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Transcript of Corporate Finance Study Slides PDP
CORPORATE FINANCE(Ref:Introduction to Accounting and Financa-Geoff Black)
Presenter: This module will be lead-managed by
Mr.Masilamani R He has about 3 decades of working,
training & consulting experience His basic degree is in statistics &
economics His MBA is in finance and economics He also has several professional
accreditations, including performance management & project management
Corporate Finance-the agenda
A. Fundamentals of Financial Management
B. Analysis of Financial Statements
C. Time Value of Money
D. Securities Valuation
E. Risk & ReturnF. Capital
BudgetingG. The Cost of
CapitalH. Dividend Policy
Master of Business Administration
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A. Fundamentals of Financial Management
1. Definition of Financial Management The management of the finances of a
business / organization in order to
achieve financial objectives.
2. Key Objective of Financial Management Create wealth for the business. Generate cash. Provide adequate return on investment
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A. Fundamental of Financial Management
1. Key elements process of financial management a) Financial Planning
Ensure enough funding is available at the
right time. b) Financial Control
Ensure that the business is meeting its
objectives.c) Financial Decision Making
Key aspects – investment, financing and
dividends.
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B. Analysis of Financial Statements
Horizontal Analysis
Vertical Analysis
Comparative Analysis
Ratio Analysis
Financil statement analysis
1. Profitability Ratio
2. Liquidity Ratio
3. Activity Ratio
4. Gearing Ratio
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B. Analysis of Financial Statements
1. Comparative Analysis
Comparative Analysis involves the comparison against the company’s past performance, against another company’s performance or against the industry average. Comparison against a benchmark will enable users to make an informed and better decision.
a) Horizontal Analysis Involves the comparison of items in the
financial statements over a two year period or more.
Comparison can be made against last year’s performance or against few years.
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B. Analysis of Financial Statements
1. Comparative Analysis
a) Vertical Analysis As not all companies are of the same size,
and comparing the absolute results of different businesses of dissimilar sizes will not provide an adequate picture.
By turning the absolute figures into percentage, we could make a more meaningful interpretation of the data.
We will compare percentages rather than the absolute figure (overcome the problems of companies with different sizes).
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis Shows the relationship between an item in
the income statement or balance sheet with
another item. Provide a meaningful data and will enable
users to understand the financial statement.
a) Profitability Ratios Measure the ability of a business entity to
earn profits. Used as an indicator of how efficient and
effective a company is in achieving its profit.
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios1) Gross Profit Margin (Ratio)
Measures the gross profit earned for every Ringgit sales.
Higher gross profit ratio indicates strong performance as the company has more profit to pay for its sales & administrative expenses.
Gross Profit Ratio = ( Gross Profit / Net Sales) x 100
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios1) Net Profit Margin (Ratio)
Measures the net profit earned for every Ringgit sales.
Higher net profit ratio indicates strong performance as the company has more profit to pay dividends to shareholders.
Net Profit Ratio = ( Net Profit / Net Sales) x 100
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Profitability Ratios1) Earning Per Share (EPS)
Measures the earning that is earned by each ordinary share after paying for tax and preference shares dividend.
The higher the earning per share the better it is.
EPS = ( Earning after Tax – Div for PS) / Total OS
PS – Preference Share, OS – Ordinary Share
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B. Analysis of Financial Statements1. Financial Ratio Analysis
a) Liquidity Ratios
Liquidity refers to the ability to generate
or raise cash.
Measure the ability of a company to meet
short term obligations or debts that might
be unexpectedly demanded to be paid
before its maturity dates.
If a company fails to pay its debts, it could
mean an end to the business.
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Liquidity Ratios1) Current Ratio
Measures the ability of a business entity to pay up current liabilities.
A current ratio of 2:1 indicates strong ability to meet short term debts.
The higher the current ratio, the more liquid the company is said to be.
Current Ratio = Current Assets / Current Liabilities
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Liquidity Ratios1) Quick Ratio
Also known as acid test ratio. Measures how many quick assets there
are to cover quick liabilities. Comprises of cash, receivables and
market securities and exclude inventory.
