Assignment – Principles of Finance

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 1: The Financial Manager and the Firm

Learning Objectives

1. IDENTIFY THE KEY FINANCIAL DECISIONS FACING THE FINANCIAL MANAGER OF ANY BUSINESS FIRM.

2. IDENTIFY THE BASIC FORMS OF BUSINESS ORGANIZATION IN THE UNITED STATES AND THEIR RESPECTIVE STRENGTHS AND WEAKNESSES.

Learning Objectives

3. DESCRIBE THE TYPICAL ORGANIZATION OF THE FINANCIAL FUNCTION IN A LARGE CORPORATION.

4. EXPLAIN WHY MAXIMIZING THE CURRENT VALUE OF THE FIRM’S STOCK IS THE APPROPRIATE GOAL FOR MANAGEMENT.

5. DISCUSS HOW AGENCY CONFLICTS AFFECT THE GOAL OF MAXIMIZING SHAREHOLDER VALUE.

Learning Objectives

6. EXPLAIN WHY ETHICS IS AN APPROPRIATE TOPIC IN THE STUDY OF CORPORATE FINANCE.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Capital Budgeting: decide which long-term

assets to acquire

• Financing: decide how to pay for short-term and

long-term assets

• Working Capital: decide how to manage short-

term resources and obligations

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Capital Budgeting

Choose the long-term assets that will yield the greatest net benefits for the firm.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Financing

Finance assets with the optimal combination of short- term debt, long-term debt, and equity.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Working Capital Management

Adjust current assets and current liabilities as needed to promote growth in cash flow.

Cash Flows Between the Firm and Its Stakeholders and Owners

How the Financial Manager’s Decisions Affect the Balance Sheet

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Poor decisions about capital budgeting,

financing, or working capital may lead to

bankruptcy or business failure

Basic Forms of Business Organization

o BUSINESS STRUCTURE

• Sole Proprietorship

• Partnership

• Corporation

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Owned by a single person who is financially

responsible for the actions and obligations of

the business

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Advantages

easiest to create

easiest to control

easiest to dissolve

right to all profit

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Disadvantages

owner’s personal assets at risk

owner’s unlimited liability for firm obligations

equity only from owner or business profit

business income taxed as personal income

difficult to transfer ownership

Basic Forms of Business Organization

o PARTNERSHIP

• A business owned by more than one person; one

or more of them financially responsible for the

actions and obligations of the business

Basic Forms of Business Organization

o PARTNERSHIP

• Advantages vs. sole proprietorship

limited protection of owners’ personal assets

owners’ limited liability for firm obligations

more sources of equity

more sources of expertise

Basic Forms of Business Organization

o PARTNERSHIP

• Disadvantages vs. proprietorship

shared control

shared profit

harder to dissolve

Basic Forms of Business Organization

o CORPORATION

• A business owned by more than one person;

none of them financially responsible for the

actions and obligations of the business. The

corporation is responsible for its obligations and

actions.

Basic Forms of Business Organization

o CORPORATION

• Advantages

protects personal assets

no shareholder liability for business

easiest to change ownership

greatest access to sources of funds

Basic Forms of Business Organization

o CORPORATION

• Disadvantages

most difficult and expensive to establish

dilutes individual control over the firm

overall higher taxes on income for shareholders

Basic Forms of Business Organization

o HYBRID FORMS OF BUSINESS ORGANIZATION

• Limited Liability Partnerships (LLPs)

• Limited Liability Companies (LLCs)

• Professional Companies (PCs)

All have the limited liability of a corporation and tax advantage of a partnership.

Organization of the Financial Function

o CHIEF EXECUTIVE OFFICER (CEO)

• Chief manager in the firm

• Ultimate power to make decisions and ultimate

responsibility for decisions

• Reports directly to the board-of-directors who

protect shareholder’s interests

Simplified Corporate Organization Chart

Organization of the Financial Function

o CHIEF FINANCIAL OFFICER (CFO)

• The V.P. of Finance/CFO is responsible for the

quality of the financial reports received by the

CEO

Organization of the Financial Function

o KEY FINANCIAL REPORTS

• The Treasurer manages and reports on the

collection and disbursement of cash

• The Risk Manager manages and reports on

activities to limit the firm’s risks in financial and

commodity markets

Organization of the Financial Function

o KEY FINANCIAL REPORTS

• The Controller is the firm’s accountant and

prepares its financial reports

• The Internal Auditor controls and reports on

activities to limit the firm’s exposure to internal

threats such as fraud and inefficient use of

resources

Organization of the Financial Function

o EXTERNAL AUDITOR

• Conducts an independent audit of a firm’s

financial activities

• Provides an opinion about whether the financial

reports the firm prepared are reasonably

accurate and conform to generally accepted

accounting principles

The Goal of the Firm

o DO NOT MAXIMIZE MARKET SHARE

• Giving away goods or services for free will

maximize a firm’s market share for a while, but

the firm will not be able to pay its bills and stay

in business

The Goal of the Firm

o DO NOT MAXIMIZE PROFIT

• Accounting profit differs from economic profit

• Profit earned may not equal cash received

Cash not received can’t be used to pay bills

• The strategy ignores the timing of future cash

flows

• The strategy ignores the risks associated with

having to wait for cash flows

The Goal of the Firm

o MAXIMIZE SHAREHOLDERS’ WEALTH!

• Future cash flows are considered

• The timing of future cash flows is considered

• The risks associated with having to wait to for

cash flows are considered

The Goal of the Firm

o MAXIMIZE SHAREHOLDERS’ WEALTH!

• Maximizing the price of a firm’s stock will

maximize the value of a firm and the wealth of

its shareholders (owners)

The Goal of the Firm

o ITS ALL ABOUT CASH FLOW!

• Positive residual cash flow may be paid to firm

owners as dividends or invested in the firm

• The larger the positive residual cash flow, the

greater the value of a firm

• Negative residual cash flow – over the long run –

leads to bankruptcy or closing a business

Agency Conflicts

o AGENCY RELATIONSHIP

• An agency relationship is created when the

owner (a principal) of a business hires an

employee (an agent)

• The owner surrenders some control over the

enterprise and its resources to the employee

• Separating ownership from control creates the

potential for agency conflicts

Agency Conflicts

o AGENCY RELATIONSHIP

• An agency relationship exists between

stockholders (principals) and the firm’s hired

management (agents)

• In large corporations, shared ownership among

many shareholders may result in relatively little

control over management

Agency Conflicts

o OWNERSHIP AND CONTROL

• Shareholders own the corporation, but

managers control the firm’s assets and may use

them for their own benefit

Major Factors Affecting Stock Prices

Agency Conflicts

o AGENCY COSTS

• Arise from (incurring and preventing) conflicts-

of-interests between a firm’s owners and its

managers

• May reduce positive residual cash flow, stock

price, and shareholder wealth

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Managers tend to focus on wealth maximization

when their compensation depends on stock

price

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Today, the firm’s stock trades at $0.95 per share.

The CEO has an option to buy 2.5 million

shares from the firm for $1.15 per share at any

time, beginning one year from today. If the

stock price rises to $3.15, the option will be

worth $5 million.

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Want to keep their jobs

• Oversight by the board of directors

• Oversight by large blockholders

• Potential takeover of the firm

• The legal and regulatory environment.

Agency Conflicts

o SARBANES-OXLEY AND REGULATORY REFORM

• Better corporate governance reduces agency

costs by requiring

more effective monitoring of managers’ activities

programs that promote appropriate behavior by managers

penalties for executives who do not fulfill their fiduciary responsibilities

Corporate Governance Regulations Designed to Reduce Agency Costs

Ethics in Corporate Finance

o WHAT ARE ETHICS?

• Ethics

society’s standards for judging whether an action is right or wrong

• Business Ethics

society’s standards for acceptable behavior applied to business and financial markets

Ethics in Corporate Finance

o EXAMPLES OF ETHICAL CONFLICT IN BUSINESS

• Agency Cost

employee’s unacceptable use of employer’s computer

• Conflict of Interest

mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money

• Information Asymmetry

seller knows about prior damage to the vehicle but the potential buyer does not

Ethics in Corporate Finance

o BUSINESS BEHAVIOR

• Regulation and market forces are not enough to

maintain integrity in the marketplace

• Business norms must be based on ethical

beliefs, customs, and practices

Ethics in Corporate Finance

o CONSEQUENCES OF UNETHICAL BEHAVIOR

• Inefficiency in the economy and costs to society

• High legal and social costs

• Problems such as the recent financial crisis in

the U.S.

Ethics in Corporate Finance

o ETHICAL BEHAVIOR

• Sometimes, it is difficult to judge whether

behavior is ethical or not

Was the manager too careful?

Did the manager take too much risk?

Was it an honest mistake?

Was it against policy, but well-intentioned?

A Framework for the Analysis of Ethical Conflicts

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 2: The Financial System and the Level of Interest Rates

Learning Objectives

1. DESCRIBE THE ROLE OF THE FINANCIAL SYSTEM IN THE ECONOMY AND THE TWO BASIC WAYS IN WHICH MONEY FLOWS THROUGH THE SYSTEM.

2. DISCUSS DIRECT FINANCING AND THE IMPORTANT ROLE THAT INVESTMENT BANKS PLAY IN THIS PROCESS.

Learning Objectives

3. DESCRIBE THE PRIMARY, SECONDARY, AND MONEY MARKETS, EXPLAINING THE SPECIAL IMPORTANCE OF SECONDARY AND MONEY MARKETS TO BUSINESS ORGANIZATIONS.

4. EXPLAIN WHAT AN EFFICIENT MARKET IS AND WHY MARKET EFFICIENCY IS IMPORTANT TO FINANCIAL MANAGERS.

Learning Objectives

5. EXPLAIN HOW FINANCIAL INSTITUTIONS SERVE THE NEEDS OF CONSUMERS, SMALL BUSINESSES, AND CORPORATIONS.

6. COMPUTE THE NOMINAL AND THE REAL RATES OF INTEREST, DIFFERENTIATING BETWEEN THEM.

The Financial System

o FINANCIAL MARKETS AND INSTITUTIONS

• Financial markets include markets for trading

financial assets such as stocks and bonds

• Financial institutions include banks, credit

unions, insurance companies, and finance

companies

The Financial System

o THE FINANCIAL SYSTEM AT WORK

• The financial system is competitive

• Money is borrowed in small amounts and

loaned in large amounts

• The system directs money to the best

investment opportunities in the economy

• Lenders earn profit from the spread between

lending and borrowing rates

The Financial System

o MOVE FUNDS FROM LENDER TO BORROWER

• The primary function of a financial system is to

efficiently transfer funds from lender-savers to

borrower-spenders

• Basic mechanisms by which funds are

transferred in the financial system

Direct Financing

Indirect Financing

The Flow of Funds Through the Financial System

Direct Financing

o DIRECT TRANSFER OF FUNDS

• lender-saver contracts with a borrower-spender

• minimum transaction $1 million

• investment banks and money center banks help

with origination, underwriting and distribution

of new debt and equity

Direct Financing

o DIRECT TRANSFER OF FUNDS

• Underwriting is a service to assist firms in

selling their debt or equity securities in a direct

financing market

Types of Financial Markets

o WHOLESALE AND RETAIL MARKETS

• Primary Market

wholesale market where firms’ new securities are issued and sold for the first time

• Secondary Market

retail market where previously issued securities are resold (traded)

Types of Financial Markets

o MARKETABILITY AND LIQUIDITY

• Marketability

ease with which a seller or buyer for an asset can be found

• Liquidity

ease with which an asset can be converted into cash without loss of value

Types of Financial Markets

o MARKETABILITY AND LIQUIDITY

• Financial markets increase marketability and

liquidity of securities

• Financial markets lower the costs of making

transactions and make participants more willing

and able to pay higher prices

Types of Financial Markets

o BROKERS AND DEALERS

• A broker brings a seller and a buyer together but

does not buy or sell in the transaction

broker does not take on risk

• A dealer participates in trades as a buyer or

seller using her own inventory of securities

dealer takes on risk

Types of Financial Markets

o EXCHANGES & OVER-THE-COUNTER MARKETS

• Exchange

location where sellers and buyers meet to conduct transactions – New York Stock Exchange (NYSE)

– Chicago Board Options Exchange (CBOE)

Types of Financial Markets

o EXCHANGES & OVER-THE-COUNTER MARKETS

• Over-the-Counter Market

dealers conduct transactions over the phone or via computer. – National Association of Securities Dealers Automated

Quotations (NASDAQ)

Types of Financial Markets

o MONEY AND CAPITAL MARKETS

• Money Market

market for low-risk securities with maturities of less than one year. – Treasury Bills (T-bills)

– Commercial Paper

Types of Financial Markets

o MONEY AND CAPITAL MARKETS

• Capital Market

market for securities with maturities longer than one year – bonds

– common stock

Selected Money Market and Capital Market Instruments June 2010

Market Efficiency

o EFFICIENT MARKET

• Current prices of securities incorporate the

knowledge and expectations of all participants

• Security prices are correct: securities are not

over-valued or under-valued.

