1.Overview 2.

Long Term Solvency – Financial leverage ratio, the Perpetuities

 Finance is concerned with determining value and making decisions degree that a firm relies on debt financing rather than Perpetuities: PV = C / r (Preferred shares)
based on value assessment. equity. Where C represents payment
Investments – Study of fin transactions from perspectives of ext.
Total Debt Ratio = TD / TA = (CL + LTD) / TA PV of Growing Perpetuity = C1 / r – g
investors
Fin Mkts & Int – Study of security mkts & financial institutions
Debt Equity Ratio = (TA – TE) / TE = TD / TE (Common shares)
Corp Fin – Capital Budgeting, Capital Structure & Working Capital Equity Multiplier = TA / TE = 1 + (Debt/Equity) Ratio
Mgmt Long Term Debt Ratio = (LTD) / (LTD + TE) Interest Rates
CB – What LT investments to engage. CS – What debt/equity to use Times Interest Earned Ratio = EBIT / Interest EAR = [1 + APR/m]m – 1
NOWC mgmt – How much ST cash flows required to pay bills? -Ability to pay off interest, how many x interest can you pay = [1 + Period Rate]m – 1
 Managers must increase value of firm via value maximization Cash Coverage Ratio = (EBIT + Depn) / Interest APR = period rate * the number periods a year
 Goal of Fin Management – Shareholder wealth maximization APR = EAR if 1 compounding period a year
through systematic value maximizing investments & financing 3. Asset Management – Activity ratios that measure
decision criteria. Determinants of stock price – underlying ability how effectively the assets of a firm are managed Finding number of periods
to generate cash flow based on amount, timing and riskiness. The Inventory Turnover = COGs / Inventory FV = PV (1+r)t
3 determine intrinsic value Days sales in Inventory = 365 / Inventory Turnover ln FV = ln PV + ln (1+r)t
 Intrinsic Value – Estimate of true value through risk and return - Measures how long inventory stays in warehouse ln FV – ln PV = t (ln (1+r))
 Market Value – Based on perceived information by marginal Rec. Turnover = Sales / Receivables t = ln (FV / PV) / ln (1+r)
investor DSO (Days sales outstanding or avg collection period)
 Agency Problem – Conflicts of interest between principal & agent. DSO = AR / Average Daily Sales Types of Loans
Direct agency cost (Salary benefiting management, monitoring) & = 365 / Receivables Turnover
Indirect (lost opportunities) To resolve agency problem, tie
FA Turnover = Sales / FA
compensation plans to performance of company.
TA Turnover = Sales / TA
1. Money Market – Trading of debt securities of less than 1 year
Capital Market – Trading of equity and long term debt (SGX)
2. Primary Market – Initially issued securities (IPO and private 4. Profitability – Combined Effects of A, L and E
offerings) Profit Margin = NI / Sales
Secondary Market – For existing financial claims (SGX/NYSE) BEP (Basic Earning Power) = EBIT / TA
2. Financial Statement Analysis ROA = NI / TA
 Book Value = Historical cost – accumulated depreciation ROE = NI*/ TE (Deduce pref. dividend from NI)
Market Value = Determined by current trading values in the Problems with ROE: don’t reflect risk. Don’t consider
amount of K invested. Might encourage managers to make
market
decisions that don’t benefit shareholders. ROE focus only on
MV equity = Market Cap = Share Price * No. Outstanding shares
return. Better measure may consider both risk and return
 Enterprise Value (EV): Assess value of underlying assets away from
non-operating cash and marketable securities. EV represents the
cost of buying over a company. 5. Market Value Ratios
EV = Market Value of Equity + Debt – Cash P/E Ratio = Price / Earnings Per Share
 Stocks: Outstanding stock (Stock held by outsiders), Treasury stock What investors will pay for $1 of earnings
(shares bought back by companies M/B Ratio = Mkt price per share / BV per share
 Sources of cash: Fall in assets (other than cash) and increase in What investors will pay for $1 of BV equity
Equity/Liabilities
 Statement of Cash flows ROE = (Prof Margin)(Total Asset Turnover)(Equity Multiplier)
Operating – Includes NI and changes in most current accounts Operating efficiency . Asset use efficiency . Financial Leverage
Investment – Changes in fixed assets = (Net Income / Sales) (Sales / Total Assets) (TA / TE)
Financing – Changes in notes payable, LTD, equity and dividends How profitable How efficient Debts
Change in Cash = ∆ in RE + ∆ in CL – ∆ in CA – ∆ in net FA + ∆ in LTD = (ROA) (Equity Multiplier)
+ common stock
 Cash Flow from Assets (CFFA) / (FCF) 3. Time Value of Money
CFFA + Interest Tax Shield = Cash Flow to Creditors + Cash Flow to Annuities describes a series of cash flows in which the
Stockholders same CF takes place each period.
CF to Creditors = Interest Paid – Net new borrowing (LT Debt & Ordinary Annuity – First CF occurs 1 period from now
Notes Payable) First CF at t = 1
Cash Flow to Stockholders = Dividends paid – Net new equity Annuity Due – First CF occurs immediately
raised First CF at t = 0
CFFA = OCF – NCS – ∆NOWC Perpetuity – Set of equal payments paid forever
OCF = EBIT + Depreciation – (EBIT * Tax Rate) Growing Perpetuity – Payments that grow a constant
OCF = (Sales – Cost)(1-T) + D(T) ^Cost does not include depn! rate and continue forever
NCS = Ending Net FA – Begn Net FA + Depreciation
∆NOWC = [New CA – New CL] – [Old CA – Old CL] *OWC excludes
Notes Payable as it is non-operating working capital. NP is an FV = PV(1+r)t = PV(1+i)n
interest bearing liability due financing activities PV = FV / (1 + r)n
Interest Tax Shield = Interest Paid * Taxes ^Not in CFFA, sep where FVIF = (1+r)t and PVIF = (1 / (1+i))n
Fin&Ops
Diff. between annuity & annuity due = (1 + i). Annuity
 Common-size BS: Compute accounts as a % of total assets
due always worth more if r > 0
Common-size IS: Compute line items as a % of sales
PV Annuity Due = PV Annuity * (1+r) Assume i/r always
positive.
1. Liquidity Ratios – Ability to convert assets to cash quickly without a
significant loss in value. Ability to meet maturity short-term
obligation
Current Ratio = CA / CL
Quick Ratio = (CA – Inventory) / CL
Cash Ratio = Cash / CL
NWC to Total Assets = (CA-CL) / TA
Interval Measure = CA / Average daily operating cost
IM measures no. of days company can operate with current cash

