Financial - Accounting
Financial Assignment
https://www.youtube.com/watch?v=RHSEEJDKJho
Discussion Question:
After having viewed the video clips and worked through the extended reading, please respond to the below discussion prompt. You should post your initial response by the date indicated in the module calendar. Please be sure to reference your sources in appropriate APA formatting and to provide substantive evidence of any claims that you make. Where appropriate, include personal anecdotes, statistics, and references to additional reading or materials. After you have posted your initial response, visit the forum again over the coming days to read the responses of your peers. You should respond to at least two other students by asking them to elaborate on a point, providing a counter-argument, suggesting a topic for debate, or referring back to the extended reading or video clips.
As a Financial Analyst of Morgan Investments Co., you are going to make a business investment decision on which of the two possible investments the company should undertake. Both projects cost £200,000 with a rate of return of 12\%. Below are the cash profits of the two projects:
Year
Project A
Project B
Profits (£)
1
36,000
37,300
2
42,000
40,000
3
56,000
56,000
4
44,000
51,000
5
35,000
39,650
6
32,500
42,500
7
66,000
80,000
Question one:
Using NPV and IRR methods, appraise the two projects and advise the Financial Directors which of the projects is viable and why.
Question two:
Which of the methods is superior? Justify your answer
Week 2 Assignment
https://www.youtube.com/watch?v=XF_3Dt-8OPE
https://www.youtube.com/watch?v=ji88LbVHbNA
https://www.youtube.com/watch?v=P4h4QenI-uU
I am including your week two assignment, here. This material comes from Chapter 5 & 6 of your textbook. You can turn this one completed word file into your week two assignment dropbox. Show your work right below each problem.
Problem 1.
The company treasurer has placed $1 Million excess company funds into a bank account. This account earns 2\% interest compounded yearly. The treasurer asks you to compute how much this account will grow to at the end of the fifth year (thus, the funds have five years to grow at a 2\% annual rate).
Problem 2.
The company treasurer has to make a $5 Million payment on lawsuit in seven years. The company lost the lawsuit and the lawsuit has various repercussions for the company. The in house attorney has stated that the company needs to place the funds in a separate account. The treasurer has struck a deal with the company’s brokerage group. If the company places funds in the account, the brokerage will invest the funds in an instrument that guarantees the company a 3\% annual compounded rate. The treasurer asks you to tell him how much money he needs to invest with the brokerage today so that after seven years the account will have the $5 Million in it.
Problem 3.
You are a stockbroker. You client wired $500,000 into her account five years ago. Today, five years later, your client asks you what annual return has she been earning on this brokerage account. The client has taken out no money and added no money to the account. The account has a $750,000 value today. The account has been invested in stocks and bonds and the broker has made all the investments and has made a few trades per year. Question one: what compounded annual return has the client earned? Does this seem like a reasonable return? (second part no exact answer).
Problem 4.
You (stockbroker) bought Google stock for a client on the IPO date nine years ago today at the $85 IPO price. (Thus, the client has had the stock in her account for nine years). Today, the stock trades for $910 per share. What annual return has the investor earned from holding Google stock in his account. Here, we assume the stock has not paid any dividends. Part 2: would your client be satisfied with this investment (again no exact answer here for part 2 only).
Problem 5.
Your friend realizes you have been taking a finance course. He inherited $100,000 from his great aunt. He has uses for $75,000 of the funds. However, he plans on placing $25,000 in a savings account. One bank quoted him a 2.00\% rate compounded quarterly and another bank quoted him a 1.975\% rate compounded daily.
He has heard the term: effective annual interest rate (page 146 textbook). He asks you to compute the effective interest rate for these two choices and then tell him which one to choose?
Problem 6.
A particular investments generates the following cash flows: $5 Million end of year one; $5 Million end of year two; $5 Million end of year three; $7 Million end of year four; and $10 Million end of year five. (see figure 6.4 on page 131 for an example).
What is the future value of this investment if the investor earns 9\% per year on all funds invested.
Problem 7.
A company plans on taking out real estate loan of $10 Million on its distribution center. The company will make even payments at the end of each year over ten years. At the end of ten years, the company will have paid back the loan and they will have made ten payments. The interest rate equals 4.5\%. What is the annual payment amount (see page 151).
https://www.youtube.com/watch?v=9sZdXJbK554
https://www.youtube.com/watch?v=tJLR3se4Pa4
https://www.youtube.com/watch?v=Q5DbfceUhOg
Week 3 Assignment
Hi Class, I am including five problems you can complete and turn into the week three dropbox - due this coming Sunday evening - 26 January. Turnin one file only.
Problem One. A $1,000 unit bond has a coupon rate of 4\% (interest paid yearly at $40 per year). The bond has five years left until it matures. The current market interest rate equals 5\%.
Compute the bond’s market value today. [Bond Value CH 7]
Problem Two. You can use the same fact situation as problem one. The only item that has change is current market interest rate equals 3\%. Compute the bond’s market value today. [Bond Value CH7]
Problem Three. A stock pays a $2 dividend in year zero. Investors think the dividends will grow at 3\% rate per year. This investor wishes to earn 15\% on any stock investments (required return). Compute the common stock’s current market value. [constant growth model CH 8]
Problem Four. A ten unit apartment building has an annual $60,000 cash flow (similar to dividend when looking at stocks). The investor thinks the end of year one cash flow will equal $60,000 times 1.025. The investor thinks these cash flows may grow at 2.5\% per year. The investor wants to earn a 9\% interest rate on this investment. Compute the possible apartment building value today. [constant growth model CH8]
Problem Five. A stock currently has $10 EPS. Analysts estimate EPS may grow at 20\% per year over the next five years. What is the estimated stock price in five years if an investor thinks the stock will then sell for a 10 P/E ratio?
Second Question. The stock currently trades at $200 per share. If the investor buys the stock today and sells the stock in five years (based on the price you computed above), what compounded return does the investor earn. [from the last lecture slides].
https://www.youtube.com/watch?v=JrGp4ofULzQ
https://www.youtube.com/watch?v=61Z-17enkN8
Week 4 Assignment
Below, I am including the projected cash flows for a long-term capital project. The
project has the following cash flows (negative numbers represent cash outflows and
positive numbers represent cash inflows):
•YR 0 = -$50 Million!
•YR 1 = $7 Million!
•YR 2 = $7 Million!
•YR 3 = $7 Million!
•YR 4 = $7 Million!
•YR 5 = $10 Million!
•YR 6 = $10 Million!
•YR 7 = $10 Million!
•YR 8 = $12 Million!
•YR 9 = $12 Million!
•YR 10 = $12 Million plus the company stops the projects and sells off the project for an additional $16 Million inflow. Thus, total inflows at year ten equals $28 Million.
The company wishes to earn 12\% on this project.
Compute the NPV and IRR for the above project. You can turn in an excel sheet for this
assignment. As an alternative, you can turn in a word file (if you turn in a word file
show your work). Regardless, this assignment only requires you to turn in one file.
Discussion Question:
After having viewed the video clips and worked through the extended reading, please respond to the below discussion prompt. You should post your initial response by the date indicated in the module calendar. Please be sure to reference your sources in appropriate APA formatting and to provide substantive evidence of any claims that you make. Where appropriate, include personal anecdotes, statistics, and references to additional reading or materials. After you have posted your initial response, visit the forum again over the coming days to read the responses of your peers. You should respond to at least two other students by asking them to elaborate on a point, providing a counter-argument, suggesting a topic for debate, or referring back to the extended reading or video clips.
Question one:
Company XYZ Ltd has debt with a market value of $4.4 billion and equity market value of $71.4 billion. The company pays 6\% interest on their bonds and its company shares’ beta is 1.81. Because of the range of countries and tax code regimes in which XYZ Ltd operates, the effective tax rate for the company is 13.1\%. Assuming the SML holds, the market risk premium is given as 9.5\%, and the current Treasury bill rate is 4.5\%.
What is the firm’s after-tax weighted average cost of capital (WACC)?
Question two:
Consider a project to produce solar water heaters. It requires a £10 million investment and offers a level after-tax free cash flow of £1.75 million per year for 10 years. The opportunity cost of capital is 12\%, which reflects the project’s business risk.
Suppose the project is financed with £5 million of debt and £5 million of equity. The interest rate is 8\% and the marginal tax rate is 35\%. Assume that the level of debt will be held for all of the 10 years, i.e. do not take repayment into account. Calculate the project’s APV and comment on your findings.
Week 5 Assignment
Complete all parts of problem 30 and problem 31 from Chapter 11 (page 315).
Turn in one file using excel or word.
Note: the CCA concept from Section 2.5 and Table 2.9 and Table 2.10; Chapter Two page 42.
Stephen A. Ross
Massachusetts Institute of Technology
Randolph W. Westerfield
University of Southern California
Bradford D. Jordan
University of Kentucky
Gordon S. Roberts
Schulich School of Business, York University
J. Ari Pandes
Haskayne School of Business, University of Calgary
Thomas A. Holloway
Haskayne School of Business, University of Calgary
Tenth Canadian Edition
OF CORPORATE FINANCE
FUNDAMENTALS
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Fundamentals of Corporate Finance
Tenth Canadian Edition
Copyright © 2019, 2016, 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited. Copyright © 1996,
1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this
publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system,
without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other
reprographic copying, a licence from The Canadian Copyright Licensing Agency (Access Copyright). For an Access
Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777.
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not
indicate an endorsement by the authors or McGraw-Hill Ryerson, and McGraw-Hill Ryerson does not guarantee the
accuracy of information presented at these sites.
ISBN-13: 978-1-25-965475-6
ISBN-10: 1-25-965475-3
1 2 3 4 5 6 7 8 9 0 TCP 1 2!3 4 5 6 7 8 9!
Printed and bound in Canada.
Care has been taken to trace ownership of copyright material contained in this text; however, the publisher will welcome
any information that enables it to rectify any reference or credit for subsequent editions.
Director of Product, Canada: Rhondda McNabb
Portfolio Managers:!Alwynn Pinard, Sara Braithwaite
Senior Marketing Manager: Loula March
Content Development Manager: Denise Foote
Content Developer: Tammy Mavroudi
Photo/Permissions Research: Mac/Cap Permissions
Portfolio Team Associates: Stephanie Giles,!Tatiana Sevciuc
Supervising Editor: Janie Deneau
Copy Editor: Karen Rolfe
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ross54753_fm_i-xxvi.indd 2 1/17/19 10:50 AM
ABOUT THE AUTHORS
Stephen A. Ross
Sloan School of Management, Massachusetts
Institute of Technology
Stephen A. Ross was the Franco Modigliani Professor of
Finance and Economics at the Sloan School of
Management, Massachusetts Institute of Technology. One
of the most widely published authors in finance and
economics, Professor Ross was widely recognized for his
work in developing the Arbitrage Pricing Theory and his
substantial contributions to the discipline through his
research in signalling, agency theory, option pricing, and
the theory of the term structure of interest rates, among
other topics. A past president of the American Finance
Association, he also served as an associate editor of
several academic and practitioner journals. He was a
trustee of CalTech. Stephen passed away in March 2017.
