corporate finance fin622 short note

8/13/2019 Corporate Finance Fin622 Short Note

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Lesson 1st

Corporate finance is the study of planning,evaluating and drawing decisions in the courseof business.

(1)SWOT analysis is also very helpful in capital budgeting process.SWOT stands for:

Strengths

Weaknesses Opportunities

Threats


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(2)Broadly speaking there are two potential sources for makinginvestments

The first sourcesemerge from the contributions of sponsors or directors

who commence the business. This portion of investment is called Capital or

Equity contribution.

The other sourceof investment is from loans and various financial

instruments and markets. Banks provide long term and short loans to the

business world and this has been the most important source of business

finance and is being used widely.

Other source of external financing is issuance of bonds and securities in

primary and secondary markets. This process is known as Capital Structure

(3) There are basically three financial statements that every businessentity runs periodically. It includes:

Balance Sheet

Income Statement

Cash Flow

Balance SheetThis is a statement of resources controlled by and obligations to settle by an

entity as on a specified date.

The format of Financial Statements is governed by International Financial

Reporting Standard in Pakistan.

Assets (both fixed and current) are placed in balance sheet in the order of

less liquid or illiquid to liquid.

This means that current assets are more liquid than fixed assets.

What is a liquid asset?

Answer: An asset that can be converted to cash quickly and without loss of

value is liquid asset

Example

Prize bond or gold highly liquid asset


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Current Assets and Current Liabilitieswhen clubbed together, give birth

to another concept known as working capital.

Current assetsare those that form part of the circulating capital of a

business. The most common current assets are stocks, trade debtors, and

cash.

Current liabilitiesare those short-term liabilities which are intended to be

constantly replaced in the normal course of trading activity.

Current liabilities typically comprise: trade creditors, accruals and bankoverdrafts.

There is another concept of Cash Cycle associatedwith working

capital

ExampleYou were still able to use money for 5 days before paying to creditors. This

means the operating cycle is positive.

Corporate Finance

Lesson 2

Types of analysis

(1) vertical analysis

(2) horizontal analysis


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Vertical AnalysisCommon Size analysis is also known as Vertical Analysis

Horizontal AnalysisBase year analysis is another tool of comparing performance

and is also known as Horizontal Analysis.

Ratio analysis

Ratio analysisis another widely acknowledged and used comparison

tool for financial managers

Question :A ratio is a relationship between ------------- or more line

items expressed in ---------------------------- of times?

Five, %age or numbers

Two, %age or numbersThree, %age or number

One, %age or number

Question :Financial ratios are useful indicators of a firms performance

and --------------------?

Financial changes

Financial situation

Financial requirementFinancial needs

Question:ratio analysis can predict future?

Profit


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Rations

Bankruptcy

Values

Financial ratioscan be used to analyze trendsand to compare the firms

financials to those of other firms.

Different ratios

Current ratio = current assets / current liabilities

Note: current ratio is a measure of short term liquidity. This is short

term solvency or liquidity measurement

Current assets inventory

Quick (or acid test) ratio =____________________________

Current liabilities

Note: using cash to buy inventory does not affect the current ratio, but

It reduces the quick ratio. This is short term solvency or liquidity

measurement

Total assets Total equity

Total debt ratio = ------------------------------------------

Total assets

Or

Total debt

--------------------


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Total assets

Note: Total debt equity ratio take into all debts of all maturities to all

creditors. This is long term solvency measurement.

Total debt

Debt-equity ratio=-----------------

Total equity

Note: This is long term solvency measurement.

EBT

Time Interest Earned ratio = -------------

Interest

Interest coverage ratio = EBIT / interest

Note: This is long term solvency measurement.

Cost of goods sold

Inventory turnover ratio= ----------------------------------

Avg. Inventory

Days sale in inventory = 365 days / inventory turnover

Note: They are intended to describe is how efficiently, or intensively, a

firm uses its assets to generate sales. This is assets management or

turnover measure.


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Sales

Account receivable turnover = -----------------------

Account receivable

Average collection period or days sales in receivables=

365 days / receivables turnover

Cost of goods sold

Payable turnover = -----------------------------------Trade credits

Average payment period = 365 days / payable turnover

Net income

Net profit or Profit margin ratio = ----------------------- * 100

Sales

Note: All other things being equal, a relatively high profit margin is

obviously. This situation corresponds to low expense ratio relative tosales. How ever, we hasten to add that other things are often not equal.

