Chapter 1 Overview of Financial Management

Investment Vehicle Model Investors provide financing to the firm in exchange for
financial securities (bonds and shares), and firm invests these funds in assets. The
income generated by the firm is distributed to the investors.
Balance Sheet Model (Accounting Model) Investment decisions are represented by
LHS/Assets and Financing decisions are represented by RHS/Liabilities & Equity on the
balance sheet.
Total Value of Assets = Total Firm Value to Investors

Corporation

Limited Liability

Double taxation (not for

Singapore

Book Values (historical costs less

accumulated depreciation)

Market Values

Separation of ownership
& management

Separation of ownership
& management

Determined by GAAP

Determined by current trading values

in the market

Unlimited Life
Ease of raising capital

3 Primary Decision Areas of Corporate Finance

Capital Budgeting Decision

What long term investments (fixed assets)

should the firm engage in?

Capital Structure Decision

How can the firm raise money for the

required investments? CL, LT Debt and
Shareholders Equity.

Working Capital Management

Ease of transferring
ownership
The Primary Goal of Financial Management is to maximize shareholder wealth
(maximize stock price).
1.
Maximize the value of the firm

How much ST cash flow does a company

need to pay its bills (manage liquidity)? NWC
= CA-CL

Roles and Responsibilities of Financial Managers

Controller

Treasurer

Supervising accounting personnel

Raising capital, managing cash and

capital expenditures

Preparation of financial and managerial

accounting information and reports

Supervises relationships with financial

institutions, work with investors and
potential investors

Analyses accounting information

Manages investments and establishes

credit policies

Planning and decision making

Manages insurance coverage

Advantages of Different Types of Business

Business

Sole Proprietorship

Partnership

Advantages

Disadvantages

Easy to start, few

regulations

Limited to life of owner

Single owner keeps all

the profits

Unlimited liability

Taxed once as personal

income

Equity capital is limited to

personal wealth

More capital available

Unlimited liability (may be

limited partnership)

Taxed once as personal

Income

Dissolves when one

partner wishes to sell/dies

More Capital available

Difficult to sell/transfer

2.

Maximize the wealth of its owners

3.

Maximize the price of its stock

4.
Maximize its contribution to the economy
Shareholder wealth is a cash-flow related concept, maximizing annual profits,
market share, sales and minimizing costs may not max wealth.
Concentrating on the long term.
Ability to generate cash flows for stockholders determines stock prices
Amount, timing, and riskiness of cash flows determine the intrinsic value of stocks.

Intrinsic Value estimate of stocks true value with accurate risk & return information
Market Price based on perceived information by the marginal investor
Reputation compilation of impressions held by all of the entitys stakeholders

Reputation management involves managing expectations and perceptions

Agency Problem Conflict of interest between principal and agent

Direct Agency Costs: expenditures benefit management, (monitoring) audit cost

Indirect Agency Costs: lost opportunities that would increase firm value

Shareholders and Managers

Shareholders and Creditors

1. Compensation plans tied to share value
2. Monitoring by creditors, analysts and investors Ways to handle the
3. Threat of being fired
agency problem
4. Awareness of good Corporate Governance
Financial Markets markets where finances are traded. Act as intermediaries between
savers and borrowers.
Money Markets debt securities of less than one year are traded: treasury securities,
commercial paper, bills and inter-bank loans. Dealer Markets
Capital Markets equity & long-term debt claims are traded. Auction Markets
Primary Market funds raised go to company directly. Government and corporations
initially issued securities. Public and private offerings.
Secondary Market funds raised do not go to company directly. Existing financial
claims are traded. Dealer Market: OTC markets (NASDAQ) Auction markets: SGX,
NYSE. Getting market value of securities is easier
Chapter 2 Financial Statement Analysis
Balance Sheet snapshot of a firms financial position at one point in time; Income
Statement firms revenues and expenses over a given period of time; Statement of RE
how much of the firms earnings were retained, rather than paid out as dividends;
Statement of Cash Flows activities on cash flows over a given period of time.

