FINANCIAL MANAGEMENT FIN 3716
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Chapter 10 w ORA E FINANE E Making Capital 7 Investment Decisions Key Concepts and Skills Understand how to determine the relevant cash flows for various types of proposed investments Understand the various methods for computing operating cash flow Understand how to set a bid price for a project Understand how to evaluate the equivalent annual cost of a project Chapter Outline Project Cash Flows A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows More about Project Cash Flow Alternative Definitions of Operating Cash Flow Some Special Cases of Discounted Cash Flow Analysis Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will only occur or not occur ifthe project is accepted These cash flows are called incremental cash flows The standalone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows Asking the Right Question 0 You should always ask yourself Will this cash flow occur ONLY if we accept the project Ifthe answer is yes it should be included in the analysis because it is incremental Ifthe answer is no it should not be included in the analysis because it will occur anyway Ifthe answer is part of it then we should include the part that occurs because ofthe project Common Types of Cash Flows Sunk costs costs that have accrued in the past Opportunity costs costs of lost options Side effects Positive side effects benefits to other projects Negative side effects costs to other projects Changes in net working capital Financing costs Taxes Pro Forma Statements and Cash Flow 0 Capital budgeting relies heavily on pro forma accounting statements particularly income statements 0 Computing cash flows refresher Operating Cash Flow OCF EBIT depreciation taxes OCF Net income depreciation when there is no interest expense Cash Flow From Assets CFFA OCF net capital spending NCS changes in NWC Table 101 Pro Forma Income Statement Sales 50000 units at 400unit Variable Costs 250unit Gross profit Fixed costs Depreciation 90000 3 EBIT Taxes 34 Net Income 200000 125000 75000 12000 30000 33000 11220 21780 J a v1 1439 WV Table 102 Projected Capital 35 f Requirements Year 0 1 2 3 20000 20000 20000 20000 90 000 60 000 30 000 0 110000 80000 50000 20000 Table 105 Projected Total Cash Flows Year 0 1 2 3 GOP 51780 51780 51780 Change 20000 20000 quot in vac NCS 90000 11000 51780 51780 71780 ma Making The Decision 0 Now that we have the cash flows we can apply the techniques that we learned in Chapter 9 0 Enter the cash flows into the calculator and compute NPV and IRR CF0 110000 CO1 51780 F01 2 002 71780 F02 1 NPV 20 CPT NPV 10648 CPT IRR 258 0 Should we accept or reject the El project mm More on NWC Why do we have to consider changes in NWC separately GAAP requires that sales be recorded on the income statement when made not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made whether we have actually paid our suppliers yet Finally we have to buy inventory to support sales although we haven t collected cash yet mm Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation itself is a noncash expense consequently it is only relevant because it affects taxes 0 Depreciation tax shield DT D depreciation expense T marginal tax rate l rlz Computing Depreciation Straightline depreciation D Initial cost salvage number of years Very few assets are depreciated straightline for tax purposes 0 MACRS Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the initial cost Depreciate to zero Midyear convention m4 Aftertax Salvage 39 If the salvage value is different from the book value of the asset then there is a tax effect I quot Book value initial cost accumulated depreciation Aftertax salvage salvage Tsalvage book value mm Example Depreciation and Aftertax Salvage You purchase equipment for 100000 and it costs 10000 to have it delivered and installed Based on past information you believe that you can sell the equipment for 17000 when you are done with it in 6 years The company s marginal tax rate is 40 What is the depreciation expense each year and the aftertax salvage in year 6 for each of the following situations l rl Example Straightline Suppose the appropriate depreciation schedule is straightline D 110000 17000 6 15500 every year for 6 years BV in year 6 110000 61550017000 Aftertax salvage 17000 417000 17000 17000 mm Example Threeyear Year MACRS D BV in year 6 percent 110000 7 36663 7 1 3333 3333110000 4amp895 16gt291 361663 81510 2 4445 4445110000 481895 Aftertax salvage 1 3 1481 1421223110000 40100070 39 10200 4 0741 0741 110000 8151 1147 Example SevenYear MACRS MAC RS Percent 1 1429 1429110000 15719 2 2449 2449110000 26939 3 1749 1749110000 19239 4 1249 1249110000 13739 5 0893 0893110000 9823 e 0392 0892110000 9812 BV in year 6 110000 715719 7 26939 7 19239 7 13739 7 9823 7 9812 14729 Aftertax salvage 000 417000 7 14729 1609160 mm Example Replacement Problem Original Machine Initial cost 100000 Annual depreciation 9000 Purchased 5 years ago Book Value 55000 Salvage today 000 Salvage in 5 years 10000 New Machine Initial cost 150000 5year life Salvage in 5 years 0 Cost savings 50000 per year 3year MACRS depreciation Required return 10 Tax rate 40 1049 Replacement Problem Computing Cash Flows Remember that we are interested in incremental cash flows If we buy the new machine then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years man Replacement Problem Pro Forma Income Statements Year 1 2 3 4 5 Cost 50000 50000 50000 50000 50000 Savings Depr New 49995 66675 22215 11115 0 Old 9000 9000 9000 9000 9000 Increm 40995 57675 13215 2115 9000 EBIT 9005 7675 36785 47885 59000 Taxes 3602 3070 14714 19154 23600 NI 5403 4605 22071 28731 35400 mm r I Replacement Problem Incremental Net Capital Spending 0 Year 0 Cost of new machine 150000 outflow Aftertax salvage on old machine 65000 465000 55000 61000 inflow Incremental net capital spending 150000 61000 89000 outflow 0 Year 5 Aftertax salvage on old machine 10000 410000 10000 10000 outflow because we no longer receive this 1u722 Replacement Problem Cash Flow From Assets Year 0 1 2 3 4 5 00 46398 53070 35286 30846 26400 Nos 89000 10000 A In 0 0 NWC CFFA 89000 46398 53070 35286 30846 16400 40723 Replacement Problem Analyzing the Cash Flows Now that we have the cash flows we 39 can compute the NPV and IRR Enter the cash flows Compute NPV 5480174 Compute IRR 3628 Should the company replace the equipment 1u724 Other Methods for Computing V OCF BottomUp Approach Works only when there is no interest expense OCF NI depreciation TopDown Approach OCF Sales Costs Tagtltes Don t subtract noncash deductions 0 Tax Shield Approach OCF Sales Costs1 T DepreciationT 1D725 Example Cost Cutting Your company is considering a new computer system that will initially cost 1 million It will save 300000 per year in inventory and receivables management costs The system is expected to last for five years and will be depreciated using 3year MACRS The system is expected to have a salvage value of 50000 at the end of year 5 There is no impact on net working capital The marginal tax rate is 40 The required return is 8 Click on the Excel icon to work through the example lg lEIVZE Example Setting the Bid Price 0 Considerthe following information Army has requested bid for multiple use dIgItIZIng deVIces MUDDs Deliver 4 units each yearforthe next 3 years Labor and materials estimated to be 10000 per unit Production space leased for 12000 peryear Requires 50000 in fixed assets with expected salvage of 10000 at the end of the prOJect depreciate straightline Require initial 10000 increase in NWC Tagtlt rate 34 Required return 15 1M7 Example Equivalent Annual Cost Analysis Burnout Batteries Initial Cost 36 each 3year life 100 per year to keep charge Expected salvage 5 Straightline depreciation Longlasting Batteries Initial Cost 60 each 5 yearlife 88 per year to keep charged Expected salvage 5 Straightline depreciation U The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue No change in l WC is required The required return is 15 and the tax rate is 34 lEIrZE Quick Quiz I 0 How do we determine if cash flows are relevant to the capital budgeting decision 0 What are the different methods for computing operating cash flow and when are they important 1 0 What is the basic process for finding the bid 39 pnce 0 What is equivalent annual cost and when should it be used may Ethics Issues I o In an LA Law episode an automobile manufacturer knowingly built cars that had a significant safety flaw Rather than redesigning the cars at substantial additional cost the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car What issues does the financial analysis overloolO man Comprehensive Problem 0 A 1000000 investment is depreciated using a sevenyear MACRS class life It requires 150000 in additional inventory and will increase accounts payable by 50000 It will generate 400000 in revenue and 150000 in cash expenses annually and the tax rate is 40 What is the incremental cash flow in years 0 1 7 and 8 1D731 wuraz r e t p a h C l 0 d n E Chapter 18 V MAENTALS OF PQRATE FINANEE ShortTerm Finance and Planning Key Concepts and Skills Understand the components of the cash cycle and why it is important Understand the pros and cons of the various shortterm nancing policies Be able to prepare a cash budget Understand the various options for shortterm financing Chapter Outline Tracing Cash and Net Working Capital The Operating Cycle and the Cash Cycle Some Aspects of ShortTerm Financial Policy The Cash Budget ShortTerm Borrowing AShort Term Financial Plan identity rearranged asse s ongterm debt equity NWC cash other CA C Cash longterm debt equity CL CA other than cash xed assets Sources Increasing longterm debt equity or current liabilities Decreasing current assets other than cash or xed s Balance sheet va d 888 Decreasing longterm debt equity or current liabilities Increasing current assets other than cash or xed ssets The Operating Cycle 0 Operating cycle time between purchasing the inventory and collecting the cash from sale of the inventory 0 Inventory period time required to V purchase and sell the inventory Accounts receivable period time required to collect on credit sales Operating cycle inventory period accounts receivable period Cash Cycle 0 Cash cycle Amount oftime we finance our inventory Difference between when we receive cash from the sale and when we have to pay for the inventory 0 Accounts payable period time between purchase of inventory and payment for the inventory 0 Cash cycle Operating cycle accounts payable period wry purchased Figure 181 Invemcty sold Invnnlory period mm wuvmm w n Accounts receivahle period 7 w Time Cash racaivnd Open ing qcle i n 31 I mumslock cash is recs The cash cycle is he Hma pannd lmm when cash 1s paid oul wed to when Example Information Inventory Beginning 200000 Ending 300000 Accounts Receivable Beginning 160000 Ending 200000 Accounts Payable Beginning 75000 Ending 100000 Net sales 1150000 Cost of Goods sold 820000 Example Operating Cycle Inventory period Average inventory 2000003000002 250000 lnventoryturnover 820000 250000 328 times Inventory period 365 328 111 days Receivables 39 penod verage receivables 1600002000002 180000 Receivablesturnover 1150000 180000 639 times Receivables period 365639 57 days Operating cycle 111 57 168 days Example Cash Cycle Payables Period Average payables 750001000002 87500 Payables turnover 820000 87500 937 times Payables period 365937 39 days Cash Cycle 168 39 129 days We have to finance our inventory for 129 days If we want to reduce our financing needs we need to look carefully at our receivables and inventory periods they both seem extensive A comparison to industry averages would help solidify this assertion ShortTerm Financial Policy 0 Size of investments in current assets Flexible conservative policy maintain a high ratio of current assets to sales Restrictive aggressive policy maintain a low ratio of current assets to sales 0 Financing of current assets Flexible conservative policy less short term debt and more longterm debt Restrictive aggressive policy more short term debt and less longterm debt 184m Carrying vs Shortage Costs 0 Managing shortterm assets involves a tradeoff between carrying costs and shortage costs Carrying costs increase with increased levels of current assets the costs to store and finance the assets Shortage costs decrease with increased levels of current assets Trading or order costs Costs related to safety reserves ie lost sales and customers and production stoppages lam Temporary vs Permanent Assets Temporary current assets Sales or required inventory buildup may be seasonal Additional current assets are needed during the peak time The level of current assets will decrease as sales occur Permanent current assets Firms generally need to carry a minimum level of current assets at all times These assets are considered permanent because the level is constant not because the assets aren t sold 1842 Figure 184 Seasonal variation 39 Total asset requ i remen Dollars General growth in xed asse and permanent q current assets 1843 Choosing the Best Policy Cash reserves High cash reserves mean that rms will be less likely to experience nancial distress and are better able to handle emergencies or take advantage ofunexpected opportunities Cash and marketable securities earn a lower return and are zero N PV investments Maturity hedging to match nancing maturities with asset maturities Finance temporary current assets with shortterm debt Finance permanent current assets and xed assets with long term debt an equity Interest Rates Shortterm rates are normally lower than longterm rates so it may be cheaperto nance with shortterm debt Firms can get into trouble if rates increase quickly or if it begins to have dif cul making ayments may not be able to re nance the s ortterm oans Have to consider all these factors and determine a compromise policy that ts the needs of the rm arm Figure 186 Flexible pollcy F Shunterm nancing Tara seasonal Cwmpromse pansy e Hesmcuve policy a Dollars General growth In securities h a r 39 39 lthnnxerm burrawmg ls used when the reserve 5 exhausled 1845 Cash Budget Forecast of cash inflows and outflows overthe next shortterm planning period Primary tool in shortterm financial planning Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover workingcapital requirements Allows a company to plan ahead and begin the search for financing before the money is actually needed we Example Cash Budget Information Pet Treats Inc specializes in gourmet pet treats and receives all income from sales Sales estimates in millions Q1 500 02 600 03 650 04 800 01 next year 550 Accounts receivable Be inning receivables 250 Average collection period 30 days Accounts payable Purchases 50 of next quarter39s sales Beginning payables 125 Accounts payable period is 45 days pense a es taxes and other expense are 30 of sales Interest and dividend payments are 50 Amajul r A 1 The initial cash balance is 80 and the company maintains a minimum balance of 50 1847 Example Cash Budget Cash Collections ACP 30 days this implies that 23 of sales are collected in the quarter made and the remaining 13 are collected the following quarter Beginning receivables of 250 will be collected in the rst quarter Q1 Q2 Q3 Q4 Beginning Receivables 250 167 200 217 Sales 500 600 650 800 Cash Collections 583 567 633 750 Ending Receivables 167 200 217 267 18718 Example Cash Budget Cash Disbursements Payables period is 45 days so half ofthe purchases will be paid for each quarter and the remaining will be paid the following quarter Beginning payables 125 Q1 Q2 Q3 Q4 Paymentofaccounts 275 313 362 338 Wagestaxes and other 150 180 195 240 expenses Capital expenditures 200 Interestanddividendpayments 50 50 50 50 Total cash disbursements 475 743 607 628 18715 Example Cash Budget Net Cash Flow and Cash Balance Q1 Q2 Q3 Q4 Total cash collections 583 567 633 750 Total cash disbursements 475 743 607 628 Net cash inflow 108 176 26 122 Beginning Cash Balance 80 188 12 38 Net cash in ow 108 176 26 122 Ending cash balance 188 12 38 160 Minimum cash balance 50 50 50 50 Cumulative surplus de cit 138 38 12 110 arm ShortTerm Borrowing Unsecured Loans Line of credit Committed vs noncommitted Revolving credit arrangement Letter of credit Secured Loans Accounts receivable nancing Assigning Factoring Inventoryloans Blanket inventorylien Trust recei t Field warehouse nancing Commercial Paper Trade Credit 18721 Example Compensating Balance 0 We have a 500000 line of credit with a 15 compensating balance requirement The quoted interest rate is 9 We need to borrow 150000 for inventory for one year How much do we need to borrow 150000115176471 What interest rate are we effectively paying interest paid 17e4710915882 Effective rate 15882150000 1059 or 1059 18722 Example Factoring 0 Last year your company had average accounts receivable of 2 million Credit sales were 24 million You factor receivables by discounting them 2 What is the effective rate of interest Receivables turnover 242 12 times APR 120298 2449 or 2449 EAR 1029812 1 2743 or 2743 18723 ShortTerm Financial Plan investment loan cash balance Quick Quiz How do you compute the operating cycle and the cash cycle 0 What are the differences between a flexible shortterm financing policy and a restrictive one What are the pros and cons of each What are the key components of a cash I budget 0 What are the major forms of shortterm borrowing 18725 Ethics Issues A large retailer such as WalMart possesses power over smaller