FV Annuity = PV Annuity * (1+r)

FV Annuity Due = FV Annuity * (1+r)
4 & 5 Risk and Return
Dividend Yield: Dividend / Initial Share Price 4 & 5 Risk and Return
Capital Gain Yield: Capital Gain / Initial Share Price
Total % return = Div Yield + Capital Gain Yield

1 + real return = (1 + nominal return) / (1 + inflation rate)

Real return ≈ Nominal Return – Inflation
Expected Returns (Future values): Take the returns * YTM = Coupon rate = interest rate  bond
probability and sum. bought at par value
Coupon rate < interest rate < YTM  bond
bought below par value (discount)
Coupon rate > interest rate > YTM  bond
Geometric – Earnings bought above par value (premium)
on average,
compounded annually Current Yield: Annual interest rate of a bond as
Risk percentage of current market price. Does not
Risk is uncertainty associated with future possible outcomes take into account capital gain or loss.
Standard Deviation (SD) measures total/standalone risk. YTM: Yield that equates PV of all cash flows to
SD measures dispersion around an expected value. from a bond to the price of a bond.

When I/R increases, bond PV falls

Rationale: Think zero coupon bonds. When I/R
rises, PV bond falls thus price falls to fit the lower
returns to attract investors
When YTM increases, bond prices fall
Rationale: Company issue 4% in Y1, then issue
4.5% in Y2 thus YTM has increased. Y1 bond’s
Markowitz Portfolio Theory
price must fall to attract investors.
Efficient portfolio is portfolio that provides
greatest return for given level of S.D (Risk)
Choose investment with lowest CV = SD/Expected rate of Line connecting all efficient portfolios is called
return the efficient frontier
CV is risk per unit return = SD/Mean
Portfolio
Risk Premium is return over and above risk-free rate
Portfolio Return = W1R1 + W2R2 + ….. where W1 + W2 … + Wn =1
Portfolio S.D = Shown above (Calculate Prtfolio return to Bonds of similar risk and maturity will have the
use) same effective (not nominal) YTM regardless of
the coupon rate
 From price of one bond, can estimate YTM to
2 stocks with negative covariance/correlation will results in a find price of another bond.
portfolio with a smaller standard deviation.
*Be careful when calculating YTM for coupon
payments more than once a year. I/R on
calculator is period YTM not annual YTM. Need
to * to get the annual YTM.

