INTRODUCTION TO FINANCIAL MANAGEMENT
CHAPTER 1
INTRODUCTION TO
FINANCIAL MANAGEMENT
It is
a well-known fact that engaging in business
is like
gambling, it is too risky. There are possibilities that your
investments will gain profits but there are also chances that
you will end up losing.
There is
need to have enough capital in putting up a business
to be used for operations and investments. The business may
be in the form of sole proprietorship, partnership or
corporation. In addition, these capital or funds must be
managed properly in order to attain the operating and
financial objectives of the business. In a corporate form of
business, there is a need to employ separate managers who
will govern the business in behalf of the owners, known as
a
shareholders. These managers, as agents, are given the power
to decide on the investments, finance and operations of the
corporation.
In this chapter, we will introduce financial management by
discussing the following:
The kinds of business organization and their goals
Different
characteristics
of
these
business
organizations
Different kinds of corporations that are acceptable
and not acceptable under Philippines laws
Who are the financial managers and what are their
roles in the company
What is
agency conflict and the how such conflicts be
resolved
Priority between ethics and profit goals
Financial Management is
the process
of planning, directing,
organizing, controlling and monitoring
resources in
of the
monetary
order to achieve objectives and goals of the
INTRODUCTION TO FINANCIAL MANAGEMENT
business. The financial
managers are responsible for
the
management of these monetary resources of the business.
I.
Kinds of Business Organizations:
A.
Sole Proprietorship is regarded as
the
simplest form of
business organization. This is owned by an individual,
known as the sole proprietor, who has the full authority
in managing the assets of the business. This kind of
business organization is subject to fewer government
regulations
as
compared
to
partnership
and
corporation. Thus, the registration is only through the
Department of Trade and Industry (DTI) and the
business income is not subject to separate taxation.
However there are disadvantages of forming a sole
proprietorship. One of which is the unlimited liability of
a
sole
the
proprietor. In this case, the debts and losses of
business shall be borne by the personal assets of
owner in
time
the
of bankruptcy. Another disadvantage is
the limited life of the business because the death of the
sole
proprietor
leads
to
termination
of
the
proprietorship. Lastly, the amount of capital raised is
significantly limited since the source of the funds of the
business
is limited only the sole proprietor unlike in the
case of partnership and corporation.
B.
Partnership, as provided by the New Civil Code (NCC) of
the Philippines, is
a
contract of two
who bind themselves
industry
to a
to
or
more persons
contribute money, property or
common fund, with the intention of
dividing the profits among
themselves. Two
or more
persons may also form a partnership for the exercise of
profession. More so, the partnership has a juridical
INTRODUCTION TO FINANCIAL MANAGEMENT
personality separate and distinct from that of each
partners (Article 1767-1768 of NCC)
A
partnership may be constituted in any form, whether
oral or written, except where immovable property
real rights
are
contributed thereto, in which case
or
a
public instrument shall be necessary. In addition, the
contract of partnership having
Thousand Pesos
a
capital of
(P3,000) or more,
in
Three
money
or
property, is required to be:
1) In public instrument and
2) Recorded in the Office of the Securities and Exchange
Commission (SEC).
However, the failure
to
comply with the above
requirements shall not affect the liability of the
partnership and the members thereof to third persons.
(Article 1771-1772 of NCC)
Partnership may be classified
partnership. In
have
a
as
General or Limited
general partnership, all the partners
unlimited liability like the sole proprietor, wherein
creditors of the partnership may have claim® against the
separate assets of the partners for payment of debt in
case of bankruptcy. However in
there are
a
limited
partnership,
partners known as limited partners that have
liability to the creditors only up to the extent of their
capital contribution, thus, their separate assets are safe
from the claims of these creditors.
Like Sole Proprietorship,
the life of the partnership is
also limited in a sense that death of one of the partners
will result to the dissolution of the
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partnership.
INTRODUCTION TO FINANCIAL MANAGEMENT
The following are the usual causes of dissolution of the
partnership:
Retirement of a partner/s
1.
2. Admission
of a partner/s
3.
Incorporation of partnership®
4.
Death
of a partner/s
An advantage of partnership is that there is usually
capital
more
raised
as
compared
proprietorship because of larger
to
the
sole
number of source of
capital. On the contrary, it has less capital compared to
corporation. Moreover, it is subjected to 30% corporate
income tax since the Tax Code of
the Philippines does
not distinguish, for tax purposes only, a partnership
from corporation.
C.
Corporation, as provided by the Corporation Code of the
Philippines (CCP), is an artificial being created by the
operation of the law, having the right of succession and
the
powers,
attributes
and properties expressly
authorized by law or incident to its existence. (Section 2
of
CCP)
more
This
juridical entity is composed of five (5) or
natural persons, not exceeding fifteen, who are
called incorporators and it must be also be registered
with the Securities and Exchange Commission (SEC).
Corporation is regarded as the most complex form of
business
organization because of its fund raising
capabilities, unlimited life and being subject
to stricter
government regulations. The owners are referred as
shareholders of the
liability. Hence,
corporation who have limited
the claim of the
corporate creditors is
only up to the amount of capital investments of
these
shareholders and the personal assets of the latter are
INTRODUCTION TO FINANCIAL MANAGEMENT
not subject
to
appropriations. These shareholders,
unlike partners, can sell their ownership to existing
shareholders or new investors without the need to
secure the consent of the other shareholders. Thus,
there
is an ease of transferring ownership
corporate form of business. However, one
in a
of the
drawbacks of this form of business is the so called dual
taxation
subject
owners
wherein the income of the corporation
to
corporate tax while
or
the
is
earnings of the
shareholders are subject
to
separate
individual income tax.
FIGURE 1-1: The Characteristic of Business Organizations:
Characteristics of
Sole
Business
Proprietorship
Partnership
Corporation
Partners
Shareholder
Organization
1. Owner(s) are
Manager
called
S
2. Owner and
NO
NO
YES
Unlimited
Unlimited
Limited**
NO
YES*
YES
Limited
Limited
Unlimited
managers are
separate
3.
Owner's
Liability
4. Separate
taxation
5. Life of the
Business
*Except in General Professional Partnership (GPP), because this
partnership will not be taxed like a corporation. According to
Section 22(B)
of the NIRC, "general professional partnerships
are those formed by person for the sole
purpose of exercising
their common profession, no part of the income of which is
derived from engaging in any trade
or
business. Moreover, for
INTRODUCTION TO
tax
FINANCIAL MANAGEMENT
purposes, the term "corporation" shall include partnership,
no matter how created or organized, joint- stock companies,
joint venture accounts (cuentas en participacion), association,
or
insurance companies
but does not include general
professional partnerships and joint venture or
formed for the purpose
consortium
of undertaking construction projects or
engaging in petroleum, coal, geothermal or
other energy
operations pursuant to an operating consortium agreement
under service contract with the Government" Hence, as an
exception GPP's income is not taxed separately using the
30%
corporate income tax.
***
Except when the doctrine of piercing the veil
of corporate
fiction applies.
The
said doctrine
shall
disregard the
separate
personality of the corporation because the
corporate fiction was used as a shield
veil of
to perpetuate
fraud, justify wrong, defeat public convenience or defend
crime.
The effect of this doctrine is to make the directors,
officers and shareholders, involved in fraud or crime,
liable for the
obligation of the corporation. (Sundiang-Aquino
Reviewer on Commercial Law, 2006 ed..pp.236-237).
Types of Corporation:
A. As to legal status:
De Jure
Corporation - this is a corporation organized in
accordance with the law. There is
a strict
or substantial
compliance with the statutory requirements
incorporation. Hence,
it exists in fact and in law.
for its
INTRODUCTION TO FINANCIAL MANAGEMENT
De Facto Corporation -
this is a corporation that exists
only in fact but not in law because there is
a
flaw in its
incorporation. Hence, it has no legal right to corporate
existence as against the state.
B. As to
functions and governing law:
Public Corporation - these are organized by the state
for the government to promote general welfare of the
public.
These
are
governed by Special laws and the
Local Government Code of the Philippines.
Private Corporation
individuals for the
are
C.
-
these are organized by private
purpose of generating profit. These
governed by the Law on Private Corporation.
As to existence of stocks:
Stock Corporation
A corporation
in
which capital
divided into shares and is authorized to
stock is
distribute to the holders thereof of such shares
dividends
or
allotments of
the surplus profits on
the
basis of the shares held. (Sec. 3 of the Corporation Code
of the
Philippines).
The
owners
are
called
as
shareholders or stockholders.
Non-stock Corporation - A corporation which has
stocks issuances
no
and no distribution of dividends to its
members. However, a corporation is not automatically
considered as
a
stock corporation if there is a statement
of capital stock. The Supreme Court ruled that if the
dividends are not supposed to be declared or there is no
distribution of retained earnings, the corporation
is still
a non-stock corporation. Moreover, the owners are
called members. (Sundiang-Aquino, Reviewer on Commercial Law
2006 ed., pp.243-246.
INTRODUCTION TO FINANCIAL MANAGEMENT
D.
As to shares being traded in stock exchange:
Publicly listed Company- this is a corporation whose
shares are offered to public or traded in the Philippine
stock exchange. Hence, this corporation undergoes
initial public offering (IPO).
Privately owned Company - this is
shares
this is
a
corporation whose
are not traded in the stock market. Moreover,
a
corporation "going private" because it restricts
the stockholders to a certain group, usually, family
member. This is sometimes called a close or closely held
corporation or privately held Corporation.
The following corporations
are
not acceptable in Philippine
Law:
Limited Liability Company - this is
which
a business structure
combines the tax advantage of
a
partnership
(General Professional Partnership) and limited liability
advantage of a corporation.
Professional Corporation - this is composed of persons
with same professions such as Doctors, Lawyers or
Certified Public Accountants.
Goals of the Corporation:
People venture into business with the hope of gaining
profits and the fear of incurring losses. It
forms
of
business
organizations
is a fact that all
whether
sole
proprietorship, partnership or corporation has the goal
of maximizing earnings or profits. More so, having big
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INTRODUCTION TO FINANCIAL MANAGEMENT
profit signals good financial and operating performance
of the business. Thus,
of success of
profit maximization, as a measure
the business, may be
the
end goal of the
sole proprietor or the partners who personally manage
their business. However, for a corporate form of
business, this profit maximization is
just
a
means to an
ultimate end goal of the corporation.
The shareholders of
from
the corporation will earn
income
their capital investments through dividend yield
and capital gains yield. The former is earned through
dividend declarations approved by the board of
directors (BOD) while the latter is through selling of
stocks or
ownership to either prospective investors
existing stockholders at
a
or
gain. This is when the stock
price is higher than the cost of investment. (in depth
discussion on dividend and capital gains yield will be on
Chapter 7 - Stock Valuation)
In
connection with this, the ultimate goal of
corporation is shareholder's wealth maximization.
is sometimes referred to as
stock price
This
maximization.
the increase in the value of stock price resulting
capital gains that shareholders will yield on
investments.
This
is
one
of
the
a
reasons
to
their
why
shareholders want the financial managers to maximize
the market value of the firm and not just to maximize its
profits.
The market value of the firm depends on the good
decision making of the financial managers regarding the
company's activities such as investment, financing and
operations. Moreover, the condition of the global
economy, inflation
rates, taxes and laws imposed upon
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INTRODUCTION TO FINANCIAL MANAGEMENT
the firm and the volatility of the
factors
The goal
stock market
are
that significantly affect the said market value.
of maximizing the market value of the corporation
is
more important than the goal of maximizing profits because of
the following reasons:
In
maximizing the market value of the corporation,
discount rate
which reflects the risks of capitalization
and the time value of money is taken into consideration
while profit maximization does not consider such.
In maximizing future profits, the company may opt
to
its dividend declaration and
decrease and postpone
instead, it will reinvest the freed up cash. If the
reinvestment is too risky and will not be successful, this
will
be
detrimental
to
the shareholders.
Thus,
shareholder's wealth is not maximized.
The following are the inappropriate
ways on how
management maximizes the profit of the corporation:
a) Management wants to
accelerate sales
by
materially increasing the selling prices of the goods
offered to the consumers, or
b) Management wants to reduce expenses by
cutting wage rates of the laborers or buying cheaper
materials for
production.
These methods
of maximizing profits will have
a
negative impact on the future earnings of the company
and
will result to agency conflicts.
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INTRODUCTION TO FINANCIAL MANAGEMENT
Stock price or market value
per share considers both
cash flows for the current and future years. Profit on the
other hand, may refer to either current year's profit or
future year's profit.
If the goal is profit maximization,
the question is which year's profit are we referring to?
For example, the company may maximize current year's
profit by decreasing advertising and promotion cost.
However, this may decrease the future years' profit
because sales of new products in the future
may be
decreased by these costs cutting done in the current
year.
The profit computation varies depending on
the
purpose. Thus, there are differences in the computation
of profit for tax purposes and profit for accounting
purposes.
IV.
Financial Managers of the Corporation:
Financial managers are employees who are responsible
for managing the monetary resources of the corporation
in order to maximize firm's value. They are also
responsible for dealing with the different
financial
markets such as stock market or bond market; and with
financial institutions like banks. These managers, who
are
the agents of the shareholders (owners), are given
the authority to perform investment, financing and
operating decisions that will benefit the corporation.
Generally, the Financial Managers are:
Board of Directors (B.O.D.) - They are direct owners and
are elected by the shareholders to
corporation.
They
are
13
charged
manage
with
the
ultimate
INTRODUCTION TO FINANCIAL MANAGEMENT
governance
of the corporation. Thus, they have
ultimate responsibility for
the
deciding on highly important
financial matters of the corporation. Moreover,
BOD
decides on when to declare and how much dividends
per share to distribute.
Chief Financial Officer (C.F.O) - also known as the Vice
President
for
Finance
(VP-Finance),
who
has
responsibility over financial planning and formulation
of
financial corporate strategies. Under his supervision
are the Treasurer and the Controller.
Treasurer - one who focuses on the financial
the
aspect of
corporation; wherein he has the responsibility on
raising and managing the capital or funds of the
company.
Moreover, he is responsible for transacting
and maintaining good relationship with various banks;
and the formulation of the company's credit policies and
collection.
Controller
- One who focuses on the accounting and
budgeting aspect of the corporation; he is responsible
for the custody
of
financial records, preparation of the
financial statements, and interpretation of financial
data. Moreover, he is responsible for the management of
the budget for the efficient usage of funds.'
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INTRODUCTION TO FINANCIAL MANAGEMENT
FIGURE 1-2:
To present the line of authority of these financial
managers, the
organizational structure
of the firm is shown
below:
BOARD of DIRECTORS
VP- Audit
Chief Executive Officer (CEO)
VP-Manufacturing
Chief Financial Officer (VP- Finance)
Controller
Treasurer
V.
VP - Sales
General Role of Financial Manager:
It is noted previously that financial managers
are
responsible for managing the monetary resources of the
corporation. Managing these resources
much fund should be invested
means
in the acquisition
how
of real
assets, how much fund shall be retained and plowed
back to the corporation or how much shall be paid
as dividends to the shareholders. Moreover, it is
out
the
responsibility of these financial managers to raise
additional capital or funds to support the
and
investments
operations of the corporation.
Therefore, the financial managers shall perform
these
roles which are geared towards the attainment of the
ultimate goal
of the corporation:
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INTRODUCTION TO FINANCIAL MANAGEMENT
Investing Decision
The investments made by these
financial managers should provide benefit to
the
corporation in the future. This should be the main
consideration of the managers when investing in
tangible assets such as machineries,
investments in financial assets
intangible assets such
as
land
or
building;
or investing
in
the
patent, trademarks or
copyright. Thus, investing decision, also known as
capital budgeting, answers the question: 'what assets
should the corporation acquire in order to provide
better returns in the future'.
In addition, the amount or percentage return as well as
the
period when to realize the said return, are
important factors in deciding whether to accept
or
reject the investment.
Financing Decision
There
are many investment
opportunities that financial managers may encounter as
they manage the monetary resources of the corporation.
However, one of the main constraints of these managers
is the scarcity of available capital. This normally results
to forgone investment opportunities. Hence,
in order to
finance these investments the financial managers
should
raise capital or money through its financing
activities. Generally, the financial managers accumulate
funds through the following means:
1.) Performing long term financing through bank
loans if the prevailing interest rate is not high; or
2.) Issuance
of financial assets such as share of stocks
(equity security) or bonds (debt security).
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INTRODUCTION TO FINANCIAL MANAGEMENT
company accumulates
In issuing share of stocks, the
fund through selling certificates
corporation to the prospective
of
ownership
investors or
of the
existing
shareholders. The cash received from these investors
will form part of the capital
of
the corporation and
return, the latter will distribute profits to
in
the
shareholders through dividend payments. On the
contrary, the issuance of bonds to the investors known
as bondholders does not indicate selling of ownership
but rather signifies borrowing
of
funds.
These
bondholders are not owners but creditors of the
corporation who receive interest payment instead of
dividends. Hence, financing decision answers the
question: "how to raise funds in order to finance
the
investments and operating activities of the firm.
Operating Decision
-
In order to
support the daily
transactions or operations of the corporation,
financial managers should decide
these
on how much funds
should be allocated to each of its operating units. Funds
raised through financing decision are not only used for
the acquisition
of
real assets or long term investments
but also for operating expenses
These are
of
the corporations.
payments for the salaries and wages of
the
employees, overhead costs, acquisition of materials
used for
production and etc. Hence, operating decision
answers the question: 'how much funds will
allocated to support the
firm.
17
be
day to day transactions of the
INTRODUCTION TO FINANCIAL MANAGEMENT
VI.
Resolution of Agency Problem:
the
Agency conflicts are problems between
principal
and agent of the company. The conflicts arise when the
financial managers (agents) prioritize their
own
personal interest rather than the best interest of the
shareholders of the company (principal). The existence
of these agency conflicts is
detrimental on the part of
the shareholders.
Thus, the following are solutions to mitigate if not
to
eliminate conflicts between the managers and the
stockholders:
Compensation Plans
-
the compensation plans may
differ among the companies depending on its capacity
in terms of finances. As part of its compensation plan,
the companies
such
as
would offer incentives to their managers
additional bonuses, percentage interest in net
income of the company and stock options. These
top of the annual
basic salary
of
are on
the managers. These
incentives are provided in order to motivate these
managers
to perform
better so
that the goal of
maximizing the value of the firm may be achieved.
Say for instance, in comparing the compensation plan of
the Chief Executive
companies: X and
Officers
(CEO)
of the two
Y. If the CEO of Company X is given an
additional incentive of 5% of the
normal profitability
of the
net income above the
corporation aside from his
basic salary while the CEO
of
Company
Y
is only
provided with annual salary of similar amount, we
assume that the former is
more
driven
performance than that of the latter.
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to
can
improve his
INTRODUCTION TO FINANCIAL MANAGEMENT
However, these compensation plans sometimes provide
pressure to
the managers wherein it results
to
the
commission of fraud. Say for example, if the CEO of
Company X prioritizes his personal interest
and wants
to gain additional incentives, he can manipulate or
window dress the statement of comprehensive
income.
Therefore, these compensation plans, if not taken
appropriately, shall motivate the managers to commit
fraud instead of maximizing the value of the firm.
Threats as to change in Board of Directors - these
Board
of Directors (BOD) who are responsible for the ultimate
governance of the corporation are elected by the
shareholders.
They
participants because
participate during
business day
board is
considered
are
of
most
board
passive
would only
meeting and not during
of the company. Having a position in the
not a
permanent. The shareholders have the
power to elect new set of BOD
with
them
as
if they are not satisfied
the performance of the board particularly
on
how
they manage the business. Threatening the members of
the BOD may motivate them to become active in
governing the corporation.
Threats as
to Management Takeover
managers who
~
the top level
are responsible for the daily governance
of the corporation are merely appointees of the Board
of
Directors (BOD). These managers are employees of
the
corporation wherein they
can
be terminated or
replaced if they fail to deliver what is due to the
corporation. Management takeover indicates that the
old
management team
is
replaced by the
new
management. Threatening the old management may
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INTRODUCTION TO FINANCIAL MANAGEMENT
motivate them to improve their poor performance and
drive them to manage the business well.
Legal
Regulatory
and
requirements
these
requirements imposed upon the corporation, especially
those
on
publicly listed companies, aim to provide security
the part of
the shareholders or investors. Say for
example, one of the regulatory requirements of
Securities and Exchange Commissions (SEC)
publicly listed corporations is
Financial
Statements
Statements.
(FS),
the
In
to file
upon the
an annual audited
auditing the
external
substantial and appropriate data
to
the
Financial
gather
auditors
support the claims
of the management as regards the presentation of the
said Financial Statement. Then, the external auditors
will provide an
opinion, qualified or unqualified,
regarding
said
the
financial
statement.
This
requirement assures that the financial statements
prepared by the management are reliable and that there
is
no
material misstatements done. Therefore, this will
prevent the management from committing acts that are
against the interest of the owners such as fraud.
Specialist Monitoring - It is assumed that employees will
perform their functions well if they are monitored by
their superior. However, monitoring of performance
not
solely within the corporation because
is
the external
parties such as investors or creditors may also
examine
the performance of the company.
Say for example, the corporation
is in need of funds and
the financial managers opt to apply for a loan in a bank.
Before the application for a loan is granted, the bank
shall initially examine the capacity of the debtor to pay
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INTRODUCTION TO FINANCIAL MANAGEMENT
its debt. Hence, if the bank lends money to
the
corporation, this signifies a healthy financial condition
of the company.
Conflicts between Stockholders and Bondholders:
Aside from the conflicts between financial managers
and stockholders, there are also conflicts between the
two
sources
funds.
of
stockholders
The
and
bondholders are investors of the firm's equity and debt
securities
respectively. As regards their conflict,
the
stockholders, as owners of the firm, want the financial
managers to invest in risky investments while
the
bondholders, as lenders of the firm, oppose to risky
investments. It should be noted that bondholders have
fixed income from interest payments of the firm while
the stockholder's income depends
on the dividend yield
and capital gains yield. The former
on
is more concerned
the capacity of the firm to pay interest irrespective of
the result of the firm's operations and investments
while the latter
which
is concerned on the dividend payments
is usually dependent on the results of the firm's
operations and investments.
Say for example,
have the option
if
the financial managers of the firm
to
invest its P 100 Million in the
following unit investment trust funds (UITF):
a.
100% equity fund (High Risk)
b.
50% equity or 50% debt (balanced fund)
C.
100% debt fund (Low Risk)
Normally, the stockholders, as risk takers, would want
the P100 Million to be invested in 100%
equity fund
because the said fund has the highest risk which will
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INTRODUCTION TO FINANCIAL MANAGEMENT
provide the highest return. Hence, if the result of
investments is
which
positive, the firm will gain high returns
shows that the expected dividends
distributed is
be
to
also high.
On the other hand, the bondholders want the managers
to invest the P100 Million in
lower risk investment
such as the 100% debt fund or the balanced fund which
provides
a
lower
return. For bondholders, they are
already assured of the fixed interest income as long as
the firm is solvent. Thus, they want the managers to
choose a low risk investment in order to avoid high
losses and still maintain its solvency.
In determining the optimal capital structure, we will
learn that
the firm may be classified
as
unlevered
(without debt) and levered (with debt). More so, the
additional issuances of debt securities in order to
accumulate more funds make the firm more risky.
connection
with
and
this,
another conflict
stockholders
may
In
between
arise.
The
Bondholders, as risk averse investor, would protect
their interest
by entering into a bond covenant
restricting the firm from issuing additional debt
securities.
In addition, they would opt
to raise funds
through additional stock issuances in lieu of additional
debt. On the other hand, the stockholders, as risk takers,
would approve the manager's decision to increase debt
securities rather than stock issuances because the latter
may dilute their stock ownership. (Brigham-Houston
Fundamental of Financial Management, 13th ed.)
