Summary BMA
Chapter 24 The many different kinds of debts
Indenture or trust deed is the agreement called between the bondholder and a trust company
(depends on the kind of bond, mostly a bank)
Registered bonds: the company (the lender)register records the ownership of each bonds and he
company pays the interest and final principal amount directly to each owner.
Bond prices are stated before adding accrued interest. This means that the bond buyer must pay not
only the quoted price but also the amount of any future interest that had accumulated.
Coupon payment is the annual interest paid over each bond. These payments provide protection for
lenders, because they can demand their money back when a company ever fails to make the
payment.
Floating-rate notes are bonds with a variable interest rate. Normally the interest rate is fixed for the
lifetime of a bond. But sometimes the payment maybe a 1% over the Us Treasury bill of the London
interbank offered rate. The interest rate had a bottom and the remaining interest rate is as high as
the LIBOR or other interest funds.
Zero-coupon bond is a bond which pays no interest at all, in this case the entire return consist of
capital appreciation. And there are other kinds of bonds with a lower interest rate and a discount,
but those are not called zero-coupon bond.
Security and seniority
Notes: unsecured short term issues debentures are longer-term issues, also unsecured.
When an bond is secured a lender is allowed to take possession of the relevant assets of the
company that refuses to pay of defaults on its debt. If these assets are insufficient, the remaining
debt will become a general claim, alongside the unsecured bonds (debts).
Mortgage bonds: Are secures bonds. Sometime they provide a claim against a specific building, but
they are more often secures on all of the firm´s property. (met hypothecaire voorwaarden, meestal
een huis dus)
Face value: The face value of bonds usually represents the principal or redemption value. Interest
payments are expressed as a percentage of face value. Before maturity, the actual value of a bond
may be greater or less than face value, depending on the interest rate payable and the perceived risk
of default. As bonds approach maturity, actual value approaches face value.
Redemption value is the price at which the issuing company may choose to repurchase a security
before its maturity date. A bond is purchased at a discount if its redemption value exceeds its
purchase price. It is purchased at a premium if its purchase price exceeds its redemption value.
Equipment trust certificate: also a secured debt. This most frequently used to finance new railroad
rolling stock, or trucks, aircraft and ships. The trustee obtains formal ownership of the equipment.
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Only when all these debts have finally been paid odd does the company become the formal owner of
the equipment. The lifetime of these debts is from1 to 15 years.
The more senior a debt is the sooner he can claim his possession. Normally seniors get around 65%
back.
Asset-backed security: instead of borrowing money directly, companies sometimes bundle up a
group of assets and then sell the cash flows from these assets. The holders of these certificates
simply receive a share of the mortgage payments. (deze constructie is de oorzaak van het ontstaan
van de financiële crisis, er worden hypotheken of andere leningen gebundeld, verkocht aan een
andere partij (voor veel meer dan ze eigenlijk waard zijn) en dan komen ze later in de problemen als
de mensen de hypotheek niet meer kunnen betalen).
Collateralized mortgage obligations: instead of issuing one class of pass-through certificated, the
company will issue several different classes of security.
-
Mortgage payments might be used first to pay of one class of security holders and only then
will other classes start to be repaid
Sinking fund (aflossingsschema) is used to pay bonds with. A company makes a series of payments
into the fond, because they need to pay issue on a regular basis. If the market price of bonds is low,
the firm will buy the bonds in the market and hand them to the dinking fund, if the price is high it will
call the bonds by lottery and put them in the sinking fund, the two ,methods of using a sinking fund.
Generally there is a mandatory fund that must be satisfied and an optional fund that can be stratifies
if the borrower chooses.
Options on bonds
Call options on bonds allows the company to repay the debt early. Puttable (or retractable) bonds
give investors the right to demand early repayment and extendible bonds give them the option to
extend the bond’s life.
Call options bonds are a natural form of protection for the companies. A bond can be sold with a call
protection. In this period companies are not allowed to call the bonds. Remember that companies
must call the bond when the bonds is more worth than the call price. And on the other hand
companies should not call the bonds when the bonds are less worth than the call price. But no
investor will buy bonds when it’s more worth then the call price. So the rule for companies is: Call
the bonds when, and only when, the market price reaches the call price. Companies will call the
bond when the market interest is lower than the coupon interest (the bond value is then higher,
towards the call price)
Puttable bonds can put there borrowers in big trouble. When there is a crisis or something like that,
a large group of investors can ask their money back. In this case companies will have a liquid
problem.
Debts covenants these prevent that a company will gamble with the money of the investors and
purposely increase the value of its default option.
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-
They protect themselves against this risk by prohibiting the company from making further
debt issues unless the ratio of debt to equity is below a specified limit.
When a company defaults (in gebreken is), the senior debt comes first in the pecking order and must
be paid off in full before the junior debt holders get a cent. Therefore, when a company issues senior
debt, the lenders will place limits on further issues of senior debt. But they don’t restrict the amount
of junior debt that the company can issue, because the senior lender are at the front of the queue.
They view the junior debt in the same way that they view equity. Of course, the converse is not true.