Current Ratio = [CA – (Inventory + Prepaid)] / CL
CA – Current Asset, CL – Current Liabilities
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
Measure the effectiveness and ability of a
company in its resources.
It can indicate how effective a company’s
inventory is being used to generate sales
or how efficient is the collection of debts
by a company.
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios1) Accounts Receivable Turnover (ART)
Measures how fast accounts receivable is collected.
Indicates the effectiveness of a business entity in managing its accounts receivables.
ART = Net Credit Sales / *Ave Account Receivable
*Ave Acc Rec = (Opening Acc Rec + Closing Acc Rec)/2
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios1) Inventory Turnover
Measures the ability of a business entity to sell its inventory.
Indicates the number of times inventory is sold.
Inventory Turnover = COGS / *Ave Inventory
COGS – Cost of Good Sold
*Ave Inventory = (Opening Inventory + Closing Inventory)/2
Master of Business Administration
6 1919
B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Activity Ratios
1) Total Assets Turnover (TAT)
Measure the relationship between sales
levels against the average total sales.
Measures the effectiveness of total
sales which are used in generating
sales.
TAT = Net Sales / Average Total Assets
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
Measure how much the assets of a
company is financed by creditor rather
than the owners.
High proportion of shareholders fund
indicates financial strength.
Heavy reliance on borrowing indicates the
risk to the investors as debts require
repayments of loan principal amount and
the interest expenses.
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Equity Ratios
Measure the financial structure of a
company.
Higher equity ratios indicate stability.
Equity Ratio = (*Total OS Fund / Total
Assets) x 100
* Total Ordinary Shareholder Fund include retained
earnings and reserves but exclude preference
shares
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Debts Ratios
Measures the financial structure of a company.
Higher debt ratios indicate that a company face a
higher risk in its ability to settle its debts.
Debt Ratio = *Total Debts / Total Assets) x 100
* Total debts = Total Liabilities + Preference S/holders Fund
Master of Business Administration
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B. Analysis of Financial Statements
1. Financial Ratio Analysis
a) Gearing Ratios
1) Debts to Equity Ratios (DER) Measures how much of total debts are
covered by equity. The lower ratio the better it is as
indicates the amount owned by equity is more than liabilities.
DER = *Total Debts / Total Shareholder
Equity
* Total debts = Total Liabilities + Preference
S/holders Fund
Master of Business Administration
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B. Analysis of Financial Statements
No Category Financial ratio Year 1 Year 2
1.Profitability Gross profit Margin
Net Profit Margin
Earnings Per share
2.Lquidity Current Ratio
Quick Ratio
3.Efficiency A/C Receivable T/O
Receivables T/O
Total Assets T/O
Financial Ratios Analysis – Practical Example
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B. Analysis of Financial Statements
No Category Financial ratio Year 1 Year 2
3.Viability. Equity ratio
Debt Ratio
Debt/Equity Ratio
4.Other Analysis
Financial Ratios Analysis – Practical Example
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C. Time Value of Money
TVM
Interest Future Value Present Value
Simple
Compound
Amortization
Annuity
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C. Time Value of Money
1. The Interest Rate
Which would you prefer -- $10,000 today or
$10,000 in 5 years?
Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!
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C. Time Value of Money
1. The Interest Rate
TIME allows you the opportunity to postpone consumption and earn INTERESTINTEREST.
Why is TIME such an important element in your decision?
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C. Time Value of Money
1. The Interest Rate
a) Simple Interest Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
b) Compound Interest Interest paid (earned) on nay previous
interest earned, as well as on the principal
borrowed (lent).
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C. Time Value of Money
1. The Interest Rate
Simple Interest - Formula
SI = P0(i)(n)P0(i)(n)
Where SI = Simple Interest
P0 = Deposit Today (t=0)
i = Interest Rate Per Period
n = Number of Time Periods
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
Simple Interest - Example
Assume that you deposit RM1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?
SI=P0(i)(n)=RM1,000(.07)(2) = RM140
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Compound Interest
When interest paid on an investment during
the first period is added to the principal.
During the second period, interest is earned
on the new sum.
