Lesson 8

Lecture by: Abdul Qadeer Khan
(ACA, ACCA)
Cost of Capital

Treasury
Management

Financial Statement
Analysis

Intro to Finance

Finance for Technical Managers (FTM Summer 2014)
A lecture by: Abdul Qadeer Khan (ACA, ACCA)
2
2
Cost of Capital
3
Cost of Capital
3
The concept cost of capital has two aspects:
o It is the cost of funds that a company raises and uses in business
o It is the return that investor expect to be paid for putting funds into the company . It is therefore
the minimum return the company should make from the its own investments to earn the cash flows
out of which investor can be paid their return.
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's
funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a
portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is
the minimum return that investors expect for providing capital to the company, thus setting a benchmark
that a new project has to meet.
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that
could have been earned by putting the same money into a different investment with equal risk. Thus, the
cost of capital is the rate of return required to persuade the investor to make a given investment.
4
Cost of Capital
4
Cost of capital is determined by the market and represents the degree of perceived risk by investors. When
given the choice between two investments of equal risk, investors will generally choose the one providing the
higher return.
Let's assume Company XYZ is considering whether to renovate its warehouse systems. The renovation will cost
$50 million and is expected to save $10 million per year over the next 5 years. There is some risk that the
renovation will not save Company XYZ a full $10 million per year. Alternatively, Company XYZ could use the
$50 million to buy equally risky 5-year bonds in ABC Co., which return 12% per year.
Because the renovation is expected to return 20% per year ($10,000,000 / $50,000,000), the renovation is a good
use of capital, because the 20% return exceeds the 12% required return XYZ could have gotten by taking the
same risk elsewhere.
The return an investor receives on a company security is the cost of that security to the company that issued it.
A company's overall cost of capital is a mixture of returns needed to compensate all creditors and stockholders.
This is often called the weighted average cost of capital, and refers to the weighted average costs of the
company's debt and equity
5
Cost of Capital
5
Cost of capital is an important component of business valuation work. Because an investor
expects his or her investment to grow by at least the cost of capital, cost of capital can be
used as a discount rate to calculate the fair value of an investment's cash flows.
Investors frequently borrow money to make investments, and analysts commonly make the
mistake of equating cost of capital with the interest rate on that money. It is important to
remember that cost of capital is not dependent upon how and where the capital was raised.
Put another way, cost of capital is dependent on the use of funds, not the source of funds.
6
6
Treasury Management
7
Treasury Management
7
Treasury management is an important function of most of the organization specially MNCs
Followings are the objectives of Treasury Management.
o Cash Management
o Management of short term financing facilities
o Long term financing arrangement
o Relations with Banks
o Of Shore Payments etc.
8
8
Financial Statement Analysis
9
Financial Statement Analysis
9
Financial statement analysis is the application of analytical tools and techniques to general-
purpose financial statement and related data to derive estimates and inferences useful in
business analysis.
Financial statement analysis is part of business analysis. Business analysis encompasses
evaluation of companys prospects and risks for the purpose of making business decisions
These business decisions extend to equity and debt valuation, credit risk assessment, earning
predictions, audit testing and countless other decisions
Analysis about company's prospects and risk require analysis of both, qualitative information
about company's business plans and quantitative information about its financial position and
performance
10
Financial Statement Analysis contd..
10
Credit Analysis
Creditors lend funds to the company in return for a promise of repayment with interest or embedded
reward.
Most of the trade credit is short term, ranging from 30 to 60 days. Trade credit terms mostly exclude
the explicit interest.
Nontrade credit provide financing to the company in return for promise of repayment with interest.
(short term and long term financing both inclusive)
The embedded profit of creditor and earning of nontrade creditor are jeopardized when a borrower
encounters financial difficulties.
Therefore it becomes important for the creditors to carry out credit analysis of the company to assess
its credit-wrothiness.
Creditworthiness assessment of down side risk instead of upside potential and focuses only liquidity
instead of solvency of the company. (liquidity is ability of company to meet its short term obligations
whereas solvency is companys long term viability and capability to pay long term obligations)
Long term credit analysis also includes projections of cash flows and evaluation of extended
profitability
11
11
Equity Analysis
Equity investors provide funds to the company in return for risks and rewards of ownership.
Equity investment is the only safeguard against all other forms of financing.
Equity investors are last to receive the payments when company is liquidated. However, on the other
side its equity investors who will enjoy the unlimited benefits when the company is making profits (of
course limited to the extent of profits made).
Accordingly equity investors are concerned with both, the downside risk and upside potential .
Major goal of equity analysis is to determine the intrinsic value i.e. (built-in value) and same is
compared with the market value of companys share. Investors buy the equity share with market value
is less than intrinsic value and sells the shares when market value is greater than intrinsic companys
To determine the intrinsic value, analyst must forecast the companys earning and cash flows to
determine its risk. This requires comprehensive in-dept analysis of companys business prospects and
financial operations.
12
12
Business Environment and Strategy Analysis
Analysis of companys future prospects is subjective and complex task. This can be achieved by
business environment and strategy analysis.
Analysis of business environment seeks to identify and assess a companys economic and industry
circumstances. This includes analysis of products, labour and capital markets within its economic and
regulatory settings. Environment analysis is also described as industry analysis
Strategy analysis on the other hand seeks to identify and assess a companys competitive strengths and
weaknesses along with its opportunities and threats. Strategy analysis is also defined as SWOT
analysis.
Financial Analysis
This involves profitability analysis, evaluation of companys return on investment. It focuses on
company sources and level of profits and measuring impact of various profitability drivers.

