SENIOR OUTCOMES SEMINAR

(BU385)

FINANCE

1. OBTAIN FINANCING•Short term debt•Long term debt•Stocks

MODEL OF THE FIRM

2. INVEST IN RESOURCES•Current assets•Fixed assets

3. TO RUN OPERATIONS•Revenues•Expenses

1. OBTAIN FINANCING

•Short term debt

MODEL OF THE FIRM

Accounts payableNotes payableAccrued expenses

•Long term debtCorporate bonds

NYSE

•StocksCommon stockPreferred stock

MODEL OF THE FIRM

2. INVEST IN RESOURCES

•Current assetsCashMarketable securitiesAccounts receivableInventories

•Fixed assetsPlant and equipmentAccumulated depreciation

MODEL OF THE FIRM

3. TO RUN OPERATIONS

•Operating profits

Total salesCost of goods soldGross margins

•Net profits

Selling and adminInterest expensesTaxesNet profit margin

WHAT the firm does:

WHY the firm does it:

HOW the firm does it:

MAXIMIZE SHAREHOLDER WEALTH

MINIMIZE RISK / MAXIMIZE RETURNS

MODEL OF THE FIRM1. OBTAIN FINANCING2. INVEST IN RESOURCES3. TO RUN OPERATIONS

BASIC CONCEPTS

•Investment: What assets should the firm acquire and how much money should they spend?

•Financing: What securities should the firm issue and how much should be raised issuing stocks and bonds?

•Dividends: What portion of the firm’s profits should be paid in dividends (payout ratio)?

•Working Capital: Management of current assets and current liabilities.

FINANCIAL RATIOS(using financial statements)

•Balance sheet - Common-sized balance sheet shows assets,liabilities, and equity as a % of total assets.

•Income statement - Common-sized income statement shows income and expense items as a % of sales.

•Statement of cash flows

INCOME STATEMENT(Common Size)

(Each line item as a percent of sales)

($ amount) (% of sales)

Sales $2,311 100.0%COGS 1,344 58.2Depreciation 276 11.9EBIT 691 29.9Interest paid 141 6.1Taxable income 550 23.8Taxes (34%) 187 8.1Net income 363 15.7%

Dividends $121 5.2% Addition to RE 242 10.5

BALANCE SHEET(Common Size)

(Each item as a percent of total assets)

($ amt) (% tot. assets)

Current Assets cash $ 84 2.5% AR 165

4.9Inventory 393 11.7

Total $ 642 19.1Fixed Assets

Net P & E $2,731 80.9

Total assets $3,373 100.0%

FINANCIAL RATIOS(standardized measures)

•Used by managers for planning and evaluation

•Used by credit managers to assess risk

•Used by investors to assess stocks and bonds

•Used to compare with industry and over time

FINANCIAL RATIOSTypes of ratios

Liquidity -ability to meet short term debt Asset management -efficiency in using resources Financial leverage management -level of risk due to debt Profitability -effectiveness in generating profits Market-based -market’s view of the firm

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Liquidity Ratios Current ratio = Current assets

Current liabilities

CR = $50,190 / $25,523

CR = 1.97 vs. 2.4 Ind. Avg.

Quick ratio = Current assets – inventories Current liabilities

QR = ($50,190 - $27,530) / $25,523

QR = .89 vs. .92 Ind. Avg.

14

Asset Management Ratios Avg collection period = Accounts receivable

Annual credit sales/365

ACP = $18,320 / ($112,760/365)

ACP = 59.3 days vs. 47 days Ind. Avg.

Inventory turnover = Cost of sales Average inventory

Inv. Turn. = $85,300 / ($27,530 + $26,470)/2

Inv. Turn. = 3.16 vs. 3.9 Ind. Avg.

15

Asset Management Ratios Fixed-asset turnover = Sales

Net fixed assets

FAT = $112,760 / $31,700

FAT = 3.56 vs. 4.6 Ind. Avg.

Total asset turnover = Sales Total assets

TAT = $112,760 / $81,890

TAT = 1.38 vs. 1.82 Ind. Avg.

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Financial Leverage Management Debt ratio = Total debt

Total assets

DR = $47,523 / $81,890

DR = 58% vs. 47% Ind. Avg.

Debt-to-equity ratio = Total debt Total equity

D/E = $47,253 / $34,367

D/E = 138.3% vs. 88.7% Ind. Avg.

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Financial Leverage Management

Times interest earned = EBIT Interest charge

Coverage Ratio = $11,520 / $3,160

Coverage Ratio = 3.65 vs. 6.7 Ind. Avg.

