Professional Documents
Culture Documents
1. Monitor financial health and threats thereof -Financial analysis and forecasting
2. Guide/direct the company’s investment decisions – Capital budgeting and working capital policy/
management
3. Direct the company’s financing decisions – Capital structure, debt policy, dividend policy
FINANCIAL ANALYSIS
Objective is to assess:
PROFITABILITY
a. Return on investment
b. Return on investment
c. Efficiency
d. Cost control
e. Shareholder value analysis
RISK
f. Market risk
g. Financial risk & flexibility
i. Leverage
ii. Solvency
iii. Liquidity
h. Quality of earnings
LIMITATIONS:
1. Companies may have divisions operating in many different industries, which can make it difficult to
find comparable industry ratios at the parent company level
2. Some ratios might indicate conflicting signal
3. ?The need to use human judgment
4. The use of alternative accounting methods
ISSUES:
Earnings quality issues
Trend Analysis
QUALITY OF EARNINGS
Quality of earnings emphasizes the degree of reliability of information about economic values
as communicated by reported earnings
High quality earnings
1. Convert to cash
2. Derived from recurring transactions related to the basic business of the company
3. Stable, predictable, and indicative of future earnings levels
4. Consistent, conservative accounting policies that result in prudent measurement
FINANCIAL PLANNING
1. Forecast sales
2. Prepare forecast income statement (e.g. using percentage of sales method)
3. Prepare forecast balance sheet. Identify assets and liabilities that “spontaneously” increase or
decrease with sales.
4. Compute Additional Funds Needed (AFN)
5. Determine financing plan.
6. Feedback costs of financing plan in forecast income statement.
AFN = f(sales growth, capital intensity*, payout ratio, spontaneous liabilities-to-sales ratio, profit
margin)
*Capital intensity = ratio of assets required per sales peso
• Constant Ratios
• Identical Growth Rates
• Be alert on situations where assumptions do not hold
o Economies of Scale
o Lumpy Assets
o Disproportionate growth rates
WORKING CAPITAL MANAGEMENT
A managerial accounting strategy focusing on maintaining efficient levels of both components of
working capital, current assets and current liabilities, in respect to each other. Working capital
management ensures a company has sufficient cash flow in order to meet its short-term debt
obligations and operating expenses.
Days Inventory =
365
Inventory Turnover Ratio (COGS/Ave Inventory)
• Indicates the length of the period between the purchase and the sale of inventory during each
operating cycle
Days Receivable =
365
AR Turnover Ratio (Sales/Ave Receivables)
• Indicates the length of the period between the sale of inventory and the collection of cash from
customers during each operating cycle
Days Payable =
365
AP Turnover Ratio*
• Indicates the length of the period between the purchase of inventory on account and the payment of
cash to suppliers during each operating cycle
*AP Turnover Ratio = Purchases on Account / Average AP
NE Cycle = DI + DR – DP
Operating Cycle = DI + DR
WC Management and Policy
Cash
• Minimum cash balance – determined by stability of inflows and outflows
• Interest rate: if high ? keep cash balance low
• Credit lines: more credit lines ? keep cash balance low
Accounts Receivables
o Credit cards – no credit risk, but high cost, with some delay in getting the money
o Evaluating criteria
• Terms
• Installment
• Interests (for delayed payment)
• Discounts (for prompt payment)
• Who will be granted / refused credit – customer information screening
• Limit
• Collection system – available options like bank, internet, bayad centers
o High interest rates ? less generous with credits
o Can also be affected by competitive pressures and operating costs
Inventories
o High interest ? low inventories (keep everything low)Accounts Payable
o Trade Credit – not only an act of buying but also a relatively easy to avail act of financing
• Cost of credit: non-availment of discounts (ex. 3/10 net 30 means you have 30 days after the sale to
pay, but if you pay within 10 days, you’ll get a 3% discount on the amount you have to pay)
o Relatively easy to stretch this type of payable and delay payment, although care should be taken to
avoid impairing supplier relationships
Short-term Loan
o Usually used for meeting seasonal requirements
o Costs of Credit lines
• Commitment fees (you have to pay this even if you don’t use it)
• Compensating balance (to be maintained in the account)
o Revolving credit – borrow and repay as you are able to up to a certain minimum
CASH MANAGEMENT
– A detailed forecast of cash inflows and outflows over a specified period
– How much cash should a firm have?
o Holding and ordering costs for cash
o Concept and effect of float
– Major sources of cash inflows
• Receivables collections
• Collections from other revenue sources
• Major sources of cash outflows
• Salaries/wages
• Rent and other overheads
• Purchases payments
Cash Balances
CAPITAL BUDGETING
The process in which a business determines whether projects are worth pursuing. A prospective
project’s lifetime cash inflows and outflows are assessed in order to determine whether the returns
generated meet a sufficient target benchmark.
a. Return on investment
b. Economic value-added
c. Payback
i. Payback Period = (Cost of Project/Annual Cash Inflows)
d. Discounted cash flow analysis: net present value and internal rate of return
1. Method that allows the direct comparison of future cash flows with present cash flows by
expressing all cash flows in terms of current peso values
2. Difference between the present value of future cash flows of a project and its initial investment
3. NPV Rule: Managers increase shareholder value by investing in projects with a positive net
present value.