Pxy = -1 risks completely eliminated I Pxy = 1 does not remove

risk
Thus if Pxy < 1 between 2 stocks, some risk will be eliminated.
2 stocks can be combined to form riskless portfolio if PXY = -1 Investment Grade: Baa/BBB and above

6. Bond Valuation TBill: < 1 Year . TNote 1<x<10 years. TBond> 10yr
Types of Risk
Total Risk = Company Specific Risk + Market Risk (a.k.a Beta)
Debenture – unsecured bond with no collateral
= Unsystematic Risk + Systematic Risk
1 Basis point – 0.01%
Market Risk (Beta) measure a stock’s market risk and volatility Sinking fund – provison to pay loan over its life
relative to the market. B(market) = 1 B=(RF asset = 0
Coupon rate – Depends on bond’s risk
characteristic when issued. Summary of factors that affect Bond Yields
1. Real Rate of Interest
Bond value = PV coupons + PV Par
2. Expected Inflation
= PV annuity + PV lump sum 3. Maturity Risk (term of the bond)
This is related to Interest Rate Risk (how interest rate
YTM = Rate earned if bond held to maturity. fluctuation affects the bond price)
If B < 1, asset has less systematic risk than market 4. Default Risk (chance of the issuer defaulting)
Rate that discounts future bond cash flows to
If B > 1, asset has more systematic risk than market 5. Liquidity Risk (ease of sale of the bond in the market)
Required rate of return (CAPM)
current value. Buy a bond when market rate is 6. Taxability
rE = rf + (rm – rf)β rd and hold the bond to maturity, rd =YTM.
 n Stock Valuation
7. Does decisionBudgeting
8. Capital rule adjust for
I time value of money,
risk and tell us whether we are creating value?
Book Value: Price paid to acquire asset, less accm. Depn *Any rule that factors time value adjusts for risk
Market Value: Price determined in a competitive market NPV
Intrinsic Value: PV of expected future cash flows 1. Estimate expected FCF (amount and timing)
IV is determined by size, timing of CF and req rate of rtrn 2. Estimate required return (CAPM or others)
3. Find NPV and subtract initial investment
Price of stock is just PV of all future expected dividends.
1. Constant Dividend (Valued stock like perpetuity)

Profitability Index (Benefit / Unit cost)

PI = Total PV of future CF / Initial Investment
Accept if NPV ≥ 0. NPV is difference of IV and Cost Accept if PI > 1 (If PI=1.1, $0.1 value created / $1)
Payback Period Do not use to compare m.exclusive
Accept if payback period < present limit 9. Capital Budgeting II
2. Constant Dividend Growth (Gordon Growth)
Dividends grow at constant % per per period Discounted Payback Period
Cash flows must be on an incremental basis.
Accept if project pays back on discounted basis
within specified time. (May reject +ve NPV Types of Relevant CF
projects, ignores cash flows beyond cut off point) 1) CF measured on an after-tax basis
For this method, Re > g and g must be constant forever 2) Changes in (NOWC) (they are relevant IF cash
Share Price grows at same rate as dividends. Average Accounting Return (Accept if AAR > rate) investment in current assets MUST be made)
AAR = Average NI / Average Book Value
P4 = D5 / (RE – g) Re can be found from CAPM (NOWC): (Cash + Inventory + A/R) – (Accruals+ A/P)
Av NI – Av of all periods. Av BV – 3) Opportunity costs
rE is the expected return of the stock Internal Rate of Return (IRR) Forgone CF when accept project, there are opp
IRR is the return that makes NPV = 0 costs in decisions.(Outflow) REMEMBER TO TAX
3. Non-constant growth IRR is Investment’s projected rate of growth 4) Externalities/Side Effects
Accept if IRR > Required Return Change in CF in other projects due your decision
Types of non-Relevant CF
Sunk Cost
Financing Cost (Ignore Interest & Div) as it has
already been factored into the discount rate.