Randolph W. Westerfield
Marshall School of Business, University of
Southern California
Randolph W. Westerfield is Dean Emeritus and the
Charles B. Thornton Professor!Emeritus in Finance of the
University of Southern California’s Marshall School of
Business. Professor Westerfield came to USC from the
Wharton School, University of Pennsylvania, where he
was the chairman of the finance department and a member
of the finance faculty for 20 years. He is a member of the
board of trustees of Oaktree Capital mutual funds. His
areas of expertise include corporate financial policy,
investment management, and stock market price behaviour.
Bradford D. Jordan
Gatton College of Business and Economics,
University of Kentucky
Bradford D. Jordan is professor of finance and holder of
the Richard W. and Janis H. Furst Endowed Chair in
Finance at the University of Kentucky. He has a long-
standing interest in both applied and theoretical issues in
corporate finance and has extensive experience teaching
all levels of corporate finance and financial management
policy. Professor Jordan has published numerous articles
on issues such as cost of capital, capital structure, and the
behaviour of security prices. He is a past president of the
Southern Finance Association, and he is co-author of
Fundamentals of Investments: Valuation and
Management,!8th edition, a leading investments text, also
published by McGraw-Hill Education.
Gordon S. Roberts
Schulich School of Business, York University
Gordon S. Roberts was a Canadian Imperial Bank of
Commerce Professor of Financial Services at the Schulich
School of Business, York University. His extensive
teaching experience included finance classes for
undergraduate and MBA students, executives, and bankers
in Canada and internationally. Professor Roberts
conducted research on the pricing of bank loans and the
regulation of financial institutions. He served on the
editorial boards of several Canadian and international
academic journals. Professor Roberts was a consultant to a
number of regulatory bodies responsible for the oversight
of financial institutions and utilities.! Gordon retired in
2016 and passed away in March 2017.
J. Ari Pandes
Haskayne School of Business, University of Calgary
J. Ari Pandes is an Associate Professor of Finance at the
University of Calgary’s!Haskayne School of Business. At
Haskayne, he teaches courses at the PhD, Executive MBA,
MBA, and senior undergraduate levels. He also teaches
courses to corporate executives. Professor Pandes conducts
research on the capital markets, which he has presented at
conferences and universities internationally, as well as to
policymakers, including the U.S. Securities and Exchange
Commission and the Bank of Canada. In addition,
Professor Pandes’ research has been cited in the press, and
he frequently provides financial and economic insights to
various media outlets.
Thomas A. Holloway
Haskayne School of Business, University of Calgary
Thomas Holloway is a full-time faculty member at
Haskayne and co-founder of hybrid wealth management
startup Responsive AI. At Haskayne, he is the faculty
supervisor of the student-managed investment fund
Calgary Portfolio Management Trust and teaches courses
in corporate finance and corporate governance.
Mr. Holloway was formerly a fixed income analyst for one
of Canada’s leading independent institutional investment
managers and is a member of Calgary CFA Society.
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IN MEMORIAM
We at McGraw-Hill Education Canada lost one of our
most esteemed authors with the passing of Gordon S.
Roberts in March 2017. Gordon was a Professor Emeritus
of Finance at the Schulich School of Business at York
University and a McGraw-Hill author for many years.
Gordon S. Roberts will be remembered as an extremely
creative and thoughtful scholar with a rigorous approach
to questions of great importance. His contributions to the
field of finance are unquestioned and are reflected in his
outst anding inter national reput ation, research
contributions, and many awards and honours. In particular,
Gordon will be remembered for making significant
contributions to the current textbook. His expertise and
rigorous approach were key to making this textbook
exciting, accurate, fair, well paced, and immediately
useful.
Prior to development work on this 10th Canadian edition
text, our own Portfolio Manager, Alwynn Pinard, had the
pleasure of working closely with Gordon. Of him she says,
“Gordon’s professionalism, adherence to deadlines, and
commitment to quality were all attributes that endeared
him to us here at McGraw-Hill Education and created the
Canadian resource you are reading today. Thank you,
Gordon. We will miss your dedication to your work and
your students and, perhaps most of all, your warmth
and wit.”
On behalf of the entire staff here at McGraw-Hill
Education who had the pleasure of working with Gordon
personally, or the pleasure of working on all the legacy
projects he helped to build, we offer our deepest
sympathies to Gordon’s wife, Sonita, and his family.
Gordon’s contributions to learning will be treasured and
never forgotten.
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BRIEF CONTENTS
Preface xvii
PART 1
Overview of Corporate Finance 1
1 Introduction to Corporate Finance 1
2 Financial Statements, Cash Flow, and Taxes 30
PART 2
Financial Statements and Long-Term
Financial Planning 69
3 Working with Financial Statements 69
4 Long-Term Financial Planning and
Corporate Growth 110
PART 3
Valuation of Future Cash Flows 146
5 Introduction to Valuation: The Time
Value of Money 146
6 Discounted Cash Flow Valuation 170
7 Interest Rates and Bond Valuation 221
8 Stock Valuation 263
PART 4
Capital Budgeting 296
9 Net Present Value and Other
Investment Criteria 296
10 Making Capital Investment Decisions 339
11 Project Analysis and Evaluation 393
PART 5
Risk and Return 431
12 Lessons from Capital Market History 431
13 Return, Risk, and the Security Market Line 467
PART 6
Cost of Capital and Long-Term
Financial Policy 521
14 Cost of Capital 521
15 Raising Capital 575
16 Financial Leverage and Capital
Structure Policy 617
17 Dividends and Dividend Policy 667
PART 7
Short-Term Financial Planning and
Management 705
18 Short-Term Finance and Planning
19 Cash and Liquidity Management 753
20 Credit and Inventory Management 779
PART 8
Topics in Corporate Finance 822
21 International Corporate Finance 822
22 Leasing 859
23 Mergers and Acquisitions 887
PART 9
Derivative Securities and Corporate
Finance 928
24 Enterprise Risk Management 928
25 Options and Corporate Securities 962
26 Behavioural Finance: Implications for
Financial Management 1012
Glossary GL-1
Appendix A: Mathematical Tables
(Available on Connect)
Appendix B: Answers to Selected End-of-Chapter
Problems (Available on Connect)
Subject Index IN-1
Equation Index IN-22
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CONTENTS
Preface xvii
PART 1
Overview of Corporate Finance 1
CHAPTER 1
Introduction to Corporate Finance 1
1.1 Corporate Finance and the Financial
Manager 2
What Is Corporate Finance? 2
The Financial Manager 2
Financial Management Decisions 3
1.2 Forms of Business Organization 5
Sole Proprietorship 5
Partnership 6
Corporation 6
Income Trust 8
Co-operative (Co-op) 8
1.3 The Goal of Financial Management 9
Possible Goals 9
The Goal of Financial Management 10
A More General Goal 11
1.4 The Agency Problem and Control of the
Corporation 12
Agency Relationships 12
Management Goals 12
Do Managers Act in the Shareholders’
Interests? 13
Corporate Social Responsibility and Ethical
Investing 14
1.5 Financial Markets and the Corporation 17
Cash Flows to and from the Firm 17
Money versus Capital Markets 18
Primary versus Secondary Markets 18
1.6 Financial Institutions 20
1.7 Trends in Financial Markets and Financial
Management 23
1.8 Outline of the Text 25
Summary and Conclusions 26
CHAPTER 2
Financial Statements, Cash Flow,
and Taxes 30
2.1 Statement of Financial Position 31
Assets 31
Liabilities and Owners’ Equity 32
Net Working Capital 32
Liquidity 34
Debt versus Equity 34
Value versus Cost 34
2.2 Statement of Comprehensive Income 36
International Financial Reporting
Standards (IFRS) 37
Non-Cash Items 38
Time and Costs 38
2.3 Cash Flow 39
Cash Flow from Assets 39
Cash Flow to Creditors and Shareholders 41
2.4 Taxes 45
Individual Tax Rates 46
Average versus Marginal Tax Rates 46
Taxes on Investment Income 46
Corporate Taxes 49
Taxable Income 51
Global Tax Rates 52
Capital Gains and Carry-Forward
and Carry-Back 52
2.5 Capital Cost Allowance 53
Asset Purchases and Sales 54
Summary and Conclusions 58
PART 2
Financial Statements and
Long-Term Financial Planning 69
CHAPTER 3
Working with Financial Statements 69
3.1 Cash Flow and Financial Statements:
A Closer Look 70
Sources and Uses of Cash 70
Statement of Cash Flows 72
3.2 Standardized Financial Statements 74
Common-Size Statements 74
Common–Base Year Financial Statements:
Trend Analysis 76
3.3 Ratio Analysis 78
Short-Term Solvency or Liquidity Measures 79
Other Liquidity Ratios 81
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Contents
vii
Long-Term Solvency Measures 82
Asset Management, or Turnover, Measures 84
Profitability Measures 86
Market Value Measures 87
3.4 The DuPont Identity 90
3.5 Using Financial Statement Information 93
Why Evaluate Financial Statements? 93
Choosing a Benchmark 94
Problems with Financial Statement Analysis 95
Summary and Conclusions 96
CHAPTER 4
Long-Term Financial Planning and
Corporate Growth 110
4.1 What Is Financial Planning? 111
Growth as a Financial Management Goal 112
Dimensions of Financial Planning 112
What Can Planning Accomplish? 113
4.2 Financial Planning Models: A First Look 114
A Financial Planning Model: The Ingredients 115
A Simple Financial Planning Model 116
4.3 The Percentage of Sales Approach 118
An Illustration of the Percentage of
Sales Approach 118
4.4 External Financing and Growth 124
External Financing Needed and Growth 124
Internal Growth Rate 127
Financial Policy and Growth 128
Determinants of Growth 130
A Note on Sustainable Growth Rate
Calculations 131
4.5 Some Caveats on Financial Planning Models 133
Summary and Conclusions 133
Appendix 4A: A Financial Planning Model For the
Hoffman Company (Available on
Connect)
Appendix 4B: Derivation of the Sustainable Growth