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Compound Interest - Formula
CI = P(1 + i)n
Where CI = Compound Interest
P = Deposit Today
i = Interest Rate Per Period
n = Number of Time Periods
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Compound Interest – ExampleDavid deposited RM100 into his saving account
in Maybank for 5 years with interest of 5% per
annum. What is the return that he is expected to
receive at the end of 5th year?
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding - Formula
FVn = PV0(1 + [i/m])mn
Where n = Compounding Period per year
i = Annual Interest Rate
FVn,m= FV at the end of Year n
PV0= PV of the Cash Flow today
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding - Example
Suppose you deposit $1,000 in an account that
pays 12% interest, compounded quarterly. How
much will be in the account after eight years if
there are no withdrawals?
Master of Business Administration
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C. Time Value of Money
1. The Interest Rate
a) Frequency of Compounding - Question
John deposit $1,000 in an account that pays 12%
interest, compounded monthly. How much will be
in the account after one year if there are no
withdrawals?
Master of Business Administration
6 38
C. Time Value of Money
1. Future Value - Formula
FV = PV (1+i)n
Where FV = Future Value
PV = Present Value
i = Rate of interest per compounding period
n = Number of Compounding Periods
Master of Business Administration
6 39
C. Time Value of Money
1. Future Value - Example
If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?
0 1 2
$2,000
FV
6%
Master of Business Administration
6 40
C. Time Value of Money
1. Present Value - Question
John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.
0 1 2 3 4 5
$5,000
FV5
8%
Master of Business Administration
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C. Time Value of Money
1. Present Value - Formula
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Where FV = Future Value
PV = Present Value
i = Rate of interest per compounding period
n = Number of Compounding Periods
Master of Business Administration
6 42
C. Time Value of Money
1. Present Value - Example
Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?
0 5 10
$4,000
6%
PV0
Master of Business Administration
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C. Time Value of Money
1. Present Value - Question
Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.
0 1 2 3 4 5
$2,500
PV0
4%
Master of Business Administration
6 44
C. Time Value of Money
1. Annuities An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Examples of Annuities Include:
- Car Loan Payments
- Insurance Premiums
- Mortgage Payments
Master of Business Administration
6 45
C. Time Value of Money
1. Annuities
a) Annuities Future Value - Formula
FVAn = R(1+i)n-1 + R(1+i)n-2 + ... + R(1+i)1 + R(1+i)0
R R R
0 1 2 n n+1
FVAn
R = Periodic Cash Flow
Cash flows occur at the end of the period
i% . . .
Master of Business Administration
6 46
C. Time Value of Money
1. Annuities
a) Annuities Future Value - Question
If one saves $1,000 a year at the end of every
year for three years in an account earning 7%
interest, compounded annually, how much will
one have at the end of the third year?
Master of Business Administration
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C. Time Value of Money
1. Annuitiesa) Annuities Present Value - Formula
PVAn = R/(1+i)1 + R/(1+i)2 + ... + R/(1+i)n
R R R
0 1 2 n n+1
PVAn
R = Periodic Cash Flow
i% . . .
Cash flows occur at the end of the period
Master of Business Administration
6 48
C. Time Value of Money
1. Annuitiesa) Annuities Present Value - Question
If one agrees to repay a loan by paying $1,000
a year at the end of every year for three years
and the discount rate is 7%, how much could
one borrow today?
Master of Business Administration
6 49
C. Time Value of Money
1. Amortization - Example
Julie Miller is borrowing $10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years.
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)R = $10,000 / 3.605 = $2,774
Master of Business Administration
6 50
C. Time Value of Money
1. Amortization – Example (Table)
[Last Payment Slightly Higher Due to Rounding]
Master of Business Administration
6 51
C. Time Value of Money
1. Amortization – Question
Supposed you borrow $6,655 to make repairs to your house, and the loan is considered a second mortgage. The term of the loan require you to make payments every three months I.e. quarterly for the next two years and the simple interest rate is 6 percent p.a. What is the amount that must be paid every three months?
