i = 10%
TIME VALUE OF MONEY

Note: r = i/n
A peso today is worth more than a peso promised
in the future
r = 5%
FV = Php 200 x [1.05]6
FUTURE VALUE
FV = Php 268.02
 Refers to the amount of money an investment will
grow to over some period of time at some given interest
rate
PRESENT VALUE
 The reverse of future value; instead of
compounding the money forward into the future, we
discount it back to the present
1. Investing in a Single Period
1.1 If you were to invest Php 100 in a time deposit that pays
10% per year, how much would you have in one year?
 Often referred to as the discounted cash flow
technique
Ans: Formula: FV = PV x (1+r)
FV = 100 x 1.10
FORMULA:
FV = Php 110
PV = FV X [1+ r]-t
2. Investing for More Than One Period
2.1 With a Php 100 investment, what will you have after
two years, assuming the interest rate doesn’t change?
1. Calculating the Value of a Single Amount
1.1 Let’s assume we are to receive Php 100 at the end of
two years. How do we calculate the present value of the
amount, assuming the interest is 8% per year compounded
annually?
Ans: Formula: FV = PV x (1+r)t
FV = 100 x 1.21
FV = Php 121
Ans: PV = 100 x (1.08)-2
3. Future Value and Compounding
PV = Php 85.73
FORMULA
2. Present Value and Compounding
FV = PV X [1+ r]t
2.1 What is the present value of receiving single amount of
Php 5,000 at the end of 3 years, if the time value of money
is 8% per year, compounded quarterly?
FV = Future Value
PV = Present Value
Ans: PV = ?
r = rate of return (r = i/n)
FV = Php 5,000
t = number of periods
t = 12 periods (3 years x 4 (quarterly))
r = 2% (r = 8% / 4)
3.1 You make a single deposit of Php 100 today. It will
remain invested for 4 years at 8% per year compounded
annually. What will be the FV of your single deposit at the
end of 4 years?
PV = FV x (1 + r)-t
PV = Php 5,000(1.02)-t
PV = Php 3,942.37
Ans: FV = Php 100 x [1 + (8%/1)]4
FV = 100 x [1.36]
PRESENT VALUE OF ORDINARY ANNUITY
FV= Php 136.04
 series of equal payments made at the end of
consecutive periods over a fixed length of time.
3.2 You make a single deposit today of Php 200. The
deposit will be invested for 3 years at an interest rate of
10% per year compounded semi-annually. What will be the
future value of your account at the end of 3 years?

 All payments are made at the same
intervals of time (such as once a month or quarter, over a
period of a year).
FV = ?

PV = Php 200
All payments are made at the end of each
period
t = 6 semi-annual periods
 The present value of an ordinary annuity is largely
dependent on the prevailing interest rate. Because of
n=2
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All payments are the same
the time value of money, rising interest rates reduce the
present value of an ordinary annuity, while declining
interest rates increase its present value.
FORMULA:
FORMULA:
P = periodic payments
𝑃𝑉AD = 𝑃
1 − (1 + 𝑟)−𝑛
𝑃𝑉OA = 𝑃
𝑟
P = periodic payments
1 − (1 + 𝑟)−(𝑛−1)
𝑟
r = rate per period
n = number of periods
r = rate per period
1. Alan wants to deposit Php 300 into a fund at the
beginning of each month. If he can earn 10% compounded
interest monthly, how much amount will be there in the
fund at the end of 6 years?
n = number of periods
1. If an ordinary annuity pays Php 50,000 per year for five
years and the interest rate is 7 percent, the present value
would be:
Ans: PVOA =Php 50,000 x
PVOA = 50,000 x
Ans: P = Php 300
r = 0.0083 (10% / 12)
1−(1+0.07)−5
n = 72 (6 years x 12 (monthly))
0.07
1−0.713
𝑃𝑉AD = 𝑃ℎ𝑝 300 𝑥
0.07
PVOA = 50,000 x 4.1
PVOA = Php 205, 000
1 − (1 + 0.0083)−(72−1)
0.0083
𝑃𝑉AD = 𝑃ℎ𝑝 300 𝑥 53.48
𝑃𝑉AD = 𝑃ℎ𝑝 16,044.58
2. A friend asks you to help him determine the appropriate
price to pay for an annuity offering a retirement income of
Php 10,000 a month for 10 years. Assume the interest rate
is 6% compounded monthly.
Ans: P = Php10,000.00
R = 0.005 (6% / 12)
n = 120 periods (10 x 12)
PVOA =Php 10,000 x
PVOA =Php 10,000 x
1−(1+0.005)−120
0.0042
0.4504
0.0042
PVOA =Php 10,000 x 107.24
PVOA =Php 1,072,380.95
Note: The present value of a series of payments, whether the
payments are the same or not, is:
PRESENT VALUE OF ANN UITY DUE
 the payments occur at the beginning of the
payment period
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ASSETS
FINANCIAL STATEMENTS
 a resource with economic value that an individual,
corporation or country owns or controls with the
expectation that it will provide a future benefit, can
generate cash flow, reduce expenses or improve sales
CURRENT ASSETS
 Current assets are short-term economic resources
that are expected to be converted into cash within one year
 Cash – most liquid; anything authorized by law as
a medium of exchange at a given time and place
 Marketable securities – near cash; very liquid
short-term investments, such
as U.S. Treasury bills or certificates of deposit, held
by the firm.
 Accounts receivable - owed to the concern by
customers arising from sale of goods or services in
the ordinary course of business
 Inventories - include raw materials, work in
process (partially finished goods), and finished goods
held by the firm
FIXED ASSETS
 long-term resources, such as plants, equipment,
and buildings
FINANCIAL ASSETS
 represent investments in the assets and securities
of other institutions. Financial assets include stocks,
sovereign and corporate bonds, preferred equity, and other
hybrid securities.
INTANGIBLE ASSETS
 economic resources that have no physical
presence. They include patents, trademarks, copyrights,
and goodwill
Generally Accepted Accounting Principles (GAAP)
 the practice and procedure guidelines used to
prepare and maintain financial records and reports;
authorized by the Financial Accounting Standards Board
(FASB)
I. INCOME STATEMENT
 provides a financial summary of the firm’s
operating results during a specified period
 Sales Revenue - the total dollar amount of sales during
the period—from which the cost of goods
sold is deducted.
 Gross profit - represents the amount remaining to
satisfy operating, financial, and tax costs.
 Operating expenses - include selling expense, general
and administrative expense, lease expense, and
depreciation expense, are deducted from gross profits
 Operating profit - often called earnings before interest
and taxes, or EBIT. Represent the profits earned from
producing and selling products; this amount does not
consider financial and tax costs.
 Financial cost (interest expense) - subtracted from
operating profits to find net profits (or earnings) before
taxes.
 Taxes are calculated at the appropriate tax rates and
deducted to determine net profits (or earnings) after
taxes
 Any preferred stock dividends must be subtracted from
net profits after taxes to arrive at earnings available for
common stockholders
 Earnings per share (EPS) - represent the
number of dollars earned during the period on behalf of
each outstanding share of common stock
LIABILITIES
 an obligation between one party and another not
yet completed or paid for
CURRENT LIABILITIES
 Short-term liabilities, expected to be paid within 1
year or less
 Accounts Payable - amounts owed for credit
purchases by the firm
 Notes Payable - outstanding short-term loans,
typically from commercial banks
 Wages Payable - The total amount of accrued
income employees have earned but not yet received
 Interest Payable - Companies, just like individuals,
often use credit to purchase goods and services to finance
over short time periods
 Dividends Payable - For companies that
have issued stock to investors and pay a dividend, this
II.
BALANCE SHEET
 presents a summary statement of the firm’s
financial position at a given time
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 a summary of the cash flows over the period of
concern. The statement provides insight into the firm’s
operating, investment, and financing cash flows and
reconciles them with changes in its cash and marketable
securities during the period.
represents the amount owed to shareholders after
the dividend was declared.
NON CURRENT LIABILITIES
 represents debt for which payment is not due in
the current year
STOCKHOLDER’S EQUITY