• Participants are confident they pay or receive

the intrinsic (fair) value of a security

Market Efficiency

o MARKET EFFICIENCY

• Operational Efficiency

extent to which transaction costs are minimized

• Informational Efficiency

extent to which security prices reflect all relevant information

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• A theory about how efficiently the stock market

processes and incorporates information

available from

private sources of information

public sources of information

historical stock prices

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Strong-Form Efficiency

Security prices always reflect all information, from every source. Even inside, or confidential information, is reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Semistrong-Form Efficiency

Security prices always reflect all public information. Inside, or confidential information, is not reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Weak-Form Efficiency

Security prices always reflect the information in past prices. No other information is reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Public markets, such as the NYSE are more

efficient than private markets due to the

information provided by a large number of

participants and effective regulation

Financial Institutions and Indirect Financing

o INDIRECT FINANCING

• An institution is both a borrower and lender

borrows money from a saver

lends money to a borrower

must repay funds to the saver – whether or not it is repaid by the borrower – Examples: banks & insurance companies

Financial Institutions and Indirect Financing

o FINANCIAL INSTITUTIONS

• Provide lending and borrowing opportunities at

the retail level for small customers and

wholesale level for large customers

• Efficiently collect funds in small amounts and

lend them in larger amounts

• Tailor loan amounts and contract terms to fit the

needs of consumers, corporations, and small

businesses

Cash Flows Between the Firm and the Financial System

The Determinants of Interest Rate Levels

o INTEREST RATE

• The fee for borrowing money expressed as a

percentage of a loan

real rate of interest – interest rate that would exist in the absence of inflation

(deflation)

nominal ate of interest – interest rate adjusted for inflation (deflation)

The Determinants of Interest Rate Levels

o REAL RATE OF INTEREST

• Determinants of the real rate of interest

expected return on productive assets

time preference for consumption

The Determinants of Interest Rate Levels

o EQUILIBRIUM RATE OF INTEREST

• Is a function of supply and demand

savers supply more funds at higher rates

spenders borrow (demand) less at higher rates

• Is the interest rate at which the quantity of

funds supplied equals the quantity of funds

demanded

The Determinants of the Equilibrium Rate of Interest

The Determinants of Interest Rate Levels

o INFLATION AND LOAN CONTRACTS

• Lenders want the interest rates in loan contracts

to include compensation for the inflation

predicted to occur over the life of the contract

• Compensation for expected inflation adjusts

loan rates to offset the higher prices for goods

and services expected to exist when a loan is

repaid and a lender spends the money

The Determinants of Interest Rate Levels

o FISHER EQUATION & NOMINAL INTEREST RATE

• The Fisher Equation

o

Where:

i = nominal interest rate

r = real rate of interest

∆Pe = expected annualized price-level change

r∆Pe = adjustment for expected price-level

change

)1.2( ee

PrPri 

The Determinants of Interest Rate Levels

o FISHER EQUATION & NOMINAL INTEREST RATE

• Simplified Fisher Equation

)2.2( e

Pri 

The Determinants of Interest Rate Levels

o FISHER EQUATION EXAMPLE

14.40% or 0.1440

0.10) x (0.04 0.10 0.04

Pr P r i

? i0.10 P0.04 r

ee

e









The Determinants of Interest Rate Levels

o SIMPLIFIED FISHER EQUATION EXAMPLE

14% or 0.14

0.10 0.04

Pe r i

? i0.10 Pe0.04 r









The Determinants of Interest Rate Levels

o REAL RATE OF INTEREST EXAMPLE

r 0.04

r 0.10 – 0.14

0.10 r 0.14

P r i

? r0.10 P0.14 i

e

e











The Determinants of Interest Rate Levels

o CYCLICAL & LONG-TERM INTEREST RATES

• Interest rates tend to rise and fall with changes

in the rate of inflation

• Rates tend to rise when the growth rate of the

economy increases and tend to fall when the

growth rate of the economy slows

The Determinants of Interest Rate Levels

o INTEREST RATE, BUSINESS CYCLE & INFLATION

• Interest rates tend to follow the business cycle

• Interest rates tend to increase during an

economic expansion

• Interest rates tend to decrease during an

economic contraction

Relation Between Annual Inflation Rate and Long-Term Interest Rate

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 3: Financial Statements, Cash Flows, and Taxes

Learning Objectives

1. DISCUSS GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) AND THEIR IMPORTANCE TO THE ECONOMY.

2. EXPLAIN THE BALANCE SHEET IDENTITY AND WHY A BALANCE SHEET MUST BALANCE.

3. DESCRIBE HOW MARKET-VALUE BALANCE SHEETS DIFFER FROM BOOK-VALUE BALANCE SHEETS.

Learning Objectives

4. IDENTIFY THE BASIC EQUATION FOR THE INCOME STATEMENT AND THE INFORMATION IT PROVIDES.

5. UNDERSTAND THE CALCULATION OF CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING ACTIVITIES REQUIRED IN THE STATEMENT OF CASH FLOWS.

6. EXPLAIN HOW THE FOUR MAJOR FINANCIAL STATEMENTS DISCUSSED IN THIS CHAPTER ARE RELATED.

Learning Objectives

7. IDENTIFY THE CASH FLOW TO A FIRM’S INVESTORS USING ITS FINANCIAL STATEMENTS.

8. DISCUSS THE DIFFERENCE BETWEEN AVERAGE AND MARGINAL TAX RATES.

Financial Statements

o PURPOSE OF FINANCIAL STATEMENTS

• Provide stakeholders a foundation for evaluating

the financial health of a firm

creditors

employees

management

stockholders

Financial Statements

o PURPOSE OF FINANCIAL STATEMENTS

• Provide stakeholders a foundation for evaluating

the financial health of a firm.

customers

general Public

regulators

suppliers

Financial Statements

o PURPOSE OF FINANCIAL STATEMENTS

• Evaluate a firm’s internal environment

efficiency

effectiveness

risk level

Financial Statements

o PURPOSE OF FINANCIAL STATEMENTS

• Evaluate a firm’s interaction with the external

environment

corporate citizenship

social responsibility

assessment of the external environment

response to the external environment

Financial Statements

o PURPOSE OF FINANCIAL STATEMENTS

• Provide information about the performance of

the firm

stakeholders want to compare actual vs. potential performance

Financial Statements and Accounting Principles

o GAAP

• Generally Accepted Accounting Principles

(GAAP)

accounting rules and standards that public companies must adhere to when they prepare financial statements and reports

established by the Financial Accounting Standards Board (FASB) and authorized by the Securities and Exchange Commission (SEC)

Financial Statements and Accounting Principles

o INTERNATIONAL GAAP

• Uniform accounting rules and procedures

promoted by the International Accounting

Standards Board

• Firms in the European Union are moving

toward a “European GAAP”

• Economic and political pressure is building in

the United States and Europe to develop a

unified accounting system

Financial Statements and Accounting Principles

o GAAP

• Guidelines, not rules

Firms have discretion about how their financial information is presented.

No two firms are required to have identical statements.

Financial Statements and Accounting Principles

o GAAP

• Guidelines, not rules.

Alternative terms on financial statements – balance sheet, statement of financial condition

– income statement, statement of operations, profit and loss statement

– cost-of-goods-sold, cost-of -sales, cost-of-revenue, cost-of- services-sold

Financial Statements and Accounting Principles

o FIVE IMPORTANT ACCOUNTING PRINCIPLES

1. Assumption of Arm’s Length Transaction

Parties involved in an economic transaction arrive at a decision independently and rationally.

2. Cost Principle

Asset values are recorded at the cost for which they were acquired.

Financial Statements and Accounting Principles

o FIVE IMPORTANT ACCOUNTING PRINCIPLES

3. Realization Principle

Revenue is recognized when a transaction is completed, although cash may be received earlier or later.

4. Matching Principle

Revenue is matched with the expense incurred to generate it.

Financial Statements and Accounting Principles

o FIVE IMPORTANT ACCOUNTING PRINCIPLES

5. Going Concern Assumption

Assume a company will continue to operate for the predictable future.

Financial Statements and Accounting Principles

o ANNUAL REPORT

• Summarizes the overall performance of a firm

for the most recent fiscal year

• Information

the company, its products, its activities, and its future

summary of financial performance for the most recent year

audited financial statements, five-year summary of financial data

The Balance Sheet

o FIRM ASSETS & FUNDING AT A POINT IN TIME

• Left side of a balance shows assets a firm owns

and uses to generate revenue

• Right side of the balance sheet shows sources

of the funds used to acquire assets

)1.3(' EquityrsStockholdeTotalsLiabilitieTotal

AssetsTotal





Diaz Manufacturing Balance Sheets as of December 31

The Balance Sheet

o ITEM ORDER

• Assets listed in order of liquidity

• Liabilities listed in order in which they are due

to be paid

• Stockholders’ equity listed last

Common stockholders are entitled to assets remaining after all other providers of funds are paid.

The Balance Sheet

o CURRENT ASSETS

• Assets likely to be converted to cash within a

year (or one operating cycle)

marketable securities

accounts receivable

inventory

The Balance Sheet

o CURRENT LIABILITIES

• Liabilities scheduled to be paid within a year (or

one operating cycle)

accounts payable

accrued wages

debt with less than a year’s maturity

taxes

The Balance Sheet

o NET WORKING CAPITAL

(3.2)sLiabilitie Current Total –

AssetsCurrent Total Capital WorkingNet 

The Balance Sheet

o NET WORKING CAPITAL EXAMPLE

• Diaz Manufacturing

Total current assets = $1,039.8 million

Total current liabilities = $377.8 million

Net working capital = Total current assets – Total current liabilities

= $1,039.8 million – $377.8 million

= $662.0 million

The Balance Sheet

o INVENTORY ACCOUNTING

• Inventory (least liquid current asset) reported

using one of two methods

FIFO (first-in-first-out) assumes merchandise is sold in the order it was acquired by a firm.

LIFO (last-in-first-out) assumes merchandise is sold in the reverse of the order it was acquired by a firm.

