Principles of Finance

Principles of Finance : Lecture 1

Steve Ellul, CFA

Copyright © 2015 Steve Ellul, CFA

Introduction

Exam: MCQ + Essay (80%)

Assignment (20%)
Tutorials

Weekly Reading Material

www.twocentsopinion.com

Steve Ellul, CFA Oct - Jan 2013 2

Business Organisation

 Sole Ownership
 Easy to initiate & limited regulation, rapid decision making
 Weak Access to Capital, Unlimited Personal Liability, dependent of life of
owner
 Partnership
 Relatively easy to form and rapidity of decision
 Relatively Weak Access to Capital, Unlimited Personal Liability, dependent
of life of owner, difficult to transfer ownership
 Corporations
 Separate Legal Entity, Unlimited Life, Easy transfer of ownership, Limited
Liability, easy to access capital.
 Harder and expensive to Set up and double taxation potential
Steve Ellul, CFA Oct - Jan 2013 3
Corporations increase value because…

Limited Liability reduces investor’s risk

Ease of Capital increases growth

opportunities

Value of an investment depend also on

its liquidity
Steve Ellul, CFA Oct - Jan 2013 4
 Objectives of the Corporation

1. Maximise Shareholder’s Wealth

2. Maximise Shareholder’s Wealth

Steve Ellul, CFA Oct - Jan 2013 5

How to Maximise Shareholder’s Wealth

Assets must generate cash

Timing of Cash Flows
Riskiness of Cash Flows
Capital Structure
Dividend Policy

Steve Ellul, CFA Oct - Jan 2013 6

The importance of EPS

Needs to be correlated with Cash Flows

Look into future EPS
EPS may decline for the good reasons
EPS may increase for the wrong reasons

Steve Ellul, CFA Oct - Jan 2013 7

 Is debt financing bad?

100% Equity Firm (BS) 50% Debt & 50% Equity Firm (BS)
Total Assets 100 Total Assets 100
Financed by: Debt 0 Financed by: Debt 50
Financed by: 100 Financed by: 50
Equity Equity
Income Statement Income Statement
Revenues 100 Revenues 100
Expenses (70) Expenses (70)
EBIT 30 EBIT 30
Interest 0 Interest (5%) (2.5)
EBT 30 EBT 27.5
Taxes (35%) (10.5) Taxes (35%) (9.6)
Net Profits 19.5 Net Profits 17.9 8

Copyright © 2013 Steve Ellul CFA

 Debt Financing is not bad

 ROE = NET INCOME/EQUITY

 ROE100% Equity = 19.5 / 100 = 19.5%
 ROELeveraged = 17.9 / 50 = 35.8%

Copyright © 2013 Steve Ellul CFA

ROE Decomposition Model

 Profit Margin
 Asset Turnover
 Equity Multiplier

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Problems with ROE

 Fails to consider risk

 Fails to consider the weight of an investment.
 Below Average ROE ?

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 Income Statement

 Summary of Profitability
 Over a period of time
 EPS: Bottom Line
 Non-Cash Transaction
 Depreciation
 Accrual Method
 EBITDA & EBIT

Copyright © 2015 Steve Ellul, CFA

Balance Sheet

 Snap shot
 List of Assets & Liabilities
 How Assets are financed
 Debt or Capital
 Numbers ≠ Cash
 Accrual Method
 Sequence according to timing
 Capital (Stockholders’ Equity) = Assets – Liabilities

Copyright © 2015 Steve Ellul, CFA

Balance Sheet

 Equity = Assets – Liabilities

 Equity = Paid-in Capital + Retained Earnings

Copyright © 2015 Steve Ellul, CFA

Balance Sheet

Copyright © 2015 Steve Ellul, CFA

Statement of Cash Flows

 Generation & Uses of CF over an accounting period

 Operating Activities
 ∆ in Working Capital
 Investing Activities
 Di/Investment in Fixed Assets
 Financing Activities
 Issuance of Debt/Equity & Distribution of Profits.

Copyright © 2015 Steve Ellul, CFA

Statement of Cash Flows

Copyright © 2015 Steve Ellul, CFA