Some examples of debt covenants (some rules that lenders prevent taking actions that would
damage the value of their loans):
-
-
Unsecured loans may incorporate a negative-pledge clause, which prohibits the company
from securing additional debt without giving equal treatment to the existing unsecured
bonds.
The loan agreement may limit the amount of additional borrowing buy the company
Lenders may place limit on the company’s dividend payments or repurchases of stock
Convertible bonds
A convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a
type of bond that the holder can convert into shares of common stock in the issuing company or cash
of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features.
Although it typically has a low coupon rate, the instrument carries additional value through the
option to convert the bond to stock, and thereby participate in further growth in the company's
equity value. The investor receives the potential upside of conversion into equity while protecting
downside with cash flow from the coupon payments. It’s actually a straight bond with an option, so
the price you pay more, is the price for the option.
Conversion ratio is the number of shares into which each bond can be converted.
Conversion price: the price you have to pay for the shares (not actually pay, because you trade
them). So it represents the value of the shares you get. Often the values is greater than the stockprice. Otherwise the investors will converts their bonds and sell their stocks with profit. To avoid this
there are lower bounds to the price:
-
Bond value: the price of a bond on the market.
Conversion value: In the securities profession the definition of conversion value is very
narrowly defined as the positive difference between the market price of a convertible
security and the price at which it is convertible.
Convertible bonds are NOT cheap debt.
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Naam van bijzondere obligatie
Callable bond
Puttable bond
Convertible bond
Mortgage bond
Senior bond
Juniro bond
Floating rate bond
Perpetual
Zero coupon bond
Risico
Hoger
Lager
Lager
Lager
Lager
Hoger
Lager
hoger
hoger
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Hoger
Lager
Lager
lager
lager
hoger
Lager
Hoger
Hoger
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Chapter 4 The value of common Stocks
Book value: net worth of the firm according to the balance sheet. The difference between assets and
liabilities gives the book values of GE’s equity. The downside of this method is that is only shows the
historic costs and not the actual value of assets.
Market value balance sheet: financial statement that uses market value of assets and liabilities
Valuation by comparables shows how much investors are prepared to pay for each dollar of assets
or earnings. First the examine a couple of similar firms. This is not always a good way of valuing the
stock price, sometimes it is close to the actual price but sometimes it is miles away.
Liquidatiewaarde: net proceeds that would be realized by selling the firm’s assets and paying of its
creditors. (when a company is liquidized, when the owner stops the company or when id defaults).
Marktwaarde van de ondernemings (Market value): aantal uitgegeven aandelen × aandelenprijs.
Dividend: periodic cash distribution from the firm to the shareholders.
P/E ratio(winst per aandeel): price per share divided by earnings per share (something else than
dividend) And remember not all profit is turned into dividend.
The value of any stock is the present value of its future cash flows (dividend). This reflects the DCF
(discounted-cash-flow) formula. Dividends represent the future cash flows of the firm. Discount (is
contant maken, de huidige waarde dus)
PV (stock) =PV (expected future dividends)
The cash payoff to owners is in two forms: cash dividends and capital gains or losses. The rate of
return the owners expected.
Expected return (rate of return): the percentage yield that an investor forecasts from a specific
investment over a set period of time, sometimes called the market capitalization rate. To calculate
the rate of return you need forecasts of dividends of next year and next year’s price.
𝑟=
𝐷𝑖𝑣1 + (𝑃1 − 𝑃0 ) 𝐷𝑖𝑣1 𝑃1 − 𝑃0
=
+
𝑃0
𝑃0
𝑃0
On the other hand you can calculate the present value of a stock price when you know the rate of
return, the dividends and the next year’s price. This formula only counts for a stock with an
unstoppable equal cash flow of dividends.
𝑃0 =
𝐷𝑖𝑣1
𝐷𝑖𝑣1 + 𝑃1
𝑜𝑟 𝑃0 =
𝑟
1+𝑟
The discount rate r is the market capitalization rate or cost of equity capital. Which is nothing more
that the opportunity cost of capital, defined as the expected return on other securities with the same
risk.
Risk class is a group of shares with approximately the same risk.
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You can use the same formula to calculate next year’s price.
𝑃1 =
𝐷𝑖𝑣2 + 𝑃2
1+𝑟
By this we can forecast P1 by forecasting Div2 and P2, and we can express P0 in terms of Div1, Div2 and
P2
𝑃0 =
1
1
𝐷𝑖𝑣1 + 𝑃2
𝐷𝑖𝑣1 𝐷𝑖𝑣2 + 𝑃2
(𝐷𝑖𝑣1 + 𝑃1 ) =
(𝐷𝑖𝑣1 +
)=
+
1+𝑟
1+𝑟
1+𝑟
1+𝑟
(1 + 𝑟)2
We can use this formula for as much year in the future as we want. The formula than gets.
𝐻
𝐷𝑖𝑣1 𝐷𝑖𝑣2 + 𝑃2
𝐷𝑖𝑣𝐻 + 𝑃𝐻
𝐷𝑖𝑣𝑡
𝑃𝐻
𝑃0 =
+
+ ⋯+
=∑
+
2
𝐻0
𝑡
(1 + 𝑟)
1+𝑟
(1 + 𝑟)
(1 + 𝑟)
(1 + 𝑟)𝐻
𝑡=1
How far can we look into the future with H? In principle the horizon period H could infinitely distant.