 represents the owners’ claims on the firm
Preferred Stock - historical proceeds from the sale of
preferred stock
Common Stock - par value of common stock
Paid-in capital in excess of par - represents the amount
of proceeds in excess of the par value
received from the original sale of common stock
Retained earnings - represent the cumulative total of all
earnings, net of dividends, that have been retained and
reinvested in the firm since its inception
IV. NOTES TO FINANCIAL STATEMENTS
 Explanatory notes keyed to
relevant accounts in the statements; they provide detailed
information on the accounting policies, procedures,
calculations, and transactions underlying entries in the
financial statement
 Bartlett Company’s balance sheets in Table 3.2
show that the firm’s total assets increased from $3,270,000
in 2011 to $3,597,000 in 2012. The $327,000 increase was
due primarily to the $219,000 increase in current assets.
The asset increase, in turn, appears to have been financed
primarily by an increase of $193,000 in total liabilities
FINANCIAL RATIOS
Ratio Analysis
 Involves methods of calculating
and interpreting financial ratios to analyze and monitorthe
firm’s performance
RATIO COMPARISONS
CROSS-SECTIONAL ANALYSIS
 involves the comparison of different firms’
financial ratios at the same point in time.
Benchmarking - A type of cross-sectional
analysis in which the firm’s ratio values are compared to
those of a key competitor or group of competitors that it
wishes to emulate.
III.STATEMENT OF CASH FL OWS
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TIME SERIES ANALYSIS
1. LIQUIDITY RATIOS
 Liquidity - ability to satisfy its short-term
obligations as they come due. It refers to the solvency of
the firm’s overall financial position—the ease with which it
can pay its bills
Evaluation of the firm’s financial performance over
time using financial ratio analysis
COMBINED ANALYSIS
the most informative approach to ratio analysis
combines cross-sectional and time-series analyses. A
combined view makes it possible to assess the trend in the
behavior of the ratio in relation to the trend for the
industry
1.1 CURRENT RATIO
One of the most commonly cited financial ratios,
measures the firm’s ability to meet its short-term
obligations
FORMULA :
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The current ratio for Bartlett Company in 2012 is
$1,223,000 , $620,000 = 1.97
CAUTIONS ABOUT USING RATIO ANALYSIS
1. Ratios that reveal large deviations from the norm merely
indicate the possibility of a problem.
INDICATION:
2. A single ratio does not generally provide sufficient
information from which to judge the overall performance
of the firm. However, if an analysis is concerned only with
certain specific aspects of a firm’s financial position, one or
two ratios may suffice
A higher current ratio indicates a greater degree of
liquidity.
1.2 QUICK (ACID-TEST) RATIO
3. The ratios being compared should be calculated using
financial statements dated at the same point in time during
the year
 similar to the current ratio except that it excludes
inventory, which is generally the least liquid current asset
 ability to pay the more current obligation from the
more current liquid asset
 The generally low liquidity of inventory results
from two primary factors:
1. Many types of inventory cannot be easily sold
because they are partially completed items, specialpurpose items
2. inventory is typically sold on credit, which means
that it becomes an account receivable before being
converted into cash
4. It is preferable to use audited financial statements for
ratio analysis.
5. The financial data being compared should have been
developed in the same way. The use of differing accounting
treatments—especially relative to inventory and
depreciation—can distort the results of ratio comparisons,
regardless of whether cross-sectional or time-series
analysis is used.
6. Results can be distorted by inflation, which can cause the
book values of inventory and depreciable assets to differ
greatly from their replacement values
FORMULA :
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
CATEGORIES OF FINANC IAL RATIOS
The quick ratio for Bartlett Company in 2012 is:
Financial ratios can be divided for convenience into five
basic categories: liquidity, activity, debt, profitability, and
market ratios. Liquidity, activity, and debt ratios primarily
measure risk. Profitability ratios measure return. Market
ratios capture both risk and return. Financial ratios can be
divided for convenience into five basic categories: liquidity,
activity, debt, profitability, and market ratios. Liquidity,
activity, and debt ratios primarily measure risk. Profitability
ratios measure return. Market ratios capture both risk and
return
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
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𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
1,223,000 − 289,000
= 1.51
620,000
extends 30-day credit terms to customers, an average
collection period of 59.7 days may indicate a poorly
managed credit or collection
department, or both
1.3 CASH RATIO
FORMULA :
𝐶𝑎𝑠ℎ + 𝐶𝑎𝑠ℎ 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠 +
𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐶𝑎𝑠ℎ 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
2.2.2 ACCOUNTS RECEIVABLE TURNOVER RATIO
FORMULA:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑜𝑣𝑒𝑟 =
2. ACTIVITY RATIOS
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑅
 Measure the speed with which various accounts
are converted into sales or cash—inflows or outflows
Average AR = (Beg. AR + Ending AR) / 2
2.1 INVENTORY TURNOVER
 commonly measures the activity, or liquidity, of a
firm’s inventory
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Net Credit Sales =
2.3 AVERAGE PAYMENT PERIOD
 The average amount of time needed to pay
accounts payable
Applying this relationship to Bartlett Company in 2012
yields:
2,088,000
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
= 7.2
289,000
FORMULA:
Note: The resulting turnover is meaningful only when it is compared
with that of other firms in the same industry or to the firm’s past
inventory turnover. An inventory turnover of 20 would not be unusual
for a grocery store, whose goods are highly perishable and must be
sold quickly, whereas an aircraft manufacturer might turn its
𝐴𝑣𝑒. 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐴𝑣𝑒. 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 =
inventory just four times per year.
=7.2 / 365days =50.7 days
2.2.1 AVERAGE COLLECTION PERIOD
 or average age of accounts receivable, is useful in
evaluating credit and collection policies
 The average amount of time needed to collect
accounts receivable
=
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
The average collection period for Bartlett Company in 2012
is
503,000
3,074,000/365
2.4. TOTAL ASSET TURNOVER
503,000
=
8,422
= 59.7days
 indicates the efficiency with which the firm uses its
assets to generate sales
Indication: The average collection period is meaningful only
in relation to the firm’s credit terms. If Bartlett Company
FORMULA:
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382,000
= 95.4 𝑑𝑎𝑦𝑠
(0.70 𝑥 2,088,000)/365
INDICATIONS: This figure is meaningful only in relation to
the average credit terms extended to
the firm. If Bartlett Company’s suppliers have extended, on
average, 30-day credit terms, an analyst would give Bartlett
a low credit rating because it was
taking too long to pay its bills.
FORMULA :
=
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠/365
The difficulty in calculating this ratio stems from the need
to find annual purchases, a value not available in published
financial statements. Ordinarily, purchases are estimated as
a given percentage of cost of goods sold. If we assume that
Bartlett Company’s purchases equalled 70 percent of its
cost of goods sold in2012, its average payment period is:
Average Age of Inventory - The average amount of time
needed to collect accounts receivable
𝐴𝑣𝑒. 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝑝𝑒𝑟 𝑑𝑎𝑦
INDICATIONS: The times interest earned ratio for Bartlett
𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
The value of Bartlett Company’s total asset turnover in 2012
is:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
Company seems acceptable. A value of at least 3.0—and
preferably closer to 5.0—is often suggested. The firm’s
earnings before interest and taxes could shrink by as much
as 78 percent [(4.5 - 1.0) / 4.5] and the firm would still be
able to pay the $93,000 in interest it owes. Thus it has a
large margin of safety
3,074,000
= 0.85
3,597,000
INDICATIONS: This means the company turns over its
assets 0.85 times per year. Generally, the higher a firm’s
total asset turnover, the more efficiently its assets have
been used. This measure is probably of greatest interest to
management because it indicates whether the firm’s
operations have been financially efficient.
3.3 FIXED PAYMENT COVERAGE RATIO
3. DEBT RATIOS
FORMULA:
 measures the firm’s ability to meet all fixed
payment obligations, such as loan interest and principal,
lease payments, and preferred stock dividends
 The debt position of a firm indicates the amount of
other people’s money being used to generate profits
Financial Leverage - The magnification of risk and
return through the use of fixed cost financing, such as debt
and preferred stock
the more debt a firm uses in relation to its total
assets, the greater its financial leverage
INDICATIONS: Like the times interest earned ratio, the fixedpayment coverage ratio measures risk. The lower the ratio, the
greater the risk to both lenders and owners, and the greater the
ratio, the lower the risk. This ratio allows interested parties to
assess the firm’s ability to meet additional fixed-payment
obligations without being driven into bankruptcy
3.1 DEBT RATIO
 measures the proportion of total assets financed
by the firm’s creditors
 The higher this ratio, the greater the amount of
other people’s money being used to generate profits.
4. PROFITABILITY RATIO
FORMULA:
 these measures enable analysts to evaluate the firm’s
profits with respect to a given level of sales, a certain level of
assets, or the owners’ investment
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
The debt ratio for Bartlett Company in 2012 is:
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =
1,643,000
= 45.7%
3,597,000
4.1 GROSS PROFIT MARGIN
 measures the percentage of each sales dollar
remaining after the firm has paid for its goods.
INDICATIONS: This value indicates that the company has
financed close to half of its assets with debt. The higher this
ratio, the greater the firm’s degree of indebtedness and the
more financial leverage it has
FORMULA:
3.2 TIMES INTEREST EARNED RATIO
Bartlett Company’s gross profit margin for 2012 is
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
 sometimes called the interest coverage ratio,
measures the firm’s ability to make contractual interest
payments
𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
=
𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
=
986,000
3,074,000
3,074,000 − 2,088,000
3,074,000
= 32.1%
FORMULA
𝐸𝐵𝐼𝑇
𝑇𝑎𝑥𝑒𝑠
418,000
𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 𝑅𝑎𝑡𝑖𝑜 =
= 4.5
93,000
𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 𝑅𝑎𝑡𝑖𝑜 =
4.2 OPERATING PROFIT MARGIN
 measures the percentage of each sales dollar
remaining after all costs and expenses other than interest,
taxes, and preferred stock dividends are deducted.
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
It represents the “pure profits”
represents the number of dollars earned during
the period on behalf of each outstanding share of common
stock
FORMULA:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔
𝑃𝑟𝑜𝑓𝑖𝑡𝑠
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
Bartlett Company’s operating profit margin for 2012 is:
=
418,000
3,074,000
FORMULA:
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙. 𝑓𝑜𝑟
𝑐𝑜𝑚𝑚𝑜𝑛
𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑑𝑒𝑟𝑠
𝐸𝑃𝑆 =
𝑛𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛
𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
= 13.6%
4.3 NET PROFIT MARGIN
𝐸𝑃𝑆 =
 measures the percentage of each sales dollar
remaining after all costs and expenses, including interest,
taxes, and preferred stock dividends have been deducted
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
INDICATION: This figure represents the dollar amount
earned on behalf of each outstanding
share of common stock.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐴𝑣𝑎𝑖𝑙. 𝑓𝑜𝑟 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑆𝑎𝑙𝑒𝑠
Bartlett Company’s net profit margin for 2012 is:
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
221,000
= $2.90
76,262
5. MARKET RATIO
221,000
= 7.2%
3,074,000
relate the firm’s market value, as measured by its
current share price, to certain accounting values.
INDICATIONS: The higher the firm’s net profit margin, the better.
4.4 RETURN ON TOTAL ASSETS (ROA)
5.1 PRICE EARNING RATIO (P/E RATIO)
often called the return on investment (ROI),
measures the overall effectiveness of management in
generating profits with its available assets
Measures the amount that investors are willing to
pay for each dollar of a firm’s earnings; the higher the P/E
ratio, the greater the investor confidence.
FORMULA:
FORMULA:
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑣𝑎𝑖𝑙 𝑓𝑜𝑟
𝑐𝑜𝑚𝑚𝑜𝑛
𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑅𝑂𝐴 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
221,000
𝑅𝑂𝐴 =
= 6.1%
3,597,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟
𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑃𝑆
If Bartlett Company’s common stock at the end of 2012 was
selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2012 is
INDICATION: The higher the firm’s return on total assets
the better. This value indicates that the company earned
6.1 cents on each dollar of asset
investment.
32.25
= 11.1
2.90
INDICATION: This figure indicates that investors were
paying $11.10 for each $1.00 of earnings.
𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 =
4.5 RETURN ON TOTAL EQUITY (ROE)
measures the return earned on the common
stockholders’ investment in the firm
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑣𝑎𝑖𝑙 𝑓𝑜𝑟
𝑐𝑜𝑚𝑚𝑜𝑛
𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑅𝑂𝐸 =
𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 𝐸𝑞𝑢𝑖𝑡𝑦
𝑅𝑂𝐸 =
5.2 MARKET BOOK (M/B) RATIO
provides an assessment of how investors view the
firm’s performance
221,000
= 12.6%
1,754,000
To calculate the firm’s M/B ratio, we first need to
find the book value per share of common stock
INDICATION: Generally, the owners are better off the
higher is this return. The calculated ROE of 12.6 percent
indicates that during 2012 Bartlett earned 12.6 cents on
each dollar of common stock equity
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑜.𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓
𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
1,754,000
= $23.00
76,262
FORMULA:
4.6 EARNINGS PER SHARE
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
𝑀𝐵 𝑅𝑎𝑡𝑖𝑜 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓
𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
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𝑀𝐵 𝑅𝑎𝑡𝑖𝑜 =
ability to pay debts in 2012 compensates for its increased degree
of indebtedness.
$32.25
= $1.40
$23.00
MARKET
INDICATION: Investors are currently paying $1.40 for each
$1.00 of book value of Bartlett Company’s stock. Clearly,
Bartlett’s future prospects are being viewed favorably by
investors, who are willing to pay more than their book
value for the firm’s shares
Investors have greater confidence in the firm in 2012 than in the
prior 2 years, as reflected in the price/earnings (P/E) ratio of 11.1.
However, this ratio is below the industry average. The P/E ratio
suggests that the firm’s risk has declined but remains above that of
the average firm in its industry. The firm’s market/book (M/B)
ratio has increased over the 2010–2012 period, and in 2012 it
exceeds the industry average. This implies that investors are
optimistic
about
the
firm’s
future
performance. The P/E and M/B ratios reflect the firm’s increased
profitability over the 2010–2012 period: Investors expect to earn
high future returns as compensation for the firm’s above-average
risk.
A COMPLETE RATIO ANALYSIS
SUMMARIZING ALL RATI OS
LIQUIDITY
In summary, the firm appears to be growing and has recently
undergone an expansion in assets, financed primarily through the
use
of
debt.
The
2011–2012
period seems to reflect a phase of adjustment and recovery from
the rapid growth in assets. Bartlett’s sales, profits, and other
performance factors seem to be growing with the increase in the
size of the operation. In addition, the market response to these
accomplishments appears to have been positive. In short, the firm
seems to have done well in 2012.
The overall liquidity of the firm seems to exhibit a reasonably
stable trend, having been maintained at a level that is relatively
consistent with the industry average in 2012. The firm’s liquidity
seems to be good.
ACTIVITY
Bartlett Company’s inventory appears to be in good shape. Its
inventory management seems to have improved, and in 2012 it
performed at a level above that of the industry. The firm may be
experiencing some problems with accounts receivable. The
average collection period seems to have crept up above that of
the industry. Bartlett also appears to be slow in paying its bills; it
pays nearly 30 days slower than the industry average. This could
adversely affect the firm’s credit standing. Although overall
liquidity appears to be good, the management of receivables and
payables should be examined. Bartlett’s total asset turnover
reflects a decline in the efficiency of total asset utilization
between 2010 and 2011. Although in 2012 it rose to a level
considerably above the industry average, it appears that the pre2011 level of efficiency has not yet been achieved.
DUPONT SYSTEM OF ANA LYSIS
 used to dissect the firm’s financial statements and
to assess its financial condition. It merges the income
statement and balance sheet into two summary measures
of profitability, return on total assets (ROA) and return on
common equity (ROE)
DEBT
COMMON SIZE STATEMEN TS
Bartlett Company’s indebtedness increased over the 2010–2012
period and is currently above the industry average. Although this
increase in the debt ratio could be cause for alarm, the firm’s
ability to meet interest and fixed-payment obligations improved,
from 2011 to 2012, to a level that outperforms the industry. The
firm’s increased indebtedness in 2011 apparently caused
deterioration in its ability to pay debt adequately. However,
Bartlett has evidently improved its income in 2012 so that it is
able to meet its interest and fixed-payment obligations at a level
consistent with the average in the industry. In summary, it
appears that although 2011 was an off year, the company’s
improved
ability
to
pay
debts
in 2012 compensates for its increased degree of indebtedness.
 A statement wherein each item is expressed in
terms of a percentage of a common base number.
PROFITABILITY
Bartlett Company’s indebtedness increased over the 2010 2012
period and is currently above the industry average. Although this
increase in the debt ratio could be cause for alarm, the firm’s
ability
to
meet
interest
and
fixed-payment
obligations improved, from 2011 to 2012, to a level that
outperforms the industry. The firm’s increased indebtedness in
2011 apparently caused deterioration in its ability to pay debt
adequately. However, Bartlett has evidently improved
its income in 2012 so that it is able to meet its interest and fixedpayment obligations at a level consistent with the average in the
industry.
In
summary,
it
appears
that although 2011 was an off year, the company’s improved
COMPARATIVE STATEMEN T
 Show the increases or decreases in account
balances and their corresponding percentages.
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ANALYZING THE FIRM’S CASH FLOW
OPERATING CASH FLOW
Cash Flow - the lifeblood of the firm
 the cash flow it generates from its normal
operations—producing and selling its output of goods
or services
Depreciation - A portion of the costs of fixed
assets charged against annual revenues over time
FORMULA:
depreciation deductions increase a firm’s cash flow
because they reduce a firm’s tax bill
𝑂𝐶𝐹 = 𝑁𝑂𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Depreciable Life of an Asset - Time period over which an
asset is depreciated
CATEGORIES OF CASH FLOW
During 2012, Baker Corporation generated $322,000 of
cash flow from producing and selling its output. Therefore,
we can conclude that Baker’s operations are generating
positive cash flows.
Operating flows – cash inflows and outflows directly
related to the sale and production of the firm’s products
and services.
Investment Flows - are cash flows associated with the
purchase and sale of both fixed assets and equity
investments in other firms
FREE CASH FLOW
 represents the cash available to investors—the
providers of debt (creditors) and equity (owners)—after the
firm has met all operating needs and paid for net
investments in fixed assets and current assets.
Financing flows - Cash flows that result from
debt and equity financing transactions; include
incurrence and repayment of debt, cash inflow from the
sale of stock, and cash outflows to repurchase stock or
pay cash dividends
FORMULA:
𝐹𝐶𝐹 = 𝑂𝐶𝐹 − 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑁𝐹𝐴𝐼)
− 𝑁𝑒𝑡 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝑁𝐶𝐴𝐼)
𝑁𝐹𝐴𝐼 = 𝐶ℎ𝑎𝑛𝑔𝑒𝑑 𝑖𝑛 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
+ 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑁𝐶𝐴𝐼 = 𝐶ℎ𝑎𝑛𝑔𝑒𝑑 𝑖𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
+ 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 (𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
+ 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠)
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THE FINANCIAL PLANNING PROCESS
 it provides road maps for guiding, coordinating,
and controlling the firm’s actions to achieve its objectives
 Planning that begins with long term, or strategic,
financial plans that in turn guide the formulation of shortterm, or operating, plans and budget
Two key aspects:
1. Cash Planning - involves preparation of the firm’s cash
budget
2. Profit Planning - involves preparation of pro forma
statements
LONG-TERM (STRATEGIC) FINANCIAL PLANS
 Plans that lay out a company’s planned financial
actions and the anticipated impact of those actions over
periods ranging from 2 to 10 years
 Those long term plans consider proposed outlays
for fixed assets, research and development activities,
marketing and product development actions, capital
structure, and major sources of financing. Also included
would be termination of existing projects, product lines, or
lines of business; repayment or retirement of outstanding
debts; and any planned acquisitions
SHORT-TERM (OPERATING) FIN ANCIAL PLANS
 specify short-term financial actions and the
anticipated impact of those actions
 These plans most often cover a 1- to 2-year
period
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INTEREST RATES AND REQUIRED RETURNS
TERM STRUCTURE OF IN TEREST RATES
Interest rate - Usually applied to debt instruments such as
bank loans or bonds; the compensation paid by the
borrower of funds to the lender; from the borrower’s point
of view, the cost of borrowing funds
 the relationship between the maturity and rate of
return for bonds with similar levels of risk
Required return - Usually applied to debt instruments such
as bank loans or bonds; the compensation paid by the
borrower of funds to the lender; from the borrower’s point
of view, the cost of borrowing funds
Yield to Maturity (YTM) - represents the compound annual
rate of return that an investor earns on the bond assuming
that the bond makes all promised payments and the
investor holds the bond to maturity
Yield curve - A graphic depiction of the term structure of
interest rates.
FACTORS THAT CAN AFFECT INTEREST RATE
 Inflation - a rising trend in the prices of most
goods and services. Typically, savers demand higher returns
(that is, higher interest rates) when inflation is high because
they want their investments to more than keep pace with
rising prices
 Risk - When people perceive that a particular
investment is riskier, they will expect a higher return on
that investment as compensation for bearing the risk
Inverted Yield Curve - A downward-sloping yield
curve indicates that short-term interest rates are generally
higher than long-term interest rates
 Liquidity preference - the general tendency of
investors to prefer short-term securities (that is, securities
that are more liquid)
Normal Yield Curve - A yield curve that indicates that
interest rates do not vary much at different maturities
Normal Yield Curve - An upward-sloping yield curve
indicates that long-term interest rates are generally higher
than short-term interest rates
Real Rate of Interest - The rate that creates equilibrium
between the supply of savings and the demand for
investment funds in a perfect world, without inflation,
where suppliers and demanders of funds have no liquidity
preferences and there is no risk
THEORIES OF TERM STRUCTURE
1. Expectations Theory - The theory that the yield curve
reflects investor expectations about future interest rates;
an expectation of rising interest rates results in an upward
sloping yield curve, and an expectation of declining rates
results in a downward-sloping yield curve
2. Liquidity Preference Theory - Theory suggesting that
long term rates are generally higher than short-term rates
(hence, the yield curve is upward sloping) because investors
perceive short-term investments to be more liquid and less
risky than long-term investments.
Borrowers must offer higher rates on long-term bonds to
entice investors away from their preferred short-term
securities
Nominal or Actual Rate of Interest - the actual rate of
interest charged by the supplier of funds and paid by the
demander.
Inflation Premium - investors will demand a higher nominal
rate of return if they expect inflation
2. Market Segmentation Theory - Theory suggesting that
the market for loans is segmented on the basis of maturity
and that the supply of and demand for loans within each
segment determine its prevailing interest rate; the slope of
the yield curve is determined by the general relationship
between the prevailing rates in each market segment
Risk Premium - additional rate of return. Investors
generally demand higher rates of return on risky
investments as compared to safe ones
Deflation - A general trend of falling prices
12
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bondholders if the terms of the indenture are
violated
COST OF BONDS TO THE ISSUER
Impact of Bond Maturity - the longer the maturity of a
bond, the less accuracy there is in predicting future
interest rates, and therefore the greater the
bondholders’ risk of giving up an opportunity to lend
money at a higher rate.
-
Impact of Offering Size - because larger offerings result
in greater risk of default
CORPORATE BONDS
Impact of Issuer’s Risk - greater the issuer’s default risk,
the higher the interest rate
 long-term debt instrument indicating that a
corporation has borrowed a certain amount of money and
promises to repay it in the future under clearly defined
terms.

