Corporate Finance Crasher

Finance and Investments Club

Financial Statements and Ratios
Financial Analysis E.I.C. Framework
Economic Analysis
Industry Analysis
Company Analysis
Financial Performance Analysis
Trend, Common Size, Financial Ratios, Composite Scores
Operating Performance
Financial Performance per unit of operating measure
Non Financial Measures
Requires primary data, typically not available in financial
reports
Sometimes data are available in industry publication
May 1, 2012 3
Trend Analysis
Base year is 100,
remaining years
numbers are % of the
base year number,
therefore represent
cumulative rate of
growth / decline
relative to the base year
Useful for
Studying growth,
Studying directional changes
Identifying improvement and
deterioration in financial
performance
Trend Analysis 20x1 % 20x0 %
Sales 10,000 125 8,000 100
Less COGS (5,500) 110 (5,000) 100
Gross Profit 4,500 150 3,000 100
Less Operating Exp (2,100) 105 (2,000) 100
Operating Income 2,400 240 1,000 100
Less Interest Exps (400) 100 (400) 100
Less Income Taxes (900) 225 (400) 100
Profit After Taxes 1,100 550 200 100
Fixed Assets 5,600 112 5,000 100
Current Assets 2,400 96 2,500 100
Total Assets 8,000 107 7,500 100
Current Liabilities 1,600 80 2,000 100
Long Term Debt 2,400 120 2,000 100
Equity 4,000 114 3,500 100
May 1, 2012 4
Common Size Statements
B/S # are % of TA
I/S # are % of Sales
Useful for
Comparing performance
across years and firms
Identifying Strength and
Weakness of a firm by
comparing its performance
with those of its industry
peers
Identifying Improvement and
Deterioration in its financial
performance, by comparing
its performance across years
May 1, 2012 5
Common Size 20x1 % 20x0 %
Sales 10,000 100% 8,000 100%
Less COGS (5,500) (55%) (5,000) (63%)
Gross Profit 4,500 45% 3,000 38%
Less Operating Exp (2,100) (21%) (2,000) (25%)
Operating Income 2,400 24% 1,000 13%
Less Interest Exps (400) (4%) (400) (5%)
Less Income Taxes (900) (9%) (400) (5%)
Profit After Taxes 1,100 11% 200 3%
Fixed Assets 5,600 70% 5,000 67%
Current Assets 2,400 30% 2,500 33%
Total Assets 8,000 100% 7,500 100%
Current Liabilities 1,600 20% 2,000 27%
Long Term Debt 2,400 30% 2000 27%
Equity 4,000 50% 3,500 47%
Financial Ratio Analysis
Financial ratio represents a relative measure where both the
numerator and the denominator are financial numbers
Designed to illuminate some aspect of how the business is
doing and identify its Strengths and Weaknesses
Depending upon the source of the numbers, 3 groups of ratio
Balance Sheet Ratio
Where both the variables are taken from the B/S
Use Ending Values of the B/S numbers in B/S Ratios
Profit and Loss Ratio
Where both the variables are taken from P&L
Mixed Ratio
Where one variable is taken from B/S and the other from P&L
Use average Values of the B/S numbers in Mixed Ratios

May 1, 2012 6
Ratio Analysis: Types of Ratios
Financial Ratios
Profitability Ratio
Activity or Efficiency Ratio
Liquidity Ratios
Leverage Ratios
Multiples or Market Ratios

May 1, 2012 7
Profitability Ratios 1
Gross Profit (GP) Ratio


Operating Profit (OP) Ratio

Net Profit (NP) Ratio


COGS Ratio = COGS / Sales
COS Ratio = 1 OP Ratio
ETR = Income Tax Exps /
EBT
May 1, 2012 8
Sales
Profit Operating
=
Sales
Profit Gross
=
Sales
Profit Net
=
Profitability Ratios 20x1 20x0
Sales 10,000 8,000
Less COGS -5,500 -5,000
Gross Profit 4,500 3,000
Less Operating Exp -2,100 -2,000
Operating Profit 2,400 1,000
Less Interest Exps -400 -400
PBT 2,000 600
Less Income Taxes -900 -400
PAT 1,100 200
GP Ratio 45% 38%
OP Ratio 24% 13%
NP Ratio 11% 3%
COGS Ratio 55% 62%
COS Ratio 76% 87%
Effective Tax Rate 45% 67%
Return on Assets (ROA)


Return on Capital
Employed or Investment
(ROCE or ROI)


Return on Equity


EPS = Earnings Per Share
DPS = Dividends Per Share
Pay Out Ratio = DPSEPS
NOPAT = EBIT * (1-ETR) = PAT + Interest
Exp * (1-ETR)