Common stocks do not expire of old age. Barring such corporate hazard as bankruptcy or acquisition
they are immoral. As H approaches infinity the present value of the terminal price ought to approach
zero. We can therefore, forget about the terminal price entirely and express today’s price as the
present value of a perpetual stream of cash dividends.
∞
∑
𝑡=1
𝐷𝑖𝑣𝑡
(1 + 𝑟)𝑡
A plausible explanation for why investors expect its stock price to rise by the end of the first year is
that they expect higher dividends and still more capital gains in the second. The DCF formula was
derived from the assumption that price in any period is determined by expected dividends and
capital gains over the next period. Notice that is not correct to say that the value of a share is equal
to the sum of the discounted stream of earnings per share.
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To estimate the price of stock when its growing consistently, we use the following formula:
𝑃0 =
𝐷𝑖𝑣1
𝑟−𝑔
G = the grow rate, and the rest is known. We can transform this formula to calculate r.
𝑟=
The expected return equals the dividend yield
𝐷𝑖𝑣1
+𝑔
𝑃0
𝐷𝑖𝑣1
𝑃0
plus the expected rate of growth in dividends (g).
An alternative approach to estimating long-run growth starts with the pay-out ratio, the ratio of
dividends to earnings per share (EPS).
𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = 1 − 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 1 −
𝐷𝑖𝑣
𝐸𝑃𝑆
Return on equity (ROE) is the ratio of earnings per share to book equity per share:
𝑅𝑒𝑢𝑡𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑅𝑂𝐸) =
𝐸𝑃𝑆
𝑏𝑜𝑜𝑘 𝑒𝑞𝑢𝑖𝑡𝑦 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
There are obvious danger in analysing any single firm’s stock with the constant growth DCF-formula.
First the underlying assumption of regular future growth is at best an approximation. Second, even if
it is an acceptable approximation, errors inevitably creep into the estimate of g.
Voor de essentie van de laatste paragraaf zie de syllabus. Hier wordt deze paragraaf heel goed en
kort uitgelegd (omdat het in het boek lastig te volgen is).
Growth stocks and income stocks. Investors buy primary growth stocks for the expectation of capital
gains and they are interested in the future growth of earnings rather than in next year’s dividend.
The buy income stock primarily for the cash dividends.
Further explanation in the syllabus.
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Chapter 30 Working capital management
Inventories
The purpose of inventory is explained. If you don’t have an inventory and you will just produce what
you think you would sell this day, that would be dump because you can’t supply costumers when
there is an unexpected increase in demand.
But holding inventories must be set against these benefits. Money tied up in inventories does not
warn interest, storage and insurance must be paid. Therefore firms, need to strike a sensible balance
between the benefits of holding inventory and costs.
The optimum order size is termed the economic order quantity, EOQ.
-
Optimal inventory levels involve a trade-off between carrying costs and order csts
Carrying costs include the cost of storing goods as well as the cost of capital tied up in
inventory
A frim can manage its inventories by waiting until they reach some minimum level and then
replenish them by ordering a predetermined quantity (reorder point)
When carrying costs are high and order costs are low, it makes sense to place more frequent
orders and maintain lower levels inventory.
Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal
inventory level rises, but less than proportional.
A just-in-time approach means that a manufactory orders only goods when needed or only produces
goods when an order is coming in. For example: Toyota keeps inventories of auto parts to a minimum by
ordering supplies only as they are needed. Thus deliveries of components to its plants are made throughout
the day at intervals as short as an hour. Toyota is able to operate successfully with such low inventories only
because it has a set of plants to ensure that strikes, traffic snarl-ups or other hazards don’t halt the flow of
components and bring production to a standstill.
Dell discovered that it did not need to keep a large stock of finished computers. Its customers are able to use
the internet to specify what features they want on their PC’s. The computer is then assembled to order and
shipped to the customer.
Credit management
Terms of sale
For some sales you ask cash on delivery (COD), likely when you deliver to irregular costumers. And
when you deliver custom-designed products you can ask for cash before delivery (CBD) or to ask for
progress payments as the work is carried out. So not all sales involve credit.
Each industries had its own particular practices when it comes to payments.
To encourage customers to pay before the final date, it is common to offer a cash discount for
prompt settlement.
If goods are bought on a regular basis, it may be inconvenient to require separate payment for each
delivery. A common solution is to pretend that all sales during the month in fact occur at the end of
the month (EOM).
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Cash discounts are often very large. If you don’t pay within the discount period, you actually lend
money against a very high interest rate. Of course, any firm that delays its payment beyond the due
date gains a cheaper loan but damages its reputation.
The promise to pay
Repetitive sakes t domestic customers are made on an open account. The only evidence of the
customer’s debt is the record in the seller’s books and a receipt signed by the buyer.
Commercial draft is needed when you need a clear commitment from the buyer before delivering
your goods. This works as follows: You draw a draft ordering payment by the customer and send this
to the customer’s bank together with the shipping documents. If immediate payment is required, the
draft is termed a sight draft; otherwise it is known as a time draft. The customer either pays up or
acknowledges the debt by signing it and adding the word accepted. The bank then hands the
shipping documents to the customer and forwards the money or trade acceptance to the seller.