years
The greater the chance that the issuer might
default
Impact of the cost of money - cost of money in the
capital market is the basis for determining a bond’s
coupon interest rate
Most bonds are issued with maturities of 10 to 30
Sinking fund requirement - A restrictive provision often
included in a bond indenture, providing for the
systematic retirement of bonds prior to their maturity
Coupon interest rate - represents the percentage of the
bond’s par value that will be paid annually, typically in two
equal semi-annual payments, as interest
GENERAL FEATURES OF A BOND ISSUE
Bondholders - who are the lenders, are promised the semiannual interest payments and, at maturity, repayment of
the principal amount
Conversion feature - allows bondholders to
change each bond into a stated number of shares of
common stock
Bond indenture - A legal document that specifies both the
rights of the bondholders and the duties of the issuing
corporation
Call Feature - gives the issuer the opportunity to
repurchase bonds prior to maturity
Call Price - is the stated price at which bonds may
be repurchased prior to maturity. Sometimes the call
feature can be exercised only during a certain period
Standard Debt Provisions - Provisions in a bond indenture
specifying certain recordkeeping and general business
practices that the bond issuer must follow; normally, they
do not place a burden on a financially sound business
Call premium - The amount by which a bond’s
call price exceeds its par value
Restrictive covenants - Provisions in a bond indenture
that place operating and financial constraints on the
borrower
1.
minimum level of liquidity
2.
Prohibit the sale of accounts receivable
3.
fixed-asset restrictions
4.
Constrain subsequent borrowing
5.
Limit the firm’s annual cash dividend payments
Stock purchase warrants - instruments that give
their holders the right to purchase a certain number of
shares of the issuer’s common stock at a specified price
over a certain period of time
BOND YIELDS
 used to assess a bond’s performance over a given
period of time
 the three most widely cited bond yields are (1)
current yield, (2) yield to maturity (YTM), and (3) yield to
call (YTC)
Sinking-Fund Requirements - A restrictive provision often
included in a bond indenture, providing for the systematic
retirement of bonds prior to their maturity
Security Interest - The bond indenture identifies any
collateral pledged against the bond and specifies how it is
to be maintained
Current yield - A measure of a bond’s cash return for the
year; calculated by dividing the bond’s annual interest
payment by its current
price.
Trustee - A paid individual, corporation, or commercial
bank trust department that acts as the third party to a bond
indenture and can take specified actions on behalf of the
Example: 1,000 par value bond with an 8 percent coupon
interest rate that currently sells for $970 would have a
current yield of 8.25% [(0.08x$1,000)/$970]
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
BOND RATINGS


