Introduction To
Business Finance
DR. OWAIS SHAFIQUE
WWW.DROWAISSHAFIQUE.WORDPRESS.COM
Introduction To Business Finance
Lecture Handouts For BBA
“In The Name Of Allah
The Most Gracious, The Most Merciful”
“Blessed be Allah in whose hands
is the kingdom of the creations;
and who has control over all things;
He who created death and life, that,
He may test which of you is best in deeds.
Allah is most Exalted in Might and oft-Forgiving.”
(Al-Quran), Surat Al-Mulk (The Sovereignty),Chapter 67, Verse 1-2]
Dr. Owais Shafique
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Introduction To Business Finance
Lecture Handouts For BBA
Topic 1
Finance: A Quick Look
Finance:
“Finance is the Art and Science of Managing Money.”
Four Basic Areas
· Business Finance
· Investments
· Financial Institutions
· International Finance
Business Finance
Addresses the following three questions:
· What long-term investments should the firm engage in?
· How can the firm raise the money for the required investments?
· How much short-term cash flow does a company need to pay its bills?
Investments
· Deals with financial assets such as stocks and bonds.
· It covers the following issues
· Pricing Financial Assets
· Associated Risks and Rewards
· Determining best mixture of financial investment
· Career opportunities in investment
· Stock Brokerage
· Portfolio Management
· Security Analysis
Financial Institutions
· Businesses dealing in financial matters
· Banks and Insurance companies
International Finance
· Covers international aspects of corporate finance, investment and financial institutions.
WHY STUDY FINANCE?
· Marketing and Finance:
· Marketers have to work with budgets
· Need to get greatest payoffs from marketing expenditures and programs
· Cost and Benefit analysis of projects
· So finance is vital for:
· Marketing research
· Design of marketing and distributions channels
· Product pricing
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Introduction To Business Finance
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· Accounting and Finance
· Accountants are required to make financial decisions as well as understand the
implications of new financial contracts
· Financial analysts make extensive use of accounting information
· Management and Finance
· Business Strategy is always disastrous if financial planning is not adhered to.
What is Business Finance?
· In order to start any new business, the following issues become vital
· What long-term investment should be taken on?
· From where to get the long-term financing to pay for investment? Bring in other owners or
borrow the money?
· How to manage everyday financial activities?
The Financial Manager
To create value, the financial manager should:
· Try to make smart investment decisions.
· Try to make smart financing decisions.
Hypothetical Organization Chart
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Introduction To Business Finance
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Business Finance and Financial Manager
· Financial Management Decisions
· Capital Budgeting
· Capital Structure
· Working Capital Management
Financial Management Decisions
· Capital Budgeting
· The process of planning and managing a firm’s long-term investments
· Financial managers concern with how much, when and how likely is cash expected to receive
· Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting
Capital Structure
· The value of the firm can be thought of as a pie.
· The goal of the manager is to increase the size of the pie.
· The Capital Structure decision can be viewed as how best to slice up the pie.
· If how you slice the pie affects the size of the pie, then the capital structure decision matters.
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Introduction To Business Finance
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The Corporate Firm
· The corporate form of business is the standard method for solving the problems encountered
in raising large amounts of cash.
· However, businesses can take other forms.
Forms of Business Organization
Three major forms
· Sole proprietorship
· Partnership
· General
· Limited
· Corporation
· Limited liability company
Sole Proprietorship
“It is the simplest form of business organization, which is owned and controlled by one man”
· Single owner (sole proprietor)
· Easy Formation
· Unlimited Liability
· Ownership
· Owner Keeps All Profit
· Management
· Easy Dissolution
Advantages
· Easiest to start
· Least regulated
· Single owner keeps all the profits
· Taxed once as personal income
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Disadvantages
· Limited to life of owner
· Equity capital limited to owner’s personal wealth
· Unlimited liability
· Difficult to sell ownership interest
Partnership
· Two or more owners (partners)
There are two types of partnership
· General partnership: all partners share in gains and losses and all have unlimited liability
for all partnership debts
· Limited partnership: one or more general partners will run the business and have
unlimited liability but there will be one or more limited partners who do not actively
participate in the business and their liability is limited to their contribution.
· Partnership dissolves when one partner dies or wishes to sell
· Difficult to transfer ownership
Advantages
· Two or more owners
· More capital available
· Relatively easy to start
· Income taxed once as personal income
Disadvantages
· Unlimited liability
Corporation / Joint Stock Company / Limited Liability Company
A business created as a distinct legal entity owned by one or more individuals or entities.
· Forming of corporation involves preparing
· Charter including corporation’s name, intended life, business purpose and number of shares
· Set of bylaws which describes the regulations for the business.
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Advantages
· Limited liability
· Unlimited life
· Separation of ownership and management
· Transfer of ownership is easy
· Easier to raise capital
Disadvantages
· Separation of ownership and management
· Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)
Goal of the Corporate Firm:
· The traditional answer is that the managers of the corporation are obliged to make efforts to
maximize shareholder wealth.
· Alternatively, the goal of the financial manager is to maximize the current value per share
of the existing stock
The Set-of-Contracts Perspective
· The firm can be viewed as a set of contracts.
· One of these contracts is between shareholders and managers.
· The managers will usually act in the shareholders’ interests.
· The shareholders can devise contracts that align the incentives of the managers with the
goals of the shareholders.
· The shareholders can monitor the managers behavior.
· This contracting and monitoring is costly.
The Agency Problem
· Agency relationship
· Principal hires an agent to represent their interest
· Stockholders (principals) hire managers (agents) to run the company
· Agency problem
· Conflict of interest between principal and agent
· Management goals and agency costs
Managerial Goals
· Managerial goals may be different from shareholder goals
· Expensive perquisites
· Survival
· Independence
· Increased growth and size are not necessarily the same thing as increased shareholder wealth.
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Do Shareholders Control Managerial Behavior?
· Shareholders vote for the board of directors, who in turn hire the management team.
· Contracts can be carefully constructed to be incentive compatible.
· There is a market for managerial talent – this may provide market discipline to the managers
– they can be replaced.
· If the managers fail to maximize share price, they may be replaced in a hostile takeover.
Managing Managers
· Managerial compensation
· Incentives can be used to align management and stockholder interests
· The incentives need to be structured carefully to make sure that they achieve their goal
· Corporate control
· The threat of a takeover may result in better management
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Introduction To Business Finance
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Financial Markets
Primary Market
· When a corporation issues securities, cash flows from investors to the firm.
· Usually an underwriter is involved
Secondary Markets
· Involve the sale of “used” securities from one investor to another.
· Securities may be exchange traded or trade over-the-counter in a dealer market.
Financial Markets
Dealer Vs. Auction Markets
· Auction markets are different from dealer markets in two ways:
· Trading in a given auction exchange takes place at a single site on the floor of the exchange.
· Transaction prices of shares are communicated almost immediately to the public.
Generally Accepted Accounting Principles:
i) Entity principle/ separate entity principle: According to this principle, a business is
treated as a separate entity from the owner. The owner’s private expenditure/spending are
not recorded in the books of the business entity.
ii) Cost principle: according to this principle an asset on the balance sheet is recorded based
on its nominal or original cost when acquired by the company.
iii) Going-concern assumption: The 'going concern' concept in accounting is an assumption
that the business will continue to exist for the foreseeable future. This assumption is also
closely related to cost principle as without the 'going concern' concept, accountants would
have to record all assets at current price instead of historical cost.
iv) Objectivity principle: definite, factual basis for assets valuation; measuring transactions
objectively. An accounting principle according to which information that is supplied in a
company's financial statement must be supported by actual and real evidence and should
not be based on personal feeling or opinion.
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v) Stable currency principle. The currency remains more or less stable and rate of inflation
is almost zero.
vi) Adequate disclosure concept: facts necessary for proper interpretation of statements;
“subsequent events”, lawsuits against the business, assets pledged as securities/collaterals,
contingent liabilities etc; reflected in Notes.
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Introduction To Business Finance
Dr. Owais Shafique
Lecture Handouts For BBA
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Introduction To Business Finance
Lecture Handouts For BBA
Topic 2
Basics of Accounting
Types of Accounting Systems:
v Single Entry Accounting System
v Double Entry Accounting System
Rules of Debit and Credit:
Rules of Debit and Credit for Assets and Liabilities & Equity:
Increase
Decrease
Assets
Debit
Credit
Liabilities & Equity
Credit
Debit
Rules of Debit and Credit for Income and Expense:
Increase
Decrease
Expense
Debit
Credit
Income
Credit
Debit
Accounting Cycle/Process
It mainly consists of Recording, Classifying and Summarizing financial transactions over an
accounting period.
Steps in Accounting Cycle
1) Analyzing financial transaction. The purpose is to see which two (or more) Accounts (or
sub-Accounts) are affected by a particular financial transaction.
2) Recording (chronologically) in journal which is called “book of original entry”. this step
is also called journalizing. Its practical illustration is given below.
3) Posting in ledger which means transferring debits and credits from journal to ledger
account. This is also called ledgerising or classification.
4) Preparing trial balance, this is done to prove the equality of debits and credits in the ledger
5) Making adjusting Entries / End of Period Adjustments
6) Prepare an Adjusted Trial Balance
7) Prepare Financial statements
8) Journalize and Post Closing Entries
9) Prepare an After Closing Trial Balance
Compound Entry. A journal entry that has more than one debit or credit entry.
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Classification of Assets:
There are two types of assets:
1. Tangible Assets which have physical existence and can be seen or touched. It includes
Fixed as well as Current assets.
2. Intangible assets which have no physical existence like goodwill, patents and copyrights etc.
• Fixed Assets – Are the assets of permanent nature that a business acquires, such as plant,
machinery, building, furniture, vehicles etc. Fixed assets are subject to depreciation.
• Long Term Assets –These are the assets of the business that are receivable after twelve
months of the balance sheet date. For example, if business has invested some money for
two years in any saving scheme or has purchased saving certificates for more than one
year, it is a long term asset.
• Current Assets – Are the receivables that are expected to be received within one year of
the balance sheet date. Debtors, closing stock & all accrued incomes are the examples
of Current Assets because these are expected to be received within one accounting
period from the balance sheet date.
The year, in which long term asset is expected to be received, long term asset is
transferred to current assets in that year.
Classification of Liabilities
Capital – is the funds invested by the owners of the business. Business has a liability to
return these funds to the owner. We know that for the purpose of accounting, business is
treated separately from its owners. This is known as Separate Entity Concept i.e. Business is
a separate entity. Therefore, if the owner gives something (can be in form of Cash or Some
other Asset) to the business then the business, not only has to return the amount to the owner
but it also has to give some return on that money. That is why we treat Capital (Owners
Funds) as a Liability.
Profit & Loss Account – The net balance of the profit and loss account i.e. either profit or
loss also belongs to the owners.
While explaining capital we said that the business has to give return to the owners. Now if the
business is managed successfully, then this return would be a Favorable figure (Profit). This
return will, therefore, be added to the Owners’ investment.
On the other hand, if the business is not managed successfully then this return would be an
un-favorable figure (Loss). It will, therefore, be deducted from the Owners’ Investment.
• Long Term Liabilities – These are the liabilities that will become payable after a period of
more than one year of the balance sheet date. For example, if business has taken a loan from
bank or any third person and it is payable after three years, it will be treated as a long term
liability for the business.
• Current Liabilities – These are the obligations of the business that are payable within
twelve months of the balance sheet date. Creditors and all accrued expenses are the examples
of current liabilities of the business because business is expected to pay these back within one
accounting period.
The year in which long term liability is to be paid back, long term liability is transferred
to current liability in that year.
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Introduction To Business Finance
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Financial Statements
• Different reports generated from the books of accounts to provide information to the
relevant persons.
• Every business is carried out to make profit. If it is not run successfully, it will sustain loss.
The calculation of such profit & loss is probably the most important objective of the
accounting function. Such information is acquired from “Financial Statements”.
• Financial Statements are the end product of the whole accounting process. These show us
the profitability of the business concern and the financial position of the entity at a
specified date.
• The most commonly used Financial Statements are ‘profit & loss account’ ‘balance sheet’
& ‘cash flow statement’.
Income & Expenditure Vs Profit & Loss Account
• Income and Expenditure Account is used for Non-Profit Organizations like Trusts, NGOs
•while Profit and Loss Account is used for Commercial organizations like limited companies.
Profit & Loss Account
• Profit & Loss account is an account that summarizes the profitability of the organization for
a specific accounting period.
• Profit & Loss account has two parts:
First part is called Trading account in which Gross Profit is calculated. Gross profit is the
excess of sales over cost of goods sold in an accounting period. In trading concern, cost of
goods sold is the cost of goods consumed plus any other charge paid in bringing the goods in
salable condition. For example, if business purchased certain items for resale purpose and any
expense is paid in respect of carriage or bringing the goods in store (transportation charges).
These will also be grouped under the heading of ‘cost of goods sold’ and will become part of
its price. In manufacturing concern, cost of goods sold comprises of purchase of raw material
plus wages paid to staff employed for converting this raw material into finished goods plus
any other expense in this connection.
Second part is called Profit & Loss account in which Net Profit is calculated. Net Profit is
what is left of the gross profit after deducting all other expenses of the organization in a
specific time period.
Income, Expenditure, And Profit & Loss
• Income is the value of goods and services earned from the operation of the business. It
includes both cash & credit. For example, if a business entity deals in garments. What it
earns from the sale of garments, is its income. If somebody is rendering services, what he
earned from rendering services is his income.
• Expenses are the resources and the efforts made to earn the income, translated in monetary
terms. It includes both expenses, i.e., paid and to be paid (payable). Consider the above
mentioned example, if any sum is spent in running the garments business effectively or in
provision of services, is termed as expense.
• Profit is the excess of income over expenses in a specified accounting period.
Profit= Income-expenses
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Classification of Expenses
• It has already been mentioned that a separate account is opened for each type of expense.
Therefore, in large business concerns, there may be a large number of accounts in
organization’s books
• As profit & loss account is a summarized record of the profitability of the organization. So,
similar accounts should be grouped for reporting purposes.
• The most commonly used groupings of expenses are as follows:
v Cost of goods sold
v Administration expenses
v Selling expenses
v Financial expenses
v Cost of goods sold (CGS) is the cost incurred in purchasing or manufacturing the product,
which an organization is selling plus any other expense incurred in bringing the product in
saleable condition. Cost of goods sold contains the following heads of accounts:
v Purchase of raw material/goods
v Wages paid to employees for manufacturing of goods
v Any tax/freight is paid on purchases
v Any expense incurred on carriage/transportation of purchased items.
v Administrative expenses are the expenses incurred in running a business effectively.
Main components of this group are:
v Payment of utility bills
v Payment of rent
v Salaries of employees
v General office expenses
v Repair & maintenance of office equipment & vehicles.
v Selling expenses are the expenses incurred directly in connection with the sale of goods.
This head contains:
v Transportation/carriage of goods sold
v Tax/freight paid on sale
v If the expense head ‘salaries’ includes salaries of sales staff then it will be excluded
from salaries & appear under the heading of ‘selling expenses’.
v Financial expenses are the interest paid on bank loan & charges deducted by bank on
entity’s bank accounts. It includes:
v Mark up on loan
v Bank charges
Receipt & Payment Account
A receipt & payment account is the summarized record of actual cash receipts and actual cash
payment of the organization for a given period of time. This is a report that provides cash
movement during the reported period. In other words, it can be defined as the summarized
record of the cash book for a specific period.
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Receipt & Payment Vs Profit & Loss Account
Receipt & payment account is the summarized record of actual cash receipts and actual cash
payment during the period while profit & loss account also includes Receivable and Payable.
Expenditure Vs Expenses
Expenditure: It is the cost benefiting or spreading over two or more accounting periods.
Expense is the portion of Expenditure for one accounting period only.
Expense is that part of Expenditure for which the benefit has already been taken.
Examples: Expenditure on fixed assets is incurred in lump sum. Then there are pre-paid costs
e.g. insurance, pre-paid rent, for more than one year/accounting period. It may be noted that
expenditure on advertisements, employees training, are directly charged to expenses because
in these cases, the number of accounting periods over which revenue is likely to be produced
(or increased) because of these, are not readily estimable.
Income Statement:
Friends & Company Limited
Income Statement
For the year ended 31st December 2012
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Special items: These are one-time items that will not recur in the future, and are disclosed
separately on Income Statement. Examples are: discontinued operations (firm selling a major
portion of its business), extra ordinary transactions (unusual in nature), and cumulative effect
of changes in accounting methods of Inventory and Depreciation.
Statement of Changes in Owner’s Equity:
Friends & Company Limited
Statement of Changes in Equity
For the year ended 31st December 2012
Particulars
(Rs. in ____ )
Opening Balance
110
Add Net Profit
20
Less Dividend Paid
(5)
Closing Balance
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Balance Sheet:
Account Form:
Friends & Company Limited
Balance Sheet
As on 31st December 2012
Report Form:
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Topic 2
Basics of Accounting (Continued…)
The Balance Sheet
· An accountant’s snapshot of the firm’s accounting value as of a particular date.
· The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
· When analyzing a balance sheet, the financial manager should be aware of three concerns:
accounting liquidity, debt versus equity, and value versus cost.
The Balance-Sheet Model of the Firm
Net Working Capital
Net Working Capital = Current Assets – Current Liabilities
NWC > 0
NWC < 0
NWC = 0
when Current Assets > Current Liabilities
when Current Assets < Current Liabilities
when Current Assets = Current Liabilities
•NWC usually grows with the firm for the healthy firms.
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Building the Balance Sheet
A firm has
· current assets of $100,
· Net fixed assets of $500,
· Short term debt of $70, and
· Long term debt of $200
Now…
· Total Assets are $100 + 500 = $600
· Total Liabilities are $70 + 200 = $270
· Shareholders’ equity is $600 – 270 = $330
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Balance Sheet Analysis
When analyzing a balance sheet, the financial manager should be aware of three concerns:
· Accounting liquidity
· Debt versus equity
· Value versus cost
Accounting Liquidity
· Refers to the ease and quickness with which assets can be converted to cash.
· Current assets are the most liquid.
· Some fixed assets are intangible.
· The more liquid a firm’s assets, the less likely the firm is to experience problems meeting
short-term obligations.
· Liquid assets frequently have lower rates of return than fixed assets.
Debt versus Equity
· Generally, when a firm borrows it gives the bondholders first claim on the firm’s cash flow.
· Thus shareholder’s equity is the residual difference between assets and liabilities.
§ Shareholders’ Equity = Assets – Liabilities
· The Use of debt in a firm’s capital structure is called “Financial Leverage”
· The more debt a firm has (as a percentage of assets) the greater is the degree of financial
leverage
· Debt acts as a lever in the sense that it magnifies both gains and losses
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Value versus Cost
· The true value of any asset is its market value, which is simply the amount of cash we
would get if we actually sold it.
· The values shown on the balance sheet for the firm’s assets are book values and generally
are not what the assets are actual worth.
· Under the Accounting standards audited financial statements of firms carry assets at
historical cost.
· For current assets, market value and book value might be somewhat similar since they are
bought and converted into cash over a relatively short span of time.
· For fixed assets, its very unlikely that the actual market value of an asset is equal to its book
value.
· Example: Land purchased for railroads a century ago
· Similarly the owner’s equity figure on the balance sheet and the true market value of the
equity need not be related.
· For Financial Managers, accounting value of the equity is not a matter of concern rather it is
the market value of the shares that matters.
Market vs. Book Value
· K Corporation has fixed assets with a book value of $700 and an appraised market value of
$1,000
· Net working capital is $400 on the books but approx. $600 would be realized if the current
accounts were liquidated
· K has $500 in long-term debt, both book & market value
· What is the book value of the equity?
· What is the market value?
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THE INCOME STATEMENT
· If we think of the balance sheet as a snapshot then we can think of income statement as a
video recording covering before and after the picture.
· The income statement measures performance over a specific period of time.
· The accounting definition of income is
Revenue – Expenses = Income
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Income Statement Analysis
There are three things to keep in mind when analyzing an income statement:
· Generally Accepted Accounting Principles (GAAP)
· Non Cash Items
· Time and Costs
Income Statement Analysis
Generally Accepted Accounting Principles (GAAP)
· “The Realization principle” is to recognize revenue when the earning process is complete, i.e.
revenue is recognized at the time of sale, which need not be the same as time of collection.
· “The matching principal” of GAAP dictates that revenues be matched with expenses. Thus,
income is reported when it is earned, even though no cash flow may have occurred.
Non Cash Items
· The primary reason that accounting income differs from cash flow is that income statement
contain non-cash items
· Depreciation is the most apparent. No firm ever writes a check for “depreciation”.
· The depreciation deduction is simply an application of the matching principle in accounting.
· Another noncash item is deferred taxes, which does not represent a cash flow.
Time and Costs
· In the short run, certain equipment, permanent labor, resources, and commitments of the
firm are fixed, but the firm can vary such inputs as non-permanent labor and raw materials.
· In the long run, all inputs of production (and hence costs) are variable.
· Financial accountants do not distinguish between variable costs and fixed costs. Instead,
accounting costs usually fit into a classification that distinguishes product costs from period costs.
· Product cost include such things as raw materials, direct labor and manufacturing overhead
and are reported on the income statement as the cost of goods sold, but they include both
fixed and variable costs.
· Period costs include selling, general, and administrative expenses which may be fixed as
well as variable.
Taxes
· One of the largest cash outflows that a Corporate firm experiences.
· The size of tax is determined through the tax schedule issued by the Central Board of Revenue.
· Taxes for partnerships and proprietorship are computed using the personal income tax schedules.
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Average vs. Marginal Tax Rates
· Average tax rate is tax bill divided by the taxable income or the percentage of the income
that goes to pay taxes
· Marginal tax rate is the extra tax you would pay if you earn one more dollar.
· Suppose a Corporation has a taxable income of $200,000. So the Tax calculation will be:
$ 50,000 x 15% = $ 7,500
($ 75,000 – 50,000) x 25% = 6,250
($ 100,000 – 75,000) x 34% = 8,500
($ 200,000 – 100,000) x 39% = 39,000
$ 61,250
· Our total tax is $61,250
· Average tax rate is $61,250 / 200,000 = 30.625%
· Marginal rate is 39%
Flat Tax rate
· There is only one tax rate and this rate is same for all income levels.
· With such a tax, the marginal tax rate is always same as the average tax rate.
· The model tax rate schedule presented earlier represents a modified flat-rate tax, which
becomes a true flat rate for the highest incomes.
· Lets take another view
Average vs. Marginal Tax Rates
· The more a corporation earns, the grater is the percentage of taxable income paid in taxes.
· So the average tax rate never goes down, even though the marginal rate does.
· It will normally be the marginal tax rate that is relevant for financial decision making, since
any new cash flows will be taxed at the marginal rate
Cost of a Tax Deductible Expense
· The businesspersons often say that a tax-deductible item, such as interest on loans, travel
expenditures, or salaries, costs substantially less than the amount spent on after-tax basis.
· Lets examine two corporations - one pays $100,000 in interest, while other has no interest
expense.
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Cost of a Tax Deductible Expense
· Interest is deducted from earnings before determining taxable income, thus saving $35,000
in taxes and costing only $65,000 on a net basis.
· Because a dividend on common stock is non tax-deductible, we say it cost 100% of amount
paid. From a purely corporate cash flow point of view, the firm would be indifferent
between paying $100,000 in interest and $65,000 in dividends.
DEPRECIATION AS A TAX SHIELD
· Although depreciation is not a new source of funds, it provides the important function of
shielding part of our income from taxes.
· Again, we take the same two corporations – one charges off $100,000 in depreciation, other
charges off none.
Depreciation as a Tax Shield
Corporation A enjoys $35,000 more in cash flow, since depreciation shielded $100,000 from
taxation in Corporation A and saved $35,000 in taxes, which eventually appeared in cash
flows.
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Topic 2
Basics of Accounting (Continued…)
Cash Flow Statement
Cash flow statement shows, how cash was generated and how it was used during the period.
These days, it is required by law to include this statement in financial statements, especially
in case of financial statements of limited companies.
Need For Cash Flow Statement
For any business, it is important to ensure that:
• Sufficient profits are made to compensate owners for the investment made, efforts put in
and the risk taken for the business,
• Sufficient funds are available to meet the obligations of the business as and when required.
The information as to profitability is provided by the Profit and Loss Account. The
information as to availability of funds or financial health is provided by the balance sheet.
But the balance sheet is prepared on a specific date and can provide information of financial
position as on that date only. Cash flow, on the other hand provides more detailed
information about the movement of funds during the period. With the help of cash flow, we
can determine the amount of cash generated form different sources and the areas on which it
is utilized.
Difference between Profitability and Liquidity
Liquidity
It is the ability of a business to pay its debts in time. By having good liquidity, we mean that a
business has sufficient liquid funds (cash and cash equivalents) so that it can repay liabilities.
Cash
Cash includes cash in hand and demand deposits.
Cash Equivalents
Cash equivalents are those short term investments that can be converted into a known amount
of cash at any time. Usually, investments up to three months maturity are included in cash
equivalents. People generally mix up profitability with liquidity. One might think that if a
business has earned, say, One Million Rupees of profit than it should have approximately the
same amount of cash in it. But mostly this is not the case. Consider the following example:
• A person starts a small business with Rs. 10,000. He purchases goods worth Rs. 20,000. Rs.
10,000 is paid in cash and remaining is payable at the end of the month. The same day, all
the goods are sold on credit of two months for Rs. 30,000.
• Now if we draw a profit and loss account at the end of the month, the business has earned a
profit of Rs. 10,000, considering no expenses.
• But at the same time, it is time to pay to the Creditors, whereas payment from debtor is not due yet.
• This means that although the business earned a profit of Rs. 10,000 but it has no cash to pay
to its creditors.
• This simple example helps us to understand that liquidity is different from profitability but
it is as important as profitability.
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Components of Cash Flow Statement
Cash flow statement is divided into three components
• Cash Flow from Operating Activities
• Cash Flow from Investing Activities
• Cash Flow from Financing Activities
Cash Flow From Operating Activities
Cash flow from operating activities is generally derived from the principal revenue producing
activities of the business.
Cash Flow from Operating Activities is the indicator of success or failure of a business’s
operations. If the cash flow from operations is continuously negative, this means that the
business revenue is not enough to recover the costs that are incurred to earn it. Therefore, in
the long run Cash flow from operations must be positive.
Examples of cash flows from operating activities are:
• Cash receipt from sale of goods and rendering of services.
• Cash receipts from fees, commission and other revenues.
• Cash payments to suppliers for goods and services.
• Cash payments to and on behalf of the employees.
• Cash payments or refunds of income taxes.
EXAMPLE
Cash Flow From Investing Activities
Cash flow from investing activities includes cash receipts and payments that arise from Fixed
and Long Term assets of the organization.
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Cash Flows from Investing Activities shows the investment trend of the business. If it is
negative (Outflow) this means that the company is investing in long term assets and is
expanding. On the other hand if it is positive (Inflow) over the years, this means that the
company is selling its long term investments.
Examples of cash flows from investing activities are:
• Cash payments to acquire property plant and equipment. These also include payments made
for self-constructed assets.
• Cash receipts from sale of property plant and equipment.
• Cash payments and receipts from acquisition and disposal of other than long term assets e.g.
Shares, debentures, TFC, long term loans given etc.
If assets are held for trading purposes or in normal course of business e.g. car / property dealers
and loans given by banks, then cash flow from these are included in Operating Cash Flow.
EXAMPLE
Cash Flow From Financing Activities
Cash flow from financing activities includes cash receipts and payments that arise from
Owners of the business and other long term liabilities of the organization.
Cash Flows from Financing Activities shows the behavior of investors (both equity capital
and debt capital). A positive figure (inflow) shows that funds are being invested in the
company and vice versa.
Examples of cash flows from financing activities are:
• Cash received from owners i.e. share issue in case of company and capital invested by sole
proprietor or partners.
• Cash payments to owners i.e. dividend, drawings etc.
• Cash receipts and payments for other long term loans and borrowings.
EXAMPLE
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Procedure Of Preparing Cash Flow
Cash Flow Statement is prepared as follows:
• We start from the Profit / Loss for the period before taxation.
• Adjustments are made for non-cash items that are included in the profit and loss account such
as Depreciation, Provisions and other items that relate to investing and financing activities.
• This gives us Operating Profit before Working Capital Changes.
• Then Working Capital Changes, i.e. increase or decrease in items of current assets and
liabilities, are added / subtracted (Cash and Cash Equivalents are not included here)
• This gives the Cash Flow from Operations.
• To this figure, we add / subtract cash flows from investing and financing activities.
• This gives us Net Increase / Decrease in Cash and Cash Equivalents.
• To this figure we add Opening Balance of Cash and Cash Equivalents (that we excluded
from current assets)
• This gives us the Closing Balance of Cash and Cash Equivalents.
Increase or Decrease is generally taken as difference in opening and closing balances of
accounts reported in balance sheets.
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Significance of Financial Statements
A good Working Knowledge of financial Statements is desirable simply because these
statements are the primary means of communicating financial information both within and
outside the firm.
External Uses of Statement Analysis
· T rade Creditors -- Focus on the liquidity of the firm.
· B ondholders -- Focus on the long-term cash flow of the firm.
· S hareholders -- Focus on the profitability and long-term health of the firm.
Internal Uses of Statement Analysis
· P lan -- Focus on assessing the current financial position and evaluating potential firm
opportunities.
· C ontrol -- Focus on return on investment for various assets and asset efficiency.
· U nderstand -- Focus on understanding how suppliers of funds analyze the firm.
Significance of Financial Statements
· The reason, we rely on accounting figures for much of our financial information is that we
are almost always unable to obtain all of market information we want.
· The only meaningful yardstick for evaluation business decisions is whether or not they
create economic value.
· Clearly, one important goal of the accountant is to report financial information to the user in
a form useful for decision making.
· But the financial statements don’t come with a user’s guide.
· We will try to fill up this gap through learning a comprehensive analysis of financial
statements.
Standardized Financial Statements
· One obvious thing we want to do with a company’s financial statements is to compare them
to those of other.
· It is almost impossible to directly compare the financial statements for two companies
because of differences in size. So we will try to standardize the financial statements.
Common-Size Statements
· One very common and useful way of standardized comparison is to work with percentages
instead of dollars.
· So, a standardized financial statement presenting all items in percentages is called a
common-size statement.
· Balance sheet items are shown as a percentage of total assets and income statement items as
a percentage of sales.
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Topic 3
Financial Statement Analysis
COMPARISON OF FINANCIAL STATEMENTS
Often it becomes very difficult to compare financial statements of two or more business
entities due to
i) Size
ii) Functional currency.
However, we can overcome these problems by utilizing two effective tools of comparison.
These tools can be used for comparing performance of single entity over period of time and
to compare two or more entities.
1) COMMON SIZE STATEMENTS
2) RATIO ANALYSIS
COMMON-SIZE STATEMENTS
· One very common and useful way of standardized comparison is to work with percentages
instead of dollars.
· So, a standardized financial statement presenting all items in percentages is called a
common-size statement.
· Balance sheet items are shown as a percentage of total assets and income statement items as
a percentage of sales.