Master of Business Administration
6 53
D. Securities ValuationSecurities Valuation
Stock Bonds
Common Stock
Preferred Stock
1. Mortgage Bond2. Eurobonds3. Zero Coupon Bonds4. Junk Bond
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Stock market
Securities Valuation
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D. Securities Valuation
1. Preferred Stock Preferred Stock is often referred to as
a hybrid security because it has many characteristics of both common and bonds.
Like common stocks- No fixed maturity date.- Failure to pay dividends does not bring on bankruptcy.
Like bonds- Dividends are for a limited time.
Master of Business Administration
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D. Securities Valuation
1. Preferred Stock – Features
a) Multiple series of Preferred Stock
b) Preferred Stock’s claim on asset &
income
c) Cumulative dividends
d) Protective provisions
e) Convertibility
f) Retirement features
g) Callable
Master of Business Administration
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D. Securities Valuation
1. Preferred Stock – Features
a) Multiple series of Preferred Stock If a company desires, it can issue
more than one series of preferred stock, and each series can have different characteristics.- Convertible- Protective provisions
Master of Business Administration
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D. Securities Valuation
1. Preferred Stock – Features
a) Claims on Assets and Income Preferred stock has priority over
Common Stock with regard to claim on assets in the case of bankruptcy.
Honored before common stockholders, but after bonds.
Must pay dividends to preferred stockholders before it pays common stockholder dividends.
Master of Business Administration
6 59
D. Securities Valuation
1. Preferred Stock – Features
a) Cumulative Dividends Cumulative features requires that all
past, unpaid preferred stock dividends be paid before any common stock dividends are declared.
b) Protective Provisions Protective provisions generally allow
for voting rights in the event of non payment of dividends.
Master of Business Administration
6 60
D. Securities Valuation
1. Preferred Stock – Features
a) Convertibility Convertible preferred stock can, at
the discretion of the holder, be converted into a predetermined number of shares of common stock.
Almost one third of preferred stock issued today is convertible.
Reduces the cost of the preferred stock to the issue
Master of Business Administration
6 61
D. Securities Valuation
1. Preferred Stock – Features
a) Retirement Features Although preferred stock has no set
maturity associated with it, issuing firms generally provide for some method of retiring the stock.
b) Callable A call provision entitles a company
to repurchase its preferred stock from their holders at stated prices over a given time period.
Master of Business Administration
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D. Securities Valuation1. Preferred Stock
a) Valuing Preferred Stock
Where Vbs=
The value of preferred stock
D =The preferred dividend
kps=
The required rate of return
Example : Xerox’s Series C preferred stock pays an annual dividend of RM6.25 and the investors required rate of return is 5%
Vps =
D
kps
Master of Business Administration
6 63
D. Securities Valuation
1. Common Stock Common stock is a certificate that
indicates ownership in a corporation. Has no maturity date. Dividend payments will normally
divided into Interim & Final Dividend In the event of bankruptcy, common
stockholders will not receive any payment until the creditors, including the bondholders and preferred stockholders, have been satisfied.
Master of Business Administration
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D. Securities Valuation
1. Common Stock – Features
a) Claim on income
b) Claim on assets
c) Voting rights
d) Preemptive rights
e) Limited liability
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6 65
D. Securities Valuation
1. Common Stock – Features
a) Claim on income
Common shareholders have the
right to residual income after
bondholders and preferred
stockholders have been paid
Can be in the form of dividends or
retained earnings.
Master of Business Administration
6 66
D. Securities Valuation
1. Common Stock – Features
a) Claim on assets
Common stock has a residual claim
on assets after claims of debt
holders and preferred stockholders.
If bankruptcy occurs, claims of the
common shareholders generally go
unsatisfied.
Master of Business Administration
6 67
D. Securities Valuation
1. Common Stock – Features
a) Voting Rights Common shareholders are entitled
to elect the board of directors. Most often are the only security
holders with a vote. A proxy gives a designated party the
temporary power of attorney to vote for the signee at the corporation’s annual general meeting.
Master of Business Administration
6 68
D. Securities Valuation
1. Common Stock – Features
a) Preemptive Rights Preemptive right entitles the
common shareholder to maintain a proportionate share of ownership in the corporation.