Floating-rate bonds - Stated interest rate is adjusted
periodically within stated limits in response to changes
in specified money market or capital market rates
Extendible notes - Short maturities, typically 1 to 5
years, that can be renewed for a similar period at the
option of holders
Putable bonds - Bonds that can be redeemed at par
(typically, $1,000) at the option of their holder either at
specific dates after the date of issue and every 1 to 5
years thereafter or when and if the firm takes specified
actions, such as being acquired, acquiring another
company, or issuing a large amount of additional
debt.
VALUATION FUNDAMENTALS
COMMON TYPES OF BONDS
Valuation - the process that links risk and return to
determine the worth of an asset.
Unsecured Bonds
 Debentures – Unsecured bonds that only creditworthy
firms can issue. Convertible bonds are usually
debentures
THREE KEY INPUTS IN THE VALUATION PROCESS
 Subordinated debentures – Claims are not satisfied
until those of the creditors holding certain (senior)
debts have been successfully satisfied
1. Cash Flow (Returns) - The value of any asset depends on
the cash flow(s) it is expected to provide over the
ownership period
 Income bonds – payments of interest is required only
when earnings are available. Commonly issued in
reorganization of a failing firm
2. Timing
3. Risk and Required Return - The level of risk associated
with a given cash flow can significantly affect its value. In
general, the greater the risk of (or the less certain) a cash
flow, the lower its value
Secured bonds
 Mortgage bonds – Secure by real estate or buildings
 Collateral trust bonds – secured by stock and (or) bonds
that are owned by the issuer. Collateral value is
generally 25% to 35% greater than bond value
BASIC VALUATION MODE L
the value of any asset is the present value of all future cash
flows it is expected to provide over the relevant time period
 Equipment trust certificates – Used to finance “rolling
stock” – airplanes, truck, boats and railroad cars. A
trustee buys the asset with funds raised through the
sale of trust certificates and then leases it to the firm;
after making the final scheduled lease payment, the
firm receives title to the asset. A type of leasing.
FORMULA:
𝑉0 =
Where:
V0= value of the asset at time zero
CFt= cash flow expected at the end of year t
CHARACTERISTICS OF C ONTEMPORARY TYPES OF
BONDS


