Chapter 1 – Overview of Financial Management Investment Vehicle Model – Investors provide financing to the firm in exchange for financial securities (bonds and shares), and firm invests these funds in assets. The income generated by the firm is distributed to the investors. Balance Sheet Model (Accounting Model) – Investment decisions are represented by LHS/Assets and Financing decisions are represented by RHS/Liabilities & Equity on the balance sheet. Total Value of Assets = Total Firm Value to Investors
Corporation
Limited Liability
Double taxation (not for Singapore
Book Values (historical costs less accumulated depreciation)
Market Values
Separation of ownership & management
Separation of ownership & management
Determined by GAAP
Determined by current trading values in the market
Unlimited Life Ease of raising capital
3 Primary Decision Areas of Corporate Finance Capital Budgeting Decision
What long term investments (fixed assets) should the firm engage in?
Capital Structure Decision
How can the firm raise money for the required investments? CL, LT Debt and Shareholders’ Equity.
Working Capital Management
Ease of transferring ownership The Primary Goal of Financial Management – is to maximize shareholder wealth (maximize stock price). 1. Maximize the value of the firm
How much ST cash flow does a company need to pay its bills (manage liquidity)? NWC = CA-CL •
Roles and Responsibilities of Financial Managers Controller
Treasurer
Supervising accounting personnel
Raising capital, managing cash and capital expenditures
Preparation of financial and managerial accounting information and reports
Supervises relationships with financial institutions, work with investors and potential investors
Analyses accounting information
Manages investments and establishes credit policies
Planning and decision making
Manages insurance coverage
Advantages of Different Types of Business Business
Sole Proprietorship
Partnership
Advantages
Disadvantages
Easy to start, few regulations
Limited to life of owner
Single owner keeps all the profits
Unlimited liability
Taxed once as personal income
Equity capital is limited to personal wealth
More capital available
Unlimited liability (may be limited partnership)
Taxed once as personal Income
Dissolves when one partner wishes to sell/dies
More Capital available
Difficult to sell/transfer
• • •
2.
Maximize the wealth of its owners
3.
Maximize the price of its stock
4. Maximize its contribution to the economy Shareholder wealth is a cash-flow related concept, maximizing annual profits, market share, sales and minimizing costs may not max wealth. Concentrating on the long term. Ability to generate cash flows for stockholders determines stock prices Amount, timing, and riskiness of cash flows determine the intrinsic value of stocks.
Intrinsic Value – estimate of stock’s true value with accurate risk & return information Market Price – based on perceived information by the marginal investor Reputation – compilation of impressions held by all of the entity’s stakeholders • Reputation management involves managing expectations and perceptions Agency Problem – Conflict of interest between principal and agent • Direct Agency Costs: expenditures benefit management, (monitoring) audit cost • Indirect Agency Costs: lost opportunities that would increase firm value • Shareholders and Managers • Shareholders and Creditors 1. Compensation plans tied to share value 2. Monitoring by creditors, analysts and investors Ways to handle the 3. Threat of being fired agency problem 4. Awareness of good Corporate Governance Financial Markets – markets where finances are traded. Act as intermediaries between savers and borrowers. Money Markets – debt securities of less than one year are traded: treasury securities, commercial paper, bills and inter-bank loans. Dealer Markets Capital Markets – equity & long-term debt claims are traded. Auction Markets Primary Market – funds raised go to company directly. Government and corporations initially issued securities. Public and private offerings. Secondary Market – funds raised do not go to company directly. Existing financial claims are traded. Dealer Market: OTC markets (NASDAQ) Auction markets: SGX, NYSE. Getting market value of securities is easier Chapter 2 – Financial Statement Analysis Balance Sheet – snapshot of a firm’s financial position at one point in time; Income Statement – firm’s revenues and expenses over a given period of time; Statement of RE – how much of the firm’s earnings were retained, rather than paid out as dividends; Statement of Cash Flows – activities on cash flows over a given period of time.