WACC takes into account firm’s after-tax equity and

debt financing costs. Rd(1-T) represents interest cost
and rE represents dividend cost.
Compute dividends until growth levels off. Find TV at
period before growth levels off. Then find PV of expected
future cash flows. NPV vs IRR
NPV and IRR will usually give same decision xcept
1. Mutually Exclusive Projects (diff. size & timing)
2. Non-conventional cash flows
Independent – CFs unaffected by accepting other
M. Exclusive – CFs impacted by accepting others
Nonconventional CFs will give 2 IRRs.
Use NPV to decide between projects
Rf = Real risk-free interest rate + Inflation Premium
G could change due economic or firm specific situation 1. Initial cash flow
Mutually Exclusive Projects -a: Initial investment in project assets (FIXED long-
Corporate Value Model (Use if firms don’t pay Div) NPV profiles cross due size differences and timing term assets etc) (NCS)
AKA Free cash flow method (CCFA = FCF) differences. Project w large CF early is less -b: Initial investment in NOWC (CURRENT assets)
CVM suggests that value of entire firm equals to PV of sensitive to disc rate. Use NPV as NPV assumes -initial set-up cost, investment.
firm’s free cash flows. reinvest @WACC while IRR reinvests @ IRR.
2. Interim CF
FCF = OCF – NCS – change in NOWC -c: Annual after-tax operating cash flow (OCF)
1.Find the market value of the firm by computing PV of ---- Any cash flow needed to support project
the firm’s expected future FCF. 2.Subtract market value –b: Subsequent annual changes in NOWC
of total debt and market value of preferred stock to get (ΔNOWC)
mv of common equity. 3.Divided market value of -a: Subsequent investments/sale of fixed assets
common equity by number of common shares (NCS)
Which project you choose depends on disc. Rate
outstanding to get intrinsic stock price value per share. Remember to factor previous asset’s depn
MIRR (Assumes CF reinvested at WACC)
MIRR is disc. Rate where PV TV = PV Costs 3. Terminal CF
Compound +ve inflow at WACC to maturity and -a: Net salvage value of FA (NCS) Calculate the
discount –ve CF to time zero at WACC. salvage. Rmbr to tax.
-b: Recovery of NOWC
-c: Remember the last OCF CF (DO NOT +DEP IN COST)
Use MIRR when 2 or more IRR & non-normal CF
OCF = EBIT(1-T) + Dep or OCF = (Sales-Cost)(1-T) + DT.
Multiple IRR -> Difference in low & high disc rate.
investments
ΔNOWC = Δ[(Cash + I + A/R) – (Accruals + A/P)]
MV Common stock = MV equity – MV Debt – Preferred stock
D = (Initial Cost – Salvage) / Years
Net Salvage Value (If S = B, then no tax effect) Not operating at full capacity (No increase in FA)
If S > B, there is a gain on sale. Tax will only be on gain: 1. Change pro-forma FA – No ∆ in pro-forma FA.
(S-B)*T. After Tax Salvage Value= S – T * (S-B) 2. Compare new pro-forma TA & L+T
If B > S there is a loss on sale. There will be tax saving 3. New pro-forma - if TA < TE+ OE mean excess fund
(cash inflow) After Tax Salvage Value= S + T * I S-B I Excess capacity indicates lower AFN, finance less
Replacement project Outflow (-) Inflow (+) debt, lower interest cost, leading to higher EPS, ROE
Initial: and profits. To balance, repay NP / LTD, pay more
NCS Investment cost: Buy new (-) sell old (+) dividend and increase cash accounts.
Interim: (Becareful of other project opp cost, mus tax) At full capacity
-Difference in depreciation  New depreciation rate Target Ratio = FA / Capacity Sales
less old depreciation rate (Incremental Dep 30k – 9k) Capital Intensity Ratio = TA / Sales
-Cash savings! ^ Part of OCF. REMEMBER TO TAX. To find additional FA needed. Take Capital intensity 12. Options
Terminal: (Remember to tax all with SV – BV) ratio * Extra sales exceeding quota. Call Option – Right to purchase asset on a date at
-Opp cost of Salvage value of old machine foregone: For IGR/SGR, assume all liabilities are NON-SPON. a given exercise price Put Option – Right to sell
-Salvage of new machine –Tax all other Opp. Cost Assume AFN = Increase in assets – Increase in RE asset on a date at a given exercise price
b = RR = (NI – Div) / NI European (On Expiration Day) American (On Any Day)
Projects with unequal lives (Do not use NPV) Internal growth rate = (ROA*b) / (1 – (ROA*b)) Call
1. Calculate OCF. Calculate NPV 2. Convert to How much firm can grow it assets by only using RE Payoff of call CT = Max {ST - X, o}
Equivalent Annual Annuities (EAA) by finding PMT. Sustainable growth rate = (ROE*b) / (1 – (ROE*b)) Profit = Payoff – Premium (Cost of option)
Assume project can be replaced infinitely. 3. Chose How firm can grow by using RE & issuing debt to Decision Making is only based on payoff
higher EAA/lower EAC. maintain constant debt ratio. (debt/asset)
Given inflation, real revenue falls. Thus, nominal Recall: Dupont Identity
revenue would increase. If inflation not reflected, at Different AFN results -> Equation method assumes
nominal discount rates, PV is biased downwards. constant profit margin, div payout & capitral struc
Fin Statement allows different items to grow at
10. Financial Planning & Forecasting different rates. PM may differ due constant int exp.
Financial planning evaluates impact of alternative Fi
investments and financing choices and thinks about
11. Working Capital Management
future possible problems. Implement, evaluate and
adjust the plan. Financing Planning consists of CB, CS, Gross WC = Total CA Net WC = CA – C
NOWC and Dividend Policy Decisions. NOWC=CA – Non Int CL = (Cash+Inv+Ar)-(Accrual + AP)