Profitability Ratios 2
May 1, 2012 9
.) . ( Exp Misc TA Average
NOPAT

=
) (Equity Average
Profit Net
=
) (CE Average
NOPAT
=

Profitability
Ratios 2
20x1 20x0 Avg.
Operating Profit 2,400 1,000
Less Interest Exp (400) (400)
PAT 1,100 200
Total Assets 8,000 7,500 7,750
Long Term Debt 2,400 2000 2,200
Equity 4,000 3,500 3,750
Effective Tax Rate 45% 67%
NOPAT 1,320 333
Average CE
5,950
ROA
17%
ROI
22%
ROE
29%
Activity or Efficiency Ratios 1
Total Asset Turnover


Fixed Asset Turnover


Working Capital Turnover


Current Asset Turnover


Capital Employed
Turnover
May 1, 2012 10
) ( CapWIP NB Average
Sales
+
=
.) . ( Exp Misc TA Average
Sales

=
) (CA Average
Sales
=
) ( CL CA Average
Sales

=
) (CE Average
Sales
=

Activity Ratios 20x1 20x0 Avg
Sales 10,000 8,000
Fixed Assets 5,600 5,000
5,300
Current Assets 2,400 2,500 2,450
Total Assets 8,000 7,500
7,750
Current Liabilities 1,600 2,000
1,800

Long Term Debt 2,400 2000
2,200
Equity 4,000 3,500 3,750
TA Turnover
1.29
FA Turnover
1.89
WC Turnover
15.38
CA Turnover
4.08
CE Turnover
1.68
Activity or Efficiency Ratios 2
Inventory Days


Receivables Days


Payables Days


Operating Cycle Days
Inventory Days
+Receivables Days
Payables Days
Turnover Ratio = 360/Days Ratio



May 1, 2012 11
360
) (

COGS
Inventory Average
=
360
) / / (

Sales Credit
R B R A Average

+
=
360
) / / (

Purchases Credit
P B P A Average

+
=
Activity Ratios 20x1 20x0 Avg
Sales 10,000 8,000
Less COGS (5,500) (5,000)
Inventory 800 700 750
A/R 400 600 500
B/R 300 400 450
A/P 900 700 800
B/P 200 200 200
Purchases 5,600
Days Turnover Ratio
Inventory Days
49.1 7.3
Receivables Days
30.6 11.8
Payables Days
64.3 5.6
Operating Cycle
13.5 26.7
Liquidity Ratios
Current Ratio


Quick Ratio


Interest Expense CFO
Current Liability CFO
Total Liability CFO




May 1, 2012 12
CL
CA
=
CL
Inventory CA
=
Liquidity Ratios 20x1 20x0
Less Interest Exps (400) (400)
Inventory 800 700
Current Assets 2,400 2,500
Current Liabilities 1,600 2,000
Long Term Debt 2,400 2,000
Total Liability 4,000 4,000
Quick CA 1,600 1,800
Current Ratio 1.50 1.25
Quick Ratio 1.00 0.90
Leverage Ratios 1
Debt Equity Ratio


Total Debt = Long Term Debt +
Current Portion of LT Debt
included in Current Liabilities +
Short Term Debt.
Weight of Debt in CE


Weight of Equity in CE
= 1 Weight of Debt
Interest Coverage Ratio

May 1, 2012 13
Equity
Debt Total
=
Interest
Interest PAT +
=
Ratio DE
Equity Debt
Debt
+
=
+
=
1
1
1
Leverage Ratios 20x1 20x0
Less Interest Exps (400) (400)
Less Income Taxes (900) (400)
Profit After Taxes 1,100 200
Equity 4,000 3,500
Long Term Debt 2,400 2,000
LTD: Current Portion 300 500
Short Term Debt 200 400
Total Debt 2,900 2,900
Debt Equity Ratio 0.73 0.83
Weight of Debt
0.42 0.45
Weight of Equity
0.58 0.55
Interest Coverage
3.75 1.50
Leverage Ratios 2
Debt Service Coverage
Ratio (DSCR)


Debt Related Payments = Interest
on Borrowings+ Current
Portion of LT Debt + Short
Term Debt.
Financial Service
Coverage Ratio (FSCR)


Financial Payments = Interest
on Borrowings + Current
Portion of LT Debt + Short
Term Debt + Lease Rental
Payments.

