This document is a short summary of BEC22306 Corporate Financial Management in 7/8 sides. This contains all the important aspects of this course.
Good luck with the preparations.
Lecture 1 Financial statement analysis
Value share = expectations of future return on equity or risk (volatility of price) - Earnings per share = net income / number of shares
- Goal of corporate finance = looking for the financial flows and try to maximize the shareholders value > - Market to book ratio = market value per share / book value per share
maximize shareholder value Make a company a cash-generating activity - Price earning ratio = price per share / earnings per share > very high number means that the stock are
Depreciation = loss of economic value overtime > If you buy a machine, it will loss an economic value in certain life overvalued
time of years. Book value means the value that goes into the books. Market value is the change of assets.
3 financial statements > The Du Pont identity
1. Profit and loss account / income statement > depreciation of machinery - Return on equity = net income / total equity = (net income / assets) x (assets / total equity)
2. Balance sheet > investment in new machinery or fixed assets value (value of the machine will go down every - ROE = (sales/sales) x (net income / assets) x (assets / total equity) = ROA x (assets / total equity) = profit
year = depreciation) margin x total asset turnover x equity multiplier
3. Cash flow statement > investing you have a negative cash flow if you are not investing, you will have an
increase of the cash flow ; payment of machine (= cash outflow) Lecture 2
! If you buy a machinery, you will generate income. Income is put on the income statement. Furthermore, Savings rate = certainty discount rate = amount of money you save each month as percentage of your total or
depreciation will affect the income, but not the cash flow statement ! gross income. How higher the savings rate, the more money you are saving per month.
! Why do you add depreciation on the cash flow statement? Because you have fixed assets One-period case (simple interest)
that depreciates each year. Furthermore, depreciation is a cost and not an expenditure that - Future value / Compound value (FV) = C0 x (1 + r)
Influence the cash flow statement. So, in a cash flow statement, you have to add the depreciation ! - Present value / Discount value (PV) = C1 / (1 + r)
Financial market can be split up into > - NPV = - Cost + PV certainty discount rate = savings rate
1. Money market = short term debt NPV = difference between present value of cash inflows (negative in one-period case) and present value of cash
2. Capital market > outflows over a period of time
a. Primary market = corporation issues securities (stocks or bonds), cash flows from investors to firm directly If NPV > 0, this is considered as good. If NPV < 0, this is a bad investment decision. Choose always the largest NPV
b. Secondary market = involve the exchange of already issued securities between investors ; traded money if this is possible, because this is the best option.
Financial statements = provide information about economic situation of the firm
- Financial statement not express the risk NPV is used in certainty and uncertainty situations to compare the NPV value in the end. If for example in
- Financial ratios generally refer to performance in previous years uncertainty situation, there will be a negative NPV, which will lead to a bad investment decision.
Net working capital = current assets – current liabilities Multiple-period case (compound interest)
- Current assets are inventories / receivables / cash. - Future value (FV) = C0 x (1 + r)T ; simple interest FV = C0 + (1+r)T
- Current liabilities are short term debts / creditors. Interest you earned each year will be reinvested in the other year > reason that difference between simple
If net working capital is positive, then available cash > cash to be paid in next 12 months. interest rate not big differs after 3 years.
Cash inflow = decrease of assets or income of debt ; cash outflow = increase of assets or decrease of debt
Liquidity ratio = ability to pay all bills in the short run What will be the interest rate (r) if all other numbers are known? r = (FV/C 0)1/T – 1 or r = (PV/Ct)-1/T – 1
- Current ratio = current assets / current liabilities - PV = Ct / (1+r)T > check if the cash flows are the same or different
- Quick ratio (acid test ratio) = (current assets – inventories) / current liabilities ; inventories are less liquid - NPV = -C0 + C1/(1+r) + C2/(1+r)2 + … > check if the cash flows are the same or different
Solvency ratio = ability to pay back all debts when firm stops to exist Compounding periods > investment m times a year
- Equity multiplier = total assets / equity - Annual rate of return = effective annual rate (EAR) = C0(1 + r/m)m or EAR = C0(1 + r/m)m – 1 or EAR=(1+r/m)m-1
- Debt equity ratio = liabilities / equity > how a firm is being financed important aspect of corporate finance EAR will increase if the m will increase.
- Debt ratio = liabilities / total assets = (total assets – total equity) / total assets - FV = C0(1 + r/m)mT > multi-period compounding frequencies
- Time interest earned ratio = EBIT / interest payable > low EBIT, high change to become bankrupt. - FV = C0 x erT > continuous compounding
- Cash coverage ratio = (EBIT + depreciation) / interest - PV = C0 x (1/erT) > continuous compounding and PV
Assets Management / Turnover ratios = ability to use the assets effectively and efficiently Simplifications
- Asset turnover ratio = sales / total assets > sales per unit of asset - PV = C/(1+r) + C/(1+r)2 + C/(1+r)3 …. = C/r > constant perpetuity = constant stream of cash flows without an
- Inventory turnover = cost of sales / average inventories > number of times a year the average inventory is sold. If end
it is very low, the inventory will be sold very quickly. PV will increase if the r will decrease Decreasing interest rate means that the risk will goes down.
