Financial Management Notes

Comprehensive Notes
For Students of BBA, MBA & M.com
Prepared By:
Muhammad Riaz Khan
Government College of Management Sciences Peshawar
Contact: +923139533123 (mriazkhan91@yahoo.com)
Financial Management
ACKNOWLEDGEMENT
I am very grateful to Almighty ALLAH who enabled me to

complete notes on FINANCIAL MANAGEMENT. I have taken efforts
for completion of these Notes. However, it would not have been
possible without the kind support and help of many individuals. I
would like to extend my sincere thanks to all of them.
I am highly indebted to Sir Mr. Jawad Anwar (Lecturer at PIMS
Peshawar) for his guidance and constant supervision as well as for
providing necessary information regarding these notes & also for their
support in completing it.
I would like to express my gratitude towards my Parents &
Friends for their kind co-operation and encouragement which help
me in completion of these notes.
My thanks and appreciations also go to my dearest colleagues
Mr. Adnan Khan and Tauseef Ullah in preparing such notes who
have willingly helped me out with their abilities.
Muhammad Riaz Khan
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Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar) Mob#+923139533123
Chapter#1
An Overview of Financial Management
Meaning of Financial Management
Financial management is concerned with the acquisition, financing, and
management of assets with some overall goal in mind.
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the enterprise.
Functions of Financial Management
Based on the above definition functions of the financial management can be categorized
into three major categories, these are
(A) Investment Decisions

Investment decisions are concerned with assets. Major decisions regarding
investment decisions are explained below.
What is the optimal firm size? It means to decide what amount of

assets should be purchased in order to keep the operations of business
going and also not increasing the size of the business.
What specific assets should be acquired? The exact asset required to

maintain the operations of the business.
What assets (if any) should be reduced or eliminated? Any asset not
contributing in the profitability of the firm should be disposed off in order to
release the excess capital.
(B) Financing Decisions

Determine how the assets (LHS of balance sheet) will be financed (RHS of balance
sheet). This means to arrange funds for purchasing assets.
What is the best type of financing? Means either to use debt or equity.
What is the best financing mix? A firm normally uses a mix of debt and equity,
financial manager decides the ratio of debt and equity which can increase the
profitability and reduce risk.
3 What is the best dividend policy (e.g., dividend-payout ratio)? Refers to the
percentage of profit to be distributed among the shareholders.
4 How will the funds be physically acquired? Means either to take loan, issue
shares debentures etc.
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(C) Asset Management Decisions
3
How do we manage existing assets efficiently? Efficiently means to

maximize their productivity and overall contribution to profits.
Financial Manager has varying degrees of operating responsibility over

assets.
Greater emphasis is made on current asset management than fixed asset
management.
Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and
control of financial resources of a concern. The objectives can be-
1.
2.
To ensure regular and adequate supply of funds to the concern.

To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders?
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures so
that adequate rate of return can be achieved.
To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.
The Goals of Corporations

Corporate goals are defined as those specific ambitions or quantifiable targets
that are set by an organization of which it commits to so as to achieve its corporate
mission and objectives. The goals must define a mark that can be specifically measured
over a period of time. The Goal of Corporations refers to the maximizing of profits while
managing the financial risks of the firm. This refers to the main purpose of a corporation
which is to maximize shareholder value in order for the investors to gain from the
corporation. This applies in capital finance where capital is raised for creating,
developing, growing or acquiring businesses.
Several examples of corporate goals can be used for inspiration for your own business.
Profit maximization
Goals reflect general statements about what the business wants to achieve.
Improving profitability is a common corporate goal. The goal statement usually includes
details about the business and aligns its actions with the company mission and values.
For example, actions might include developing new markets, products or services. Other
examples include reducing unnecessary costs, changing suppliers or raising prices.
Stated simply, the goal must be clearly understood by all employees. It must also be
flexible enough. If market conditions change, the goal can be adjusted.
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Efficiency
Corporate goals typically reflect a commitment to improve existing operations.
This includes striving for excellence. It also involves producing results through effective
teamwork and using technology to innovate. Successful corporate leaders realize that
they have to be vigilant about reducing product errors, waste and customer
dissatisfaction. Corporate goals may also specify planned methods or strategies. For
example, to reduce product errors, a business might set a goal of implementing a Six
Sigma initiative, a quality management technique.
Expansion
Increasing market share is common corporate goal. This often involves targeting
new audiences, such as younger customers. Reaching out to a new demographic may
also involve using new marketing techniques. For example, a small business can
promote its products and services using social media technology. A company can
expand its market presence by designing, developing and delivering new products.
Satisfaction
Corporate leaders recognize that employee satisfaction contributes to
productivity. Corporate goals related to employees typically demonstrate a commitment
to the workforce. Programs may include training courses, events and resources. These
allow employees to develop professional skills and enhance collaboration. For example,
a common goal strives to create a culture based trust and respect for all. This improves
employee retention rates, reduces absenteeism and increases employee morale.
Sustainability
Corporate goals usually demonstrate a commitment to the community. A
business has a responsibility to be an asset, not a liability. For example, a company may
aspire to improve the environmental performance of the tools and technology used in its
facilities, by its customers and by its suppliers. Short-term goals address todays
problems and long-term goals prepare for the future.
Business Ethics and Social Responsibility

What is Business Ethics?
The concept has come to mean various things to various people, but
generally it's coming to know what it right or wrong in the workplace and doing
what's right -- this is in regard to effects of products/services and in relationships
with stakeholders.
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Business ethics is the behavior that a business adheres to in its daily

dealings with the world. The ethics of a particular business can be diverse. They
apply not only to how the business interacts with the world at large, but also to
their one-on-one dealings with a single customer.
Many businesses have gained a bad reputation just by being in business.
To some people, businesses are interested in making money, and that is the
bottom line. It could be called capitalism in its purest form. Making money is not
wrong in itself. It is the manner in which some businesses conduct themselves
that brings up the question of ethical behavior.
Good business ethics should be a part of every business. There are many factors
to consider. When a company does business with another that is considered
unethical, does this make the first company unethical by association? Some
people would say yes, the first business has a responsibility and it is now a link in
the chain of unethical businesses.
Many global businesses, including most of the major brands that the
public use, can be seen not to think too highly of good business ethics. Many
major brands have been fined millions for breaking ethical business laws. Money
is the major deciding factor
Social Responsibility:
Social responsibility and business ethics are often regarding as the same
concepts. However, the social responsibility movement is but one aspect of the
overall discipline of business ethics. The social responsibility movement arose
particularly during the 1960s with increased public consciousness about the role
of business in helping to cultivate and maintain highly ethical practices in society
and particularly in the natural environment.
Social responsibility is an ethical theory that an entity, be it an organization or individual,
has an obligation to act to benefit society at large. Social responsibility is a duty every
individual has to perform so as to maintain a balance between the economy and the
ecosystems.
Agency Relationships in Financial Management
Management acts as an agent for the owners (shareholders) of the firm.

An agent is an individual authorized by another person, called the
principal, to act in the latters behalf.
Agency Theory is a branch of economics relating to the behavior of
principals and their agents.
Principals must provide incentives so that management acts in the
principals best interests and then monitor results.
Incentives include stock options, perquisites, and bonuses.
Shareholders and managers have divergent goals. The Shareholders goal is to

maximize shareholder value while the manager's goals are Job security, Power, status,
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and compensation etc. Thus, managers may have the incentive to take actions that are
not in the best interest of the shareholders. Because managers usually own only a small
interest in most large corporations, potential agency conflicts are significant
Managerial compensation:
The compensation package should be designed to meet two objectives: one is to
attract and retain capable managers; two is to align managers' actions with the interest
of shareholders.
Performance shares: Management receives a certain number of shares if

the company achieves predefined performance benchmarks.
Executive stock options: Management is granted an option to buy stock at
a stated price within a specified time period.
Agency Problems: Shareholders (Through Managers) Vs. Creditors:
Managers are the agent of both shareholders and creditors. Shareholders
empower managers to manage the firm. Creditors empower managers to use the loan.
Though employed by shareholders managers work in the best interest of shareholders,
They deprive creditors in two different ways,
By investing in riskier projects they maximize the profits which on turn is

received by the shareholders and creditors bear only risk for them
By increasing dent the company increases leverage and in turn the risk of
insolvency is increased but creditors get nothing as risk premium.
To protect themselves against shareholders, creditors often include restrictive
covenants in debt agreements. In the long-run, a firm that deals unfairly with
creditors may impair the shareholders' interest because the firm may
lose access to the debt markets or

Be saddled with high interest rates and restrictive covenants.
*End of Chapter*
7
Chapter#2
Financial Statements, Cash Flow and Taxes
Financial Statements Definition:
Summary report that shows how a firm has used the funds entrusted to it by
its stockholders (shareholders) and lenders, and what is its current financial position.
The three basic are the (1) balance sheet, which shows firm's assets, liabilities, and net
worth on a stated date; (2) income statement (also called profit & loss account), which
shows how the net income of the firm is arrived at over a stated period, and (3) cash flow
statement, which shows the inflows and outflows of cash caused by the
firm's activities during a stated period.
Basic Financial Statements

A business is a financial entity separate from its owners. Each business must keep
financial records. Financial statements have generally agreed-upon formats and follow
the same rules of disclosure. This puts everyone on the same level playing field, and
makes it possible to compare different companies with each other, or to evaluate
different year's performance within the same company. There are three main financial
statements:
Income Statement
Balance Sheet
Statement of Cash Flows
Each financial statement tells its own story. Together they form a comprehensive
financial picture of the company, the results of its operations, its financial condition, and
the sources and uses of its money. Evaluating past performance helps managers
identify successful strategies, eliminate wasteful spending and budget appropriately for
the future. Armed with this information they will be able to make necessary business
decisions in a timely manner
There are 5 types of Accounts.
Assets
Liabilities
Owners' Equity (Stockholders' Equity for a corporation)
Revenues
Expenses
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All the accounts in an accounting system are listed in a Chart of Accounts. They are
listed in the order shown above. This helps us prepare financial statements, by
conveniently organizing accounts in the same order they will be used in the financial
statements.
Financial Statements
The Balance Sheet lists the balances in all Assets, Liability and Owners' Equity
accounts.
The Income Statement lists the balances in all Revenue and Expense accounts.
The Balance Sheet and Income Statement must accompany each other in order
to comply with GAAP. Financial statements presented separately do not comply with
GAAP. This is necessary so financial statement users get a true and complete financial
picture of the company.
All accounts are used in one or the other statement, but not both. All accounts
are used once, and only once, in the financial statements. The Balance Sheet shows
account balances at a particular date. The Income Statement shows the accumulation in
the Revenue and Expense accounts, for a given period of time, generally one year. The
Income Statement can be prepared for any span of time, and companies often prepare
them monthly or quarterly.
It is common for companies to prepare a Statement of Retained Earnings or a
Statement of Owners' Equity, but one of these statements is not required by GAAP.
These statements provide a link between the Income Statement and the Balance Sheet.
They also reconcile the Owners' Equity or Retained Earnings account from the start to
the end of the year.
The Statement of Cash Flows is the third financial statement required by

