Presentation1

CORPORATE FINANCE

(Ref:Introduction to Accounting and Finance-Geoff Black)

Do you think ..-you know nothing about accounting Y/N

-accounting needs advanced mathemetical skills Y/N

-accounting requires an IQ of 200 plus Y/N

-accounting is boring Y/N

-accounting is only relevant for some people Y/N

you can only help him find it within himself -'Galileo-an italian professor

you cannot teach a person anything

To learn from each other, because,

Why are we here?

Negative Slab or Positive Boon' Mr. Anchovy, our experts describe you

as a appallingly dull fellow, unimaginative, timid, lacking in

initiative, spineless, easily dominated, no sense of humour, tedious company

and irrepressibly drab and awful.'

And , in most professions these would be considerable drawbacks, in accounting they are a positive boon' -

Monty Python, 'The Lion Tamer Sketch”

Do you really don't know what's accounting?

Consider this snippet of conversation:

“Tan, wrote his car off yesterday. He'd gone into the red to pay for it, but - would you credit it –

the car wasn't insured. There's no accounting for some people. The bottom line is you need to

protect your assets”

: This module will be lead-managed by Mr.Masilamani R He has about 3 decades of working, training & consulting

experience His basic degree is in statistics & economics His MBA is in finance and economics He also has several professional accreditations, including

business performance management & project management

Presenter:

Why accounting Course?Offered to all incoming Masters students at any School of Business.

In particular, this lecture is designed for those who have no previous education or training in accounting.

The intention is for this lecture to teach at the most basic level.

To teach the “alphabet” of accounting so that students can learn to speak in “full sentences” in the accounting (and other) courses.

Students with even minimal background may wish to skim or skip sections of the lecture.

Food for ThoughtWith reference to non-business, performance management occurs in Sun Tzu's The Art of War. Sun Tzu claims that, 'to

succeed in war, one should have full knowledge of one's own strengths and weaknesses as well as those of one's enemies.

Lack of either set of knowledge might result in defeat' Parallels between the challenges in business and those of

war include: * collecting data - both internal and external

* discerning patterns and meaning in the data (analyzing) * responding to the resultant information

Financial and Management Accounting

Accounting has two main divisions:

Financial accounting

Primarily prepared for users external to the company.

Revenues, earnings, assets, etc.

Management accounting

Primarily for internal purposes

Costing, budgeting, net present value, etc.

This lecture will focus mainly on financial accounting for business. Thus it is called 'CORPORATE FINANCE'

Corporate Finance

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms

Learning Emphasis

In business management program we emphasise more on application of accounting and finance

concepts, skills and practices.

This course focuses on using student awareness of accounting and finance to learn how to apply

in practice

Course AimsThe broad aims of this course are to:

1. Introduce the basic principles and underlying concepts of accounting and finance;

2. Describe profit and loss accounts, balance sheets and cash flows tatements and generally how they are prepared;

3. Explain in detail how these statements may be read and interpreted, including points of weakness and their shortcomings; and

4. Provide basic understanding of how management accounting can assistmanagers in planning, control and decision.

Course OutcomesAt the completion of this course, it is expected that you will be able to:

1. Explain the effect of decision, transactions and events on financial

performance and construct simple sets of accounts;

2. Interpret published financial statements intelligently and translate

financial information accordingly to match the various needs of business

problems;

3. Identify the main uses and limitations of financial information and

administer them effectively for decision-making, planning and control;

4. Apply cash flow statements, cash forecasts and consolidate data for

capital investments, project appraisals and management budget; and

5. Evaluate company performance, estimate its cost of capital and justify

the processes of budgeting.

Corporate Finance

Day OneA. Fundamentals of

Financial

ManagementB. Analysis of Financial

StatementsC. Time Value of

MoneyD. Securities Valuation

Day TwoE. Risk & ReturnF. Capital BudgetingG. The Cost of CapitalH. Dividend Policy

AccountingAccounting can be simply defined as the recording,

summarising and interpretation of financial information

The key aspects of accounting are therefore,

1. Identifying the key financial components of the oganisation e.g. assets, liabilities, capital, revenue and cash flow

2. Measuring the monetary values of key financial components in a way which represents a true and fair view of the organisation

3. Communicating the financial information in ways that are

useful to the users of the organisation

Accrual vs Cash accounting why do some report cash and some accrual?It really depends on the needs of the users.