suppliers In theory WalMart could force these suppliers to sell on payment terms that were well beyond a typical industry norm How would this impact WaIMart s cash cycle How would this impact the supplier s cycle Are there any ethical issues involved in such a practice we Comprehensive Problem 0 V th a quoted interest rate of 5 and a 10 compensating balance what is the effective rate of interest use a 200000 loan proceeds amount 0 V th average accounts receivable of 5 million and credit sales of 24 million you factor receivables by discounting them 2 What is the effective rate of interest 18727 18728 rl e t p a h C l 0 d n E Chapter 5 Calculators Introduction to Valuation The Time Value of Money Key Concepts and Skills Be able to compute the future value of an investment made today Be able to compute the present value of cash to be received at some future ate Be able to compute the return on an investment Be able to compute the number of periods that equates a present value and a future value given an interest rate Be able to use a financial calculator and a spreadsheet to solve time value of money problems Chapter Outline 39 Future Value and Compounding Present Value and Discounting More about Present and Future Values Basic Definitions 0 Present Value earlier money on a time line 0 Future Value later money on a time line 0 Interest rate exchange rate between earlier money and later money Discount rate Cost of capital Opportunity cost of capital Required return Future Values Suppose you invest 1000 for one year at 5 peryear What is the future value in one year Interest 100005 50 Value in one year principal interest 1000 50 1050 Future Value FV 10001 05 1050 Suppose you leave the money in for another year How much will you have two years from now FV 1000105105 10001052 1 102 50 Future Values General Formula FV PV1 rt FV future value PV present value r period interest rate expressed as a decimal t number of periods Future value interest factor 1 rt Effects of Compounding Simple interest Compound interest Consider the previous example FV with simple interest 1000 50 50 1100 FV with compound interest 110250 The extra 250 comes from the interest of 0550 250 earned on the first interest payment Calculator Keys 0 Texas Instruments BAll Plus FV future value PV present value IN period interest rate PY must equal 1 for the IN to be the period rate Interest is entered as a percent not a decimal N number of periods Remember to clear the registers CLR TVM after each problem Other calculators are similar in format Future Values Example 2 Suppose you invest the 1 000 from the previous example for 5 years How much would you have 5 N 5 IN 1000 PV CPT FV 427628 o The effect of compounding is small for a small number of periods but increases as the number of periods increases Simple interest would have a future value of 1250 for a difference of 2628 Future Values Example 3 Suppose you had a relative deposit 10 at 55 interest 200 years ago How much would the investment be worth today 200 N 55 lY 10 PV CPT FV 44718984 What is the effect of compounding Simple interest 10 20010055 12000 Compounding added 44706984 to the value of the investment Future Value as a General Growth Formula 0 Suppose your company expects to increase unit sales of widgets by 15 per year for the next 5 years If you sell 3 million widgets in the current year how many widgets do you expect to sell in the fifth yeal 5 N15 IlY 3000000 PV CPT FV 6034072 units remember the sign convention 504m Quick Quiz Part 0 What is the difference between simple interest and compound interest 0 Suppose you have 500 to invest and you believe that you can earn 8 per year over the next 15 years How much would you have at the end of 15 years using compound interest How much would you have using simple interest 5ch Present Values How much do I have to invest today to have some amount in the future FV PV1 r Rearrange to solve for PV FV 1 r When we talk about discounting we mean finding the present value of some future amount When we talk about the value of something we are talking about the present value unless we specifically indicate that we want the future value 5042 Present Value One Period Example Suppose you need 10000 in one year for the down payment on a new car If you can earn 7 annually how much do you need to invest today 3 PV 100001071 934579 quot39 Calculator 1N7IY10000 FV CPT PV 934579 5043 Present Values Example 2 0 You want to begin saving for your daughter s college education and you estimate that she will need 150000 in 17 years lfyou feel confident that you can earn 8 per year how much do you need to invest today N 17 Y 8 FV150000 CPT PV 4054034 remember the sign convention 5044 Present Values Example 3 0 Your parents set up a trust fund for you 10 years ago that is now worth 1967151 Ifthe fund earned 7 per year how much did your parents invest N 10 Y 7FV1967151 CPT PV 10000 5045 Present Value Important Relationship For a given interest rate the longer the time period the lower the present value What is the present value of 500 to be received in 5 years 10 years The discount rate is 10 Syears N 5 Y10 FV 500 CPT PV31046 10years N 10 Y10 FV 500 CPT PV19277 5045 Present Value Important Relationship ll 0 For a given time period the higherthe interest rate the smaller the present value What is the present value of 500 received in 5 years ifthe interest rate is 10 15 Rate 10 N 5 IN 10FV 500 CPT PV 31o4e Rate 15 N 5 IN 15 FV 500 CPT PV 24859 5047 Quick Quiz Part 0 What is the relationship between present value and future value 0 Suppose you need 15000 in 3 years If you can earn 6 annually how much do you need to invest today 0 If you could invest the money at 8 would you have to invest more or less than at 6 How much 5043 The Basic PV Equation I Refresher PVFV1rt 0 There are four parts to this equation PV FV randt If we know any three we can solve for the fourth 0 If you are using a financial calculator be sure to remember the sign convention or you will receive an error or a nonsense answer when solving for r ort 5049 Discount Rate Often we will want to know what the implied interest rate is on an investment Rearrange the basic PV equation and solve for r FV PV1 r r FVPVW i If you are using formulas you will want to make use of both the yX and the 1x keys 5072 Discount Rate Example 1 0 You are looking at an investment that will pay 1200 in 5 years if you invest 1000 today What is the implied rate of interest r 1200 1000 5 1 03714 3714 Calculator the sign convention matters N 5 PV 1000 you pay 1000 today FV 1200 you receive 1200 in 5 years CPT IN 3714 50721 Discount Rate Example 2 0 Suppose you are offered an investment that will allow you to double your money in 6 years You have 10000 to invest What is the implied rate of interest FV 20000 CPT IlY 1225 50722 Discount Rate Example 3 0 Suppose you have a 1year old son and you want to provide 75000 in 17 years towards his college education You currently have 5000 to invest What interest rate must you earn to have the 75000 when you need it N 17 PV 5000 FV 75000 CPT IN 1727 50723 Quick Quiz Part III 0 What are some situations in which you might want to know the implied interest rate 0 You are offered the following investments You can invest 500 today and receive 600 in 5 years The investment is low risk You can invest the 500 in a bank account paying 4 What is the implied interest rate forthe first choice and which investment should you choose 50724 Finding the Number of Penods 39 Start with the basic equation and solve fort remember your logs FV PV1 rt t InFVPV In1 r You can use the financial keys on 39 the calculator as well just remember the sign convention Till 50725 Number of Periods Example 1 You want to purchase a new car and you are willing to pay 20000 If you can invest at 10 per year and you currently have 15000 how long will it be before you have enough money to pay cash for the car lY 10 PV 45000 FV 20000 CPT N 302 years 50725 Number of Periods Example 2 0 Suppose you want to buy a new house You currently have 15000 and you figure you need to have a 10 down payment plus an additional 5 of the loan amount for closing costs Assume the type of house you want will cost about 150000 and you can earn 75 per year How long will it be before you have enough money forthe down payment and closing costs 50727 Number of Periods Example 2 Continued How much do you need to have in the future Down payment 1150000 15000 Closing costs 05150000 15000 6750 Total needed 15000 6750 21750 Compute the number of periods PV 15000 FV 21750 IN 75 CPT N 514 years Using the formula t In2175015000n1075 514 years 50723 Quick Quiz Part IV When might you want to compute the 1 number of periods 1 Suppose you want to buy some new 39 furniture foryour family room You currently have 500 and the furniture you want costs 600 If you can earn 6 how long will you have to wait if you don t add any additional money 50729 Spreadsheet Example 0 Use the following formulas for TVM calculations FVratenperpmtpv PVratenperpmtfv RATEnperpmtpvfv NPERratepmtpvfv The formula icon is very useful when you can t remember the exact formula 0 Click on the Excel icon to open a spreadsheet containing four different examples scram Work the Web Example Many financial calculators are available online Click on the web surfer to go to Investopedia s web site and work the following example You need 50000 in 10 years If you can earn 6 interest how much do you need to invest today You should get 2791974 5031 Table 54 PV Pusan vuua wha Imam cash Haws am mm Xuday r mum value mm cash ows are warm in ma mm humus mu mu m mum a mm mm par puma lypicmy um um nlways on yea I Mumbew of perim ypivaliy but nox always quot19 numbecomars c out amour v r1quot b mw m Mun value new Fv 0 MI mum u HY WWW FV on amp n39 me mm m y 11 am we prueal valuellclon l 39 39 7 quotquot lu ell39m r L n rumum 5032 Comprehensive Problem You have 10000 to invest for five years How much additional interest will you earn if the investment provides a 5 annual return when compared to a 45 annual return How long will it take your 10000 to double in value if it earns 5 annually What annual rate has been earned if 1000 grows into 4000 in 20 years 50733 5034 r e t p a h C l 0 d n E Chapter 9 Net Present Value and Other Investment Criteria Key Concepts and Skills Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute internal rates of return standard and modified and understand their strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion Be able to compute the profitability index and understand its relation to net present value Chapter Outline 39 Net Present Value The Payback Rule The Discounted Payback fl The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules Does the decision rule adjust forthe time value of money Does the decision rule adjust for risk Does the decision rule provide information on whether we are creating value for the firm Net Present Value 0 The difference between the market value of a project and its cost How much value is created from undertaking an investment The first step is to estimate the expected future h flows The second step is to estimate the required return for projects of this risk level The third step is to find the present value of the cash flows and subtract the initial investment Project Example Information 0 You are reviewing a new project and have estimated the following cash flows Year 0 CF 165000 Year 1 CF 63120 NI 13620 Year2 CF 70800 NI 3300 Year3 CF 91080 NI 29100 Average Book Value 72000 Your required return for assets of this risk level is 12 NPV Decision Rule 0 If the NPVis positive accept the project 0 A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners 0 Since our goal is to increase owner wealth NPV is a direct measure of how well this project will meet our goal Computing NPV for the Project 0 Using the formulas NPV 165000 63120112 708001122 910801123 1262741 0 Using the calculator CF0 165000 CO1 63120 F01 1 002 70800 F02 1 CO3 91080 F03 1 NPV 12 CPT NPV 1262741 0 Do we accept or reject the project quot Decision Criteria Test NPV 0 Does the NPV rule account for the time value of money 0 Does the NPV rule account for the risk of the cash flows 0 Does the NPV rule provide an indication about the increase in value 0 Should we consider the NPV rule for our primary decision rule Calculating NPVs with a Spreadsheet Spreadsheets are an excellent way to compute NPVs especially when you have to compute the cash flows as well Using the NPV function The first component is the required return entered as a decimal The second component is the range of cash flows beginning with year 1 Subtract the initial investment after computing the NPV Payback Period 0 How long does it take to get the initial cost back in a nominal sense 0 Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered 0 Decision Rule Accept if the payback period is less than some preset limit Computing Payback for the Project 0 Assume we will accept the project if it pays back within two years Year 1 165000 63120 101880 still to recover Year 2 101880 70800 31 080 still to recover Year 3 31080 91080 60000 project pays back in year 3 Do we accept or reject the project Decision Criteria Test Payback 0 Does the payback rule account forthe time value of money 0 Does the payback rule account forthe risk of the cash flows 0 Does the payback rule provide an indication about the increase in value 0 Should we consider the payback rule for our primary decision rule Advantages and Disadvantages of Payback 0 Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity Disadvantages lgnoresthe time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects and new projects Discounted Payback Period 0 Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis f 0 Compare to a specified required period u 0 Decision Rule Accept the project ifit pays back on a discounted basis within the specified time Computing Discounted Payback for the Project Assume we will accept the project if it pays back on a discounted basis in 2 years Compute the PV for each cash flow and determine the payback period using discounted cas Year1 165000 63120112i 108643 Year 2 108643 mace112Z 52202 Year 3 52202 910801123 42627 project pays back in year 3 Do we accept or reject the project Decision Criteria Test Discounted Payback Does the discounted payback rule account for the time value of money Does the discounted payback rule account for the risk of the cash flows Does the discounted payback rule provide an indication about the increase in value Should we consider the discounted payback rule for our primary decision rule Advantages and Disadvantages of Discounted Payback 0 Advantages Disadvantages Includes time value May reject positive of money NPV investments Easy to understand Requires an Does not accept arbitrary cutoff negative estimated DOW NPV investments Ignores cash flows when all future beyond the cutoff cash flows are point DOSithe Biased against Biased towards longterm projects liquidity such as RampD and new products w Average Accounting Return There are many different definitions for average accounting return The one used in the book is Average net income average book value Note that the average book value depends on how the asset is depreciated Need to have a target cutoff rate Decision Rule Accept the project if the AAR is greater than a preset rate Computing AAR for the Project Assume we require an average accounting return of 25 39 Average Net Income 13620 3300 29100 3 15340 51quot AAR 1534072000 213 213 Do we accept or reject the project quot Decision Criteria Test AAR 0 Does the AAR rule account for the time value of money 0 Does the AAR rule account for the risk of the cash flows 0 Does the AAR rule provide an indication about the increase in value 0 Should we consider the AAR rule for our primary decision rule Advantages and Disadvantages of AAR I 0 Advantages Disadvantages Easy to calculate Not a true rate of Needed return time value information will Of money is usually be Ignored available Uses an arbitrary bench mark cutoff rate Based on accounting net income and book values not cash flows and market values Internal Rate of Return 39 This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated 1 cash flows and is independent of interest rates found elsewhere IRR Definition and Decision Rule 0 Definition IRR is the return that makes the NPV 0 3 0 Decision Rule Accept the project if the 39 IRR is greater than the required return Computing IRR for the Project If you do not have a financial calculator then this becomes a trial and error process 0 Calculator Enter the cash flows as you did with NPV Press IRR and then CPT IRR 1613 gt 12 required return 0 Do we accept or reject the project NPV Profile for the Project 70000 60000 lt 50000 7 40000 7 gt 30000 7 2 20000 7 10000 7 IRR 1613 710000 1 720000 v 0 0 002 004 006 008 01 012 014 016 01 0 Discount Rate Decision Criteria Test IRR 0 Does the IRR rule account forthe time value of money 0 Does the IRR rule account for the risk of the cash flows 0 Does the IRR rule provide an indication about the increase in value 0 Should we consider the IRR rule for our primary decision criteria Advantages of IRR 0 Knowing a return is intuitively appealing 0 It is a simple way to communicate the value of a project to someone who doesn t know all the estimation details 0 lfthe IRR is high enough you may not need to estimate a required return which is often a difficult task Calculating lRRs With A Spreadsheet 0 You start with the cash flows the same