Enterprise Value = Market Value of Equity + Debt Cash.

It assesses the value of the underlying business assets unencumbered by debt and
separate from any cash and marketable securities.
Sources of Cash (bring in cash)

Uses of Cash (cash outflow)

Decreases in assets other than cash

Increases in assets other than cash

Increases in equity and liability

Decreases in equity and liabilities

Operating net income and changes in most current accounts (AP, AR, Invent);
Investment changes in fixed assets; Financing changes in notes payable, LT debt,
equity accounts and dividends.
Cash = Retained Earnings (Net Income) + CL - CA other than cash -Net fixed
assets + Long Term Debt + Common Stock
Cash = Operating Activities: Net Income + depreciation + non-interest bearing
current liabilities - current assets other than cash. Investment activities: - (net fixed
assets + depreciation) Financing Activities: +interest bearing current liabilities longterm debt +common stock - dividends
Accounts Payables do not bear interest

M/B Ratio: Market Price per share/Book Value per share how much investors are Financial Markets allow companies, government and individuals to increase utility

willing to pay for $1 of book value equity

Savers can invest in fin assets & earn compensation for deferred consumption

Borrowers have more access to capital to invest in productive assets

Dupont Identity

Provide information about returns required for various levels of risk

ROE = ROA X EM = PM X TA TO X EM = NI/SALES x SALES/TA x TA/TE

Profit Margin: measure of firms

operating efficiency how well
does it control costs
Total Asset Turnover: measure
of firms asset use efficiency
how well does it manage its
assets.
Equity Multiplier: measure of the
firms financial leverage.
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Common-size Balance Sheet as a percent of total assets; Common-size Income
Statements all line items as a percent of sales.
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Expected Portfolio Return: Weighted average of E(R) on individual stocks

Liquidity Ratios: measure ability to pay liabilities in the short run (ability to convert
assets to cash quickly without a significant loss in value)

Current Ratio: Current Assets/Current Liabilities

Quick Ratio: Current Assets Inventory / Current Liabilities

Cash Ratio: Cash / Current Liabilities

NWC to Total Assets Ratio: Net Working Capital / Total Assets

Interval Measure: Current Assets / Average daily operating costs - (how many days
of operations can the current assets fund)

Chapter 3 Time Value of Money

Asset Management Ratios: measure how effectively assets are managed

Inventory Turnover: COGS/Inventory

Days Sales in Inventory: 365/Inventory Turnover = 365XInventory/COGS (no. of

days taken to sell that set of inventory)

Receivables Turnover: Sales/Receivables

Days Sales Outstanding: AR/Avg Daily Sales = 365/Receivables turnover (number

of days after making sales before receiving cash)

Fixed Asset Turnover: Sales/Net Fixed Assets (for every $ of fixed asset, how
much sales can it generate)

Total Asset Turnover: Sales/Total Assets

Pure Discount Loans: Like zero-coupon bonds, pure discount bonds, principal (and all
interest) paid at maturity, no periodic interest payment, issued at discount
Interest Only Loans: Interest paid throughout loan period, principal at maturity
Loans with Fixed Principal Payments: Interest and fixed principal payments over life
Amortized Loan: Equal payments cover interest expense and reduce principal

Lost Earnings: Interest Revenue earned on investing the money

Loss of Purchasing Power: Due to Inflation. Real value is less than nominal value

Expected Portfolio : Find , treating portfolio as 1 stock (or below). CVp same
Portfolio Risk Premium based on market risk.