Enterprise Value = Market Value of Equity + Debt – Cash. It assesses the value of the underlying business assets unencumbered by debt and separate from any cash and marketable securities. Sources of Cash (bring in cash)
Uses of Cash (cash outflow)
Decreases in assets other than cash
Increases in assets other than cash
Increases in equity and liability
Decreases in equity and liabilities
Operating – net income and changes in most current accounts (AP, AR, Invent); Investment – changes in fixed assets; Financing – changes in notes payable, LT debt, equity accounts and dividends. ∆Cash = ∆Retained Earnings (Net Income) + ∆CL - ∆CA other than cash -∆Net fixed assets + ∆Long Term Debt + ∆Common Stock ∆Cash = Operating Activities: Net Income + depreciation + ∆non-interest bearing current liabilities - ∆current assets other than cash. Investment activities: - (∆net fixed assets + depreciation) Financing Activities: +∆interest bearing current liabilities ∆longterm debt +∆common stock - dividends Accounts Payables do not bear interest
M/B Ratio: Market Price per share/Book Value per share how much investors are Financial Markets allow companies, government and individuals to increase utility • willing to pay for $1 of book value equity Savers can invest in fin assets & earn compensation for deferred consumption • Borrowers have more access to capital to invest in productive assets Dupont Identity • Provide information about returns required for various levels of risk ROE = ROA X EM = PM X TA TO X EM = NI/SALES x SALES/TA x TA/TE •
Profit Margin: measure of firm’s operating efficiency – how well does it control costs Total Asset Turnover: measure of firm’s asset use efficiency – how well does it manage its assets. Equity Multiplier: measure of the firm’s financial leverage. " Common-size Balance Sheet – as a percent of total assets; Common-size Income Statements – all line items as a percent of sales. "
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" Expected Portfolio Return: Weighted average of E(R) on individual stocks
Liquidity Ratios: measure ability to pay liabilities in the short run (ability to convert assets to cash quickly without a significant loss in value) • Current Ratio: Current Assets/Current Liabilities • Quick Ratio: Current Assets – Inventory / Current Liabilities • Cash Ratio: Cash / Current Liabilities • NWC to Total Assets Ratio: Net Working Capital / Total Assets • Interval Measure: Current Assets / Average daily operating costs - (how many days of operations can the current assets fund)
Chapter 3 – Time Value of Money
Asset Management Ratios: measure how effectively assets are managed • Inventory Turnover: COGS/Inventory • Days Sales in Inventory: 365/Inventory Turnover = 365XInventory/COGS (no. of days taken to sell that ‘set’ of inventory) • Receivables Turnover: Sales/Receivables • Days Sales Outstanding: AR/Avg Daily Sales = 365/Receivables turnover (number of days after making sales before receiving cash) • Fixed Asset Turnover: Sales/Net Fixed Assets (for every $ of fixed asset, how much sales can it generate) • Total Asset Turnover: Sales/Total Assets
Pure Discount Loans: Like zero-coupon bonds, pure discount bonds, principal (and all interest) paid at maturity, no periodic interest payment, issued at discount Interest Only Loans: Interest paid throughout loan period, principal at maturity Loans with Fixed Principal Payments: Interest and fixed principal payments over life Amortized Loan: Equal payments cover interest expense and reduce principal
Lost Earnings: Interest Revenue earned on investing the money Loss of Purchasing Power: Due to Inflation. Real value is less than nominal value
Expected Portfolio σ: Find σ, treating portfolio as 1 stock (or below). CVp same Portfolio Risk Premium based on market risk.