Rights – certificates issued to the shareholders giving them an option to purchase a stated number of shares of stock at a specified price during a two to ten week period.
Master of Business Administration
6 69
D. Securities Valuation
1. Common Stock – Features
a) Limited Liability Liability of the shareholder is limited
to the amount of their investment.
Limited liability feature aids the firm in raising funds.
Master of Business Administration
6 70
D. Securities Valuation
1. Common Stock
a) Valuing Common Stock
Where Vcs=
The value of common stock
D0 =The preferred dividend
g=
Growth rate
kcs=
The required rate of return
gk
gDV
CSCS
10
Master of Business Administration
6 71
D. Securities Valuation
1. Common Stock
a) Valuing Common Stock – Example
Consider the valuation of a common
stock that paid RM2.00 dividend at the
end of the last year and is expected to
pay a cash dividend in the future.
Dividends are expected to grow at 10%
and the investors required rate of
return is 15%
Master of Business Administration
6 72
D. Securities Valuation
1. Bond – type of debt or long term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year.
a) Types of Bondsi. Debentures
Any unsecured long term debt. Viewed as more risky than
secured bonds and provide a higher yield than secured bonds.
Master of Business Administration
6 73
D. Securities Valuation
1. Bond
a) Types of Bondsi. Mortgage Bonds
A bond secured by a lien on real property.
Typically, the value of the real property is greater than that of the bonds issued.
ii. Eurobonds Securities (bonds) issued in a
country different from the one in whose currency the bond is denominated.
Master of Business Administration
6 74
D. Securities Valuation
1. Bond
a) Types of Bondsi. Zero Coupon Bonds
Issued at a substantial discount from the RM1,000 face value with a zero coupon rate.
Return comes from appreciation of the bonds.
Advantages – cash outflows don’t occur with zero coupon bonds.
Master of Business Administration
6 75
D. Securities Valuation
1. Bond
a) Types of Bonds
i. Junk Bonds (High Yield Bonds)
High risk debt with ratings of BB
or below by Moody’s and
Standard & Poor’s.
High yield – typically pay 3% ~
5% more than AAA grade long
term bonds.
Master of Business Administration
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D. Securities Valuation
1. Bond
a) Terminologyi. Claims on assets and income
In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock.
ii. Par Value Face value of the bond, returned
to the bondholder at maturity. Corporate bonds are issued at
denomination of RM1,000
Master of Business Administration
6 77
D. Securities Valuation
1. Bond
a) Terminologyi. Coupon Interest Rate
The percentage of the par value of the bond that will be paid out annually in the form of interest.
ii. Maturity The length of time until the bond
issuer returns the par value to the bondholder and terminates or redeem the bonds.
Master of Business Administration
6 78
D. Securities Valuation
1. Bond
a) Terminologyi. Convertibility
May allow the investor to exchange the bond for a predetermined number of the firm’s shares of common stock.
ii. Indenture The legal agreement between the
firm issuing the bond and the trustee who represents the bondholders.
Master of Business Administration
6 79
D. Securities Valuation
1. Bonda) Terminology
i. Call Provision A provision such that if the
prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.
Issuer must pay the bondholder at premium.
There is also call protection period where the firm can’t call for a specified period.
Master of Business Administration
6 80
D. Securities Valuation
1. Bonda) Valuation
Assigning a value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate.
The value of a bond is combination of:-- the amount and timing of cash
flows to be received by investors.- the time to maturity of the loan.- the investor’s required rate of return.
Master of Business Administration
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D. Securities Valuation1. Bond
a) Valuation - Formula
)1()1(1 bn
bt
n
tb
k
M
k
IV
Where Vb=
Intrinsic value
I =Interest to be received
n =Number of period to maturity
kb=
Required rate of return for bondholder
M =Par value of the bond at maturity
Master of Business Administration
6 82
D. Securities Valuation
1. Bonda) Valuation - Formula
Vb = I(PVIFAkb,n) + M(PVIFkb,n)
Where Vb=
Intrinsic value
I =Interest to be received
n =Number of period to maturity
kb=
Required rate of return for bondholder
M =Par value of the bond at maturity
Master of Business Administration
6 83
D. Securities Valuation
1. Bonda) Valuation – Example
Consider a bond issued by Toyota with a maturity date of 2008 and a stated coupon of 5.5%. In December 2004, with 4 years left to maturity, Investors owning the bonds are requiring a 4% rate of return. Calculate the price of Toyota Bond.