SD of a 2 stock portfolio:
Ordinary Annuity: Payments are made at the end of the period.
Annuity Due: Payments are made at the beginning of the period
2 +
2
2
Correlation

= w12Coefficient/Covariance:
1.0
Perpetuity: Infinite series of equal payments. PV = payment/interest rate.
(1 w1 ) 2 + 2w-1.0
p
1
1 (1 w1 ) 12 1 2
Growing Perpetuity: set of payments which grow at a constant rate each period and
If =-1.0, 2 stocks can form a riskless portfolio
Long Term Solvency Ratios (Financial Leverage): extent of relying on debt financing continue forever. PV = payment/(interest rate growth rate)
If =+1.0, there is no reduction of risk for the 2 stock portfolio
rather than equity. More debt means more likely to default

Total Debt Ratio: Total Debt / Total Assets

Total Risk = Company-specific (Unsystematic Risk) + Market (Systematic) Risk
FV interest factor =
PV factor =

Debt Equity Ratio = Total Debt / Total Equity

Unsystematic Risk: caused by random events specific to firm. Can be diversified

Equity Multiplier Ratio = Total Assets / Total Equity = DE-ratio +1

Systematic Risk: affects most if not all firms. Cannot be diversified away.

Long Term Debt Ratio = Long Term Debt/Long Term Debt + Total Equity
Effective Annual Rate (EAR): the actual rate paid (or received) after taking into

Times Interest Earned Ratio = EBIT / Interest (given what I earn, how much can it consideration any compounding that may occur during the year.
measures stocks market/systematic risk, shows volatility relative to market, indicating
cover my interests payable)
Annual Percentage Rate (APR): annual rate that is quoted by law. Period rate = APR / how risky a stock is if held in a well-diversified portfolio. Market is 1.

Cash Coverage Ratio = EBIT + Depreciation / Interest

number of periods per year.

Profitability Ratios: measures how successful a business is in earning returns on its

investments. Combined effects of liquidity asset management and debts.

Profit Margin = Net Income/Sales

Basic Earning Power = EBIT/Total Assets

ROA = Net Income / Total Assets

ROE = Net Income (-preferred dividends) / Total Common Equity

o ROA is lowered by debt interest expense lowers net income which also lowers
ROA
o ROE increases with debt
o ROE does not consider risk and amount of capital invested
Market Value Ratios: relate firms stock price to earnings, cash flow & book values

P/E Ratio: Price/Earnings how much investors are willing to pay for $1 of earnings

Geometric mean: what you

actually earn per year on
average compounded
annually. Also known as
mean holding period return or
average compound return
earned per year over a multiyear period.
Arithmetic mean: what you
earned in a typical year.

Chapter 4 Risk and Return I

Dividend Yield (%) = Dividend/Initial Share Price
Capital Gain Yield (%) = Capital Gain/Initial Share Price
Percentage return = dividend yield + capital gains yield
Impact of Inflation:
Expected Returns take into account uncertainties that are present in diff scenarios.

OR
Risk is the uncertainty associated with future possible outcomes.
Investment risk is the potential for investment return to fluctuate up and down
Standard deviation measures stand-alone risk of an investment
Using Historical Data: Ravg = Arithmetic mean (avg annual return) Rt = realized ROR
Coefficient of Variation CV better measure of risk

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Chapter 5 Risk and Return II
Risk-Return Trade-off for a portfolio is measured by portfolios expected return and
standard deviation (volatility of the portfolio)
Diversification involves investing in different asset classes and sectors. It reduces
variability of returns without equivalent reduction in expected returns.
Well Diversified Portfolios have very little unsystematic risk. Risk = systematic risk

Portfolios Beta, p is the weighted average of the assets betas.

Buying or Selling bonds before maturity can result in gains or losses outside coupon
Bonds of similar risk & maturity will be priced similarly regardless of coupon

Systematic Risk Principle:

There is a reward for
bearing risk but there is no
reward for bearing risk
unnecessarily. Expected
return on a risky asset
depends only on .
>1 implies that the asset
has more systematic risk
than the overall market
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Price
Vs
YTM

Risk Premium = (RM RF) = Expected Return Risk Free Rate

Market Risk Premium = RM RF (since market beta is always 1) also risk-reward ratio
Security Market Line: Graphical representation of the CAPM, and market equilibrium

Assets below SML are overpriced and assets above SML are underpriced

Premium Bonds: YTM < Current Yield < Coupon Rate

Discount Bonds: YTM > Current Yield > Coupon Rate
Par Value: YTM = Current Yield = Coupon Rate
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Capital Asset Pricing Model: equation describing SML. Appropriate return for risk

Chapter 6 Bond Valuation

Bonds are long term debt instruments sold to raise money. Bonds are fixed-income
investments, and this regular income is what makes bonds less volatile than stocks.
Bond owners are creditors of the company and not owners (unlike stockholders)
Coupon: A bonds interest (payment)
Coupon Rate: Annual coupon divided by the par value of the bond (annual)
Par: Face value of a bond (principal amount) that will be repaid at maturity.