GAAP, for full disclosure. The Cash Flow statement shows the inflows and outflows of
Cash over a period of time, usually one year. The time period will coincide with the
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Income Statement. In fact, account balances are not used in the Cash Flow statement.
The accounts are analyzed to determine the Sources (inflows) and Uses (outflows) of
cash over a period of time.
There are 3 types of cash flow (CF):
Operating - CF generated by normal business operations
Investing - CF from buying/selling assets: buildings, real estate, investment portfolios,
equipment.
Financing - CF from investors or long-term creditors
The SEC (Securities and Exchange Commission) requires companies to follow
GAAP in their financial statements. That doesn't mean companies do what they are
supposed to do. Enron executives had millions of reasons ($$) to falsify financial
information for their own personal gain. Auditors are independent CPAs hired by
companies to determine whether the rules of GAAP and full disclosure are being
followed in their financial statements. In the case of Enron and Arthur Andersen, auditors
sometimes fail to find problems that exist, and in some cases might have also failed in
their responsibilities as accounting professionals.
Retained Earnings
The Retained Earnings (RE) account has a special purpose. It is used to
accumulate the company's earnings, and to pay out dividends to the company's
stockholders. Let's look at the first part of that for a moment.
At the end of the fiscal year, all Revenue and Expense accounts are closed to
Income Summary, and that account is closed to Retained Earnings. Profits increase RE;
losses will decrease RE. So the RE account might go up or down from year to year,
depending on whether the company had a profit or loss that year.
The changes in the RE accounts are called "Changes in Retained Earnings" and
are presented in the financial statements. This information can be included in the Income
Statement, in the Balance Sheet, or in a separate statement called the Statement of
Changes in Retained Earnings. Each company can decide how to present the
information, but it must be presented in one of those three places.
Most financial statements today include a Statement of Retained Earnings. Some
companies prepare a Statement of Stockholders' Equity to give a more comprehensive
picture of their financial events. This statement includes information about how many
shares of stock were outstanding over the year, and provides other valuable information
for large companies with a complex capital structure. The changes in RE are included in
the Stockholders' Equity statement.
Net Cash Flow:
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Net cash flow refers to the difference between a company's cash inflows and
outflows in a given period. In the strictest sense, net cash flow refers to the change in a
company's cash balance as detailed on its cash flow statement.
How it works/Example:
Net cash flow is also known as the "change in cash and cash equivalents." It is
very important to note that net cash flow is not the same as net income, free cash flow,
or EBITDA.
You can approximate a company's net cash flow by looking at the period-overperiod change in cash on the balance sheet. However, the statement of cash flows is a
more insightful place to look. Net cash flow is the sum of cash flow from operations
(CFO), cash flow from investing (CFI), and cash flow from financing (CFF).
Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as
presented by Yahoo! Finance. At the bottom of the cash flow statement, we see that the
change in cash and cash equivalents is calculated to be $632 million. This means that
when the cash flow from operations, cash flow from investing, and cash flow from
financing is added up, Wal-Mart added $632 million to its cash balance in 2010.
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Dividends
Dividends are payments companies make to their stockholders. These must be
made from earnings. Since we record accumulated earnings in the RE account, all
dividends must come out of that account. There are several types of dividends, but they
all must come from Retained Earnings. In order to pay dividends, the RE account MUST
have a positive, or Credit, balance.
If the RE account has a Debit balance, we would call that a Deficit, and the
company would not be able to pay dividends to its stockholders. Deficits arise from
successive years of posting losses in excess of profits.
Market Value Added (MVA)
Market value added represents the difference in the total value of the firm
and the total capital supplied by the investors.
MVA measures the performance of the managers from the creation of the
company till current year, because it compares the par value of share with
the current market value means the total increase in the firm share till
date.
Share holders wealth is maximized by maximizing the difference in market
value of the stock and the amount of wealth supplied by the shareholders.
MVA = Market value of stock Equity capital supplied by
shareholders.
Or
= (Shares outstanding) (Stock Price Total Common Equity
Or
MVA = Total Market value Total investor supplied capital
Greater the market value more efficiency and more profitable the firm is
Economic Value Added (EVA)
Economic value added is the difference between after tax profits of the
firm and the total dollar cost of capital. EVA is the value created by the
management due to profitable operations of the business.
Economic value added measures the firm efficiency in the current year
only that how much the firm earned more than its cost of capital
EVA = NOPAT Cost of capital required for operations

EVA = (Operating capital) (ROIC WACC)
Where ROIC is Return on invested capital and WACC is the weighted average cost
of capital
And NOPAT is net operating profit after tax
Positive EVA means firm is generating more profit than its cost and
additional investment will increase the value of the firm
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The EVA shows the true economic profit of the business greater the
value more profitable the firm is.
Free Cash flows
Free cash flow is the amount of cash remaining after the company makes
investment in assets that are necessary for the firms operations, or the
cash which is left over from the investment in assets.
In other words free cash flow is the amount of cash available for
distribution to all investors that is shareholders and debt holders.
So the value of the company is directly related to the amount of free cash
flow generated
Uses of free cash flow

Following are the uses of free cash flows
1.
2.
3.
4.
5.
To pay interest to debt holders

To repay or redeem bonds
Pay dividend to shareholders
To repurchase some of its stock
Buy short term investments
Calculating free cash flows

Free cash flows can be calculated using the following equations
FCF = NOPAT Net investment in operating assets
Where net investment in operating assets means net increase in both current and fixed
assets
Or FCF = Operating cash flow Gross investment in operating capital
Where Operating cash flow = NOPAT + Depreciation
And Gross investment in operating capital = Net investment in operating assets +
Depreciation
What Is Depreciation?
Depreciation is the process by which a company allocates an asset's cost over
the duration of its useful life. Each time a company prepares its financial statements, it
records a depreciation expense to allocate a portion of the cost of the buildings,
machines or equipment it has purchased to the current fiscal year. The purpose of
recording depreciation as an expense is to spread the initial price of the asset over its
useful life. For intangible assets - such as brands and intellectual property - this process
of allocating costs over time is called amortization. For natural resources - such as
minerals, timber and oil reserves - its called depletion.
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Chapter#3
Financial Statement Analysis
Financial statement analysis can be referred as a process of understanding the risk
and profitability of a company by analyzing reported financial info, especially annual and
quarterly reports.
Reasons for Analysis

Financial statements analysis may be carried out by either internal or external
users.
What do internal users use it for?
Internal users (Management) analyze financial statements for the following reasons.
Evaluating the financial statements

Planning according to the past performance.
And controlling company operations
What do external users use it for?
To check long term solvency for Investment decisions

Creditors to check the liquidity for Credit decisions
Investors for Valuation for investment decisions.
Government for regulations and tax purposes.
Advantages of financial statement analysis

The different advantages of financial statement analysis are listed below:
The most important benefit if financial statement analysis is that it provides an

idea to the investors about deciding on investing their funds in a particular
company.
Another advantage of financial statement analysis is that regulatory authorities

like IASB can ensure the company following the required accounting standards.
Financial statement analysis is helpful to the government agencies in analyzing

the taxation owed to the firm.
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Above all, the company is able to analyze its own performance over a specific
time period.
Ratio Analysis
Quantitative analysis of information contained in a companys financial
statements. Ratio analysis is based on line items in financial statements like the
balance sheet, income statement and cash flow statement; the ratios of one item or
a combination of items - to another item or combination are then calculated. Ratio
analysis is used to evaluate various aspects of a companys operating and financial
performance such as its efficiency, liquidity, profitability and solvency.
Ratio analysis can be made by
Comparing one company to another

Comparing one year with another year of the same company
Comparing one company with the industry
Following are the different categories of financial ratios.
(A) Liquidity: Can we make required payments as they fall due?

(B) Asset management: Do we have the right amount of assets for the
level of sales?
(C) Debt management: Do we have the right mix of debt and equity?
(D) Profitability: Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?
(E) Market value: Do investors like what they see as reflected in P/E and
M/B ratios?
These ratios are now explained below
(A)
Liquidity Ratios.
Liquidity ratios measure the ability of the company that whether it can pay
its short term obligations or not.
This is done by comparing a company's most liquid assets (or, those that
can be easily converted to cash), its short-term liabilities.
In general, the greater the coverage of liquid assets to short-term liabilities
the better as it is a clear signal that a company can pay its debts that are
coming due in the near future and still fund its ongoing operations.
Short term creditors and suppliers are more interested in these ratios.
Liquidity ratios can be measured using two ratios these are
1
2
Current ratio
Quick/ liquid. Acid test ratio
Current Ratio
The current ratio is a popular financial ratio used to test a

company's liquidity (also referred to as its current or working
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capital position) by deriving the proportion of current assets available

to cover current liabilities.
The concept behind this ratio is to ascertain whether a company's
short-term assets (cash, cash equivalents, marketable securities,
receivables and inventory) are readily available to pay off its short-term
liabilities (notes payable, current portion of term debt, payables,
accrued expenses and taxes).
In theory, the higher the current ratio, the better. the company liquidity
is
Formula
Shows that the company has 2.6 of current assets to pay off 1 re of current liability.
Quick ratio
Quick ratio compares quick assets with current liabilities.

It further refines the current ratio by measuring the amount of the
most liquid current assets there are to cover current liabilities.
The quick ratio is more conservative than the current ratio because it
excludes inventory and other current assets, which are more difficult to
turn into cash.
Therefore, a higher ratio means a more liquid current position.
Formula
Quick Ratio = Quick Asset/ Current Liabilities
Or
It shows that company have 1.3 of quick assets to pay current liabilities of Re 1
(B) Asset Management Ratios
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Asset Management Ratios attempt to measure the firm's success in managing its assets
to generate sales. These ratios shows that how efficiently a company is using their
assets
Following are the asset management ratios.
Inventory Turnover Ratio
The Inventory Turnover and Days' Inventory Ratios measure the firm's
management of its Inventory.
Inventory turnover means the speed through which old inventory is
replaced with new one.
In general, a higher Inventory Turnover Ratio is indicative of better
performance since this indicates that the firm's inventories are being sold
more quickly.
Formula
Sales/ inventory
300000/50000 = 6 times
Which shows that we the companys old inventory is replaced 6 times annually
Receivable management ratio- The days of sales outstanding Ratio
Days of sales outstanding also called the average collection period refers
to the days in which account receivables are collected.
This ratio measures the ability of an organization that how efficiently
company is their credit sales and receivables
it shows the days during which money is tied up due to credit sales
More quickly the debts are recovered more fund will be available for the
organization and hence will show efficiency
Formula
DSO (in times)
= Sales/receivables
DSO (in days)
= receivables/ average daily sales

Or
= receivables * 365/ annual sales

= 20000 * 365/ 200000
= 36.5 days
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Shows that it takes 36.5 days for an average debtor to be collected
Fixed assets turnover Ratio
This ratio shows that how efficiently the firm uses their fixed assets.
Greater the fixed assets turnover greater is their efficiency.
Formula
Sales/Net fixed Assets
Total Assets Turnover ratio
Shows the turnover of total assets with respect of sales.