as you did forthe NPV You use the IRR function You first enter your range of cash flows beginning with the initial cash flow You can enter a guess but it is not necessary The default format is a whole percent you will normally want to increase the decimal places to at least two Summary of Decisions for the Project Summary Net Present Value Accept Payback Period Reject Discounted Payback Period Reject Average Accounting Return Reject Internal Rate of Return Accept NPV VS IRR NPV and IRR will generally give us the same decision Exceptions Nonconventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different issue of sca e Timing of cash flows is substantially different IRR and Nonconventional Cash Flows 0 When the cash flows change sign more than once there is more than one IRR 0 When you solve for IRR you are solving for the root of an equation and when you cross the xaxis more than once there will be more than one return that solves the equation 0 If you have more than one IRR which one do you use to make your decision Another Example Nonconventional Cash Flows 0 Suppose an investment will cost 90000 initially and will generate the following cash flows Year 1 132000 Year 2 100000 Year 3 1 50000 0 The required return is 15 0 Should we accept or reject the project NPV Profile LRR 1011 and 4266 400000 200000 7 000 gt 200000 2 400000 7 600000 300000 005 01 015 01 025 03 035 04 04 05 0 1000000 Discount Rate Summary of Decision Rules The NPV is positive at a required return of 15 so you should Accept If you use the financial calculator you would get an IRR of 1011 which would tell you to Reject Ii You need to recognize that there are nonconventional cash flows and look at the NPV profile IRR and Mutually Exclusive Projects Mutually exclusive projects If you choose one you can t choose the other Example You can choose to attend graduate school at either Harvard or Stanford but not both Intuitively you would use the following decision rules NPV choose the project with the higher NPV IRR choose the project with the higher IRR Example With Mutually Exclusive Projects Period Project Project A B 0 500 400 1 325 325 2 325 200 IRR 1943 2217 NPV 6405 6074 The required return for both projects is 10 Which project should you accept and why NPV NPV Profiles IRR forA 1943 IRR for B 2217 Crossover Point 118 Discount Rate Conflicts Between NPV and IRR NPV directly measures the increase in value to the firm 0 Wheneverthere is a conflict between NPV and another decision rule you should always use NPV IRR is unreliable in the following situations Nonconventional cash flows Mutually exclusive projects Modified IRR Calculate the net present value of all cash outflows using the borrowing rate Calculate the net future value of all cash inflows using the investing rate Find the rate of return that equates these values Benefits single answer and specific rates for borrowing and reinvestment 9739 Profitability Index Measures the benefit per unit cost based on the time value of money 1 A profitability index of 11 implies that 39 quot for every 1 of investment we create an additional 010 in value This measure can be very useful in situations in which we have limited capital Advantages and Disadvantages of Profitability Index Advantages Disadvantages Closely related to May lead to NPV generally incorrect decisions leading to identical in comparisons of decisions mutually exclusive Easy to understand 39nVeStmemS and communicate May be useful when available investment funds are limited Capital Budgeting In Practice We should consider several investment criteria when making decisions Iquot NPV and IRR are the most i commonly used primary investment criteria Payback is a commonly used secondary investment criteria Summary DCF Criteria Net present value Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion Internal rate of return Discount rate that makes NPV 0 ake the project if the IRR is greater than the required return Same decision as NPV with conventional cash ows IRR is unreliable with nonconventional cash ows or mutually s exclusive project Profitability lndegtlt Bene tcost ratio Take investment if Pl gt1 Cannot be used to rank mutually exclusive project s May be used to rank projects in the presence of capital rationing Summary Payback Criteria Payback period Length of time until initial investment is recovered Take the project if it pays back within some speci ed penod Doesn t account for time value of money and there is an arbitrary cutoff period Discounted payback period Length of time until initial investment is recovered on a discounted basis Take the project ifit pays back in some specified period There is an arbitrary cutoff period Summary Accounting Criterion Average Accounting Return Measure of accounting profit relative to book value Similar to return on assets measure Take the investment ifthe AAR exceeds some specified return level Serious problems and should not be used Quick Quiz 0 Consider an investment that costs 100000 and has a cash inflow of 25000 every year for 5 years The required return is 9 and required payback is 4 years What is the payback period What is the discounted payback period What is the NPV What is the IRR Should we accept the project 0 What decision rule should be the primary decision method 0 When is the IRR rule unreliable Ethics Issues An ABC poll in the spring of 2004 found that one third of s udents age 12 17 admitted to cheating and the percentage increased as the students got older and felt more grade pressure If a book entitled How to Cheat A User s Guide would generate a positive NPV would it be proper for a publishing company to offer the new boolO Should a firm exceed the minimum legal limits of government imposed environmental re ulations and be responsible forthe environmen even ifthis responsibility leads to a wealth reduction for the firm ls environmental damage merely a cost of doing business Should municipalities offer monetary incentives to induce firms to relocate to their areas 947 Comprehensive Problem An investment project has the following cash flows CFO 1000000 CO1 008 200000 each lfthe required rate of return is 12 what decision should be made using NPV How would the IRR decision rule be used forthis project and what decision would be reached How are the above two decisions related r m p a h C l 0 d n E Chapter 1 9 REORATE FINA QE u y Introduction to Corporate Finance 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 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 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 ofthe firm Financial Manager 0 Financial managers try to answer some or all of these questions 0 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 A 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 rm Forms of Business Organization Three major forms in the United States Sole Proprietorship Partnership General Limited Corporation C Corp 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 owners 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 Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership Corporation Advantages Disadvantages Limited liability Separation of Unlimited life ownership and Separation of management ownership and Double taxation management income taxed at the corporate rate lesrfserigfis easy and then dividends E t taxed at the 013 0 ralse g personal rate Goal of Financial Management 0 What should be the goal of a corporation Maximize profit Minimize costs Maximize market share Maximize the current value of the company s stock 0 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 0 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 0 Corporate control The threat of a takeover may result in better management 0 Other stakeholders Work the Web Example 0 The Internet provides a wealth of information about individual companies 0 One excellent site is financeyahoocom 0 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 fortobacco companies to sell a product that is known to be addictive and a dangerto the health of the user Is it relevantthat 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 End of Chapter Chapter 6 p mm GMT FIngg Formulas Discounted Cash Flow Valuation 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 l 1 Chapter Outline 39 Future and Present Values of Multiple Cash Flows Valuing Level Cash Flows Annuities and Perpetuities r Comparing Rates The Effect of Compounding Loan Types and Loan Amortization Multiple Cash Flows Future Value Example 61 Find the value at year 3 of each cash flow and add them together Today year 0 FV 70001083 881798 Year 1 FV 40001082 466560 Year 2 FV 4000108 4320 Year 3 value 4000 Total value in 3 years 881798 466560 4320 4000 2180358 Value at year 4 21 803581 08 2354787 Multiple Cash Flows FV Example 2 Suppose you invest 500 in a mutual fund today and 600 in one year If the fund pays 9 annually how much will you have in two years FV 5001092 600109 124805 2 Multiple Cash Flows Example 3 2 Continued How much will you have in 5 years if you make no further deposits 1 First way FV 5001095 6001094 161626 1quot Second way use value at year 2 FV 1248051093 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 FV 1001084 3001082 13605 34992 48597 Multiple Cash Flows Present Value Example 63 Find the PV of each cash flows and add them Year 1 CF 200 1121 17857 Year 2 CF 400 1122 31888 Year 3 CF 600 1 123 42707 Year 4 CF 800 1124 50841 Total PV 17857 31888 42707 50841 143293 Example 63 Timeline 0 1 2 3 4 L 200 400 600 800 quot 39 17857 1 31888 42707 1 50841 143293 Multiple Cash Flows Using a Spreadsheet 0 You can use the PV or FV functions in Excel to find the present value or future value of a set of cash flows 0 Setting the data up is half the battle if it is set up properly then you can just copy the formulas 0 Click on the Excel icon for an example Iii Multiple Cash Flows PV Another Example 0 You are considering an investment that will pay you 1000 in one year 2000 in two years and 3000 in three years Ifyou want to earn 10 on your money how much would you be willing to pay PV1000111 90909 PV 2000 112 165289 PV 3000 113 225394 PV 90909 165289 225394 481592 emu Multiple Uneven Cash Flows 7 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 f 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 I pressing the down arrow and then compute Clear the cash flow keys by pressing CF and then CLR Wor arm 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 I u 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 CID oco1 4o F01 1 c02 75 F02 1 NPV I 15 CPT NPV 9149 No the broker is charging more than you would be willing to pay 542 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 ifyou desire an interest rate of 12 Use cash flow keys CF CFD 0 CO1 0 F01 39 02 25000 F02 5 NPV 12 CPT NPV 108471 Ema Saving For Retirement Timeline 0 25K 25K 25K 25K 25K L J l I Notice that the year 0 cash ow 0 CF0 0 E The cash ows in years 17 39 are 0 C01 0 F01 39 J The cash ows in years 40 7 44 are 25000 C02 25000 F02 5 am Quick Quiz Part I 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 ofthe cash flows at year 5 What is the value ofthe cash flows today What is the value ofthe cash flows at year 3 545 Annuities and Perpetuities Defined Annuity finite series of equal payments that occur at regular intervals Ifthe first payment occurs at the end ofthe period it is called an ordinary annuity Ifthe first payment occurs at the beginning of the period it is called an annuity due 0 Perpetuity infinite series of equal payments ewe Annuities and Perpetuities 39 39 Basic Formulas Perpetuity PV C r Annuities 5P1 Annuities and the Calculator 0 You can use the PMT key on the calculator for the equal payment 0 The sign convention still holds 0 Ordinary annuity versus annuity due You can switch your calculator between the two types by using the 2quotd BGN 2quotd Set on the TI BAII 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 Ema Annuity Example 65 0 You borrow money TODAY so you need to compute the present value 48 N1 IN 632 PMT CPT PV 2399954 24000 0 Formula 1 17101 PV632 T 23399954 Ema Annuity Sweepstakes Example 0 Suppose you win the Publishers Clearinghouse 10 million sweepstakes The money is paid in equal annual installments of 33333333 over 30 years lfthe appropriate discount rate is 5 how much is the sweepstakes actually worth today PV 333333331 110530 05 512415029 Emu 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 5721 39l Buying a House Continued 0 Bank loan Monthly income 36000 12 3000 Maximum payment 283000 840 PV 8401 1100536 005 140105 r 0 Total Price Closing costs 04140105 5604 Down payment 20000 5604 14396 Total Price 140105 14396 154501 5722 Annuities on the Spreadsheet Example The present value and future value formulas in a spreadsheet include a I place for annuity payments 1 Click on the Excel icon to see an example 5723 Quick Quiz Part H 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 5724 Finding the Payment 0 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 4 year loan what is your monthly payment 20000 C1 1 1006666743 0066667 C 48826 5725 Finding the Payment on a Spreadsheet 0 Another TVM 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 0 Click on the Excel icon for an example 5725 Finding the Number of Payments Example 66 0 Start with the equation and remember your logs 1000 201 11015 015 751 11015 1 1015 25 125 1015 t n125 n1015 93111 months 776 years 0 And this is only if you don t charge anything more on the card 5727 Finding the Number of Payments Another Example 0 Suppose you borrow 2000 at 5 and you are going to make annual payments of 73442 How long before you pay off the loan 2000 734421 11 05 05 136161869 1 1105 1105 863838131 1157624287 105 t ln1157624287 n105 3 years 5723 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 5729 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 emu 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 5731 Future Values for Annuities 39 Suppose you begin saving for your retirement by depositing 2000 per year in an IRA If the interest rate is 75 how much will you have in 40 years FV 2000107540 1075 45451304 5732 Annuity Due 39 You are saving for a new house and you put 10000 peryear in an account paying 8 The first payment is made today How much will you have at the end of 3 years FV 100001083 1 08108 3506112 5733 Annuity Due Timeline 0 1 2 3 10000 10000 10000 32464 3501612 5734 Perpetuity Example 67 39 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 5735 Quick Quiz Part IV l 0 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 ifthe first payment is made in one month 0 What if the first payment is made today 0 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 5735 Work the Web Example l 0 Another online financial calculator can be found at MoneyChimp 0 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 6 5737 Table 62 mum yam mm mum can aw are warm nanny mm vllw what am quotowl in worm m me Mule mares rule m I return In munnu ram perpenod lyp callyw1nalllwlyx um ya umhurul Mada Weary mu um ifwwi nu numberal wan ail mnum t xmun39 A genus n1 Identical c Ema Growing Annuity A growing stream of cash flows with a fixed maturity W C CX1g Gang 1 2 1 r 1 r PV C JGWW r g K j 5739 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 ifthe discount rate is 10 percent PV 20 009 1 03 26512157 10 03 110 emu Growing Perpetuity A growing stream of cash flows that lasts forever V C laxaggt0xaggt 1 r39 1w 39 1ri3 39 C 7A g P39V 5pm Growing Perpetuity Example The expected dividend next year is 130 and dividends are expected to grow at 5 forever Ifthe discount rate is 10 what is the value of this promised dividend stream 130 7 10 05 216 00 5742 Effective Annual Rate EAR 0 This is the actual rate paid or received after accounting for compounding that occurs during the year 0 If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison 5743 Annual Percentage Rate This is the annual rate that is quoted bylaw 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 5744 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 1 545 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 thly 5745 Computing EARS Example Suppose you can earn 1 per month on 1 invested toda What is the APR 112 12 How much are you effectiver earning FV 11011Z 11268 Rate11268 111268 1268 Suppose if you put it in another account you earn 3 per quarter What is the APR 34 12 How much are you effectiver earning FV11034 112 Rate11255 111255 1255 EPA EAR Formula Decisions Decisions II 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 05253653B5 1 539 Second account EAR 1 05321 1 537 Which account should you choose and why 5749 Decisions Decisions Continued 0 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 Daily rate 0525 365 00014383562 FV 100100014383562365 10539 Second Account Semiannual rate 0539 2 0265 FV 100102652 10537 0 You have more money in the first account 5750 Computing APRs from EARS If you have an effective rate how can you compute the APR Rearrange the EAR equation and you get 5751 APR Example 0 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 APR 1211 2 1 1391139386515152 3 or 1 1 5752 Computing Payments with AP Rs I e 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 Montth rate 169 12 01408333333 Number of months 212 24 3500 on 1 10140833333324 01408333333 C 17288 5753 Future Values with Monthly Compounding 0 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 Montth rate 09 12 0075 Number of months 3512 420 FV 50 10075420 1 0075 14708922 5754 