Net income

Return on assets = ------------------------*100


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Total assets

Note:measure of profit per dollar of assets.

Net income

Return on equity =------------------ * 100

Total equity

Note:

ROE is a measure how the shareholder fared during the year. Since

befitting shareholder our goal, ROE in accounting sense, the true

bottom-line measure of performance.

Net income

Earning per share =---------------------------

Total share (o/s)

BASIC OVERVIEW OF

RATIOS

Short Term Solvency Or Working Capital Ratios

(1) CURRENT RATIO(2) QUICK RATIO


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(3) CASH RATIOLong Term Solvency Or Financial Leverage Ratios

(1) TOTAL DEBT RATIO(2) DEBT EQUITY RATIO(3) EQUITY MULTIPLIER(4) TIME INTEREST EARNED RATIO(5) CASH COVERAGE RATIO

Assets Management Or Asset Utilization Turnover Ratios

(1) INVENTORY TURNOVER AND INV. DAYS(2) RECEIVABLE TURNOVER AND AVERAGE

COLLECTON PERIOD

(3) PAYALE TURNOVER AND AVERAGEPAYMENT PERIOD

(4) TOTAL ASSETS TURNOVER(5)

CAPITAL INTENSITY

PROFITABILITY RATIOS

(1) NET PROFIT OR PROFIT MARGIN(2) RETURN ON ASSETS(3) RETURN ON EQUITY

MARKET VALUES RATIOS

(1) PRICE-EARNING SHARE OR PE RATIO


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(2) MARKET-TO-BOOK RATIO(3) EPS

Ratios are subject to the limitations of accounting

methods. Different accounting choices may result in

significantly different ratio values.

Corporate finance

Lesson 3rd

Time Value of Moneyis based on the concept that a dollar that you have

today is worth more than the promise or expectation that you will

receive a dollar in the future.

Time value of money divided into following

topics

(1)present value


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(2)

Future value

(3)Annuities

(4)perpetuity

Present value

The present value of a future cash flow is the nominal amountof money

to change hands at some future date, discounted to account for the timevalue of money

Discount factor = 1/1+r

PV = 1 / 1+r. C1

Future value

Future value measures what money is worth at a specified time in thefuture assuming a certain interest rate.

Determine the future value

without compounding

Fv=pv(1+rt)


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Determine the future value

with compounding

Fv=pv(1+i)n

AnnuitiesEqual annual series of cash flow

Annuities may be

(1) equal annual deposit

(2) equal annual withdrawal

(3) equal annual payments

(4) equal annual receipts

Annuities is key of equal annual cash flow

Present value of annuity = c [1/r-1/r (1+r)t]

= c {1-[1/ (1+r) t]

/ r}


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Future value of annuity = [(1+r)t 1] / r

Annuity

A level stream of cash flows for a fixed period of time.

Ordinary annuity

Cash flow that occurs at the end of each period for some fixed

number of period is called an ordinary annuity.

Annuity due

Cash flow occurs at the beginning of each period.

PerpetuityAn annuity in which the cash flow continue forever.

OrPerpetuity is a cash flow without a fixed time horizon.

Consol

Also called perpetuity and type of perpetuity

Present value of perpetuity= C/r


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Lesson 4Discounting cash flow & Effective annual interest

Effective Annual Rate EARInterest rate that is annualized using compound interest

FormulaEAR = [1 + i/n) n 1

BOND VALUATION

A bond is a financial instrument or a debt securityissued by a company

to raise money. It is offered to general public or to institutions.

Equity & Debt (Bonds)

Equity represents ownershipand is a residual claim

Lesson 5

BondBondContract between investor and issuer

It is debt instrument.

Use to raise capital and return pay interest to investor

Bonds are redeemable

Coupon interest

Interest payment per period

Coupon rate


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Interest payment stated is annualized term

Or

The rate at which issuer pays interest to investor is know

as coupon rate

Current yield = annual coupon payment / bond price

Maturity date

The date on which company return the principle amount

back to investor

Discount bond

Bond sells less than the face or par value so the return on

a bond is greater than the current yield, in this case capital

gain at maturity.

Premium bond

Bond sells more than the face or par value so return on a

bond less than the current yield. In this case capital loss at

maturity.

Interest rate risk & bond

The risk arising from fluctuating interest rate is known as interest raterisk.Two things to change sensitivity to change interest rate

(1)time to maturity

(2)coupon rate

Small changes in interest rate will have greater impact on yield to

maturity and bond.