.

In most cases, you can choose which method to use. Learn how they work and the advantages and disadvantages of each so you can choose the better one for your business.

In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts

What is accrual accounting?

Revenue and expenses reported for an accounting period are the revenue earned and expenses matched to or incurred in generating that income – regardless of whether the income has actually been received or cash paid for the expenditure

.

For ExampleWhere we have performed some work for a client and invoiced this client,

we would include this revenue in our reporting for the period, regardless of whether we have actually received payment or not. On the expense side, we

would include expenses such as electricity and gas consumed during the period even if the bill is not due for payment until the following period

What is Cash Accounting The cash method is the more commonly used method of accounting in small business. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.

Example Your computer installation business finishes a job in November,

and doesn't get paid until three months later in January.Under the cash method, you would record the payment in January. Under

the accrual method, you would record the income in your November books

The Accounting FormulaHas 3 Major Components to reflect the

organisation value:

a)Assets-the value of the resources of the organisation

b)Capital-the value of the owner's interest in the organisation

c)Liabilities-the value of others' claim on the organisation

ASSETS - LIABILITIES=CAPITAL

The Basic Accounting Statements1.The Balance Sheet-A financial summary showing the assets, liabilities and capital of the organisation at a particular date2.The Income statement-A financial summary showing revenue and expenses for the financial period3.The Cash flow Statement is a summary of cash and bank balances over a defined past period

A. Fundamentals of Financial Management

1.Definition of Financial Management

The management of the finances of a business / organization

in order to achieve financial objectives.

1.Key Objectives of Financial Management

Create wealth for the business.

Generate cash.

Provide adequate return on investment

A. Fundamentals of Financial Management

1. Key elements of the process of financial

management

a) Financial Planning Ensure enough funding is available at the right

time.

b) Financial Control Ensure that the business is meeting its

objectives.

c) Financial Decision Making Key aspects – investment, financing and

dividends.

Financial Statement Analysis

Comparative Analysis

B. Analysis of Financial Statements

Ratio Analysis

Horizontal Analysis

Vertical Analysis

1. Profitability Ratio

2. Liquidity Ratio

3. Activity Ratio

4. Gearing Ratio

5. Other Ratios


1. Comparative Analysis

Comparative Analysis involves the comparison against the

company’s past performance, against another company’s

performance or against the industry average. Comparison

against a benchmark will enable users to make an informed

and better decision.

a) Horizontal Analysis Involves the comparison of items in the financial

statements over a two year period or more. Comparison can be made against last year’s

performance or against few years.


1. Comparative Analysis

a) Vertical Analysis As not all companies are of the same size, and

comparing the absolute results of different businesses

of dissimilar sizes will not provide an adequate

picture. By turning the absolute figures into percentage, we

could make a more meaningful interpretation of the

data. We will compare percentages rather than the absolute

figure (overcome the problems of companies with

different sizes).

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1. Financial Ratio Analysis Shows the relationship between an item in the income

statement or balance sheet with another item. Provide a meaningful data and will enable users to understand

the financial statement.

a) Profitability Ratios Measure the ability of a business entity to earn profits. Used as an indicator of how efficient and effective a

company is in achieving its profit.

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1. Financial Ratio Analysis

a) Profitability Ratios

1) Gross Profit Margin (Ratio) Measures the gross profit earned for every

Ringgit sales. Higher gross profit ratio indicates strong

performance as the company has more profit to

pay for its sales & administrative expenses.

Gross Profit Ratio = ( Gross Profit / Net Sales) x 100

30




1) Net Profit Margin (Ratio) Measures the net profit earned for every Ringgit sales. Higher net profit ratio indicates strong performance as

the company has more profit to pay dividends to

shareholders.

Net Profit Ratio = ( Net Profit / Net Sales) x 100

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1) Earnings Per Share (EPS) Measures the earning that is earned by each

ordinary share after paying for tax and preference

shares dividend. The higher the earning per share the better it is.

EPS = ( Earning after Tax – Div for PS) / Total OS

PS – Preference Share, OS – Ordinary Share

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a) Liquidity Ratios

Liquidity refers to the ability to generate or raise cash.

Measure the ability of a company to meet short term

obligations or debts that might be unexpectedly

demanded to be paid before its maturity dates.

If a company fails to pay its debts, it could mean an end

to the business.