Formula (Available on Connect)
PART 3
Valuation of Future Cash Flows 146
CHAPTER 5
Introduction to Valuation: The Time
Value of Money 146
5.1 Future Value and Compounding 147
Investing for a Single Period 147
Investing for More than One Period 147
A Note on Compound Growth 153
5.2 Present Value and Discounting 154
The Single-Period Case 154
Present Values for Multiple Periods 155
5.3 More on Present and
Future Values 157
Present versus Future Value 157
Determining the Discount Rate 158
Finding the Number of Periods 161
Summary and Conclusions 163
CHAPTER 6
Discounted Cash Flow Valuation 170
6.1 Future and Present Values of Multiple
Cash Flows 171
Future Value with Multiple Cash
Flows 171
Present Value with Multiple Cash Flows 173
A Note on Cash Flow Timing 176
6.2 Valuing Annuities and Perpetuities 178
Present Value for Annuity Cash Flows 178
Future Value for Annuities 183
A Note on Annuities Due 185
Perpetuities 185
Growing Perpetuities 187
Formula for Present Value of Growing
Perpetuity 188
Growing Annuity 189
Formula for Present Value of Growing
Annuity 189
6.3 Comparing Rates: The Effect of
Compounding 190
Effective Annual Rates and Compounding 190
Calculating and Comparing Effective
Annual Rates 191
Mortgages 193
EARs and APRs 194
Taking It to the Limit: A Note on Continuous
Compounding 195
6.4 Loan Types and Loan Amortization 196
Pure Discount Loans 196
Interest-Only Loans 196
Amortized Loans 197
Summary and Conclusions 201
Appendix 6A: Proof of Annuity Present Value
Formula 219
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Contents
viii
CHAPTER 7
Interest Rates and Bond Valuation 221
7.1 Bonds and Bond Valuation 222
Bond Features and Prices 222
Bond Values and Yields 223
Interest Rate Risk 226
Finding the Yield to Maturity 228
7.2 More on Bond Features 231
Is It Debt or Equity? 231
Long-Term Debt: The Basics 231
The Indenture 232
7.3 Bond Ratings 235
7.4 Some Different Types of Bonds 237
Financial Engineering 237
Stripped Bonds 239
Floating-Rate Bonds 240
Other Types of Bonds 240
7.5 Bond Markets 242
How Bonds Are Bought and Sold 242
Bond Price Reporting 242
A Note on Bond Price Quotes 244
Bond Funds 244
Bonds and Restructuring 244
7.6 Inflation and Interest Rates 245
Real versus Nominal Rates 245
The Fisher Effect 246
Inflation and Present Values 247
7.7 Determinants of Bond Yields 248
The Term Structure of Interest Rates 248
Bond Yields and the Yield Curve: Putting
It All Together 249
Conclusion 251
Summary and Conclusions 252
Appendix 7A: Managing Interest Rate Risk 260
Appendix 7B: Callable Bonds and Bond Refunding
(available on Connect)
CHAPTER 8
Stock Valuation 263
8.1 Common Stock Valuation 264
Common Stock Cash Flows 264
Common Stock Valuation: Some Special
Cases 265
Changing the Growth Rate 271
Components of the Required Return 272
8.2 Common Stock Features 274
Shareholders’ Rights 274
Dividends 275
Classes of Stock 276
8.3 Preferred Stock Features 277
Stated Value 277
Cumulative and Non-Cumulative Dividends 278
Is Preferred Stock Really Debt? 278
Preferred Stock and Taxes 279
Beyond Taxes 280
8.4 Stock Market Reporting 281
Growth Opportunities 282
Application: The Price–Earnings Ratio 282
Summary and Conclusions 284
Appendix 8A: Corporate Voting 293
PART 4
Capital Budgeting 296
CHAPTER 9
Net Present Value and Other
Investment Criteria 296
9.1 Net Present Value 297
The Basic Idea 297
Estimating Net Present Value 298
9.2 The Payback Rule 302
Defining the Rule 302
Analyzing the Payback Period Rule 303
Redeeming Qualities 304
Summary of the Rule 304
The Discounted Payback Rule 305
9.3 The Average Accounting Return 306
Analyzing the Average Accounting Return
Method 308
9.4 The Internal Rate of Return 308
Problems with the IRR 313
Redeeming Qualities of the IRR 318
9.5 The Profitability Index 319
9.6 The Practice of Capital Budgeting 320
9.7 Capital Rationing 323
Summary and Conclusions 324
Appendix 9A: The Modified Internal Rate of Return 336
CHAPTER 10
Making Capital Investment
Decisions 339
10.1 Project Cash Flows: A!First!Look 340
Relevant Cash Flows 340
The Stand-Alone Principle 340
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Contents
ix
10.2 Incremental Cash Flows 341
Sunk Costs 341
Opportunity Costs 341
Side Effects 342
Net Working Capital 343
Financing Costs 343
Inflation 343
Capital Budgeting and Business Taxes
in Canada 344
Other Issues 344
10.3 Pro Forma Financial Statements and
Project Cash Flows 344
Getting Started: Pro Forma Financial
Statements 344
Project Cash Flows 346
Project Total Cash Flow and Value 347
10.4 More on Project Cash Flow 348
A Closer Look at Net Working Capital 348
Depreciation and Capital Cost
Allowance 350
An Example: The Majestic Mulch
and Compost Company (MMCC) 350
10.5 Alternative Definitions of!Operating
Cash Flow 354
The Bottom-up Approach 355
The Top-down Approach 356
The Tax Shield Approach 356
Conclusion 357
10.6 Applying the Tax Shield Approach to the
Majestic Mulch and Compost Company
Project 357
Present Value of the Tax Shield
on CCA 359
Salvage Value versus UCC 359
10.7 Some Special Cases of Discounted
Cash Flow Analysis 361
Evaluating Cost-Cutting Proposals 361
Replacing an Asset 363
Evaluating Equipment with Different
Lives 366
Setting the Bid Price 368
Summary and Conclusions 370
Appendix 10A: More on Inflation and Capital
Budgeting 388
Appendix 10B: Capital Budgeting with
Spreadsheets 389
Appendix 10C: Deriving the Tax Shield on CCA!
Formula 391
CHAPTER 11
Project Analysis and Evaluation 393
11.1 Evaluating NPV Estimates 394
The Basic Problem 394
Projected versus Actual Cash Flows 394
Forecasting Risk 395
Sources of Value 395
11.2 Scenario and Other What-If Analyses 396
Getting Started 396
Scenario Analysis 397
Sensitivity Analysis 400
Simulation Analysis 401
11.3 Break-Even Analysis 403
Fixed and Variable Costs 403
Accounting Break-Even 405
Accounting Break-Even: A Closer Look 407
Uses for the Accounting Break-Even 407
11.4 Operating Cash Flow, Sales Volume, and
Break-Even 408
Accounting Break-Even and Cash Flow 408
Cash Flow and Financial Break-Even
Points 410
11.5 Operating Leverage 413
The Basic Idea 414
Implications of Operating Leverage 414
Measuring Operating Leverage 414
Operating Leverage and Break-Even 416
11.6 Managerial Options 417
Summary and Conclusions 420
PART 5
Risk and Return 431
CHAPTER 12
Lessons from Capital Market
History 431
12.1 Returns 432
Dollar Returns 432
Percentage Returns 434
12.2 The Historical Record 436
A First Look 439
A Closer Look 440
12.3 Average Returns: The First Lesson 440
Calculating Average Returns 441
Average Returns: The Historical Record 441
Risk Premiums 442
The First Lesson 442
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12.4 The Variability of Returns: The Second
Lesson 443
Frequency Distributions and Variability 443
The Historical Variance and Standard
Deviation 444
The Historical Record 446
Normal Distribution 446
Value at Risk 447
The Second Lesson 449
2008: The Bear Growled and Investors
Howled 449
Using Capital Market History 449
12.5 More on Average Returns 451
Arithmetic versus Geometric Averages 451
Calculating Geometric Average Returns 451
Arithmetic Average Return or Geometric
Average Return? 453
12.6 Capital Market Efficiency 454
Price Behaviour in an Efficient Market 454
The Efficient Markets Hypothesis 455
Market Efficiency—Forms and Evidence 457
Summary and Conclusions 459
CHAPTER 13
Return, Risk, and the Security
Market Line 467
13.1 Expected Returns and Variances 468
Expected Return 468
Calculating the Variance 470
13.2 Portfolios 472
Portfolio Weights 472
Portfolio Expected Returns 473
Portfolio Variance 474
Portfolio Standard Deviation and
Diversification 475
The Efficient Set 478
Correlations in the Financial Crisis of
2007–2009 481
13.3 Announcements, Surprises, and Expected
Returns 481
Expected and Unexpected Returns 482
Announcements and News 482
13.4 Risk: Systematic and Unsystematic 483
Systematic and Unsystematic Risk 484
Systematic and Unsystematic Components of
Return 484
13.5 Diversification and Portfolio Risk 485
The Effect of Diversification: Another
Lesson from Market History 485
The Principle of Diversification 486
Diversification and Unsystematic Risk 487
Diversification and Systematic Risk 488
Risk and the Sensible Investor 488
13.6 Systematic Risk and Beta 490
The Systematic Risk Principle 490
Measuring Systematic Risk 490
Portfolio Betas 491
13.7 The Security Market Line 493
Beta and the Risk Premium 493
Calculating Beta 498
The Security Market Line 501
13.8 Arbitrage Pricing Theory and Empirical
Models 505
Summary and Conclusions 507
Appendix 13A: Derivation of the Capital Asset
Pricing Model 518
PART 6
Cost of Capital and Long-Term
Financial Policy 521
CHAPTER!14
Cost of Capital 521
14.1 The Cost of Capital: Some Preliminaries 522
Required Return versus Cost of Capital 522
Financial Policy and Cost of Capital 523
14.2 The Cost of Equity 523
The Dividend Growth Model Approach 523
The SML Approach 526
The Cost of Equity in Rate Hearings 527
14.3 The Costs of Debt and Preferred Stock 529
The Cost of Debt 529
The Cost of Preferred Stock 529
14.4 The Weighted Average Cost of Capital 530
The Capital Structure Weights 531
Taxes and the Weighted Average Cost
of Capital 531
Solving the Warehouse Problem and
Similar Capital Budgeting Problems 533
Performance Evaluation: Another Use
of the WACC 535
14.5 Divisional and Project Costs of Capital 535
The SML and the WACC 536
Divisional Cost of Capital 538
The Pure Play Approach 538
The Subjective Approach 539
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14.6 Company Valuation with the WACC 540
14.7 Flotation Costs and the Weighted
Average Cost of Capital 543
The Basic Approach 543
Flotation Costs and NPV 544
Internal Equity and Flotation Costs 545
14.8 Calculating WACC for Loblaw 547
Estimating Financing Proportions 547
Market Value Weights for Loblaw 547
Cost of Debt 548
Cost of Preferred Shares 549
Cost of Common Stock 550
CAPM 550
Dividend Valuation Model Growth Rate 551
Loblaw’s WACC 551
Summary and Conclusions 552
Appendix 14A: Adjusted Present Value 564
Appendix 14B: Economic Value Added and the
Measurement of Financial
Performance 570
CHAPTER 15
Raising Capital 575
15.1 The Financing Life Cycle of a Firm:
Early-Stage Financing and Venture
Capital 576
Venture Capital 576
Some Venture Capital Realities 577