May 1, 2012 14
Payment Related Debt
CFO
=
Payments Financial
CFO
=
Leverage Ratios 20x1 20x0
CFO 3,000 2,400
Interest Exps 400 400
LTD: Current Portion 300 500
Short Term Debt 200 400
Lease Liability:
Current Portion
- 200
Debt Related
Payment
900 1,300
Financial Payment
900 1,500
DSCR
3.33 1.85
FSCR
3.33 1.60
Market Ratios and
Multiples
Market to Book Ratio
Price (Equity Total Shares
#)
Dividend Yield
DPS Price
Earnings Yield
EPS Price = 1 PE Ratio
Price Multiples
P-E Ratio = Price EPS
P-Sales, P-CFO Multiples = P
Sales or CFO per share
Total Return to
Shareholders
= (Equity Cash Dividend + (End of the
current year Share Price End of the last
year Share Price)) End of the last years
Share Price
May 1, 2012 15
Market Ratios 20x1 20x0
Profit After Taxes 1,100 200
Equity 4,000 3,500
# of Shares 1,000 1,000
Share Price 30 22
Capital Gains 8
Dividend 600 -
DPS 0.60 -
EPS 1.10 0.20
BV of Equity per share
4.00 3.50
MTB
7.5 6.3
Dividend Yield
2.0%
-
Earnings Yield
3.7% 0.9%
P-E Ratio
27.3 110.0
P-S Ratio
3.00 2.75
P-CFO Ratio
10.0 9.2
TRS
39% -
Drivers of ROE







ROE = Net Profit Margin
x Capital Employed Turnover
x Financial Leverage Multiplier
= ROI x Financial Leverage Multiplier

Financial Leverage Multiplier = 1 + [Avg(Debt) / Avg(Equity)]

May 1, 2012 16
) (Equity Average
Income Net
ROE=
uity) Average(Eq
CE Average
CE Average
Sales
Sales
Income Net ) (
) (
=
Overall
Profitability
11%
Overall
Efficiency
= 1.68
Overall
Leverage
= 1.59
Drivers of ROE
Net
Profit
Margin
COGS%
Operating Exp%
Interest Exp%
Other Income%
Income Tax%

Capital
Employed
Turnover
FA Turnover
WC Turnover
CA Turnover
Inv Turnover
A/R Turnover
CL Turnover
A/P Turn

Financial
Leverage
Multiplier
Debt Equity Ratio
Weight of Debt
Weight of Equity
May 1, 2012 17
B/S, I/S & Other numbers used
B/S 20x1 20x0
Fixed Assets 5,600 5,000
Current Assets 2,400 2,500
Inventory 800 700
A/R 400 600
B/R 300 400
Other CA 500 500
Cash 400 300
Total Assets 8,000 7,500
Current Liabilities 1,600 2,000
A/P 900 700
B/P 200 200
LT Debt: Current 300 500
Short Term Debt 200 400
Lease Liab: Current 0 200
Long Term Debt 2,400 2,000
Equity 4,000 3,500
Total Liab & Eq. 8,000 7,500
May 1, 2012 18
I/S 20x1 20x0
Sales 10,000 8,000
Less COGS (5,500) (5,000)
Gross Profit 4,500 3,000
Less Operating Exp (2,100) (2,000)
Operating Income 2,400 1,000
Less Interest Exps (400) (400)
Less Income Taxes (900) (400)
Profit After Taxes 1,100 200
Other Info. 20x1 20x0
CFO
3,000 2,400
# of Shares 1,000 1,000
Share Price $30.00 $22.00
Financial Management
Financial Management
Financial Management involves three decisions:
Investment Decisions
Financing Decisions
Dividend Decisions
Whether a financial decision involves investing
and/or financing, it also will be concerned with two
specific factors: expected return and risk.
Expected return is the difference between potential
benefits and potential costs. Risk is the degree of
uncertainty associated with these expected returns.


The Agency Relationship
An agent is a person who acts forand exerts
powers ofanother person or group of
persons.
The person (or group of persons) the agent
represents is referred to as the principal.
The relationship between the agent and his or
her principal is an agency relationship.
There is an agency relationship between the
managers and the shareholders of
corporations.

Costs of Agency Relationship
There are costs involved with any effort
to minimize the potential for conflict
between the principals interest and the
agents interest.
These are:
Monitoring Costs
Bonding Costs
Residual Costs
How to reduce Agency Costs?
Motivating Managers: Executive
Compensation-
Salary
Bonus
ESOP
Stock Appreciation Rights
Sweat Equity
EVA-linked Bonus

Financial Markets: Debt Market
Bonds, notes, and medium-term notes are
issued by corporations, the government,
government agencies, and municipal bodies.
Corporate debt securities backed by specific
assets as collateral are referred to as secured
notes or secured bonds.
If they are not backed by specific assets, they
are referred to as debentures.
In India, bonds and debentures have different
connotations.
Corporate Bond Market
The corporate bond market involves all bonds
that have credit risk, i.e., bonds issued by all
entities other than the Central Government
This includes not just the bonds issued by
private Indian firms but, more significantly,
bonds issued by sub-national agencies such as
state governments (SG) and municipalities, as
well as the Public Sector Units
Compared to the stock of central government
bonds, issues of bonds by the state
government are significantly smaller
Corporate Bond Market
Corporate debt issued by firms is either in the
form of short-term instruments called
commercial paper (CP) or corporate
debentures/bonds (CB)