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a) Liquidity Ratios

1) Current Ratio Measures the ability of a business entity to pay up

current liabilities. A current ratio of 2:1 indicates strong ability to

meet short term debts. The higher the current ratio, the more liquid the

company is said to be.

Current Ratio = Current Assets / Current Liabilities

34



a) Liquidity Ratios

1) Quick Ratio Also known as acid test ratio. Measures how many quick assets there are to

cover quick liabilities. Comprises of cash, receivables and market

securities and exclude inventory.

Current Ratio = [CA – (Inventory + Prepaid)] / CL

CA – Current Asset, CL – Current Liabilities

35



a) Activity Ratios

Measure the effectiveness and ability of a company in

its resources.

It can indicate how effective a company’s inventory

is being used to generate sales or how efficient is the

collection of debts by a company.

36



a) Activity Ratios

1) Accounts Receivable Turnover (ART) Measures how fast accounts receivable is

collected. Indicates the effectiveness of a business entity

in managing its accounts receivables.

ART = Net Credit Sales / *Ave Account

Receivable

*Ave Acc Rec = (Opening Acc Rec + Closing Acc Rec)/2

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a) Activity Ratios

1) Inventory Turnover Measures the ability of a business entity to sell its

inventory. Indicates the number of times inventory is sold.

Inventory Turnover = COGS / *Ave Inventory

COGS – Cost of Good Sold

*Ave Inventory = (Opening Inventory + Closing Inventory)/2

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a) Activity Ratios

1) Total Assets Turnover (TAT)

Measure the relationship between sales levels

against the average total sales.

Measures the effectiveness of total assets which

are used in generating sales.

TAT = Net Sales / Average Total Assets

39



a) Gearing Ratios

Measure how much the assets of a company is

financed by creditor rather than the owners.

High proportion of shareholders fund indicates

financial strength.

Heavy reliance on borrowing indicates the risk to the

investors as debts require repayments of loan

principal amount and the interest expenses.

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a) Gearing Ratios

1) Equity Ratios

Measure the financial structure of a company.

Higher equity ratios indicate stability.

Equity Ratio = (*Total OS Fund / Total Assets) x 100

* Total Ordinary Shareholder Fund include retained earnings

and reserves but exclude preference shares

41



a) Gearing Ratios

1) Debts Ratios

Measures the financial structure of a company.

Higher debt ratios indicate that a company face a

higher risk in its ability to settle its debts.

Debt Ratio = *Total Debts / Total Assets) x 100

* Total debts = Total Liabilities + Preference S/holders Fund

42



a) Gearing Ratios

1) Debts to Equity Ratios (DER) Measures how much of total debts are covered by

equity. The lower the ratio the better it is as it indicates

the amount owned by equity is more than

liabilities.

DER = *Total Debts / Total Shareholder Equity

* Total debts = Total Liabilities + Preference S/holders Fund

Activity No. Category Financial ratios 2005 2004

1 Profitability

Gross Profit Margin

Net Profit Margin

Earning Per Share

2 Liquidity Current Ratio

Quick Ratio

3 Activity Accounts receivable turnover

Inventory turnover

B. Analysis of Financial Statements1.Financial Ratios Analysis – Practical Example

No. Category Financial ratios 2005 2004

3 Activity Total Asset Turnover

4 Gearing Equity Ratios

Debt Ratio

Debt to Equity ratio

5 Other ratios

Any additional covering ratios

the above under the respective

category

e.g. interest cover, dividend cover,

dividend yeild, debt collection

B. Analysis of Financial Statements1.Financial Ratios Analysis – Practical Example

C. Time Value of Money

TVM

Interest Future Value Present Value

Simple

Compound

Amortization

Annuity


1. The Interest Rate

Which would you prefer -- $10,000 today or

$10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!



TIME allows you the opportunity to postpone consumption and earn INTEREST.

Why is TIME such an important element in your decision?



a) Simple Interest Interest paid (earned) on only the original

amount, or principal, borrowed (lent).

b) Compound Interest Interest paid (earned) on any previous

interest earned, as well as on the principal

borrowed (lent).

C. Time Value of Money1. The Interest Rate

Simple Interest - Formula

SI = P0(i)(n)

Where SI = Simple Interest

P0 = Deposit Today (t=0)

i = Interest Rate Per Period

n = Number of Time Periods



Simple Interest - Example

Assume that you deposit RM1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?