SD of a 2 stock portfolio: Ordinary Annuity: Payments are made at the end of the period. Annuity Due: Payments are made at the beginning of the period 2 + 2 2 Correlation σ = w12σCoefficient/Covariance: −≤ ρ ≤ ρ1.0σ σ Perpetuity: Infinite series of equal payments. PV = payment/interest rate. (1 − w1 ) σ 2 + 2w-1.0 p 1 1 (1 w1 ) 12 1 2 Growing Perpetuity: set of payments which grow at a constant rate each period and If ρ=-1.0, 2 stocks can form a riskless portfolio Long Term Solvency Ratios (Financial Leverage): extent of relying on debt financing continue forever. PV = payment/(interest rate – growth rate) If ρ=+1.0, there is no reduction of risk for the 2 stock portfolio rather than equity. More debt means more likely to default • Total Debt Ratio: Total Debt / Total Assets Total Risk = Company-specific (Unsystematic Risk) + Market (Systematic) Risk FV interest factor = PV factor = • Debt Equity Ratio = Total Debt / Total Equity Unsystematic Risk: caused by random events specific to firm. Can be diversified • Equity Multiplier Ratio = Total Assets / Total Equity = DE-ratio +1 Systematic Risk: affects most if not all firms. Cannot be diversified away. • Long Term Debt Ratio = Long Term Debt/Long Term Debt + Total Equity Effective Annual Rate (EAR): the actual rate paid (or received) after taking into • Times Interest Earned Ratio = EBIT / Interest (given what I earn, how much can it consideration any compounding that may occur during the year. β measures stock’s market/systematic risk, shows volatility relative to market, indicating cover my interests payable) Annual Percentage Rate (APR): annual rate that is quoted by law. Period rate = APR / how risky a stock is if held in a well-diversified portfolio. Market β is 1. • Cash Coverage Ratio = EBIT + Depreciation / Interest number of periods per year.
Profitability Ratios: measures how successful a business is in earning returns on its investments. Combined effects of liquidity asset management and debts. • Profit Margin = Net Income/Sales • Basic Earning Power = EBIT/Total Assets • ROA = Net Income / Total Assets • ROE = Net Income (-preferred dividends) / Total Common Equity o ROA is lowered by debt – interest expense lowers net income which also lowers ROA o ROE increases with debt o ROE does not consider risk and amount of capital invested Market Value Ratios: relate firms stock price to earnings, cash flow & book values • P/E Ratio: Price/Earnings how much investors are willing to pay for $1 of earnings
Geometric mean: what you actually earn per year on average compounded annually. Also known as mean holding period return or average compound return earned per year over a multiyear period. Arithmetic mean: what you earned in a typical year.
Chapter 4 – Risk and Return I Dividend Yield (%) = Dividend/Initial Share Price Capital Gain Yield (%) = Capital Gain/Initial Share Price Percentage return = dividend yield + capital gains yield Impact of Inflation: Expected Returns take into account uncertainties that are present in diff scenarios.
OR Risk is the uncertainty associated with future possible outcomes. Investment risk is the potential for investment return to fluctuate up and down Standard deviation measures stand-alone risk of an investment Using Historical Data: Ravg = Arithmetic mean (avg annual return) Rt = realized ROR Coefficient of Variation CV better measure of risk
" Chapter 5 – Risk and Return II Risk-Return Trade-off for a portfolio is measured by portfolio’s expected return and standard deviation (volatility of the portfolio) Diversification involves investing in different asset classes and sectors. It reduces variability of returns without equivalent reduction in expected returns. Well Diversified Portfolios have very little unsystematic risk. Risk = systematic risk
Portfolio’s Beta, βp is the weighted average of the assets betas.
Buying or Selling bonds before maturity can result in gains or losses outside coupon Bonds of similar risk & maturity will be priced similarly regardless of coupon
Systematic Risk Principle: There is a reward for bearing risk but there is no reward for bearing risk unnecessarily. Expected return on a risky asset depends only on β. β>1 implies that the asset has more systematic risk than the overall market "
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Price Vs YTM
Risk Premium = (RM – RF)β = Expected Return – Risk Free Rate Market Risk Premium = RM – RF (since market beta is always 1) also risk-reward ratio Security Market Line: Graphical representation of the CAPM, and market equilibrium • Assets below SML are overpriced and assets above SML are underpriced
Premium Bonds: YTM < Current Yield < Coupon Rate Discount Bonds: YTM > Current Yield > Coupon Rate Par Value: YTM = Current Yield = Coupon Rate "
" Capital Asset Pricing Model: equation describing SML. Appropriate return for risk
Chapter 6 – Bond Valuation Bonds are long term debt instruments sold to raise money. Bonds are fixed-income investments, and this regular income is what makes bonds less volatile than stocks. Bond owners are creditors of the company and not owners (unlike stockholders) Coupon: A bond’s interest (payment) Coupon Rate: Annual coupon divided by the par value of the bond (annual) Par: Face value of a bond (principal amount) that will be repaid at maturity.
