Fin Summary v5

7/26/2019 Fin Summary v5

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Module 1Tools of Finance

Financial Markets- Shift future resources to present to increase consumption and satisfaction.- Shift resources to the future by lending and common shares to increase future value.

CF1

NPV = -------- CF0(1+ i)

CF0IRR = NPV = 0 = CF1 + -----------

(1+ IRR)

- IRR > market rate = acceptable investment and + NPV.- IRR < market rate = unacceptable andNPV.

Compound Interest = CF0= [1 + (i/m)]m t

YTM = Bond Market Value = Coupon + Coupon + Coupon + (Bond Face Value + Coupon)1+r (1+r)2 (1+r)3 (1+r)4

Forward Interest Rates:

1f4= Cube Root (1 + Spot Rate4)4/ (1 + Spot Rate1)

1

1f3= Square Root (1 + Spot Rate3)3/ (1 + Spot Rate1)

1

1f2= (1 + Spot Rate2)2

/ (1 + Spot Rate1)1


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Module 2Investment Decisions

Shareholder Wealth1. Residual claim

- Equity has no contract that requires money to be paid to shareholders at any time.- Shareholders have entitlement to vote for the directors of the company.- Directors and management are agents of the sh areholders.

- Shareholders have ownership claim on remaining corporate resources2. Limited l iabi li ty

- Possible losses are limited to the value of the shares that the shareholder owns.

1) Maximize shareho lder wealth.2) Maximize the market value of sh ares.

Investment Decisions1. Total value of company increases by NPV of investment - costs to undertake.2. Shareholders wealth increase = NPV of investments

Share Values and Price/Earnings RatiosEarnings per share = Earnings / # shares

P/E ratio = Share price / earnings per share

Price per share = (Earnings per share x payout ratio) / (re-g)

Share Price = (Div + Growth Rate) / (reGrowth Rate)

Payout rat io = Dividends / Total Earnings

Module 3Earnings, Profit, and Cash Flow

Corporate Cash Flowsactivity across timeFinancial cash flows - cash amounts that are expected to occur at the times for which theexpectations are recorded.

Typical Cash Flows (Company with zero debt, 100% equity financed) (000s) Now Year 1 Year 2 Year 3

Customers 0 +17 500 +23 500 +4 000Operations 0 -7 000 -3 830 -5 200

Assets -10 000 -4 000 -2 000 0Government 0 -4 000 -8 085 +5 600

Capital (FCF) -10 000 +2 500 +9 585 +4 400

2 500 000 9 585 000 4 400 000NPV = -10 000 000 + -------------- + ------------- + ------------- = +3 500 000

(1.10) (1.10)2 (1.10)3


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Module 4Investment Decisions using the WACC

WACC is the discount rate which:1) Operating risks of the project;2) Proportional debt and equity financing3) Interest deductibility for debt financed portion.

Debt Cost = Debt Required Rate x (1-Corporate Income Tax Rate)

To calculate WACC1) Required rate for equity2) Debts after tax cost rate3) All equity free cash flows4) Proportions intended for debt and equity financing.

NPV = FCF(t) *(1 + rv*)t

WACC = rv* = D (rd*) + E (re)V V

FCF(t)* = Unleveraged (ungeared) free cash flow: the amount of free cash flow that thecompany is expected to generate at time tdue to the project not includ ing ITS.rd*= Cost of debt as a rate to the investment; equal to rd x (1Corp Tax Rate)rd= Return on debt of investmentre= Return on equity of investmentD= Debt amountE= Equity amountV = Total investment = D + E

It Interest cash flow at time t.Tc Corporate income tax rate.ITSt Interest tax shield cash flow, equal to It x TC.FCF*t Unleveraged (ungeared) free cash flow: amount of free cash flow a company is

expected to generate at t due to a project, not including ITS. Equal to FCFtITSt.

Income tax sh ield= expected interest payment each period X the corporate income tax rate.

Adjusted Present ValueAPV = when amounts of debt that projects will use are known but not proportions.

1) Calculate PV assuming all equity financing

2) Calculate PV of tax shieldAll Equity Value + Interest Tax Shield Value - Present Outlay = APV

n FCF*tWACC/NPV0= ---------

t=0(1+rv*)

t

n FCF*t ITStAPV0= -------- + --------

t=0 (1+rv)

t (1+rd)t


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Module 5Estimating Cash Flows for Investment Projects

#1 - Depreciation Expenses for Tax PurposesStraight-line depreciation involves equal amounts for each year.

#2 - Change in Taxes Should Company Accept the Project with P&LSales Revenue

Other RevenueTotal Revenue

Direct ExpenseLaborOtherManagementMarketing

Total Direct ExpensesDepreciation

SubtotalTotal Expense

Profit Before TaxLess TaxesNet Income

SR + ORDED = EBITT = NI

#3 - Working Capital = ARAP + C + I = WCAccounts ReceivableAccounts PayableCash and Inventories

#4 - Project Cash Flows = SDE + WC + AT = FCFSales RevenueTotal Direct ExpenseChange in Net Working Capital

AssetsTaxesFCF-Free Cash Flow


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Module 6Investment Analysis

Payback Period- Problems with the payback period;

a. Ignores CF beyond the maximum acceptable payback period.b. Does not DCF within the maximum acceptable period and gives equal weight to all.c. Inconsistent with shareholder opportunity costs.