If the credit from the customer it shaky you can ask the customer to arrange for a bank to accept the
time draft and thereby guarantee the customer’s debt. These bankers’ acceptances are often used in
overseas trade, These acceptance are sellable to other banks if you want your money immediately
(or sooner than the deadline).
Also you can let the customer arrange an irrevocable letter of credit. In this case the customer’s
bank sends you a letter stating that it has established a credit in your favour at a bank. Then you
transfer the money to your account.
When you don’t receive payment and you can’t get your goods back. You become a general creditor
of the company. This is avoidable by making a conditional sale, so that you remain the owner of the
goods until payment has been made.
Credit analysis
A number of ways to find out if the credit of the customer is good enough.
-
Check if the customer paid in the past (for existing firms)
Use the firm’s financial statements to make your own assessment (for new firms)
Look how highly investors value the firm (if you are able to, for new firms)
Seek the views of a specialist in credit assessment (the simplest way)
Ask the customer’s bank to perform a credit check
These data is often available from rating agencies or credit bureaus.
Only check large an doubtful orders, otherwise it don’t make sense.
Collecting policy
When a company is in arrears, the usual procedure is to send a statement of account and to follow
this at intervals with increasingly insistent letters or telephone calls. If none of these has effect, most
companies turn the debt over to a collection gent or an attorney.
Small firms who don’t have the scale benefits can obtain some benefits by farming out part of the job
to a factor, which is called factoring.
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The factor and the client agree on a credit limit for each customer. The client makes a sale to an
approved customer, it sends a copy to factoring, and the factor typically charges a fee of 1% or 2%
for administrator and a roughly similar sum for assuming the risk of non-payment. In addition to
taking over the task of debt collection, most factoring agreements also provide financing for
receivable, firms can also raise money by borrowing against their receivables.
If you don’t want help with collection but do want protection against bad debts, you can obtain
credit insurance. Banks are much more willing to lend when exports have been insured.
There is always a potential conflict between the collection operation and the sales department. Sales
representatives commonly complain that they no sooner win new customer than the collection
department frightens them off with threating letter. The collection manager, on the other hand,
bemoans the fact that the sales force is concerned only with winning orders and does not care
whether the goods are subsequently paid for.
There is also a possibility of business loans. This when a firm lends money to its customer. This
happens when the customers is in need of money when for example the bank cut it account off. You
do this when:
-
You have more information than the bank about the customer’s business
You need to look beyond the immediate transaction and recognize that your firm mays stand
to lose some profitable future sales if the customer goes out of business.
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Chapter 6
Projects always cost money, mostly a lot of money. To estimate if the investment is worth it there a
number of solutions for this. There are three general rules:
-
Only cash flow is relevant
Always estimate cash flows on an incremental basis (=differentiële kasstroom)
Be consistent in your treatment of inflation
Only cash flow is relevant
Net present value depends on future cash flows. Cash flows is just the difference between cash
received and cash pay-out. Nothing more, most people confuse this with the accounting principle.
Cash flow represent the dollars you can pay with. It is a totally different thing from the amount of
dollars which are presented on the income statement. Because most of these dollars are not cash
flow, there are counted as expenses but there are not. Like investments, you invest money, you pay
it, but it is not shown on the income statement.
Always estimate cash flows on a after-tax basis.
Make sure the cash flows are recorded only when they occur and not when work is undertaken or a
liability is incurred.
Always estimate cash flows on an incremental basis
The value of a project depends on all the additional cash flows that follow from project acceptance.
Do not confuse average with incremental payoffs. This means that you don’t put more money in a
project that is running bad, either when it’s running good. Always makes sure that the NPV is positive
when you invest a new sum of money in a project.
Include all incidental effects. Sometimes a new project will help the firm´s existing business in a good
way or a bad way. This you have to bring along in the calculation of the NPV. Be aware of hidden
costs.
Forecast sales today and recognize after-sales cash flows to come later. Financial manager should
forecast all incremental cash flows generated by an investment. Sometimes these incremental cash
flows last for decades.
Do not forget working capital requirements. Net working capital is the difference between a
company’s short assets and liabilities. Most projects entails an additional investment in working
capital. Also included this in your calculations for NWC.
Include opportunity costs. The cost of a resource may be relevant to the investment decision even
when no cash changes hands. Compare with or without, and make sure you calculate all the options
good. This can be really difficult
Forget sunk costs (kosten die al zijn gemaakt). They are past and irreversible, so you can forget them
and they are not relevant. It is often cheaper to continue the project
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Beware of allocated overhead costs. Include items as supervisory salaries, rent, heat and light. These
costs must be paid and therefore needed to be included in the NWC calculation. But only included
the extra expenses incurred for doing the project.
Remember salvage value. Don’t forget costs like disarming costs when a project comes to an end.
Some projects have a significant shut-down costs. Remember this and don’t forget.
Threat inflation consistently
Interest rates are usually quoted in nominal rather than real terms. But investors take inflation into
account when they decide what is an acceptable rate of interest (real). Selling prices, labour costs
and material costs are al influenced by the rate of inflations. Tax does not increase because of
inflation. Discount nominal cash flows at a nominal discount rate. Discount real cash flows at a real
rate. Never mix real cash flows with nominal discount rates with real rates.