SI = P0(i)(n) = RM1,000(.07)(2) = RM140



a) Compound Interest

When interest paid on an investment during

the first period is added to the principal.

During the second period, interest is earned

on the new sum.



a) Compound Interest - Formula

CI = P(1 + i)n

Where CI = Compound Interest

P = Deposit Today

i = Interest Rate Per Period

n = Number of Time Periods



a) Compound Interest – Example

David deposited RM100 into his saving account

in Maybank for 5 years with interest of 5% per

annum. What is the return that he is expected to

receive at the end of 5th year?



a) Frequency of Compounding – Formula (future value)

FVn= PV0(1 + [i/m])mn

Where n = Compounding Period per year

i = Annual Interest Rate

FVn,m= FV at the end of Year n

PV0= PV of the Cash Flow today



a) Frequency of Compounding - Example

Suppose you deposit $1,000 in an account that

pays 12% interest, compounded quarterly. How

much will be in the account after eight years if

there are no withdrawals?



a) Frequency of Compounding - Question

John deposit $1,000 in an account that pays 12%

interest, compounded monthly. How much will be

in the account after one year if there are no

withdrawals?


1. Future Value - Formula

FV = PV (1+i)n

Where FV = Future Value

PV = Present Value

i = Rate of interest per compounding period

n = Number of Compounding Periods


1. Future Value - Example

If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

0 1 2

$2,000

FV

6%


1. Present Value - Question

John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.

0 1 2 3 4 5

$5,000

FV5

8%


1. Present Value - Formula

Since FV = PV(1 + i)n.

PV = FV / (1+i)n.

Where FV = Future Value

PV = Present Value

i = Rate of interest per compounding period

n = Number of Compounding Periods


1. Present Value - Example

Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?

0 5 10

$4,000

6%

PV0


1. Present Value - Question

Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.

0 1 2 3 4 5

$2,500

PV0

4%


1. Annuities An Annuity represents a series of equal payments

(or receipts) occurring over a specified number of

equidistant periods.

Examples of Annuities Include:

- Car Loan Payments

- Insurance Premiums

- Mortgage Payments


1. Annuities

a) Annuities Future Value - Formula

FVAn = R(1+i)n-1 + R(1+i)n-2 + ... + R(1+i)1 + R(1+i)0

R R R

0 1 2 n n+1

FVAn

R = Periodic Cash Flow

Cash flows occur at the end of the period

i% . . .


1. Annuities

a) Annuities Future Value - Question

If one saves $1,000 a year at the end of every

year for three years in an account earning 7%

interest, compounded annually, how much will

one have at the end of the third year?


1. Annuities

a) Annuities Present Value - Formula

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

R R R

0 1 2 n n+1

PVAn

R = Periodic Cash Flow

i% . . .

Cash flows occur at the end of the period


1. Annuities

a) Annuities Present Value - Question

If one agrees to repay a loan by paying $1,000

a year at the end of every year for three years

and the discount rate is 7%, how much could

one borrow today?


1. Amortization - Example

Julie Miller is borrowing $10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years.

PV0 = R (PVIFA i%,n)

$10,000 = R (PVIFA 12%,5)

$10,000 = R (3.605)

R = $10,000 / 3.605 = $2,774

Ending Balance

End of Year

Payment Interest Principal

$10,000 0 --- --- ---

8,426 1 $2,774 $1,200 $1,574

6,663 2 2,774 1,011 1,763

4,689 3 2,774 800 1,974

2,478 4 2,774 563 2,211

0 5 2,775 297 2,478

$13,871 $3,871 10,000


1. Amortization – Example (Table)

[Last Payment Slightly Higher Due to Rounding]


1. Amortization – Question

Suppose you borrow $6,655 to make repairs to

your house, and the loan is considered a

second mortgage. The terms of the loan

require you to make payments every three

months, i.e. quarterly, for the next two years

and the simple interest rate is 6 percent p.a.

What is the amount that must be paid every

three months?

D. Securities Valuation

Securities Valuation

Stock Bonds

Common Stock

Preferred Stock

1. Mortgage Bond2. Eurobonds3. Zero Coupon Bonds4. Junk Bond

Stock market

Securities Valuation

D. Securities Valuation-Investment Appraisal

1. Preferred Stock Preferred Stock is often referred to as a hybrid

security because it has many characteristics of both common stocks and bonds.