1 1Payback: ------- - ----------------

rv* rv*(1+rv*)n

where nis the number of periods in the projects total lifetime.

Average (Accounting) Return on Investment (AROI)AROI = accounting profits / NBV investments.

- Result compared to a minimal acceptable return based on an industry or company average- AROI does not DCF.

IRR vs. NPV- Cash flow sign changes across time can yield multiple IRRs.- To accept a project, IRR < hurdle rate.- IRR can cause problems in multiple-period CF investments that require a different discount

rate for each cash flow.- YTM of security with same risk and CF patterns as the investment would have to be found.

Mutually Exclusive Investment Decisions- NPV is best where multiple investment options compared and subsequently ranked.- If IRR must be used, incremental cash f low analysisshould be used.

1. Take any two pro jec tsout of the group.

2. Find the one that has the highest po si t ive cash f low to tal.3. Investment with highest CF is d efender, the other challenger.4. Subtr act CF of chal lengerfrom the defender.5. Results are incremental cash f lows.6. Find th e IRR of the incremental cash flows.7. I f the IRR > hurdle rate, keep defender and throw out challenger and visa versa.8. Pick next project from group and repeat p rocess-using winner of #5 until only one

investment remains.9. Calculate the IRR of the w inner.10. If it is greater than the hurdle rate, accept it, if not then reject all the projects.

- Never use if;

1. More than one change of sign across time.2. Projects differ in risk or financing and require different hurdle rates.

Cost-Benefit Ratio

CBR = inflowst/ (1+rv*)t/ outflowst/ (1+rv*)

t- Accept if CBR is >1 = positive NPV- Reject if CBR is


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Profitability Index- Ratio of accumulated PV of FCF to the present CF of an investment.

PI = PV of Cash Flows / Total InvestmentPI > 1 OKPI < 1 Reject

Capital Rationing

- Used to choose group of projects that will maximise shareholder wealth with limited funds.- Investments accepted in order of PI, until budget exhausted.

Inflation- Real rate of retur n= nominal rate - influence of inflation for time in the future.- Inflation occurs, costs of assets will increase across time faster than the rate of inflation.- Results in FCF increasing at a slower rate than inflation.- Accelerating depreciation schedules have been put in place to help offset this effect:

double-declining balance, or sum-of-the-years digits methods.Real rate of return = (1 + nominal rate) / (1 + inflation rate)

Renewable Investmentswhen two investments have different time durations:1) Calculate NPV of both investments.2) Divide by annuity factor from PV for t periods tables (% and t)3) Result = constant annuity outlay per period.4) Choose the investment with lowest outlay per period.

Leasing- Contractual agreement between asset owner (lessor) and asset user (lessee).- Financialor capitallease.Advantages- Higher tax benefi ts.

- Inform at ion asymm etr iesexist on certain types of assets, leasing can lower the costs.- Economies of scalein the management of specialised asset leasing.Misconceptions- Leasing saves money because does not have to make large outlay to purchase.- Lessee debt capacity is higher since they do not need to borrow money to buy asset.Evaluating Leases- CF used would include:

- Cost of purchasing- Lost depreciation tax shields- Lease payments- Lease payment tax shields.

- Correct discount rate for performing NPV is the after tax interest rate (rd*).- Important to know which lease rate would allow for positive NPV when negotiating lease.


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Module 7Investment Risk

- Secur i ty market l ine(SML)- relationship between risk and return as being positive.- Higher the risk, the higher the required return.- Capital supplier risk = standard deviat ion of rates on return on ent i re port fol io o f

assets.- Risk of set of securities quote probabilities of various rates of return or the probabi l i ty

distr ibut ions of returns, for example;

- Mean of probabi l i t ies;

0.085 x 0.35 = 0.02975+ 0.11 x 0.10 = 0.01100+ 0.135 x 0.30 = 0.04050+ 0.16 x 0.25 = 0.04000

Mean = 12.125 %

- Standard deviat ion;(0.085-0.12125)2x 0.35 = 0.00045992(0.110-0.12125)2x 0.10 = 0.00001266(0.135-0.12125)2x 0.30 = 0.00005672(0.160-0.12125)2x 0.25 = 0.00037539

= 0.000904690.00090469 = 0.03008

= 3.008%

- Resul t = r isk inherent in a p ort fol io.

- Morowitz - sharehold ers are risk-averseand require higher returns for higher risks.- Positive relationship between return and standard deviation of return only t rue for the

ent i re port fol ioand not for the individual assets within.- Part of standard deviation of return for individual assets is divers i f ied awaywhen included

in a portfolio with others.

- Average Return of two investments.- Average Standard Deviationof two investments.

Return

Risk


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- Port fol ios return probabi l i ty distr ibut ion = must know how individual asset returnsinteract fromjo in t probab i l i ty d is tr ibu tion;

Asset 'B' Returns7% 12% Probability

Asset 'A'Returns

10% 0.35 0.1 0.45

20% 0.3 0.25 0.55Probability 0.65 0.35 1

- Each cell describes the probability of a particular set of returns being simultaneouslyearned by both assets A and B.