Present Value with Daily Compounding 0 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 Daily rate 055365 00015068493 Number of days 33651095 FV 15000 1000150684931095 1271856 5755 Continuous Compounding 0 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 0 Example What is the effective annual rate of 7 compounded continuously EAR e 7 1 0725 or 725 5755 Quick Quiz Part V 39 What is the definition of an APR 1 What is the effective annual rate 1 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 5757 Pure Discount Loans Example 612 0 Treasury bills are excellent examples of pure discount loans The principal amount is repaid at some future date without any periodic interest payments 0 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 PV 10000107 934579 5753 InterestOnly Loan Example 0 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 0 This cash flow stream is similar to the cash flows on corporate bonds and we will talk about them in greater detail later 5759 Amortized Loan with Fixed Principal Payment Example 0 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 0 Click on the Excel icon to see the amortization table ripen 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 4N a w 5000 PV CPT PMT 450960 Click on the Excel icon to see the amortization table 5pm Work the Web Example There are web sites available that can easily prepare amortization tables Click on the web surfer to check out the wwwbankratecom 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 3 5752 Quick Quiz Part VI 0 What is a pure discount loan What is a good example of a pure discount loan 0 What is an interestonly loan What is a good example of an interestonly loan 0 What is an amortized loan What is a good example of an amortized loan 5753 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 egtltpected 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 ofthis practice 5754 Comprehensive Problem An investment will provide you with 100 at the end of each year for the next 10 ears What is the present value ofthat annuity Ifthe discount rate is 8 annually What is the present value ofthe above if the payments are received at the beginning of each 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 opening the account with 1 000 today and then make the 100 deposits at the end of each year 5755 5755 r e t p a h C l 0 d n E i AMENIALS OF RPDRATE FINANQE Chapter 8 Stock Valuation Key Concepts and Skills 0 Understand how stock prices depend on future dividends and dividend growth 0 Be able to compute stock prices using the dividend growth model 0 Understand how corporate directors are elected 0 Understand how stock markets work 0 Understand how stock prices are quoted Chapter Outline 39 Common Stock Valuation Some Features of Common and Preferred Stocks 3 The Stock Markets 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 OnePeriod Example 0 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 ofthe expected cash flows Price 14 2 12 1333 OrFV 16 Y20 N 1CPT PV l333 TwoPeriod Example l 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 ThreePeriod Example 0 Finally what if you decide to hold the stock forthree 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 212 210122 2205 15435 123 1333 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 a expected future dividends rt So how can we estimate all future dividend payments 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 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 PD 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 price PD 5014 20 Dividend Growth Model Dividends are expected to grow at a constant percent per period P0 D11R D2 1R2 D3 1R3 P0 Do1g1R Do1g21R2 D01g31R3 With a little algebra and some series work this reduces to P 2 D0lt1ggt 2 D1 0 R g R g DGM Example 1 0 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 fOI 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 g Stock Price Sensitivity to Required Return R Example 83 Gordon Growth 39 Company l 0 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 P0 4 16 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 P4D41gR gD5R g P4 41064 16 06 5050 What is the implied return given the change in price during the four year p rio 5050 401return4 return 6 PV 40 FV 5050 N 4 CPT IIY 6 The price is assumed to grow at the same rate as the dividends Nonconstant Growth Problem Statement 0 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 allexpected future dividends Nonconstant Growth Example Solution Compute the dividends until growth levels off D1 112 120 DZ 120115 138 138105 1449 39 Find the expected future price P2 D3 R g 14492 05 966 Find the present value ofthe expected future cash flows PD 12012136966122 867 J Quick Quiz Part l 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 dividends by 3 per year beginning with the next dividend The required return stays at 15 Using the DGM to Find R 39 Start with the DGM Do1g D1 P0 R g Rg Mgg Po Po R g Finding the Required Return Example 0 Suppose a firm s stock is selling for 1050 It just paid a 1 dividend and dividends are expected to grow at 5 per year What is the required return i R 11051050 05 15 I 0 What is the dividend yield 11051050 10 i What is the capital gains yield g 5 Table 81 Stock Valuation V Summary xnwuamunmwuzymasmmmk mm moo A mwwwmmmmmK Dv 2 D a quotW 1mm MW my my quotm V n can 21me c P 0 7g m mm mm mmmmm mm m mpmnlam P 7 70 a o 5 39HRv 4mnrquot umy umy r Q m gr p39 39 W i I 7w gt11quotqu mm mm m pquot x m mama mm and g y m mum yams yvaldwumch 5 lama mm 5 ma ulnwlh mm m mamas In W namely mm mum 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 desired 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 0 Dividends Stated dividend that must be paid before dividends can be paid to common stockholders Dividends are not a liability ofthe 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 0 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 Floor traders Operations Floor activity NAS DAQ 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 0 Electronic Communications Networks provide trading in NASDAQ securities 0 Click on the web surfer and visit Instinet Reading Stock Quotes Sample Quote COSTCO WHOLESALE c NasdauGS com mv same 7331 t u7i1ulimpmn ListTrzze Dzlstnge 70mm rami39irw MEDMFY amnanap sAu am 9 an 5 Vniurre PrevCiase 1324 Avgvu i n 1333 Mama Ca am 131 men 39E i m Amman gm i 255 guwmannmimm WKWEN 10 mm mgm Annuwizsmnwwahsn What information is provided in the stock uote Click on the web surfer to go to Bloomberg for current stock quotes Quick Quiz Part 0 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 0 What are some of the major characteristics of common stock 0 What are some of the major characteristics of preferred stock Ethics Issues 0 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 r m p a h C l 0 d n E Chapter 14 Cost of Capital Key Concepts and Skills Know how to determine a firm s cost of equity capital Know how to determine a firm s cost of debt Know how to determine a firm s overall cost of capital Understand pitfalls of overall cost of capital and how to manage them Chapter Outline 0 The Cost of Capital Some Preliminaries The Cost of Equity 0 The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital 0 Divisional and Project Costs of Capital 0 Flotation Costs and the Weighted Average Cost of Capital Why Cost of Capital Is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects Required Return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided Cost of Equity 0 The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Business risk Financial risk There are two major methods for determining the cost of equity Dividend growth model SML or CAPM The Dividend Growth Model Approach 39 Start with the dividend growth model formula and rearrange to solve for RE Dividend Growth Model Example Suppose that your company is expected to pay a dividend of 1 50 per share next year There has been a steady growth in dividends of 51 per year and the market expects that to continue The current price is 25 What is the cost of equity 051111111 25 Example Estimating the Dividend Growth Rate 0 One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 2005 123 2006 130 130 7 123 123 57 2007 136 136 7130 130 46 2008 143 143713613651 2009 150 150 7143 143 49 Average 57 46 51 49 4 51 Advantages and Disadvantages 39 of Dividend Growth Model 0 Advantage easy to understand and use 39 Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren t growing at a reasonably constant rate Extremely sensitive to the estimated growth rate an increase in g of 1 increases the cost of equity by 1 Does not explicitly consider risk The SML Approach Use the following information to compute our cost of equity Riskfree rate Rf Market risk premium ERM Rf Systematic risk of asset 3 H RE Rf IBEERMRf Mu Example SML 0 Suppose your company has an equity beta of 58 and the current riskfree rate is 61 Ifthe expected market risk premium is 86 what is your cost of equity capital RE 61 5886 111 0 Since we came up with similar numbers using both the dividend growth model and the SML approach we should feel good about our estimate 1441 Advantages and Disadvantages of SML 0 Advantages Egtltplicitly adjusts for systematic risk Applicable to all companies as long as we can estimate beta 0 Disadvantages Have to estimate the expected market risk premium which does vary over time Have to estimate beta which also varies over time We are using the past to predict the future which is not always reliable 1442 Example Cost of Equity Suppose our company has a beta of 15 The market risk premium is expected to be 9 and the current riskfree rate is 6 We have used analysts estimates to determine that the market believes our dividends will grow at 6 per year and our last dividend was 2 Our stock is currently selling for 1565 What is our cost of equity Using SML RE 6 159 195 Using DGM RE 21061565 06 1955 1443 Cost of Debt The cost of debt is the required return on our company s debt We usually focus on the cost of longterm debt or bonds The required return is best estimated by computing the yieldtomaturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate 1444 Example Cost of Debt Suppose we have a bond issue currently outstanding that has 25 years left to maturity The coupon rate is 9 and coupons are paid semiannually The bond is currently selling for 90872 per 1000 bond What is the cost of debt N 50 PMT 45 FV 1000PV 90872 CPT IN 5 YTM 52 10 1445 Cost of Preferred Stock 0 Reminders Preferred stock generally pays a constant dividend each period Dividends are expected to be paid every period forever 0 Preferred stock is a perpetuity so we take the perpetuity formula rearrange and solve for RP 0 RP D P0 1445 Example Cost of Preferred Stock 39 Your company has preferred stock that has an annual dividend of 3 If the current price is 25 What is the cost of preferred stock 1447 The Weighted Average Cost 39 of Capital 0 We can use the individual costs of capital that we have computed to get our average cost of capital for the firm This average is the required return on the firm s assets based on the market s perception of the risk of those assets The weights are determined by how much of each type of financing is used 1443 Capital Structure Weights 0 Notation E market value of equity of outstanding shares times price per share D market value of debt of outstanding bonds times bond price V market value ofthe firm D E 0 Weights wE EN percent financed with equity wD DV percent financed with debt 1449 Example Capital Structure Weights Suppose you have a market value of equity equal to 500 million and a market value of debt equal to 475 million What are the capital structure weights V 500 million 475 million 975 million wE EN 500975 5128 5128 wD DV 475 975 4872 4872 1472 Taxes and the WACC We are concerned with aftertax cash flows so we also need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liability This reduction in taxes reduces our cost of debt Aftertax cost of debt RUMTC Dividends are not tax deductible so there is no tax impact on the cost of equity WACC WERE WDRD1Tc 14721 Extended Example WACC l 0 Equity Information 0 Debt Information 50 million shares 1 billion in 80 per share outstanding debt Beta 115 face value Market risk Current quote premium 9 110 Riskfree rate 5 coupon rate 9 semiannual coupons 15 years to maturity 0 Tax rate 40 14722 Extended Example WACC 0 What is the cost of equity RE 5 1159 1535 0 What is the cost of debt N 30 PV 1100 PMT 45 FV 1000 CPT IN 39268 RD 39272 7854 0 What is the aftertax cost of debt RD1Tc 785414 4712 14723 Extended Example WACC Ill 0 What are the capital structure weights E 50 million 80 4 billion D 1 billion 110 11 billion V 4 11 51 billion WE EV 451 7843 WD DV 11 51 2157 What is the WACC WACC 78431535 21574712 1306 14724 Eastman Chemical Click on the web surfer to go to Yahoo Finance to get information on Eastman Chemical EMN Under Profile and Key Statistics you can find the following information of shares outstanding Book value per share Price per share Beta Under analysts estimates you can find analysts estimates of earnings growth use as a proxy for dividend growth The Bonds section at Yahoo Finance can provide the Tbill rate Use this information along with the CAPM and DGM to estimate the cost of equity 14725 Eastman Chemical II Go to FINRA to get market information on 6 Eastman Chemical s bond issues Enter Eastman Oh to find the bond information Note that you may not be able to find information on all bond issues due to the illiquidity ofthe bond market Go to the SEC site to get book valve information from the firm s most recent 10Q 14725 Eastman Chemical lll Find the weighted average cost of the debt Use market values if you were able to get the information Use the book values if market information was not available They are often very close Compute the WACC Use market value weights if available 14727 Example Work the Web 0 Find estimates of WACC at wwwvauepronet 0 Look at the assumptions How do the assumptions impact the estimate of WACC 14723 Table 141 Cost of Equity w W 7 A Dividend gmwm model approach lmm Chewy a R I Dy P n p is the DIAUIIM stock print a SML approach mm Chapter I3 RERIBEXIHM39RV me sysiematic n39sk DI the equity 14729 Table 141 Cost of Debt bur 39 39 gammy on up wtslanding am The coupon rate isjme svam mvm murky 15 cowde iq ch er V a I me an has no gummy traded dam mu ma Don M debt can bu massaged us ma yield m malurjty on smrauy rated bonds bond ratings an aisun in Chaplsr 71 wan Table 141 WACC Ill vwm mm 39A MA und n A The lm39s WAGE ls mo ovum mquirod rmurn onma m gs a whcla1tls me E rm 5 Thu WACC is calculated as WACC EN x He DrVI x Rn x I Tc 39 n i m mantel value M the rm39s dam and V E D Noxa ma E vs ma manage av ma 9D L ls dehl 14731 Divisional and Project Costs of Capital 0 Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm s current operations If we are looking at a project that does NOT have the same risk as the firm then we need to determine the appropriate discount rate for that project Divisions also often require separate discount rates 14732 quot Using WACC for All Projects 39 Example 0 What would happen if we use the WACC for r all projects regardless of risk 0 Assume the WACC 15 39 Project Required Return IRR A 20 17 B 15 18 C 10 12 14733 The Pure Play Approach Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project ofthat risk Often difficult to find pure play companies 14734 Subjective Approach Consider the project s risk relative to the firm overall Ifthe project has more riskthan the firm use a discount rate greater than the WACC Ifthe project has less risk than the firm use a discount rate less than the WACC You may still accept projects that you shouldn t and reject projects you should accept but your error rate should be lower than not considering differential risk at all 14735 Subjective Approach 5 Example Risk Level Discount Rate Very Low Risk WACC 8 Low Risk WACC 3 39 In Same Risk as Firm WACC g High Risk WACC 5 Very High Risk WACC 10 ER a 14735 Flotation Costs The required return depends on the risk not how the money is raised However the cost of issuing new securities should not just be ignored either Basic Approach Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term 14737 NPV and Flotation Costs Example Your company is considering a project that will cost 1 million The project will generate after ax cas 0 250000 per year for 7 years The WACC is 15 and the rms target DE ratio is 6 The otation cost for equity is 5 and the otation cost for debt is 3 What is the NPV for the project after adjusting for flotation co s fA 3753 6255 425 V of future cash ows NPV 1040105 1000000l10425 4281 The project would have a positive NPV of 40 105 without considering otation costs Once we considerthe cost of issuing new securities the NPV becomes negative 14733 Quick Quiz What are the two approaches for computing the cost of equity How do you compute the cost of debt and the after tax cost of debt How do you compute the capital structure weights required for the WACC What is the WACC What hap ens if we use the WACC for the discount rate for al projects What are two methods that can be used to compute the appropriate discount rate when WACC isn t appropriate How should we factor flotation costs into our analysis may Ethics Issues 39 How could a project manager adjust the cost of capital ie appropriate discount rate to increase the likelihood of having hisher project accepted Is this ethical or nancially