 3 weeks If you file the return electronically through a tax service you can get the estimated refund tomorrow The service subtracts a 50 fee and pays you the remaining expected refund The actual refund is then mailed to the preparation service Assume you expect to get a refund of 978 What is the APR with weekly compounding What is the EAR How large does the refund have to be for the APR to be 15 What is your opinion of this practice 6C64 Comprehensive Problem An investment will provide you with 100 at the end of each year for the next 10 years What is the present value of that annuity if the discount rate is 8 annually What is the present value of the above if the payments are received at the beginning of each year If you deposit those payments into an account earning 8 what will the future value be in 10 years What will the future value be if you open the account with 1000 today and then make the 100 deposits at the end of each year 6C65 Chapter 2 Financial Statements Taxes and Cash Flows Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow 21 Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm s cash flow from its financial statements 22 Balance Sheet The balance sheet is a snapshot of the firm s assets and liabilities at a given point in time Assets are listed in order of decreasing liquidity Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets Liabilities Stockholders Equity 23 The Balance Sheet Figure 21 Total Value 01 LIahllllla Total Value at Ansel and Sharaholders39 Equ Y quot NM 39 1 l 10 FIGURE The Balance Shack Left Side Tum Value quuzu Right Sidz Tom Valquot or has me Sharehnlders Equity Net Working Capital and Liquidity Net Working Capital Current Assets Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm Liquidity Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress But liquid assets typically earn a lower return Tradeoff to find balance between liquid and illiquid assets 25 US Corporation Balance Sheet Table 21 TABLE 21 Balance Sheets uscoRPoRA1IoN s in 2008 and 2009 Balance sneels milllons Liablrmes and Owner s Equity Assets 2003 2009 2003 2009 Current assets Currenl liabllilies Cash a 104 150 Accounts payable a 232 as 266 Accounts recelvable 455 538 Notes payable amp Invemory 553 555 Total m m Total 1112 1403 F1xed assets Net plant and Longaterm debt 55 408 454 equipment w m Owners equlty Common stock and paidin surplus 600 640 Retained earnings 1529 w Total liabilltles and Total assets owners equlty 3112 Market Value vs Book Value The balance sheet provides the book value of the assets liabilities and equity Market value is the price at which the assets liabilities or equity can actually be bought or sold Market value and book value are often very different Why Which is more important to the decision making process 27 Income Statement The income statement is more like a video of the firm s operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle GAAP says to show revenue when it accrues and match the expenses required to generate the revenue 28 US Corporation Income Statement Table 22 US CORPORATION TABLE 2 2 2009 Income Statement Income Statement in millions Net sales 1509 Cost of goods sold 750 Depreciation 65 Earnings before interest and taxes 694 Interest paid 70 Taxable income 624 Taxes 34 Net income m Dividends 103 Addition to retained earnings 309 Work the Web Example Publicly traded companies must file regular reports with the Securities and Exchange Commission These reports are usually filed electronically and can be searched at the SEC public site called EDGAR Click on the web surfer pick a company and see what you can find Taxes The one thing we can rely on with taxes is that they are always changing Marginal vs average tax rates Marginal tax rate the percentage paid on the next dollar earned Average tax rate the tax bill taxable income Other taxes Example Marginal Vs Average Rates Suppose your firm earns 4 million in taxable income What is the firm s tax liability What is the average tax rate What is the marginal tax rate If you are considering a project that will increase the firm s taxable income by 1 million what tax rate should you use in your analysis The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements The statement of cash flows does not provide us with the same information that we are looking at here We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets Cash Flow From Assets Cash Flow From Assets CFFA Cash Flow to Creditors Cash Flow to Stockholders Cash Flow From Assets Operating Cash Flow Net Capital Spending Changes in NWC Example US Corporation Part OCF EBIT depreciation taxes 547 NCS 88 and ending net fixed assets beginning net fixed assets depreciation 130 Changes in NWC i8 ending NWC beginning NWC 330 CFFA 547 130 330 87 Example US Corporation Part II CF to Creditors is and interest paid net new borrowing 24 CF to Stockholders is and