An Overview of Finance
Chapter 1
Career Opportunities
in Finance
Financial markets
Investments
Managerial finance
Career Opportunities
in Financial Markets
 Financial institutions
 Banks
 Insurance companies
 Savings and loans
 Credit unions
Career Opportunities
in Investments
 Stock brokerage firms
Career Opportunities
in Investments
 Banks
Career Opportunities
in Investments
 Investment companies
Career Opportunities
in Investments
 Insurance companies
Career Opportunities
in Managerial Finance
 All types of businesses
 Skills used in other fields besides finance
History of
Financial Markets
 Early 1900s - banks were full service
financial organizations
 Crisis of 1907
 Bank failures during 1920s
 Great depression 1929 - 1933
 Legislative reform
 Deregulation since 1970s
History of Investments
 Early 1900s investments dominated by
small group of wealthy investors
 Industrialization during WWI
 Growth of investment firms by 1920s
 Stock market crash 1929 – 1932; market
value decreased > 80%
History of Investments
 Regulations of securities
 Prosperity after WWII
 Inflation and high interest in 1970s
 Increase in individual and institutional
investors
History of
Managerial Finance
 Emergence as a separate field of study
 Early 1900s
 Emphasis on mergers and capitalization
 Wave of mergers during 1920s
 Bankruptcies in 1930s
History of
Managerial Finance
 Liquidity stressed during 1940s & ‘50s
 Analysis and maximizing value in late
1950s and the 1960s
 Innovative risk management in 1970s
History of
Managerial Finance
 Focus on valuation continued in 1980s,
analysis expanded to include:
 Inflation and effects on business decisions
 Deregulation of financial institutions
 Increase in computer analysis and
electronic information transfer
 Increased importance of global markets
 Innovative financial products
History of
Managerial Finance
 1990s have seen evolution continue
 Continued globalization of business
 Further increase in use of technology
 Regulatory attitude of government
Importance of
Managerial Finance
 Financial managers no longer merely
fund the business needs
 Financial managers coordinate decisions
 People in marketing, accounting,
production, and personnel need to
understand finance to do their job well
The Financial Manager’s
Responsibilities
 Obtain and use funds in a way that will
maximize the value of the firm
 Forecasting and planning
 Major investment and financing decisions
 Coordination and control
 Dealing with financial markets
Financial Assets
(Instruments)
Chapter 2
Assets
 Tangible asset
 a physically observable, or touchable, item
Assets
 Financial asset
 an asset that represents a promise to
distribute cash flows some time in the
future
Promissory
Note
Major Financial Instruments

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Treasury bills
Repurchase agreements
Federal funds
Bankers’ acceptances
Commercial paper
Negotiable CDs
Eurodollars
Money market funds


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Treasury notes/bonds
Municipal bonds
Term loans
Mortgages
Corporate bonds
Preferred stock
Common stock
Financial Instruments and
the Firm’s Balance Sheet
 Firm issues financial instruments so it
can purchase the tangible assets
necessary to produce income
Balance Sheet - Equity
 Common equity
 stockholder’s total investment in the firm
 Par value
 nominal or face value of a stock or bond
 Retained earnings
 earnings the firm has not paid out as dividends
throughout its history
 Additional paid-in capital
 difference between the value of newly issued stock
and its par value
Debt
 A loan to an individual, company, or
government
 Debt features
 Principal value
 Face value
 Maturity value
 Par value
More Debt Features
 Interest payments or discounted
securities
 Maturity date
 Priority to assets and earnings
 Control of the firm (voting rights)
Short-Term Debt


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

Treasury Bills (T-bills)
Repurchase Agreement (Repo)
Federal Funds
Banker’s Acceptance
Commercial Paper
Certificate of Deposit
Eurodollar Deposit
Money Market Mutual Funds
Long-Term Debt
 Term Loans
 Bonds
 Government bonds
 Treasury bonds
 Municipal bonds
– Revenue bonds
– General obligation bonds
 Corporate bonds
 Mortgage bonds
Bonds

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Debenture
Subordinated debenture
Income bond
Putable bond
Indexed (purchasing power) bond
Floating rate bond
Zero coupon bond
Junk bond
Bond Contract Features





Bond Indenture
Trustee
Restrictive covenant
Call provision
Sinking fund
 call for redemption by annual lottery
 buy bonds on the open market
 Convertible
Bond Ratings
 Moody’s Investors Service (Moody’s)
 Standard & Poor’s Corporation (S&P)
 Investment grade bonds
 triple B or better
 Criteria for rating bonds
 Importance of bond ratings
 Changes in ratings
Stock (Equity)
 Preferred stock has preference over common
stock in distribution of dividends and assets;
dividend payments are fixed
 Preferred stock may provide for cumulative
dividends, conversion into common stock,
voting rights, dividend participation, sinking
funds, call provisions, and even maturity
Stock (Equity)
 Common stock
 represents ownership in a corporation
 common stockholders vote for members of
the board of directors
 has last claim on distribution of earnings
and assets
 may have preemptive rights to purchase
any additional shares sold by the firm
Stock (Equity)
 Classified stock
 special purpose stock
 Closely held corporations
 Publicly owned corporations
Derivatives
 Value depends on some underlying asset
such as a stock or bond
 Option - contract that gives the right to
buy or sell an asset at a set price within a
specified period of time
 Call: holder has the right to buy
 Put: holder has the right to sell
 Striking price: exercise price of the option
Derivatives
 Covertibles - bonds or preferred stocks
that can be exchanged for common stock
at the option of the holder
 Conversion ratio defines the number of
shares of stock the convertible holder
receives upon conversion
 Futures - arrangement for delivery of an
item at a set future date at a set price
Derivatives
 Swaps - an agreement to exchange cash
flows or assets at a set time in the future
Rationale for Using Different
Types of Securities
 Differences in trade-off between risk and
expected after tax return
 Appeal to broad market and different
investment needs
 Differences in popularity through time
Which Financial Instrument
is Best?
 Issuer’s or investor’s viewpoint ?
 Bonds
 fixed interest payments
 does not represent ownership
 may have restrictions on dividends
 interest expense is deductible
Which Financial Instrument
is Best?
 Preferred stock
 fixed payment - but not obligated
 no voting rights
 higher after-tax cost since dividends are
not deductible expenses
Which Financial Instrument
is Best?
 Common Stock








no obligation of dividend payments
no maturity date for “repayment”
sales increases creditworthiness
prospects affect terms
gives control to stockholders
shares the income of the firm
higher costs of distribution than debt
dividends are not deductible
Financial Instruments in
International Markets
 American Depository Receipts (ADRs)
 represent ownership in stocks of foreign
countries that are held in trust by a bank
located in the country the stock is traded
 Foreign debt
 sold by a foreign borrower but
denominated in the currency of the country
in which it is sold
Financial Instruments in
International Markets
 Eurodebt
 debt sold in a country other than the one in
whose currency the debt is denominated
 Eurobonds
 Eurocredits: usually tied to London
InterBank Offer Rate (LIBOR)
 Euro-commercial paper (Euro-CP)
 Euronotes
Financial Instruments in
International Markets
 Equity instruments
 Euro stock is traded in countries other
than the “home” country of the company,
not including the United States
 Yankee stock is stock issued for foreign
companies that is traded in the United
States
Financial Markets and
the Investment Banking Process
Chapter 3
Financial Markets
 A system comprised of individuals and
institutions, instruments, and procedures
that bring together borrowers and
savers.
Flow of Funds
 Provides the ability to transfer income
through time
 Borrowing sacrifices future income to
increase current income.
 Saving, or investing, sacrifices current
income in exchange for greater expected
income in the future.
Flow of Funds
 1. Direct Transfer
 business sells its stock directly to investors
Flow of Funds
 2. Indirect Transfer through Investment
Bankers
 investment banker acts as middleman and
facilitates issuance of securities by reselling
the securities to savers
Flow of Funds
 3. Indirect Transfer through financial
intermediary
 bank or mutual fund obtains funds from
savers and uses the money to lend or
purchase securities
Market Efficiency
 Economic Efficiency
 Funds are allocated to their optimal use at
the lowest cost
 Transactions costs associated with buying
and selling
Market Efficiency
 Information Efficiency
 Prices of investments reflect existing
information and adjust quickly when new
information enters the market
 Three categories
Informational Efficiency
 1. Weak-form efficiency
 all information contained in past price
movements is fully reflected in current
market prices
 information about recent or past price
trends is of no use when searching for
abnormal returns
Informational Efficiency
 2. Semistrong-form efficiency
 current market prices reflect all publicly
available information
 financial analysis is of no use for finding
mispriced securities
 insiders can profit on their own company’s
stock
Informational Efficiency
 3. Strong-form efficiency
 current market prices reflect all pertinent
information, whether publicly available or
privately held
 even insiders cannot earn abnormal
returns
Types of Financial Markets
 Money Markets
 instruments traded mature in one year or
less
 Capital Markets
 includes instruments with maturities
greater than one year
Types of Financial Markets
 Debt Markets
 treasury, corporate, mortgage-backed,
money market, municipal, etc...
 Equity Markets
 stock markets
Equity Markets
 Primary
 corporations raise funds by issuing new
securities
 Secondary
 securities are traded among investors after
they have been issued
Derivatives Markets
 Options, futures and swaps are securities
whose value is determined, or derived
directly from other assets
 These can be used to manage risk or to
speculate
Types of Stock Market
Transactions
 1. Secondary market
 trading existing stocks
 2. Primary market
 existing firm issues additional shares
 3. Initial Public Offering (IPO)
 privately held company offers stock to the
public for the first time
 called “going public”
The Stock Exchanges
 Organized security exchanges
 tangible physical entities
 New York Stock Exchange (NYSE)
 American Stock Exchange (AMEX)
 Chicago Stock Exchange (CHX)
 Philadelphia Stock Exchange (PHLX)
NYSE Members
 1. Commission brokers
 2. Independent brokers
 3. Competitive traders
 4. Specialists
Listing Requirements
 Quantitative and qualitative
characteristics a firm must possess to be
listed on an exchange
 Vary by exchange
 Number of shareholders, number of
public shares, market value of public
shares, pre-tax income, etc...
Over-the-Counter Market
(OTC)
 Collection of brokers and dealers
connected electronically
 Provides for trading in securities not
listed on the organized exchanges
Over-the-Counter Market
(OTC)
 1. Dealers hold inventory and make a
market
 2. Brokers act as agents in bringing
together dealers with investors
 3. Electronic network provides
communications link
NASD
 Many of the dealers and brokers of the
OTC are members of the National
Association of Securities Dealers
(NASD), which licenses and oversees
trading practices.
NASDAQ
 The computerized trading network used
by NASD is the NASD Automated
Quotation System (NASDAQ) and is a
sophisticated market of its own, separate
from the OTC.
Investment Banker
 Organization that underwrites and
distributes new issues of securities
 Helps businesses and other entities
obtain needed financing
Investment Banking
Process
 1. Help corporations design securities
with the features that are most attractive
to investors given existing market
conditions.
 2. Buy these securities from the
corporations.
 3. Then resell the securities to investors
(savers).
Raising Capital: Stage I
Decisions
 1. Dollars to be raised
 2. Type of securities used
 3. Competitive bid or negotiated deal
 4. Selection of an investment banker
Raising Capital: Stage II
Decisions
 1. Reevaluating the initial decisions
 2. Best efforts or underwritten issues
 3. Issuance (flotation) costs
 4. Setting the offering price
Selling Procedures
 Registration statement
 filed with the SEC
 Prospectus
 summarizes a new security issue and the
issuing company
 Underwriting syndicate
 group of investment banking firms to
distribute the new issue
Shelf Registration
 Securities registered with the SEC for
sale at a later date
Maintenance of the
Secondary Market
 To facilitate orderly market for the new
security, the investment banker
maintains a market for the security
following its issue.
Regulation of Securities
Markets
 Securities and Exchange Commission
(SEC)
 U.S. government agency regulates the
issuance and trading of stocks and bonds
 to ensure investors receive fair financial
disclosures
 to discourage fraud and misleading stock
manipulation
SEC Regulation
 1. Jurisdiction over interstate offerings of
new securities to the general public in
amounts of $1.5 million or more
 2. Regulates national securities
exchanges, and listed companies must file
annual reports
SEC Regulation
 3. Control stock trades by corporate
insiders
 4. Prohibit manipulation of securities
prices by pools or wash sales
International Financial
Markets
 Increasingly global markets
 Greatest growth in emerging markets of
the Pacific Rim
 U. S. exchanges still dominate worldwide
trading activity
Financial Intermediaries and
the Banking System
Chapter 4
Financial Intermediaries
 Specialized financial firms that facilitate
the indirect transfer of funds from savers
to borrowers by offering savings
instruments and borrowing instruments
Financial Intermediation
 The process by which financial
intermediaries transform funds
provided by savers into funds
used by borrowers
Benefits of Intermediaries
 Reduced costs
 Risk/diversification
 Funds divisibility/pooling
 Financial flexibility
 Related services
Types of Intermediaries
 Commercial banks
 Credit unions
 Thrift institutions
 Mutual funds
 Whole life insurance
companies
 Pension funds
Safety (Risk) of Financial
Institutions
 Banks, thrifts and credit unions
 insured by FDIC
 regulated by Federal Reserve
 Insurance companies
 regulated by states
 Pensions
 ERISA established PBGC
 Mutual funds
 SEC
Evolution of Banking
Systems
 Storage of valuables (gold & silver)
 Depository receipts
 Receipts could be traded
 Inventory could be lent out
 Only necessary to maintain enough
reserves to cover demand for withdrawal
(fractional reserves)
Fractional Reserve System
 When the amount of reserves maintained
by a financial institution to satisfy
requests for withdrawals is less than 100
percent of total deposits
Excess Reserves
 Reserves at a bank in excess of the
amount required
 Equal to the total reserves minus the
required reserves
 Available for lending
 an increase in reserves increases the money
supply
Money Supply
 Maximum change in the money supply
equals the excess reserves divided by the
reserve requirement
Excess reserves
Maximum  in M S 
Reserve requirements
U. S. Banking System
 Dual banking system
 bank chartering exists both at state and national
levels
 Intrastate branching
 establishing branch banks within the same state
 Interstate branching
 establishing branch banks in more than one state
Bank Holding Company
 Corporation that owns controlling
interest in one or more banks
Central Banking - The
Federal Reserve System
 Manages the monetary policy of the
country
 Decentralized network of regional,
district banks
 Supervised by the Board of Governors,
appointed by the President
Responsibilities of the Fed
 Monetary Policy
 influence economic conditions (interest
rates) by managing the nations money
supply
Monetary Policy
 Open Market Operations
 buy and sell Treasury securities to expand
or contract the nation’s money supply
 Primary Dealer
– has established relationship with the Federal
Reserve to buy and sell government securities
Monetary Policy
 Reserve requirements
 Discount rate
 charged by the Fed for loans it makes to
banks to meet temporary shortages in
required reserves
Responsibilities of the Fed
(continued)
 Monetary Policy
 Regulate and supervise financial
institutions operating in the United
States
 Check clearing operations provided by
its payment system
U. S. Banking Trends
 Deregulation
 Large financial service corporations
 Overlapping of products available
International Banking
 Other countries have fewer financial
institutions, but with more branches
 Foreign banks are allowed to engage in
non-banking business activities
 Most of the world’s largest banks are not
U. S. banks
 Edge Act
 International Banking Facilities (IBFs)
The Cost of Money
(Interest Rates)
Chapter 5
The Cost of Money
 Interest rates represent the prices paid to
borrow funds
 Equity investors expect to receive
dividends and capital gains
The Cost of Money
 1. Production opportunities
 returns available within an economy from
investment in productive assets
 2. Time preferences for consumption
 the preferences of consumers for current
consumption as opposed to saving for
future consumption
The Cost of Money
 3. Risk
 the chance that a financial asset will not
earn the return promised
 4. Inflation
 the tendency of prices
to increase over time
Interest Rate Levels
 Supply and demand interact to
determine interest rates between capital
markets
 Demand typically declines during
business recessions, shifting the
equilibrium rate down
Interest Rate Levels
 Financial markets are interdependent
Interest Rate Levels
 Financial markets are interdependent
 Shifts in risk premiums, inflation rates,
supply, and demand affect segments of
the market differently
Determinants of Market
Interest Rates
 Quoted interest rate =
 k = k* + IP + DRP + LP + MRP
 k=the quoted or nominal rate
 k*=the real risk-free rate of interest
 IP=inflation premium
 DRP=default risk premium
 LP=liquidity, or marketability, premium
 MRP, maturity risk premium
The Real Risk-Free Rate of
Interest, k*
 The rate of interest that would exist on
default-free U. S. Treasury securities if
no inflation were expected
 Ranges from 1 to 4 percent in the U. S. in
recent years
The Nominal Risk-Free Rate
of Interest, kRF
 kRF = k* + IP
 The rate of interest on a security that is
free of all risk, except inflation
 Proxied by the T-bill rate or T-bond rate
 kRF includes an inflation premium
Inflation Premium (IP)
 A premium for expected inflation that
investors add to the real risk-free rate of
return
Default Risk Premium (DRP)
 Difference between the interest rate on a
U. S. Treasury bond and a corporate
bond of equal maturity and
marketability
 Compensates for risk that a borrower
will default on a loan
Liquidity Premium (LP)
 Premium added to the rate on a security
if the security cannot be converted to
cash on short notice and at close to the
original cost
Interest Rate Risk
 Risk of capital losses to which investors
are exposed because of changing interest
rates
Maturity Risk Premium
(MRP)
 Premium that reflects the interest rate
risk
 Bonds with longer maturities have
greater interest rate risk
 Reinvestment rate risk
Term Structure of Interest
Rates
 Relationship between yields and
maturities of securities
 The graph is a yield curve
Yield Curve
Interest Rate
Figure 5-4
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
Mar-80
Mar-01
1
5
10
20
Years to Maturity
Yield Curve
 “Normal” Yield Curve
 upward sloping yield curve
 Inverted (“Abnormal”) Yield Curve
 downward sloping yield curve
Term Structure Theories
(Explanations)
 Expectations theory
 shape of the yield curve depends on
investors’ expectations about future
inflation rates
 Liquidity preference theory
 lenders prefer to make short-term loans
rather than long-term loans (all else equal)
Term Structure Theories
(Explanations)
 Market segmentation theory
 each borrower has a preferred maturity
and the slope of the yield curve depends on
the supply of and demand for funds in the
long-term market relative to the short-term
market
Other Factors That Influence
Interest Rate Levels
 Federal Reserve policy
 Level of the federal budget deficit
 Foreign trade balance
 Level of business activity
Interest Rates
and Stock Prices
 Higher interest rates increase costs and
thus lower a firm’s profits
 Interest rates affect the level of economic
activity and corporate profits
 Interest rates affect investment
competition between stocks and bonds
Business Organizations and
the Tax Environment
Chapter 6
Alternative Forms of
Business Organization
 Sole Proprietorship - unincorporated
business owned by one individual
Alternative Forms of
Business Organization
 Sole Proprietorship
 Partnership - unincorporated business
owned by two or more persons
Alternative Forms of
Business Organization
 Sole Proprietorship
 Partnership
 Corporation - legal entity created by a
state, separate and distinct from its
owners and managers, having unlimited
life, easy transferability of ownership,
and limited liability
Alternative Forms of
Business Organization
 Sole Proprietorship
 Partnership
 Corporation
 corporate charter is filed with the state
providing information about the company
and directors
Alternative Forms of
Business Organization
 Sole Proprietorship
 Partnership
 Corporation
 corporate charter is filed with the state
providing information about the company
and directors
 bylaws are for internal management and
procedures
Finance in the Organizational
Structure of the Firm
Board of Directors
President
VP Marketing
VP Finance
(CFO)
VP Manufacturing
Treasurer
Credit
Manager
Inventory
Manager
Controller
Director of
Capital
Budgeting
Cost
Accounting
Financial
Accounting
Tax
Department
The Goals of the
Corporation
 Stockholder wealth maximization
 considers the risk and timing associated
with expected earnings per share in order
to maximize the price of the firm’s
common stock
The Goals of the
Corporation
 Stockholder wealth maximization
 Managerial incentives to maximize
shareholder wealth
The Goals of the
Corporation
 Stockholder wealth maximization
 Managerial incentives to maximize
shareholder wealth
 Social responsibility
The Goals of the
Corporation
 Stockholder wealth maximization
 Managerial incentives to maximize
shareholder wealth
 Social responsibility
 Stock price maximization and social
welfare
Managerial Actions to
Maximize Shareholder Wealth
 Profit Maximization
 Will profit maximization also result in
stock price maximization?
Managerial Actions to
Maximize Shareholder Wealth
 Profit Maximization
 Consider:
 total corporate profit versus earnings per
share (EPS)
 timing of earnings
 risk of project
 risk of financing
 dividend payout versus reinvestment
Agency Relationships
 Owner/principal hires an agent and
delegates decision-making authority to
that agent to act on behalf of the
principal
 Agency problem exists when conflict of
interest between principal and agent
 between stockholders and managers
 between stockholders and creditors
Stockholders versus
Managers
 The threat of firing
 The threat of hostile takeover
 due to underpriced stock
 may be warded off with poison pill or
greenmail
 Structuring management incentives
 executive stock options
 performance shares
Stockholders versus
Creditors
 Creditors lend based on expectations
 riskiness of the firms existing assets
 expectations concerning the riskiness of
future asset additions
 the firm’s existing capital structure
 expectations concerning future capital
structure changes (amount of debt)
 Stakeholders must be treated fairly
Factors Affecting Stock Prices
The External Environment
 Legal constraints
 General level of economic activity
 Tax laws
 Conditions in the stock market
Factors Affecting Stock Prices
External Constraints
 Antitrust laws
 Environmental regulations
 Product and workplace safety
regulations
 Employment practice rules
 Federal reserve policy
 International developments
Factors Affecting Stock Prices
Strategic Policy Decisions
Controlled by Management
 Types of product or services
produced
 Production methods used
 Relative use of debt financing
 Dividend policy
Factors Affecting Stock Prices
Level of Economic Activity and
Corporate Taxes
Expected profitability
Timing of cash flows
Degree of risk
Factors Affecting Stock Prices
Stock Market Conditions
Stock price
Business Ethics
 Company’s attitude and conduct toward
its stakeholders (employees, customers,
stockholders…)
 Ethical behavior requires fair and honest
treatment toward all parties
Business Ethics
 Avoids fines and legal expenses
 Builds public trust
 Attracts business from customers who
appreciate and support the firm’s
policies
 Attracts and keeps employees of the
highest caliber
 Supports the economic viability of the
communities in which it operates
Forms of Businesses in
Other Countries
 Public limited company (PLC)
 Aktiengesellshaft (AG)
 Sociedad Anónima (SA)
 Industrial groups
 keiretsu
 chaebol
Multinational Corporations
 Operate in more than one country
 To seek new markets
 To seek raw materials
 To seek new technology
 To seek production efficiency
 To avoid political and regulatory hurdles
Multinational versus Domestic
Managerial Finance
 Different currency denominations
Multinational versus Domestic
Managerial Finance
 Different currency denominations
 Economic and legal ramifications
 Language differences
 Cultural differences
Multinational versus Domestic
Managerial Finance
 Different currency denominations
 Economic and legal ramifications
 Language differences
 Cultural differences
 Role of governments
Multinational versus Domestic
Managerial Finance
 Different currency denominations
 Economic and legal ramifications
 Language differences
 Cultural differences
 Role of governments
 Political risk
The Federal Income Tax
System
 Count on changes
 indexed items
 new tax laws
Individual Income Taxes
 Progressive tax: higher tax on higher
incomes
 Taxable income is gross income minus
exemptions and allowable deductions
 Marginal tax rate is the tax on the last
unit of income
 Average tax rate is taxes paid divided by
taxable income
Taxes On Dividend and
Interest Income
 Dividends are paid out of earnings that
have already been taxed
 Interest on most state and local
government bonds (municipals) is not
subject to federal income taxes
Comparing Yields Tax-free
and Taxable
Equivalent pre-tax yield
on a taxable investment
=
Yield on tax-free investment
1 - Marginal tax rate
A taxpayer in the 30% marginal tax bracket who
could buy a municipal bond that yields 10 %
would have to receive a before-tax yield of 14.3%
on a corporate or US Treasury bond to have the
same after-tax yield.
10%