r = appropriate required return (discount rate)
n = relevant time period
Zero (or low) coupon bonds - Issued with no (zero) or a
very low coupon (stated interest) rate and sold at a
large discount from par. A significant portion (or all) of
the investor’s return comes from gain in value (that is,
par value minus purchase price)
Junk bonds - Debt rated Ba or lower by Moody’s or BB
or lower by Standard & Poor’s. Commonly used by
rapidly growing firms to obtain growth capital, most
often as a way to finance mergers and takeovers
the value of a bond is the present value of the payments
its issuer is contractually obligated to make, from the
current time until it matures
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𝐶𝐹1
𝐶𝐹2
𝐶𝐹𝑛
+
+⋯+
(1 + 𝑟)1 (1 + 𝑟)2
(1 + 𝑟)𝑛
Interest rate risk - The chance that interest rates will
change and thereby change the required return and
bond value
BOND VALUE BEHAVIOR
 In practice, the value of a bond in the marketplace
is rarely equal to its par value
 The required return is likely to differ from the
coupon interest rate because either (1) economic
conditions have changed, causing a shift in the basic cost of
long-term funds; or (2) the firm’s risk has changed
STOCK VALUATION
Differences between Debt and Equity
 Increases in the basic cost of long-term funds or in
risk will raise the required return; decreases in the cost of
funds or in risk will lower the required return