- Join t (inter ior) probabi l i t iesmust sum in rows and columns to equal the originalprobabilities of the individual security returns while the sum of all cells = 100% (1.0).

Portfolio Events and ProbabilitiesAsset A Asset B Portfolio Probability

Event 1 10.0% 7.0% 8.5% 0.35Event 2 10.0% 12.0% 11.0% 0.1Event 3 20.0% 7.0% 13.5% 0.3Event 4 20.0% 12.0% 16.0% 0.25

- Whole portfolio has less risk than the average risk of the securities due to divers i f icat ion.- Method for figuring out risk of a portfolio is using the correlat ion coeff ic ient.

Market Model and Individual Asset Risk- Sharpe and Lentner= only relevant risk in a market where everyone understands the

benefits of diversification is the und ivers i f iable or systematic r iskof an asset.

Riskm

- Common factor is called the mark et factor (Riskm).- Systematic r isk of secur i t iesis based upon the extent to which the market influences

their returns. Measure of undiversifiable risk of a security (j):

Systematic Riskj = Std. Deviation of return(j)x Correlation of (j) with the market.

- Correlation = 1 = systematic risk = standard deviation = not diversifiable.- Low correlation to the market will have much of its risk diversified away when held in a

portfolio with other securities = low systematic risk.

Risk of

average

Portfolio

# of securities in portfolio


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Std deviation of returnj x Correlation of j with the marketBetaj (j) = ---------------------------------------------------------------------------------

Std deviation of market returnjm

j = ------2m

j is the beta coefficient for j;jm is the covariance of j and the market;2m is the variance of the market.

- Regression coeff ic ient - provides same information as previous systematic risk measure, butscaled to the risk of the market as a whole.

- Example: of 1.0 indicates that anxpercent increase or decrease in the return on the marketis associated with anxpercent increase or decrease in the return on that security.

- of 1.5 indicates anxpercent increase or decrease in the market will result in a 1.5xreturn.

- Steeper the slope (), greater returns on security j gear upward (or downward) the returns onthe market portfolio.

Security Market Line

- If the financial market sets securities returns based upon their risks when held in welldiversified portfolios, systematic r iskwill be an appropriate measure of r isk for indiv idu alassets and secur i t ies, and the SML will dictate the set of r isk-adjusted returns:

- Above relates the amount of systematic r iskinherent in the returns of a security to thereturn required on that security by the market.

- Relationship is positive where higher systematic r iskof j, the higher i ts expected return.- SML is located with repect to two important points, the risk -free rate (rf)and the market

portfolios r isk-return locatio n (m).- m = return of E(rm) and of 1.0

E(rj) = rf + [E(rm)rf] j

- Investments must have returns > capital suppliers opportunity costs to be acceptable.

Return of

security j Slope

Line of best fit

Return of

the market

j

rf

m

Erj

E(rm)SML


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Capital Asset Pricing Model (CAPM)- System that generates required rates of return b ased on r isk o f assets.

- WACC = average of risk-adjusted rates of return of various endeavours, including asset typesand FCF expectations.

- Acceptable = investment expected return > return on SML investments systematic risk level.- Goodinvestments would plot above the SML, perpendicularly above their systematic risk.- Investment A is above the WACC = acceptable but below the SML = does not offer return high

enough to compensate for its risk.- Investment B has the opposite problem.

E(re) = Risk Free Rate + (Beta equity x Market Risk Premium)

E(rd) = Risk Free Rate + (Beta debt x Market Risk Premium)Tax Adjusted Debt Cost = E(rd) x (1Corp Tax Rate)

WACC = E(re) x Equity financed + TADC x Debt financedTotal E&D Total E&D

Estimating Systematic Risk- Use SML for estimating required returns the amount of systematic risk of a project.

a. If project is same risk as company, and shares are traded on stock market, look up coeff ic ient of the companys shares in financial reporting services that supply data.

b. If risk differs from company average, investment may be similar to another company.coeff ic ient of other companycan be used. Also valuable when the shares of theinvesting company are not traded, but those of a similar company are, and theinvestment is simply a scale change.

- If market coefficients are unavailable, systematic r isk measuremust be constructed.- Begin with coefficient for company thinking ofundertaking project, and adjusting coefficientfor differences between the project and company.

Considerations- Volati le pro jects revenuesare volatile in to overall market relative to company average,

adjustment to coefficient must be made.- Fixed costs of project is highproportion of total cost, coefficient must be adjusted upward

for op erational gearing.

ReturnA

Erj

ARISKWACCB

ReturnB

WACC

SML

j


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Beta(project/ungeared) = Beta (equity) x (% equity) + Beta (debt) x (% debt financed)

v= e E/V + d D/Veand d are observed equity and debt coefficientsE and D are their observed market valuesV is the sum of E and D.

- Revenue r isk d i f ferent ial adjustment:

Project revenue volatilityRevenue-adjusted = vX ------------------------------------

Company revenue volatility

- Operat ional gear ing adjustm ent:(1 + project fixed cost %)

Project y = Revenue adjusted X -------------------------------------(1 + company fixed cost %)

Estimating the WACC of an Investment- Return required on the equity of the project.

