financial management scdl

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Financial managementFinancial management

By Prof. Augustin Amaladas

M. Com., AICWA., PGDFM., B.Ed.

e-mail: [email protected] www.augustin.co.nr

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Welcome To SCDL

Financial Management


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*11.CAPITAL BUDGETING*11.CAPITAL BUDGETING

*9.LEVERAGES*9.LEVERAGES

*8.CAPITAL STRUCTURE*8.CAPITAL STRUCTURE

*7.SOURCES OF LONG *7.SOURCES OF LONG TERM AND MEDIUM TERMTERM AND MEDIUM TERM

*5.CASH FLOW STATEMENTS*5.CASH FLOW STATEMENTS

5.FUND FLOW STATEMENT5.FUND FLOW STATEMENT

*4.RATIOS*4.RATIOS

*10.CAPITAL mARKET*10.CAPITAL mARKET

*3.FINANCIAL STATEMENTS*3.FINANCIAL STATEMENTS

*2.FORMS OF BUSS.ORG.*2.FORMS OF BUSS.ORG.

1.FINANCIAL FUNCTION1.FINANCIAL FUNCTION

*6.CAPITALISATION*6.CAPITALISATION

*13.CASH MANAGEMENT*13.CASH MANAGEMENT

*14.RECEIVABLE*14.RECEIVABLEMANAGEMENTMANAGEMENT

*15.INVENTORY*15.INVENTORYMANAGEMENTMANAGEMENT

*16.DIVIDEND *16.DIVIDEND POLICYPOLICY

*12.WORKING CAPITAL*12.WORKING CAPITALMANAGEMENTMANAGEMENT


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Welcome by SCDL to AZtecsoftWelcome by SCDL to AZtecsoft


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MANAGEMENT PROCESSES,

DEFICIENCY FINDINGMANAGEMENT AUDIT MANAGEMENT PLANNINGMANAGEMENT SERVICES PLANNING AND CONTROL SYSTEMSMANAGEMENT ACCOUNTING TAX PLANNING, TAX ADVICINGTAX ACCOUNTING

GOVERNMENT ACCOUNTINGCOST STANDARD, COST REVENUE

ANALYSIS, COST ANALYSIS, COST AND

PRODUCTION STATISTICS COST ACCOUNTING

PRINCIPLES OF FINANCIAL REPORTING, AUDITING STANDARDS,

UNIFORM STATEMENTS,AUDITING OF RECORDS AND

STATEMENTS

FINANCIAL AUDITINGCOMPUTERS, PUNCHED CARD RECORDS,TAX

RECORDS, INCOME STATEMENT ANALYSIS,

BALANCE SHEET EMPHASISBOOK KEEPING(SINGLE ENTRY AND DOUBLE ENTRY )1775 1800 1825 1850 1875 1900 1925 1950 1975 1985 1990 1995 2005


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• COST MANAGEMENT:•

ACTIVITY BASED ACCOUNTING, LIFE CYCLE

COSTING,

VALUE CHAIN ANALYSIS,

TARGET COSTING, KAIZEN COSTING

RESPONSIBILITY ACCOUNTING,CURRENT COST ACCOUNTING, INFLATIONARY ACCOUNTING

EDP ENVIRONMENTAL AUDITHUMAN BEHAVIOUT, MANPOWER VALUES, INTER GOVERNMENTAL RELATIONS

SOCIAL ACCOUNTINGTOTALSYSTEMS PLANNING,

INTER DECIPLINARY APPLICATIONS

TOTAL SYSTEM RECVIEW EFFECTIVENESS AUDITING

EFFECTIVENESS EVALUATIOn COMPUTERS CYBERNETICS

INFORMATION SYSTEMS ORGANISATIONAL MODEL,

ORGANISATIONAL PLANNING, DECISION THEORY, COST BENEFIT ANALYSIS

MANAGEMENT SCIENCES

1775 1800 1825 1850 1875 1900 1925 1950 1975 1985 1990 1995 2005

GROWTH OF ACCOUNTABILITYKNOWLEDGE:FINANCIAL ACCOUNTING

Cost accounting,Management Accounting

Tax accounting and Management


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FLOW OF CASH/SHORT TERM FLOW OF CASH/SHORT TERM AND LONG TERMAND LONG TERM

information

Accounts payable

RAW mATERIAL

ADRBonds(281)Preference

Shares

Bad debts

Accounts receivable

DebtorsWork in progress

information

OverheadsLabour

Equity shares

CASH

GDR

informationIn

form

ati

on

Rights issueRights issue

Leasing/Hr.PurLeasing/Hr.Pur

Reserves Reserves

Public depositsPublic deposits


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FLOW OF CASH - LONG FLOW OF CASH - LONG TERMTERM

ADRLong term loansPreference

SharesEquity shares

CASHShort term

GDR

land

furniture

investments

goodwill

building

Patent rightsKnow how

Copy right


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FLOW OF CASH-SHORT FLOW OF CASH-SHORT TERMTERM

information

Accounts payable

RAW mATERIAL

Bad debts

Accounts receivable

DebtorsWork in progress

information

OverheadsLabour

informationIn

form

ati

on

Discounting billscreditorsCash credit Sale of investments

Bad debts

Bad debts

Issue of long term fundsSale of fixed assets

Bank overdraft

cash cashCommerCommer

Cial papersCial papers


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Working capital finance(361)Working capital finance(361)

Inter corpoInter corpoRate depositsRate deposits

Trade creditTrade credit

Bills discountsBills discounts

Outstanding Outstanding ExpensesExpenses

Cash creditCash credit

Packing creditPacking credit

overdraftoverdraftLetter of creditLetter of credit

loanloan

CommercialCommercialpaperspapers

pledgepledge

HypothecationHypothecation

lienlien

mortgagemortgage

1.Spontaneous1.Spontaneous 2.Bank guarantee2.Bank guarantee 3.Fund based3.Fund based 4.Security4.Security


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Users of information and goalsUsers of information and goals

organisation

shareholders

public

Benefactors

governmentbanks

Debenture holders

Loan vendor

Preference shareholderscreditors debtors

customers

dividend

liquidity

Dividend/value in the share market

Interest/return of capital

Interest/return of capital

Timely payment Timely supply

Good product

Less pollution

Good name

tax


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The Position of Capital Budgeting

Capital Budgeting

L o n g T e rm A sse ts S h o rt T e rm A sse ts

Investm ent D ecison

D e b t/E qu ity M ix

Financing D ecis ion

D iv id en d P a yo ut R a tio

D ividend D ecis ion

Financial Goa l of the F irm :W ealth Maxim isation

Page-3


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Scope of Financial ManagementScope of Financial Management

CapitalCapitalBudgetingBudgeting

Management of Management of Mergers, reorganisationMergers, reorganisation

FinancingFinancingFinancialFinancialAnalysisAnalysis

Management ofManagement ofCurrent AssetsCurrent Assets

Method ofMethod ofRaising fundsRaising funds

ImplementationImplementation

DetermineDetermineFinancing mixFinancing mix

FinancialFinancialControlControl

ReceivablesReceivablesSelectionSelection

IdentificationIdentificationMarketableMarketableSecuritiesSecurities

CashCash

FinancialFinancialForecastingForecasting

InventoryInventoryManagementManagement

SourceSourceidentificationidentification

ProfitProfitplanningplanning DividendDividend

policypolicy


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Role of Finance in a Typical Role of Finance in a Typical Business Organization-page- 9Business Organization-page- 9

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department


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Unit-2 Forms of Business Unit-2 Forms of Business organisationorganisation Sole trading Partnership Companies


My business!! My family?My business!! My family?

What will happen if this deal does not materialise?

16e-mail: [email protected] www.augustin.co.nr

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PartnershipPartnership

h

Should we build this

plant?


Ulta pultaUlta pultaCompany Company Ltd.???Ltd.???

Min

i com

pute

r


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Nature of Financial Nature of Financial Statements-Page-30Statements-Page-30

Financial accounting

1. Introduction

2. BasicAccounting

3. Process ofaccounting

4. BRS

5. Rectification ofErrors

Final accounts


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Unit-3 Financial statementsUnit-3 Financial statements


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Chapter-2: Basics of financial Chapter-2: Basics of financial accountingaccounting 1.Concepts 2.system of accounting 3.Types of Expenditure 4.Terms used in financial accounts 5.Double entry / Single entry 6. Depreciation methods 7. Practical consideration relating to

depreciation


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1.concepts& conventions1.concepts& conventions Meaning: Basic assumptions upon which the basic

process of accounting based. a] Business entity concept- b] Dual aspect concept c] Going concern concept d] Accounting period concept e] Cost concept f] Money measurement concept g] Matching Concept

• ConventionsCoservativismMaterialityConsistency


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a] Business entity concept-a] Business entity concept-

Business is different from the owner We pass Journal entry when owner

contributes towards capital. When amount / goods withdrawn for personal

use we make an entry in the business When Income tax paid by the owner out of

business money we make an entry In the books of accounts.


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b] Dual aspect conceptb] Dual aspect concept

Every debit has equal amount of credit Asset =Liability Liability creates asset If asset>Liability= profit If Liability> Assets= loss


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c] Going concern conceptc] Going concern concept

Business will go for at least for a reasonable period.

Depreciation is provided based on this assumption.

If this assumption is not made all Fixed assets will be valued at realised value like current assets.


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d] Accounting period conceptd] Accounting period concept

Fixing time limit for accounts Profit for the period It can be one week or two weekor 6

months/one year or 5 years But to find profit we normally consider

12 months period Financial year for income tax point of

view 1st April-31st March of the following year

Calendar year –January to December Divali to Divali


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e] Cost concepte] Cost concept The cost to the organisation (Actual) is

recorded in the books Assets are not recorded according to the

market price every year. Depreciation is calculated on cost not

based on market price Accounting records may not show the

real worth of the business Market price may be disclosed with in

bracket in the balance sheet


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ExerciseExercise

Accounting Test Question SV No.1:Company XYZ uses a perpetual inventory system. Append below the following transaction relating to its merchandise inventory during the month of Nov’06

Date:Transaction Nov 1 inventory on hand - 3,000 units @ $8 each Nov 7Bought 5,000 units for $8.40 each Nov 13Sold 4,000 units for $14.00 each Nov 17Bought 6,000 units for $8.20 each Nov 24Sold 7,000 units for $14.00 each Nov 30Inventory on hand -3000 units


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Required: Compute the inventory balance Company XYZ would report on its November 30 2006 balance sheet and the cost of goods sold for the period of November 2006 income statement using each of the following inventory methodology:

(1) First-in, first-out (FIFO) 2) Last-in, first-out (LIFO) (3) Average cost[ Refer Answer ]


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f] Money measurement conceptf] Money measurement concept

Every thing which can be expressed in terms of Money is recorded in the books

Beautiful women are working /Handsome boys working in AZTEC /Efficient engineers worth Rs.5000 crores –How do you record?.

Good working environment? Highly motivated employees?


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g] Matching Conceptg] Matching Concept

Matching Cost with revenue It is used to estimate correct profits Accrual/ cash basis of accounting

– Even cash paid /received if it belongs to accounting period we consider them as expenditure /income

– Salary outstanding for the last month?

– Income from Investments yet to be received?

– Rent received in advance for next year?


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ConventionsConventions Customs and traditions that are

followed by the accountants while preparing the financial statements.

Why do we respect elders? Why do we shake hands? Why do Young Indians hate receiving

dowry?


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CoservativismCoservativism

To be on the safer side Expect future losses as current year loss not future income is treated as current

year income. Stock is valued cost price / market price

which ever is lower Making provision for bad debts is based

on this assumptions.


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MaterialityMateriality

Material impact on profitability are considered

Insignificant transactions ignored from recording

Pen purchased, pencil purchased? Wine purchased regularly?


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ConsistencyConsistency

Accounting policies and procedures should be followed consistently

Method of depreciation should be followed consistently.

Stock valuation- cost/market price whichever is lower is consistently followed

If not followed it amount to change in the policy of the company


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2.system of accounting 2.system of accounting (26)(26)

1.Cash system: unless cash received /paid in

the accounting year can not be considered as income/expenses respectively


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2.Mercantile2.Mercantile

Mercantile/Accrual/due concept: Even cash received/paid but due for

payment/due for receipt (yet to be received/payable) if they belong to current accounting year are considered.

If last year expenditure paid this year? If you receive/paid in advance ?