The method to calculate this is quite simple.
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Chapter 5
Payback period
A project’s payback period is found by counting the number of years it takes before the cumulative
cash flow equal the initial investment. The payback rule states that a project should be accepted if its
period is less than some specified cut-off period.
There are a few difficulties with this method:
-
The payback rule ignores all cash flows after the cut-off date.
The payback rule gives equal weight to all cash flows before the cut-off date.
A frim has to decide on an appropriate cut-off date. This is important, because otherwise it will reject
all good long-term projects and accept all bad short-term projects.
Three ways why the rules is used:
-
It is simple to communicate an idea of project profitability, it is simple to explain to all
partied involved in the project decision.
Some managers think that quicker profits mean quicker promotion, so only the short-term is
relevant.
Worries about future ability to raise capital, it is simpler to use this method.
Sometimes companies discount the cash flows before they compute the payback period, the
discounted payback rule. This answers the question in how many years does the project have to last
in order for it make sense in terms of net present value? This a better way to use it, but it is still not
as accurate as the NPV.
Internal (or discounted-cash-flow) rate of return
𝑝𝑎𝑦𝑜𝑓𝑓
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
−1
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Accept investment opportunities offering rates of return in excess od their opportunity costs of
capital. IRR is used to set the NPV to 0.
𝑁𝑃𝑉 = 𝐶0 +
𝐶1
=0
1 + 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 =
𝐶1
−1
−𝐶0
C1= the payoff and –C0 is the investment.
The discount rate that makes NPV=1 is also the rate of return. This is the base for all IRR
calculations. This method is known as the discounted-cash-flow (DCF) rate of return or internal rate
of return.
To calculate this I refer to the formula paper provided by Nyenrode.
The easties way is to plot the equation en read the crossing point, this is the IRR.
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The internal rate of return rule is to accept an investment project if the opportunity cost of capital is
less than the internal rate of return. It the opportunity cost are higher than the discount rate, then
the project had a positive NPV (when discounted at the opportunity cost of capital). And otherwise
There are a few pitfalls you must not forget.
1. This method does not calculate lend of borrowed money in the IRR. Because you count with
the money you have and not of the cost (or benefits) form capital)
2. In some cases you have multiple rates of return. There are more ways to make the equation
equal to zero. And also in some cases there is no IRR. So always uses a plot to see what
answer is right.
3. Is about the mutually exclusive projects. De IRR houdt geen rekening met de omvang van de
projecten. Een klein project met een relatief hoge IRR kan een lagere absolute NPC hebben
dan een groot project met een lage IRR en een absoluut hogere NPV. Het gevaar bestaat dus
dat je alleen maar kortlopende projecten kiest en geen rekening houdt met wat er op de
langere termijn wordt verdient. Zie ook het blad bij college 8.
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Chapter 28 Financial Analysis
In this chapter ratios are very important. It tells you how the company is performing in comparison
with other companies in the same branch.
Measuring performance
Market capitalization: a measurement of the value of the ownership interest that shareholders hold
in a business enterprise. Is equal to the share price multiplied with the number of outstanding
shares.
Market value added: The difference between the book value of equity and the market value of
equity. So the value added by the good performance of the company. Or the value lost.
Financial managers and analysts uses the market-to-book ratio to calculate how much value had
been added for each dollar that shareholders have invested. See formula paper.
There are two drawbacks in using this method:
-
-
The market value of the company’s shares reflects investor’s expectations about future
performance. Investors pay attention to current profits and investments, but market value
measures can nevertheless be noisy measures of current performance.
You can’t look up the market value of privately owned companies whose shares are not
traded. Nor can you observe the market value of divisions or plants that are parts of lager
companies.
The cost of capital is the minimum acceptable rate of return on capital investment. It is an
opportunity cost of capital, because it equals the expected rate of return on investment
opportunities open to investors in financial markets.
The profit after deducting all costs, including the cost of capital, is called the company’s economic
value added (EVA). You can also express EVA as follows:
𝐸𝑉𝐴 = (
𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
− 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) × 𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
= (𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) × 𝑡𝑜𝑡𝑎𝑙𝑐𝑎𝑝𝑖𝑡𝑎𝑙
The return on capital (ROC) is equal to the total profits that the company has earned for its debt and
equity holders, divided by the amount of money that they have contributed.
𝑅𝑂𝐶 =
𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
(𝑎𝑣𝑒𝑟𝑎𝑔𝑒)𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
To measure the firm’s return per dollar of investment. Companies uses a few common rates. Such as
the return on capital (ROC), the return on equity (ROE) and the return on assets (ROA), these are
called the book rates of return. We uses average when you calculate the rate of return over the
entire book year or period. See the formula paper for the detailed formulas.
Attention: The after-tax is there with a reason. The WACC is the weighted average and also corrected
for tax expenses.
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These ratios show current performance and are not affected by the expectations about future events
that are reflected in today´s stock market prices. They are based on book value, the historic costs
minus depreciation. So older assets could be highly underrated.