 14.3%
1  0.30
Individual Income Taxes
 Interest paid by individuals is generally
not deductible, with the exception of
mortgage interest
 Capital gains versus ordinary income
 profit from sale of capital asset
 benefits of long-term capital gains
 Business versus personal expenses
Corporate Income Taxes
 Interest and dividend income received by
a corporation
 70% of dividends received by another
corporation is excluded from taxable
income
 Interest and dividends paid by a
corporation
 interest is deducted from income
Corporate Income Taxes
 Corporate capital gains
 currently taxed at same rate
 Corporate loss carryback and carryover
 losses can be carried back 2 years and
carried over to the next 20 years
 Accumulated earnings tax
Corporate Income Taxes
 Consolidated corporate tax returns
 if own 80% or more
 S Corporations
 small corporation that elects to be taxed as
a proprietorship or partnership yet retains
limited liability and other benefits of
incorporating
Corporate Tax Rates
in Other Countries
I. Developed
Markets
Australia
Tax Rate
Canada
44.6
France
36.7
Germany
57.4/44.1
Italy
53.2
Japan
51.6
Netherlands
35.0
Switzerland
28.5
United Kingdom
31.0
United States
40.0
36.0%
Corporate Tax Rates
in Other Countries
II. Emerging Markets Tax Rate
Brazil
25.0
Chile
15.0
China, PR
33.0
India
35.0
Indonesia
30.0
Korea
30.8
Malaysia
30.0
Mexico
34.0
Philippines
35.0
Thailand
30.0
Depreciation
 Expensing the price of a long-term asset
over time
End of Chapter 6
Business
Organizations
and the
Tax Environment
Analysis of
Financial Statements
Chapter 7
Financial Statements
and Reports
 Annual Report
 a report issued annually by a corporation
to its stockholders
 management’s opinion of the past year’s
operations and the firm’s future prospects
Financial Statements
and Reports
 Annual Report
 basic financial statements
 income statement
 balance sheet
 statement of retained earnings
 statement of cash flows
Financial Statements
and Reports
 Income Statement
 a statement summarizing the firm’s
revenues and expenses over an accounting
period, generally a quarter or a year
Financial Statements
and Reports
 Balance Sheet
 a statement of the firm’s financial position
at a specific point in time
Financial Statements
and Reports
 Balance Sheet - points worth noting
 1. Cash versus other assets
 2. Liabilities versus stockholders equity
 3. Breakdown of common equity account
 common stock
 paid in capital
 retained earnings
Financial Statements
and Reports
 Balance Sheet - points worth noting
 4. Accounting alternatives
 FIFO (first-in, first-out)
 LIFO (last-in, first-out)
 Accelerated or straight-line depreciation
 The time dimension
– balance sheet is at a point in time
Financial Statements
and Reports
 Statement of Retained Earnings
 a statement reporting changes in the firm’s
retained earnings as a result of the income
generated and retained during the year
 the balance sheet figure for retained
earnings is the sum of the earnings retained
for each year the firm has been in business
Financial Statements
and Reports
 Accounting income versus cash flow
 cash flows
 the cash receipts and the cash disbursements,
as opposed to the revenues and expenses
reported for computation of net income,
generated by a firm during some specified
period
Financial Statements
and Reports
 Accounting income versus cash flow
 accounting profit
 a firm’s net income as reported on its income
statement
 operating cash flows
 those cash flows that arise from normal
operations
 the difference between cash collections and
cash expenses
Financial Statements
and Reports
 Statement of cash flows
 a statement reporting the impact of a
firm’s operating, investing, and financing
activities on cash flows over an accounting
period
Financial Statements
and Reports
 Statement of cash flows
 sources of cash
 increase in liability or equity account
 decrease in an asset account
 uses of cash
 decrease in a liability or equity account
 increase in an asset account
Ratio Analysis
 Liquidity ratios
 ratios that relates the firm’s cash and other
assets to its current liabilities
 Liquid asset
 an asset that can be easily converted into
cash without significant loss of its original
value
Ratio Analysis
 Current ratio
 indicates the extent to which current
liabilities are covered by assets expected to
be converted into cash in the near future
Current assets
Current ratio 
Current Liabilitie s
Ratio Analysis
 Quick (acid test) ratio
 deducts inventories from current assets
and divides the remainder by current
liabilities
 a variation of the current ratio
Current assets - Inventorie s
Quick ratio 
Current Liabilitie s
Ratio Analysis
 Asset management ratios
 ratios that measure how effectively a firm
is managing its assets
Ratio Analysis
 Inventory turnover ratio
Cost of Goods Sold

Inventorie s
Ratio Analysis
 Days sales outstanding (DSO)
Receivables
Receivables


Average sales per day  Annual sales 


360
Ratio Analysis
 Fixed assets turnover ratio
Sales

Net fixed assets
Ratio Analysis
 Total assets turnover ratio
Sales

Total assets
Ratio Analysis
 Debt management ratios
 analyze the company’s use of debt
 Financial leverage
 the use of debt financing
Ratio Analysis
 Debt ratio
Total debt

Total assets
Ratio Analysis
 Times-interest-earned (TIE) ratio
EBIT

Interest Charges
Ratio Analysis
 Fixed charge coverage ratio
EBIT  Lease payments

Interest  Lease   Sinking fund payments 


1  Tax rate


Charges payments
Ratio Analysis
 Profitability ratios
 ratios showing the effect of liquidity, asset
management, and debt management on
operating results
Ratio Analysis
 Net profit margin on sales
Net income

Sales
Ratio Analysis
 Return on total assets (ROA)
Net income

Total assets
Ratio Analysis
 Return on common equity (ROE)
Net income available
to common stockholde rs

Common equity
Ratio Analysis
 Market value ratios
 ratios that relate the firm’s stock price to
its earnings and book value per share
Ratio Analysis
 Earnings per share (EPS)
Net income available
to common stockholde rs

Number of common
shares outstandin g
Ratio Analysis
 Price/Earnings (P/E) ratio
Market price per share

Earnings per share
Ratio Analysis
 Book value per share
Common equity

Number of common
shares outstandin g
Ratio Analysis
 Market/Book (M/B) ratio
Market price per share

Book value per share
Ratio Analysis
 Trend analysis
 an analysis of a firm’s financial ratios over
time
 used to determine improvement or
deterioration in its
financial situation
Ratio Analysis
 Summary of ratio analysis:
The Du Pont Chart
 a chart designed to show the relationships
among return on investment, asset
turnover, the profit margin, and leverage
Ratio Analysis
 Du Pont Equation
ROA  Net profit margin  Total assets turnover
Net income
Sales