E (rj) = rf + [E(rm)rf] j is determined as above

rf = government bond interest rates (YTMs) for comparable investments bonds.E(rm) = function of risk-free rate and estimate the difference between E(rm) and rf.

- Historic al average market(i.e. LSE, NYSE) return above the risk -free rate.- Once the equity required return is determined - find after tax co st of capi tal.- Find the WACC of the project = WACC = rv*= D/V (rd*) + E/V (re)

Certainty Equivalents

- Possible to adjust downward expected FCF for risk characteristics creating a certainty-equivalentCF, and to DCF at risk-free rate.

CFE(rm)rfCFce= --------------------- X Covariance (CF,rm)

Variance (rm)

- CFce = expected risky cash flow (CF) - adjustment for systematic risk.- Variance (rm) is the standard deviation

2of market return- Covariance (CF, rm) is the coefficient of the CF x variance of the market return of the cash

flow with the overall market.

Risk Resolution across Time- Risk of investment can change as time passes.- Common error = treat the investments entire cash flow set as having the same risk.- Basic question is whether to undertake an initial outlay, where the desirability of that outlay

depends upon the outcome of the test.


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Module 8Dividend Policy

- Residual cash not paid as dividendsis still owned by shareholders.- Retained cash is reinvested in the company on behalf of shareholders.- Cash-retentionor reinvestmentdecision.Dividend Irrelevancy- Net result of changing a companys dividend is subs t i tutabi l ity of capi tal gains(i.e. share

value increases) as the dividend is reduced for cash when it is paid.- Increased dividends = decreased market value, and vise-versa.- Increase in dividends would be shown as a widening of the dividend pipe and a narrowing of

the retention pipe resulting in a smaller investment amount.Increase in div idends = increase in n ew equi ty (more s hares issued)

Decrease in div idends = decrease in new equi ty ( less s hares issued)

Taxation of Dividends- From shareholders perspective, it is after-tax dividends that are of interest.- Dividend sub st i tute for capi tal gainsare liable for taxation.- Dividends are taxed more heavily than capital gains.- Dividends paid are taxed at the shareholder level.

- Imputat ion systems= amount of company taxes to shareholders based upon the dividendspaid and give shareholders a credit on their taxes for that amount.

- Double payment effect= personal income tax liabilities of shareholders = the tax credit.Transactions Costs- Shareholders may prefer one dividend policy to another depending on preferences for

consuming wealth across time and costs paid to achieve the desired consumption pattern.Flotation Costs- Companies incur costs in raising money from capital markets when they pay dividends so high

as to require new shares to be issued.Combined Friction- Optimal dividend policy: find all investments with +NPV & retain cash to undertake.

- Cash left over, dividend could be paidpassive residual div idend p ol icy.Dividend Clientele Irrelevancy- Differing groups of shareholders become known as clientelesin finance.- Groups that would be willing to pay extra to get the type of dividend policy that is best suited to

their own tax and consumption benefits must pay change premium.- Switching policies can be costly to shareholders and is likely non-optimal.Signaling- Interests of managers and shareholders to have share prices reflect new information (good or

bad) as quickly as possible.- Alterations in dividend policy are subtle way to communicate this information.Share Repurchase

- Cash dividend to shareholders.- Money received in share repurchases is taxed more lightly.- Signs of signal attemptsthat receive a positive response from holders.- Not so positive for shareholders is a targeted sh are repurchase.- Repurchase only particular shares usually held by potential buyers.- Repurchase price = signi f icant premium over the market pr ice.

Bird -in-hand - Passiv e Residual - Perfect MarketTradit io nal - Dividend Signal l ing


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Module 9 - Capital Structure

Capital Structure, Risk and Capital Costs- Debt is not cheaper than equity.- Assurance of debt increases the ROE - impl ic i t costof borrowing.- EBIT-EPS c hart.- Differences in level of steepness in EPS rangesare described as gearing o r leverage.

Irrelevancy: Modigliani & Miller- Makes no di f ference to shareholder weal th whether the company b orrows m oney or not.- Shareholders can borrow and lend on the same basis as companies and any benefit/loss

residing in company borrowing can be duplicated/canceled by shareholders borrowing orlending transactions in their own personal portfolios.

- Wealth increase is impossible since identicalFCF expectations can be achieved in a differentmanner, and less expensively.

- Debt is more risky than its capital claims.- Gains from issueing low interest debt offset by increases in the risk and attendant returns

required by shareholders.

- Debt in the capital structure increases risk.1) Risk is related to beta.2) Beta is related to the variation in return.3) Since debt is first in line, debt amplifies the variability of return.4) Gearing or leverageis description of amplification of variability idea.

Ungeared Company

EBIT outcome EPS outcome Probability15000 1.5 .1120000 12.00 .55

150000 15.00 .35

Geared Company

EBIT outcome Interestoutcome

Equityoutcome

EPS outcome Probability

15000 40000 -25000 -5 .1120000 40000 80000 16 .55150000 40000 110000 22 .35

Arbitrage and Prices

- Arbitrageis a transactio n where an instantaneous risk -free profi t is real ized.- Market prices adjust to cause all equivalent FCF to sell for the same price.- Forces of demand and supply.