Shows the efficiency of total assets, that how much of revenue is
generated by total assets
Greater turnover shows that assets produce greater sales with respect to
their value.
Formula
Sales/ Total Assets
(C) Debt Management Ratio
Debt management ratios show how the firm is financed and how better the
firm van pay their long term debt and interest payment.
Investors, creditors and banks are often interested in calculating these
ratios
Three important debt management ratios are
Total Liabilities to total assets ratio
This ratio compares total liabilities of the firm with total assets
Shows the percentage of assets purchased by taking liabilities
Higher the ratio greater will be the leverage, which shows that most of the
assets are financed through debt.
If most assets are financed through debt solvency risk will be high and will
be less attractive for investors and long term creditors.
Formula
Total liabilities/ Total assets
= 150,000/250,000
= 0.6 or 60%
Which means that 60% of the assets are financed through liabilities?
Times Interest earned Ratio
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Shows the firms ability that whether the firm can pay their fixed interest
charges or not? In other words it compares the firms profits with fixed
interest charges,
Banks and other financial institutes which grant loan to the organization
are interested in this ratio.
This ratio shows that what amount of profit is available for payment of one
dollar of interest, greater the ratio more profit is available, better is the
ability to service debt
Formula
200000/10000
=20
Which means that the company has 20 Rs of profit to pay I Re of interest?
Earnings before interest tax depreciation and amortization (EBITDA) Ratio
Interest coverage ratio does not fully explain the firms ability to service
debt because interest is not the only payment which a company makes
but it also has to pay some portion of its loan and also lease payment
Similarly EBIT is not the total cash available for all these payments
EBITDA is used to find the amount of free cash flow available for payment
of interest, repayment of principle amount and also lease installment.
Greater the ratio means more free cash is available for payment of the
above payments.
Formula
NPBITDA + Lease payments/Interest expense Principle Payment Lease payment
(D) Profitability ratios
These ratios, much like the operational performance ratios, give users a
good understanding of how well the company utilized its resources in
generating profit and shareholder value.
The long-term profitability of a company is vital for both the survivability of
the company as well as the benefit received by shareholders.
Profit margin to sales
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Profit margin to sales compares net profit available to shareholders for

distribution with sales.
Net profit available for shareholders is the absolute profit from which all
types of expenses, taxes and preference dividend has been deducted
To a large degree, it is the quality, and growth, of a company's earnings
that drive its stock price.
Theatrically greater the profit margin ratio greater will be the performance
of the business, or more profitable the business is.
Formulas:
Net profit margin ratio = Profit available for shareholders/ sales

Basic Earning Power Ratio
This ratio shows the basic or raw earning capacity of the assets of the
business
This ratio is calculated by taking EBIT (earnings before interest and tax),
which shows that tax effects and interest is not taken into consideration.
Formula
Basic Earning power = EBIT/ Total Assets
Return on Total Assets
Return on total assets is calculated by comparing Net profit available for

shareholders with total assets
This ratio shows the final earning power and final earning capacity of the
business
Greater the ratio more profitable the business is and more efficiently the
business is utilizing its resources
Formula
Return on Total assets = Net profit available for shareholders/ Total asset
Return on Equity:
This ratio indicates how profitable a company is by comparing its

net income to its average shareholders' equity.
The return on equity ratio (ROE) measures how much the
shareholders earned for their investment in the company.
The higher the ratio percentage, the more efficient management is
in utilizing its equity base and the better return is to investors.
Formula:
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(E) Market Value Ratios

Market Value Ratios relate an observable market value, the stock price, to book values
obtained from the firm's financial statements.
Price-Earnings Ratio (P/E Ratio)
The Price-Earnings Ratio is calculated by dividing the current market price per
share of the stock by earnings per share (EPS). (Earnings per share are
calculated by dividing net income by the number of shares outstanding.)
The P/E Ratio indicates how much investors are willing to pay per dollar of
current earnings. As such, high P/E Ratios are associated with growth stocks.
(Investors who are willing to pay a high price for a dollar of current earnings
obviously expect high earnings in the future.)
In this manner, the P/E Ratio also indicates how expensive a particular stock is.
This ratio is not meaningful, however, if the firm has very little or negative
earnings.
Where
Market-to-Book Ratio
The Market-to-Book Ratio relates the firm's market value per share to its
book value per share.
This shows the amount of money an investor is willing to pay to get 1
rupee ownership in that company
Since a firm's book value reflects historical cost accounting, this ratio
indicates management's success in creating value for its stockholders.
Greater the ratio more interested the investors are in your company and
will show greater growth in the shares.
Where
Book value per share = Total equity/ total outstandding shares,
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Trend Analysis, Common Size Analysis and Percent Change Analysis
Trend Analysis
An aspect of technical analysis that tries to predict the future movement of a
stock based on past data. Trend analysis is based on the idea that what has happened
in the past gives traders an idea of what will happen in the future.
Trend analysis
Trend analysis Is one of the tools for the analysis of the companys monetary statements
for the investment purposes. Investors use this analysis tool a lot in order to determine
the financial position of the business. In a trend analysis, the financial statements of the
company are compared with each other for the several years after converting them in
the percentage. In the trend analysis, the sales of each year from the 2008 to 2011 will
be converted into percentage form in order to compare them with each other. In order to
convert the figures into percentages for the comparison purposes, the percentages are
calculated in the following way:
Trend analysis percentage = (figure of the previous period figure of the current
period)/total of both figures
The percentage can be found this way and if the current-year percentages were greater
than previous year percentage, this would mean that current-year result is better than
the previous year result.
CommonSize Analysis
Commonsize analysis (also called vertical analysis) expresses each line item on a
single year's financial statement as a percent of one line item, which is referred to as a
base amount. The base amount for the balance sheet is usually total assets (which is
the same number as total liabilities plus stockholders' equity), and for the income
statement it is usually net sales or revenues. By comparing two or more years of
commonsize statements, changes in the mixture of assets, liabilities, and equity
become evident. On the income statement, changes in the mix of revenues and in the
spending for different types of expenses can be identified.
Percentage Change Analysis
A percent change analysis shows how two items changed as a percentage from one
period to another period. Used on a balance sheet, a percent change analysis shows
how a balance sheet account changes from year to year, or quarter to quarter. The
balance sheet accounts are assets, liabilities and stockholders' equity. Percent change
analysis is important for managers and investors to see how a company is growing or
retracting from year-to-year.
*End of Chapter*
22
Chapter#4
Financial Planning and Forecasting Financial Statements
Financial Planning - Definition, Objectives and
Importance
Definition of Financial Planning
Financial Planning is the process of estimating the capital required and determining its
competition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise.
Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:
a. Determining capital requirements- This will depend upon factors like cost of
current and fixed assets, promotional expenses and long- range planning. Capital
requirements have to be looked with both aspects: short- term and long- term
requirements.
b. Determining capital structure- The capital structure is the composition of capital,
i.e., the relative kind and proportion of capital required in the business. This
includes decisions of debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally
utilized in the best possible manner at least cost in order to get maximum returns
on investment.
Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes
and budgets regarding the financial activities of a concern. This ensures effective and
adequate financial and investment policies. The importance can be outlined as1. Adequate funds have to be ensured.
2. Financial Planning helps in ensuring a reasonable balance between outflow and
inflow of funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company.
23
5. Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance
to growth of the company. This helps in ensuring stability and profitability in
concern.
Forecasting Financial Statements

Introduction:
Financial Forecasting describes the process by which firms think about and
prepare for the future. The forecasting process provides the means for a firm to express
its goals and priorities and to ensure that they are internally consistent. It also assists the
firm in identifying the asset requirements and needs for external financing.
For example, the principal driver of the forecasting process is generally the sales
forecast. Since most Balance Sheet and Income Statement accounts are related to
sales, the forecasting process can help the firm assess the increase in Current and
Fixed Assets which will be needed to support the forecasted sales level. Similarly, the
external financing which will be needed to pay for the forecasted increase in assets can
be determined.
Strategic Planning:
Strategic planning provides the vision, direction and goals for the business.
Strategic planning is an organization's process of defining its strategy, or direction, and
making decisions about allocating resources to pursue this strategy. In order to
determine the direction of the organization, it is necessary to understand its current
position and the possible avenues through which it can pursue a particular course of
action. A financial forecast is an estimate of future financial outcomes for a company.
Using historical internal accounting and sales data, in addition to external market and
economic indicators, a financial forecast is an economist's best guess of what will
happen to a company in financial terms over a given time periodwhich is usually one
year.
Operating Plans:
Operational planning is a subset of strategic work planning which describes
short-term ways of achieving milestones and explains how. The strategic plan will be put
into operation during a given operational period. An operational plan draws directly from
agency and program strategic plans to describe agency and program missions and
goals, program objectives, and program activities.
Like a strategic plan, an operational plan addresses four questions:
Where are we now?

Where do we want to be?
How do we get there?
24
How do we measure our progress?
The Financial Plans:

Financial planning is the process of meeting your life goals through the proper
management of your finances. Life goals can include buying a home, saving for your
childs education or planning for retirement. The financial planning process involves the
following steps:
Gathering relevant financial information

Setting life goals
Examining your current financial status
Coming up with a financial strategy or plan for how you can meet your goals
Implementing the financial plan
Monitoring the success of the financial plan, adjusting it if necessary
Using these steps, you can determine where you are now and what you may need in the
future in order to reach your goals.
Financial planning is a systematic approach whereby the financial planner helps the
customer to maximize his existing financial resources by utilizing financial tools to
achieve his financial goals. Financial planning is simple mathematics. There are 3 major
components:
Financial Resources (FR)

Financial Tools (FT)
Financial Goals (FG)
When you want to maximize your existing financial resources by using various financial
tools to achieve your financial goals, which is financial planning.
Financial Planning: FR + FT = FG
Computerized Financial Planning Model:

The financial plan describes the practice's financial strategy, projects the
strategy's future effect on the practice, and establishes goals by which the practice's
manager can measure subsequent performance. The act of putting together a financial
plan is called the financial planning process. It is a process that consists of analyzing the
practice; projecting future outcomes of decisions that have to be made regarding
finances, investments, and day to day operations; deciding which alternatives to
undertake; and measuring performance against goals that are established in the
financial plan.
Computer financial planning models can aid the practice manager in projecting
future outcomes of various financial, investment, and operational decisions. These
models can be created inexpensively by non-computer programmers with the aid of
computer software on the market today. The financial planning process for a
25
hypothetical practice was summarized, and the financial model used to test out various
alternatives available to the practice was described
Sales Forecasts:
Sales forecasting is estimating what a company's future sales are likely to be
based on sales records as well as market research. The information used in them must
be well organized and may include information on the competition and statistics that
affect the businesses' customer base. Companies try to forecast sales in hopes of
identifying patterns so that revenue and cash flow can be maximized.
Before the forecasting process begins, marketing, sales, or other managers
should determine how far ahead the estimate should be done. Short-term forecasting is
a maximum of three months and is often effective for analyzing budgets and markets.
Intermediate forecasting is between a period of three months and two years and may be
used for schedules, inventory and production. Long-term forecasting is for a minimum of
two years and is good for dealing with growth into new markets or new products. Sales
forecasts should be conducted regularly and all results need to be measured so that
future methods can be adjusted if necessary.
Basically, sales forecasting is analyzing all parts of a business from total
inventory to the strengths and weaknesses of salespeople. Managers must think about
changes in customer sales or other changes that could affect the estimated figures.
They must be competitive when assessing the competition and how they can surpass
others in the marketplace to better meet the needs of the target market.
Financial Statement Forecasting Methods

