1. SENIOR OUTCOMES SEMINAR
(BU385)
FINANCE

2. MODEL OF THE FIRM 1. OBTAIN FINANCING 2. INVEST IN RESOURCES
Short term debt
Long term debt
Stocks
2. INVEST IN RESOURCES
Current assets
Fixed assets
3. TO RUN OPERATIONS
Revenues
Expenses

3. MODEL OF THE FIRM 1. OBTAIN FINANCING Short term debt Accounts payable
Notes payable
Accrued expenses
Long term debt
Corporate bonds
Stocks
Common stock
Preferred stock
NYSE

4. MODEL OF THE FIRM 2. INVEST IN RESOURCES Current assets Cash
Marketable securities
Accounts receivable
Inventories
Fixed assets
Plant and equipment
Accumulated depreciation

5. MODEL OF THE FIRM 3. TO RUN OPERATIONS Operating profits Total sales
Cost of goods sold
Gross margins
Net profits
Selling and admin
Interest expenses
Taxes
Net profit margin

6. WHAT the firm does: WHY the firm does it: HOW the firm does it:
MODEL OF THE FIRM
OBTAIN FINANCING
2. INVEST IN RESOURCES
3. TO RUN OPERATIONS
WHY the firm does it:
MAXIMIZE SHAREHOLDER WEALTH
HOW the firm does it:
MINIMIZE RISK / MAXIMIZE RETURNS

7. BASIC CONCEPTS
Investment: What assets should the firm acquire and how much money should they spend?
Financing: What securities should the firm issue and how much should be raised issuing stocks and bonds?
Dividends: What portion of the firm’s profits should be paid in dividends (payout ratio)?
Working Capital: Management of current assets and current liabilities.

8. (using financial statements)
FINANCIAL RATIOS
(using financial statements)
Balance sheet
- Common-sized balance sheet shows assets,
liabilities, and equity as a % of total assets.
Income statement
- Common-sized income statement shows
income and expense items as a % of sales.
Statement of cash flows

9. (Each line item as a percent of sales)
INCOME STATEMENT
(Common Size)
(Each line item as a percent of sales)
($ amount) (% of sales)
Sales $2, %
COGS ,
Depreciation
EBIT
Interest paid
Taxable income
Taxes (34%)
Net income %
Dividends $ %
Addition to RE

10. (Each item as a percent of total assets)
BALANCE SHEET
(Common Size)
(Each item as a percent of total assets)
($ amt) (% tot. assets)
Current Assets cash $ % AR
Inventory
Total $
Fixed Assets
Net P & E $2,
Total assets $3, %

11. (standardized measures)
FINANCIAL RATIOS
(standardized measures)
Used by managers for planning and evaluation
Used by credit managers to assess risk
Used by investors to assess stocks and bonds
Used to compare with industry and over time

12. FINANCIAL RATIOS Types of ratios
Liquidity
-ability to meet short term debt
Asset management
-efficiency in using resources
Financial leverage management
-level of risk due to debt
Profitability
-effectiveness in generating profits
Market-based
-market’s view of the firm

13. Liquidity Ratios Current ratio = Current assets Current liabilities
CR = $50,190 / $25,523
CR = vs. 2.4 Ind. Avg.
Quick ratio = Current assets – inventories Current liabilities
QR = ($50,190 - $27,530) / $25,523
QR = .89 vs Ind. Avg.

14. Asset Management Ratios
Avg collection period = Accounts receivable Annual credit sales/365
ACP = $18,320 / ($112,760/365)
ACP = 59.3 days vs. 47 days Ind. Avg.
Inventory turnover = Cost of sales Average inventory
Inv. Turn. = $85,300 / ($27,530 + $26,470)/2
Inv. Turn. = vs. 3.9 Ind. Avg.

15. Asset Management Ratios
Fixed-asset turnover = Sales Net fixed assets
FAT = $112,760 / $31,700
FAT = vs. 4.6 Ind. Avg.
Total asset turnover = Sales Total assets
TAT = $112,760 / $81,890
TAT = vs Ind. Avg.

16. Financial Leverage Management
Debt ratio = Total debt Total assets
DR = $47,523 / $81,890
DR = 58% vs. 47% Ind. Avg.
Debt-to-equity ratio = Total debt Total equity
D/E = $47,253 / $34,367
D/E = 138.3% vs. 88.7% Ind. Avg.