Summation of Capital Structure Irrelevancy- The M & M ideas make clear that the total value of the company must be unaffected by a

change in its capital structure.


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Company Values without taxes- Behavior of required rates of return and overall capital cost of the company; it alters the

companys capital structure.

- Weighted average relationships determining rv we can imply;rv = D/V (rd) + (1 - D/V) (re)

- Higher proportion of lower-cost debt offsets lower proportion of higher cost - equity such thattheir weighted average is unchanged.

Capital Structure and Taxes- Companies are taxed on the amount of incomeorprofit that they make.- Income tax shields.- Deductibility of interest payments cause a bias in capital structure towards the use of

borrowing instead of equity capital.- Debt is cheaperin that total of taxes paid by companies and shareholders will be lower than if

the companies were to issue equity.

Capital Structure Relevance with Taxes- Because of the tax advantage in borrowing, a company with debt in its structure will be more

valuable than an otherwise identical company that does not borrow.

- Value of tax benefit:

VITS = ITS / rd- Valued of debt plus equi tyor APV type situation:

V = VU + VITS

- WACC steadily declines as the company substitutes debt for equity in its capital structure.- As company value is increasing, ungeared FCFmust stay the same as D/V increases.- If V = FCF*/ rv*, rv*must be declining as D/V increases.- Cost of capital is therefore lower, the higher its proportion of debt.

Capital Structure Irrelevancy - Taxes- Miller: companies in economies with progressive personal taxes undertake more borrowing.- Interest rates necessary to sell bonds to high personal-tax investors will cause the benefits of

company borrowing to disappear.- Tax benefits of company borrowing compete with other mechanisms used to reduce taxes

(depreciation, credits) that tends to reduce debts advantages, particularly when the amounts ofincome that require shelter from taxes is uncertain.

rd

rv

re

25%20%15%10%

5%0%

0 16.67% 33.33% 50.00% 66.67% 83.33% 100.00%

12.0%

rv


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Agency Problems- Agencydeals with situations where the decis ion-making author i tyof a pr incipal

shareholderor bondholder is delegated to an agentsuch as managers of a company.- Confl ic ts of in terestmay arise among principals and agents.- To resolve conflicts of interest is by complex debt cont rac ts.- Debt claims carry a conv ert ibi li ty provis ion; under certain conditions, at the option of the

lender, a bond can be exchanged for common shares.

- Agency conflict occurs when a company in financial distress is unwilling to undertake aprofitable investment because the resulting effect would benefit bondholders, not shareholders.

Agency Costs- Costs of bankruptcy or financial distress are:

a. Legal processof realigning the claims on assets from those specified in the originalborrowing contract.

b. Imp l ic i t and opportu ni ty costsincurred relative to what would have happened had thecompany financed instead by equity capital.

Agency Considerations- Perk consum pt ionbeyond the point where management productivity is efficiently enhanced.- Conglomerat ionto increase the size and reduce the CF risk of the company.

Company Borrowing Decision- Importance to optimal amount of borrowing is tax considerations.- Nettax benefits of borrowing.- Risky business should borrow less (or be lent less) than companies that are not so risky.- Ruleprobably works due to agency costsrisk is likely to make agency costs higher.

Book Values and Borrowing- Practitioners preferBook v aluesused for measuring the extent of company borrowing.- Academic prefer that market values.- Book values in the real world make sense.

- BV is a good measure of the extent of which values will not be upset by financial distress whenengaged in borrowing.

Deciding on Capital Structure1. Use simu lat ion to forecast CFand financial statements across the foreseeable future under

the various alternative proposals for financing.2. If significant chance of conf l i c t wi th bor rowingcontracts in ways that would damage the

operational aspects of the firm, borrowing should be avoided.3. If tax benef its of borrowingsimply replace other tax benefits there is little reason to borrow.4. If company value is largely based in tangible assets, more borrowing is sustainable.5. Industry g earing rat iosare useful to see what other companies have been able to sustain.

6. If potential lenders fear company action to the detriment of bondholders, the company shouldattach covenants to the bonds to alleviate some of that concern - conv ert ibi li ty provis ion s.

7. Reasons to avoid new equity issuance such as loss of ownership contro land considerationsmay outweigh the negative aspects of borrowing.

8. Once a tentative conclusion has been made, see if the result would be inconsistent with thecapital structures of other companies in the same line of business.

9. If so, it should be determined whether this is an improvement over the usual practice or asignal that something has been left out of the analysis.


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Module 10Working Capital Management

WCM = cu rrent assets & cu rrent l iabi l i t ies.

Risk, Return, and Term on Investments- Short-term finance tends to be risky in requiring the firm to frequently renew the principal

amounts of financing outstanding.

- Interest rates are not the reason for return or cost differences between short and long terms.- Costs depend on reversibi l i ty differencesbetween the types of finance.- Where companies find themselves with unforeseen reductions in the need for financing, short-

term finance is dispensed with quickly at the end of its term.- Short-term finance is less costly than long-term finance and because lower costs mean higher

return, it also exhibits a higher return.- Exactly oppositeof the risk return characteristic of its assets.