Debt Market
The Wholesale Debt Market (WDM) deals in fixed
income securities
Trades in a variety of debt instruments including
Government Securities, Treasury Bills and Bonds
issued by Public Sector Undertakings/ Corporates/
Banks like Floating Rate Bonds, Zero Coupon Bonds,
Commercial Papers, Certificate of Deposits,
Corporate Debentures, State Government loans, SLR
and Non-SLR Bonds issued by Financial Institutions,
Units of Mutual Funds and Securitized debt by banks,
financial institutions, corporate bodies, trusts and
others
The Retail Debt Market (RDM) trades in central
government long-term securities for retail investors

Equity Market
Primary Market
Secondary Market
OTC Market: are arrangements in
which investors or their
representatives trade securities
without sharing a physical location.
Stocks traded on the OTC markets
are called unlisted

Some Concepts
Firm Value:
present value of the firms cash flows.
Tricky part is determining the size, timing, and risk
of those cash flows.
Time Value of Money
Compounding/Discounting
Compounding Conversion
Annual/Semi-annual/Quarterly/Continuous
Present Value Concept



Perpetuity



Perpetuity
Cash flows expected to continue forever


Growing Perpetuity
Cash flows growing at a constant rate and
continuing forever

Can g be more than r forever? Can it be more than
r for a few years?


PV=CF/i
g r
C
PV

=
Annuity



Series of cash flows of equal amount occurring
at regular even interval
With constant cash flows
Future Value
Present Value

Growing Annuity
Growing stream of cash flows with fixed maturity



(
(

|
|
.
|

\
|
+
+

=
T
r
g
g r
C
PV
) 1 (
1
1
What is the present value of a four-year annuity of $100
per year that makes its first payment two years from today if the
discount rate is 9%?



22 . 297 $
09 . 1
97 . 327 $
0
= = PV
0 1 2 3 4 5
$100 $100 $100 $100 $323.97 $297.22
97 . 323 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
4 3 2 1
4
1
1
= + + + = =

= t
t
PV
Day count convention
Day count convention refers to the
method used for arriving at the holding
period (number of days) of a bond to
calculate the accrued interest.
the conventions followed in Indian
market are given below:
Bond market: The day count convention followed
is 30/360
Money market: The day count convention
followed is actual/ 365
Yield of a treasury bill
Yield = [(100-P)/P] X 365/D X 100
Assuming that the price of a 91 day Treasury
bill at issue is Rs.98.20. Whats the yield?
After say, 41 days, if the same Treasury bill is
trading at a price of Rs. 99, whats the yield?
Bond Mathematics
Classifying Bonds:
Issuer:
Govt.
Corporate
Municipality
Maturity;
Short
Medium
Long
Coupon Rate:
Fixed
Floating
Zero coupon
Redemption Features:
Callable
Putable
Convertible
Bond Yield
Current yield
Yield-to-maturity (YTM)
Yield-to-call (YTC) and yield-to-put (YTP)
Bond Equivalent Yield
Annual Percentage Rate (APR)
Effective Annual Rate (EAR)
Yield Measures
Current Yield = (Annual Rupee Amount of
interest / Price)
Yield to Maturity (YTM) = It is the interest rate
which equals the Present Value of Cash flows
with Price. YTM computed on the basis of
market conventions ( frequency and basis) is
called bond equivalent yield
Yield to Call: The issuer of the bond may
exercise call option, if the market interest
rates are falling below the coupon rate. The
Price at which the bond may be called is
referred as Call Price. YTM computed on the
basis of Call Price instead of Redemption
price is Yield to Call.
Bond Yield
Yield to Put: In a bond issue if an investor is
having a Put Option and YTM computed by
taking Put Price is Yield to Put.
Taxable Equivalent Yield
= Nominal Tax-free Yield / (1- Marginal Tax-
Rate)
Bond Yield
Yield for a Portfolio: It is the interest rate that
equates the present value of cash flows of the
portfolio with market value of portfolio.
Annual Percentage Rate
Certain annualized yields are quoted so often
that they are given special names.
For example, when a 6-month yield is quoted
on an annualized basis, the quote is referred
to as bond equivalent yield.
When a one-month yield is quoted on an
annualized basis (by multiplying one month
rate by 12), it is referred to as Annual
Percentage Rate.
Accrued Interest
When an investor purchases a bond between
coupon payments, the investor must
compensate the seller of the bond for the
coupon earned from time of the last coupon
payment to settlement date of the bond. This
amount is called accrued interest. In
computation of accrued interest days count is
very much important
Accrued Interest
The accrued interest is calculated according to
the formula
AI = (rate X days/360) X FV
where rate = coupon rate on the GOI security
FV= face value being purchased.
days = number of days between the last
coupon payment date and the settlement
date calculated as per the 30/360
convention.
Clean and dirty price
The amount that the buyer pays the seller is
the agreed upon price plus accrued interest.
This is often referred to as the full price or
dirty price.
The price of the bond without accrued
interest is called the clean price
Risks of Fixed Income Securities
Credit Risk: Government Securities and
Treasury Bills do not have any Credit Risk. But
other bonds carry this
Price Risk
Reinvestment Risk: All coupon payment
securities have re-investment risk
Bond Pricing
A bond is typically issued at par value of the principal
amount.
However, in the secondary market, the price of a
bond can fluctuate greatly from its par value.
The price of a bond is determined by:
Expected periodic cash flows
The discount rate used for each cash flow.
Value of debt security = Present value of future
interest payments + Present value of maturity value.
Bond Pricing
The present value of a debt security, V, is:

A simple example
A fixed-rate bond, currently priced at 102.9,
has one year remaining to maturity and is
paying 8% coupon. Assuming the coupon is
paid semiannually, what is the yield of the
bond?
Valuing a Straight Coupon Bond
What will be the value of the bond, if the interest is paid
semi-annually?
Bond: Price Yield Relationship
A fundamental property of a bond is that its
price changes in the opposite direction of the
change in the interest rates.
Compute the price of a bond with a par value
of Rs.1000 to be paid in ten years, a coupon
rate of 10%, and a required yield of 3%, 5%,
15% and 25%. Coupon payments are made
annually.
Bond: Price-Yield Relationship
If the coupon rate is more than the yield,
the security is worth more than its maturity
valueit sells at a premium.
If the coupon rate is less than the yield, the
security is less than its maturity valueit sells
at a discount.
If the coupon rate is equal to the yield, the
security is valued at its maturity value.
Term Structure
The term structure describes the relationship
of spot rates with different maturities.
One needs zero rates to construct the term
structure.
Zero Rates
A zero rate (or spot rate), for maturity T is the
rate of interest earned on an investment that
provides a payoff only at time T

Example

Maturity
(years)
Zero Rate
(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
Bond Pricing
To calculate the cash price of a bond we discount
each cash flow at the appropriate zero rate
The theoretical price of a two-year bond providing a
6% coupon (face value 100) semiannually is


3 3 3
103 9839
0 05 0 5 0 058 1 0 0 064 1 5
0 068 2 0
e e e
e


+ +
+ =
. . . . . .
. .
.
Bond Yield
The bond yield is the discount rate that makes the
present value of the cash flows on the bond equal
to the market price of the bond
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39
The bond yield (continuously compounded) is
given by solving

to get y=0.0676 or 6.76%.

3 3 3 103 9839
0 5 1 0 15 2 0
e e e e
y y y y
+ + + =
. . . .
.
Par Yield
The par yield for a certain maturity is the
coupon rate that causes the bond price to equal
its face value.
In our example we solve


g) compoundin s.a. (with get to 87 6
100
2
100
2 2 2
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
. c=
e
c
e
c
e
c
e
c
=
|
.
|

\
|
+ +
+ +


Common (Equity) Stocks
Because common stock never matures, todays value
is the present value of an infinite stream of cash
flows (i.e., dividend).
But dividends are not fixed.
Not knowing the amount of the dividendsor even
if there will be future dividends makes it difficult to
determine the value of common stock.
So what are we to do?



Basic Valuation Models
Dividend Valuation Model (DVM):
Constant dividend: Let D be the constant DPS:


The required rate of return (r
e
) is the return shareholders
demand to compensate them for the time value of money tied up in
their investment and the uncertainty of the future cash flows from
these investments.

Valuation Models
Dividend growth at a constant rate (g): (also
known as Gordon Model)

OR
OR
Dividend and Earnings Growth
Growth in dividends occurs primarily as a result of
growth in EPS.
Growth in earnings, in turn, results from a number of
factors, including (1) inflation, (2) retention ratio; and
(3) ROE.
Shareholders care about all dividends, both current
and those in the future.
If most of a stocks value is due to long-term cash
flows, why do managers and analysts pay so much
attention to quarterly earnings?
Valuation Models
Varying Dividend Growth Rate:
For many companies, it is unreasonable to assume
that it grows at a constant rate.
P
0
= Present value of dividends based on short-run
non-constant rate + Present value of dividends
using constant growth rate.
Differential Growth
Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable
future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock .
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
Differential Growth
) (1 Div Div
1 0 1
g + =
- Assume that dividends will grow at rate g
1
for N
years and grow at rate g
2
thereafter.
2
1 0 1 1 2
) (1 Div ) (1 Div Div g g + = + =
N
N N
g g ) (1 Div ) (1 Div Div
1 0 1 1
+ = + =