dividends paid net new equity raised 63 CFFA 24 63 87 Cash Flow Summary Table 25 r mmgm Wt m im i itg as Flow from assets C35 ow to creditors ndholdrs C hi dwmmhassms 059 a iqg p bh l w w 77 wyrshphm seyri fnbn aw jin39frr fyir iti g a i fl i A 4 l s I v Whaiiar Qp ra9qg cash owEamings b lqmiigterestaod zamps m nwfl39 a quotT s 39 quot N tfm i l p dm 39 Wing 39 p r LEn i NWCfE 39 1 39 5h bjwta sthcm3 i j i l e x i rag44 217 Example Cash Flows OCF 1014 500 368 1146 NCS 2194 2261 500 433 Changes in NWC 3625 1787 3596 2140 382 CFFA 1146 433 382 331 CF to Creditors 93 538 581 136 CF to Stockholders 285 462 372 195 CFFA 136 195 331 The CF identity holds Example Balance Sheet and Income Statement Information Current Accounts 2009 CA 3625 CL 1787 2008 CA 3596 CL 2140 Fixed Assets and Depreciation 2009 NFA 2194 2008 NFA 2261 Depreciation Expense 500 Longterm Debt and Equity 2009 LTD 538 Common stock amp APIC 462 2008 LTD 581 Common stock amp APIC 372 Income Statement EBIT 1014 Taxes 368 Interest Expense 93 Dividends 285 Quick Quiz What is the difference between book value and market value Which should we use for decisionmaking purposes What is the difference between accounting income and cash flow Which do we need to use when making decisions What is the difference between average and marginal tax rates Which should we use when making financial decisions How do we determine a firm s cash flows What are the equations and where do we find the information Ethics Issues Why is manipulation of financial statements not only unethical and illegal but also bad for stockholders Comprehensive Problem Current Accounts 2009 CA 4400 CL 1500 2008 CA 3500 CL 1200 Fixed Assets and Depreciation 2009 NFA 3400 2008 NFA 3100 Depreciation Expense 400 Longterm Debt and Equity RE not given 2009 LTD 4000 Common stock amp APIC 400 2008 LTD 3950 Common stock amp APIC 400 Income Statement EBIT 2000 Taxes 300 Interest Expense 350 Dividends 500 Compute the CFFA Chapter 7 Interest Rates and Bond Valuation Chapter Outline Bonds and Bond Valuation More about Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields 71 Key Concepts and Skills Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Understand the term structure of interest rates and the determinants of bond yields 72 Bond Definitions Bond Par value face value Coupon rate Coupon payment Maturity date Yield or Yield to maturity 73 Present Value of Cash Flows as Rates Change Bond Value PV of coupons PV of par Bond Value PV of annuity PV of lump sum As interest rates increase present values decrease So as interest rates increase bond prices decrease and vice versa 74 Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10 and annual coupons The par value is 1000 and the bond has 5 years to maturity The yield to maturity is 11 What is the value of the bond Using the formula B PV of annuity PV of lump sum B 1001 111151110001115 B 36959 59345 96304 Using the calculator N 5 W 11 PMT 100 FV 1000 CPT PV 96304 75 Valuing a Premium Bond with Annual Coupons Suppose you are reviewing a bond that has a 10 annual coupon and a face value of 1000 There are 20 years to maturity and the yield to maturity is 8 What is the price of this bond Using the formula B PV of annuity PV of lump sum B 1001 110820 08 1000 10820 o B 98181 21455 119636 Using the calculator N 20 IN 8 PMT 100 FV 1000 CPT PV 119636 76 Graphical Relationship Between Price and Yieldto maturity YTM 1500 1400 1300 1200 1100 1000 900 800 700 600 0 2 4 6 8 10 12 14 Bond Prices Relationship Between Coupon and Yield If YTM coupon rate then par value bond price If YTM gt coupon rate then par value gt bond price Why The discount provides yield above coupon rate Price below par value called a discount bond If YTM lt coupon rate then par value lt bond price Why Higher coupon rate causes value above par Price above par value called a premium bond 78 The Bond Pricing Equation 1 1 1 1quott FV r 1 1quott Bond Value C Example 71 Find present values based on the payment penod How many coupon payments are there What is the semiannual coupon payment What is the semiannual yield B 701 110814 08 1000 1 0814 91756 Or PMT 70 N 14 IN 8 FV 1000CPT PV 91756 Interest Rate Risk Price Risk Change in price due to changes in interest rates Longterm bonds have more price risk than shortterm bonds Low coupon rate bonds have more price risk than high coupon rate bonds Reinvestment Rate Risk Uncertainty concerning rates at which cash flows can be reinvested Shortterm bonds have more reinvestment rate risk than longterm bonds High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds Eond va ue s Figure 72 mm 5 768 62 mm ISOyew mm 51 04752 1year band 81667 50m 50211 lt 5 1 15 20 News vate Wu Value 01 a Band m a m Frcen Emmaquot Rnln V r l uem lnlares Natasand mum 3mm any m 5 2n Computing Yield to Maturity Yield to Maturity YTM is the rate implied by the current bond price Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity If you have a financial calculator enter N PV PMT and FV remembering the sign convention PMT and FV need to have the same sign PV the opposite sign YTM with Annual Coupons Consider a bond with a 10 annual coupon rate 15 years to maturity and a par value of 1 000 The current price is 92809 Will the yield be more or less than 10 N 15 PV 92809 FV 1000 PMT 100 CPT IN 11 YTM with Semiannual Coupons Suppose a bond with a 10 coupon rate and semiannual coupons has a face value of 1 000 20 years to maturity and is selling for 119793 Is the YTM more or less than 10 What is the semiannual coupon payment How many periods are there N 40 PV 119793PMT 50 FV 1000 CPT IN 4 Is this the YTM YTM 42 8 Table 71 quotEmma quot IT quot7 mam 1 Bond value C x 139 i 1 m 4 rm 511 3 sin them 39 CECDHFOM paid each period r Haze per paricd f Numbero i periods 1 quotW f 39o r 353sz 4W aminmed mt wmmww A A Current Yield vs Yield to Maturity Current Yield annual coupon price Yiellcd to maturity current yield capital gains er Example 10 coupon bond with semiannual coupons face value of 1000 20 years to maturity 119793 price Current yield 100 119793 0835 835 Price in one year assuming no change in YTM 119368 Capital gain yield 119368 119793 119793 0035 35 YTM 835 35 8 which is the same YTM computed earlier Bond Pricing Theorems Bonds of similar risk and maturity will be priced to yield about the same return regardless of the coupon rate If you know the price of one bond you can estimate its YTM and use that to find the price of the second bond This is a useful concept that can be transferred to valuing assets other than bonds Bond Prices with a Spreadsheet There is a specific formula for finding bond prices on a spreadsheet PRICESettIementMaturityRateYldRedemption FrequencyBasis YIELDSettlementMaturityRatePrRedemption FrequencyBasis Settlement and maturity need to be actual dates The redemption and Pr need to be input as of par value Click on the Excel icon for an example Differences Between Debt and Equity Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt merely due to debt since it has no debt 720 The Bond Indenture Contract between the company and the bondholders that includes The basic terms of the bonds The total amount of bonds issued A description of property used as security if applicable Sinking fund provisions Call provisions Details of protective covenants Bond Classifications Registered vs Bearer Forms Security Collateral secured by financial securities Mortgage secured by real property normally land or buildings Debentures unsecured Notes unsecured debt with original maturity less than 10 years Seniority Bond Characteristics and Required Returns The coupon rate depends on the risk characteristics of the bond when issued Which bonds will have the higher coupon all else equal Secured debt versus a debenture Subordinated debenture versus senior debt A bond with a sinking fund versus one without A callable bond versus a noncallable bond Bond Ratings Investment Quality High Grade Moody s Aaa and SampP AAA capacity to pay is extremely strong Moody s Aa and SampP AA capacity to pay is very strong Medium Grade Moody s A and SampP A capacity to pay is strong but more susceptible to changes in circumstances Moody s Baa and SampP BBB capacity to pay is adequate adverse conditions will have more impact on the firm s ability to pay Bond Ratings Speculative Low Grade Moody s Ba and B SampP BB and B Considered possible that the capacity to pay will degenerate Very Low Grade Moody s C and below and SampP C and below income bonds with no interest being paid or in default with principal and interest in arrears Government Bonds Treasury Securities Federal government debt Tbills pure discount bonds with original maturity of one year or less Tnotes coupon debt with original maturity between one and ten years Tbonds coupon debt with original maturity greater than ten years Municipal Securities Debt of state and local governments Varying degrees of default risk rated similar to corporate debt Interest received is taxexempt at the federal level Example 74 A taxable bond has a yield of 8 and a municipal bond has a yield of 6 If you are in a 40 tax bracket which bond do you prefer 81 4 48 o The aftertax return on the corporate bond is 48 compared to a 6 return on the municipal At what tax rate would you be indifferent between the two bonds 81 T 6 o T 25 Zero Coupon Bonds Make no periodic interest payments coupon rate 0 The entire yieldtomaturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes deep discount bonds or original issue discount bonds Ole Treasury Bills and principalonly Treasury strips are good examples of zeroes FloatingRate Bonds Coupon rate floats depending on some index value Examples adjustable rate mortgages and inflationlinked Treasuries There is less price risk with floating rate bonds