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Mercantile love!!!!???Mercantile love!!!!???

Last year I loved her? Next year I shall love him depends on type of bike model!!!!


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Life EducationLife Education

If I do not get married to him I will not be happy- Girl said

If I do not get married to her I will not be happy- Boy said

If both get married what will happen!!!!


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Structure of FinancialStatement-(Chapter-3)page-34


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1.Production

Prime Cost

1.Godown

1.canteen

2

Cost of sales

6.sales5.profit

1.Factory administration

4.Sales and distribution3.General administration

Total cost

Bin card

Stores ledger

Cost calculations/operating activity

++ =

+

+

Danger

Facility department

Factory cost/works cost


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Financial StatementsFinancial Statements

Balance Sheet Income Statement Cashflow Statement Statement of Retained Earnings


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Review: Major Balance Sheet Review: Major Balance Sheet ItemsItems

Assets Current assets:

– Cash & securities

– Receivables

– Inventories Fixed assets:

– Tangible assets

– Intangible assets

Liabilities and Equity Current liabilities:

– Payables

– Short-term debt Long-term

liabilities Shareholders'

equity


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An Example: Dell An Example: Dell Abbreviated Balance Sheet-34Abbreviated Balance Sheet-34 Assets:

– Current Assets: $7,681.00

– Non-Current Assets: $3,790.00

– Total Assets: $11,471.00 Liabilities:

– Current Liabilities: $5,192.00

– LT Debt & Other LT Liab.: $971.00

– Equity: $5,308.00

– Total Liab. and Equity: $11,471.00


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An Example: DellAn Example: DellAbbreviated Income Statement-page-47Abbreviated Income Statement-page-47

Sales $25,265.00Costs of Goods Sold -$19,891.00Gross Profit $5,374.00Cash operating expense -$2,761.00EBITDA 2,613.00Depreciation & Amortization -$156.00Other Income (Net) -$6.00EBIT $2,451.00Interest -$0.00EBT $2,451.00Income Taxes -$785.00Special Income/Charges -$194.00Net Income (EAT) $1,666.00


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Financial Statement AnalysisFinancial Statement Analysis External users rely on

publicly-available information to perform financial analysis

Such information is contained in corporate annual report


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Life educationLife education

Lady in a seashore


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1. Use the statement of cash flows in decision making

2. Compute the standard financial ratios used for decision making

3. Use ratios in decision making4. Measure economic value added by a

company’s operations

Chapter Learning ObjectivesChapter Learning Objectives


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What do you learn??What do you learn?? Here's how you'll benefit from this course: Understand the contents of the balance sheet,

cashflow, and income statements Contribute to better costing and working capital

management Review production capacity and investment proposals Evaluate long, medium and short term financing Review financial statements and analyse them using

ratios to determine your business strengths and weaknesses

Apply techniques to make decisions that create genuine value


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FOUR BASIC FINANCIAL STATEMENTSAnnual Report ContentsAnnual Report Contents


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FOUR BASIC FINANCIAL STATEMENTS

1

Annual Report ContentsAnnual Report Contents


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FOOTNOTES TO THE FINANCIAL STATEMENTS

1

2



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SUMMARY OF ACCOUNTING METHODS

1

2

3



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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS

1

2

3

4



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AUDITOR’S REPORT

1

2

3

4

5



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AUDITOR’S REPORT

COMPARATIVE FINANCIAL DATA FOR A SERIES OF YEARS

1

2

3

4

5

6



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Financial Statement AnalysisFinancial Statement Analysis

Before you jump to a decision, consider the following:

1. Financial statements provide data about what happened during the accounting period

Pick the one annual report component which provides investors and creditors with the most descriptive information about the corporation’s activities and financial condition


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2. Investors and creditors use information contained in the annual report to:

Forecast future income and cash flows

Assess risk of investing in or lending to the corporation


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4



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Financial Statement Analysis-Financial Statement Analysis-page-51page-51

Management’s discussion and analysis (MD&A) includes:

Evaluation of current business operations Assessment of future operations


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Tools to Evaluate Financial Tools to Evaluate Financial InformationInformation


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1


Horizontal Analysis


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2

1


Horizontal Analysis

Vertical Analysis


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3

2

1


Horizontal Analysis

Vertical Analysis

Ratio Analysis


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Perform a horizontal analysis of comparative financial

statements


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1


Horizontal Analysis


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Horizontal AnalysisHorizontal Analysis

Examines percentage change in each item on the financial statements

Compares current year’s dollar amount with prior year’s dollar amount

Expresses the change in– Dollars

– Percentage


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First, calculate dollar change from base year (prior year) to current year


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First, calculate Rupee/dollar change from base year (prior year) to current year

Second, divide Rupee/ dollar change by base-year dollar amount


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DOLLAR AMOUNT INCREASE (DECREASE)Amounts in thousands


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1996 1995 Dollars %Receivables (net) $325,384 $272,225


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2007 2006 Dollars %Receivables (net) $325,384 $272,225

Difference


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1996 1995 Dollars %Receivables (net) $325,384 $272,225 $53,159

Difference


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2007 2006 Dollars %Receivables (net) $325,384 $272,225 $53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528


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Trend PercentagesTrend Percentages

Specialized form of horizontal analysis

Shows trend of financial statement items over longer time periods such as 5 or 10 years


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Base year (earliest year in the time series) set at 100%

All other years expressed as percentage of base year


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Income statement amounts for Ray’s Seafood Shack are presented in the next slide

Compute the trend percentages for these items


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Trend PercentagesTrend Percentages(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346

Divide x 100

Net Sales 206% 160% 145% 137% 130% 100%


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346

Divide x 100

Net Sales 206% 160% 145% 137% 130% 100%


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346

Divide

x 100

Net Sales 206% 160% 145% 137% 130% 100%


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346

Divide x 100

Net Sales 206% 160% 145% 137% 130% 100%


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346

Divide x 100

Net Sales 206% 160% 145% 137% 130% 100%


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346Cost of Sales 373 265 201 259 280 193

Net Sales 206% 160% 145% 137% 130% 100%

Cost of Sales 193 137 104 134 145 100


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2008 2007 2006 2005 2004 2003Net Sales $714 $553 $502 $474 $451 $346Cost of Sales 373 265 201 259 280 193Gross Profit 341 288 301 215 171 153

Net Sales 206% 160% 145% 137% 130% 100%Cost of Sales 193 137 104 134 145 100Gross Profit 223 188 197 140 112 100


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Horizontal Analysis and Horizontal Analysis and Trend Percentages: A SummaryTrend Percentages: A Summary

Tools used to compare financial

results of companies of different sizes

and/or in different industries


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Vertical AnalysisVertical Analysis


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2


Vertical Analysis


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Vertical AnalysisVertical Analysis Compares each item on the financial

statement to a key, or base, item Base-item dollar amount always set to

100% Income statement

– Net sales = 100% Balance sheet

– Total assets = 100%


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2007 2006 AMOUNT % AMOUNT

%Net sales $430,013 100% $362,386 100%Cost of Goods Sold 336,589 78 284,897 79Gross Profit 93,424 22 77,489 21Selling, General & Admin. 72,363 17 65,096 18Income from Operations 21,061 5 12,393 3Income Taxes 7,072 2 4,350 2Net Income $13,989 3% $8,043 2%



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Vertical AnalysisVertical Analysis Once financial

statement items are converted into percentages of the base item, users can compare one company’s financials against another’s

These are called common-size statements


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Prepare common-size financial statements for benchmarking against the

industry average and key competitors


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Common-Size StatementsCommon-Size Statements

Show all items as percentages of the key, or base, amount– Use no dollar amounts

Facilitate financial statement comparison among different sized companies

Improve user’s ability to assess company performance against industry averages


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Common-Size StatementsCommon-Size Statements

Can also be used to evaluate company performance over time


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Benchmarking Against the Benchmarking Against the Industry AverageIndustry Average

Benchmarking is a term used to describe the process of comparing a company’s activities to a standard of

excellence achieved by industry leaders


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A company also can compare its common-size financials to those of its industry’s leaders

Determine where it differs Design and implement business

processes to bring financial results in line with these benchmark entities

Benchmarking Against Key Benchmarking Against Key CompetitorsCompetitors


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Chineese tree

Life education


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Interpretation of Financial Interpretation of Financial Statements-Ratio Analysis-Unit-4Statements-Ratio Analysis-Unit-4


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Interpretation of Financial Statement Interpretation of Financial Statement Analysis( Ratio Analysis)-page 55- Unit-4Analysis( Ratio Analysis)-page 55- Unit-4

By Prof. Augustin Amaladas


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A leading company in the health-care and consumer products industry

Sales revenues of $14-billion

Assets of $13-billion

PROCTER & GAMBLE and BRISTOL-PROCTER & GAMBLE and BRISTOL-MYERS SQUIBBMYERS SQUIBB


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How would you compare Bristol-Myers Squibb’s performance against other industry competitors?

Companies differ in size, so you can’t compare absolute dollar amounts

Need to use ratios - tools to translate financial data into percentages - which can be compared across companies

PROCTER & GAMBLE and PROCTER & GAMBLE and BRISTOL-MYERS SQUIBBBRISTOL-MYERS SQUIBB


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PROCTER & GAMBLE

Sales revenues $33.4

Net income 2.6

Assets 28.0

PROCTER & GAMBLE and PROCTER & GAMBLE and BRISTOL-MYERS SQUIBBBRISTOL-MYERS SQUIBB


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BRISTOL-MYERS SQUIBB

Sales revenues $13.7Net income

1.8Assets 13.0

PROCTER & GAMBLE


Net income 2.6

Assets 28.0

Opening Vignette - Opening Vignette - Bristol-Myers SquibbBristol-Myers Squibb


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1.8Assets 13.0

PROCTER & GAMBLESales revenues $33.4Net income 2.6

Assets 28.0

Which company was better in generating net income from sales revenues earned?



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1.8Assets 13.0

You can use the return on sales ratio to compare


Assets 28.0

Which company was better in generating net income from sales revenues earned?



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PROCTER & GAMBLE


Net income 2.6



110


$2.6$33.4

= 7.78%



111



1.8


$2.6$33.4

= 7.78%


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BRISTOL-MYERS SQUIBBSales revenues $13.7

Net income 1.8

$1.8$13.7

= 13.13%


$2.6$33.4

= 7.78%

Opening Vignette -Bristol-Myers SquibbOpening Vignette -Bristol-Myers Squibb


113



PROCTER & GAMBLE



Although P&G’s sales were higher


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1.8

$1.8$13.7

= 13.13%


$2.6$33.4

= 7.78%

Bristol-Myers’ return on sales was nearly twice that of P&G


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Financial Statement AnalysisFinancial Statement Analysis External users rely on

publicly-available information to perform financial analysis

Such information is contained in corporate annual report


116

Financial Statement Analysis: Financial Statement Analysis: Lecture OutlineLecture Outline Review of Financial Statements Ratios

– Types of Ratios– Examples

The DuPont Method Ratios and Growth Summary

– Strengths– Weaknesses– Ratios and Forecasting


117

Financial AnalysisFinancial Analysis

Assessment of the firm’s past, present and future financial conditions

Done to find firm’s financial strengths and weaknesses

Primary Tools:– Financial Statements– Comparison of financial ratios to past,

industry, sector and all firms


118

The Main IdeaThe Main Idea

Value for the firm comes from cashflows Cashflows can be calculated as:

(Revt - Costt - Dept)x(1-) + Dept

—OR— (Revt - Costt)x(1-) + xDept

—OR— Revtx(1-) - Costtx(1-) + xDept


119

Review: Major Balance Sheet Review: Major Balance Sheet ItemsItems

Assets Current assets:

– Cash & securities

– Receivables

– Inventories Fixed assets:

– Tangible assets

– Intangible assets

Liabilities and Equity Current liabilities:

– Payables

– Short-term debt Long-term

liabilities Shareholders'

equity


120

An Example: Dell An Example: Dell Abbreviated Balance SheetAbbreviated Balance Sheet Assets:






– Equity: $5,308.00



121

Absorption Costing vs. Variable Absorption Costing vs. Variable

Costing Income StatementsCosting Income Statements

Absorption Costing Variable Costing:

Sales $60,000 Sales $60,000

Cost of sales 30,000 Variable costs:

Gross profit $30,000 Cost of sales 30,000

Operating expenses: Operating expenses 6,000

Variable $6,000 Total variable costs $36,000

Fixed 20,000 Contribution margin: $24,000

Total operating expenses $26,000 Fixed costs 20,000

Income $4,000 Income $4,000


122

Absorption CostingAbsorption Costing

Income StatementIncome Statement

Sales XXXCost of Goods Sold:

Beginning inventory XXXCost of goods manufactured XXX Cost of goods available XXXEnding inventory XXX

Cost of goods sold XXXGross Margin XXXOperating Expenses:

Selling XXXAdministrative XXX XXX

Income before Taxes XXX


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ABSORPTION COSTING PRO-ABSORPTION COSTING PRO-FORMAFORMA

££Sales Revenue xxxxxLess Absorption Cost of Sales Opening Stock (Valued @ absorption cost) xxxx Add Production Cost (Valued @ absorption cost) xxxx Total Production Cost xxxx Less Closing Stock (Valued @ absorption cost) (xxx) Absorption Cost of Production xxxxAdd Selling, Admin & Distribution Cost xxxxAbsorption Cost of Sales (xxxx)Un-Adjusted Profit xxxxxFixed Production O/H absorbed xxxx Fixed Production O/H incurred (xxxx) (Under)/Over Absorption xxxxxAdjusted Profit xxxxx


124

Variable CostingVariable Costing

Income StatementIncome StatementSales XXXCost of Goods Sold:

Beginning inventory XXXCost of goods manufactured XXX Cost of goods available XXXEnding inventory XXX

Variable cost of goods sold XXXProduct Contribution Margin XXXVariable Selling Expense XXXTotal Contribution Margin XXXFixed Expenses:

Factory XXXSelling XXXAdministrative XXX XXX

Income before Taxes XXX


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Marginal costing cost sheetMarginal costing cost sheet ££Sales Revenue xxxxx

Less Marginal Cost of Sales Opening Stock (Valued @ marginal cost) xxxx Add Production Cost (Valued @ marginal cost) xxxx Total Production Cost xxxx Less Closing Stock (Valued @ marginal cost) xxx) Marginal Cost of Production xxxx

Add Selling, Admin & Distribution Cost xxx Marginal Cost of Sales (xxxx)

Contribution xxxxx Less Fixed Cost (xxxx) Marginal Costing Profit xxxxx


126

An Example: DellAn Example: DellAbbreviated Income StatementAbbreviated Income StatementSales $25,265.00Costs of Goods Sold -$19,891.00Gross Profit $5,374.00Cash operating expense -$2,761.00EBITDA 2,613.00Depreciation & Amortization -$156.00Other Income (Net) -$6.00EBIT $2,451.00Interest -$0.00EBT $2,451.00Income Taxes -$785.00Special Income/Charges -$194.00Net Income (EAT) $1,666.00


127

Objectives of Ratio AnalysisObjectives of Ratio Analysis Standardize financial information for

comparisons Evaluate current operations Compare performance with past

performance Compare performance against other

firms or industry standards Study the efficiency of operations Study the risk of operations


128

Rationale Behind Ratio Rationale Behind Ratio AnalysisAnalysis A firm has resources It converts resources into profits through

– production of goods and services– sales of goods and services

Ratios– Measure relationships between resources and

financial flows– Show ways in which firm’s situation deviates from

Its own past Other firms The industry All firms-


129

financials can be used in

benchmarking



130

Using Ratios to Make Using Ratios to Make Business DecisionsBusiness Decisions


131

3

Ratio Analysis



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Types of Ratios-59Types of Ratios-59 Financial Ratios:

– Liquidity Ratios Assess ability to cover current obligations

– Leverage Ratios Assess ability to cover long term debt obligations

Operational Ratios:– Activity (Turnover) Ratios

Assess amount of activity relative to amount of resources used

– Profitability Ratios Assess profits relative to amount of resources used

Valuation Ratios: Assess market price relative to assets or earnings


133


Ratios - the relationship between two items on financial statements - permit users to calculate a variety of financial comparisons

These ratios can be compared to: Prior years’ financial results Industry averages Benchmark entities’ ratios


134

Ratios measure an entity’s ability to: Pay current liabilities Sell inventory and collect receivables Pay long-term debt Generate profits from operations Sustain shareholder wealth



135

Measuring the Company’s Ability to Pay Current Measuring the Company’s Ability to Pay Current Liabilities-Page-59Liabilities-Page-59

One measure of entity’s ability to pay its current obligations is to look at working capital

Current assets - current liabilities

2 ratios help users assess working capital information


136

Measuring the Company’s Ability to Pay Current Measuring the Company’s Ability to Pay Current LiabilitiesLiabilities



2 ratios help users assess working capital information– Current ratio


137

Measuring the Company’s Measuring the Company’s Ability to Pay Current Ability to Pay Current LiabilitiesLiabilities



2 ratios help users assess working capital information– Current ratio– Quick (acid-test) ratio


138



139

Ability to Pay Current Ability to Pay Current LiabilitiesLiabilities

Current ratio


140


Current ratio Current assets

Current liabilities


141

Ability to Pay Current Ability to Pay Current Liabilities-page-59Liabilities-page-59

Current ratio Current assets

Current liabilities

$7,681.00$5,192.00

= 1.48

Assets:Current Assets:

$7,681.00Non-Current Assets:

$3,790.00Total Assets:

$11,471.00Liabilities:

Current Liabilities:$5,192.00

LT Debt & Other LT Liab.: $971.00

Equity: $5,308.00Total Liab. and Equity:

$11,471.00


142

Ability to Pay Current Ability to Pay Current Liabilities-page-60Liabilities-page-60

Quick ratio


143


Quick ratio Current assets - inventory - prepaid items

Current liabilities


144


Liquid ratio Current assets - inventory - prepaid items

Current liabilities

$25,240$114,744

= .22


145

Measuring the Company’s Ability to Sell Measuring the Company’s Ability to Sell Inventory and Collect ReceivablesInventory and Collect Receivables

Entity’s operating cycle– Time to go from cash to inventory to

receivables to cash

is critical to generating cash inflows from operating activities

3 ratios help users assess management’s skill in selling inventory and collecting receivables


146

Inventory turnover

Measuring the Company’s Ability to Measuring the Company’s Ability to Sell Inventory and Collect Sell Inventory and Collect Receivables-page-63Receivables-page-63

1


147

Inventory turnover

A/R turnover

Measuring the Company’s Ability to Sell Inventory Measuring the Company’s Ability to Sell Inventory and Collect Receivablesand Collect Receivables

1

2


148

Inventory turnover

A/R turnover

Days’ sales in receivables

Measuring the Company’s Ability to Measuring the Company’s Ability to Sell Inventory and Collect Sell Inventory and Collect ReceivablesReceivables

123


149

Inventory Turnover-page-63Inventory Turnover-page-63 Number of times the

average level of inventory is sold during the accounting year

Measures time required to earn return on company’s investment in inventory

2008


150

Inventory TurnoverInventory Turnover

Cost of goods soldAverage inventory

=$19,891/$4000=4.972 times


Average inventory $ 4000Average debtors $5000


151

Inventory TurnoverInventory Turnover High ratio indicates ability

to quickly sell inventory Too high a ratio may

indicate inadequate inventory levels

Turnover ratio should be compared to historical and industry averages

Analyze significant variances


152

Accounts Receivable Accounts Receivable Turnover-page-65Turnover-page-65

Number of times the average level of A/R is collected during the accounting year

Measures ability to collect cash from credit customers

$


153

Accounts Receivable Accounts Receivable TurnoverTurnover

Net credit salesAverage net A/R


154

Net credit sales*Average net A/R

$25,265.005000

= 5.053 times



155

Days’ Sales in ReceivablesDays’ Sales in Receivables

Number of equivalent days’ sales revenue represented by the outstanding A/R balance

Measures A/R balance in terms of number of days it would take to generate the equivalent dollar amount of sales

$


156

Average net A/R(Net sales / 365 days)

$5000($25265 / 365 days)

= 72.23 days

Days’ Sales in ReceivablesDays’ Sales in Receivables


157

Measuring the Company’s Ability to Pay Measuring the Company’s Ability to Pay Long-Term Debt-67Long-Term Debt-67

Bondholders and long-term lenders are concerned about an entity’s ability to repay debt principal and accumulated interest on long-term notes and loans

2 ratios help these users assess the entity’s ability to pay its long-term obligations

Debt ratio Times-interest-earned ratio


158

Debt Ratio-page-67Debt Ratio-page-67

Relationship between company’s total liabilities and total assets

Measures proportion of total assets provided through debt

1 - debt ratio = proportion of assets provided by equity


159

Debt Ratio-page 67Debt Ratio-page 67

Total LiabilitiesTotal Equity

Assets:Current Assets:

$7,681.00Non-Current Assets:

$3,790.00Total Assets:

$11,471.00Liabilities:

Current Liabilities:$5,192.00

LT Debt & Other LT Liab.: $971.00

Equity: $5,308.00Total Liab. and Equity:

$11,471.00


160

Debt RatioDebt Ratio

Total LiabilitiesTotal Assets

$971.00$5,308.00

=.1829


161


Total LiabilitiesTotal Assets

2,00000$323,497

= .38


162


If debt ratio = 1.0, company used all debt to finance acquisition of its assets– A highly unlikely

situation Thus, debt ratio is

generally less than 1.0

LOANS,NOTES,BONDS,

ETC.


163


The higher the ratio, the more cash the company must commit toward paying annual interest expense and loan principal

As a result, company’s cash flow might be negatively affected


164

Lenders and creditors might require company to appropriate portion of retained earnings to ensure sufficient assets to repay interest and loan principal



165

Times-Interest-Earned Ratio-Times-Interest-Earned Ratio-page-70page-70

Relationship between company’s net income from operations and interest expense

Measures ability of company to cover, or pay for, its interest expense out of operating income


166

Times-Interest-Earned RatioTimes-Interest-Earned Ratio

Income from operationsInterest expense


167


Income from operations Interest expense

2,613.000

= &




168

high ratio indicates ease in meeting debt interest payments



169

A low ratio would signal possible difficulties in making payments to lenders and bondholders



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Measuring a Company’s Measuring a Company’s ProfitabilityProfitability

Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently

Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices


171

4 profitability ratios are commonly used in financial statement analysis



172


Return on sales



173


Return on sales Return on assets



174


Return on sales Return on assetsReturn on equity



175


Return on sales Return on assetsReturn on equityEarnings per share

Measuring a Company’s Measuring a Company’s Profitability-page-74Profitability-page-74


176

Relationship between a company’s net income and net sales

Measures management’s ability to efficiently and effectively manage company operations

Shows percentage of each net sales dollar earned as net income

Return on SalesReturn on Sales


177

Return on Sales-Net profit ratio-Return on Sales-Net profit ratio-7373

Net incomeNet sales revenue


178


Net income Net sales revenue

$1,666.00 $25,265.00

=0 .065


$1,666.00Average inventory $ 4000Average debtors $5000


179

Higher rate tells users that more net sales dollars add to a company’s profits– And fewer dollars go to

cover company expenses Company conducts its

business effectively, manages expenses


Net Income


180

Ratio of the return to the two groups that provide financing to the company– Creditors and investors

and average assets owned during the period

Measures company’s success in generating income from its available resources

Return on Assets-74Return on Assets-74


181

Net income + interest expenseAverage total assets

Return on AssetsReturn on Assets


182

Net income + interest expenseAverage total assets

$1,666.00 + 0 9000

= .185




Average total assets $9000 e-mail: [email protected] www.augustin.co.nr

183

Return on Assets Return on Assets

Why do we add back interest expense to

net income?