4. If you raise the discount rate, the NPV declines. There is an inverse relationship between NPV and
discount rate.
5. NPV is one of two methods using discounted cash flows. The other one is internal rate of return
(IRR).
6. Main Features:
a. Additivity property
b. Based on the Discounted Cash Flow (DCF) model – takes into account the time value of money
c. It is a measure of wealth – measure tied to the ultimate objective
Components:
– IO = Initial Outlay
– CF = Cash Flows
– r = Required rate of return (Risk-return tradeoff)
– n = Number of periods
General Formula:
– Multiple IRR’s
– Mutually Exclusive Projects can give conflicting signals between IRR & NPV – This is where the
Incremental IRR Approach is used
– Capital Rationing
– Unequal Lives (Choosing between Long- and Short- Lived Equipment)
• Replacement/Investment Timing
DCF Guideline
Cost of Capital
– rate of return that shareholders could expect to earn if they invested in equally risky securities
– Cost is a function of risk and the time value of money.
– Debt is always the least expensive source of capital.
– Equity is always the most expensive source of capital.
– Retained earnings is a form of equity; retained earnings has a lower cost than other equity because
you are in control of the business.
a. Public
b. Private
Yield Curve
o A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-
term bonds due to the risks associated with time.
Computing returns
o Market rate of interest is the required rate of return on the debt instrument. If the investor holds on
the instrument until maturity, he/she earns the market rate of interest. This rate is also called YIELD
TO MATURITY.
o Rate of Return: Equity – Return on equity instruments have 2 sources: dividends and capital
appreciation
• Total equity return = dividend yield + capital gain as a % of price
o Risk-Return Benchmarks
o Risk-free rate – government securities
o Market rate of return for all risky assets – returns from investing in a portfolio corresponding to the
stock market index
o Market risk premium – additional return investors seek or require from an investment in a risky
asset; equals the market return less risk-free rate
Risk and diversification
o Unique risk – risk that can be eliminated through diversification
o Market risk – risk that cannot be diversified away; vulnerability to macroeconomic changes that
affect all stocks
CORPORATE FINANCING
2 Basic Financing Decisions:
1. How much profit should be plowed back into the business rather than paid out as dividends?
o Dividend policy
2. What proportion of the deficit should be financed by borrowing rather than by an issue of equity?
o Debt policy
Reasons for relying on internal funds:
1. Payment mechanism
2. Borrowing and lending – channeling savings toward those who can best use them
3. Pooling risk
&nbps;
Debt Policy
find the combination of securities that has the greatest overall appeal to investors, the combination
that maximizes the market value of the firm
Mondigliani and Miller – propositions depend on PERFECT CAPITAL MARKETS! Payout policy
doesn’t matter in perfect capital markets; also showed financing decisions don’t matter in perfect
markets
Proposition I: The market value of any firm is independent of its capital structure.
– As long as investors can borrow or lend on their own account on the same terms as the firm, they
can “undo” the effect of any changes in the firm’s capital structure
– Firm value is determined on the left-hand side of the balance sheet by real assets
– We implicitly assume that both companies and individuals can borrow and lend at the same risk-
free rate of interest
– Leverage increases the expected stream of earnings per share but not the share price – the change
in the expected earnings stream is exactly offset by a change in the rate at which the earnings are
capitalized
Proposition II: The expected rate of return on the common stock of a levered firm increases in
proportion to the debt-equity ratio (D/E), expressed in market values; the rate of increase depends on
the spread between rA, the expected rate of return on a portfolio of all the firm’s securities, and rD,
the expected return on the debt.
Kinds of Debt
Foreign bonds
– Bonds that are sold to local investors in another country’s bond market
Bond price
– Shown as a percentage of face value
– Price is stated net of accrued interest
– Sometimes bonds are sold with a lower interest payment but at a larger discount on their face
value, so investors receive a significant part of their return in the form of capital appreciation
Zero-coupon bond
– Pays no interest at all; the entire return consists of capital appreciation
Debentures
– Longer-term unsecured issues
Notes
– Shorter-term issues
Mortgage bonds
– Form a majority of secured debt
Asset-backed securities
– When companies bundle up a group of assets and then sell the cash flows from these assets
Sinking fund
– Part of the issue is repaid on a regular basis before maturity
Call option
– Allows the company to pay back the debt early
– Exercised when interest rates fall and bond prices rise, to be able to issue another at a higher price
and a lower interest rate
– Call the bond when, and only when, the market price reaches the call price!