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Take the balance sheet first. Instead of putting rupee values in balance sheet, we place %age
against each line item with regard to total asset. The total assets are taken as 100 and every
line item relationship with total assets expressed in %age is placed against it. Take a look at
the attached Common Size balance sheet.
During 2002 total assets were 60.73% of total assets and that has been increased to 62.87% of
total assets in 2003. Every line-item on asset side is expressed as % of total assets. You are
now in a position to compare financial statements over a period of time to know what
developments have been made over time.
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In common size income statement every line item is expressed as %age of sales. In other
words, cost of sales, operating expenses and net income add up to 100%. Let look at the
Common Size Income Statement.
Cost of Sales in 2002 was 53.94% of sales, which dropped to 51.47% in 2003. This is a
favorable symptom because any reduction in cost will lead to increase in profit. This is
confirmed when we look at the gross profit. In 2002 GP was 46.06% of sales and that
increased to 48.53% in 2003. The comparison here reveals that company has improved it
performance over the year 2002.
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A2Z Inc., Common-Size Balance Sheet
Suppose we ask: “What happened to A2Z’s net plant and equipment (NP&E) over the period?”
· Based on the 20X1 and 20X2 B/S, NP&E rose from $2,731 to $2,880, so NP&E rose by
$149.
· Did the firm’s NP&E go up or down? Obviously, it went up, but so did total assets. In fact,
looking at the standardized statements, NP&E went from 80.9% of total assets to 80.3% of
total assets.
· If we standardized the 20X2 numbers by dividing each by the 20X1 number, we get a
common base year statement. In this case, $2,880 / $2,731 = 1.0545, so NP&E rose by
5.45% over this period.
· If we standardized the 20X2 common size numbers by dividing each by the 20X1 common
size number, we get a combined common size, common base year statement. In this case,
80.3%/ 80.9% = 99.26%, so NP&E almost remained the same as a percentage of assets.
· In absolute terms, NP&E is up by $149 or 5.45%, but relative to total assets, NP&E fell by
2.6%.
· Current assets rose from 19.1% in 20X1 to 19.7% in 20X2
· Current liabilities declined from 16.0% to 15.1% of total liabilities and equity over the
same time.
· Total equity rose from 68.1% of total liabilities and equity to 72.2%.
· Overall, A2Z’s liquidity as measured by current assets compared to current liabilities,
increased over the year. Also, A2Z’s indebtness diminished as a percentage of total assets.
· So we may conclude that balance sheet as grown stronger
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A2Z Inc., Common-Size Income Statement
· This statement tells us what happened to each dollar in sales.
· For A2Z interest expense eats up 6.1% of sales, while taxes take another 8.1% of sales
figure.
· Following this, 15.7% of revenues from sales flow down to bottom as net income; one-third
of which is paid in dividends and remainder two-thirds is taken as retained earnings for
business.
· As far as cost is concerned, 58.2% of revenues are spent on the goods sold
Base Year Analysis: Common Size analysis is also known as Vertical Analysis. Base year
analysis is another tool of comparing performance and is also known as Horizontal Analysis.
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In this case, performance is compared over, say, five years period. The earliest year or the
first year is taken as base year and every line item in the balance sheet of base year is taken as
100%. In the subsequent years amounts of every line item are expressed as %age of base year
amount.
You can see the Base Year analysis example from the attached balance sheet. Comparison is
being made from the year 2001 to 2006; therefore, the earliest year i.e., 2001 is labeled as
base year. Total fixed assets in 2001 were Rs. 100,000/- expressed as 100% (cell H9: in blue
font). In year 2005 the total investment in fixed assets has risen to Rs. 155,000/-, which is
155% of base year amount (Rs. 100,000). This means that from 2002 to 2005, 55%
investment of base year amount has been injected in fixed assets and that further increased to
60% at the end of year 2006.
Standardized Financial Statements
Although an organization’s common-size statements provide a better analytical insight into
the it’s strength and standing, yet it’s performance and efficiency can be better judged by
comparing these with those of the firm’s competitors.
Ratios Analysis
This is another widely acknowledged and used comparison tool for financial managers. A
ratio is a relationship between two or more line items expressed in %age or number of times.
Financial ratios are useful indicators of a firm’s performance and financial situation. Most
ratios can be calculated from information provided by the financial statements. Financial
ratios can be used to analyze trends and to compare the firm’s financials to those of other
firms. In some cases, ratio analysis can predict future bankruptcy.
Financial ratios can be classified according to the information they provide.
Ratios Analysis:
· Another way of avoiding the problems involved in comparing companies of different sizes,
is to calculate and compare financial ratios.
· One problem with ratios is that different people and different sources frequently don’t
compute them in exactly the same way.
· While using ratios as a tool for analysis, you should be careful to document how you
calculate each one, and, if you are comparing your numbers to those of another source, be
sure you know how their numbers are computed.
For each of the ratios we discuss, several questions come to mind:
· How is it computed?
· What is it intended to measure, and why might we be interested?
· What is the unit of measurement?
· What might a high or low value be telling? How might such values be misleading?
· How could this measure be improved?
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Financial ratios are traditionally grouped into the following categories:
· Short-term solvency, or liquidity, ratios
· Ability to pay bills in the short-run
· Long-term solvency, or financial leverage, ratios
· Ability to meet long-term obligations
· Asset management, or turnover, ratios
· Intensity and efficiency of asset use
· Profitability ratios
· Ability to control expenses
· Market value ratios
· Going beyond financial statements
1) Short-Term Solvency, or Liquidity Measures
· The primary concern to which these ratios relate, is the firm’s ability to pay its bills over the
short run without undue stress. So these ratios focus on current assets and current liabilities.
· Liquidity ratios are particularly interesting to short-term creditors. Since financial managers
are constantly working with banks and other short-term lenders, an understanding of these
ratios is essential
Current assets and liabilities
· Their book values and market values are likely to be similar.
· They can and do change fairly rapidly, hence unpredictable
Current Ratio
Current Ratio = Current Assets .
Current Liabilities
· Because current assets and liabilities are converted into cash over the following 12 months,
the current ratio is a measure of short run liquidity.
· The unit of measurement is either dollars or times.
For A2Z Corporation, the 20X2 current ratio is
Current Ratio = $708 / $540= 1.31 times
We can say that
•A2Z has a $1.31 in current assets for every $1 in current liabilities OR
•A2Z has its current liabilities covered 1.31 times over.
•To a creditor (particularly a short-term creditor like supplier), the higher the current ratio,
the better
•To firm, high current ratio indicates liquidity, but it may also indicate an inefficient use of
cash and other short-term assets.
•We would expect to see a current ratio of at least 1, because a current ratio of less than 1
would mean that net working capital is negative
•Like any other ratio, current ratio is effected by various transactions.
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•If a firm borrows over long-term,
•The short run effect would be an increase in cash as well as in long term liabilities.
•Current liabilities would not be affected, so the current ratio would rise.
•An apparently low current ratio may not be a bad sign for a company with a large reserve of
unlimited borrowing power.
Current Events
A firm wants to payoff some of its suppliers and creditors. What would happen to current ratio?
•Current ratio moves away from 1. if it is greater than 1 it will get bigger. But if it is less than
1, it will get smaller.
•Suppose a firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. and
uses $1 in cash to reduce current liabilities, then new current ratio is ($4-2) / ($2-1) = 3
•Reversing the situation to $2 in current assets and $4 in current liabilities, the change will
cause current ratio to fall to 1/3 from ½
Suppose a firm buys some inventory. What would happen in this case?
•Nothing happens to current ratio. Because in this scenario, one current asset (cash) goes
down while another current asset (inventory) goes up. Total current assets are unaffected.
What happens if a firm sells some merchandise?
•Current ratio would usually rise because inventory is shown at cost and sale would normally
be at something greater than cost (difference is markup).
•So, the increase in either cash or receivables is greater than the decrease in inventory.
•This increases current assets and current ratio rises.
Quick (or Acid-Test) Ratio
· Inventory is often the least liquid current asset. And its book values are least reliable as
measures of market value since the quality of inventory isn’t considered. Some of the
inventory may turn out to be damaged, obsolete or lost.
· Relatively large inventories are often a sign of short-term trouble.
· The firm may have overestimated sales and overbought or overproduced as a result, hence
tied up a substantial portion of its liquidity in slow moving inventory
It is computed just like current ratio, except inventory is omitted.
Quick Ratio = Current Assets – Inventory
Current Liabilities
For A2Z, this ratio in 20X2 was
Quick Ratio = $708 – 422 = 0.53 times
$540
· The quick ratio here tells a somewhat different story than the current ratio, because
inventory accounts for more than half of A2Z’s current assets
· If the same figure is for an aircraft manufacturing corporation, then this would certainly be
a cause for a BIG concern.
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Cash Ratio
A very short-term creditor may be interested in the cash ratio
Cash Ratio =
Cash
.
Current Liabilities
Current ratio for A2Z in 20X2 was 0.18
2) Long Term Solvency Measures:
· These ratios are intended to address the firm’s long-run ability to meet its obligations, or its
financial leverage.
Total Debt Ratio
This ratio takes into account all debts of all maturities to all creditors. It is computed as
Total Debt Ratio= Total Assets – Total Equity
Total Assets
For A2Z Corporation
Total Debt Ratio= $3,588 – 2,591 = 0.28 times
$3,588
· So A2Z uses 28% debt. Whether this is high or low, or whether it even makes any
difference depends on whether or not capital structure matters.
· A2Z has 28% debt against total assets, thus there is 72% equity against total assets.
· Here we draw two variations out of total debt ratio
•Debt-equity ratio
•Equity multiplier
· Debt–Equity ratio = Total Debt / Total Equity
= 28% / 72% = 0.39 times
· Equity Multiplier = Total Assets / Total Equity
= 100% / 72% = 1.39 times
OR
= 1 + Debt-Equity ratio = 1.39 times
Interest Coverage Ratio
· Also known as Times Interest Earned (TIE) ratio, refers to the ability of the firm to cover is
interest obligations.
Interest Coverage ratio = Earnings before Interest & Taxes
Interest
For A2Z corporation:
= $691 / $141 = 4.9 times
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Cash Coverage Ratio
· A problem with Interest Coverage Ratio is that it is based on Earnings before Interest and
Taxes (EBIT) which is not really a measure of cash available to pay interest.
· The reason is that depreciation, a non-cash expense has been deducted out. So we use:
Cash Coverage ratio = EBIT + Depreciation
Interest
For A2Z corporation:
= $691 + 276 = $967 = 6.9 times
$141
$141
3) Asset Management or Turnover Measures
The measures in this section are sometimes called Asset Utilization Ratios. These are
intended to describe how efficiently or intensively a firm uses its assets to generate sales.
Inventory Turnover Ratio
Inventory turnover can be calculated as:
Inventory Turnover ratio = Cost of goods Sold
Inventory
For A2Z, ITR = $1,344 / $422 = 3.2 times
So A2Z sold off or turned over the entire inventory 3.2 times. As long as stock-out and
foregoing sales situation doesn’t arise, the higher this ratio is, the more efficiently inventory
is being managed
Days’ Sales in Inventory
If we know sales were turned over 3.2 times during the year, we can calculate easily how
long it took to turnover on average.
Days’ Sales in Inventory =
365 days
.
Inventory Turnover
For A2Z Days’ Sales in Inventory = 365 / 3.2 = 114 days
So inventory stays for just less than 4 months before being sold or it would take 114 days to
sell off current inventory.
Receivables Turnover
Now we take a look on how fast we collect on the sales of inventory.
Receivables Turnover =
Sales
.
Accounts Receivables
For A2Z Receivables Turnover = $2,311 / $188 = 12.3 times
So A2Z collected its outstanding credit accounts and reloaned the money 12.3 times during
the year. (Assuming all the sales are credit sales. If not, we use only credit sales for this ratio)
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Days’ Sales in Receivables
Days’ Sales in Receivables =
365 days
.
Receivables Turnover
For A2Z Days’ Sales in Receivables = 365 / 12.3 = 30 days
So A2Z collects on its credit sales in a month, or the firm has 30 days’ worth of sales
uncollected. This ratio is also called Average Collection Period
A Variation: Payables Turnover
It describes a how long does the firm take to pay its bills, and is computed as:
Payables Turnover = Cost of Goods Sold
Accounts payables
For A2Z Payables Turnover = $1,344 / $344 = 3.9 times
So days it took to turnover the payables are = 365 / 3.9 = 94 days
This figure is very significant to the current as well as potential creditors of A2Z.
Total Asset turnover
Total Assets Turnover =
Sales
.
Total Assets
For A2Z Total Assets Turnover = $2,311 / $3,558 = 0.64 times
In other words, for every dollar in assets, A2Z generated $0.64 in sales.
Capital Intensity Ratio
It is simply the reciprocal of total assets turnover, or:
Capital Intensity Ratio = Total Assets
Sales
· It is interpreted as the dollar investment in assets needed to generate $1 in sales. Higher
values represent capital intensive industries.
· For A2Z, this ratio is 1.56, i.e. A2z has to invest $1.56 in assets to get $1 in sales.
4) Profitability Measures
· In one form or the other, these ratios are intended to measure how efficiently the firm uses
its assets and how efficiently the firm manages its operations.
· The focus in this group is on the bottom line – net income.
Profit Margin
Every company, big or small, pays very close attention to their profit margin
Profit Margin= Net income
Sales
For A2Z company the profit margin will be = $ 363 / $2,311 = 15.7%
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· A2Z generates a little less than 16 cents in profit for every dollar in sales.
· Other Things being equal, a relatively high profit margin is obviously desirable,
corresponding to low expenses vs. sales.
· But Other Things are not always equal !
· For example, lowering the sales price will usually increase unit sales but will normally
cause profit margin to shrink. Total Profit of operating cash flow may go up or down.
Return on Assets
Return on Assets (ROA) is a measure of profit per dollar of assets:
Return on Assets =
Net income
Total Assets
For A2Z, ROA = $ 363 / $3,588 = 10.12%
Return on Equity
· Return on equity (ROE) is a measure of how the stockholders fared during the year.
· Since benefiting the shareholders is the goal of corporation, ROE is a true bottom line
measure of performance.
Return on Equity =
Net income
Total Equity
For A2Z, ROE = $ 363 / $2,591 = 14%
Therefore, for every dollar in equity, A2Z generated 14 cents in profit. But this is correct in
accounting terms only.
ROA and ROE
· Because ROA and ROE are most widely used and commonly cited numbers, so it should be
kept in mind that these are accounting rates of return.
· That is why these are called return on book assets and return on book equity
· ROE is sometimes called return on Net Worth
5) Market Value Measures
· This group of measures is based, in part, on information not necessarily contained in
financial Statements, like market price per share.
· These measures can be calculated directly only for publicly traded companies.
Earnings Per Share
EPS =
Net income
.
Shares Outstanding
Assuming,
•A2Z has 33 million shares outstanding and stock sold for $88 per share at the end of year.
So the Earnings per Share (EPS) will be:
EPS = $363 / 33 = $11
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Price-Earning Ratio
Price-earnings or PE ratio is defined as:
PE ratio =
Price per share
Earnings per share
For A2Z, PE ratio = $ 88 / $11 = 8 times
· So A2Z shares sell for eight times earnings or it carries a PE multiple of 8.
· Since PE ratio measures how much investors are willing to pay per dollar of current earnings,
higher PEs are often taken to mean that the firm has significant prospects for future growth.
· If a firm had no or almost no earnings, its PE would probably be quite large; so careful
interpretation is required.
Book Value per share
Book Value is calculated as:
Book Value =
Total equity
.
No. of shares outstanding
For A2Z, Book Value = $ 2,591 / 33 = $78.5
Since book value per share is an accounting number, it reflects historical costs.
Market-to-Book ratio
It is defined as:
Mark-to-Book ratio = Market value per share
Book value per share
For A2Z, Mark-to-Book ratio = $ 88 / $78.5 = 1.12 times
· The market-to-Book ratio compares the market value of the firm’s investment to their costs.
· A value less than 1 could mean that the firm has not been successful overall in creating
value for its stockholders.
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Topic 3
Financial Statement Analysis (Continued…)
The Du Pont Identity
· The difference between the two profitability measures, ROA and ROE, is the use of debt
financing , or financial leverage.
· The relationship between these measure can be illustrated by decomposing ROE into its
component parts.
Recall,
Return on Equity = ROE =
Net income
Total Equity
Multiplying it by Assets / Assets (without changing anything)
ROE = Net income = Net income x Assets .
Total Equity
Total Equity x Assets
ROE = Net income x Assets .
Total Equity x Assets
ROE =
Net income
Assets
. x
Assets
.
Total Equity
So, we have expressed ROE as a product of two other ratios – ROA and the equity multiplier
ROE = ROA x Equity multiplier
Or
ROE = ROA x (1 + Debt-Equity ratio)
Looking back at A2Z:
•Debt-Equity Ratio = 0.39
•ROA = 10.12%
•while ROE calculated previously = 14%
Now, using the decomposition method:
ROE = 10.12% x 1.39 = 14%
We can further decompose ROE by multiplying the top and bottom by total sale:
ROE = Sales x Net Income x
Assets
.
Sales
Assets
Total Equity
Rearranging a bit,
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ROE = Net Income x Sales
Sales
Assets
x
Lecture Handouts For BBA
Assets
.
Total Equity
Return on Assets
ROE = Profit Margin x Total Assets Turnover x Equity Multiplier
This last Expression is called Du Pont identity after the Du Pont Corporation, which
popularized its use.
Now for A2Z, ROE = 15.7% x 0.64 x 1.39 = 14%
The Du Pont identity tells us that ROE is affected by three things:
· Operating efficiency (as measured by profit margin)
· Asset use efficiency (as measured by total assets turnover)
· Financial Leverage (as measured by equity multiplier)
Considering the Du Pont identity,
· it appears that a firm could leverage up its ROE by increasing its amount of debt
· this will only happen if ROA exceeds interest rate on debt.
· The decomposition of ROE is a convenient way of systematically approaching the financial
statements analysis.
· If ROE is unsatisfactory by some measure, then Du Pont identity tells you where to start
looking for the reasons.
Dividend Payout
We have seen earlier that the net income is divided into two pieces.
· The first piece is cash dividend paid to stockholders
· Leftover amount is the addition to retained earnings
Dividend Payout ratio = Cash Dividends
Net Income
A2Z’s Net Income was $363, of which $121 was paid out in dividends. As a percentage:
= $121 / $363 = 33.33%
Retention Ratio
Retention ratio = Retained Earnings
Net Income
Anything A2Z does not pay out in form of dividends must be retained in the firm. So
retention ratio is:
= $242 / $363 = 662/3%
· So A2Z retains two-thirds of its net income.
· The retention ratio is also known as the plowback ratio, as this is the amount which is
plowed back into the business
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Payout and Retention
Q: LMN corporation pays out 40% of net income in form of dividends. What is its retention ratio?
A: If payout ratio is 40%, retention ratio is = 1 – 40% = 60%
Q: If net income of LMN is $800, how much did stockholders actually receive?
A: Dividends are = $800 x 40% = $320
Internal and Sustainable Growth
· Firm’s Return on Assets and Return on Equity are frequently used to calculate two
additional numbers, both of which have to do with the firms ability to grow.
· Investors and others are frequently interested in knowing how rapidly a firm’s sales can grow.
· But the important thing to recognize is that if sales are to grow, assets have to grow as well,
at least over the long run.
· Further if assets are to grow, then the firm must somehow obtain money to pay for the
purchases.
· So, the growth has to be financed. And more so, a firm’s ability to grow depends on its
financing policies.
· A firm has two broad sources of financing:
Ø Internal financing simply refers to what the firm earns and subsequently plows back
into the business.
Ø External financing refers to funds raised by either borrowing money or selling stock.
Internal Growth Rate
A firm having a policy of internal financing, won’t borrow funds and won’t sell any new
stock. Internal growth rate represents how rapidly the firm grow.
Internal Growth rate =
ROA x b
(1 – ROA) x b
.
where ROA is return on assets and b is the retention ratio
For A2Z this rate is
=
0.1012 x 2/3
.
(1 – 0.1012) x 2/3
= 7.23%
Relying solely on internal financing, A2Z can grow at a maximum rate of 7.23% per year.
Sustainable Growth Rate
Ø If a firm only relies on the internal financing , then through time, its total debt ratio will
decline, because assets will grow but total debt will remain the same (or even fall if some
is paid off).
Ø Frequently, firms have a particular total debt ratio or equity multiplier that they view as optimal.
Ø With this in mind we now consider how rapidly a firm can grow if
Ø it wishes to maintain a particular total debt ratio; and
Ø it is unwilling to sell new stock
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Given these assumptions, the maximum growth rate that can be achieved is called the
Sustainable Growth Rate:
Sustainable Growth rate =
ROE x b
(1 – ROE) x b
.
For A2Z this rate is
=
0.14 x 2/3
.
(1 – 0.14) x 2/3
= 10.29%
The reason for Sustainable Growth rate (10.29%) being larger than internal growth rate
(7.23%) is that, as the firm grows, it will have to borrow additional funds if it has to maintain
a constant debt ratio.
This new borrowing is an extra source of financing in addition to internally generated funds,
so A2Z can expand more.
Determinants of Growth
Ø Using Du Pont identity, we saw that ROE can be decomposed into its various components
Ø Since ROE appears so prominently in determination of Sustainable growth rate, the factors
determining ROE are also important determinants of growth.
Ø We know that:
ØROE = Profit Margin x Total Assets Turnover x Equity Multiplier
· Anything that increases ROE will increase the Sustainable growth rate. Increasing the
retention ratio will have the same effect.
· So putting it all together, the firm’s ability to sustain growth depends explicitly on the four
factors:
Profit margin
An increase in profit margin will increase the firm’s ability to generate funds internally and
thereby increase its sustainable growth.
Total Assets Turnover
An increase in firm’s total assets turnover increases the sales grow and thereby increases the
sustainable growth rate. Increasing total assets turnover is the same thing as decreasing
capital intensity.
Financial Policy
An increase in the debt-equity ratio increases the firm’s financial leverage. Since this makes
additional debt financing available, it increases the sustainable growth rate.
Dividend Policy
A decrease in the percentage of net income paid out as dividends will increase the retention ratio.
This increases internally generated equity and thus increases internal and sustainable growth.
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· The sustainable growth rate illustrates the explicit relationship between the firm’s four
major areas of concern:
· Operating efficiency (as measured by profit margin)
· Asset use efficiency (as measured by total assets turnover)
· Financial policy (as measured by the debt-equity ratio)
· Dividend policy (as measured by the retention ratio)
If sales are to grow at a rate higher than the sustainable growth rate, the firm must
· increase profit margins,
· increase total assets turnover,
· increase financial leverage,
· increase earnings retention, or
· Sell new shares
Using Financial Statements Information
Why Evaluate Financial Statements
· Primary reason for looking at the accounting information is that we don’t have and cant
expect to get market value information. But if we have such information, we will use it
instead of accounting data.
· If there is a conflict between accounting and market data, market data would be preferred.
· Financial statements analysis is an application of management by exception and boils down
to comparing ratios for one business with some average or representative ratios.
· The ratios differing considerably from averages are studied further.
Internal Uses
Performance Evaluation
· Profit margin and return on equity
· Comparing the performance of different divisions
· Planning for the future
· Historical information used for generating projections
· Checking the realism of assumptions for the projections
External Uses
Customers:
· To evaluate the credit standing of a new customer
· Large customers would eye on the sustainability of the firm
· Suppliers:
· Evaluate the financial worth of the supplier
· Suppliers would be concerned about the creditworthiness of the firm
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Competitors
· Potential strength of the competitors in case of a new product launched by a firm
· Acquisition of new firms
· Identification of potential targets
· What to offer.
Choosing a Benchmark
· Benchmarking is to establish a standard to follow for comparison.
· Some methods of benchmarking are:
· Time-Trend analysis
· Peer Group Analysis
Time-Trend Analysis
· Based on the historical data of the firm
· If the current ratio of a firm is 2.4 for the recent financial statements, we may compare it
with the current ratios for last 10 years.
· We may find that current ratio has declined over the years because of
· More efficient usage of current assets
· Change in the nature of business of the firm
· Change in business practices of the firm
Peer Group Analysis
Identifying the firms
· competing in the same markets,
· Having similar assets,
· Operate in similar ways
Benchmarking:
· averages for this group of firms OR
· the top firms among the group
Problems with Financial Statements Analysis
· No underlying theory to help identify the items or ratios to look at or to guide in
establishing benchmark
· Very little help on value and risk
· Which ratios matter the most?
· What a high or low value might be?
•Firms with many diversified businesses
•Different accounting standards and procedures in different parts of the world
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Topic 3
Financial Statement Analysis (Continued…)
Predicting Financial Distress - The Z-Score Analysis
“You’re neither right nor wrong because other people agree with you. You’re right because
your facts are right and your reasoning is right – that’s the only thing that makes you right.
And if your facts and reasoning are right, you don’t have to worry about anybody else.”
Warren Buffett- American legendary investor
Every rational investor who intends to invest in a company desires to have maximum return
from that investment. It requires making investment decision after analyzing the projected
company from different perspectives. However, a special emphasis is on determining that
company’s profitability and repaying capacity. The rationale behind it is to ensure that the
company is able to pay the money it owes to the investors/shareholders and creditors or is in
financial distress?
Financial distress is defined as a state under which a company faces difficulty or is unable to
pay the money it dues to the creditors and shareholders. These companies are characterized
by illiquid assets, high leveraged costs and returns highly sensitive towards economic
circumstances. This condition leads the company towards bankruptcy unless proper remedial
measures are adopted to put it back to the track of financial stability.
Investors can protect themselves from losses that may incur as an aftermath of investment in
a company that is on the verge of bankruptcy provided they are aware about the bankruptcy
position of that company prior to investment. To identify companies’ repaying capacity,
investors calculate and analyze various ratios. Although ratio analysis serves as an effective
tool for determining the financial strengths and weaknesses of a company’s performance but
the fact is that every ratio is distinctive in nature and guides the investors from a different
perspective. Moreover, sometimes many of these ratios oppose each other. Consequently, it is
difficult for the investors to come up with an accurate opinion about whether the company is
away from bankruptcy or is moving towards bankruptcy.
To detect the possibility of a company’s bankruptcy in advance, Edward I. Atlman developed
Z Score Analysis in 1960’s.
Edward I. Altman is serving as a Professor of Finance at Stern School of Business, New York
University. His name is listed among 100 most influential people in financial research by the
Treasury & Risk Management Magazine of UK. He is known worldwide for his research in
the areas of credit risk analysis, corporate bankruptcy, capital markets and regulations in
banking.
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Z score analysis is a diagnostic measure of corporate financial health developed by Altman to
forecast the probability of bankruptcy in a company within a period of 2 years. It was
developed after an in depth research conducted on 66 manufacturing companies. These 66
corporations were divided in to two equal groups i.e. 33 bankrupt companies with assets size
between $1 million to $26 million and 33 non bankrupt healthy firms with assets size
between $5 million to $130 million. 22 common ratios were calculated and analyzed on all
these selected companies. Financial data of these companies were taken from Moody’s
industrials manuals and from the respective companies annual reports. Multiple Discriminant
Analysis was applied in this research which is a statistical analytical tool through which many
characteristics can be summarized in to a single score.
Outcome of this study revealed 5 ratios that were sorted out of 22 ratios analyzed. These 5
ratios perform best collectively in predicting the probability of bankruptcy. Ratios are
weighted with Discriminant Coefficients and then summed up. Final score is known as “Z
Score”. The Z score formula is as follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
1.2, 1.4, 3.3, 0.6, and 1 represents Discriminant weights or coefficients assigned to the ratios
and X1 to X5 are the five ratios screened.
X1 represents Working Capital/Total Assets (WC/TA). This ratio determines the liquidity
position of a company in comparison to the total capitalization. Working capital is the
difference between current assets and current liabilities. Companies that hold positive
working capital in relation to total assets are generally strong enough to pay the liabilities
due. In contrast companies with negative working capital could be on the road to bankruptcy.
X2 represents Retained Earnings/Total Assets (RE/TA). This ratio determines the leverage
position of the company. Retained earnings refers to the amount of money which is not
distributed to the shareholders out of net profit and is retained by the company either for
further investment or for meeting the contingencies. These are added in shareholders’ equity
of the companies. Generally companies who possess high retained earnings as compared to
the total assets finance their assets through the reinvestment of profit in to the business
instead of taking debt. Consequently, it depicts company’s strength in relaying on internal
equity rather than external equity.
X3 represents Earnings before Interest and Taxes/Total Assets (EBIT/TA). This ratio
determines the ability of the company’s assets in generating profits independent of taxes and
finance costs. It illustrates the earning power of assets. A high ratio indicates potential of
company’s assets in generating operating profits.
X4 represents Market Value of Equity/Book Value of Total Liabilities (MVE/TL). This
ratio determines the proportion by which a company’s assets are financed through equity and
debts (assets value determined by market value of equity and liabilities). It gives market
dimension to the analysis as it shows the actual worth of company’s equity in the market i.e.
it adds technical analysis perspective which is not based on fundamentals. Companies whom
liabilities exceed market value of equity fall close to bankruptcy.
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X5 represents Sales/Total Assets (S/TA). This ratio determines the efficiency of the
company’s assets in generating sales. It is also known as Total Assets Turnover.
Interpreting a company’s Z score is quite easy.
A score above 2.99 indicates that company is in
Safe zone and is not leading towards bankruptcy.
A score between 1.81 and 2.99 indicates that company is in Grey zone meaning by it is
neither safe nor is about to be declared as bankrupt. In this situation, a detailed analysis
should be conducted to locate the area that is creating gap between Safe zone and Grey zone
and for taking further remedial steps by the company’s management.
A score below 1.81 indicates that the company is in Distress zone and is leading towards
bankruptcy.
Primarily this model was formulated for manufacturing companies therefore it was criticized
by many financial experts and researchers due to non applicability on certain sectors as two
of the above mentioned five ratios are not applicable to all business sectors.
First one is X4-Market Value of Equity/Book Value of Total Liabilities (MVE/TL). This
ratio can be calculated only for public companies therefore investors cannot calculate it for
private companies. Second one is X5- Sales/Total Assets (S/TA). It differs with respect to
industry such as for non manufacturing and emerging markets credits. For example, there is
no concept of sales in case of banks as banks are service providing companies and do not
have sales so it cannot be calculated for banks.
To resolve the conundrum, Altman developed multiple versions of Z score analysis after
thorough research on these respective sectors i.e. Z score for Private Companies and Z score
for Non Manufacturing and Emerging Market Credits.
For private companies, X4-Market Value of Equity/Book Value of Total Liabilities
(MVE/TL) is replaced with Book Value of Equity/Book Value of Total Liabilities (BVE/TL).
Book value of equity is the net worth of the company and can be calculated by subtracting
total liabilities from total assets. Thus the issue of calculating market value of equity for
private companies is no more in existence.