To forecast financial data, corporate leadership and department heads rely on various
methods and tools. These include appraisal methodologies, such as vertical and
horizontal analyses, as well as financial ratios, such as net profit margin and return on
equity. Forecasted financial information is also known as pro forma or projected
accounting information.
Following are some methods of forecasting Financial Statements
Statistical Forecasting
Statistical forecasting enables department heads to project financial statements based

on assumptions and internally derived factors. For example, supervisors may review the
state of the economy and take government-published GDP metrics to estimate how
much the company might grow sales in the future -- say, in one, two or 10 years. Gross
domestic product, or GDP, is the total market value of goods and services produced
within a nation's borders during a given period.
Ratio Method
In ratio analysis, a company uses previously calculated metrics to forecast financial

statement data. Financial ratios indicate everything from efficiency and profitability to
solvency and liquidity. Examples include net profit margin, asset-turnover ratio and
26
return on equity, or ROE. A company may, for example, forecast income data for each of
the next five years by multiplying current-year sales by the current-year ROE. The firm
then may adjust the final number by including material cost and labor expense
projections.
Vertical Method
Vertical analysis means a company sets a financial statement item as a numerical

standard and compares other items with the benchmark. For example, a company may
set total sales as the benchmark for income statement forecasts. The business then may
calculate that material costs amounted to a certain percentage -- say, 50 percent -- of
total sales over the last 12 months. Using this proportion, accountants may extrapolate
by setting material costs at 50 percent of total sales for the next five years.
Horizontal Method
In horizontal analysis, the goal is to review financial data year over year, giving analytical
prominence to the study of historical information. For example, a business may analyze
its sales data over a five-year period and determine that the average revenue-growth
rate is 11 percent. The organization then may use the same number to forecast that
sales will grow 11 percent for each of the next five or 10 years.
*End of Chapter*
Chapter#5
Financial Environment
Introduction:
Financial environment is the outcome of a range of functions of the economy
on all financial outcomes of an area or a country. It includes forex markets, bond
markets, stock markets and commodity markets.
Financial Markets
A market is a venue where goods and services are exchanged.

A financial market is a place where individuals and organizations wanting
to borrow funds/capital are brought together with those having a surplus of
funds.
Types of Financial markets:

Some Financial markets are as follows
1-Real/tangible/Physical assets Markets and Financial Asset Market
Real assets are tangible assets that determine the productive capacity of an
economy, that is, the goods and services its members can create. These include land,
27
buildings, machines, and knowledge that can be used to produce goods and services.
Other common examples of investments in Real Assets are paintings, antiques, precious
metals and stones, classic cars etc.
While Financial Asset Market refers to that market where financial assets are
dealt. Financial Assets, (Assets in the form of paper) or more commonly known
as Securities, include stocks, bonds, unit trusts etc. In essence, financial assets or
securities represent legal claim on future financial benefits.
2-Spot Markets and Future Markets:
The spot market is where securities (e.g. shares, bonds, funds, warrants and
structured products) and goods (e.g. commodities) are traded. In spot market goods are
delivered on the same day or within a few days In other words, the transaction takes
place immediately or within a short period of time (T+3; transactions are usually settled
three working days after they take place).
Future market transactions are transactions in which the price, number and
delivery date of the traded securities are agreed when the transaction is concluded but
delivery and payment take place at a future time. Usually, the term "forward transaction"
is used if the time period is three days or more.
3-Money Market and Capital Market
The money market is a segment of the financial market in which financial
instruments with high liquidity and very short maturities are traded. The money market is
used by participants as a means for borrowing and lending in the short term, from
several days to just under a year.
A capital market is one in which individuals and institutions trade those securities and
instruments whose maturity is more than one year.
4-Primary Market and Secondary market
The primary market is where securities are created. It's in this market that firms
sell new stocks and bonds to the public for the first time. Or the market in which new
shares are issued
The secondary market is that market in which second hand shares and bonds
are traded. Stock exchange is the market in which one investor buys 3nd hand shares
from another investor
5-Private and Public Markets:
A private market, also known as the private market sector, is the part of a
nation's economy that is not controlled by the government. It is operated by individuals
and firms with the aim of making profits. It is the complete opposite of a public sector
which is operated by the government with the aim of providing goods and services.
Financial Institutions
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Financial institutions are the organizations that are involved in providing various
types of financial services to their customers. Examples of financial institutions include;
Banks, Credit Unions, Asset Management Firms, Insurance companies and pension
funds among others.
Following are some financial institutions:
1-Commercial Banks
This is a financial institution providing services for businesses, organizations and
individuals. Services include offering current, deposit and saving accounts as well as
giving out loans to businesses. Commercial banks are defined as a bank whose main
business is deposit-taking and making loans.
2-Savings and Loan Associations
A savings and loan association (S&L) is a financial institution that specializes
in savings deposits and mortgage loans, and has become one of the
primary sources of mortgage loans for homebuyers today.
It offers mortgage services to people from the savings and deposits received
from private investors.
3-Mutual Savings Bank:
A Mutual Savings Bank is a financial establishment which is licensed through a
centralized or state government and provides individuals with a secure place to invest in
mortgages, credit, stocks and other securities. It is owned and operated by the
depositors.
4-Credit union:
This is a mutual financial organization formed and managed by a group of people
with a common affiliation, such as employees of a company or a trade union. When you
deposit money into a credit union, you become a member and a partial owner.
5-Insurance Companies:
These are corporate entities that insure people against loss. The client pays a
fee, known as a premium, in exchange for the promise of the company to protect the
client financially in the event of certain potential misfortunes. The different t types of
insurance include life, Vehicle, health, liability and homeowners.
6-Investment Banks:
Unlike commercial banks, investment banks do not take deposits. Their focus is
assisting individuals, corporations, and governments in raising capital by underwriting
and/or acting as the client's agent in the issuance of securities. An investment bank may
also assist companies involved in mergers and acquisitions.
7-Mutual Fund Companies:
29
Sometimes called investment companies, these are companies that pool money
from many investors to purchase securities. Each fund invests in a different group of
securities for the investors. They serve the general public.
The Stock Exchange or Stock Market
Stock exchanges are privately organized markets which are used to facilitate
trading in securities.
Stock Exchange (also called Stock Market or Share Market) is one important
constituent of capital market Stock Exchange is an organized market for the purchase
and sale of industrial and financial security. It is convenient place where trading in
securities is conducted in systematic manner i.e. as per certain rules and regulations.
It performs various functions and offers useful services to investors and
borrowing companies. It is an investment intermediary and facilitates economic and
industrial development of a country. Stock exchange is an organized market for buying
and selling corporate and other securities. Here, securities are purchased and sold out
as per certain well-defined rules and regulations. It provides a convenient and secured
mechanism or platform for transactions in different securities. Such securities include
shares and debentures issued by public companies which are duly listed at the stock
exchange and bonds and debentures issued by government, public corporations and
municipal and port trust bodies.
Over-the-counter (OTC)
A decentralized market, without a central physical location, where market
participants trade with one another through various communication modes such as the
telephone, email and proprietary electronic trading systems. An over-the-counter (OTC)
market and an exchange market are the two basic ways of organizing financial markets.
In an OTC market, dealers act as market makers by quoting prices at which they will buy
and sell a security or currency. A trade can be executed between two participants in an
OTC market without others being aware of the price at which the transaction was
effected. In general, OTC markets are therefore less transparent than exchanges and
are also subject to fewer regulations.
What are the Bid-ask spread?
The amount by which the ask price exceeds the bid. This is essentially the
difference in price between the highest price that a buyer is willing to pay for an asset
and the lowest price for which a seller is willing to sell it.
For example, if the bid price is $20 and the ask price is $21 then the "bid-ask spread" is
$1.
30
The Cost of Money:

Concept of the Cost of Money
The cost of money refers to the price paid for using the money, whether
borrowed or owned. In other words the cost of money is the expectation of investor from
investing or lending money every sum of money used by corporations bears cost. The
interest paid on debt capital and the dividends paid on ownership capital are examples
of the cost of money. The supply of and demand for capital is the factor that affects the
cost of money. In addition, the cost of money is affected by the following factors as
below:
Factors Affecting the Cost of Money

1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in
productive assets. Increase in production opportunities in an economy increases the
cost of money. Higher the production opportunities more will be the demand for money
which leads to higher cost of money.
2. Time Preference for Consumption
Time preference for consumption refers to the preference of consumers for
current consumption as opposed to future consumption. The cost of money also
depends on whether the consumers prefer to consume in current period or in future
period. If the consumers prefer to consume in current period, they spend larger portion
of their earnings in current consumption. It leads to the lower saving. Lower saving
reduces the supply of money causing the cost of money increase. Therefore, as much
as the consumers give high preference to current consumption, the cost of money will
increase and vice versa.
3. Risk
Risk refers to the chance of loss. In the context of financial markets, risk means
the chance that investment would not produce promised return. The degree of risk
perceived by investors and the cost of money has positive relationship. If an investor
perceives high degree of risk from a given investment alternative, he or she will demand
higher rate of return, and hence the cost of money will increase.
4. Inflation
Inflation refers to the tendency of prices to increase over periods. The expected
future rate of inflation also affects the cost of money, because, it affects the purchasing
power of investors. Increase in rate of inflation results in decline in purchasing power of
investors. The investors will demand higher rate of return to commensurate against
decline in purchasing power because of inflation.
Interest Rate Levels
31
What is interest rate?

Interest rate is the rate of interest charged for the amount of money borrowed.
Banks or lending institutions usually have general guidelines for the rate they intend to
charge. Money borrowed by the bank on short term basis (such as overdraft facility) or
long term basis (debentures, mortgages or bank loans) has different interest rate.
These are factors that influence the level of market interest rates:
Expected levels of inflation:
Over time, as the cost of products and services increase, the value of money
decreases. Consumer will therefore have to spend more money for the same products or
services which had cost less in the previous year. As for finance lending sector,
borrowers may find it is attractive to borrow now but less attractive for lender. The value
of money now has fallen as compared to the time when they lent their money. In order to
compensate this loss, lenders have to increase the interest rate.
Demand and supply of money:
Demand and supply of money can affect interest rates. In United States, The
Federal Reserve Bank has taken a step to manipulate money supply through an open
market operation, by purchasing large volumes of government security to increase
money supply, thus reduce the interest rates, or sell large volumes of government
security to reduce money supply which will subsequently increase interest rates.
On the other hand, liquidity preference theory is linked to demand of money.
Developed by John Keynes, this theory explains how demand and supply for money
influence interest rates. It states that demand for liquidity is determined by transaction,
precaution and speculation motives.
Monetary policy and intervention by the government:
One of the governments strategies to control the flow of money within its
consumers is by monetary policy. People will avoid borrowing money when the interest
rates are high. This in turn will reduce the money outflow and affect the countrys
revenue as consumers will not be spending unless it is necessary. In order to stimulate
growth, government may offer lower interest rates on borrowing which subsequently
attracts consumer to spend more borrowing. As a result, when the growth rate increases
rapidly to the extent that economy may face overheat problem, the government then
have to curb this by imposing higher interest rates.
General economic conditions:
Economic condition may face series its booms and slumps. The world economy
has been on the slump side since the past five years with many business closures.
Banks are unable to provide loan at lower rate as they have to cover their cost.
Apart from the above, other factors such as political and financial stability and investors
demand for debt securities also affect interest rates. While increase in interest rates
32
helps consumer to save more, it is not good news for lenders and business as they lose
their revenue. Globally, this also adversely affects the world economy.
Determinants of market interest rates