Like common stocks- No fixed maturity date.- Failure to pay dividends does not bring on bankruptcy.

Like bonds

- Dividends are for a limited time.


1. Preferred Stock – Features

a) Multiple series of Preferred Stock

b) Preferred Stock’s claim on asset & income

c) Cumulative dividends

d) Protective provisions

e) Convertibility

f) Retirement features

g) Callable



a) Multiple series of Preferred Stock If a company desires, it can issue more than

one series of preferred stock, and each series

can have different characteristics.- Convertible- Protective provisions



a) Claims on Assets and Income Preferred stock has priority over Common

Stock with regard to claim on assets in the

case of bankruptcy. Honored before common stockholders, but

after bonds. Must pay dividends to preferred stockholders

before it pays common stockholder dividends.



a) Cumulative Dividends Cumulative features requires that all past,

unpaid preferred stock dividends be paid

before any common stock dividends are

declared.

b) Protective Provisions Protective provisions generally allow for

voting rights in the event of non payment of

dividends.



a) Convertibility Convertible preferred stock can, at the

discretion of the holder, be converted into a

predetermined number of shares of common

stock. Almost one third of preferred stock issued

today is convertible. Reduces the cost of the preferred stock to the

issue



a) Retirement Features Although preferred stock has no set maturity

associated with it, issuing firms generally

provide for some method of retiring the stock.

b) Callable A call provision entitles a company to

repurchase its preferred stock from their

holders at stated prices over a given time

period.


1. Preferred Stock

a) Valuing Preferred Stock

Where Vps= The value of preferred stock

D = The preferred dividend

kps= The required rate of return

Example : Xerox’s Series C preferred stock pays an annual dividend of RM6.25 and the investors required rate of return is 5%

Vps =

D

kps


1. Common Stock Common stock is a certificate that indicates

ownership in a corporation. Has no maturity date. Dividend payments will normally divided into

Interim & Final Dividend In the event of bankruptcy, common stockholders

will not receive any payment until the creditors,

including the bondholders and preferred

stockholders, have been satisfied.


1. Common Stock – Features

a) Claim on income

b) Claim on assets

c) Voting rights

d) Preemptive rights

e) Limited liability



a) Claim on income

Common shareholders have the right to

residual income after bondholders and

preferred stockholders have been paid

Can be in the form of dividends or retained

earnings.



a) Claim on assets

Common stock has a residual claim on assets

after claims of debt holders and preferred

stockholders.

If bankruptcy occurs, claims of the common

shareholders generally go unsatisfied.



a) Voting Rights Common shareholders are entitled to elect the

board of directors. Most often are the only security holders with

a vote. A proxy gives a designated party the

temporary power of attorney to vote for the

signee at the corporation’s annual general

meeting.



a) Preemptive Rights Preemptive right entitles the common

shareholder to maintain a proportionate share

of ownership in the corporation.

Rights – certificates issued to the shareholders

giving them an option to purchase a stated

number of shares of stock at a specified price

during a two to ten week period.



a) Limited Liability Liability of the shareholder is limited to the

amount of their investment.

Limited liability feature aids the firm in

raising funds.


1. Common Stock

a) Valuing Common Stock

Where Vcs= The value of common stock

D0 = The preferred dividend

g= Growth rate

kcs= The required rate of return

gk

gDV

C SC S

10


1.Common Stock

a) Valuing Common Stock – Example

Consider the valuation of a common stock that paid

RM2.00 dividend at the end of the last year and is

expected to pay a cash dividend in the future.

Dividends are expected to grow at 10% and the

investors required rate of return is 15%


1. Bond – type of debt or long term promissory note,

issued by a borrower, promising to its holder a

predetermined and fixed amount of interest per

year.

a) Types of Bonds

i. Debentures Any unsecured long term debt.

Viewed as more risky than secured

bonds and provide a higher yield than

secured bonds.


1. Bond

a) Types of Bonds

i. Mortgage Bonds A bond secured by a lien on real property. Typically, the value of the real property is

greater than that of the bonds issued.

ii. Eurobonds Securities (bonds) issued in a country

different from the one in whose currency

the bond is denominated.


1. Bond

a) Types of Bonds

i. Zero Coupon Bonds Issued at a substantial discount from the

RM1,000 face value with a zero coupon

rate. Return comes from appreciation of the

bonds. Advantages – cash outflows don’t occur

with zero coupon bonds.