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INTRODUCTION TO FINANCIAL MANAGEMENT
Ethical Considerations:
It is true that the ultimate
goal of the corporation is
maximizing the firm's market value or the maximization
of the shareholder's wealth. This goal should be
achieved not through fraudulent acts but in an ethical
manner of doing business. Moreover, the
company
should maintain its Corporate Social Responsibility
(CSR) at all times such as avoiding things that has
adverse effects in the society and to the people. Ethics
and the goal
of maximizing shareholder wealth
generally lean towards similar ends because ethical
behavior builds good reputation that will benefit the
organization in the long run. However, in case of conflict
between ethics and profit goals, the former shall prevail
because unethical dealings will provide results
taint the
that
goodwill of the company.
Say for example in the United States, the WorldCom
bankruptcy in 2002 was marked
as one
of the top
business scandals wherein the management led by CEO
Bernie Ebbers fraudulently inflated
assets by $11 billion
and overstated the income of the company by $3.8
billion. The material misstatement is due to the failure
of the management to report such amount as
operating
expenses. Moreover, WorldCom first reported the said
amount as
capital expenditures rather than operating
evident that the management of the
company window dressed the financial statements by
expenses. It
is
presenting a good financial performance but in fact the
business is already bankrupt. Due to this business
scandal, US Congress passed the so called Sarbanes-
Oxley Act which set
regulation.
23
a
more
stringent
business
INTRODUCTION TO FINANCIAL MANAGEMENT
In the Philippines, there are lots of business scandals
which must be addressed by the government. One of
which is
the Globe Asiatique Fund Scam mastermind
allegedly by Mr. Delfin Lee. In this scandal, a developer,
with
good track record like Delfin Lee, was allowed by
Pag-ibig to process the loan application of their buyers,
then will forward to Pag-ibig for the release the funds,
thereby making the process faster. However, it turned
out that 60% of the P7 billion
were
lent
to
Pag-ibig funds for housing
the fictitious borrowers processed
fraudulently by Globe Asiatique. Now, irrespective of
the reasons
be
the management have in doing such, may it
a move to
still
save the company from bankruptcy, they
committed
a
fraudulent
and
unethical
act.
Therefore, the end no matter how noble, does not justify
the
means. (opinion.inquirer.net/how--globe-asiatique-scam-was-
done by: Neal H. Cruz, March 19, 2014)
24
INTRODUCTION TO FINANCIAL MANAGEMENT
CHAPTER EXERCISES
NAME
SCORE:
SECTION:
DATE:
TRUE or FALSE: Write X if the statement is true while M if false.
1.
Financial
Accounting is the process of planning, directing,
organizing, controlling and monitoring the monetary resources
of the company in order to achieve its objectives or goals.
2.
The ultimate goal of the corporation is maximizing its
market
value which is the same as shareholder's wealth maximization.
Profit maximization does not consider the discount rate which
reflects the risks
of capitalization and the time value
of money
unlike market value maximization.
4.
Profit maximization and cost minimization are goals of any
business organization.
5.
Profit maximization is the primary goal of
all
business
organization.
b.
Shareholder's wealth maximization may be obtained through
increase in
amounts of dividends declared and decrease of
company's stock price.
7. The roles of financial managers are to decide on its investing,
financing and operating activities.
8.
The treasurer's responsibility mainly focuses on the accounting
and budgeting processes.
9.
The controller's responsibility
is to
raise adequate funds and
maintain control of such funds for the company.
25
INTRODUCTION TO FINANCIAL MANAGEMENT
10. The Chief Financial Officer is also known as the Vice President of
Finance
Department who supervises the treasurer not
the
controller.
11. The board of directors is considered owners who are responsible
for the overall governance of the corporation.
12. Board of directors decides on
highly significant financial matters
of the firm while controller is responsible in the capital
budgeting aspect of the firm.
13. The external auditor not the controller has the ultimate
responsibility in preparing the financial statement of the firm
since they will provide
an
opinion whether qualified or
unqualified.
14. Funds raised
through financing decision are not only used for
investments but also for the funding of the operating expenses of
the corporations.
15.
In investing decision, the financial manager answers the question
how much fund must be raised in order to
finance the investing
activities.
16. The
financial managers decide on the operating activities
of the
firm wherein they allocate funds for the acquisition of
non-
current assets or real assets.
17.
Financing activities focuses on fund raising, an example of
is through
issuance of corporate bonds (equity security) or
which
share
of stocks (debt security).
18. The acquisition of raw materials and equipment is an example of
investing and operating activity, respectively.
19. The sole proprietorship business is subject to lesser regulations
as compared to the Corporation as a business.
26
INTRODUCTION TO FINANCIAL MANAGEMENT
20. The amount
of capital
of the
that of the partnership as
21. The Corporation
is a
a
corporation is usually smaller than
business.
legal entity created by
the state and is
a
direct extension of the legal status of its owners and managers,
that is, the owners and managers are the corporation.
22. De Facto Corporation
law because there is
23.
is a
corporation that exists in fact and in
no flaw in its incorporation.
Even if there is statement of capital stock but the dividends are
supposed to be declared, the corporation
not
is still a non-stock
corporation.
24. Closed
or Private Corporation, Public Corporation and
Professional Corporation are accepted in the Philippines.
25. The partnership form of organization has easy
transferability of
ownership as opposed to corporation.
26. One
disadvantage of forming a corporation is that shareholders
have limited liability.
27. Partnership must be registered in the Department of Trade and
Industry (DTI)
rather than Securities and Exchange Commission
(SEC).
28. The liability
of
a sole proprietor is unlimited while the
shareholder's liability is limited only up to the amount of
investment in stocks.
29. The limited liability characteristic of owners of the corporation is
subject to an exception called the doctrine of piercing the veil of
corporate fiction.
30. The
the
life of the corporation is limited only up
to
50 years while
life of a partnership business is unlimited since the original
27
INTRODUCTION TO FINANCIAL MANAGEMENT
partners
may transfer their ownership to their heirs through
succession.
31. The actions that maximize a firm's stock price are inconsistent
with maximizing social welfare.
32.
Limited Liability Company (LLC) is a new type of organization
that is
hybrid between
provides that they
are
partnership and
a
taxed and has a
a
corporation. This
limited liability like
a
corporation.
33.
The Limited Liability Company is not accepted in the Philippines
while the Limited Partnership is acceptable in the Philippines.
34.
Publicly listed company is
a
corporation whose shares
are
traded
in the Philippine stock exchange while privately owned
company's shares are not offered to the public.
35. Professional corporation, like General professional partnership,
is
composed
organization
in
of professionals and
is
acceptable business
the Philippines.
36. Financial Managers are agents of the Shareholders, the latter being
the real owners of
the corporation are principals.
37. If these agents do not
prioritize the interest of the principal
owners rather their own interest,
38.
agency conflicts may exist.
Compensating managers with stock can reduce the agency
problem between stockholders and managers.
39.
Paying these managers with large fixed salaries rather than
increasing the threat as to takeover can mitigate the agency
conflicts between stockholders and managers.
28
INTRODUCTION TO FINANCIAL MANAGEMENT
40. Threatening the old management may motivate them to rectify
their
poor performance and drive them to manage the business
well.
41.
There is a conflict between stockholders and bondholder
wherein the former wants the management
investments while the latter
42. Bondholders are
wants the less
providers of
take
to
risky
risky investments.
funds since
they invested in the
debt security issued by the firm, hence they are also deemed
as
owners of the firm.
43. Good reputation may be attained through ethical business
practices and is considered as the best advertisement.
44. The firm
should
always consider their corporate social
responsibility in doing business.
45. Unethical behavior will eventually lead
to failure of achieving
organizations goals as mirrored by the results of this
the
behavior on
Enron and WorldCom.
46. Ethics and the goal of maximizing
lean towards of
shareholder wealth generally
opposite ends since managers of
an
organization
would not profit from ethical behavior.
47. If there
are conflict between profit maximization and ethical
consideration, the latter must prevail.
48. If there are conflict between shareholder's wealth maximization
and ethical consideration, the former should prevail.
49. One of the ways to minimize losses is to window dress the
financial statement in order to make it
prospective investors.
29
more attractive to
INTRODUCTION TO FINANCIAL MANAGEMENT
50.
The management in order to
save
the firm from bankruptcy may
perform unethical conduct since the end if
it is with noble
intention may justify the means.
51.
By allowing a culture of leniency towards any action, both legal
or
otherwise, the organization greatly allows itself to profit in the
long-run thereby able to maximize shareholder wealth in the
process.
52. There is
a
very small amount of incentive in
maintaining ethical
behavior in an organization.
53. Unethical behavior will
eventually lead to failure of achieving the
organizations goals as mirrored by the results of this behavior on
Enron and WorldCom.
54. An entity wishing to
ensure its
selection as a government
contractor should ensure that government officials receive
sumptuous gifts. The benefits of being selected as a government
contractor far exceeds the cost of the gifts provided and justifies
the action undertaken since it will all inure
to
the benefit of the
shareholders.
55.
The primary goal of a publicly-owned firm interested in serving its
stockholders should be to maximize expected EPS.
56. Restrictive covenants in
reduce agency
57.
debt agreements are an effective way
to
conflicts between stockholders and managers.
Managers generally welcome hostile takeovers since they often
increase the company's
58. One disadvantage
of
stock price.
forming a corporation is that your
shareholders have limited liability.
59. Relative to sole proprietorships,
regulations, but find
it easier to
corporations generally face more
raise capital.
30
INTRODUCTION TO FINANCIAL MANAGEMENT
60.
Bondholders generally want managers to select risky projects, but
shareholders prefer that managers select safe projects.
61.
Since they are guaranteed a
certain set of cash flows, corporate
bondholders generally want corporate
risk/high return projects.
62.
managers
The actions that maximize a firm's stock price
with maximizing social welfare.
63. The concepts
the
are
inconsistent
of social responsibility and ethical responsibility on
part of corporations
are
relevant in maximizing stock
64. One of the
to select high
completely different and neither is
price.
ways in which firms can mitigate or reduce agency
problems between bondholders and stockholders is by increasing
the amount of debt in the
capital structure.
65. The threat of takeover is
way in which the agency problem
between stockholders and managers can be alleviated.
66.
one
Managerial compensation can be structured to reduce agency
problems between stockholders and managers.
67. The threat of a takeover can reduce the agency problem between
bondholders and stockholders.
68.
Closed/Private
Corporation,
Public
Corporation
and
Professional Corporation are accepted in the Philippines.
69. In part due
to
limited liability and ease
of
ownership transfer,
corporations have less trouble raising money in financial markets
than other organizational forms.
70. The ultimate goal of a publicly-owned firm interested in serving its
stockholders should be to increase profits and decrease costs.
"THAT IN ALL THINGS, GOD MAY BE GLORIFIED"
31
FINANCIAL ENVIRONMENT
CHAPTER 2
FINANCIAL ENVIRONMENT
In chapter 1, we have learned that the ultimate goal of the
corporation is maximization of its market value or
shareholder's wealth maximization. One
achieve this primary goal
is
proper allocation of funds to
activities.
of the means to
maximize profits through
its operating and investing
to
However, there are times when firm's capital is not sufficient
to support its investments and operational activities wherein
there is a need to
raise additional funds through the utilization
financial markets, financial institutions or stockholders
infusing additional capital. Companies under financial distress
may engage in the issuance of its financial assets (debt and
equity securities) in the financial markets or borrow money
of
from the financial institutions.
In this chapter, we will learn financial environments by discuss
following:
the
The different kinds of markets
The different financial intermediaries
The transfer of financial assets
Direct and Indirect
transfer
Stock market transactions
Stock market efficiency
Financial environments are factors and situations
that
primarily affect the financial aspects of the corporation. The
principal factors are the sources
of
financing through A)
Financial Markets and B) Financial Intermediaries.
The main source of funds used for investments and operations
from the savings of the investors. The financial managers
acquire these funds through equity financing and debt
come
financing. These financing transactions take place in the so
35
FINANCIAL ENVIRONMENT
called financial markets and with the intervention
of the
different financial intermediaries and institution.
On the other hand, there
are
other markets not classified as
financial markets but can affect the operating and investing
activities of the firm.
I.
Different types of markets
A. Financial Markets are the place where financial assets such
as Equity Securities (shares of Stock) and Debt Securities
(Bond certificates) are issued and traded.
1.
Stock Market -
this is a market where equity securities
are being issued and traded. In this market, the
stockholders may sell their stock investments
or
the
firm may issue additional stocks if the stock price is
overvalued or may purchase stocks if undervalued.
For
example,
if the firm has to raise funds but wants to
avoid high interest rate, the firm may issue equity
securities in this market.
2. Bond Market - this is a market where debt securities are
being issued and traded. This is also referred as the
fixed-income market because the investors or so called
bondholders receive fixed interest payments from their
investments
assuming they will hold the bond until
maturity or on a longer period of time.
For example, if the firm has to raise funds but the stock
price is undervalued, the firm may issue debt securities
rather equity securities in this market.
36
FINANCIAL ENVIRONMENT
3.
Money Market - this is
a market where short-term debts
with maturities of one year or less are used as a source
of financing.
An example of this short-term debt security
is
a
Treasury bill which is issued by the government with
maturity of one year or less.
4. Capital Market - this
market where long-term debt
is a
and equity securities are involved, for financing.
The examples of
the
long-term debt security are
Treasury note and Treasury bond wherein the former is
a debt security issued by
the
government usually with
maturity of more than one year but not
years while the latter
is
more
than 10
a debt security issued by
the
government with maturity of more than 10 years.
B.
Other markets:
1. Physical Market is also known as real asset or tangible
markets because the products involved are real estate,
property plant and equipment, inventories, etc. Hence,
those assets not
qualified as financial assets are sold
in
this market.
Say for example, the acquisition of raw materials to be
used for the manufacture of products takes place in this
market. In addition, if the firm has to expand its
operations and increase its production, the firm has to
purchase machineries in this market.
2. Spot Market - this is a market where assets or goods are
sold for and delivered on the spot or today. Thus, the
37
FINANCIAL ENVIRONMENT
determination of
price and delivery of goods is
on
the
same date.
An example is when a rice dealer went to the farm
during harvest to purchase all the harvest at an agreed
price and to be delivered on the same day; this takes
place in spot market.
Another
example
when
is
a
Philippine
based
corporation purchased inventories on February 14,
2017 from
a US based corporation to be imported and
paid on March 3, 2018, the Philippine corporation
to
has
pay in US dollars. This is an example of an exposed
liability position (ELP) where the amount of accounts
payable changes as the
exchange
changes.
rate
Therefore, there is a need to purchase foreign currency
to settle the accounts payable. The purchase of foreign
currency will be on the settlement date, March 3, 2018.
Thus, the determination of exchange rate (price) and
delivery of investment in foreign currency (US dollars)
is
on the spot.
3. Future Market - this is a market where future contracts
are
sold. A future contract is
a
contract that
gives the
purchaser an obligation to buy an asset (and the seller
an obligation
to
trade an asset) at a predetermined
price at a future date. Thus, the price is agreed today
but the delivery of goods is in the future.
An example is when
a
month before harvest
to
at an
rice dealer went to the farm
purchase all the future
agreed price today and to
38
harvest
be delivered on the
of harvest; this takes place in future market.
a
day
FINANCIAL ENVIRONMENT
Another example, is investing in a 1.) forward contract
or
2.) option contract (both hedge instruments) to
hedge foreign currency transaction (hedge item).
In a forward contract,
the exchange rate used to value
the purchase or sale of foreign currency is a forward
rate. Hence, the forward rate (price)
is
already
determined today but the delivery of the investment in
foreign currency (ex. US Dollars -$)
An option contract
value
is
is in the future.
an example of a derivative whose
is derived from the price of an "underlying" asset.
Option contracts are classified
as
call option (option to
buy) or put option (option to sell). This contract has
option price set at the inception of
which is
4.
an
the transaction
exercisable by the investor in the future, hence
making the transaction
under future market.
Private Market - this is
a market
agreement
where negotiation and
takes place personally between two parties.
Hence, making the contract unique or tailor-made.
Say for example, investing in a
life insurance is
personal
between the insured and insurer. The policy holder
being the insured while insurance company being
insurer.
Another
the
example of transaction that takes
place in a private market is when a depositor opens
a
savings or checking account in a bank.
5.
Public Market
-
this is a market where
a
security or
contracts with standardized features are being traded
and held by individuals.
39
FINANCIAL ENVIRONMENT
For
example,
in stock markets and bond
markets, the
securities (stock certificates and bond certificates)
issued
by the corporation have standard features.
Hence, making them available for trading
or
exchange
unlike the life insurance policy discussed above.
Financial Intermediaries:
Financial Intermediaries
provide financing
are
the
to
the organizations that
individuals, corporation or
other organizations by raising funds
or
money from:
investors.
1.
Mutual Funds (MF) money
from the
the investment company pools
investors
then
invests these
accumulated amount in a portfolio of securities whether
equity (shares of stock), debt (bonds) or money market
(short term securities). In Mutual Fund, the investors
purchased shares of the investment company thereby
giving the former the right to receive dividends. The
body that regulates these mutual funds is the Securities
and Exchange Commission.
is
or
An example of mutual fund
Sun Life Balanced Fund, Philequity Peso Bond Fund
ALFM Growth Fund. (philpad.com/best-mutual-funds-
in-the-philippines-2015)
2.
Unit Investment Trust Fund (UITF)
the investment
company sells units of investment to the investors to
accumulate a trust fund. The trust fund may be invested
also in equity, debt or balance of equity and debt. Hence,
the investors
stock. The
own
units of investments not shares of
regulatory body which supervises
these unit
investment trust funds is the Banko Sentral ng Pilipinas.
An example of investment in
40
UITF is
the BPI Equity Index
FINANCIAL ENVIRONMENT
Fund
of
the
Bank
Philippine Island.
(philpad.com/mutual-fund-vs-uitt-similarities-andof
the
differences-advantages-and-disadvantages)
3. Pension Fund - these are pooled contribution from the
employees or from the employers that serves
as the
investment plans for the retirement benefits of the
employees. The accumulated funds may be invested
shares of stocks
the amount of
4.
or
in
in a mutual fund in order to increase
pensions received by the retirees.
Financial institution
this is a
kind of financial
intermediary that provide additional financial services
other than pooling and investing of funds. One type of
financial institution is
a
bank which may serve as debtor
and creditor at the same time
by accepting
cash
deposits from savers (borrowing) and providing loans
to individual or to other firms (lending). Another type
of financial institution is the insurance company that
sells protection against the losses from fortuitous
events like fire, accidents and death.
Transfer of Securities:
Direct Transfer
In a direct transfer of securities, the equity
securities evidenced by stock certificates and
debt securities evidenced by bond certificates
are issued directly
to the investors. In turn, these
investors pay directly to the issuing company.
Thus, the securities do not pass through the
possession of any financial intermediaries.
41
FINANCIAL ENVIRONMENT
Indirect Transfer:
In
an indirect transfer of securities, the issuing
company seeks the aid of the financial institution
to easily issue their securities to the investors,
thus there is mediation between the issuer and
the
investor. Moreover, the investor may acquire
securities from the intermediary that
are
different from what have been issued by the
corporation. Therefore, indirect transfers
of
securities are classified as:
Indirect transfer through
Investment Bank
the securities of the company are bought by
the
investment bank or
the
SO
underwriter with the intention of
them to a
called
reselling
prospective investor. The securities
of the issuing company will be in the
the investors. Thus, no
new
hands of
form of capital is
created.
Indirect
through
transfer
Intermediary
Financial
the securities of the company
are bought by these financial intermediaries
without the intention of
securities;
rather they
reselling the said
will sell their own
securities to the new investors. The securities
of the issuing company are
in the possession
of the financial intermediaries while the new
investors will get the
securities issued by the
financial intermediaries e.g. Investors will
receive the insurance policies issued by the
Insurance Companies. Thus, new form of
capital is created.
42
FINANCIAL ENVIRONMENT
IV.
Stock Market Transaction:
Stock
Markets are markets where shares of stocks of
corporation are sold to new investors and
or
existing stockholders. The Philippines had two stock
markets, namely: 1.) Manila Stock Exchange (MSE)
which was established on August 8, 1927; and 2.).
Makati
Stock
Exchange
(MkSE),
which
was
established on May 27, 1963. However, these two
markets were unified forming the Philippine Stock
Exchange on December 23, 1992 with eight (8)
constituent indices such
as:
PSE Composite Index (PSEi)
PSE All shares Index (ALL)
PSE Holding Firms Index (HDG)
PSE Industrial Index (IND)
PSE Financial
Index (FIN)
→
note
PSE Mining and Oil Index (M-0)
PSE Property Index (PRO)
PSE Services Index (SVC)
figure below illustrates the stock position of
portfolio investments with the performance of the
The
abovementioned indices.
43
FINANCIAL ENVIRONMENT
Figure 2-1: The Stock Market Index and Stock
Position of
investments
ACCOUNT BALANCES
MARKET INDEX
6,966.18
+55.84
ALI
67
FIN
92
(+0.81%)
IND
203
TURNOVER 4.59B
PRO
3,970.47
CASH
+18.15
6.584.67
+73.57
10.930.58
20.85
10.199.94
-3413
2.988.77
+25.69
1,513.77
+8.32
4,526.20
MARGIN/CREDIT
1.547.59 +12.37
0.00
BUYING POWER
4,526.20
YIEW PORTFOLIO
VIEW ORDERS
STOCK POSITION
BUY / SELL
BID PRICE
ASK PRICE
ASK VOLUME
.69
470
83.70
85.75
0.3400
87
46,700
18.50
18.88
5,300
0.0400
0.57
947,400
6.94
6.95
80,000
3.63
2,000
50.00
51.40
7,900
46.50
-0.2000
0.4283
15,300
46.50
47.00
7,500
2052.00
30.00
1.48
50
2,044.00
2,052.00
8,400
85.75
BUY I SELL
18.50
SELL
6.94
BUY I SELL
51.40
BUY ] SELL
BUY [ SELL
BID VOLUME
DIFF
LAST
CODE
BUY SELL
490,040
(SOURCE: www.bpitrade.com)
This figure shows that the investor has invested in the stocks
of the following company as shown in the
•
Bank of the
CODE column:
Philippine Island (BPI)
East West Bank (EW)
Petron Corporation (PCOR)
Philippine National Bank (PNB)
San Miguel Corporation (SMC)
Philippine Long Distance and Telephone Company
(TEL)
The LAST column shows the current stock price while the
DIFF column is the
peso value increase or decrease in the
said price of these stocks. The BID VOLUME column
displays the number
buyers want
to
of outstanding stocks that the willing
buy while the ASK VOLUME column is the
number of outstanding stocks that willing sellers want
to
sell. The BID PRICE column illustrates the stock prices that
buyers are willing to pay while the ASK PRICE column is the
stock prices that sellers are willing to accept. Say for
example, in BPI stock, the BID price is
44
P 83.70 while the
FINANCIAL ENVIRONMENT
ASK price is
P
85.75.
There will be a bargain between the
willing buyer and seller until they meet at an agreed price.
Now, if the BID equals to ASK price, say for example at
agreed price of P84.50, this will be new current market
price of the stock to be shown in the LAST column.
The following are the stock market transaction:
1. Initial Public Offering (IPO) Markets
are
markets where the stocks of a closely held
corporation, going public,
are offered to the
=
public for the first time. The closely held
corporations undergo IPO in order to
raise
additional capital to finance their operating and
investing activities. To aid these corporations in
going public,
the investment
purchase
the
banker may
offered shares
at
underwriter's price then sell them to public
at a
retail
all
new
price. Hence, this
transfer
is in the form of indirect
through investment bank. However, the
corporation may also undergo IPO through
direct transfer where individual investors may
place their respective bid prices and
corporation selling directly to them.
Generally, the IPO
the
transaction is classified as
primary market transaction since the new stocks
were
sold
shareholders.
to
the
An
public,
exception
who
is
are
when
new
the
outstanding stocks of the corporation owned by
the existing shareholders were sold to the public,
the IPO transaction is under a secondary market
transaction.