The Balance Sheet

o INVENTORY ACCOUNTING

• When the cost of inventory is increasing

FIFO reporting says a firm sold the less expensive inventory and leads to – higher balance in inventory

– lower cost-of-goods-sold

– higher taxable income

– higher income taxes

– higher net income

The Balance Sheet

o INVENTORY ACCOUNTING

• When the cost of inventory is increasing

LIFO reporting says a firm sold the more expensive inventory and leads to – lower balance in inventory

– higher cost-of-goods-sold

– lower taxable income

– lower income taxes

– lower net income

The Balance Sheet

o INVENTORY ACCOUNTING

• When the cost of inventory is decreasing

FIFO reporting says a firm sold the more expensive inventory and leads to – lower balance in inventory

– higher cost-of-goods-sold

– lower taxable income

– lower income taxes

– lower net income

The Balance Sheet

o INVENTORY ACCOUNTING

• When the cost of inventory is decreasing

LIFO reporting says a firm sold the less expensive inventory and leads to – higher balance in inventory

– lower cost-of-goods-sold

– higher taxable income

– higher income taxes

– higher net income

The Balance Sheet

o INVENTORY ACCOUNTING

• Firms may switch from one inventory

accounting method to the other under

extraordinary circumstances but not frequently

The Balance Sheet

o LONG-TERM ASSETS

• Real Assets

land

buildings

equipment

• Intangible Assets

goodwill

patents

copyrights

The Balance Sheet

o LONG-TERM ASSETS

• Real assets decline with use and are depreciated

Depreciation expense reduces taxable income and income taxes.

Assets are depreciated using either the straight line or accelerated depreciation method.

• Intangible assets lose value over time and are

amortized (equivalent to depreciated)

The Balance Sheet

o LONG-TERM LIABILITIES

• Long-term debt

bank loans

mortgages

bonds with a maturity longer than one year

The Balance Sheet

o EQUITY

• Common Stock

ownership with control in a firm

• Preferred Stock

ownership without control in a firm

features make it an equity security that resembles debt

The Balance Sheet

o OTHER BALANCE SHEET ACCOUNTS

• Retained earnings

Profit kept and used to acquire assets.

• Treasury stock

Shares of its own stock a firm holds rather than sell them to the public.

Market Value vs. Book Value

o RECORDING ASSET VALUE

• Assets are traditionally reported at historical

cost on a balance sheet

• Balance sheet amount does not reflect current

market value – only the acquisition cost

Market Value vs. Book Value

o ASSET VALUATION

• Better information is provided to management

and investors by marking-to-market —

reporting balance sheet items at current market

values

difficult to determine market values of assets

• The difference between the market values of

assets and liabilities is a realistic estimate of the

market value of shareholders’ equity

The Income Statement

o INCOME STATEMENT: OVERVIEW

• Measures the profitability of a firm for a

reporting period

• Revenue is income from selling products and

services – for cash or credit

• Expenses include costs of providing products

and services, and asset utilization (depreciation

and amortization)

(3.3) Expenses – Revenues income Net 

Diaz Manufacturing Income Statements

The Income Statement

o NET INCOME EXAMPLE

• Diaz Manufacturing

Revenues = $1,563.7 million

Expenses = $1,445.2 million

Net Income = Revenues – Expenses

= $1,563.7 million – $1,445.2 million

= $ 118.5 million

The Income Statement

o DEPRECIATION

• The cost of a physical asset, such as plant or

machinery, is written off over its lifetime. This

is called depreciation, a non-cash expense

• Firms use one of these depreciation methods

straight-line depreciation

accelerated depreciation – Firms may choose to use one for internal purposes and

another for tax purposes or for statements released to the public.

The Income Statement

o AMORTIZATION

• Amortization expense is related to using

intangible assets

goodwill

patents

licenses – Like depreciation, it is a non-cash expense.

The Income Statement

o EXTRAORDINARY ITEM

• Income or expense associated with events that

are infrequent and abnormal

separated from the results of ordinary income

shown separately on the income statement

The Income Statement

o EBITDA AND EBIT

• Earnings-before-interest-taxes-depreciation-

and-amortization (EBITDA)

income from selling goods and services minus the cost of providing them

• Earnings-before-interest-and-taxes (EBIT)

EBITDA minus depreciation and amortization

The Income Statement

o EBT AND NI

• Earnings-before-taxes (EBT)

EBIT minus interest expense

taxable income

• Net income (NI)

EBT minus taxes

Statement of Retained Earnings

o RETAINED EARNINGS

• Shows cumulative effect of adjustments to

shareholders’ equity resulting from profit,

losses, and paying dividends

• Shows changes in the account for a period

based on profit, loss, or dividend paid

Diaz Manufacturing Statement of Retained Earnings

Cash Flows

o NET CASH FLOWS VERSUS NET INCOME

• Accountants focus on net income and

shareholders focus on net cash flows. These are

not the same because of delays in inflows and

outflows, and non-cash revenues and expenses

Cash Flows

o CASH FLOWS TO INVESTORS

• Cash flows available to investors from operating

activities (CFOA)

(3.4) expenses Noncash

TaxesCurrent – EBIT CFOA





Cash Flows

o CFOA EXAMPLE

• Diaz Manufacturing

EBIT = $168.4 million

Current Taxes = $44.3 million

Non-cash expenses = $83.1 million

million $207.2

$83.1m $44.3m – $168.4m

Expenses Cash-Non Taxes Current – EBIT CFOA







Cash Flows

o CASH FLOWS TO WORKING CAPITAL

• To compute the net cash flows into or out of

working capital

(3.5) NWC- NWC CFNWC

Period PreviousPeriod Current 

Cash Flows

o CFNWC EXAMPLE

• Diaz Manufacturing

NWC 2011 = $662.0 million

NWC 2010 = $342.0 million

million $320.0

$342.0 – $662.0m

NWC – NWC CFNWC 201020112011







Cash Flows

o STATEMENT OF CASH FLOWS

• Summarizes cash outflows and cash inflows

during a period

• Cash flows result from operating activities,

investing activities, and financing activities

• Net cash flows equals cash inflows minus cash

outflows

Diaz Manufacturing Statement of Cash Flows

Cash Flows

o STATEMENT OF CASH FLOWS ORGANIZATION

• Operating Activities

cash inflows – sell goods and services

cash outflows – raw materials

– inventory

– salaries and wages

– utilities

– rent

Cash Flows

o STATEMENT OF CASH FLOWS ORGANIZATION

• Investing Activities

cash outflows and inflows due to – buying and selling long-term assets such as plant and

equipment

– buying and selling bonds and stocks issued by other firms

Cash Flows

o STATEMENT OF CASH FLOWS ORGANIZATION

• Financing Activities

cash inflow – issue debt

– issue equity

– borrow money

cash outflow – pay interest or dividends

– repay loan principal

– purchase treasury stock

Interrelations Among the Financial Statements

Federal Income Tax

o CORPORATE INCOME TAX

• U.S. has a progressive tax with rates ranging

from 15 percent to 39 percent

higher taxable income = higher the tax liability

Corporate Tax Rates for 2010

Federal Income Tax

o AVERAGE VERSUS MARGINAL TAX RATE

• Average tax rate

total taxes paid divided by taxable income for the period

• Marginal tax rate

rate paid on the last dollar earned or the next dollar that will be earned

Federal Income Tax

o DIVIDENDS AND INTEREST ARE NOT EQUAL

• U.S. tax code

allows interest payments on debt to reduce firms’ taxable income

does not allow dividend payments to equity to reduce firms’ taxable income – debt financing has a lower cost relative to equity financing

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 4: Analyzing Financial Statements

Learning Objectives

1. EXPLAIN THE THREE PERSPECTIVES FROM WHICH FINANCIAL STATEMENTS CAN BE VIEWED.

2. DESCRIBE COMMON-SIZE FINANCIAL STATEMENTS, EXPLAIN WHY THEY ARE USED, AND BE ABLE TO PREPARE AND USE THEM TO ANALYZE THE HISTORICAL PERFORMANCE OF A FIRM.

Learning Objectives

3. DISCUSS HOW FINANCIAL RATIOS FACILITATE FINANCIAL ANALYSIS, AND BE ABLE TO COMPUTE AND USE THEM TO ANALYZE A FIRM’S PERFORMANCE.

4. DESCRIBE THE DUPONT SYSTEM OF ANALYSIS AND BE ABLE TO USE IT TO EVALUATE A FIRM’S PERFORMANCE AND IDENTIFY CORRECTIVE ACTIONS THAT MAY BE NECESSARY.

Learning Objectives

5. EXPLAIN WHAT BENCHMARKS ARE, DESCRIBE HOW THEY ARE PREPARED, AND DISCUSS WHY THEY ARE IMPORTANT IN FINANCIAL STATEMENT ANALYSIS.

6. IDENTIFY THE MAJOR LIMITATIONS IN USING FINANCIAL STATEMENT ANALYSIS.

Background for Financial Statement Analysis

o PERSPECTIVES FOR ANALYSIS

• Stockholder

• Manager

• Creditor

Background for Financial Statement Analysis

o STOCKHOLDER’S PERSPECTIVE

• Focus on

net cash flows

risk

rate of return

market value of firm’s stock

Background for Financial Statement Analysis

o MANAGER’S PERSPECTIVE

• Focus on

rate of return

efficient use of assets

controlling costs

increasing net cash flows

increasing market value of firm’s stock

job security

Background for Financial Statement Analysis

o CREDITOR’S PERSPECTIVE

• Focus on

predictability of revenues and expenses

ability to meet short-term obligations

ability to make loan payments as scheduled

no unanticipated change in risk

Common-Size Financial Statements

o COMMON-SIZE FINANCIAL STATEMENTS

• Show the dollar amount of each item as a

percentage of a reference value

Common-size balance sheet may use total assets as the reference value; each item is expressed as a percentage of total assets.

Common-size income statement may use net sales as the reference value; each item is expressed as a percentage of net sales.

.

Common-Size Financial Statements

o COMMON-SIZE BALANCE SHEET

• Standardizes the amount in a balance sheet

account by converting the dollar value of each

item to its percentage of total assets

Dollar values on a regular balance sheet provide information on the number of dollars associated with a balance sheet account.

Percentage values on a common-size balance sheet provide information on the relative size or importance of the dollars associated with a balance sheet account.

Exhibit 4.1: Common-Size Balance Sheets for Diaz Manufacturing

Exhibit 4.2: Common-Size Income Statements for Diaz Manufacturing

Financial Ratios and Firm Performance

o RATIOS IN FINANCIAL ANALYSIS.

• Ratios establish a common reference point

across firms – even though the numerical value

of the reference point will differ from firm-to-

firm

Ratios make it easier to compare the performance of large firms to that of small firms.

Ratios make it easier to compare the current and historical performance of a single firm as the firm changes over time.

Financial Ratios and Firm Performance

o RATIOS USED VARY ACROSS FIRMS

• occupancy ratios (hotel)

• sales-per-square foot (retailing)

• loans-to-assets (banking)

• medical cost ratio (health insurance)

Financial Ratios and Firm Performance

o RATIO VALUES VARY WITHIN AN INDUSTRY

• 2010 Gross Margin

Big Lots Target Walmart

40.6% 30.5% 24.9%

Financial Ratios and Firm Performance

o CATEGORIES OF COMMON FINANCIAL RATIOS

• Liquidity ratios

• Efficiency ratios

• Leverage ratios

• Profitability ratios

• Market Value ratios

Financial Ratios and Firm Performance

o LIQUIDITY RATIOS

• Indicate a firm’s ability to pay short-term

obligations with short-term assets without

endangering the firm. In general, higher ratios

are a favorable indicator.