Debt - includes all borrowing incurred by a firm,
including bonds, and is repaid according to a fixed
schedule of payments

Equity - consists of funds provided by the firm’s
owners (investors or stockholders) and is repaid
subject to the firm’s performance
Discount – the amount by which a bond sells at a value
that is less than its par value
Premium – the amount by which a bond sells at a value
that is greater than it

When the required return is greater than the coupon
interest rate, the bond value, B0, will be less than its par
value, M

When the required return falls below the coupon
interest rate, the bond value will be greater than par
value
COMMON AND PREFERRED STOCK
COMMON STOCK

The true owners of a corporate business are the
common stockholders

The true owners of a corporate business are the
common stockholders

They are assured of only one thing: that they
cannot lose any more than they have invested in
the firm
OWNERSHIP
Privately owned stock - The common stock of a firm is
owned by private investors; this stock is not publicly
traded
Publicly owned stock - The common stock of a firm is
owned by public investors; this stock is publicly traded

Constant Required Returns When the required
return is different from the coupon interest rate and is
constant until maturity, the value of the bond will approach
its par value as the passage of time moves the bond’s value
closer to maturity
Closely owned stock - The common stock of a firm is
owned by an individual or a small group of investors
(such as a family); these are usually privately owned
companies
Widely owned stock - The common stock of a firm is
owned by many unrelated individual or institutional
investors
PAR VALUE
 An arbitrary value established for legal purposes in
the firm’s corporate charter and which can be used to find
the total number of shares outstanding by dividing it into
the book value of common stock
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PREEMPTIVE RIGHT
VOTING RIGHTS
Allows common stockholders to
maintain their proportionate ownership in the corporation
when new shares are issued, thus protecting them from
dilution of their ownership
 each share of common stock entitles its holder to
one vote in the election of directors and on special issues
Proxy statement - A statement transferring the
votes of a stockholder to another party
Dilution of ownership - A reduction in each previous
shareholder’s fractional ownership resulting from the
issuance of additional shares of common stock
Proxy battle - The attempt by a nonmanagement group to
gain control of the management of a firm by soliciting a
sufficient number of proxy votes
Dilution of earnings - A reduction in each previous
shareholder’s fractional claim on the firm’s earnings
resulting from the issuance of additional shares of
common stock
Supervoting shares - Stock that carries with it
multiple votes per share rather than the single vote per
share typically given on regular shares of common stock
Nonvoting common stock - Common stock that carries no
voting rights; issued when the firm wishes to raise capital
through the sale of common stock but does not want to
give up its voting control
Rights - Financial instruments that allow
stockholders to purchase additional shares at a price
below the market price, in direct proportion to their
number of owned shares
DIVIDENDS
AUTHORIZED, OUTSTANDING AND ISSUED SHARE




 The payment of dividends to the firm’s
shareholders is at the discretion of the company’s board of
directors.
Authorized share - Shares of common stock that a
firm’s corporate charter allows it to issue
Outstanding shares - Issued shares of common stock
held by investors, including both private and public
investors
Treasury stock - Issued shares of common stock
held by the firm; often these shares have been
repurchased by the firm
Issued shares - Shares of common stock that
have been put into circulation; the sum of outstanding
shares and treasury stock
PREFERRED STOCK
 gives its holders certain privileges that make them
senior to common stockholders
 Preferred stockholders are promised a fixed
periodic dividend, which is stated either as a percentage or
as a dollar amount
 Par-value preferred stock - Preferred stock with a
stated face value that is used with the specified dividend
percentage to determine the annual dollar dividend
Example:
 No-par preferred stock - Preferred stock with no
stated face value but with a stated annual dollar dividend
FEATURES OF PREFERRED STOCK
How many shares of additional common stock can
Golden sell without gaining approval from its
shareholders? The firm has 35 million authorized
shares, 15 million issued shares, and 1 million shares of
treasury stock. Thus 14 million shares are outstanding
(15 million issued shares minus 1 million shares of
treasury stock), and Golden can issue 21 million
additional shares (35 million authorized shares minus 14
million outstanding shares) without seeking shareholder
approval. This total includes the treasury shares
currently held, which the firm can reissue to the public
without obtaining shareholder approval
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
Cumulative preferred stock - Preferred stock for which
all passed (unpaid) dividends in arrears, along with the
current dividend, must be paid before dividends can be
paid to common stockholders

Noncumulative preferred stock - Preferred stock for
which passed (unpaid) dividends do not accumulate