17. Financial Leverage Management
Times interest earned = EBIT Interest charge
Coverage Ratio = $11,520 / $3,160
Coverage Ratio = vs. 6.7 Ind. Avg.
Equity multiplier = Total assets Total equity
EM = $81,890 / $34,367
EM = vs Ind. Avg.

18. Profitability Ratios Gross profit margin = Sales - Cost of sales Sales
GPM = ($112,760 - $85,300) / $112,760
GPM = 24.4% vs. 25.6% Ind. Avg.
Net profit margin = EAT Sales
NPM = $5,016 / $112,760
NPM = 4.45% vs. 5.1% Ind. Avg.

19. Profitability Ratios ROI = EAT Total Assets ROI = $5,016 / $81,890
ROI = 6.13% vs. 9.28% Ind. Avg.
ROE = EAT Stockholders equity
ROE = $5,016 / $34,367
ROE = 14.6% vs % Ind. Avg.

20. Market-Based Ratios
P/E ratio = Market price per share Current earnings per share
Market to book ratio= Market price per share Book value per share

21. Dividend Policy Ratios
Payout ratio = Dividends per share EPS
Dividend yield = Expected dividends per share Stock price

22. Financial Ratio Analysis
Trend analysis
XYZ current ratio
Cross-sectional analysis
XYZ current ratio
Industry averages
Both simultaneously
XYZ current ratio
Industry averages

23. Relationships Among Ratios
This is the Dupont formula:
ROE = Net profit  Total Assets  Equity margin turnover multiplier or
ROE = NPM  TAT  EM

24. Dupont Formula 14.6% = 4.45%  1.38  2.38 17.5% = 5.10%  1.82  1.89
Example of the Dupont formula:
ROE = NPM  TAT  EM
Company:
14.6% = 4.45%  1.38  2.38
Industry average:
17.5% = 5.10%   1.89

25. (PV-present value, FV-future value)
TIME VALUE OF MONEY
(PV-present value, FV-future value)
Rate of return (interest/discount rate)
B. Single Amount – PV / FV (PV Princ. #1)
C. Annuities:
FV: Sinking Fund (saving for college)
PV: Capital Recovery (car payment)
D. Cash Flows (PV Principle #2)
E. Bond valuation/Stock valuation
F. Perpetuities

26. Interest Rates Simple Interest Interest paid on the principal sum only
Compound Interest
Interest paid on the principal and on prior interest that has not been paid or withdrawn. Note: this is referred to as a discount rate when computing the PV of a FV sum of money.
Real Interest Rate
Real rate = nominal rate – inflation

27. What’s the FV of an initial $100 after 3 years if i = 10%?
PV/FV Single Amount
What’s the FV of an initial $100 after 3 years if i = 10%? 1 2 3
10% PV
100
FV = ?
$133.10
Finding FVs (moving to the right
on a time line) is called compounding.

28. What’s the PV of $100 due in 3 years if i = 10%?
PV/FV Single Amount
What’s the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting, and it’s the reverse of compounding. 1 2 3
10%
PV = ?
$75.13 FV
100

29. PV/FV Single Amount PV Principle # 1
There is an inverse relationship between interest rate and PV (present value).
How much is $1000 received one year from now worth today-using 5% and 15% discount rate?
FV Rate PV (n = 1)
$1, % $952
$1, % $870

30. What’s the FV of a 3-year ordinary annuity of $100 at 10%?
FV: Sinking Fund (saving for college)
What’s the FV of a 3-year ordinary annuity of $100 at 10%? 1 2 3
10%
PMT=100
100
100
110
121
FV = 331

31. What’s the PV of this ordinary annuity?
PV: Capital Recovery (car payment)
What’s the PV of this ordinary annuity? 1 2 3
10%
PMT=100
100
100
90.91
82.64
75.13
= PV

32. (PV-present value, FV-future value)
TIME VALUE OF MONEY
(PV-present value, FV-future value)
Cash Flows (PV Principle #2):
Cash flows closer in time have more value than cash flows received later (“bird in the hand” principle).
year CF1 CF2
1 $100 $300
total $750 $750
PV $ $630

33. What is the PV of this uneven cash flow stream?
Cash Flows (PV Principle #2)
What is the PV of this uneven cash flow stream? 1 2 3 4
10%
100
300
300 50
90.91
247.93
225.39
34.15
= PV
Option #1: total cash=$750

34. What is the PV of this uneven cash flow stream?
Cash Flows (PV Principle #2)
What is the PV of this uneven cash flow stream? 1 2 3 4
10%
300
300
100 50
272.73
247.93
75.13
34.15
= PV
Option #2: total cash = $750

35. Bonds and Their Valuation
Key features of bonds
Bond valuation
Measuring yield
Assessing risk

36. Key Features of a Bond
1. Par value: Face amount; paid at maturity. Assume $1,000.
2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest.
Generally fixed.
(More…)

37. 3. Maturity: Years until bond
must be repaid. Declines.
4. Issue date: Date when bond
was issued.
5. Default risk: Risk that issuer will not make interest or principal payments.