Sales
Total Assets
Ratio Analysis
 Comparative ratio analysis
 an analysis based on a comparison of a
firm’s ratios with those of other firms in
the same industry
Uses and Limitations of
Ratio Analysis
 1. Large firms operate divisions in
different industries
 difficult to develop meaningful industry
averages
 2. If the goal is to be better than average,
industry averages are not the target
 focus on the industry leaders’ ratios
Uses and Limitations of
Ratio Analysis
 3. Inflation distorts balance sheets
 depreciation and inventory costs affect
income statements
 comparative analysis of firm over time
 comparing firms of different ages
Uses and Limitations of
Ratio Analysis
 4. Seasonal factors distort ratios
 use monthly averages as base for inventory
and receivables instead of one particular
month
 5. Window dressing techniques
 make financial statements appear better
than they actually are
 borrowing “long-term” to be repaid
quickly distorts liquidity ratios
Uses and Limitations of
Ratio Analysis
 6. Different accounting practices
 distorts comparisons
 inventory valuation
 depreciation methods
Uses and Limitations of
Ratio Analysis
 7. Difficult to generalize about “good” or
“bad” ratios
 high current ratio can indicate strong
liquidity or excessive cash
 high fixed assets turnover can indicate
efficient use or undercapitalized
Uses and Limitations of
Ratio Analysis
 8. Firm may have some “good” ratios
and others that look “bad”
 difficult to tell whether overall the
company is strong or weak
 statistical procedures can analyze the net
effects of a set of ratios
Stock Dividends
and Stock Splits
 Stock splits
 an action taken by the firm to increase the
number of shares outstanding, such as
doubling the number of shares outstanding
by giving each shareholder two new shares
for each one formerly held
Stock Dividends
and Stock Splits
 Stock dividends
 a dividend paid in the form of additional
shares of stock rather than in cash
 Balance sheet effects
 stock splits reduce the stock “par value”
proportionately
 stock dividends do not reduce the “par
value” but transfer retained earnings to
common stock and paid-in capital accounts
Stock Dividends
and Stock Splits
 Price effects
 merely issuing additional shares does not
increase the market value of the company,
and can reduce share price due to dilution
 increasing earnings and dividends
increases the value of the company
Financial Planning
and Control
Chapter 8
Financial Planning
 The projection of sales, income, and
assets based on alternative production
and marketing strategies, as well as the
determination of the resources needed to
achieve these projections
Financial Control
 The phase in which financial plans are
implemented
 Control deals with the feedback
and adjustment process
required to ensure
adherence to plans and
modification of plans
because of unforeseen changes
Sales Forecasts
 A forecast of a firm’s unit and dollar
sales for some future period
Sales Forecasts
 A forecast of a firm’s unit and dollar
sales for some future period
 Generally based on recent sales trends
plus forecasts of the economic prospects
for the nation, region, industry, and so
forth
Projected (Pro Forma)
Financial Statements
 Project the asset requirements for the
coming period, then project the liabilities
and equity that will be generated under
normal operations, and subtract the
projected liabilities and equity from the
required assets to estimate the additional
funds needed (AFN) to support the level
of forecasted operations
Projected
Balance Sheet Method
 A method of forecasting financial
requirements based on forecasted
financial statements
 1. Forecast the Income Statement
 2. Forecast the Balance Sheet
 Adjust for spontaneously generated funds
obtained from routine business transactions
Projected
Balance Sheet Method
 A method of forecasting financial
requirements based on forecasted
financial statements
 1. Forecast the Income Statement
 2. Forecast the Balance Sheet
 3. Determine how to raise the additional
funds needed
Projected
Balance Sheet Method
 A method of forecasting financial
requirements based on forecasted
financial statements
 1. Forecast the Income Statement
 2. Forecast the Balance Sheet
 3. Determine how to raise the additional
funds needed
 4. Financing feedbacks
Projected
Balance Sheet Method
 Financing feedbacks are the effects on
the income statement and balance sheet
of actions taken to finance forecasted
increases in assets
Projected (Pro Forma)
Financial Statements
 Analysis of the forecast
 determine if the forecast meets the firm’s
financial targets
 planned management changes must be
incorporated into the forecasts
 iterative process
Other Considerations
in Forecasting
 Excess capacity
Sales level
Full capacity sales 
 Percent of capacity used 
 to generate sales level 
Other Considerations
in Forecasting
 Economies of scale
 variable cost of goods sold ratio changes
with size of the firm
 this affects the addition to retained
earnings, and thus the AFN
Other Considerations
in Forecasting
 Lumpy assets
 assets that cannot be acquired in small
increments, but must be obtained in large,
discrete amounts
Other Considerations
in Forecasting
 Lumpy assets
 assets that cannot be acquired in small
increments, but must be obtained in large,
discrete amounts
 small increase in sales can require
significant increase in plant and equipment
Financial Control Budgeting and Leverage
 Relationship between sales volume and
profitability under different operating
conditions
 Control phase and process
Operating
Breakeven Analysis
 An analytical technique for studying the
relationship among sales revenues,
operating costs, and profits
 Only deals with the operating section of
the income statement
Operating
Breakeven Analysis
 Operating breakeven point
 represents the level of production and sales
where operating income is zero
 the point where revenues from sales just
equal total operating costs
Breakeven Graph
Revenues and Costs
($ millions)
Total Sales
1,400 Revenues (P x Q)
Total Operating
1,200 -Operating Profit
Costs (F + Q x V)
(EBIT > 0)
000 Operating Breakeven
SBE 855 Point (EBIT = 0)
00 - Operating
- Loss
-(EBIT < 0)
00 00 100
Total fixed Costs (F)
93.5
0
20
40 57 60
QBE
80
100
120
Units Produced and
Sold(millions)
Breakeven Computation
Sales
Total
revenues (P = operating
x Q)
costs
=
Total
variable
costs
+
Total
fixed
costs
(P x Q) = TOC = (V x Q) + F
F
F
QBE 

P - V Contributi on margin
SBE
F
F


 V  Gross profit margin
1-  
P
Using Operating
Breakeven Analysis
 New product decisions
 required sales to achieve profitability
 Expansion of operations
 increase fixed and variable costs
 increase sales
 Modernization and automation
 increased fixed and reduced variable costs
Operating Leverage
 The existence of fixed operating costs,
such that a change in sales will produce a
larger change in operating income
(EBIT)
Operating Leverage
 Degree of operating leverage (DOL)
 the percentage change in NOI (or EBIT)
associated with a given percentage change
in sales
 EBIT   EBIT 

 

Percentage change in NOI  EBIT   EBIT 
DOL 


Percentage change in sales  Sales 
 Q 




 Sales 
 Q 
Operating Leverage
Q P - V 
DOL Q 
Q P - V   F

Q  P   Q  V 
Gross profit
DOL S 

Q  P   Q  V   F
EBIT
Operating Leverage
 Operating leverage and operating
breakeven
 higher operating leverage increases
operating breakeven point
Financial Leverage
 The existence of fixed financial costs such
as interest
 When a change in EBIT results in a
larger change in EPS
Financial Leverage
 Degree of financial leverage (DFL)
 the percentage change in EPS that results
from a given percentage change in EBIT
Financial Leverage
 EPS 


Percentage change in EPS
EPS 
DFL 
 
Percentage change in EBIT  EBIT 


 EBIT 
EBIT
EBIT
DFL 

EBIT - I EBIT - Financial BEP 
Combining Operating
and Financial Leverage
 The greater degree of operating leverage, or
fixed operating costs for a particular level of
operations, the more sensitive EBIT will be to
changes in sales volume
Combining Operating
and Financial Leverage
 The greater degree of operating leverage, or
fixed operating costs for a particular level of
operations, the more sensitive EBIT will be to
changes in sales volume
 The greater the degree of financial leverage (or
fixed financial costs for a particular level of
operations), the more sensitive EPS will be to
changes in EBIT
Combining Operating
and Financial Leverage
 If a firm has a considerable amount of
both operating and financial leverage,
then a small change in sales will lead to
wide fluctuations in EPS
 Degree of total leverage (DTL)
 the percentage change in EPS resulting
from a change in sales
Combining Operating
and Financial Leverage
Gross profit
EBIT
DTL 

EBIT
EBIT - Financial BEP 
Gross profit

EBIT - Financial BEP 
S  VC
Q P - V 


EBIT - I QP  V   F   I
Using Leverage and
Forecasting for Control
 Changes in operations affect income,
which impacts on the balance sheet and
the financing needs of the firm
 Forecasted results and their impact can
be adjusted ahead of time
 Feedback needs evaluated
Cash Budgeting
 Cash budget
 a schedule showing cash receipts, cash
disbursements, and cash balances for a
firm over a specified time period
 Target (minimum) cash budget
 the minimum cash balance a firm desires to
maintain in order to conduct business
Cash Budgeting
 Disbursements and receipts method
(scheduling)
 the net cash flow is determined
by estimating the
cash disbursements and
the cash receipts
expected to be generated
each period
The Time Value of Money
Chapter 9
The Time Value of Money
 Which would you rather have ?
 $100 today - or
 $100 one year from today
 Sooner is better !
The Time Value of Money
 How about $100 today or $105 one year
from today?
 We revalue current dollars and future
dollars using the time value of money
 Cash flow time line graphically shows the
timing of cash flows
Cash Flow Time Lines
 Time 0 is today; Time 1 is one period from today
Interest rate
0
1
5%
Time
Cash Flows
-100
Outflow
105
Inflow
2
3
4
5
Future Value
 Compounding
 the process of determining the value of a
cash flow or series of cash flows some time
in the future when compound interest is
applied
Future Value
 PV = present value or starting amount,
say, $100
 i = interest rate, say, 5% per year would
be shown as 0.05
 INT = dollars of interest you earn during
the year $100 0.05 = $5
 FVn = future value after n periods or
$100 + $5 = $105 after one year
 = $100 (1 + 0.05) = $100(1.05) = $105
Future Value
FV1  PV  INT
 PV  PV(i)
 PV(1  i)
Future Value
 The amount to which a cash flow or
series of cash flows will grow over a
given period of time when compounded
at a given interest rate
Compounded Interest
 Interest earned on interest
FVn  PV(1  i)
n
Cash Flow Time Lines
Time
0 5%
1
2
3
4
5
5.00
5.25
5.51
5.79
6.08
Total Value 105.00
110.25
-100
Interest
115.76 121.55 127.63
Future Value Interest Factor
for i and n (FVIFi,n)
 The future value of $1 left on deposit for
n periods at a rate of i percent per period
 The multiple by which an initial
investment grows because of the interest
earned
Future Value Interest Factor
for i and n (FVIFi,n)
 FVn = PV(1 + i)n = PV(FVIFi,n)
Period (n)
1
2
3
4
5
6
4%
1.0400
1.0816
1.1249
1.1699
1.2167
1.2653
5%
6%
1.0500
1.1025
1.1576
1.2155
1.2763
1.3401
1.0600
1.1236
1.1910
1.2625
1.3382
1.4185
For $100 at i = 5% and n = 5 periods
Future Value Interest Factor
for i and n (FVIFi,n)
 FVn = PV(1 + i)n = PV(FVIFi,n)
Period (n)
1
2
3
4
5
6
4%
1.0400
1.0816
1.1249
1.1699
1.2167
1.2653
5%
6%
1.0500
1.1025
1.1576
1.2155
1.2763
1.3401
1.0600
1.1236
1.1910
1.2625
1.3382
1.4185
For $100 at i = 5% and n = 5 periods
$100 (1.2763) = $127.63
Financial Calculator
Solution
 Five keys for variable input
 N = the number of periods
 I = interest rate per period
may be I, INT, or I/Y
 PV = present value
 PMT = annuity payment
 FV = future value
Two Solutions
 Find the future value of $100 at 5%
interest per year for five years
 1. Numerical Solution:
Time
0
5%
Cash
-100
Flows
1
2
3
5.00
5.25
5.51
4
5.79
5
6.08
Total Value 105.00 110.25 115.76 121.55 127.63
FV5 = $100(1.05)5 = $100(1.2763) = $127.63
Two Solutions
2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PV = -100 PMT = 0 FV = ?
Output: = 127.63
Graphic View of the Compounding
Process: Growth
 Relationship among Future Value,
Growth or Interest Rates, and Time
Future Value of $1
5
i= 15%
4
i= 10%
3
i= 5%
2
1
0
1
0
2
4
6
i= 0%
8
10
Periods
Present Value
 Opportunity cost
 the rate of return on the best available
alternative investment of equal risk
 If you can have $100 today or $127.63 at
the end of five years, your choice will
depend on your opportunity cost
Present Value
 The present value is the value today of a
future cash flow or series of cash flows
 The process of finding the present value
is discounting, and is the reverse of
compounding
 Opportunity cost becomes a factor in
discounting
Cash Flow Time Lines
0
1
2
3
4
5
5%
PV = ?
127.63
Present Value
 Start with future value:
 FVn = PV(1 + i)n
 1 
FVn
PV 
 FVn 
n
n
(1  i)
 1  i  
Two Solutions
 Find the present value of $127.63 in five years
when the opportunity cost rate is 5%
 1. Numerical Solution:
0
5% 1
2
3
PV = ? ÷ 1.05
÷ 1.05
÷ 1.05
-100.00 105.00
110.25
115.76
4
÷ 1.05
5
127.63
121.55
$127.63 $127.63
PV 

 $127.63(0.7835)  $100
5
1.2763
1.05
Two Solutions
 Find the present value of $127.63 in five
years when the opportunity cost rate is
5%
 2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PMT = 0 FV = 127.63 PV = ?
Output: = -100
Graphic View of the
Discounting Process
Present Value of $1
 Relationship among Present Value,
1 Interest Rates, and Time
i= 0%
0.8
0.6
i= 5%
0.4
i= 10%
0.2
0
2
4
6
8
i= 15%
10
12
14
16
18
Periods
20
Solving for Time and
Interest Rates
 Compounding and discounting are
reciprocals
 FVn = PV(1 + i)n
 1 
FVn
PV 
 FVn 
n
n
(1  i)
 1  i  
Four variables: PV, FV, i and n
If you know any three, you can solve for the fourth
Solving for i
 For $78.35 you can buy a security that
will pay you $100 after five years
 We know PV, FV, and n, but we do not
know i
0 i=?
-78.35
1
2
3
4
FVn = PV(1 + i)n
$100 = $78.35(1 + i)5 Solve for i
5
100
Numerical Solution
 FVn = PV(1 + i)n
 $100 = $78.35(1 + i)5
$100
5
1  i  
 1.2763
$78.35
1
5
1  i   1.2763  1.05
i  1.05 - 1  0.05
Financial Calculator
Solution
 Inputs: N = 5 PV = -78.35 PMT = 0
FV = 100 I = ?
 Output: = 5
 This procedure can be used for any rate
or value of n, including fractions
Solving for n
 Suppose you know that the security will
provide a return of 10 percent per year,
that it will cost $68.30, and that you will
receive $100 at maturity, but you do not
know when the security matures. You
know PV, FV, and i, but you do not know
n - the number of periods.
Solving for n
 FVn = PV(1 + i)n
 $100 = $68.30(1.10)n
 By trial and error you could substitute
for n and find that n = 4
0 10%
-68.30
1
2
n-1
n=?
100
Financial Calculator
Solution
 Inputs: I = 10 PV = -68.30 PMT = 0
FV = 100 N = ?
 Output: = 4.0
Annuity
 An annuity is a series of payments of an equal
amount at fixed intervals for a specified
number of periods
 Ordinary (deferred) annuity has payments at
the end of each period
 Annuity due has payments at the beginning of
each period
 FVAn is the future value of an annuity over n
periods
Future Value of an Annuity
 The future value of an annuity is the
amount received over time plus the
interest earned on the payments from the
time received until the future date being
valued
 The future value of each payment can be
calculated separately and then the total
summed
Future Value of an Annuity
 If you deposit $100 at the end of each year for
three years in a savings account that pays 5%
interest per year, how much will you have at the
end of three years?
0
5%
1
2
100
100
3
100.00 = 100 (1.05)0
105.00 = 100 (1.05)1
110.25 = 100 (1.05)2
315.25
Future Value of an Annuity
FVA n  PMT(1  i)0  PMT(1  i)1    PMT(1  i)n -1  PMT
n -1