Callable feature - A feature of callable preferred stock
that allows the issuer to retire the shares within a
certain period of time and at a specified price

Convertible feature - A feature of convertible
preferred stock that allows holders to change each
share into a stated number of shares of common stock
Zero-growth model - An approach to dividend valuation
that assumes a constant, nongrowing dividend stream.
VENTURE CAPITAL
 Privately raised external equity capital used to
fund early stage firms with attractive growth prospects


𝑃𝑜 =
Venture capitalists - Providers of venture capital;
typically, formal businesses that maintain strong
oversight over the firms they invest in and that have
clearly defined exit strategies
𝐷1
𝑟𝑠
Constant-growth model (Gordon-growth model) - A
widely cited dividend valuation approach that assumes
that dividends will grow at a constant rate, but a rate
that is less than the required return
Angel capitalists - Wealthy individual investors
who do not operate as a business but invest in
promising early-stage companies in exchange for a
portion of the firm’s equity
𝑃𝑜 =
𝐷1
𝑟𝑠 − 𝑔
GOING PUBLIC
Variable growth model - A dividend valuation approach
that allows for a change in the dividend growth rate
When a firm wishes to sell its stock in the primary market,
it has three alternatives:
1.
Initial public offering - The first public sale of a
firm’s
stock
2.
Rights offering - new shares are sold to existing
stockholders
3.
Private placement - the firm sells new securities
directly to an investor or group of investors

Investment banker - Financial intermediary that
specializes in selling new security issues and advising
firms with regard to major financial transactions

Underwriting - The role of the investment
banker in bearing the risk of reselling, at a profit, the
securities purchased from an issuing corporation at an
agreed-on price

Underwriting syndicate - A group of other bankers
formed by an investment banker to share the financial
risk associated with underwriting new securities

Selling group - A large number of brokerage
firms that join the originating investment banker(s);
each accepts responsibility for selling a certain portion
of a new security issue on a commission basis
Book value per share - The amount per share of
common stock that would be received if all of the firm’s
assets were sold for their exact book (accounting) value and
the proceeds remaining after paying all liabilities (including
preferred stock) were divided among the common
stockholders
Liquidation value per share - the actual amount per share
of common stock that would be received if all of the firm’s
assets were sold for their market value, liabilities (including
preferred stock) were paid, and any remaining money were
divided among the common stockholders
COMMON STOCK VALUATION
Basic valuation model:
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RISK AND RETURN

Risk - A measure of the uncertainty surrounding the return
that an investment will earn or, more formally, the
variability of returns associated with a given asset

Investment risk- probability of earning less than the
expected return
Total rate of return - The total gain or loss experienced on
an investment over a given period of time; calculated by
dividing the asset’s cash distributions during the period,
plus change in value, by its beginning-of period investment
value


Investment 1- Treasury Bills which offer an 8% rate of
return. The T-bills would be bought at a discount and
would return their par value at maturity.
Investment 2- A corporate bond selling at par which
have a 9% coupon and a 10-year maturity. In this case,
your firm will sell the bond at the end of one year.
Therefore, the rate of return will depend by the rate
of interest rate level by the time of selling. A strong
economy will cause rising of interest rates and will
decrease the market value of the bond, while the
opposite would be true if the economy is weak.
Investment 3- Capital budgeting Project 1 has zero
cash flows during the year and the payoff at the end
of the year will depend at the state of the economy.
Investment 4- Project 2 is an alternative capital project
but with different payoff distribution with Project 1.
Where:
r = actual, expected, or required rate of return
during period t
Ct = cash (flow) received from the asset investment
in the time period t-1 to t
Pt = price (value) of asset at time t
Pt-1 = price (value) of asset at time t-1
TOTAL RISK AND MARKE T RISK
TOTAL RISK - the riskiness of an asset held in isolation
RISK PREFERENCES

Risk averse - The attitude toward risk in which investors
would require an increased return as compensation for
an increase in risk

Risk neutral - The attitude toward risk in which
investors choose the investment with the higher return
regardless of its risk

PROBABILITY DISTRIBU TION
Here is a sample scenario for probability distribution with
the same initial investment of P100,000 each.
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Variance & Standard Deviation
Since variance is measured in the same units as the
outcomes, in this case percentages, but squared. To attach
meaning to the squared percentage of variance, Standard
Deviation is used to measure dispersion of an asset.
Measures of Portfolio Risk
A. Covariance of Portfolio Risk
Historical Data:
TIME
Thus, the standard deviation of Project 2 (in previous data)
is:
1
RETURN A
rA
0.50
RETURN B
rB
0.25
2
3
4
0.40
-0.07
0.09
0.15
0.32
-0.20
Additional Data:
Sample Mean for Stock A = 0.23
MARKET RISK - an asset’s relevant, or effective risk, if it is
held as one of a large number of assets in a portfolio
Sample Mean for Stock B = 0.13
Sample Standard Deviation of Stock A = 0.2655
Combining stocks in portfolio reduces risk because when
there are stocks with less-than-expected returns, the
loss/es will be offset to some degree of stocks whose
returns are greater than expected
Sample Standard Deviation of Stock b = 0.2308
COVAB = ∑(rA - rA)( (rB – rB)
n–1
= (0.5-0.23)(0.25-0.13)+(0.40-.023)(0.15-.013)+(-.0.07.23)(-0.32-0.13)+(0.09-0.23)(-0.2-0.13)
EXPECTED RETURN ON A PORTFOLIO
4-1
= 0.0250/ 3
STOCK
EXPECTED
RETURN
STANDARD
DEVIATION
AMOUNT
INVESTED
INVESTM
ENT
PROPORT
ION
A
0.23
0.27
50,000.00
0.5
B
0.13
0.23
30,000.00
0.3
C
0.10
0.09
20,000.00
0.2



Expected Portfolio Return = 0.5(0.23)+.3(0.13)+0.2(0.10)
B. Correlation Coefficient
= 0.174 or 17.4%
r = COVAB/ (SA)(SB)
PORTFOLIO RISK
Factors affecting Portfolio Risk
1.
Individual Security Risk- Each stock kind of risk
affects your Portfolio Risk
2.
Investment Proportion- Your Portfolio Risk is
related to what kind of risk of each stock you
chose to invest and include in your portfolio
3.
Degree of Diversification between stocks – High
diversification means lower Portfolio Risk
= 0.00833/(0.2655)(0.2308)
= 0.14, r=-1 < r < 1
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= 0.00833*
If zero, there are stocks that moves in the same
direction one or more another stocks
If negative, it means it is diversified portfolio
because it shows that stock move irrelevant with
each other
If positive, stocks are not properly diversified
because they move together in the same way
most of the time.
CAPM EQUATION
RISK AND RETURN: THE CAPITAL ASSET
PRICING MODEL
 The basic theory that links risk and return for all
assets
 Thus far we have observed a tendency for riskier
investments to earn higher returns, and we have learned
that investors can reduce risk through diversification. Now
we want to quantify the relationship between risk and
return. In other words, we want to measure how much
additional return an investor should expect from taking a
little extra risk


beta coefficient (b) - a relative measure of
nondiversifiable risk. An index of the degree of
movement of an asset’s return in response to a change
in the market return
market return - The return on the market portfolio of all
traded securities
NOTE: Other things being equal, the higher the beta, the
higher the required return, and the lower the beta, the
lower the required return
COST OF CAPITAL
 Represents the firm’s cost of financing and is the
minimum rate of return that a project must earn to
increase firm value
SOURCES OF LONG TERM CAPITAL
1. COST OF LONG TERM DEBT
 The financing cost associated with new funds
raised through long-term borrowing
Net proceeds - Funds actually received by the firm from
the sale of a security
Flotation costs - The total costs of issuing and selling a
security