The coupon floats so it is less likely to differ substantially from the yieldtomaturity Coupons may have a collar the rate cannot go above a specified ceiling or below a specified oo Other Bond Types Disaster bonds Income bonds Convertible bonds Putbonds There are many other types of provisions that can be added to a bond and many bonds have several provisions it is important to recognize how these provisions affect required returns Bond Markets Primarily overthecounter transactions with dealers connected electronically Extremely large number of bond issues but generally low daily volume in single issues Makes getting uptodate prices difficult particularly on small company or municipal issues Treasury securities are an exception Work the Web Example Bond quotes are available online One good site is Bonds Online Click on the web surfer to go to the site Follow the bond search corporate links Choose a company enter it under Express Search Issue and see what you can find 3 Treasury Quotations Highlighted quote in Figure 74 8 Nov 21 13629 13630 5 436 What is the coupon rate on the bond When does the bond mature What is the bid price What does this mean What is the ask price What does this mean How much did the price change from the previous day What is the yield based on the ask price Clean vs Dirty Prices Clean price quoted price Dirty price price actually paid quoted price plus accrued interest Example Consider a Tbond with a 4 semiannual yield and a clean price of 1 28250 Number of days since last coupon 61 Number of days in the coupon period 184 Accrued interest 61184041000 1326 Dirty price 128250 1326 129576 So you would actually pay 129576 for the bond Inflation and Interest Rates Real rate of interest change in purchasing power Nominal rate of interest quoted rate of interest change in actual number of dollars The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation The Fisher Effect The Fisher Effect defines the relationship between real rates nominal rates and in a on 1 R 1 r1 h Where R nominal rate r real rate h expected inflation rate Approximation R r h Example 75 If we require a 10 real return and we expect inflation to be 8 what is the nominal rate R 11108 1 188 188 Approximation R 10 8 18 Because the real return and expected inflation are relatively high there is significant difference between the actual Fisher Effect and the approximation Term Structure of Interest Rates Term structure is the relationship between time to maturity and yields all else equal It is important to recognize that we pull out the effect of default risk different coupons etc Yield curve graphical representation of the term structure Normal upwardsloping longterm yields are higher than shortterm yields Inverted downwardsloping longterm yields are lower than shortterm yields Figure 76 UpwardSloping interest rate Yield Curve A Upwardslaying term structure Neminal interest rate Interim rate risk premium i In atiun pram um T Heal rate Time to maturity Figure 76 Downward Sloping Yield Curve B Downwardsinging term structure Nominal interest rate In ation prem um Humrest Irate i T Heal rate Time m maturity Figure 77 FIGURE 77 Treasury yield curve 7 I Yield to maturity of current bills notes and bonds The Treasury Y39eld curve May 2008 Samoa Reprinted by permission of The Walt Street 5 Journal via Copyright IV Clearance Center 2008 by A Dow Jones amp Company Inc 2008 All Rights Reserved 4 one year 390 Worldwide A Tuesday 2 1 0 I i l i I 1 3 6 2 5 10 30 Monthsi Years Maturity 741 Factors Affecting Bond Yields Default risk premium remember bond ra ngs Taxability premium remember municipal versus taxable Liquidity premium bonds that have more frequent trading will generally have lower required returns Anything else that affects the risk of the cash flows to the bondholders will affect the required returns Quick Quiz How do you find the value of a bond and why do bond prices change What is a bond indenture and what are some of the important features What are bond ratings and why are they important How does inflation affect interest rates What is the term structure of interest rates What factors determine the required return on bonds Ethics Issues In 1996 allegations were made against Moody s that it was issuing ratings on bonds it had not been hired to rate in order to pressure issuers to pay for their service The government conducted an inquiry but charges of antitrust violations were dropped Even though no legal action was taken does an ethical issue exist Comprehensive Problem What is the price of a 1000 par value bond with a 6 coupon rate paid semiannually if the bond is priced to yield 5 and it has 9 years to maturity What would be the price of the bond if the yield rose to 7 What is the current yield on the bond if the YTM is 7 Chapter 1 Introduction to Corporate Finance Chapter Outline Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the