- Days in inventory = 365 / inventory turnover > number of days it takes to sell an average inventory - PV = C/(1+r) + C(1+g)/(1+r)2 + C(1+g)2/(1+r)3 …. = C/(r-g) > growing perpetuity = constant stream of increasing
Profitability ratios cash flows without end
- Return on assets (ROA) = EBIT / total assets = net income / total assets - PV = C(1/r – 1/(r(1+r) T) = C((1-(1/(1+r)T)/r) > annuity = level stream of regular payments that lasts for a fixed
- Return on equity (ROE) = net income / equity number of periods ; PV = C / r > present value annuity for infinity
- (Net) profit margin = net income / sales > lot of income per sale Annuity factor = 1/(1+r)T
- FV = C[((1+r)T – 1) / r] > future value of an annuity
, - PV = C(1 – [(1+g)/(1+r)]T / (r-g))
Bond = certificate showing that a borrower owes a specified sum.
To repay the money, the borrower has agreed to make interest and principal payments on designated “maturity” Shorter option: investment / (1+r)T
dates. Strengths of discounted payback period
3 types of bonds > pure discount bonds / coupon bonds / consols - Simple ; Uses time value of money
- Consol is perpetuity (PV=C/r). Weaknesses of discounted payback period
Applications - Ignores cash flows beyond payback period
- PV = F / (1+R)T > bond valuation - Arbitrary benchmark for payback period
- P0 = Div1 / (1 + R) + P1 / (1+R) > zero growth valuation Div1=D0(1+g) Average Accounting Return (AAR) consists of 3 steps >
P1 = Div2/ (1+R) + P2 / (1 + R) 1. Determine average net income
P0 = Div1 / (1 + R) + Div2 / (1 + R)2 + … = Div1 / R 2. Determine average investment
- P0 = Div1 / (1 + R) + Div1 (1 + g)/ (1 + R)2 + Div1 (1 + g)2/ (1 + R)3 + …. = Div1/ (R-g) > constant growth valuation 3. Determine average accounting return
P = Div1/(r-g)
Pt=P0(1+g)T ; R = Div1/P + g ; retention ratio = (earning per share – dividend 0) / earnings per share AAR = average net income / average accounting return
- Net cash flows = cash inflows – cash outflows If average accounting return > target return on investment, this is a good average.
Lecture 3 Strengths of AAR
Discount rate (= cash flows across time) compensates for > - Simple return based measure
- Delayed consumption reward for waiting with consumption Weaknesses of AAR
- Risk how more risky it will be, how higher the discount rate will be - Does not use cash flows but an accounting measure
- Inflation money today has a different value than money next year - Does not use time value of money
Real discount rate = nominal discount rate / inflation = (1 + nominal discount rate) / (1 + inflation) - Arbitrary target rate of return
NPV = difference between present value of cash inflows (negative in one-period case) and present value of cash Internal Rate of Return (IRR) = discount rate that returns a zero NPV
outflows over period of time Example: NPV = 0 = -100 + 110 / (1+R)
NPV = -Cost + PV = -investment + PV Multiple Internal Rate of Return is possible > NPV = 0 = -200 + 100/(1+R) + 100/(1+R)2 + …
If NPV > 0, this is considered as good. If NPV < 0, this is a bad investment decision. Choose always the largest NPV if
this is possible, because this is the best option. Independent project = acceptance or rejection is independent of the acceptance of rejection of other projects
Mutually Exclusive Projects = You can accept A or you can accept B or you can reject both of them, but you
Strengths of NPV cannot accept both of them.
- Uses cash flows cash flows are appropriate
- Uses all cash flows other approaches ignore cash flows beyond a certain date Profitability index (PI) = PV of cash flows subsequent to initial
- Discounts cash flows fully incorporates the time value of money investment / initial investment
Payback period = period how long it takes to pay the money back If more than one project is shown, you have to compare
Strengths of payback period these projects based on PI and NPV. In both situations, only
- Good for analyzing for very small scale investment one should be the highest. If this is not the case, you have to
- Firms with severe capital rationing calculate the ratio of PV of incremental Cash Flows and
- Simple to understand Investment as shown on the slide.
Weaknesses of payback period
- Timing of cash flows PV1 = (70/1.12) + (10/1.12)2 = 70.5
- Payments after the payback period not used
- Arbitrary benchmark for payback period > what is payback period exactly ; what is good or bad
Discounted payback period = cash inflow / (1+r) n with the discounting payback period it will take a longer time Incremental cash flows consists of few concepts, which you have to understand >
before you paid the amount back - Cash flows > incremental cash flow consists of Net profit after taxes and Depreciation
Depreciation is not a cash flow, but a cost.
- Sunk costs = cash flow that has already occurred
E.g. Marketing research on the market potential of a product. ; Production permits that have already been
paid.
Rule: Ignore all sunk costs.
- Opportunity costs = lost revenues that you forego as a result of making the proposed investment
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