Underwriting cost - compensation earned by
investment bankers for selling the security

Administrative cost – issuer expenses such as
legal, accounting, and printing
BEFORE-TAX COST OF DEBT
 The before-tax cost of debt, rd, is simply the rate
of return the firm must pay on new borrowing
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3. COST OF COMMON STOCK
 the rate at which investors discount the expected
common stock dividends of the firm to determine its share
value
USING THE CONSTANT-GROWTH VALUATION MODEL
 Assumes that the value of a share of stock equals
the present value of all future dividends (assumed to grow
at a constant rate) that it is expected to provide over an
infinite time horizon
AFTER-TAX COST OF DEBT

Unlike the dividends paid to equity holders, the
interest payments paid to bondholders are tax deductible
for the firm, so the interest expense on debt reduces the
firm’s taxable income and, therefore, the firm’s tax liability.
USING THE CAPITAL ASSET PRICING MODEL
 describes the relationship between the required
return, rs, and the nondiversifiable risk of the firm as
measured by the beta coefficient, b
2. COST OF PREFERRED STOCK
 is the ratio of the preferred stock dividend to the
firm’s net proceeds from the sale of the preferred stock
4. COST OF RETAINED EARNINGS
 to the firm is the same as the cost of an equivalent
fully subscribed issue of additional common stock
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COST OF NEW ISSUES O F COMMON STOCK
 determined by calculating the cost of common
stock, net of underpricing and associated flotation costs
underpriced – stock sold at a price below its current market
price, Po
CAPITAL BUDGETING
 The process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of
maximizing owners’ wealth
MOTIVES FOR CAPITAL EX PENDITURE
Capital Expenditure - an outlay of funds by the firm that
is expected to produce benefits over a period of time
greater than 1 year
WEIGHTED AVERAGE COS T OF CAPITAL
 reflects the expected average future cost of capital
over the long run. It is found by weighting the cost of each
specific type of capital by its proportion in the firm’s capital
structure
Operating expenditure - An outlay of funds by the firm
resulting in benefits received within 1 year
CAPITAL BUDGETING PROCESS
1.Proposal generation
2. Review and analysis
3. Decision making
4. Implementation
5. Follow-up
BASIC TERMINOLOGY AP PROACH
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
Independent projects - those whose cash
flows are unrelated to (or independent of) one another;
the acceptance of one project does not eliminate the
others from further consideration

Mutually exclusive projects - those that have the same
function and therefore compete with one another so
that the acceptance of one eliminates from further
consideration all other projects that serve a similar
function

Unlimited Funds - The financial situation in which a firm
is able to accept all independent projects that provide
an acceptable return

Capital rationing - The financial situation in which
a firm has only a fixed number of dollars available for
capital expenditures, and numerous projects compete
for these dollar

Accept-reject approach - The evaluation of capital
expenditure proposals to determine whether they meet
the firm’s minimum acceptance criterion.

Ranking approach - The ranking of capital expenditure
projects on the basis of some predetermined measure,
such as the rate of return
Decision Criteria

If the NPV is greater than $0, accept the project
 If the NPV is less than $0, reject the project
CAPITAL BUDGETING TE CHNIQUES
NPV AND THE PROFITABILITY INDEX
 For a project that has an initial cash outflow
followed by cash inflows, the profitability index (PI) is
simply equal to the present value of cash inflows divided by
the initial cash outflow:
PAYBACK PERIOD
 the amount of time required for the firm to
recover its initial investment in a project, as calculated from
cash inflows
 the payback period is generally viewed as an
unsophisticated capital budgeting technique, because it
does not explicitly consider the time value of money
Decision Criteria
 If the payback period is less than the maximum
acceptable payback period, accept the project
 If the payback period is greater than the maximum
acceptable payback period, reject the project
Decision Criteria:
Note: The length of the maximum acceptable payback
period is determined by management. This value is set
subjectively.
 When companies evaluate investment
opportunities using the PI, the decision rule they follow is
to invest in the project when the index is greater than 1.0
 NPV and PI methods will always come to the same
conclusion regarding whether a particular investment is
worth doing or not
INTERNAL RATE OF RETURN
 one of the most widely used capital budgeting
techniques. The internal rate of return (IRR) is the discount
rate that equates the NPV of an investment opportunity
with $0 (because the present value of cash inflows equals
the initial investment). It is the rate of return that the firm
will earn if it invests in the project and receives the given
cash inflows.
NET PRESENT VALUE
 A sophisticated capital budgeting technique; found
by subtracting a project’s initial investment from the
present value of its cash inflows discounted at a rate equal
to the firm’s cost of capital
 Mathematically, the IRR is the value of r in that
causes NPV to equal $0
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 Financial leverage - concerned with the
relationship between the firm’s EBIT and its common stock
earnings per share (EPS). Taxes are clearly variable, rising
and falling with the firm’s profits, but interest expense and
preferred dividends are usually fixed. When these fixed
items are large (that is, when the firm has a lot of financial
leverage), small changes in EBIT produce larger changes in
EPS.
Decision Criteria:

If the IRR is greater than the cost of capital, accept
the project

If the IRR is less than the cost of capital, reject the
project
 Total Leverage - is the combined effect of
operating and financial leverage. It is concerned with the
relationship between the firm’s sales revenue and EPS.
BREAKEVEN ANALYSIS
 also called cost-volume-profit analysis, (1) to
determine the level of operations necessary to cover all
costs and (2) to evaluate the profitability associated with
various levels of sales.
Operating breakeven point - level of sales necessary to
cover all operating costs. At that point, earnings before
interest and taxes (EBIT) equals $0
FORMULA for Operating breakeven point:
LEVERAGE AND CAPITAL STRUCTURE
Leverage - refers to the effects that fixed costs have on the
returns that shareholders earn
Capital Structure - The mix of long-term debt and
equity maintained by the firm
Operating leverage - use of fixed operating costs to
magnify the effects of changes in sales on the firm’s
earnings before interest and taxes
Degree of Operating Leverage - a numerical measure of the
firm’s operating leverage. It can be derived using the
following equation
 Operating Leverage - is concerned with the
relationship between the firm’s sales revenue and its
earnings before interest and taxes (EBIT) or operating
profits. When costs of operations (such as cost of goods
sold and operating expenses) are largely fixed, small
changes in revenue will lead to much larger changes in EBIT
Whenever the percentage change in EBIT resulting from a
given percentage change in sales is greater than the
percentage change in sales, operating leverage exists. This
means that as long as DOL is greater than 1, there is
operating leverage.
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