Master of Business Administration
6 84
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
First Relationships The value of a bond is inversely
related changes in investor’s present required rate of return (interest rate).
As interested rate increases (decreases), the value of the bond decreases (increases).
Master of Business Administration
6 85
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
Second Relationship The market value of a bond will be
less than the par value if the investor’s required rate of return is above the coupon interest rate.
However, it will be valued above par value if the investor’s required rate of return is below the coupon interest rate.
Master of Business Administration
6 86
D. Securities Valuation
1. Bonda) Valuation – 3 important relationships
Third Relationship Long term bonds have greater
interest rate risk than the short term bonds.
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6 87
E. Risk & Return
Risk & Return
Risk & Return?
Market Risk
Summary
Diversification
Master of Business Administration
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E. Risk & Return
1. Risk & Returna) What is Risk?
The possibility that an actual return will differ from our expected return.
Uncertainty in the distribution of possible outcomes.
b) What is Return? Expected Return - the return that an investor
expects to earn on an asset, given its price, growth potential, etc.
Required Return - the return that an investor requires on an asset given its risk.
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E. Risk & Return1. Expected Return - Example
State of Economy
Probability Return
(P) Company A Company B
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Master of Business Administration
6 90
E. Risk & Return
1. How do we Measure Risk?
A more scientific approach is to
examine the stock’s STANDARD
DEVIATION of returns.
Standard deviation is a measure of the
dispersion of possible outcomes.
The greater the standard deviation, the
greater the uncertainty, and therefore ,
the greater the RISK.
Master of Business Administration
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E. Risk & Return1. How do we Measure Risk?
a) Formula for Standard Deviation
Where n =The number of possible outcomes
ki=
The value of ith possible rate of return
P(ki) =Probability that ith return will occur
k =Expected value of the rate of return
)()(2
1ii kPkk
n
t
Master of Business Administration
6 92
E. Risk & Return
1. How do we Measure Risk? - Example
Company A Company B
Recession (4% -10%)2 (.2) = 7.2 (-10% -14%)2(.2) = 115.2
Normal (10% - 10%)2 (.5) = 0 (14% - 14%)2 (.5) = 0
Boom (14% -10%)2 (.3) = 4.8 (30% - 14%)2 (.3) = 76.8
Variance 12 192
Std Deviation 3.46% 13.86%
Master of Business Administration
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E. Risk & Return
1. How do we Measure Risk? - Summary
Company A Company B
Expected Return 10% 14%
Standard Deviation 3.46% 13.86%
Which stock would you prefer? How would you decide?
It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return.
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E. Risk & Return
1. Diversification Investing in more than one security to
reduce risk. If two stocks are perfectly positively
correlated, diversification has no effect on
risk. If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified. If you owned a share of every stock
traded on the BSKL and Mesdaq, would
you be diversified? YES! Would you have eliminated all of your
risk? NO! Common Stock portfolios still
have risk.
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E. Risk & Return
1. Diversification Some risk can be diversified away and some can
not.a) Market Risk is also called Non - diversifiable
risk. This type of risk can not be diversified away.
Unexpected changes in interest rates. Unexpected changes in cash flows due to
tax rate changes, foreign competition, and the overall business cycle.
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E. Risk & Return
1. Diversificationa) Firm-Specific risk is also called diversifiable
risk. This type of risk can be reduced through diversification.
A company’s labor force goes on strike.
A company’s top management dies in a plane crash.
A huge oil tank bursts and floods a company’s production area.
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E. Risk & Return
1. Market Risk As we know, the market compensates investors for
accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. So - we need to be able to measure market risk.
Beta: a measure of market risk. Specifically, it is a measure of how an individual
stock’s returns vary with market returns. It’s a measure of the “sensitivity” of an
individual stock’s returns to changes in the market.