Equity multiplier = Total assets Total equity

EM = $81,890 / $34,367

EM = 2.38 vs. 1.89 Ind. Avg.

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Profitability Ratios Gross profit margin = Sales - Cost of sales

Sales

GPM = ($112,760 - $85,300) / $112,760

GPM = 24.4% vs. 25.6% Ind. Avg.

Net profit margin = EAT Sales

NPM = $5,016 / $112,760

NPM = 4.45% vs. 5.1% Ind. Avg.

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Profitability Ratios ROI = EAT

Total Assets

ROI = $5,016 / $81,890

ROI = 6.13% vs. 9.28% Ind. Avg.

ROE = EAT Stockholders equity

ROE = $5,016 / $34,367

ROE = 14.6% vs. 17.54% Ind. Avg.

20

Market-Based Ratios

P/E ratio = Market price per share Current earnings per share

Market to book ratio= Market price per share Book value per share

21

Dividend Policy Ratios Payout ratio = Dividends per share

EPS

Dividend yield = Expected dividends per share Stock price

22

Financial Ratio Analysis Trend analysis 2000 01 02

XYZ current ratio 1.9 2.2 2.3

Cross-sectional analysis 2002

XYZ current ratio 2.3 Industry averages 2.5

Both simultaneously 2000 01 02

XYZ current ratio 1.9 2.2 2.3 Industry averages 2.5 2.4 2.5

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Relationships Among Ratios

This is the Dupont formula:

ROE = Net profit Total Assets Equity margin turnover multiplier

or ROE = NPM TAT EM

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Dupont Formula

Example of the Dupont formula:

ROE = NPM TAT EM

Company: 14.6% = 4.45% 1.38 2.38

Industry average: 17.5% = 5.10% 1.82 1.89

TIME VALUE OF MONEY (PV-present value, FV-future value)

A. Rate of return (interest/discount rate)

B. Single Amount – PV / FV (PV Princ. #1)

C. Annuities:• FV: Sinking Fund (saving for college)• PV: Capital Recovery (car payment)

D. Cash Flows (PV Principle #2)

E. Bond valuation/Stock valuation

F. Perpetuities

Interest Rates

Simple Interest Interest paid on the principal sum only

Compound Interest Interest paid on the principal and on prior interest

that has not been paid or withdrawn. Note: this is referred to as a discount rate when computing the PV of a FV sum of money.

Real Interest Rate Real rate = nominal rate – inflation

What’s the FV of an initial $100 after 3 years if i = 10%?

FV = ?$133.10

0 1 2 310%

Finding FVs (moving to the righton a time line) is called compounding.

PV100

PV/FV Single Amount

10%

What’s the PV of $100 due in 3 years if i = 10%?

Finding PVs is discounting, and it’s the reverse of compounding.

FV100

0 1 2 3

PV = ?$75.13

PV/FV Single Amount

PV/FV Single Amount

A. PV Principle # 1 There is an inverse relationship between

interest rate and PV (present value).

How much is $1000 received one year from now worth today-using 5% and 15% discount rate?

FV Rate PV (n = 1)$1,000 5% $952$1,000 15% $870

What’s the FV of a 3-year ordinary annuity of $100 at 10%?

PMT=100 100100

0 1 2 310%

110 121FV = 331

FV: Sinking Fund (saving for college)

What’s the PV of this ordinary annuity?

PMT=100 100100

0 1 2 310%

90.91

82.64

75.13248.69 = PV

PV: Capital Recovery (car payment)

TIME VALUE OF MONEY (PV-present value, FV-future value)

Cash Flows (PV Principle #2):

Cash flows closer in time have more value than cash flows received later (“bird in the hand” principle).

year CF1 CF2 1 $100 $300 2 300 300 3 300 100 4 50 50 total $750 $750 PV $598 $630

What is the PV of this uneven cashflow stream?

0

100

1

300

2

300

310%

50

4

90.91247.93225.39 34.15

598.38 = PV

Cash Flows (PV Principle #2)

Option #1: total cash=$750

What is the PV of this uneven cashflow stream?

0

300

1

300

2

100

310%

50

4

272.73247.93 75.13 34.15

629.94 = PV

Cash Flows (PV Principle #2)

Option #2: total cash = $750

Bonds and Their Valuation

Key features of bonds Bond valuation Measuring yield Assessing risk

Key Features of a Bond

1. Par value: Face amount; paid at maturity. Assume $1,000.

2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest.