184

Total assets are financed by 2 sources:– Investors (equity)– Creditors (debt)

Net income is the return attributable to investors in the company’s stock

Interest expense is the return paid to creditors for using their funds to acquire assets



185

Relationship between net income available to common stockholders and the equity they provide

Measures company’s success in using stockholders’ investments to generate net income

Return on Equity-75Return on Equity-75


186

Return on EquityReturn on Equity

Net income - preferred dividendsCommon contributed capital + retained

earnings


187



earnings

$30,555*($286,676 + $255,773) / 2

= .1126

* X ltd. does not have preferred stock


188

Relationship between net income available to common stockholders and the number of shares of common stock issued

Expresses net income in terms of one share of the company’s common stock

Earnings Per Share-77Earnings Per Share-77


189

Earnings Per ShareEarnings Per Share

Net income - preferred dividends# of shares of common stock

outstanding


190


Net income - preferred dividends# of shares of common stock outstanding

$30,555,000*40,221,000 shares

= $.76


191

Earnings Per ShareEarnings Per Share In addition to net

income, EPS is presented for several other elements on the corporate income statement

Discontinued operations Extraordinary items Cumulative effect of

accounting change

Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory


192

Analyzing the Company’s Analyzing the Company’s Stock as an InvestmentStock as an Investment


193

Investors expect to receive 2 types of returns on their investments in a corporation’s common stock

Gains earned when they sell the corporation’s stock

Periodic dividends paid by the corporation to its stockholders



194

Financial analysts use several ratios to assess value of stock investments

Price/earnings ratio Dividend yield Book value



195

Price/Earnings Ratio-77Price/Earnings Ratio-77

Relationship between a stock’s market price and its earnings per share

Measures the number of times one share of stock sells above the current period’s reported earnings

Assists financial analysts in deciding if a stock is overpriced or underpriced


196

Calculating the P/E ratio

Price/Earnings RatioPrice/Earnings Ratio


197


Market value of stockEarnings per share



198

Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year





199


The income statement reports EPS of $.92





200



What is Asian Art’s price/earnings ratio?



Market value of stock

Earnings per share


201




202



$15.75$.92

= 17.12


203

P/E ratioP/E ratio

If a stock has low P/E ratio say 3/1 it may be considered as an undervalued stock.

If the ratio is 80/1 it may be viewed as overvalued.

This ratio is more popular in the secondary market.


204

Dividend YieldDividend Yield Ratio of dividends per share of stock to

the stock’s market value Indicates the percentage of a stock’s

market value “returned” to the stockholder in the form of dividends

Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock


205

Dividend YieldDividend Yield

Annual dividends per shareStock’s market value per share

If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?


206

Dividend Yield-78Dividend Yield-78



207



$1.25

$15.75

= .079


208

Book ValueBook Value Relationship between

common stockholders’ equity and number of common shares outstanding

Measures the accounting value of one share of the corporation’s common stock

DE

BIT

CR

ED

IT


209

Book ValueBook Value

Total equity - preferred equity# of shares of common stock outstanding

The book value of one share of Lands’ End common stock is:

$201,192,0004,02,21,000 shares

= $5.00/share


210

Review: Major Income Review: Major Income Statement ItemsStatement Items Gross Profit = Sales - Costs of Goods Sold EBITDA

= Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the

firm’s cashflows and, thus, the value of the firm’s shares


211


Thomas Thomas Cooper –Cooper –DictionaryDictionary


212

Accounting Test Question No IFS 4:Accounting Test Question No IFS 4: Effect of Management Decisions On Ratios Require: Put by letter whether each of the actions listed

below will immediately -increase (I), -decrease (D) or -have no effect (N) on the ratios shown. Current ratio Acid-test ratio Debt to Equity

ratio 1.Company issued ordinary shares for cash 2.Bought raw material on account 3.Received money from accounts receivable 4.Expiration of prepaid rent


213

5.Payment of cash dividend 6.Purchase long term investment with

cash 7.Sale of fixed assets for cash with no

gain or loss 8.Stock write off 9.Refinance on a long term basis

currently matured debt 10.Bought fixed asset with a 6 month

note


214

Answer to Accounting Answer to Accounting Test Question IFS No 4::

Current ratio Acid-test ratio Debt to equity ratio

1.Company issued ordinary shares for cash I I D

2.Bought raw material on accountI D I 3.Received money from accounts

receivable N N N 4.Expiration of prepaid rent D N I


215

5.Payment of cash dividendDDI 6.Purchase long term investment with cash

– D D N 7.Sale of fixed assets for cash with no gain or

loss I I N 8.Stock write off D N I 9.Refinance on a long term basis currently

matured debt I I N 10.Bought fixed asset with a 6 month note

D D I


216

Accounting Test Question No IFS 1: Details of financial performance of Company XYZ For year 2005 Income Statement: Net Sales - $ 7 million, Cost of Goods sold - $ 3 million

– Net Income - $1.2 million– Balance Sheet ($’000):-2007

Assets Cash $2,00,240 Accounts Receivable $8,10,620 Inventory $8,30,710 Property, plant and equipment ( net)

$2,59,02,420

Total Assets $4,43,03,990 e-mail: [email protected] www.augustin.co.nr

217

Liabilities & Shareholders’ Equity: Current liabilities710640 Notes payable550990 Paid-in capital1,5001,500 Retained earnings1,670860Total

Liabilities & Shareholders’ Equity4,4303,990The average industry for


218

Company’s line of business are: Inventory Turnover 5 times Average Collection period 45 days Asset Turnover 2 times Required: Evaluate Company XYZ’s asset

management relative to its industry.


219

Accounting Test Question No IFS 2:Accounting Test Question No IFS 2:

Append below Company TIM s Income Statement and Balance Sheet:

Income Statement (000) 2006-2007 Net Sales Rs.7,05,06,200 Net Income Rs.3,40,410 Balance Sheet (000):-Assets2006-2007 Current Assets Rs.1,84,01,570 Property, plant and equipment ( net)

Rs.2,59,02,420 Total Assets Rs.4,43,03,990


220

Current Liabilities1,15,01,190 Long term liabilities RS. 8,10,440 Paid-in capital1 RS.50,01,500 Retained earnings Rs.9,70,860 Required: Determine the following ratios for 2006- 2007: profit margin on sales return on assets (ROA) return on shareholders equity (2) Determine the amount of dividends paid to

the shareholders during2006- 2007


221

Answer to Accounting Answer to Accounting Test Question IFS No 2:: 1(a) Profit margin on sales = Net Income/ Net Sales = Rs.340,000/Rs.7,050,000 = 4.8% 1(b) Return on Assets (ROA) = Net Income/(Average Total Assets)/2 =RS.340,000/(Rs.4,430,000+3,990,000)/2 = 8.1%


222

1(c) Return on Shareholders equity = Net Income/ (Average Total Shareholder fund)/2 =Rs.340,000/(Rs.3,170,000+2,360,000)/2 =12.3%

Computation of Dividend paid during Year 2005: Retained earnings beginning of year 2005

RS.860,000 Add: Net Income Rs.340,000 Less: Retained earnings end of year 2005

(Rs.970,000) Dividends paid during 2007 Rs.230,000


223

Accounting Test Question No IFS 3: Append below Company XYZ’s Income

Statement and Balance Sheet: Income Statement ($’000)2005 Net Sales 7,100 Interest expense 40 Income tax expense 150 Net Income 210


224

Balance Sheet ($’000):- Assets2005 Cash 200 Accounts Receivable 810 Inventory 830 Property, plant and equipment ( net) 2,590 Total Assets 4,430 Liabilities & Shareholders’ Equity: Current liabilities 710 Long-term liabilities 550 Paid-in capital 1,500 Retained earnings 1,670 Total Liabilities & Shareholders’ Equity4,430


225

Required: Determine the following ratios for 2005: (a) current ratio (b) acid-test ratio (c) debt to equity ratio (d) times interest earned ratio


226

Answer:3Answer:3 (a) current ratio= Current asset/current liabilities = ($200,000+$810,000+$830,000)/$710,000)=

2.59

(b) acid-test ratio= (Current assets- inventory)/current liabilities =($200,000+$810,000)/$710,000= 1,42


227

(c) debt to equity ratio =(Total liabilities)/Shareholders fund =($710,000+$550,000)/($1,500,000+ $1,670,000) =0.39

(d) times interest earned ratio =(Net Income+ Interest Expense+ Income

Tax)/InterestExpense =($210,000+$40,000+$150,000)/$40,000 =10 times


228

Some difficulty in ratiosSome difficulty in ratios

All profitability and expenses ratios Sales in the denominator

All turn over ratios, sales in the numerator.

Propritory ratio=Total assets/owner’s funds

Shareholders’ funds=Equity shares+Reserves and surplus


229

Exercise problems-103Exercise problems-103

1.1.NC 1.2 decrease 1.3 NC 1.4 NC 1.5 Increase


230

Exercise-2.Exercise-2.

1.GP ratio=15*100/30=50% 2.NP ratio=5*100/30=16.67% 3.STR=COGS/Average stock=15/2.5=6.0

times 4.CR=8/3=2.67 5.LR=6/3=2


231

Exercise-3Exercise-3

GP 33.33% 35% NP 20% 25% ROCE 15% 20% STR 4 5 CR 1.5 2 D/E 0.17241 0.24 Capital employed=3.4-.2=3.2


232

Exercise-4Exercise-4

1. current ratio=550/200=2.75 2.Acid test ratio=400/200=2 3.Operating

ratio=1480*100/1800=82.22% 4.STR=1150/200=5.75 times 5. DTR=1800/250=7.2 times 6.ROPR=


233

Prob.13.Prob.13.

1.sales=3,20,000 2.sundry debtors=80,000 3. sundry creditors=80,000 4. closing stock=31,000 5. Opening stock=29,000


234

Prob.12Prob.12 Balance sheet: General reserve at the beginning=2,00,000 Proposed addition=1,00,000 Profits and loss appro.=20,000 10% Debentures=1,00,000 Current liabilities(Proposed dividend)=2,00,000 Fixed assets=7,20,000 Stock=2,53,125 Sundry debtors=84,375 Tranfer to general reserve=1,00,000 Balance transferred to balance sheet=20,000 Net profit=2,50,000 Provision for tax=7500 Net profit=2,50,000;gross profit=6,07,500;sales=10,12,500;

purchases=1,30,625.


235

Prob.9Prob.9 Balance sheet.Liabilities AssetsEquity shares 2,00,000 Fixed assets

2,25,000R/S 1,00,000 current liabilities

1,75,000Long term liabilities NILOver draft 60,000Sundry creditors 40,000 4,00,000

4,00,000


237

Chapter Objective 5Chapter Objective 5Use ratios in decision making


238

Limitations of Financial Limitations of Financial AnalysisAnalysis No one ratio or year’s worth of financial

information should be relied upon to provide a complete assessment of a corporation’s financial condition

Analysts should: Examine trends over time Benchmark to industry and key competitors Seek answers about why ratios are different


239

Limitations of Financial Limitations of Financial AnalysisAnalysis


240


Grant’s ratios were reasonably good up until several years before its failure


241


But analysts and the investing public continued to believe the company’s strong history would carry it forward



242


But analysts and the investing public continued to believe the company’s strong history would carry it forward

Financial statement users didn’t consider the social and economic changes of the early 1970s and how these affected the retailer!



243

The Complexity of Business The Complexity of Business DecisionsDecisions

Business environment is complicated by numerous local,

regional, national, and global issues - all must

be considered when evaluating current

financial condition or forecasting future

potential for income


244


– Current Assetsinventories$391 $7,681.00





– Equity: $5,308.00



245

Current Ratio:

Quick (Acid Test) Ratio:

Liquidity Ratio Examples: DellLiquidity Ratio Examples: Dell


246

Ratio Comparison: Current RatioRatio Comparison: Current Ratio

0

0.5

1

1.5

2

2.5

Cu

rren

t R

atio

Dell 2.08 1.66 1.45 1.72 1.48

Industry 1.80 1.80 1.90 1.60

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


247

Debt Ratio:

Leverage Ratio Examples: Leverage Ratio Examples: DellDell


248

Ratio Comparison: Debt RatioRatio Comparison: Debt Ratio

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Deb

t R

atio

Dell 54.70% 73.07% 69.70% 66.25% 53.73%

Industry 62.96% 60.00% 52.38% 62.96%



249

Return on Assets (ROA):

Return on Equity (ROE):

Profitability Ratio Examples: Profitability Ratio Examples: DellDell


250

Profitability Ratio Examples: Profitability Ratio Examples: DellDell Net Profit Margin:

Retention Ratio


251

0%

10%

20%

30%

40%

50%

60%

70%

80%

RO

E

Dell 28.13% 64.27% 73.01% 62.90% 31.39%

Industry 22.30% 30.60% 25.50% 18.00%


Ratio Comparison: ROERatio Comparison: ROE


252

0%

5%

10%

15%

20%

25%

RO

A

Dell 12.66% 17.31% 22.12% 21.23% 14.52%

Industry 6.80% 10.90% 7.20% 5.70%


Ratio Comparison: ROARatio Comparison: ROA


253

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Pro

fit

Mar

gin

Dell 5.14% 6.68% 7.66% 8.00% 6.59%

Industry 3.40% 4.74% 3.79% 2.85%


Ratio Comparison: Profit MarginRatio Comparison: Profit Margin


254

Total Asset Turnover Ratio:

Inventory Turnover Ratio:

Activity (Turnover) Ratio Activity (Turnover) Ratio Examples: DellExamples: Dell


255

0%

50%

100%

150%

200%

250%

300%

350%

Ass

et T

urn

ove

r

Dell 2.47 2.59 2.89 2.65 2.20

Industry 2.00 2.30 1.90 2.00


Ratio Comparison: Asset TurnoverRatio Comparison: Asset Turnover


256

The DuPont SystemThe DuPont System

Method to breakdown ROE into:– ROA and Equity Multiplier

ROA is further broken down as:– Profit Margin and Asset Turnover

Helps to identify sources of strength and weakness in current performance

Helps to focus attention on value drivers


257


Profi t M argin T ota l A sse t T urnover

RO A E quity M ultip l ie r

RO E


258




RO E

EquityCommon

Assets Total

Assets Total

IncomeNet MultiplierEquity ROAROE


259




RO E

Assets Total

Sales

Sales

IncomeNet TurnoverAsset TotalMarginProfit ROA


260




RO E

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet MultiplierEquity TurnoverAsset TotalMarginProfit ROE


261

The DuPont System: DellThe DuPont System: Dell

Multiplier EquityROA

Multiplier EquityTurnover Asset TotalMarginProfit Equity Common

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNet ROE

31.39%

2.16111452.0

2.16112.20250.0659$5,308.00

$11,471.00

$11,471.00

$25,265.00

$25,265.00

$1,666.00ROE


262

A Note on Sustainable Growth A Note on Sustainable Growth and Stock Returnsand Stock Returns In the long run

– Sustainable growth and long run capital gains (g) = ROE x

Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0):– r = g + D1/P0 = g + Do(1+g)/P0

Note: r & g must be quarterly if D is quarterly and annual if D is annual


263

Example: Predicted Example: Predicted Sustainable Growth for DellSustainable Growth for Dell Based on the most

recent numbers:– ROE = 31.39% &

= 100%

– g = 0.3139 x 1 = 31.39%

– r = 0.3139 + 0/P = 31.39%

Based on 5 year averages:– ROE = 51.94% &

= 100%

– g = 0.5194 x 1 = 51.94%

– r = 0.3139 + 0/P = 51.94%


264

Summary of Financial RatiosSummary of Financial Ratios

Ratios help to:– Evaluate performance– Structure analysis– Show the connection between activities and

performance Benchmark with

– Past for the company– Industry

Ratios adjust for size differences


265

Limitations of Ratio AnalysisLimitations of Ratio Analysis

A firm’s industry category is often difficult to identify

Published industry averages are only guidelines

Accounting practices differ across firms Sometimes difficult to interpret deviations

in ratios Industry ratios may not be desirable

targets Seasonality affects ratios


266

Ratios and ForecastingRatios and Forecasting

Common stock valuation based on– Expected cashflows to stockholders– ROE and are major determinants of cashflows to

stockholders Ratios influence expectations by:

– Showing where firm is now– Providing context for current performance

Current information influences expectations by:– Showing developments that will alter future

performance


267

How Might Ratios Help Me on How Might Ratios Help Me on the IEM?the IEM? Analysis of AAPL, IBM and MSFT, and

comparisons to the S&P500 companies can help to:– Assess the (absolute and relative) financial state of

each company– Show each company’s strengths and weaknesses– Predict sustainable growth rate

Combined with current information, this can help to:– Assess likely future performance– Predict future valuation and earnings growth– Predict returns


268

Financial Statement Analysis: Financial Statement Analysis: Lecture OutlineLecture Outline Review of Financial Statements Ratios

– Types of Ratios– Examples

The DuPont Method Ratios and Growth Summary

– Strengths– Weaknesses– Ratios and Forecasting


269

Financial AnalysisFinancial Analysis

Assessment of the firm’s past, present and future financial conditions

Done to find firm’s financial strengths and weaknesses

Primary Tools:– Financial Statements– Comparison of financial ratios to past,

industry, sector and all firms


270

Sources of DataSources of Data

Annual reports– Via mail, SEC or company websites

Published collections of data– e.g., Dun and Bradstreet or Robert Morris

Investment sites on the web– Examples

http://moneycentral.msn.com/investor http://www.marketguide.com


271

The Main IdeaThe Main Idea

Value for the firm comes from cashflows Cashflows can be calculated as:

(Revt - Costt - Dept)x(1-) + Dept

—OR— (Revt - Costt)x(1-) + xDept

—OR— Revtx(1-) - Costtx(1-) + xDept


272







– Equity: $5,308.00



273

Review: Major Income Review: Major Income Statement ItemsStatement Items Gross Profit = Sales - Costs of Goods Sold EBITDA

= Gross Profit - Cash Operating Expenses EBIT = EBDIT - Depreciation - Amortization EBT = EBIT - Interest NI or EAT = EBT- Taxes Net Income is a primary determinant of the

firm’s cashflows and, thus, the value of the firm’s shares


274

An Example: DellAn Example: DellAbbreviated Income StatementAbbreviated Income StatementSales $25,265.00Costs of Goods Sold -$19,891.00Gross Profit $5,374.00Cash operating expense -$2,761.00EBITDA 2,613.00Depreciation & Amortization -$156.00Other Income (Net) -$6.00EBIT $2,451.00Interest -$0.00EBT $2,451.00Income Taxes -$785.00Special Income/Charges -$194.00Net Income (EAT) $1,666.00


275

Objectives of Ratio AnalysisObjectives of Ratio Analysis Standardize financial information for

comparisons Evaluate current operations Compare performance with past

performance Compare performance against other

firms or industry standards Study the efficiency of operations Study the risk of operations


276

Rationale Behind Ratio Rationale Behind Ratio AnalysisAnalysis A firm has resources It converts resources into profits through

– production of goods and services– sales of goods and services

Ratios– Measure relationships between resources and

financial flows– Show ways in which firm’s situation deviates from

Its own past Other firms The industry All firms-


277

Types of RatiosTypes of Ratios Financial Ratios:

– Liquidity Ratios Assess ability to cover current obligations

– Leverage Ratios Assess ability to cover long term debt obligations

Operational Ratios:– Activity (Turnover) Ratios

Assess amount of activity relative to amount of resources used

– Profitability Ratios Assess profits relative to amount of resources used

Valuation Ratios: Assess market price relative to assets or earnings


278

Current Ratio:

Quick (Acid Test) Ratio:

Liquidity Ratio Examples: DellLiquidity Ratio Examples: Dell


279

Ratio Comparison: Current RatioRatio Comparison: Current Ratio

0

0.5

1

1.5

2

2.5

Cu

rren

t R

atio

Dell 2.08 1.66 1.45 1.72 1.48

Industry 1.80 1.80 1.90 1.60



280

Debt Ratio:

Leverage Ratio Examples: Leverage Ratio Examples: DellDell


281

Ratio Comparison: Debt RatioRatio Comparison: Debt Ratio

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Deb

t R

atio

Dell 54.70% 73.07% 69.70% 66.25% 53.73%

Industry 62.96% 60.00% 52.38% 62.96%



282

Return on Assets (ROA):

Return on Equity (ROE):

Profitability Ratio Examples: Profitability Ratio Examples: DellDell


283

Profitability Ratio Examples: Profitability Ratio Examples: DellDell Net Profit Margin:

Retention Ratio


284

0%

10%

20%

30%

40%

50%

60%

70%

80%

RO

E

Dell 28.13% 64.27% 73.01% 62.90% 31.39%

Industry 22.30% 30.60% 25.50% 18.00%


Ratio Comparison: ROERatio Comparison: ROE


285

0%

5%

10%

15%

20%

25%

RO

A

Dell 12.66% 17.31% 22.12% 21.23% 14.52%

Industry 6.80% 10.90% 7.20% 5.70%


Ratio Comparison: ROARatio Comparison: ROA


286

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Pro

fit

Mar

gin

Dell 5.14% 6.68% 7.66% 8.00% 6.59%

Industry 3.40% 4.74% 3.79% 2.85%


Ratio Comparison: Profit MarginRatio Comparison: Profit Margin


287

Total Asset Turnover Ratio:

Inventory Turnover Ratio:

Activity (Turnover) Ratio Activity (Turnover) Ratio Examples: DellExamples: Dell


288

0%

50%

100%

150%

200%

250%

300%

350%

Ass

et T

urn

ove

r

Dell 2.47 2.59 2.89 2.65 2.20

Industry 2.00 2.30 1.90 2.00


Ratio Comparison: Asset TurnoverRatio Comparison: Asset Turnover


289


Method to breakdown ROE into:– ROA and Equity Multiplier

ROA is further broken down as:– Profit Margin and Asset Turnover

Helps to identify sources of strength and weakness in current performance

Helps to focus attention on value drivers


290




RO E


291




RO E

EquityCommon

Assets Total

Assets Total

IncomeNet MultiplierEquity ROAROE


292




RO E

Assets Total

Sales

Sales

IncomeNet TurnoverAsset TotalMarginProfit ROA


293




RO E

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet MultiplierEquity TurnoverAsset TotalMarginProfit ROE


294

The DuPont System: DellThe DuPont System: Dell

Multiplier EquityROA

Multiplier EquityTurnover Asset TotalMarginProfit Equity Common

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNet ROE

31.39%

2.16111452.0

2.16112.20250.0659$5,308.00

$11,471.00

$11,471.00

$25,265.00

$25,265.00

$1,666.00ROE


295

A Note on Sustainable Growth A Note on Sustainable Growth and Stock Returnsand Stock Returns In the long run

– Sustainable growth and long run capital gains (g) = ROE x

Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0):– r = g + D1/P0 = g + Do(1+g)/P0

Note: r & g must be quarterly if D is quarterly and annual if D is annual


296

Example: Predicted Example: Predicted Sustainable Growth for DellSustainable Growth for Dell Based on the most

recent numbers:– ROE = 31.39% &

= 100%

– g = 0.3139 x 1 = 31.39%

– r = 0.3139 + 0/P = 31.39%

Based on 5 year averages:– ROE = 51.94% &

= 100%

– g = 0.5194 x 1 = 51.94%

– r = 0.3139 + 0/P = 51.94%


297

Inventory turnover

A/R turnover

Days’ sales in receivables

Measuring the Company’s Ability to Measuring the Company’s Ability to Sell Inventory and Collect Sell Inventory and Collect ReceivablesReceivables

123


298

Inventory TurnoverInventory Turnover Number of times the

average level of inventory is sold during the accounting year

Measures time required to earn return on company’s investment in inventory

1998


299




300



$588,017($164,816 + $168,652) / 2

= 3.53


301

Inventory TurnoverInventory Turnover High ratio indicates ability

to quickly sell inventory Too high a ratio may

indicate inadequate inventory levels

Turnover ratio should be compared to historical and industry averages

Analyze significant variances


302


Number of times the average level of A/R is collected during the accounting year

Measures ability to collect cash from credit customers

$


303


Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently

Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices


304




305


Return on sales



306


Return on sales Return on assets



307


Return on sales Return on assetsReturn on equity



308


Net income - preferred dividendsCommon contributed capital +

retained earnings


309



earnings

$30,555*($286,676 + $255,773) / 2

= .1126

* Lands’ End does not have preferred stock


310

Relationship between net income available to common stockholders and the number of shares of common stock issued

Expresses net income in terms of one share of the company’s common stock



311


Net income - preferred dividends# of shares of common stock

outstanding


312


Net income - preferred dividends# of shares of common stock outstanding

$30,555,000*40,221,000 shares

= $.76

* Lands’ End does not have preferred stock; numbers shown are actual amounts


313

Earnings Per ShareEarnings Per Share In addition to net

income, EPS is presented for several other elements on the corporate income statement

Discontinued operations Extraordinary items Cumulative effect of

accounting change

Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory


314



315

Investors expect to receive 2 types of returns on their investments in a corporation’s common stock

Gains earned when they sell the corporation’s stock

Periodic dividends paid by the corporation to its stockholders



316

Financial analysts use several ratios to assess value of stock investments

Price/earnings ratio Dividend yield Book value



317


Relationship between a stock’s market price and its earnings per share

Measures the number of times one share of stock sells above the current period’s reported earnings

Assists financial analysts in deciding if a stock is overpriced or underpriced


318




319





320






321







322



What is Asian Art’s price/earnings ratio?