Choosing a Venture Capitalist 577
Conclusion 578
15.2 The Public Issue 578
15.3 The Basic Procedure for a New Issue 579
Securities Registration 580
Exempt Securities and Crowdfunding 580
Alternative Issue Methods 581
15.4 The Cash Offer 582
Types of Underwriting 583
Bought Deal 583
Dutch Auction Underwriting 583
The Selling Period 584
The Overallotment Option 585
Lockup Agreements 585
The Quiet Periods 585
The Investment Dealers 586
15.5 IPOs and Underpricing 587
IPO Underpricing: The 1999–2000
Experience 587
Evidence on Underpricing 587
Why Does Underpricing Exist? 589
15.6 New Equity Sales and the Value of
the Firm 592
15.7 The Cost of Issuing Securities 594
IPOs in Practice: The Case of Seven
Generations Energy 596
15.8 Rights 597
The Mechanics of a Rights Offering 597
Number of Rights Needed to Purchase
a Share 598
The Value of a Right 599
Theoretical Value of a Right 601
Ex Rights 601
Value of Rights after Ex-Rights Date 602
The Underwriting Arrangements 602
Effects on Shareholders 603
Cost of Rights Offerings 604
15.9 Dilution 605
Dilution of Proportionate Ownership 605
Dilution of Value: Book versus Market
Values 605
15.10 Issuing Long-Term Debt 607
Summary and Conclusions 609
CHAPTER 16
Financial Leverage and Capital
Structure Policy 617
16.1 The Capital Structure Question 618
Firm Value and Stock Value: An Example 618
Capital Structure and the Cost of Capital 620
16.2 The Effect of Financial Leverage 620
The Basics of Financial Leverage 620
Corporate Borrowing and Homemade
Leverage 625
16.3 Capital Structure and the Cost of Equity
Capital 627
M&M Proposition I: The Pie Model 627
The Cost of Equity and Financial Leverage:
M&M Proposition II 628
Business and Financial Risk 629
16.4 M&M Propositions I and II with Corporate
Taxes 632
The Interest Tax Shield 633
Taxes and M&M Proposition I 633
Taxes, the WACC, and Proposition II 635
16.5 Bankruptcy Costs 637
Direct Bankruptcy Costs 638
Indirect Bankruptcy Costs 638
Agency Costs of Equity 639
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16.6 Optimal Capital Structure 640
The Static Theory of Capital Structure 640
Optimal Capital Structure and the Cost of
Capital 641
Optimal Capital Structure: A Recap 642
Capital Structure: Some Managerial
Recommendations 644
16.7 The Pie Again 645
The Extended Pie Model 645
Marketed Claims versus Non-Marketed
Claims 646
16.8 The Pecking-Order Theory 647
Internal Financing and the Pecking
Order 647
Implications of the Pecking Order 647
16.9 Observed Capital Structures 648
16.10 Long-Term Financing under Financial Distress
and Bankruptcy 650
Liquidation and Reorganization 650
Agreements to Avoid Bankruptcy 652
Summary and Conclusions 653
Appendix 16A: Capital Structure and Personal
Taxes 663
Appendix 16B: Derivation of Proposition II
(Equation 16.4) 666
CHAPTER 17
Dividends and Dividend Policy 667
17.1 Cash Dividends and Dividend Payment 668
Cash Dividends 669
Standard Method of Cash Dividend
Payment 669
Dividend Payment: A Chronology 669
More on the Ex-Dividend Date 670
17.2 Does Dividend Policy Matter? 672
An Illustration of the Irrelevance of
Dividend Policy 672
17.3 Real-World Factors Favouring a Low Payout 674
Taxes 675
Some Evidence on Dividends and Taxes in
Canada 677
Flotation Costs 677
Dividend Restrictions 678
17.4 Real-World Factors Favouring a High Payout 678
Desire for Current Income 678
Uncertainty Resolution 679
Tax and Legal Benefits from High Dividends 679
Conclusion 680
17.5 A Resolution of Real-World Factors? 680
Information Content of Dividends 680
Dividend Signalling in Practice 681
The Clientele Effect 682
17.6 Establishing a Dividend Policy 683
Residual Dividend Approach 684
Dividend Stability 687
A Compromise Dividend Policy 688
Some Survey Evidence on Dividends 688
17.7 Stock Repurchase: An Alternative to Cash
Dividends 690
Cash Dividends versus Repurchase 691
Real-World Considerations in a Repurchase 692
Share Repurchase and EPS 692
17.8 Stock Dividends and Stock Splits 693
Some Details on Stock Splits and Stock
Dividends 693
Value of Stock Splits and Stock Dividends 694
Reverse Splits 695
Summary and Conclusions 696
PART 7
Short-Term Financial Planning
and Management 705
CHAPTER 18
Short-Term Finance and Planning 705
18.1 Tracing Cash and Net Working Capital 706
18.2 The Operating Cycle and the Cash
Cycle 708
Defining the Operating and Cash Cycles 709
Calculating the Operating and Cash
Cycles 711
Interpreting the Cash Cycle 714
18.3 Some Aspects of Short-Term Financial Policy 715
The Size of the Firm’s Investment in Current
Assets 716
Alternative Financing Policies for Current
Assets 717
Which Financing Policy Is Best? 721
Current Assets and Liabilities in Practice 722
18.4 The Cash Budget 724
Sales and Cash Collections 724
Cash Outflows 725
The Cash Balance 726
18.5 A Short-Term Financial Plan 727
Short-Term Planning and Risk 728
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18.6 Short-Term Borrowing 729
Operating Loans 729
Letters of Credit 731
Secured Loans 731
Factoring 733
Securitized Receivables—A Financial
…
Interest Rates and Bond Valuation
Class 3
Michele Vincenti, Phd, MBA, CIM, FCSI, STI, CFP, CMC
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
7.‹#›
Chapter Outline
Bonds and Bond Valuation
More on Bond Features
Bond Ratings
Some Different Types of Bonds
Bond Markets
Inflation and Interest Rates
Determinants of Bond Yields
7.‹#›
Bond Definitions 7.1
Bond
Par value (face value)
Coupon rate
Coupon payment
Maturity date
Yield or Yield to maturity
7.‹#›
Introduction
When a corporation or government wishes to borrow money from the public on a long term basis, it usually does so by issuing or selling debt securities called bonds.
In this section we discuss the cash flows associated with a bond and how bonds can be valued using the discounted cash flow method.
7.‹#›
Bond Definitions 7.1
Bond: is normally an interest only loan, meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan.
Par value (face value): Is the principal amount of a bond that is repaid at the end of the term.
Coupon rate: the annual coupon divided by the face value of a bond. Or the return on an investment in bond for the lender or bond buyer.
Maturity date: is the specified date at which the principal amount is paid.
7.‹#›
Yield to Maturity
Yield or Yield to maturity: is the total return anticipated on a bond if the bond is held until it matures. It is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal.
As time passes, interest rates change in the market place, the coupon rate and maturity date are specified when it was issued and so are fixed.
For an already issued bond instrument, to determine its value we need to know the number of periods remaining until maturity, the face value, the coupon and the market interest rate for bonds with similar features.
By trying to value an already issue bond, we are calculating the bond yield.
7.‹#›
Present Value of Cash Flows as Rates Change
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lump sum
Remember, as interest rates increase the PV’s decrease
So, as interest rates increase, bond prices decrease and vice versa.
Remember PV of annuity is;
PV of lumpsum is;
7.‹#›
Bond Pricing Equation
7.‹#›
Valuing a Discount Bond with Annual Coupons
Consider a bond with a coupon rate of 10\% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11\%. What is the value of the bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
B = 369.59 + 593.45 = 963.04
Using the calculator:
N = 5; I/Y = 11; PMT = 100; FV = 1000
CPT PV = -963.04
7.‹#›
6.8
Remember the sign convention on the calculator. The easy way to remember it with bonds is we pay the PV (-) so that we can receive the PMT (+) and the FV(+).
Slide 6.8 discusses why this bond sells at less than par
Valuing a Premium Bond with Annual Coupons
Suppose you are looking at a bond that has a 10\% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8\%. What is the price of this bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
B = 981.81 + 214.55 = 1196.36
Using the calculator:
N = 20; I/Y = 8; PMT = 100; FV = 1000
CPT PV = -1196.36
7.‹#›
Class Practice
Malahat Inc. has 7.5\% coupon bonds on the market that have ten years to maturity with a face value of $1000. The bonds make annual payments. If the Yield to maturity on these bonds is 8.75\%, what is the current bond price?
7.‹#›
Solution
The price of any bond is the PV of the interest payment, plus the PV of the par value. Notice this problem assumes an annual coupon. The price of the bond will be:
P = $75({1 – [1/(1 + .0875)10 ] } / .0875) + $1,000[1 / (1 + .0875)10] = $918.89
Using the calculator:
N = 10; I/Y = 8.75; PMT = 75; FV = 1000
CPT PV = -918.89
7.‹#›
Example – Semiannual Coupons
Most bonds in Canada make coupon payments semiannually.
Suppose you have a 8\% semiannual-pay bond with a face value of $1,000 that matures in 7 years. If the yield is 10\%, what is the price of this bond?
The bondholder receives a payment of $40 every six months (a total of $80 per year)
The market automatically assumes that the yield is compounded semiannually
The number of semiannual periods is 14
Or PMT = 40; N = 14; I/Y = 5; FV = 1000; CPT PV = -901.01
7.‹#›
Calculating Coupon Rate
Provided we have the face value, the present value, YTM, we can calculate the coupon rate using the bond pricing formula. Remember
7.‹#›
Calculating Coupon Rate
Goldstream enterprises has bonds on the market making annual payments, with nine years to maturity and selling for $948 with face value of $1000. At this price, the bonds yield is 5.9\%. What must be the coupon rate on the bond?
7.‹#›
Calculating Coupon Rate
7.‹#›
Find the Yield to Maturity
Yield-to-maturity is the rate implied by the current bond price
Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity
If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)
7.‹#›
Find the Yield to Maturity
Consider a bond with a 10\% annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $928.09.
Will the yield be more or less than 10\%?
N = 15; PV = -928.09; FV = 1000; PMT = 100
CPT I/Y = 11\%
7.‹#›
Finding Yield to Maturity
Suppose a bond with a 10\% coupon rate and semiannual coupons has a face value of $1000, 20 years to maturity and is selling for $1197.93.
Is the YTM more or less than 10\%?
What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT I/Y = 4\% (Is this the YTM?)