45
FINANCIAL ENVIRONMENT
2. Seasoned Offering
is the issuance of
additional
shares of stocks of the company after its first
time offering in order
to
finance the
capital
budget or to improve its capital structure. This
kind
offering may be done by family
corporations
3.
or
publicly listed corporations.
Primary Markets - are involved
with the issuance
or selling of new shares of stocks to the investors
through
the aid of the investment bankers. The
cash proceed from primary market transaction
goes to the corporation. Thus, the transactions in
this market change
the size
of the capital
structure of the company.
4.
Secondary Market - are involved with the sale of
the outstanding shares of stocks
to
the
existing
shareholders or to new investors. The cash
proceed from secondary market transaction goes
to
the selling shareholders, not the corporation.
Thus, the capital structure of the company is not
affected by the secondary market transactions.
To illustrate the stock market transactions:
In January 2, 2018, TRIPLE B CONSTRUCTION, a
family corporation engaged in construction
business, wants
to finance
to
raise additional fund in order
their additional capital expenditure.
To address their financial needs, the board of
directors decided to have the
corporation listed
in the Philippine Stock Exchange (PSE) so that
they can sell new stocks to the public.
On
February 1, 2018, TRIPLE B CONSTRUCTION
46
FINANCIAL ENVIRONMENT
sold its
shares to the public for the first time. The
outstanding and authorized capital stocks of the
corporation are 500,000 and 1,000,000 shares
respectively.
In
June 30, 2018 the TRIPLE B CONSTRUCTION,
now
a publicly listed company, sold additional
250,000 shares to fund their expansion projects.
Hence, the outstanding shares as of this date are
750,000.
One of
the stockholders, named Don Bernabe,
owned 200,000 shares. He sold half of his
ownership to his brother Mr. Jeffries on October
30, 2018. On the other hand, TRIPLE B
CONSTRUCTION repurchased the
remaining
100,000 shares of Don Bernabe On November
30, 2018.
Analysis of the transactions:
The Initial Public
Offering (IPO) was performed on
February 1, 2018.
The Seasoned Offering (SO) was after the IPO, in
this illustration, it was done on June 30, 2018
when
additional 250,000 shares were sold.
The IPO and SO are considered as sale of shares
under primary market transaction.
The sale of
Mr. Jeffries
outstanding shares by Don Bernabe to
on
October 30, 2018 is
a secondary
market transaction since the capital structure
firm is not affected.
47
of the
FINANCIAL ENVIRONMENT
The
stock repurchase by TRIPLE B CONSTRUCTION
from Don Bernabe on November 30, 2018
is
considered as primary market transaction because
such purchase affected the capital structure of the
firm.
Stock Market Efficiency:
Stock market may be considered as efficient
or
inefficient market. If the stocks market shows that
the market prices of the stocks are about equal
close
or
to intrinsic values, there is market efficiency.
In this situation, the stock price reflects all publicly
available information hence, are fairly priced. Thus,
Investors returns or losses under efficient market
are relatively low.
On the
other hand,
if the stock market is
inefficient,
the stock prices are considered to be highly
overvalued or undervalued. Hence, the investors are
not
confident
to invest unless they knew some
information over the others.
There are three levels of efficiency in Efficient
Market Hypothesis
(EMH) namely:
Weak form
this level shows that the
information regarding
past
or
historical
prices of a particular stock is not conclusive
in
predicting stock prices. Hence, an investor
cannot
the
beat the market by simply analyzing
past performances of the stock.
Semi-strong form
this level shows that all
the available public information is already
48
FINANCIAL ENVIRONMENT
incorporated in the stock prices. Hence, the
investors
cannot beat the market solely by
analyzing the published financial reports of
the company unless they have information
from company
insiders.
Strong form
this level show that investors
cannot beat the market
even
with insider
information. Hence, the investors in this
efficient market cannot earn high returns.
The stock prices can be classified as:
a) Market value - also known as perceived value, is
the price of the stock which is
in the market. In
currently traded
the Philippines, the market
prices of the stocks of publicly listed companies
are readily available in the Philippine Stock
Exchange (PSE).
b) Intrinsic value
stock. This is
this is the true value of the
the price that the willing buyer will
bid and willing seller will ask provided that all
necessary information
about the stock
available. The intrinsic value
can
is
be estimated
using either the a) Dividend Discount Model or
b) Corporate Valuation Model.
(In
depth
discussion regarding these models will be
on
Chapter 7 - Stock Valuation.)
If the so called market value (perceived value) is
equal
to
the intrinsic value (true value),
the
stock price is at equilibrium. Hence, the investor
is neutral as to selling or buying stocks.
49
FINANCIAL ENVIRONMENT
If the market value of the stock is higher than
the intrinsic value, the stock price is deemed as
overvalued. Thus, the stockholders are expected
to sell than to
buy shares.
If the market value is lower than the intrinsic
value, the stock price
is
investors are expected
undervalued. Hence,
to
the
purchase more shares
to take advantage of lower price. (BrighamHouston, Fundamentals of FINANCIAL MANAGEMENT
13th ed,
page 46-49)
50
FINANCIAL ENVIRONMENT
CHAPTER EXERCISES
NAME
SCORE:
SECTION:_
DATE:
TRUE or FALSE: Write X if the statement is true while M if false.
1.
Financial environments are factors and situations that primarily
affect the operating
2.
aspects of the corporation.
Financial Markets are where
physical assets such as stocks and
bonds are issued and traded.
3.
The firm may increase funds through the
issuance of debt
4.
sale
of equity security or
security in capital market.
The real asset or tangible markets are
where financial assets are
sold or traded.
5.
In a private market, the contracts
between two persons are with
standardized feature making it available for trade.
6.
An example of transaction
in a
private market is when an investor
signs a contract of deposit with
a bank, while trading of stocks
is
an example transaction in public market.
7.
Public Market is market where a security
or
contracts with
tailor-made features are being traded and held by individuals.
8.
Money Market is
a
financial market in which funds are borrowed
or loaned for short periods.
Capital Markets involve instruments with maturities
of longer
than one year.
10. In
a
secondary market the outstanding shares are sold by a
shareholder to an
investor thereby increasing the capital structure
of the corporation.
51
FINANCIAL ENVIRONMENT
11. If
the goods are
to
be delivered in the future
and the price is
determined today, it is a spot market transaction.
12.
Treasury bonds are long term debt securities issued by the
corporation which provides for
a
fixed interest income for more
than 10 years.
13. Treasury bills are debts of the government with
more
than 10
years of maturity.
14. Mutual
from
Funds are pooled contribution from the employees or
the employers that serves as the investment plans for the
retirement benefits
of the employees.
15. Spot Market is a market where assets or goods are delivered
today and the price of the said assets is determined today.
16. An example of spot market transaction is buying of foreign
currency using the forward
17.
rate.
A derivative is a contract whose value depends on the value
of an
underlying asset.
18. Option contracts are transacted
contract has
20.
future market because
an option price set at the inception
transaction which
19.
in the
of the
is exercisable by the investor in the future.
Call option contract gives the investor a right to sell if the option
price (exercise price) is greater than the market price.
In a Put option contract, it is said to be
"in the money"
transaction if
than
the exercise strike price (option price) is lower
the so called market price.
52
FINANCIAL ENVIRONMENT
21. In an
option to buy
a
foreign currency, when the spot market
price is lower than the exercise strike price it is said to be
"out of
the money" transaction.
22.
If the option price is
"at the
equal to the spot market price, it said to be
money" whether the option is put or call option.
23. Future market is a market where assets or
the future while the
price of the said assets
goods are delivered in
is determined today.
24. If the investor ALEX has P 10,000 cash to invest in
highly risky
investment, he should invest in bond market rather than stock
market to earn more.
25. In a primary stock market transaction, the transfer of capital from
seller to investor changes the
capital structure of the corporation.
secondary stock market transaction, the transfer of capital
26. In a
from seller to investor involves the sale of outstanding
shares of
the corporation, thus, it changes the capital structure of the said
corporation.
27.
Initial Public Offering is the first time offering of closely held
company's stocks to the public.
28. The IPO is classified as primary market transaction or secondary
market transaction, wherein the former transaction shows that
new stocks were sold to new investors while the latter shows that
new
29. In a
stocks were sold to
existing stockholders.
seasoned offering, the additional shares
were
of the company
issued after its first time offering in order to finance its
investment and operations.
30. A transfer of securities
investors will
is an
through an intermediary in which the
be holding the securities of the issuing corporation
indirect transfer through investment bank.
53
FINANCIAL ENVIRONMENT
31.
If APOLLO Bank, after knowing the plan of CHUA Corporation to
go
public, purchased all the latter's shares at a certain price then
offered these shares to the
public, the transfer is
deemed as
indirect transfer through underwriter.
32.
If APOLINARIO Corp, a life insurance company, purchased all the
shares of MANALO Corporation after knowing the plan of the
latter to go public then offered its own insurance policy to the
public, the transfer is known as indirect transfer through financial
intermediary.
33. Capital market involves investment
is
long term debt securities
only such as bonds and notes while stock market is where equities
are being sold and traded.
34. Mutual funds are investment companies that pools investment
from the public then
place these funds in equity security but not in
debt security investments.
35. In a Unit Investment Trust Fund
(UITF), the investor will buy units
of investment from the investment company while in Mutual Fund
(MF) the investor will purchase shares
of the said investment
company.
36. If HENDRY SY invested his P 100,000 in mutual fund of Bee-Dee-
Owe while his P 50,000 was invested in
former investment is
is regulated
UITF of Bee-Pee-Eye, the
regulated by BSP while the latter investment
by SEC.
37. An efficient stock market is where the
considered to be
stock prices
are
highly overvalued or undervalued.
38. An undervalued stock will be a
the intrinsic value
"good buy" because it
is lower than the market value.
54
shows that
FINANCIAL ENVIRONMENT
39.
The stock is undervalued if
the perceived value is lower than
true value, hence the investors will be indifferent in buying or
selling.
40. In efficient market hypothesis, the strong form shows
investors can
earn
41. In a
that
beat the market with insider information and will
high returns.
weak form of efficient market, an investor cannot beat the
market by simply analyzing the past performances of the stock.
42. In a semi-strong form of efficient market, not all the available
public information is incorporated in
the
stock prices, Hence,
analyzing the published financial reports are significant to beat
the market.
43. Intrinsic value, also known as the perceived value, is the price
that the willing buyer will bid and willing seller will ask provided
that all necessary information about the stock is available.
44. Historically the Philippines had two stock markets but these
markets were unified forming the Philippine Stock with six (6).
constituent indices.
45. Treasury bonds and corporate bonds are both traded in capital
market but with different interest rates.
46.
Ceteris paribus, the corporate bond's interest rate is always
higher than the interest rate of Treasury bond.
47.
Investment in equity securities (stock) and
debt securities
(bonds) are long term investments but the former is riskier than
the latter.
48. Ceteris paribus, investment in stocks is expected to provide
higher return than the investment in bonds because the higher
the risk, the higher the return.
55
FINANCIAL ENVIRONMENT
49. Low interest
(stocks)
rate triggers the
in the stock
firm to issue equity securities
market instead of issuing debt securities
(bonds) in the bond market.
Initial Public Offering is generally performed by family
corporations that are going public through issuance of stocks to
50. The
the public for the first time in the stock market; however, it may
also be performed by publicly listed companies through issuance
of corporate bonds for the first time in the
51. The main product under
the
bond market.
secondary market
is
outstanding
investor thereby
increasing the capital structure of the corporation.
shares which are sold
by a shareholder to an
52. Issuing 2 million shares of DMZI new stock to the public is a kind
of secondary market transaction.
53. A financial market in which funds are borrowed or loaned for
short periods is a capital market.
Indirect Transfers through
54.
Investment Bankers is a transfer of
security particularly shares of stock through
which the investors will
an intermediary
in
be holding the securities of the
corporation / Business.
55. Investment Banks
usually specialize assisting organizations raise
capital by "syndicating" or arranging for the sale of the securities
offered by the borrower as opposed to Commercial Banks
performing general banking services such as depositary,
checking, trust and various loan products.
"In
everything you do, never forget to seek the blessings of the Lord
for he has the final answer."-ysb
56
FINANCIAL STATEMENT ANALYSIS
CHAPTER 3
FINANCIAL STATEMENT ANALYSIS
Corporations, especially those publicly listed companies,
are
mandated by the Securities and Exchange Commission (S.E.C.)
to file their annual Audited Financial Statements. These
financial statements are composed of:
1) Statement of Financial Position which is traditionally known
as Balance Sheet;
2) Statement of Comprehensive Income also known as
Income
Statement;
3) Statement of Cash Flows,
4) Statement of Changes in Owner's Equity and
5) Notes to Financial Statements.
These aforementioned statements are the primary
means to
communicate the material financial information to its
users
regarding the operating performance, profitability and the
ability of company to meet its obligations. However, users
cannot easily determine the financial status of the company by
merely looking at the values stated in the Financial Statements.
Thus, there are tools and techniques developed by the financial
analysts that helps evaluate the company's performance and
conditions.
In this chapter, we will explore the following:
Different tools and techniques in analyzing the financial
statements of the company.
The significance and formulas
of
the
different
performance measurement ratios that reflects the
liquidity, solvency, efficiency and profitability of the
company.
analyzing the financial statements, financial managers
use the following tools and techniques such as: a) Horizontal
In
Analysis, b) Vertical Analysis, c) Financial Ratios and d) DuPont
Technique.
59
FINANCIAL STATEMENT ANALYSIS
HORIZONTAL ANALYSIS
Horizontal analysis of financial statements
is a method of
comparing the Peso value or amount of the particular line
item in the Statement of Financial Position, Statement of
Comprehensive
Income or Cash Flow Statements over
a
consecutive accounting period. Moreover, this
two or more
peso value can be converted into percentages for purposes
of comparing the performance of different companies in
industry. Horizontal analysis, which is
analysis, provides assessment
decrease
these
in
of
an
also known as trend
the significant increase or
different items in
the financial
statements. Thus, in performing Horizontal analysis
as a
technique, we can use the a) Peso value or b) Percentage
change for comparison and evaluation of company's
performance.
%
To
illustrate, use following Statement of Financial Position
of FSA
Corporation for the year 2014 and 2015 as shown in
table below:
TABLE 3-1: FSA Corporation Statement of Financial Position
STATEMENT OF FINANCIAL POSITION AS OF DECEMBER 31 (in Millions of Pesos)
2014
2015
2014
ASSET
LIABILITIES and SHAREHOLDER'S EQUITY
Current Asset (CA)
Current Liability(CL)
Cash
Accounts Receivable
Inventory
TOTAL CURRENT ASSET
800
900
1,300
1,100
700
2,800
750
Accounts Payable
400
Notes Payable
1,600
1,450
TOTAL CURRENT LIABILITY
2,000
1,900
3,500
3,700
2,750
Non-Current Liability (NCL)
Bonds Payable
Non-Current Asset (NCA)
Property,Plant and Equipment
Intangible Asset
TOTAL NON-CURRENT ASSET
5,600
4,900
other Long Term Debt
2,600
2,350
TOTAL NON-CURRENT LIABILITIES
8,200
7,250
2,400
2,600
5,900
6,300
Shareholder's Equity
TOTAL ASSETS
10000
Common Stocks
500
700
Retained Earnings
2,600
1,100
TOTAL SHAREHOLDER'S EQUITY
3,100
1,800
11,000
10,000
TOTAL LIABILITIES AND EQUITY
60
FINANCIAL STATEMENT ANALYSIS
If the financial
manager will perform Horizontal or Trend
Analysis on the a) Cash and Cash equivalents item and b) Notes
Payable item as shown in the Statement of Financial Positions
above, what will be the assessment using: 1) Peso Value or 2)
Percentage Change?
In using Peso Value for comparison and analysis,
the
amount of
Cash and Cash Equivalents for the year 2015 was
increased
by
P
100 million while the amount of Notes
Payable decreased by 150 million. The increase in the
amount
of cash
may signify that there
are
revenues
generated or the inflows of cash are more than outflow. On
the other
hand, the decrease in Notes Payable may imply
that there are payments
of
obligations made by the FSA
corporations.
In using Percentage for comparison and analysis, there
need to convert the Peso
is a
value into percentages where
in
prior period values will serve as the base amount (100%).
To calculate the percentage change in values from prior
period to the current period, we will use the formula below:
Prior Year
Current Year
Percentage Change =
Prior Year
If the percentage change resulted to
a
positive (+), this
implies that there is increase in the peso value of the line
item subject to evaluation while negative ( - ) percentage
means
that there is decrease in the peso value.
Thus, the change in Cash and Cash Equivalent from P 800
P 900 million in 2015 will be
million for the year 2014 to
reported as 12.5
%
increase in the value of cash or
value of the prior period.
reported as 112.5% of the cash
61
be
FINANCIAL STATEMENT ANALYSIS
Percentage Change =P 900 Million - P 800 Million_=
P
800 Million
On the other hand, the change Notes Payable
Billion for the year
12.5%
from P 1.6
2014 to P 1.45 Billion in 2015 will be
reported as 9.375% decrease in the value of Notes Payable
or
be
reported as 90.625% of the Notes Payable value
of
the prior period.
Percentage Change =P 1.45 Million- P 1.6 Billion = (- 9.375%)
P 1.6 Billion
II. VERTICAL ANALYSIS
Vertical analysis of financial statements is a technique that
involves assessment of the
period
different line items in a single
Financial Statement. These items which
are
commonly shown in the Financial Statements using their
Peso values shall be expressed
in
amount or the base amount. In this
managers
can
percentage of
a
total
technique, the financial
appropriately evaluate
the
financial
information of companies of different sizes because
using
percentages for comparison provides more useful and
relevant conclusions than using the peso values in
comparing these companies of different sizes.
In addition, Vertical Analysis is performed on the Statement
of Financial
Position (Balance Sheet) where in the base
amount in calculating the percentages is Total Assets while
the base amount for
the Statement of Comprehensive
Income (Income Statement) is Net Sales. After using this
technique, the financial statements prepared are known as
62
FINANCIAL STATEMENT ANALYSIS
common
sheet
size financial statements. Thus, traditional balance
and income statement shall
be termed as common
size balance sheet and common size income statement,
respectively.
> To illustrate, let us assume the Statement of Financial
Position of FSA
Corporation for the year 2015 as shown
in table 3-1. In
using this technique, the balance sheet
items are presented as
a
proportion of the total assets.
Hence, the base amount for purposes of calculating the
percentages shall be Total Asset of FSA Corporation
amounting to P 10 Billion.
Say for example in computing the proportion
of Cash
and Cash Equivalents to Total Assets, the Peso Value
P
900 Million shown in
table 3-1 shall be divided by the
P10 Billion Peso value to get 9%. The other items
presented in percentage form are shown in Table 3-2:
Table 3-2: FSA Corporation Common Size Balance Sheet
Common Size Balance Sheet as of December 31, 2015
LIABILITIES and SHAREHOLDER'S EQUITY
ASSETS
Current Liabilities:
Current Assets:
Cash and Cash Equivalents
Accounts Receivable
Inventories
Total Current Asset
900
9.00%
1,100
11.00%
750
7.50%
2,750
27.50%
Accounts Payable
Notes Payable
Total Current Liabilities
450
4.50%
1,450
14.50%
1,900
19.00%
Non-Current Liabilities
Bonds Payable
Non-Current Assets:
Property, Plant and Equipment (net)
4,900
49.00%
Intangible Assets
2,350
23.50%
7,250
72.50%
Total Non-current Asset
Other Long term debt
Total Non-Current Liabilities
3,700
37.00%
2,600
26.00%
6,300
63.00%
Shareholder's Equity:
TOTAL ASSETS
10,000
100.00% Common Stocks
Retained Earnings
Total Shareholder's Equity
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY
On the
other hand, when applying this technique to
700
1,100
1,800
10,000
100.00%
the
Statement of Comprehensive Income, income and expenses are
compared to the Net Sales. For example, if the Net Sales
63
7.00%
11.00%
18.00%
FINANCIAL STATEMENT ANALYSIS
Revenue of FSA Corporation in 2015 is P 50 Million and the
total Cost of Goods Sold is
will be
P 25
million, the Cost of Goods Sold
reported as 50% of the Net Sales. Moreover, if the
resulting Net Income amounted to
P
5 Million, the said Net
Income will be presented as 5%
FINANCIAL RATIO:
Financial ratio as a tool and technique in financial analysis is the
comparison between one
of financial information with other
financial information. This comparison formulates relationship
that provides relevant information in evaluating the operating
performance and financial condition
of
the
company.
Generally, financial ratios can be classified into four aspects
such as the following:
A. Liquidity Ratio - this measures the ability of the
company to meet its short term obligations.
B.
Leverage Ratio - this measures the ability of the
company to meet its long term obligation when they fall
due.
C. Activity Ratio
-
this measures how the company
productively uses or manages its assets.
D. Profitability Ratio
this measures the overall financial
performance of the firm and its return
on investments.
Classifications of Financial Ratios:
A.
LIQUIDITY RATIOS are the ratios that measure the ability of
a company to pay its short term
64
debt obligations when they
FINANCIAL STATEMENT ANALYSIS
fall due. Moreover, it measures the capacity of the company
to convert
short term assets into cash.
The liquidity ratios
greater than 1 signifies that the company is in good
financial standing and that the
current liabilities of the said
company will be met.
Financial managers or analysts commonly use these
following liquidity ratios:
Current Ratio
Quick Ratio
Cash Ratio
Working Capital To Total
Asset Ratio
A.1. Current Ratio:
Current ratio, which is
also termed as working capital
ratio, indicates whether or not the company has
sufficient resources to pay its debt obligations that are
within 12 months. This ratio shows the liquidity of
company which is the ability of assets to be easily and
due
a
quickly converted into cash at the lowest
cost. The
acceptable current ratio varies for different industries
however; it is commonly ranging from 1.5:1 to 2:1. If the
higher than the acceptable level (rule of
thumb) of 2:1, this may signify that the company is not
current ratio is
utilizing
its current assets
efficiently. In contrary, low
current ratio means that the company will have
difficulty in paying its short term debts.
The current ratio is
calculated by using the formula:
Current Ratio =
65
Total Current Assets
Total Current Llabilities
FINANCIAL STATEMENT ANALYSIS
Illustrative Problem 3-3:
LEAD Company's Statement of Financial Position for
the
year
2018 shows
cash amounting to
250,000.00, Marketable Securities
of
P
P 25,000.00,
Accounts receivable of P 50,000.00, Inventories of P
75,000.00, Non-current Assets of P600,000.00,
the Total Shareholder's Equity and Long Term
are
and
Debt
P600,000.00 and P 200,000.00 respectively. What
is the Current Ratio?
SOLUTION:
Total Current Assets
Current ratio
Total Current Liabilities
Current ratio
Cash + Marketable Security + Accounts Receivable + Invenentory
Total Assets - [ Total Shareholder's Equity + Long term Debt]
Current ratio
250,000 + 25,000 + 50,000 + 75,000
=
1,000,000 - 600,000 + 200,000]
Current ratio
400, 000
=
200,000
=2:1
A.2.Quick Ratio:
Quick ratio is a more stringent measurement of the
ability of the company to pay its short term debt
obligation using the quick assets of the company. The
quick assets used are composed of the most liquid asset
which is
cash and those highly liquid current assets that
are easily convertible into cash such
as
marketable
securities and accounts receivables. Among the
current
assets, the inventories are excluded as components of
the quick assets because of its difficulty to convert into
cash, thus it is considered as less liquid current
66
asset.
FINANCIAL STATEMENT ANALYSIS
The acceptable level of Quick ratio varies for
different
commonly set at 1. This ratio is also
industries but it is
known as the Acid Test ratio.