Z score formula and its interpretation for private companies is as follows:
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For non manufacturing and emerging companies, X5 i.e. Sales/Total Assets is not required to
be calculated. Z score formula and its interpretation for Non-Manufacturer Industrials &
Emerging Market Credits is as follows:
Generally, Z score analysis gives 72-80 % correct results within a period of 2 years and is
quite authentic. However, like other analytical tools it is also subject to certain limitations.
It provides accurate results to the extent up to which the information given in financial
statements depicts. Generally, companies use to understate their profits to take the advantage
of tax evasion. Therefore Z score result would be misleading for those companies whom
statements are window dressed. Moreover, Z scores are affected when exceptional write offs
are recorded by companies time to time thereby resulting high variation in scores.
In spite of the above mentioned limitations, the effectiveness of Z score cannot be denied.
That is why it is used worldwide by many financial experts, consultancy firms, investors,
companies’ management, etc as a valuable analytical tool for determining the chances of
bankruptcy in companies.
Summing up, Z score analysis should be conducted regularly to remain updated about
companies’ performance. Moreover, when the scores show significant variations for
consecutive years; other detailed analyses should be conducted. Most importantly, relying
only on this analysis is not wise. It should be used as a tool that complements other analytical
tools.
References:
Altman, E. I. (2000, July). PREDICTING FINANCIAL DISTRESS OF COMPANIES:
REVISITING THE Z-SCORE AND ZETA MODEL. Retrieved from International Insolvency
Institute: http://www.iiiglobal.org/component/jdownloads/viewdownload/648/5645.html
McClure, B. (2011, January 15). How To Calculate A Z-Score. Retrieved from Investopedia:
http://www.investopedia.com/articles/fundamental/04/021104.asp#ixzz1V6njlQJs
Mohan, M. (2012, October 21). 79 Warren Buffett Quotes On Investing. Retrieved from
Minterest: http://www.minterest.com/warren-buffet-quotes-quotations-on-investing
Edward
Altman
PhD.
(n.d.).
Retrieved
from
http://www.financialsense.com/contributors/edward-altman-phd
Dr. Owais Shafique
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Topic 4
Time Value of Money
Time Value of Money
•It refers to the fact that a dollar in hand today is worth more than a dollar promised at some
time in future.
•The trade-off between money today and money later depends on, among other things, the
rate one can earn by investing the money today for some interest income.
Time Value of Money offers an overview of the information required to calculate the future
and present values of individual cash flows, ordinary annuities, due perpetuities and
investments with uneven cash flows. TVM is based on the concept that a dollar that you have
today is worth more than the promise or expectation that you will receive a dollar in the
future. Money that you hold today is worth more because you can invest it and earn interest.
After all, you should receive some compensation for foregoing spending.
This topic has been divided into following topics, which will be explained in detail:
1. Present Value
2. Future Value
3. Annuities
4. Perpetuity
Simple Interest vs. Compound Interest
Its most basic form, interest is calculated by multiplying principal (amount invested) by rate
(% of interest) multiplied by time (number of periods the interest is calculated). This is called
simple interest.
I=Pxrxt
Where
P => principal amount
r => interest rate
t => time periods (years)
I => simple interest
However, if interest is left in the account to accumulate for a longer period (usually longer
than one year), common practice requires that after interest is earned and credited for a given
period, the new sum of principal + interest must now earn interest for the next period, etc.
This is compound interest.
I = P x r^t
Future Value
•It refers to the amount of money an investment will grow to over some period of time at
some given interest rate.
•Alternatively, future vale is the cash value of an investment at some time in future.
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Future value measures what money is worth at a specified time in the future assuming a
certain interest rate.
This is used in time value of money calculations.
To determine future value (FV) without compounding:
FV = PV . ( 1 + r )^t
or
FV = PV x ( 1 + r )t
or
FV = PV x FVIF
or
FV = PV / PVIF
Where PV is the present value or principal, t is the time in years, and r stands for the per
annum interest rate. To determine future value when interest is compounded:
FV = PV . ( 1 + i )^n
or
FV = PV x ( 1 + i )n
Where PV is the present value, n is the number of compounding periods, and i stands for the
interest rate per period. The relationship between i and r is:
i=r/X
Where X is the number of periods in one year. If interest is compounded annually, X = 1. If
interest is compounded semiannually, X = 2. If interest is compounded quarterly, X = 4. If
interest is compounded monthly, X = 12 and so on. This works for everything except
compounded continuously, which must be handled using exponential.
Similarly, the relationship between n and t is:
n=t.x
or
n=txX
For example, what is the future value of 1 money unit in one year, given 10% interest? The
number of time periods is 1, the discount rate is 0.10, the present value is 1 unit, and the
answer is 1.10 units. Note that this does not mean that the holder of 1.00 unit will
automatically have 1.10 units in one year, it means that having 1.00 unit now is the
equivalent of having 1.10 units in one year.
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Present Value
· It refers to the current value of the future cash flow discounted at the appropriate discount rate.
· In other words, the amount one would need to invest today at some pre-determined interest rate
to get some desired amount in future is the present value of the desired money.
The present value of a future cash flow is the nominal amount of money to change hands at
some future date, discounted to account for the time value of money. A given amount of
money is always more valuable sooner than later because this enables one to take advantage
of investment opportunities.
PV = FV / ( 1 + r )^t
or
PV = FV x PVIF
or
PV = FV / FVIF
The present value of delayed payoff may be found by multiplying the payoff by a discount
factor which is less than 1. If C1 denotes the expected payoff at period 1, then
Present Value (PV) = discount factor . C1
This discount factor is the value today of $1 received in the future. It is usually expressed as
the reciprocal of 1 plus a rate of return.
Discount Factor = 1 / ( 1 + r )
The rate of return r is the reward that investors demand for accepting delayed payment.
The present value formula may be written as follow:
PV = 1 / (1+r) . C1
To calculate present value, we discount expected payoffs by the rate of return offered by
equivalent investment alternatives in the capital market. This rate of return is often referred to
a the discount rate, hurdle rate or opportunity cost of capital. If the opportunity cost is 5
percent expected payoff is $200,000, the present value is calculated as follows:
PV = 200,000 / 1.05 = $190,476
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Present Value vs. Future Value
· What we called the present value factor is just the reciprocal of the future value factor.
· Future value factor = (1 + r)t
· Present value factor = 1/(1 + r)t
If we let FVt stand for the future value after t periods, then the relationship between the future
value and the present value is:
PV x (1 + r)t = FV
PV = FV / (1 + r)t = FV x [1/ (1 + r)t]
This is also known as basic present value equation.
PVIF = Present Value Interest Factor
FVIF = Future Value Interest Factor
EVALUATING INVESTMENTS
· A company is considering the purchase of an asset for $335, which may be sold for $400 in
three years. If the discounting factor is 10%, is this a good investment?
· Since the company can invest $335 elsewhere at 10%, in three years, it would grow to:
· $335 x (1 + r)t = $335 x 1.13
= $335 x 1.331
= $445.89
•Since the proposed purchase of asset pays out only $400, it is not as good as other
investment alternatives
•Another way of looking at it is to calculate the present value of $400 in three years at 10%:
$400 x [1/(1+r)t] = $400 / 1.13 = $400 / 1.331
= $300.53
This tells us that we only have to invest about $300 to get $400 in three years, not $335
What Rate Is Enough?
· Assume the total cost of a college education will be $50,000 when a child enters college in
12 years. The Parents have $5,000 to invest today.
· What rate of interest must you earn on your investment to cover the cost of your child’s
education?
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About 21.15%
Benjamin Franklin: A Case Study
· Benjamin Franklin died on April 17, 1790. In his will, he gave 1,000 pounds sterling to
Massachusetts and the city of Boston. He gave a like amount to Pennsylvania and the city
of Philadelphia.
· The money was paid to Franklin when he held political office, but he believed that
politicians should not be paid for their service!
· Franklin originally specified that the money should be paid out 100 years after his death
and used to train young people.
· Later, however, after some legal wrangling, it was agreed that the money would be paid out
200 years after Franklin’s death in 1990.
· By that time, the Pennsylvania bequest had grown to about $2 million; the Massachusetts
bequest had grown to $4.5 million. The money was used to fund the Franklin Institutes in
Boston and Philadelphia.
· Assuming that 1,000 pounds sterling was equivalent to 1,000 dollars, what rate did the two
states earn? (Note: the dollar didn’t become the official U.S. currency until 1792.)
· For Pennsylvania, the future value is $ 2 million and the present value is $ 1,000. There are
200 years involved, so we need to solve for r in the following:
$ 1,000 = $ 2 million/(1 + r )200
(1 + r )200 = 2,000.00
Solving for r, the Pennsylvania money grew at about 3.87% per year. The Massachusetts money
did better; check that the rate of return in this case was 4.3%. Small differences can add up!
Finding the Number of Periods
If we deposit $5,000 today in an account paying 10%, how long does it take to grow to $10,000?
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Finding the Number of Periods: Rule of 72
· For reasonable rates of return, the time it takes to double the money, is given approximately by
t = 72 / r%
· Continuing with the example, we have discount rate of 10%, so: t = 72 / 10 = 7.2 years
· This rule is fairly applicable to discount rates in 5% to 20% range.
Finding the Number of Periods: An Example
· A company has been saving up to purchase an asset. Total cost will be $10 million. The
company has currently about $2.3 millions.
· How long it will have to wait,
· if it can earn 5% on the money?,
· if it can earn 16% on the money?
•At 5% the company will have to wait for a long time:
$2.3 = $10 / 1.05t
1.05t = 4.35
t = 30 years
•At 16 %, it will make it in 10 years
Valuation of Multiple Cash Flows
Future Value with Multiple Cash Flows
Present Value with Multiple Cash Flows
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ANNUITY
· We will frequently encounter situations where we have multiple cash flows that are all the
same amount.
· Series of equal installments for a loan-repayment
· A series of constant, or level, cash flows that occur at the end of each period for some fixed
number of periods is called an ordinary Annuity.
An annuity is an equal, annual series of cash flows. Annuities may be equal annual deposits,
equal annual withdrawals, equal annual payments, or equal annual receipts. The key is equal,
annual cash flows. Annuities work in the following way.
Illustration:
Assume annual deposits of $100 deposited at end of year earning 5% interest for three years.
Year 1: $100 deposited at end of year
= $100.00
Year 2: $100 × .05 = $5.00 + $100 + $100
= $205.00
Year 3: $205 × .05 = $10.25 + $205 + $100
= $315.25
There are tables for working with annuities. Future Value of Annuity Factors is the table to
be used in calculating annuities due. Just look up the appropriate number of periods, locate
the appropriate interest, take the factor found and multiply it by the amount of the annuity.
For instance, on the three-year 5% interest annuity of $100 per year. Going down three years,
out to 5%, the factor of 3.152 is found. Multiply that by the annuity of $100 yields a future
value of $315.20.
The present value of annuity can be finding out by the following formula:
Present value of annuity = C [1 - 1/(1 + r)^t ]/r OR PVA=C . (1 - Present value factor)/r
Where
C = Periodic payment or annuity
r = rate of interest
t = number of periods
The term in the parenthesis is called present value interest factor of an annuity (PVIFAr,t).
PVIFA = Present Value Interest Factor Annuity
FVIFA = Future Value Interest Factor Annuity
The expression in brackets is the annuity factor, which is the present value at discount rate r
of an annuity of $1 paid at the end of each of t periods.
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Future Value of Annuity = FVA = PMT x FVIFA
Present Value of Annuity = PVA = PMT x PVIFA
Where, PMT means Payment or C
PVIFA = (1 - Present value factor)/r
OR
[1 - 1/(1 + r)t ]/r
How much can you afford?
•By looking at your budget you know you can pay $632 for a new car, bank is offering you a
loan for 48 months at 1% per month. How much should you borrow?
PVIFA = (1 – Present value factor)/r
= [1 - (1/1.0148 )]/0.01
= (1 – 0.6203)/0.01 = 37.9740
•So, Present value = $632 x 37.9740 = $ 24,000
•Therefore, you can afford to borrow $24,000
Finding the Payment
•If you want to buy a new car costing $23,000. With a 10% down payment, the bank will loan
you the rest at 9% per year (.75% per month) for 60 months. How much will each monthly
payment be?
•You will borrow 0.90 x $23,000 = $20,700. This is the amount today, so it’s the PV. The
rate is .09/12 = .0075, and there are 60 periods:
$20,700 = C x [( 1 - 1/(1.0075)60]/.0075
= C x 48.1734
C = $20,700/48.1734
C = $429.70 per month
Finding the number of payments
•To repay a loan of $1,000, Mr. X can only afford to pay $20 per month. Interest rate is 1.5%
per month.
How long will it take to repay the loan?
•Here, PV = $1,000, C = $20 , r = 1.5% per month
$1000 = $20 x (1 – PVF)/0.015
($1,000/20) x 0.015 = 1 – PVF
PVF = 0.25 = 1/ (1 + r)t
1.015t = 1/0.25
1.015t = 4
t = ln 4 / ln 1.015
•So how long will it take to quadruple the money?
1.015x = 4 è 93 month or 7.75 years
Finding the rate
•An insurance company offers to pay you $1,000 per year if you pay $6,710 up front. What
rate is applicable in this 10-year annuity?
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•Here
C = $1,000, PV = $6,710 and t = 10, r = ?
$6,710 = $1,000 x (1 – PVF) / r
6.71 = {1- [1 /(1 + r)10]} / r
Looking at the PVIFA table for 10 periods, 6.7101 is the value for 8%. So insurance
company is offering 8%
Or to make it easy lets use this formula
$6,710 = $1,000 x PVIFA
6.71 = PVIFA
Looking at the PVIFA table for 10 periods, 6.7101 is the value for 8%. So insurance
company is offering 8%
Annuity Future Value
FV = C x (Future value factor - 1)/r
= C x [(1 + r)t - 1]/r
or
FV = PMT x FVIFA
Future Value for Annuities
•Previously we determined that a 21-year old could accumulate $1 million by age 65 by
investing $15,091 today and letting it earn interest (at 10% compounded annually) for 44
years.
•Now, rather than plunking down $15,091 in one chunk, suppose she would rather invest
smaller amounts annually to accumulate the million.
•If the first deposit is made in one year, and deposits will continue through age 65, how large
must they be?
•Set this up as a FV problem:
$1,000,000 = C x [(1.10)44 - 1] / 0.10
C = $1,000,000/652.6408 = $1,532.24
Becoming a millionaire just got easier!
•Unfortunately, most people don’t start saving for retirement that early in life. (Many don’t
start at all!)
•Suppose a 40-year old person has decided it’s time to get serious about saving. Assuming
that he wishes to accumulate $1 million by age 65, he can earn 10% compounded annually,
and will begin making equal annual deposits in one year, how much must each deposit be?
•Set this up as a FV problem:
r = 10%
t = 65 - 40 = 25
FV = $1,000,000
Then:
$1,000,000 = C x [(1.10)25 - 1] / 0.10
C = $1,000,000/98.3471 = $10,168.07
•Moral of the story: Putting off saving for retirement makes it a lot more difficult!
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Annuities Due
•So far, we have discussed only ordinary annuities, where cash flows occur at the end of each
period, e.g. loan repayments
•However, when you lease an asset, the first lease payment is usually due immediately,
second at the beginning of second period and so on.
•An Annuity due is an annuity for which cash flows occur at the beginning of each period.
•The time line for Annuity due, having 5 payments of $400 each, would be like:
•Present value of a four year $400 ordinary annuity at 10% is $1,267.95
•Adding on the extra $400, we get $1,667.95, the present value of this annuity due.
PEPETUITY
· A special case of annuity, where the stream of cash flows continue forever.
· The present value of a perpetuity is
· Perpetuity PV = C / r
Perpetuity is a cash flow without a fixed time horizon.
For example if someone were promised that they would receive a cash flow of $400 per year
until they died, that would be perpetuity. To find the present value of a perpetuity, simply
take the annual return in dollars and divide it by the appropriate discount rate.
The present value of perpetuity can be finding out by the following formula:
Present value of perpetuity = C/r
Where C is the annual return in dollars and r is the discount rate.
Illustration:
If someone were promised a cash flow of $400 per year until they died and they could earn
6% on other investments of similar quality, in present value terms the perpetuity would be
worth $6,666.67.
Present value of perpetuity= ($400 / .06 = $6,666.67)
· Suppose we expect to receive $1000 at the end of each of the next 5 years. Our opportunity
rate is 6%. What is the value today of this set of cash flows?
§ PV = $1000 x (1 - [1/1.065]) / 0.06
· = $1000 x 4.212364
· = $4212.364
· Now suppose the cash flow will be $1000 per year forever, making it a perpetuity. In this
case, the PV is easy to calculate:
PV = C/r = $1000/.06 = $16,666.67
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Effective Annual Rates
· If a rate is quoted as 10% compounded semiannually, then what this means is that the
investment actually pays 5% every six months.
· Is 5% every six months the same thing as 10% per year?
· $1 x 1.10 = $1.10
· $1 x 1.052 = $1.1025
· 10% compounded semiannually is equivalent to 10.25% compounded annually.
· 10.25% is called effective annual rate (EAR)
· Suppose three banks offer you the following rates for a savings account:
· Bank A: 15%, compounded daily
· Bank B: 15.5%, compounded quarterly
· Bank C: 16%, compounded annually
· Which one would you opt for:
· Bank C is offering 16% per year, since there is no compounding during the year, this is
effective rate
· Bank B actually paying 0.155/4 = 0.03875 or 3.875% per quarter. An investment of $1 at
this rate for 1 year would grow to:
$1 x 1.038754 = $1.1642
So, EAR is 16.42%.
· For saving, it is good. For borrowing it is worse
· Bank A is compounding daily, so the daily interest rate is actually 0.15 / 365 = 0.000411 or
0.0411%. An Investment of $1 at this rate for 365 days would grow to:
· $1 x 1.000411365 = $1.1618
· So, EAR is 16.18%
· This is not as good as Bank B’s 16.42% for a saver, and not as good as Bank C’s 16% for a
borrower
· Two Lessons:
· The highest quoted rate is not necessarily the best rate
· Compounding during the year can lead to a significant difference between the quoted rate
and the effective rate
· EAR is computed in three steps
· Divide the quoted rate by the number of times the interest is compounded
· Add 1 and raise it to the power of number of times the interest is compounded.
· Subtract 1
So
EAR = (1 + Quoted rate / m)m – 1
where m is the number of times the interest is compounded
The EAR of 12% compounded monthly is:
EAR = (1 + Quoted rate / m)m – 1
= (1 + 0.12/12)12 – 1
= (1.01)12 – 1
= 1.12685 – 1
= 12.6825%
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Compounding Number of times Effective
period
compounded
annual rate
· Year
1
10.00000%
· Quarter
4
10.38129
· Month
12
10.47131
· Week
52
10.50648
· Day
365
10.51558
· Hour
8,760
10.51703
· Minute
525,600
10.51709
•A bank is offering 12% compounded quarterly. If you put $100 in an account
•how much you will earn at the end of one year?
•what is the EAR?
•how much will you have at the end of two years?
•The bank is offering 12%/4 = 3% every quarter; investing $100 for 4 periods at 3% per
period, the future value is
FV = $100 x 1.034 = $112.55
The EAR is 12.55%
•We can calculate the yield of two years in two ways
•Recognize two years as eight quarters:
$100 x 1.038 = $126.68
•Using EAR for two years:
$100 x 1.12552 = $126.68
•Anytime we do a present value or future value calculation, the rate we use must be an actual
or effective rate.
Annual Percentage Rates
•Annual percentage rate (APR) is the interest rate charged per period multiplied by the
number of periods per year.
•Laws in some countries require that the lenders disclose an APR on virtually all the
consumer loans in a prominent and un-ambiguous way.
•A typical credit card agreement quotes an interest rate of 18% APR. Monthly payments are
required. What is the actual interest rate you pay on such a credit card ?
•APR of 18% with monthly payments is really 0.18 / 12 = 0.015 or 1.5% per month.
•So, EAR = (1 + 0.18/12)12 – 1
= 10.1512 – 1 = 19.56%
Effective Annual Rate – EAR
The Effective Annual Rate (EAR) is the interest rate that is annualized using compound
interest. The EAR is the annualized equivalent of interest with shorter compounding periods.
It can be calculated from the following formula:
EAR = [1 + i/n) n - 1
Where n is the number of times (or periods) interest is compounded during the year and i is
the interest rate per period.
Explanation: The effective annual rate is a value used to compare different interest plans. If
two plans were being compared, the interest plan with the higher effective annual rate would
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be considered the better plan. The interest plan with the higher effective annual rate would be
the better earning plan.
For every compounding interest plan there is an effective annual rate. This effective annual
rate is an imagined rate of simple interest that would yield the same final value as the
compounding plan over one year.
When interest is compounded more than once in a year, EAR will be greater than the stated
or quoted interest rate.
Bank A pays 15% interest on deposit, compounded monthly.
Bank A = (1 + .15/12)12 - 1
=1.16075 – 1
= 16.075%
Bank B pays 15% interest on deposit, compounded quarterly.
Bank B = (1 + .15/4)4 - 1
=(1.0375) 4 – 1
= 1.15865 – 1
= 15.865%
Bank C pays 15% interest on deposit, compounded half yearly.
Bank C = (1 + .15/2)2 - 1
= (1.075) 2 - 1
= 1.155625 – 1
= 15.5625%
Example:
A bank offers 12% compounded quarterly. If you place 1000 in an account
today, how much you have at the end of two years? What is EAR?
Solution:
EAR = (1 + .12/4)4 – 1= 12.55%
= (1.1255)2 X 1000 = 1266.75
OR
Quarterly interest is 12/4 = 3%
=(1.03)8 X 1000 = 1.2667 X 1000 =1266.77
Loans
•Whenever a lender extends a loan, some provision will be made for repayment of the
principal amount.
Here we discuss three forms of repayment of principle and interest patterns.
•Pure Discount Loans
•Interest-only Loans
•Amortized Loans
Pure Discount Loans
•The borrower receives money today and repays a single lump sum at some time in the future.
•A borrower is able to repay $25,000 in 5 years. Given a discount rate of 12%, what amount
of money the lender should lend,?
Present value = $25,000 / 1.125 = $14,186
Interest-Only Loans
•Calls for the borrower to pay interest each period and to repay the entire principal at some
time in the future.
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•With a 3-year, 10%, interest-only loan of $1,000, the borrower would pay $1,000 x 0.10 =
$100 in interest at the end of first and second years,
•At the end of third year, he would return $1000 plus the $100 in interest for that year.
Amortized Loans
•Amortized loan requires the borrower to repay parts of the loan amount over time.
•The process of paying off a loan by making regular principal deductions is called amortizing
the loan. A loan can be amortized in two ways:
•Borrower pays the interest each period plus some fixed amount, e.g. medium-term business loans
•Borrower makes a single fixed payment every period, car loans and mortgages
Amortization Schedule - Fixed Principal
A $5000 loan at an interest rate of 9% for 5 years
Amortization Schedule – Fixed payments
•Again taking a $5000 loan at an interest rate of 9% for 5 years; we first need to determine
the payment.
•Since this loan’s cash flows are in the form of an ordinary annuity. So, solving for payments:
$5000 = C x (1 – 1/0.095) / 0.09
= C x (1 – 0.6499) / 0.09
•C = $5000 / 3.8897
= $1,285.46
Amortization Schedule - Fixed Payments
Beginning
Total
Interest
Year
Balance
Payment
1
$5,000.00
$1,285.46
2
4,164.54
1,285.46
3
3,253.88
1,285.46
4
2,261.27
1,285.46
5
1,179.32
1,285.46
Totals
$6,427.30
$1,427.31
Dr. Owais Shafique
Interest
Paid
$450.00
374.81
292.85
203.51
106.14
Principal
Paid
$835.46
910.65
992.61
1,081.95
1,179.32
$5,000.00
Ending
Balance
$4,164.54
3,253.88
2,261.27
1,179.32
0.00
.
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Topic 5
BONDS
· An evidence of debt issued by a corporation or a governmental body.
· When a corporation (or government) wishes to borrow from public on a long term basis, it
does so by issuing or selling debt securities generally called bonds
· A bond represents a loan made by investors to the issuer. In return for his/her money, the
investor receives a legal claim on future cash flows of the borrower.
· The issuer promises to:
· Make regular coupon payments every period until the bond matures, and
· Pay the face/par/maturity value of the bond when it matures.
· Default - since the abovementioned promises are contractual obligations, an issuer who
fails to keep them is subject to legal action on behalf of the lenders (bondholders).
· B Corporation
· Wants to borrow $1,000 for 30 years at 12 % interest rate
· Will pay 0.12 x $1,000 = $120 in interest every year for 30 years.
· Will repay $1,000 at the end of 30 years
· B Corporation
· $120 regular interest payments are the bond’s coupons
· $1,000 is the par value or face value of the bond
· Annual coupon divided by the par value ($120/$1000 = 12%) is the coupon rate
· 30 years is the maturity time
Bond Values and Yields
· The value of bonds may fluctuate as the interest rates change by time in the market place,
though the cash flows from a bond remains the same.
· When interest rates rise, the present value of the bond’s remaining cash flows decline and
the bond is worth less
· When the interest rates fall, the bond is worth more
· To determine the value of bond at a particular point in time, we need to know
· No. of periods remaining till maturity,
· The face value,
· The coupon rate, and
· The market interest rate for similar bonds
· The interest rate required in the market on bonds is called the bond’s Yield to Maturity
· The X Corporation
· Issues a bond with 10 years to maturity having annual coupon of $80. similar bonds have a
yield to maturity of 8%.
· X bond’s cash flows have two components:
· an annuity component (coupons) and
· a lump sum (face value paid at maturity)
· The X Corporation
· At the going interest rate of 8% the present value of $1,000 paid in 10 years is:
§ PV = $1,000 / 1.0810 = $1,000 / 2.1589 = $463.19
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· Present value of the annuity of 80$ per year for 10 years is:
§ PV = $80 x (1 – 1/1.0810) / 0.08
§ PV = $80 x 6.7101
= $536.81
The X Corporation
•To get the bonds value we add up both parts
Total bond value = $463.19 + $536.81
= $1,000
•This means that the bond sells for exactly its face value.
Alternatively
•Interest rate change
•Interest rate risen to 10% after one years (9 years to maturity)
•Now the present value of $1,000 paid in nine years at 10% is
$1,000 / 1.109 = $1,000/2.3579 = $424.10
•And present value of $80 annuity for 9 years at 10% is
$80 x (1 – 1/1.109)/0.10 = $80 x 5.7590 = $460.72
· Adding both parts:
· Total bond value is $424.10 + 460.72 = $884.82
· Therefore, the bond should sell for about $885
· Because the bond sells for less than the going rate, investors are wiling to lend something
less than $1,000.
· Because the bond sells for less than face value, it is said to be a discount bond.
· The investor who purchased and kept bond would get $80 per year and would have a $115
gain at maturity as well. This gain compensates the lender for below-market coupon rate.
Another way to see why bond is discounted by $115 is to note that the $80 coupon is $20
below the coupon on a newly issued par value bond. So the investor who buys and keeps the
bond gives up $20 every year for 9 years. At 10 % this annuity is worth:
$20 x (1 – 1/1.109)/0.10 = $20 x 5.7590 = $115.18
Just as rise of interest rates reflected a decline in the price of the bond, a drop of 2% in
interest rates would result in the bond being sold for more than $1000. Such a bond is said to
sell at a premium or is called a premium bond.
VALUING A BOND
· Assume you have the following information.
· BMN, Inc. bonds have a $1000 face value
· The promised annual coupon is $100
· The bonds mature in 20 years
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· The market’s required return on similar bonds is 10%
· Present value of the face value
o = $1000 x [1/1.1020 ] = $1000 x .14864
· = $148.64
· Present value of the coupon payments
o = $100 x [1 - (1/1.1020)]/.10 = $100 x 8.5136
· = $851.36
· The value of each bond = $148.64 + 851.36
· = $1000
Valuing a Bond : A Discount Bond
Assume you have the following information.
BMN, Inc. bonds have a $1000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 12%
· Present value of the face value
§ = $1000 x [1/1.1220 ] = $1000 x .10366
o = $103.66
· Present value of the coupon payments
o = $100 x [1 - (1/1.1020)]/.10 = $100 x 7.4694
· = $746.94
•Value of each bond = $103.66 + 746.94 = $850.60
•Assume you have the following information.
BMN, Inc. bonds have a $1000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 8%
Present value of the face value
= $1000 x [1/1.0820 ] = $1000 x .21455 = $214.55
•Present value of the coupon payments
= $100 x [1 - (1/1.0820)]/.08 = $100 x 9.8181 = $981.81
Value of each bond = $214.55 + 981.81=$1,196.36
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Valuing Bonds
Based on our examples we can write a general expression for the value of a bond. If a bond
has
•a face value of F paid at maturity
•a coupon of C paid per period
•t periods to maturity
•a yield of r per period
Its value is
Bond value = C x [1 – 1/(1+r)t]/r + F/ (1+r)t
Bond value = C x [1 – 1/(1+r)t]/r + F/ (1+r)t
= Present value + Present value of coupons of face amount
Semiannual Coupons
· Bond yields are quoted like APRs, the quoted rate is equal to the actual rate per period
multiplied by the number of periods in a year.
· When the payments of coupons are made on semiannually, each payment of half of the
annual coupon, it is referred to as semiannual coupon bond
· If an ordinary bond has a coupon rate of 14% then the owner gets $140 per year but in two
installments each of $70. in this case, the Yield to maturity is 16%
· So with a 16% quoted yield, the true yield is 8% per period.
· Now if the bond has seven years to maturity
· What would be the bond’s price?
· What is the effective annual yield on this bond?
· The bond should sell at a discount because it has a coupon rate of 7% per six months when
the market requires a requires 8% every six months.
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· present value of the face value
= $1000 /1.0814 = $1000/2.9372 = $340.46
· present value of 14 period annuity of $70 at 8% discount rate is
= $70 [1 - (1/1.0814)] /0.08 = $70 x 8.2442 = $577.10
Total Present value tells that the bond should sell for:
$340.46 + 577.10 = $917.56
To calculate the effective annual yield on this bond, note that 8% every six months is
equivalent to
EAR = (1 + 0.08)2 – 1 = 16.64%
Interest Rate Risk
· The risk that arises for bond owners from fluctuating interest rates is called interest rate risk.
· The risk on a bond depends on how sensitive its price is to interest rate changes
· The sensitivity directly depends on
· Time to maturity
· Coupon rate
· While looking at a bond following should be kept in mind
· All other things being equal, the longer time to maturity, the grater the interest rate risk
· All other things being equal, the lower the coupon rate, the greater the interest rate risk
· We can illustrate these characteristics graphically
Interest Rate Risk
Time to Maturity
Interest Rate Risk
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· The slope of the line connecting the prices is much steeper for 30-year maturity than it is for
1-year maturity
· The steepness tells that a relatively small change in interest rate will lead to a substantial
change in the bond’s value.
· In comparison, one year bond is relatively less sensitive to interest rate changes
· The reason for longer term bonds having greater interest rate sensitivity is that a large
proportion of the bond’s value comes from the $1000 face amount.