38. How does adding a call provision affect a bond?
Issuer can refund if rates decline. That helps the issuer but hurts the investor.
Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.
Most bonds have a deferred call and a declining call premium.
(Note: convertible bonds would have lower yields.)

39. What’s a sinking fund?
Provision to pay off a loan over its life rather than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after issuance.

40. Sinking funds are generally handled in 2 ways
1. Call x% at par per year for sinking fund purposes.
2. Buy bonds on open market.
Company would call if rd is below the coupon rate and bond sells at a premium. Use open market purchase if rd is above coupon rate and bond sells at a discount.

41. What’s the value of a 10-year, 10% coupon bond if rd = 10%?1 2 10
10%
...
V = ?
100
100
,000
$100
$100 $1 ,
000 V  + . . . + + B   1   10   10 1 + r 1 + r 1 + r d d d
= $ $ $385.54
= $1,000.

42. What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887?1 9 10
rd=?
... 90 90 90
PV1 .
PV10
PVM
1,000
887
Find rd that “works”!
r = 10.91%

43. What’s interest rate (or price) risk
What’s interest rate (or price) risk? Does a 1-year or 10-year 10% bond have more risk?
Interest rate risk: Rising rd causes bond’s price to fall. rd
1-year
Change
10-year
Change 5%
$1,048
$1,386
4.8%
38.6%
10%
1,000
1,000
4.4%
25.1%
15%
956
749

44. What is reinvestment rate risk?
The risk that CFs will have to be reinvested in the future at lower rates, reducing income.
Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

45. Year 1 income = $50,000. At year-end get back $500,000 to reinvest.
If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

46. Bond Risk
Long-term bonds: High interest rate risk, low reinvestment rate risk.
Short-term bonds: Low interest rate risk, high reinvestment rate risk.
Nothing is riskless!

47. What factors affect default risk and bond ratings?
Financial performance
Debt ratio
Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio
Current ratios
(More…)

48. What factors affect default risk and bond ratings?
Provisions in the bond contract
Secured versus unsecured debt
Senior versus subordinated debt
Sinking fund provisions
Debt maturity
Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies

49. Stocks and Their Valuation
Features of common stock
Determining common stock values
Efficient markets
Preferred stock

50. Common Stock: Owners, Directors, and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

51. Different Approaches for Valuing Common Stock
Dividend growth model
Using the multiples of comparable firms (P/E)
Free cash flow method

52. Stock Value = PV of Dividends What is a constant growth stock?
P0 = D1/(r-g) Preferred stock: P = D/r
What is a constant growth stock?
One whose dividends are expected to
grow forever at a constant rate, g. 6

53. What’s the Efficient Market Hypothesis (EMH)?
Securities are normally in equilibrium (S/D) and are “fairly priced.” One cannot “beat the market” except through good luck or inside information. 28

54. 1. Weak-form EMH:
Can’t profit by looking at past trends, support for weak-form but “technical analysis” is still used.
2. Semistrong-form EMH:
All publicly available information is reflected in stock
3. Strong-form EMH:
All information, even inside information, is embedded in stock prices. 29

55. Perpetuities and Their Valuation
Key features of perpetuities:
Fixed income
No maturity date
Valuation:
Perpetual Bond: P = I / k
Preferred Stock: P = D / k

56. Capital Budgeting (Capital Investment)
Methods of evaluation:
NPV: Net Present Value = PV(cash flows) – Net investment
IRR: Internal rate of return = true yield on investment
PB: payback = number of years to get back your investment.
PI: profitability index = PV(cf’s) / Net Invest
B. Discount rate: WACC = weighted average cost of capital

57. Capital Budgeting (Capital Investment)
Discount rate: WACC = weighted average cost of capital (hurdle rate)
Type of funding Rate Proportion Prod
Short term debt 8% %x.15=1.2
Long term debt 10% %x.35=3.5
Stocks % %X.50=10.0
WACC= %
WACC = weighted average cost of capital

58. Working Capital (Operating Capital)
Net Working capital = Current Assets – Current Liabilities