The explanation of these determinants of interest rates is given as under:
Risk Free Interest Rate (kRF=k*+IP)
Risk free rate is one of the determinants of the interest rate. Risk free rate means
the rate of interest received if no risk is taken. Factually speaking, there is no such thing
as a risk-free rate of return because no investment can be entirely risk-free. All the
investments and securities include a certain amount of risk. A company may go bankrupt
or close down. However, if we talk about the relevant risk involved in different securities,
the government-issued securities are considered as risk-free, since the chances of
default of a government are minimal. These government issued securities provide a
benchmark for the determination of interest rates. Internationally the US T-Bills are
considered as risk free rate of return.
In Pakistan, Government of Pakistan T-Bills can be used as a proxy for risk free
rate of return, however, since Pakistan faces some sovereign risk, the T-bills would not
be considered entirely risk-free in the true sense.
Inflation (g):
The expected average inflation over the life of the investment or security is
usually inculcated in the nominal interest rate by the issuer of security to cover the
inflation risk. For instance, consider a bond with a maturity of 5 years. If the inflation rate
in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the investors
would not be willing to invest in the bond since the gains from the interest rate would be
exactly offset by the inflate ion rate which is actually eroding the wealth of the investor.
To secure the investor against inflation the issuers, while quoting nominal interest rates,
add the rate of inflation to the real interest rate.
Default Risk Premium (DR):
Default risk refers to the risk that the company might go bankrupt or close down
& bonds, or shares issued by the company may collapse. Default Risk Premium is
charged by the investor, as compensation, against the risk that the company might goes
bankrupt. Companies may also default on interest payments, something not very
unusual in the corporate world. In USA, rating agencies like
Moodys and S&P grade securities (debt and equity instruments) according to
their financial health and thus identify those companies which have a good ability to pay
off their principal lending and interest charges and those which might default on the
payments.
Maturity Risk Premium (MRP):
33
The maturity risk premium is linked to the life of that security. For example, if you
purchase the long term Federal Investment Bonds issued by the government of
Pakistan, you are assuming certain risk, because changes in the rates of inflation or
interest rates would depreciate the value of your investment. These changes are more
likely in the long term and less likely in the short term. Maturity risk Premium is linked to
life of the investment. The longer the maturity period, the higher the maturity risk
premium.
Sovereign Risk Premium (SR):
Sovereign Risk refers to the risk of government default on debt because of
political or economic turmoil, war, prolonged budget and trade deficits. This risk is also
linked to foreign exchange (F/x), depreciation, and devaluation. Now-a-days the
individuals as well as institutions are investing billions of rupees globally. If a bank wants
to invest in Pakistan, it will have to take view of Pakistans political, economic, and
financial environment. If the bank sees some risk involved it would be willing to lend at a
higher interest rate. The interest rate would be high since the bank would add sovereign
risk premium to the interest rate. Here it may be clarified that Pakistan is not considered
as risky as many other countries of Africa and South America.
Liquidity Preference (LP):
Investor psychology is such that they prefer easily encashable securities.
Moreover, they charge the borrower for forgoing their liquidity. A higher liquidity
preference would always push the interest rates upwards.
So summing up Quoted interest rate=k=k*+IP+DRP+LP+MRP
The above relation includes all the above factors.
The Term Structure of Interest Rates
The relationship between interest rates or bond yields and different terms or
maturities. The term structure of interest rates is also known as a yield curve and it plays
a central role in an economy. The term structure reflects expectations of market
participants about
future
changes in interest
rates and
their assessment of
monetary
policy conditions.
34
In general terms, yields increase in line with maturity, giving rise to an upward
sloping yield curve or a "normal yield curve." One basic explanation for this phenomenon
is that lenders demand higher interest rates for longer-term loans as compensation for
the greater risk associated with them, in comparison to short-term loans. Occasionally,
long-term yields may fall below short-term yields, creating an "inverted yield curve" that
is generally regarded as a harbinger of recession.
What determines the shape of the yield curve?

The yield curve, also known as the "term structure of interest rates," is a graph
that plots the yields of similar-quality bonds against their maturities, ranging from
shortest to longest. (Note that the chart does not plot coupon rates against a range of
maturities -- that's called a spot curve.)
How it works/Example:
The yield curve shows the various yields that are currently being offered
on bonds of different maturities. It enables investors at a quick glance to compare the
yields offered by short-term, medium-term and long-term bonds.
The yield curve can take three primary shapes. If short-term yields are lower than longterm yields (the line is sloping upwards), then the curve is referred to a positive (or
"normal") yield curve. Below you'll find an example of a normal yield curve:
If short-term yields are higher than long-term yields (the line is sloping downwards), then
the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an
example of an inverted yield curve:
35
Finally, a flat yield curve exists when there is little or no difference between short- and
long-term yields. Below you'll find an example of a flat yield curve:
It is important that only bonds of similar risk are plotted on the same yield curve.
The most common type of yield curve plots Treasury securities because they are
considered risk-free and are thus a benchmark for determining the yield on other types
of debt.
The shape of the yield curve changes over time. Investors who are able to predict how
the yield curve will change can invest accordingly and take advantage of the
corresponding change in bond prices.
Yield curves are calculated and published by The Wall Street Journal, the Federal
Reserve, and a variety of other financial institutions.
*End of Chapter*
36
Chapter # 06
Risk and Return
What is Risk?
The probability or threat of quantifiable damage, injury, liability, loss, or
any other negative occurrence that is caused by external or internal
vulnerabilities, and that may be avoided through preemptive action.
In Finance: The probability that an actual return on an investment will be
lower than the expected return. Financial risk can be divided into the following
categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk,
Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations
risk, Payment system risk, Political risk, Refinancing risk, risk, Settlement,
Sovereign risk, and Underwriting risk.
What Are the Different Types of Risk?

*Systematic Risk - Systematic risk influences a large number of assets. A
significant political event, for example, could affect several of the assets in your
portfolio. It is virtually impossible to protect yourself against this type of risk.
*Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific
risk". This kind of risk affects a very small number of assets. An example is news
that affects a specific stock such as a sudden strike by
employees. Diversification is the only way to protect you from unsystematic risk.
Now that we've determined the fundamental types of risk, let's look at
more specific types of risk, particularly when we talk about stocks and bonds.
Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This
type of risk is of particular concern to investors who hold bonds in their portfolios.
Country Risk - Country risk refers to the risk that a country won't be able to
honor its financial commitments. When a country defaults on its obligations, this
can harm the performance of all other financial instruments in that country as well
as other countries it has relations with. Country risk applies to stocks, bonds,
mutual funds, options and futures that are issued within a particular country.
Foreign-Exchange Risk - When investing in foreign countries you must consider
the fact that currency exchange rates can change the price of the asset as
37
well. Foreign-exchange risk applies to all financial instruments that are in a

currency other than your domestic currency.
Interest Rate Risk - Interest rate risk is the risk that an investment's value will
change as a result of a change in interest rates. This risk affects the value of
bonds more directly than stocks.
Political Risk - Political risk represents the financial risk that a country's
government will suddenly change its policies. This is a major reason why
developing countries lack foreign investment.
Market Risk - This is the most familiar of all risks. Also referred to as volatility,
market risk is the day-to-day fluctuation in a stock's price. Market risk applies
mainly to stocks and options. As a whole, stocks tend to perform well during a
bull market and poorly during a bear market - volatility is not so much a cause but
an effect of certain market forces.
Investment Return:
A performance measure used to evaluate the efficiency of an investment
or to compare the efficiency of a number of different investments. To calculate
ROI, the benefit (return) of an investment is divided by the cost of the investment;
the result is expressed as a percentage or a ratio.
The
rate of return on
an investment
can be
calculated as
follows:
In the above formula "gains from investment", refers to the proceeds

obtained from selling the investment of interest. Return on investment is a very
popular metric because of its versatility and simplicity. That is, if an investment
does not have a positive ROI, or if there are other opportunities with a higher
ROI, then the investment should be not be undertaken.
Return on investment, or ROI, is the most common profitability ratio. There are
several ways to determine ROI, but the most frequently used method is to divide
net profit by total assets. So if your net profit is $100,000 and your total assets
are $300,000, your ROI would be .33 or 33 percent.
Return on investment isn't necessarily the same as profit. ROI deals with
the money you invest in the company and the return you realize on that money
based on the net profit of the business. Profit, on the other hand, measures the
performance of the business. Don't confuse ROI with the return on the owner's
equity. This is an entirely different item as well. Only in sole proprietorships does
equity equal the total investment or assets of the business.
Stand Alone Risk

38
Standalone risk describes the danger associated with investing in a

particular instrument or investing in a particular division of a company. A typical
investment portfolio contains a wide array of instruments in which case investors
are exposed to a large number of risks and potential rewards. In contrast, a
standalone risk is one that can easily be distinguished from these other types of
risk.
When an investor only invests in one type of stock, then his or her entire
investment returns depend on the performance of that security. If the company
that issued the stock performs well then the stock will grow in value but if the firm
becomes insolvent then the stock may become worthless. Therefore, such an
investor is exposed to standalone risk because that individual's entire investment
could be lost due to the poor performance of a single asset.
Additionally, someone who invests in a wide array of securities is also
exposed to standalone risk if that individual holds each type of instrument in a
separate brokerage account. In such situations, the investor would not lose
everything if one asset dropped in value, but each holding account would expose
the investor to a different standalone risk since each account would only hold one
type of security.
Probability Distribution
A statistical function that describes all the possible values and likelihoods
that a random variable can take within a given range. This range will be between
the minimum and maximum statistically possible values, but where the possible
value is likely to be plotted on the probability distribution depends on a number of
factors, including the distributions mean, standard deviation, skewness and
kurtosis. Academics and fund managers alike may determine a particular stock's
probability distribution to determine the possible returns that the stock may yield
in the future. The stock's history of returns, which can be measured on any time
interval, will likely be comprised of only a fraction of the stock's returns, which will
subject the analysis to sampling error. By increasing the sample size, this error
can be dramatically reduced.
There are many different classifications of probability distributions, including the
chi square and normal and binomial distributions.
39
Expected Rate of Return:

Expected return is calculated as the weighted average of the likely profits
of the assets in the portfolio, weighted by the likely profits of each asset class.
Expected return is calculated by using the following formula:
Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+
wnRn
Example: Expected Return
For a simple portfolio of two mutual funds, one investing in stocks and the other
in bonds, if we expect the stock fund to return 10% and the bond fund to return
6% and our allocation is 50% to each asset class, we have the following:
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
Expected return is by no means a guaranteed rate of return. However, it can be
used to forecast the future value of a portfolio, and it also provides a guide from
which to measure actual returns.
Standard Deviation
Standard deviation can be defined in two ways:
1. A measure of the dispersion of a set of data from its mean. The more spread
apart the data, the higher the deviation. Standard deviation is calculated as the
square root of variance.
2. In finance, standard deviation is applied to the annual rate of return of an
40
investment to measure the investment's volatility. Standard deviation is also

known as volatility and is used by investors as a gauge for the amount of
expected volatility.
Standard deviation is a statistical measurement that sheds light on historical
volatility. For example, a volatile stock will have a high standard deviation while a
stable blue chip stock will have a lower standard deviation. A large dispersion
tells us how much the fund's return is deviating from the expected normal returns.
Example: Standard Deviation
Standard deviation () is found by taking the square root of variance:
(165)1/2 = 12.85%.
We used a two-asset portfolio to illustrate this principle, but most portfolios
contain far more than two assets. The formula for variance becomes more
complicated for multi-asset portfolios. All terms in a covariance matrix need to be
added to the calculation.
Risk aversion
Risk aversion is a concept in economics and finance, based on the
behavior of humans (especially consumers and investors) while exposed
to uncertainty to attempt to reduce that uncertainty.
Risk aversion is the reluctance of a person to accept a bargain with an
uncertain payoff rather than another bargain with more certain, but possibly
lower, expected payoff. For example, a risk-averse investor might choose to put
his or her money into a bank account with a low but guaranteed interest rate,
rather than into a stock that may have high expected returns, but also involves a
chance of losing value.
Example:
A person is given the choice between two scenarios, one with a
guaranteed payoff and one without. In the guaranteed scenario, the person
receives $50. In the uncertain scenario, a coin is flipped to decide whether the
person receives $100 or nothing. The expected payoff for both scenarios is $50,
meaning that an individual who was insensitive to risk would not care whether
they took the guaranteed payment or the gamble. However, individuals may have
different risk attitudes.
Risk in a Portfolio Context