(4.2) liabilites Current

Inventory – assets Current Ratio Quick

(4.1) liabilites Current

assets Current Ratio Current





Financial Ratios and Firm Performance

o EFFICIENCY RATIOS

• Indicate a firm’s ability to use assets to produce

sales. These are also called turnover ratios. In

general, higher numbers are a favorable

indicator.

(4.7) AssetsTotal

Sales Net Turnover AssetTotal

(4.3) Inventory

Sold Goods of Cost TurnoverInventory





Financial Ratios and Firm Performance

o EFFICIENCY RATIOS

• For the efficiency ratio below, a lower number is

generally a positive signal

(4.4)

TurnoverInventory

Days 365 Inventory in Sales Days 

Financial Ratios and Firm Performance

o LEVERAGE (DEBT) RATIOS

• Indicate whether a firm is using the appropriate

amount of debt financing. In general, higher

ratios indicate greater potential return and

greater bankruptcy risk.

(4.10) Equity Total

Debt Total Equity-to-Debt

(4.9) AssetsTotal

Debt Total Ratio Debt Total





Financial Ratios and Firm Performance

o LEVERAGE (DEBT) RATIOS

• For the ratio below, a higher number generally

indicates less bankruptcy risk and (possibly)

lower potential return

(4.12) Expense Interest

Taxes & Interest Before Earnings

Earned Interest Times 

Financial Ratios and Firm Performance

o PROFITABILITY RATIOS

• Indicate whether a firm is generating adequate

profit from its assets. In general, higher ratios

indicate better performance.

(4.19) Equity Total

Income Net Equity on Return

(4.18) AssetsTotal

Income Net Assetson Return

(4.16) Sales Net

Income Net Margin Profit Net







Financial Ratios and Firm Performance

o MARKET VALUE RATIOS

• Indicate how the market is valuing the firm’s

equity. Higher ratios indicate greater

shareholder wealth.

(4.22) Share PerEquity of ValueBook

Share Per Price Book-to-Market

(4.21) Share Per Earnings

Share Per Price Ratio Earnings-Price





Exhibit 4.3: Ratios for Time-Trend Analysis for Diaz Manufacturing

The DuPont System

o THE DUPONT SYSTEM

• Diagnostic tool for evaluating a firm’s financial

health

• Uses related ratios that link the balance sheet

and income statement

• Based on two equations that connect a firm’s

ROA and ROE

• Used by management and shareholders to

understand factors that drive ROE

The DuPont System

o THE DUPONT EQUATION

• In ratio form (Equation 4.26)

• Shows that return-on-equity is driven by

profitability, operating efficiency, and amount of

leverage (debt)

Equity Total

AssetsTotal

AssetsTotal

Sales Net

Sales Net

Income Net ROE 

Exhibit 4.4: Two Basic Strategies to Earn a Higher ROA

Exhibit 4.5: Relations in the DuPont System of Analysis

Selecting a Benchmark

o BENCHMARK RELEVANCE

• A ratio or ratio analysis is relevant only when

compared to an appropriate benchmark

Trend Analysis – comparison to the firm’s historical performance

Peer Group Analysis – comparison to a select group of firms in the same industry

Industry Analysis – comparison to the aggregate of firms in the same industry

Selecting a Benchmark

o BENCHMARK RELEVANCE

• A ratio or a ratio analysis is relevant only when

compared to the appropriate benchmark(s).

Benchmarks may be used in combination.

Level and trend should be considered when evaluating a firm’s performance and its future.

Exhibit 4.6: Peer Group Ratios for Diaz Manufacturing

Exhibit 4.7: Peer Group Analysis for Diaz Manufacturing

Limitations of Financial Statement Analysis

o FINANCIAL STATEMENT ANALYSIS

• Weaknesses

not an exact science

relies on accounting data and historical costs

few guidelines or principles for determining whether a ratio is “high” or “low”, or is a reason for confidence or for concern

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 5: The Time Value of Money

Learning Objectives

1. EXPLAIN WHAT THE TIME VALUE OF MONEY IS AND WHY IT IS SO IMPORTANT IN THE FIELD OF FINANCE.

2. EXPLAIN THE CONCEPT OF FUTURE VALUE, INCLUDING THE MEANING OF THE TERMS PRINCIPAL, SIMPLE INTEREST AND COMPOUND INTEREST, AND USE THE FUTURE VALUE FORMULA TO MAKE BUSINESS DECISIONS.

Learning Objectives

3. EXPLAIN THE CONCEPT OF PRESENT VALUE, HOW IT RELATES TO FUTURE VALUE, AND USE THE PRESENT VALUE FORMULA TO MAKE BUSINESS DECISIONS.

4. DISCUSS WHY THE CONCEPT OF COMPOUNDING IS NOT RESTRICTED TO MONEY, AND USE THE FUTURE VALUE FORMULA TO CALCULATE GROWTH RATES.

The Time Value of Money

o EXCHANGING CONSUMPTION OPPORTUNITIES

• How does a manager determine the value of a

future cash-flow, whether the cash-flow is a

payment to be made or income to be received?

• How much is a series of future cash-flows

worth today?

• The price/value today of cash-flows that occur

in the future is determined by the time-value-of-

money (TVM).

The Time Value of Money

o CONSUME TODAY OR TOMORROW?

• TVM is based on the belief that people prefer to

consume goods today rather than wait to

consume the same goods tomorrow

An apple we can have today is more valuable to us than an apple we can have in one year.

Money has a time value because buying an apple today is more important than buying an apple in one year.

The Time Value of Money

o CONSUME TODAY OR TOMORROW?

• A dollar someone has today can be spent for

consumption or loaned to earn interest

• A dollar loaned earns interest that increases

wealth and the ability to consume

• The rate of interest determines the trade-off

between consumption today and saving

(investing)

The Time Value of Money

o TIMELINES AID PROBLEM SOLVING

• Timelines are an effective way to visualize cash

flows

• Present cash outflows as negative values

• Present cash inflows as positive values

Five-year Timeline for a $10,000 Investment

The Time Value of Money

o FUTURE VALUE VERSUS PRESENT VALUE

• Cash-flows are evaluated based on future value

or present value

• Future value measures what cash-flows are

worth after a certain amount of time has passed

• Present value measures what future cash-flows

are worth before a certain amount of time has

passed

The Time Value of Money

o FUTURE VALUE VERSUS PRESENT VALUE

• Compounding is the process of increasing cash-

flows to a future value

• Discounting is the process of reducing future

cash-flows to a present value

Future Value of $100 at 10 Percent

Future Value and Compounding

o SINGLE PERIOD LOAN

• We can determine the balance in an account at

the end of a period if we know the interest rate

earned on the principal

• If principal of $X is loaned for one period at the

interest rate i, the account balance will increase to $X(1 + i)1

• The term (1+ i)n is the future value interest factor or future value factor

Future Value and Compounding

o TWO-PERIOD LOAN • A two-period loan is two consecutive single-

period loans

• Interest earned is added to the account at the end of the first period and the new account balance is the amount that earns the interest rate i during the second period

• The account balance is $X(1 + i)1 at the end of the first period and $X(1 + i)2 at the end of the second period.

Future Value and Compounding

o TWO-PERIOD LOAN

• The principal is the initial deposit or loan

amount

• Simple interest is paid on the original principal

amount only

• Compound interest consists of both simple

interest and interest-on-interest

How Compound Interest Grows on $100 at 10 Percent

Future Value and Compounding

o FUTURE VALUE EQUATION • The general equation to find a future value

where:

FVn = future value of investment at end of period n

PV = original principle (P0) or present value

i = the rate of interest per period

n = the number of periods, often in years

(5.1)i) (1PV x FV n

n 

Future Value and Compounding

FUTURE VALUE EXAMPLE

You deposit $100 in a savings account earning 10%

compounded annually for five years. How much is

in the account at the end of that time?

5

5

5

FV $100 (1 0.10)

= $100 (1.10)

= $100 1.6105

= $161.05

  





Future Value of $1 for Different Periods and Interest Rates

Future Value Factors

Future Value and Compounding

o COMPOUNDING MORE THAN ONCE A YEAR

• The more frequently interest is compounded,

the larger the future value of $1 at the end of a

given time period

• If compounding occurs m times within a period, the future value equation becomes

).()mi PV x (FV

mn

n 251 

Future Value and Compounding

o COMPOUNDING WITHIN A PERIOD EXAMPLE

• You deposit $100 in an account that pays 5%

annually with semi-annual compounding for

two years. What is the ending account balance?

2 2 2

4

FV $100 (1+0.05 / 2)

= $100 (1+0.025)

= $100 (11038)

= $110.38

  





Future Value and Compounding

o CONTINUOUS COMPOUNDING

• When compounding occurs on a continuous

basis, the future value equation becomes

e = 2.71828, the base of the natural logarithm

)3.5( nin

ePVFV 



Future Value and Compounding

o CONTINUOUS COMPOUNDING EXAMPLE

• Your grandmother wants to put $10,000 in a

savings account. How much money will she

have at the end of five years if the bank pays 5%

annual interest compounded continuously?

25.840,12$

284025.1000,10$

)71828.2(000,10$

000,10$

505.0

505.0













eFV n

Using Excel – Future Value and Compounding

Future Value and Compounding

o CALCULATOR EXAMPLE

• Future Value

Suppose we lend $5,000 at 15% for 10 years. How much money will we have at the end of that time?

Enter

Answer

N i PMT PV FV

10 15 0

20,227.79

-5,000

Present Value and Discounting

o PRESENT VALUE EQUATION

• General equation to find present value

o

• This equation has the same elements as

Equation 5.1, the future value equation. They

differ only in the arrangement of the elements.

Here, (1 + i)n is used for division and is called the present value factor or discount factor.

(5.4) i) (1

FV PV

n

n

 

Present Value and Discounting

Comparing Future Value & Present Value Calculations

Present Value and Discounting

o PRESENT VALUE EQUATION

• A present value calculation takes end-of-the-

period cash flows and reverses the effect of

compounding to determine the equivalent

beginning-of-the-period cash flows

This is discounting and the interest rate i is called the discount rate.

Present value (PV) is often referred to as the discounted value of future cash-flows.

Present Value and Discounting

o PRESENT VALUE CALCULATION EXAMPLE

• You intend to buy a BMW 330 Sports Coupe one

year from today. You predict the car will cost

$40,000. If your bank pays 5% interest on

savings, compounded annually, how much will

you need to deposit today to have $40,000 after

one year?

095.24 $38,

0.05 1

$10,000 PV 

 

Present Value and Discounting

o PRESENT VALUE CONCEPTS

• Time and the discount rate affect present value

The greater the amount of time before a cash flow is to occur, the smaller the present value of the cash-flow.

The higher the discount rate, the smaller the present value of a future cash-flow.

Present Value Factors

Present Value of $1 for Different Periods and Discount Rates

Future Value and Present Value Compared

Present Value and Discounting

o CALCULATOR EXAMPLE

• Present Value

What is the present value of $1,000 to be received 10 years from now if the discount rate is 9%?

Enter

Answer

N i PMT PV FV

10 9 0 1,000

-422.41

Finding the Interest Rate

o TIME VALUE OF MONEY CALCULATIONS

• Many situations require using a time value of

money calculation to determine a rate of

change or growth rate

• An investor or analyst may want

the growth rate in sales

the rate-of-return on an investment

the effective interest rate on a loan

Compound Growth Rates

o CALCULATOR EXAMPLE

• Compound Growth Rate

A firm’s sales increased from $20 million to $35 million in three years. What was the average annual growth rate in sales?