The Quick or Acid Test ratio is
calculated by using the
formula:
Quick Ratio =
Current Assets-Inventories
Total Current Liability
Quick Ratio =
Cash+Marketable Securities+Accounts Receivable
Total Current Liabilities
%
Illustrative Problem 3-4:
The 2018
Balance Sheet of PAREX Company has Total
current assets and total current liabilities amounting
to P
400,000.00 and P 200,000.00 respectively. The
current assets are composed of cash amounting to P
100,000.00, Marketable Securities of P 45,000.00,
Accounts receivable of P 95,000.00 and Inventories of
P 160,000.00 What is
the Quick Ratio?
SOLUTION:
Quick Ratio
Cash + Marketable Securities + Accounts Receivable
=
Total Current Liabilities
Quick Ratio
100,000 + 45,000 + 95,000
=
200,000
Quick Ratio =
240,000
200,000
- 1.2:1
A.3. Cash Ratio:
Cash ratio is considered to be the most
stringent and
conservative among the liquidity ratios because it only
67
FINANCIAL STATEMENT ANALYSIS
uses cash and cash equivalents in paying the short term
obligations of the company. This ratio shows
the
such as
comparison of the company's most liquid assets
Cash and marketable securities over its total current
liabilities.
The Cash ratio is calculated by using the formula:
Cash+Marketable Securities
Cash Ratio =
Total Current Liabilities
Illustrative Problem 3-5:
IYSB Company has Total current assets and total
current liabilities amounting to P 400,000.00 and
P 200,000.00 respectively. The
current assets are
composed of cash amounting to P 100,000.00,
Marketable Securities of P 50,000.00, Accounts
receivable of P 90,000.00 and Inventories
of P
160,000.00 What is the Cash Ratio?
SOLUTION:
Cash + Marketable Securities
Cash Ratio
=
Cash Ratio
=
Total Current Liabilities
100,000 + 50,000
Cash Ratio =
200,000
150,000
200,000
: 0.75 : 1
A 4. Working Capital to Total Asset Ratio:
Companies usually have higher value of current assets
over the value of the current liabilities. Working Capital,
which measures the company's potential value of cash
reserves, is the difference between the total current
68
FINANCIAL STATEMENT ANALYSIS
assets and total current liabilities. This is sometimes
called as
Net Working Capital. Financial managers often
compare this Net Working Capital over the value of the
Total Assets.
The Working Capital to Total Asset Ratio is
by using the formula:
Working Capital to Total
Asset Ratio
=
calculated
Current Assets-Current Liabilities
Total Assets
Illustrative Problem 3-6:
JMS Company's Statement of Financial Position
for the year
200,000.00
2018 shows Total current assets of P
and
Non-current
assets
of
P
300,000.00, and the Total Shareholder's Equity
and Long Term Debt are P 300,000.00 and
P
100,000.00 respectively.
a. What is the amount of Net
Working Capital?
b. What is the Net Working Capital to Total
Assets Ratio?
SOLUTION:
Net Working Capital = Total Current
Assets - Total Current Llabilities
Net Working Capital = 200,000
100,000
Net Working Capital = 100,000
Net Working Capital To Total Assets Ratio
Net Working Capital To Total
=
Net Working Capital
Total Assets
Assets Ratio =
100,000
500,00
Net Working Capital To Total Assets Ratio = 0.20
69
or
20 %
FINANCIAL STATEMENT ANALYSIS
Equity Ratio
Total Shareholder's Equity
=
Total Asset
Illustrative Problem 3-8:
ADCM
Incorporated has a total Net worth
of P
2018.
2,500,000.00 in
an
outstanding Loans payable, Bonds payable and
Accounts payable amounting to P 600,000.00, P
1,400,000.00 and P 500,000.00, respectively.
What is the Equity
ratio of ADCM Incorporated?
SOLUTION:
Equity Ratio
=
Equity Ratio =
Equity Ratio
Total Shareholder's Equity
Total Asset
Total Shareholder's Equity
Total Equity + Total Liability
2,500,000
=
2,500,000 + 2,500,000
Equity Ratio
=
2, 500, 000
=
5, 000, 000
0.5 or 50 %
B.3. Debt to Equity Ratio:
Debt to Equity ratio
is a ratio
that shows the proportion
of company's funds financed by debt compared to funds
financed by equity. This ratio
is a
good measure of the
financial status of the company.
The higher debt to
equity ratio implies that the company is highly financed
by debt or creditors, thus increases the
financial risk of
the company. On the contrary, lower debt to equity ratio
signifies that the contribution from the stockholders
is
more than from creditors, thus the company has better
standing in terms of solvency yet it does not increase
earnings through leverage.
72
FINANCIAL STATEMENT ANALYSIS
The debt to equity ratio is calculated by using the
formula:
Debt to
Equity Ratio
=
Total Liability
Total Shareholder's Equity
Illustrative Problem 3-9:
In 2018, ALGER Corporation has total
amounting
to
5,000,00 0.00
P
stockholder's equity
of P
assets
and
total
2,000,000.00. What
is
the Debt to Equity ratio of ALGER Corporation?
SOLUTION:
Debt to
Equity Ratio =
Total Liability
Total Shareholder's Equity
Debt to Equity Ratio
Total Asset - Total Shareolder's
Equity
Total Shareholder's Equity
Debt to Equity Ratio
Debt to
5,000,000 - 2,000,000
=
Equity Ratio =
2,000,000
3, 000, 000
2, 000, 000
= 1.5
B.4. Times Interest Earned Ratio (TIER):
Times Interest Earned Ratio, which is sometimes
referred as interest coverage ratio, is a ratio that
indicates the degree to which interests are covered by
earnings before interest and taxes (EBIT).
measures
This ratio
the number of times the interest payments
can be made
by the company through the use of EBIT. If
the TIER of a company is low, this implies that
the
ability of the company to meet its interest expenses is
impaired because of less earning generated from
73
FINANCIAL STATEMENT ANALYSIS
operations. However, higher TIER shows a
good
financial standing of the company.
The Times Interest Earned Ratio is calculated by using
the formula:
Times Interest Earned Ratio =
Earnings Before Interest and Tax (EBIT)
Interest Expense
* Illustrative Problem 3-10:
CDA Corporation's Statement of Comprehensive
Income presented a total Gross Profit of P
1,500,000.00, Operating expenses amounting to P
300,000.00 and Interest expense amounting to P
400,000.00. The tax rate is 30%. What is the
Times Interest Earned Ratio of CDA
Corporation?
SOLUTION:
Times Interest Earned Ratio
Earnings Before Interest and Tax (EBIT)
Interest Expense
Times Interest Earned Ratio
Gross Profit - Operating Expense
Interest
Times Interest Earned Ratio
=
Expense
1,500,000 - 300,000
400,000
Times Interest Earned Ratio
=
1, 200, 000
400, 000
3 times
B.5. Cash Coverage Ratio:
Cash Coverage Ratio
is a ratio that indicates the extent
to which interests are covered not only by earnings but
by the cash flows generated from operations.
This ratio
shows the use of company's earnings exclusive of non74
FINANCIAL STATEMENT ANALYSIS
cash expenses in meeting its interest expenses. Thus,
this measures how many
times the interest
payment
can be made by the company through earnings before
after
and taxes
interest
adding back
Depreciation.
The Cash Coverage Ratio is calculated by using the
formula:
Cash Coverage Ratio
=
Earnings Before Interest and Tax (EBIT)+ Depreciation
Interest Expense
Illustrative Problem 3-11:
CCR Corporation's Statement of Comprehensive
Income presented a total Gross Profit of P
750,000.00, Operating expenses amounting
to P
150,000.00 and Interest expense amounting
to P
200,000.00. The tax rate is 30% and one-third
(1/3) of the Operating
expenses
comes
from
annual depreciation. What is the Cash Coverage
Ratio
of CCR Corporation?
SOLUTION:
Cash
Coverage Ratio
Earnings Before Interest and Tax (EBIT) + Depreciation
Interest Expense
Cash Coverage Ratio
(Gross Profit -
Operating Expense) + Depreciation
Interest Expense
Cash Coverage Ratio =
Cash Coverage
75
(750,000- 150,000) + 50,000
200,000
Ratio
650,000
200,000
=
3.25 times
FINANCIAL STATEMENT ANALYSIS
C.
ACTIVITY RATIO
measures
how efficiently the company
produces revenue through the management of its assets.
Moreover, this ratio indicates the company's capacity of
converting its assets into the sales revenue. Activity ratios
are also known
as efficiency ratio or asset management
ratio.
Financial managers
use
the following activity
ratios in
analyzing the financial statements:
Asset Turnover Ratio
Accounts Receivable Turnover Ratio
Days' Sales Receivable
Inventory Turnover Ratio
Days' Sales in Inventory
Accounts Payable Turnover Ratio
Days Payable Outstanding
Cash Conversion Cycle
C.1.Asset Turnover Ratio:
Asset Turnover Ratio, which is also referred as Sales to
Asset ratio, indicates the value of peso sales generated
by the each peso of asset employed by the company. It is
assumed that
high asset turnover ratio signifies the
effective use of company's assets. However, if this ratio
is determined at a low level, which implies an inefficient
use
of assets, there is a need to analyze the performance
of key assets such as receivable and inventories.
The Asset Turnover Ratio is calculated by using the
formula:
Asset Turnover Ratio =
76
Sales Revenue
Average Assets
FINANCIAL STATEMENT ANALYSIS
~ Illustrative Problem 3-12:
Corporation's
Comprehensive
2018
Statement
Income presented
a
of
total Sales
Revenue of P 1,200,000.00 and Cost of Sales of P
750,000.00. The total assets of JCOO Corporation
2014 amounted to P 400,000.00 which is
higher by P 200,000 as of 2018. What is the Asset
in
Turnover Ratio of JCOO Corporation?
SOLUTION:
Sales Revenue
Asset Turnover Ratio
Asset Turnover Ratio
Average Assets
1,200,000
=
( 400,000 + 600,000)/ 2
Asset Turnover Ratio
1, 200, 000
500, 0000
=
2.4 times
C.2.Accounts Receivable Turnover Ratio and Days' Sales
Receivable:
Accounts Receivable Turnover Ratio indicates how many
times the company collects
receivables
during
an
its
average accounts
accounting period.
Thus,
measuring how fast the Collection Department of the
company collects its credit sales. In Addition, the higher
the Accounts Receivable Turnover Ratio, the more
efficient the company is managing its credits granting to
customers, and vice versa.
The Accounts Receivable Turnover Ratio is calculated
using the formula:
77
FINANCIAL STATEMENT ANALYSIS
Credit Sales
Accounts Receivable Turnover Ratio
=
Average Accounts Receivable
Days' Sales Receivable indicates how fast the company
collects it credit sales in terms of
known as
days. This is also
Average Collection Period. In measuring the
average collection period of the company in days,
financial manager uses the formula:
Days'Sales Receivable =
Average Receivables (AR)
Average Daily Sales
[ Beginning AR +Ending AR)]
Days' Sales Receivable =
(Sales Revenue
Illustrative Problem 3-13:
Corporation's
2018
Statement
Comprehensive Income presented a total
of
Sales
Revenue of P 3,600,000.00. The 2018 accounts
receivable of BERMEO Corporation amounted to
P
400,000.00 which is higher by P 200,000 in 2017.
a.
What is the Accounts Receivable Turnover
Ratio?
b.
What is the Days' Sales Outstanding or the
Average Collection Period?
SOLUTION:
Accounts
Receivable Turnover Ratio
Credit Sales
Average Accounts Receivable
Accounts Receivable Turnover Ratio
3,600,000
(200,000 + 400,000)/2
78
FINANCIAL STATEMENT ANALYSIS
Accounts Receivable Turnover Ratio
=
=
3, 600, 000
300, 000
6 times
Days'Sales Receivable =
Days'Sales Receivable =
Days'Sales Receivable
=
Average Receivables (AR)
Average Daily Sales
(200,000 + 400,000)/2
3,600,000/360
300,000
10,000
=
30
days
The analysts evaluate the two foregoing ratios by
comparing them to the company's credit policy and
industry average.
C.3.Inventory Turnover Ratio and Days' Sales Inventory:
Inventory Turnover Ratio measures the number of times
the company replaces its average inventories during an
accounting period due to sales. This ratio shows how
the company manages its inventory efficiently. Thus,
high inventory ratio implies better sales efficiency while
low inventory ratio may signify obsolete inventories or
that too much inventory is held in stock.
The Inventory Turnover Ratio is calculated using the
formula:
Inventory Turnover Ratio
Cost of Sales Sales
Average Inventory
Days' Sales Inventory indicates how quick the company
can sell its inventories in terms of days or the number of
days the company holds these inventories before selling
to customers.
This is also known
as Average Inventory
Period. In measuring the average inventory period of
the
company in days, financial manager uses
formula:
79
the
FINANCIAL STATEMENT ANALYSIS
Average Inventory (Inv.)
Days'Sales Inventory =
Average Daily Sales
( Beginning Inv.+Ending Inv.)
Days'Sales Inventory =
Sales
(Cost of
360
Illustrative Problem 3-14:
Statement
2018
Corporation's
of
Comprehensive Income presented a total Sales
Revenue of P 5,000,000.00 and Cost of Goods Sold
of P 3,000,000.00. The Statement of Financial
Position shows Inventory value of P 350,000.00 in
2018 and P 250,000.00 in 2017.
C.
What is the Inventory
d. What is the Days'
Turnover Ratio?
Sales Inventory?
SOLUTION:
Inventory Turnover Ratio
Inventory Turnover Ratio =
Days 'Sales Receivable
Average Inventory
3,000,000
(250,000 + 350,000)/2
Inventory Turnover Ratio =
Days'Sales Invetory
Cost of Sales
=
3, 000,000
300, 000
10 times
Average Inventory
Average Daily Cost of Sales
=
Days'Sales Receivable
(250,000 + 350,000)/2
3,000,000/360
300, 000
8,333.33
80
=
36
days
FINANCIAL STATEMENT ANALYSIS
C.4.Accounts Payable Turnover
Ratio and Days' Sales
Inventory:
Accounts Payable Turnover Ratio indicates the number
of times the company pays its outstanding average
accounts payable during an accounting period.
ratio shows the creditworthiness
how it manages
its
of
This
the company
or
payments to the creditors. Thus,
high accounts payable turnover ratio means that
the
company pays its purchase on account in a short period
of time.
The Accounts Payable Turnover Ratio is calculated
using the formula:
Accounts Payable Turnover Ratio =
Purchases*
Average Accounts
Payable
*Purchases = Cost of Goods Sold + Ending
Inventory - Beginning Inventory
Days' Payable Outstanding shows the number of days
it
will take for the company to pay its liability from date of
purchase. This is also termed as Accounts Payable
Period. In measuring the accounts payable period
of the
company in days, financial manager uses the formula:
Days' Payable Outstanding =
Days'payable Outstanding
81
Average Accounts Payable (AP)
Average Daily Purchases
[( Beginning AP+Ending AP)/2]
(Purchases*/360)
FINANCIAL STATEMENT ANALYSIS
The Statement of
Comprehensive Income of DPO
Industries in 2018 shows an amount of P
of Goods
750,000.00 Cost
Statement of Financial Position
Sold.
Its
2018
shows Inventory
value of P 175,000.00 and Accounts Payable of P
250,000.00.
Last year, Inventory and Accounts
Payable amounted to P 125,000.00 and
P 150,000
respectively.
a.
What is the Accounts Payable Turnover Ratio?
b.
What is the Days' Payable Outstanding?
SOLUTION:
Accounts Payable Turnover Ratio
Purchases
=
Average Accounts Payable
* Purchases
=
Cost of Goods Sold
+ Ending Inventory
Beginning Inventory
* Purchases = 750,000 + 175,000- 125,000 = 800, 000
Accounts
Payable Turnover Ratio
800,000
(150,000 + 250,000)/2
Accounts Payable Turnover Ratio =
=
800, 000
200, 000
4 times
Days 'Payable Outstanding
Average Accounts Payable (AP)
Average Daily Purchases
Days' Payable Outstanding = (150,000 + 250,000)/2
(800,000 /360 days)
82
FINANCIAL STATEMENT ANALYSIS
200,000
Days' Payable Outstanding = 2222.22
90
days
C.5. Normal Operating Cycle:
This cycle starts from the purchase of materials from
the supplier, followed by the sale of finished goods
inventory to the customers then finally the collection of
cash payments made by these customers. The delay of
time between purchase of materials and the sale of
finished goods is called the Average Inventory period
(AIP); and the delay
of
time between sale of finished
goods and the collection of customer payment is
the
Average Receivable Period (ARP). Normal Operating
Cycle is the summation of these two periods, the AIP
and
ARP, thus, is the delays in collecting cash payments.
On the contrary, the delay of time between purchase of
materials and the
payment made to the supplier
referred as Accounts
is
Payable Period (APP). (These
periods which are considered as components of
the
working capital were discussed above.)
Cash Conversion Cycle measures the number
of
days
from cash being paid to the suppliers up to the time
cash is received from sales. Hence, it is the period of
time from the purchase of
raw
materials up to the
collection of receivable.
The objective in working capital management is to
shorten the cash conversion cycle by implementing a
policy that speeds up the collections
and
from customers
slows down the payment to the supplier. The cash
conversion cycle can be calculated by using the formula:
83
FINANCIAL STATEMENT ANALYSIS
Cash Conversion Cycle
= AIP + ARP
APP
Illustrative Problem 3-15:
CCC Company's Statement of Comprehensive
Income in 2018 presented Sales Revenue
amounting to P 1,000,000.00 and Cost of
Goods
Sold of P 750,000.00. Its 2018 Statement of
Financial Position shows Inventory value of
P
175,000.00, Accounts Receivable of P 50,000.00
and Accounts Payable of P 250,000.00. Last year,
Inventory, Accounts Receivable and Accounts
Payable amounted to
P 125,000.00,
P 150,000.00
and P 150,000.00 respectively.
a.
Calculate
the Average Receivable Period or
Average Collection Period
b.
Calculate the Average Inventory Period
C.
Calculate the Accounts Payable Period
d. Calculate the Cash Conversion Cycle
SOLUTION:
A. Average Receivable Period
=
Average Receivables (AR)
Average Daily Sales
Average Receivable Period =
Average Receivable Period =
B.
(150,000 + 50,000)/2
1,000,000/360 days
100,000
=
2,777.77
36 days
Average Inventory Period
Average Inventory (INV)
Average Daily Cost of Sales
Average Inventory Period
84
=
(125,000 + 175,000)/2
750,000/360 days
FINANCIAL STATEMENT ANALYSIS
150,000
Average Inventory Period =
72 days
2,083.33
C. Accounts Payableble Period
Average Accounts Payable (AP)
Average Daily Purchases
Accounts Payable Period
(150,000 + 250,000)/2
=
Accounts Payable Period =
800,000/360 days
200,000
=
2,222.22
D. Cash Conversion Cycle = ARP + AIP -
90 days
APP
Cash Conversion Cycle = NOC - APP
Cash Conversion Cycle = (36 days +
72 days)
90duys
Cash Conversion Cycle =
>
18
days
Notes:
Account Receivable Period is also known as
Day's Sales Outstanding
Day's Sales Receivable
Average Collection Period
Inventory Period is also known
as
Day's Sales Inventory
Average age of Inventory
Inventory Conversion Period
Accounts Payable Period is also
Day's Purchases Payable
Average age of Payable
85
known as
FINANCIAL STATEMENT ANALYSIS
D. PROFITABILITY RATIO measures the overall financial
provided by returns
generated from investments and sales. The Profitability
ratios can be classified into a) Margins b) Returns and
performance of the company
c) Shareholder's
Interest.
as
The following are major
profitability ratios used by financial managers to
analyze the Financial Status of the company:
1.
As to Margins:
Gross Profit Margin (GPM)
Operating Profit Margin (0PM)
Net Profit Margin (NPM)
2. As to Returns
Return on Sales (ROS)
Return on Assets
(ROA)
Return on Equity (ROE)
3. As to Shareholder's Interest
Earnings Per Share (EPS)
Price-Earnings Ratio (PER)
Dividend Yield (DY)
Pay
Out Ratio (POR)
Plow Back
Ratio (PBR)
D.1. Margins:
Statement
of Comprehensive
Income shows the
earnings of the company in terms of gross profit,
operating profit and net profit. The Gross profit
is
calculated by deducting the production cost from sales
revenue while Operating profit is computed after
deducting the operating expenses incurred by
the
company from its gross margin. The Operating profit
is
also referred as Earnings Before Interest and Tax
(EBIT). On one hand, the Net profit is equal to EBIT less
the interest expenses and taxes.
86
FINANCIAL STATEMENT ANALYSIS
Gross Profit Margin indicates the proportion of gross
profit over the sales revenue generated by the company
from operations. This shows the earning capacity of the
company
after taking
cost of
account the
into
production. Thus, the formula is:
Gross
Gross Profit
Profit Margin =
Net Sales
Operating Profit Margin shows the
percentage of
operating profit or the EBIT over the sales revenue
generated by the company from operations. Thus, the
formula is:
Operating Profit Margin =
Net Profit Margin reveals
the
Operating Profit
Net Sales
percentage of the Net
Income After Tax (NIAT) over the sales revenue
generated from operations.
This shows the earning
capacity of the company after paying all its expenses
such
as production costs, operating costs, financing
costs
and taxes. Thus, the formula is:
Net Profit Margin =
Net Income After Tax
Net Sales
Illustrative Problem 3-16:
SGV Company's
Income
in
Statement
2018
of
revealed
Comprehensive
Sales
Revenue
amounting to P 2,000,000.00 and Cost of Goods
Sold of P1,000,000.00. The Operating expenses
and interest expense incurred by the company are
P 400,000.00 and P 100,000.00, respectively. The
tax rate is 30%.
87
FINANCIAL STATEMENT ANALYSIS
a.
Calculate the Gross Profit Margin of
SGV
Company.
b. Calculate the
Operating Profit Margin
of SGV
Company.
C.
Calculate the Net Profit Margin of
SGV
Company.
SOLUTION:
2,000,000.00
Net Sales
less: (Cost
of Goods
1,000,000.00
Sold)
1,000,00 0.00
Gross Profit
less: (Operating Expenses)
400,000.00
Operating Income / EBIT
600,000.00
less: (Interest Expense)
100,000.00
Earnings Before Tax
500,000.00
less: (Income
150,000.00
Tax)
Net Income After Tax
350,000.00
1. Gross Profit Margin =
Gross Profit
Net Sales
Gross Profit Margin =
1, 000, 000
2, 000, 000
Operating Profit
B. Operating Profit Margin
Net Sales
Operating Profit Margin =
=
C. Profit Margin =
Net Profit
Margin =
0.5 or 50%
600, 000
2, 000, 000
0.3 or 30%
Net Income After Tax
Net Sales
350,000
2, 000,000
88
=
0.175 or 17.50%
FINANCIAL STATEMENT ANALYSIS
These ratios indicate the profitability of the company
through the relationship of the peso
value of income
generated from sales, employment of assets and
investment in equity. The major components
profitability ratios are
Assets and c)
a) Return
on
Sales b)
of these
Return on
Return on Equity.
Return on Sales shows the proportion of
profit, after
payment of all expenses, over the sales revenue.
ratio is the
This
same as the net profit margin discussed
above. Thus, the formula is:
Return on Sales
=
Net Income
Net Sales
Return on Assets measures the relationship of the peso
value of
income generated for every peso of
asset
employed by the company. It shows how the company
efficiently uses its assets. This ratio expresses
the
percentage of net income of the company over its total
assets. Thus, the formula is:
Return on Assets
Return
Net Income
Average Assets
on Equity illustrates the relationship of the peso
value of income earned per
equity investments by the
shareholders. This ratio is one of
profitability ratios,
the most significant
especially to
shareholders, because
it
company is through the
the
owners
shows how profitable the
use
of investments from its
owners. Thus, the formula is:
Return on
89
or
Equity
Net Income
Average Equity
FINANCIAL STATEMENT ANALYSIS
o
Illustrative Problem 3-17:
LEAD
REVIEW
Company's
Statement
of
Comprehensive Income in 2018 revealed Sales
Revenue amounting to P 4,000,000.00 and Cost of
Goods Sold of P 2,000,000.00.