Market value of stock

Earnings per share


323




324

Price/Earnings RatioPrice/Earnings RatioMarket value of stock

Earnings per share

$15.75$.92

= 17.12


325

Dividend YieldDividend Yield Ratio of dividends per share of stock to

the stock’s market value Indicates the percentage of a stock’s

market value “returned” to the stockholder in the form of dividends

Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock


326



If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?


327




328

See you in the next chapterSee you in the next chapterBRSBRS

Life education

God and Poor man


329

TIME TO REST


330

Chapter-8 capital structure& cost Chapter-8 capital structure& cost of capitalof capital


331

Chapter 16: Capital Structure Chapter 16: Capital Structure Decisions: The BasicsDecisions: The Basics

Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory Example: Choosing the optimal structure Setting the capital structure in practice


332

Basic DefinitionsBasic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of

capital rs and rd are costs of stock and debt re and wd are percentages of the firm

that are financed with stock and debt.


333

How can capital structure affect How can capital structure affect value?value?

1tt

t

)WACC1(

FCFV

(Continued…)

WACC = wd (1-T) rd + we rs


334

A Preview of Capital Structure A Preview of Capital Structure EffectsEffects The impact of capital structure on value

depends upon the effect of debt on:– WACC– FCF

(Continued…)


335

The Effect of Additional Debt The Effect of Additional Debt on WACCon WACC Debtholders have a prior claim on cash

flows relative to stockholders. – Debtholders’ “fixed” claim increases risk of

stockholders’ “residual” claim.– Cost of stock, rs, goes up.

Firm’s can deduct interest expenses.– Reduces the taxes paid– Frees up more cash for payments to

investors– Reduces after-tax cost of debt

(Continued…)


336

The Effect on WACC The Effect on WACC (Continued)(Continued) Debt increases risk of bankruptcy

– Causes pre-tax cost of debt, rd, to increase

Adding debt increase percent of firm financed with low-cost debt (wd) and

decreases percent financed with high-cost equity (we)

Net effect on WACC = uncertain.

(Continued…)


337

The Effect of Additional Debt The Effect of Additional Debt on FCFon FCF Additional debt increases the

probability of bankruptcy.– Direct costs: Legal fees, “fire” sales, etc.– Indirect costs: Lost customers, reduction in

productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers

(Continued…)


338

Impact of indirect costs– NOPAT goes down due to lost customers

and drop in productivity– Investment in capital goes up due to

increase in net operating working capital (accounts payable goes up as suppliers tighten credit).

(Continued…)


339

Additional debt can affect the behavior of managers.– Reductions in agency costs: debt “pre-

commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.

– Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects.

(Continued…)


340

Asymmetric Information and Asymmetric Information and SignalingSignaling Managers know the firm’s future

prospects better than investors. Managers would not issue additional

equity if they thought the current stock price was less than the true value of the stock (given their inside information).

Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.


341

Uncertainty about future pre-tax operating income (EBIT).

Note that business risk focuses on operating income, so it ignores financing effects.

What is business risk?What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk


342

Business Risks- Unit-9

Uncertainty about demand (unit sales).

Uncertainty about output prices.

Uncertainty about input costs.

Product and other types of liability.

Degree of operating leverage (DOL).


343

What is operating leverage, and how does What is operating leverage, and how does it affect a firm’s business risk?-9.3( 252)it affect a firm’s business risk?-9.3( 252)

Operating leverage is the change in EBIT caused by a change in quantity sold.

The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

(More...)


344

Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.

(More...)

Sales

$ Rev.TC

F

QBE Sales

$ Rev.

TC

F

QBE

EBIT}


345

Operating BreakevenOperating Breakeven

Q is quantity sold, F is fixed cost, V is

variable cost, TC is total cost, and P is

price per unit.

Operating breakeven = QBE

QBE = F / (P – V)

Example: F=$200, P=$15, and V=$10:

QBE = $200 / ($15 – $10) = 40.(More...)


346

Probability

EBITL

Low operating leverage

High operating leverage

EBITH

In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.


347

Business Risk versus Financial Risk-253Business Risk versus Financial Risk-253

Business risk:– Uncertainty in future EBIT.– Depends on business factors such as competition,

operating leverage, etc. Financial risk:

– Additional business risk concentrated on common stockholders when financial leverage is used.

– Depends on the amount of debt and preferred stock financing.


348

Firm U Firm L

No debt $10,000 of 12% debt

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

Consider Two Hypothetical Firms

Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.


349

Impact of Leverage on Returns

EBIT $3,000 $3,000Interest 0 1,200EBT $3,000 $1,800Taxes (40%) 1 ,200 720NI $1,800 $1,080

ROE 9.0% 10.8%

Firm U Firm L


350

Why does leveraging increase Why does leveraging increase return?return?

More EBIT goes to investors in Firm L.

– Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280.

– Taxes paid: U: $1,200; L: $720.

Equity $ proportionally lower than NI.


351

Now consider the fact that EBIT is not known with certainty. What is the

impact of uncertainty on stockholder profitability and risk for Firm U and

Firm L?

Continued…


352

Firm U: Unleveraged

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

Economy

Bad Avg. Good


353

Firm L: Leveraged

Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.

Economy

Bad Avg. Good


354

Firm U Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROIC 6.0% 9.0% 12.0%ROE 6.0% 9.0% 12.0%TIE n.a. n.a. n.a.

Firm L Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROIC 6.0% 9.0% 12.0%ROE 4.8% 10.8% 16.8%TIE 1.7x 2.5x 3.3x


355

Profitability Measures:

E(BEP) 15.0% 15.0%E(ROIC) 9.0% 9.0%E(ROE) 9.0% 10.8%

Risk Measures:ROIC 2.12% 2.12%

ROE2.12% 4.24%

U L


356

ConclusionsConclusions Basic earning power (EBIT/TA) and

ROIC (NOPAT/Capital = EBIT(1-T)/TA) are unaffected by financial leverage.

L has higher expected ROE: tax savings and smaller equity base.

L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk. (More...)


357

In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.

– U and L: ROIC = 2.12%.

– U: ROE = 2.12%.

– L: ROE = 4.24%.

L’s financial risk is ROE - ROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.)

(More...)


358

For leverage to be positive (increase expected ROE), BEP must be > rd.

If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE.

In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”


359


Fighting Spirit


360

Capital Structure Theory-261Capital Structure Theory-261

MM theory– Zero taxes

– Corporate taxes

– Corporate and personal taxes

Trade-off theory

Signaling theory

Debt financing as a managerial constraint


361

MM Theory: Zero TaxesMM Theory: Zero Taxes MM prove, under a very restrictive set of

assumptions, that a firm’s value is unaffected by its financing mix:

– VL = VU.

Therefore, capital structure is irrelevant. Any increase in ROE resulting from financial

leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.


362

MM Theory: Corporate TaxesMM Theory: Corporate Taxes Corporate tax laws favor debt financing over

equity financing.

With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.

MM show that: VL = VU + TD.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.


363

Value of Firm, V

0Debt

VL

VU

MM relationship between value and debt when corporate taxes are considered.

Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.

TD


364

Cost of Capital (%)

0 20 40 60 80 100Debt/Value Ratio (%)

MM relationship between capital costs and leverage when corporate taxes are

considered.

rs

WACCrd(1 - T)


365

Miller’s Theory: Corporate and Miller’s Theory: Corporate and Personal Taxes- Page261(9.4)Personal Taxes- Page261(9.4)

Personal taxes lessen the advantage of corporate debt:– Corporate taxes favor debt financing since

corporations can deduct interest expenses.– Personal taxes favor equity financing, since

no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.


366

Miller’s Model with Corporate and Personal Taxes

VL = VU + [1 - ]D.

Tc = corporate tax rate.Td = personal tax rate on debt income.Ts = personal tax rate on stock income.

(1 - Tc)(1 - Ts)(1 - Td)


367

Tc = 40%, Td = 30%, and Ts = 12%.

VL = VU + [1 - ]D

= VU + (1 - 0.75)D

= VU + 0.25D.

Value rises with debt; each $1 increase in debt raises L’s value by $0.25.

(1 - 0.40)(1 - 0.12)(1 - 0.30)


368

Conclusions with Personal Conclusions with Personal TaxesTaxes Use of debt financing remains

advantageous, but benefits are less than under only corporate taxes.

Firms should still use 100% debt.

Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.


369

Trade-off TheoryTrade-off Theory

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.

At low leverage levels, tax benefits outweigh bankruptcy costs.

At high levels, bankruptcy costs outweigh tax benefits.

An optimal capital structure exists that balances these costs and benefits.


370

Signaling TheorySignaling Theory

MM assumed that investors and managers have the same information.

But, managers often have better information. Thus, they would:– Sell stock if stock is overvalued.

– Sell bonds if stock is undervalued. Investors understand this, so view new stock

sales as a negative signal. Implications for managers?


371

Debt Financing and Agency Debt Financing and Agency CostsCosts One agency problem is that managers

can use corporate funds for non-value maximizing purposes.

The use of financial leverage:– Bonds “free cash flow.”– Forces discipline on managers to avoid perks

and non-value adding acquisitions.

(More...)


372

A second agency problem is the potential for “underinvestment”.– Debt increases risk of financial distress.

– Therefore, managers may avoid risky projects even if they have positive NPVs.


373

Choosing the Optimal Capital Structure: Example

Currently is all-equity financed.

Expected EBIT = $500,000.

Firm expects zero growth.

100,000 shares outstanding; rs = 12%;

P0 = $25; T = 40%; b = 1.0; rRF = 6%;

RPM = 6%.e-mail: [email protected] www.augustin.co.nr

374

Estimates of Cost of Debt

Percent financedwith debt, wd rd

0% - 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0%

If company recapitalizes, debt would be issued to repurchase stock.


375

The Cost of Equity at Different The Cost of Equity at Different Levels of Debt: Hamada’s Levels of Debt: Hamada’s Equation Equation MM theory implies that beta changes

with leverage.

bU is the beta of a firm when it has no debt (the unlevered beta)

bL = bU [1 + (1 - T)(D/S)]


376

The Cost of Equity for wThe Cost of Equity for wdd = =

20%20% Use Hamada’s equation to find beta:

bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity:

rs = rRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%


377

Cost of Equity vs. LeverageCost of Equity vs. Leverage

wd D/S bL rs

0% 0.00 1.000 12.00%

20% 0.25 1.150 12.90%

30% 0.43 1.257 13.54%

40% 0.67 1.400 14.40%

50% 1.00 1.600 15.60%


378

The WACC for wThe WACC for wdd = 20% = 20%

WACC = wd (1-T) rd + we rs

WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)

WACC = 11.28%

Repeat this for all capital structures under

consideration.


379

WACC vs. LeverageWACC vs. Leverage

wd rd rs WACC

0% 0.0% 12.00% 12.00%

20% 8.0% 12.90% 11.28%

30% 8.5% 13.54% 11.01%

40% 10.0% 14.40% 11.04%

50% 12.0% 15.60% 11.40%


380

Corporate Value for wCorporate Value for wdd = 20% = 20%

V = FCF / (WACC-g)

g=0, so investment in capital is zero; so

FCF = NOPAT = EBIT (1-T).

NOPAT = ($500,000)(1-0.40) = $300,000.

V = $300,000 / 0.1128 = $2,659,574.


381

Corporate Value vs. LeverageCorporate Value vs. Leverage

wd WACC Corp. Value

0% 12.00% $2,500,000

20% 11.28% $2,659,574

30% 11.01% $2,724,796

40% 11.04% $2,717,391

50% 11.40% $2,631,579


382

Debt and Equity for wDebt and Equity for wdd = 20% = 20%

The dollar value of debt is:

D = wd V = 0.2 ($2,659,574) = $531,915.

S = V – D

S = $2,659,574 - $531,915 = $2,127,659.


383

Debt and Stock Value vs. Debt and Stock Value vs. LeverageLeverage

wd Debt, D Stock Value, S

0% $0 $2,500,000

20% $531,915 $2,127,660

30% $817,439 $1,907,357

40% $1,086,957 $1,630,435

50% $1,315,789 $1,315,789Note: these are rounded; see Ch 16 Mini Case.xls for full calculations.


384

Wealth of ShareholdersWealth of Shareholders

Value of the equity declines as more debt is issued, because debt is used to repurchase stock.

But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).