YTM = 4\%*2 = 8\%
7.‹#›
Class Practice
Leechtown Co. has 4.3\% coupon bonds on the market with face value $1000 and 18 years to maturity. The bonds make annual payments. If the bond currently sells for $870, what is the yield to maturity?
7.‹#›
Solution
PMT=43
FV = 1000
PV = -870
N = 18
P/YR = 1
I/Y = 5.452
7.‹#›
Bond Prices: Relationship Between Coupon
and Yield
If YTM = coupon rate, then par value = bond price in the secondary market
If YTM > coupon rate, then par value > bond price in the secondary market.
Selling at a discount, called a discount bond
If YTM < coupon rate, then par value < bond price in the secondary market.
Selling at a premium, called a premium bond
7.‹#›
Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Reinvestment Rate Risk
Uncertainty concerning the interest rates at which cash flows can be reinvested
Short-term bonds have more reinvestment rate risk than long-term bonds
7.‹#›
Differences Between Debt and Equity 7.2
Debt
Not an ownership interest
Bondholders do not have voting rights
Interest is considered a cost of doing business and is tax deductible
Bondholders have legal recourse if interest or principal payments are missed
Excess debt can lead to financial distress and bankruptcy
Equity
Ownership interest
Common shareholders vote for the board of directors and other issues
Dividends are not considered a cost of doing business and are not tax deductible
Dividends are not a liability of the firm and shareholders have no legal recourse if dividends are not paid
An all equity firm can not go bankrupt
7.‹#›
Bonds Classification
Security: debt securities are classified according to the collateral and mortgages used to protect the bondholder.
Collateral – secured by financial securities
Mortgage – secured by real property, normally land or buildings
Debentures – unsecured debt with original maturity of 10 years or more
Notes – unsecured debt with original maturity less than 10 years
Seniority: indicates preference in position over other lenders when making claims against the assets of the borrower.
7.‹#›
Bond Classification
Call premium: amount by which the call price exceeds the par value of the bond
Deferred call: Call provision prohibiting the company from redeeming the bond before certain date.
Call protected: Bond during period in which it cannot be redeemed by the issuer
Canada plus call: Call provision that compensates bond investors for interest differential, making it unattractive for an issuer to call a bond.
Negative covenants: it is a “thou shall not” covenant. It limits or prohibits actions that the company or borrower may take.
Positive covenants: “is a thou shall”. It specifies an action that the firm agrees to take or conditions the firm must abide by.
7.‹#›
Bond Characteristics and Required Returns
The coupon rate depends on the risk characteristics of the bond when issued
Which bonds will have the higher coupon, all else equal?
Secured debt versus a debenture
(secured debt is less risky because the income from the security is used to pay it off first)
Subordinated debenture (will be paid after the senior debt) versus senior debt
(subordinate will have higher coupon rate)
A bond with a sinking fund versus one without
(bonds without a sinking fund will have a higher coupon rate)
A callable bond versus a non-callable bond
(callable bonds will have a higher coupon rate)
7.‹#›
6.26
Debenture: secured debt is less risky because the income from the security is used to pay it off first
Subordinated debenture: will be paid after the senior debt
Bond without sinking fund: company has to come up with substantial cash at maturity to retire debt and this is riskier than systematic retirement of debt through time
Callable – bondholders bear the risk of the bond being called early, usually when rates are lower. They don’t receive all of the expected coupons and they have to reinvest at lower rates.
Bond Ratings – Investment Quality 7.3
High Grade
DBRS’s AAA – capacity to pay is exceptionally strong
DBRS’s AA – capacity to pay is very strong
Medium Grade
DBRS’s A – capacity to pay is strong, but more susceptible to changes in circumstances
DBRS’s BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay
7.‹#›
Bond Ratings - Speculative
Low Grade
DBRS’s BB, B, CCC, CC
Considered speculative with respect to capacity to pay.
Very Low Grade
DBRS’s C – bonds are in immediate danger of default
DBRS’s D – in default, with principal and/or interest in arrears
7.‹#›
6.28
It is a good exercise to ask students which bonds will have the highest yield-to-maturity (lowest price) all else equal.
Stripped or Zero-Coupon Bonds 7.4
Make no periodic interest payments (coupon rate = 0\%)
The entire yield-to-maturity comes from the difference between the purchase price and the par value
Cannot sell for more than par value
Sometimes called zeroes, or deep discount bonds
Bondholder must pay taxes on accrued interest every year, even though no interest is received
7.‹#›
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Stock Valuation
Class 4
Oludamola Durodola, PhD, Mcom, Bcom, Bsc, CSC,
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
8.‹#›
.
Chapter 8 Outline
Common Stock Valuation
Common Stock Features
Preferred Stock Features
Stock Market Reporting
8.‹#›
.
Introduction
In the previous chapter we examined bonds and bond valuation, in this chapter we turn to the other major source of financing for corporations: common and preferred shares or stocks.
We will examine cash flows associated with a share of stock and then examine the dividend discount model (DDM).
We will also examine the various important features of common and preferred stock with emphasis on shareholder’s right.
We close out by discussing how shares of stock are traded and how stock prices and other important information are reported in the financial press.
8.‹#›
.
Introduction
Shares are units of ownership interest in a corporation or financial asset that provide for an equal distribution in any profits, if any are declared, in the form of dividends.
Freshly issued shares are traded in the primary market and the transaction is between the issuing firm and investors.
Already issued shares are traded in the secondary market and the transaction is from one investor to another.
8.‹#›
.
Cash Flows for Shareholders 8.1
If you buy a share of stock, you can receive cash in two ways
The company pays dividends (Check RBC, TD AND CIBC on investor edge)
You sell your shares, either to another investor in the market or back to the company (Check yahoofinance.com)
As with bonds, the price of the stock is the present value of these expected cash flows
8.‹#›
.
One Period Illustration
Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20\% on investments of this risk, what is the maximum you would be willing to pay?
Compute the PV of the expected cash flows
PV = FV / (1 + r)t
Price = (14 + 2) / (1.2) = $13.33
Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33
8.‹#›
.
Two Periods Illustration
Now what if you decide to hold the stock for two years? In addition to the $2 dividend in one year, you expect a dividend of $2.10 in second year and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay now?
PV = FV / (1 + r)t
PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33
8.‹#›
.
Three Periods Illustration
Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and a stock price of $15.435. Now how much would you be willing to pay?
PV = FV / (1 + r)t
PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33
8.‹#›
.
Developing the Model
You could continue to push back the date when you would sell the stock
You would find that the price of the stock is really just the present value of all expected future dividends
So, how can we estimate all future dividend payments?
8.‹#›
.
Estimating Dividends: Three Special Cases
Constant dividend or Zero Growth
The firm will pay a constant dividend forever. D1=D2=D3=D4=constant.
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
Supernormal growth
Dividend growth is not consistent initially, but settles down to constant growth eventually
8.‹#›
.
Zero Growth Model
If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity
P0 = D / R
Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10\% with quarterly compounding. What is the price?
P0 = .50 / (.1 / 4) = $20
8.‹#›
.
Constant Dividend Growth Model
Dividends are expected to grow at a constant percent per period.
8.‹#›
.
DGM – Example 1
Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2\% per year. If the market requires a return of 15\% on assets of this risk, how much should the stock be selling for?
P0 = .50(1+.02) / (.15 - .02) = $3.92
8.‹#›
.
DGM – Example 2
Suppose TB Pirates, Inc. is expected to pay a $2 dividend in year one. 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) = $13.33
Why isn’t the $2 in the numerator multiplied by (1.05) in this example?
The numerator is not multiplied by 1.05 because the dividend is being paid one year from now.
8.‹#›
.
Stock Price Sensitivity to Dividend Growth, g
D1 = $2; R = 20\%
8.‹#›
.
7.14
As the growth rate approaches the required return, the stock price increases dramatically.
Stock Price Sensitivity to Required Return, R
D1 = $2; g = 5\%
8.‹#›
.
7.15
As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.
Gordon Growth Illustration 1
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 1+g
8.‹#›
.
Gordon Growth Illustration 2
What is the price expected to be in year 4?
P4 = D5 / (R – g)
D5 = D4 x (1+g)
D4 = D1 (1+g)3 = 4(1+0.06)3 = 4.764
D5 = 4.764(1+0.06) = 5.05
P4 = 5.05 / (.16 - .06) = 50.50
The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a Present Value, so we have to start with a future cash flow.
8.‹#›
.
Class Practice 1
BCG Inc has just paid a cash dividend of $2 per share. Investors require a 16\% return from investments such as this. If the dividend is expected to grow at a steady 8\% per year, what is the current value of the stock? what will the stock be worth in five years?
8.‹#›
.
Solution 1
The last dividend was D0 = 2
P0 = D1/ (r-g) = D0 x (1+g)/ (r-g)
P0 = 2 x (1.08) / 0.16-0.08)
P0 = 2.16/0.08 = $27
What is the stock worth in 5 years?
D5 = D0 x (1+g)5
D5 = $2 x 1.4693 = 2.9387
P5 = D5(1+g)/(r-g)
= 2.9387 x 1.08/ 0.08
= 3.1738/0.08
= $39.67
8.‹#›
.
Non Constant Growth
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. If the 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 all expected future dividends.
8.‹#›
.
Non constant Growth illustration
Compute the dividends until growth levels off
D0= $1
D1 = D0 (1+g) = 1(1.2) = $1.20
D2 = D1(1+g) = 1.20(1.15) = $1.38
D3 = D2(1+g) = 1.38(1.05) = $1.449
P2 is the value, at year 2, of all expected dividends year 3 on and forever.
Find the expected future price
P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future cash flows
P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
8.‹#›
.
Class Practice 2
Chamberlain Corp is expected to pay the following dividends over the next four years: $12, $8, $7 and $2.5. Afterwards, the company pledges to maintain a constant 5\% growth rate in dividends forever. If the required return on the stock is 12\%, what is the current price?
8.‹#›
.
Solution 2
The stock begins constant growth in Year 4, so we can find the price of the stock in Year 4, at the beginning of the constant dividend growth, as:
P4 = D4 (1 + g) / (R – g) = $2.50(1.05) / (.12 – .05) = $37.50
The price of the stock today is the PV of the first four dividends, plus the PV of the Year 4 stock price. So, the price of the stock today will be:
P0 = $12.00 / 1.12 + $8.00 / 1.122 + $7.00 / 1.123 + $2.50 / 1.124 + $37.50 / 1.124 = $47.50
8.‹#›
.
Components of Required Return
Thus far we have taken the required return or discount rate r as given.
We can derive the required return by making r in the dividend discount model equation a subject of formula.
R = D1/P0 + g
R= Dividend yield+ Capital gains yield
Dividend yield is a stock’s cash dividend divided by it’s current price.