sound 1474 Comprehensive Problem A corporation has 10000 bonds outstanding with a 6 annual coupon rate 8 years to maturity a 1000 face value and a 1100 market price The company s 100000 shares of preferred stock pay a 3 annual dividend and sell for 30 per share The company s 500000 shares of common stock sell for 25 per share and have a beta of 15 The riskfree rate is 4 and the market return is 12 Assuming a 40 tax rate what is the company s CC 4741 1442 r e t p a h C l 0 d n E Chapter 7 Interest Rates and Bond Valuation 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 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 Bond Definitions 39 Bond Par value face value Coupon rate a i Coupon payment I Maturity date I Yield orYieId to maturity V Present Value of Cash Flows as quot 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 Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10 and annual coupons The parvalue 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 B1001 111151110001115 B 36959 59345 96304 Using the calculator N 5 IY 11 PMT 100 FV 1000 CPT PV 96304 Valuing a Premium Bond with 39 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 ofthis bond Using the formula B PV of annuity PV of lump sum B 1001 1108ZD08 100010t32D B 9818121455 119636 Using the calculator N 20 IN 8 PMT 100 FV 1000 CPT PV 119636 il Q I lU i z i a 39 5 391 Graphical Relationship Between Price and Yieldtomaturity YTM 4 y I Bond Prices Relationship 39 Between Coupon and Yield IfYTM coupon rate then par value bond price IfYTM gt coupon rate then par value gt bond price Why The discount provides yield above coupon rate Price below parvalue called a discount bond IfYTM 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 1 L7 1rt FV r 1rt Example 71 0 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 100010814 91756 Or PMT 70 N 14 Y 8FV1000CPT 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 onds Reinvestment Rate Risk Uncertainty conceming rates at which cash flows can be reinvested Shortterm bonds have more reinvestment rate risk than longterm nds High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds I0 15 lnwmsl mm as Villa I113 Bond mm a w Puluml Calpm Ran m mug mme mm and Mumva have x Mum 7 v 1 I my m s sumo mm m no Imam 5 95952 511m 0 9x357 50211 712 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 rwith 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 0 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 15PV 92809 FV 1000 PMT 100 CPT IN 11 YTM with Semiannual Coupons 0 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 Y 4 Is this the YTM YTM 42 8 Table 71 41n39rF 1r Bond vllue r C x wha m c Coupon paid my period r Rate per period umber a1 a ond s inquot value J Ewan bendynlua upon arm impli lld rlnoum mm a yield m V V dimquot rat7 s umn ml nlculaled bpn yum anallst vs cabmllurdo 51 lu youp ombar pun humsing maple In manMy Ind magma Nils pp mummy by bin and mummy To do mtg uy d v m d 9 a n Lamar Dala nan 39 dgciaans mam Hvllue39 lslolindmc m ma Current Yield vs Yield to Maturity Current Yield annual coupon price Yiell l to maturity current yield capital gains er Example 10 coupon bond with semiannual coupons face value of1000 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 oo35 35 YTM 835 35 8 which is the same YTM computed earlier Bond Pricing Theorems 0 Bonds of similar risk and maturity will be priced to yield about the same return regardless of the coupon rate I 0 If you know the price of one bond you can estimate its YTM and use that to find the price of the second bond 0 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 PRICESettIementMaturityRateYdRedemption FrequencyBas39s YIELDSettementMaturityRatePrRedemption 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 Equity Not an ownership interest Ownership interest Creditors do not have Common stockholders voting rights vote for the board of Interest is considered a Irectors and other Issues cost of doing business and Dividends are not is tax deductible considered a cost of doing Creditors have legal bUSine 5 and are n t ax recourse if interest or dedu 39 395 principal payments are Dividends are not a liability 39 of the rm and debt can lead to stockholders have no legal financial distress and recourse if dividends are bankruptcy 01 l An all equity rm can not go bankrupt merely due to debt since it has no debt 772D 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 0 Registered vs Bearer Forms 0 Security Collateral secured by financial securities rtgage secured by real property normally land or buildings Debentures unsecured Notes unsecured debt with original maturity less than 10 years 0 Seniority Bond Characteristics and Required Returns 0 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 0 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 debtwith original maturity greater than ten y ars 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 0 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 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 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 gtltamples 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 floor Other Bond Types Disaster bonds Income bonds Convertible bonds Put bonds 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 0 Primarily overthecounter transactions with dealers connected electronically 0 Extremely large number of bond issues but generally low daily volume in single issues 0 Makes getting uptodate prices difficult particularly on small company or municipal issues 0 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 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 128250 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 0 Real rate of interest change in purchasing power 0 Nominal rate of interest quoted rate of interest change in actual number of dollars 0 The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation The Fisher Effect 0 The Fisher Effect defines the relationship between real rates nominal rates and inflation 1 R 1 r1 h where R nominal rate r real rate h expected inflation rate 0 Approximation 39 R r h Example 75 0 Ifwe require a 10 real return and we expect inflation to be 8 what is the nominal rate R 11108 1 188 188 0 Approximation R 10 8 18 0 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 s ructure Normal upwardsloping longterm yields are higher than shortterm yie ds Inverted downwardsloping longterm yields are lower than shortterm yields igure 76 UpwardSloping Inkeresl rate Yield Curve A Upwardslopan term structure Nominal imerest Interest rate risk premium In a on premium Heal tale Time to maiumy Figure 76 Downward Sloping Yield Curve 3 Downwardslopan term structure Interest rate ll 5 risk pramlurn Nomlnal 5 In ation Interest 3 premium 5 L f Real rate Time 3 maturin Figure 77 naun 77 Trzaawy mm cunt Y39s P smy v mm m w mm m malunly chulram ma mm m mm May um 51 rr immuer m mgm a m Answer Jaw as mm am n m m m m 3 w W m a n my Ban Nurdmdn 2 5w an 1 a 5 Momma Ymrs Mammy Factors Affecting Bond Yields Default risk premium remember bond ratings 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 ofthe 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 ofantitrust violations were dropped Even though no legal action was taken does an ethical issue exist Comprehensive Problem 0 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 5 and it has 9 years to maturity 0 What would be the price ofthe bond ifthe yield rose to 7 0 What is the current yield on the bond ifthe YTM is 7 r m p a h C l 0 d n E FIN371 6FirstMidtermFa11201 0 Student 1 Which one of the following is a capital budgeting decision A determining how many shares of stock to issue 7c ital structure m C deciding how to re nance a debt issue that is maturing icapital structure debtequity D determining how much inventory to keep on hand iworking capital management E determining how much money should be kept in the checking account iworking capital mgmt 2 Which one of the following is a capital structure decision A determining which one of two projects to accept wapital budgeting B determining how to allocate investment funds to multiple projects icapital budgeting C determining the amount of funds needed to finance customer purchases of a new product iworking capital mgmt If 4 l E determining how much inventory Will be needed to upport a project iworking capital mgmt 3 Which one of the following is a working capital management decision A determining the amount of equipment needed to complete a job B determining whether to pay cash for a purchase or use the credit offered by the supplier C determining the amount of longterm debt required to complete a project D determining the number of shares of stock to issue to fund an acquisition E determining whether or not a project should be accepted 4 Which of the following are advantages of the corporate form of business ownership I limited liability for firm debt II double taxation III ability to raise capital IV unlimited firm life A I and II only B III and IV only C I III and IV only D II III and IV only E I II III and IV 5 Which one of the following is a primary market transaction A sale of currently outstanding stock by a dealer to an individual investor B sale of a new share of stock to an individual investor C stock ownership transfer from one shareholder to another shareholder D gift of stock from one shareholder to another shareholder E gift of stock by a shareholder to a family member 6 Which of the following are included in current liabilities I note payable to a supplier in eight months II amount due from a customer next month III account payable to a supplier that is due next week IV loan payable to the bank in fourteen months A I and III only B II and III only C I II and III only D I III and IV only E I II III and IV 7 Which of the following are expenses for accounting purposes but are not operating cash ows for financial purposes I interest expense II taxes III costs of goods sold IV depreciation A IV only B II and IV only C I and III only D I and IV only E I II and IV only 8 Your firm has total assets of 4900 fixed assets of 3200 longterm debt of 2900 and shortterm debt of 1400 What is the amount of net working capital A 100 B 300 C 600 D 1700 E 1800 9 Andre39s Bakery has sales of 687000 with costs of 492000 Interest expense is 26000 and depreciation is 42000 The tax rate is 35 percent What is the net income A 42750 B 44450 C 82550 D 86450 E 124550 10 Given the tax rates as shown what is the average tax rate for a rm with taxable income of 311360 Taxable Income Tax Rate 0 7 50000 15 50001 75000 25 75001 7 100000 34 100001 335000 39 A 2825 percent B 3109 percent C 3362 percent D 3548 percent E 3900 percent Galaxy Interiors 2009 Income Statement S in millions Net sales 21415 Cost of goods sold 16408 Depreciation 1 611 Earnings before interest and taxes 3396 Interest paid 1 282 Taxable Income 2114 Less Taxes 740 Net income 1374 Galaxy Interiors 2008 and 2009 Balance Sheets in millions w M M w Cash 668 297 Accounts payabIe 1694 1532 Accounts receivable 1611 1527 Notes payable 2 500 0 Inventory 3 848 2 947 Total 4 194 1 532 Total 6 127 4 771 Longeterm debt 9800 10650 Net fixed assets 17 489 17 107 Common stock 7500 7000 Retained earnings 2 122 2 696 Total assets 23 616 21 878 Total Iiab amp equity 23 616 21 878 11 What is the cash ow from assets for 2009 A 1732 B 2247 C 2961 D 3915 E 4267 12 The 2008 balance sheet of The Sports Store showed 800000 in the common stock account and 67 million in the additional paidin surplus account The 2009 balance sheet showed 872000 and 8 million in the same two accounts respectively The company paid out 600000 in cash dividends during 2009 What is the cash ow to stockholders for 2009 A 1372000 B 772000 C 628000 D 372000 E 1972000 13 Which one of the following is a use of cash A increase in notes payable B decrease in inventory C increase in longterm debt D decrease in accounts receivables E decrease in common stock 14 Which one of the following is a source of cash A increase in accounts receivable B decrease in common stock C decrease in longterm debt D decrease in accounts payable E decrease in inventory 15 Which one of the following accurately describes the three parts of the Du Pont identity A operating efficiency equity multiplier and profitability ratio B financial leverage operating efficiency and profitability ratio C equity multiplier profit margin and total asset turnover D debtequity ratio capital intensity ratio and pro t margin E return on assets profit margin and equity multiplier 16 A firm has a debtequity ratio of 042 What is the total debt ratio A 030 B 036 C 044 D 158 E 238 17 A firm has 160000 shares of stock outstanding sales of 194 million net income of 126400 a price ea1nings ratio of 187 and a book value per share of 912 What is the markettobook ratio A 1 62 B 184 C 223 D 245 E 257 Galaxy United Inc 2009 Income Statement Net sales 627800 Less Cost of goods sold 521400 Less Depreciation 11 200 Earnings before interest and taxes 95200 Less Interest paid 10 100 Taxable Income 85100 Less Taxes 28 900 Net income 56 200 Galaxy United Inc 2008 and 2009 Balance Sheets w w M M Cash 17000 24700 Accounts payable 128600 134700 Accounts rec 54100 56700 Longterm debt 147500 141000 Inventory 189 400 186 700 Common stock 125000 140000 Sub total 260500 268100 Retained earnings 120 700 131 800 Net fixed assets 261 300 279400 Total 521 800 547 500 Total 521 800 547 500 The par value of the common stock is 1 per share 18 How many days of sales are in receivables Use 2009 values A 1708 days B 2333 days C 2649 days D 2941 days E 3297 days Precision Tool 2009 Income Statement Net sales 36408 Less Cost of goods sold 28225 Less Depreciation 1 760 Earnings before interest and taxes 6423 Less Interest paid 510 Taxable Income 5913 Less Taxes 2 070 Net income 3 843 Precision Tool 2008 and 2009 Balance Sheets M w M w Cash 2060 1003 Accounts payable 7250 8384 Accounts rec 3411 4218 Long term debt 9800 11500 Inventory 18 776 21 908 Common stock 15000 17500 Total 24247 27129 Retained earning 6 357 3 825 Net fixed assets 14 160 14 080 Total assets 38 407 41 209 Total liab amp equity 38 407 41 209 19 How many days on average does it take Precision Tool to sell its inventory Use 2009 values A 16430 days B 18777 days C 21963 days D 24746 days E 28331 days 20 The plowbaek ratio is A equal to net income divided by the change in total equity B the percentage of net income available to the firm to fund future growth C equal to one minus the retention ratio D the change in retained earnings divided by the dividends paid E the dollar increase in net income divided by the dollar increase in sales 21 Wagner Industrial Motors which is currently operating at full capacity has sales of 29000 current assets of 1600 current liabilities of 1200 net xed assets of 27500 and a 5 percent pro t margin The rm has no longterm debt and does not plan on acquiring any The rm does not pay any dividends Sales are expected to increase by 45 percent next year If all assets shortterm liabilities and costs vary directly with sales how much additional equity nancing is required for next year A 25975 B 201 19 C 96730 D 109908 E 1 5 1 5 25 22 Stop and Go has a 45 percent pro t margin and a 15 percent dividend payout ratio The total asset turnover is 16 and the debtequity ratio is 060 What is the sustainable rate of growth A 913 percent B 954 percent C 989 percent D 1026 percent E 1085 percent 23 A rm has a retention ratio of 45 percent and a sustainable growth rate of 62 percent The capital intensity ratio is 12 and the debtequity ratio is 064 What is the pro t margin A 628 percent B 767 percent C 947 percent D 1238 percent E 1463 percent 24 Cross Town Express has sales of 132000 net income of 12600 total assets of 98000 and total equity of 45000 The rm paid 7560 in dividends and maintains a constant dividend payout ratio Currently the rm is operating at full capacity All costs and assets vary directly with sales The rm does not want to obtain any additional external equity At the sustainable rate of growth how much new total debt must the rm acquire A 0 B 431 1 C 5989 D 6207 E 6685 25 Gerold invested 6200 in an account that pays 5 percent simple interest How much money will he have at the end often years A 8710 B 9000 C 9300 D 9678 E 10099 26 You invested 1650 in an account that pays 5 percent simple interest How much more could you have earned over a 20year period if the interest had compounded annually A 84922 B 93011 C 98219 D 102115 E 107794 27 You want to have 35000 saved 6 years from now to buy ahouse How much less do you have to deposit today to reach this goal if you can earn 55 percent rather than 5 percent on your savings Today39s deposit is the only deposit you will make to this savings account A 73394 B 79118 C 82460 D 84511 E 91902 28 Penn Station is saving money to build a new loading platform Two years ago they set aside 24000 for this purpose Today that account is worth 28399 What rate of interest is Penn Station earning on this investment A 639 percent B 747 percent C 878 percent D 923 percent E 967 percent 29 Which one of the following statements is correct given the following two sets of project cash ows Project A Project B Year 1 6000 2000 Year 2 0 3000 Year 3 2500 3000 Year 4 2500 3000 A The cash ows for Project B are an annuity but those of Project A are not B Both sets of cash ows have equal present values as of time zero given a positive discount rate C The present value at time zero of the nal cash ow for