13
13
For all the above mentioned analysis an analyst need to scrutinize the financial statements of
a company study the following:
o Planning activities
o Financing activities
o Investing activities and
o Operating activities.
In addition to the above various other information given in the financial statements e.g
Management discussions and analysis, directors report, auditors report, explanatory notes and
other information including the notice of Annual General Meeting (AGM) provides
information about the above mentioned activities.
Information about the company can also be gathered from the web searches, news papers
and other business publications.
14
Horizontal Analysis
Vertical Analysis
Trend Percentages
Ratio Analysis
Methods of Financial Statement Analysis
15
Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
16
Vertical Analysis
For a single financial statement, each
item
is expressed as a percentage of a
significant total,
e.g., all income statement items are
expressed as a percentage of sales
17
Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
18
Ratio Analysis
Expression of logical relationships
between items in a financial statement
of a single period
(e.g., percentage relationship between
revenue and net income)
19
Horizontal Analysis Example
The management of Clover Company provides you with comparative balance
sheets of the years ended December 31, 1999 and 1998. Management asks
you to prepare a horizontal analysis on the information.
20
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets 315,000 $ 289,700 $
21
Calculating Change in Dollar Amounts
Since we are measuring the amount of the
change between 1998 and 1999, the dollar
amounts for 1998 become the base year
figures.
Dollar
Change
Current Year
Figure
Base Year
Figure

22
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $
Inventory 80,000 100,000
Land 40,000 40,000
Total assets 315,000 $ 289,700 $
$12,000 $23,500 = $(11,500)
23
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $ (48.9)
Inventory 80,000 100,000
Land 40,000 40,000
Total assets 315,000 $ 289,700 $
($11,500 $23,500) 100% = 48.9%
24
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $ (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets 315,000 $ 289,700 $ 25,300 $ 8.7
25
Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
26
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable 67,000 $ 44,000 $ 23,000 $ 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity 315,000 $ 289,700 $ 25,300 $ 8.7
27
Now, lets apply the
procedures to the
income statement.

28
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
29
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Gross margin 160,000 165,000 (5,000) (3.0)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
Sales increased by 8.3% while net income decreased by 21.9%.
30
CLOVER CORPORATION
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Gross margin 160,000 165,000 (5,000) (3.0)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These
increased costs more than offset the increase in sales, yielding an overall decrease in net income.
31
Vertical Analysis Example
The management of Sample Company now asks to prepare a
vertical analysis for the comparative balance sheets of the
company.
32
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash 82,000 $ 30,000 $ 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total 483,000 $ 387,000 $ 100% 100%
33
Sample Company
Balance Sheet (Assets)
% of Total Assets
1999 1998 1999 1998
Cash 82,000 $ 30,000 $ 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total 483,000 $ 387,000 $ 100% 100%
$82,000 $483,000 = 17% rounded
$30,000 $387,000 = 8% rounded
34
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
% of Total Assets
1999 1998 1999 1998
Acts. Payable 76,000 $ 60,000 $ 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000 50,000 10% 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total 483,000 $ 387,000 $ 100% 100%
$76,000 $483,000 = 16% rounded
35
Trend Percentages Example
Wheeler, Inc. provides you with the following operating data and
asks that you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820 $
Expenses 2,033 1,966 1,870 1,803 1,701
Net income 372 $ 278 $ 242 $ 188 $ 119 $
36
Wheeler, Inc. provides you with the following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820 $
Expenses 2,033 1,966 1,870 1,803 1,701
Net income 372 $ 278 $ 242 $ 188 $ 119 $
$1,991 - $1,820 = $171
37
Using 1995 as the base year, we develop the following percentage
relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%
$1,991 - $1,820 = $171
$171 $1,820 = 9% rounded
38
90
100
110
120
130
140
1995 1996 1997 1998 1999
%

o
f

1
0
0

B
a
s
e

Years
Sales
Expenses
Trend line
for Sales
39
Ratios can be expressed in three different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)

CAUTION!
Using ratios and percentages without considering the underlying causes may be
hazardous to your health! & lead to incorrect conclusion
Ratios

Lesson 8

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lesson 8

Uploaded by

Copyright:

Available Formats

Lecture by: Abdul Qadeer Khan

You might also like