1. Bond

a) Types of Bonds

i. Junk Bonds (High Yield Bonds)

High risk debt with ratings of BB or below

by Moody’s and Standard & Poor’s.

High yield – typically pay 3% ~ 5% more

than AAA grade long term bonds.


1. Bond

a) Terminologyi. Claims on assets and income

In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock.

ii. Par Value Face value of the bond, returned to the

bondholder at maturity. Corporate bonds are issued at

denomination of RM1,000


1. Bond

a) Terminologyi. Coupon Interest Rate

The percentage of the par value of the bond that will be paid out annually in the form of interest.

ii. Maturity The length of time until the bond issuer

returns the par value to the bondholder and terminates or redeem the bonds.


1. Bond

a) Terminologyi. Convertibility

May allow the investor to exchange the bond for a predetermined number of the firm’s shares of common stock.

ii. Indenture The legal agreement between the firm

issuing the bond and the trustee who represents the bondholders.


1. Bonda) Terminology

i. Call Provision A provision such that if the prevailing

interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.

Issuer must pay the bondholder at premium.

There is also call protection period where the firm can’t call for a specified period.


1. Bonda) Valuation

Assigning a value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate.

The value of a bond is combination of:-- the amount and timing of cash flows to be

received by investors.- the time to maturity of the loan.- the investor’s required rate of return.


1. Bonda) Valuation - Formula

)1()1(1 bn

bt

n

tb

k

M

k

IV

Where Vb= Intrinsic value

I = Interest to be received

n = Number of period to maturity

kb= Required rate of return for bondholder

M = Par value of the bond at maturity


1. Bonda) Valuation - Formula

Vb= I(PVIFAkb,n) + M(PVIFkb,n)

Where Vb= Intrinsic value

I = Interest to be received

n = Number of period to maturity

kb= Required rate of return for bondholder

M = Par value of the bond at maturity


1. Bonda) Valuation – Example

Consider a bond issued by Toyota with a

maturity date of 2008 and a stated coupon of

5.5%. In December 2004, with 4 years left to

maturity, Investors owning the bonds are

requiring a 4% rate of return. Calculate the price

of Toyota Bond.


1. Bonda) Valuation – 3 important relationships

First Relationships The value of a bond is inversely related to

changes in investor’s present required rate of

return (interest rate). As interested rate increases (decreases), the

value of the bond decreases (increases).



Second Relationship The market value of a bond will be less than

the par value if the investor’s required rate of

return is above the coupon interest rate. However, it will be valued above par value if

the investor’s required rate of return is below

the coupon interest rate.



Third Relationship Long term bonds have greater interest rate

risk than the short term bonds.

E. Risk & Return

Risk & Return

Risk & Return?

Market RiskSummary

Diversification

E. Risk & Return

1. Risk & Returna) What is Risk?

The possibility that an actual return will differ from our expected return.

Uncertainty in the distribution of possible outcomes.

b) What is Return? Expected Return - the return that an investor

expects to earn on an asset, given its price, growth potential, etc.

Required Return - the return that an investor requires on an asset given its risk.

E. Risk & Return

1. Expected Return - Example

State of Economy

Probability Return

(P) Company A Company B

Recession .20 4% -10%

Normal .50 10% 14%

Boom .30 14% 30% k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

E. Risk & Return

1. How do we Measure Risk?

A more scientific approach is to examine the

stock’s STANDARD DEVIATION of returns.

Standard deviation is a measure of the dispersion

of possible outcomes.

The greater the standard deviation, the greater

the uncertainty, and therefore , the greater the

RISK.

E. Risk & Return

1. How do we Measure Risk?

a) Formula for Standard Deviation

Where n = The number of possible outcomes

ki= The value of ith possible rate of return

P(ki) = Probability that ith return will occur

k = Expected value of the rate of return

)()(2

1ii kPkk

n

t

E. Risk & Return

1. How do we Measure Risk? - Example

Company A Company B

Recession (4% -10%)2 (.2) = 7.2 (-10% -14%)2(.2) = 115.2

Normal (10% - 10%)2 (.5) = 0 (14% - 14%)2 (.5) = 0

Boom (14% -10%)2 (.3) = 4.8 (30% - 14%)2 (.3) = 76.8

Variance 12 192

Std Deviation 3.46% 13.86%

E. Risk & Return

1. How do we Measure Risk? - Summary

Company A Company B

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Which stock would you prefer? How would you decide?