Enter

Answer

N i PMT PV FV

3

20.51

0 35 -20

Compound Growth Rates

o CALCULATOR EXAMPLE

• Compound Growth Rate

The house at 1245 Maple St. was appraised at $247,000 in 2006 and at $173,000 in 2011. What is the average annual change in its value?

Enter

Answer

N i PMT PV FV

5

-6.874

0 173000 -247000

The Rule of 72

o ESTIMATE THE NUMBER OF PERIODS

• The Rule of 72 is used to estimate the time

(number of periods) it takes for an amount to

double.

The time it takes for the amount to double is approximately equal to 72/i, where i equals the percentage earned each period.

The Rule of 72 is fairly accurate for interest rates between 5% and 20%.

The Rule of 72

o CALCULATOR EXAMPLE

• Time required for an amount to double

If you can earn 8% compounded annually, how long will it take for your money to double?

Enter

Answer

N i PMT PV FV

9.006

8 0 2 -1

The Rule of 72

o CALCULATOR EXAMPLE

• Time required for an amount to double

If you can earn 8% compounded monthly (.667%/month), how many months will it take for an amount to double?

Enter

Answer

N i PMT PV FV

104.32

.667 0 2 -1

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 6: Discounted Cash Flows and Valuation

Learning Objectives

1. EXPLAIN WHY CASH FLOWS OCCURRING AT DIFFERENT TIMES MUST BE ADJUSTED TO REFLECT THEIR VALUE AS OF A COMMON DATE BEFORE THEY CAN BE COMPARED, AND COMPUTE THE PRESENT VALUE AND FUTURE VALUE FOR MULTIPLE CASH FLOWS.

2. DESCRIBE HOW TO CALCULATE THE PRESENT VALUE AND THE FUTURE VALUE OF AN ORDINARY ANNUITY AND HOW AN ORDINARY ANNUITY DIFFERS FROM AN ANNUITY DUE.

Learning Objectives

3. EXPLAIN WHAT A PERPETUITY IS AND WHERE WE SEE THEM IN BUSINESS AND CALCULATE THE VALUE OF A PERPETUITY.

4. DISCUSS GROWING ANNUITIES AND PERPETUITIES, AS WELL AS THEIR APPLICATION IN BUSINESS, AND CALCULATE THEIR VALUES.

5. DISCUSS WHY THE EFFECTIVE ANNUAL INTEREST RATE (EAR) IS THE APPROPRIATE WAY TO ANNUALIZE INTERESTS RATES, AND CALCULATE THE EAR.

Multiple Cash Flows

o FUTURE VALUE OF MULTIPLE CASH FLOWS

1. Draw a timeline to determine the number of

periods for which each cash flow will earn the

rate-of-return

2. Calculate the future value of each cash flow

using Equation 5.1

3. Add the future values

Future Value of Two Cash Flows

6

Exhibit 6.1 Future Value of Two Cash Flows This exhibit shows a timeline for two cash flows invested in a savings account that pays 10 percent interest annually. The total amount in the savings account after two years is $2,310, which is the sum of the future values of the two cash flows.

Future Value of Three Cash Flows

Exhibit 6.2 Future Value of Three Cash Flows The exhibit shows a timeline for an investment program with a three-year horizon. The value of the investment at the end of three years is $3,641, the sum of the future values of the three separate cash flows.

Present Value of Three Cash Flows

8

Level Cash Flows: Annuities and Perpetuities

o ANNUITY

• A series of equally-spaced and level cash flows

extending over a finite number of periods

o PERPETUITY

• A series of equally-spaced and level cash flows

that continue forever

Level Cash Flows: Annuities and Perpetuities

o ORDINARY ANNUITY

• cash flows occur at the end of a period

mortgage payment

interest payment to bondholder

Exhibits 6.1, 6.2, and 6.3

o ANNUITY DUE

• cash flows occur at the beginning of a period

lease

Exhibit 6.7

Level Cash Flows: Annuities and Perpetuities

o CALCULATE PRESENT VALUE OF AN ANNUITY

11

)1.6( )1(

1 1

1

0

   





   





 





 

  



i

i CF

i

PVFA CF

PVFACFPVA

n

Level Cash Flows: Annuities and Perpetuities

o CALCULATE PRESENT VALUE OF AN ANNUITY

• To calculate a future value or a present value is

to calculate an equivalent amount

• The amount reflects an adjustment to account

for the effect of compounding

Level Cash Flows: Annuities and Perpetuities

o CALCULATE PRESENT VALUE OF AN ANNUITY

Present value of an annuity

amount needed produce the annuity

current fair value or market price of the annuity

amount of a loan that can be repaid with the annuity

19.154,5$ 0.08

0.08)1/(1 (1 $2000PVA

3

3

 

 

  

Level Cash Flows: Annuities and Perpetuities

o PRESENT VALUE OF AN ANNUITY EXAMPLE

• A contract will pay $2,000 at the end of each

year for three years and the appropriate discount

rate is 8%. What is a fair price for the contract?

14

Level Cash Flows: Annuities and Perpetuities

o CALCULATOR EXAMPLE

• Present Value of Annuity

15

Enter

Answer

N i PMT PV FV

3 8 2,000 0

-5,154.19

Pmt $2,430.45

Pmt5784.164/000,400$

0.0051042

0.0051042)1/(1 (1 Pmt$400,000

360







 

  

Level Cash Flows: Annuities and Perpetuities

o CALCULATE AN ANNUITY EXAMPLE

• You borrow $400,000 to buy a home. The 30-

year mortgage requires 360 monthly payments

at a monthly rate of 6.15%/12 or .51042%. How

much is the monthly payment?

16

Present Value Annuity Factors

17

Level Cash Flows: Annuities and Perpetuities

o LOAN AMORTIZATION

• How borrowed funds are repaid over the life of

a loan

• Each payment includes less interest and more

principal; the loan is paid off with the last

payment

• Amortization schedule shows interest and

principal in each payment, and amount of

principal still owed after each payment

Amortization Table for a 5-Yr, $10,000 Loan at 5% Interest

19

Using Excel – Loan Amortization Table

Using Excel – Calculating the Interest Rate for an Annuity

Level Cash Flows: Annuities and Perpetuities

o FINDING THE INTEREST RATE

• The present value of an annuity equation can be

used to find the interest rate or discount rate for

an annuity

• To determine the rate-of-return for an annuity,

solve the equation for i

• Using a calculator is easier than a trial-and-error

approach

Level Cash Flows: Annuities and Perpetuities

o CALCULATOR EXAMPLE

• Finding the Interest Rate

An insurer requires $350,000 to provide a guaranteed annuity of $50,000 per year for 10 years. What is the rate-of-return for the annuity?

23

Enter

Answer

N i PMT PV FV

10

7.073

50,000 0 -350,000

(6.2) i

1i)(1 CF

i

1- Factor ValueFuture CF

Factor ValueFuturePVAFVA

n

nn



 

  





Level Cash Flows: Annuities and Perpetuities

o FUTURE VALUE OF AN ANNUITY

• The future value of an annuity equation is

derived from Equation 6.1

24

Future Value of 4-Yr Annuity: Colnago C50 Bicycle

25

Exhibit 6.6 The exhibit shows a timeline for a savings plan to buy a Colnago C50 bicycle. Under this savings plan, $1,000 is invested at the end of each year for four years at an annual interest rate of 8 percent. We find the value at the end of the four-year period by adding the future values of the separate cash flows, just as in Exhibits 6.1 and 6.2.

Level Cash Flows: Annuities and Perpetuities

o CALCULATOR EXAMPLE

• Future Value of an Annuity

Colnago Bicycle C50

26

Enter

Answer

N i PMT PV FV

4 8 1,000

-4,506.11

0

Level Cash Flows: Annuities and Perpetuities

o PERPETUITY

• A stream of equal cash flows that goes on

forever

• Preferred stock and some bonds are perpetuities

• Equation for the present value of a perpetuity

can be derived from the present value of an

annuity equation

27

).( i

CF

i

)( CF

i

i)( CF

ityor an annue factor fesent valuCFPVP

36

011

1 1

Pr 0



 

   





   





 







Level Cash Flows: Annuities and Perpetuities

o PRESENT VALUE OF A PERPETUITY

28

Level Cash Flows: Annuities and Perpetuities

o VALUING PERPETUITY EXAMPLE

• Suppose you decide to endow a chair in finance.

The goal of the endowment is to provide

$100,000 of financial support per year forever. If

the endowment earns a rate of 8%, how much

money will you have to donate to provide the

desired level of support?

29

000,250,1$ 08.0

000,100$ 0

 i

CF PVP

Level Cash Flows: Annuities and Perpetuities

o ORDINARY ANNUITY VERSUS ANNUITY DUE

• Present Value of Annuity Due

Cash flows are discounted for one period less than in an ordinary annuity.

• Future Value of Annuity Due

Cash flows are earn compound interest for one period more than in an ordinary annuity.

30

Level Cash Flows: Annuities and Perpetuities

o ORDINARY ANNUITY VERSUS ANNUITY DUE

• The present value or future value of an annuity

due is always higher than that of an ordinary

annuity that is otherwise identical.

31

1

Due

1

Due

)(1FVA FVA

(6.4) )(1PVA PVA

i

i





Ordinary Annuity versus Annuity Due

32

Cash Flows That Grow at a Constant Rate

o GROWING ANNUITY

• equally-spaced cash flows that increase in size

at a constant rate for a finite number of periods

o GROWING PERPETUITY

• equally-spaced cash flows that increase in size

at a constant rate forever

Cash Flows That Grow at a Constant Rate

o GROWING ANNUITY

• Multiyear product or service contract with

periodic cash flows that increase at a constant

rate for a finite number of years

o GROWING PERPETUITY

• Common stock whose dividend is expected to

increase at a constant rate forever

34

Cash Flows That Grow at a Constant Rate

o GROWING ANNUITY

• Calculate the present value of growing annuity

(only) when the growth rate is less than the

discount rate.

35

  (6.5)

i1

g1 1

g-i

CF PVA

n

1

n  

  

  

  





 

Cash Flows That Grow at a Constant Rate

o GROWING ANNUITY EXAMPLE

• A coffee shop will operate for fifty more years.

Cash flow was $300,000 last year and increases

by 2.5% each year. The discount rate for similar

firms is 15%. Estimate the value of the firm.

128,452,2$

9968.0000,460,2$

15.1

025.1 1

025.015.0

500,307$

500,307$)025.01(000,300$1

50

0





 

  

  

  

 

 



PVA

CF

Cash Flows That Grow at a Constant Rate

o GROWING PERPETUITY

• Use Equation 6.6 to calculate the present value

of growing perpetuity (only) when the growth

rate is less than discount rate.

• It is derived from equation 6.5 when the number

of periods approaches infinity

37

  (6.6)

g-i

CF PVP 1

0 

Cash Flows That Grow at a Constant Rate

o GROWING PERPETUITY EXAMPLE

• A firm’s cash flow was $450,000 last year. You

expect the cash flow to increase by 5% per year

forever. If you use a discount rate of 18%, what

is the value of the firm?

38

615,634,3$

13.0

500,472$

05.018.0

500,472$

500,307$)05.01(000,450$1

0



 





PVP

CF

The Effective Annual Interest Rate

o DESCRIBING INTEREST RATES

• The most common way to quote interest rates is

in terms of annual percentage rate (APR). It

does not incorporate the effects of

compounding.

• The most appropriate way to quote interest rates

is in terms of effective annual rate (EAR). It

incorporates the effects of compounding.