Measuring efficiency
Asset turnover ratio: shows how much sales are generated by each dollar of total assets, and
therefore it measures how hard the firm’s assets are working. How efficiently the business is using its
entire asset base. Also in this case you can use averages.
Inventory turnover ratio: How much inventory is in the company. Efficient firms don’t tie up more
capital than they need in raw materials and finished goods. You can also measure this in days and
with averages if it is over a year or period.
Receivables turnover ratio: measures the firm’s sales as a proportion of its receivables. If the ratio is
high it can show that the company is quick to follow up on late payers. But sometimes it also
indicated that the firm has an unduly restive credit policy and offers credit to customers who can be
relied on the pay promptly. Or they sell their receivables. Also the average collection period can be
measures. It this is very low the company has little sales on credit or sells them at a discount. So be
alert on how to interpret these ratios.
The Du Pont system
This is NOT mentions on the formula paper.
Profit margin: the proportion of sales that finds its way into profits. This can be misleading. When
companies have debt, a portion of the profits from the sales must be paid as interest to the firm’s
lenders. So it is useful to uses to operating profit margin.
The Du Pont system shows that the ROA depends on 2 factors, the asset turnover and the operating
profit margin. It is defined as follows:
𝑅𝑂𝐴 =
𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑠𝑎𝑙𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
=
×
𝑎𝑠𝑠𝑒𝑡𝑠
𝑎𝑠𝑠𝑒𝑡𝑠
𝑠𝑎𝑙𝑒𝑠
It is named after the chemical company that makes the formula well known by using it very often.
This helps to identify the constraints that firms faces.
Because debt increases the returns to shareholders in good times and reduces them in bad times, it
is said to create a financial leverage. They measure how much financial leverage the firm has taken
on.
Debt ratio: financial leverage is usually measured by the ratio of long-term debt to total long-term
capital. Measures how much of every dollar of long term capital is in the form of debt. You can also
use the Long-term debt-equity ratio. Again the book ratio of the debt is used. Sometimes it is wise to
include all debt, then you uses the total debt ratio.
Other leverage ratios are: Times-interest-earned ratio and the cash coverage ratio. These ratios are
relatively simple and the speak for themselves. For all ratios see the formula paper.
We can use a large form of the Du Pont system. In this case it is broken into four parts: the leverage
ratio, assert turnover, operating profit margin and the debt burden. See as follows:
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𝑅𝑂𝐴 =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑒𝑞𝑢𝑖𝑡𝑦
𝑎𝑠𝑠𝑒𝑡𝑠 𝑠𝑎𝑙𝑒𝑠 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
=
×
×
𝑒𝑞𝑢𝑖𝑡𝑦 𝑎𝑠𝑠𝑒𝑡𝑠
𝑠𝑎𝑙𝑒𝑠
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
×
𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
The middle two terms are the ROA. The leverage can either increase or decrease the ROE.
Measuring liquidity
You want to know it you can repay a bank loan. This is why it is important to know what the liquidity
of a company is. Liquid assets can be converted into cash quickly and cheaply. This is necessary for
unexpected bills and other expenses. Liquidity assets are easy to pay bills, but it can disappear in
seconds. Otherwise illiquid assets will not disappear during the night, but you can’t convert them into
cash easily. Some assets have a habit of become illiquid when they were very liquid. But too much
cash on bank account is also not good, not efficient.
Net-working-capital-to-total –assets ratio: currents assets are most liquid. They include cash,
marketable securities, inventories and account receivable. Net working capital is the difference
between current assets and current liabilities.
Quick (acid-test) ratio: Some current assets are closer to cash than others. In this case inventory is
excluded from the formula.
Cash ratio: only measures the most liquid assets of a firm. If this is low, it is no problem if the firm an
borrow money on the short term.
Interpreting financial ratios
You can compare ratios with the common-size financial statements. This can in two different ways.
You can compare them with the ratios from the same firm from the past. Or you can compare these
ratios with other firms in the same branch. This is because companies can differ from each other
very much, so a legal comparison can be made only when we look to companies in the same
branches.
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Chapter 29 Financial planning
Short-term liablities
Remember there is a cash circle.
Cash
Raw materials
Receivables
Finished goods
The financial manager’s problem is to forecast future sources and uses of cash.
The first step is to begin with forecasting the future inflows of cash. In this cash you have to
remember that not all receivables are paid on time, so some receivables are collected in the
following period.
Ending accounts receivables = beginning accounts receivables + sales – collections
There are a few ways that cash can flow in, but on the other hand there are a lot of ways you can
cash out, a lot of cash-out flows. A few examples
-
Payments on accounts payable
Inverse in inventories
Labour, administrative, and other expenses
Capital expenditures
Taxes, interest and dividend payments
NO depreciation, because this no cash flow.
Most managers want a minimum operating cash balance, to absorb unexpected cash inflows and
outflows. This is the reason why mostly more liabilities are taken then directly needed. You have to
sum up the needs of credit in the following periods. This is called cumulative financing requirement.
Next it is necessary to develop a short-term financing plan that covers the forecasted requirements
in de most economical way
-
Remember that some outflows will result in a giant inflow of cash because of acquiring an
asset worth more or equal to the cash outflow.