Portfolio
A collection of investments all owned by the same individual
or organization. These investments often include stocks, which are investments
in individual businesses; bonds, which are investments in debt that are designed
to earn interest; and mutual funds, which are essentially pools of money from
many investors that are invested by professionals or according to indices.
41
A group of investments such as stocks, bonds and cash equivalents,

mutual funds, exchange-traded funds, and closed-end funds that are selected on
the basis of an investor's short-term or long-term investment goals. Portfolios are
held directly by investors and/or managed by financial professionals.
Portfolio Return
The monetary return experienced by a holder of a portfolio. Portfolio
returns can be calculated on a daily or long-term basis to serve as a method of
assessing a particular investment strategy. Dividends and capital appreciation
are the main components of portfolio returns.
Portfolio returns can be calculated through various methodologies such as
a time-weighted and money-weighted return. However, the overall return must be
compared to the required benchmarks and risk of the portfolio as well.
Calculation Portfolio Return:

To determine the expected return on a portfolio, the weighted average expected
return of the assets that comprise the portfolio is taken.
Formula 17.4
E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn
Example:
Assume an investment manager has created a portfolio with the Stock A and
Stock B. Stock A has an expected return of 20% and a weight of 30% in the
portfolio. Stock B has an expected return of 15% and a weight of 70%. What is
the expected return of the portfolio?
Answer:
E(R) = (0.30) (20%) + (0.70) (15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%
Portfolio Risk
Portfolio risk is the possibility that an investment portfolio may not achieve
its objectives. There are a number of factors that contribute to portfolio risk, and
while you are able to minimize them, you will never be able to fully eliminate
them.
Portfolio risk refers to the combined risk attached to all of the securities
within the investment portfolio of an individual. This risk is generally unavoidable
because there is a modicum of risk involved in any type of investment, even if it
is extremely small. Investors often try to minimize portfolio risk through
diversification, which involves purchasing many securities with different
characteristics in terms of potential risk and reward. There are some risks which
42
cannot be solved through diversification, and these risks, known as market risks,
can only be lessened by hedging with contrasting investments.
Calculating Beta Coefficient

A measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole. Beta is used in the capital asset pricing
model (CAPM), a model that calculates the expected return of an asset based on
its beta and expected market returns.
Also known as "beta coefficient."
Beta coefficient is a measure of sensitivity of a share price to movement in
the market price. It measures systematic risk which is the risk inherent in the
whole financial system. Beta coefficient is an important input in capital asset
pricing model to calculate required rate of return on a stock. It is the slope of the
security market line.
Formula
Beta coefficient is calculated as covariance of a stock's return with market
returns divided by variance of market return. A slight modification helps in
building another key relationship which tells that beta coefficient equals
correlation coefficient multiplied by standard deviation of stock returns divided by
standard deviation of market returns. Beta coefficient is given by the following
formulas:
=
Covariance of Market Return with Stock Return

Variance of Market Return
Standard Deviation of Stock Returns

= Correlation Coefficient
Between Market and Stock Standard Deviation of Market Returns
The Relationship between Risk and Rate of Return

There are two primary concerns for all investors: the rate of return they
can expect on their investments and the risk involved with that investment. While
investors would love to have an investment that is both low risk and high return,
the general rule is that there is a more or less direct trade-off between financial
risk and financial return. This does not suggest that there is some perfect linear
relationship between risk and return, but merely that the investments that
promise the greatest returns are generally the riskiest.
Low levels of uncertainty (low risk) are associated with low potential
returns. High levels of uncertainty (high risk) are associated with high potential
returns. The risk/return tradeoff is the balance between the desire for the lowest
possible risk and the highest possible return. This is demonstrated graphically in
the chart below. A higher standard deviation means a higher risk and higher
possible return.
43
A common misconception is that higher risk equals greater return. The risk/return
tradeoff tells us that the higher risk gives us the possibility of higher returns.
There are no guarantees. Just as risk means higher potential returns, it also
means higher potential losses.
Physical assets verses securities

An item of economic, commercial or exchange value that has a tangible or
material existence. For most businesses, physical assets usually refer to cash,
equipment, inventory and properties owned by the business. Physical assets are
the opposite of intangible assets, which are non-physical assets such as leases,
computer programs or agreements.
A financial instrument that represents: an ownership position in a publiclytraded corporation (stock), a creditor relationship with governmental body or a
corporation (bond), or rights to ownership as represented by an option. A security
is a fungible, negotiable financial instrument that represents some type of
financial value. The company or entity that issues the security is known as the
issuer.
Securities are typically divided into debt securities and equities. A debt
security is a type of security that represents money that is borrowed that must be
repaid, with terms that define the amount borrowed, interest rate and
maturity/renewal date. Debt securities include government and corporate bonds,
certificates of deposit (CDs), preferred stock and collateralized securities (such
as CDOs and CMOs).
Capital Asset Pricing Model (CAPM)

The capital asset pricing model provides a formula that calculates the
expected return on a security based on its level of risk. The formula for the
capital asset pricing model is the risk free rate plus beta times the difference of
the return on the market and the risk free rate.
44
Risk and the Capital Asset Pricing Model Formula

To understand the capital asset pricing model, there must be an
understanding of the risk on an investment. Individual securities carry a risk of
depreciation which is a loss of investment to the investor. Some securities have
more risk than others and with additional risk; an investor expects to realize a
higher return on their investment.
For example, assume that an individual has $100 and two acquaintances
would like to borrow the $100 and both are offering a 5% return ($105) after 1
year. The obvious choice would be to lend to the individual who is more likely to
pay, i.e., carries less risk of default. The same concept can be applied to the risk
involved with securities.
What is Beta?
In finance, the beta () of an investment is a measure of the risk arising
from exposure to general market movements as opposed to idiosyncratic factors.
The market portfolio of all investable assets has a beta of exactly 1. A beta below
1 can indicate either an investment with lower volatility than the market, or a
volatile investment whose price movements are not highly correlated with the
market. An example of the first is a treasury bill; the price does not go up or down
a lot, so it has a low beta. An example of the second is gold. The price of gold
does go up and down a lot, but not in the same direction or at the same time as
the market.
A measure of a security's or portfolio's volatility. A beta of 1 means that
the security or portfolio is neither more nor less volatile or risky than the wider
market. A beta of more than 1 indicates greater volatility and a beta of less than 1
indicates less. Beta is an important component of the Capital Asset Pricing
Model, which attempts to use volatility and risk to estimate expected returns
Volatility Verses Risk

Risk:
-Risk exposure to the chance of injury or loss; a hazard or dangerous chance.
The degree of probability of such loss.
-If you are worried about the risk level of a certain investment, you are worried
about the potential permanent loss of your money.
45
-Risk is based on the actual fundamentals of a company or country
Volatility:
Tending to fluctuate sharply and regularly.
-The volatility of a stock or bond does not necessarily have to equate with its risk.
-The more volatile stock goes up and down much more violently. But it makes
billions of dollars every year, and has billions of dollars of cash on hand to
weather hard economic times.
-If the less volatile stock has never made a profit, has declining sales and will be
forced to take on more debt to pay its short term liabilities, is it really Less risky
as the volatility implies?
-Volatility simply refers to the price action. Usually this is expressed in terms of a
stocks Beta
-A securitys volatility matters if the money is needed immediately because you
may be forced to sell and take a loss when the security has only temporarily
declined.
Conclusion
-There is an important difference between an investments volatility and its risk.
-An investments volatility should be a concern to investors if the money is
needed in the immediate future. But just because an investment is more volatile
does not necessarily mean it is more risky in the long term. As an investments
time horizon gets longer, the effect of volatility is reduced greatly.
-The stock market as a whole is much more volatile than a bank CD, but that
does not mean savers should bypass any investment in the stock market
altogether. Instead, it means that investors should know the potential for short
term volatility to affect the value of their investments and plan accordingly.
End of Chapter
46
Chapter #08
COST OF CAPITAL
Introduction
Assets of the firm re financed by three major fixed sources of funds, these fixed
sources of finance are called capital of the firm. These are
1. Debt
2. Preferred stock
3. Common stock
The investors who have provided these funds demand some return on these
funds. This required return is basically the cost of capital for that company. This return
depends on the riskiness of the security.
The cost of these different capitals and also the combine weighted average cost of
capital (WACC) are now discussed in detail.
Cost of Debt
Debt is the major source of finance for a company. Company normally acquires
debt by issuing bonds, and pay interest on bonds they issue. The first step for
calculating the cost of debt is to determine what rate of return bond holders demand (rd),
which is basically the interest rate on that bond. Here we will use the current market rate
of interest instead of coupon rate of interest. For example market rate of interest is 12%.
If there are no taxes on a company we can say that this rd is the cost of debt. But this
interest paid on debt is a deductable expense from profits so this interest reduces the
profits and hence reduces the tax liability as well. Hence the real cost of debt is not the
interest but it is lesser than the interest expense up to the saving in taxes. So the actual
cost of debt is the interest rate less tax savings.
Mathematically
After tax cost of debt = Interest Tax savings
= rd - rdT
(Where T is the corporate tax rate)
= rd (1-T)
For example if rd = 12% and Tax rate is 40% then
After tax cost of debt = 12 %( 1- .4)
= 7.2%
So after tax cost of capital is 7.2%
Cost of Preferred stock

Preferred stock is that which are preferred in payment of dividend. Some
preferred stock is issued without stated maturity, but most of the preferred stock has a
finite maturity. It should be noted that preferred stock dividend is not a deductible
expense and hence the issuer bears the full cost of dividend without any tax adjustment.
47
The component cost of preferred stock rps is the cost used for calculating the weighted
average cost of capital. For proffered stock having stated maturity the method used is
same as used for bonds, but without considering the effect of taxes. For bonds having
no specific maturity eps so calculated as
rps = Dps/Pps(1-f)
Where D is the dividend per share, P is the price per share and f is the floatation cost.
Floatation cost is recorded in percentage of the amount realized on issue of preference
shares and it is basically the cost incurred on issuing these preference shares.
For example if dividend per share is 12, and price per share is 90 and floatation cost is
4%of the amount realized. By putting the values in the above equation we find that.
rps
=12/90(1-04)
=12/86.4
=13.89%
Cost of Common equity