39

The Effective Annual Interest Rate

o CALCULATE ANNUAL PERCENTAGE RATE (APR)

• APR = (periodic rate) x m

m is the # of periods in a year

• APR does not account for the number of

compounding periods or adjust the annualized

interest rate for the time value of money

• APR is not a precise measure of the rates

involved in borrowing and investing

40

The Effective Annual Interest Rate

o ANNUAL PERCENTAGE RATE (APR) EXAMPLE

• Anna is charged 1% interest when she borrows

$2000 for one week. What is the annual

percentage interest rate (APR) on the loan?

41

52% or 0.52 52 x (0.01) APR 

The Effective Annual Interest Rate

o EFFECTIVE ANNUAL INTEREST RATE (EAR)

• EAR accounts for the number of compounding

periods and adjusts the annualized interest rate

for the time value of money

• EAR is a more accurate measure of the rates

involved in lending and investing

42

The Effective Annual Interest Rate

o EFFECTIVE ANNUAL RATE (EAR) EXAMPLE

• Anna is charged 1% interest when she borrows

$2000 for one week. What is the effective annual

interest rate (EAR)?

43

67.77% or 0.6777

1 – 1.6777

1 – 0.01) (1 EAR 52







The Effective Annual Interest Rate

o EFFECTIVE ANNUAL RATE (EAR) EXAMPLE

• Your credit card has an APR of 12 % (1% per

month). What is the EAR?

44

12.68% or 0.1268

1 – 1.1268

1- 0.01) (1

1 – 0.12/12) (1 EAR

12

12









Consumer Protection and Information

o CONSUMER PROTECTION AND INFORMATION

• Truth-in-Lending Act (1968) requires that

borrowers be told the actual cost of credit

• Truth-in-Savings Act (1991) requires that the

actual return on savings be disclosed to

consumers

• Credit Card Act (2009) limits credit card fees

and interest rate increases, and requires better

disclosure of contract details

45

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 7: Risk and Return

Learning Objectives

1. EXPLAIN THE RELATION BETWEEN RISK AND RETURN.

2. DESCRIBE THE TWO COMPONENTS OF A TOTAL HOLDING PERIOD RETURN, AND CALCULATE THIS RETURN FOR AN ASSET.

3. EXPLAIN WHAT AN EXPECTED RETURN IS AND CALCULATE THE EXPECTED RETURN FOR AN ASSET.

Learning Objectives

4. EXPLAIN WHAT THE STANDARD DEVIATION OF RETURNS IS AND WHY IT IS VERY USEFUL IN FINANCE AND CALCULATE IT FOR AN ASSET.

5. EXPLAIN THE CONCEPT OF DIVERSIFICATION.

6. DISCUSS WHICH TYPE OF RISK MATTERS TO INVESTORS AND WHY.

Learning Objectives

7. DESCRIBE WHAT THE CAPITAL ASSET PRICING MODEL (CAPM) TELLS US AND HOW TO USE IT TO EVALUATE WHETHER THE EXPECTED RETURN OF AN ASSET IS SUFFICIENT TO COMPENSATE AN INVESTOR FOR THE RISKS ASSOCIATED WITH THAT ASSET.

Risk and Return

o PEOPLE DO NOT WANT TO LOSE MONEY

• Why would a person choose an investment with

a higher risk of loss when there is a lower-risk

opportunity available?

Risk and Return

o PEOPLE DO NOT WANT TO LOSE MONEY

• A person will prefer a higher-risk opportunity if

the probability of an adequate reward is high

enough

A higher-risk investment must offer a potential return high enough to make it as attractive as the lower-risk alternative.

The potential return a person requires depends on the amount of risk – the probability of being dissatisfied with an outcome.

Risk and Return

o RISK/RETURN RELATIONSHIP

• The higher the risk, the higher the required

rate-of-return (possible/expected return)

This is the risk/return relationship.

Risk and Return

o INSIGHT INTO THE RISK/RETURN RELATIONSHIP

• Most people are risk averse – they do not like

risk

• People vary in their risk tolerance –the amount

of risk they will accept

Risk and Return

o INSIGHT INTO THE RISK/RETURN RELATIONSHIP

• An optimal combination of risk and return is

the highest expected return for a given amount

of risk

• An optimal combination of risk and return is

the lowest level of risk for a given expected

return

Risk and Return

o RISK

• default

• misuse

• slow pay

• theft

o RISK

• cost increase

• price decline

• missed opportunity

• not enough

• ….. many others

Risk and Return

o RETURN

• Refers to expected return.

“Expected” means there is some uncertainty about what the return will actually be. – “I expect to earn around 9%.”

• The higher the risk, the higher the required rate

of (expected) return

Quantitative Measures of Return

o EXPECTED RETURN AND REALIZED RETURN

• Expected return

estimated or predicted before the outcome is known

• Realized return

calculated after the outcome is known – Both are important in financial decision-making.

Quantitative Measures of Return

o HOLDING PERIOD RETURN

• Total holding period return consists of capital

appreciation (Rca) and income (Ri)

00

01

P

P

P

PP

priceinitial

onappreciaticapital R

ca

 

 

0

11

P

CF

priceinitial

CF

priceinitial

flowcash R

i 

Quantitative Measures of Return

o TOTAL HOLDING PERIOD RETURN

)1.7( 0

1

0

1

0 P

CFP

P

CF

P

P RRR

icat

 

 

Quantitative Measures of Return

o TOTAL HOLDING PERIOD RETURN EXAMPLE

• Ella buys a stock for $26.00. After one year, the

stock price is $29.00 and she receives a dividend

of $0.80. What is her return for the period?

%62.1414615.0 00.26$

80.3$

00.26$

80.0$)00.26$00.29($

0

1

or

P

CFP RRR

icat



 

 

Quantitative Measures of Return

o EXPECTED RETURN

• E(RAsset), is the weighted average of the

possible investment returns. Multiply each

return by the probability that it will occur,

then add.

)2.7()(…)()()()( 22111 nn

n

i iiasset RpRpRpRpRE  



Quantitative Measures of Return

o EXPECTED RETURN EXAMPLE

• There is 30% chance the total return on Dell

stock will be -3.45%, a 30% chance it will be

+5.17% , a 30% chance it will be +12.07% and a

10% chance that it will be +24.14%. Calculate

the expected return.

 

%55.60655.0

02414.003621.001551.0010305.0

)2414.010(.)1207.030(.

)0517.030(.)0345.0(30.)(

or

RE Del l









Quantitative Measures of Return

o EXPECTED RETURN

• If each possible outcome is equally likely (p1

= p2 = p3 = … = pn = p = 1/n), the expected

return formula reduces to

n

RRRR

n

R RE n

n

i i

asset

 

 

…)( )( 3211

Variance and Standard Deviation as Measures of Risk

o CALCULATE VARIANCE

1. Square the difference between each possible

outcome and the mean

2. Multiply each squared difference by its

probability of occurring

3. Add

   )3.7()()(

1

22

 

 n

i

iiR RERpRVar 

Variance and Standard Deviation as Measures of Risk

o CALCULATE VARIANCE

• If all possible outcomes are equally likely, the

formula becomes

 

n

RER n

i

i

R

 



 1

2

2

)(



Variance and Standard Deviation as Measures of Risk

o CALCULATE STANDARD DEVIATION

• Standard deviation is the square root of the

variance

  2

R

Variance and Standard Deviation as Measures of Risk

o VARIANCE AND STANDARD DEVIATION

• Variance and Standard Deviation for Dell Stock

       

084.00071.0

0071.0

0031.000006.00009.00030.0

)0655.02414.0(10.)0655.01207.0(30.

)0655.00517.0(30.)0655.0345.0(30.

22

222











Dell

Dell





Variance and Standard Deviation as Measures of Risk

o NORMAL DISTRIBUTION

• A symmetric distribution completely described

by its mean (average) and standard deviation

Completely described by its mean and standard deviation says they are all we need to draw conclusions about its shape and the location of items in the distribution.

Variance and Standard Deviation as Measures of Risk

o NORMAL DISTRIBUTION

• Mean (average) is at the center

• Areas to the left and right of the mean are

mirror images of each other

• Values less than the mean are on the left and

values greater than the mean are on the right

Variance and Standard Deviation as Measures of Risk

o NORMAL DISTRIBUTION

• The mean is the reference point to which all

other values in the distribution are compared

• To use standard deviation as a distance

measure, consider how many standard

deviations are between a value in the

distribution and the mean

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• For a normal distribution, the standard

deviation tells us, based on what has happened

in the past, the probability that an outcome will

occur

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• Is used in a context similar to “The average

return on the S&P 500 is 3%. What is the

probability of it being between 3% and 1%?”

When the difference between 3% and 1% is converted to

a standard deviation, it becomes a distance.

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• For a normal distribution, the standard

deviation distance between 3% and 1% is the

same as between 3% and 5%

• Outcomes that occur most often are closest to

the mean – convert to fewer standard deviations.

Outcomes that rarely occur are farthest from the

mean – convert to more standard deviations

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• A unit of measure or distance

“Forty-three percent of the time, the number is more than the average but less than 62.”

• A measure of frequency

“A professional makes that putt more than 99% of the time.”

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• For a normal distribution, a standard deviation

is associated with the probability that an

outcome occurs within a certain distance from

the mean

Variance and Standard Deviation as Measures of Risk

o STANDARD DEVIATION

• For a normal distribution

90% of outcomes are not more than 1.645 standard deviations from the mean

95% of outcomes are not more than 1.960 standard deviations from the mean

99% of outcomes are not more than 2.575 standard deviations from the mean

Normal Distribution

Standard Deviation and Width of the Normal Distribution

Variance and Standard Deviation as Measures of Risk

o HISTORICAL MARKET PERFORMANCE

• On average, annual returns have been higher for

riskier securities

• Exhibit 7.3 shows that small stocks have the

largest standard deviation of returns and the

largest average return

• On other end of spectrum, Treasury bills have

the smallest standard deviation and the smallest

average return

Distributions of Annual Total Returns for U.S. Stocks & Bonds

Monthly Returns for Apple Inc. Stock and the S&P 500 Index

Cumulative Value of $1 Invested in 1926

Exhibit 7.5

Risk and Diversification

o DIVERSIFICATION

• By investing in two or more assets whose

returns do not always move in same direction at

the same time, investors can reduce the risk in

their investment portfolios

Risk and Diversification

o SINGLE-ASSET PORTFOLIOS

• Returns for individual stocks are largely

independent of each other and approximately

normally distributed. A simple tool for

comparing risk and return for individual stocks

is the coefficient of variation (CV).

)4.7( )(

i

Ri i

RE CV

 

Risk and Diversification

o COEFFICIENT OF VARIATION EXAMPLE

• Stock A has an expected return of 12% and a

standard deviation of 12% while Stock B has an

expected return of 16% and a standard deviation

of 20%. What is the coefficient of variation for

these stocks?

75. 20.

16. )(

1 12.0

12.0 )(





B

A

RCV

RCV

Risk and Diversification

o SHARPE RATIO

• A modified version of the coefficient of

variation

)5.7(

)(

Ri

rfi RRE

SRatioSharpe 

 

Risk and Diversification

o PORTFOLIOS OF MORE THAN ONE ASSET

• The coefficient of variation and Sharpe Ratio

have a critical shortcoming when applied to a

portfolio of assets – they cannot account for the

interaction of assets’ risks when they are

grouped into a portfolio

• Expected return for portfolio made up of two

assets

)()()( 2211 RERERE Portfolio xx 

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• Expected return for portfolio made up of

multiple assets

     

  )6.7()((

…)(()(()(()( 22111

nn

n

i iiPortfol i o

RE

RERERERE



  

x

xxx

Risk and Diversification

o EXPECTED RETURN FOR PORTFOLIO EXAMPLE

• A portfolio consists of $100,000 in Treasury bills

that yield 4.5%; $150,000 in Proctor and Gamble

stock with an expected return of 7.5%; and

$150,000 in Exxon Mobil stock with an expected

return of 9.0%. What is the expected return for

this $400,000 portfolio?