· The present value of this amount is not affected by small change in interest rate if amount is
to be received in an year
· While, even a small change in interest rate when compounded for 30 years, will have a
significant effect on the present value.
· Interest rate risk increases at a decreasing rate.
· If we compared a 10-year bond with a 1-year bond, obviously, 10 year bond has much
greater risk
· But if we compare a 20 year bond to a 30 year bond, the 30 year bond will have a somewhat
greater interest rate risk but the difference is fairly small.
· The bonds with lower coupons have greater interest rate risk
· If two bonds with different coupon rates have same maturity, the value of the one with the
lower coupon is proportionately more dependent on the face amount to be received. So its
value will fluctuate more as interest rate changes
· In other words, bond with higher coupon has a larger cash flow early in its life, so its value
is less sensitive to changes in discount rate
The following statements about bond pricing are always true.
· 1. Bond prices and market interest rates move in opposite directions.
· 2. When a bond’s coupon rate is (greater than / equal to / less than) the market’s required
return, the bond’s market value will be (greater than / equal to / less than) its par value.
· The following statements about bond pricing are always true.
· 3. Given two bonds identical but for maturity, the price of the longer-term bond will change
more than that of the shorter-term bond, for a given change in market interest rates.
· 4. Given two bonds identical but for coupon, the price of the lower-coupon bond will
change more than that of the higher-coupon bond, for a given change in market interest rates.
Finding the Yield to Maturity
· We have seen that the price of a bond can be written as the sum of its annuity and lump sum
components.
· Knowing that there is an $80 coupon rate for 6 years and a $1000 face value, the price of
the bond is:
o $995.14 = $80 x [1 – 1/(1 + r)6]/r + 1000 / (1 + r)6
· r is the unknown discount rate or the yield to maturity
· To solve the above equation for r we will have to use trial and error method, as we can not
explicitly calculate r
· We can speed up the trial and error process by using our knowledge about prices and yields
· Since the bond is selling at a discount, we know that the yield is greater than 8%.
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· If we compute the price at 10%, price is $912.89 which is lower than the actual price, so
10% is too high. Rather it should be between 8% and 10%
· Computing at 9% reveals that this is in fact the bond’s yield to maturity
Debt vs. Equity
· Securities issued by the corporations may be classified roughly as
· Equity Securities
· Debt Securities
· When corporations borrow, they generally promise to
· Make regular scheduled interest payments, and
· Repay the original amount borrowed (principal)
· The main differences between debt and equity are the following
· Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
· Corporation’s payment of interest on debt is considered as a cost of doing business and is
fully tax deductible. While dividends paid to stockholders are not tax deductible.
· The main differences between debt and equity are the following
· Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the
assets of the firm, resulting in bankruptcy or financial failure. This possibility does not
arise when equity is issued.
DIFFERENT TYPES OF BONDS
· Government Bonds
· Zero Coupon Bonds
· Floating-Rate Bonds
· Other Bonds
Government Bonds
· When the government wishes to borrow money for more than one year, it sells what are
known as treasury notes and bonds (mostly in the form of ordinary coupon bond) to the public.
· Govt. treasury issues have no default risk
· These issues are exempted from income taxes
Zero Coupon Bonds
· A bond that pays no coupon at all and are offered at a price that is much lower than its
stated value.
· Suppose N company issues a $1000 face value, 5 year zero coupon bond.
· Initial price is set at $497, yielding 15% to maturity
· Total interest paid over the life of the bond is $1000 – 497 = $503
· For tax purposes, the issuer of a zero coupon bond deducts interest every year even though
no interest is actually paid.
· Because of the tax break, the yields are lower than the yields on taxable bonds
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Floating Rate Bonds
· In case of floating rate bonds, the coupon payments are adjustable with respect to an interest
rate index such as treasury bill interest rate.
· The value of a floating rate bond depends on this adjustment and its definition. In most
cases, the coupon adjusts with a lag to some base rate.
· The majority of the floating rate bonds have the following features
· Holder has the right to redeem the note at par on the coupon payment date after some
specified period of time. This is called a put provision
· Coupon rate has a floor and a ceiling i.e. coupon is subjected to a minimum and a
maximum. Thus coupon rate is capped and upper and lower rates are the called the collar
· An interesting type of floating rate bonds is an Inflation-linked bond.
· Such bonds have coupons that are adjusted according to the rate of inflation (the principal
amount may be adjusted as well).
Other types of Bonds
· Income bonds have coupon payments dependent on company income sufficient enough to
support such payment
· Convertible bonds can be swapped for a fixed number of shares at anytime before maturity
at the holder’s option.
· Put bonds allows the holder to force the issuer to buy the bond back at a stated price.
REAL VS NOMINAL INTEREST RATES:
The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose household deposits $100 with a bank for 1 year and they receive
interest of $10.
At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per
annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated
by adjusting the nominal rate charged to take inflation into account.
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If inflation in the economy has been 10% in the year, then the $110 in the account at the end
of the year buys the same amount as the $100 did a year ago. The real interest rate, in this
case, is zero. After the fact, the 'realized' real interest rate, which has actually occurred, is:
ir = in — p
where p = the actual inflation rate over the year.
The expected real returns on an investment, before it is made, are:
ir = in — pe
where:
in = nominal interest rate
ir = real interest rate
pe = expected or projected inflation over the year.
Market interest rates
There is a market for investments which ultimately includes the money market, bond market,
stock market and currency market as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists generally
agree that the interest rates yielded by any investment take into account:
The risk-free cost of capital
Inflationary expectations
The level of risk in the investment
The costs of the transaction
Risk-free cost of capital
The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever
entirely riskfree, bills issued by major nations are generally regarded as risk-free benchmarks.
This rate incorporates the deferred consumption and alternative investments elements of
interest.
Inflationary expectations
According to the theory of rational expectations, people form an expectation of what will
happen to inflation in the future. They then ensure that they offer or ask a nominal interest
rate that means they have the appropriate real interest rate on their investment.
This is given by the formula:
in = ir + pe
Where:
in = offered nominal interest rate
ir = desired real interest rate
pe = inflationary expectations
Risk
The level of risk in investments is taken into consideration. This is why very volatile
investments like shares and junk bonds have higher returns than safer ones like government
bonds.
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The extra interest charged on a risky investment is the risk premium. The required risk
premium is dependent on the risk preferences of the lender.
If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns
to double. So for an investment normally returning $100 they would require $200 back. A
risk-averse lender would require more than $200 back and a risk-loving lender less than
$200. Evidence suggests that most lenders are in fact risk-averse.
Generally speaking a longer-term investment carries a maturity risk premium, because longterm loans are exposed to more risk of default during their duration.
Liquidity preference
Most investors prefer their money to be in cash than in less fungible investments. Cash is on
hand to be spent immediately if the need arises, but some investments require time or effort
to transfer into spend able form. This is known as liquidity preference. A 10-year loan, for
instance, is very illiquid compared to a 1- year loan. A 10-year US Treasury bond, however,
is liquid because it can easily be sold on the market.
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Topic 6
Common Stock Valuation
A company can raise capital from variety of sources. We already covered the loans as a
potential source of capital enhancement. Bonds are a kind of loan that is different form a
bank loan.
In this segment, we know that a company may sell its shares to general public (primary
market) to gather funds needed for investment purposes. These shares are significantly
different from the Bonds in many aspects. For example, the salient features of a stock or
share are as under:
No promised cash flow for dividend
No date of maturity – Investment for ever
Problems in observing rate of return
Common stock, also referred to as common shares, is as the name implies the most usual and
commonly held form of stock in a corporation. The other type of shares that the public can
hold in a corporation is known as preferred stock. Common stock that has been re-purchased
by the corporation is known as treasury stock and is available for a variety of corporate uses.
Common stock typically has voting rights in corporate decision matters, though perhaps
different rights from preferred stock. In order of priority in a liquidation of a corporation, the
owners of common stock are near the last. Dividends paid to the stockholders must be paid to
preferred shares before being paid to common stock shareholders.
Valuation of a share of common stock is difficult due to :
· Not even promised cash flows are known in advanced
· Life of investment is forever, since common stock has no maturity
· Market rate of return is not easily observed
COMMON STOCK VALUATION:
The following models are commonly used to valuate the common stock:
DIVIDEND DISCOUNT MODEL / Basic Stock Value:
It is not an easy job to predict or forecast future stock price.
Dividend discount model states that today’s price is equal to the present value of all future
dividends.
Suppose you buy a share of stock today, with a plan to sell it in a year, hoping that its worth
will be $70 at that time, along with a dividend payment of $10 per share.
· If you require a 25% return on your investment, what is the most would you pay for the
stock?
· Alternatively, what is the present value of the $10 dividend along with the $70 ending value
at 25%?
· The present value of the investment is
· Present value = ($10 + $70)/1.25 = $64
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· So, $64 is the value you would assign to the stock today.
· Generalizing this valuation, let
· P0 => current price of stock
· P1 => price in one period
· D1 => Dividend paid at the end of the period
· So
P0 = (D1 + P1)/(1 + R)
· Where R is the market rate of return
· But this possible only if we know P1, making the problem more complicated
· So, if we want to know the price in one year i.e. P1 and we somehow know the price in two
years P2 with D2 dividend expected in two years, then
§P1 = (D2 + P2)/(1 + R)
· Now substituting this expression for P1 into our previous expression for P0 , we would have
the following equation:
=div1/ (1+r) + div2+P2/ (1+r)2
So,
P0 = Div + P1 / (1 + r)
After 2 years the value of stock is:
=div1/ (1+r) + div2+P2/ (1+r)2
After 3 years the value of stock is:
=div1/(1+r) + div2/(1+r)2 + div3+P3/(1+r)3
When the time horizon is infinitely far, then we do not consider the final price as it has no
present value today. This mean the PV of stock depends only on future dividends.
So the formula is
After t years the value of stock is:
=div1/(1+r) + div2/(1+r)2 + … + divt /(1+r)t
This is also known as the basic stock value method.
Zero Growth Stocks:
Assumptions:
Assumed NO GROWTH by the company
Company pays out all as dividend what it earns every year.
It means that NOTHING is reinvested in business.
It means that investors may forecast that future dividends will not increase. Dividends over
the years are at the same level – perpetuity.
If the value of stock is the PV of all future dividend then
PV = DIV / r
When company pay out everything as dividend then earnings and dividend will be equal and
PV can be calculated as:
PV = EPS / r
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CONSTANT GROWHT MODEL / GORDON GROWTH MODEL:
This is known as Constant-growth Dividend Discount Model or Gordon Growth Model.
Assume that dividends will grow at a constant growth rate. For example 5% per year.
It means that Dividend of Rs. 2 per share at 5% constant growth rate is
Div1 = 2
Div2 = 2 x 1.05 = 2.10
Div3 = 2 x (1.05)2 = 2.205
Fitting these into formula:
= D1/(1+r) + D1(1+g)/(1+r)2 + D1(1+g)2/(1+r)3 ….
= 2/1.12 + 2.10/ (1.12)2 + 2.205/ (1.12)3= 1.79 + 1.67 + 1.57 + ….
Although the number of terms is infinite, the PV of dividend is proportionately smaller than
the preceding term and this will continue as long as growth rate is less than the discount rate.
Because the far distant dividends will be close to zero, the sum of all of these terms is finite
despite the fact that an infinite number of dividends will be paid.
So we can write equation as:
P0 = D0 x (1+g) / (r – g)
This is known as Constant-growth Dividend Discount Model or Gordon Growth Model.
For example:
2 x 1.05 / .12 - .05 = 30.00
Gordon model is valid as long as g < r
Example:
Dividend paid = Rs. 2.30
Growth rate = 5%
Required return = 13%
What will be the value of stock after five years?
D5 = 2.30 X (1.05)5 = 2.935
P5 = 2.935 x 1.05 / (.13 -.05) = 38.53
Example: The next dividend of a company will be Rs 4 per share. Investors demand 16% return
on share having same risk level as of this company. The dividend growth is 6% per year.
Calculate the value of this company’s stock today and in four years using Gordon growth model.
Solution:
Next dividend has already been given:
Po = D1 / (r –g)
Po = 4 / (.16 -.06)
Po = 40
Price in 4 years:
D4 = 4 x (1.06)3 = 4.764
P4 = 4.764 x 1.06 / (0.16 -0.06) = 50.50
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Preferred Stock Features
· Stock with dividend priority over common stock, normally with a fixed dividend rate,
sometimes without voting rights.
· Preference means only that the holders of the preferred shares must receive a dividend
before holders if common shares are entitled to anything.
Stated Value
· Preferred shares have stated liquidating value
· Cash dividend is described in terms of dollars per share.
Accumulation of Dividend
· A preferred dividend is not like interest on a bond. The directors may decide not to pay the
dividends on preferred stock irrespective of the net income of company.
· If preferred stocks are cumulative and are not paid a particular year, they will be carried
forward as an arrearage.
· Unpaid preferred dividends are not debts of the firm. Directors can defer the preferred
dividend indefinitely. However, in this scenario, common stockholders must also forego
dividends. Sometimes these delayed payments are compensated by voting rights.
Is Preferred Stock Debt?
· Preferred shareholders are only entitled to receive a stated dividend and they are only
entitled to the stated value of their shares
· Preferred stocks hold credit ratings much like bonds
· These are sometimes convertible into common stock and are often callable.
The Stock Market
Primary Market
· The market in which new securities are originally sold to the investors (IPOs)
· Companies sell securities to raise money mostly through the use of underwriters.
Secondary Market
The market in which previously issued securities are traded among investors
Dealer
· An agent who buys and sells securities from a maintained inventory
· It stands ready to buy securities from investors wishing to sell them and sells securities to
investors wishing to buy them
· The price that the dealer wishes to pay is the bid price and the price at which the dealer sells
the securities is called the strike price.
· The difference between the bid and ask price is called the spread
Broker
· An agent who arranges security transactions among investors, matching investors wishing
to buy securities with investors wishing to sell securities
· They do not buy or sell securities for their own accounts. Facilitating trades others is their
business
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Topic 7
Capital Budgeting
Capital budgeting:
Capital Budgeting is the planning process used to determine a firm's long term investments
such as new machinery, replacement machinery, new plants, new products, and research and
development projects. Capital budgeting process is carried out for projects involving heavy
initial upfront cost. These projects can take any of the following forms:
• New project
• Expansion project
• Modernization / Replacement
• Research & development
• Exploration
• Other / social responsibility – Pollution control etc.
The classification of investment projects
a) By project size
Small projects may be approved by departmental managers. More careful analysis and Board
of Directors' approval is needed for large projects of, say, half a million dollars or more.
b) By type of benefit to the firm
• an increase in cash flow
• a decrease in risk
• an indirect benefit (showers for workers, etc).
c) By degree of dependence
• Mutually exclusive projects (can execute project A or B, but not both)
• Complementary projects: taking project A increases the cash flow of project B.
• Substitute projects: taking project A decreases the cash flow of project B.
d) By type of cash flow
• Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
• Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
Relevant Costs:
These are costs that are relevant with respect to a particular decision. A relevant cost for a
particular decision is one that changes if an alternative course of action is taken. Relevant
costs are also called differential costs.
Making correct decisions is one of the most important tasks of a successful manager. Every
decision involves a choice between at least two alternatives. The decision process may be
complicated by volumes of data, irrelevant data, incomplete information, an unlimited array
of alternatives, etc. The role of the managerial accountant in this process is often that of a
gatherer and summarizer of relevant information rather than the ultimate decision maker.
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The costs and benefits of the alternatives need to be compared and contrasted before making
a decision. The decision should be based only on RELEVANT information. Relevant
information includes the predicted future costs and revenues that differ among the
alternatives. Any cost or benefit that does not differ between alternatives is irrelevant and can
be ignored in a decision. All future revenues and/or costs that do not differ between the
alternatives are irrelevant. Sunk costs (costs already irrevocably incurred) are always
irrelevant since they will be the same for any alternative.
To identify which costs are relevant in a particular situation, take this three step approach:
1. Eliminate sunk costs and committed costs
2. Eliminate costs and benefits that do not differ between alternatives
3. Compare the remaining costs and benefits that do differ between alternatives to make the
proper decision.
4. Take care of opportunity cost.
The Payback Rule
The payback period is the amount of time required for an investment to generate cash flows
sufficient to recover its initial cost.
· This investment pays for itself back in exactly two year OR payback period is two years.
· “An investment is acceptable if its calculated payback period is less than some
specified number of years.”
· Suppose the initial investment is $60,000, and the cash flows are $20,000 in the first year
and $90,000 in the second.
· The cash flows over the first two years are $110,000, so the project pays back sometime in
the second year.
· After the first year, the project has paid back $20,000, leaving $40,000 to be recovered
· Note that this $40,000 is $40,000/90,000 = 4/9 of the second year’s cash flows.
· Spreading this ratio over 365 days:
4/9 x 365 = 162 days (approx.)
· Which means, that the pay back period is just over 1 year and 5 months.
· The Projected cash flows from a proposed investment are:
Year Cash Flow
1
$100
2
200
3
500
· The project costs $500. what is the payback period for this investment?
· After the first 2 years, the cash flows total $300.
· After the 3rd year, the total cash flow is $800, so the project pays back sometimes between
the end of year 2 and end of year 3.
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· Out of $500 cash flows for 3rd year, we need to cover $200, so we will have to wait
$200/500 = 0.40 years to do this.
· The payback period is 2.4 years or about two years and five months.
· Based on this method of calculating payback, we can make decisions on investments.
· Decide on the cutoff time, say two years, for the investment
· Accept all the projects having payback of two years or less and reject all those having
payback more than two years
Year
0
1
2
3
4
A
-$100
30
40
50
60
B
-$200
40
20
10
C
-$200
40
20
10
130
D
-$200
100
100
-200
200
E
-$50
100
- 50,000,000
•Payback period of Project A is 2.6 years.
•Project B never pays back
•Project C has a payback period of 4 years
•Project D has two payback periods; 2 and 4 years (both correct).
•Project E is unrealistic but it pays back in 6 months, thereby illustrating that a rapid payback
does not guarantee a good investment
•Compared to NPV, payback period rule has some shortcomings.
•Time value of money is ignored
•It fails to consider risk differences
•It doesn’t provide an objective basis for a particular number for the cutoff period
•Primary shortcomings of payback period rule:
•By ignoring time value, we may be led to take investments that are worth less than they cost
•By ignoring cash flows beyond cutoff, we may be led to reject profitable long term investments
•Generally, it tends to bias us towards shorter term investments
•Qualities of payback period rule:
•Simple and easy to calculate, useful for large number of small investment decisions by
corporation
•Its biasness towards short term projects, emphasizes on liquidity, i.e. quickly freeing up cash
for other uses
•It adjusts for more uncertain cash flows expected in later part of a project’s life (though by
ignoring them altogether)
•Consider the following investments:
Year
Long
Short
0
-$250
-$250
1
100
100
2
100
200
3
100
0
4
100
0
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•The payback on long is
2 + $50/100 = 2.5 years
•The payback on short is
1 + $150/200 = 1.75 years
•With a cutoff of two years, short is accepted and long is not
•Is payback period rule giving us the right decisions?
•Suppose, we require a 15% return on this kind of investment; NPV for the two investments is:
NPV (Short) =
-$250 +100/1.15 + 200/1.152 = -$11.81
NPV (Long) =
-$250 + 100 x (1 – 1/1.154)/.15 = $35.5
•We can see that the NPV of shorter term investment is negative, which would diminish the
value of shareholders’ equity.
•Longer term investment increases share value.
Summary
•A break-even measure; in accounting sense but not in economic sense
•Does not focus on right issue of impact of investment on value of stock
•Simplicity helpful for decisions on minor investments
Advantages
•Easy to understand
•Adjusts for uncertainty of later cash flows
•Biased towards liquidity
Disadvantages
•Ignores the time value of money
•Requires an arbitrary cutoff point
•Ignores cash flows beyond the cutoff date
•Biased against long term projects, such as research and development and new projects
Discounted Payback Period:
Length of time required to recover the initial cash outflow from the discounted future cash
inflows. This is the approach where the present values of cash inflows are cumulated until
they equal the initial investment. For example, assume a machine purchased for $5000 yields
cash inflows of $5000, $4000, and $4000. The cost of capital is 10%. Then we have
The payback period (without discounting the future cash flows) is exactly 1 year. However,
the discounted payback period is a little over 1 year because the first year discounted cash
flow of $4545 is not enough to cover the initial investment of $5000. The discounted payback
period is 1.14 years (1 year + ($5000 - $4545)/$3304 = 1 year + .14 year).
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Accounting Rate of Return - (ARR):
The ARR method also called the return on capital employed (ROCE) or the return on
investment (ROI) method of appraising a capital project is to estimate the accounting rate of
return that the project should yield. If it exceeds a target rate of return, the project will be
undertaken.
ARR = Average net income
Average book value
ARR =
Average net income
.
Average Initial Investment
Suppose we are deciding whether or not to open a store in a new shopping center.
•The required investment in improvements is $500,000
•The store has a 5-years life, as everything reverts to the owners of the shopping center after
that time.
•The required investment would be 100% depreciated over 5 years, i.e.
$500,000 / 5 = $100,000 per year
•Tax rate is 25%
Average Accounting Return
Year 1
Year 2
Year 3
Revenue
$433,333
$450,000
$266,667
Expenses
200,000
150,000
100,000
Earnings before
Depreciation
$233,333
$300,000
$166,667
Depreciation
100,000
100,000
100,000
Earnings before taxes $133,333
$200,000
$ 66,667
Taxes (25%)
33,333
50,000
16,667
Net income
$100,000
$150,000
$50,000
•Average net income is:
[$100,000 + 150,000 +50,000 + 0 +(-50,000)]/5
= $50,000
•Average book value =
•($500,000 + 0) / 2 = $250,000
•The average accounting return is:
Average net income = $50,000
Average book value 250,000
“A project is acceptable if its average accounting return
accounting return”
Year 4
$200,000
100,000
Year 5
$133,333
100,000
$100,000
100,000
$0
0
$0
$ 33,333
100,000
-$ 66,667
- 16,667
-$50,000
exceeds a target average
Advantages:
•Easy to calculate
•Needed information will usually be available
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Disadvantages:
* It is not a rate of return in any meaningful economic sense, as it ignores time value of money.
* It does not take account of the timing of the profits from an investment.
* It implicitly assumes stable cash receipts over time.
* It is based on accounting profits and not cash flows. Accounting profits are subject to a
number of different accounting treatments.
* It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment.
* It takes no account of the length of the project.
* It ignores the time value of money.
The payback and ARR methods in practice:
Despite the limitations of the payback method, it is the method most widely used in practice.
There are a number of reasons for this:
* It is a particularly useful approach for ranking projects where a firm faces liquidity
constraints and requires fast repayment of investments.
* It is appropriate in situations where risky investments are made in uncertain markets that
are subject to fast design and product changes or where future cash flows are particularly
difficult to predict.
* The method is often used in conjunction with NPV or IRR method and acts as a first
screening device to identify projects which are worthy of further investigation.
* It is easily understood by all levels of management.
* It provides an important summary method: how quickly will the initial investment be
recouped?
PROFITABILITY INDEX – PI:
PI is also defined as benefit cost ratio. It is a relationship between the PV of all the future
cash flows and the initial investment. This relationship is expressed as a number calculated
by dividing the PV of all cash flows by initial investment.
Decision rule:
PI > 1; accept the project
PI < 1; reject the project
•So if a project cost $200 and the present value of its future cash flows is $220, then the
profitability index would be
§PI = $220 /200 = 1.10
•Also, the NPV for this investment is $20, so this a desirable investment.
•The profitability index for a positive NPV investment would be bigger than 1.00 and less
than 1.00 for a negative NPV investment
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•The PI of 1.10 tells us that per dollar invested, $1.10 in value or $0.10 in NPV results. So it
measures value created per dollar invested.
•It is often proposed as a measure of performance of government or other non-profit
investments.
•When capital is scarce, it is sensible approach to allocate it to those projects with highest PI
•Consider an investment which costs $5 and has a $10 present value and an investment
costing $100 with a $150 present value.
•The first of these investments has an NPV of $5 and a PI of 2, while the second one has an
NPV of $50 and a PI of 1.50.
•If theses are mutually exclusive investments, then the second one is preferred even though it
has a lower PI
•This ranking problem is very similar to IRR ranking problem
Advantages:
•Closely related to NPV, generally leading to identical decisions
•Easy to understand and communicate
•May be useful when available investment funds are limited
Disadvantages:
•Like IRR it is a percentage and therefore ignores the scale of investment.
•May lead to incorrect decisions in comparisons of mutually exclusive investments
The NPV method is preferred over the PI method. This is because PI greater than 1 implies
that the Net Present Value of the project is positive. Secondly, NPV clearly states whether to
undertake or reject a project or not and return a dollar value by which the economic
contribution is made to value of firm. This is not the case with PI which only expresses the
relative profitability of projects being considered.
Net Present Value:
· An investment is worth undertaking if it creates value for its owners characterized by worth
in marketplace being more than what it costs to acquire.
· NPV measures the NET benefit by which the value of a firm would increase in case the
project in undertaken.
The formula for calculating NPV can be written as:
NPV = Co + C1 / (1 + r)
Where:
Co = the cash flow at time o or investment and therefore cash outflow
r = the discount rate/the required minimum rate of return on investment
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative (-): reject the project
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· For example, you buy a run-down house for $25,000 and spend another $25,000 on
painters, plumbers and so on to get it fixed up. So your total investment is $50,000.
· When the work is completed, you place the house on the market and find that it is worth
$60,000.
· The market value ($60,000) exceeds the cost ($50,000) by $10,000.
· If you consider yourself as manager and have brought together some fixed assets, labor and
material etc., you have created $10,000 in value.
· Now what you as a manager has to do is to identify the feasibility of investing $50,000
ahead of time.
· In other words you are trying to determine whether a proposed investment or project will be
worth more than it costs once it is in place, a topic we call Capital Budgeting
· The difference between an investment’s market value and its cost is called the net present
value of the investment (NPV).
· Alternatively, NPV is a measure of how much value is created or added today by
undertaking an investment.
· Given our goal of creating value for our shareholders, the capital budgeting process can be
viewed as a search for investment with positive net present values.
· Investment decisions are greatly simplified when there is a market for assets similar to the
investment we are considering.
· Capital budgeting becomes more difficult when we cant determine the market price for
comparable investment.
· The reason is that we are then faced with problem of estimating the value of an investment
using only indirect market information
Estimating Net Present Value
If we want to estimate the value of a new business, say fertilizer, we will
· Try to estimate the future cash flows we expect the new business to produce
· Apply discounted cash flow procedure to estimate the present value of the cash flows
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· Estimate the difference between the present value of the future cash flows and the cost of
investment.
· This is know as discounted cash flow (DCF) valuation.
· Suppose the cash revenues from our fertilizer business will be $20,000 per year.
· Cash costs (including taxes) will be $14,000 per year
· The business will be wound up in 8 years
· The plant, property and equipment will worth $2,000 as salvage value at that time.
· The project costs $30,000 to launch
· Discount rate on similar projects is 15%
· Is this a good investment?
· What will be the effect on price per share of 1,000 shares from taking the investment?
· Calculating the present value of the future cash flows:
PV = $6,000 x (1 – 1/1.158)/0.15 + 2,000 / 1.158
= $6,000 x 4.4873 + 2,000/3.0590
= $26,924 + 654
= $27,578
•Comparing this value with the $30,000 estimated cost, the NPV is;
NPV = -$30,000 + 27,578 = -$2,422
•Therefore this is not a good investment, as it would decrease the total value of stock by $2,422.
•With 1,000 shares outstanding, best estimate of impact of taking up this project is a loss of
value of $2,422/1,000 = $2.422 per share
•Form this example we notice that if NPV is negative, the effect on share value will be
unfavorable. If NPV were positive, the effect would be favorable.
•Given that the goal of financial management is to increase the share value, this discussion
leads to the net present value rule
“An investment should be accepted if the net present value is positive and rejected if it
is negative.”
· In the unlikely event that NPV is turned out to be zero, we would be indifferent between
taking and not taking the investment
· Two comments
· The task of coming up with cash flows and the discount rate is much more important than
the process of discounting itself.
· The process of discounting cash flows would only give us an estimated figure of NPV. The
true NPV can be found by putting the investment for sale and see what we got for it.
· Suppose we are asked to decide whether or not a new product be launched.
· Based on projected costs and sales, we expect that the cash flows over the 5-year life of the
project will be $2,000 in first two years, $4,000 in the next two and $5,000 in the last year.
· It would cost about $10,000 to begin production. Given a 10% discount rate, what should we do?
· The total value of the product by discounting its cash flow to present:
PV = $2,000/1.1 + 2,000/1.12 + 4,000/1.13 + 4,000/1.14 + 5,000/1.15
= $1,818 + 1,653 + 3,005 + 2,732 + 3,105
= $12,313
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· The present value of the expected cash flows is $12,313, but the cost of getting those cash
flows is $10,000 so the NPV is $12,313 – 10,000 = $2,313
· So based on the NPV rule we should take on the project.
Advantage of NPV:
It ensures that the firm reaches an optimal scale of investment.
Internal Rate of Return (IRR):
The IRR is the discount rate at which the NPV for a project equals zero. This rate means that
the present value of the cash inflows for the project would equal the present value of its
outflows.
The IRR is the break-even discount rate.
The IRR is found by trial and error.
Where r = IRR
IRR of an annuity:
Where:
Q (n, r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).
Example:
What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and
costs $120?
Q = 120 / 20 = 6
•With IRR, we try to find a single rate of return that summarizes the merits of a project
•We want this rate to be an “internal” rate in the sense that it only depends on the cash flows
of a particular investment, not on rates offered elsewhere
•Consider a project that costs $100 today and pays $110 in one year.
•Obviously it pays a return of 10%, since it pays $1.10 for every dollar we put in.
•This 10% is in fact the internal rate of return
IRR Rule
“Based on IRR rule an investment is acceptable if the IRR exceeds the required
return. It should be rejected otherwise”
•Now for our example, NPV for the investment at discount rate R is:
NPV = -$100 + 110/(1 + R)
•Now if we don’t know the discount rate, it represents a problem. But still we could ask, how
high the discount rate would have to be before this project was unacceptable.
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•The investment is economically a break-even proposition when the NPV is zero because the
value is neither created nor destroyed.
•To find the break-even discount rate, we set NPV equal to zero and solve for R
NPV = 0 = -$100 + 110/(1 + R)]
$100 = $110/(1 + R)
1 + R = $110/100 = 1.10
R = 10%
•This 10% is what we already have called the return on this investment.
“the IRR on an investment is the required return that results in a zero NPV when it is
used as the discount rate”
•The fact that the IRR is simply the discount rate that makes the NPV equal to zero is
important because it tells us how to calculate the return on more complicated investments
•Suppose you are looking at an investment with the cash flows $60 per year for two years
•With our understanding on calculating IRR by equating NPV to zero:
NPV = 0 = -$100 + 60/(1 + IRR) + 60/(1 + IRR)2
•The only way to find IRR in general is by trial and error method
•If we start with a 0% rate, then
NPV = $120 – 100 = $20
•At 10% discount rate:
NPV = -$100 + 60/1.1 + 60/1.12 = $4.13
•We are getting closer!