t 0
1  i t
 1  i n  1
n
nt 

 PMT  1  i 
 PMT 

t 1

i


 1.053  1
FVA 3  $100
  $100(3.1525)  $315.25
 0.05 
Future Value of an Annuity
 Financial calculator solution:
 Inputs: N = 3 I = 5 PV = 0 PMT = 100 FV = ?
 Output: = 315.25
 To solve the same problem, but for the
present value instead of the future value,
change the final input from FV to PV
Annuities Due
 If the three $100 payments had been
made at the beginning of each year, the
annuity would have been an annuity due.
 Each payment would shift to the left one
year and each payment would earn
interest for an additional year (period).
Future Value of an Annuity
 $100 at the end of each year
0
5%
1
2
100
100
3
100.00 = 100 (1.05)0
105.00 = 100 (1.05)1
110.25 = 100 (1.05)2
315.25
Future Value of
an Annuity Due
 $100 at the start of each year
0
100
5%
1
2
100
100
3
105.00
= 100 (1.05)1
110.25
= 100 (1.05)2
115.7625 = 100 (1.05)3
331.0125
Future Value of
an Annuity Due
 Numerical solution:
n
t
FVA(DUE) n  PMT  1  i  
 t 1

 n

n -t 
 PMT  1  i    1  i 

 t 1

 1  i n  1

 PMT 
  1  i 
i



Future Value of
an Annuity Due
 Numerical solution:
  1.053  1

FVA(DUE)n  $100 
  1.05
  0.05 

 $1003.1525  1.05
 $331.0125
Future Value of
an Annuity Due
 Financial calculator solution:
 Inputs: N = 3 I = 5 PV = 0 PMT = 100 FV = ?
 Output: = 331.0125
Present Value of an Annuity
 If you were offered a three-year annuity
with payments of $100 at the end of each
year
 Or a lump sum payment today that you
could put in a savings account paying 5%
interest per year
 How large must the lump sum payment
be to make it equivalent to the annuity?
Present Value of an Annuity
0
100
 95.238
1
1.05
100
 90.703
2
1.05
100
 86.384
3
1.05
272.325
5%
1
2
3
100
100
100
Present Value of an Annuity
 Numerical solution:
 1 
 1 
 1 
PVA n  PMT 
 PMT 
   PMT 
1
2
n
 1  i  
 1  i  
 1  i  
n
1 
 PMT  

t  1 1  i t


Present Value of an Annuity
 1 
 1 
 1 
PVA n  PMT 
 PMT 
   PMT 
1
2
n






1

i
1

i
1

i






1 

1

n
1 

1  i n 

 PMT  
  PMT 
t
i


 t 1 1  i  


1 

1



1.05 3 
  $100(2.7232)  $272.32
 $100 
 0.05 


Present Value of an Annuity
 Financial calculator solution:
 Inputs: N = 3 I = 5 PMT = -100
= 0 PV = ?
 Output: = 272.325
FV
Present Value of
an Annuity Due
 Payments at the beginning of each year
 Payments all come one year sooner
 Each payment would be discounted for
one less year
 Present value of annuity due will exceed
the value of the ordinary annuity by one
year’s interest on the present value of the
ordinary annuity
Present Value of
an Annuity Due
0
100
 1.05 
1
100
1.05
1.05
100
100
 1.05 
1
1.05
100
0
1.05
1
5%
1
 100.000 100
 95.238
100


 1.05 
 90.703
2
2
1.05
1.05
285.941
2
100
3
Present Value of
an Annuity Due
 Numerical solution:
 n

 n -1 1 
1 
PVA(DUE)n  PMT  
  1  i 
  PMT   
1
t
 t  0 1  i  
 t 1 1  i  

1 


1



n


1

i


 PMT  
  1  i 
i










Present Value of
an Annuity Due
1 


 1 

3

1.05 


PV(DUE)3  $100 
  1.05
  0.05 







 $100 [(2.72325)(1.05)]
 $100 (2.85941)
 $285.941
Present Value of
an Annuity Due
 Financial calculator solution:
 Switch to the beginning-of-period mode,
then enter
 Inputs: N = 3 I = 5 PMT = -100 FV
= 0 PV = ?
 Output: = 285.94
 Then switch back to the END mode
Solving for Interest Rates
with Annuities
 Suppose you pay $846.80 for an
investment that promises to pay you $250
per year for the next four years, with
0 payments
1 made at 2the end of3each year4
i=?
-846.80
1 

1

250
250

1 250
i 4 

$846.80  $250 
i




250
Solving for Interest Rates
with Annuities
 Numerical solution:
 Trial and error using different values for
i using until you find i where the present
value of the four-year, $250 annuity
equals $846.80. The solution is 7%.
Solving for Interest Rates
with Annuities
 Financial calculator solution:
 Inputs: N = 4 PV = -846.8 PMT = 250
FV = 0 I = ?
 Output: = 7.0
Perpetuities
 Perpetuity - a stream of equal payments
expected to continue forever
 Consol - a perpetual bond issued by the
British government to consolidate past
debts; in general, and perpetual bond
Payment
PMT
PVP 

Interest Rate
i
Uneven Cash Flow Streams
 Uneven cash flow stream is a series of
cash flows in which the amount varies
from one period to the next
 Payment (PMT) designates constant cash
flows
 Cash Flow (CF) designates cash flows in
general, including uneven cash flows
Present Value of
Uneven Cash Flow Streams
 PV of uneven cash flow stream is the sum
of the PVs of the individual cash flows of
the stream
 1 
 1 
 1 
PV  CF1 
 CF2 
   CFn 
1
2
n
 1  i  
 1  i  
 1  i  
 1 
  CFt 
t
t 1
 1  i  
n
Future Value of
Uneven Cash Flow Streams
 Terminal value is the future value of an
uneven cash flow stream
FVn  CF1 1  i n -1  CF2 1  i n - 2    CFn 1  i 0

n

t 1
CFt 1  i n - t
Solving for i with
Uneven Cash Flow Streams
 Using a financial calculator, input the CF
values into the cash flow register and
then press the IRR key for the Internal
Rate of Return, which is the return on
the investment.
Compounding Periods
 Annual compounding
 interest is added once a year
 Semiannual compounding
 interest is added twice a year
 10% annual interest compounded semiannually

would pay 5% every six months
adjust the periodic rate and number of periods
before calculating
Interest Rates
 Simple (Quoted) Interest Rate
 rate used to compute the interest payment paid
per period
 Effective Annual Rate (EAR)
 annual rate of interest actually being earned,
considering the compounding of interest
m
i simple 

  1.0
EAR   1 
m 

Interest Rates
 Annual Percentage Rate (APR)
 the periodic rate multiplied by the number of
periods per year
this is not adjusted for compounding

 More frequent compounding:
i simple 


FVn  PV  1 
m 

mn
Amortized Loans
 Loans that are repaid in equal payments
over its life
 Borrow $15,000 to repay in three equal
payments at the end of the next three
years, with 8% interest due on the
outstanding loan balance at the
beginning of each year
Amortized Loans
0
8%
15,000
1
2
PMT
PMT
PVA 3 

$15,000 
PMT
1  i 
1
PMT

1  i 
2
3
PMT
t 1
1  i t
3
PMT
t 1
1.08


t
3
PMT

PMT
1  i 3
Amortized Loans
 Numerical Solution:
1 

13
3
3


PMT
1 

1.08 

$15,000  
 PMT 
 PMT 
t
t 
 0.08 
t 1 1.08
 t 1 1.08 


$15,000  PMT 2.5771
$15,000
PMT 
 $5,820.50
2.5771
Amortized Loans
 Financial calculator solution:
 Inputs: N = 3 I = 8 PV = 15000 FV =
0 PMT = ?
 Output: = -5820.5
Amortized Loans
Repayment of Remaining
Beginning
a
Payment (2) Interest (3) Principalb (2)- Balance (1)Amount (1)
(4)=(5)
(3)=(4)
 Amortization Schedule shows how a loan will
1
$ repaid
15,000.00 with
$
5,820.50
$
1,200.00of $interest
4,620.50
$
10,379.50
be
a
breakdown
and
2
10,379.50
5,820.50
830.36
4,990.14
5,389.36
3
5,389.36
5,820.50
431.15
5,389.35
0.01
principle on each payment date
Year
aInterest
is calculated by multiplying the loan balance at the beginning
of the year by the interest rate. Therefor, interest in Year 1 is
$15,000(0.08) = $1,200; in Year 2, it is $10,379.50(0.08)=$830.36;
and in Year 3, it is $5,389.36(0.08) = $431.15 (rounded).
bRepayment
of principal is equal to the payment of $5,820.50 minus
the interest charge for each year.
cThe
$0.01 remaining balance at the end of Year 3 results from
rounding differences.
c
Comparing Interest Rates
 1. Simple, or quoted, rate, (isimple)
 rates compare only if instruments have the
same number of compounding periods per
year
 2. Periodic rate (iPER)
 APR represents the periodic rate on an
annual basis without considering interest
compounding
 APR is never used in actual calculations
Comparing Interest Rates
 3. Effective annual rate, EAR
 the rate that with annual compounding (m=1)
would obtain the same results as if we had used the
periodic rate with m compounding periods per
year
m
i SIMPLE 

EAR   1 
  1.0
m 

m
 1  i PER   1
Valuation Concepts
Chapter 10
Basic Valuation
 From the time value of money we realize
that the value of anything is based on the
present value of the cash flows the asset
is expected to produce in the future
Basic Valuation
Asset
value  V 
^
CF
1
1  k 
1
N

t 1

^
CF
2
1  k 
2

^
CF
N
N
1  k 
^
CF
t
1  k 
t
^t = the cash flow expected to be generated by
CF
the asset in period t
Basic Valuation
 k = the return investors consider
appropriate for holding such an asset usually referred to as the required
return, based on riskiness and economic
conditions
Valuation of Financial
Assets - Bonds
 Bond is a long term debt instrument
 Value is based on present value of:
 stream of interest payments
 principal repayment at maturity
Valuation of Financial
Assets - Bonds
 kd = required rate of return on a debt
instrument
 N = number of years before the bond
matures
 INT = dollars of interest paid each year
(Coupon rate Par value)
 M = par or face, value of the bond to be
paid off at maturity
Valuation of Financial
Assets - Bonds
Bond
value
 Vd 
N
INT
INT
1  k d 1 1  k d 2
INT
  1  k
t 1

d
t

M
1  k d N

INT

M
1  k d N 1  k d N
Valuation of Financial
Assets - Bonds
 Genesco 15%, 15year, $1,000 bonds
valued at 15% required rated of return
Valuation of Financial
Assets - Bonds
 Numerical solution:
1

15
1 


1
.
15
Bond  $150
0.15

value




 1 
  $1,000
15 

 1.15 


Vd = $150 (5.8474) + $1,000 (0.1229)
= $877.11 + $122.89 = $1,000
Valuation of Financial
Assets - Bonds
 Financial Calculator Solution:
Inputs: N = 15; I = k = 15; PMT = INT =
150
M = FV = 1000; PV = ?
Output: PV = -1,000
Changes in Bond Values
over Time
 If the market rate associated with a bond
(kd) equals the coupon rate of interest,
the bond will sell at its par value
Changes in Bond Values
over Time
 If interest rates in the economy fall after
the bonds are issued, kd is below the
coupon rate. The interest payments and
maturity payoff stay the same, causing
the bond’s value to increase (investors
demand lower returns, so they are
willing to pay higher prices for bonds).
Changes in Bond Values
over Time
 Current yield is the annual interest
payment on a bond divided by
its current market value
Current  INT
yield
Vd
 Ending    Beginning 
 bond value   bond value  V
Capital
d, End  Vd, Begin





gains 
Vd,Begin
 Beginning 
 bond value 
yield


Changes in Bond Values
over Time
Discount bond
 A bond that sells below its par value,
which occurs whenever the going rate of
interest rises above the coupon rate
Premium bond
A bond that sells above its par value,
which occurs whenever the going rate of
interest falls below the coupon rate
Changes in Bond Values
over Time
 An increase in interest rates will cause
the price of an outstanding bond to fall
 A decrease in interest rates will cause the
price to rise
 The market value of a bond will always
approach its par value as its maturity
date approaches, provided the firm does
not go bankrupt
Time path of value of a 15% Coupon,
$1000
par
value
bond
when
interest
Year
k d = 10% k d = 15% k d = 20%
rates
are
10%,$1,000.00
15%, and
20%
0
$1,380.30
$766.23
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
$1,368.33
$1,355.17
$1,340.68
$1,324.75
$1,307.23
$1,287.95
$1,266.75
$1,243.42
$1,217.76
$1,189.54
$1,158.49
$1,124.34
$1,086.78
$1,045.45
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$1,000.00
$769.47
$773.37
$778.04
$783.65
$790.38
$798.45
$808.14
$819.77
$833.72
$850.47
$870.56
$894.68
$923.61
$958.33
$1,000.00
Changes in Bond Values
over Time
 Time path of value of a 15% Coupon, $1000
par value bond when interest rates are 10%,
15%, and 20%
Bond Value
$1,500
$1,250
Kd < Coupon Rate
Kd = Coupon Rate
$1,000
$750
$500
Kd > Coupon Rate
$250
$0
1
3
5
7
9
11
13
15
Years
Yield to Maturity
 YTM is the average rate of return earned
on a bond if it is held to maturity
Approximate yield
to maturity
Annual
Accrue d
interest  capital gains

Average value of bond
 M - Vd 
INT  

 N 

 2 Vd   M 


3


Bond Values with
Semiannual Compounding
INT
2N
M
2
Vd  

t
2N
t 1 
kd  
kd 
1 
 1 

2 
2 

Interest Rate Risk
on a Bond
 Interest Rate Price Risk - the risk of
changes in bond prices to which investors
are exposed due to changing interest rates
 Interest Rate Reinvestment Rate Risk the risk that income from a bond portfolio
will vary because cash flows have to be
reinvested at current market rates
Value of Long and Short-Term
15% Annual Coupon Rate Bonds
Current Market
Interest Rate, k d
5%
10%
15%
20%
25%
Value of
1-Year
14-Year
Bond
Bond
$ 1,095.24
$ 1,045.45
$ 1,000.00
$
958.33
$
920.00
$
$
$
$
$
1,989.86
1,368.33
1,000.00
769.47
617.59
Value of Long and Short-Term
15% Annual Coupon Rate Bonds
Bond
Value
($) 2,000
14-Year Bond
1,500
1,000
1-Year Bond
500
0
5
10
15
20
25
Interest Rate, k d (%)
Valuation of Financial
Assets - Equity (Stock)
 Common stock
 Preferred stock
 hybrid
 similar to bonds with fixed dividend amounts
 similar to common stock as dividends are not
required and have no fixed maturity date
Stock Valuation Models
 Terms:
Stock Valuation Models
 Terms: Expected Dividends
D̂ t  dividend the stockholde r expects to
recieve at the end of Year t
D 0 is the most recent dividend already paid
D̂1 is the next dividend expected to be paid,
and it will be paid at the end of this year
D̂ 2 is the dividend expected at the end of two years
All future dividends are expected values, so the
estimates may differ among investors
Stock Valuation Models
 Terms: Market Price
P0  the price at which a stock
sells in the market tod ay
Stock Valuation Models
 Terms: Intrinsic Value
P̂0  the value of an asset that, in the
mind of an investor, is justified
by the facts and may be different
from the asset's current market
price, its book value, or both
Stock Valuation Models
 Terms: Expected Price
P̂t  the expected price of the stock
at the end of each Year t
Stock Valuation Models
 Terms: Growth Rate
g  the expected rate of change
in dividends per share
Stock Valuation Models
 Terms: Required Rate of Return
k s  the minimum rate of return on a
common stock that stockholde rs
consider acceptable , given its
riskiness and returns available on
other investment s
Stock Valuation Models
 Terms: Dividend Yield
D̂1
 the expected dividend divided
P0
by the current price of a share
of stock
Stock Valuation Models
 Terms: Capital Gain Yield
P1  P0
 the change in price (capital gain)
P0
during a given year divided by its
price at the beginning of the year
Stock Valuation Models
 Terms: Expected Rate of Return
k̂ s  the rate of return on a common
stock that an individual investor
expects to receive
 expected dividend yield
 expected capital gains yield
Stock Valuation Models
 Terms: Actual Rate of Return
k s  the rate of return on a common
stock that an individual investor
actually receives, after the fact;
equal to the dividend yield plus
the capital gains yield
Stock Valuation Models
 Expected Dividends as the Basis for
Stock Values
 If you hold a stock forever, all you receive
is the dividend payments
 The value of the stock today is the present
value of the future dividend payments
Stock Valuation Models
 Expected Dividends as the Basis for
Stock Values
Value of Stock  Vs  Pˆ 0  PV of expected future dividends
D̂1
D̂ 2
D̂ 