A firm can raise common stock by either issuing new shares or retaining the
profits and reinventing them the in the business. For issuing new shares the company
must incur floatation cost in shape of brokerage and commission etc. Here in this part of
discussion we will ignore floatation cost by assuming rising of equity by retaining the
profit.
The cost of capital is the expectation of share holders from the investment they
have made in a specific company. Their expectations are based on several aspects of
the company. In which the most important is the amount of risk they are taking in
investing in that company. Besides risk the cost of equity also depends on the market
risk premium, the annual dividend they are announcing, the annual growth of the
company. Overall market situation etc
There are three different methods for calculating the cost of capital. These are as
following.
The Capital Asset Pricing Model Approach

The Capital Asset Pricing Model (CAPM) is a model which describes the
relationship between risk and required rates of return. The main concept behind CAPM
is an investors required rate of return greatly depends on the risk he is taking by holding
that security along with the risk free rate. The overall model of CAPM is as under.
rs = rRF + (RPm)b
Or
rs = rRF + (rm-rRF)b
(Where re is required rate of return on equity, rRF is the risk free rate; RPm is the market
risk premium)
To understand the required return on equity using CAPM individual elements of this
model are now discussed
the first step for calculating cost of equity is to calculate the risk free rate. Risk
free rate is that rate of return which is earned on such type of securities which have
relatively zero risk. Practically there are no such securities which are completely free
from risk. But here we will take the rate of treasury securities s the risk free rate. We will
48
take the rate of return on T-bonds instead of T-bills because T-bonds are long term
securities and have relatively no fluctuation in their interest rates. So the risk free rate
will be the rate of interest on T-bonds.
The 2nd is to calculate the market risk premium. It is calculated by subtracting

the risk free return from the market return. Market risk premium is the excess return over
the risk free return, which an investor can earn on an average security. Market return
can be calculated using the average return of the historical data, or can also be
calculated by forward looking approach using the discounted cash flow model.
Third step for calculating return on equity is to calculate beta. Beta measures the
relevant risk of an individual security compared to the market portfolio. More risky a
business greater will be its beta and it will increase the market risk premium accordingly.
The above discussion can be summarized that the cost of equity (rs) under the CAPM
approach depends on three main factors, risk free rate, market risk premium and beta.
Greater these items are greater will be the cost of equity.
Dividend Yield Plus Growth Rate, or Discounted Cash Flow

approach
Cost of equity can also be calculated using the dividend yield plus growth
approach. Under this method return on equity (rs) is calculating by discounting the future
dividends. Equation is derived by rearranging the equation of calculating the price per
share. The basic equation is
Po = Di/ (rs - g)
By rearranging the above equation for re we get
rs = (Di / po )+ g
Where Di is the dividend per share, po is the market price per share and g is the growth
rate of the expected dividend, or the capital gain on securities.
Dividend per share and price per share are simple and normally they are known. We will
have to find the expected growth on shares. There are three methods for calculating
growth on shares these are discussed below.
Using historical growth data. The future growth for an individual security can be
calculated by finding the growth pattern of the previous years. For this purpose an
average is calculated for all the growth rates of previous years with an expectation that
dividend will grow at the same rate for the coming year as well
2nd approaches for calculating growth are from the retention ratio. Normally if a
company retains their profits it increases the book value of the shares of the firm, which
causes the market value of shares to rise and hence a company earns capital. So we
can predict growth of the company using the retention ratio.
Mathematically
g = (Retention rate) (ROE)
g = (1 - payout rate) (ROE)
g = (1 0.65) (15%) = 5.25%.
3rd approaches for calculating growth are the analysts forecast.
49
Bond Yield plus Risk Premium Approach

Some analyst estimates the cost of equity by subjective procedure. They add a
specific judgmental risk premium with the interest rate of the firm own long term debt.
This interest premium ranges from 3 to 5 percent based on judgment of the analyst.
Mathematically
rs =
Bond yield + Bond risk premium
This method is very subjective but still it gives near to accurate answer
Adjusting the Cost of debt for floatation Cost

Floatation cost is the cost of incurred for issuing new shares. These costs may
be brokerage commission taxes etc. in previous methods of calculating cost of equity it
was assumed that equity is raised by reinvesting the profits of the company, hence no
floatation cost was taken into consideration. But if we issue new shares floatation cost
must be taken into consideration. And rs will become re and the equation will become as
re = [Di / Po(1-F)] + g
Where F is the percentage floatation cost
Weighted Average Cost of Capital

Weighted average cost of capital is the combine or composite cost of the total
capital of the firm. Which include debt, preferred stock and common stock it is the
weighted average of all the costs of individual capitals? Weight is the percentage
proportion of any component of the capital. Greater the amount of an individual capital,
greater weight will be assigned to that capital component. These percentage proportions
of capital (weights) are based on the target or optimal capital of the management.
Optimum capital is that mix of debt, preferred stock and common stock which causes the
company stock prices to be maximized by earning more income and taking low risk.
WACC = (Cost of debt) (Weight of debt) + (Cost of of preferred stock)(Weight of
preferred stock) + (Cost of equity)(weight of equity)
WACC = wdrd(1 - T) + wpsrps + wcers
Suppose the stock price is $150 million of common stock, $25 million of preferred stock,
and $75 million of debt. Hence the total capital of the firm is 250 million
First we calculate the individual weights of the components of the capital, as following
wce = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
Then calculate the individual cost of capital and put them in the equation of WACC
WACC = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
WACC = 1.8% + 0.9% + 8.4% = 11.1%.
Factors effecting WACC

WACC is affected by a number of factors some of them can be controlled by the
firm and some cannot be controlled by the firm.
50
Factors the firm cannot control

Three most important factors which are beyond the control of the firm re
The level of interest rates affects the overall cost of capital directly. An increase in
interest rate also increases the cost of capital. It affects cost of debt directly as a
company must issue new bonds at higher rate if there is increase in market rate of
interest. it also increases cost of equity because of increase in risk free rate.
Market risk premium higher market risk premium rises the cost of equity, and hence
the overall WACC
Tax rate If tax rates increases it will decrease the cost of debt. As interest is a
deductable expense and reduces the tax liability. So there is an inverse relationship
between tax rates and WACC.
Factors the firm can control

Capital structure policy Every component of the capital has different cost, and if their
ratio is changed it will automatically change the overall cost of capital (WACC)
Dividend Policy If a company retains greater portion of its profits and reinvest it in the
same business, it will keep increasing its equity and hence will change its capital
structure and automatically WACC
Investment policy if a company invest the new capital in similar assets having the same
risk the risk premium and beta will not change hence the cost of capital will not change
but if the firm changes its investment policy and invest in different assets the risk level
will change and the required rate of return will also change accordingly. And hence
WACC will change
*End Of Chapter*
51
Chapter #09
Corporate Valuation and value based
Management
Corporate Valuation an Overview:
Valuation means the process of determining the value of
an asset or company. Corporate valuation is the process of determining the
worth of a firm. In order to evaluate new projects, consider mergers and
acquisitions, or make strategic decisions, the financial analyst must understand
the factors that drive corporate value. Since public companies are valued in the
context of the broader stock market, it will be necessary to examine both internal
and external factors that determine prices in the context of the global economy.
Business Valuation:
The process of determining the economic value of a business or company.
Business valuation can be used to determine the fair value of a business for a
variety of reasons, including sale value, establishing partner ownership and
divorce proceedings. Often times, owners will turn to professional business
valuators for an objective estimate of the business value.
In finance, valuation is the process of estimating what something is worth.
Items that are usually valued are a financial asset or liability. Valuations can be
done on assets (for example, investments in marketable securities such as
stocks, options, business enterprises, or intangible assets such as patents and
trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are
needed for many reasons such as investment analysis, capital budgeting, merger
and acquisition transactions, financial reporting, taxable events to determine the
proper tax liability, and in litigation.
Business Valuation Methods

OR
The Corporate Valuation Model
Following methods are used for the Valuation of Business
Asset Based approaches
The asset, or cost, approach considers the value of a business to be
equivalent to the sum of its parts; or the replacement costs for this business.
This is an objective view of a business. It can be effective in quantifying the fair
market value of an entity's tangible assets, as it adjusts for the replacement costs
of existing, potentially deteriorating, assets.
Income Based approaches
52
The income approach identifies the fair market value of a business by

measuring the current value of projected future cash flows generated by the
business in question. It is derived by multiplying cash flow of the company times
an appropriate discount rate. In contrast the asset based approaches, which are
very objective; the income based approaches require the valuator to make
subjective decisions about discount rates or capitalization. Many considerations
and variables are measured to account for the specific contribution of primary
value drivers in a business that result in influencing cash flow: revenue drivers,
expense drivers, capital investment, etc. This method, which comes in several
approaches, is useful as it identifies fundamental factors driving the value of a
business.
Market Comparison Based approaches
The Market Comparison approach to a business valuation is based upon
current conditions amongst active business buyers, recent buy-sell transactions,
and other fairly comparable business entities. Financial attributes of these
comparable companies and the prices at which they have transferred can serve
as strong indicators of fair market value of the subject company
Value Based Management

Value based management is a structured approach to measure the
performance of a firm's section managers or products in terms of the total
advantage they provide to shareholders. This is usually the utilization of
shareholder value added metrics.
Value based management focusing on creating wealth for shareholders.
(VBM) can help managers make decisions in the context of the financial
objectives of the company and the expectations of the shareholders. Managers
need to have an understanding of their key value drivers, which can be intangible
assets, the financial structure, asset turns and working capital. Each requires a
different type of focus and management attention.
SAS software can be used to enhance the effectiveness of a VBM
implementation by providing better analysis and predictive capabilities and aiding
communication within the company and with external parties. SAS software can
be used to implement VBM in the following ways:
Strategy mapping: business drivers that affect shareholder value can be
mapped to show the links between each and what can be done to improve them.
Alignment: ensure the goals cascaded throughout the organization are in line
with the overall corporate objectives, and that there is top to bottom alignment of
activities.
Internal communication: the strategic vision and long term corporate goals can
be shared with all employees through the Web. Performance reporting can be
updated automatically and delivered to the desktop.
53
Measurements: measures can be summed and amalgamated, target and actual

data can be collected and reported automatically, and early indicators of variance
can be displayed. Appropriate VBM drivers can be linked to each metric.
Investor communication: disclosure of relevant information, the goal being to
avoid unnecessary surprises and minimize the uncertainty. Top level views can
give management an overall view of VBM performance.
Continuous improvement: highlight key areas that need improvement through
drill down and analysis, correlation of drivers with outcomes and personalized
information portals.
Corporate Governance and shareholders wealth