Capital gains yield is the dividend growth rate or the rate at which the value of an investment grows
In other words, the required return of a stock is made up of two parts: The dividend yield and the capital gains yield
8.‹#›
.
Using the Constant DGM to Find R
Start with the constant DGM:
8.‹#›
.
Example – Finding the Required Return
Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5\% per year. What is the required return?
R = [1(1.05)/10.50] + .05 = 15\%
What is the dividend yield?
1(1.05) / 10.50 = 10\%
What is the capital gains yield?
g =5\%
8.‹#›
.
Class Practice 3
GlenHill Corp is expected to maintain a constant 5.2\% growth rate in its dividends indefinitely. If the company has a dividend yield of 6.3\%, what is the required return on the company stock?
8.‹#›
.
Solution 3
(LO1) The required return of a stock is made up of two parts: The dividend yield and the capital gains yield. So, the required return of this stock is:
R = Dividend yield + Capital gains yield = 0.063 + 0.052 = 0.115 or 11.50\%
8.‹#›
.
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 and are not tax deductible
Dividends received by individual shareholders are partially sheltered by the dividend tax credit
Dividends received by corporate shareholders are not taxed
This prevents double taxation of dividends
8.‹#›
.
7.29
Dividend exclusion: If corporation A owns less than 20\% of corporation B stock, then 30\% of the dividends received from corporation B are taxable. If A owns between 20\% and 80\% of B, then 20\% of the dividends received are taxable. If A owns more than 80\%, a consolidated statement can be filed and dividends received from B are essentially untaxed.
Preferred Stock Features 8.3
Dividends
Most preferreds have a stated dividend that must be paid before common dividends can be paid
Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely
Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid
Preferred stock generally does not carry voting rights
8.‹#›
.
7.30
Point out that there are a lot of features of preferred stock that are similar to debt. In fact, many new issues have sinking funds that effectively convert what was a perpetual security into an equity security with a definite maturity. However, for tax purposes, preferred stock is equity and dividends are not a tax deductible expense.
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Introduction to Valuation: The Time Value of Money
Class 2
Michele Vincenti, MBA, CIM, FCSI, STI, CFP, CMC
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
5.‹#›
4.0
These slides primarily use the formulas to work the problems with a brief introduction to financial calculators.
Chapter 5 Outline
Future Value and Compounding
Present Value and Discounting
More on Present and Future Values
Summary and Conclusion
5.‹#›
Introduction
One of the basic problems that financial managers face is how to determine the value today of cash flows that are expected in the future.
In the most general sense, the phrase “time value of money” refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in the future.
The tradeoff between money now and money later thus depends on, among other things, the rate you can earn by investing.
Our goal in this chapter is to explicitly evaluate this trade-off between dollars today and dollars at some future time.
5.‹#›
Basic Definitions
Present Value – earlier money on a time line
Future Value – later money on a time line or the cash value of todays investment sometime in the future.
Interest rate – “exchange rate” between earlier money and later money
Discount rate
Cost of capital
Opportunity cost of capital
Required return
5.‹#›
4.3
It’s important to point out that there are many different ways to refer to the interest rate that we use in time value of money calculations. Students often get confused with the terminology, especially since they tend to think of an “interest rate” only in terms of loans and savings accounts.
Basic Definitions
Simple Interest is the interest earned only on the original principal amount invested.
Compounding: Is the process of accumulating interest in an investment over time to earn more interest.
Compound Interest: is interest earned on both the initial principal and the interest reinvested from prior periods.
5.‹#›
4.4
It’s important to point out that there are many different ways to refer to the interest rate that we use in time value of money calculations. Students often get confused with the terminology, especially since they tend to think of an “interest rate” only in terms of loans and savings accounts.
Future Value- General Formula
FV = PV(1 + r)t
FV = future value
PV = present value
r = period interest rate, expressed as a decimal
T = number of periods
Future value interest factor = (1 + r)t
5.‹#›
4.5
It’s important to point out that there are many different ways to refer to the interest rate that we use in time value of money calculations. Students often get confused with the terminology, especially since they tend to think of an “interest rate” only in terms of loans and savings accounts.
Future Value – Example 1 – 5.1
Suppose you invest $1000 for one year at 5\% per year. What is the future value in one year?
Interest = 1000(.05) = 50
Value in one year = principal + interest = 1000 + 50 = 1050
Future Value (FV) = 1000(1 + .05) = 1050
Suppose you leave the money in for another year. How much will you have two years from now?
FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50
5.‹#›
4.6
Point out that we are just using algebra when deriving the FV formula. We have 1000(1) + 1000(.05) = 1000(1+.05)
Calculator Keys
Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = period interest rate
P/Y must equal 1 for the I/Y 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
5.‹#›
4.7
I am providing information on the Texas Instruments BA-II Plus – other calculators are similar. If you recommend or require a specific calculator other than this one, you may want to make the appropriate changes.
Note: the more information students have to remember to enter the more likely they are to make a mistake. For this reason, I normally tell my students to set P/Y = 1 and leave it that way. Then I teach them to work on a period basis, which is consistent with using the formulas. If you want them to use the P/Y function, remind them that they will need to set it every time they work a new problem and that CLR TVM does not affect P/Y.
If students are having difficulty getting the correct answer, make sure they have done the following:
Set decimal places to floating point (2nd Format, Dec = 9 enter)
Double check and make sure P/Y = 1
Make sure to clear the TVM registers after finishing a problem (or before starting a problem) It is important to point out that CLR TVM clears the FV, PV, N, I/Y and PMT registers. C/CE and CLR Work DO NOT affect the TVM keys
The remaining slides will work the problems using the notation provided above for calculator keys. The formulas are presented in the notes section.
Future Value – Example 2
Suppose you had a relative deposit $10 at 5.5\% interest 200 years ago. How much would the investment be worth today?
Formula Approach
FV = 10(1.055)200 = 447,189.84
Calculator Approach
200 N
5.5 I/Y
10 PV
CPT FV = -447,189.84
5.‹#›
4.8
Calculator: N = 200; I/Y = 5.5; PV = 10; CPT FV = -447,198.84
Class Practice 1
Bank of Vancouver pays 7\% simple interest on its savings account balances whereas Bank of Calgary pays 7\% interest compounded annually. If you made a $6000 deposit in each bank, how much more money would you earn from your Bank of Calgary account at the end of 9 years?
5.‹#›
Solution 1
The simple interest per year is:
$6,000 × 0.07= $420
So after 9 years of simple interest you will have:
$420 × 9 = $3,780 in interest.
The total balance will be $6,000 + $3,780 = $9,780
With compound interest we use the future value formula:
FV = PV(1 +r)t
FV = $6,000(1.07)9 = $11,030.76
The difference is:
$11,030.76– $9,780 = $1,250.76
5.‹#›
Class Practice 2
What is the difference between simple interest and compound interest?
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?
5.‹#›
4.11
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Solution 2
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
5.‹#›
4.12
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Present Value
Present value describes the current value of a future cash flows discounted at the appropriate discount rate.
It attempt to answer the question, how much do you have to invest today to get a certain value amount in the future?
Present value is thus just the reverse of future value, therefore instead of compounding the money forward into the future, we discount it back to the present.
5.‹#›
4.13
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Present Value
How much do I have to invest today to have some specified amount in the future?
FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t
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.
5.‹#›
4.14
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Present Value – One Period Example
Suppose you need $10,000 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?
Formula Approach
PV = 10,000 / (1.07)1 = 9345.79
Calculator Approach
1 N
7 I/Y
10,000 FV
CPT PV = -9345.79
5.‹#›
4.15
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Present Value
You want to begin saving for your daughter’s college education and you estimate that she will need $150,000 in 17 years. If you feel confident that you can earn 8\% per year, how much do you need to invest today?
Formula Approach
PV = 150,000 / (1.08)17 = 40,540.34
Calculator Approach
N = 17
I/Y = 8
FV = 150,000
CPT PV = -40,540.34
5.‹#›
4.16
N = 15; I/Y = 8; PV = 500; CPT FV = -1586.08
Formula: 500(1.08)15 = 500(3.172169) = 1586.08
500 + 15(500)(.08) = 1100
Class Practice 3
Suppose you need $15,000 in 3 years. If you can earn 6\% annually, how much do you need to invest today?
If you could invest the money at 8\%, would you have to invest more or less than your answer above? How much?
5.‹#›
4.17
Relationship: The mathematical relationship is PV = FV / (1 + r)t. One of the important things for them to take away from this discussion is that the present value is always less than the future value when we have positive rates of interest.
N = 3; I/Y = 6; FV = 15,000; CPT PV = -12,594.29
PV = 15,000 / (1.06)3 = 15,000(.839619283) = 12,594.29
N = 3; I/Y = 8; FV = 15,000; CPT PV = -11,907.48 (Difference = 686.81)
PV = 15,000 / (1.08)3 = 15,000(.793832241) = 11,907.48
Solution 3
N = 3; I/Y = 6; FV = 15,000; CPT PV = -12,594.29
PV = 15,000 / (1.06)3 = 15,000(.839619283) = 12,594.29
N = 3; I/Y = 8; FV = 15,000; CPT PV = -11,907.48 (Difference = 686.81)
PV = 15,000 / (1.08)3 = 15,000(.793832241) = 11,907.48
5.‹#›
4.18
Relationship: The mathematical relationship is PV = FV / (1 + r)t. One of the important things for them to take away from this discussion is that the present value is always less than the future value when we have positive rates of interest.
N = 3; I/Y = 6; FV = 15,000; CPT PV = -12,594.29
PV = 15,000 / (1.06)3 = 15,000(.839619283) = 12,594.29
N = 3; I/Y = 8; FV = 15,000; CPT PV = -11,907.48 (Difference = 686.81)
PV = 15,000 / (1.08)3 = 15,000(.793832241) = 11,907.48
Chapter 6 Outline
Future and Present Values of Multiple Cash Flows
Valuing Level Cash Flows: Annuities and Perpetuities
Comparing Rates: The Effect of Compounding
Loan Types and Loan Amortization
5.‹#›
Introduction
Last chapter we covered the basics of discounted cash flow valuation.
So far we have only dealt with single cash flows, meanwhile in reality most investments have multiple cash flows.
In this section, we examine ways to value multiple cash flows.
We start with future value…..
5.‹#›
Note on Cash Flow Timing
In working present and future value problems, cash flow timing is critically important.
In almost all such calculations, it is implicitly assumed that the cash flow occur at the end of each period.
5.‹#›
Multiple Cash Flows 6.1 – FV Example 1
You currently have $7,000 in a bank account earning 8\% interest. You think you will be able to deposit an additional $4,000 at the end of each of the next three years. How much will you have in three years?
5.‹#›
Multiple Cash Flows FV Example 1 continued
Find the value at year 3 of each cash flow and add them together.