The Operating
expenses and interest expense incurred by the
company are P 800,000.00 and
P
200,000.00,
respectively. The tax rate is 30%.
The 2018 Statement of Financial Position of LEAD
REVIEW Company shows a Total Assets
6,000,00 0.00
and
2,000,000.00.
Last Year,
amounted
Total
of P
Liabilities
of
the
Assets
Total
P
to P 4,000,000.00 and Total Equity
amounted to P 3,000,000.00
a. Calculate the Return
on Sales
of
LEAD
REVIEW Company.
b. Calculate the Return
on Asset of LEAD
REVIEW Company.
C.
Calculate the Return on Equity of LEAD
REVIEW Company.
SOLUTION:
Net Sales
4,000,000.00
less: (Cost of Goods Sold)
Gross Profit
2,000,000.00
2,000,000.00
less: (Operating Expenses)
Operating Profit / EBIT
less: (Interest Expense)
Earnings Before Tax
less: (Income Tax)
Net Income After Tax
90
800,000.00
1,200,000.00
200,000.00
1,000,000.00
300,000.00
700,000.00
FINANCIAL STATEMENT ANALYSIS
A. Return on Sales =
Net Income
Net Sales
700, 000
Return on Sales
B. Return On Assets
4, 000, 000
=
0.175 or17.50%
Net Income After Tax
=
Return on Assets
Average Assets
700,000
=
(4,000,000 + 6,000,000)/2
Return on Assets =
C. Return on Equity =
Return on Equity
700,000
5, 000, 000
= 0.14 or 14 %
Net Income After Tax
Average Equity
700,000
(3,000,000 + 4,000,000)/2
Return on Equity =
700, 000
3, 500, 000
= 0.20 or 20 %
D.2.Shareholder's Interest:
The stockholders or investors may expect return on
their investments through the dividends paid by the
company or the capital gains from increasing stock
price. Thus, these stockholders primarily look into the
earnings, dividend policy and stock prices
of the
company throughout their investment. To aid them in
their decision making, there are
ratios that show the
profitability of the company and its impact to
the
interest of these shareholders or investors. These ratios
are usually translated in terms of share of stocks
highlight the said impact on shareholder's interest.
91
to
FINANCIAL STATEMENT ANALYSIS
Earnings Per Share indicates the
ratio of the annual
income and the common stocks of the company. In
addition, this shows how much of the total earnings
may be given to each share of common stocks. Thus, the
formula is:
Earnings Per Share
Net Income - Preferred Dividends
Number of Outstanding Common Stocks
Price
Earnings Ratio reflects the ratio of the
price
per share of
market
common stock and the earnings per
share. This ratio
is used
by the
investors
or
stockholders in assessing the ability of the company to
sustain growth and generate cash flows in the future.
Thus, the formula is:
Price
Earnings Ratio
Market Price Per Share
=
Earnings Per Share
Payout Ratio shows the proportion
of
earnings
that is
paid out to shareholders as dividends. Investors,
who
prefer short term returns like cash dividends rather
than capital gains, usually search for companies with
high pay-out ratio. Thus, the formula is:
Payout Ratio =
Dividends Per Share
Earnings Per Share
Plowback Ratio, which is also referred as Retention
Ratio,
shows the proportion of earnings that is not paid
out to
stockholders rather
reinvested to
and growth.
it is plowed back or
the company to be used for its expansion
This ratio is
the
complement
of the
payout
ratio; hence, the higher the payout ratio will result to a
lower plow back ratio. Thus, the formula is:
Plow Back Ratio
=
Earnings Per Share - Dividends Per Share
Earnings Per Share
92
FINANCIAL STATEMENT ANALYSIS
Plowback Ratio can be calculated
Or alternatively,
using this formula:
Plow Back Ratio = 1 - Payout Ratio
Dividend Yield indicates the return on investment for
the stockholders in terms of dividend
paid. In addition,
this implies how much the investors will
receive as
the
dividend income for every peso invested in
company's share of stock. Thus, the formula is:
Dividend Yield
=
Dividend Per Share
Market Price Per Share
Illustrative Problem 3-18:
DMZI Company's Statement
of
Comprehensive
Income in 2018 reflects a total Net Income of P
2,000,000.00. DMZI Company has
a total
500,000 outstanding common stocks which
be sold
at a market price of P 40.00 a share.
the policy of the company to pay annual
of
can
It is
cash
dividends of P 1.00 per share to common stocks.
a.
Calculate the Earnings Per Share of DMZI
Company.
b.
Calculate the Price Earnings Ratio of DMZI
Company.
C.
the Payout Ratio of DMZI
Calculate
Company.
d.
Calculate the Plowback Ratio of DMZI
Company.
e.
Calculate the Dividend Yield of DMZI
Company
93
FINANCIAL STATEMENT ANALYSIS
SOLUTION:
A. Earnings Per Share
Net Income
-
- Preferred Dividends
Number of Outstanding Common Stocks
Earnings Per Share =
=
B. Price Earnings Ratio
Price
2, 000, 000 -
0
500,000
4 per share
Market Price Per Share
=
Earnings Per Share
Earnings Ratio =
40
=
10:1
Dividend Per Share
C. Payout Ratio =
Payout Ratio
Earnings Per Share
0.25: 1
=
D. Plowback Ratio
Earnings Per Share - Dividend Per Share
Earnings Per Share
Plowback Ratio
E. Dividend Yield
4 =
Dividend Per Share
Market Price Per Share
Dividend Yield =
IV.
= 0.75: 1
40
0.025 or 2.5%
DuPont Technique is a tool that analyzes the return
asset and
on
return on equity of the company by breaking
down into component
ratios.
Hence, these component
ratios are factors affecting the return on asset and
equity.
94
FINANCIAL STATEMENT ANALYSIS
The Return on Asset, which indicates the amount of
earnings for every peso of assets employed, can be
broken down into two component ratios such as:
net
profit margin and asset turnover. On the other hand, the
Return on Equity, which shows the
earned for every peso of
amount
of income
equity invested by
the
shareholders, is calculated by multiplying the following
ratios: leverage factor, asset turnover and net profit
margin.
Thus the formulas are:
Return on Asset
=
Asset Turnover
Return on Asset =
x
Net
Profit Margin
Net Sales_
Net Income
Average Assets
Net Sates
Return on Asset =
Net Income
Average Asset
Return on Equity =
Net Profit Margin
Leverage Factor x Asset Turnover X
Return on Asset
=
Average Asset
Net Income
Net Sales
Average Equity Average Assets
Return on
Equity =
95
Net Sales
Net Income
Average Equity
INVESTMENTS: RISK AND
RETURN
CHAPTER 4
INVESTMENTS: RISK AND RETURN
Generally, financial managers
are
tasked to
perform
functions
requiring them to invest corporate funds in different types of
investment. The
idea is that these corporate funds earn a profit
return. Like starting up a business, investments have
potential returns as well as it may also involve
potential losses.
or
These losses are viewed in the business
as risks. Losses are
direct manifestations of risks. In essence, returns and
risks
are
direct opposites. Undeniably, investors wish that they would
have higher returns but lower risks or have returns without
risks. However, it is a reality that returns
hand in hand with
risks.
go
In fact, some old adage say that "the higher the
risk, the
higher the return." In this chapter, we shall validate this maxim
and see if it is indeed
true.
In this chapter, we will deal with the following concept
of risk
and returns and some of the theories that existed before we
enjoyed the simplicity of the models we utilize for computing
risks and returns.
INVESTMENT
Overview of Investment in
a
single asset or Stand-alone
Investments
It is with business, as with human behavior, that we try to
place our money and efforts in some activity that would give us
a reward. Say for instance, we try to plant avocado seeds with
the hope that one day we shall reap from this avocado seeds
once it has become a full-grown seed. Similarly, businesses
have assets that they want to utilize
the profits or
to
be able to reap
return in the future. More SO, it is
or enjoy
actually the
idea of starting a business: investing or putting up money or
seed capital with the hope of recouping this investment and
117
INVESTMENTS: RISK AND RETURN
earn
profit in the future. In this discussion,
shall
we
particularly deal with investments in securities.
generally pieces of paper containing the cost of
be
investing in such securities and the kind of return to
Securities
are
=
idea of
expected in the future by holding such securities. The
①
securities
comes
from the two-way concept of business.
companies need money to
run
Some
②
while others
their businesses
that needs
have money to spare. When these two meet, the one
money shall
borrow
money from the one who has
the money.
one borrowing shall issue a paper (security) as a
commitment or promise to the holder of the security
The
(investor)
to have a claim in
the future for their investment.
While the concept may be simple, securities vary from form-to-
form and may involve several complexities.
A
concept
is
prevalent with securities: they represent economic claims
against future benefits. Further to this concept investments
have common important features which is risk and return. The
ultimate
goal of understanding risks and
returns
determine what kind and how much return do investors
and the
is to
want
accompanying risk they will undertake. Or simply, for a
financial theory
point of view, we want to discover the
amount
of return the investors will demand
money in a security with
a
for investing or putting up
particular level of risk. In the
sections below, we shall be dealing
with
single type
a
of
security or a single-asset investment or a stand-alone
investment. Further topics will then focus on
investment in a
portfolio of securities or assets.
isang
RETURN (Stand-alone or
Behaviorally speaking,
single asset)
a
income has the free reign
person who controls
tao
,
is a
hanak
a
disposable
on what to do with such income. As
succinctly discussed in the previous section,
because of a
lang
a
person invests
potential income from executing such particular
118
INVESTMENTS: RISK AND RETURN
investment.
In fact, it is the return or profit-making
characteristic of a person that drives
expectation
him/her to invest. The
of return is inherent in investing. In fact, the
motivation to increase wealth is, by far, the most important
reason
for investing.
What then is return? Return is simply a profit earned on
top of the investment made. Simply put, it is the percentage of
let
the growth
of an investment. Mathematically speaking, it can
be represented through the formula:
return (%) =
proceeds or current value of investment
-
investment
investment
above formula shows that return could simply be a
percentage change equation. Investors typically measure
The
return in terms of how much cash flow as generated when such
investment is collected (proceeds) or how much is the current
value of the investment. Below is an example of the application
of return:
* Illustrative Problem 4-1
Mr.
Alexis recently placed
inherited from his father
to a
his
P1,000,000
money market
placement today. After one year, Mr. Alexis
decided to move the funds and instead use the
money to purchase shares in Sam Michael
Corporation. Mr. Alexis received P1,040,000 from
the money market placement.
To determine the return Mr. Alexis generated:
return (%) =
return (%)
proceeds or current value of investment - investment
investment
P1,040,000 - P1,000,000
P1,000,000
return (%) = 4%
119
INVESTMENTS: RISK AND RETURN
Therefore, Mr. Alexis generated a
4% return on
his investment in the money market placement.
The above example shows us a typical computation of
return. However, for some other securities, there may be other
computation considering the different
circumstance and complexity of the security in particular.
Narrowing down these complexities, we can identify two
forms of return or yield
behaviors of returns: fixed returns and variable returns. As
evident from the name
securities behave in
behave. Below are
of the return type, investments
a manner
some
or
relative to how their returns
cases of describing the returns of both
fixed- and variable-income investments:
CASE 1: Fixed-income
Mr. Billyilly recently purchased a bond at
a nominal rate
of 3% for P1,000,000. He immediately researched the
quality of the bonds with similar features and found
that such bond is expected to have a
return or
yield of
4%.
In the above problem,
the return as it is
there is no need to compute for
already provided: 4%. Note however
that the nominal rate of 3% is not the return
as
it
represents only the annual interest payment to be made
by the issuer to the bondholder.
CASE 2: Variable-income (series of time)
Mr. Clarkson purchased the stock of IY Convergence,
Inc. which proposed a five year return plan. After one
year of holding their stock, Mr. Clarkson is expected to
earn 7%. Returns for the succeeding years are 5%, 10%,
8% and 9%.
120
INVESTMENTS. RISK AND RETURN
To
determine the expected return
average return of IY
of
Mr. Clarkson, the
Convergence, Inc. must be
computed:
return
=
7% + 5% + 10% + 8% + 9%
return = 7.8%
CASE 3: Variable-income (probability-based)
Mr. Dylan purchased
stock of Benguett Consolidated
Mining Corp. which provided, in its prospectus, paya
off table of the amount of return expected in
a
given
market condition for copper which is its prime product.
The pay-off table is as follows:
Demand for copper
Return on
Probability
particular
of demand
demand
High (>10 billion metric
18%
20%
12%
50%
8.7%
30%
tons)
Normal (5-10 billion metric
tons)
Low (<5 billion metric tons)
In the problem above, we can compute for Mr. Dylan's
expected return
on
Benguett
by extending the pay-off
table to include expected returns on each particular
condition
demand
by multiplying the return on particular
by its probability of occurring:
121
INVESTMENTS: RISK AND RETURN
Demand for
Return on
Probability Expected
copper
particular
of demand
return
demand
High >10
18%
x
20%
=
12%
x
50%
=
3.6%
billion metric
tons)
Normal (5-10
6%
billion metric
tons)
Low (<5 billion
-8.7%
30%
x
metric tons)
-2.61%
=
-
Expected Return
on
Benguett
=
6.99% z→
stock
By looking at the three scenarios above, we can see that
the
computation of returns may vary depending on the situation of
the particular security.
above may show
a
You can
particularly expect that Case 3
realistic example on how returns are
computed in real life. In some
of our
discussions below, we
may refer to Case 3 as an example.
Notes:
Expected Rate of Return
return that is
-
the percentage
expected to be realized
on
or
rate of
an investment
after taking into account the probability of possible
outcomes.
Required Rate of Return -
the
minimum rate of return
acceptable by the investor on the portfolio investment.
122
Expected
Return
INVESTMENTS: RISK AND RETURN
Actual Rate of
Return
the percentage or rate that is
actually earned by the investor on the portfolio
investment.
Market Equilibrium - the
event when the required rate
of return is equal to the expected rate
of return on an
investment.
RISK (Stand-alone or single asset)
It is
quite difficult to discuss with ease the concept
of risk
without touching on the topic of return. More importantly, it
should be emphasized that risk involves a probability of loss on
the part of the investor. As
it
was previously mentioned,
losses incurred are actually manifestations of risk.
other hand,
the
Risk, on the
is a measure of the chance of loss.
to
While several measures of risk are available, the standard
deviation is one of the
primary tools by financial managers in
determining the level of risk. Why standard deviation?
Standard deviation is a statistical tool to determine the amount
of variability or dispersion
or
of data from the
average, the mean
the midpoint. Generally, a low standard deviation indicates
that the data points tend to be very close to the mean;
high
standard deviation indicates that the data points are spread
out over
a large range of values. To refresh, standard
deviation's formula (population)
is:
x)2P where;
o = standard deviation
X= data within
x = mean
the population
or average of the population
P = the corresponding probability of each data
123
INVESTMENTS: RISK AND RETURN
Translating this to investments, the higher the standard
deviation means a higher the probability of experiencing
different
amounts of return.
experiencing the different
Now, what is
amounts of return?
The problem
with different amounts of return is that there is
experiencing
a
wrong in
a danger of
loss. Let us discuss the impact of standard
deviation using Case
3 above:
Illustrative Problem 4-2
Mr. Dylan purchased a stock of Benguett Consolidated
Mining Corp. which provided, in its prospectus, a pay-off
table of the amount of return expected in a
given market
condition for copper which is its prime product. The payoff table is
as
follows:
A
B
C
Demand for copper
Return on
Probability
particular
of demand
demand
High >10 billion metric
18%
20%
12%
50%
8.7%
30%
tons):
Normal (5-10 billion metric
tons)
Low (<5 billion metric
tons)
In this problem,
we are given the same information and we
are to find out the standard deviation of Benguett
Consolidated to
measure its corresponding risk. Again
we
will create additional columns in the table but this to
include several other new columns to
account
components of the standard deviation computation:
124
for
INVESTMENTS: RISK AND RETURN
A
B
C
D
Demand for copper
Return on
Probability
Expected
particular
of demand
return
18%
20%
3.6%
12%
50%
6%
-8.7%
30%
-2.61%
demand
High (>10 billion
metric tons)
Normal (5-10 billion
metric tons)
Low (<5 billion metric
tons)
Expected Return on
6.99%
Benguett stock (x)
F
G
(x-x)2
(x - x)2P
[B - x]
[E2]
[C x F]
High >10 billion
18%-6.99% =
1.212201%
0.24244%
metric tons)
11.01%
E
or
0.0024244
Normal (5-10 billion
12%-6.99% =
metric tons)
5.01%
0.251001%
0.12550%
or
0.0012550
Low (<5 billion
-8.7%-6.99%
metric tons)
2.461761%
0.73853%
or
-15.69%
0.0073853
i
0.0110647
E(x - x)2P
(variance)
0.1051889
or
(standard deviation)
10.51889%
125
INVESTMENTS: RISK AND RETURN
As
computed above,
we
can
conclude that
Benguett'
Consolidated Mining's standard deviation is around 10.52%.
expected from Benguett
This means that the return
Consolidated Mining is between 10.52% above or below
its
expected return of 6.99%. Further expounding, investors can
expect, with this level of risk (standard deviation) that it could
statistically earn anywhere close to -3.53% (6.99%
10.52%)
and 17.51% (6.99% + 10.52%).
If we are to
look at the general notion of risk as presented
above using standard deviation, it seems
that risk is about the
dispersal of the possible returns rather than the loss itself.
That notion is exactly the notion of risk.
of return that could be expected
It is the
from a
possible range
security. If we are
look at Investor Mr. Billy from Case 1, we notice that
to
the
investor expects a single amount of return which is 4%. This is
virtually riskless as the investor expects no other return lower
than
4%. However, he must expect as
well that no other return
will occur higher than 4%. Consequently, Mr. Dylan from Case
3 and Illustrative Problem 3-2 holding Benguett Consolidated
Mining expects
a
return of 6.99% subject however
to
the
possibility of earning a lower or a higher amount. As such, Mr.
Dylan has no assurance that he shall receive the expected
6.99%. He runs the risk of earning a negative return or a return
lower than 6.99%.
Special Metric: Coefficient of Variation
It is quite easy to compare investments with similar return but
different standard deviations or investments with similar
standard deviations but different returns. However, it is
quite
difficult to compare investments which have different returns
and different standard deviations. So to allow investors to
compare
different investments, the coefficient of variation may
be utilized.
126
INVESTMENTS: RISK AND RETURN
The coefficient
of variation is a formula to represent the
deviation) per unit of return:
relative level of risk
(standard
O
Using the coefficient of variation, investors could easily
compare several investments with different returns and risks.
Risk Aversion and Risk Premium
Again, comparing Case
1
and 3 above,
we notice
that the
"riskless" security acquired in Case 1 by Mr. Billy earned a 4%
yield while the "risky" security in Case
expected return of
mentioned
3
for Mr. Dylan has an
6.99%. We notice that the earlier maxim
("The higher the risk, the higher the return")
is
actually true. Naturally, investors who take on more risks with
"risky" securities tend to demand a higher return. In fact, most
financial management and financial economic theories are
developed under the assumption that a normal
behaves in that way. That behavior is what we
investor
call
risk
aversion. Ideally, investors do not want risk but if you provide
them securities with a considerable amount of risk, they will
higher return. Consequently, securities that have
higher risk tend to have higher returns.
ask for a
cases mentioned, the riskier asset (Benguett
Consolidated Mining in Case 3) has a higher return at 6.99%
In
the
than the less
risky asset (the bond in Case 1)
4%. The difference of 2.99%
is
with
more
return of
what we call the risk premium.
Risk premium is the additional or excess return
investors for taking on a
a
risky security.
127
provided to
INVESTMENTS: RISK AND RETURN
iba 't
PORTFOLIO j
-
nd
iba hanak
Stoll
In the previous sections, we discussed return and risk in the
context of a stand-alone investment. Realistically speaking
however, investments are executed using various types
of
securities. These securities operate, interact and correlate with
each other in
a
given market. The idea of
portfolio is that
investors do not put
their money in
but instead put it in
several types of investment. The mere
a
single type of investment
act
putting money in several types of investment already
constitutes establishing a portfolio. What then is a portfolio?
of
A
portfolio
is a collection of assets or securities that
a
particular firm has for it investors. If you can remember that
a
security is
piece of paper, then
portfolio
figuratively a
place where you put all your "paper" securities. While there
are largely similar concepts for returns and risks in standa
alone investment and
a
a
is
portfolio, there are largely other
concepts that are different.
Risk in
a Portfolio context: Diversifying portfolios by adding
more securities
It was discussed
previously that risk can be measured by a
securities' standard deviation. Moreover, we established
that
the higher the standard deviation, the higher the expected risk
that
investors assume on the security. However, risk in a
portfolio context involves
another element. Notice that
securities do not
securities.
"stand alone" but coexist with several other
The market (environment) is actually a large
portfolio of securities, each of which has its own risk and
return. Nonetheless, even
if
each security has its
own
characteristics, its coexistence with other securities exhibit
characteristic that
is essential in the context
correlation.
128
of a
portfolio:
INVESTMENTS: RISK AND RETURN
Correlation, statistically speaking, is the
measure of the
relationship between two variables. In the
investments
and portfolio, correlation is the
context
measure
of
of the
kind of coexistence between two securities. For instance,
In 0 Offset
Security A increased its return by 10% while Security B N
'
decreasedits return by 10%. We can simply say that
Security A
inversely related to Security B. We note, however, that
Security A has its own risk as well as Security B. When we
place them together in a portfolio, the risk is eventually
is
reduced
or
tempered. This is due to the fact that the
two
securities are negatively correlated.
If we add more securities to the portfolio of Security A
and B,
we expect that the relevant risk of the whole portfolio is
decreasing. We should note, though, that while the risk
decreases as we add more securities to the portfolio, we can
never
eliminate risk. The process of adding more securities and
thus decreasing the risk is what we call diversification. During
diversification, the risk of the overall portfolio decreases up to
a
point that the risk stops decreasing. The risk that can be
eliminated through diversification is called unsystematic or
diversifiable risk. On the other hand, the risk that can
eliminated even
never
be
if the investment is fully diversified is called
the systematic, non-diversifiable or market risk. In addition,
the market risk
represents the particular risk of a security in
relation to its existence in the
market containing all types of
securities. Consequently, among these two kinds of risk, we are
more interested with the systematic or the market risk
provides us
that is
a
as
picture of the true risk of a security or the risk
common
to all investors. Furthermore, this market risk
directly impacts the return of a particular security which will
be
discussed in the immediately succeeding section.
129
lang
INVESTMENTS: RISK AND RETURN
Returns in a Portfolio context
It was discussed in detail that returns are the potential profits
of each
particular type of security. Return in a portfolio context
is not at
all difficult; it is simply the weighted average
returns of each type
returns
of
of all the
security. However, we emphasize that
computed in a portfolio context shall be directly
related to the risk determined also in a portfolio
context and in
particular its market risk. Financial theorists developed
model to help estimate or determine a particular security's
required
return
by taking into account benchmark returns
as
well as the market risk identified in the previous section. This
model is what we call the Capital Asset Pricing Model or CAPM.
Capital Asset Pricing Model or CAPM
Before we deal with the totality of the CAPM, we should
first equip ourselves with its basic assumptions, as
compiled and summarized by William N. Goetzmann:
1.
All assets/securities in the world are traded.
2.
All assets/securities are infinitely divisible.
3. All investors in the world collectively hold all
assets.
4. For every borrower, there is a lender.
5.
There is a riskless security in the world.
6. All investors borrow and lend at the riskless rate.
7. Everyone agrees on
return and
8.
the
inputs to the Mean-STD (the
risk in a stand-alone context) picture.*
Preferences are well-described
by simple utility
functions.*
9.