385

Stock Price for wStock Price for wdd = 20% = 20% The firm issues debt, which changes its

WACC, which changes value.

The firm then uses debt proceeds to

repurchase stock.

Stock price changes after debt is issued, but

does not change during actual repurchase (or

arbitrage is possible). (More…)


386

Stock Price for wStock Price for wdd = 20% = 20%

(Continued)(Continued) The stock price after debt is issued

but before stock is repurchased

reflects shareholder wealth:

– S, value of stock

– Cash paid in repurchase.

(More…)


387


(Continued)(Continued) D0 and n0 are debt and outstanding shares

before recap.

D - D0 is equal to cash that will be used to

repurchase stock.

S + (D - D0) is wealth of shareholders’ after

the debt is issued but immediately before the

repurchase. (More…)


388


(Continued)(Continued) P = S + (D – D0)

n0

P = $2,127,660 + ($531,915 – 0)

100,000

P = $26.596 per share.


389

Number of Shares Number of Shares RepurchasedRepurchased # Repurchased = (D - D0) / P

# Rep. = ($531,915 – 0) / $26.596

= 20,000. # Remaining = n = S / P

n = $2,127,660 / $26.596

= 80,000.


390

Price per Share vs. LeveragePrice per Share vs. Leverage

# shares # shares

wd P Repurch. Remaining

0% $25.00 0 100,000

20% $26.60 20,000 80,000

30% $27.25 30,000 70,000

40% $27.17 40,000 60,000

50% $26.32 50,000 50,000


391

Optimal Capital StructureOptimal Capital Structure

wd = 30% gives:

– Highest corporate value

– Lowest WACC

– Highest stock price per share

But wd = 40% is close. Optimal

range is pretty flat.


392

Debt ratios of other firms in the industry.

Pro forma coverage ratios at different capital structures under different economic scenarios.

Lender and rating agency attitudes(impact on bond ratings).

What other factors would managers consider when setting the target

capital structure?


393

Reserve borrowing capacity.

Effects on control.

Type of assets: Are they tangible, and hence suitable as collateral?

Tax rates.


394

Life EducationLife Education

War prisoner’s wife


395

Capital Budgeting-Chapter-Capital Budgeting-Chapter-11(297)11(297)


Ch. 11:Ch. 11:Capital BudgetingCapital BudgetingDecision CriteriaDecision Criteria

1999, Prentice Hall, Inc.396


Capital BudgetingCapital Budgeting:: the process of the process of planning for purchases of long-planning for purchases of long-

term assets.term assets. example: Suppose our firm must decide whether

to purchase a new plastic molding machine for $125,000. How do we decide?

Will the machine be profitable? Will our firm earn a high rate of return

on the investment?397


Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting

How do we decide if a capital investment

project should be accepted or rejected?


399

Capital BudgetingCapital Budgeting

Time value of money is a fundamental concept. If the interest rate in the economy is 10%, $1 today is worth $1.10 net year, $1.21 two years from today and $1.331 three years from today etc…

So, $1.10 next year $1.21 two years from now, $1.331 three years from now are all worth $1 today.


400

100(1+.12)=112(1.12)=125.44 100=112 100=125.44 112=100 125.44=100 Today’s worth of 112 at the end 1st year is =100 today 100=112/1.12 (1+K) A(1+K)^n=FV PV(1+K)^n=FV


401


Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I be willing to pay for the right to this stream of cash flows assuming that my only other alternative is to put the money in a bank account and get 10% interest?

Ans: $3, why?– Each year’s cash inflow is worth a dollar

today.


402


If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project is _____

Ans: 10cents. How computed?– The cash inflows are worth $3 in today’s

dollars, the outflows are $2.90 in today’s dollars, so the NPV (always in current dollars) is Cash Inflows – Cash Outflows = $0.10.


403


The basic equation of compound interest is shown on p. 96:

PV(1+r)n = FV (1+r)n is called the “factor” To get the present value of a stream of cash

inflows divide each future inflow amount by the factor for that year (this is called deflating the FV) and add all the deflated inflows … this is the formula on


404


To get the present value of a stream of cash outflows compute the sum of the deflated cash outflows.

To compute NPV of a project subtract PV(outflows) from PV(Inflows).

To do the computations by hand you can use special formulas for perpetuities and annuities. We will ignore this.

For this course, you should know how to do the computations using a financial calculator.


405

Principles underlying Cash FlowsPrinciples underlying Cash Flows

1. Decision based on cash flows-Non cash charges not considered ie.Depreciation for tax calculation only. We add depreciation after calculating tax with profit after tax

2.The amount of long term funds are used for capital investment purpose are considered.

3.Cash inflow is defined as profit after tax but before depreciation


406


4.Interest on long term loan is not considered as it is used for discounting purpose.

5. Incremental cost and incremental benefits are considered.

6.Quantify the detremental impact or benefits are considered.


407


7.Sunk cost are irrelevant. 8.Opportunity costs are to be

considered. 9. share of existing overheads has no

value 10. short term loan –interest on such

loan to be deducted from contribution.


408


11. salvage value to be determined and tax benefit on short term capital gain to be deducted from salvage value. And tax benefit on short term capital loss to be added to salvage value.

12. while valuing lease/buy tax benefit on interest payment and tax benefit on depreciation have to be deducted from equated annual/monthly instalment.

13. While valuing lease net lease payment after tax has to be considered.


409

Relevant cost and relevant Relevant cost and relevant benefitbenefit

Required for decision making Costs that are affected by by the decision Costs and benefits that are independent of

a decision are not relevant and need not be considered.

Future cash inflows and future outflows are relevant.

Sunk costs are irrelevant


410

Relevant cost and relevant Relevant cost and relevant benefitbenefit Allocated common costs are irrelevant Opportunity costs are relevant (shadow

price) Incremental costs are relevant

incremental benefits are relevant. Avoidable costs are relevant and

unavoidable costs are irrelevant for decision making.


411

Relevant and irrelevantRelevant and irrelevant

Five engineers already employed on monthly salary but will not be sent out if not employed in an another project. The salary paid to those engineers are relevant or irrelevant to estimate the price for the project?

Two more engineers are selected exclusive to the new project-are the costs relevant to take decision for new project?


412

Examples:Examples: 1.Aztec. Spent Rs.20,00,000 for feasibility study before expansion is dead cost (sunk cost) therefore it is not considered as cash outflow.

2. If feasibility study can be sold to other companies say, for Rs. 5,00,000 is an opportunity cost which should be considered as cash inflow for the project.


413

Examples:Examples:

3. Plant is Rs. 36,00,000, working capital is Rs. 24,00,000 required for a project. The company issues Equity capital Rs.26,00,000 and term loan Rs.16,00,000 then the cash outflow for the project is Rs. 42,00,000 as long term funds such as Equity capital and long term loan equal to Rs.42,00,000. If short term funds are employed for long term purpose we do not consider such funds as out flow.


414

DepreciationDepreciation 4. Depreciation should be calculated as per

Block assets method. The assets are similar nature having the rate of depreciation the costs are to be clubbed together. If any new asset(s) purchased during the year the amounts incurred on such asset are to be added.

Depreciation can not be calculated in the year of sale but the sale value(scrap ) is deducted from the block value.

If the some of the assets of the block are not sold and WDV(Balance in the block) exceeds sale value of the assets of the same block we can provide depreciation on the balance.


415

If Sale value exceeds the block WDV value there is a capital gain which attracts capital gain. In such situation sale minus tax on short term capital gain will be cash inflow.

If all assets of the block is sold and the WDV of the block exceeds sale value we get short term capital loss. The real cash inflow is equal to scrap plus tax benefit on short term capital loss .

Example:1. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000

The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is 25% . How do we calculate depreciation? Life is 3 years


416

.75*5,00,000= = =2,10,937.5-1,00,000 = 1,10,937(loss) 1,00,000+1,10937(.339) =1,37,607(Inflow) Suppose salvage value is 3,00,000Short term capital gain= 3,00,000-2,10,937=89,063Tax on 89,063=89063*.339=30,192Net cash inflow =3,00,000-30,192 =2,69,807.This should be discounted to today’s value


417

Depreciation and their impact Depreciation and their impact in fin.A/c, fin.Mgt.,Income tax in fin.A/c, fin.Mgt.,Income tax etc.etc.

By Prof.Augustin Amaladas

M.Com.,AICWA.,B.ED.,PGDFM


418

MeaningMeaning

Reduction in the value of fixed assets due to wear and tear and due to effluction of time.

All assets except land can be depreciated. The underlying principle of depreciation is

that cash flows generated by an asset over its life cannot be considered income until provision is made for asset’s replacement.

It is an allocation of past cash flows. Depreciation expense appears on the income

statement, but has no impact on the statement of cash flows.


419

Depreciation methodsDepreciation methods

Straight line method Written down value method Sinking fund method Machine Hour rate method Unit cost method Depletion asset method Depreciation Fund method Sum of digits method Accelerated depreciation method


420

Impact on booksImpact on books

Depreciation Expense Net income Asset Equity Return on assets Return on Equity Turnover Ratios Cash flow NPV IRR Pay back


421

Impact of TaxImpact of Tax

Block asset method Purchase of Asset Sale of Asset Short term/Long-term Capital asset Asset used less than 180 days during the

previous year Asset purchased preceding previous year

but put into use less than 180 days during the current previous year


422

Impact of TaxImpact of Tax

Rate decided by whom?


423

Inflation and Inflation and DepreciationDepreciation

If prices are rising, Incomes and taxes will be over stated / Under stated

Replacement?


424

Accounting StandardAccounting Standard

AS-06 As-10


425

Tax planningTax planning

U/S-32 of IT act When own funds used in plant and machinery

-18.66% saving When borrowed funds used –Tax savings

through depreciation-22.91% Depreciation on intangible assets can be

provided at 25% rate. The eligible assets are: Know how, patent right, copy right,

Trade mark, licenses, franchises, any other commercial rights


426

Carry forward and set of depreciation in Carry forward and set of depreciation in the subsequent periodsthe subsequent periods

Any number of years provided filed returns


427

Amalgamation, absorption, Amalgamation, absorption, reconstruction and demergerreconstruction and demergerCAN NEW CO. CARRY FORWAD AND SET OF

LOSS AND DEPRECIATION? SEC 72 A TO BE FULFILLED1. ACCUMULATED LOSSES REMAIN

UNABSORBED FOR 3 OR MORE YEARS2. 75% OF BOOK VALUE TO BE HELD ATLEAST

FOR 2 YEARS BEFORE AMALGAMATION


428

1. THE AMALGAMATED CO. CONTINUES TO HOLD 3/4TH OF BOOK VALUE ATLEAST FOR 5 YEARS

2. NEW CO. SHOULD CONTINUE FOR ANOTHER 5 YEARS

3. NEW CO. SHOULD ACHIEVE ATLEAST 50%OF INSTALLED CAPACITY BEFORE END OF 5 YEARS AND SHOULD CONTINUE FOR 5 YEARS


429

A LTD AMALGAMATES WITH B LTD AS ON 2007A LTD AMALGAMATES WITH B LTD AS ON 2007


430

OTHER TAX OTHER TAX BENEFITSBENEFITS1. Expenditure on amalgamation or de-merger –

allowed under sec 35DD both revenue and capital expenditure allowed

2. Expenditure on scientific research can be carried forward

3. Expenditure on acquisition of patent rights copyrights – depreciation can be provided


431

OTHER TAX BENEFITSOTHER TAX BENEFITS

1. Expenditure for obtaining license for tele-communication service can be written off

2. Preliminary expenses3. Capital expenditure on family

planning4. Bad debts are allowed


432

Calculation of Depreciation- Calculation of Depreciation- continuescontinues

Example:1. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000 The rate of depreciation as per Companies Act is 20% whereas income

tax rate of depreciation is 25% . Life is 3 years. Tax rate=30% surcharge 10% and 3% educational cess.

How do we calculate Capital loss? Cash Inflow at the end of third year?.

Short term capital loss Block value at the end of 2nd year- scrap at the end of three years =Rs.2,81,750-Rs. 1,00,000

=Rs. 1,81,750 Cash Inflow at the end of third year =Rs.1,00,000+(*33.90% *1,81,750)

= Rs.1,61,613

*Tax= 30%+10%(30%)+3%*33=33.99%


433

Depreciation as per Income tax Depreciation as per Income tax actact

Year Beginning value

Depreciation25%

End value

123

5,00,0003,75,0002,81,750

1,25,000 93,750 No

3,75,0002,81,750


434

owned funds Vs borrowed fundsowned funds Vs borrowed funds

If owned funds are invested in plant and machinery one can get tax saving on depreciation.