1. Percentage of Sales Approach

-Income statement: (Old - % Sales I Pro Forma )
All costs vary directly with sales. (Net profit margin no
change) Dividends depends on the dividend policy.
Interest rate does not grow as sales!

-Balance sheet: (Old - % Sales - PF)

Assuming that all assets (fixed and current) vary
directly with sales (assuming that the firm operates at
max capacity) Accounts payable also generally vary
directly. Notes payable, long-term debt DO NOT VARY
as they depend on capital structure.
Payables Turnover = (COGS + End Inv – Begn Inv)
2. AFN = Required increase in A – Increase in RE & L /Average Payables (Take Av)
Inventory Turnover = COGS / Inventory Price of Price Price PV
Receivables Turnover = Sales / Receivables Underlying + of = of + of
Stock Put Call Exercise Price
Minimizing cash holdings: Use lockbox, wire transfers,
remote disbursement account. Forecast safety stocks Value of Call = C0 = S0 – PV(x)
Lockbox Problems – Find daily benefit/cost then use Intrinsic Value
perpetuity to value whether it is a positive NPV project. Call = Stock Price – Exercise Price
Put = Exercise Price – Stock Price
Float – Difference between cash on bank & book values
Time value is the difference between option price
Size of float – Mailing Time, Process/Availability delay
and intrinsic value. Invstmnt – Payoff, Gain - Profit
Disbursement F – Firm writes cheques Bank > Book
REMEMBER TO ADD NI TO RETAINED EARNINGS! Collection F – Cheque received increase Book > Bank
To calculate float = Avai Bal at Bank – Book Balance Call Options Value Bounds
3. Additional Financing Needed Net Float = Disbursement float + Collection float Upper Bound – Less than or equal to stock price
E.g NPV = Immediate Cash Inflow – Cost Lower Bound – Max {ST - X, o}

Credit Management – Examining tradeoff between Max(S0 – X, 0) ≤ C0 ≤ S0

increased sales and the cost of granting more credit. If values are out of bounds, can do arbitrage
A/R = Credit Sales per day * Time of collection period
DSO = Receivables / Sales Per day
Require more funding if TA > TL + SE
Cash Discount – Implied interest if cust no take discnt.
AFN Assumptions: Firm operating at full capacity,
Cmpnsating Bal: Effective I/R = (Interest / (Bal w/o CB))
constant profit margin and constant div. payout ratio.
∆S = S1 – S0 RR = (NI – DIV) / NI “2/10 net 45” True price: 0.98P. Interest for late
To balance, borrow more NP, LTD. Lower div payout payment is 0.02P. So your period rate (that moment):
How to tell if operating at full capacity? 0.02P/0.98P = 2.0408%! Find the period (45-10=35),
1. Estimate full capacity sales periods per year = (365/35). Then find EAR = (1+period
If pro-forma < full capacity sales. Not at full cap rate)^n – 1. CPT I/R = N = 1, PV = -98, FV= 100, PMT = 0