Security distributions are normal, or at least well
described by two parameters.*
10. There are only two periods of time in our world.
* Represent those statistical parameters essential to
develop the model though may not necessarily reveal
economic condition.
130
an
INVESTMENTS: RISK AND RETURN
The list above simply describes the characteristics of
a
perfect frictionless economy. Nonetheless, more than
anything listed above, the CAPM simply wants to
put
a
security's risk as the only variable in the model. The CAPM
factors out nuances of imperfection to fully identify how
a
security would behave in terms of risk and return in a
portfolio context. With the above condition, the risk,
the
only remaining variable in the model, will help determine
the amount of return
a
particular security must provide
or
simply determines the required return from a particular
security. Before we provide the mathematical model,
must
we
first identify the components needed:
r = the required return of a particular security
I=
refers to the risk-free rate of return or the return of the
riskless security; An example of a
are
riskless securities
government notes and bonds (Treasury Notes,
Treasury Bills and Treasury Bonds) which exhibit
virtually a low amount of risk.
I'm
=
refers to the market return or the overall return of the
whole market containing all the "risky"
and "non-
risky" securities
MRP = refers to the market risk premium or the additional
or excess return
provided by the market as
premium for having "risky" securities; this can
a
be
determined by subtracting the risk-free rate of
return from the market return
This is the measure of the riskiness of a security.
The Beta also measures the responsiveness of a
B = Beta
particular security with the fluctuations of returns
the market. In relation to the earlier discussion
risk, the Beta
is
in
on
conceptually the measurement of the
systematic or market risk
131
of
particular security.
INVESTMENTS: RISK AND RETURN
'
to
As such, the formula for the CAPM is:
T= T, + B(MRP)
r=
Risk free rate + Risk Premium
From the equation, we can fully understand that all
components except the Beta
context. The
is
other
constant in the CAPM
Beta, therefore, represents the security and,
in
particular, its risk in relation to the market. We can
ultimately see that a security's return is largely dependent
on the level of risk that particular security exhibits.
Illustrations below are provided to show several cases
involving various levels of Beta:
CASE 1: Beta is exactly 1.0 (Average Beta)
Company A recently acquired the shares of
PDMT with a Beta of 1.0. It wishes to determine
the required return of such particular stock. The
government Treasury Bills yield 4%. On the
other hand, the prevailing market return is 10%.
To determine the required return on PDMT
shares:
r=
4% + 1.0(10%
4%)
r = 4% + 1.0(6%)
r = 10%
Notice that the return of PDMT shares is
which is
10%
equal to market return. This means that
PDMT shares will respond directly to the
fluctuations of the market. Simply put, a 10%
132
INVESTMENTS: RISK AND RETURN
increase in the return of the market will
also
make PDMT shares increase by 10%. Conversely,
a
50% decrease in the market return will make
PDMT shares decrease by 50%.
CASE 2: Beta is below 1.0 (Defensive or Conservative Beta)
Company B recently acquired the shares
Equity Ventures with
a
of ABBA
Beta of 0.8. It wishes to
determine the required return of such particular
stock. The government Treasury Bills yield 4%.
On the other hand, the prevailing market return
is 10%.
To determine the required return on ABBA
shares:
r=
4% + 0.8(10%
r=
4% + 0.8(6%)
4%)
r= 8.8%
In this example, we see that ABBA's return is less
than the market return. This
periods
means
that in
of fluctuations, ABBA shares
will
respond directly at a lower degree than it could
have responded had its Beta been 1.0.
This
means that a 20% increase in the market return
will translate to a lower increase in the return
for ABBA. Note however, that it is not simply
a
matter of proportion (meaning 1:0.8 ratio) but
rather
a
degree of responsiveness. Further to
this, we could also conclude that a 30% decrease
in the market return will translate to
a
lower
decrease in return for ABBA and thus minimized
the
losses experienced.
133
INVESTMENTS: RISK AND RETURN
CASE 3: Beta is above 1.0 (Aggressive Beta)
Company C recently acquired the shares of
Carcamo Corporation with a Beta
wishes to determine the
of 1.5. It
required return of such
particular stock. The government Treasury Bills
yield 4%. On the other hand, the prevailing
market return is 10%.
To determine the
required return on Carcamo
Corporation shares:
r=
B(r'm
4% + 1.5(10%
r=
4% + 1.5(6%)
r'=
If +
4%)
r = 13%
Taking the applied concepts above, Carcamo's
return is higher than that of the market.
Consequently, any change or fluctuation in the
market returns will cause a higher degree
of
change for Carcamo. However, note that in the
three cases above, the direction of the movement
of the shares shall be in the same direction as the
movement of the market only that we could
notice the varying degrees of responsiveness
with the market.
The Security Market Line (SML)
The
Security Market Line was developed together with the
CAPM
to graphically depict the interaction between the
Beta (risk) and the
further
relation
required rates of returns. The SML can
encapsulate several scenarios that could occur
to the changes in risk-free rates of
in
returns and
market returns as well as the Beta of individual securities.
134
INVESTMENTS: RISK AND RETURN
basic graphical representation of the SML is shown in
The
Figure 4-1 below:
Figure 4-1
The Security Market Line
The
Security
Required
Rate of
Return
A line
representing
the risk-free
rate
of return
Beta
In the figure above, the elements of the Security Market
Line
is
provided. Note that
a
special line
is drawn
representing the risk-free rate of return. The region
from
the horizontal axis to the special line represents the riskfree rate of return. As the Beta increases, the required rate
of return plotted along the Security Market Line also
increases consistent with how Beta behaves in the CAPM
formula. In fact the SML is has an equation similar to that of
the CAPM:
In some instances,
the Security Market Line shifts
due to
changes occurring with its components most especially
with the risk-free rate of return and the market return.
First, when inflation expectations increase, the risk-free
rate also increases. However, it should be emphasized that
the market return must also increase in the same degree as
the risk-free rate:
135
INVESTMENTS: RISK AND RETURN
Illustrative Problem 4-3
Previously, the Treasury bills yield 4% while the market
return is at 10%. Currently, the investors believe
due to expected inflation, the risk-free rate
should be pegged at
that
of return
6% rather than 4%.
The SML Equation previously would have looked like:
SML = 4% + B(10% - 4%)
Because of the expected inflation, the SML equation
would become:
SML = 6% + B(12%
Note that a
-
6%)
2% increase in the risk-free rate of return
also translated to an increase in the market return of
2%. Thus the risk-free rate of return and the market
return shifted to 6% and 12%. Note also that
the
increase in inflation expectations SHOULD
the market risk
NOT change
premium (MRP). In the example above,
the 6% MRP from the original equation (10%
not change
can
4%) did
in the
new SML equation (12% 6%). We
graphically depict this situation in Figure 4-2 below:
Figure 4-2
Change in SML due to change in inflation expectations
136
INVESTMENTS: RISK AND RETURN
We can see that the SML equation shifted upward as
result of the change in inflation expectation.
Second, the SML may change because of
a
a
consequent
change in the behavior of investors. More importantly,
there is
a
considerable
of
amount
change in the risk
aversion of the investors. The change in the
risk aversion of
the investors manifest through the increase in the risk
premium they are demanding for "risky" securities. The
change may
markets or
occur
extreme
because of the restlessness of the
changes in macroeconomic factors
or
any other factor that will drive the investors to change their
behavior towards "risky" securities.
Illustrative Problem 4-4
Currently, the risk-free rate of return based on the yield
of
Treasury bills amount
to
4%. During the previous
year, investors project the market return at 10%.
However, due to the increasing volatility of the European
market, the investors have become more averse of the
risk
involved
in
holding
securities
other
than
government-issued securities. As a result, the investors
believe that the market risk premium should increase by
2%.
The first SML equation should be presented as:
SML = 4% + B(10%
4%)
SML = 4% + B(6%)
We notice that the MRP in the first SML equation
is 6%.
Now we present the second SML equation to reflect the
change in risk aversion of the investors:
SML = 4% + B(12% 4%)
SML = 4% + B(8%)
137
INVESTMENTS: RISK AND RETURN
Note that the MRP increased
by 2%
to
become 8% to
reflect the increase in risk aversion of the investors.
Consequently, the market return of
10% should
to 12%. In this case, we hold the
risk-free rate of return constant as there are no changes
increase also by 2%
in inflation
averse
expectations but rather
behavior
a
change in risk-
of the investors. We
can
also
graphically depict this situationin Figure 4-3:
Figure 4-3
investors' risk aversion
Change in SML due to change in
In this situation, rather than shifting upward, the SML's slope
became steeper due to the increase in the investors' risk
aversion.
138
INTEREST RATES
CHAPTER 5
INTEREST RATES
When investors put
up money in particular
demand a certain cost for the use
of their
securities, they
money. In the
previous chapter, we identified that this is the return. Similar
to
that of profit, the return
is
the cost of using investor or
lender's money. As we discovered the concept of risk premium,
we also know that investors would demand
a higher return.
Thus, this is in line with the maxim that "the
higher the
expected risk, the higher the expected return".
In this section, we shall focus
which
particular kind of security
is debt. Moreover, we will be discussing the following:
on a
Nominal interest rates and Annual percentage rate
Effective interest rates and Annual percentage yield
Real risk free rate
Inflation premium
Default risk premium
Liquidity premium
Maturity risk premium
INTEREST RATES
Most of us are more familiar with the term interest
return. Interest rates
are
as benchmark for other
rates than
essential as they are commonly used
types of securities in determining an
acceptable level of required return. More importantly, interest
rates depict certain macroeconomic factors. Essentially, debt
securities would show
a
quoted or nominal interest rate to
indicate how much would the lender be paid upon settlement
of such debt. The interest
quarterly
or
may be paid annually, semi-annually,
monthly. More so, the interest may either be
simple interest or compounded interest.
The Nominal Interest Rate, also known as stated or coupon
rate, is the interest rate used to compute the interest payment
157
INTEREST RATES
received by the investors from debt securities. The
interest
payment does not consider compounding effect.
Annual Percentage Rate (APR) is the cost of source
of
financing that considers simple interest. This rate
is
computed using the formula:
APR =
Where:
I- is the interest amount
P - is the principal
T- is the time
period
Illustrative Problem 5-1:
Antonio Tenedero Company (ATC) issued 100 bond
certificates with P1,000 face value each. The total
interest of
Annual
P3,000 is payable semi-annually. What is the
Percentage Rate of Interest or Coupon rate?
SOLUTION:
APR:
APR
P3,000
=
P100,000 x
180
360
APR = 6%
The result shows
coupon rate or
pays
that the annual percentage rate or
nominal rate is 6%. Hence, the issuer
interest of P6,000 per year or P 3,000
months.
158
every six
INTEREST RATES
The Effective Interest Rate,
the interest rate
also known as the discount rate,
is
used to compute the present value factors.
The interest payment considers the compounding effect.
%
Annual Percentage Yield (APY)
is the cost of
of fund that considers the effect of
source
compounding. This
is also known as Effective
Annual Rate. This yield is computed using the
formula:
APY or EAR or
Eff%= {[1+ m Im - 1}
Where:
APY - is the Annual Percentage
Yield
i - is the nominal interest rate per year
is
m
the number
of compounding
periods within a year
%
Illustrative Problem 5-2:
ABC Company borrowed P 200,000 for 180 day period.
The firm will repay the P 200,000 principal amount and
P6,000 interest. What is the Annual Percentage Yield
considering the compounding effect?
APR =
SOLUTION:
P6,000
APR
=
P200,000 x
180
360
APR = 6%
Based on the Annual Percentage Rate formula, the
nominal interest rate in this problem is 6% without
be used
considering compounding effect. This rate shall
in computing for the Annual Percentage Yield (APY).
159
INTEREST RATES
Since the said loan matures in 180 days, the number of
compounding period
within
a
year is 2 m =
360
semi-
annual]. Thus,
APY = ([1 +
APY
=
m
]m - 1}
{1.0609 -
1}
APY = 0.0609 or 6. 09%
The result shows that the cost of short term fund is
6.09%. This is the effective rate
the effect
of interest considering
of compounding.
Assume instead that the loan is payable or outstanding
for
90-day period. What is the Annual Percentage Yield
(APY)?
APR =
APR =
P6,000
P200,000 x
90
360
APR = 12%
Based on the Annual Percentage Rate formula, the
nominal interest
rate in this problem is 12% without
considering the effect of compounding. This rate shall
be used in
computing for the Annual Percentage Yield
(APY). Since the said loan matures in 90 days, the
number of compounding
360
period within a year is
quarter]. Thus,
m
160
4
[m =
INTEREST RATES
APY = ([1+ 44 ]4 - 1}
APY
=
{1.1255
1}
APY = 0..1255 or 12.55%
This time the cost of short
term
fund is 12.55% after
assuming that the loan is payable in 90 days.
Components of Nominal Interest Rates:
Real risk-free interest rate (r*)
The real risk-free rate of interest
represents the actual
yield of risk-free debt security. Common to many
territories,
government-issued Treasury bills simulate
risk-free debt securities. However, these Treasury bills
are infused with inflation premium to provide
a
premium for the possibility of encountering inflation.
The real risk-free interest rate is the "true"
rate assuming there is no expected inflation.
Risk-free interest rate
We have
risk-free
(ror r* + IP)
previously encountered and utilized above the
risk-free interest rate
Asset Pricing Model
return serves
as
as a
component of the Capital
(CAPM). Again,
the risk-free rate of
a component of the nominal interest
However, we may closely attribute this to the
preceding component which is the real risk-free interest
rate.
is noted in the title of this section, the riskfree interest rate is imputed with inflation premium
rate. As it
(IP) to protect the investors from the effects of inflation.
161
INTEREST RATES
may also be either applicable to shortterm or long-term securities and would definitely differ
Risk-free rates
under the two.
As discussed in the previous chapter, the Security
Market Line (SML) changes due
to the increase or
decrease in the inflation rates. In this chapter, the
nominal risk free rate or simply risk free rate (r)
is
calculated using either a) simple format or b) cross
term format.
r*
The simple format, [r
+ IP], is used
when the real risk free rate and inflation rate is
relatively low thereby having an immaterial cross term
result. On the other hand, the cross term format shall be
used to
compute the nominal risk free rate if the real
risk free rate and inflation is relatively
high. In this case,
the cross term result shall be material or significant.
Thus, the cross term format is:
* Rfr = r* + IP +
Inflation Premium
(r* X IP)
(IP)
Inflation generally affects investment
technically
decisions
"eats" up the interest to be received
lender-investor after a certain period
as
it
by a
of time. The
inflation premium, as described previously, protects the
lender from the effects of inflation. But how does
inflation affect interest?
We all know that interest is a form
you have
of return. Suppose
money today amounting to P1,000 pesos.
You
have no immediate use for
the money today so you
chose to invest your investible money at a particular
investment opportunity that will provide a 5% interest
for
one
year. As such, you expect to receive P1,050
pesos at the end of one year. Before you made the
162
INTEREST RATES
investment, you noticed a nice USB flash disk costing
P1,000. Since you really do not need one at that time,
you have forgone purchasing the same. After one year,
receive your P1,050, the principal you lent plus the
5% interest rate. Shortly thereafter, you needed the USB
flash disk for school work. Upon seeing the same flash
you
disk
you saw one year ago in the store, the price had
already gone up to P1,070. This is because there was
7% inflation for the year.
In the illustration above, the lender lost the opportunity
to
purchase the USB flash disk because the proceeds he
received one year after was not enough to pay
for the
new price of the item. Now, to protect lenders from this
situation, the real risk-free interest rates are increased
or "padded" by an inflation premium to provide
allowance for possible inflation.
Default Risk Premium (DRP)
The default risk premium originated from the risk
where the borrower is unable to make timely interest or
principal payments. Normally, sovereign state-issued
debt securities
carry no
or governments-issued debt securities
default risk as most sovereign states
and
governments ensure timely payment of interest and
principal. Therefore, default risk premium is closely
inherent to corporate-issued debt securities where the
possibility of default is
present. In most instances, the
default risk premium depends on several
characteristics
of
the
issuing corporation.
credit
These
characteristics are ultimately embodied in some credit
scores or
credit ratings. The lower the credit score
163
or
INTEREST RATES
credit rating, the higher will the default risk premium
be.
Liquidity Premium (LP)
Liquidity premium is an additional interest provided for
debt securities that are
to cash.
Liquidity, per
instrument to
fairly more difficult to
se, refers to
convert
the ability of an
be easily converted into
Therefore,
cash.
securities that are easier to be converted into cash have
low liquidity premium as they have less risk of not
being convertible into cash. Conversely, securities that
are more difficult to be converted
liquidity premium
to
into cash have higher
compensate for the risk assumed
by investors of not being able to dispose
or
convert
these securities into cash.
Maturity Risk Premium (MRP)
Generally, market interest rates increase. However, the
price of debt instruments decrease when interest rates
increase. This phenomenon is further discussed
Chapter
6 of this text.
In this section,
in
we are more
concerned with risk generated by the decrease in the
price of debt instruments caused by the general
increase in interest rates.
be
encountered
instruments, a
To offset the losses that could
by the decreasing price of debt
maturity risk premium is imputed
on
long-term debt securities.
Nominal interest rate, therefore, is the sum total of the
components mentioned above. The formula for which is:
NIR =
[r* + IP] + DRP + LP + MRP
164
INTEREST RATES
However,
it is noteworthy to mention that not all kinds of debt
security can hold the same component altogether. The
components of interest rates depend on the kind of debt
securities being issued such whether this security is either:
A. Government issued or
Corporate issued
B. Short term or Long term security
INTEREST RATES COMPONENTS OF THE GOVERNMENT AND
CORPORATE ISSUED SECURITIES:
Short- term debt security:
Government
issued security such as Treasury Bill or
T-Bill.
Interest rate = r* + IP
Corporate issued security such as Corporate Note.
Interest rate = r* + IP + DRP + LP
> Long term debt security:
Government issued security such as Treasury Bond
Interest rate = r* + IP + MRP
Corporate issued security such as Corporate Bond
Interest rate = r* + IP + DRP + LP + MRP
165
VALUATION OF BONDS
CHAPTER 6
VALUATION OF BONDS
Companies primarily accumulate cash inflows through
its
earnings from the operating and investing activities. However,
these earnings may not be enough to fund other activities of
the company. Thus, there is
a
need to raise additional fund
through issuance of financial instruments to the investors such
as equity or debt instruments. The issuance of equity
instruments such as shares of stock is selling interest of the
company. The investors of these equity instruments,
who
are
part owner of the company, are known as shareholders. On the
other hand, the issuance of debt instruments such as bonds is
borrowing money with the intention to repay at a certain date.
The investors of these debt instruments, who are not part
owners
but lenders
of
the
known
as
at a premium or
at a
company, are
bondholders.
In
this chapter, we will discuss the following:
Characteristics of bonds
Valuation of bonds: issued at par,
discount
Determine the difference between yield
to
maturity
and yield to call
Computation of the required rate of return
Computation of the expected total returns on bond
investments
long-term debt instrument issued by government
to raise needed
agencies or corporations to the public in order
A Bond is a
funds. Moreover, it
holder of
is
a long term contract indicating that the
these instruments will receive a fixed interest
payment, known as coupon payment, each year until
its
maturity date and also receive a principal payment, known as
face value, on the said maturity date.
183
VALUATION OF BONDS
CHARACTERISTICS OF BONDS:
There are different kinds of bonds in the market. In general,
bonds are issued at par in which the coupon interest rate is in
equilibrium with the market interest rate. However, bonds can
be valued above or below its face value
depending on
the
fluctuation of interests in the market. Some bonds would have
attached provisions which
or
give rights
or privilege to the issuer
bondholder while other bonds do
bonds have differences, they
A.
not have.
Though
these
still have common characteristics.
Common Characteristics:
Maturity Date is
the date
which payment of the
specified in the bond on
Face Value is to be made
by
the issuer.
Face Value is the amount borrowed by the issuer
which is to be
paid at maturity date.
It is also known
as the Par value or Maturity value. For illustrations
and problem solving, we assume that the face value
of the bond is P1,000. (Note
amount which is
however that any other
multiple of P1,000 such as P10,000
or P500,000 can be used)
>
Coupon Payment is the amount
of interest payment
fixed each year until maturity of the bond. It is
calculated by multiplying the coupon interest rate to
the face value of the bond.
Coupon Interest Rate is the rate stated
which
is
used
for
annual
in the bond
interest payment
calculation. It is also known as Stated Interest rate
or Nominal Interest Rate.
184
VALUATION OF BONDS
%
CBM Corporation issued a 20 year, P1000 bond
with stated rate of 6% on January 31. 2012.
The
Maturity Date is January 31, 2032
which is
20
years from the date of
issuance.
The Face Value or Par Value is P1000
which shall be redeemed on January 31,
2032 (maturity date)
The Coupon interest rate
or stated rate is
6%
The Annual Coupon Payment is P60 [Face
Value x Stated Rate]
B. Other Characteristics:
1.
Issued with Call Provision - A provision that gives
rights or privilege to the issuer to redeem the bond
"call price" prior to its maturity.
at a certain
feature is normally attached to
a
This
corporate bond but
not to a treasury bond. Bonds with call provision are
referred to as callable bonds. These callable bonds
may have a provision stating that
A) the issuer may exercise the right to call the bond
starting from issue date, or
B) the issuer may not call until five(5) years
after
issuance.
The bond which
contains
a
provides
call protection such
a
as
deferred call
callable bond
with provision B.
When to exercise its rights to call?
The issuer will call the bond provided that the
right to call is already exercisable, such that the
185
VALUATION OF BONDS
call protection
of the bond expires. Moreover, the
decline in the market interest rate which
the value of the bond
to
appreciate will
causes
initiate
the issuer to call the said bond.
In the
event that the market interest rate
significantly declines, it is more advantageous,
cost-wise, for the issuer to call the old bonds and
replace
them by
new
bonds at
a
lower interest
rate.
* Will investor demand higher interest rate?
Since the issuer will call the bond any time prior
to
its maturity provided that the right
exercisable and
the
is
market interest rates
declines, it will be detrimental
to
the long term
investors who will reinvest in a lower interest
rate bond after the call made
by the issuer. Thus,
this is the risk borne by a callable bondholder. In
contrast with the Non-Callable Bond, there is no
risk of
early redemption of bonds, thus,
bondholder may retain the bond until it matures.
Because of the higher risk to be borne
by
investors in a
Callable bond than in Non-callable
bond, the investors in former bond will demand
a
higher interest rate in addition to call premium
than in the latter bond.
C) Issued with Put Provision - It is a provision that
gives right or privilege to the bondholder to "put
back" or require the issuer
to
repurchase the
said bond at a certain "put price" prior to
186
VALUATION OF BONDS
maturity. Bonds with put provisions are
called
putable bond.
When to exercise its rights
to put back?
The bondholder will require the issuer to
repurchase the bond prior to its maturity
provided that the right
to
put
back is already
exercisable. Moreover, the rise in the market
interest rate which causes the value of the bond
to decline will initiate the bondholder to put
back the said bond.
D) Issued with Convertible features -this gives the
bondholders the right or option to convert the
bond into number of shares of common stocks at
a predetermined price. The bondholders
have to pay cash in
order to exercise their option
rather they have to exchange
certain number
do not
the bonds for
of stocks. Therefore, the bond
considered as the payment in exchange
is
for the
stocks. The bond with such features is known
as
convertible bonds. The coupon payment offered
to
a convertible bond is practically lower than
those offered to a non-convertible bond with
same credit risk.
Issued with Warrants
this gives the bondholder
the right or option not
to
convert the bond but
an option to buy shares of common stock from a
company
at
a
predetermined price.
bondholders have to pay cash in
order
exercise their rights provided by warrant.
187
The
to
VALUATION OF BONDS
PARTIES IN THE ISSUANCE OF BONDS:
The
parties involved in the issuance of bonds are:
Bondholder
and Issuer.