1
2

1  k s  1  k s 
1  k s 

D̂ t

t
t 1 1  k s 
Stock Valuation Models
Stock Values with Zero Growth
A zero growth stock is a common stock
whose future dividends are not expected to
grow at all
D
D
D
P̂0 


1
2

1  k s  1  k s 
1  k s 
D
P̂0 
ks
D
k̂ s 
P0
Stock Valuation Models
 Normal, or Constant, Growth
 Growth that is expected to continue into
the foreseeable future at about the same
rate as that of the economy as a whole
 g = a constant
Stock Valuation Models
 Normal, or Constant, Growth
 (Gordon Model)
D0 1  g  D0 1  g 
D0 1  g 
P̂0 


1
2

1  k s 
1  k s 
1  k s 
1
D 0 1  g 
D̂1


ks  g
ks  g
2

Expected Rate of Return on
a Constant Growth Stock
k̂ s 
D̂ 1
P0

g
 Dividend yield  Capital gain
Nonconstant Growth
 The part of the life cycle of a firm in
which its growth is either much faster or
much slower than that of the economy as
a whole
Nonconstant Growth
 1. Compute the value of the dividends that
experience nonconstant growth, and then find
the PV of these dividends
 2. Find the price of the stock at the end of the
nonconstant growth period, at which time it
becomes a constant growth stock, and discount
this price back to the present
 3. Add these two components to find the
intrinsic value of the stock, P̂.
0
Changes in Stock Prices
 Investors change the rates of return
required to invest in stocks
 Expectations about the cash flows
associated with stocks change
Valuation of Real
(Tangible) Assets
 Valuation is still based on expected cash
flows of the asset
Valuation of Real
(Tangible) Assets
Year
1
2
3
4
5
Expected Cash Flow, CF
$120,000
100,000
150,000
80,000
50,000
To earn a 14% return on investments like this, what
is the value of this machine?
Cash Flow Time Lines
0 14% 1
2
3
4
5
$120,000 $100,000 $150,000 $80,000 $50,000
PV of $120,000
PV of $100,000
PV of $150,000
PV of $80,000
PF of $50,000
Asset Value = V0
$356,790 
$120,000 $100,000 $150,000 $80,000 $50,000




1
2
3
4
1.14
1.14
1.14
1.14
1.145
Risk and Rates of Return
Chapter 11
Defining and
Measuring Risk
 Risk is the chance that an outcome other
than expected will occur
 Probability distribution is a listing of all
possible outcomes with a probability
assigned to each
 must sum to 1.0 (100%)
Probability Distributions
 It either will rain, or it will not
 only two possible outcomes
Outcome (1)
Probability (2)
Rain
0.40 = 40%
No Rain
0.60 = 60%
1.00 100%
Probability Distributions
 Martin Products and U. S. Electric
State of the
Economy
Boom
Normal
Recession
Probability of This
State Occurring
0.2
0.5
0.3
1.0
Rate of Return on Stock if
This State Occurs
Martin Products
U.S. Electric
110%
22%
-60%
20%
16%
10%
Expected Rate of Return
 The rate of return expected to be realized
from an investment
 The mean value of the probability
distribution of possible returns
 The weighted average of the outcomes,
where the weights are the probabilities
Expected Rate of Return
State of the
Economy
(1)
Boom
Normal
Recession
Probability of
This State
Occurring (Pr i)
(2)
0.2
0.5
0.3
1.0
Martin Products
Return if This State Product:
Occurs (ki)
(2) x (3)
^
(3)
110%
22%
-60%
= (4)
22%
11%
-18%
15%
^
km =
Expected Rate of Return
State of the
Economy
(1)
Boom
Normal
Recession
U. S. Electric
Return if This
Product:
State Occurs (ki) (2) x (3)
Probability of
This State
Occurring (Pr i)
(2)
0.2
0.5
0.3
1.0
^
(3)
20%
16%
10%
^
km=
= (4)
4%
8%
3%
15%
Expected Rate of Return
k̂  Pr1k 1  Pr2k 2    Prnk n
n
  Pri k i
i 1
Continuous versus Discrete
Probability Distributions
 Discrete probability distribution
 the number of possible outcomes is limited,
or finite
b. U. S. Electric
Discrete Probability
Probability
Distributions
of
a. Martin Products
Probability
of
0.5 Occurrence
0.5 Occurrence
0.4 -
0.4 -
0.3 -
0.3 -
0.2 -
0.2 -
0.1 -
0.1 -
-60 -45 -30 -15 0 15 22 30 45 60 75 90 110
Rate of
Return (%)
Expected Rate
of Return (15%)
-10
-5
0
5
10
16 20
Expected Rate
of Return (15%)
25 Rate of
Return (%)
Continuous versus Discrete
Probability Distributions
 Continuous probability distribution
 the number of possible outcomes is
unlimited, or infinite
Continuous
Probability
Probability Density
Distributions
U. S. Electric
Martin Products
-60
0
15
Expected Rate of
Return
110
Rate of Return
(%)
Measuring Risk:
The Standard Deviation
 Calculating Martin Products’ Standard
Deviation
Expected
Payoff Return
^
ki
k
(1)
(2)
110%
15%
22%
15%
-60%
15%
ki - ^k
(1) - (2) = (3)
95
7
-75
(ki - ^k)2
(4)
9,025
49
5,625
Probability
(5)
(ki -^k)2Pr i
(4) x (5) = (6)
0.2
1,805.0
0.5
24.5
0.3
1,687.5
Variance  σ 2  3,517.0
2
Standard De viation σ M  σ M
 3,517  59.3%
Measuring Risk:
The Standard Deviation
Variance   
2
 k
n

2
i
- k̂ Pri
Standard deviation     
 k
i 1
2
n
i 1

2
i
- k̂ Pri
Measuring Risk:
Coefficient of Variation
 Standardized measure of risk per unit of
return
 Calculated as the standard deviation
divided by the expected return
 Useful where investments differ in risk
and expected returns
Risk

Coefficient of variation  CV 

Return k̂
Risk Aversion
 Risk-averse investors require higher
rates of return to invest in higher-risk
securities
Risk Aversion and
Required Returns
 Risk premium (RP)
 the portion of the expected return that can
be attributed to the additional risk of an
investment
 the difference between the expected rate of
return on a given risky asset and that on a
less risky asset
Portfolio Risk and the
Capital Asset Pricing Model
 CAPM
 a model based on the proposition that any
stock’s required rate of return is equal to
the risk-free rate of return plus a risk
premium, where risk reflects
diversification
 Portfolio
 a collection of investment securities
Portfolio Returns
 Expected return on a portfolio, kp
 the weighted average expected return on
the stocks held in the portfolio
k̂ p  w 1k̂ 1  w 2k̂ 2    w N k̂ N

N
 w k̂
j
j 1
j
Portfolio Returns
 Realized rate of return, k
 the return that is actually earned
 actual return is generally different from
the expected return
Portfolio Risk
 Correlation coefficient, r
 a measure of the degree of relationship
between two variables
 positively correlated stocks rates of return
move together in the same direction
 negatively correlated stocks have rates of
return than move in opposite directions
Portfolio Risk
 Risk reduction
 combining stocks that are not perfectly
positively correlated will reduce the
portfolio risk by diversification
 the riskiness of a portfolio is reduced as the
number of stocks in the portfolio increases
 the smaller the positive correlation, the
lower the risk
Firm-Specific Risk versus
Market Risk
 Firm-specific risk
 that part of a security’s risk associated
with random outcomes generated by
events, or behaviors, specific to the firm
Firm-Specific Risk versus
Market Risk
 Firm-specific risk
 that part of a security’s risk associated with
random outcomes generated by events, or
behaviors, specific to the firm
 it can be eliminated by proper diversification
Firm-Specific Risk versus
Market Risk
 Market risk
 that part of a security’s risk that cannot be
eliminated by diversification because it is
associated with economic, or market
factors that systematically affect most
firms
Firm-Specific Risk versus
Market Risk
 Relevant risk
 the risk of a security that cannot be
diversified away--its market risk
 this reflects a security’s contribution to the
risk of a portfolio
The Concept of Beta
 Beta coefficient,
 a measure of the extent to which the
returns on a given stock move with the
stock market
 = 0.5: stock is only half as volatile, or
risky, as the average stock
 = 1.0: stock is of average risk
 = 2.0: stock is twice as risky as the
average stock
Portfolio Beta Coefficients
 The beta of any set of securities is the
weighted average of the individual
securities’ betas
β p  w 1β 1  w 2 β 2    w N β N

N
w β
j j
j1
The Relationship between
Risk and Rates of Return
k̂ j  expectedrate of return on the j stock
th
The Relationship between
Risk and Rates of Return
k̂ j  expected rate of re turn on the j stock
th
k j  required rate of re turn on the j stock
th
The Relationship between
Risk and Rates of Return
k̂ j  expectedrate of return on the j stock
th
k j  required rate of return on the jth stock
k RF  risk  free rate of return
The Relationship between
Risk and Rates of Return
k̂ j  expectedrate of return on the j stock
th
k j  required rate of return on the jth stock
k RF  risk  free rate of return
RPM  k M - k RF   market risk premium
The Relationship between
Risk and Rates of Return
k̂ j  expectedrate of return on the jth stock
k j  required rate of return on the jth stock
k RF  risk  free rate of return
RPM  k M - k RF   market risk premium
RPj  k M - k RF β j  risk premium on the jth stock
Market Risk Premium
 RPM is the additional return over the
risk-free rate needed to compensate
investors for assuming an average
amount of risk
 Assuming:
 Treasury bonds yield = 6%
 Average stock required return = 14%
 Thus, the market risk premium is 8%:
 RPM = kM - kRF = 14% - 6% = 8%
Risk Premium for a Stock
 Risk premium for stock j
= RPj = RPM
j
The Required Rate of Return
for a Stock
k j  k RF  RPM  β j
 k RF  k M  k RF  β j
k j  required rate of return for stock j
The Required Rate of Return
for a Stock
 Security Market Line (SML)
 The line that shows the relationship
between risk as measured by beta and the
required rate of return for individual
securities
Security Market Line
Required
Rate of
Return
khigh = 22
(%)
kM = kA =
Safe Stock:
Risk
Premium: 4%
14
kLow = 10
kRF = 60
2.0
SML : k j  k RF  k M  k RF  β j
Market (Average
Stock): Risk
Premium: 8%
Relatively
Risky Stock:
Risk
Premium =
16%
Risk-Free
Rate: 6%
0.5
1.0
Risk,
j
The Impact of Inflation
 kRF is the price of money to a riskless
borrower
 The nominal rate consists of
 a real (inflation-free) rate of return, k*
 an inflation premium (IP)
 An increase in expected inflation would
increase the risk-free rate, kRF
Changes in Risk Aversion
 The slope of the SML reflects the extent
to which investors are averse to risk
 An increase in risk aversion increases the
risk premium, which increases the slope
Changes in a Stock’s Beta
Coefficient
 The risk of a stock is affected by
 composition of its assets
 use of debt financing
 increased competition
 expiration of patents
 Any change in the required return (from
change in or in expected inflation)
affects the stock price
Stock Market Equilibrium
 The condition under which the expected
return on a security is just equal to its
required return
k̂ j  k j
 Actual market price equals its intrinsic
value as estimated by the marginal
investor, leading to price stability
Changes in Equilibrium
Stock Prices
 Stock prices are not constant due to
changes in:
 risk-free rate, kRF
 Market risk premium, kM - kRF
 Stock X’s beta coefficient, x
 Stock X’s expected growth rate, gX
 Changes in expected dividends, D0(1+g)
Physical Assets
versus Securities
 Riskiness of a physical asset is only
relevant in terms of its effect on the
stock’s risk
Word of Caution
 CAPM
 based on expected conditions
 only have historical data
 as conditions change, future volatility may
differ from past volatility
 estimates are subject to error
The Cost of Capital
Chapter 12
Cost of Capital
 The firm’s average cost of funds, which
is the average return required by the
firm’s investors
 What must be paid to attract funds
The Logic of the Weighted
Average Cost of Capital
 The use of debt impacts a fim’s ability to
use equity, and vice versa, so the
weighted average cost must be used to
evaluate projects, regardless of the
specific financing used to fund
a particular project
Basic Definitions
 Capital component
 types of capital used by firms to raise
money
 kd = before tax interest cost
 kdT = kd(1-T) = after tax cost of debt
 kps = cost of preferred stock
 ks = cost of retained earnings
 ke = cost of external equity (new stock)
Basic Definitions
 WACC = weighted average cost of
capital
 Capital structure
 combination of different types of capital
used by a firm
After-Tax Cost of Debt
 The relevant cost of new debt—its yield
to maturity (YTM)
 Taking into account the tax deductibility
of interest
 Used to calculate the WACC
 kdT = bondholders’ required rate of
return minus tax savings
 kdT = kd - (kd T) = kd(1-T)
Cost of Preferred Stock
 Rate of return investors require on the
firm’s preferred stock
 the preferred dividend divided by the net
issuing price
k ps 
Dps
NP

Dps
P0 - Flotation costs
Cost of Retained Earnings
 Rate of return investors require on the
firm’s common stock
D̂1
k Three
 g  k̂ s
s  ksolutions:
RF  RP 
P0
1. CAPM
2. Bond yield plus risk premium
3. Discounted cash flow (DCF)
The CAPM Approach
k s  k RF  k M - k RF  β s
The Bond-Yield-PlusPremium Approach
 Estimate a risk premium above the bond
interest rate
 Judgmental estimate for premium
 “Ballpark” figure only
k s  Bond yie ld  Risk premium
 10%  4%  14%
The Discounted Cash Flow
(DCF) Approach
 Price and expected rate of return on a
share of common stock depend on the
dividends expected on the stock
P0 

D̂1
1  k s 
1

D̂2

1  k s 
2
 1  k 
t 1
D̂t
t
s

D̂
1  k s 

DCF Approach
 Internal equity, ks
 based on the fact that investors demand the
firm use funds that are retained to earn an
appropriate rate of return
D̂1
ks 
g
P0
Cost of Newly Issued
Common Stock
 External equity, ke
 based on the cost of retained earnings
 adjusted for flotation costs (the expenses of
selling new issues)
D̂1
D̂1
ke 
g
g
NP
P0 1  F 
Target Capital Structure
 Optimal capital structure
 percentage of debt, preferred stock, and
common equity that will maximize the
price of the firm’s stock
Weighted Average Cost of
Capital, WACC
 A weighted average of the component costs
of debt, preferred stock, and common
equity
 Proportion   After - tax    Proportion   Cost of    Proportion   Cost of  
 
  
 
  
 


 
of

cost
of

of
preferred

preferred

of
common

common
 
  
 