Project A will be discounted using an exponent of three D The present value of Project A cannot be computed because the second cash ow is equal to zero E As long as the discount rate is positive Project B will always be worth less today than will Project A 30 You just won the grand prize in a national writing contest As your prize you will receive 2000 a month for ten years If you can earn 7 percent on your money what is this prize worth to you today A 17225271 B 17841106 C 18133840 D 18533333 E 19045025 31 Your car dealer is willing to lease you a new car for 245 a month for 48 months Payments are due on the rst day of each month starting with the day you sign the lease contract If your cost of money is 65 percent what is the current value of the lease A 1033103 B 1038699 C 1219774 D 1220314 E 1300831 32 Your grandfather left you an inheritance that will provide an annual income for the next 10 years You will receive the rst payment one year from now in the amount of 4000 Every year after that the payment amount will increase by 6 percent What is your inheritance worth to you today if you can earn 95 percent on your investments A 3169915 B 3666667 C 4112121 D 4346412 E 4690817 33 You are considering a project which will provide annual cash in ows of 4500 5700 and 8000 at the end of each year for the next three years respectively What is the present value of these cash ows given a 9 percent discount rate A 14877 B 15103 C 15429 D 16388 E 16847 FIN37 1 6FirstMidtermF 211120 10 Key 1 Which one of the following is a capital budgeting decision determining how many shares of stock to issue E deciding whether or not to purchase a new machine for the production line C deciding how to re nance a debt issue that is maturing D determining how much inventory to keep on hand E determining how much money should be kept in the checking account Refer to section 11 AACSB NA Bloom39x Corrprehension Dif culty Baric Learning Objective 11 Ross Chapter 01 14 Section 1 Topic Capital budgeting 2 Which one of the following is a capital structure decision A determining which one of two projects to accept B determining how to allocate investment funds to multiple projects C determining the amount of funds needed to finance customer purchases of a new product g determining how much debt should be assumed to fund a project E determining how much inventory will be needed to support a project Refer to section 11 AACSB NA Bloom39x Corrprehension Dif culty Baric Learning Objective 11 Ross Chapter 01 16 Section 1 Topic Capital structure 3 Which one of the following is a working capital management decision A determining the amount of equipment needed to complete a job E determining whether to pay cash for a purchase or use the credit offered by the supplier C determining the amount of longterm debt required to complete a project D determining the number of shares of stock to issue to fund an acquisition E determining whether or not a project should be accepted Refer to section 11 AACSB NA Bloom39x Corrprehension Dif culty Baric Learning Objective 11 Ross Chapter 01 19 Section 1 Topic Working capital management 4 Which of the following are advantages of the corporate form of business ownership I limited liability for firm debt II double taxation III ability to raise capital IV unlimited firm life A I and II only B III and IV only Q I III and IV only D II III and IV only E I II III and IV Refer to section 12 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 13 Ross Chapter 01 27 Section 12 Topic Corporation 5 Which one of the following is a primary market transaction A sale of currently outstanding stock by a dealer to an individual investor E sale of a new share of stock to an individual investor C stock ownership transfer from one shareholder to another shareholder D gift of stock from one shareholder to another shareholder E gift of stock by a shareholder to a family member Refer to section 15 AACSB NA Bloom39x Corrprehension Dif culty Baric Learning Objective 13 Ross Chapter 01 56 Section 15 Topic Primary market 6 Which of the following are included in current liabilities I note payable to a supplier in eight months 11 amount due from a customer next month 111 account payable to a supplier that is due next week IV loan payable to the bank in fourteen months A I and 111 only B 11 and 111 only C I H and 111 only D I III and IV only E I II III and IV Refer to section 21 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 21 Ross Chapter 02 16 Section 2 Topic Current liabilities 7 Which of the following are expenses for accounting purposes but are not operating cash ows for nancial purposes I interest expense II taxes III costs of goods sold IV depreciation A IV only 13 II and IV only C I and III only QI and IV only E I II and IV only Refer to sections 22 and 24 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 22 and 24 8 Your rm has total assets of 4900 xed assets of 3200 longterm debt of 2900 and shortterm debt of 1400 What is the amount of net working capital A 100 E 300 C 600 D 1700 E 1800 Net working capital 4900 3200 1400 300 AACSB Analytic Bloom39x Analij Dif culty Baric Learning Objective 21 Ross Chapter 02 49 Section 2 Topic Net working capital 9 Andre39s Bakery has sales of 687000 with costs of 492000 Interest expense is 26000 and depreciation is 42000 The tax rate is 35 percent What is the net income A 42750 B 44450 Q 82550 D 86450 124550 Net income 687000 492000 26000 42000 1 35 82550 AACSB Analytic Bloomlv Application Di iculry Baxic learning Objective 2 2 Rom Chapter 02 54 Section 22 Topic Net income 10 Given the tax rates as shown what is the average tax rate for a rm with taxable income of 311360 Taxable Income Tax Rate 0 50000 15 50001 75000 25 75001 100000 34 100001 335000 39 A 2825 percent B 3109 percent Q 3362 percent D 3548 percent E 3900 percent Tax 1550000 2525000 3425000 39211360 10468040 Average tax rate 10468040311360 3362 percent AACSB Analytic 19100va Application learning Objective 2 3 Rom Chapter 02 56 Section 2 3 Topic Average tax rate Galaxy Interiors 2009 Income Statement S in millions Net sales 21415 Cost of goods sold 16408 Depreciation 1 611 Earnings before interest and taxes 3396 Interest paid 1 282 Taxable Income 2114 Less Taxes 740 Net income 1374 Galaxy Interiors 2008 and 2009 Balance Sheets in millions m 2009 M w Cash 668 297 Accounts payabIe 1694 1532 Accounts receivable 1611 1527 Notes payable 2 500 0 Inventory 3 848 2 947 Total 4 194 1 532 Total 6 127 4 771 Longeterm debt 9800 10650 Net fixed assets 17 489 17 107 Common stock 7500 7000 Retained earnings 2 122 2 696 Total assets 23 616 21 878 Total liab amp equity 23 616 21 878 Ram Chapter 02 11 What is the cash ow from assets for 2009 A 1732 13 2247 C 2961 D 3915 E 4267 Change in net working capital 4771 1532 6127 4194 1306 Net capital spending 17107 17489 1611 1229 Operating cash ow 3396 1611 740 4267 Cash ow from assets 4267 1229 1306 1732 AACSB Analytic Bloom s Analysis Di iculty Intermediate Learning Objective 24 Rom Chapter 02 70 Section 24 Topic Caxh ow om assets 12 The 2008 balance sheet of The Sports Store showed 800000 in the common stock account and 67 million in the additional paidin surplus account The 2009 balance sheet showed 872000 and 8 million in the same two accounts respectively The company paid out 600000 in cash dividends during 2009 What is the cash ow to stockholders for 2009 A 1372000 E 772000 C 628000 D 372000 E 1972000 Cash ow to stockholders 600000 872000 8000000 800000 6700000 772000 AACSB Analytic 13100va Application Dif culty Baric E 0C Learning Objective 24 Ross Chapter 02 97 Section 24 Topic Cash ow to nockholderx 13 Which one of the following is a use of cash A increase in notes payable B decrease in inventory C increase in longterm debt D decrease in accounts receivables L decrease in common stock Refer to section 31 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 3 Ross Chapter 03 9 Section 3 Topic Use of cash 14 Which one of the following is a source of cash A increase in accounts receivable B decrease in common stock C decrease in longterm debt D decrease in accounts payable L decrease in inventory Refer to section 31 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 3 Ross Chapter 03 11 Section 3 Topic Source of cash 15 Which one of the following accurately describes the three parts of the Du Pont identity A operating efficiency equity multiplier and profitability ratio 13 financial leverage operating efficiency and profitability ratio Q equity multiplier profit margin and total asset turnover D debtequity ratio capital intensity ratio and pro t margin E return on assets profit margin and equity multiplier Refer to section 34 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 33 Rom Chapter 03 39 Section 34 Topic Du Pont identity 16 A firm has a debtequity ratio of 042 What is the total debt ratio a 030 B 036 C 044 D 158 E 238 The debtequity ratio is 042 Iftotal debt is 42 and total equity is 100 then total assets are 142 Total debt ratio 42l42 030 AACSB Analytic 13100va Application Dif culty Baric Learning Objective 32 Ross Chapter 03 5 7 Section 33 Topic Longterm solvency ratiox 17 A firm has 160000 shares of stock outstanding sales of 194 million net income of 126400 a price eamings ratio of 187 and a book value per share of 912 What is the markettobook ratio i 162 B 184 C 223 D 245 E 257 Earnings per share 126400160000 079 Price per share 079 x 187 14773 Markettobook ratio 147739 12 162 AACSB Analytic Bloom s Application Di iculty Intermediate Learning Objective 32 Rom Chapter 03 Section 33 Topic Wket value ratios Galaxy United Inc 2009 Income Statement Net sales 627800 Less Cost of goods sold 521400 Less Depreciation 11 200 Earnings before interest and taxes 95200 Less Interest paid 10 100 Taxable Income 85100 Less Taxes 28 900 Net Income 56 200 Galaxy United Inc 2008 and 2009 Balance Sheets w w M M Cash 17000 24700 Accounts payable 128600 134700 Accounts rec 54100 56700 Long term debt 147500 141000 Inventory 189 400 186 700 Common stock 125000 140000 Subvtotal 260500 268100 Retained earnings 120 700 131 800 Net fixed assets 261 300 279 400 Total 521 800 547 500 Total 521 800 547 500 The par value of the common stock is 1 per share Rom Chapter 03 18 How many days of sales are in receivables Use 2009 values A 1708 days 13 2333 days C 2649 days D 2941 days L 3297 days Accounts receivable turnover for 2009 62780056700 1107 Days sales in receivables for 2009 3651107 3297 CSB Analytic 13100va Application Di iculty Basic Learning Objective 32 Ross Chapter 03 73 Section 33 Topic Asset utilization ratios Precision Tool 2009 Income Statement Net sales 36408 Less Cost of goods sold 28225 Less Depreciation 1 760 Earnings before interest and taxes 6423 Less Interest paid 510 Taxable Income 5913 Less Taxes 2 070 Net income 3 843 Precision Tool 2008 and 2009 Balance Sheets w M m m Cash 2060 1003 Accounts payable 7250 8384 Accounts rec 3411 4218 Long term debt 9800 11500 Inventory 18 776 21 908 Common stock 15000 17500 Total 24247 27129 Retained earning 6 357 3 825 Net fixed assets 14 160 14 080 Total assets 38 407 41 209 Total liab amp equity 38 407 41 209 Ross Chapter 03 19 How many days on average does it take Precision Tool to sell its inventory Use 2009 values A 16430 days B 18777 days C 21963 days D 24746 days L 28331 days Days sales in inventory 3652822521908 28331 days AACSB Analytic 13100va Application Dif culty Baric Learning Objective 32 Ross Chapter 03 81 Section 33 Topic Asset utilization ratiox 20 The plowback ratio is A equal to net income divided by the change in total equity E the percentage of net income available to the rm to fund future growth C equal to one minus the retention ratio D the change in retained earnings divided by the dividends paid E the dollar increase in net income divided by the dollar increase in sales Refer to section 43 AACSB NA Bloom39x Knowledge Dif culty Baric Learning Objective 41 Rom Chapter 04 26 Section 43 Topic Plowback ratio 21 Wagner Industrial Motors which is currently operating at full capacity has sales of 29000 current assets of 1600 current liabilities of 1200 net xed assets of 27500 and a 5 percent pro t margin The rm has no longterm debt and does not plan on acquiring any The rm does not pay any diVidends Sales are expected to increase by 45 percent next year If all assets shortterm liabilities and costs vary directly with sales how much additional equity nancing is required for next year A 25975 B 201 19 C 96730 D 109908 1 5 1 5 25 Projected assets 1600 27500 gtlt 1045 3040950 Projected liabilities 1200 gtlt 1045 1254 Current equity 1600 27500 1200 27900 Projected increase in retained earnings 29000 X 05 X 1045 151525 Equity funding need 3040950 1254 27900 151525 25975 AACSB Analytic 13100va Application Dif culty Baric Learning Objective 42 Ross Chapter 04 45 Section 4 2 Topic Equity nancing 22 Stop and Go has a 45 percent pro t margin and a 15 percent diVidend payout ratio The total asset turnover is 16 and the debtequity ratio is 060 What is the sustainable rate of growth A 913 percent B 954 percent C 989 percent D 1026 percent L 1085 percent Return on equity 0045 X 160 X 1 060 01152 Sustainable growth 01152 X 1 01511152 X 1 0151085 percent AACSB Analytic 13100va Application Dif culty Baric Learning Objective 43 Ross Chapter 04 52 Section 4 4 Topic Sustainable growth 23 A rm has a retention ratio of 45 percent and a sustainable growth rate of 62 percent The capital intensity ratio is 12 and the debtequity ratio is 064 What is the pro t margin A 628 percent 8 767 percent C 947 percent D 1238 percent L 1463 percent 0062 ROE gtlt 04511 ROE X 045 ROE 129734 0129734 PM gtlt 112 X 1 064 PM 1463 percent AACSB Analytic Bloom39x Anal xix Dif culty Intermediate Learning Objective 43 Ross Chapter 04 54 Section 44 Topic Pro t margin 24 Cross Town Express has sales of 132000 net income of 12600 total assets of 98000 and total equity of 45000 The lm paid 7560 in dividends and maintains a constant dividend payout ratio Currently the rm is operating at full capacity All costs and assets vary directly with sales The rm does not want to obtain any additional external equity At the sustainable rate of growth how much new total debt must the rm acquire A 0 B 431 1 C 5989 D 6207 L 6685 Dividend payout ratio 756012600 060 Retention ratio 1 060 040 Sustainable growth 1260045000 gtlt 0401 1260045000 X 040 0126126 Projected total assets 98000 gtlt 1126126 11036035 Current debt 98000 45000 53000 Projected equity 45000 12600 gtlt 1126126 X 040 5067568 Net debt required 11036035 53000 5067568 6685 AACSB Analytic Bloom39x Analysis Dif culty Intermediate Learning Objective 42 Rom Chapter 04 56 Section 44 Topic External nancing need 25 Gerold invested 6200 in an account that pays 5 percent simple interest How much money will he have at the end of ten years A 8710 B 9000 Q 9300 D 9678 10099 Ending value 6200 6200 x 05 x 10 9300 AACSB Analytic 19100va Application Di iculry Baxic Iearning Objective 51 Rom Chtpter 05 21 Section 51 Topic Future value 26 You invested 1650 in an account that pays 5 percent simple interest How much more could you have earned over a 20year period if the interest had compounded annually A 84922 13 93011 C 98219 D 1021 15 L 107794 Simple interest 1650 1650 x 05 x 20 3300 Annual compounding 1650 X 10520 437794 Difference 437794 3300 107794 Enter 20 5 l650 N INY PV PMT FY Solve for 437794 AACSB Analytic 19100va Application Di iculry Intermediate learning Objective 51 Rom Chapter 05 23 Section 51 Topic Simple Venus compound interest 27 You want to have 35000 saved 6 years from now to buy a house How much less do you have to deposit today to reach this goal if you can earn 55 percent rather than 5 percent on your savings Today39s deposit is the only deposit you will make to this savings account A 73394 13 79118 C 82460 D 84511 E 91902 Present value 35000 x 11 056 2611754 Presentvalue 35000 x 11 0556 2538360 Difference 2611754 2538360 73394 Enter 6 5 3 5000 N 1 Y PV PMT FY Solve for 26ll754 Enter 6 55 35000 N L Y PV PMT FV Solve for 2538360 AACSB Analytic 19100va Application Di iculty Intermediate Learning Objective 52 Rom Chapter 05 37 Section 52 Topic Present value 28 Penn Station is saving money to build a new loading platform Two years ago they set aside 24000 for this purpose Today that account is worth 28399 What rate of interest is Penn Station earning on this investment A 639 percent B 747 percent 9 878 percent D 923 percent E 967 percent 28399 24000 x 1 r239 r 878 percent Enter 2 24000 28399 N LY PV39 PMT FV39 Solve for 878 AACSB Analytic Bloom s Analyxis Di iculty Baxic Learning Objective 53 Rom Chapter 05 46 Section 53 Topic Interext rate 29 Which one of the following statements is correct given the following two sets of project cash ows Project A Project B Year 1 6000 2000 Year 2 0 3000 Year 3 2500 3000 Year 4 2500 3000 A The cash ows for Project B are an annuity but those of Project A are not B Both sets of cash ows have equal present values as of time zero given a positive discount rate C The present value at time zero of the nal cash ow for Project A will be discounted using an exponent of three D The present value of Project A cannot be computed because the second cash ow is equal to zero L As long as the discount rate is positive Project B will always be worth less today than will Project A Refer to section 61 AACSB NA Bloom s Comprehension Di iculty Basic Learning Objective 6 Rory Chapter 06 14 Section 61 Topic Present value 30 You just won the grand prize in a national writing