1. The Bondholder is the investor who extends loans to
the
company certain amount of money equivalent to the
value of
known
the bond issued. These Bondholders are also
as
lenders or creditors of the
company.
2. The Issuers of bonds may either be the Government or a
Corporation.
> The bonds issued by the government are generally
referred to
as Treasury bonds or Government bonds.
Since these bonds are issued by the government
which is
bankrupt, it
is
certain that the bondholder will receive payment
at
an entity that does not
go
maturity date, thus, Treasury bonds has no default
risk or
credit risk. However, the prices of these
bonds vary indirectly as to market interest rates. As
the market interest rate increases, the value of the
bond decreases, and vice versa.
The bonds issued
by the corporation are known
as
corporate bonds. It is a reality that some of the
corporations encounter financial crisis
or worse,
they turn into bankruptcy. A corporation facing
these scenario may not be able to pay the agreed
interest and the face value of the bond, thus, there is
a
high probability of default risk in these kinds
bonds. It is well settled that the higher
of
the expected
risk, the higher the expected return. Since corporate
bonds have higher default or credit risks as
188
VALUATION OF BONDS
compared to Treasury bonds, the investors of the
former type of bond may demand additional yield or
interest in order
to compensate for default risk. This
additional yield on a corporate bond is
called default
premium.
Default Risk - it is the risk that the issuer may
not pay its obligation. It is also known
as
Credit
risk
Default Premium
investor of
a
the
additional yield that the
bond requires due to credit or
default risk is embedded in such bond.
VALUATION OF BONDS:
There are four factors affecting the valuation of the bonds.
These are coupon interest rates, the discount rate,
years until
maturity or call, and the face value of the bond.
The coupon interest rate
used to compute the
made
or simply, interest rate is the
rate
peso amount of interest payments to
be
by the issuer throughout the life of the bond. This rate is
bond upon its
also known as the "stated rate" indicated in the
issuance and it will be
constant until the bond matures.
referred to as the effective interest
The discount rate, which is
This is also
rate is used to compute the present value factors.
which is the minimum
known as the required rate of return
acceptable rate
as an
for
an investor. This rate fluctuates over
adjustment based on
company, the political
Bonds
are
Coupon
Payments
the financial status of the issuing
and economic status and other factors.
classified either
Bond. The
time
as
Nonzero Coupon Bond or Zero
former offers a stream of coupon
during the life
interest
of the bond while the latter does not
189
VALUATION OF BONDS
pay any interest at all. However, both kinds of bonds pay the
terminal value or the face value
at
the maturity
date.
A. Nonzero Coupon Bond:
equal to the present values of cash
flows from interest or coupon payments and cash flow from
The Value of this Bond is
the terminal or face value which is the maturity value of the
bond. The equation used to calculate present values of these
cash inflows in order to determine the bond's value (BV) is
(1 + D1
Where CP is the Coupon Payment
year,
(1+ D)T T (1 + D)T
(1+D)2
or
the Interest payment per
FV is the Face Value or the maturity value and
number of years until maturity of
n
is the
the bonds.
Alternatively, the Bond's Value can also be computed by
getting the present value of the cash inflows
of interest
payments and face value through the following formula:
1) Interest payments or coupon payments:
CP = [CIR x FV]
>
PVCP= [ CP X PV(OA - D. D) ]
2) Face value or par value.
>
Where: CP is
PVrV = [FV X PV(- D, D) 1
Coupon Payment
CIR is
Coupon Interest Rate or the Stated Rate
FV is the Face Value or the
Par Value of the Bond
PV CP is the Present Value of the
Coupon Payment
PVFy is the Present Value of the Face
Value
payment
(OA- D, n) is the Present Value Factor
Ordinary
190
Annuity
VALUATION OF BONDS
PV
(-D. n) is the Present Value Factor of One or Single
payment
Dis the Discount Rate or the Effective Interest Rate
n is the number of years or periods for discounting
Thus, the Bond's Value is (BV) = [PV cP
+
Investors of bonds (creditor) pay certain amount to the issuer
(debtor) in exchange for the bond's value. The amount of
payment could be equal to the face value
known as issued at par, above the face
is known as
of the bond which is
value of the bond which
issued at a premium; or below the face
value of the
bond which is known as issued at a discount.
Illustrative Problem 6-1
What is the value of
a fifteen-year (15), P1000
corporate bond with stated rate of 10% per annum?
Assume that:
A.
The bond of similar quality yields 10% rate.
B. The bond of similar quality yields 8% rate.
C. The bond of similar quality yields 12% rate
Scenario A: The
bond yields a rate of 10% and the stated rate of
10%.
+
(1+ D)1
100
(1+ 0.1)1
(1+D)"
(1+ D)2
(1 + D) (1+ D)"
100
(1+ 0.1)2
191
100
1,000
(1+ 0.1)15
(1+ 0.1)15
VALUATION OF BONDS
Alternatively;
= [ (CP x PV(OA- D. n) )
+
(FV x PV(1- D.n) ) ]
=[(10% x P1000) x PV(0A-10%.15)]+[P1,000 x PV(1- 10%, 15) ]
= [P100 x 7.36669] + [P1,000 x 0.26333]
736.67
+
263.33
= P 1,000
The Present Value factor of ordinary annuity payment at 10%
for
a
period of fifteen (15) periods
value factor for
is 7.36669.
The present
one or single payment for fifteen (15) periods
at the same discount rate of 10% is 0.26333. The present value
of the cash inflows from interest payments amount to P736.67
while the
principal payment which
is the face value has
a
present value of P 263.33. Moreover, the following analyses are
discussed below.
Analyses: If the Discount rate is equal to the Stated rate;
The Market Value of the bond amounts
P1,000 which is equal
to
to
the Face or Par
value.
The Amount to
be paid by
the investor is
equal to the Face or Par value.
> The Bond is issued at
par or at face.
Scenario B:
The bond yields
a
rate of 8% and the stated rate of
10%.
+
(1+ D)1
(1+D)"
(1+ D)2
192
(1 + Dya (1
+ D)"
VALUATION OF BONDS
100
(1+ 0.08)1
+
100
100
1,000
(1+ 0.08)2
(1+ 0.08)15
(1+ 0.08)15
BV = P 1,171.19
Alternatively;
+
= [ (CP x PV(0A- D.n)) + (FV x PV(1- D. n) ) ]
=[(10% x P1000): PV(0A-8%, 15) ]+[P1,000 x PV(1 - 8%,15) ]
= [P100 x 8.55948] +
= P855.95
[P1,000 x 0.31524]
P315.24
+
= P1,171.19
The Present Value factor of ordinary annuity payment at
for
a
period of fifteen (15) periods
value factor for
one or
8%
is 8.55948. The present
single payment for
fifteen
(15) periods
at the 8% discount rate is 0.31524. The present value of the
cash inflows from interest payments amounted to P855.95
while the present value of the principal payment is P315.24.
Moreover, the following analyses are discussed below.
Analysis: If the Discount rate is lower than the Stated
rate;
The Market value of the bond amounts
to
P1,171.19 which is above the Face or Par
value.
The Amount to be paid by the investor is
higher than the Face or Par value.
The Bond is issued at a premium.
The difference between the market value of
the bond and the face value is called bond
premium.
193
VALUATION OF BONDS
Scenario C: The
bond yields a rate of 12% and the stated rate of
10%.
+
(1+D)"
+ D)2 (1+ D)" (1 + D)"
(1+ D)1
100
100
(1+ 0.12)1
+
100
(1+ 0.12)2
1,000
(1+ 0.12)15 (1 + 0.12)15
Alternatively;
+
= [ (CP x PV(0A-D.m)) + (FVXPV@-D.m)) ]
=[(10% x P1000) x PV(0A- 12%, 15) ]+[P1,000xPV(1 - 12%.15) ]
= [ P100 x 6.81086] + [P1,000 x 0.18269]
= P681.09
+ P182.69
= P 863.78
The Present Value factor of
ordinary annuity payment at 12%
period of fifteen (15) periods is 6.81086. The present
value factor for one or single payment for fifteen (15) periods
for a
at
the 12% discount rate is 0.18269.
The present value of the
cash inflows from interest payments amounted to P681.09
while
the present value of the principal payment is P182.78.
Moreover, the
following analyses are discussed below.
Analyses:
if the Discount rate is
higher than the Stated
rate;
The Market value of the bond amounts to P
863.78 which is below the Face or Par value.
194
VALUATION OF BONDS
The Amount
be paid by the investor
lower than the Face or Par value.
to
is
The Bond is issued at discount.
The
difference between the market value
of
the bond and the face value is called bond
discount.
B. Zero Coupon Bonds:
This bond has no coupon interest payment but
are
usually sold below its Face Value or issued at a discount.
The
investors of this kind of bonds receive earnings
through the appreciation or
from
rise in the bond's value
the discounted selling price (price paid by
the
bondholder) to the Face value (price paid by the issuer)
when redeemed at the date of maturity. Since there are
no periodic interest payments in this kind of bonds, the
only cash inflow to be expected by the bondholder is the
principal payment or face value. Thus, to calculate the
valuation
of
a
zero coupon bond, the
following
equations can be used:
=
[FV xPV(1-D,n) ]
Illustrative Problem 6-2:
BlueBlurry Corporation issued a zero coupon bond with
15 years until maturity and a P1000 Face value.
Determine the value of the bond if the Discount rates
(required rate of return) are as follows:
195
VALUATION OF BONDS
A. 8%
B. 9%
Case A: If the Discount rate or the required rate
of return is 8%:
(1+ D)"
1,000
(1+ 0.08)15
Alternatively;
[P1000x PV(1- D,n ]
[P1000 x 0.31524]
=
=
The present
discount or
P315.24
value factor for one or single payment
required rate of return for 15 periods is
at 8%
0.31524.
Using the formula for valuing a Zero Coupon Bond, the
bond
can is selling at P315.24. Thus, the investor who will eventually
be the bondholder can purchase the bond at P315.24 today
then wait for
amount
15 years until maturity in order to receive the
of P1,000 which is the face value of the said bond.
Case B: If the Discount rate
or the required rate of return is 9%:
(1+ D)n
1,000
(1 + 0.09) 15
BV = P 274.54
Alternatively;
PV Face Value
196
VALUATION OF BONDS
[P1000 x PV(1- D,n) ]
[P1000 x 0.27454]
=
P274.54
The present value factor for one
or
single payment at
9%
discount or required rate of return for 15 periods is 0.27454.
Thus, the investor can purchase the bond at a value of P274.54
today but will receive the amount of P1000 which is the face
value when
NOTE:
maturity date
comes.
In compounding other than annual payments,
semi-annual or quarterly payment, determine first
such
as
the number
of payment periods in a year. Adjust number of periods (n) by
multiplying the number of payment periods per year by
number of
years until maturity. Before computing the coupon
payment (CP), adjust the coupon interest rate (CIR) by dividing
the number of payment period from the annual coupon
interest rate. Also, for the adjusted discount rate (D) used in
present value functions, divide the Discount rate by the
number of payment periods in a year.
If a bond issued and
sells at 100, this means that the
selling price of the bond or the value of the bond is 100 percent
of the par
selling
at
value, thus issued at par. However if the bond is
90, this means that the value of the bond is 90
percent of the par, thus issued at a discount;
while selling at
110 means that the value of the bond is 110 percent of its
par
value, thus issued at a premium.
REQUIRED RATE OF RETURN:
A bond's yield is the required rate
of return or discount rate
that will make the discounted value of
the expected future cash
inflows equal to the current market value
the intrinsic value of a bond to
197
of the bond. When
the investor equates to
the
VALUATION OF BONDS
market value, there is equilibrium between the required rate
return
of
of a bond and the bond's yield.
The bond's yield is commonly known as the yield
to
(YTM) which is the required rate of return on
bond if the
bondholder does
not
a
maturity
intend to sell the bond but rather hold it
until its maturity.
The YTM is the discount rate used
to
compute the present
value factors for single payment and annuity due which in turn
are used to calculate the bond's market value. This is
sometimes referred to as the internal rate of return which can
be calculated through interpolation; or trial and error solution.
Thus, using the above formula shown in the Nonzero Coupon
Bond Valuation discussion which is;
BV = 21-17
+
(1+D)"
or
[PV Coupon Payment + PV Face Value]
We
can do interpolation or trial and error calculation for the
YTM
the
or the Discount rate (D) given the current market value of
bond, the coupon payment and the face value
or
maturity
value. The aim here is to get the economic rate of return or the
estimated discount rate
that will equate the current market
value of the bond and the discounted cash inflows from the
coupon payments and principal payment. The Bond Valuation
(BV) to be used must be the current market value of the
or
bond
the bond price.
Illustrative Problem 6-3
A P1000 ABCD Corporate bond was issued on January 1,
2018 with annual coupon interest rate
of 8%. The
current market value of the bond is P935.82 and it
matures in
10 years.
198
VALUATION OF BONDS
Determine the
Discount rate
or
the Yield to
Maturity.
The current market value is P935.82 which is below
the bond's par value of P1000. It shows that the bond
was
issued at a discount. Based from
the analyses
summarized in Scenario 3 where the Bond Valuation
(BV) calculated is also at a discount, here it is safe to
assume that the discount rate must be higher than the
stated rate of 8%. Since we want
to equalize the
current market value with the present values of the
expected cash inflows, the discount rate that should
used in calculating the present values may be
not
be
any rate
below 8%, thus let us try to interpolate using 8.5%
and 9.5%.
Using 8.5% as the discount rate, we must
determine the
first
present values of the expected cash
inflows of the bond. The present value factor for
single payment is
a
6.56135 while the present value
factor of ordinary annuity is 0.44229. Using such
factors, the bond valuation with 8.5% discount rate
is calculated as follows:
BV = [ PVcoupon Payment
+
PVFace value]
BV = [ P 80 (6.56135) + P 1000 (0.44229)]
BV = P 524.91 + P 442.29
BV = P967.20
The valuation
of
a
bond with the following
characteristics: 8.5% discount rate, 8% stated rate
and 10 years
until maturity; amounted to P967.20
which is higher than the current market value
of P
935.82. Thus, we must now determine a bond
199
VALUATION OF BONDS
valuation lower than the current market value of
935.82. It is
well settled that the there
is
an
P
inverse
relationship with the Discount rate and the present
value factors. We
now
try a higher discount rate of
9.5%.
With 9.5% as the discount rate, the present value
for a single payment and ordinary annuity
are 0.40351 and 6.278798. The bond valuation
factors
with the following factors is calculated as follows:
PV Coupon Payment
BV = [ P 80 (6.278798) +
+
P
1000 (0.40351)]
BV = P 502.30 + P 403.51
BV = P905.81
The above computation shows that the valuation of
a bond with the 9.5% discount rate amounted to
P905.81 which is below than the current market
value of P 935.82. Since the current market value of
P935.82 is between the bond prices of P905.81
P967.20, we can assume that the Yield
or
the appropriate Discount
to
and
Maturity
rate for the current
market value is any rate between 8.5 to 9.5%.
To illustrate, we interpolate rates between 8.5%
and 9.5%:
Table A: Summary of Rates and Bond Prices
8.50%
Discount Rates
9.50%
967.20 P 935.82 P 905.81
Bond Prices
200
VALUATION OF BONDS
Interpolation Process
R1 - R2
P1 - P2
R1 - R3
P1 -P3
The above table shows the summary of the
discount rates with their corresponding Bond
Prices calculated from
Problem
the given the Sample
6-3. The said problem required to
calculate the Discount Rate (R)
Maturity (YTM).
Discount Rate
It is
or the Yield
clearly shown in Table
(R2) signifies
the
to
A that
YTM with
corresponding bond price (P2) of P935.82.
Thus, in determining
the
value of R2(YTM), we
must use the interpolation process formula as
follows:
STEP 1:
Interpolation Process Formula
8.5%
8.5%
P967.20 -
9.5%
P935.82
P967.20 - P905.81
STEP 2: Interpolation Process Formula
8.5%
P31.38
(-1%)
P61.39
STEP 3: Interpolation Process Formula
[8.5%- R2]
(P61.39)
P31.38 (-1%)
201
VALUATION OF BONDS
STEP 4:
Interpolation Process Formula
P5.21815
(- P0.3138)
P61.39 R2
STEP 5: Interpolation Process Formula
P61.39 R2
P5.21815 + P0.3138
STEP 6:
Interpolation Process Formula
P61.39 R2
P5.53195
STEP 7: Interpolation Process Formula
P 5.53195
P61.39 R2
P61.39
P61.39
= P5.53195 : P61.39
=
From the
0.090111 or 9 %
Interpolation Process,
we
determined the
Discount Rate (R2) or The Yield to Maturity of the given
bond with a current market value of P935.82. The YTM
which is also known as
calculated
from
the
the internal rate of return (/RR)
given
sample problem
is
approximately 9%.
In order to check if the approximated YTM or Discount
rate of 9% equates the present values of the expected
cash inflows from the bond and the current market
value, we must use the Present value factors of 9% and
substitute it to the bond valuation formula.
202
VALUATION OF BONDS
PV Coupon Payment + PVFace value]
BV = [ P 80 (6.41766) + P 1000 (0.42241)]
BV = P 513.41 + P 422.41
The present value factors for single payment and
ordinary annuity of the 9% discount rate
and
are
0.42241
6.41766, respectively. Using such PV factors, the
present value of interest payments amounted
to
P531.41 while present value of the Face value
or
maturity value amounted to 422.241. Thus, summation
of
these present value cash inflows equates to the
current market value of P935.82.
We illustrated the process of
determining the
YTM through interpolation. Aside from the
interpolation process,
how to calculate the
of return
or
there are
other ways
on
approximated required rate
the YTM such
as
using excel and
financial calculator.
>
Alternatively, we can approximate YT using
this equation:
CP +
[(Face Value - Bond Value)/t]
Bond Value (0.6) + Face Value (0.4)
Yield to Maturity is the rate of return earned
by the
bondholder who held the bond until maturity. However, there
are bonds with features that prevent the bondholder
holding the bond until maturity, such as callable
203
from
bond. The call
VALUATION OF BONDS
provision shall be exercised by the issuer prior to the maturity
bond especially when the market interest rate falls
below the coupon rate of the bond.
of the
In the perspective of the issuer, it is advantageous to call
or
redeem the bond because there is an increase in the bond price
the issuing
company can save annual interest payments if they redeem a
when market interest rate falls.
high rate coupon bond when
such
Moreover,
rate
falls. The amount paid
by the issuer in order to call or redeem the bond is
which is
usually equal to
As to the
price
the par value plus one year interest.
perspective of the bondholders or investors, there is
the risk that their income from a bond portfolio
the interest rate falls. This risk, which is
bonds, is
call
SO
will decline if
significant on callable
called reinvestment risk This shows that the
expected savings in the perspective of the issuer is the
corresponding expected decline in
bondholder when the
To illustrate, assume
the income
of the
former will exercise its right to call.
that a 10 year callable bond has 12%
coupon interest rate upon issuance and assume that it
issued at 1,000 par value. This bond is with
call
period of 4 years from issuance, meaning, the issuer
the bond from issue date (year 0)
until the
was
protection
cannot call
end of fourth year
(year 4). In the beginning of year 5, the market interest rate falls
from 12% to 10%. The call premium is 5%.
The market interest rate decline to 10% will increase
the bond value from P 1,000 to P 1,087.11
BV = [ PVCoupon Payment t PV Face valuel
BV = [P 120 (4.35526) + P 1000 (0.5644739)]
BV
=
P 522.63 +
P 564.47
BV = P1, 087.11
204
VALUATION OF BONDS
The issuer, in exercising its right to call, will have to pay
the call
price of P1,050 [P1,000 face value + 50 call
premium] to the bondholder and in turn redeem the
P
1,000 callable bond. This shows that the issuer is willing
to pay the excess
or
premium of P50 on the fifth year
(year 5) to redeem the 12% callable bond and replace
these with 10% bond. Hence, assuming the new bonds
will still be issued at par value, (effective interest rate
equals nominal interest rate) the issuer will
interest
save
payment of 2% due to the decline in market
rate from 12% to 10%. Or, if it will be issued at the new
bond price of P 1,087.11, the bond premium received
amounting to P87.11 is higher than the call premium
paid of P50, thus earning excess amount.
The savings or earnings of the issuer,
due to decline in
interest rate, are the corresponding decline in the
income of the bondholder. Thus in this case, when
interest rate
decreased and issuer redeemed the bond,
the payment received by the bondholder in year 5 shall
be reinvested at a lower rate of 10%. This illustrates the
SO
called reinvestment risk discussed above.
On the other hand, when the interest rate increases resulting to
decline in the bond price, the risk is known as
interest rate risk
or price risk
Thus, if the issuer exercised its right to call when interest rate
fall, the rate of return that will be earned by the bondholder of
this kind of bond is
is the
SO
called yield
to call (YTC). Shown below
equation on how to calculate the approximate YTC:
Call Price
t=1
205
VALUATION OF BONDS
Where:
Dc is the Yield to Call or the Rate of return when
called
CP is the Coupon interest payment
Call Price
exercise
is
the price paid by
the issuer upon
of its right to call
n is the number of years until the issuer can call
or redeem the bond
Alternatively, we can approximate YTC using this equation:
CP + [(Call Price - Bond Price)/ n]
Bond Price (0.6)
+ Call Price (0.4)
Illustrative Problem 6-4
CBA Corporation has bonds outstanding with P1000 face
value and 10
years left until maturity. They have 12
annual coupon payments, and the current market value
is P1120. These bonds can be called starting 5
years at
105% of the face value.
1. Determine the Yield to Maturity assuming the
Corporation did not exercise its rights to call.
2. Determine the Yield to Call if
assuming the
corporation called in 5 years.
Approximate Yield to Maturity (YTM):
CP + (Face
Value - Bond Value)/t]
Bond Value (0.6) + Face Value (0.4)
[P120 + (P1000 - P1120) / 10]
P1120 (0.6)
Y
=
10.075%
206
+
P1000 (0.4)
VALUATION OF BONDS
The approximate YTM which is the required rate of return the
bondholder will receive at maturity date is 10.075%. This rate
is
also the
Discount rate that which equates the Present value
of the income stream: interest
payments and maturity value;
with the current market value of the bond. To check whether
the approximated
TYM
is
correct, let us determine the current
market value of the bond:
+
BV = P 1,117.90 or P1,118
Using the Approximated YTM of 10.075% in discounting the
income streams, the
approximated bond value calculated
amounted to P1,118 which is near the current market value of
P1,120. There
is a discrepancy due to rounding off differences
in the Present value factors. Thus, we
can use
this formula in
lieu of the interpolation process for convenience.
Approximate Yield to Call (YTC):
[CP + (Call Price
Bond Price)/n]
Bond Price (0.6) + Call Price (0.4)
[P120 + (P1050 - P1120)/ 5]
=
P1120 (0.6)
+
P1050 (0.4)
P106
P1092
=
9.707%
approximated Yield to call (YTC) is 9.707% which is the
rate of return earned by the bondholder, who bought : callable
The
207
VALUATION OF BONDS
bond with
a
price of P1120, when the issuing corporation
called or redeemed the bond 5 years from today.
The
callable bond given in Sample Problem 6-4
protection which
exercise its
is
has a call
4 years. This means that the issuer can only
rights to call starting on the 5th years
from the
issuance of the bond, thereby protecting the bondholder from
redeeming the bond. However, after the protection period, the
call protection ceases and the bondholder now bears the risk of
redemption prior to maturity. In this case, when the issuing
company exercised its rights to call on the 5th year, the
bondholder's return will be 9.707% (YTC) instead of 10.075%
(YTM) because the bond was redeemed prior to maturity.
Moreover, when the right of the company to call is already
exercisable, it does not mean that the issuing company will call
or
redeem
outright the said bond. Thus, the issuer may
or may
not redeem the bond depending on the interest rates or the
bond values in the market. If the
bond price on the call period
is higher than call price, the issuer will be expected to redeem
or
call the bond.