  
 













debt   debt   
stock   stock    equity   equity  


Wd

k dT

Wps

k ps

Ws

ks
Marginal Cost of Capital
 MCC
 the cost of obtaining another dollar of new
capital
 the weighted average cost of the last dollar
of new capital raised
MCC Schedule
 Marginal cost of capital schedule
 a graph that relates the firm’s weighted
average of each dollar of capital to the total
amount of new capital raised
 reflects changing costs depending on
amounts of capital raised
MCC Schedule
 Weighted Average Cost of Capital (WACC) (%)
WACC3=11.5%
11.5 WACC2=11.0%
11.0 -
10.5 -
WACC1=10.5%
New Capital Raised
(millions of dollars)
100
150
Break Point
 BP
 the dollar value of new capital that can be
raised before an increase in the firm’s
weighted average cost of capital occurs
Break
Total amount of lower costcapital of a giventype

Point Proportion of this type of capital in the capital structure
MCC Schedule
 Weighted Average Cost of Capital (WACC) (%)
WACC3=11.5%
11.5 -
WACC2=11.0%
11.0 -
10.5 -
WACC1=10.5%
BPRE
BPDebt
New Capital Raised
(millions of dollars)
100
150
MCC Schedule
 Schedule and break points depend on
capital structure used
MCC Schedule
 Weighted Average Cost of Capital (WACC) (%)
Smooth, or Continuous,
Marginal Cost of Capital
Schedule
WACC
0-
Dollars of New Capital Raised
Combining the MCC and
Investment Opportunity Schedules
 Use the MCC schedule to find the cost of
capital for determining whether a project
should be purchased
 Investment Opportunity Schedule (IOS)
 graph of the firm’s investment
opportunities ranked in order of the
projects’ rates of return
Combining the MCC and
Investment Opportunity Schedules
Percent
12.0 -
ReturnC = 12.0%
ReturnB = 11.6%
ReturnD = 11.5%
11.5 -
ReturnE = 11.3%
WACC2=11.0%
11.0 10.5 -
WACC3=11.5%
MCC
IRRA = 10.8%
WACC1=10.5%
Optimal Capital
Budget - $139
20
40
60
80
IOS
100 120 140 160 180
New Capital Raised and invested (millions of dollars)
Capital Budgeting
Chapter 13
Capital Budgeting
 The process of planning investments in
assets whose cash flows are expected to
extend beyond one year
Importance of
Capital Budgeting
 Long term impact
 Timing
 Substantial expenditures for which funds
must be raised (either internally,
externally, or both)
Project Classifications
 Replacement decisions
 decisions to determine whether to purchase
capital assets to take the place of existing
assets to maintain existing operations
Project Classifications
 Expansion decisions
 decisions to determine whether to purchase
capital projects and add them to existing
assets to increase existing operations
Project Classifications
 Independent projects
 projects whose cash flows are not affected
by the acceptance or rejection of other
projects
Project Classifications
 Mutually exclusive projects
 a set of projects where the acceptance of
one project means the others cannot be
accepted
Steps in the Valuation
Process
 1. Determine the cost, or purchase price, of the asset
 2. Estimate the cash flows expected from the asset
 3. Evaluate the riskiness of the projected cash flows to
determine the appropriate rate of return to use for
computing the present value of the estimated cash flows
 4. Compute the present value of the expected cash flows
 5. Compare the present value of the expected cash
inflows with the initial investment, or cost, required to
acquire the asset
Cash Flow Estimation
 Cash is different from accounting profits
 Count cash flows after taxes
 Only incremental cash flows are relevant
to the accept/reject decision
 the change in a firm’s net cash flow
attributable to an investment project
Problems in
Cash Flow Estimation
 1. Sunk costs
 already incurred and cannot be recovered
 2. Opportunity costs
 return on the best alternative use of an
asset
 3. Externalities
 the effect accepting a project will have on
the cash flows in other areas of the firm
Problems in
Cash Flow Estimation
 4. Shipping and Installation
 the depreciable basis for an asset includes the
purchase price plus shipping and installation
 5. Depreciation
 depreciation is a non-cash expense affecting
taxable income, thus taxes
 6. Inflation
 expected inflation should be built into the
expected cash flows
Identifying Incremental
(Relevant) Cash Flows
 Cash flows that occur only at the start of
the project’s life
 Cash flows that continue throughout a
project’s life
 Cash flows that occur only at the end, or
termination of the project
Identifying Incremental
(Relevant) Cash Flows
 Initial investment outlay
 includes the incremental cash flows
associated with a project that occur only at
the start of a project’s life, CF0
^
Identifying Incremental
(Relevant) Cash Flows
 Incremental operating cash flow
 changes in day-to-day cash flows that result
from the purchase of a capital project and
continue until the firm disposes of the asset
Incremental Operating
Cash Flow
 Re venue- Cash Expense s- Taxes
 NI t  De prt
 EBTt  1  T   De prt
 S t - OCt - De prt   1  T   De prt
 S t - OCt   1  T   TDe prt 
Identifying Incremental
(Relevant) Cash Flows
 Terminal cash flow
 the net cash flow that occurs at the end of
the life of a project, including the cash
flows associated with:
 1. final disposal of the project
 2. returning the firm’s operations to where
they were before the project was accepted
Cash Flow Estimation and
the Evaluation Process
 Expansion projects
 initial investment outlays required
 estimate the cash flows once production
begins
 terminal cash flow
Cash Flow Estimation and
the Evaluation Process
 Replacement analysis
 must consider cash flow from old asset and
new asset in decision
 cash flows from the new asset take the
place of cash flows from the old asset
Capital Budgeting
Evaluation Techniques
 1. Payback
 2. Net present value (NPV)
 3. Internal rate of return (IRR)
Payback
 Payback period is the length of time
before the original cost of an investment
is recovered from the expected cash flows
 Unrecovere d cost at start 

Number
of
years
before

 

  of full - recovery year 
Payback  
full recovery of


Total
cash
flow
during
 original investment  


 

 full - recovery year 
Net Present Value
 NPV is a method of evaluating capital
investment proposals by finding the
present value of future net cash flows,
discounted at the rate of return required
by the firm
 One of two discounted cash flow (DCF)
techniques using time value of money
that we will cover
Net Present Value
CF̂1
CF̂2
CF̂n
NPV  CF̂0 


1
2
n
1  k  1  k 
1  k 
n
CF̂t

t
t  0 1  k 
Discounted Payback
 Discounted payback is the length of time
it takes for a project’s discounted cash
flows to repay the initial cost of the
investment
Internal Rate of Return
 IRR is the discount rate that forces the
PV of a project’s expected cash flows to
equal its initial cost
 Similar to the YTM on a bond
CF̂1
CF̂2
CF̂n
CF̂0 


0
1
2
n
1  IRR  1  IRR 
1  IRR 
n
CF̂t
0

t
t  0 1  IRR 
Comparison of the NPV and
IRR Methods
 NPV profile is a graph (curve) showing
the relationship between a project’s NPV
and various discount rates (required
rates of return)
 IRR is at the point where the NPV
profile crosses the X axis
NPVs and the Required Rate
of Return
 Crossover rate
 the discount rate at which the NPV profiles
of two projects cross and, thus, at which
the project’s NPVs are equal
Independent Projects
 NPV and IRR will both lead to the same
decision
 if a project’s NPV is positive, its IRR will
exceed k, while if NPV is negative, k will
exceed the IRR
Mutually Exclusive Projects
 If NPV profiles cross, NPV and IRR
decisions may conflict depending on
discount rate selected
 project size differences
 timing differences
 reinvestment rate may not match IRR
 NPV method is preferred
Multiple IRRs
 A project can have two or more IRRs
 unconventional cash flow pattern
 large outflow during or at the end of its life
 NPV profile is required
Conclusions on the Capital
Budgeting Decision Methods
 Payback and discounted payback indicate risk
and liquidity of a project
 NPV gives a direct measure of the dollar
benefit to the shareholders
 IRR provides information about a project’s
“safety margin”
 IRR reinvestment assumption may be
unrealistic
 Watch out for multiple IRRs
Incorporating Risk in
Capital Budgeting Analysis
 Stand-alone risk
 the risk an asset would have if it were a
firm’s only asset
 measured by the variability of the asset’s
expected returns
Incorporating Risk in
Capital Budgeting Analysis
 Scenario analysis
 a risk analysis technique in which “good”
and “bad” sets of financial circumstances
are compared with a most likely, or bestcase situation
Incorporating Risk in
Capital Budgeting Analysis
 Worst-case scenario
 an analysis in which all of the input
variables are set at their worst reasonably
forecasted values
Incorporating Risk in
Capital Budgeting Analysis
 Best-case scenario
 an analysis in which all of the input
variables are set at their best reasonably
forecasted values
Incorporating Risk in
Capital Budgeting Analysis
 Base case
 an analysis in which all of the input
variables are set at their most likely values
Incorporating Risk in
Capital Budgeting Analysis
 Corporate (within-firm) risk
 risk not considering the effects of
stockholders’ diversification
 measured by a project’s effect on the firm’s
earnings variability
Incorporating Risk in
Capital Budgeting Analysis
 Beta (market) risk
 that part of a project’s risk that cannot be
eliminated by diversification
 measured by the project’s beta coefficient
Corporate
(Within-Firm) Risk
 Diversification (risk reduction)
 as long as assets are not perfectly positively
correlated some diversification can be
achieved
 adding projects can help reduce corporate
risk
Beta (or Market) Risk
 Project required rate of return, kproj
 the risk adjusted required rate of return
for an individual project
 kproj = kRF + (kM - kRF) proj
Beta (or Market) Risk
 Pure play method
 estimating beta of a project using firms
whose only business is the product in
question to approximate its own project’s
beta
How Project Risk is
Considered in Capital
Budgeting Decisions
 Risk-adjusted discount rate
 required rate of return that applies to a
particularly risky stream of income
 equal to the risk-free rate of interest plus a
risk premium appropriate for the level of
risk attached to a particular project’s
income stream
Capital Rationing
 A situation in which a constraint is
placed on the total size of the firm’s
capital investment
Multinational Capital
Budgeting
 Repatriation of earnings
 process of sending cash flows from a
foreign subsidiary back to the parent
company
Multinational Capital
Budgeting
 Exchange rate risk
 uncertainty associated with the price at
which the currency from one country can
be converted into the currency of another
country
Multinational Capital
Budgeting
 Political risk
 the risk of expropriation of a foreign
subsidiary’s assets by the host country, or
of unanticipated restrictions on cash flows
to the parent company
Capital Structure and
Dividend Policy Decisions
Chapter 14
Capital Structure
 The combination of debt and equity used
to finance a firm
Equity
Debt Equity
Equity Debt Equity Equity
Debt Equity Equity
Debt Debt Equity Equity
Debt Debt Equity
Target Capital Structure
 The optimal mix of debt, preferred stock,
and common equity with which the firm
plans to finance its investments
 May change over time
 Trade-off between risk and return to
achieve goal of maximizing the price of
the stock
Factors Influence Capital
Structure Decisions
 1. Firm’s business risk
 2. Firm’s tax position
 3. Financial flexibility
 4. Managerial attitude
Business Risk
 The risk associated with projections of a
firm’s future return on assets (ROA) or
return on equity (ROE) if the firm uses
no debt
Business Risk
 Depends on several factors
 1. Sales variability - volume and price
 2. Input price variability
 3. Ability to adjust output prices
 4. The extent to which costs are fixed
(operating leverage)
Financial Risk
 The portion of stockholder’s risk, over
and above basic business risk, resulting
from the manner in which the firm is
financed
 Financial risk results from using
financial leverage
Financial Leverage
 The extent to which fixed-income
securities (debt and preferred stock) are
used in a firm’s capital structure
Determining the Optimal
Capital Structure
 Maximize the price of the firm’s stock
 Changes in use of debt will cause changes
in earnings per share, and thus, in the
stock price
 Cost of debt varies with capital structure
 Financial leverage increases risk
Determining the Optimal
Capital Structure
 EPS indifference analysis
 the level of sales at which EPS will be the
same whether the firm uses debt or
common stock financing
 at lower sales, EPS is higher with stock
financing
 at higher sales, EPS favors debt financing
The Effect of Capital
Structure on Stock Prices
and the Cost of Capital
 Maximizing EPS is not the same as
maximizing stock price
 Stock risk (Beta) increases with debt
Liquidity and Capital
Structure
 Difficulties with analysis
 1. Impossible to determine exactly how
either P/E ratios or equity capitalization
rates (ks values) are affected by different
degrees of financial leverage
Liquidity and Capital
Structure
 Difficulties with analysis
 2. Managers may be more or less
conservative than the average stockholder,
so management may set a different target
capital structure than the one that would
maximize the stock price
Liquidity and Capital
Structure
 Difficulties with analysis
 3. Managers of large firms have a
responsibility to provide continuous service
and must refrain from using leverage to the
point where the firm’s long-run viability is
endangered
Liquidity and Capital
Structure
 Financial strength indicators
 Times-interest-earned (TIE) ratio
 a ratio that measures the firm’s ability to meet
its annual interest obligations
 calculated by dividing earnings before interest
and taxes (EBIT) by interest charges
Capital Structure Theory
 1. Tax benefit/bankruptcy cost trade-off
theory
 2. Signaling theory
Trade-Off Theory
 1. Interest is tax-deductible expense,
therefore less expensive than common or
preferred stock
Trade-Off Theory
 2. Interest rates rise as debt/assets ratio
increases; tax rates fall at high debt
levels; probability of bankruptcy
increases as debt/assets ratio increases
Trade-Off Theory
 3. Threshold debt level below which the
effects in point (2) are immaterial, but
beyond this point the higher interest
rates reduce the tax benefits and even
further the bankruptcy costs lower the
value of the stock
Trade-Off Theory
 4. Theory and empirical evidence
support these ideas, but the points cannot
be identified precisely
Trade-Off Theory
 5. Many large, successful firms use much
less debt than the theory suggests-leading to the development of signaling
theory
Signaling Theory
 Symmetric information
 investors and managers have identical
information about the firm’s prospects
Signaling Theory
 Asymmetric information
 managers have better information
about their firm’s prospects than
do outside investors
Signaling Theory
 Signal
 an action taken by a firm’s management
that provides clues to investors about how
management views the firm’s prospects
Signaling Theory
 Reserve borrowing capacity
 the ability to borrow money at a reasonable
cost when good investment opportunities
arise
 firms often use less debt than “optimal” to
ensure that they can obtain debt capital
later if it is needed
Variations in Capital
Structures among Firms
 Wide variations in use of financial
leverage among industries and firms
within an industry
 TIE measures how safe the debt is
 percentage of debt
 interest rate on debt
 company’s profitability
Dividend Policy
 Dividends
 payments made to stockholders from the
firm’s earnings, whether those earnings
were generated in the current period or in
previous periods
Dividend Policy
 Dividends affect capital structure
 retaining earnings increases common
equity relative to debt
 financing with retained earnings is cheaper
than issuing new common equity
Dividend Policy
and Stock Value
 Dividend irrelevance theory
 theory that a firm’s dividend policy has no
effect on either its value or its cost of
capital
 investors value dividends and capital gains
equally
Dividend Policy
and Stock Value
 Optimal dividend policy
 the dividend policy that strikes a balance
between current dividends and future
growth and maximizes the firm’s stock
price
Dividend Policy
and Stock Value
 Dividend relevance theory
 the value of a firm is affected by its
dividend policy
 the optimal dividend policy is the one that
maximizes the firm’s value
Investors and
Dividend Policy
 Information content (Signaling)
 Signaling hypothesis says that investors
regard dividend changes as signals of
management’s earnings forecasts
Investors and
Dividend Policy
 Clientele effect
 the tendency of a firm to attract the type of
investor who likes its dividend policy
Investors and
Dividend Policy
 Free cash flow hypothesis
 all else equal, firms that pay dividends
from cash flows that cannot be reinvested
in positive net present value projects (free
cash flows) have higher values than firms
that retain free cash flows
Dividend Policy in Practice
 Types of dividend payments
 Residual dividend policy
 a policy in which the dividend paid is set
equal to the earnings minus the amount of
retained earnings necessary to finance the
firm’s optimal capital budget
Dividend Policy in Practice
 Types of dividend payments
 Stable, predictable dividend policy
 payment of a specific dollar dividend each
year, or periodically increase the dividend
at a constant rate
 the annual dividend is fairly predictable by
investors
Dividend Policy in Practice
 Types of dividend payments
 Constant payout ratio
 percentage of earnings, such as 50%
 must watch out for reductions not to signal
permanent decline in earnings
Dividend Policy in Practice
 Payment procedures
 Declaration date
 date on which a firm’s board of directors
issues a statement declaring a dividend
Dividend Policy in Practice
 Payment procedures
 Holder-of-record date
 the date on which the company opens the
ownership books to determine who will
receive the dividend
Dividend Policy in Practice
 Payment procedures
 Ex-dividend date
 the date on which the right to the next
dividend no longer accompanies a stock
 usually two business days prior to the
holder-of-record date
Dividend Policy in Practice
 Payment procedures
 Payment date
 the date on which the company actually
mails the dividend checks
Dividend Policy in Practice
 Dividend reinvestment plans -DRIPs
Dividend Policy in Practice
 Dividend reinvestment plans -DRIPs
 a plan that enables a stockholder to
automatically reinvest dividends received
back into the stock of the paying firm
 can either repurchase existing shares or
involve newly issued shares
Factors Influencing
Dividend Policy
 1. Constraints on dividend payments
 debt contract restrictions
 cannot exceed “retained earnings”
 cash availability
 IRS restrictions on improperly
accumulated retained earnings
Factors Influencing
Dividend Policy
 2. Investment opportunities
 large capital budgeting projects affect
dividend-payout ratios
Factors Influencing
Dividend Policy
 2. Investment opportunities
 large capital budgeting projects affect
dividend-payout ratios
 3. Alternative sources of capital
 flotation costs
 increasing capital costs
 ownership dilution
Capital Structures and Dividend
Policies Around the World
 Companies in Italy and Japan use more
debt than companies in the United States
or Canada, but companies in the United
Kingdom use less than any of these
 Different accounting practices make
comparisons difficult
 Gap has narrowed in recent years
 Dividend-payout ratios vary greatly also
Capital Structures and Dividend
Policies Around the World
 Logical analysis would indicate that:
 1. Tax codes generally favor use of debt in developed
countries
 2. In countries where capital gains are not taxed,
investors should show a preference for stocks
compared with countries that have capital gains taxes
 3. Investor preferences should lead to relatively low
equity capital costs in those countries that do not tax
capital gains
 Reality does not match these conclusions
Capital Structures and Dividend
Policies Around the World
 What about risk, especially bankruptcy costs?
 Foreign banks are closely linked to corporations that
borrow from them, and have substantial influence over
the management of the debtor firms
 Equity monitoring costs are comparatively low in the
United States
 These indicate that U.S. firms should have more equity
and less debt than firms in countries such as Japan and
Germany
Working Capital
Management
Chapter 15
Working Capital
Terminology
 Working capital management
 the management of short-term assets
(investments) and liabilities (financing
sources)
Working Capital
Terminology
 Working capital
 a firm’s investment in short-term assets
 cash
 marketable securities
 inventory
 accounts receivable
Working Capital
Terminology
 Net working capital
 Current assets minus current liabilities
 the amount of current assets financed by
long-term liabilities
Working Capital
Terminology
 Working capital policy
 target levels for each current asset account
 how current assets will be financed
Working Capital
Terminology
 Working capital only includes current
liabilities that are specifically used to
finance current assets
Working Capital
Terminology
 Working capital does not include current
liabilities that may be due in the current
period if they are due from long-term
capital decisions, even though these must
be considered when assessing the firm’s
ability to meet its current obligations
Working Capital
Terminology
 Not working capital:
 current maturities of long-term debt
 financing associated with a construction
program that will be funded with the
proceeds of a long-term security issue after
the project is completed
 use of short-term debt to finance fixed
assets
The Requirement for
External Working Capital
Financing
 Seasonal variations
 Business cycles
 Expansion requires more
working capital
The Cash Conversion Cycle
 The length of time from the payment for
the purchase of raw materials to
manufacture a product until the
collection of accounts receivable
associated with the sale of the product
The Cash Conversion Cycle
 1. The inventory conversion period
 length of time required to convert
materials into finished goods and then to
sell those goods
 the amount of time the product remains in
inventory in various stages of completion
The Cash Conversion Cycle
 1. The inventory conversion period
Inve ntory
Inve ntory
Inve ntory
conversion 

