Objective: maximize firm value, increase stock price Decisions: Investment, Working Capital, Financing, Distribution

Principal (shareholders) Agent (Manager): Career Concern, Empire Building, Private Benefits of Control, Shirking
Current Assets Current Liabilities = Net working capital (Current = less than a year)
Financial leverage: use of debt to acquire assets
Average tax rate: total taxes paid / total taxable income. Marginal tax rate: amount of tax payable on the next dollar earned.
Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Shareholders
Cash Flow from Assets = Operating Cash Flow (EBIT + Dep - Tax) Net Capital Spending (Ending Net Fixed Assets Beginning
NFA + Dep) Change in Net Working Capital
Cash Flow to Creditors = Interest Paid Net New Borrowing
Cash Flow to Shareholders = Dividend Paid Net New Equity Raised
Current Ratio: Current Assets / Current Liabilities distorted by seasonal influences, slow-moving inventories built up out of
proportion to market opportunities, abnormal payment of accounts payable just prior to the balance sheet date.
Quick Ratio (Acid-Test Ratio): Current Assets Inventory/ Current Liabilities
Cash Ratio Cash / Current Liabilities Very short-term creditor might be interested in this ratio.
Solvency Ratios : ability to meet long-term debt payment.
Total Debt Ratio: Total Liabilities/Total Assets Debt-equity Ratio: Total Liabilities / Shareholders' Equity
Times Interest Earned Ratio: EBIT/Interest operating profits decline without impairing ability to pay interest.
Cash Coverage Ratio: (EBIT + Depreciation) / Interest
Asset Management Ratios: how a firm manages its investment and fixed assets
Inventory Turnover: Cost of Goods Sold/ Inventory how fast inventory items move through a business.
Days Sales in Inventory: 365/ days Inventory Turnover average length of time items spent in inventory.
Receivables Turnover: Sales/ Accounts Receivable how fast the firm collects on the credit sales.
Average Collection Period: 365/ days Receivables Turnover
Asset Turnover: Sales / Total Assets high-> efficient management using its investment in total assets to generate sales.
Profitability Ratios
Profit Margin: Net Income / Sales measures total operating and financial ability of management.
Return on Assets (ROA): Net Income / Total Assets return on total assets after recognition of taxes and financing costs.
Return on Equity (ROE): Net Income/ Total Equity ROE exceeds ROA reflects the use of financial leverage.
Market Value Ratios
Earnings Per Share (EPS): Net Income / Shares Outstanding
Price-Earnings Ratio (PE): Price Per Share / Earnings Per Share willing to pay per dollar of current earnings.
Price-Sales Ratio: Price Per Share / Sales Per Share used when the firm reported negative earnings for the period.
Market-to-Book Ratio (MB): Market Value Per Share / Book Value Per Share book value per share: total equity / no. of shares
outstanding. less than 1: not successful overall in creating value for its shareholders.
Linking Ratios
ROA = Profit Margin x Asset Turnover
(Net Income / Sales) x (Sales / Total Assets) = (Net income / Total Assets) return on assets related to
profitability & turnover.
ROE (Du Pont Identity): Profit Margin x Asset Turnover x Equity Multiplier = ROE
(Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Equity) [operating efficiency, asset use efficiency, and financial
leverage]
Total equity taken from beginning: Sustainable Growth = Return on Equity x Retention Rate (g = ROE x b)
Total equity taken from ending:
Assumption: not alter capital structure
Future Value: Vt = V0 (1 + r)t (compounding: interest on interest)
Present value & discounting:
Longer the time period, the lower the present value. Higher the interest rate, smaller the present value
Rule of 72: time it takes to double your money is given approximately by 72 / r.
Future value of cash flow:
Present Value of cash flow:
Annuity: value of cash flows is the same for a number of years.
PV of annuity
FV of annuity
Annuity Due = Ordinary Annuity (1+ r)
cash flow starts from beginning
Present Value of a Perpetuity = C / r

EAR
APR

NPV: PV of all future cash flows - initial cost C [

1
r

1+r 2
1+r t

(1
] I ; -I +
1
C 1 C2
+

1+r

year 2010: I year 2011: C1

Positive NPV: worth more than it costs, creates value (Accept). Negative NPV: destroy value (reject).
Independent projects, take all positive NPV. Mutually exclusive projects, take highest and positive NPV.
Equivalent Annuity (Different lives)

IRR: discount rate that makes the NPV 0 Accept if IRR > required return
NPV of the project decreases as we increase the discount rate
discount rate below the IRR, the NPV of the project is positive
Nonconventional: cash flows change signs more than once, there will be more than one IRR
Mutually exclusive & nonconventional: X IRR
Crossover point: NPV(A) = NPV (B)
Payback period: length of time it takes to recover the initial investment payback<pre-specified accept
1. ignores the time value of money.(use the discounted payback period) 2. It ignores the cash flows after the payback
period. 3. The standard for payback period is arbitrary.
AAR = Average net income / Average book value AAR > target AAR accept
1. not a true rate of return and ignores the time value of money. 2. arbitrary cutoff rate. 3. based on accounting net income
and book values, not cash flows and market values.
PI measures the benefit per unit cost, based on the time value of money. PI = PV/I Accept PI>1
Rank the projects PI from highest to lowest, select from the top of the list until the capital budget is exhausted. Check if
whole budget is exhausted.
Bond: certificate showing that a borrower owes a specified sum. make interest and principal payments on designated dates.
(maturity)
Pure discount bond (zero coupon): a single payment at a fixed future date. payment at maturity: face value or par value

1+r T

F
P=

F P = interest

Corporate bonds offer cash payments not just at maturity, but also at regular times in between.
P=
Semiannual coupons use semiannual discount rate (/2), T x 2 (30 years, 60 semiannual cash flows)
Inverse relation between bond price and discount rate. (Not symmetric too)
coupon rate = discount rate, price = par value. coupon rate less than discount rate, price less than par value.
Consol: bond that never stop paying a coupon, has no final maturity date. (perpetuity) P=C/r
Yield to maturity (YTM): average rate of return on a bond if it is bought now and held until maturity.
common stock: ownership interest in a firm (Vote at company meetings. Collect periodic dividend payments. Sell the share
at the owners discretion) (Residual claim. Limited liability. Voting rights.)
Stock valuation
Zero growth: dividend is constant Div/r
Constant growth:
P0 is higher when: expected dividend per share is larger. risk-adjusted discount rate or required rate of return is lower.
expected growth rate of dividend is higher. stock price will grow at the same constant rate as the dividend
Non-constant growth

Stock price & growth opportunities