contest As your prize you will receive 2000 a month for ten years If you can earn 7 percent on your money what is this prize worth to you today A 17225271 B 17841106 C 18133840 D 18533333 E 19045025 39 079042 17 11 1 12 APV2000 gt quot O7 7 17225271 5 1 Enter 10x12 712 2000 N IY PV PMT FV Solve for 47225271 AACSB Analytic 19100va Application Di iculty Bmic Learning Objective 61 Rom Chapter 06 26 Section 62 Topic Annuity prexent value 31 Your car dealer is willing to lease you a new car for 245 a month for 48 months Payments are due on the rst day of each month starting with the day you sign the lease contract If your cost of money is 65 percent what is the current value of the lease A 1033103 E 103 8699 C 1219774 D 1220314 E 1300831 AduePV245 1l 1038699 0065 12 1 Enter 48 6512 724SBGN N IY PV PMT FV Solve for 1038699 AACSB Analytic 19100va Application Di iculty Bmic Learning Objective 62 Rom Chapter 06 48 Section 2 Topic Annuity present value 32 Your grandfather left you an inheritance that will provide an annual income for the next 10 years You will receive the rst payment one year from now in the amount of 4000 Every year after that the payment amount will increase by 6 percent What is your inheritance worth to you today if you can earn 95 percent on your investments A 3 169915 13 3666667 C 4112121 D 4346412 E 4690817 7 l006 To GAPV4000 S3l69915 00957006 AACSB Analytic 19100va Application Di iculty Bmic 33 You are considering a project which will provide annual cash in ows of 4500 5700 and 8000 at the end of each year for the next three years respectively What is the present value of these cash flows given a 9 percent dis count rate A 14877 E 15103 C 15429 D 16388 E 16847 PV 4500 5700 8000 1009 1 1009Z 10093 PV 15103 AACSB Analytic 13100va Application Di iculty Basic Learning Objective 6 1 Ross C Section 61 Topic Present value FIN37 l 6FirstMidtermFa1120 10 Summary Category of Questions AACSB Analytic 2l AACSB NA 12 Bloom39s Analysis 5 Bloom39s Application 16 Bloom39s Comprehension 5 Bloom39s Knowledge 7 Dif culty Basic 27 Dif culty Intermediate EOC 212 Learning Objective 11 Learning Objective 13 Learning Objective 21 Learning Objective 22 Learning Objective 22 and 24 Learning Objective 23 Learning Objective 24 Learning Objective 31 Learning Objective 32 Learning Objective 33 Learning Objective 41 Learning Objective 42 Learning Objective 43 Learning Objective 51 Learning Objective 52 Learning Objective 53 Learning Objective 61 Learning Objective 62 Ross Chapter 01 Ross Chapter 02 Ross Chapter 03 Ross Chapter 04 Ross Chapter 05 Ross Chapter 06 Section 11 Section Lnio Section Section 21 Section 22 Section 22 and 24 Section 23 Section 24 Section 31 Section 33 hwwt b b Nb b U mhmommwwHHNNNHHhNNHD b NNWHQ Section 34 Section 42 Section 43 Section 44 Section 51 Section 52 Section 53 Section 61 Section 62 Topic Accounting versus cash ow Topic Annuity present value Topic Asset utilization ratios Topic Average tax rate Topic Capital budgeting Topic Capital structure Topic Cash ow from assets Topic Cash ow to stockholders Topic Corporation Topic Current liabilities Topic Du Pont identity Topic Equity nancing Topic External nancing need Topic Future value Topic Growing annuity Topic Interest rate Topic Longterm solvency ratios Topic Market value ratios Topic Net income Topic Net working capital Topic Plowback ratio Topic Present value Topic Primary market Topic Pro t margin Topic Simple versus compound interest Topic Source ofcash Topic Sustainable growth Topic Uses ofcash Topic Working capital management HHHHHHHWHHHH HHHHHHHHHHi HNNHLANHHNLAHHH Chapter 2 V MAENTALS OF PQRATE FINANEE Financial Statements I Taxes and Cash Flow Key Concepts and Skills Know the difference between book value and market value Know the difference between accounting income and cash ow Know the difference between average and marginal tax rates Know how to determine a firm s cash ow from its financial statements Chapter Outline The Balance Sheet The Income Statement Taxes Cash Flow Balance Sheet 0 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 V thout significant loss of value Balance Sheet Identity Assets Liabilities Stockholders Equity The Balance Sheet Figure 21 Tom Value at Llahllllla Tolal Value 039 Assam and Sharaholders39 Equ y The Balance Sam LeR 5mg Tum Value quuzh mm Sidz Total Valua or Lib ikies ma summary 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 rm Liquidity Ability to convert to cash quickly without a signi cant loss in value Liquid rms are less likely to experience nancial distress But liquid assets typically earn a lowe r t m Tradeo to nd balance between liquid and illiquid assets US Corporation Balance Sheet mm Ll m r mm Table 21 us wwonno alumna mm mm amen In m m Ame u cm m m mum dam umm um Heumeu Barnum Tam mm namxm Tom iauL WW my 5 m 5 m Owuar s Equuy zoos Market Value vs Book Value 0 The balance sheet provides the book value of the assets liabilities and equity 0 Market value is the price at which the assets liabilities or equity can actually be bought or sold 39 0 Market value and book value are often very different Why 0 Which is more important to the decision making process Example 22 Klingon Corporation KLINGON CORPORATION Balance Sheets Market Value versus Book Value Book Market Book Assets Market Liabilities and Shareholders Equity 35 400 600 LTD 700 1000 SE 1100 1600 500 500 600 1100 1100 1600 Income Statement 0 The income statement is more like a video of the firm s operations for a specified period of time 0 You generally report revenues first and then deduct any expenses for the period 0 Matching principle GAAP says to show revenue when it accrues and match the expenses required to generate the revenue US Corporation Income Statement Table 22 v5 aonpmno 7 71 mm mm Smut Wm wwmem s m mHltnnl Net 1km 1 tDg Dual 4 gwd add 7an e amquot a Eau uyratowmtevustawlnws 3 am Intnmal pmd 7o Taxammlwamv s 524 m m N s m 1 us mm 9 Man on m mum earnings 239 Work the Web Example 0 Publicly traded companies must file regular reports with the Securities and Exchange Commission 0 These reports are usually filed electronically and can be searched at the SEC public site called EDGAR 0 Click on the web surfer pick a company and see what you can find Taxes 0 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 0 Other taxes Example Marginal Vs Average Rates 0 Suppose your firm earns 4 million in taxable income What isthe firm s tax liability What is the average tax rate What isthe marginal tax rate 0 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 0 Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements 0 The statement of cash flows does not provide us with the same information that we are looking at here V 0 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 39 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 BIS ending NWC beginning NWC 330 CFFA 547 130 330 87 Example US Corporation Part 0 CF to Creditors 88 and interest paid net new borrowing 0 CF to Stockholders 88 and E dividends paid net new equity raised CFFA 24 63 87 Cash Flow Summary Table 25 0 Cash ow hum assets Cash aw Yo cm um handheld5M 4 cm law no sxocknumrs mm on aw mm as owning my quotw 7 Non main gt w A cm in m walking aaoiul mwc m oneme no Eamlng beloremmmdmusam Mamba 7 Vans Nev mum sm n Emma m rum mans r Swiminn no bad nuts Dalmatianquot 15234 cm law a madamAm am pm um nuw muy mm M l 15 I Example Balance Sheet and k Income Statement Information 391 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 ampAPIC 372 Income Statement EBIT 1014 Taxes 368 Interest Expense 93 Dividends 285 Example Cash Flows 0CF 1014 500 368 1146 NCS 2194 2261 500 433 Changes in vaC 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 39 1 The CF identity holds 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 0 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 o 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 rl e t p a h C l 0 d n E Chapter 4 LongTerm n Financial Planning and Growth Key Concepts and Skills Understand the financial planning process and how decisions are interrelated Be able to develop a nancial plan using the percentage of sales approach Be able to compute external financing needed and identify the determinants of a firm s growth Understand the four major decision areas involved in longterm financial planning Understand how capital structure policy and dividend policy affect a firm s ability to row Chapter Outline What Is Financial Planning Financial Planning Models A First Look The Percentage of Sales Approach External Financing and Growth Some Caveats Regarding Financial Planning Models Elements of Financial Planning Investment in new assets determined by capital budgeting decisions Degree of financial leverage determined by capital structure decisions Cash paid to shareholders determined by dividend policy decisions Liquidity requirements determined by net working capital decisions Financial Planning Process Planning Horizon divide decisions into shortrun decisions usually next 12 months and longrun decisions usually 2 5 years Aggregation combine capital budgeting decisions into one large project Assumptions and Scenarios Make realistic assumptions about important variables Run several scenarios where you vary the assumptions by reasonable amoun s Determine at a minimum worst case normal case and best case scenarios Role of Financial Planning Examine interactions help management see the interactions between decisions Explore options give management a systematic framework for exploring its opportunities Avoid surprises help management identify possible outcomes and plan accordingly Ensure feasibility and internal consistency hep management determine if goals can be accomplished and ifthe various stated and unstated goals ofthe firm are consistent with one another Financial Planning Model Ingredients Sales Forecast many cash flows depend directly on the level of sales often estimated using sales growth rate Pro Forma Statements setting up the plan using projected nancial statements allows for consistency and ease of interpretation Asset Requirements the additional assets that will be required to meet sales projec ions Financial Requirements the amount offinancing needed to pay for the required assets Plug Variable determined by management deciding what type of nancing will be used to make the balance sheet balance Economic Assumptions explicit assumptions about the coming economic environmen Example Historical Financial Statements Gourmet Coffee Inc Gourmet Coffee Inc Income Statement For Year Ended December 31 2009 Balance Sheet December 31 2009 400 Assets 1000 Debt Revenues 2000 3931in 600 Less costs 1600 Net Income 400 Total 1000 Total 1000 Example Pro Forma Income Statement 0 Initial Assumptions Gourmet Coffee Inc Revenues will grow at 150 Pro Forma Income Statement 0 ForYear Ended 2010 2000115 All items are tied directly to saesy Revenues 2300 and the current relationships are Less costs 11840 optimal Consequently all other items Wm Net Income 460 also grow at 15 xample Pro Forma Balance Sheet Gourmet Coffee Inc Case Pro Forma Balance Sheet DIVIdends are the plug Case1 vari y increases at 15 Assets 1150 Debt 460 Dividends 460 NI Equity 690 7 7 370 increasein equityTotal 1150 Total 1150 90 dividends paid 39 0353 Gourmet Coffee Inc Debt is the plug Pro Forma Balance Sheet variable and no Case 2 dividends are paid Assets 1150 Debt 90 Debt 1 15 Equity 1060 600460 90 Repay 400 90 310 in debt 479 Total 1150 Total W Percentage of Sales Approach Some items vary directly with sales while others do not Income Statement osts may vary directly with sales if this is the case then the pro t margin is constant Depreciation and interest expense may not vary directly with sales if this is t e case then the pro t margin is not constant Dividends are a management decision and generally do not vary directly with sales this in uences additions to retained rnings Balance Sheet Initially assume all assets including xed vary directly with sales Accounts payable will also normally vary directly with sales Notes payable longterm debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure The change in the retained earnings portion of equity will come from the dividend decision Example Income Statement Tasha s Toy Emporium Income Statement 2009 Sales Less costs EBT Less taxes 40 of EBT Net Income Dividends Add To RE 5 000 3000 2000 000 of Sales 60 40 16 24 Tasha s Toy Emporium Pro Forma Income Statement 2010 Sales 5500 Less costs 3300 EBT W Less taxes 880 Net Income W Dividends 660 Add To RE 660 Assume Sales grow at 10 Dividend Payout Rate 50 441 Example Balance Sheet Balance Sheet Tasha s Toy Emporium t A Curren ro urrent A of Pro Sales Form Sales Forma a ASSETS Liabilities amp Owners Equity CurrentAssets Current Liabilities 500 10 550 900 18 990 AIR 2000 40 2200 NIP 2500 na 2500 Inventory 3000 60 3300 Total 3400 na 3490 Total 5500 110 6050 LT Debt 2000 na 2000 Fixed Assets Owners39 Equity Net PPampE 80 4400 CS ampAPC 2000 na 2000 Total Assets 190 10450 RE 2100 na 2760 Total 4100 na 4760 Total L amp OE 9500 10250 442 Example External Financing Needed 0 The firm needs to come up with an additional 200 in debt or equity to make the balance sheet balance TA TLampOE 10450 10250 200 Choose plug variable 200 EFN Borrow more shortterm Notes Payable Borrow more longterm LT Debt Sell more common stock CS amp APIC Decrease dividend payout which increases the Additions To Retained Earnings i Example Operating at Less than Full Capacity Suppose that the company is currently operating at 80 capacity Full Capacity sales 5000 8 6250 Estimated sales 5500 so we would still only be operating a 8 Therefore no additional xed assets would be required Proforma o al Assets 6 50 4000 10050 Total Liabilities and Owners Equity 10250 Choose plug variable for 200 EXCESS nancing Repay some shortterm debt decrease Notes Payable Repay some longterm debt decrease LT Debt Buy back stock decrease CS amp APIC Pay more in dividends reduce Additions To Retained Earnings Increase cash account Work the Web Example 39 Looking for estimates of company growth rates What do the analysts have to say j quot Check out Yahoo Finance click the 39 web surfer enter a company ticker and follow the Analyst Estimates link Growth and External Financing 0 At low growth levels internal financing retained earnings may exceed the required investment in assets 0 As the growth rate increases the internal financing will not be enough and the firm will have to go to the capital markets for money I 0 Examining the relationship between growth and external financing required is a useful tool in longrange planning The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing Using the information from Tasha s Toy Emporium ROA1200l9500 1263 B 5 ROAXb lROAXb 1263gtlt5 0674 171263X5 674 Internal Growth Rate The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio Using Tasha s Toy Emporium ROE 12004100 2927 b ROEXb lROEXb 7 2927gtlt5 7172927x5 1714 Sustainable Growth Rate 1714 Determinants of Growth Profit margin operating efficiency Total asset turnover asset use efficiency 5 Financial leverage choice of optimal debt ratio 47 Dividend policy choice of how much to pay to shareholders versus reinvesting in the firm Important Questions 0 It is important to remember that we are working with accounting numbers therefore we must ask ourselves some important questions as we go through the planning process How does our plan affect the timing and risk of our cash flows Does the plan point out inconsistencies in our oals If we follow this plan will we maximize owners wealth Quick Quiz What is the purpose of longrange planning What are the major decision areas involved in developing a plan What is the percentage of sales approach How do you adjust the model when operating at less than full capacity What is the internal growth rate What is the sustainable growth rate What are the major determinants of growth Ethics Issues Should managers overstate budget requests or growth projections if they know that central headquarters is going to cut funds across the board Comprehensive Problem XYZ has the following financial information for 2009 Sales 2M Net Inc 04M Div 01M CA 04M FA 36M CL 02M LTD 1M 08 2M RE 08M What is the sustainable growth rate If 2010 sales are projected to be 24M what is the amount of external financing needed assuming XYZ is operating at full capacity and profit margin and payout ratio remain constant r e t p a h C l 0 d n E Chapter 13 Return Risk and the Security Market Line Key Concepts and Skills Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line Understand the riskreturn tradeoff Be able to use the Capital Asset Pricing Model Chapter Outline Expected Returns and Variances Portfolios Announcements Surprises and Expected Returns 39 Risk Systematic and Unsystematic i Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line The SML and the Cost of Capital A Preview I Expected Returns Expected returns are based on the probabilities of possible outcomes In this context expected means average if the process is repeated many times The expected return does not even have to be a possible return ER Z piRi i1 Example Expected Returns 39 0 Suppose you have predicted the following returns for stocks C and T in three possible states of the economy What are the expected returns State Probabilitv C T Boom 03 15 25 Normal 0 5 10 Recession 777 2 Variance and Standard Deviation Variance and standard deviation measure the volatility of returns 39 Using unequal