 Cost of goods  Annual costof goods sold 
period

 

360

 sold per day  
The Cash Conversion Cycle
 2. The receivables collection period
 average length of time required to convert
the firm’s receivables into cash
 also called days sales outstanding (DSO)
The Cash Conversion Cycle
Receivables
Receivables
Receivables


collectionperiod Averagedaily credit sales  Annual credit sales


360


The Cash Conversion Cycle
 3. The payables deferral period
 average length of time between the
purchase of raw materials and labor and
the payment of cash for them
Payables
Accounts payable
Accounts payable
defe rral 

Cre dit purchases per day  Cost of goods sold 
period


360


The Cash Conversion Cycle
 4. The cash conversion cycle
 net the three periods
 average length of time a dollar is tied up in
current assets
Cash
Inventory
Receivables Payables
conversion = conversion + collection _ deferral
cycle
period
period
period
Working Capital Investment
and Financing Policies
 Two basic questions:
 1. What is the appropriate level for current
assets, both in total and by specific
accounts?
 2. How should current assets be financed?
Alternative Current Asset
Investment Policies
 Relaxed current asset investment policy
 relatively large amounts of cash and
marketable securities and inventories are
carried and sales are stimulated by a
liberal credit policy that results in a high
level of receivables
Alternative Current Asset
Investment Policies
 Restricted current asset investment
policy
 holdings of cash and marketable securities
and inventories are minimized
Alternative Current Asset
Investment Policies
 Moderate current asset investment policy
 a policy that is between the relaxed and
restricted policies
Current Assets
 Permanent current asset
 current asset balances that do not change
due to seasonal or economic conditions
 these balances exist even at the trough of a
firm’s business cycle
Current Assets
 Permanent current asset
Permanent current assets
Current Assets
 Temporary current asset
 current assets that fluctuate with seasonal
or economic variations in a firm’s business
Current Assets
 Temporary current asset
Temporary current assets
Alternative Current Asset
Financing Policies
 Maturity matching, or “self-liquidating”
approach
 a financing policy that matches asset and
liability maturities
 this would be considered a moderate
current asset financing policy
Alternative Current Asset
Financing Policies
 Aggressive approach
 a policy where all of the fixed assets of a
firm are financed with long-term capital,
but some of the firm’s permanent current
assets are financed with short-term
nonspontaneous sources of funds
Alternative Current Asset
Financing Policies
 Conservative approach
 a policy where all of the fixed assets, all of
the permanent current assets, and some of
the temporary current assets of a firm are
financed with long-term capital
Advantages and Disadvantages of
Short-Term Financing
 Speed
 a short-term loan can be obtained much
faster than long-term credit
 Flexibility
 for cyclical needs, avoid long-term debt
 cost of issuing long-term debt is higher
 penalties for payoff prior to maturity
 restrictive covenants
Advantages and Disadvantages of
Short-Term Financing
 Cost of long-term versus short-term debt
 yield curve is generally upward sloping
 short term interest rates are generally
lower than long-term rates
Advantages and Disadvantages of
Short-Term Financing
 Risk of long-term versus short-term debt
 short-term debt subjects the firm to more
risk than long-term debt
 short-term interest expenses fluctuate
 firm may not be able to repay short-term
debt, thus might be forced into bankruptcy
Short-Term Credit
 Any liability originally scheduled for
repayment within one year
Sources of Short-Term
Financing
 Accruals
 continually recurring short-term liabilities
 liabilities such as wages and taxes that
increase spontaneously with operations
 Accounts payable (trade credit)
 credit created when one firm buys on credit
from another firm
Sources of Short-Term
Financing
 Short-term bank loans
 maturity typically 90 days
 promissory note specifies terms and
conditions
 amount, interest rate, repayment schedule,
collateral, and any other agreements
Sources of Short-Term
Financing
 Short-term bank loans (cont.)
 compensating balances of 10 to 20 percent
may be required to be maintained in a
checking account
 line of credit may be arranged
 specified maximum amount of funds
available
Sources of Short-Term
Financing
 Short-term bank loans (cont.)
 revolving credit agreement
 line of credit where funds are committed,
or guaranteed
 commitment fee
 fee charged on the unused balance of a
revolving credit agreement
Sources of Short-Term
Financing
 Commercial paper
 unsecured short-term promissory notes
issued by large, financially sound firms to
raise funds
Sources of Short-Term
Financing
 Secured loans
 loan backed by collateral
 for short-term loans, the collateral is often
either inventory or receivables
 factoring is the sale of receivables
 the lender may seek recourse (payment)
from the borrowing firm for uncollectible
receivables used to secure a loan
Computing the Cost of
Short-Term Credit
 Interest rate
=
Dollar cost of borrowing
Amount of usable funds
m
  Interest rate 
Effective
  1.0
 EAR  1  
annual rate
  per period 
Annual
 Inte re strate 
  m  i SIMPLE
 APR  
pe rce ntagerate
 pe r pe riod 
Computing the Cost of
Short-Term Credit
 Discount interest loan
 a loan in which the interest, which is
calculated on the amount borrowed
(principal), is paid at the beginning of the
loan period
 interest is paid in advance
Managing Cash and
Marketable Securities
 Cash management
 goal of minimizing the amount of cash the
firm must hold for use in conducting its
normal business activities, but sufficient to:
 pay suppliers
 maintain its credit rating
 meet unexpected cash needs
Firms Hold Cash For:
 1. Transaction balance
cash balance necessary for day-to-day
operations
the balance associated with routine payments
and collections
 2. Compensating balance
deposit to meet bank loan requirements
Firms Hold Cash For:
3. Precautionary balance
cash balance held in reserve for unforeseen
fluctuations in cash flows
access to line of credit can reduce the need
for precautionary balances
4. Speculative balance
cash balance that is held to enable the firm to
take advantage of any bargain purchases
that might arise
easy access to borrowed funds can reduce the
need for speculative balances
Cash Management
Techniques
 Cash forecasts
 predict the timing of cash flows
 Synchronized cash flows
 cash inflows coincide with cash outflows,
permitting a firm to hold low transaction
balances
Cash Management
Techniques
 Float
 the difference between the balance shown
in a checkbook and the balance on the
bank’s records
 Disbursement float
 the value of checks that have been written
and disbursed but that have not fully
cleared through the banking system and
thus have not been deducted from the
account on which they were written
Cash Management
Techniques
Collection float
 the amount of checks that have been
received and deposited but that have not yet
been credited to the account in which they
were deposited, because they have not
cleared through the banking system
Cash Management
Techniques
 Net float
 the difference between disbursement float
and collection float
 the difference between the balance shown
in the checkbook and the balance shown on
the bank’s books
Cash Management
Techniques
 Acceleration of receipts
 lockbox arrangement
 reduce float by having payments sent to
post office boxes located near customers
– faster mail delivery
– faster check clearing within the same
Federal Reserve district
Cash Management
Techniques
 Acceleration of receipts
 preauthorized debit system
 allows a customer’s bank to periodically
transfer funds from that customer’s
account to a selling firm’s bank account
for the payment of bills
Cash Management
Techniques
 Acceleration of receipts
 concentration banking
 a technique used to move funds from many
bank accounts to a more central cash pool
in order to more effectively manage cash
Cash Management
Techniques
 Disbursement control
 centralized disbursement system
 more control, but can delay payments
Cash Management
Techniques
 Disbursement control
 centralized disbursement system
 more control, but can delay payments
 zero-balance account (ZBA)
 special account used for disbursements
that has a balance of zero when there is no
disbursement activity
Cash Management
Techniques
 Disbursement control
 controlled disbursement accounts (CDA)
– checking accounts in which funds are not
deposited until checks are presented for
payment, usually on a daily basis
Cash Management
Techniques
 Marketable securities
 securities that can be sold on short notice
without loss of principal or original
investment
 substitute for cash balances
 temporary investment
– finance seasonal or cyclical operations
– amass funds to meet financial requirements
in the near future
Credit Management
 Credit policy
 a set of decisions that include a firm’s
credit standards, credit terms, methods
used to collect credit accounts, and credit
monitoring procedures
Credit Management
 Credit standards
 standards that indicate the minimum
financial strength a customer must have to
be granted credit
Credit Management
 Terms of credit
 the payment conditions offered to credit
customers
 length of credit period and any cash
discounts offered
Credit Management
 Credit period
 the length of time for which credit is
granted
 after that time, the credit account is
considered delinquent
Credit Management
 Cash discount
 a reduction in the invoice price of goods
offered by the seller to encourage early
payment
Credit Management
 Collection policy
 the procedures followed by a firm to collect
its accounts receivables
Credit Management
 Receivables monitoring
 the process of evaluating the credit policy
to determine if a shift in the customers’
payment patterns occurs
Credit Management
 Receivables monitoring
 1. Days sales outstanding (DSO)
 the average length of time required to
collect accounts receivable
 also called the average collection period
Credit Management
 Receivables monitoring
 2. Aging schedule
 report showing how long accounts
receivable have been outstanding
 the report divides receivables into specified
periods, which provides information about
the proportion of receivables that is
current and the proportion that is past due
for given lengths of time
Aging Schedule
Age of Account
(in days)
0-30
31-60
61-90
Over 90
Net Amount
Outstanding
$ 72,000
90,000
10,800
7,200
$180,000
Fraction of
Total Receivables Average Days
40%
50%
6%
4%
100%
18
55
77
97
DSO = 0.40 (18 days) + 0.50 (55 days) + 0.06 (77 days) + 0.04 (97 days)
= 43.2 days
Credit Management
 Analyzing proposed changes in credit
policy
 Use NPV analysis the same as for capital
budgeting analysis (Chapter 13)
 Timing of the cash inflows and cash
outflows is important to the analysis
Inventory Management
 Raw materials
 inventories purchased from suppliers that
will ultimately be transformed into finished
goods
 Work in-process
 inventory in various stages of completion
Inventory Management
 Finished goods
 inventories that have completed the
production process and are ready for sale
 Optimal inventory level
 sustain operations at the lowest possible
cost
Inventory Management
 Stockout
 when a firm runs out of inventory and
customers arrive to purchase the product
Inventory Management
 Inventory costs
 carrying costs
 storage, insurance, use of funds,
depreciation, etc…
 ordering costs
 costs of placing an order
 the cost of each order is generally fixed
regardless of the average size of inventory
Inventory Management
 Total inventory costs (TIC)
=
Total
carrying
costs
+
Total
ordering
costs
 Carrying cost  Ave rageunits   Cost pe r  Numbe r of 
  