Formula Approach
Today (year 0): FV = 7000(1.08)3 = 8,817.98
Year 1: FV = 4,000(1.08)2 = 4,665.60
Year 2: FV = 4,000(1.08) = 4,320
Year 3: value = 4,000
Total value in 3 years = 8817.98 + 4665.60 + 4320 + 4000 = 21,803.58
5.‹#›
4.23
The book discusses that there are two ways to work this problem. The first method, computing the FV one year at a time and adding the cash flows as you go along, is illustrated in Example 6.1 in the book. The slides illustrate the other method, finding the future value at the end for each cash flow and then adding.
Point out that you can find the value of a set of cash flows at any point in time, all you have to do is get the value of each cash flow at that point in time and then add them together.
The students can read the example in the book. It is also provided here.
You think you will be able to deposit $4,000 at the end of each of the next three years in a bank account paying 8 percent interest. You currently have $7,000 in the account. How much will you have in three years? In four years?
Point out that there are several ways that this can be worked. The book works this example by rolling the value forward each year. The presentation will show the second way to work the problem.
Calculator:
Today (year 0 CF): 3 N; 8 I/Y; -7000 PV; CPT FV = 8817.98
Year 1 CF: 2 N; 8 I/Y; -4000 PV; CPT FV = 4665.60
Year 2 CF: 1 N; 8 I/Y; -4000 PV; CPT FV = 4320
Year 3 CF: value = 4,000
Total value in 3 years = 8817.98 + 4665.60 + 4320 + 4000 = 21,803.58
Value at year 4: 1 N; 8 I/Y; -21803.58 PV; CPT FV = 23,547.87
I entered the PV as negative for two reasons. (1) It is a cash outflow since it is an investment. (2) The FV is computed as positive and the students can then just store each calculation and then add from the memory registers, instead of writing down all of the numbers and taking the risk of keying something back into the calculator incorrectly.
Multiple Cash Flows FV Example 1 continued
Calculator Approach
Today (year 0 CF): 3 N; 8 I/Y; -7000 PV; CPT FV = 8817.98
Year 1 CF: 2 N; 8 I/Y; -4000 PV; CPT FV = 4665.60
Year 2 CF: 1 N; 8 I/Y; -4000 PV; CPT FV = 4320
Year 3 CF: value = 4,000
Total value in 3 years = 8817.98 + 4665.60 + 4320 + 4000 = 21,803.58
5.‹#›
Quick Quiz – Part I
You are offered an investment that will pay you $200 in one year, $400 the next year, $600 the year after, and $800 at the end of the following year. You can earn 12\% on similar investments. How much is this investment worth today?
Remember :
PV = FV / (1 + r)t
5.‹#›
4.25
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Solution
Find the PV of each cash flow and add them
Formula Approach
Year 1 CF: 200 / (1.12)1 = 178.57
Year 2 CF: 400 / (1.12)2 = 318.88
Year 3 CF: 600 / (1.12)3 = 427.07
Year 4 CF: 800 / (1.12)4 = 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93
5.‹#›
4.26
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Solution
0
1
2
3
4
200
400
600
800
178.57
318.88
427.07
508.41
1432.93
5.‹#›
4.27
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Solution
Calculator Approach
Year 1 CF: N = 1; I/Y = 12; FV = 200; CPT PV = -178.57
Year 2 CF: N = 2; I/Y = 12; FV = 400; CPT PV = -318.88
Year 3 CF: N = 3; I/Y = 12; FV = 600; CPT PV = -427.07
Year 4 CF: N = 4; I/Y = 12; FV = 800; CPT PV = - 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93
5.‹#›
4.28
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Class Practice 5
You are considering an investment that will pay you $1000 in one year, $2000 in two years and $3000 in three years. If you want to earn 10\% on your money, how much would you be willing to pay?
5.‹#›
4.29
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Solution 5
Formula Approach
PV = 1000 / (1.1)1 = 909.09
PV = 2000 / (1.1)2 = 1652.89
PV = 3000 / (1.1)3 = 2253.94
PV = 909.09 + 1652.89 + 2253.94 = 4815.93
Calculator Approach
N = 1; I/Y = 10; FV = 1000; CPT PV = -909.09
N = 2; I/Y = 10; FV = 2000; CPT PV = -1652.89
N = 3; I/Y = 10; FV = 3000; CPT PV = -2253.94
PV = 909.09 + 1652.89 + 2253.94 = 4815.93
5.‹#›
4.30
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Finding the Number of Payments
In this section you were given PV, C, r but asked to find “t” or N using the calculator approach
5.‹#›
4.31
The easiest way to work this problem is to use the uneven cash flow keys and find the present value first and then compute the others based on that.
CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2; C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT FV = 1226.07
Value in year 3: PV = 874.17; N = 3; I/Y = 7; CPT FV = 1070.90
Using formulas and one CF at a time:
Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 = 100(1.07)2 = 114.49
Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 = 200(1.07) = 214
Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 = 200
Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 / 1.07 = 280.37
Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 = 262.03
Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18 (difference due to rounding)
Value at year 3 = 114.49 + 214 + 200 + 280.37 + 262.03 = 1070.89
Finding the Number of Payments – Example 2
Suppose you borrow $2000 at 5\% and you are going to make annual payments of $734.42. How long before you pay off the loan?
5.‹#›
4.32
Sign convention matters!!!
5 I/Y
2000 PV
-734.42 PMT
CPT N = 3 years
Finding the Number of Payments – Example 2 continued
Formula Approach
2000 = 734.42(1 – 1/1.05t) / .05
.136161869 = 1 – 1/1.05t
1/1.05t = .863838131
1.157624287 = 1.05t
t = ln(1.157624287) / ln(1.05) = 3 years
Calculator Approach
Sign convention matters!!!
5 I/Y
2000 PV
-734.42 PMT
CPT N = 3 years
5.‹#›
Annuity Due – Example 1
You are saving for a new house and you put $10,000 per year in an account paying 8\% compounded annually. The first payment is made today. How much will you have at the end of 3 years?
Formula for future value annuity due is provided;
5.‹#›
4.34
Note that the procedure for changing the calculator to an annuity due is similar on other calculators.
Calculator
2nd BGN 2nd Set (you should see BGN in the display)
3 N
-10,000 PMT
8 I/Y
CPT FV = 35,061.12
2nd BGN 2nd Set (be sure to change it back to an ordinary annuity)
What if it were an ordinary annuity? FV = 32,464 (so receive an additional 2597.12 by starting to save today.)
Annuity Due – Example 1 Timeline
0 1 2 3
10000 10000 10000
32,464
35,061.12
5.‹#›
4.35
If you use the regular annuity formula, the FV will occur at the same time as the last payment. To get the value at the end of the third period, you have to take it forward one more period.
Annuity Due – Example 1 continued
Formula Approach
FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12
Calculator Approach
2nd BGN 2nd Set (you should see BGN in the display)
3 N
-10,000 PMT
8 I/Y
CPT FV = 35,061.12
2nd BGN 2nd Set (be sure to change it back to an ordinary annuity)
5.‹#›
Effective Annual Rate (EAR)
This is the actual rate paid (or received) after accounting for compounding that occurs during the year
If you want to compare two alternative investments with different compounding periods, you need to compute the EAR for both investments and then compare the EAR’s.
The EAR (Effective annual interest rate) is the interest rate expressed as if it were compounded once per year.
5.‹#›
Effective Annual Rate (EAR)
Remember that the APR is the quoted rate
m is the number of times the interest is compounded in a year
5.‹#›
Annual Percentage Rate (APR)
This is the annual rate that is quoted by law
By definition APR is the interest rate charged per period multiplied by 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
5.‹#›
Annual Percentage Rate APR
What is the APR if the monthly rate is .5\%?
.5(12) = 6\%
What is the APR if the semiannual rate is .5\%?
.5(2) = 1\%
What is the monthly rate if the APR is 12\% with monthly compounding?
12 / 12 = 1\%
5.‹#›
Converting APR to EAR
Suppose you can earn 1\% per month on $1 invested today.
What is the APR? 1(12) = 12\%
How much are you effectively earning? Calculator approach press 12 2nd function NOM, 2nd function EFF
5.‹#›
Converting APR to EAR
Suppose if you put it in another account, you earn 3\% per quarter.
What is the APR? 3(4) = 12\%
How much are you effectively earning? Calculator approach 4 P/Yr, 12 2nd function NOM, 2nd function EFF
5.‹#›
Converting EAR to APR
If you have an effective rate, how can you compute the APR? Rearrange the EAR equation and you get:
5.‹#›
Converting EAR to APR
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?
Calculator approach: 12 P/Yr, 12 2nd function EFF 2nd function NOM.
5.‹#›
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Financial Statements, Taxes and Cash Flow
Michele Vincenti, Ph.D., MBA, CIM, FCSI, STI, CFP, CMC, CITP
Class 5
2.*
Chapter Outline
The Balance Sheet
The Income Statement
Cash Flow
Taxes
Capital Cost Allowance
Summary and Conclusions
2.*
Balance Sheet - 2.1
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 liquidity
Ease of conversion to cash
Without significant loss of value
Balance Sheet Identity
Assets = Liabilities + Stockholders’ Equity
2.*
Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.
2.*
The Balance Sheet - Figure 2.1
2.*
The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)
Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm.
The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions.
Remember that shareholders’ equity consists of several components and that total equity includes all of these components not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.
2.*
Net Working Capital and Liquidity
Net Working Capital
Current Assets – Current Liabilities
Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out
Usually positive in a healthy firm
Liquidity
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
However, liquid assets earn a lower return
Tradeoff between liquid and illiquid assets
2.*
Canadian Enterprises Balance Sheet – Table 2.1
See 2.14: Canadian Enterprises Example
2.*
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example.
Here is an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. Later in the chapter, a hot link is provided to the 1999 annual report for McGraw-Hill. If you don’t have access to the internet for your presentation, I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing.
This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.
2.*
Market Vs. Book Value
The balance sheet provides the book value of the assets, liabilities and equity.
Market value is the price at which the assets, liabilities or equity can actually be bought or sold.
Market value and book value are often very different. Why?
Which is more important to the decision-making process?
2.*
Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities and equity of the firm.
Assets are listed at historical costs less accumulated depreciation – this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the “Total Assets” line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth.
Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market’s estimation of the current value of ALL of the assets of the firm.
The best estimate of the market value of the firm’s assets is market value of liabilities + market value of equity.
Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.
2.*
Income Statement - 2.2
The income statement is more like a video of the firm’s operations for a specified period of time.
You generally report revenues first and then deduct any expenses for the period
Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue
2.*
Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.
2.*
Canadian Enterprises Income Statement – Table 2.2
See 2.14: Canadian Enterprises Example
2.*
The first example computing cash flows has a link to the information in this table. The arrow in the corner is used to return you to the example.