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E. Risk & Return
1. Market Risk
A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.
A firm with a beta > 1 is more volatile than the market (ex: computer firms).
A firm with a beta < 1 is less volatile than the market (ex: utilities).
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E. Risk & Return
1. Summary of Risk & Return
We know how to measure risk, using standard deviation for overall risk and beta for market risk.
We know how to reduce overall risk through diversification.
We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
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F. Capital Budgeting
Methodology
Payback Period
Net Present Value
Internal Rate Of Return
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F. Capital Budgeting
1. Importance of Capital Budgeting
Capital budgeting is the process of evaluating
proposed large, long-term investment projects.
capital budgeting ensures that proposed
investment will add value to the firm.
Effective capital budgeting can improve both the
timing of asset acquisitions and the quality of
assets purchased.
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Payback Period (PBP)
PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflows.
Formula for PBP :-
PBP = Year b4 full recovery +
Unrecovered cost at start of yr
Cash flow during year
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
The present value of an investment project’s
net cash flows minus the project’s initial cash
outflow.
Formula for NPV :-
)1(0 k
CFNPV t
n
t
t
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
NPV’s values:- NPV = 0, the firm’s overall value will not
change if the new project is adopted.
NPV > 0, the firm’s overall value will
increase.
NPV < 0, the firm’s overall value will be
decrease.
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Net Present Value (NPV)
NPV’s Decision Rules:- For independent projects : accept all
independent projects having NPVs greater
than or equal to 0.
For mutually exclusive projects : projects
having highest positive NPV will be
ranked first.
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Internal Rate of Return (IRR)
IRR is the estimated rate of return for a
proposed project, given the project’s
incremental cash flows.
Formula for IRR :-
)1(0
0 IRR
CFt
n
t
t
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Internal Rate of Return (IRR)
IRR Decision Rules:-
For independent project – accept projects
having IRRs greater than the hurdle rate.
For mutually exclusive projects – projects
are ranked from highest to lowest IRR.
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Conflicting ranking between NPV & IRR
For Independent Projects Both the NPV and IRR methods will
produce the same accept / reject indication. Accept projects having NPV > 0, IRR >
the hurdle rate. For mutually exclusive projects
Project having a higher NPV should be
chosen instead of a higher IRR.
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F. Capital Budgeting
1. Capital Budgeting Decision Method
a) Conflicting ranking between NPV & IRR For mutually exclusive projects
Reason for higher choosing higher NPVi. NPV method makes maximizing the
firm value.ii. NPV method assumes that a project’s
cash flows can be reinvested at the cost of capital.
iii. Whereas, IRR method’s assumption on cash flows reinvestment is the IRR.
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WACC
Cost of PS Cost of Debt
Cost of Equity
G. The Cost of Capital
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G. The Cost of Capital
When we say a firm has a “cost of capital” of, for
example, 12%, we are saying:-
The firm can only have a positive NPV on a
project if return exceeds 12%.
The firm must earn 12% just to compensate
investors for the use of their capital in a project.
The use of capital in a project must earn 12% or
more, not that it will necessarily cost 12% to
borrow funds for the project.
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G. The Cost of Capital
1. Cost of Debt (Kd)
We use the after tax cost of debt because interest payments are tax deductible for the firm.
Formula for Cost of DebtKd after taxes = Kd (1 – tax rate)
Example : If the cost of debt for ABC Sdn Bhd is
10% and its tax rate is 40% then :-
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G. The Cost of Capital
1. Cost of Preferred Stock (Kps)
Preferred Stock has a higher return bonds, but is less costly than common stock. WHY?
In case of default, preferred stockholders get paid
before common stockholders. However, in case of bankruptcy, the holders of
preferred stock get paid only after short and long
term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend
and usually cannot vote on the firm’s affairs.
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G. The Cost of Capital
1. Cost of Preferred Stock (Kps)
Formula for Cost of Preferred Stock
kps =
D
Vps
Example : If ABC Sdn Bhd is issuing preferred stock at $100 per share, with a stated dividend of $12, then the cost of preferred stock :-
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G. The Cost of Capital
1. Cost of Equity (Kcs)
The cost of equity is the rate of return that
investors require to make an equity investment in
a firm.