Bond valuation


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Bond valuation is the process of determining the fair price of abond.

The fair value of a bond is the present value of the stream of cash flows itis expected to generate.

(1)general relationship

(2)bond pricing

General Relationships

o Present value relationship

Coupon yield

Current yield Yield to maturity

Present value relationship

C F

Po = ----------- + ------------

(1+r)t (1+r)

T

There is inverse relationship between price and discount rate. Thehigher the interest rate the lower the price of a bond

Coupon yield

Coupon yield are called nominal yield

Coupon yield = C/F

C: is coupon payment

F: is percentage of face value

Current yield

Current yield = coupon payment / bond price

YTM


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C F

Market price = -------------- + --------------

(1+YTM)t (1+YTM)

T

If YTM increases, the rate of return will be less than yield.If the YTM decreases, the rate of return will be greater than yield.

Bond pricing

Relative price approach

Arbitrage free price approach

Arbitrage free price approach

C F

Po = ------------ + ------------(1+r t)t

(1+rT)T

Lesson 6

Term structure & interest rate

Term structure


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Relationship between long term

&short term rates

(1)When long term rate is greater than

short term ratethan the term

structure is upward sloping

(2)when short term rate is greater

than long term ratethen termstructure will be downward

sloping

Q: the term structure of interest rate,

also know as ----------?

Coupon rate

Coupon yield

Yield curve

Current yield


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Q: there are ----------- main patterns

created by the term structure of

interest rate?

Two

Three

Five

Eight

Market interest rate

In market interest rate

ultimately includesmoney market,

bond market, stock market, andcurrency market as well as retail

financial institutions like bank.

Risk free cost of capital

Real interest on risk free loan,while no loan is ever entirely risk-free


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Rate of incorporates the deferred

consumption and alternative

investment is element of interest.

Inflationary expectations

In = ir+pe

In: nominal interest rate

Ir: real interest rate

Pe: inflationary expectations

Risk

The level of risk in investment is

taken into consideration.

Risk premium


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The extra interest charged on

risky investment is called risk

premiumLonger-term investment carries a

maturity risk premium, because long

term loan are more exposed to more

risk of default during this duration.

Liquidity preferenceCash is on hand to be spent immediately if the need arises,

but some investments require time or effort to transfer into

spending able form. This is known as liquidity preference

Lesson # 7

DIVIDEND DISCOUNT MODELDividend discount model states that todays price is equal tothe present value of all future dividends.

After One year


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P0 = Div + P1 / (1 + r)

After 2 years the value of stock is:=div1/ (1+r) + div2+P2/ (1+r) 2

After 3 years the value of stock is:=div1/(1+r) + div2/(1+r)2 + div3+P3/(1+r)3

PV of stock depends only on future dividends

.DIVIDEND GROWTH MODELS:If the value of stock is the PV of all future dividend then

PV = DIV / r

When company pay out everything as dividend then earningsand dividend will be equal and PV can be calculated as:PV = EPS / r

CONSTANT GROWHT MODEL:

P0 = D1 x (1+g) / (r g)This is known as Constant-growth Dividend Discount Model orGordon Growth Model

Gordon model is valid as long as g < r

Lesson 8

Fundamental Analysis


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Three step process:In large organizations fundamental analysis is usually performed in three steps:

Analysis of the macroeconomic situation, usually including bothinternational and national economic indicators, such as GDP growth rates,inflation, interest rates, exchange rates, productivity, and energy prices.

Industry analysis of total sales, price levels, the effects of competingproducts, foreign competition, and entry or exit from the industry.

Individual firm analysisof unit sales, prices, new products, earnings, andthe possibilities of new debt or equity issues

Often the procedure stresses the effects of the overall economic situation onindustry and firm analysis and is known as top down analysis.

If instead the procedure stresses firm analysis and uses it to build its industryanalysis, which it uses to build its macroeconomic analysis, it is known as

bottom up analysis.

Capital budgetingCapital Budgeting is the planning process used to determine afirm's long term investments such as new machinery,replacement machinery, new plants, new products, andresearch and development projects.Capital budgeting process is carried out for projects involvingheavy initial upfront cost.

classification of investment projects

BY PROJECT SIZE


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BY TYPE OF BENEFIT TO THE FIRM

BY DEGREE OF DEPENDANCE

BY DEGREE OF STATISTICAL DEPENDANCE

BY TYPE OF CASH FLOW

Relevant Costs:These are costs that are relevant with respect to a particulardecision. A relevant cost for a particular decision is one thatchanges if an alternative course of action is taken. Relevantcosts are also called differential costs.