Think about the uncertainty in the estimations you did. It is a model and nothing is sure. This
is why sometimes there is more capital necessary.
Some sources to find short-term capital:
-
Bank loan: mostly the most cheapest way to lent money. The best way to use this it to invest
the money. Because the depreciation will pay the interest back.
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-
Stretching payables: this can be quite expensive when you pay later then the discount
period. It can be a loan with about 25% on a yearly basis.
Syndicated loans, a loan provided by multiple banks
Loan sales and CDO’s, samengevoegde leningen. Dit is de redden van het ontstaan van de
crisis, deze warden verkocht, maar niemand wist meer welke lening bij wie hoorden.
Secured loans, are loans with securities. The most well-known example is that of the
mortgage.
Commercial paper, a kind of obligation with a maturity shorter than 1 year.
Medium term notes, a kind of obligation with a maturity shorter than 1 year
Remember that all ways of borrowing cash will cost money. So this must be paid, if you still run short
in the next period you will have to borrow more money to pay the extra interest of the loan you got
in the first period.
Short-term financing plans are developed by trial and error. There are a lot of questions that remain
after you completed your goal.
Most companies have financial planning models which help to provide the calculations necessary for
the short-term financial plan.
Planning horizon: time horizon for a financial plan. Most companies are asked to make 3 plans. One
best case, a normal (expected) and a worst case scenario. These financial plans help managers ensure
that their financial strategies are consistent with their capital budgets. They highlight the financial
decisions necessary to support the firm’s production and investment goal.
Long-term financial plan
Contingency planning: making a financial planning is not just forecasting. It is important to think
ahead an state goals that the companies wants to achieve in several years. The planners have to take
all these possibilities and option into consideration.
Considering options: Planners need to think whether there are opportunities for the company to
exploit its existing strengths. This will be a good thing for the company in the future.
Forcing consistency: Financial plans should help to ensure that the firm’s goals are mutually
consistent. For example: if your goal is larger profit margin and a higher sales growth, this is not
common. In most cases this will effect each other negatively.
A few steps are important in the process of making a good financial planning:
-
Project next year’s income plus depreciation, assuming the goals set.
Project what additional investment in net working capital and fixed assets will be needed to
support this increased activity and how much of the net income will be paid out as dividends.
Finally, construct a forecast, or pro forma, balance sheet that incorporates the additional
assets and the new levels of debt and equity.
Pitfalls in model design
The model mentioned above is the percentage of sales model (all goals are expressed in a expected
percentage of future sales revenue), is too simple. So it will not cover all pitfalls and will not give a
full and complete picture. And in reality many variables will NOT be proportional to sales.
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Financial planning models help the manager to develop consistent forecasts of crucial financial
variables. Remember not to make models to complex and don’t add to much complexity. And a
planning does not tell you whether the plan is optimal, it only shows the results of the plan, not the
best options.
And also: In any field there will always be 10 problems that can be addresses (the number people can
remember). The remaining problems there is no formal solution.
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Chapter 30 Working capital management
Bank loans
There are a lot of different bank loans. We will discuss the most common±
Commitment: Establishes a line of credit that allows to borrow up to an established limit from the
bank. This line of credit may be an evergreen credit (with not fixed maturity) or a revolving credit
(revolver) with a fixed maturity. Are relatively expensive, you must also pay interest over the amount
of credit that you don’t use.
Maturity: many bank loans are for only a few months. Such as a bridge loan, a loan to finance the
purchase of new equipment or the acquisition of another firm. In this case the loan serves as interim
financing until the purchase is completed and long-term financing arranged. Also a self-liquidating
loan. A loan that pays itself back, such as buying inventory with this loan.
Term loans are loans with a longer-maturity term. Usually these loans are paid back in terms, but
sometimes there is one final balloon payment, a large last term payment. Or just one bullet
payment, the loan is paid back at once. These loans can be negotiated, so the terms are not solid.
Rate of interest: If the rate of interest is not fixed it can fluctuate. Mostly used for this is the LIBOR.
There is a fixed rate of interest and if the LIBOR is above this level, the interest rate becomes higher.
Or the interest is stated above LIBOR with a fixed percentage. So if LIBOR is 2% and 4% above LIBOR,
the interest rate is 6%.
Syndicated loans: A large loan for the long-term that is provided by multiple banks to spread the risk
of the loan. This cost also money, to find other banks to provide the loan.
Loan sales and collateralized debt obligations: this made it possible to trade with loans. This was the
reason for the economic crisis.
Security: This is common on receivables. Then there Is a floating charge. Most firms can lend up to
80% of their receivables. If they drop the limit of credit drops, is normal because you do not need
that much of credit any more when your receivables drop. Also you can secure inventories and of
course buildings (mortgage). You can only move the inventory when the lending is paid off otherwise,
the bank has no money.
Commercial paper
In this case the bank is a middle person for the credit line, but this is costly and complicated. Iy you
need money in another way there is the option of commercial paper. They are just as bonds. Actually
these commercial papers are bonds with a really short maturity time, shorter than 1 year, mostly 60
days or so. Because of this, the risk is higher, so the price (and return on capital) too. Also assetbacked commercial paper.