Callability: the issuer can redeem the bond before it expires Seniority: Preference in position over other creditors. Subordinated debt is junior Debenture: Bond backed by issuer’s general credit/ability to repay and not assets Basis Points: measures of differences in yields. 1 basis point = 0.01% " Convertibility: option of exchanging bond for stock Capital Market Line: the tangential line joining the Risk Free Rate to the efficient frontier Protective Covenant: part of indenture that limits certain actions a company may choose to take during the term of the bond. of all possible portfolios in the market Sinking Fund Provision: pay off loan over its life like an amortized loan. Reduced risk to " Security Market Line Capital Market Line investor and shortens average maturity. Not good if rates decline after issuance. Bond Indenture: Bond contract specifying principal, coupon, maturity, amt of bonds, Graphical representation of market’s risk Shows rate of return, which depend on backing assets/securities, sinking fund, call provisions & protective covenants and return at a given time risk free rate and levels of risk of a specific portfolio Coupon Rate/YTM on a bond depends on risk characteristics when issued Beta x-axis
Standard deviation x-axis
Higher
Unsecured
Subordinated
No Sinking Fund
Callable
Both nonefficient and efficient portfolios
Only efficient portfolios
Lower
Secured
Senior
Sinking Fund
Non callable
Factors Affecting Default Risk & Bond Ratings Financial Performance Debt Ratio
TIE Ratio Where market portfolios and risk free assets are determined by CML, security factors Yield To Maturity – rate earned if bond is held to maturity. Rate at which cash flows are Current Ratio are determined by SML. CML is superior to SML in measuring risk factors. discounted to the present value. Interest rate required on a bond in the market. When YTM > Coupon Rate, bond sells below par value - Discount Bond Interest Rate rises, YTM increase, Bond prices decrease When YTM < Coupon Rate, bond sells above par value - Premium Bond Effect of Time on Bond Prices Interest rate falls, YTM decreases, Bond prices increase Holding a bond till maturity ensures repayment of principal as long as no default
Bond Contract Provisions Secured/Unsecured Debt Senior/Subordinated Debt Guarantee & sinking fund provision Debt maturity
1. 2. 3. 4. 5. 6.
Real Rate of Interest Expected Future Inflation Interest Rate Risk Default Risk Taxability Liquidity Risk
Pure Discount Bonds: 0-coupon bonds, sold at discount (YTM comes from difference between PV and principal sum) cannot sell more than par value. T bills Floating Rate Bonds: coupon rate float depending on index such as inflation. Less price risk. Coupon floats and unlikely to differ from YTM. Collar controlling rate Disaster bonds: issued by property and casualty companies. Pay interest and principal as usual unless claims reach a certain threshold for a single disaster. At that point, bondholders may lose all remaining payments Higher required return. LECTURE 4: Risks & Returns I Income bonds – coupon payments depend on level of corporate income. If earnings are not enough to cover the interest payment, it is not owed. Higher required return. Convertible bonds – bonds can be converted into shares of common stock at the bondholders discretion Lower required return Put bond – bondholder can force the company to buy the bond back prior to maturity Lower required return Structure of Interest Rates: r/s of time to maturity and yields ceteris paribus Does not include effects of default risk, different coupons
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Normal: LT yields are more than ST
Inverted: LT yields are less than ST Factors that affect Bond Yields:
Fischer Effect: 1+Nominal Rate = (1+real rate)(1+inflation) Approximation: Nominal Rate = Real Rate + Inflation