If assets are acquired on borrowed funds one can get tax benefit on depreciation and also tax benefit on interest.

The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest.


435

Exercise-2 owned funds Vs Exercise-2 owned funds Vs borrowed fundsborrowed funds An assessee who carries on a business, acquires a

plant and machinery costing Rs.10,00,000 in a year one. This plant is used for 5 years and will be discarded at the end of 5th year for Rs. 2,00,000.

Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 5th year. Cost of Capital is 10% and rate of depreciation is 15%.

Required: 1. Evaluate when owned funds are invested 2. When 75% cost of plant is financed by deposit

taken from public at the rate of 9%pa.


436

year beginningDepreciati

on End valueTax benefit

on depre

discount factor

present value

1 10,00,000 1,50,000 8,50,000 50,850 0.909 50,799

2 8,50,000 1,27,500 7,22,500 43,223 0.826 35,702

3 7,22,500 1,08,375 6,14,125 36,739 0.751 27,591

4 6,14 112 92119 5,22,006 31,228 0.683 21,328

55,22,006

Present value

0.621,35,420


437

Present value of scrap =*3,09,158*.620=1,91,678 *Scrap value=2,00,000 *Calculation of short term capital gain as the asset is depreciated Book value at the end of 4th year-scrap value=5,22,000-2,00,000 =3,22,000Tax savings on STCG=3,22,000*.339

=*1,09,158Present value on tax saving on STCG= 1,09,158*0.620=37,004=67,678Net present cash out flow valueInitial cash out flow-Present value of tax savings on depreciation-

present value of cash inflow on scrap Rs.10,00,000-Rs.1,35,420-Rs.1,91,678=Rs.6,72,902


438

Lease vs PurchaseLease vs Purchase Purchase with Borrowed Funds:- If assets are acquired on borrowed funds one can get

tax benefit on depreciation and also tax benefit on interest.

The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest.

Lease- Deduction can be claimed in respect of lease rentals

and lease management fees.


439

Exercise-3 Lease vs PurchaseExercise-3 Lease vs Purchase An assessee who carries on a business, acquires a plant and

machinery costing Rs.10,00,000 in a year one. This plant is used for ten years and will be discarded at the end of ten years for Rs. 2,00,000.

Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 10th year. Discounting rate is 10% and rate of depreciation is 15%.

Required: 1. Evaluate when plant taken on lease by paying lease rental of

Rs. 3,50,000 for the first five years in the beginning and 50,000 thereafter for the remaining years.

2. When 75% cost of plant is financed by deposit taken from public at the rate of 9%p.a.


440

Purchase by instalment vs Hire Purchase by instalment vs Hire


441


Apologies to the ---------


442


shoes


443

Short cut techniques by using Short cut techniques by using ordinary calculator.ordinary calculator. Future value at 10% year 1. 1.1Year 2. 1.1*=Year 3. 1.1*= = Year 5. 1.1*= = = =


444

Scientific calculatorScientific calculator

Amount*1.1= for the first year Amount *1.1*1.1= for the second year Amount *1.1*1.1= = = = 6th year value


445

Present value by ordinary Present value by ordinary calculatorcalculator 1st year 1.1/= 2nd year 1.1/= = 6rd year 1.1/= = = = = =


446

WDV value WDV value 15% depreciation as per WDV value at the end of 1st year= 0.85*asset value=Value at the end of 2nd year =0 .85*asset value= =Value at the end of 6th year=0.85*asset value= = = = = =


The Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project,

b) consider the time value of money,c) incorporate the required rate of return

on the project.

Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting


Payback PeriodPayback Period

The number of years needed to recover the initial cash outlay.

How long will it take for the project to generate enough cash to pay for itself?




00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150




00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.Payback period = 3.33 years.


Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will

compare the payback calculation to some standard set by the firm.

If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?

Accept the project.


Drawbacks of Payback Period:Drawbacks of Payback Period:

Firm cutoffs are subjective. Does not consider time value of money. Does not consider any required rate of

return. Does not consider all of the project’s cash

flows.



Does not consider all of the project’s cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!453



Does not consider all of the project’s cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0

This project is clearly unprofitable, but we would accept it based on a 4-year paybackcriterion! 454


Discounted PaybackDiscounted Payback

Discounts the cash flows at the firm’s required rate of return.

Payback period is calculated using these discounted net cash flows.

Problems: Cutoffs are still subjective. Still does not examine all cash flows.



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2

years 88.32 459



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

DiscountedYear Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2

years 88.32 3 250 168.75 460



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 .52 years



00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 .52 years

The Discounted The Discounted Payback Payback

is is 2.522.52 years years


Other MethodsOther Methods

1) Net Present Value (NPV)2) Profitability Index (PI)3) Internal Rate of Return (IRR)

Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return.


Net Present ValueNet Present Value

NPV = the total PV of the annual net NPV = the total PV of the annual net cash flows - the initial outlay.cash flows - the initial outlay.

NPVNPV = - IO = - IO ACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1


Net Present ValueNet Present Value

Decision RuleDecision Rule::

If NPV is positive, If NPV is positive, ACCEPTACCEPT.. If NPV is negative, If NPV is negative, REJECTREJECT..


NPV ExampleNPV Example

Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.


NPV ExampleNPV Example

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000

Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.


NPV with the HP10B:NPV with the HP10B:

-276,400 CFj 83,000 CFj 4 shift Nj 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71.


NPV with the HP17BII:NPV with the HP17BII:

Select CFLO mode. FLOW(0)=? -276,400 INPUT FLOW(1)=? 83,000 INPUT #TIMES(1)=1 4 INPUT FLOW(2)=? 116,000 INPUT #TIMES(2)=1 INPUT EXIT CALC 15 I% NPV You should get NPV = 18,235.71


NPV with the TI BAII Plus:NPV with the TI BAII Plus:

Select CF mode.



Select CF mode. CFo=? -276,400 ENTER



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER

CPT



Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER

CPT You should get NPV = 18,235.71 477


Profitability IndexProfitability Index


(1 + k)(1 + k) tt

nn

t=1t=1



t


(1 + k)(1 + k) tt

nn

t=1t=1

PI = IO ACFt

(1 + k)

n

t=1




If PI is greater than or equal If PI is greater than or equal to 1, to 1, ACCEPTACCEPT..

If PI is less than 1, If PI is less than 1, REJECTREJECT..480


PI with PI with the the

HP10B:HP10B:

-276,400 CFj 83,000 CFj 4 shift Nj 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71. Add back IO: + 276,400 Divide by IO: / 276,400 = You should get PI = 1.066


Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.


483


Toss a coin




(1 + k)(1 + k) tt

nn

t=1t=1



n

t=1IRR: = IO

ACFt

(1 + IRR) t


(1 + k)(1 + k) tt

nn

t=1t=1



IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay.

This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.

n

t=1IRR: = IO

ACFt

(1 + IRR) t


Calculating IRRCalculating IRR

Looking again at our problem: The IRR is the discount rate that

makes the PV of the projected cash flows equal to the present value of outlay.

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000


This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

This way, we have to solve for IRR by trial and error.

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


IRR with your CalculatorIRR with your Calculator

IRR is easy to find with your financial calculator.

Just enter the cash flows as you did with the NPV problem and solve for IRR.

You should get IRR = 17.63%!


IRRIRR


If IRR is greater than or equal If IRR is greater than or equal to the required rate of return, to the required rate of return, ACCEPTACCEPT..

If IRR is less than the required If IRR is less than the required rate of return, rate of return, REJECTREJECT..


IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +)

Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)




0 1 2 3 4 5

(500) 200 100 (200) 400 300



We could find 3 different IRRs!

0 1 2 3 4 5

(500) 200 100 (200) 400 300

1 2 31 2 3


Summary Problem:Summary Problem:

Enter the cash flows only once. Find the IRR. Using a discount rate of 15%, find NPV. Add back IO and divide by IO to get PI.

0 1 2 3 4 5

(900) 300 400 400 500 600


Summary Problem:Summary Problem:

IRR = 34.37%. Using a discount rate of 15%, NPV = $510.52. PI = 1.57.

0 1 2 3 4 5

(900) 300 400 400 500 600


498

NPV ProfilesNPV Profiles

A graphical representation of project NPVs at various different costs of capital.

k NPVL NPVS

0 $50 $40 5 33 2910 19 2015 7 1220 (4) 5


499

Drawing NPV profilesDrawing NPV profiles

-10

0

10

20

30

40

50

60

5 10 15 20 23.6

NPV ($)

Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

SL

.

.

...

.

..

.

. .


500

Comparing the NPV and IRR Comparing the NPV and IRR methodsmethods If projects are independent, the two

methods always lead to the same accept/reject decisions.

If projects are mutually exclusive …– If k > crossover point, the two methods

lead to the same decision and there is no conflict.

– If k < crossover point, the two methods lead to different accept/reject decisions.


501

Finding the crossover pointFinding the crossover point

1. Find cash flow differences between the projects for each year.

2. Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%.

3. Can subtract S from L or vice versa, but better to have first CF negative.

4. If profiles don’t cross, one project dominates the other.


502

Reasons why NPV profiles crossReasons why NPV profiles cross

Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects.

Timing differences – the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPVS > NPVL.


503

Reinvestment rate assumptionsReinvestment rate assumptions

NPV method assumes CFs are reinvested at k, the opportunity cost of capital.

IRR method assumes CFs are reinvested at IRR.

Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.

Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.


504

Since managers prefer the IRR to the Since managers prefer the IRR to the NPV method, is there a better IRR NPV method, is there a better IRR measure?measure? Yes, MIRR is the discount rate that

causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.

MIRR assumes cash flows are reinvested at the WACC.


505

Calculating MIRRCalculating MIRR

66.0 12.1

10%

10%

-100.0 10.0 60.0 80.0

0 1 2 310%

PV outflows

-100.0 $100

MIRR = 16.5%158.1

TV inflows

MIRRL = 16.5%

$158.1

(1 + MIRRL)3=


506

Why use MIRR versus IRR?Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.

Managers like rate of return comparisons, and MIRR is better for this than IRR.


507

Project P has cash flows (in 000s): CFProject P has cash flows (in 000s): CF00 = =

-$800, CF-$800, CF11 = $5,000, and CF = $5,000, and CF22 = -$5,000. = -$5,000.

Find Project P’s NPV and IRR.Find Project P’s NPV and IRR.

Enter CFs into calculator CFLO register.

Enter I/YR = 10. NPV = -$386.78. IRR = ERROR Why?

-800 5,000 -5,000

0 1 2k = 10%


508

Multiple IRRsMultiple IRRs

NPV Profile

450

-800

0400100

IRR2 = 400%

IRR1 = 25%

k

NPV


509

Why are there multiple IRRs?Why are there multiple IRRs?

At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.

At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.

In between, the discount rate hits CF2 harder than CF1, so NPV > 0.

Result: 2 IRRs.


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Solving the multiple IRR problemSolving the multiple IRR problem

Using a calculator– Enter CFs as before.– Store a “guess” for the IRR (try 10%)

10 ■ STO ■ IRR = 25% (the lower IRR)

– Now guess a larger IRR (try 200%)200 ■ STO ■ IRR = 400% (the higher IRR)

– When there are nonnormal CFs and more than one IRR, use the MIRR.


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When to use the MIRR instead of When to use the MIRR instead of the IRR? Accept Project P?the IRR? Accept Project P?

When there are nonnormal CFs and more than one IRR, use MIRR.– PV of outflows @ 10% = -$4,932.2314.– TV of inflows @ 10% = $5,500.– MIRR = 5.6%.

Do not accept Project P.– NPV = -$386.78 < 0.– MIRR = 5.6% < k = 10%.


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Moral:– Use NPV as the first step in evaluating projects.– If capital is in short supply, try and find the best mix of

projects to take using simulation rather than use some arbitrary short-cuts (IRR etc.).

– Look at payback period as a second step, especially if the projects are otherwise comparable (in magnitude of investment, life of cash flows). If strategic flexibility in the firm’s investment base matters, payback period is a healthy tool in spite of serious theoretical deficiencies.

– In other words, be careful of using only NPV because cash flows in the far future are hard to predict.


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Bringing rain inside


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Thank YouThank You


financial management scdl

Economy & Finance