Generally fixed.(More…)

3. Maturity: Years until bondmust be repaid. Declines.

4. Issue date: Date when bondwas issued.

5. Default risk: Risk that issuer will not make interest or principal payments.

How does adding a call provision affect a bond?

Issuer can refund if rates decline. That helps the issuer but hurts the investor.

Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.

Most bonds have a deferred call and a declining call premium.

(Note: convertible bonds would have lower yields.)

What’s a sinking fund?

Provision to pay off a loan over its life rather than all at maturity.

Similar to amortization on a term loan.

Reduces risk to investor, shortens average maturity.

But not good for investors if rates decline after issuance.

1. Call x% at par per year for sinking fund purposes.

2. Buy bonds on open market.

Company would call if rd is below the coupon rate and bond sells at a premium. Use open market purchase if rd is above coupon rate and bond sells at a discount.

Sinking funds are generally handledin 2 ways

What’s the value of a 10-year, 10% coupon bond if rd = 10%?

V

rB

d

$100 $1,000

11 10 10 . . . +

$100

1+ r d

100 100

0 1 2 1010%

100 + 1,000V = ?

...

= $90.91 + . . . + $38.55 + $385.54= $1,000.

+++1 r+ d

What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value

bond that sells for $887?

90 90 90

0 1 9 10rd=?

1,000PV1 . . .PV10

PVM

887 Find rd that “works”!r = 10.91%

...

What’s interest rate (or price) risk? Does a 1-year or 10-year 10% bond

have more risk?

rd 1-year Change 10-year Change

5% $1,048 $1,386

10% 1,000 4.8% 1,000 38.6%

15% 956 4.4% 749 25.1%

Interest rate risk: Rising rd causes bond’s price to fall.

What is reinvestment rate risk?

The risk that CFs will have to be reinvested in the future at lower rates, reducing income.

Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

Year 1 income = $50,000. At year-end get back $500,000 to reinvest.

If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

Long-term bonds: High interest rate risk, low reinvestment rate risk.

Short-term bonds: Low interest rate risk, high reinvestment rate risk.

Nothing is riskless!

Bond Risk

What factors affect default risk and bond ratings?

Financial performance Debt ratio Coverage ratios, such as

interest coverage ratio or EBITDA coverage ratio

Current ratios

(More…)

Provisions in the bond contract Secured versus unsecured debt Senior versus subordinated debt Sinking fund provisions Debt maturity

Other factors Earnings stability Regulatory environment Potential product liability Accounting policies

What factors affect default risk and bond ratings?

Stocks and Their Valuation

Features of common stock Determining common stock

values Efficient markets Preferred stock

Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of

shareholders, their goal should be: Maximize stock price.

Common Stock: Owners, Directors, and Managers

Dividend growth model Using the multiples of comparable

firms (P/E) Free cash flow method

Different Approaches for Valuing Common Stock

ssss r

D

r

D

r

D

r

DP

1. . .

111ˆ

33

22

11

0

One whose dividends are expected togrow forever at a constant rate, g.

Stock Value = PV of Dividends

What is a constant growth stock?

P0 = D1/(r-g) Preferred stock: P = D/r

What’s the Efficient MarketHypothesis (EMH)?

Securities are normally in equilibrium (S/D) and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.

1. Weak-form EMH:

Can’t profit by looking at past trends, support for weak-form but “technical analysis” is still used.

2. Semistrong-form EMH:All publicly available information is reflected in stock

3. Strong-form EMH:All information, even inside information, is embedded in stock prices.

Perpetuities and Their Valuation

Key features of perpetuities: Fixed income No maturity date

Valuation: Perpetual Bond: P = I / k Preferred Stock: P = D / k

Capital Budgeting(Capital Investment)

A.Methods of evaluation:1.NPV: Net Present Value = PV(cash flows) –

Net investment2.IRR: Internal rate of return = true yield on

investment3.PB: payback = number of years to get back

your investment.4.PI: profitability index = PV(cf’s) / Net Invest

B. Discount rate: WACC = weighted average cost of capital

Capital Budgeting(Capital Investment)

Discount rate: WACC = weighted average cost of capital (hurdle rate)

Type of funding Rate Proportion ProdShort term debt 8% .15 8%x.15=1.2Long term debt 10% .35 10%x.35=3.5Stocks 20% .50

20%X.50=10.0WACC=

14.7%

WACC = weighted average cost of capital

Working Capital(Operating Capital)

Net Working capital = Current Assets – Current Liabilities