Remember that these are simplified income statements for illustrative purposes.
Earnings before interest and taxes is often called operating income.
COGS would include both the fixed costs and the variable costs needed to generate the revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes.
The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered.
It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRs early in the asset’s life. This reduces the “expense” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s cash flow and not just its EPS.
2.*
The Concept of Cash Flow - 2.3
Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements
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
2.*
Cash Flow From Assets
Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders
Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC
2.*
The first equation is how the cash flow from the firm is divided among the investors that financed the assets.
The second equation is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.
2.*
Taxes - 2.4
The one thing we can rely on with taxes is that they are always changing
Marginal vs. average tax rates
Marginal – the percentage paid on the next dollar earned
Average – the tax bill / taxable income
Other taxes
2.*
Capital Cost Allowance (CCA) - 2.5
CCA is depreciation for tax purposes
CCA is deducted before taxes and acts as a tax shield
Every capital assets is assigned to a specific asset class by the government
Every asset class is given a depreciation method and rate
Half-year Rule – In the first year, only half of the asset’s cost can be used for CCA purposes
2.*
Some CCA Classes – Table 2.8
2.*
Example: CCA Calculation
ABC Corporation purchased $100,000 worth of photocopiers in 2004. Photocopiers fall under asset class 8 with a CCA rate of 20\%. How much CCA will be claimed in 2004 and 2005?
2.*
CCA Example – Solution
Year Beginning
Fixed
Assets CCA Ending
Fixed
Assets
2004 50000
(100,000 x 50\%) 10,000
(50,000 x 20\%) 40000
(50,000 - 10,000)
2005 90,000
(40,000 + 50,000) 18,000
(90,000 x 20\%) 72,000
(90,000 - 18,000)
2.*
Quick Quiz
What is the difference between book value and market value? Which should we use for decision making 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?
What is CCA? How is it calculated?
Introduction To Corporate Finance
Michele Vincenti, Ph.D, MBA, M.A. (HOS), CIM, FCSI, STI, CFP, CMC, C.I.M., F.CIM
Chapter
One
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
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 Corporation
Financial Institutions
Trends in Financial Markets and Financial Management
1.2
1.1
www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.
Khoa Nguyen (K) - Should I take out the link?
Corporate Finance
Some important questions that are answered using finance
What long-term investments should the firm take on?
Where will we get the long-term financing to pay for the investment?
How will we manage the everyday financial activities of the firm?
1.3
1.2
Emphasize that “business finance” is just another name for the “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.
Financial Manager
Financial managers try to answer some or all of these questions
The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer – oversees cash management, capital expenditures and financial planning
Controller – oversees taxes, cost accounting, financial accounting and data processing
1.4
1.3
Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.
Financial Management Decisions
Capital budgeting
What long-term 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 day-to-day finances of the firm?
1.5
1.4
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc.
Be sure and define debt and equity.
Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.
Forms of Business Organization
Three major forms in Canada
Sole proprietorship
Partnership
General
Limited
Corporation
In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies
1.6
1.5
www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is: http://www.nolo.com/encyclopedia/sb_ency.html#Subtopic16
Sole Proprietorship
Advantages
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income
Disadvantages
Unlimited liability
Limited to life of owner
Equity capital limited to owner’s personal wealth
Difficult to sell ownership interest
1.7
1.6
www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.
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
1.8
1.7
www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements.
Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership
Written agreements are essential due to the unlimited liability.
Limited partners cannot be involved in the business or else they may be deemed as general partners.
Corporation
Advantages
Limited liability
Unlimited life
Separation of ownership and management
Transfer of ownership is easy
Easier to raise capital
Disadvantages
Separation of ownership and management
Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)
1.9
1.8
www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations.
Discuss how separation of ownership and management can be both an advantage and a disadvantage:
Advantages
You can benefit from ownership in several different businesses (diversification)
You can take advantage of the expertise of others (comparative advantage)
Easier to transfer ownership
Disadvantage
Agency problems if management goals and owner goals are not aligned
The instructors manual provides additional discussion of limited liability companies and S-corporations
Goal Of Financial Management
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
Does this mean we should do anything and everything to maximize owner wealth?
1.11
1.9
Try and have the students discuss each of the goals above and the inherent problems of the first three goals:
Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow?
Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners.
Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not happy.
Maximize the current value of the company’s stock
There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits.
The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm.
This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock.
Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help.
The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s.
Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.
Primary Goal of Financial Management
Three equivalent goals of financial management:
Maximize shareholder wealth
Maximize share price
Maximize firm value
1.12
The Agency Problem
Agency relationship
Principal hires an agent to represent their interests
Stockholders (principals) hire managers (agents) to run the company
Agency problem
Conflicts of interest can exist between the principal and the agent
Agency costs
Direct agency costs
Indirect agency costs
1.13
1.11
Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada.
A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range.
Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor.
Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs.
Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
The Agency Problem
Direct Costs: These costs come in two forms;
The first is corporate expenditure that benefits management but costs the shareholders such as the purchase of expensive and luxurious unneeded corporate jet.
The second is an expense that arises from the need to monitor management actions such as paying outside auditors to assess the accuracy of financial statement information.
Indirect Costs: management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
These are opportunity costs emerging from lost opportunity to increase shareholder’s wealth by not investing in a potentially profitable project.
1.13
1.12
Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada.
A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range.
Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor.
Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs.
Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their goal
Corporate control
The threat of a takeover may result in better management
Conflicts with other stakeholders
Stakeholders relates to anyone who potentially has a claim on a firm such as creditors, shareholders, suppliers, customers, employees etc.
Such groups also attempt to exert control over the firm by introducing alternate, socially oriented goals.
1.14
1.13
Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.
Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders.
Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
What is the role of financial markets in corporate finance?
Cash flows to and from the firm
Money vs. capital markets
Primary vs. secondary markets
How do financial markets benefit society? By linking the deficit sector of the economy to the surplus sector for enhanced economic growth
1.16
1.14
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
What is the role of financial markets in corporate finance?
Financial markets can be classified as either money market or capital market.
Short-term debt securities are bought and sold in the money market. Examples are bankers acceptance, treasury bills etc.
Money market is a dealer market typically dealers buy and sell among themselves at their own risks.
1.16
1.15
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
What is the role of financial markets in corporate finance?
Capital markets are markets for long term debt and shares of stock.
The Toronto Stock exchange is a capital market. www.tsx.ca
The bond market as well is a capital market.
1.16
1.16
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
What is the role of financial markets in corporate finance?
In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation.
Corporations engage in two types of primary market transactions, public offering and private placement.
Public offering involves selling securities to the general public.
Private placement is a negotiated sale involving a specific buyer
1.16
1.17
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
Primary versus Secondary Market
A secondary market involves one shareholder or owner or creditor selling to another.
Therefore the secondary markets provide the means for transferring ownership of corporate securities .
There are two kinds of secondary markets; auction markets and dealer markets.
The first dealer markets in stocks and long terms debts are called over the counter (OTC) markets.
1.16
1.18
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
Financial Institutions
Financial institutions act as intermediaries between funds suppliers (savers both individuals corporations ) and users of funds
Institutions earn income on services provided:
Indirect finance – Earn interest on the spread between interest earned on loans and interest paid on deposits
Direct finance – Service fees (i.e. bankers acceptance and stamping fees)
1.16
1.19
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.
Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
Cash Flows to and from the Firm
1.17
Trends in Financial Markets and Management
Financial Engineering
Derivative Securities
Advances in Technology – i.e. E-business
Deregulation
Corporate Governance Reform
Next week activity
For the week following, cover Interactive Pro Material for week 1& week 2.
Class participation attracts marks and I will be logging in to check your activity rate
1.19
Trends in Financial Markets and Management
Asynchronous Activity
https://www.lovemoney.com/gallerylist/77190/amazons-future-plans-from-cashless-stores-to-home-robots
Based on the link above, as a group evaluate AMAZONs capital budgeting goals according to the goals of financial management as highlighted on slide 9 of this lecture note power point.
1.19
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?
1.20
Summary 1.9
You should know:
The advantages and disadvantages between a sole proprietorship, partnership and corporation
The primary goal of the firm
What an agency relationship and cost are
The role of financial markets
1.21
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w or quality improvement; it was just all part of good nursing care. The goal for quality improvement is to monitor patient outcomes using statistics for comparison to standards of care for different diseases
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low (The Top Health Industry Trends to Watch in 2015) to assist you with this discussion.
https://youtu.be/fRym_jyuBc0
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After the components sending to the manufacturing house
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No matter which type of health care organization
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3. Furman v. Georgia is a U.S Supreme Court case that resolves around the Eighth Amendments ban on cruel and unsual punishment in death penalty cases. The Furman v. Georgia case was based on Furman being convicted of murder in Georgia. Furman was caught i
One major ethical conflict that may arise in my investigation is the Responsibility to Client in both Standard 3 and Standard 4 of the Ethical Standards for Human Service Professionals (2015). Making sure we do not disclose information without consent ev
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The inbound logistics for William Instrument refer to purchase components from various electronic firms. During the purchase process William need to consider the quality and price of the components. In this case
4. A U.S. Supreme Court case known as Furman v. Georgia (1972) is a landmark case that involved Eighth Amendment’s ban of unusual and cruel punishment in death penalty cases (Furman v. Georgia (1972)
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Your paper must be at least two pages in length (not counting the title and reference pages)
The word assimilate is negative to me. I believe everyone should learn about a country that they are going to live in. It doesnt mean that they have to believe that everything in America is better than where they came from. It means that they care enough
Data collection
Single Subject Chris is a social worker in a geriatric case management program located in a midsize Northeastern town. She has an MSW and is part of a team of case managers that likes to continuously improve on its practice. The team is currently using an
I would start off with Linda on repeating her options for the child and going over what she is feeling with each option. I would want to find out what she is afraid of. I would avoid asking her any “why” questions because I want her to be in the here an
Summarize the advantages and disadvantages of using an Internet site as means of collecting data for psychological research (Comp 2.1) 25.0\% Summarization of the advantages and disadvantages of using an Internet site as means of collecting data for psych
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One thing you will need to do in college is learn how to find and use references. References support your ideas. College-level work must be supported by research. You are expected to do that for this paper. You will research
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3 The first thing I would do in the family’s first session is develop a genogram of the family to get an idea of all the individuals who play a major role in Linda’s life. After establishing where each member is in relation to the family
A Health in All Policies approach
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Read Connecting Communities and Complexity: A Case Study in Creating the Conditions for Transformational Change
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Use the bolded black section and sub-section titles below to organize your paper. For each section
Losinski forwarded the article on a priority basis to Mary Scott
Losinksi wanted details on use of the ED at CGH. He asked the administrative resident