Medium-term notes (MTN): a longer maturity date than commercial paper. Longer than 270 days,
but shorter than 10 years. Shorter than normal bonds.
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Chapter 1 Goals and Governance of the firm
Managers need to make decisions about investments, because real assets cost money. These
decisions are called capital budgeting or capital expenditure (CAPEX). You have to invest in tangible
assets and intangible assets (such as R&D) to keep continue the business operations. Managers don’t
make these big investment dissensions on their own. And most investments dissensions are small
investments.
Capital structure is the decision of getting equity or debt to finance investment dissension. Capital
refers to the long-term source of financing. All decisions regarding the financing, the maturity, early
pay-off all that kinds of decisions are important.
Equity can be raised in two ways: Issue new shares or invest the cash flow generated from the other
assets. In this case the reinvestment is on behalf of the existing stockholders and no new shares are
issued.
Pay-out decision is the decision the pay out the cash flows generated by the assets.
What is a cooperation? It is a legal entity. It is a legal person that is owned by its shareholders, in the
view of the law. The law regulates how the cooperation is organised en how particular organs are
formed and what their functions are.
There is a Limited liability for the shareholders. This means that the shareholders cannot be held
responsible for the corporations’ debts. Corporations can life forever, because owners (stockholders)
can trade their shares without interrupting the daily basis of the company.
The head of the financial department of a cooperation is the CFO (chief financial officer). The knows
the headlines of the cooperation and makes the financial plans. Under the CFO there is the treasurer
and controller. The treasurer is responsible for the short-term cash management and the controller
will control the intern accounting systems and oversees preparation of its financial statements and
tax return.
For the investments the cost of capital is important and the opportunity cost of capital. This depends
on the risk of the proposed project. But it is not the interest rate the company pays. The opportunity
cost of capital is the expected rate of return forgone by bypassing of other potential investment
activities for a given capital. It is a rate of return that investors could earn in financial markets.
One thing have all shareholders in common: they want maximized the current market value of
shareholders investment in the firm. And if the firm takes to many high risk decisions the
shareholders will sell their shares and show the management that they don´t agree the way the
management takes investment decisions.
Each shareholder want three things
-
to be as rich as possible, that is, to maximize his or her current wealth
to transform that wealth into the most desirable time pattern of consumption either by
borrowing to spend now or investing to spend later
to manage the risk characteristics of that consumption plan.
The only thing the manager can do is maximizing the profits. And the other things will follow
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There is a possibility of market-timing. In this case you buy stock on a closed market from a company
which is making substantial profit on an open market. This is illegal
En should managers always make profits for the shareholders? This is a moral question and the right
answer is that it is not the best thing to do. To make profit for all costs.
And companies are managed by the board of directors because not all shareholders can vote for the
investment decisions and can fire a board or hire board managers.
Agency theory
In political science and economics, the principal–agent problem or agency dilemma treats the
difficulties that arise under conditions of incomplete and asymmetric information when a principal
hires an agent, such as the problem of potential moral hazard and conflict of interest, in as much as
the principal is—presumably—hiring the agent to pursue the principal's interests.
Various mechanisms may be used to try to align the interests of the agent in solidarity with those of
the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance
measurement (including financial statements), the agent posting a bond, or fear of firing.
The principal–agent problem is found in most employer/employee relationships, for example, when
shareholders hire top executives of corporations. Political science has noted the problems inherent in
the delegation of legislative authority to bureaucratic agencies.
As another example, the implementation of legislation (such as laws and executive directives) is open
to bureaucratic interpretation, which creates opportunities and incentives for the bureaucrat-asagent to deviate from the intentions or preferences of the legislators. Variance in the intensity of
legislative oversight also serves to increase principal–agent problems in implementing legislative
preferences.
Agency theorie (organisatiekosten): Gaat uit van tegengestelde belangen tussen de eigenaren (zijn
de aandeelhouders, deze houden afstand van de onderneming en kunnen om deze reden niet alles
beslissen en moeten taken uit handen geven) en managers (zijn lasthebbende, moeten aan de ene
kant presteren, maar de onderneming moet ook goed lopen)
-
Deze scheiding veroorzaakt residual loss andere beslissen over je geld
Agency costs = redidual loss + monitoring costs + branding costs
o Residual loss: de gevolgen van de daden van het management komen uiteindelijk
voor de rekening van de eigenaars. Je laat andere over je geld beschikken. Dit kan
worden verkleind door de volgende maatregelen:
 Monitoring costs: Kosten om het te laten presteren (beloningen), hierdoor
worden managers geprikkeld meer winst te maken. Ook kunnen
aandeelhouders toezicht instellen in de vorm van raad van commissarissen.
 Bonding costs: Kosten die gemaakt worden om te laten zien dat het
management werkt en presteert conform de regels. Zoals jaarrekeningen en
overige rapportages (gaat ook ten kosten van de aandeelhouders, ze houden
immers minder winst over)
o Deze maatregelen kosten allemaal geld, maar zouden het residual loss moeten
verkleinden. Dit gaat vooral spelen in organisaties die vrij groot zijn (anders zijn er
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ook geen aandeelhouders). Dit zorgt dus voor een rem op de grote van de
onderneming
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