CAPM (Capital Asset Pricing Model)
- The CAPM is one of the most commonly used
ways to determine the cost of common stock.
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G. The Cost of Capital
1. Cost of Equity (Kcs)
Formula for Cost of Equity
kcs= krf + ß (km – krf)
Where krf= The risk free rate
ß = The firm’s beta
km= The return on the market
Example : ABC Sdn Bhd has a ß = 1.6. The risk free on T-bills is currently 4% and the market return has averaged 15%:-
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G. The Cost of Capital
1. Weighted Average Cost of Capital (WACC)
Formula for WACC
WACC = wd (Cost of Debt) + wcs (Cost of Equity) + wps (Cost of PS)Example : ABC Sdn Bhd maintains a mix of 40%
debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is :-
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H. Dividend Policy
Dividend Policy
Types
Impact
Alternatives
Chronology
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H. Dividend Policy
1. Types of Dividend Policy
a) Constant Payout Ratio
b) Constant Nominal Dividend (Regular)
c) Special Dividend Payout
d) Cash Dividend Payment
2. Chronology of Date of Dividend Payment
a) Declaration Date
b) Ex Dividend Date
c) Record Date
d) Payment Date
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H. Dividend Policy
1. Impact of Dividend Policy – Firm Value
a) Arguments for Irrelevancy Theory
Signaling Effect
Clientele Effect
b) Arguments against Irrelevancy Theory
Bird in the Hand Theory
Taxes
Floatation Costs
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H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Dividend
Firms sometimes tend to distribute additional
shares in the form of dividends to a firm’s
shareholders rather than giving cash
dividends, which are kept in the firm for
investment.
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H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Dividend – Example
A firm has 10 million shares outstanding.
Currently the market value of the firm is RM20
million. Therefore, price per share is to be
RM2.00. Assume that the firm is to issue
another 1 million shares as a stock dividend. The
total number of shares outstanding will be 11
million. Hence, given the market value of the
firm, the new price per share will be?
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H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Split
Stock Split involve issuing of additional
shares to firm’s stockholders.
The investors’ percentage ownership in the
firm remain unchanged.
The investor is neither better nor worse off
before the stock split.
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H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Split – Example
YTM Bhd. Is planning a two for one stock split.
You own 5,000 shares of YTM Bhd’s stock that
is currently selling for RM12.00 per share. What
is the value of your YTM Bhd. Stock now, and
what will it be after the split?
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H. Dividend PolicyH. Dividend Policy
1. Alternative Dividend Policy
a) Stock Repurchase
It is a common practice for developed and
developing markets for a firm to buy back
stock from its shareholders.
Reasons for repurchase :-
- an effective substitute for dividends.
- the price of stocks are undervalued.
- Provide internal investment opportunity.
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H. Dividend PolicyH. Dividend Policy
1. Alternative Dividend Policy
a) Stock Repurchase – ExampleUEB Bhd. Has RM0.8 million in cash for its next
dividend. However, it is considering a repurchase of its own shares instead of paying dividends. The firm has 10 million shares outstanding, currently selling at RM2.00 per share. The P/E is 10 times and the firm’s EPS is RM0.20. What will be the firm’s dividend per share? If stock is repurchased, how many shares will be remain outstanding and what will the new EPS be?
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Accrual AccountingWhat is accrual accounting?
Revenue and expenses reported for an accounting period are the revenue earned and expenses matched to or incurred in generating that income – regardless of whether the income has actually been received or cash paid for the expenditure.
For ExampleWhere we have performed some work for a client and invoiced this client, we would include this revenue in our reporting for the period, regardless of whether we have actually received payment or not. On the expense side, we would include expenses such as electricity and gas consumed during the period even if the bill is not due for payment until the following period.
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Brief Introduction to Accounting contd.
So why are some reports cash and some accrual?
It really depends on the needs of the users.Reporting Types
There are two types of accounting or reporting:1. Financial Accounting2. Management Accounting
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Thank You