g Corporation Key Concepts and Skills Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets Corporate Finance Some important questions that are answered using finance What longterm investments should the firm take on Where will we get the longterm financing to pay for the investment How will we manage the everyday financial activities of the firm Financial Manager Financial managers try to answer some or all of these questions The top financial manager within a firm is usually the Chief Financial Officer CFO Treasurer oversees cash management credit management capital expenditures and financial planning Controller oversees taxes cost accounting financial accounting and data processing Financial Management Decisions Capital budgeting What longterm investments or projects should the business take on Capital structure How should we pay for our assets Should we use debt or equity Working capital management How do we manage the daytoday finances of the firm Forms of Business Organization Three major forms in the United States Sole Proprietorship Partnership g General Limited Corporation CCorp SCorp Limited Liability Company Sole Proprietorship Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Limited to life of owner Equity capital limited to owner s personal wealth Unlimited liability Difficult to sell g ownership interest Partnership Advantages Two or more owners More capital available Relatively easy to start Income taxed once as personal income 3 Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership Corporation Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise cap al Disadvantages Separation of ownership and management Double taxation income taxed at the corporate rate and then dividends taxed at the personal rate 3 Goal of Financial Management What should be the goal of a corporation Maximize profit Minimize costs Maximize market share Maximize the current value of the company s stock Does this mean we should do anything and everything to maximize owner wealth The Agency Problem Agency relationship Principal hires an agent to represent hisher interests Stockholders principals hire managers agents to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs Managing Managers Managerial compensation Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal Corporate control The threat of a takeover may result in better management Other stakeholders Work the Web Example The Internet provides a wealth of information about individual companies One excellent site is financevahoocom Click on the web surfer to go to the site choose a company and see what information you can find Financial Markets Cash flows to the firm Primary vs secondary markets Dealer vs auction markets Listed vs overthecounter securities NYSE NASDAQ Quick Quiz What are the three types of financial management decisions and what questions are they designed to answer What are the three major forms of business organization What is the goal of financial management What are agency problems and why do they exist within a corporation What is the difference between a primary market and a secondary market Ethics Issues Is it ethical for tobacco companies to sell a product that is known to be addictive and a danger to the health of the user Is it relevant that the product is legal Should boards of directors consider only price when faced with a buyout offer Is it ethical to concentrate only on shareholder wealth or should stakeholders as a whole be considered Should firms be penalized for attempting to improve returns by stifling competition eg Microsoft Chapter 2 Financial Statements Taxes and Cash Flows Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow 21 Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash flow Know the difference between average and marginal tax rates Know how to determine a firm s cash flow from its financial statements 22 Balance Sheet The balance sheet is a snapshot of the firm s assets and liabilities at a given point in time Assets are listed in order of decreasing liquidity Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets Liabilities Stockholders Equity 23 The Balance Sheet Figure 21 Total Value 01 LIahllllla Total Value at Ansel and Sharaholders39 Equ Y quot NM 39 1 l 10 FIGURE The Balance Shack Left Side Tum Value quuzu Right Sidz Tom Valquot or has me Sharehnlders Equity Net Working Capital and Liquidity Net Working Capital Current Assets Current Liabilities Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out Usually positive in a healthy firm Liquidity Ability to convert to cash quickly without a significant loss in value Liquid firms are less likely to experience financial distress But liquid assets typically earn a lower return Tradeoff to find balance between liquid and illiquid assets 25 US Corporation Balance Sheet Table 21 TABLE 21 Balance Sheets uscoRPoRA1IoN s in 2008 and 2009 