  
  

 
 pe r unit   in inve ntory   orde r   orde rs 

C  PP 

Q
 
2

O

T
 
Q
Inventory Management
 Economic order quantity (EOQ)
 the optimal quantity that should be
ordered
 it is the quantity that will minimize the
total inventory costs
Inventory Management
 EOQ model
 formula for determining the order quantity
that will minimize total inventory costs
2O T
EOQ 
C  PP
Inventory Management
 EOQ model extensions
 reorder point
 the level of inventory at which an order
should be placed
Inventory Management
 EOQ model extensions
 reorder point
 the level of inventory at which an order
should be placed
 safety stocks
 additional inventory carried to guard
against changes in sales rates or
production/shipping delays
Inventory Management
 EOQ model extensions
 quantity discount
 a discount from the purchase price offered
for inventory ordered in large quantities
 seasonal adjustments
 EOQ computed separately for each season
to account for sales variations
Inventory Management
 Inventory control systems
 red-line method
 an inventory control procedure in which a
red line is drawn around the inside of an
inventory-stocked bin to indicate the
reorder point level
Inventory Management
 Inventory control systems
 computerized inventory control system
 a system of inventory control in which a
computer is used to determine reorder
points and to adjust inventory balances
Inventory Management
 Inventory control systems
 just-in-time system
 a system of inventory control in which a
manufacturer coordinates production with
suppliers so that raw materials or
components arrive just as they are needed
in the production process
Inventory Management
 Inventory control systems
 out-sourcing
 the practice of purchasing components
rather than making them in-house
Multinational Working
Capital Management
 Cash management
 speed up collections and slow down
disbursements
 shift cash as rapidly as possible to those
areas where it is needed
 put temporary cash balances to work
earning positive returns
Multinational Working
Capital Management
 Credit management
 credit policy is more important
 risk of default
 political and legal collection constraints
 exchange rate changes between sale and
time receivable is collected
Multinational Working
Capital Management
 Inventory management
 concentrate inventory or distribute ?
 costs versus distribution schedules
 exchange rates affect inventory
 threat of expropriation
 tax effects
Investment Concepts
Chapter 16
Investment Concepts
 Investors
 individuals who purchase investments with
current savings in anticipation of relatively
stable growth on average, or in the long
term
Investment Concepts
 Speculators
 individuals who search for mispriced
securities in an effort to earn abnormal
returns
Investment Concepts
 Speculators
 gamble on whether the prices of financial
assets believed to be mispriced will adjust
accordingly in the market
The Investment Process
 Investment objectives
 1. Retirement planning
The Investment Process
 Investment objectives
 2. Supplement current income
The Investment Process
 Investment objectives
 3. Shelter current income from taxes
The Investment Process
 Investment objectives
 4. Achieve future goals
The Investment Process
 Income securities
 preferred stock
 corporate bonds
 steady dividend or interest payments
The Investment Process
 Investor’s attitude toward risk
 risk tolerance level
 an investor’s ability and willingness to
tolerate, or accept, risk
Implementation to Achieve
Investment Objectives
 Transaction costs
 the costs associated with trading securities,
which include the costs of time, effort, and
phone calls, as well as brokerage
commissions that are incurred
Implementation to Achieve
Investment Objectives
 Investment portfolio
 a combination of investment instruments
Stock
Bond
Real
Estate
Implementation to Achieve
Investment Objectives
 Asset allocation
 the proportion of funds invested in various
categories of assets, such as money market
instruments, long-term debt, stocks, and
real estate
Implementation to Achieve
Investment Objectives
 Monitoring the investment positions
 to make sure goals are met
 to adjust to changing economic and legal
conditions
 to include new investment instruments
Investment Alternatives
 Risk tolerance
 Time frame
Securities Transactions
 Brokerage firms versus financial
intermediaries
 broker
 agent (middleman) who helps investors
trade financial instruments such as stocks,
bonds, and derivatives
 investors directly provide funds to users of
those funds
Securities Transactions
 Brokerage firms versus financial
intermediaries
 financial intermediaries
 banks and S&Ls
 manufacture financial products such as
mortgages, automobile loans, NOW
accounts, or pension funds
 allow savers to indirectly provide funds to
borrowers
Securities Transactions
 Brokerage firms
 full-service brokerage firm
 offers a variety of services to its clients,
including research information, monthly
publications that contain investment
recommendations, advisory services, etc...
Securities Transactions
 Brokerage firms
 discount brokerage firm
 offers clients only the basic services
associated with trading securities
 trade execution and related reporting
requirements
Securities Transactions
 Trading securities
 trading quantities
 round lots
– multiples of 100 shares
 odd lots
– trades with shares that are not in
multiples of 100
Securities Transactions
 Trading securities
 types of orders
 market order
– an order to execute a transaction at the best
price available when the transaction reaches
the market
 stop order
– an order that specifies the price at which an
order to buy or sell at the market price (a
market order) is initiated
Securities Transactions
 Trading securities
 types of orders
 limit order
– an order to buy or sell a stock at no worse
than a specified price
 day order (DO)
– instruction to cancel an order if the price
conditions are not met by the end of the
trading day
Securities Transactions
 Trading securities
 types of orders
 good ‘til cancelled (GTC)
– indicates an order is active until the
price limitations are met or until the
investor cancels it
 fill or kill order
– instructs the broker to cancel the order
if it cannot be executed immediately
Securities Transactions
 Trading securities
 evidence of ownership
 physical possession of shares registered in
your name
 brokerage firm holds shares in street name
(registered to the brokerage firm)
Securities Transactions
 Trading securities
 security insurance
 provided by most brokerage firms
 SIPC limit of $500,000
 additional limits from private
organizations
Investment Information
 Value Line Investment Survey
 Moody’s Investment Services
 Standard and Poor’s
 New York Times
 The Wall Street Journal
Investment Information
 Barron’s
 Investor’s Business Daily
 Business Week
 Forbes
 Fortune
 Money
Investment Information
 Stock
Quotes
Investment Information
 Bond Quotes
Investment Information
 Treasuries Quotes
Computing Investment
Returns
 Individual security
Dollar

return

Income

Ending value
-
Beginning value
received of investment of investment
INC

P1
-
P0
Computing Investment
Returns
 Holding period return (HPR)
 the return earned over the period of time
an investment is held
 Ending value - Beginning value 

Income  
Rate of
of inve stment of inve stment 

 k 
Beginning value of inve stment
return

INC  P1 - P0  Holding period

P0
return (HPR)
Computing Investment
Returns
 Dividend yield
 the part of the total return associated with
the dividends paid by the firm
 computed by dividing the amount of
dividends paid by the stock price
 Capital gain (loss)
 change in the market value of a security
Computing Investment
Returns
 Annualized rate of return
INC  P1 - P0   360 
k


P0
 T 
Computing Investment
Returns
 Simple arithmetic average return
 computed by summing each return and
then dividing by the number of returns
 does not consider compounding
Computing Investment
Returns
 Simple arithmetic average return
k1  k 2    k N
KA 
N
N

k
t 1
N
t
Computing Investment
Returns
 Geometric average return
 computed by taking the nth root of the
growth multiple and subtracting 1.0
 takes into account compounding
Computing Investment
Returns
 Geometric average return


K G  1  k 1   1  k 2     1  k N 
1
N
 N
1  k t 

 t 1


 1.0
1
N
 1.0
Computing Investment
Returns
 Computing the return on a portfolio
 Value of 
 Value of 
 Value of 
 Security 1 
 Security 2 
 Security N 
k 1  
k 2    
k N
kp  
 Portfolio 
 Portfolio 
 Portfolio 
 value 
 value 
 value 

w 1k1
n
  w jk j
j1

w 1k1

wnkn
Indexes
Measuring Market Returns
 Dow Jones Industrial Average (DJIA)
 30 largest industrial firms in U. S.
 Standard & Poor’s family of indexes
 S&P 500, S&P 400, S&P Industrials
 Exchange indexes
 NYSE, AMEX, NASDAQ
 Russell 3,000
 Wilshire 5,000
Indexes
Measuring Market Returns
 Market capitalization
 the total market value of a firm’s stock
 computed by multiplying the number of
shares outstanding by the market price per
share
Indexes
Measuring Market Returns
 Bull market
 a rising stock market
 Bear market
 a falling stock market
Alternative Investment
Strategies
 Buy-and-hold strategy
 strategy allowing investors to purchase
securities with the intent to hold them for a
long period, perhaps a number of years
Alternative Investment
Strategies
 Margin trading
 type of trade that allows an investor to
borrow from his or her broker some
portion of the funds needed to purchase an
investment
Alternative Investment
Strategies
 Margin requirement
 the minimum percent of the total purchase
price an investor must have to buy stock
(or other investments) on margin
Alternative Investment
Strategies
 Hypothecation agreement
 assigns securities as collateral for a margin
loan
Alternative Investment
Strategies
 Broker loan rate
 the rate charged by brokers to borrow
funds for margin trading
Alternative Investment
Strategies
 Actual margin
 the percentage of investor’s equity
 must meet the margin requirement when
the stock is purchased
Alternative Investment
Strategies
 Actual margin
Investor's equity
Market value of investment
 Price per  Amount 
  

# shares  
share   borowed


 Price per

# shares  
 share 
Alternative Investment
Strategies
 Margin call
 a call from the broker to add more funds to
a margined account
 Maintenance margin
 the lowest actual margin the broker will
permit margined investors to have at any
time
Alternative Investment
Strategies
 Short selling
 type of trade that allows an investor to
borrow the stock of another investor and
then sell it, but with a promise to replace
the stock at a later date
 cannot sell short on a downtick
Alternative Investment
Strategies
 Downtick
 a decrease in price from one trade to
another
Alternative Investment
Strategies
 Uptick
 occurs when the price of the most recent
trade is higher than
the previous trade
Alternative Investment
Strategies
 Zero-plus tick
 occurs when the price of the latest trade
equals the price of the previous trade, but
exceeds the price from one trade earlier
 Shorting against the box
 occurs when an investor short sells a stock
he or she also owns
 refers to having the securities in a strong,
or safe deposit, box
Security Valuation
and Selection
Chapter 17
Fundamental Analysis
versus Technical Analysis
 Fundamental analysis
 the practice of evaluating the information
contained in financial statements, industry
reports, and economic factors to determine
the intrinsic value of a firm
Fundamental Analysis
versus Technical Analysis
 Intrinsic value
 the “true” or economic, value of a firm
Fundamental Analysis
versus Technical Analysis
 Fundamentalist
 analysts who utilize analysis in an attempt
to forecast future stock price movements
Fundamental Analysis
versus Technical Analysis
 Technical analysis
 examination of supply and demand for
securities to determine trends in price
movements of stocks or financial
instruments
Fundamental Analysis
versus Technical Analysis
 Technicians
 the term given to analysts who examine
stocks and financial markets using
technical analysis
Economic Analysis
 Forecasting business cycles
 to determine when to expect changes in the
business cycle, or the direction in which
aggregate economic activity is moving
Economic Analysis
 Business cycle
 the movement in aggregate economic
activity as measured by the gross domestic
product (GDP)
Economic Analysis
 Expansion
 increasing economic activity
Economic Analysis
 Contraction
 decreasing economic activity
Economic Analysis
 Gross Domestic Product (GDP)
 a measure of all of the goods and services
produced in the economy during a specified
time period
Economic Analysis
 Recession
 two consecutive quarters of economic
contraction, or decline, in the GDP
Economic Analysis
Economic Analysis
 Economic indicators
 Leading economic indicators
 economic measures that tend to move prior to,
or precede, movements in the business cycle
Economic Analysis
 Economic indicators
 Lagging economic indicators
 economic measures that tend to move after, or
follow, movements in the general economy
(business cycles)
Economic Analysis
 Economic indicators
 Coincident indicators
 economic measures that tend to mirror, or
move at the same time as, business cycles
Business Cycles
Business Cycles - Monetary
Policy and Fiscal Policy
 Monetary Policy
 the means by which the Federal Reserve
influences economic conditions by
managing the nation’s money supply
Business Cycles - Monetary
Policy and Fiscal Policy
 Fiscal Policy
 Government spending, which is primarily
supported by the government’s ability to
tax individuals and businesses
Business Cycles - Monetary
Policy and Fiscal Policy
 Deficit spending
 situation that occurs when the government
spends more than it collects in taxes
Industry Analysis
 Cyclical industries
 industries that tend to be directly related to
business cycles such that they perform best
during expansions and worst during
contractions
Industry Analysis
 Defensive, or countercyclical, industries
 industries that tend to perform best when
the economy is in a contraction or
recession, but are generally the poorest
performers in expanding economies
Industry Analysis
 Industry life cycle
 the various phases of an industry with
respect to its growth in sales and its
competitive conditions
Industry Life Cycle
Industry
Sales
Mature
Expansion
(Growth)
Introductory
Life-Cycle
Evaluating the Firm’s
Financial Position
 Financial statement analysis
 comparison to other similar firms
 forecast direction for future
 predict earnings and dividends
 risk evaluation
Stock Valuation Techniques
 Dividend discount models (DDM)
 a model that utilizes the discounted cash
flow principle to value common stock
 value is represented by the present value of
the dividends expected to be received from
investing in the stock
Stock Valuation Techniques
 Dividend discount models (DDM)
Value of stock  Vs  P̂0  PV of expected future dividends

D̂1
1  k s 
1


t 1
D̂ 2

1  k s 
D̂ t
1  k s 
t
2

D̂ 
1  k s 
Stock Valuation Techniques
 Valuation using P/E ratios
 ratio computed by dividing the current
market price per share, P0, by the earnings
per share, EPS0
Stock Valuation Techniques
 Evaluation using the economic value
added (EVA) approach
 method used to evaluate if the earnings
generated by a firm are sufficient to
compensate the suppliers of funds - both
the bondholders and the stockholders
Stock Valuation Techniques
 Evaluation using the economic value
added (EVA) approach
Invested


EVA  IRR - WACC   

capital


Invested


 EBIT 1 - T    WACC 

capital


Economic Value Added
(EVA)
 Changing the capital structure can
change value because the WACC is
affected
 Increasing the efficiency of the firm
through reductions in operating expenses
or increases in revenue will increase
operating income and thus increase value
Technical Analysis
 Charting - using charts and graphs
 Bar chart
 a graph that indicates the high, low, and
closing price movements for a stock during a
specified period
Technical Analysis
 Charting - using charts and graphs
 Trend line
 a line that indicates the direction of the stock
price movements
 it is drawn so that it touches either the high
prices or the low prices for some of the trading
days
Technical Analysis
 Charting - using charts and graphs
 Trend line penetration
 the point at which the trading line crosses the
trend line
Technical Analysis
Technical Analysis
 Measures and indicators used by
technical analysts
 The Dow Theory
 a technique used to predict reversals in market
patterns by examining the movements of the
Dow Jones Industrial Average and the Dow
Jones Transportation Average
Technical Analysis
 Measures and indicators used by
technical analysts
 Moving averages
 stock price averages for a fixed time frame,
say 100 days, computed for a particular period
of time
Technical Analysis
 Measures and indicators used by
technical analysts
 Technical indicators
 measures used by technical analysts to forecast
future movements in stock prices
Technical Analysis
 Measures and indicators used by
technical analysts
 Market breadth indicators
 measure the trading volume and the range of
trading that takes place in the market
Technical Analysis
 Measures and indicators used by
technical analysts
 Advance/decline line
 a graph that depicts the results computing the
difference between the number of advancing
stocks and the number of declining stocks over
some time period
Technical Analysis
 Measures and indicators used by
technical analysts
 Sentiment indicators
 technical indicators that are used to monitor
the “mood” or psychology of the market
Stock Selection Criteria
 Growth stocks
 stocks of firms that have many positive net
present value opportunities
 in general, these firms exhibit sales and
earnings growth that significantly exceed
the industry averages
Stock Selection Criteria
 Value stocks
 stocks of firms that are mispriced,
especially those that are undervalued
$1.99
Investment Selection in
Efficient Markets
 Abnormal returns
 returns that exceed the returns earned by
investments with similar risks
 Weak form efficiency
 current market prices reflect all historical
information, including any information
that might be provided by examining past
price movements and trading volume data
Investment Selection in
Efficient Markets
 Semistrong form efficiency
 current market prices reflect all publicly
available information, including
information contained in historical data
and information contained in current
financial statements
 Strong form efficiency
 current market prices reflect all
information, whether it is public or private
Investment Selection in
Efficient Markets
 Even if we accept that abnormal returns
cannot be earned on a consistent basis,
we still need to evaluate the investments
we select to ensure the risk position is
appropriate and that our investment
goals are being met