•These and other possibilities are summarized in the following table
Discount Rate
NPV
0%
$20.00
5
11.56
10
4.13
15
-2.46
20
-8.33
•NPV appears to be zero between 10% and 15%, so IRR is somewhere in that range
•With a little effort we can find that the IRR is about 13.1%
•So if our required return is less than 13.1% we would take this investment, otherwise reject it
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•A project has total up-front cost of $435.44. the cash flows are $100 in 1st year, $200 in 2nd
year, and $300 in 3rd year
•What is the IRR?
•At 18% required return, should we take this investment?
•NPV calculated at different discount rates is as below:
Discount Rate
NPV
0%
$164.56
5
100.36
10
46.15
15
0.00
20
-39.61
•At 18% required rate, we should not take this investment
•IRR and NPV rules always lead to identical decisions as long as
•Project’s cash flows are conventional i.e. first cash flow (initial investment) is negative and
rest are positive
•Projects are independent i.e. decision to accept or reject one project does not affect the
decision to accept or reject any other
Problems with IRR:
•Problems with IRR come about when:
•cash flows are not conventional or
•when we are trying to compare two or more investments
•Non-conventional Cash Flows
•Suppose we have a mining project that requires a $60 investment. Our cash flows in the 1st
year will be $155. in the second year the mine is depleted, but we have to spend $100 to
restore the terrain
•Here both the 1st and 3rd year cash flows are negative.
•Non-conventional Cash Flows
•To find IRR, the NPV at different rates are
Discount Rate
NPV
0%
- $5.00
10
- 1.74
20
- 0.28
30
.06
40
- 0.31
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•The IRR of both 25% and 331/3% are correct, making it a Multiple rates of return problem
•In this example IRR rule breaks down completely
•Should we take this investment on 10% required rate? By IRR rule we should.
•But since NPV is negative at any discount rate less than 25%, so this is not a good investment
•NP is positive only if the required return is between 25% and 331/3%
•Moral of the Story
•Cash flows are not conventional
•So the obvious question “What is the rate of return?” may not be answered, although NPV
works just fine
•Mutually Exclusive Investments
•If two investments X and Y are mutually exclusive, then taking one of them means that we
cant take the other one
•Two projects that are not mutually exclusive are said to be independent
•e.g. we can build a gas station OR an apartment building on a corner plot but not both
•So the question arises: “which investment is best?”
•Answer: The one with largest NPV
•Cash flows from two mutually exclusive events
Year
Investment A
Investment B
0
-$100
-$100
1
50
20
2
40
40
3
40
50
4
30
60
•IRR for A is 24% and IRR for B is 21%
•NPV for the investments for different required returns
Discount rate
NPV (A)
NPV (B)
0%
$60.00
$70.00
5
43.13
47.88
10
29.06
29.79
15
17.18
14.82
20
7.06
2.31
25
- 1.63
- 8.22
•IRR for A (24%) is larger than that for B (21%). However investment having higher NPV
depends on required return
•B has greater total cash flow but it pays back more slowly than A. So it has higher NPV at
lower discount rates
•If our required return is 10%, B has higher NPV and is better of the two even though A has
higher returns
•If our required return is 15%, then obviously A is better
•At any discount rate less than 11.1%, NPV for B is higher, so B benefits more than A, even
though A’s IRR is higher
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•At any rate greater than 11.1%, investment A has greater NPV
•Moral of the story
•Whenever we have mutually exclusive investments, we shouldn't rank them based on their returns
•In other words, IRR can be misleading in determining the best investment
•Instead we should look at their relative NPVs to avoid possibility of choosing incorrectly
Qualities of IRR
•Most widely used
•Easily communicated and understood
•We can estimate IRR even if we don’t know the discount rate
Disadvantage of IRR:
• It expresses the return in a percentage form rather than in terms of absolute dollar returns.
Making Capital Investment Decisions
•We shall now spread the numbers for a proposed investment or project and, based on those
numbers make an initial assessment about whether or not the project should be undertaken.
•We will focus on a the process of setting up a discounted cash flow analysis.
•While evaluating a proposed investment, special attention is paid to the relevance of the
information available for decision making
Project Cash Flows
•To evaluate a proposed investment, we must consider the changes in the firm’s cash flows
and then decide whether or not they add value to the firm
•The first step is, thus, to decide which cash flows are relevant and which are not
Relevant Cash Flows
•A relevant cash flow for a project is a change in the firm’s overall future cash flow that
comes about as direct consequence of the decision to take the investment
•Since the relevant cash flows are defined in terms of changes in, or increments to, the firm’s
existing cash flow, they are called the incremental cash flows associated with the project
Incremental Cash Flows
•The incremental cash flows for project evaluation consist of any and all changes in the
firm’s future cash flows that are a direct consequence of taking the project.
•The Stand-Alone Principle
•The assumption that evaluation of a project may be based on the project’s incremental cash flows
•Analysis of the project as a “minifirm” with its own future revenues and costs, its own assets
and its own cash flows
Incremental Cash Flows
•It seems easy enough to decide whether a cash flow is incremental or not. Even so there are
situations where mistakes are easy to make.
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•Sunk Costs
•Opportunity Costs
•Side Effects
•Net Working Capital
•Financing Costs
•Other Issues
Sunk Costs
•A cost that has already been incurred and cannot be recouped and therefore should not be
considered in an investment decision
•e.g. a consultant’s fee for evaluating the option of launching a new product
•Opportunity Costs
•The most valuable alternative that is given up if a particular investment is undertaken
•e.g. option of selling a piece of land (bought years ago) at market rates instead of
establishing a school upon it
•How much should be charged to school project in terms of opportunity costs; amount
at which we bought the piece of land or its current market price?
•Side Effects
•It is not unusual for a project to have side or spillover effects both good and bad
•e.g. sales of a new car by a certain company might come at the expense of the other
cars of the same company
•This phenomenon is called erosion, piracy or cannibalism
•So cash flows from the new product line should be adjusted downward to reflect lost profits
on other lines
•Net Working Capital
•Normally a project requires investments in net working capital in addition to long term assets.
•e.g. cash in hand, inventories & accounts receivables as well as accounts payables; the
balance being the net working capital
•As the project winds down, net working capital gets freed-up. So investment in NWC
resembles a loan as firm provides NWC at the beginning and recovers it towards the end
•Financing Costs
•We don’t include interest paid or any other financing costs like dividend or principle paid
while analyzing a proposed investment, as we are interested in the cash flow generated by the
assets of the project
•The mixture of debt and equity a firm actually chooses to use in financing a project is a
managerial variable and does not form part of the project evaluation process
•Other Issues
•We are only concerned in measuring cash flows and when it actually occurs rather than
when it occurs in accounting sense
•We are interested in after-tax cash flows as in fact incremental cash flows means after-tax
incremental cash flows
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Topic 8
Risk & Return
Risk & Uncertainty:
If you buy an asset or any stock or share, the gains or losses you get on this investment are
called return on investment. This return has normally two components. First, it is the income
part that you may receive in terms of dividend (owning a share) and second part comes from
the capital appreciation or increase in the market value of that share.
The above discussion suggests that the reward of return you get is the due to bearing the risk.
Risk refers to the variability of returns. You may get dividend on a share – say 2% or 15%, or
even you may not get anything from the issuing firm. Look at this simple example: the
expected returns (income part only) can vary from 0 to 15%. This is called risk. However,
you can use probabilities to determine your return. For instance, if the economy remains in
boom, which has 60% chances, then our return will be 8%. So attaching probability we can to
some extent, determine the return under risk conditions.
The other important thing to remember is that – greater the risk, larger the profit.
Uncertainty, refers to a situation where our ability to attach a probability to an outcome is ceased.
From hereafter, we shall discuss the ways and means to measure the risk.
RETURNS
•One of the responsibilities of the financial manager is to assess the value of the proposed
investment.
•In doing this, it is important that we first look at what financial investments have to offer.
•At a minimum, the return we require from a proposed non-financial investment must be at
least as large as what we can get from buying financial assets of similar risk.
•Lessons from market history
•There is a reward for bearing risk
•The greater the potential reward, the greater the risk.
•If you buy an asset of any sort, your gain (or loss) from that investment is called your return
on investment.
•This return, usually termed as dollar returns, has normally two components:
•Income earned (Dividend)
•Capital gain
•Alternatively, dollar returns are the sum of the cash received and the change in dollar value
of the asset.
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•Suppose you bought 100 shares of a corporation one year ago at $25.
•Over the last year, you received $20 (= 20 cents per share × 100 shares) in dividends.
•At the end of the year, the stock sells for $30.
•How did you do?
•You invested $25 × 100 = $2,500.
•At the end of the year, you have stock worth $3,000 and cash dividends of $20.
•Your dollar gain was $520 = $20 + ($3,000 – $2,500).
•Dollar returns: $520 gain
•If you sell the stock at the end of the year:
Total Cash Inflow = $2,500 + 520 = $3,020
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•If you don’t sell the stocks of the company, rather hold it
•You should still consider the capital gain as part of your return
•It is not just a paper gain
Percentage Returns
•It is more convenient to summarize the information about returns in percentage terms, as in
this way, your return does not depend on how much you actually invest.
•Dividend yield = Dividend / beginning price
•Capital gains yield = (ending price – beginning price) / beginning price
•Total percentage return = dividend yield + capital gains yield
Percentage return = Dividend yield + Capital gain yield
Beginning market value
= Dividend + Change in Market value
Beginning market value
•In our example:
•Dividend Yield = $20 / 2,500 = 0.8%
•Capital gains yield= ($3,000 – 2,500) / 2,500 = 20%
•Percentage returns = 20% + 0.8 = 20.8%
•Suppose you buy some stock for $25 per share. At the end of the year, the price is $35 per
share. During the year, you get a $2 dividend per share
•What is the dividend yield? capital gains yield? percentage return?
•If your total investment was $1,000 how much do you have at the end of the year?
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•Dividend yield = $2/25 = 0.08 = 8%
•Capital gains yield = ($35 - 25)/25 = 40%
•Percentage Return = 8% + 40% = 48%
•So, if you had invested $1,000, you would have had $1,480 at the end of the year
Variability of Returns / Variance:
•We know that year-to-year returns on common stocks tend to be more volatile than the
returns on long term bonds.
•Measuring this variability is the key factor in examining the topic of risk.
•First we draw a frequency distribution for the common stock returns to count up the number
of times the annual return on large stock portfolios falls within a certain percentage range
Now we need to measure the spread in returns.
•For example, if the returns on small stock in a particular year was 17.3%, we need to know
how far the actual return deviate from this average, or we need a measure of the volatility of
returns.
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•The most commonly used measures for this purpose are variance and its square root, the
standard deviation
•Variance measure the average squared differences between the actual returns and the
average return. The biggest the number is the more the actual returns tend to differ from the
average return.
•The larger the variance or standard deviation is the more spread out the returns will be.
•Suppose, a particular investment had returns of 10%, 12%, 3% and -9% over the last four
years.
•Average return is (0.10 + 0.12 + 0.03 – 0.09)/4 = 4%
•To compute the variance, we take deviations of the actual returns from this average return,
take squares of these deviations and the average of the squared deviations will be our
variance.
Variance = .0270 / (4-1) = .009
Standard Deviation = Ö.009 = .09487 or 9.487%
In general, the variance for T historical returns is:
Var(R) = [(R1 - R)2 +……+(RT - R)2] / (T -1
The standard deviation is always the square root of the variance.
What are the average returns? variances? Standard deviations?
Which investment was more volatile
•Company X average returns,
Rx = (-.20 + .50 + .30 + .10)/4 = .175
•Company Y average returns,
RY = (.05 + .09 - .12 + .20)/4 = .055
•Now we calculate variance for Company X
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•Summarizing the calculations:
• Standard deviation for company X, 29.87% more than twice Company Y’s 13.27%. This
indicates that company X is more volatile investment.
Expected Return
•Consider a single period of time, say a year. We have two stocks, L and U. and they are
expected to have a return of 25% and 20% respectively in the coming year
•Why to invest and hold stock U?
•Stock L having higher expected return may actually perform abnormally. It could go up to
70% in economic boom or may slide to -20% in recession.
•While stock U may earn 30% in recession and 10% during a boom.
•If the probabilities of occurring a boom and a recession are 0.5 each then the expected return
for both the stocks can be calculated as:
Risk Premium
•The difference between the return on a risky investment and that on a risk-free investment.
•Suppose, risk-free investments are currently offering 8 percent. In other words, risk-free rate
(Rf) is 8%.
•Using this information, we can calculate the projected risk premia on stocks U and L.
•Risk Premium (U) = expected return – Risk-free rate
= E(RU) – Rf
= 20% - 8% = 12%
•Risk Premium (L) = 25% - 8% = 17%
•Unequal Probabilities Case:
•If the risk-free rate is 10%
•Risk Premium (U) = E(RU) – Rf
= 26% - 10% = 16%
•Risk Premium (L) = -2% - 10% = -12%
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Calculating the Variance
•To calculate the variances of the returns
•Determine the squared deviations from the expected return
•Multiply each possible squared deviation by its probability
•Add up all the products
•Stock L has a higher expected return, but U has less risk.
•You could get 70% return on your investment in L but you could also lose 20%
•An investment in U will always pay at least 10%
•Which of these stocks should you buy?
•For the economy conditions with unequal probabilities, we have summarized the
computations in the following table:
•Standard deviation for Stock L is
σL = √0.1296 = 0.36 or 36%
•Standard deviation for Stock U is much smaller
σU = √0.0064 = 0.08 or 8%
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Modern Portfolio Theory (MPT) proposes how rational investors will use diversification to
optimize their portfolios, and how an asset should be priced given its risk relative to the
market as a whole. The basic concepts of the theory are Mark with diversification, the
efficient frontier, capital asset pricing model and beta coefficient, the Capital Market Line
and the Securities Market Line.
MPT models the return of an asset as a random variable and a portfolio as a weighted
combination of assets; the return of a portfolio is thus also a random variable and
consequently has an expected value and a variance. Risk in this model is identified with the
standard deviation of portfolio return. Rationality is modeled by supposing that an investor
choosing between several portfolios with identical expected returns will prefer that portfolio
which minimizes risk.
Risk and Reward
The model assumes that investors are risk averse. This means that given two assets that offer
the same return, investors will prefer the less risky one. Thus, an investor will take on
increased risk only if compensated by higher expected returns. Conversely, an investor who
wants higher returns must accept more risk. The exact trade-off will differ by investor. The
implication is that a rational investor will not invest in a portfolio if a second portfolio exists
with a more favorable risk-return profile - i.e. if for that level of risk an alternative portfolio
exists which has better expected returns.
Portfolios
•Portfolio is the group of assets such as stocks and bonds held by an investor
•Portfolio weights are the percentages of the total portfolio’s value that are invested in each
portfolio asset.
•If we have $50 in one asset and $150 in another, then our total portfolio is worth $200.
•The percentage of first asset in portfolio is $50/200 = 0.25, while the same for the second
asset is $150/200 = 0.75
•So, the portfolio weights are 0.25 and 0.75
•Lets return to our stocks L and U, where you pay half your money in each, i.e. portfolio
weights are 0.50 and 0.50.
Alternatively, Portfolio expected return can be calculated as:
•E(RP) = 0.50 x E(RL) + 0.50 x E(RU)
= 0.50 x 25% + 0.50 x 20%
= 22.5%
•Suppose we had n assets in our portfolio, where n is any number, and let xi stand for
percentages of out money in asset i, then the expected return is:
E(RP) = x1 x E(R1) + x2 x E(R2) +…….+ xn x E(Rn)
•Variance on a portfolio is not generally a simple combination of the variances of the assets
in the portfolio
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•Applying a different set of weights, i.e. 2/11 (about 18%) in stock L and other 9/11 (about
82%) in stock U:
•If a recession occurs, portfolio returns will be
RP = 2/11 x -20% + 9/11 x 30% = 20.91%
•If a boom occurs, portfolio returns will be
RP = 2/11 x 70% + 9/11 x 10% = 20.91%
•The returns are the same, showing zero variance.
•Hence, combining assets into portfolios can substantially alter the risks faced by the investor
•Suppose we have the following projections on three stocks
•What would be the expected return on a portfolio
•with equal amounts invested in each of the assets?
•with half investment in A, remainder divided between B an C?
The expected returns on individual stocks are calculated as
•E(RA) = 8.8%
•E(RB) = 8.4%
•E(RC) = 8.0%
If a portfolio has equal investment in each asset, the portfolio weights are all the same, 1/3
each in this case.
So portfolio expected return is:
•E(RP) = 1/3 x 8.8% + 1/3 x 8.4% + 1/3 x 8.0%
•= 8.4%
•In case of Stock A having half the investment (1/2 weight) and remainder divided equally
(1/4 each) between B and C, portfolio returns are:
•E(RP) = 1/2 x 8.8% + 1/4 x 8.4% + 1/4 x 8.0%
•= 8.5%
•Portfolio returns pattern for the case where A has 50% weights and B and C have 25% each
are:
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•Portfolio returns when economy booms is calculated as:
.50 x 10% + .25 x 15% + .25 x 20% = 13.75%
•Portfolio returns when economy goes bust is calculated as:
.50 x 8% + .25 x 4% + .25 x 0% = 5.00%
•Variance is thus:
σ2 = .40 x (.1375 - .085)2 + .60 x (.05 - .085)2
= .0018375
•Standard Deviation is calculated to be 4.3%
•For equally weighted portfolio, standard deviation is about 5.4%
Risk
•The true risk of an investment is the unanticipated or surprising part of the return.
•If we always receive exactly what we expect then the investment will be risk-free.
•Systematic Risk
•A risk that influences a large number of assets. It is also called market risk
Gross Domestic Product (GDP)
•Interest rate
•Inflation
•Affects wages, cost of supplies, values of the assets owned by company and selling price
•Unsystematic Risk
•A risk that affects a single or at most a small number of assets. Because these risks are
unique to individual companies or assets, they are also called unique or asset specific risks.
•The oil strike call in a company will affect that company and perhaps, its primary
competitors and suppliers. But it will have little effect on world oil markets and
companies not in the oil business
•We know till now that the actual return, R can be broken down into its expected and surprise
components:
R = E(R) + U
where U is the surprise component
•Since the surprise component has a systematic and an unsystematic component, so:
R = E(R) + Systematic portion (m) + Unsystematic portion (ε)
•Thus
R = E(R) + m + ε
Systematic Risk and Specific Risk
Specific risk is the risk associated with individual assets - within a portfolio these risks can be
reduced through diversification (specific risks "cancel out"). Systematic risk, or market risk,
refers to the risk common to all securities systematic risk cannot be diversified away.
Diversification and Portfolio Risk
•Suppose if the standard deviation of annual return on a portfolio of 500 large common stocks
is, say 20%, does that mean that the standard deviation of annual returns of a certain stock in
that portfolio is 20%?
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Diversification and Portfolio Risk
Source; Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of
Financial and Quantitative Analysis 22 (Sep. 1987), pp. 353–64.
•Standard deviation declines as the number of securities is increased.
•By the time we have 100 randomly chosen stocks, the portfolio’s standard deviation has
declined by about 60% (from 49% to 20%)
Principle of Diversification
•Benefit in terms of risk reduction from adding securities drops off as we add more and more
securities.
•With 10 securities most of the effect is already utilized, and with 30, there is very little
remaining benefit.
Two key points:
•Some of the riskiness associated with individual assets can be eliminated by forming
portfolios.
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•The process of spreading an investment across assets (and forming portfolio) is called
diversification
•The principle of diversification tells us that spreading an investment across many assets
will eliminate some of the risk.
•There is a minimum level of risk that cannot be eliminated simply by diversifying. This
minimum level is called nondiversifiable risk.
If we hold a single stock the value of our investment would fluctuate because of companyspecific events.
•If we hold a large portfolio, some of the stocks in the portfolio will go up and other may go
down because of respective company-specific events.
•Net effect on the overall value of the portfolio will be relatively small.
“Unsystematic risk is essentially eliminated by diversification, so a relatively large
portfolio has almost no unsystematic risk.”
•Systematic risk cannot be eliminated by diversification, as it affects almost all assets to some degree.
•So the size or type of portfolio will have little effect on systematic risk making it
nondiversifiable risk.
Summarizing
- Total risk = Systematic risk + Unsystematic risk
- Systematic risk is also called nondiversifiable risk or market risk
- Unsystematic risk is also called diversifiable risk, unique risk or asset-specific risk.
CAPITAL ASSET PRICING MODEL:
The asset return depends on the amount paid for the asset today. The price paid must ensure
that the market portfolio's risk / return characteristics improve when the asset is added to it.
The CAPM is a model which derives the theoretical required return (i.e. discount rate) for an
asset in a market, given the risk-free rate available to investors and the risk of the market as a
whole. The CAPM is usually expressed:
• β, Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is
usually found via regression on historical data. Betas exceeding one signify more than
average "riskiness"; betas below one indicate lower than average.
•
is the market premium, the historically observed excess return of the
market over the risk-free rate.
Once the expected return, E(ri), is calculated using CAPM, the future cash flows of the asset
can be discounted to their present value using this rate to establish the correct price for the
asset. (Here again, the theory accepts in its assumptions that a parameter based on past data
can be combined with a future expectation.) A more risky stock will have a higher beta and
will be discounted at a higher rate; less sensitive stocks will have lower betas and be
discounted at a lower rate. In theory, an asset is correctly priced when its observed price is
the same as its value calculated using the CAPM derived discount rate. If the observed price
is higher than the valuation, then the asset is overvalued; it is undervalued for a too low price.
Summarizing this discussion we can say that CAPM tell us:
– Time value of money: risk free rate “Rf” is a rate when you don’t take risk. it is just
waiting for money.
– Reward for risk: the equation “Erm – Rf” represents reward for taking average
systematic risk in addition to waiting.
– Systematic risk: is measured by beta. This measure the systematic risk present in an
assets or portfolio, relative to average asset.
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Topic 9
COST OF CAPITAL
Cost of Capital
The required return is necessary to make a capital budgeting project such as building a new
factory worthwhile. Cost of capital would include the cost of debt and the cost of equity. The
cost of capital determines how a company can raise money (through a stock issue, borrowing,
or a mix of the two). This is the rate of return that a firm would receive if it invested its
money someplace else with similar risk.
•When we say that the required return on an investment is, say, 10% we mean that the
investment will have a positive NPV only if its return exceeds 10%.
•Alternatively, the firm must earn 10% on the investment just to compensate its investors for
the use of the capital needed to finance the project.
•Thus, 10% is the cost of capital associated with the investment.
•While evaluating a risk-free project, we
•look at the capital markets and observe the current rate offered by risk-free investments.
•Use this rate to discount the project’s cash flows
•So the cost of capital here is the risk-free rate.
•If the project is risky, then required return is obviously higher
•In other words, the cost of capital for a risky project is greater than the risk free rate, and the
appropriate discount rate would exceed the risk free rate.
•So we can use the terms required return, appropriate discount rate and cost of capital
interchangeably.
•The cost of the capital associated with an investment depends on the risk of that investment.
•Thus, it is the use of money, not the source of money that matters.
•We know that a firm’s overall cost of capital will reflect the required return on the firm’s
assets as a whole.
•Given that a firms uses both debt and equity capital, this overall cost of capital will be a
mixture of the returns needed to compensate its creditors and stockholders.
•Cost of capital will reflect
•Cost of equity capital
•Cost of debt capital
Cost of Equity:
•Recall that under the assumption that the firm’s dividend will grow at a constant rate g, the
price per share of the stock, P0, is:
P0 = D0 x (1 + g) = D1 .
RE – g
RE – g
•Where
•D0 is the dividend just paid
•D1 is the next period’s projected dividend
•RE is the required return on the stock
•g is the growth rate
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•We can rearrange this to solve for RE as:
RE = D1 / P0 + g
•To estimate we need three things; D0, P0 and g. The first two can be directly observed while
g must be estimated
•Suppose, GSS company paid a dividend of $4 per share last year. The stock’s current price
is $60 per share. Assuming that the dividends are estimated to grow steadily at 6% per year,
what is the cost of the capital for GSS?
•Under the dividend growth model:
D1 = D0 x (1 + g)
= $4 x 1.06 = $4.24
•The cost of equity is:
RE = D1 / P0 + g
= $4.24/60 + 0.06 = 13.07%
•Estimating g
•To estimate the dividend growth rate, we can use the dividend observations for previous years.
•Alternatively we can use analysts’ forecasts of future growth rates
•Suppose a company has the following dividend pattern in the past years:
•The average of the four growth rates is
(9.09 + 12.50 + 3.70 + 10.71) / 4 = 9%
•This 9% can be used as an estimate for expected growth rate, g.
•Dividend growth approach
•Easy to understand and use
•Only applicable to companies paying dividends at a constant growth rate
•Estimated cost of equity is very sensitive to estimated growth rate.
•This approach not necessarily considers risk
The primary advantage of dividend growth model is that it is very simple to understand and
use. However, there are some problems also associated with this approach.
It is only applicable to the firms which pay dividend regularly if not constantly. Therefore, a
firm with no dividend history will find it useless.
The other problem is an unrealistic assumption of constant growth of dividends. We may not
find any such company which has a history of constant growth in dividends. These two
limitations make this model to be used in selected scenarios, for example, where the company
may have distributed the dividends consistently in the past.
The other problem is that the estimated cost of equity is very sensitive to the estimated
growth rate.
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Finally, this approach does not take into account the risk level. There is no direct adjustment
for the riskiness of the investment. For instance, there is no adjustment for the degree of
certainty or uncertainty in estimated growth rate for dividends.
The other way to compute the cost of equity is SML (security market line) which tells us that
the required rate of return on a risky investment depends on three things.
i) The risk free rate, Rf
ii) Market risk premium, (Erm – Rf)
iii) Systematic risk of the asset known as beta, B
Using SML we can write the equation as under:
Ere = Rf + Be x (Erm – Rf)
Where
Ere = is expected return on equity.
Be = is Beta of equity.
This method is also suffering from advantages and disadvantages. First it explicitly adjusts
the risk and second, it is applicable to companies other than just those with steady dividend
growth. Thus it may be useful in wider circumstances.
The SML approach heavily relies on two things – the market risk premium and beta
coefficient. And if our estimates are not very accurate then the cost of equity number will be
incorrect and misleading as well. The demerit of both dividend model and SML is that both
consider past data to predict the future.
Economic conditions and indicator in future are not the same as were in past. However, both
methods do provide us relative guidance in computing the cost of equity.
Cost of Debt
Debt component of capital may include several line items like preferred stocks, loans from
various financial institutions with varying terms and cost. Some of the loans may be having
fixed or floating interest rate. The other items in the debt are bonds and leases.
The effective rate that a company pays on its current debt can be measured in either beforeor after-tax returns; however, because interest expense is deductible, the after-tax cost is seen
most often. This is one part of the company's capital structure, which also includes the cost of
equity.
A company will use various bonds, loans and other forms of debt, so this measure is useful
for giving an idea as to the overall rate being paid by the company to use debt financing. The
measure can also give investors an idea as to the risky-ness of the company compared to
others, because riskier companies generally have a higher cost of debt.
To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal
tax rate (beforetax rate x (1-marginal tax)). If a company's only debt were a single bond in
which it paid 5%, the before-tax cost of debt would simply be 5%. If, however, the
company's marginal tax rate were 40%, the company's after-tax cost of debt would be only
3% (5% x (1-40%)).
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The Tax Effect
•Interest paid by corporation is tax deductible but payments to stockholders, such as
dividends are not tax deductible.
•This means that the government pays some of the interest.
•So we need to distinguish between the pretax and after-tax
•Suppose a firms borrows a $1 million at 9%. Tax rate is 34%
•The total interest bill will be $90,000 per year. This amount is tax deductible, so the $90,000
reduces the tax bill by 0.34 x $90,000 = $30,600
•The after-tax interest bill is thus $90,000 - 30,600 = $59,400
•The after-tax interest rate is $59,400/1 million = 5.94%
•Alternatively, if TC stands for corporate tax rate, then the after tax rate that we use for the
cost of debt can be written as RD x (1 – TC).
•So 9% x (1 – 0.34) = 5.94%
Cost of Debt – Bonds
Like loans, bonds may have several issues of varying terms, carrying different interest cost
with wide gap between their cost and market value. Leases may have the same characteristics
like loans and debts.
To find the cost of debt, we need to calculate the cost of each class of debt and then finding
the weighted average of the cost of debt. For example, if there are five bond issues
outstanding at any time, we will calculate the cost of each issue and then move to weighted
average of cost of bond by using their individual weight in total bond capital.
•Cost of debt is the return that firm’s creditors demand on the new borrowings.
•This cost of debt can be observed directly or indirectly using the interest rates in the
financial markets.
•Alternatively, we can use the firm’s bond ratings to estimate the interest rates on newly
issued bonds of same rating.
•Coupon rate on the firm’s outstanding debt is irrelevant as it relates the firm’s cost of debt
when the bonds were issued not the cost of debt today.
•Suppose, the GenTech company issued a 30-year, 7% bond 8 years ago. The bond is
currently selling for 96% of it’s face value, i.e. $960. What is GenTech’s Cost of debt?
•Using our knowledge of bond valuation, we can calculate that yield to maturity is about
7.37%. So the GenTech’s Cost of debt, RD is 7.37%
A company may have several bond issues outstanding. From debt family we need to calculate
first the cost of each class of debt and then we will calculate the cost of debt by taking into
account cost of each component using their weight age from total debt. Consider the
following example:
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A company has four outstanding bond issues having different yield to maturity and market
value. We have both book values and market values in the above table but using market
values are preferred for computing weighted average of cost of bond interest because the
market value reflect the current risk level in prices, Total BV of bond debt is 1493 million
and third column from left hosts the % portion of each issue from the total bond debt. In
fourth and 5th columns we have market values of bonds and weight of each issue from total
market value.
In the last two columns we have cost of each issue by multiplying YTM with BV and MV.
The weighted average cost of bond debt is 7.37% using market values.
Like the way we calculated the bond single rate as cost of debt, the cost of loan with a
difference that normally we take the book values of debt in computing the single loan rate.
It will be pertinent to note here that the interest paid on loans, bonds and leases are tax
deductible whereas the dividend paid to preference shareholders is NOT tax deductible.
When we are calculating the single cost rate of debt family we must take into account the tax
deductibility of loans, bonds and leases.
After-tax Cost of Debt
After-tax cost of debt = Interest rate x (1 - tax rate)
EXAMPLE:
0.08 = 10% x (1 - 0.2)
This explains how we work out the after tax cost of debt.
Cost of Preferred Stock
•Preferred stock has a fixed dividend paid every period forever making it a perpetuity.
•Cost of preferred stock, RP is:
RP = D/ P0
where
D is fixed dividend
P0 is the current price per share of preferred stock
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•Alternatively, the cost of preferred stock can be estimated by observing the required return
on other similarly rated shares of preferred stock.
•One issue of the preferred stocks of CG inc. paid $1.78 annually and sold for $25.35 per
share. The other issue paid $1.72 annually sold for $24.90 per share. What is the cost of
preferred stock of CG inc.?
