Benchmarking

Ratios are not very helpful by themselves; they need to be compared to something

Time-Trend Analysis

Used to see how the firms performance is changing through time

Internal and external uses

Peer Group Analysis

Compare to similar companies or within industries

Potential Problems

There is no underlying theory, so there is no way to know which ratios are most
relevant

Benchmarking is difficult for diversified firms

Globalization and international competition makes comparison more difficult

because of differences in accounting regulations

Varying accounting procedures, i.e. FIFO vs. LIFO

Different fiscal years

Extraordinary events

Why is the Du Pont identity a valuable tool for analyzing the performance of a
firm? Discuss the types of information it reveals compared to ROE considered
by itself.

Return on equity is probably the most important accounting ratio that measures the
bottom-line performance of the firm with respect to the equity shareholders. The Du
Pont identity emphasizes the role of a firms profitability, asset utilization
efficiency, and financial leverage in achieving an ROE figure. For example, a firm
with ROE of 20% would seem to be doing well, but this figure may be misleading if it
were marginally profitable (low profit margin) and highly levered (high equity multiplier).
If the firms margins were to erode slightly, the ROE would be heavily impacted.
Differences Between Debt and Equity

Debt includes all borrowing incurred by a firm, including bonds, and is repaid
according to a fixed schedule of payments.

Equity consists of funds provided by the firms owners (investors or stockholders)

that are repaid subject to the firms performance.

Debt financing is obtained from creditors and equity financing is obtained from
investors who then become part owners of the firm.

Creditors (lenders or debt holders) have a legal right to be repaid, whereas

investors only have an expectation of being repaid.

Differences Between Debt and Equity: Voice in Management

Unlike creditors, holders of equity (stockholders) are owners of the firm.

Stockholders generally have voting rights that permit them to select the firms
directors and vote on special issues.

In contrast, debt holders do not receive voting privileges but instead rely on the
firms contractual obligations to them to be their voice.

Differences Between Debt and Equity: Claims on Income and Assets

Equity holders claims on income and assets are secondary to the claims of
creditors.
 Their claims on income cannot be paid until the claims of all creditors,
including both interest and scheduled principal payments, have been
satisfied.

Because equity holders are the last to receive distributions, they expect greater
returns to compensate them for the additional risk they bear.

Unlike debt, equity capital is a permanent form of financing.

Equity has no maturity date and never has to be repaid by the firm.

Differences Between Debt and Equity: Tax Treatment

Interest payments to debt holders are treated as tax-deductible expenses by the

issuing firm.

Dividend payments to a firms stockholders are not tax-deductible.

The tax deductibility of interest lowers the corporations cost of debt

financing, further causing it to be lower than the cost of equity financing.

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BOND

Yield To Maturity - Is the discount rate that makes the present value of the coupon
and principal payments equal to the price of the bond.

YTM is viewed as a promised yield.

Interest Rate Risk

Risk that arises for bond owners from fluctuating interest rates is called rate risk.

How much interest rate risk a bond has depends on how sensitive its price is to
interest changes.

This sensitivity directly depends on two things:-

- the time to maturity

- coupon rate

Two things to keep in mind:-

- the longer the time to maturity, the greater the interest rate risk.
 - the lower the coupon rate, the greater the interest rate risk.

WACC is the required return on the firms assets, based on the markets perception of the
risk of those assets

Limitations of WACC
 A firms WACC should be used to evaluate the cash flows for a new project only if
the level of systematic risk for the project is the same as that for the portfolio of
projects that currently comprise the firm.

A firms WACC should be used to evaluate a project only if that project uses the
same financing mix the same proportions of debt, preferred shares and common
shares used to finance the firm as a whole.

Advantages and Disadvantages of Payback

Advantages

Easy to understand.

Adjusts for uncertainty of later cash flows.

Biased toward liquidity.

Disadvantages

Ignores the time value of money.

Requires an arbitrary cutoff point.

Ignores cash flows beyond the cutoff date.

Biased against long-term projects, such as research and development, and

new projects.

AAR is always defined as: some measure of average accounting profit some
measure of average accounting value

The specific definition is average net income average accounting value

Based on the average accounting return rule, a project is acceptable if its average
accounting return exceeds a target average accounting return.

Advantages

Includes time value of money

Easy to understand
 Does not accept negative estimated NPV investments when all future cash
flows are positive

Biased towards liquidity

Disadvantages

May reject positive NPV investments

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff point

Biased against long-term projects, such as R&D and new products

IRR Definition and Decision Rule

Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project if the IRR is greater than the required
return

NPV and IRR will generally give us the same decision

Exceptions

Nonconventional cash flows cash flow signs change more than once

Mutually exclusive projects

Initial investments are substantially different (issue of scale)

Timing of cash flows is substantially different

Payback period

Length of time until initial investment is recovered

Take the project if it pays back within some specified period

Doesnt account for time value of money, and there is an arbitrary cutoff
period

Discounted payback period

Length of time until initial investment is recovered on a discounted basis

Take the project if it pays back in some specified period

 There is an arbitrary cutoff period

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Common Types of Incremental Cash Flows

Sunk costs: costs that have accrued in the past

A cost that has already been incurred and cannot be removed and therefore
should not be considered in an investment decision.

Opportunity costs: costs of lost options

The most valuable alternative that is given up if a particular investment is

undertaken.

Therefore it should be considered in an investment decision.

Side effects

Positive side effects: benefits to other projects

Negative side effects: costs to other projects

Changes in net working capital

Financing costs

Interest paid or any other financing costs such as dividends or principle

repaid will not be included because we are interested in the cash flow
generated by the assets of the project.

E.g. interest paid is a component of cash flow to creditors and not cash flow
from assets.

Taxes

Why do we have to consider changes in NWC separately?

General accounting principle requires that sales be recorded on the income

statement when made, not when cash is received

It also requires that we record cost of goods sold when the corresponding
sales are made, whether we have actually paid our suppliers yet
 Finally, we have to buy inventory to support sales, although we havent
collected cash yet