It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return.

E. Risk & Return

1. Diversification Investing in more than one security to reduce risk.

If two stocks are perfectly positively correlated,

diversification has no effect on risk.

If two stocks are perfectly negatively correlated, the

portfolio is perfectly diversified.

If you owned a share of every stock traded on the

BSKL and Mesdaq, would you be diversified? YES!

Would you have eliminated all of your risk? NO!

Common Stock portfolios still have risk.

E. Risk & Return

1. Diversification Some risk can be diversified away and some can

not.a) Market Risk is also called Non - diversifiable

risk. This type of risk can not be diversified away.

Unexpected changes in interest rates. Unexpected changes in cash flows due to

tax rate changes, foreign competition, and the overall business cycle.

E. Risk & Return

1. Diversificationa) Firm-Specific risk is also called diversifiable

risk. This type of risk can be reduced through diversification.

A company’s labor force goes on strike.

A company’s top management dies in a plane crash.

A huge oil tank bursts and floods a company’s production area.

E. Risk & Return

1. Market Risk As we know, the market compensates investors for

accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. So - we need to be able to measure market risk.

Beta: a measure of market risk. Specifically, it is a measure of how an individual

stock’s returns vary with market returns. It’s a measure of the “sensitivity” of an individual

stock’s returns to changes in the market.

E. Risk & Return

1. Market Risk

A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.

A firm with a beta > 1 is more volatile than the market (ex: computer firms).

A firm with a beta < 1 is less volatile than the market (ex: utilities).

E. Risk & Return

1. Summary of Risk & Return

We know how to measure risk, using standard deviation for overall risk and beta for market risk.

We know how to reduce overall risk through diversification.

We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.

F. Capital Budgeting

Methodology

Payback Period

Net Present Value

Internal Rate Of Return


1. Importance of Capital Budgeting

Capital budgeting is the process of evaluating

proposed large, long-term investment projects.

capital budgeting ensures that proposed

investment will add value to the firm.

Effective capital budgeting can improve both the

timing of asset acquisitions and the quality of

assets purchased.


1. Capital Budgeting Decision Method

a) Payback Period (PBP)

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflows.

Formula for PBP :-

PBP = Year b4 full recovery + Unrecovered cost at start of yr

Cash flow during year



a) Net Present Value (NPV)

The present value of an investment project’s

net cash flows minus the project’s initial cash

outflow.

Formula for NPV :-

)1(0 k

CFNPV t

n

t

t




NPV’s values:- NPV = 0, the firm’s overall value will not

change if the new project is adopted.

NPV > 0, the firm’s overall value will

increase.

NPV < 0, the firm’s overall value will be

decrease.




NPV’s Decision Rules:- For independent projects : accept all

independent projects having NPVs greater

than or equal to 0.

For mutually exclusive projects : projects

having highest positive NPV will be

ranked first.



a) Internal Rate of Return (IRR)

IRR is the estimated rate of return for a

proposed project, given the project’s

incremental cash flows.

Formula for IRR :-

)1(0

0 IRR

CFt

n

t

t



a) Internal Rate of Return (IRR)

IRR Decision Rules:-

For independent project – accept projects

having IRRs greater than the hurdle rate.

For mutually exclusive projects – projects

are ranked from highest to lowest IRR.



a) Conflicting ranking between NPV & IRR

For Independent Projects Both the NPV and IRR methods will

produce the same accept / reject indication. Accept projects having NPV > 0, IRR >

the hurdle rate. For mutually exclusive projects

Project having a higher NPV should be

chosen instead of a higher IRR.



a) Conflicting ranking between NPV & IRR For mutually exclusive projects

Reason for higher choosing higher NPVi. NPV method makes maximizing the

firm value.ii. NPV method assumes that a project’s

cash flows can be reinvested at the cost of capital.

iii. Whereas, IRR method’s assumption on cash flows reinvestment is the IRR.

G. The Cost of Capital

WACC

Cost of PS

Cost of Equity

Cost of Debt


When we say a firm has a “cost of capital” of, for

example, 12%, we are saying:-

The firm can only have a positive NPV on a

project if return exceeds 12%.

The firm must earn 12% just to compensate

investors for the use of their capital in a project.