Every decision involves a choice between at least two

alternatives.

To identify which costs are relevant in a particularsituation, take this three step approach:1. Eliminate sunk costs and committed costs2. Eliminate costs and benefits that do not differ betweenalternatives

3. Compare the remaining costs and benefits that do differbetween alternatives to make the proper decision.4. Take care of opportunity cost

Lesson 9Net present value (NPV)Two aspects of NPV method of project evaluation


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(1) initial investment or upfront cost

(2) benefit (cash flow) emerging from the

project

The present value of future cash flow is calculated using adiscount rate. And if this PV of future cash flow is greater thanthe initial investment, the NPV is stated as positive. If the PVof future cash flow is less than initial investment, then it isbetter to scrap the project.NPV = PV required investment

Formula net present value

NPV = Co +C1 / 1+r

Co = the cash flow at time o or investment and therefore cashoutflowr = the discount rate/the required minimum rate of return oninvestment

The discount factor r can be calculated using:

Q (t, i) = 1/ (1+i)tWeighted Average Cost of Capital

All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.Multiply the cost of each capital component by its proportional weight and thesumming

FormulaWACC = E / V * Re + D / V * Rd * ( 1 Tc )

Re = cost of equityRd = cost of debtE = market value of the firm's equityD = market value of the firm's debt


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V = E + DE/V = percentage of financing that is equityD/V = percentage of financing that is debt

Tc = corporate tax rate

Opportunity CostThe cost of an alternative that must be forgone in order to pursue acertain action is called opportunity cost.

Lesson 10The Internal Rate of Return (IRR)

The IRR is the discount rate at which the NPV for a project equals zero.This rate means that the present value of the cash inflows for the projectwould equal the present value of its outflows.

(1)The IRR is the break-even discount rate.(2)The IRR is found by trial and error.

IRR OF AN ANNUITY

Q (n, r) = Io / C

Q (n, r) is the discount factorIo

is the initial outlayC is the uniform annual receipt (C1 = C2 =....= Cn).

Net present value vs. Internal rate of returnNPV and IRR methods are closely related because:i) Both are time-adjusted measures of profitability, andii) Their mathematical formulas are almost identical.


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NPV vs. IRR: Independent projects

Independent project: Selecting one project does not preclude the

choosing of the other. With conventional cash flows (-|+|+) noconflict in decision arises; in this case both NPV and IRR lead to thesame accept/reject decisions.

NPV vs. IRR: Dependent projects

NPV clashes with IRR where mutually exclusive projects exist.

Advantage of NPV:It ensures that the firm reaches an optimal scale of investment

Lesson 11THE PAYBACK PERIOD (PP)

The time it takes the cash inflows from a capital investment project toequal the cash outflows, usually expressed in years'. When decidingbetween two or more competing projects, the usual decision is to acceptthe one with the shortest payback.Payback is often used as a "first screening method".

For a project with equal annual receipts: PP = Io / Ct


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DISADVANTAGES OF PAYBACK

(1) It Ignore The Timing Of Cash Flow Within ThePayback Period, The Cash Flow After The EndOf Payback Period And Therefore The TotalProject Return

(2) It ignore the time value of money(3) Unable to distinguish between projects within

the same payback period.

(4) It may lead to excessive investment in short-term

projects

Advantages of the payback method

Payback can be important: long payback means capital tiedup and high investment risk.The method also has theadvantage that it involves a quick, simple calculationand aneasily understood concept

DISCOUNTED PAYBACK PERIOD

Length of timerequired to recover the initial cash

outflowfrom the discounted future cash inflows. This is the

approach where the present values of cash inflows are

cumulated until they equal the initial investment.

THE ACCOUNTING RATE OF RETURN

ARR method also called return on capital

employed(ROCE) or return on investment (ROI)

Formula


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ARR on total investment = net annual profit / investment outlay

Or

= [Rt+ c-d / Io]

Note the net annual profit excludes depreciation

Profitability indexThis is also known as benefit-cost ratio. It is a relationship between thePV of all the future cash flows and the initial investment.

This is a variant of the NPV method

PI= PV / Io

corporate finance fin622 short note

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