•Using the first issue, cost of preferred stock was
RP = D/ P0
= $1.78/25.35 = 7.02%
•Using the second issue, the cost was
RP = D/ P0
= $1.72/24.90 = 6.91%
•So the CG inc.’s cost of preferred stock appears to have been in between 6.9 to 7%
Capital Structure
Capital structure of a typical company may consist of ordinary shares, preference stock, short
term and long term loan, bonds and leases. These components in capital structure have their own
cost and if we add all the individual components cost after adjusting with the weight age of each,
the resultant value is known as weighted cost of capital. As you have already covered in your
earlier lessons that normally we use WACC as discount rate to find the present value of future
cash flows emerging from a project, so it is of immense importance to calculate the correct
WACC. If the WACC is incorrect it may lead to serious consequences.
In order to compute the WACC we need to calculate the individual components cost. First of all
we take up the Equity part of the capital and will see how we can compute the cost of equity.
Capital Structure Weights
•We can calculate the market value of the firm’s equity, E by multiplying the number of
shares outstanding by the price per share.
•Market value of firm’s debt D can be calculated by multiplying the market price of a single
bond by the number of bonds outstanding.
•For multiple bond issues, we repeat this calculation for each and then add up the results.
•For the debt not publicly traded, we observe the yield on similar publicly traded debt and
estimate the market value of privately held debt using this yield as discount rate.
•For short term debt we use the book values as estimate of the market value as both should be alike.
•Now the combined market value of debt and equity, V is
V=E+D
•Dividing both sides by V, we get the percentages of the total capital represented by debt & equity
100% = E/V + D/V
•These percentages are called capital structure weights
•For example, if the total market value of a company’s stocks were calculated as $200 million
and the total market value of the company’s debt were calculated as $50 million, then
combined value would be $250 million.
•Now E/V = $200/250 = 80%. So 80% of the firm’s financing would be equity and remaining
20% would be debt.
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WEIGHTED AVERAGE COST OF CAPITAL
•To calculate the firm’s overall cost of capital, we multiply the capital structures with the
associated costs and add up the pieces. The result is called the Weighted Average Cost of
Capital (WACC)
WACC = (E/V) x RE + (D/V) x RD x (1 – TC)
Where:
RE = cost of equity
RD = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
•The WACC is the overall return the firm must earn on its existing assets to maintain the
value of the stock.
•It is also the required return on any investments by the firm that have the same risks as
exiting operations. So for evaluating the cash flows a proposed expansion project, this is the
discount rate to be used.
•For the firm using preferred stocks in its capital structure, the WACC would be:
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1 – TC)
•Suppose a company wants to renovate its warehouse distribution system. The plan will cost
$50 million and is expected to save $12 million per year after the taxes over next six years.
•The company has a target debt-equity ratio of 1/3 (i.e. E/V is 0.75 and D/V is 0.25).
•The company has a cost of debt of 10% and a cost of equity of 20%.
•Assuming a tax rate of 34%, should the company go for the project?
•The Weighted Average Cost of Capital is:
WACC = (E/V) x RE + (D/V) x RD x (1 – TC)
= .75 x 20% + .25 x 10% x (1 – .34)
= 16.65%
Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its respective
use in the given situation. By taking a weighted average, we can see how much interest the
company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often
used internally by company directors to determine the economic feasibility of expansionary
opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk
that is similar to that of the overall firm.
WACC and Capital Budgeting
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often
used internally by company directors to determine the economic feasibility of expansionary
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opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk
that is similar to that of the overall firm.
Popular methods of capital budgeting include net present value (NPV), internal rate of return
(IRR), discounted cash flow (DCF) and discounted payback period. The discount rate used to
find out the PV of future cash flow is normally the WACC.
In capital budgeting context it should be remember that WACC will only be appropriate
discount rate if the proposed project has the same risk level. If the risk levels of proposed and
existing projects are different then it would be misleading to use WACC as discount rate.
Consider the following example that will aid in understanding the use of WACC in capital
budgeting decisions.
• Example: a company intends to undertake a project that will yield after tax saving of Rs. 4
million at the end of year one. However, after that these savings are estimated to grow at 6
percent. The debt equity ratio of 0.5. Cost of equity is 25% and cost of debt is 11%. This
project has the same level of risk as the existing company business. Advise company on the
financial viability of project. Assume tax rate of 40 percent.
• WACC = 2/3*25 + 1/3 * 11(1-40) = 18.86
• PV = benefit / WACC - g
• PV = 4,000,000 / .1886 – 0.06 = 31,104,199/Since the NPV is positive the project can be undertake.
WHEN TO USE WACC:
As we have covered in our lecture that using WACC as discount rate for discounting the cash
flow of intended project, is only feasible if the proposed project fall within the firms existing
activities circle. For example if a Oil manufacturing concern plans to establish another
production facility then the existing WACC of the firm can be used as discount rate.
However, if the same firm is thinking to set up a new spinning unit, then using existing
WACC would be fatal and inappropriate.
WACC of a company reflects the level of risk and WACC is only appropriate discount rate if
the intended investment is replica of company’s existing activities – having same level of
risk.
Using WACC as discount rate when the intended project has different risk level as of
company then it will lead to incorrect rejections and/or incorrect acceptance.
For example, a company having two strategic units and one unit having lower risk than the
other, using WACC to allocate resource will end up putting lower funds to high risk and
larger funds to low risk division.
The other side of this issue emerges from the situation when a firm is having more than one
line of business. For example a firm has two divisions: one of these has relatively low risk
and the other has high risk.
In this case, the firm’s overall WACC would be the sum of two different costs of capital,
which is one for each business division. If two of these are contenders for the resources, the
riskier division would tend to have greater returns so it would be having the major chunk.
The other one might have huge profit potential ends up with insufficient resources allocated.
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EMN Corporation
•EMN Corporation has 77.3 million shares of stock outstanding. The book value per share is
$17.62, but the stock actually sells for $45.41.
•The total equity is about $1.36 billion on a book value basis but is closer to $3.51billion on a
market value basis.
•EMN paid $1.76 per share in dividends last year and analysts estimate this dividend to grow
by 7% through next 5 years.
•The estimated cost of equity using dividend growth model is thus:
RE = [$1.76 (1 + 0.07)/ $45.41] + 0.07
= 0.1115 or 11.15%
•EMN has four long term bond issues that account for essentially all of its long term debt. To
calculate the cost of debt, we will have to combine these four issues by computing a
weighted average.
•The basic information (as in year 2005) is as follows:
•To calculate the weighted average cost of debt, we take the percentage of the total debt
represented by each issue and multiply by the yield on the issue
•We then add to get the overall weighted average cost of debt. For comparison purpose, we
use both book and market values.
As these calculations show for EMN, whether market values or book values are used, cost of
debt remains 6.34%.
This is because
•Market values and book values are similar
•EMN has no preferred stock
Now to calculate the WACC for EMN on book value basis, we have the following
information
•EMN’s equity is worth $1.362 billion
•EMN’s debt is worth $1.489 billion
•Total value is $2.851 billion
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•So
•E/V = $1.362b/ 2.851b = 0.48, and
•D/V = $1.489b/ 2.851b = 0.52
•Assuming a tax rate of 34%, EMN’s WACC will is:
WACC = (E/V) x RE + (D/V) x RD x (1 – TC)
= 0.48 x 11.15% + 0.52 x 6.34% x (1 - 0.34)
= 7.53%
Now to calculate the WACC for EMN on market value basis, we have the following
information
•EMN’s equity is worth $3.510 billion
•EMN’s debt is worth $1.540 billion
•Total value is $5.050 billion
So
•E/V = $ 3.510b/ 5.050b = 0.70, and
•D/V = $ 1.540b/ 5.050b = 0.30
•Assuming a tax rate of 34%, EMN’s WACC will is:
WACC = (E/V) x RE + (D/V) x RD x (1 – TC)
= 0.70 x 11.15% + 0.30 x 6.34% x (1 - 0.34)
= 9.06%
•Thus, using market value weights, we get 9.06% for EMN’s WACC which is much higher
than 7.53%
WACC we get using book value.
•So using book values can lead to trouble particularly if equity book values are used.
•EMN’s market-to-book ratio is about 2.6, so book values significantly overstate the
percentage of EMN’s financing that comes from debt.
CAPITAL STRUCTURE
•The guiding principle in choosing the debt-equity ratio, is again to choose a course of action
that maximizes the value of a share of stock.
•When it comes to capital structure decisions, this is the same thing as maximizing the value
of the whole firm.
•Recall, WACC tells us that the firm’s overall cost of capital is the weighted average of the
costs of various components of the firm’s capital structure.
•Usually, while describing WACC, we take the capital structure of the firm as given. But what
happens to the cost of capital when we vary the amount of debt financing, or Debt-equity ratio?
•Recall that the WACC is the discount rate appropriate for the firm’s overall cash flows.
•Since the values and discount rates move in the opposite directions, we can say that the value of
the firm’s cash flows (or the value of the firm) is maximized when the WACC is minimized.
•So we can safely say that one capital structure is better than the other if it results in a lower
weighted average cost of capital
•Further, a particular debt-equity ratio represents the optimal capital structure if it results in
the lowest possible WACC.
•This optimal capital structure is also called firm’s target capital structure.
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Financial Leverage
•Financial leverage refers to the extent to which a firm relies on the debt. The more debt
financing a firm uses in capital structure, the more financial leverage it employs.
•Financial leverage can dramatically alter the payoffs to the shareholders in the firm, but it
may not affect the overall cost of capital.
•While illustrating how financial leverage works, we shall ignore taxes here, and describe the
impact of leverage in terms of its effect on earnings per share, EPS and return on equity, ROE.
•For meaningful analysis, we shall use cash flows instead of these accounting figures, but
results will be the same
•The TA Corporation currently has no debt in its capital structure. The company is
considering a restructuring that would involve issuing debt and using proceeds to buy back
some of the outstanding equity.
•The following table presents both current and proposed capital structures.
Current
Proposed
Assets
$8,000,000 $8,000,000
Debt
$0
$4,000,000
Equity
$8,000,000 $4,000,000
Debt/Equity ratio
0
1
Share price
$20
$20
Shares outstanding 400,000
200,000
Interest rate
10%
10%
EPS and ROE under current capital structure
•The impact of leverage is evident in the above figures, when we examine the restructuring
effect on EPS and ROE.
•Particularly, the variability in both EPS and ROE is much larger under the proposed capital
structure, illustrating how financial leverage acts to magnify gains and losses to
shareholders.
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Calculating Break-Even Point:
A. With no Debt
EPS = EBIT/400,000
B. With $4,000,000 in debt at 10%:
EPS = (EBIT - $400,000)/200,000
Calculating Break-Even Point
C. Solve for the break-even EBITBE:
EBITBE/400,000 = (EBITBE - $400,000)/200,000
D. With a little algebra:
EBITBE = $800,000
And EPSBE = $2.00/share
•The MPD Corporation currently uses no-debt financing and it has decided to go for capital
restructuring which would incorporate $1 million debt at 9% debt.
•MPD has 200,000 shares outstanding and the price per share is $20.
•If the restructuring is expected to increase EPS, what is the minimum level for EBIT that
MPD’s management must be expecting?
•To answer we have to calculate the Break-even EBIT
•Under the old capital structure,
EPS = EBIT/200,000
•Under the new capital structure, interest expense will be $1 million x 0.09 = $90,000
•With $1 million proceeds MPD will repurchase $1million/20 = 50,000 shares of stock,
leaving 150,000 outstanding.
•EPS is thus (EBIT -$90,000)/150,000
•Equating both scenarios
EBIT/200,000 = (EBIT -$90,000)/150,000
EBIT = (4/3) x (EBIT -$90,000)
EBIT = $360,000
•While EPS is $1.80 and management of MPD expects this figure to exceed
•From the above discussion, the following conclusions can be drawn:
•The effect of financial leverage depends on the company’s EBIT. When EBIT is relatively
high, leverage is beneficial.
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•Under the unexpected scenario, leverage increases the returns to the shareholders, as
measured by ROE and EPS.
•From the above discussion, the following conclusions can be drawn
•Shareholders are exposed to more risk under the proposed capital structure since the EPS
and ROE are much more sensitive to changes in EBIT in this case.
•Because of impact that financial leverage has on both the expected return to stockholders
and the riskiness of the stock, capital structure is an important consideration
Homemade Leverage
•The last conclusion is not necessarily correct because the shareholders can adjust the amount
of financial leverage by borrowing and lending on their own.
•The use of personal borrowing to alter the degree of financial leverage is called homemade leverage.
•Returning to our discussion of TA corporation, we will now illustrate that it makes no
difference whether or not TA uses the proposed capital structure.
•Proposed Capital Structure
Recession
Expected
Expansion
EPS
$0.50
$3.00
$5.50
Earnings for 100 shares
$50.00
$300.00
$550.00
Net cost = 100 shares at $20 = $2,000
Original capital structure and homemade leverage
Recession
EPS
$1.25
Earnings for 200 shares
250.00
less interest on $2,000 at 10%
200.00
Net earnings
$50.00
Net cost = 200 shares at $20 – amount borrowed
= $4,000 – 2,000 = $2,000
Expected
$2.50
500.00
200.00
$300.00
Expansion
$3.50
750.00
200.00
$550.00
•The proposed capital structure results in a debt-equity ratio of 1
•To replicate this capital structure at the personal level, the stockholder must borrow enough
to create this same debt-equity ratio of 1.
Unlevering
•Now, under the condition that TA management adopted the proposed capital structure,
suppose, an investor who owned 100 shares preferred the original capital structure
•To create leverage, investors borrow on their own, while to unlever investors must loan out
the money.
•In TA, the corporation borrowed an amount equal to half it s value. The investor can unlever
the stock by simply solving loaning out the money in the same proportion
•The investor sells 50 shares for $1,000 total and then loans out $1,000 at 10%.
Recession
Expected
Expansion
EPS (Proposed structure)
$0.50
$3.00
$5.50
Earnings for 50 shares
25.00
150.00
275.00
plus interest on $1,000 at 10%
100.00
100.00
100.00
Total Payoff
$125.00
$250.00
$375.00
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Topic 9
COST OF CAPITAL (Continued…)
Modigliani & Miller Model
A financial theory stating that the market value of a firm is determined by its earning power
and the risk of its underlying assets, and is independent of the way it chooses to finance its
investments or distribute dividends. Remember, a firm can choose between three methods of
financing: issuing shares, borrowing and spending profits (as opposed to dispersing them to
shareholders in dividends). The theorem gets much more complicated, but the basic idea is
that, under certain assumptions, it makes no difference whether a firm finances itself with
debt or equity.
Notes:
In "Financial Innovations and Market Volatility" Merton Miller explains the concept using
the following analogy:
"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is.
Or he can separate out the cream and sell it at a considerably higher price than the whole milk
would bring. (That's the analog of a firm selling low-yield and hence high-priced debt
securities.) But, of course, what the farmer would have left would be skim milk with low
butterfat content and that would sell for much less than whole milk. That corresponds to the
levered equity. The M and M proposition says that if there were no costs of separation (and,
of course, no government dairy-support programs), the cream plus the skim milk would bring
the same price as the whole milk."
Modigliani-Miller theorem
The Modigliani-Miller theorem forms the basis for modern thinking on capital structure.
The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric
information and in an efficient market, the value of a firm is unaffected by how that firm is
financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It
does not matter what the firm's dividend policy is.
3. How WACC remains constant?
The weight age average cost of capital will be constant if the proportionate of weight age of
all sources remains constant i.e. common stock, preferred stock, bonds and any other long
term debt. And also the return on common & preferred stock and interest on debt remains
constant, then WACC remains constant.
When we talk about WACC remains constant we actually mean that any combination of debt
& equity from 100% will not alter the overall cost of capital. That means that if you slice
bread into four pieces and then each piece into two to make total of eight pieces. Now you
have more pieces but not more bread.
In the example on the next page, what we mean from 100% or bread is that it corresponds to
total capitalization in the chart.
We have various debt – equity combinations in the chart but the total capitalization in every
case is 6 million. This is the basis of our statement – WACC remains constant.
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•We have seen that corporate borrowing is relatively less significant when it comes to
corporate structure, because investors can borrow or lend on their own.
•So, in our TA corporation, the stock price remains almost the same whichever capital
structure company chooses.
•This result is based upon a famous argument by two noble laureates, Franco Modigliani and
Merton Miller (commonly known as M&M).
•We shall discuss the two propositions presented by M&M.
•The 1st proposition states that it is completely irrelevant how a firm chooses to arrange its finances.
•Imagine two firms having identical assets and operations depicted on the left hand side of
the balance sheet.
•But the right hand side is different because the two firms finance their operations differently.
•In this case we can view the capital structure question in terms of a pie model.
•The size of the pie does not depend on how it is sliced
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•Although changing the capital structure may not change the firm’s total value, it does cause
important changes in the firm’s debt and equity.
•Now we examine the firm which changes its debt-equity ratio; and for simplification we
ignore taxes here.
•We know that
WACC = (E/V) x RE + (D/V) x RD
where V = E + D
•We also know that WACC can be interpreted as the required return on the firm’s overall
assets (RA). Thus
RA = (E/V) x RE + (D/V) x RD
•Rearranging
RE = RA +(RA – RD) x (D/E)
•This 2nd proposition tells us that the cost of equity depends on three things
•The required return on firm’s assets RA
•The firm’s cost of debt RD, and
•As the firm raises its debt-equity ratio, the increase in leverage raises the risk of the equity
and therefore the required return or cost of equity (RE)
•WACC remains the same, supporting M&M proposition 1
•RCD corporation has a WACC of 12% (ignoring taxes). It can borrow at 8%.
•Assuming that RCD has a target capital structure of 80% equity and 20% debt, what is its
cost of equity?
•What is the cost of equity if the target capital structure is 50% equity?
•Calculate WACC in both cases to verify it remains the same.
•According to M&M proposition 2, the cost of equity, RE, is:
RE = RA +(RA – RD) x (D/E)
•In the 1st case, debt-equity ratio is .2/.8 = .25, so the cost of equity is
RE = 12% + (12% - 8%) x 0.25
= 13%
•In the second case, debt-equity comes out to be 1.0, so the cost of equity is 16%
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•Now assuming equity financing is 80%, the cost of equity is 13% and tax rate is zero,
WACC is
WACC = (E/V) x RE + (D/V) x RD
= 0.80 x 13% + 0.20 x 8% = 12%
•In the second case, equity financing is 50%, the cost of equity is 16%. WACC is
WACC = (E/V) x RE + (D/V) x RD
= 0.50 x 16% + 0.50 x 8% = 12%
•So WACC is 12% in both cases.
Business and Financial Risk
•M&M proposition 2 shows that the firm’s cost of equity can be broken into two components
•The required return on firm’s assets, RA depends on the nature of the firm’s operating activities
•The risk inherent in the firm’s operations is called the business risk, and we know that this
business risk depends on the systematic risk of the firm’s assets.
•M&M proposition 2 shows that the firm’s cost of equity can be broken into two components
•(RA – RD) x (D/E) is determined by the firm’s financial structure.
•For an all equity firm, this component is zero.
•The increase in debt financing raises the required return on equity because the risk born by
the investors increases.
•This extra risk is called financial risk.
Business Risk
Risk associated with the unique circumstances of a particular company, as they might affect
the price of that company's securities.
Risks can fester and spread anywhere inside an organization. Many are industry-specific,
such as the regulatory concerns within financial services and healthcare. Others are common
to all industries, such as supply chain capacity, financial reporting reliability, human
resources availability, and consumer relationship integrity. Productivity specialist’s help you
identify, prioritize, and manage risks so that you can enhance performance and ultimately,
business value.
Financial Risk
• An assessment of the possibility that a given investment or loan will fail to bring a return
and may result in a loss of the original investment or loan.
• The risk that a company will not have adequate cash flow to meet financial obligations
• The risk that an investment will be unable to return profit to an investor.
Corporate Taxes & Capital Structure
•Debt features
•interest paid on debt is tax deductible; a benefit for the firm
•Failure to meet debt financing may lead to bankruptcy; a cost of debt financing
•To examine the effect of corporate taxes, we consider two firms (Firm U & Firm L),
identical on left side of balance sheet. So their assets and operations are the same.
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•Assuming EBIT to be $1,000 every year for both firms, the difference is that Firm L has
issued $1,000 worth of perpetual bonds at 8% interest every year.
Firm U
Firm L
EBIT
$1,000
$1,000
Interest
0
80
Taxable Income
$1,000
$ 920
Taxes (30%)
300
276
Net Income
$ 700
$ 644
•To simplify, we assume
•Depreciation is zero
•Capital spending is zero
•There are no additions to Net Working Capital
•Thus cash flow from assets is simply equal to EBIT – Taxes.
C ash Flow from Assets
Firm U
EBIT
$1,000
- Taxes
300
Total
$ 700
Firm L
$1,000
276
$ 724
Now the cash flow to stockholders and bondholders are
Cash Flow
Firm U
Firm L
To Stockholders
$700
$644
To Bondholders
0
80
Total
$700
$724
•Total cash flow to Firm L is $24 more, as its tax bill is $24 less.
•Interest being tax deductible has generated a tax saving equal to interest payment multiplied
by tax rate, i.e. $80 x 0.30 = $24
•This tax saving is called the Interest Tax Shield
•Since debt is perpetual, the same $24 shield will be generated every year forever.
•Since Firm L’s cash flow is always $24 greater, its worth is more than Firm U by the value
of this $24 perpetuity.
•Because the tax shied is generated by paying interest, it has the same risk as the debt, and
8% is therefore the appropriate discount rate.
•The value of the tax shield is:
PV = $24 / 0.08 = (0.30 x $1,000 x 0.08) / 0.08
= 0.30 x $1,000 = $300
Corporate Taxes & Capital Structure
So:
PV of interest tax shield = (TC x D x RD)/RD
= TC x D
•We may conclude here that the value of Firm L, VL, exceeds the value of the firm U, VU,
by the present
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value of the interest tax shield, TC x D.
•M&M Proposition 1 With taxes therefore states that:
VL = VU + TC x D
Problems associated with high gearing
A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the
degree to which a firm's activities are funded by owner's funds versus creditor's funds.
The higher a company's degree of leverage, the more the company is considered risky. As for
most ratios, an acceptable level is determined by its comparison to ratios of companies in the
same industry. The best known examples of gearing ratios include the debt-to-equity ratio
(total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity /
assets), and debt ratio (total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are. A
greater proportion of equity provides a cushion and is seen as a measure of financial strength.
M & M model says that debt financing increases the value of firm due to tax shield. However,
there are certain aspects of high gearing that discourage borrowing. These aspects are:
Bankruptcy Costs:
Bankruptcy is a legal proceeding whereby an individual or a business can declare an inability
to pay back debts. Bankruptcy allows individuals or businesses to either restructure their debt
and pays it back within a payment plan , or have most of their debts absolved completely.
As debt increases, a chance of default of repayment of principal and interest increases.
Investors dislike this and will result in fall in value of firm’s securities. The interest tax shield
should overweigh the bankruptcy cost.
The argument that expected indirect and direct bankruptcy costs offset the other benefits from
leverage so that the optimal amount of leverage is less than 100% debt financing.
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Direct Bankruptcy Costs: The costs that are directly associated with bankruptcy, such as
legal and administrative expenses
Indirect Bankruptcy Costs: The costs of avoiding a bankruptcy filing incurred by a
financially distress firm
Financial Distress Costs: The direct and indirect costs associated with going bankrupt or
experiencing financial distress
Direct bankruptcy costs:
In case of liquidation disposal of assets will fetch less than going concern value of assets.
And there are other costs like liquidation and redundancy costs. The loss in value is normally
borne by the debt holders and that’s why they demand higher returns for their investment for
higher gearing and eventually this will drive down the firm’s security value.
Indirect Bankruptcy Costs:
When a firm goes into liquidation or approaches near bankruptcy because under sever
financial distress. Employees leaving, supplier refusing to provide goods on credit, and
customers even leaving fearing firm will not be able to honors its warranty and after sales
services commitments. This will reduce future cash flow and therefore, value of firm.
Static Theory of Capital Structure
•A firm borrows up to the point where tax benefit from an extra dollar in debt is exactly equal
to the cost that comes from the increased probability of financial distress
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Optimal Capital Structure
•The maximum value of the firm, VL* is reached at a debt level of D*, so this is the optimal
amount of borrowing
•Alternatively, the firm’s capital structure is composed of D*/ VL* in debt and (1 - D*/ VL*)
in equity.
•The difference between the value of firm in static theory and the M&M value of the firm
with taxes is the loss in value from the possibility of financial distress
•The difference between the static theory value of the firm and the M&M value with no taxes
is the gain from leverage, net of distress costs.
•We know that the capital structure that maximizes the value of the firm is also the one that
minimizes the cost of capital.
•We illustrate this discussion focusing on the three cases
Case 1
•With no taxes and bankruptcy costs, the value of the firm and its weighted average cost of
capital (WACC) are not affected by capital structure
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Case 2
•With corporate taxes and no bankruptcy costs the value of the firm increases and the WACC
decreases as the amount of debt goes up.
Case 3
•With corporate taxes and bankruptcy costs, the value of the firm, VL, reaches a maximum at
D*, the optimal amount of borrowing. At the same time, the WACC is minimized at D* / E*
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Optimal capital structure
Capital structure with a minimum weighted-average cost of capital and thereby maximizes
the value of the firm's stock, but it does not maximize earnings per share (Eps). Greater
leverage maximizes EPS but also increases risk. Thus, the highest stock price is not reached
by maximizing EPS. The optimal capital structure usually involves some debt, but not 100%
debt. Ordinarily, some firms cannot identify this optimal point precisely, but they should
attempt to find an optimal range for the capital structure. The required rate of return on equity
capital (R) can be estimated in various ways, for example, by adding a percentage to the
firm's long-term cost of debt. Another method is the Capital Asset Pricing Model (CAPM)
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Capital structure is a business finance term that describes the proportion of a company's
capital, or operating money, that is obtained through debt and equity. Debt includes loans and
other types of credit that must be repaid in the future, usually with interest. Equity involves
selling a partial interest in the company to investors, usually in the form of stock. In contrast
to debt financing, equity financing does not involve a direct obligation to repay the funds.
Instead, equity investors become part-owners and partners in the business, and thus are able
to exercise some degree of control over how it is run.
Some Managerial Recommendations
•Tax benefits from leveraging is only important to the firms that are in a tax-paying position.
Firms with substantial losses will get little value from the interest tax shield.
•Firms that have substantial tax shields from other sources, such as depreciation, will get less
benefit from leverage.
•Firms with a greater risk of experiencing financial distress will borrow less than the firms
with a lower risk.
•The cost of financial distress depends primarily on the firm’s assets and it will be determined
by how easily the ownership of those assets can be transferred
•Tangible assets vs Intangible assets
Pecking order theory
In corporate finance, pecking order theory (or pecking order model) postulates that the
cost of financing increases with asymmetric information. Financing comes from three
sources, internal funds, debt and new equity. Companies prioritize their sources of financing,
first preferring internal financing, and then debt, lastly raising equity as a “last resort”.
Hence: internal financing is used first; when that is depleted, then debt is issued; and when it
is no longer sensible to issue any more debt, equity is issued. This theory maintains that
businesses adhere to a hierarchy of financing sources and prefer internal financing when
available, and debt is preferred over equity if external financing is required (equity would
mean issuing shares which meant 'bringing external ownership' into the company). Thus, the
form of debt a firm chooses can act as a signal of its need for external finance.
The pecking order theory is popularized by Myers and Majluf (1984) when he argues that
equity is a less preferred means to raise capital because when managers (who are assumed to
know better about true condition of the firm than investors) issue new equity, investors
believe that managers think that the firm is overvalued and managers are taking advantage of
this over-valuation. As a result, investors will place a lower value to the new equity issuance.
Pecking order theory starts with asymmetric information as managers know more about their
companies prospects, risks and value than outside investors. Asymmetric information affects
the choice between internal and external financing and between the issue of debt or equity.
There therefore exists a pecking order for the financing of new projects.
Asymmetric information favours the issue of debt over equity as the issue of debt signals the
boards confidence that an investment is profitable and that the current stock price is
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undervalued (were stock price over-valued, the issue of equity would be favoured). The issue
of equity would signal a lack of confidence in the board and that they feel the share price is
over-valued. An issue of equity would therefore lead to a drop in share price. This does not
however apply to high-tech industries where the issue of equity is preferable due to the high
cost of debt issue as assets are intangible
Dividend Policy
The policy a company uses to decide how much it will pay out to shareholders in dividends.
Distribution of a portion of a company's earnings, decided by the board of directors, to a class
of its shareholders is called dividend. The dividend is most often quoted in terms of the dollar
amount each share receives (i.e. dividends per share or DPS). It can also be quoted in terms
of a percent of the current market price, referred to as dividend yield.
Lots of research and economic logic suggests that dividend policy is irrelevant (in
theory) for capital structure decision.
Types of Dividends and Important Dates:
TYPES OF DIVIDEND
1. Cash (most common) are those paid out in form of "real cash". It is a form of investment
interest/income and is taxable to the recipient in the year they are paid. It is the most common
method of sharing corporate profits.
2. Stock or Scrip dividends (common) are those paid out in form of additional stock shares
of the issuing corporation, or other corporation (e.g., its subsidiary corporation). They are
usually issued in proportion to shares owned (e.g., for every 100 shares of stock owned, 5%
stock dividend will yield 5 extra shares). This is very similar to a stock split in that it
increases the total number of shares while lowering the price of each share and does not
change the market capitalization
3. Property or dividends in specie are those paid out in form of assets from the issuing
corporation, or other corporation (e.g., its subsidiary corporation). Property dividends are usually
paid in the form of products or services provided by the corporation. When paying property
dividends, the corporation will often use securities of other companies owned by the issuer.
Important Dates:
Dividends must be declared (i.e., approved) by a company’s Board of Directors each time
they are paid. There are four important dates to remember regarding dividends.
Declaration date: The declaration date is the day the Board of Director’s announces their
intention to pay a dividend. On this day, the company creates a liability on its books; it now
owes the money to the stockholders. On the declaration date, the Board will also announce a
date of record and a payment date.
Date of record: Shareholders who properly registered their ownership on or before this date
will receive the dividend. Shareholders who are not registered as of this date will not receive
the dividend. Registration in most countries is essentially automatic for shares purchased
before the ex-dividend date.
Ex dividend date: Is set by the exchange where the stock is traded, several days (usually
two) before the date of record, so that all trades made on previous dates can be properly
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settled and the shareholder list on the date of record will accurately reflect the current owners.
Purchasers buying before the ex-dividend date will receive the dividend. The stock is said to
trade cum dividend on these dates. Purchasers buying on or after the ex-dividend date will not
receive the dividend. The stock trades ex-dividend on these dates.
Payment date: The date when the dividend cheques will actually be mailed to the
shareholders of a company.
Dividend Policies
Stable dividend per share: look favorably by investors and implies low risk firm. it
increases the marketability of firm’s share. Cash flow can be planned as dividend amount can
be ascertained with accuracy (aid in financial planning)
Constant dividend payout (div per share/Eps): A fixed %age is paid out as dividend.