) (1 ) (1 Div ) (1 Div Div
2 1 0 2 1
g g g
N
N N
+ + = + =
+
.
.
.
.
.
.
Differential Growth
) (1 Div
1 0
g +
Dividends will grow at rate g
1
for N years and grow
at rate g
2
thereafter
2
1 0
) (1 Div g +
N
g ) (1 Div
1 0
+
) (1 ) (1 Div
) (1 Div
2 1 0
2
g g
g
N
N
+ + =
+

0 1 2


N N+1

Differential Growth
We can value this as the sum of:
an N-year annuity growing at rate g
1

(

+
+

=
T
T
A
R
g
g R
C
P
) 1 (
) 1 (
1
1
1
plus the discounted value of a perpetuity growing at
rate g
2
that starts in year N+1
N
B
R
g R
P
) 1 (
Div
2
1 N
+
|
|
.
|

\
|

=
+
Differential Growth
Consolidating gives:
N T
T
R
g R
R
g
g R
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 N
1
1
+
|
|
.
|

\
|

+
(

+
+

=
+
Or, we can cash flow it out.
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
Estimates of Parameters
The value of a firm depends upon its growth
rate, g, and its discount rate, R.
Where does g come from?
g = Retention ratio Return on retained earnings


Where does R come from?
The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating R.
Concept of Risk and Return
The Concept of Risk
Whenever you make a financing or investment
decision, there is some uncertainty about the
outcome.
Though the terms risk and uncertainty are often
used to mean the same thing, there is a distinction
between them.
Uncertainty is not knowing what is going to happen.
Risk is the degree of uncertainty.
Thus, greater the uncertainty, the greater the risk.
Types of Risks
Cash flow risk
Business risk
Sales risk
Operating risk
Financial risk
Default risk
Reinvestment risk
Prepayment risk
Call risk
Interest rate risk
Purchasing power risk
Currency risk
Portfolio risk
Diversifiable risk
Nondiversifiable risk

Cash Flow Risk
Cash flow risk is the risk that the cash flows of
an investment will not materialize as
expected.
Business risk is the risk associated with
operating cash flows.
The greater the fixed operating costs relative
to variable operating costs, the greater the
operating risk.
Cash Flow Risk
Financial risk is the risk associated with how a
company finances its operations.
The more fixed-cost obligations (i.e., debt) incurred
by the firm, the greater its financial risk.
The cash flow risk of a debt security is default risk or
credit risk.
Default risk is affected by both business riskwhich
includes sales risk and operating riskand financial
risk.
Reinvestment Risk
Consider two 5-year bonds-Bond X (bearing
10% coupon, payable annually) and Bond Y(
Zero-coupon with 10% yield). Suppose,
intermittent coupons can be reinvested 9%,
8%, 7%, 6% and 5% respectively.
Which bond has higher reinvestment risk and
why?
Reinvestment Risk
If we compare two bonds with the same yield-
to-maturity and the same time to maturity,
the bond with the greater coupon rate has
more reinvestment rate risk.
Two types of risk closely related to
reinvestment risk of debt securities are
prepayment risk and call risk.
There is reinvestment risk for assets other
than stocks and bonds, as well.
Interest Rate Risk
Interest rate risk is the sensitivity of the change in an
assets value to changes in market interest rates.
Lets compare the change in the value of the
Company X bond to the change in the value of the
Company Y bond as the market interest rate changes.
Suppose that it is now January 1, Year 2. Whats the
value of the bonds if: yields remain at 10%, yield
increases to 12%; yield decreases to 8%?
Interest Rate Risk
Company Ys bond value is more sensitive to
changes in yield.
For a given maturity, the greater the coupon
rate, the less sensitive the bonds value to a
change in the yield. Why?
For a given coupon rate, the longer the
maturity of the bond, the more sensitive the
bonds value to changes in market interest
rates.
Purchasing Power Risk
Purchasing power risk is the risk that the price
level may increase unexpectedly.
Purchasing power risk is the risk that future
cash flows may be worth less or more in the
future because of inflation or deflation,
respectively, and that the return on the
investment will not compensate for the
unanticipated inflation.

Purchasing Power Risk
Consider the 11.0% and 9.1% inflation rates for the years
Year 1and Year 2, respectively. If you borrowed Rs.1,000
at the beginning of Year 1 and paid it back two years
later. But how much is a Year 2 rupee worth relative to
beginning-of-Year 1 rupees?
Financial managers need to assess purchasing power risk
in terms of both their investment decisionsmaking sure
to figure in the risk from a change in purchasing power of
cash flowsand their financing decisions
understanding how purchasing power risk affects the
costs of financing.