Balance sneels milllons Liablrmes and Owner s Equity Assets 2003 2009 2003 2009 Current assets Currenl liabllilies Cash a 104 150 Accounts payable a 232 as 266 Accounts recelvable 455 538 Notes payable amp Invemory 553 555 Total m m Total 1112 1403 F1xed assets Net plant and Longaterm debt 55 408 454 equipment w m Owners equlty Common stock and paidin surplus 600 640 Retained earnings 1529 w Total liabilltles and Total assets owners equlty 3112 Market Value vs Book Value The balance sheet provides the book value of the assets liabilities and equity Market value is the price at which the assets liabilities or equity can actually be bought or sold Market value and book value are often very different Why Which is more important to the decision making process 27 Income Statement The income statement is more like a video of the firm s operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle GAAP says to show revenue when it accrues and match the expenses required to generate the revenue 28 US Corporation Income Statement Table 22 US CORPORATION TABLE 2 2 2009 Income Statement Income Statement in millions Net sales 1509 Cost of goods sold 750 Depreciation 65 Earnings before interest and taxes 694 Interest paid 70 Taxable income 624 Taxes 34 Net income m Dividends 103 Addition to retained earnings 309 Work the Web Example Publicly traded companies must file regular reports with the Securities and Exchange Commission These reports are usually filed electronically and can be searched at the SEC public site called EDGAR Click on the web surfer pick a company and see what you can find Taxes The one thing we can rely on with taxes is that they are always changing Marginal vs average tax rates Marginal tax rate the percentage paid on the next dollar earned Average tax rate the tax bill taxable income Other taxes Example Marginal Vs Average Rates Suppose your firm earns 4 million in taxable income What is the firm s tax liability What is the average tax rate What is the marginal tax rate If you are considering a project that will increase the firm s taxable income by 1 million what tax rate should you use in your analysis The Concept of Cash Flow Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements The statement of cash flows does not provide us with the same information that we are looking at here We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets Cash Flow From Assets Cash Flow From Assets CFFA Cash Flow to Creditors Cash Flow to Stockholders Cash Flow From Assets Operating Cash Flow Net Capital Spending Changes in NWC Example US Corporation Part OCF EBIT depreciation taxes 547 NCS 88 and ending net fixed assets beginning net fixed assets depreciation 130 Changes in NWC i8 ending NWC beginning NWC 330 CFFA 547 130 330 87 Example US Corporation Part II CF to Creditors is and interest paid net new borrowing 24 CF to Stockholders is and dividends paid net new equity raised 63 CFFA 24 63 87 Cash Flow Summary Table 25 r mmgm Wt m im i itg as Flow from assets C35 ow to creditors ndholdrs C hi dwmmhassms 059 a iqg p bh l w w 77 wyrshphm seyri fnbn aw jin39frr fyir iti g a i fl i A 4 l s I v Whaiiar Qp ra9qg cash owEamings b lqmiigterestaod zamps m nwfl39 a quotT s 39 quot N tfm i l p dm 39 Wing 39 p r LEn i NWCfE 39 1 39 5h bjwta sthcm3 i j i l e x i rag44 217 Example Cash Flows OCF 1014 500 368 1146 NCS 2194 2261 500 433 Changes in NWC 3625 1787 3596 2140 382 CFFA 1146 433 382 331 CF to Creditors 93 538 581 136 CF to Stockholders 285 462 372 195 CFFA 136 195 331 The CF identity holds Example Balance Sheet and Income Statement Information Current Accounts 2009 CA 3625 CL 1787 2008 CA 3596 CL 2140 Fixed Assets and Depreciation 2009 NFA 2194 2008 NFA 2261 Depreciation Expense 500 Longterm Debt and Equity 2009 LTD 538 Common stock amp APIC 462 2008 LTD 581 Common stock amp APIC 372 Income Statement EBIT 1014 Taxes 368 Interest Expense 93 Dividends 285 Quick Quiz What is the difference between book value and market value Which should we use for decisionmaking purposes What is the difference between accounting income and cash flow Which do we need to use when making decisions What is the difference between average and marginal tax rates Which should we use when making financial decisions How do we determine a firm s cash flows What are the equations and where do we find the information Ethics Issues Why is manipulation of financial statements not only unethical and illegal but also bad for stockholders Comprehensive Problem Current Accounts 2009 CA 4400 CL 1500 2008 CA 3500 CL 1200 Fixed Assets and Depreciation 2009 NFA 3400 2008 NFA 3100 Depreciation Expense 400 Longterm Debt and Equity RE not given 2009 LTD 4000 Common stock amp APIC 400 2008 LTD 3950 Common stock amp APIC 400 Income Statement EBIT 2000 Taxes 300 Interest Expense 350 Dividends 500 Compute the CFFA

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