Under this policy the dividend amount will vary because the net income is not constant. Thus
results in variability of return to investors. the dividends may drop to nil in case of loss.
market price of share will lower.
Hybrid dividend policy: This contains feature of both the above mentioned policies.
Dividend consists of stable base amount and %age of increment in fat income years. This is
more flexible policy but increases uncertainty of future cash flow or return to investors. The
extra slice of %age is only paid when there is high jump in income. So it is not regularly paid.
Fluctuating dividends: When the firm is having investment opportunities on its plate or
unstable capital expenditure, then dividends are of residual amount i.e., amount left after
meeting capital expenditure.
Financial Planning Process and Control
Financial planning is often thought of as a way to manage debt, but a good financial plan
really is a way to make certain that you have financial security throughout your life. Many
small business owners consider their business as their investment in their future, but that is a
huge risk to take. As any economist will tell you, diversification is the only sure way to create
security in the long run. Your business is one stream of income. Putting together a financial
plan that allows for multiple streams of income is what provides you security in the longer
term.
The essential components of a good financial plan are investing, retirement planning,
insurance, borrowing and using credit, tax planning, having a will, and ensuring the right
people receive your assets. Financial planning is the process of meeting your life goals
through the proper management of your finances. Life goals can include buying a home,
saving for your child's education or planning for retirement.
The financial planning process involves gathering relevant financial information, setting life
goals, examining your current financial status and coming up with a plan for how you can
meet your goals given your current situation and future plans.
There are personal finance software packages, magazines and self-help books to help you do
your own financial planning. However, you may decide to seek help from a professional
financial planner if:
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• You need expertise you don't possess in certain areas of your finances. For example, a
planner can help you evaluate the level of risk in your investment portfolio or adjust your
retirement plan due to changing family circumstances.
• You want to get a professional opinion about the financial plan you developed for yourself.
• You don't feel you have the time to spare to do your own financial planning.
• You have an immediate need or unexpected life event such as a birth, inheritance or major
illness.
• You feel that a professional adviser could help you improve on how you are currently
managing your finances.
• You know that you need to improve your current financial situation but don't know where to
start.
A financial planner is someone who uses the financial planning process to help you figure out
how to meet your life goals. The planner can take a "big picture" view of your financial
situation and make financial planning recommendations that are right for you. The planner
can look at all of your needs including budgeting and saving, taxes, investments, insurance
and retirement planning.
In addition to providing you with general financial planning services, many financial planners
are also registered as investment advisers or hold insurance or securities licenses that allow
them to buy or sell products. Other planners may have you use more specialized financial
advisers to help you implement their recommendations. With the right education and
experience, each of the following advisers could take you through the financial planning
process. Ethical financial planners will refer you to one of these professionals for services
that they cannot provide and disclose any referral fees they may receive in the process.
Similarly, these advisers should refer you to a planner if they cannot meet your financial
planning needs.
The Financial Planning Process consists of the Following five Steps
1. Establishing and defining the client-planner relationship.
The financial planner should clearly explain or document the services to be provided to you
and define both his and your responsibilities. The planner should explain fully how he will be
paid and by whom. You and the planner should agree on how long the professional
relationship should last and on how decisions will be made.
2. Gathering client data, including goals.
The financial planner should ask for information about your financial situation. You and the
planner should mutually define your personal and financial goals, understand your time frame
for results and discuss, if relevant, how you feel about risk. The financial planner should
gather all the necessary documents before giving you the advice you need.
3. Analyzing and evaluating your financial status.
The financial planner should analyze your information to assess your current situation and
determine what you must do to meet your goals. Depending on what services you have asked
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for, this could include analyzing your assets, liabilities and cash flow, current insurance
coverage, investments or tax strategies.
4. Developing and presenting financial planning recommendations and/or alternatives.
The financial planner should offer financial planning recommendations that address your
goals, based on the information you provide. The planner should go over the
recommendations with you to help you understand them so that you can make informed
decisions. The planner should also listen to your concerns and revise the recommendations as
appropriate.
5. Implementing the financial planning recommendations.
You and the planner should agree on how the recommendations will be carried out. The
planner may carry out the recommendations or serve as your "coach," coordinating the whole
process with you and other professionals such as attorneys or stockbrokers.
The Control Process:
When plans are finalized and put to action or implemented, then the actual performance is
compared with the budgeted numbers. The difference between the actual and budgeted
numbers is called variance. This variance is investigated as to know the real causes of the
difference. The investigation leads to initiate the corrective action and to adjust the budget of
future periods. The investigation result is known as feedback.
There are three types of feedback emerging from investigation of variance.
1. Change The Strategy or Course of Action – If something went wrong with strategy, the
course of action is fine tuned or changed to ensure future actual results conform to original
plan. For example, if sales was less than the budgeted and variance investigation revealed that
sales force could not be motivated then some incentives and bonuses can be offered to
motivate the sales force. The future period budgets will be adjusted for the proposed
incentive expenses.
2. Do Nothing – if the results are in line with the planned, no action is required.
3. Change The Plan – Targets or plan itself is revised rather than changing strategy. For
example the targeted profit is scaled down.
For example we continue the example in 1 above, if sales were less than budgeted and
investigation revealed that the sales target was not realistic, then the sales targets will be
adjusted for future period.
Budget Preparation Process:
1. Budget Policy & Details – Communicating To All
This includes disseminating details like the budgeting period, time table and formation of
budgeting committee. The main objective is to make clear of the scope and roles of people
involved in this process. Normally, budgeting period is a period of 12 months. It may be
calendar year or any combination of 12 months. However, it is always broken down into 12
periods of one month or into quarters because of comparison with actual performance and
control purposes.
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This process is formalized by forming a committee comprising of different front line
managers and a very senior person is appointed to head this committee. Such a person should
have a clear vision of future and unambiguous understanding of corporate objectives.
Budgets are used to translate the ultimate objectives into monetary terms as a course of action
to accomplishment of those objectives.
A budget has to be finalized before the start of the period for which it is being prepared. For
example, budget for 2006 must be completed before January 2006. The time to complete
budget will vary firm to firm, on the type of budget and the budget period. There are different
phases in budget preparations and timeliness is set for each phase.
2. Determining The Limiting Factor
Budget preparation normally begins with the identification of limiting factor. This refers to a
factor that limits the stretch of company or hinders company’s achievement of specific
objective. The first step will be to determine the sales during the budget period. The first
question will be “do we have the capacity to produce this much?” Assuming that the answer
is “no” then, production capacity is the limiting factor. You can’t achieve what you have
determined and need to cut-down your plans or revise your target sales.
The other areas may be the availability of labor force and/or raw materials. If there’s no
limiting factor then company can start with the target sales and if there’s one that hampers
target, then it would be what can be achieved with the available resources.
3. Production Budget Preparation
The primary source of inflow comes from the principal activity or sale of goods. Therefore,
in budget preparation sales is the kick off point.
Sales budget is prepared in quantitative form. Each product sales is mentioned in number of
units to be produced. There is a standard specification of a unit in terms of the input material
requirements; labor time and amount of overhead needed to manufacture it. There’s also a
standard selling price of each product unit.
Sales in monetary term are calculated by multiplying number of units to be produced by
standard selling price.
Next step will be to determine the expense side of number of units to be produced in the
budget period. This is known as production cost budget and is divided into three categories.
First step will be to determine the total raw material requirements by multiplying the number
of units to be produced by standard quantities of input materials. The dollar value of direct
material cost is calculated by multiplying derived quantities by the standard purchase price.
In second step, direct material requirements are worked out. Standard time to produce one
unit is multiplied with number of units to be produced. The total production hours are
multiplied by standard labor rate per hour to reach at total labor cost.
The third segment in cost of sales determination is to estimate the overhead to be absorbed
per unit of output. This is normally done by dividing the estimated amount of overheads by
the activity level – labor hours.
Adding these three segments – direct materials, direct labor and overhead render total cost of
production.
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4. Other Ancillary Policy Issues Determination
The other items that are determined in this phase includes but not limited to the minimum
level of finished goods level, purchases of each raw materials and raw material ending
inventory levels.
5. Functional Budgets & Negotiation
After the sales and production cost budget has been determined then comes the step where
individual departments or functional budgets are prepared. Every functional manager is required
to prepared and present before the budget committee budget for the forthcoming period.
6. Adjustments & Trimming
Once the sales, production cost and functional budgets have been submitted to the committee
then there are discussions and negotiations and adjustments are made in the light of available
resources and short term objective of the firm. If there is shortage of resources then
departmental budgets are trim down. At the point where the trade off between resources and
resource utilization is achieved, it is deemed as final.
7. Finalization Of Budget & Implementation
Final version of budget is presented to head of committee who then present it to chief
executive officer. If CEO has some reservations it may ask for reconsideration or can approve
as is. After CEO ratification the budget is approved for implementation.
8. Variance Analysis & Investigation
After the budget is approved and implemented, the actual performance is compared with the
budgeted one and variances are calculated. Variance is the difference between the actual and
budgeted numbers. The variance is investigated as to know the root cause of difference. The
information is used to adjust the next budgets period.
Specific Phases of the Budget
The Budget process can be divided into distinct phases:
Common Purposes/Functions behind Budget Activity
Planning -- involves determining organizational and program objectives and evaluating
alternative means for their achievement. Planning also includes prioritizing.
Control -- defined as monitoring, comparing information to a standard and taking corrective
action. For a budget to serve this function well it must have four characteristics:
It must be well-conceived (i.e., result from a good planning process) and be approved by the
board It must be broken down into increments corresponding to the periodic financial
statements Financial statements must be prepared on a timely basis and compared to the budget
The board and staff must take action where such comparison indicates a potential problem.
Management -- allocating resources deliberately and prudently to achieve program objectives.
This includes programming approved goals into specific projects and activities, the design of
organizational units to carry out programs, staffing, and procurement of resources.
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Cash Budgets
Overall Layout of a Cash Budget
Here we have a cash budget statement that starts with the cash balance brought down (b/d)
from last month, last week or yesterday (this is the cash we had in the safe or our purse or
wallet at the end of the previous period). Then we add the cash receipts to the balance b/d to
give us the total amount of cash we then have available to us: this is the amount of money we
can spend.
However, we usually have bills to pay, so we take away from the cash available the amount
of money we have to pay for our bills, utilities, materials, labor and so on. Starting with the
balance b/d adding the receipts and taking away the payments leaves us with the balance
carried down (C/D); and this is what we have left at the end of the month ready for use at the
start of the following month.
Alternative Layout of a Cash Budget
In addition to dealing with debtors and creditors, which we will deal with shortly, there is the
key issue of alternative layouts. Here we see an alternative layout that has exactly the same
information in as the previous example but they are presented in a different order.
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Topic 10
Islamic Banking and Finance
“Blessed be Allah in whose hands
is the kingdom of the creations;
and who has control over all things;
He who created death and life, that,
He may test which of you is best in deeds.
Allah is most Exalted in Might and oft-Forgiving.”
[Qur'an 67: 1-2]
The Holy Quran criticizes Ribâ (usury) in the following words:
“Those who swallow Ribâ (usury) cannot rise up save as he ariseth whom the devil hath
prostrated by (his) touch. That is because they say: "Trade is just like Ribâ (usury)," whereas
Allâh permitteth trading and forbiddeth Ribâ (usury). He unto whom an admonition from his
Lord cometh and (he) refraineth (in obedience thereto), he shall keep (the profits of) that
which is past, and his affair (henceforth) is with Allah. As for him who returneth (to usury) –
Such are rightful owners of the Fire. They will abide therein.
Allah hath blighted usury and made almsgiving fruitful. Allah loveth not the impious and
guilty”
(Holy QURAN, Al-Baqarah, Chapter # 2, Verse 275-276, n.d.)
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Topic 11
Mergers & Acquisitions
Growth is very essential for a company because a company can add value by expanding it
business and can attract the first rate human resources. The growth can be internal and
external. During our previous studies we have covered internal growth and evaluation
process. Companies acquire assets for its expansion or make investment in business. External
growth involves taking over or acquiring a separate entity or already established business.
However, there are significant differences in internal and external growth method.
This rationale is particularly alluring to companies when times are tough. Strong companies
will act to buy other companies to create a more competitive, cost-efficient company. The
companies will come together hoping to gain a greater market share or to achieve greater
efficiency. Because of these potential benefits, target companies will often agree to be
purchased when they know they cannot survive alone.
One plus one makes three: this equation is the special alchemy of a merger or an acquisition.
The key principle behind buying a company is to create shareholder value over and above
that of the sum of the two companies. Two companies together are more valuable than two
separate companies - at least, that's the reasoning behind M&A.
The important reason for merger and acquisition is the increase in the sales. Operating
economies can be achieved by increasing sales and utilizing fixed cost effectively.
Synergy and sources of synergy:
One plus one makes three: this equation is the special alchemy of a merger or an acquisition.
The key principle behind buying a company is to create shareholder value over and above
that of the sum of the two companies. Two companies together are more valuable than two
separate companies - at least, that's the reasoning behind M&A.
Synergy is the magic force that allows for enhanced cost efficiencies of the new business.
Synergy takes the form of revenue enhancement and cost savings.
Synergies and Types of Synergies:
It results from complementary activities .for instance, one firm may have substantial amount
of financial resources while the other has profitable investment opportunities.
Synergy is the energy or force created by the working together of various parts or processes.
Synergy in business is the benefit derived from combining two or more elements (or
businesses) so that the performance of the combination is higher than that of the sum of the
individual elements (or businesses).
The enhanced result of two or more people, groups or organizations working together is
called synergy. In other words, one and one equal three! It comes from the Greek "synergia,"
which means joint work and cooperative action. The word is used quite often to mean that
combining forces produces a better product.
However, in the field of software development, synergy is not the result. In many cases, the
more people assigned to a programming job, the more the quality suffers.
The idea that the value and performance of two companies combined will be greater than the
sum of the separate individual parts.
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Types of Synergies:
1-Operational synergies
2- Financial synergies
Operating Synergies:
By merging, the companies hope to benefit from the following:
• Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all
the money saved from reducing the number of staff members from accounting, marketing and
other departments. Job cuts will also include the former CEO, who typically leaves with a
compensation package.
• Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new
corporate IT system, a bigger company placing the orders can save more on costs. Mergers
also translate into improved purchasing power to buy equipment or office supplies - when
placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
• Acquiring new technology - To stay competitive, companies need to stay on top of
technological developments and their business applications. By buying a smaller company
with unique technologies, a large company can maintain or develop a competitive edge.
• Improved market reach and industry visibility - Companies buy companies to reach new
markets and grow revenues and earnings. A merge may expand two companies' marketing
and distribution, giving them new sales opportunities. A merger can also improve a
company's standing in the investment community: bigger firms often have an easier time
raising capital than smaller ones.
Financial synergies:
If the future cash flow stream of two companies is not positively correlated then combining
the two will reduce the variability of cash flow or will bring stability in cash flow thus may
increase the value by having cheaper financing available. Lenders and creditors like to have
stable cash flow that signals the ability of company to settle its short term and long term
obligations.
Diversification normally reduces the risk. If the earnings of two combined entities remain
unchanged then there are still chances of increased firm value. In this case, the reduction in
the risk level will add value to the firm.
From shareholders’ stand point if there are no operating economies in a merger, then it will
not add value to the shareholders’ wealth.
This should be noted that managers often consider the total risk as this effect the job security
and diversification argument can make sense from a managerial stand point if not a
shareholders’.
If the future cash flow of merged entities is not perfectly positively correlated then by
merging the two cash flow variations can be reduced.
Other synergies:
Surplus Human Resources: companies with skilled managers and staff can best utilize these
resources only if they have problems to solve. The acquisition of inefficient companies is
sometimes the only way of using skilled human resources.
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Surplus cash flow: companies with large amounts of surplus cash may see the acquisition of
other companies as the only possible application for these funds.
Market power: horizontal mergers may enable the company to seek a degree of monopoly
power which could increase its profitability.
Organic growth: growth using mergers and acquisition is speedier than the organic growth.
That said, achieving synergy is easier said than done - it is not automatically realized once
two companies merge. Sure, there ought to be economies of scale when two businesses are
combined, but sometimes a merger does just the opposite. In many cases, one and one add up
to less than two. Sadly, synergy opportunities may exist only in the minds of the corporate
leaders and the deal makers. Where there is no value to be created, the CEO and investment
bankers - who have much to gain from a successful M&A deal - will try to create an image of
enhanced value. The market, however, eventually sees through this and penalizes the
company by assigning it a discounted share price. We'll talk more about why M&A may fail
in the next tutorial.
Types of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here
are a few types, distinguished by the relationship between the two companies that are
merging:
• Horizontal merger - Two companies that are in direct competition and share the same
product lines and markets.
• Vertical merger - A customer and company or a supplier and company. Think of a cone
supplier merging with an ice cream maker.
• Market-extension merger - Two companies that sell the same products in different markets.
• Product-extension merger - Two companies selling different but related products in the
same market.
• Conglomeration - Two companies that have no common business areas.
There are two types of mergers that are distinguished by how the merger is financed. Each
has certain implications for the companies involved and for investors:
o Purchase Mergers - As the name suggests, this kind of merger occurs when one company
purchases another. The purchase is made with cash or through the issue of some kind of debt
instrument; the sale is taxable.
Acquiring companies often prefer this type of merger because it can provide them with a tax
benefit. Acquired assets can be written-up to the actual purchase price, and the difference
between the book value and the purchase price of the assets can depreciate annually, reducing
taxes payable by the acquiring company. We will discuss this further in part four of this
tutorial.
Consolidation Mergers - With this merger, a brand new company is formed and both
companies are bought and combined under the new entity. The tax terms are the same as
those of a purchase merger.
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Profitable growth constitutes one of the prime objectives of most of the business firms. It can
be achieved internally either through the process of introducing /developing new products or
by expanding / enlarging the capacity of existing products the firm is engaged. Alternatively
the growth process can be facilitated externally by the acquisitions of existing business firms.
This acquisition is technically referred to as mergers, acquisitions, amalgamations, takeovers,
absorption, consolidation etc. Mergers are a tool used by companies for the purpose of
expanding their operations and increasing their profit.
Usually mergers occur in a consensual setting where executives from the target company help
those from the purchaser in a due diligence process to ensure that the deal is beneficial to
both parties. Acquisitions can also happen through a hostile takeover by purchasing the
majority of outstanding shares of a company in the open market against the wishes of the
target's board. In most of the countries, business laws vary from state to state whereby some
companies have limited protection against hostile takeovers. One form of protection against a
hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".
Why mergers fail?
Lack of planning or overoptimistic planning
Planning is a crucial exercise that will help determine the success or failure of a merging
organization. However, many merging organizations do not have adequate or complete
integration and implementation plans in place. Only one out of five companies that have
acquired another has developed a clear and satisfactory implementation plan.
Putting the forecast results on paper is much simpler than actually achieving them. During the
planning phase the synergies may be over-estimated because of the subjective judgment
issues in estimations. A major downside of the planning process is that it can take the focus
away from daily business activities. It can also fail to address serious HR issues and activities
that can have a strong impact on the organization. Another flaw in many M&A plans is that
they often include expectations that are unrealistic and that will stretch the merging
organizations beyond their capabilities.
Human integration
As discussed above, the early stages of mergers and acquisitions (i.e. Planning and negotiation)
are often carried out in secret and do not usually involve human resources in the discussions.
This lack of involvement by human resources can have a detrimental impact on the merger,
since it means that many issues that are directly linked to the success or failure of the merger
will have been overlooked. If legal and financial experts are driving the strategic work behind
the integration, then a number of important considerations critical for the financial success of
the merger, such as the productivity of the new employees, may be overlooked unless human
resources and corporate communications staff members provide their input.
Corporate culture
Even if two companies seem to have all the right ingredients in place for a successful merger,
cultural differences can break the deal. It is not enough for two companies to appear to fit well
on paper; at the end of the day, if the people are not able to work together, the merger will not
succeed. Poor communications and inability to manage cultural differences are the two main
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causes of failed mergers. Cultural differences that cannot be resolved affect communications,
decision-making, productivity and employee turnover at all levels of the organization.
All the best laid plans – exhaustive analyses of strategies, marketing tactics, legal issues, etc.
– can fall apart if the people cannot work together. If the two workforces fail to unite behind
the strategic goals underlying the consolidation, even the best financial deals and most
rigorous legal contracts fail to guarantee success.
An example which demonstrates the importance of cultural differences is the Daimler
Chrysler merger. The post-merger phase highlighted the difficulty of trying to integrate two
very divergent cultures. Even though in the beginning, Daimler-Benz and Chrysler both
expressed their commitment to working together and sharing work practices and product
development methods, this commitment did not materialize, a phenomenon exemplified by
the Daimler management’s unwillingness to use Chrysler parts in Mercedes cars.
Lack of communications:
Employee communications is considered as being one of the most important issues which
needs to be addressed during a merger or acquisition process. Poor communication between
people at all levels of the organization, and between the two organizations that are merging,
is one of the principal reasons why mergers fail.
Middle management and lower level employees in particular are kept in the dark when it
comes to merger issues. Most of companies customize merger information for middle
management and lower levels of employees. Therefore, it is not surprising that many
managers find themselves learning more about their corporation from reading the daily
business section of the newspaper than from their own superiors.
Not only is lack of communication a serious issue for merging organizations, the deliberate
withholding of information from employees on the part of the senior executives who are
dealing with the merger, is also a major problem, and contributes to confusion, uncertainty
and a loss of trust and loyalty on the part of employees. In some cases, companies even feel
the need to lie to their employees by making reassuring statements about the continuity of
their roles and pay packages, and by falsely stating that there will be no redundancies.
Lack of information, no clear direction and confusing messages, all boil down to uncertainty,
which is destructive.
Talent Departure:
An increase in the turnover rate of productive employees is one of the greatest prices of
corporate mergers. Mergers and acquisitions often lead to the loss of the merging companies’
greatest assets: talented employees and key decision-makers. According to the American
Management Association, one out of four top performers leaves the company within 3
months of the announcement of an event involving major change in the organization and 47%
of senior managers in the acquired company leave within the first year.
A Wall Street Journal article estimated that 50-75% of managers in companies that have
merged plan to leave within three years. Yet the decision to merge or acquire is often based
on the desire to gain a talented workforce, and new knowledge and expertise. This obvious
contradiction is not dealt with satisfactorily by company leaders who are not taking sufficient
steps to resolve this problem. They need to realize that when employees leave the company
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following a merger or acquisition, they are taking with them the knowledge and expertise that
was part of the reason the merger occurred in the first place.
Employees are the most important assets companies have. Yet they are totally forgotten about
when a deal is being done. The boards and senior management just don’t get it.
Frequently, employees do not leave of their own free will following an M&A transaction, as
companies reduce their headcounts and downsize in a bid to reduce costs. At the same time,
however, companies in today’s economy seem to be rated more and more on their innovative
capabilities and unique expertise, which reinforces the notion that employees are a
company’s greatest assets.
Not only do merging companies suffer a drop in productivity as a result of losing talented
employees, but lower morale and a sense of insecurity on the part of the employees who
remain in the newly-merged organization can also lead to productivity problems.
Remaining employees end up distrusting their employer and often become reluctant to
safeguard the interests of the new company. They also become de-motivated to work to their
best abilities. The resulting loss of creative power can cripple a corporation that is competing
within a rapidly changing industry.
Loss of Customers:
With the loss of employees also comes the loss of customers during mergers and acquisitions.
Some of the most talented employees, responsible for bringing in valuable business to their
organizations, are often the ones who leave, resulting in the loss of key customers.
All companies need to remember: it’s the people who produce profits, represent the company,
establish rapport with the customers, and, ultimately, are the ones that will make the
combined company succeed. Even if merging companies succeed in retaining the employees
that bring in the business, customers may still decide to take their business to other
companies if they fear that their level of service is going to deteriorate in the newly merged
organization. Lack of communication on the part of management is therefore the culprit not
only when it comes to the employees of the merging organizations, but also when it comes to
their customers.
Merger and Acquisition Process:
Determining the Target (Company)
Once the management has decided to expand through mergers and acquisitions, it must
determine the prospective target company in the sector it is interested in.
First step in this regard would be to evaluate the feasibility from commercial and financial
viewpoint. M & A transactions are carried out as going concern and purchase of assets basis,
we will highlight the areas that need special focus by the management:
Organizational information: that includes management, skill and expertise, other
employees, payroll structure and appointment terms, unionization, benefit plans.
Sales & Marketing: historic sales trend and analysis, products – strengths, market share,
sales net work, market reputation.
Technology: Technical expertise required to run the targeted company, future assessment,
research & development required.
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Financial & Accounting information: historical accounts, profitability analysis, assets and
liabilities true position, accounting policies, equity analysis.
Cash & Bank: details of bank accounts, collaterals against loans, details of agreements like
leases, forward rates, etc.
Tax: tax computations like for depreciation, deferred tax, any pending case with tax
department, outstanding liabilities for income and sales tax, rather for other taxes as well.
Formulation of Scheme:
Once the prospecting phase is over, the companies seek the help of legal and financial
consultants to finalize the details of proposed scheme of merger.
Memorandum of Association:
The object clause of amalgamated company should be examined to see if it permits
continuation of the business amalgamating (transfer) company by it, if it does not, then
suitable amendments / alteration must be made in the manner prescribed in the companies act.
Intimation to Stock Exchange and Notification:
As soon as the offer of merger is made, the stock exchanges where these companies are listed
should be notified and the fact of the offer should be announced in the newspapers. To ensure
proper disclosure, the announced is made in the form approved by the regional stock
exchange.
Directors Approval of the Proposed Scheme
The proposed scheme of merger should be submitted to the Board of Director of each
company for their approval.
Shareholders Approval:
The scheme, once approved by the Board of Directors, should be placed before shareholders
at a general meeting for their approval. It is not a legal necessity, but the company in practice
gets the scheme approved by its shareholders before they file an application for the sanction
of the court.
Transfer of Assets and Liabilities, issuance of Shares, etc.
Finally, the companies can implement the scheme by transferring assets and liabilities by
issuing of shares and given any other consideration to the members of the amalgamating
company, as per the scheme of merger.
Cultural due diligence
When merging with another firm, most companies focus more on the deal than on the
subsequent integration of the companies. This may explain, at least in part, why most of them
fail. Despite popular beliefs to the contrary, the single greatest barrier to business success is
the one erected by culture.
How important is culture in an organization? In recent years it has been acknowledged as
being as significant a factor in international business as the bottom line. While the mergers
and acquisitions boom has slowed somewhat in 2002, the percentage of acquisitions across
borders has continued to increase, expected to reach 50 percent of all M&A activity by 2003.
According to the International Labor Organization, 70 percent of mergers and acquisitions
worldwide fail to meet their strategic objectives within two years. International consultants
KPMG revealed in a recent study “the overwhelming cause for failure of M & As is the
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people and the cultural differences.” Meaning that in the majority of instances, these business
ventures run aground due to organizational culture conflicts.
Since knowledge is power, the obvious approach is for the acquiring party to perform a
cultural due diligence before making the final decision, to determine if there is cultural
synergy between the partners. This is often rejected by the company being investigated,
however, since it requires allowing the (as yet uncommitted) outside faction full access to HR
policy and company personnel.
Anti-takeover tools:
Takeovers are not easy – there is always some opposition to takeovers by some or all of the
stakeholders of target company. In this section, you will learn how to thwart a takeover attempt
successfully. The following methods have been used in practical life to stop a takeover:
Poison pill:
Poison pill originally meant a literal poison pill (often a glass vial of cyanide salts) carried by
various spies throughout history, and by Nazi leaders in WWII Spies could take such pills
when discovered, eliminating any possibility that they could be interrogated for the enemy's
gain. It has since become a term referring to any strategy, generally in business or politics, to
increase the likelihood of negative results over positive ones for anyone who attempts any
kind of takeover.
Pac-Man:
The Pac-Man defense is a defensive option to stave off a hostile takeover. It is when a
company that is under a hostile takeover acquires its would-be buyer.
The most quoted example in U.S. corporate history is the attempted hostile takeover of
Martin Marietta by Bendix Corporation in 1982. In response, Martin Marietta started buying
Bendix stock with the aim of assuming control over the company. Bendix persuaded Allied
Corporation to act as a "white knight," and the company was sold to Allied the same year.
The incident was labeled a "Pac-Man defense" in retrospect.
The name refers to when Pac-Man, the star of the videogame of the same name, turns around
and devours the ghost that was previously pursuing him (after eating a Power Pill that allows
him to do so). The term (though not the technique) was coined by buyout guru Bruce
Wasserstein.
White knight (business)
In business, a white knight may be a corporation, a private company, or a person that intends
to help another firm. There are many types of white knights.
The first type refers to the friendly acquirer of a target firm in a hostile takeover attempt by
another firm. The intention of the acquisition is to circumvent the takeover of the object of
interest by a third, unfriendly entity, which is perceived to be less favorable. The knight
might defeat the undesirable entity by offering a higher and more enticing bid, or strike a
favorable deal with the management of the object of acquisition. In short, if Company T
(target) is going to be acquired by Company H (hostile firm), but Company A (acquirer) can
acquire ownership of Company T, and then Company A would be acting as the white knight.
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The second type refers to the acquirer of a struggling firm that may not necessarily be under
threat by a hostile firm. The financial standing of the struggling firm could prevent any other
entity being interested in an acquisition. The firm may already have huge debts to pay to its
creditors, or worse, may already be bankrupt. In such a case, the knight, under huge risk,
acquires the firm that is in crisis. After acquisition, the knight then rebuilds the firm, or
integrates it into itself.
Disposal of Key Assets:
Disposal of key assets is also very important tools which go in anti, because some times vital
assets when go to liquidate or companies go to amalgamate then, too many hurdles come in
order to process the disclosure of the assets, because investment made by the investor.
Acquisition by the Target / Targeted Repurchase:
A targeted repurchase is a technique used to avert a hostile takeover in which the target
firm purchases back its own stock from an unfriendly bidder, usually at a price well above
market value.
Politics
Political pressure is an effective anti-take over tool. Two good examples will make you
understand better how a government can stop takeover bid.
DWP – Middle East based port company acquired the management of some US ports after
successful bidding. Later, as the congress raised concern about the security of its ports, US
president had to interfere to stop this bid. On the same lines, an Indian business tycoon had a
successful bidding of a French steel manufacturer but later French government intervened
and cancelled the bid.
A poison pill may also be used in politics such as attaching an amendment so distasteful to a
bill that even the bill's supporters are forced to vote against it. This manipulative tactic may
be intended to simply kill the bill, or to create a no-win situation for the bill's supporters, so
that the bill's opponents can accuse them of voting for something bad no matter what. This is
sometimes known as a "wrecking amendment".