Note: for discussion
and problem solving, we assume that the
bonds are not callable unless otherwise stated or if it deals
with the yield to call calculation.
Expected Total Returns on Bonds:
The expected total returns on bonds are the
amount of cash
inflows from interest payments, maturity value (face value)
and
call price. The total return attributable to the bondholder
can either
until
be the Yield to Maturity (YTM) if the bond is
maturity, or the Yield to Call (YTC) if the bond was
by the issuer prior
to
held
called
maturity. Moreover, the bondholder may
opt not to hold the bond until maturity but sell
it to other
investors when the market interest rate declines. When this
208
VALUATION OF BONDS
happens, the bondholder's return on such investment will be
the cash inflows from the interest payments and the gain on
sale of the said bond. In this case, we can use another equation
calculate the expected total return on the bond without
using the YTM and YTC formula. The expected total return
to
formula on a bond is the summation of the Current Yield and
Capital Gain / (Loss) Yield:
ETR
=
ETR
+ CG/(L)Y
+
Where:
ETR is the Expected Total Return or the rate
on
of return
investment
CY is the Current Yield which is the rate of return on the
interest payments received
CGY/(L)Y is the Capital Gains/Loss Yield which is the
rate of return when the bond is sold
BPn is the Bond Price New (Selling Price) calculated
after the
BPo
change in the Discount rate
is the Bond Price Old (Cost) which is the current
market value of the Bond
Illustrative Problem 6-5
AMV
purchased on January 1, 2017 a P1000 face value
bond issued by CBM Corporation with 9% annual coupon
interest and 10 years to maturity for P950. If AMV sold
the bond on January 1, 2018 for P970 to Wash Sy Gorres,
what is the total rate of return earned by AMV on the
investment?
209
VALUATION OF BONDS
ETR
+ CG/(L)Y
= CY
ETR
=
ETR
=.
+
90
+
970 - 950
950
ETR
The
=
950
11.58%
Expected total return received by AMV from selling the
bond 1 year from issuance is 11.58%
which is composed of the
current yield of 9.47% and the capital gains yield of 2.11%. The
price of the bond increases from P950
to
P970
which
encouraged the bondholder to sell the bond to other investor
(Wash Sy Gorres).
In case
said bond but held it
that the bondholder did not sell the
until maturity, the expected total returns
received will not be 11.58% rather the Yield to Maturity (YTM)
which
is 9.79% (calculated using the approximate YTM
formula). Therefore, in selling the said bond, the bondholder
earned a higher return by 1.79%.
210
VALUATION OF STOCKS
CHAPTER 7
VALUATION OF STOCKS
Stock
or
share of stocks generally represents some form of
ownership in an entity. Shares may take several forms for
different organizations and these several forms entitle the
owner or
the shareholder different rights. Some classes have
voting rights while some do not have. Other classes may
receive priority rights in dividends distribution and liquidation
over all other classes of shares. By merely
looking at these
benefits from stocks, it could be easily compared to bonds
(which were previously discussed in Chapter 6 of this book).
One very important difference between stocks and bonds is the
regularity of cash flows. For bonds, the contractual cash flows
in the form of interest payments are made periodically while
the dividends for stocks may not be made
regularly.
In this chapter, we will discuss the following:
Different kinds of stocks
Different kinds of preference shares
Non-discounted method in valuing stocks
Discounted method in valuing stocks:
Discounted Dividend Model
Corporate Valuation Model
Stocks
or
shares of stock, in this chapter, shall be
common or ordinary shares of stock.
A separate
construed as
portion in this
chapter shall deal with preference shares. Stocks are securities
that represent ownership of
a
company and entitlement
of
such company's net assets and profits. Usually, stocks are
classified into common
or
ordinary and preferred.
There are
several distinctions between ordinary and preferred shares.
In
the table below, the characteristics of each class of shares are
briefly provided:
231
VALUATION OF STOCKS
Table 7-1
Characteristics of Ordinary and Preference Shares
Preference
Ordinary
1. Claim
Yes but with
Yes
over
priority in
assets
distribution
during
liquidation
2. Claim over
Yes but
Yes but with
earnings
depends on
priority in
distribution
the plan
dividend
(dividends)
distribution
distribution
of
Preference
Shares
May not
receive
dividends
3. Voting rights
No
Yes
(influence/control
over corporate
actions)
While ordinary and preference shares may have common
characteristics such as par value or stated
value, preference
shares have more distinct kinds. This is due to the fact that
preference
shares
characteristics
are
considered
hybrid
having
of bond or an instrument/security with liability
and that of a stock. Below is
preference shares:
232
a
list of different kinds of
VALUATION OF STOCKS
Cumulative - Those shares which entitle the holder to
1.
current
or
dividends as well as those dividends in
those dividends which
were not
arrears
provided in previous
years.
Non-cumulative
2.
-
Those shares which entitles the
holder to only current dividends. The company is
longer liable for dividends not declared
in
no
previous
years to holders of these shares.
3.
Participating - Those shares that entitles the holder to
surplus profits after the provision of the basic dividend
to all classes of shares.
4.
Only the basic dividend shall be
Non-participating
provided to holders of this kind of preference shares.
Surplus profits after the provision of the basic dividend
shall be given
5.
Redeemable
to other classes of shares.
-
These are preference shares that grant
the right or power to redeem,
purchase or "buy back" the shares after a certain period.
the issuing company
6.
Convertible
These are shares that can be converted
into another
class of shares (usually convertible
to
ordinary shares).
The succeeding segments on this chapter will discuss
how the
value of two classes of stock are determined and why it is
necessary to determine such value.
233
VALUATION OF STOCKS
Stock Valuation
Stock Valuation is simply the process of determining a stock's
value. In some countries, stock value is a part of
a
service
rendered to an entity called Fairness Opinion or Valuation
Services. In
the Philippines, non-listed and
-traded entities
wishing to trade in the local stock exchange are mandated to
acquire a Fairness Opinion or a Valuation Report from
accredited firms. The opinion or report contains a computation
of the value of the
company's stock. However, why
is it
necessary to determine the value of a stock?
Investors make decisions by simply
determining the potential
for profit or loss. Each security an investor hold may either
give such investor gains or losses in a particular period of time.
As in the case of stocks,
of the
investors profit from the appreciation
stock's value. It is necessary therefore that the investor
is guided in determining whether a stock shall profit or not.
That is
the time stock valuation enters. Fundamentally
speaking, investors are at advantage if it would be able to
estimate properly a stock's intrinsic (or "true") value. By
comparing the intrinsic value with
is
traded, an investor
will
the amount at which
be guided. The
basic
a stock
principle of
using the intrinsic value is shown below as:
Intrinsic Value > Stock Price (Traded Price)
"undervalued" =
Buy/Acquire
Intrinsic Value < Stock Price (Traded Price) ¾ "overvalued" =
Sell/Do not acquire
The rules
developed
to
provided above are rudimentary rules
guide
an
investor in possession of the
intrinsic value.
234
correct
VALUATION OF STOCKS
Methods of Stock Valuation
A.
Non-discounted Techniques
The valuation of stocks may involve
summarily,
on
financial
a
computation based,
statements and
fundamental
information. This method of stock valuation takes into
consideration the
financial performance of
the company or the
current book value of its shareholders' equity. Furthermore,
these techniques utilize market information and employ the
market information to the net income of
the firm being valued.
1. Book Value or Net Asset Value Approach
The net asset value or book value
shareholders' equity portion
objective of this approach is
Per Share or
approach utilizes the total
of the financial statements. The
to
determine the Net Asset Value
the Book Value Per Share which ultimately
represents the equity or the value of each ordinary share. It is
also the amount that would be
paid on each share assuming
that the company is liquidated. The term net asset value is
generally used for funds (such as mutual funds)
value is
while book
general term used for different types of businesses.
several applications of this approach,
net assets are
In
the book values of the
adjusted to reflect its current fair value rather
than historical costs.
The formula for the book value
or net asset value
approach is:
Book Value or Net Asset Value per share
Total Shareholders'Equity (or Total
Assets
Total Liabilities)
Number of outstanding shares
In this formula, it is assumed that the company is using
only a single class of shares which are common or ordinary
shares. However, in instances when there are other classes of
235
VALUATION OF STOCKS
shares other than ordinary shares, the portion of the
preference shares are excluded to
reflect the correct value per
share:
Book Value or Net Asset Value per share
Total Shareholders'Equity- Total equity attributable to preference shares
Number of outstanding common shares
In both situations, the total assets of the company may
be adjusted as deemed necessary to
reflect its current fair
market value.
This approach is commonly used for companies that are
currently not traded in any market or companies that are
closely-held. This approach is also prevalently used by mutual
funds to represent the value of each unit of the fund. It
commonly uses the notation NAVPU which is
the Net Asset
Value Per Unit. While it can be seen from that the value of stock
can
be
computed with ease, it is
valuation approach.
on
not all
too perfect for
a
One prevailing weakness of this formula is,
hand, very evident
from its definition. It assumes that the
company shall liquidate presently and that
shows approximately
how
the value computed
much the shareholders will receive
upon liquidation. This condition, however, goes against
the
very basic principle of accounting which is the Going Concern
principle. The Going Concern principles simply states that an
accounting method shall be adopted under the assumption that
the company will continue operations for an indefinite period
of time and under no circumstances that
near future. Furthermore, it
it shall liquidate in the
also factors out the expected
profits in future periods.
236
VALUATION OF STOCKS
* Illustrative Problem 7-1:
Company has the following information derived
from its most recent audited financial statements:
SEC
Total Assets = P20,000,000,000
Total Liabilities = P10,000,000,000
Total Shareholders' Equity = P10,000,000,000
No. of ordinary shares issued and outstanding =
1,000,000,000 shares
To determine the NAVPS or BVPS:
Total Shareholders' Equity
No. of ordinary shares issued and outstanding
NAVPS or BVPS
P10,000,000,000
1,000,000,000
NAVPS or BVPS = P10 per share
If the company had another class of stock such as
preferred shares amounting
to
600,000,000 shares with
a total equity of P2,500,000,000, then
the NAVPS or
BVPS shall be P7.50 per share.
Total Shareholders'Equity - Total equity attributabte to preference shares
No. of
ordinary shares issued and outstanding
P10,000,000,000 - P2,500,000,000
1,000,000,000
NAVPS or BVPS = P7.50 per share
2. Price-Earnings Relative Valuation Approach
Several investors believe that the value (price) of a stock is
related to its financial
performance, particularly its net income.
Furthermore, these investors believe that the change in the
237
VALUATION OF STOCKS
price
of a stock
is directly attributable to its earnings. We
understand from the discussion in
Statement Analysis)
the price of a stock
that a
multiplier
and its earnings -
Chapter
3
(Financial
can be derived
that is the
by using
Price-Earnings
company in target, the prevailing
Price-Earnings Ratio (or also called the Price-Earnings
Ratio. In the valuation of a
Multiple) of similar or comparable entities is utilized
determine the value of the
to
target stock.
The basic argument of this approach is that the income
statement provides a more accurate view in valuing a business
It
also argues that the value of an operating business arises
from its ability to generate income and not
from historical
accumulation of assets. Furthermore, income statement data
are substantially derived from a particular reporting period
and as such encounters a
considerably lower level of distortion
than the balance sheet with which values come from varying
periods.
The computation
of the value of
the stock using this
approach can be illustrated using this formula:
Corporate Value
= Net Income
X PE Ratio or
Value of Stock =
PE Multiple of similar companies
Corporate Value
No. of ordinary shares issued and outstanding
In the above formula, the current (or projected) net
of the company is multiplied by the Price-Earnings
income
Ratio or Multiple of similar companies. Similar companies may
be interpreted in the manner most relative to the entity being
valued such as it
may be companies in the
same
geographical
same sector or industry or other qualifications
deemed appropriate.
area,
238
that
iS
VALUATION OF STOCKS
Illustrative Problem 7-2
NA
Technologies, Inc. has
a
net
income of P1 billion
reported on the previous year's audited financial
statements. In the same period, the company has
billion
in
shares
issued
outstanding.
and
1
NA
Technologies is currently operating in the computer and
gadgets industry. Information has been gathered that the
prevailing P/E Ratio (price-earnings ratio) in the
computer industry is 5x.
To determine the value of the stock:
Corporate Value
=
Net Income
Multiple of similar companies
X PE Ratio or PE
Corporate Value
=
P1 billion x 5x
Corporate Value
=
P5,000,000,000
Value of Stock
Corporate Value
=
Value of Stock =
No. of ordinary shares issued and outstanding
P5 billion
billion shares
Value of Stock = P5 per share
Note: In some instances, the corporate value is
Liquidity Discount
to
reflect
or adjust
reduced by a
the
expected
marketability of a stock. This is usually done during initial
public offerings.
Christopher Glover, in his book Valuation of
Unquoted Companies (5th ed.), mentioned that the most
popular level of discount is 25%. Applying the same in
the case
above, the Corporate Value of P5 billion should be reduced by
25% to equal P3.75 billion.
B.
Discounted Techniques
involve
the
consideration of future cash flows that may generated
from
The
most
common
valuation
239
techniques
VALUATION OF STOCKS
such stock. Considering that the computations may involve
future cash flows, appropriate discounting should be made to
place these future cash flows to its present value.
Discounted Dividend Model
This model takes into consideration the expected cash flows of
investment in
stocks which are dividends and stock price upon
sale. Simply put, the value of the stock depends
value of all the dividends and the price
on the present
of the stock once it is
sold. This model primarily relies on the proper estimation of a
stock's growth rate which is one of the key features of this
valuation method.
Common elements exist in this stock valuation method:
Po stock price today
D1
or
D - dividends or dividend at the end of the year
ke or r - required return or cost of equity
g
growth
rate
TD - terminal date or horizon
TV - terminal value
The Discounted Dividend Model assumes that dividends grow
in three possible ways namely:
a) Zero or No Growth stocks
-
A situation where a
stock and its dividends do
not
that this valuation model
is
grow. Considering
primarily based on
dividends and growth rate, preferred shares
exhibit the same characteristics as that
no
growth
ordinary
stocks.
of zero
Under
or
this
assumption, dividends today (Do) is equal to
future dividends such as D1. D2, D3 and so on.
240
VALUATION OF STOCKS
The formula for the valuation of zero or no growth stockis:
110
Po
* Illustrative Problem 7-3:
RF
Hotels Corporation has paid P5.00 dividends last year
to
its stockholders. The company expects that this
dividend will not grow in its succeeding years of
operation. The shareholders expect a 10% return on RF's
stock.
To determine
Po
-
Po
=
RF's stock price:
D
r
P5.00
10%
Po= P50.00
b) Constant Growth stocks - A situation where a
stock
and its dividends grow at a constant rate
throughout its life. Constant growth stocks
exhibit a kind of growth rate that does not
change during the life of such stock. In fact, zero
or no growth stock may
be
a
form of constant
growth stock, only that it has zero
or no
growth
during the life of that stock.
The formula for the valuation of constant growth stock is:
Po
=
Emphasis should be drawn on the D1 component. The
used in
of the
dividend
this formula should always be the dividend at the
year and not any other dividend such
241
as
end
dividends
VALUATION OF STOCKS
recently declared (Do). Further the formula above, however,
must be used with care as the growth rate must always be
than the required rate
become
of return.
less
Otherwise, the formula may
inoperable or illogical.
Illustrative Problem 7-4
NN Stock is
expected to declare a P7.00 dividend at the
end of the year.
Similar stocks return 16%. NN's stock is
expected to grow at a rate of 6% annually for the rest of
the stock's life.
To determine NN's stock price:
Po
=
Po
=
P7.00
16% - 6%
P. E P70.00
c
Non-constant Growth stocks
A
situation where
a stock and its dividends grow at a different rate
at the earlier part of its life. Such
growth shall
terminate at a horizon or terminal date where
the stock and its dividends begin
constant rate. As
to
grow at a
such, there are two phases in
the life of non-constant growth stocks: the
non-
constant growth phase and the constant growth
phase. The non-constant growth phase consists
of
dividends growing at a varying rate
or at a
rate different from the constant growth
rate.
After the non-constant phase (at the terminal
date), the constant growth phase then consists of
dividends growing constantly until infinity.
242
VALUATION OF STOCKS
As mentioned above,
which
the terminal date is the
period
in
the dividends stop growing non-constantly and begins
growing at a constant rate forever. In relation to this terminal
date,
relevant value comes up which is called the terminal
value. The terminal value is
computed similarly
to a constant
growth stocks in which the dividends in the constant growth
phase of the stock
is collected and discounted to the terminal
date.
The formula for the valuation
Po:
In
(1+r) (1+r)2
of non-constant growth stock is:
(1+ r)3
computing for dividends beyond D1, the growth rate
applicable may be utilized on a D1 to compute for succeeding
dividends. This concept can be illustrated in this equation:
D2 = D, X (1 + g)
D3 = D, X (1 + 9) or D2 X (1+g)
In the above formulas, care must be taken in using a correct
growth
rate if the dividend
is within the non-constant growth
phase or already at the constant growth phase.
Once the non-constant growth phase stops (at
the terminal
date), the dividends then grow constantly. Analyzing the
situation at the terminal date, it could be understood that
dividends will grow at the same rate until infinity. To be
able to
express these dividends, it should be "collected" (discounted)
at the terminal date. The terminal value
TV =
243
is then computed as:
VALUATION OF STOCKS
It should be
emphasized that the dividend in the
computation
terminal value
is the dividend after the terminal date in which
the growth rate utilized is the
constant growth rate.
Illustrative Problem 7-5
A Industries, Inc. expects to pay P3.00 per share dividend to its
common stockholders at the end of the year. The dividend is
expected to grow 25 percent a year until the end of the third
year (t = 3), after which time the dividends is expected to grow
at a constant rate of
5 percent a year. A Industries' stockholders
require a 12% return
on
this stock
To
determine the A's stock price:
A
timeline
should be made to
assist the
analyst in
understanding the characteristics of the stock, the dividends
and the relevant
periods in which these dividends appear.
Proper analysis should be made on how the dividends are to be
recognized and placed on the timeline.
25%
5% growth in dividends forever
growth in dividends
D.
D.
D1 = P3.00
D2 = D1 X (1 + r)
D2
=
P3.00 X (1 +
D2
=
P3.75
25%)
D3 = D2 X (1 + r)
D3
=
P3.75 x (1 + 25%)
D3 = P4.6875
244
D.
D.
VALUATION OF STOCKS
Note: D3, in
this problem, is the dividend at the terminal date
D4 = D3 X (1 + r)
D4 = P4.6875 X (1: 5%)
D4 = P4.921875
Note: The growth rate for D4 now becomes
5% (as opposed to
25%) considering that the stock has already entered the
constant
growth phase. Further, D4
is the dividend after the
terminal date (DTD+1).
TV =
P4.921875
TV =
12% - 5%
TV = P70.3125
With all the components of the stock price already determined
and pre-computed, the stock price can already be computed:
Po
+
=
(1 + 12%)
P4.6875
P3.75
P3.00
(1+ 12%)2 (1+ 12%)3
P70.3125
(1 + 12%)3
P.= P59.05
Note: It should be
emphasized that the terminal value should
be discounted at the same rate as that of the dividend at the
terminal date (D3 in this problem).
245
VALUATION OF STOCKS
1. Corporate Valuation or Free Cash Flow Model
This
model computes a
present value of the
npany's market value based on
the
company's free cash flows. Upon
determination of the market value of the company, the longterm debt and preferred
share capital is deducted leaving the
market value of the common stock to be divided by the number
of
outstanding common shares to determine the stock's
intrinsic value.
The discounting concepts are very similar to that of the
discounted dividend
model, however with some new elements:
Po - stock price today
MV Firm market value of the firm
_ Debt+Preferred
market value of debt and preferred stock
free cash flow at the end
of year
WACC - weighted average cost of capital
g - growth rate
TD - terminal date or horizon
TV - terminal value
OCS - outstanding common stock
As mentioned previously, the corporate valuation or
free cash flow model uses the same structure of discounting as
that
of the discounted dividend model. It may also be in the
form of a zero or no growth,
constant growth or non-constant
growth stock. Before we discuss the formulas in
computing the
stock price, we should first familiarize ourselves with the new
elements of this valuation method.
The market value of the firm represents the total value
of the company (the total market value of its assets). It is the
sum of
all the free cash flows of the company discounted to its
246
VALUATION OF STOCKS
present value. It should also be noted that these assets
are
primarily sourced out from the firm's liabilities, preference
shares and ordinary shares.
types of sources
It is understood that these three
each have claim over the market value of the
firm. In the same manner, considering the three
sources of cash
each have their
own required returns, the WACC or weighted
average cost of
capital should be used to discount such free
The WACC, therefore, is the composite weighted
average of all the required returns of creditors, preference
shareholders and ordinary shareholders. The computation of
cash flows.
the WACC is discussed in detail in Chapter 7 of this text.
The free cash flow (FCF) is the cash generated before
any payment is made
creditors and
to
the above investors (the sources
shareholders). Free cash flow originally comes
from the computation of the net income but distinctly modified
to
reflect the actual cash flows of the firm:
FCF = [EBIT(1 - TAX RATE) + Depreciation and Amortization]
- [Capital Expenditures + ANet Working Capital]
Before
free cash
being able to compute the stock price using the
flow model, it is first important to determine the
market value of the firm. The market value firm is computed as
follows:
Zero
or no growth firms:
MV Firm
Constant growth firms:
Firm
-
- g
247
VALUATION OF STOCKS
Non-constant growth firms:
MV Firm
(1+ WACC) (1 + WACC)2
(1 + WACC)3
(1+ WACC)™D
(1+ WACC)™D
After computing
for the market value of the firm
(MV Firm), the stock price can already be computed by dividing
the market value of the firm minus the sum of the market
values
of debt and
preferred shares by the number
of
outstanding common stock:
Po
=
MVFirm - MVDebt+Preferred
The market value of the firm less the market value of
debt and preferred shares represent the remainder of the
firm's market value that is available to common or ordinary
shareholders. This amount then represents the intrinsic value
of the firm's common stock.
8479 Corporation has projected Earnings Before Interest and
Tax (EBIT) for the next year of P600 million, with
tax rate of
40%, projected depreciation expense, capital expenditures and
increase in working capital for the
next
year of P100 million,
P200 million
and P120 million, respectively. The capital
structure of the company is 40% for debt and 60% for equity. Its
WACC is
10%. The company's free cash flow is expected to
at a constant
grow
rate of 6 percent a year. The firm has P500 million
in debt and
preferred shares with 20 million preferred shares
outstanding and 300 million ordinary shares outstanding.
248
VALUATION OF STOCKS
To compute for 8479's stock price:
It is first important to compute for the correct free cash flow of
the company. Considering that this is a constant growth stock,
it is also important
to
note that the free cash flow needed for
the computation is the free cash flow at the end of the year
(FCF1).
+ANet Working Capital]
FCF:=[P600 million (1-40%)+P100 million]-[P200 million+P120 million]
FCF.=P140 million
After computing the correct FCF, the market value of the firm
should be
computed next:
WACC - g
P140 million
10%
6%
= P3.5 billion
Once the market value of the firm
values
is
computed, the
market
of debt and preferred must first be deducted from the
market value of the firm. The resulting market value
common or ordinary shares
shall
outstanding ordinary shares:
Po
=
Po
=
P3.5 billion - P500 million
300 million shares
P.= P10 per share
249
of
be divided by the number
VALUATION OF STOCKS
Choosing the best valuation method
Valuation methods above present to us various kinds of
techniques and points-of-view in computing for
stock. As investors are wary
of
the price
of the
each kind of valuation
technique, choosing the best valuation method does not all the
picking the most accurate one. As it is in providing
luations, uncertainties arising from
Opinions and
more mean
Fairness
each
different
valuation
method
are
addressed
by
comparatively looking at the results of each valuation method.
Rather than
choosing one alternative, it is best to look at the
varying results as
a
reasonable range of the correct intrinsic or
"true" value.
250