The use of capital in a project must earn 12% or

more, not that it will necessarily cost 12% to

borrow funds for the project.


1. Cost of Debt (Kd)

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Formula for Cost of DebtKd after taxes = Kd (1 – tax rate)

Example : If the cost of debt for ABC Sdn Bhd is

10% and its tax rate is 40% then :- Cost of debt

is?


1. Cost of Preferred Stock (Kps)

Preferred Stock has a higher return bonds, but is less costly than common stock. WHY?

In case of default, preferred stockholders get paid

before common stockholders. However, in case of bankruptcy, the holders of

preferred stock get paid only after short and long

term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend

and usually cannot vote on the firm’s affairs.


1. Cost of Preferred Stock (Kps)

Formula for Cost of Preferred Stock

kps =D

Vps

Example : If ABC Sdn Bhd is issuing preferred stock at $100 per share, with a stated dividend of $12, then the cost of preferred stock :-


1. Cost of Equity (Kcs)

The cost of equity is the rate of return that

investors require to make an equity investment in

a firm.

CAPM (Capital Asset Pricing Model)

- The CAPM is one of the most commonly used

ways to determine the cost of common stock.


1. Cost of Equity (Kcs)

Formula for Cost of Equity

kcs= krf + ß (km – krf)

Where krf= The risk free rate

ß = The firm’s beta

km= The return on the market

Example : ABC Sdn Bhd has a ß = 1.6. The risk free on T-bills is currently 4% and the market return has averaged 15%:-


1. Weighted Average Cost of Capital (WACC)

Formula for WACC

WACC = wd (Cost of Debt) + wcs (Cost of Equity) + wps (Cost of PS)

Example : ABC Sdn Bhd maintains a mix of 40% debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is :-

H. Dividend Policy

Dividend Policy

Types

Impact

Alternatives

Chronology

H. Dividend Policy

1. Types of Dividend Policy

a) Constant Payout Ratio

b) Constant Nominal Dividend (Regular)

c) Special Dividend Payout

d) Cash Dividend Payment

2. Chronology of Date of Dividend Payment

a) Declaration Date

b) Ex Dividend Date

c) Record Date

d) Payment Date

H. Dividend Policy

1. Impact of Dividend Policy – Firm Value

a) Arguments for Irrelevancy Theory

Signaling Effect

Clientele Effect

b) Arguments against Irrelevancy Theory

Bird in the Hand Theory

Taxes

Floatation Costs

H. Dividend Policy

1. Alternative Dividend Policy

a) Stock Dividend

Firms sometimes tend to distribute additional

shares in the form of dividends to a firm’s

shareholders rather than giving cash

dividends, which are kept in the firm for

investment.

H. Dividend Policy


a) Stock Dividend – Example

A firm has 10 million shares outstanding.

Currently the market value of the firm is RM20

million. Therefore, price per share is to be

RM2.00. Assume that the firm is to issue

another 1 million shares as a stock dividend. The

total number of shares outstanding will be 11

million. Hence, given the market value of the

firm, the new price per share will be?

H. Dividend Policy


a) Stock Split

Stock Split involve issuing of additional

shares to firm’s stockholders.

The investors’ percentage ownership in the

firm remain unchanged.

The investor is neither better nor worse off

before the stock split.

H. Dividend Policy


a) Stock Split – Example

YTM Bhd. Is planning a two for one stock split.

You own 5,000 shares of YTM Bhd’s stock that

is currently selling for RM12.00 per share. What

is the value of your YTM Bhd. Stock now, and

what will it be after the split?

H. Dividend PolicyH. Dividend Policy


a) Stock Repurchase

It is a common practice for developed and

developing markets for a firm to buy back

stock from its shareholders.

Reasons for repurchase :-

- an effective substitute for dividends.

- the price of stocks are undervalued.

- Provide internal investment opportunity.

H. Dividend PolicyH. Dividend Policy


a) Stock Repurchase – ExampleUEB Bhd. Has RM0.8 million in cash for its next

dividend. However, it is considering a repurchase of its own shares instead of paying dividends. The firm has 10 million shares outstanding, currently selling at RM2.00 per share. The P/E is 10 times and the firm’s EPS is RM0.20. What will be the firm’s dividend per share? If stock is repurchased, how many shares will be remain outstanding and what will the new EPS be?

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