Combining Risk and Rates of Return on Assets and Financing- Finance short-term assets with short-term liabilities and long-term with long-term.- Matur i ty matching.

Optimisation and Short-term Investment- Balance costs and benefits to produce highest net benef i tor lowest net cost.

Asset Type Benef i t Cost

Cash Highest liquidity Forgone interestMarketableSecurities

Liquidity Zero NPV

AccountsReceivable

Increased revenue Delayed, uncertaincash receipts

Inventories More efficient

production schedule,sales flexibility

Capital costs,

transaction costs

- Eff ic ient m anagement of asset investments

Total Cost

Max. net benefit

Optimum usage

Total benefit

Amount of short-term assets used

Totalbenefit andtotal cost


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Management of Cash Balances- Cash and near cash assets offer the high liquidity benefit.

a. Transact ion balancesdebts must eventually be paid in cash.b. Precaution ary/anticipatory reservesevents that cannot be anticipated which

require cash, as well as anticipated future cash needs of major dimensions.c. Compensat ing b alancescash amounts contractually left on deposit with banks.

- Costs of cash balances are the t ransact ions costsof switching between higher and lower

interest-bearing securities and accounts, and the differential interest r ate earned.- Cash usage model :

- Interest penalty of ipercent (interest foregone) in holding cash balancesj.- Fixed transaction cost of $T for cash replenishment.- Optimising of cash replenishment amounts:

$r = [(2 x $D x $T)/ i ]1/2

$r is the optimal amount of cash replenishment,$D is the total annual amount of cash spent by the firm econom ic order quant i ty.

- Seasonal or c ycl ic cash requ irements= specify a probability distribution of potential cashbalance changes.

$M is the lower bound, the minimum amount of cash on hand.$U is the upper bound.$R is a return point.

- Cash falls to $M, interest bearing securities are cashed to return the balance to $R.- Cash balances increase $U, securities are bought with excess cash to bring the balance to $R.- If $U and $R are well chosen, the costs of maintaining the cash balance are minimised.- The formula below chooses $R;

Time

Minimum

Replenishment

Usage

Maximum

Cash Balances

Time

$U

$R

$M

CashBalances


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$R = [(3 x $T x s2) / 4I]1/3+ $M

$T and i are as aboves2is the variance of the changes in cash balances if the amount of increase / decrease incash balances is expected, by the probability distribution, to be $c for each of the number oftimes (t) cash balances can change per day, s2= $C2x t.

- $U is part of this solution;

$U = $M +3 ($R - $M)

Management of Receivables- Necessary to hold accounts receivable and inventory stocks.- Inventories are handled similarly to cash but with the cost of shortages considered.- Higher level of receivables = more credit sales and more customers willing to purchase =

longer waits for actual receipt of cash = increase likelihood of bad debt.- Discerning who should receive credit:

a. Credit-reporting agencies supply information.

b. History of customer accounts can yield information of a customer paying.c. Sophisticated statistical analysis (i.e. discriminant analysis).

- Accepts everybody:

Expected Prof i t = (# good customers x p rof i t per custom er) + (# bad custom ers x loss

per customer)

- If company performs a credit analysis:

Abo ve + (- the cos t of the credi t analysis)

- Calculate NPV associated with a proposed change in credit terms for a company;

NPV = Change PV of sales receiptschange variable costschange WCM

Management of Short-term Financing- Matur i ty matching.- Short-term financing as required with short-term investments, for balance of risk and return.- Takes advantage of credit extended by a vendor.- Payment terms are described such as 2/10 net 30which states 2% discount for payment

within 10 days and payment beyond that is at full market price and is due in 30 days.- Interest cost is composed of an annualised discount percentage given for early payment.

i = (1 + [discount % / (1discount %)]365/discountdays

Working capital management involves two levels of activity:1) Application of management techniques to specific asset and financing decisions.2) Policies for decisions, so that the company automatically determines each of these small

decisions well considered policy.


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Financial Ratio Analysis = L + P + CS + E

Liquidity = CR + QR

Current Ratio= Current Assets / Current Liabilities

Quick Ratio= Current AssetsInventory / Current Liabilities

Profitability = PM + ROTA + ROSA + ROE + PS

Profi t Margin= Net Profit after Taxes / Sales

Return o n Total Assets= Net Profit after Taxes / Total Assets

Return on Speci f ic Assets(e.g. Inventory) = Net Profits after Taxes / Specific Asset

Return on Owners Equi ty= Net Profit after Taxes / Owners Equity

Percentage of Sales= Item chosen / Sales at 100%

Capital Structure = FCAR + DR + TIE

Fixed to Current Asset Ratio= Fixed Assets / Current Assets- Gearing ratios (leverage)= contributions of shareholders with the financing

provided by the companys creditors and other providers of loan capital.- Low gear ing rat ios= less risk when the economy goes into a recession, but

also lower returns when the economy recovers.- High gear ing rat iosexperience the opposite.-

Debt Ratio= Total Debt / Total Assets

Times Interest Earned= Profit before Taxes + Interest Charges / Interest Charges

Efficiency = IT + ACP + FAT

Inventory Turn over= Sales / Inventory

Average Col lect ion Per iod= Debtors / Sales per Day

Fixed A sset Turnover= Sales / Fixed Assets

O/S AP = Days O/S x AP Amount x (Rate FinanceRate Return)Days

Exam ple: O/S AP = (20/30) x 700,000 x (20% - 8%)


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Module 11International Financial Management

Exchange Rates and the Law of One Price- Law states that the same thing cannot sell for different prices at the same time.- Purchasing power par ityacross countries.- Frictions to purch asing power equi l ibr ium= transaction and information costs, positive and

negative impediments to free trade imposed by governments.