Puttable bonds
– Give investors the option to demand early repayment
Extendible bonds
– Give investors the option to extend the bond’s life
Project finance
– Debt supported by a particular project
Dividend Policy
Dividend policy – the trade-off between retaining earnings on the one hand and paying out cash and
issuing new shares on the other
1. Legal requirements
a. Firm’s liquidity position
2. Repayment need
3. Expected rate of return (Future Investments)
4. Stability of earning
5. Desire of control
6. Access to the capital market
7. Shareholder’s individual tax situation
Dividends
– Shares are sold cum dividend until a few days before the record date, at which point they are trade
ex dividend
– Companies are not allowed to pay a dividend out of legal capital (par value of outstanding shares)
– Taxed as ordinary income
Forms of dividends
– But shareholders prefer a steady progression in dividends; they would move only partway toward
their target payment.
– DIV1-DIV0 = adjustment rate
x (target ratio x EPS1 – DIV0)
– The more conservative the company, the lower would be its adjustment rate
Information in Dividends and Stock Repurchases
– Most managers don’t increase dividends until they are confident that sufficient cash will flow in to
pay them
– Announcements of dividend cuts are usually taken by investors as bad news (stock price falls) and
dividend increases are good news (stock price rises)
– Investors do not get excited about the level of a company’s dividend; they worry about the change
– A company that announces a repurchase program is not making a long-term commitment to earn
and distribute more cash
– Companies repurchase shares when they have accumulated more cash than they can invest
profitably or when they wish to increase their debt levels – Shareholders are frequently relieved to
see companies paying out the excess cash rather than frittering it away on unprofitable investments
– Stock repurchases may also be used to signal a manager’s confidence in the future
– When companies offer to repurchase their stock at a premium, senior management and directors
usually commit to hold onto their stock
The Dividend Controversy: Does a dividend decision change the value of a stock, rather than simply
providing a signal of stock value?
– Rightists – conservative group which believes that an increase in dividend payout increases firm
value
o Whenever dividends are taxed more heavily than capital gains, firms should pay the lowest cash
dividend they can get away with; available cash should be retained or used to repurchase shares
o Investors should pay more for stocks with low dividend yields / accept a lower pretax rate of return
from securities offering returns in the form of capital gains rather than dividends
– Middle-of-the-road party – claims that dividend policy makes no difference
o Modigliani and Miller – irrelevance of dividend policy in a world without taxes, transaction costs, or
other market imperfections
o The only way to finance extra dividend is to sell shares – Capital loss borne by old shareholders just
offsets the extra cash dividend they receive
o Old shareholders can cash in by selling some of their shares
o Enough firms may have switched to low-payout policies to satisfy fully the clientele’s demand; no
incentive for additional firms to switch to low-payout policies
– Taxes on dividends have to be paid immediately, but taxes on capital gains can be deferred until
shares are sold and capital gains are realized
– Rule: Adopt a target payout that is sufficiently low as to minimize reliance on external equity
Dividend Theories
Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller also
theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as
the “dividend-irrelevance theory”, indicating that there is no effect from dividends on a company’s
capital structure or stock price.
In the determination of the value of a company, dividends are often used. However, MM’s dividend-
irrelevance theory indicates that there is no effect from dividends on a company’s capital structure or
stock price. MM’s dividend-irrelevance theory says that investors can affect their return on a stock
regardless of the stock’s dividend.
Bird-in-the-Hand Theory
The bird-in-the-hand theory, however, states that dividends are relevant. Remember that total return
(k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner (Gordon/Litner) took
this equation and assumed that k would decrease as a company’s payout increased. As such, as a
company increases its payout ratio, investors become concerned that the company’s future capital
gains will dissipate since the retained earnings that the company reinvests into the business will be
less.
Tax-Preference Theory
Taxes are important considerations for investors. Remember capital gains are taxed at a lower rate
than dividends. As such, investors may prefer capital gains to dividends. This is known as the “tax
Preference theory”.
Additionally, capital gains are not paid until an investment is actually sold. Investors can control when
capital gains are realized, but, they can’t control dividend payments, over which the related company
has control.
Dividend Signaling
A theory that suggests company announcements of an increase in dividend payouts act as an
indicator of the firm possessing strong future prospects. The rationale behind dividend signaling
models stems from game theory. A manager who has good investment opportunities is more likely to
“signal” than one who doesn’t because it is in his or her best interest to do so.
Clientele Effect
The theory that a company’s stock price will move according to the demands and goals of investors in
reaction to a tax, dividend or other policy change affecting the company. The clientele effect assumes
that investors are attracted to different company policies, and that when a company’s policy changes,
investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will
move.
Relevant Formulas