Callability: the issuer can redeem the bond before it expires

Seniority: Preference in position over other creditors. Subordinated debt is junior
Debenture: Bond backed by issuers general credit/ability to repay and not assets
Basis Points: measures of differences in yields. 1 basis point = 0.01%
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Convertibility: option of exchanging bond for stock
Capital Market Line: the tangential line joining the Risk Free Rate to the efficient frontier Protective Covenant: part of indenture that limits certain actions a company may
choose to take during the term of the bond.
of all possible portfolios in the market
Sinking Fund Provision: pay off loan over its life like an amortized loan. Reduced risk to "
Security Market Line
Capital Market Line
investor and shortens average maturity. Not good if rates decline after issuance.
Bond Indenture: Bond contract specifying principal, coupon, maturity, amt of bonds,
Graphical representation of markets risk Shows rate of return, which depend on
backing assets/securities, sinking fund, call provisions & protective covenants
and return at a given time
risk free rate and levels of risk of a
specific portfolio
Coupon Rate/YTM on a bond depends on risk characteristics when issued
Beta x-axis

Standard deviation x-axis

Higher

Unsecured

Subordinated

No Sinking Fund

Callable

Both nonefficient and efficient portfolios

Only efficient portfolios

Lower

Secured

Senior

Sinking Fund

Non callable

Factors Affecting Default Risk & Bond Ratings

Financial Performance
Debt Ratio

TIE Ratio
Where market portfolios and risk free assets are determined by CML, security factors
Yield To Maturity rate earned if bond is held to maturity. Rate at which cash flows are Current Ratio
are determined by SML. CML is superior to SML in measuring risk factors.
discounted to the present value. Interest rate required on a bond in the market.
When YTM > Coupon Rate, bond sells below par value - Discount Bond
Interest Rate rises, YTM increase, Bond prices decrease
When YTM < Coupon Rate, bond sells above par value - Premium Bond
Effect of Time on Bond Prices
Interest rate falls, YTM decreases, Bond prices increase
Holding a bond till maturity ensures repayment of principal as long as no default

Bond Contract Provisions

Secured/Unsecured Debt
Senior/Subordinated Debt
Guarantee & sinking fund provision
Debt maturity

1.
2.
3.
4.
5.
6.

Real Rate of Interest

Expected Future Inflation
Interest Rate Risk
Default Risk
Taxability
Liquidity Risk

Pure Discount Bonds: 0-coupon bonds, sold at discount (YTM comes from difference
between PV and principal sum) cannot sell more than par value. T bills
Floating Rate Bonds: coupon rate float depending on index such as inflation. Less price
risk. Coupon floats and unlikely to differ from YTM. Collar controlling rate
Disaster bonds: issued by property and casualty companies. Pay interest and principal
as usual unless claims reach a certain threshold for a single disaster. At that point,
bondholders may lose all remaining payments Higher required return.
LECTURE 4: Risks & Returns I
Income bonds coupon payments depend on level of corporate income. If earnings are
not enough to cover the interest payment, it is not owed. Higher required return.
Convertible bonds bonds can be converted into shares of common stock at the
bondholders discretion Lower required return
Put bond bondholder can force the company to buy the bond back prior to maturity
Lower required return
Structure of Interest Rates: r/s of time to maturity and yields ceteris paribus
Does not include effects of default risk, different coupons

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Normal: LT yields are more than ST

Inverted: LT yields are less than ST

Factors that affect Bond Yields:

Fischer Effect:
1+Nominal Rate = (1+real rate)(1+inflation)
Approximation:
Nominal Rate = Real Rate + Inflation