Risk and Diversification

o EXPECTED RETURN FOR PORTFOLIO EXAMPLE

%3.70731.0

)90.0375.0()075.0375.0()045.025.0()(

375.0 000,400$

000,150$

25.0 000,400$

000,100$

&

or

RE Portfol io

EMGP

TB









xx

x

Monthly Returns for Netflix & Southwest Airlines (1 of 2)

Exhibit 7.6

Monthly Returns for Netflix & Southwest Airlines (2 of 2)

Exhibit 7.7

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• When stock prices move in opposite directions,

the price change of one stock offsets some of

the price change of another stock

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• Risk for a portfolio of two stocks is less than the

average of the risks associated with the

individual stocks. The portfolio’s risk is

)7.7(2 2,121

2

2

2

2

2

1

2

1

2

2 RRRPortfolioAsset  xxxx 

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• In the variance equation, is the covariance

between stocks 1 and 2. Covariance indicates

whether stocks’ returns tend to move in the

same direction at the same time. If so, the

covariance is positive. If not, it is negative or

zero.

2,1R 

    )8.7()(()((),( 2,2

1

1,121

  

  

  

RERRERRRCOV i

n

i

ii p

Risk and Diversification

o PORTFOLIO VARIANCE EXAMPLE

• The variance of the annual returns of CSX and

Wal-Mart stock are 0.03949 and 0.02584

respectively. The covariance between returns is

0.00782. Calculate the variance of a portfolio

consisting of 50% CSX and 50% Wal-Mart.

02024.0

)00782.0)(5.0)(5.0(2)02584.0()5.0()03949.0()5.0(

2

22

2,121

2

2

2

2

2

1

2

1

2

2





 RRRPortfolioAsset

 xxxx

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

o To measure the strength of the covariance

relationship, divide the covariance by the product

of the standard deviations of the assets’ returns.

This result is the correlation coefficient that

measures the strength of the relationship between

the assets’ returns.

)9.7(

21

2,1

2,1

RR

R

R 

  

o CORRELATION COEFFICIENT EXAMPLE

• Correlation coefficient for the annual returns of

CSX and Wal-Mart

2449.0 1607.01987.0

00782.0

1607.002584.0

1987.003949.0

,

, 

 





WalMartCSX

WalmartCSX

WalmartCSX

WalMart

CSX



 





Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• A correlation coefficient cannot be greater than

+1 or less than -1

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• Negative correlation

stock X is higher when stock Y is lower; stock X is lower when stock Y is higher

• Positive correlation

stock X is higher when stock Y is higher; stock X is lower when stock Y is lower

• Zero Correlation

no relationship or pattern linking returns on the stocks.

Risk and Diversification

o PORTFOLIOS WITH MORE THAN ONE ASSET

• If assets are not perfectly correlated, risk can be

reduced by creating a portfolio using assets

having different risk characteristics

• For each asset, account for the covariance

between that asset and every other asset in the

portfolio

Risk and Diversification

o LIMITS ON DIVERSIFICATION BENEFITS

• Adding an asset whose returns do not replicate

the returns on an asset already in the portfolio

will reduce the standard deviation of the

portfolio returns

The amount by which the standard deviation of portfolio returns is reduced gets smaller with each asset added

Risk and Diversification

o LIMITS OF DIVERSIFICATION

• When the number of assets in a portfolio is

large, adding another stock has almost no effect

on the standard deviation

• Most risk-reduction from diversification may be

achieved with 15-20 assets

• Diversification can virtually eliminate risk

unique to individual assets, but the risk

common to all assets in the market remains

Risk and Diversification

o THE LIMITS OF DIVERSIFICATION

• Firm-specific risk relevant for a particular firm

can be diversified away and is called

diversifiable, unsystematic, or unique risk.

• Risk that cannot be diversified away is non-

diversifiable, or systematic risk. This is the risk

inherent in the market or economy.

Firm-specific risk is, in effect, reduced to zero in a diversified portfolio but some systematic risk remains.

Total Risk in a Portfolio as the Number of Assets Increases

Exhibit 7.8

Systematic Risk

o WHY SYSTEMATIC RISK IS ALL THAT MATTERS

• Investors do not like risk and will not bear risk

they can avoid by diversification

Well-diversified portfolios contain only systematic risk.

Portfolios that are not well-diversified face systematic risk plus unsystematic risk.

No one compensates investors for bearing unsystematic risk, and investors will not accept risk that they are not paid to take.

Systematic Risk

o MEASURING SYSTEMATIC RISK

• Systematic risk of an individual asset depends

on how the behavior of the market influences

the return on that asset. Systematic risk cannot

be eliminated by diversification.

• Standard deviation measures total risk of an

asset. It cannot be used to measure the risk of a

diversified portfolio.

Monthly General Electric Company Stock and S&P 500 Index Returns

Exhibit 7.9

Slope of Relation Between GE Returns and S&P 500 Returns

Exhibit 7.10

Systematic Risk

o MEASURING SYSTEMATIC RISK

• If the average return for all assets (the market

return) is used as the benchmark and its

influence on the return for a specific stock can

be quantified, the expected return on that stock

can be calculated

• The market’s influence on a stock’s return is

quantified in the stock’s beta

Systematic Risk

o MEASURING SYSTEMATIC RISK

• If the beta of an asset is

zero, the market has no measurable effect on the asset’s return

positive, the market has a positive effect on the asset’s return

negative, the market has a negative effect on the asset’s return

Systematic Risk

o MEASURING SYSTEMATIC RISK

• If the beta of an asset is

0, the asset has no measurable systematic risk

> 1, the systematic risk for the asset is greater than the average for assets in the market

< 1, the systematic risk for the asset is less than the average for assets in the market

Compensation for Bearing Systematic Risk

o MEASURING SYSTEMATIC RISK

• The risk premium is the difference between the

market rate of return and the risk-free rate of

return

• The difference between the required return on a

risky asset (Ri) and the return on a risk-free

asset Rrf is an investor’s compensation for risk

• E(Ri) = Rrf + Compensation for bearing

Systematic risk

Compensation for Bearing Systematic Risk

o MEASURING SYSTEMATIC RISK

• Since compensation for bearing systematic risk

depends on the asset

E(Ri) = Rrf + (Amount of Systematic Risk)  (Compensation/Unit of Systematic Risk)

Compensation for Bearing Systematic Risk

o MEASURING SYSTEMATIC RISK

• Beta is the number of units of systematic risk

• Compensation for Risk = β  (Compensation

per Unit of Systematic Risk)

• Compensation per Unit of Systematic Risk =

E(Rm) – Rrf

• Equation 7.10 is the Capital Asset Pricing Model

  (7.10)R – )E(R R )E(R rfmirfi



Compensation for Bearing Systematic Risk

o CAPITAL ASSET PRICING MODEL

• The Capital Asset Pricing Model (CAPM)

describes the relationship between risk and

required expected return for an asset

  rfmirfi

R – )E(R R )E(R 

Compensation for Bearing Systematic Risk

o CAPITAL ASSET PRICING MODEL EXAMPLE

• A stock has a beta of 1.5. The expected return

on the market is 10% and the risk-free rate is

4%. What is the expected return for the stock?

 

%1313.0

0.04-0.101.50 0.04

)R – )(E(R R )E(R rfmirfi

or



 

Compensation for Bearing Systematic Risk

o THE SECURITY MARKET LINE

• The graph of the CAPM equation is known as

the Security Market Line (SML)

• The SML illustrates the CAPM’s prediction for

the required expected total return for various

values of beta. The expected total return

depends on an asset’s current price.

0

1)( P

CFP RE

T

 

Compensation for Bearing Systematic Risk

Exhibit 7.11 The Security Market Line

Compensation for Bearing Systematic Risk

o THE SECURITY MARKET LINE

• If the expected return is greater than the

required return estimated with the CAPM, the

expected return will plot above the SML

• If the expected return is less than the required

return estimated with the CAPM, the expected

return will plot below the SML

Compensation for Bearing Systematic Risk

o THE SECURITY MARKET LINE

• If an asset’s expected return plots above the

SML, the asset is considered underpriced

• If an asset’s expected return plots below the

SML, the asset is considered overpriced

Compensation for Bearing Systematic Risk

o THE CAPM AND PORTFOLIO RETURNS

• The expected return for a portfolio is the

weighted average of the expected returns of the

assets in the portfolio

• The beta of a portfolio is the weighted average

of the betas of the assets in the portfolio

)10.7()(…)()()(

22111 nn

n

i iiportfol ioassetn x  xxx  



Compensation for Bearing Systematic Risk

o PORTFOLIO BETA EXAMPLE

• You invest 25% of your retirement savings in a

fully diversified market fund, 25% in risk-free

Treasury bills, and 50% in a house with twice as

much systematic risk as the market. What is the

beta of your portfolio?

25.1

)00.250.0()00.025.0()0.125.0(

)()()()( 1





   HouseHouseTBTBFundFund

n

i iiportfol io x  xxx

Compensation for Bearing Systematic Risk

o EXPECTED PORTFOLIO RETURN EXAMPLE

• In the previous problem, what rate of return

would you expect to earn from the portfolio if

the risk-free rate is 4% and the expected return

on the market 10%?

 

 

% 11.5 or 0.115,

(0.06) 1.2504.0

04.010.025.1 0.04

)( R )E(R Portfoli o AssetnrfPortfoli o Assetn







 rfm

RRE

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Bond Valuation and the Structure of Interest Rates

Learning Objectives

1. DESCRIBE THE MARKET FOR CORPORATE BONDS AND THREE TYPES OF CORPORATE BONDS.

2. EXPLAIN HOW TO CALCULATE THE VALUE OF A BOND AND WHY BOND PRICES VARY NEGATIVELY WITH INTEREST RATE MOVEMENTS.

3. DISTINGUISH BETWEEN A BOND’S COUPON RATE, YIELD TO MATURITY, AND EFFECTIVE ANNUAL YIELD.

Learning Objectives

4. EXPLAIN WHY INVESTORS IN BONDS ARE SUBJECT TO INTEREST RATE RISK AND WHY IT IS IMPORTANT TO UNDERSTAND THE BOND THEOREMS.

5. DISCUSS THE CONCEPT OF DEFAULT RISK AND KNOW HOW TO COMPUTE A DEFAULT RISK PREMIUM.

6. DESCRIBE THE FACTORS THAT DETERMINE THE LEVEL AND SHAPE OF THE YIELD CURVE.

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• Life insurance companies and pension funds

buy most corporate bonds

Transactions tend to be in very large dollar amounts.

• Less than 1% of all corporate bonds are traded

on organized exchanges

Most transactions take place through dealers in the over-the-counter (OTC) market.

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• At the end of 2007, the amount of corporate and

foreign debt outstanding was $10.1 trillion,

ranking the debt market second behind the

market for corporate equity ($20.8 trillion).

Corporate Bonds

o MARKET FOR CORPORATE BONDS

• Only a small fraction of the bonds outstanding

are traded each day.

The market is thin compared to markets for money- market securities and stocks.

Corporate bonds are less marketable than securities with large daily trading volumes.

Prices in the market tend to be more volatile than those of securities with greater trading volumes.

Corporate Bonds

o BOND PRICE INFORMATION

• Corporate bond pricing is not considered

transparent.

It is difficult for investors to obtain important information on prices and volume.

Many transactions are negotiated directly between buyer and seller with little centralized reporting of transaction details.