Currency Risk
Currency risk is the risk that the relative values of the
domestic and foreign currencies will change in the
future, changing the value of the future cash flows.
As financial managers, we need to consider currency
risk in our investment decisions that involve other
currencies and make sure that the returns on these
investments are sufficient compensation for the risk
of changing values of currencies.
Holding Period Returns
The holding period return is the return
that an investor would get when holding
an investment over a period of n years,
when the return during year i is given as
r
i
:
1 ) 1 ( ) 1 ( ) 1 (
return period holding
2 1
+ + + =
=
n
r r r
Holding Period Return: Example
Suppose your investment provides the following
returns over a four-year period:
Year Return
1 10%
2 -5%
3 20%
4 15%
% 21 . 44 4421 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
1 ) 1 ( ) 1 ( ) 1 ( ) 1 (
return period holding Your
4 3 2 1
= =
=
+ + + + =
=
r r r r
Risk Premium
Added return obtained from investing in securities
with greater risk
measures of risk that we discuss are variance and standard
deviation
Expected Return, Risk and Diversification
As managers, we are concerned about the
overall risk of the businesss portfolio of
assets.
The return on a portfolio (r
p
) is the weighted
average of the returns on the assets in the
portfolio, where the weights are the
proportion invested in each asset.



Portfolio Risk
Portfolio risk depends not only on stand alone risk of
each individual asset in the portfolio but also on their
co-movement.
A statistical measure of how two variablesin this
case, the returns on two different investments
move together is the covariance.
The portfolios variance depends on:
The weight of each asset in the portfolio.
The standard deviation of each asset in the portfolio.
The covariance of the assets returns.
Portfolio Variance
Let cov
1,2
represent the covariance of two
assets returns. We can write the portfolio
variance as:


It can be shown that for a large portfolio of multiple
of assets, the portfolio variance depends more on
the covariances than on the respective variances of
individual assets.
Portfolo Risk and Return Combinations
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Portfolio Risk (standard deviation)
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
The Efficient Set for Two Assets
We can consider other
portfolio weights besides
50% in stocks and 50% in
bonds
100%
bonds
100%
stocks
Portfolo Risk and Return Combinations
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Portfolio Risk (standard deviation)
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
The Efficient Set for Two Assets
100%
stocks
100%
bonds
Note that some portfolios are
better than others. They have
higher returns for the same level of
risk or less.
The Efficient Set for Many Securities
The section of the opportunity set above the
minimum variance portfolio is the efficient frontier.
r
e
t
u
r
n

o
P
minimum
variance
portfolio
Individual Assets
Riskless Borrowing and Lending
Now investors can allocate their money across
the T-bills and a balanced mutual fund.
100%
bonds
100%
stocks
r
f
r
e
t
u
r
n

o
Balanced
fund
Riskless Borrowing and Lending
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the
steepest slope.
r
e
t
u
r
n

o
P
r
f
Diversifiable and Non-diversifiable Risks
We refer to the risk that goes away as we add assets
to a portfolio as diversifiable risk (also known as
unsystematic risk).
We refer to the risk that cannot be reduced by
adding more assets as nondiversifiable risk (also
known as systematic risk).
The idea that we can reduce the risk of a portfolio by
introducing assets whose returns are not highly
correlated with one another is the basis of modern
portfolio theory (MPT).

Diversifiable and Nondiversifiable Risks
Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure
of total risk.
For well-diversified portfolios, unsystematic
risk is very small.
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk.
The Capital Asset Pricing Model
William Sharpe took the idea that portfolio return and
risk are the only elements to consider and developed a
model that deals with how assets are priced.
This model is referred to as the capital asset pricing
model (CAPM).
All the assets in each portfolio, even on the frontier, have
some risk.
However, regardless of the level of risk one chooses, one
can get the highest expected return by a mixture of a
portfolio in the efficient frontier and a risk free asset
(lending or borrowing).

Capital Market Line
This line is referred to as the capital market line
(CML).
If the portfolios along the capital market line are the
best deals and are available to all investors, it follows
that the returns of these risky assets will be priced to
compensate investors for the risk they bear relative
to that of the market portfolio.
The CML specifies the returns an investor can expect
for a given level of risk.

CAPM
The CAPM uses this relationship between expected
return and risk to describe how assets are priced.
The CAPM specifies that the return on any asset is a
function of the return on a risk-free asset plus a risk
premium.
The return on the riskfree asset is compensation for
the time value of money.
The risk premium is the compensation for bearing
risk.
CAPM
The expected return on an individual asset is
the sum of the expected return on the risk-
free asset and the premium for bearing
market risk.


If we represent the expected return on each asset and its beta as a
point on a graph and connect all the points, the result is the security
market line (SML).