Spot and Forward Exchange Rates- Spot rate= rate for given currency to be exchanged for another on that day.- Forward rate= going price for exchanging between currencies at some future time.- Forward exchange contract= commitment to purchase or sell currency at a fixed price and

time in the future.- Avo id the r isk of exchange rate f luctuat ionsor to hedgesuch transactions.- Forward exchange market can be used to speculatein exchange rates = commitment to

purchase a currency but has no future dollar inflow expectations.- If currency is selling at a higher forward rate than spot rate = forward premium- If lower = forward discoun t.

Exchange Rates and Interest Rates- Same as hedging through borrowing funds in the required currency at an existing interest rate,

and exchange those funds for the local currency at the existing exchange rate.- The amount of dollars required to pay off loan with cash expected from collecting receivables

at a future time point;Amount borrowed = $ receivable / (1 + existing interest rate).

- Loan amount is then switched to local currency at the spot rate.- Local currency is then invested for the duration of the loan at the local interest rate.- Receivables, when received, are used to pay off the original loan.- Cash proceeds = same as purchasing foreign funds in the forward exchange market.

- Necessity of foreign exchange and interest rate markets, due to interest rate pari ty.- Interest rate pari ty= borrowing/lending in one currency at applied interest rate will produce

the same final wealth as borrowing/lending in other currency at its interest rate.- Interest rates must adjust to ensure such parity or there will be arbitrage opportunities.

Relative interest rate = Relative forward exchange discount / premium.

Forward Exchange, Interest Rates, and Inflation- Inflation, differential inflat ion, influences exchange and interest rate markets.- Inflation affects the future purchasing power of that currency.- Forward exch ange rate two currencies = expectat ion o f di f ferent ial inf lat ion rates.- If inflation is expected to exist during the loan period, the real(in terms of purchasing power)

return is expected to be less than the nominal return.

Nominal interest rate = real interest rate + effect of inflation

(1+ nominal rate)n = (1+ real rate)nx (1+ inflation rate)nwhere nis the number of periods in question

- Ratio forward exchange rateto spot exchang e rate= ratio expected inflation rates of twocurrencies.


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- Interest rate differentials= caused by inf lat ion d ifferentials = cause of observed discountor premium o n forward exchange.

International Financial Management:Hedging International Cash Flow- Arguments to hedging exchange exposure:

a. Real assets in other countries will experience nominal increases in value as inflation

increases and exchange rates move down in that currency.b. Significant transaction costs to hedging.

- Foreign exchange opt ion. Allows holder to buy/sell foreign currency in the future.- Cost of options is usually higher than forward contract.- Forward contract to sell cash hedges exchange risk.Investing in Foreign Real Assets- Deciding financial viability of foreign investment.

1) Estimate expected DCFand discount at the investments cost of capital.2) When currency translat ionshould be done in the evaluation of an investment.3) Use interest rate structu reof foreign currency to estimate r isk-adjusted foreign

currency discou nt rate.

4) Find foreign currency NPV.5) Translate foreign currency NPV at spo t exchange rateto find domestic value.

- Diversif icationif a shareholders are not well diversified across international borders, aforeign investment may deserve lower risk profile than a pure domestic one assuming theforeign investments CF are not well correlated with a comparable domestic one.

- Relat ive uncertaint ies of the investmentalterations in foreign trade laws, exchangerestrictions, asset confiscation, and friction repatriation can increase the risk of a foreigninvestment.

Financial Sources for Foreign Investment- Exchange rate changes due to inflation in the foreign country.- Domest ic c urrency value of a real assetin foreign currency will not necessarily change,

because the Forex rate effect upon value will be offset by the inflationary effect.- Foreign real assets tend to experience increases in value as inflation increases, where as

monetaryassets do not and are serious candidates for the hedging of exchange risk.- International capital market: long-term funds are called eurobonds;- Short-term borrowings are called Eurocurrency.- Borrowing rates are lower in eurobond/currency markets = lower regulatory costs.- Repatr iat ion o f fund s= problem for companies whose shareholders are foreigners.- Some countries have significant measures in place that seek to keep prof i ts earned by

foreign f i rms within their borders.- Management fees, royalties, loan interest and principal repayments, and transfer payments are

used to repatriate funds to the domestic parent company.

Financial Solutions to other International Investment Risks- Moral hazard risks= dealing with foreign authorities.- Management of this risk = agency theory.- Anticipate potential situations where the host country would be likely to take action, and build

automatic and irreversible counter-incentive into the original agreement.- Involves a thi rd partywho the host country must appease (i.e. World Bank, IMF).