Corporate Bonds

o FEATURES OF CORPORATE BONDS

• long-term claims against company assets

• face (par) value is $1,000

• coupon rate is the annual coupon payment (C)

divided by a bond’s face value (F)

• fixed amounts paid to lenders for the life of the

contract

Vanilla Bonds

o TYPES OF CORPORATE BONDS

• Vanilla bond

coupon payments fixed for the life of the bond

repay principal and retire the bonds at maturity

contracts have the features and provisions found in most bond covenants.

annual or semiannual coupon payments

Zero Coupon Bonds

o TYPES OF CORPORATE BONDS

• Zero coupon bond

no coupon payments

pays face value at maturity.

sell at deep discount

Convertible Bonds

o TYPES OF CORPORATE BONDS

• Convertible bonds

may be exchanged for shares of the firm’s stock

sells for a higher price than a comparable non- convertible bond

bondholders benefit if the market value of the company’s stock gets high enough

Bond Valuation

o BOND PRICE

• In an efficient market, the price of an asset

equals the present value of its future cash flows.

• To calculate a bond’s price, follow the same

process used to value any financial asset.

Bond Valuation

CALCULATE BOND PRICE

• Determine the required rate-of-return

• Determine expected future cash flows – the

coupon payments and par value

• Compute the current market value, or price (PB)

by calculating the present value of the expected

cash flows

PB = PVCoupon Payments+ PVPar Value

Bond Valuation

o GENERAL EQUATION FOR THE PRICE OF A BOND

)1.8( )1(

… )1()1(

2

2

1

1

n

nn

B

i

FC

i

C

i

C P



 

 

 

Cash Flows for a Three-Year Bond

Bond Valuation

o BOND VALUATION EXAMPLE

• Calculator solution

Determine the price of the bond in Exhibit 8.1 with a financial calculator

Enter

Answer

N i PMT PV FV

3 10 80 1,000

-950.26

Using Excel – Calculate Bond Price

Bond Valuation

o PAR, PREMIUM, AND DISCOUNT BONDS

• If a bond’s coupon rate is equal to the its yield,

its price equals its face value; it is a par bond

• If a bond’s coupon rate is less than its yield, its

price is less than its face value; it is a discount

bond

• If a bond’s coupon rate is greater than its yield,

its price is greater than its face value; it is a

premium bond

Bond Valuation

o SEMIANNUAL COMPOUNDING

• Most bonds issued in Europe pay annual

coupons, most issued in the U.S. pay

semiannual coupons

• Eq. 8.2 shows how to value bonds that pay semi-

annual coupons

)2.8( )1(

… )1()1()1(

321 mn

mn

B

mi

FmC

mi

mC

mi

mC

mi

mC P



 

 

 

 

Bond Valuation

o SEMIANNUAL COMPOUNDING EXAMPLE

• What is the price of a three-year, 5% coupon

bond with a market yield of 8% and semi-

annual coupon payments?

Semi-annual market yield = 8%/2 = 4%

Semi-annual coupon payment = $50/2 = $25

36.921$

07.810$55.20$37.21$22.22$11.23$04.24$

)04.1(

1000$25$

)04.1(

25$

)04.1(

25$

)04.1(

25$

)04.1(

25$

)04.1(

25$ 654321





 

B P

Bond Valuation

o CALCULATOR SOLUTION

• Semiannual Compounding Example

Enter

Answer

N i PMT PV FV

6 4 25 1,000

-921.37

Bond Valuation

o ZERO COUPON BONDS

• Zero coupon bonds do not make coupon

payments but pay their face value at maturity

• The price (or yield) of a zero coupon bond is a

special case of Equation 8.2, where all coupon

payments equal zero

Bond Valuation

o ZERO COUPON BONDS

• Pricing equation for a zero coupon bond

• Zero coupon bonds pay cash only at maturity

and must sell for less than similar bonds which

make periodic interest payments

)3.8( )1(

mn

mn

B

mi

F P

 

Bond Valuation

o ZERO COUPON BOND PRICE EXAMPLE

• What is the price of a zero coupon bond with a

$1,000 face value, 10-year maturity, and

semiannual compounding? The market rate on

similar bonds is 12%.

80.311$ )06.01(

1000$

)212.01(

1000$ 2020 

 

 

B P

Bond Yields

o YIELD TO MATURITY (YTM)

• YTM

the rate that makes the present value of the bond’s cash flows equal the price of bond

the rate a bondholder earns if the bond is held to maturity and all coupon and principal payments are made as promised – changes daily as interest rates change

Bond Yields

o EFFECTIVE ANNUAL YIELD • In bond trading, the EAR is called the effective

annual yield (EAY). The way to annualize a bond yield

• Simple annual yield is yield per period multiplied by the number of compounding periods; for bonds with annual compounding, simple annual yield = semiannual yield  2

1 – rate/m) Quoted (1 EAY m



Bond Yields

o YIELD TO MATURITY AND EFFECTIVE ANNUAL YIELD EXAMPLE

• An investor buys a 30-year bond with a $1,000

face value for $800. The bond’s coupon rate is

8% and interest payments are made semi-

annually. What are the bond’s yield to maturity

and effective annual yield?

Bond Yields

o YIELD TO MATURITY AND EFFECTIVE ANNUAL YIELD EXAMPLE

• Step 1:

Enter

Answer

N i PMT PV FV

60

5.07

40 1,000 -800

Bond Yields

o YIELD TO MATURITY AND EFFECTIVE ANNUAL YIELD EXAMPLE

• Step 2:

Calculate YTM

Enter

Answer

x =

.0507 2

.1014

Bond Yields

o YIELD TO MATURITY AND EFFECTIVE ANNUAL YIELD EXAMPLE

• Step 3:

Calculate EAY

Enter

Answer

X2

– = 1.0507

1

.1040

Bond Yields

o REALIZED YIELD

• The return earned on a bond given the cash

flows actually received by investor

• The interest rate at which the present value of

actual cash flows generated by the investment

equals bond’s price

• The realized yield is important because it allows

investors to see what they actually earned on

their investments.

Interest Rate Risk

o BOND THEOREMS

• Bond theorems are statements about the math used

in bond pricing.

Bond prices are inversely related to interest rate movements.

As interest rates decline, prices of bonds rise; as interest rates rise, prices of bonds decline.

For a given change in interest rates, prices of longer-term bonds change more than prices of shorter-term bonds.

Interest rate risk increases as maturity increases, but at a decreasing rate.

Relation Between Bond Price Volatility and Maturity Exhibit 8.2 Relation Between Bond Price Volatility and Maturity

Interest Rate Risk

o BOND THEOREMS

• For a given change in interest rates, prices of

lower-coupon bonds change more than prices

of higher-coupon bonds.

Relation Between Bond Price Volatility and the Coupon Rate

Interest Rate Risk

o BOND THEOREM APPLICATIONS

• If interest rates are expected to increase, avoid

long-term bonds – they will experience the

largest price declines.

• If interest rates are expected to decline, buy

zero-coupon bonds. Their prices will increase

more than those of coupon-paying bonds.

The Structure of Interest Rates

o RISK CHARACTERISTICS OF BONDS

• Four features of debt instruments are

responsible for most of the differences in

corporate borrowing costs and determine the

level and structure of interest rates:

Marketability

Call feature

Default risk

Term-to-maturity

The Structure of Interest Rates

o MARKETABILITY

• How quickly and easily a security can be sold at

at low transaction cost and at fair market value

The selling price varies directly with the degree of marketability.

The transaction cost varies inversely with the degree of marketability.

The yield-to-maturity varies inversely with the degree of marketability.

The Structure of Interest Rates

o MARKETABILITY

• The difference in yields between a highly

marketable security (ihigh mkt) and a less

marketable security (ilow mkt) is the marketability

risk premium (MRP)

• U.S. Treasury bills are considered the most

marketable of all securities

0 – i iMRP low mkthigh mkt



The Structure of Interest Rates

o CALL PROVISION

• Bond issuer’s option to purchase a bond from

the bondholder at a predetermined price before

maturity.

When bonds are called, bondholders suffer financial loss because they must surrender higher-yield bonds and replace them with lower-yield bonds.

The Structure of Interest Rates

o CALL PROVISION • The difference in interest rates between a callable

bond and a non-callable bond is the call premium (CIP)

• Callable bonds sell for lower prices and higher yields than non-callable bonds

• Bonds paying high yields are more likely to be called when interest rates decline; these bonds have a high CIP

0 – i iCIP cal lnocal l



The Structure of Interest Rates

o DEFAULT RISK

• Risk that a borrower may not make payments as

promised

• Lenders are paid a default risk premium for

purchasing securities with default risk

• The default risk premium (DRP) is the

difference between the yield on a security with

default risk, idr, and the risk-free rate, irf

• Yield on T-bills is a proxy for the risk-free rate.

The Structure of Interest Rates

o BOND RATINGS

• Individuals and small businesses rely on outside

agencies for information on the default potential

of bonds.

The two most prominent credit rating agencies are Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P). – Both services rank bonds in order of probability of default and

publish ratings as letter grades.

The Structure of Interest Rates

o BOND RATINGS

• The highest grade bonds have the lowest default

risk and are rated Aaa or AAA.

Investment grade bonds are rated Aaa to Baa.

State and federal laws typically require commercial banks, insurance companies, pension funds, certain other financial institutions, and government agencies to purchase only investment-grade securities.

Corporate Bond Rating Systems

Default Risk Premiums for Selected Bond Ratings

Exhibit 8.5 Default Risk Premiums for Selected Bond Ratings

The Structure of Interest Rates

o TERM STRUCTURE OF INTEREST RATES

• The term structure of interest rates

the relationship between yield to maturity and term-to- maturity on a bond

the graph of the term structure of interest rates is a yield curve – The shape and position of the yield curve are not constant.

– As the overall level of interest rates changes, the yield curve shifts up and down and changes its shape and slope.

The Structure of Interest Rates

o BASIC SHAPES (SLOPES) OF YIELD CURVES

1. Ascending or normal yield curves slope

upward from left to right and imply higher

interest rates are likely

2. Descending or inverted yield curves slope

downward from left to right and imply lower

interest rates are likely

3. Flat yield curves imply interest rates unlikely

to change

The Structure of Interest Rates

o SHAPE OF THE YIELD CURVE

• Three factors that influence the shape of the

yield curve

1) Real rate of interest

2) Expected rate of inflation

3) Interest rate risk

The Structure of Interest Rates

o THE REAL RATE OF INTEREST

• The real rate of interest changes with the

business cycle.

Highest rates occur at the end of an economic expansion.

Lowest rates occur at the end of an economic contraction.

Changes in the expected future real rate of interest can affect the slope of the yield curve.

The Structure of Interest Rates

o THE EXPECTED RATE OF INFLATION

• If higher inflation is forecast, the yield curve

will slope upward because longer-term yields

will contain a larger inflation premium than

shorter-term yields

• If investors believe inflation will subside, the

yield curve will slope downward

The Structure of Interest Rates

o INTEREST RATE RISK

• The longer the maturity of a security, the

greater its interest rate risk – the risk of selling

the security at a lower price – and the higher its

yield-to-maturity

• The interest rate risk premium adds upward

bias to the slope of the yield curve

Yield Curves for Treasury Securities at Three Different Points in Time

Exhibit 8.6

The Structure of Interest Rates

o CUMULATIVE EFFECT OF FACTORS

• In an economic expansion, the real rate of

interest and the inflation premium increase

monotonically . Interest rate risk increases.

• In an economic contraction, the real rate of

interest and inflation premium decrease

monotonically. Interest rate risk decreases.