Beta and CAPM
A portfolio that combines the risk-free asset
and the market portfolio has an expected
return of 12% and a SD of 18%. The risk-free
rate is 5%, and the expected return on the
market portfolio is 14%. Assume CAPM holds.
What expected rate of return would a security
earn if it had a 0.45 correlation with the
market portfolio and a SD of 40%?
SML
Suppose you observe the following situation:
Security: Pete Corp.
Beta 1.3
E(Return) 23%
Repete Co
Beta 0.6
E(Return) 13%
Assume that securities are correctly priced. Based on CAPM
what is the expected Rm? What is the risk-free rate?
Capital Structure Theories
What is Capital Structure?
The combination of debt and equity used to
finance a firms projects is referred to as its
capital structure.
The capital structure of a firm is some mix of
debt, internally generated equity, and new
equity.
But what is the right mixture?
Why do some industries tend to have firms
with higher debt ratios than other industries?
M&M Hypothesis
M&M reasoned that if the following conditions hold, the value of the firm
is not affected by its capital structure:
Condition 1: Individuals and corporations are able to borrow and lend
at the same terms (referred to as equal access).
Condition #2: There is no tax advantage associated with debt financing
(relative to equity financing).
Condition #3: Debt and equity trade in a market where assets that are
substitutes for one another trade at the same price. This is referred to
as a perfect market.
Condition #4: There are no bankruptcy costs
Condition #5: All cash flow streams are perpetuities (i.e., no growth)
Condition #6: Corporate insiders and outsiders have the same
information (i.e., no signalling opportunities)
Condition #7: Managers always maximize shareholders wealth (i.e., no
agency cost)
Condition # 8: Firms only issue two types of claims: risk-free debt and
(risky) equity
Condition # 9: Operating cash flows are completely unaffected by
changes in capital structure
Condition # 10: All firms are assumed to be in the same risk class
(operating risk)
M&M Hypotheses
Proposition I (1958): World without tax
The market value of a firm is independent of its capital structure
and is given by capitalizing its expected return at the rate K
u
appropriate to its risk class.
Proposition II: World with only corporate tax
The market value of a levered firm is equal to market value of
the unlevered firm plus present value of tax shield on debt
Proposition III (Miller, 1977): World with both personal
and corporate tax
Personal Tax and Capital Structure
If debt income (interest) and equity income (dividends and
capital appreciation) are taxed at the same rate, the interest
tax shield is still D and increasing leverage increases the value
of the firm
If debt income is taxed at rates higher than equity income,
some of the tax advantage to debt is offset by a tax
disadvantage to debt income. Whether the tax advantage
from the deductibility of interest expenses is more than or
less than the tax disadvantage of debt income depends on:
the firms tax rate; the investors tax rate on debt income; and
the investors tax rate on equity income. But since different
investors are subject to different tax rates (for example,
pension funds are not taxed), determining this is a problem
If investors can use the tax laws effectively to reduce to zero
their tax on equity income, firms will take on debt up to the
point where the tax advantage to debt is just offset by the tax
disadvantage to debt income

Trade-off Theory of Capital Structure
A firms debt equity decision is a trade-off between
interest tax shields and the cost of financial distress.
It recognises that target debt ratios may vary from firm to
firm.
Unlike M&M theory, it avoids extreme predictions and
rationalises moderate debt ratios.
Higher profits imply more debt servicing capacity and
more taxable income to shield and so should give a
higher target debt ratio.
Capital Structure and Financial Distress
Costs of Financial Distress:
Cost of forgoing a long term profitable project
Cost of lost sales
Costs associated with suppliers.
Legal costs
Value of the firm = Value of the firm if all-
equity financed + Present value of the interest
tax shield Present value of financial distress
Pecking Order Theory
Firms prefer using internally generated capital (retained
earnings) to externally raised funds (issuing equity or debt).
Firms try to avoid sudden changes in dividends.
When internally generated funds are greater than needed for
investment opportunities, firms pay off debt or invest in
marketable securities.
When internally generated funds are less than needed for
investment opportunities, firms use existing cash balances or
sell off marketable securities.
If firms need to raise capital externally, they issue the safest
security first; for example, debt is issued before preferred
stock, which is issued before common equity.

Signaling Theory
MM assumed that investors have the same
information about a firms prospects as its
managers- this is called symmetric
information.
Agency Cost
Optimal Capital Structure
The mix of debt and equity that maximizes the
value of the firm is referred to as the optimal
capital structure.
So what good is this analysis of the tradeoff
between the value of the interest tax shields
and the costs of distress if we cannot apply it
to a specific firm?
While we cannot specify a firms optimal
capital structure, we do know the factors that
affect the optimum.

Capital Structure: Different Industries
The greater the marginal tax rate, the greater the benefit
from the interest deductibility and, hence, the more
likely a firm is to use debt in its capital structure.
The greater the business risk of a firm, the greater the
present value of financial distress and, therefore, the less
likely the firm is to use debt in its capital structure.
The greater extent that the value of the firm depends on
intangible assets, the less likely it is to use debt in its
capital structure.

Cost of Capital
Beta