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Topic 12
Decision Making Under Crisis
CUBAN CRISIS (A Case Study)
Introduction:
Crises, as discussed earlier, have many levels, i.e. local, national, trans-national and global
level. However, generally, one is tended to perceive ‘crises’ only as an international
phenomenon. It must be kept in mind that crises do occur even at individual level and
demand the same degree of concern as at any higher level. However, 1962, is the year, when
the concept of ‘Crises’ was always discussed at global level and ultimately, it was virtually
perceived by everyone as a ‘matter of global level’. How this concept developed is a lengthy
affair to understand. The concept of ‘crises’ and crisis management also got meteor during
this period.
The 20th century spent only one day, when there was no war on this blue planet. It was an
intensely bleeding century. Terms like war of attrition, war of destruction, limited war, total
war etc were quite frequently used.’ During the 1940s and 1950s the term ‘cold war’ was
used so often that it became virtually a cliché. Yet the label was, in many senses, an
appropriate one and described very graphically the conflict relationship between the United
States and the Soviet Union that developed in the aftermath of the Second World War. On the
one hand, Soviet-American hostility was sufficiently acute and the competition between them
sufficiently intense to merit the term ‘war’. On the other hand, it was not war in the more
usual sense of the word: the conflict did not involve continual or unremitting violence.
Although the Cold War was punctuated by local or regional hostilities, its weapons were not
solely, and perhaps not even primarily, the tank and the machine gun but were more subtle
means of influence such as the propaganda leaflet, economic aid and diplomatic manoeuvres.
There were occasions, however, when it appeared as if the situation might be transformed
from this relatively subdued mode of conflict into much more overt and large-scale violence
involving the two superpowers themselves. Indeed, one of the major features of the Cold War
was the sporadic occurrence of direct confrontations between the United States and the Soviet
Union (and, to a slightly lesser extent, between the United States and Communist China),
confrontations that threatened to initiate a process of ‘hot war’ between the protagonists.
The Second World War physically or apparently ended but down and under, much more
serious war started. This war surfaced at 11:45 a.m. on 16th of October, 1962, when the US
president was informed that USSR has deployed enough missiles in Cuba, which could
destroy America. When the world learnt about this lethal threat, a horror and chaos prevailed
on the globe. This state of cute danger, to the entire world was termed as ‘crisis’. For the first
time, the terminology became so much popular that it assumed the shape of a proper field of
study. From then onwards, this incident is popularly referred to as ‘Cuban Crisis’. The
resolution of these crises also oozed out a lot for the scholars and intellectuals to explore. The
13 days long crises have left numerous lessons also
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Crisis Management Process
a. The Sudden Shock. It was sudden shock for the president of USA John F. Kennedy
When, on Tuesday morning, on 16th of October, 1962, he was informed by the intelligence
sources that Russia was placing missiles and atomic weapons in Cuba. The evidence was
based on a U-2 photographic mission. That was the beginning of the Cuban Missile Crisis
between the two giant atomic nations i.e. Russia and USA. The process of ‘Crises
Management’ was also initiated instantly.
b. Perceptions/Misperceptions. No sooner the U.S President got the information, the
process of crisis management started. At 11:45 a.m. the same day, in the Cabinet Room, a
formal presentation was made by The Central Intelligence Agency (CIA) to a number of high
officials of the government. The experts arrived and explained the photographs, which were
taken by the U.2. It is interesting to note that none of the officials believed the experts. Their
opinions were also funny. After seeing the photographs and getting the briefing from the
experts, the big minds and big officials refused to accept the CIA’s version and gave their
perceptions/interpretations as under:(1). President John F. Kennedy. He thought that it was not a missile site and it appeared to
him like a football ground.
(2). Robert F. Kennedy (Senator). He believed that it was a farm or basement of a house.
(3). None of the officials. believed deployment of surface to surface Ballistic Missiles, but
the concern did grow more and more .
c. Later, in a post mortem study it was discovered that reports had come from agents within
Cuba indicating the presence of missiles in September 1962. Most of the reports were false;
some were the result of confusion by untrained observers, between surface-to-air missiles and
surface-to-surface missiles. Several reports, however, turned out to be accurate; one from a
former employee at the Hilton Hotel, in Havan, who believed a missile installation was being
constructed near San Cristobal, and another from someone who overheard Premier fidel
Castro’s Pilot, talking in a boastful intoxicated way, one evening, about the nuclear missiles
that were going to be furnished to Cuba by Russia. But before these reports were given
substance, they had to be checked and rechecked. They were not even considered substantial
enough to pass on to the President or other high officials within the government. In
retrospect, this was perhaps a mistake.
d. “The important fact, of course, is that the missiles were uncovered and the information was
made available to the government and the people before the missiles became operative and in
time for the United States to act.”
Now that the first information had been received, the real deliberated and planned efforts
were launched to get the complete information. On 17th of October, some more information
was received which confirmed several missile installations with at least, 16 and possibly 32
missiles. The missiles were capable of carrying atomic warheads and could be operational
within a week.
2. Practical Steps
a. Formation of Crises Management Group. Keeping in view the gravity of the situation, a
crises management group was immediately formed, comprising the most able, experienced,
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knowledgeable and trustworthy officials. The same group that met that first morning in the
Cabinet Room, met almost continuously through the next twelve days and almost daily for
some six weeks thereafter.
b. Composition of the Group. The group, which was later to be called the ‘Ex-Comm’ (the
Executive Committee of the National Security Council), included the following:
(1). Secretary of State - Dean Rusk
(2). Secretary of Defense - Robert McNamara
(3). Director of the Central Intelligence Agency (CIA) - John McCone.
(4). Secretary of the Treasury - Douglas Dillon.
(5). President Kennedy’s adviser on national-security affairs – McGeorge Bundy.
(6). Presidential Counsel - Theodore C. Sorensen.
(7). Under Secretary of State - George Ball
(8). Deputy Under Secretary of State U. Alexis Johnson; General Maxwell Taylor
(9). Chairman of the Joint Chief of the Staff - Edward Martin,
(10). Assistant Secretary of State for Latin America; originally, Charles Bohlen, who, after
the first day, left to become Ambassador to France and was succeeded by Llewellyn
Thompson as the adviser on Russian affairs; Rosewell Gilpartric,
(11). Deputy Secretary of Defense; Paul Nitze,
(12). Assistant Secretary of Defense; Intermittently at various meetings, Vice president
Lyndon B. Johnson, Adlai Stevenson
(13). Ambassador to the United Nations; Kenneth O’Donnell, Special Assistant to the
President
(14). Donald Wilson, who was deputy Director of the United States information Agency.
This was the group that met, talked, argued, and fought together during that crucial period of
time. From this group came the recommendations from which president Kennedy was
ultimately to select his course of action.
In the words of Robert F. Kennedy, “They were men of the highest intelligence, industrious,
courageous, and dedicated to their country’s well-being. It is no reflection on them that none
was consistent in his opinion from the very beginning to the very end.”
c. Avoiding Panic. “To keep the discussions from being inhibited and because the President
did not want to arouse attention, he decided not to attend all the meetings of our committee.
This was wise. Personalities change when the President is present, and frequently even strong
men make recommendations on the basis of what they believe, the President wishes to hear.
He instructed our group to come forward with recommendations for one course or possibly
several alternative courses action.”
3. Decision Making
Once the deployment of missile sites was confirmed, the group was given the final
responsibility to work out options. As it has been discussed in detail in the ‘Decision Making
Section’, we may observe many interesting but difficult situations also in the process of
decision making. Right in the first meeting of the group an interesting incident took place
which speaks of the sensitivity of the lethal situation and keeping the nerves composed under
such circumstances. An interesting dialogue between the president and the Commandant of
the Marine Corps, General David M. Shoup took place in this difficult situation. Addressing
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the President, the General said, “you are in a pretty bad fix, Mr. President.’ The president
answered abruptly, “You are in it with me.” Everyone laughed, and with no final decision,
the meeting adjourned.
4. Options
a. The options of decision makers kept changing or drifting frequently.
b. On 18th of October, when some more information had come in, majority wanted naval
blocked.
c. The level of tension and anxiety kept increasing moment to moment. 19th of October was
the day when day and night meetings continued. The decision makers once again changed
their decision as concrete information was now available that there were many missile sites
with at least 16 to 32 missiles. This information again change the opinion of the decision
makers.
d. Before 20th of October, majority was in favour of blockade. As the new information came
in, everyone got more offended with an offensive attitude. Almost everyone wanted a very
severe military action except McNamara.
e. The president was given final briefing on 20th of October. In the final briefing majority
argued for military attack and only McNamara argued for blockade.
f. Former Secretary of State, Dean Acheson strongly favoured air attack.
g. Final option/Discussion. President gave the final decision in favour of Blockade. The
president knew that 80 million Americans would die in the first few minutes, if the missiles
were launched.
5. Informing the Nation (President’s Speech)
After having completely analysing the situation and taking a final decision, it was now
decided that president should formally inform the nation. Excellent communication skills
were demonstrated by the president. The importance of communication during the crises can
be seen here. Before making a speech, through the personal intervention of the president with
several newspapers, the only stories written on Monday morning were reports that a major
speech was to be given by the president and that the country faced a serious crises.
At 7’o clock he appeared on television before the nation to explain the situation in Cuba and
the reasons for the quarantine (Blockade). He emphasized that the blockade was the initial
step only. It amounted to satisfy the nation that crises would be successfully managed even if
the decision makers had to go beyond the blockade. This was an ideal use of flexibility in
decision making.
6. President Meets the Cabinet
The president also took the cabinet into confidence the same day. There was tremendous
criticism on the decision and people wanted much more severe combat action. Many
congressional leaders were sharp in their criticism. They felt that the President should take
more forceful action, a military attack or invasion, and that the blockade was far too weak a
response. The president, after listening to the frequently emotional criticism, explained that
he would take whatever steps were necessary to protect the security of the United States, but
that he did not feel greater military action was warranted initially. Because it was possible
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that the matter could be resolved without a devastating war, he had decided on the course he
had outlined. He assured them, he had taken measures to prepare military forces and place
them in a position to move. He reminded them that, once an attack began, the adversaries
could respond with a missile barrage from which many millions of Americans would be
killed. It was feared that 80 million Americans would be killed few minutes.
7. Meeting With Organization of American States
He held a meeting with the organization of American states and briefed them about the whole
situation. He sought their willing consent for the action also.
8. Blockade Went into Effect
The Navy deployed 180 ships into the Caribbean. The Strategic Air Command was dispersed
to civilian landing fields around the country, to lessen its vulnerability in case of attack. The
B-52 bomber force was ordered into the air fully loaded with atomic weapons. As one came
down to land, another immediately took its place in the air.
9. Diplomatic Front
a. Whenever crises of such a macro level are apprehended or perceived, all actors are
activated and efforts start on all fronts. Now at one end the precise information about the
missiles deployment was speedily coming in the diplomatic efforts also started instantly.
When the Russian ambassador was asked by the U.S Government, he showed his total
ignorance and point blank refused of any such happening. The USSR government was also
contacted. In the words of Robert F. Kennedy. “That same afternoon, from a draft prepared
by Nicholas Katzenbach, the Deputy Attorney General, and myself, President issued exactly
this kind of warning and pointed out the serious consequences that would result from such a
step. A week later, Moscow disclaimed publicly any intention of taking such action and
stated that there was no need for nuclear missiles to be transferred to any country outside the
Soviet Union, including Cuba. During this same period of time, an important official in the
Soviet Embassy, returning from Moscow, brought a personal message from Khrushchev for
President Kennedy, stating that he wanted the President to be assured that under no
circumstances would surface-to-surface missiles be sent to Cuba. An American senator says
“We had been deceived by Khrushchev, but we had also fooled ourselves.”
b. On 23rd October (Tuesday), was the important meeting with the organization of American
States. It was anticipated that difficulty may be experienced in obtaining the two thirds vote
of support necessary for the ordering of a quarantine. However, the case was so smartly
presented a number contributed, men, supplies and ships during the several weeks that
followed. It was a big diplomatic achievement. Americans were now able to establish a firm
legal foundation for their action under the OAS Charter, and their position was greatly
strengthened around the world. The Soviet Union and Cuba now faced the united action of
the whole western Hemisphere. However, the Russians still insisted that they had not carried
out any activity.
c. The Americans now started collecting evidence to convince the whole world and the
United Nations. They prepared a twenty five miles long film indicating launching pads,
missiles, concrete bunkers, nuclear storage and many other allied facilities. These were sent
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to United Nations and also many other influential agencies. Even at this stage tremendous
communication took place between United States and Soviet Russia. The heads of the States
also communicated at personal level. The Russian however, denied the realities till end.
d. Television debates were also arranged between Russian and American representatives in
which facts were brought out by the Americans.
e. When UN secretary general Mr. U-thant learnt about the ground realities, he suggested that
American should lift the blockade and start negotiation. Arguing the lethal nature of the
crises the Americans refused to go for lengthy process of negotiations.
f. At the end when the Russian vessels were stopped by the US blockade, the UN was in
picture, Russian had last at diplomatic level, OAS was supporting the Americans, the Russian
were with left no option but to confess their venture. Although, Russian tried to find many
alternative escape routes but they had to submit to the will of the world. They ultimately
agreed to render the missiles non-operational. The crises were over after extensive anxiety
and efforts of 13 days.
LESSONS LEARNT
Analysis of Information. In the chapter dealing with analysis we have discussed in detail the
significance of carrying out critical analysis to establish reliability of the information. It is
interesting to see that even a man like John F. Kennedy perceived the missiles sites as
football ground and his senator brother thought that it was basement of a house. Ultimately
when detailed and undeniable evidence was produced the perception was totally changed.
The lesson learnt is that frequent information received before or during the crises may or may
not be correct. Therefore, no decisions should be taken in hurry without proper analysis and
authenticity of the information.
Time is a Vital Factor. As the famous and old saying goes “Time and tides never wait for
the man”, a crises manager has to run with the speed of the crises. It is worth noting that
during Cuban Crises, the whole group was round the clock busy for consecutively thirteen
days and thirteen nights. Any relaxation or negligence in terms of time, can create
unmanageable problems during the crises management process.
Everyone Must be Listened Sympathetically. The crises management group comprised
men of letters, ability and experience. Everyone of them was taken to be an authority in his
own field yet, very glaring differences occurred among all of them. Their opinions and
perceptions clashed with each other yet, everyone listened to everyone, very patiently and
respectfully. The difference of opinion, arguments and counter arguments and many view
points ultimately lead to a successful solution.
All Concerned Government Departments Must be Represented. It must be appreciated
and accepted that no single person can have command over numerous branches of knowledge
in the modern world. Eye is a very small organ in the human body but only an eye specialist
can deal with the problems related to eyes. Similarly, a politician can not replace a military
soldier and an economist can not answer the questions relating to atomic weapons. Seeing the
nature and level of crises, all relevant government departments, specialists of various subjects
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and experts must form part of the crises management organization. Wherever, the vacuum is
left, it will always be filled by another critical situation.
Different Sources of Information. Receive information from maximum possible reliable
sources. The massive and mighty information technology has made the things much easier
today. During the crises our decisions should not be based on information received from one
source only. As many sources of information as possible should be used and the conclusion
should be drawn using the proper research methodology
Place Yourself in the Other’s Shoes. In political or violent crises it is of great significance
to put yourself in the shoes of your adversary. This will help in measuring the level and kind
of reaction/ retaliation by the opposite. This is useful even in the profession of marketing and
business activity. It is the wearer who knows where the shoe pinches. During a price hike the
best information can be obtained from the customer. Likewise, during the crises the best
feedback is given by the victims. If some particular actor is a source of crises, you always
need to analyse, how he will react against your decision.
Miscalculations and Misunderstandings Escalate Crisis. It is self explanatory that if the
things are miscalculated, misinterpreted and misunderstood, the decisions would also assume
the same shape. In other words wrong decisions would be made which can only escalate the
crises. In June 1963, while delivering a speech at American University, referring to Cuban
crises, John F. Kennedy said “Above all, while defending our own vital interests, nuclear
powers must avert those confrontations which bring an adversary to the choice of either a
humiliating defeat or a nuclear war.”
CONCLUSION
The Cuban Crisis appeared with a chaos and confusion. The first information was not even
taken seriously. However, the efforts for crises management started. A group of experts was
immediately formed, process of getting precise information was accelerated, diplomatic front
became active and all efforts started to win the sympathies of the states. Options were worked
out and decision making was improved day by day. According to 13 Days the Cuban Missile
Crises “The Cuba crisis of 1962 seems to have been an occasion when decision – makers
increased their efficiency by making themselves aware of alternatives. Information,
experience, training and time for consideration, are amongst factors relevant to efficient
decision – making which, along with legitimization, determine the degree to which States can
respond to their environment in ways which do not deny needs to others.” Although it was
known to the decision makers that the missiles would eliminate 80 million Americans in few
minutes, yet spreading of panic was preempted.
This is a classic example of crisis management, which avoided an annihilating atomic war.
The factors contributing towards its success are mainly, establishing authenticity of the
information, making best use of the time, listening carefully to different views, accepting
ground realities and evolving effective decision making process. It is a point to remember
that the president himself controlled the media to avoid panic at home and stem the tide of
rumours to overtake.
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THE IDEAL CRISES MANAGER
Verily in the messenger of Allah ye have a good example....
(The Qur’an, XXXIII,21)
Introduction:
In the words of S.A. Rehman “In the context of interstate relations the word diplomacy seems
to have acquired a bad odour. This is an instance of history projecting itself into semantics.
The Machiavellian tradition effected a divorce between the art of negotiation and the moral
imperative in the national and international fields. But this tradition carried within itself the
seeds of his own nemesis. It has left a trail of bitterness, suspicions and misunderstandings in
its wake which continue to bedevil human relations.”
Hazrat Muhammad (P.B.U.H) was born in the traditional tribal society of Makkah. He did not
own lands, gardens, trade companies or anything which could make one rich and a king. As
the Quran commands, His (P.B.U.H) character was the strongest weapon with Him (P.B.U.H)
which conquered the hearts of the people. He did fight many wars but he managed,
unprecedented crises using the diplomatic tools or Islamic diplomacy.
A diplomat means an honest, able, successful and par excellence negotiator, conciliator and
arbitrator. Prophet (P.B.U.H) will remain an ideal diplomat to be followed till the day of
resurrection.
“Diplomacy as the art of negotiation existed before Islam. In Greece, it meant deception
and cunning, in Byzantine, it comprised coercion and corruption and the role played by
the Florentine diplomats of the Renaissance like Dante, Petrarch, Boccaccio and their
later pupils like Guicciardini and Machiavelli.”
“Muhammad employed diplomacy as a means of education. The Prophet-King of Arabia is
the only king in world history who never lived in a palace, whose seat of power was
practically a mud hut, and who had only one piece of furniture in his reception room for
envoys: a leather-covered bolster. This he (P.B.U.H) offered to his guests, contenting himself
with the solid earth for his own seat.
On the other hand, our Prophet (P.B.U.H) had blessed qualities to be a successful diplomat
and ideal crises manager forever. In the words of Afzal Iqbal
“The Prophet was cheerful, gentle and kind by temperament. He was not stern, rigid or
narrow-minded. He was not fussy and never shouted nor uttered a bad word. He did
not pick holes in others nor did he encourage them to talk ill in his presence.... He had
completely eliminated three things from his character: argumentation, unnecessary
talking, and meddling in matters which did not concern him.... While talking of others
he always kept three considerations in mind – he never talked ill, he never picked holes
and he never talked scandal. He only talked on subjects which could lead to some useful
results.... He disliked listening to his own praise.”
Muhammad (P.B.U.H) emphasised moral integrity at a time when world morality was at a
low ebb. He (P.B.U.H) counted on moral influence as the most essential qualification of an
envoy, who was not to permit himself to depart from honesty even though the dishonesty of
others seemed apparently to justify such a course. Let us eschew evil, he (P.B.U.H) preached,
and not pay back evil in its own coin, however great temptation; for two evils do not make a
good. ‘Repel evil with that which is best,’ commends the Qur’an.
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The value of this lead given by the Prophet (P.B.U.H) over fourteen hundred years ago will
be realised when we notice that Western diplomacy, even after the rise of Islam, remained
undecided on the question whether character, cunning or probity were the most effective
instruments of diplomacy. Even some modern diplomats have sought to justify the diplomatic
lie. All these negative, immoral and unethical acts or instruments can only worsen the crises,
rather than managing them.
Practical Examples of Crises Management by the Prophet (P.B.U.H)
In that critical era of the Prophet (P.B.U.H) tribal society of Arabs was full of crises. The
crises also varied in nature, time, geographical boundaries, tribal entities and egoistic
problems that would always end at bloodshed. Ruthlessness would prevail and it appeared as
if it was not a human society. The greatest crises manager, The last Prophet (P.B.H.U)
managed countless crises using the tool of negotiations, morality, ethics and His (P.B.U.H)
very transparent personality. Some of the examples are given below.
1. The Crises of the Black Stone (Hajr-e-Aswad).
The first glimpse of crisis manager is seen in Hazrat Muhammad (P.B.U.H), at a very young
age, when he was not even invested with the role of Prophet-hood. The Makkan tribes were
rebuilding their place of worship, i.e., Ka’aba, inherited by the Quraish, from Hazrat Ibrahim.
When building was completed, a big issue cropped up that is fixing the Black Stone (The
Stone of Destiny. Fixing the Black Stone was a matter of great honour for the tribe who could
get it. Over this issue very serious crises occurred. Every tribe wanted to snatch this honour.
Bowl full of blood was brought and the blood liquors joined together. This was a vow for the
worst possible retaliation. The crises continued for four days and breathless anxiety prevailed.
“A great bloodshed was not away. On the fifth day the oldest living Qurayshi gave a
suggestion that whoever would enter Ka’aba, the next day, should be accepted as an
arbitrator. The night was with nerves taut and in alternating waves of hope and fear. The long
hours of the dark night seem to stretch into infinity.”
With the dawn of the day young Muhammad in his early twenties enters the Holy Ka’aba.
Everyone says “He is trustworthy one. We are satisfied.” It was really a nerve testing crises
situation. Everyone was thinking with shaken nerves. No one could appreciate the awaited
decision. It was a classic example of pre-empting a very serious crisis. Prophet Muhammad
(P.B.U.H) asked for a sheet, put the Black Stone in it and called leaders of all the tribes to
hold the sheet together and carry the Black Stone to its place.
Hazrat Muhammad (P.B.U.H) then lifted the stone himself and fixed it in its place. Everyone
was feeling honoured and a bloodshed situation was saved. All the leaders and tribes also
thanked Hazrat Muhammad (P.B.U.H) for resolving the serious crises.
2. Treaty of Medina.
This is another classic example of pre-empting serious crises. Prophet (P.B.U.H) migrated to
Medina in the fifty –third years of his life. He (P.B.U.H) has been driven out by his own
people. Structure of society in Medina was not different than Makkah. Lack of leadership:
caused by their pride, conceit, ambition and endless rivalry for tribal supremacy existed.
There were ideological factions also. To avoid any un-toward situation Hazrat Muhammad
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(P.B.U.H) entered into a treaty which is known as the first written alliance in the history of
conduct of international relations. The treaty comprised 47 articles and every tribe, faith and
faction was given representation in the treaty. The control was retained by the Prophet
(P.B.U.H) Himself which was ratified by all member of the treaty. The world ‘equality’
occurs time and again in the treaty. Very clear rules, ways and mechanism to resolve disputes
and critical situations were framed however, in case of failure the matter was to be referred to
the Prophet (P.B.U.H). Why so? Montgomary Walls observes
“The Provision that disputes were to be referred to the Prophet (P.B.U.H) would not
itself increase his (P.B.U.H) power unless he had sufficient tact and diplomacy to find a
settlement that would command general agreement.”
If this treaty was not concluded, there were all the chances of bloodshed.
3. Treaty of Hudabiya ( A classic example of pre-empting crises.)
The treaty of Hudaybiya is very well known in the history. Hudaybiya is a small village in the
north of Makkah. During February 628 A.D-(ZE-Qa,da’) Prophet (PBUH) with nearly 1400
Companions came for performance of Umra (little pilgrimage) which was right of everyone
as no arms were permitted in the Holy Ka’aba. Contrary to all traditions Arabs of Makkah
decided to deny this right to Arabs from Medina.
Khalid Bin Walid, who was later to become one of the most distinguished generals of Islam,
was one of the ringleaders of this movement which rallied all the tribes in Makkah to give
battle to the intended pilgrims from Medina. Prophet (P.B.U.H) offered a treaty of peace
which was denied by the Makkans.
However, when they saw the dedication of the companions of Prophet (P.B.U.H) ‘Urwa (an
old Quraysh) addressing the Quraysh said
“I have been to Khusro in his kingdom, and Caesar in his kingdom, and the Negus in his
kingdom, but never have I seen a king among a people like Muhammad among his
companions. I have seen a people who will never abandon him for any reason, so form
your own Opinion.”
He (Urwa) also misbehaved with The Prophet (PBUH) but Prophet preserved his calm in the
face of provocation, and instead of sealing the traditional Arab revenge. He (P.B.U.H) freed
all the prisoner captured by his men and decided to proceed with his project, to manage the
crisis, through peaceful means. The treaty was ultimately finalized and thus crisis was ideally
managed. Apparently it appeared as if the Muslims have surrendered to the dictation of
Makkans and many companions of the Prophet (P.B.U.H) were also unhappy, but later the
Qu’aran referred to this decision in these words:“And He it is Who hath withheld men’s hands from you, and hath withheld your hands
from them, in the valley of Makkah, after He had made you victors over them. Allah is
Seer of what ye do”
That is how the crises which could turn into a bloody combat clash were managed by the
great crises manager Hazrat Muhammad (P.B.U.H).
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4. Conquest of Makkah.
Makkah was the birth place of the Prophet (P.B.U.H) from where he was forcibly driven out,
in utter helplessness. He (P.B.U.H) was now entering Makkah with a very strong army. When
they entered Makkah one of the commanders is reported to have said:Today is the day of war,
Sanctuary is no more!
When Prophet (P.B.U.H) heard this slogan, He (P.B.U.H) stopped the shouter and addressing
the Makkans said:“Go! You are relieved; no more responsibility burdens you today; you are the freed
ones.”
Makkah was full of Prophet (P.B.U.H)’s enemies who had hurt him to an extent that would
be unbearable for anyone but He (P.B.U.H) pardoned everyone. Had this strategy not been
used, a series of crises would have cropped up. When He (P.B.U.H) forgave a woman like
Hinda she was stunned at this gentle generosity. Identifying herself she told the Prophet:
“Never was a camp more hateful in my eyes than yours, and today none is more beloved
and beautiful than the camp of the Apostle of God.”
Muhammad (P.B.U.H), in the hour of his triumph, restrained his army from shedding blood
and showed every sign of humility and thanksgiving. Has any conqueror in history behaved
so gently or mercifully with the Vanquished foe?
CONCLUSION.
We have gone through only few examples which are self explanatory that Prophet (P.B.U.H)
successfully resolved and stopped the wars and the bloodshed. Although the world today has
changed and values have also been altered, de-shaped and changed yet, the man and his heart
still remains the same. According to Afzal Iqbal “The Prophet (P.B.U.H) implied the
following principles to overcome most of the crises. It can be called moral diplomacy.
Gentleness in human relations
Trust in truth
Faithful communication
Patience for a cause
Modesty and Moderation
Loyalty
Conclusion
1. Having gone through the course we have learnt that crisis is an integral and inseparable
part of human life. Crises walk with the man throughout his life at individual as well as
collective level. The concept of crises is not new. Although, different terminologies have
been used during different eras but the essence really means ‘crises’. Crises accompanied the
man at the time of his birth and welcomed him on this planet also. As the human race grew
more and more the crises also kept changing their form, nature and phenomena. There is
hardly a country in the world that has not faced or is not facing crises in one way or the other
as there is hardly any individual on this earth who has not experienced crises.
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2. Crises can be natural or un-natural i.e. created by the man himself are created by the
natural circumstances. Climatical conditions, weather and land forms, all contribute towards
creation of crises. Earthquakes, snow storms, thunder storms, heavy rains, floods, scorching
heat or freezing cold, prolonging summers or winters all create or contribute towards serious
abnormal conditions which are extremely inhospitable to human life. All these phenomena
are sources of crises. Pakistan is a multi-culture nation having an agrarian economy,
marching towards industrialization and facing all the challenging situations, which have been
created by globalization and vested interests of developed countries, for developing countries.
It is a dire need of the time that we become academically strong, develop our own concept
with a futuristic outlook and design our own means and methods to manage our crises
ourselves. We must clearly understand our basic concepts, have command over research
skills, develop the ability to appreciate and analyse the potential crisis, develop a flawless
decision making ability and have the right means and resources at the right locations. Never
loose sight of the universal truth that human are the basic element for creation of crises and
then they have to face the consequences and mange it themselves. The former comes through
innocence or ignorance and later, requires resources and expertise. Our new world has
innovated many new forms of crises. It has now become a permanent feature and a whole
time job to mange crisis. We cannot afford any ignorance or slackness, by turning our deaf
ear towards this loud sounding bell. Start from yourself and know up to global level.
Be prepared for all times. We now need permanent and efficient organizations to manage the
crises successfully.
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Topic 13
Ethics
"Remembering that I'll be dead soon is the most important tool
I've ever encountered to help me make the big choices in life.
Because almost everything — all external expectations, all pride,
all fear of embarrassment or failure — these things just fall away
in the face of death, leaving only what is truly important."
~ Steve Jobs
Ethics are in your Heart, not in any handouts. I have taught you ethics throughout this course
and also made you aware that if you think with an open mind then you can always
differentiate between right and wrong. I have fulfilled my obligation to impart the knowledge
of business finance on you all and have tried to develop and polish your analytical, critical
thinking and decision making skills. I tried my best to introduce you all to the field of finance
and have always stressed on the fact that no matter what we always have to and need to make
the right ethical decisions. I believe I have been able to develop your acumen to a level where
you can make sound financial decisions for yourselves, your organizations and your country.
I wish that you all have the courage to walk the right path and always consider ethics in your
decision making. I strongly believe all of you will make your country proud of you one day.
In the words of Iqbal:
“Nahin Hay Na Umeed Iqbal Apni Kishtay Veern Say
Zraa Num Ho To Ye Mtti Bary Zrkhaiz Hay Saqi”
In the end I only want to advise you to always think rationally and critically. You must
always think out of the box when making decisions or analysing. Borden your mind and
broaden your abilities by broadening your knowledge. Never make a decision without
analysing all the information you have. When you finally make a decision then stick to it and
if it turns out to be a bad decision then take action to make it right. Remember we all make
mistakes but don’t ever let a mistake make you feel like calling it Quits. As it is said “Girtay
hain shahsawar he Maidan e Jang main Wo tifl kya girain jo ghutnon k bal rengtay hain”.
Always trust your instincts. If you fail try again and again until you succeed. If a tiny ant does
not give up how can we.
“If I can convince it and believe it, I can achieve it, it’s not my aptitude
but my attitude that will determine my altitude.”
I wish you Good Luck in all your future endeavours! It was nice teaching you!
Owais Shafique
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Jawanon ko meri aah-e-sahar day
Phir in shaheen bachon ko baal-o-par day
Khudaya aarzoo meri yahi hei
Mera noor-e-baseerat aam kar day
– Allama Sir Muhammad Iqbal
The
End!!!
J
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