probabilities forthe entire range of possibilities til Weighted average of squared gill deviations 02 ZR R1 ER2 Example Variance and Standard Deviation Consider the previous example What are the variance and standard deviation for each stock Stock C 52 3 15 992 5 10992 22 992 2029 cs 450 Stock T 52 325 1772 520 1772 2 1 1772 7441 cs 863 Another Example Consider the following information State Probabili ABC Inc Boom 15 Normal 50 8 Slowdown 15 4 Recession 10 3 What is the expected return What is the variance What is the standard deviation Portfolios 0 A portfolio is a collection of assets 0 An asset s risk and return are important in how they affect the risk and return of the I portfolio The riskreturn tradeoff for a portfolio is measured by the portfolio expected return and standard deviation just as with individual assets Example Portfolio Weights 0 Suppose you have 15000 to invest and you have purchased securities in the following amounts What are your portfolio weights in each security 2000 of DCLK 3000 of K0 DCLK 215 133 4000 of INTC Ko 315 2 6000 of KEI INTC 415 267 KEI 615 4 Portfolio Expected Returns The expected return ofa portfolio is the weighted average of the expected returns of the respective assets in the portfolio ERP iijaej You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities run Example Expected Portfolio Returns Consider the portfolio weights computed previously Ifthe individual stocks have the following expected returns what is the expected return for the portfolio DCLK 1969 KO 525 INTC 1665 KEI 1824 ERP 1331969 2525 2671665 418241541 13m Portfolio Variance 0 Compute the portfolio return for each state RP W1R1 W2R2 mem 0 Compute the expected portfolio return using the same formula as for an individual asset 0 Compute the portfolio variance and standard deviation using the same formulas as for an individual asset 1342 Example Portfolio Variance Considerthe following information Invest 50 of your money in Asset A State Probability A B PorthIiO Boom 4 30 5 125 Bust 6 10 25 75 H 0 What are the expected return and U 39 standard deviation for each asset 0 What are the expected return and standard deviation for the portfolio 1343 Another Example 0 Considerthe following information State Probabilitv X Z Boom 25 15 10 Normal 60 10 9 Recession 15 5 10 0 What are the expected return and standard deviation for a portfolio with an investment of 6000 in asset X and 4000 in asset Z 1344 Expected vs Unexpected Returns 0 Realized returns are generally not equal to expected returns There is the expected component and the unexpected component At any point in time the unexpected return can be either positive or negative Overtime the average ofthe unexpected component is zero 1345 Announcements and News 0 Announcements and news contain both an expected component and a surprise component It is the surprise component that affects a stock s price and therefore its return This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated 1345 Efficient Markets Efficient markets are a result of investors trading on the unexpected portion of announcements 39 quot The easier it is to trade on surprises M the more efficient markets should be Efficient markets involve random price changes because we cannot predict surprises 1347 Systematic Risk 39 Risk factors that affect a large number of assets Also known as nondiversifiable risk A or market risk lt i Includes such things as changes in GDP inflation interest rates etc 1343 Unsystematic Risk 39 Risk factors that affect a limited number of assets Also known as unique risk and asset specific risk 3 39i Includes such things as labor strikes quot part shortages etc 1349 Returns Total Return expected return unexpected return Unexpected return systematic portion unsystematic portion Therefore total return can be expressed as follows Total Return expected return systematic portion unsystematic portion 1372 Diversification I 0 Portfolio diversification is the investment in several different asset classes or sectors 0 Diversification is not just holding a lot of assets 0 For example ifyou own 50 Internet stocks you are not diversified 0 However if you own 50 stocks that span 20 different industries then you are diversified 13721 Table 137 l 2 5716 76 4 2959 so a 2564 54 a 24 93 5 In As 20 se 44 so 2M1 42 4a 29 46 A2 so 211 u ma 1959 do 200 942 39 00 1M 39 400 1929 as son 1927 39 1 ooa 1911 as m gm we ham Yuma I m M 5mm Nm vay Sm mm A 0mm mm mm m Emma and mmwmw Alum zz mm man no 15304 My wan mm 1mm 2 sumw M J 5mg 39 xsk inducingquot an mm 5m An Am summ Janm al Human su Dcml ar mm up M 3737 13722 The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However there is a minimum level of risk that cannot be diversified away and that is the systematic portion 13723 Figure 131 Divamlmbla Mk 3 a Avmgn annual slandavd devialian my ID 13724 Diversifiable Risk 0 The risk that can be eliminated by combining assets into a portfolio 0 Often considered the same as unsystematic unique or assetspecific risk 0 If we hold only one asset or assets in the same industry then we are exposing ourselves to risk that we could diversify away 13725 Total Risk Total risk systematic risk unsystematic risk The standard deviation of returns is a measure of total risk For welldiversified portfolios unsystematic risk is very small Consequently the total risk for a diversified portfolio is essentially equivalent to the systematic risk 13725 Systematic Risk Principle There is a reward for bearing risk There is not a reward for bearing risk unnecessarily 5 The expected return on a risky asset depends only on that asset s systematic risk since unsystematic risk can be diversified away 13727 Table 138 saws Yahou my me 2305 rmmmma cam Hem Ooeffldent A 43 The Gun swam 5 54 ExxanMonn 114 Anemmmm a F xch ma 1 av 213 aoogwa 250 13723 Measuring Systematic Risk How do we measure systematic risk We use the beta coefficient What does beta tell us A beta of 1 implies the asset has the same systematic risk as the overall market A beta lt 1 implies the asset has less systematic riskthah the overall marke A beta gt 1 implies the asset has more systematic riskthah the overall market 13729 Total vs Systematic Risk 0 Considerthe following information Standard Deviation Beta Security C 20 125 Security K 30 095 0 Which security has more total risk 0 Which security has more systematic risk 0 Which security should have the higher expected return 1373 Work the Web Example 0 Many sites provide betas for companies 0 Yahoo Finance provides beta plus a lot of other information under its Key Statistics link Click on the web surfer to go to Yahoo Finance Enter a ticker symbol and get a basic quote Click on Key Statistics 13731 Example Portfolio Betas Consider the previous example with the following four securities Security Weight Beta DCLK 133 2685 KO 2 0195 INTC 267 2161 KEI 4 2434 o What is the portfolio beta 1332685 2195 2672161 42434 1947 43732 Beta and the Risk Premium 0 Remember that the risk premium expected return riskfree rate 0 The higher the beta the greater the risk premium should be 0 Can we define the relationship between the risk premium and beta so that we can estimate the expected return YES 13733 Example Portfolio Expected V W Returns and Betas 13734 RewardtoRisk Ratio Definition and Example The rewardtorisk ratio is the slope of the line illustrated in the previous example Slope ERA Rf BA 0 Rewardtorisk ratio for previous example 20 816 0 75 What if an asset has a rewardtorisk ratio of 8 implying that the asset plots above the line What if an asset has a rewardtorisk ratio of 7 implying that the asset plots below the line 13735 Market Equilibrium 0 In equilibrium all assets and portfolios must have the same rewardtorisk ratio and they all must equal the rewardtorisk ratio for the market ERA Rf ERM Rf A 5M 13735 Security Market Line The security market line SML is the representation of market equilibrium The slope of the SML is the rewardtorisk ratio ERM Rf BM But since the beta for the market is ALWAYS equal to one the slope can be rewritten Slope ERM Rf market risk premium 13737 The Capital Asset Pricing Model CAPM The capital asset pricing model defines the relationship between risk and return ERA Rf BAERM Rf If we know an asset s systematic risk we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets 13733 Factors Affecting Expected Return I Pure time value of money measured by the riskfree rate 3 Reward for bearing systematic risk measured by the market risk premium I Amount of systematic risk measured 5 by beta 13739 Example CAPM Consider the betas for each ofthe assets given earlier Ifthe riskfree rate is 415 and the market risk premium is 85 what is the expected return for each Security Beta Expected Return DCLK 2685 KO 0195 INTC 2161 KEI 2434 415 268585 2697 415 019585 581 415 216185 2252 415 243485 2484 1374 Figure 134 E E 3 E E E 1 E 4 MM 7 L0 Assel beta 04 rewatd 1m beanng an avmga amount av sysxemanc risk The equa an descnbing lhe SML can he wrimm Em RI MA 50M Ry which is Ina capum usiol pricing model CAPML 13741 Quick Quiz How do you compute the expected return and standard deviation for an individual asset For a portfolio What is the difference between systematic and unsystematic r39sk What type of risk is relevant for determining the expected return Consider an asset with a beta of 12 a riskfree rate of 5 and a market return of 13 What is the rewardtorisk ratio in equilibrium What is the expected return on the asset 13742 Comprehensive Problem 0 The risk free rate is 4 and the required return on the market is 12 What is the required return on an asset with a beta of 1 0 What is the rewardrisk ratio 0 What is the required return on a portfolio consisting of 40 of the asset above and the rest in an asset with an average amount of systematic risk 13743 1344 r m p a h C l 0 d n E Chapter 3 Working With Financial Statements Key Concepts and Skills Understand sources and uses of cash and the Statement of Cash Flows Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Be able to compute and interpret the Du Pont Identity Understand the problems and pitfalls in financial statement analysis Chapter Outline 39 Cash Flow and Financial Statements A Closer Look Standardized Financial Statements V i Ratio Analysis i The Du Pont Identity Using Financial Statement Information 2009 2008 2009 2008 Cash 696 58 AP 307 303 AIR 956 992 NIP 26 119 Inventory 301 361 Other CL 1662 1353 Other CA 303 264 Total CL 1995 1775 Total CA 2256 1675 LT Debt 843 1091 Net FA 3138 3358 CS 2556 2167 Total 5394 5033 Total Liab 5394 5033 Assets amp Equity Numbers in millions of dollars Sample Income Statement Revenues 5000 Cost of Goods Sold 2006 Expenses 1740 Depreciation 116 EBIT 1138 Interest Expense 7 Taxable Income 1131 Taxes 442 Net Income 689 EPS 361 Dividends per share 108 Numbers in millions of dollars except EPS amp DPS Sources and Uses Soumes Cash inflow occurs when we sell something Decrease in asset account Sample BIS Accounts receivable inventory and net xed assets Increase in liability or equi account unts payable other current liabilities and common Uses Cash out ow occurs when we buy something Increase in asset account nd other current assets Decrease in liability or equity account Notes payable and longterm debt Statement of Cash Flows 0 Statement that summarizes the sources and uses of cash 0 Changes divided into three major categories Operating Activity includes net income and changes in most current accounts Investment Activity includes changes in fixed assets Financing Activity includes changes in notes payable longterm debt and equity accounts as well as dividends Sample Statement of Cash Flows Numbers in millions of dollars Standardized Financial Statements CommonSize Balance Sheets Compute all accounts as a percent of total assets CommonSize Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information particularly as the company grows They are also useful for comparing companies of different sizes particularly within the same industry Ratio Analysis 0 Ratios allow for better comparison through time or between companies 0 As we look at each ratio ask yourself what the ratio is trying to measure and why that information is important 0 Ratios are used both internally and externally Categories of Financial Ratios 39 Shortterm solvency or liquidity ratios Longterm solvency or financial leverage ratios quot Asset management orturnover ratios 39 i Profitability ratios Market value ratios Computing Liquidity Ratios 0 Current Ratio CA CL 2256 1995 113 times Quick Ratio CA Inventory CL 2256 3011995 98 times 0 Cash Ratio Cash CL 696 1995 35 times 0 NWC to Total Assets NWC TA 2256 1995 5394 05 Interval Measure CA average daily operating costs 2256 2006 1740365 2198 days E 34 Computing Longterm Solvency Ratios Total Debt Ratio TA TE TA 5394 2556 5394 5261 DebtEquity TD TE 5394 2556 2556 111 times Equity Multiplier TATE 1 DE 1111211 Longterm debt ratio LTD LTD TE 843 843 2556 2480 Computing Coverage Ratios 39 Times Interest Earned EBIT Interest 1138 7 16257 times Depreciation Interest 1138 116 7 17914times Computing Inventory Ratios 39 Inventory Turnover Cost of Goods Sold Inventory 2006 301 666 times Inventory Turnover 365666 55 days Computing Receivables Ratios 39 Receivables Turnover Sales Accounts Receivable 5000 956 523 times Receivables Turnover 365 523 70 days Computing Total Asset Turnover 0 Total Asset Turnover Sales Total Assets 50005394 93 It is not unusual forTAT lt 1 especially if a firm has a large amount of fixed assets NWC Turnover Sales NWC 5000 2256 1995 1916 times Fixed Asset Turnover Sales NFA 50003138 159 times Computing Profitability Measures Profit Margin Net Income Sales 689 5000 1378 Return on Assets ROA Net Income Total Assets L 689 5394 1277 39f lr39 Return on Equity ROE Net IncomeTotal Equity 689 2556 2696 Computing Market Value Measures Market Price 8765 per share Shares outstanding 1909 million PE Ratio Price per share Earnings per share 8765 361 2428 times Markettobook ratio market value per share book value per share 8765 2556 1909 655 times Deriving the Du Pont Identity ROE NI TE Multiply by 1 TATA and then rearrange ROE NI TE TATA ROE NI ITA TATE ROA EM Multiply by 1 SalesSales again and then rearrange ROE NI ITA TATE Sales Sales ROE NI Sales Sales ITA TA TE ROE PM TAT EM Using the Du Pont Identity ROEPMTATEM Profit margin is a measure of the firm s operating efficiency how well it controls costs Total asset turnover is a measure of the firm s asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firm s financial leverage Expanded Du Pont Analysis Du Pont Data HMANcIALsrnEMEms run nu Dam 12mm endlna Demkr31m7 w numbr1 m m mum sumsnm Curvequot meta 39cWem hames Cam 5 1 mumps mum veceuum sea mm mama mummy u om mm in mm mm Fixed mm Tom mmw um wm Tamaleun Total hawms and Imammu 4 x I Equry Extended Du Pont Chart Why Evaluate Financial Statements 0 Internal uses Performance evaluation compensation and comparison between divisions Planning for the future guide in estimating future cash flows 0 External uses Creditors Suppliers Customers Stockholders Benchmarking Ratios are not very helpful by themselves they need to be compared to something 0 TimeTrend Analysis Used to see how the firm s performance is changing through time Internal and external uses 0 Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes a 3724 Real World Example l Ratios are figured using financial data from the 2007 Annual Report for Home Depot Compare the ratios to the industry as they are reported in Tables 311 and 312 in the book Home Depot s fiscal year ends Feb 3 Be sure to note how the ratios are computed in the table so you can compute comparable numbers Home Depot sales 77349 MM Real World Example Liquidity ratios Current ratio 115x Industry 17x Quick ratio 23x Industry 4x Longterm solvency ratio DebtEquity ratio Debt Worth 15x Industry 11x Coverage ratio Times Interest Earned 116x Industry 5x Real World Example III Asset management ratios Inventory turnover 44x Industry 38x Receivables turnover 61 4gtlt 6 days Industry 269X 14 days Total asset turnover 17x Industry 26x Profitability ratios Profit margin before taxes 86 Industry 25 ROA profit before taxes total assets 149 Industry 64 ROE Sprofit before taxes ltangible net worth 374 ndustry 119 Potential Problems There is no underlying theory so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures ie FIFO vs LIFO Different fiscal years Extraordinary events Work the Web Example 0 The Internet makes ratio analysis much easier than it has been in the past Click on the web surfer to go to wwwreuterscom Click on Stocks then choose a company and enter its ticker symbol Click on Ratios to see what information is available Quick Quiz What is the Statement of Cash Flows and how do you determine sources and uses of cash How do you standardize balance sheets and income statements and why is standardization useful What are the major categories of ratios and how do you compute specific ratios within each category What are some of the problems associated with financial statement analysis Ethics Issues Should financial analysts be held liable fortheir opinions regarding the financial health of firms How closely should ratings agencies work with the firms they are reviewing le what level of independence is appropriate Comprehensive Problem 39 XYZ Corporation has the following financial information for the previous year s quot Sales 8M PM 8 CA 2M FA 6M NWC 1 M LTD 3M 39 Compute the ROE using the DuPont Analysis r w p a h C l 0 d n E