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Module 12Options, Agency, Derivatives, and Financial Engineering

Options- Call op t ion= allows purchase another security or asset at fixed price and time period.- Strike or exercis e price - price of option allows you to purchase the shares.- Expirat ion date - final date you can exercise the option.- European- can only be exercised at expiration.

- American- can be exercised any time before or at expiration.- In the money - option can be exercised profitable.- Out of the money option can be exercised in a loss.- Option w r i ter - issuer of the option is often termed the.- Covered opt ionor cal l- if the writer actually owns the underlying securities.- Put opt ion- allows the holder to sell at a fixed price for a fixed period of time.- Spreads, str ips, straddles, hedges, butterf l ies.

Option Valuation- As long as there is some chance that an option could have some exercise value prior to

expiration, the at the money opt ionwould sell for a price > zero.

- Out of the money opt ions- market price is lower since security must increase more in value.- In the mo ney opt ionsalso sell for more than their exercise value as the holder stands to gain

at exercising the benefit of possible interim increases in underlying asset or security value, butis not at risk for all possible reductions in underlying asset value.

- Option m arket value is always above exercise value = opt ion premium.

Calculating the Value of a Simple Option- Assume price changes are binomial; they can take only one of two values.- Example: stock trading at $1.50 has a 60% chance of increasing to $2.40, and a 40% chance

of decreasing to $0.90:

So= current price of underlying security

X = strike priceu = upward multiplierd = downward multiplieruSo= underlying security increased price resultdSd= underlying security decreased price resultCu= option payoff at expiration if underlying security price is up = uSo - XCd = option payoff at expiration if underlying security price is down = dSo X

Y = shares to purchase = (CuCd) / (So (u-d))Z = amount to lend at RFR = (uCddCu) / (u-d)(1+rf)Co= current market value of the option = Yso + Z

q = 0.6

1-q = 0.4 0.6

So= $1.50

dSo= 0.6 x $1.50= $0.90

uSo= 1.6 x $1.50= $2.40


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- Second:invoke law of one pr icewe can discover Coby calculating the value of anotherinvestment that offers the same FCF or cal l equivalent port fol io.

- Payoff if underlying shares increase becomes;YoSo + Z(1 + rf) = Cu

- If shares decrease it becomes;

YdSo + Z(1 + rf) = Cd- Value of the option is equal to the cost of the call equivalent portfolio,

YSo+ Z

Hedge Ratio = m = So (u-d) / (CuCd)

uSomCu = dSo - mCd

Valuing Realistic Options- Any realistic model must allow for multiple prices.

- Black-Scholes opt ion mo delis essentially the same as the many short per iod binom ialmodels, except the time-periods are continuous.

Co= SoN(d1)Xe-rfTN(d2)

d1= [ln(So/X) + rfT]/(T1/2) + 0.5(T1/2)

d2 = d1(T1/2)

SoN(d1)= value of the cumulativenormal unit distribution at the point d1.Xe-rfT= exercise price multiplied by e-rfT, which is a continuously compounded

interest or discount rate with e = base of a natural logarithm, rf = risk-free rate, and T= time remaining until option expiry.N(d2)= cumulative normal distribution value.ln= natural log of the bracketed expression.= standard deviation of the price of the underlying security.

Five variables for d etermining opt ion value; So, X, rf, , and T.So= Security priceX = Strike pricer f= Risk free rate of interest

= Standard deviation of underlying security price (volatility,)

T= Time until expiration- Soand Xidentifies the exercise value of the option, and how far in or out of the mon ey.- rf determines how much money must be set aside to exercise the option at expiration; as

interest rates increase, the PV of future outlay to exercise declines and option value increases.- is positively related to option value. Random movement in security price is likely to help than

harm option value.- As Tincreases, option value increases.- If the So/X ratio is high = option is in the money = low proportion of debt in capital structure.- If S/X ratio is low = company has lots of debt.- Increase in means that the operating assets of the firm are more risky.


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Agency- Efficient market for company take-oversis an important solution to the agency problem of

manager-shareholder conflict.- Any solution to an agency problem requires an overall gain in solving the problem, which is

allocated in a way that the agent has an incent ive to part ic ipatein the solution.

Derivatives

- Financial security whose return or outcome is derived from other assets value or return.- Most common type of transaction = hedging of r isk.

Types of Derivatives- Interest Rate= forward contracts, futures contracts, options, and swaps.- Stock Market= futures contracts on market indexes, options on market indexes.- Mortgage= complex derivatives.- Foreign Exchange= forward / future contracts, options, swaps.- Real As set= forward / future contracts, options contracts.- Swaps = Derivatives designed to hedge r isks o f interest rate and foreign exchange.- Hybrid and Exotic = formulated from com binat ions of oth er types of der ivat ives.

Financial Engineering- Designing a hybrid/exotic financial security to fit specific risk-shaping intentions of firm.- All financial securities can have some combination of;

a. Credi t extension- loans, bonds, etc.b. Price fixing- futures / forward contractsc. Price Insuranc e- call / put options

- Invention of new hybrid financial securities to fit exactly some requirement of an individualfinancial market participant is a matter of combining these elements into a package that willproduce a profile of cash flow expectations meeting this need.

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