Corporate Governance is "the system by which an organization is directed
and controlled." In particular, corporate governance is concerned with the
potential abuse of power and the need for openness, integrity and accountability
in corporate decision making. The main objective of the firm is always to
maximize shareholders wealth. The major decisions that have an influence on
shareholder wealth maximization are investment, financing and dividend
decisions. This study was carried out to clearly show the extent to which
corporate governance contributes to shareholder wealth maximization. It
delineates the role, duties and obligations of all Board of Directors and therefore
helps avoid agency conflicts. The researcher looked at the various variables of
corporate governance i.e. the Board composition, Number of Board meetings,
attributes of board members and directors' remuneration strategy and showed
the extent to which they contribute towards shareholder wealth maximization.
End of Chapter
Chapter #10
Capital Structure Decisions
Capital Structure
A mix of a company's long-term debt, specific short-term debt, common equity
and preferred equity. The capital structure is how a firm finances its overall
operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings. Short-
54
term debt such as working capital requirements is also considered to be part of

the capital structure.
Target or optimal Capital Structure

The target (optimal) capital structure is simply defined as the mix of debt,
preferred stock and common equity that will optimize the company's stock price.
As a company raises new capital it will focus on maintaining this target (optimal)
capital structure.
The optimal capital structure indicates the best debt-to-equity ratio for a
firm that maximizes its value. Putting it simple, the optimal capital structure for a
company is the one which proffers a balance between the idyllic debt-to-equity
ranges thus minimizing the firms cost of capital. Theoretically, debt financing
usually proffers the lowest cost of capital because of its tax deductibility.
However, it is seldom the optimal structure for as debt increases, it increases the
companys risk.
There are numerous ways in which a companys optimal capital structure can be
estimated. The most commonly used ones are:
Method 1
One method of estimating a companys optimal capital structure is utilizing the
average or median capital structure of the principle companies engaged in the
market approach. This approach is helpful as the appraiser is well aware about
which companies are included in the analysis and the degree to which they are
related to the subject company. However, this method features a limitation that
fluctuations in market prices and the spread out nature of debt offerings and
retirements might cause the actual capital structure of a principle company to be
significantly different from the target capital structure.
Method 2
This method is applied if the risk of a company did not change because of
the nature of its capital structure, and a company would wish as much debt as
possible, as the interest payments are tax deductible and debt financing is
always cheaper than equity financing. The main objective of this method is
determining the debt level at which the benefits of increased debt does not
overshadow the increased risks and potential costs associated with an
economically distressed company.
Business and Financial Risk

1-Business Risk
A company's business risk is the risk of the firm's assets when no debt is used.
Business risk is the risk inherent in the company's operations. As a result, there
are many factors that can affect business risk: the more volatile these factors, the
riskier the company. Some of those factors are as follows:
Sales risk - Sales risk is affected by demand for the company's product as well
as the price per unit of the product.
55
Input-cost risk - Input-cost risk is the volatility of the inputs into a company's
product as well as the company's ability to change pricing if input costs change .
As an example, let's compare a utility company with a retail apparel
company. A utility company generally has more stability in earnings. The
company has less risk in its business given its stable revenue stream. However,
a retail apparel company has the potential for a bit more variability in its earnings.
Since the sales of a retail apparel company are driven primarily by trends in the
fashion industry, the business risk of a retail apparel company is much higher.
Thus, a retail apparel company would have a lower optimal debt ratio so that
investors feel comfortable with the company's ability to meet its responsibilities
with the capital structure in both good times and bad.
2-Financial Risk:
A company's financial risk, however, takes into account a company's leverage. If
a company has a high amount of leverage, the financial risk to stockholders is
high - meaning if a company cannot cover its debt and enters bankruptcy, the
risk to stockholders not getting satisfied monetarily is high.
Capital Structure Theory-The Modigliani-Miller Models

The ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) is a
theorem on capital structure, debatably forming the basis for modern thinking
on capital structure. The basic theorem states that, under a certain market price
process (the classical random walk), in the absence of taxes, bankruptcy costs,
agency costs, and asymmetric information, and in an efficient, the value of a firm
is unaffected by how that firm is financed.[1] It does not matter if the firm's capital
is raised by issuing stock or selling debt. It does not matter what the
firm's dividend policy is. Therefore, the ModiglianiMiller theorem is also often
called the capital structure irrelevance principle.
Assumptions Required for Modigliani-Miller Theorems
1. Control aspects of shares ignored.
2. Shareholders can lend and borrow at the same interest rate as rms.
3. No bankruptcy.
4. Tax ignored
Checklist for Capital Structure Decisions:
Debt ratios of other firms in the industry.

Lender and rating agency attitudes
(impact on bond ratings).
Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible and hence suitable as collateral?
Tax rates.
56
Chapter #11
Distribution to Shareholders: Dividends and
Repurchase
Dividend vs. Capital Gain
Capital gains and dividends are both financial gains available to investors
of stock. Capital gains can be obtained, not just by selling shares, but also
through the sale of other capital assets such as property, plant, equipment,
machinery that is held for a longer period of time. Dividends, however, are only
obtained by investing in stock and are paid to shareholders at different intervals
depending on the amount of revenue generated and the types of shares held by
shareholders. The tax rate for capital gains will be higher than tax applied for
dividends.
Dividends Versus Capital Gains: What Do Investors Prefer?
When deciding how much cash to distribute to stockholders, financial
managers must keep in mind that the firms objective is to maximize shareholder
value. Consequently, the target payout ratio-defined as the percentage of net
income to be paid out as cash dividends should be based in large part on
investors, preferences for dividends versus capital gains: do investors prefer (1)
to have the firm distribute income as cash dividends or (2) to have it either
repurchase stock or else plow the earnings back into the business, both of which
should result in capital gains? This preference can be considered in terms of the
constant growth stock valuation model:
D1
P0 = ------------Ks - g
If the company increases the payout ratio, it raises D1. This increase in the
numerator, taken alone, would cause the stock price to rise. However, if D1 is
raised, then less money will be available for reinvestment, that will cause the
expected growth rate to decline, and that would tend to lower the stocks price.
Thus any change in payout policy will have two opposing effects. Therefore, the
firms optimal dividend policy must strike a balance between current dividends
and future growth so as to maximize the stock price.
Dividends are irrelevant
In Miller and Modiglianis (MM) world with no taxes, no transaction costs, and
homogeneous information, dividend policy does not affect the value of the
company.
57
The decision of how a company finances its business is separate

from the decision of what and how much to invest in capital
projects.
- If an investor wants cash flow, he/she could sell some shares.
- If an investor wants more risk, he/she could borrow to invest.
- An investor is indifferent about a share repurchase or a dividend.
Bottom line: Dividend policy does not affect a firms value
Dividend Policy Issues
Clientele Effect: Investors needing current income will be drawn to firms
with high payout ratios. Investors preferring to avoid taxes will be drawn to
firms with lower payout ratios. (i.e., firms draw a given clientele, given their
stated dividend policy). Therefore, firms should avoid making drastic
changes in their dividend policy.
Information Content: Changes in dividend policy may be signals
concerning the firms financial condition. A dividend increase may signal
good future earnings. A dividend decrease may signal poor future earnings.
Dividend Stability:
According to this policy, the percentage of earnings paid out as dividends remain
constant irrespective of the level of earnings. Thus, as earnings of a company
fluctuate, dividends paid by it also fluctuate accordingly. The following figure
shows the behavior of dividends in case this policy is adopted
Most of the firms follow stable dividends or gradually increasing dividends due to
following reasons
Many investors consider dividends as a part of regular income to meet

their expenses. Hence, they prefer a predictable pattern of dividends
rather fluctuating pattern. A fall in the dividend income may lead to sale of
some shares, on the other hand when the dividend income increases, an
investor may invest some of the proceeds as reinvestment in shares. Both
58
the cases involve transaction cost and inconvenience for investor. They
prefer regular dividends.
The dividend policy of firms conveys a lot to the investors. Increasing
dividends mean better prospects of the company. On the contrary,
decreasing dividends suggest bad earnings expectations. In addition,
stable dividends are signs of stable earnings of the company. On the other
hand, varying dividends lead to uncertainty in the mind of shareholders.
Certain investors mainly institutional consider the stability of dividends as
an important criterion before they decide on the investment in that
particular firm.
Establishing a dividend policy in Practice:

Dividend policy refers to the policy which is used as a guide when a firm
makes dividend decisions. It assists the board of directors in establishing how
much should be paid to shareholders in dividends.
Dividend policy should be established in such a way that it provides for adequate
financing for the firm. Dividend policy must also be aligned with the main
objective of the firm which is to maximize shareholders wealth.
Investors tend to prefer stable increasing dividends as opposed to fluctuating
dividends.
Factors which affect dividend policy
There are number of external and internal factors which affect dividend policy.
External factors which affect dividend policy
Contractual constraints refer to restrictive provisions in a loan agreement and
may include dollar or percentage of earnings limit on dividends and an inability to
make dividend payments until certain levels of earnings is reached.
Legal constraints - this type of constraints depends on the location of the firm.
Usually, due to legal constraints, firms are not able to pay out any dividends if the
firm has any overdue liabilities or if it is bankrupt.
Market reactions a firm needs to consider how markets will react to its dividend
decisions. For example, if dividends are not paid or decreasing then markets will see it
as a negative signal and the stock price will likely to drop. This will decrease
shareholders wealth. If dividends are paid out consistently or even increasing in
amounts, this can be seen as a positive signal by the market participants and stock
price will likely to increase. This will increase shareholders wealth.

Current and expected state of the economy If state of the economy is
uncertain or heading downward than it may be wise for management to pay
59
smaller or no dividends to prepare a safety reserve for the company which can
help to deal with future negative economic conditions.
Internal factors which affect dividend policy
Financing needs of the firm Mature firms usually have better access to
external financing. Therefore, they are more likely to pay out a large portion of
earnings in dividends. If a company is young and rapidly growing than it will likely
be unable to pay a large portion of earnings in dividends as it will require retained
earnings to finance acceptable projects and its access to external financing is
likely to be limited.
Preference of the shareholders a firm should consider the needs and
interests of the majority of its shareholders when making dividend decisions. For
example, if shareholders will be able to earn higher returns by investing
individually then what firm can earn by reinvesting funds than a higher dividend
payment should be considered.
Stability of earnings If earnings of the company are not stable from period to
period than it is wise to follow conservative payments of dividends.
Earnings requirement this constraint is imposed by the firm. It consists of a
firm not being able to pay out in dividends more than the sum of the current and
the most recent past retained earnings. However, the firm still can pay out
dividends even if it incurred losses in the current financial period.
Dividend reinvestment plan (DRIP):

Dividend Reinvestment Plans (Also known as Dividend Reinvestment
Programs or DRIPs) are a great tool for long-term investors. The compounding
interest of DRIPs allows investors to purchase additional shares of stock at no
cost -- simply reinvest the dividends, and when enough money is accrued,
additional shares are automatically purchased.
How dividend reinvestment plans does (DRIPs) work?

When an investor enrolls in a dividend reinvestment plan, he will no longer
receive dividends in the mail or directly deposited into his brokerage account.
Instead, those dividends will be used to purchase additional shares of stock in
the company that paid the dividend.
What are the benefits of dividend reinvestment plans?

Enrolling in a DRIP is fairly easy. Cash dividends paid by the company are
automatically reinvested into additional shares. Once the investor has enrolled in
60
a DRIP, the process becomes entirely automated and usually requires minimal
attention or monitoring.
Many dividend reinvestment plans are often part of a direct stock
purchase plan. If the investor holds at least one of his shares directly, he can
have his checking or savings account automatically debited on a regular basis to
purchase additional shares of stock, usually at no cost to the buyer.
The Fee to purchase through dividend reinvestment programs is normally
small, if any. Dividend reinvestment plans also allow the investor to purchase
fractional shares. Over decades, this can result in significantly more wealth in the
investor's hands.
Stock Dividends and Stock Splits

Like cash dividends, stock dividends and stock splits also have effects on
a company's stock price. Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a
company pays out stock. As a result, a company's shares outstanding will
increase, and the company's stock price will decrease. For example, suppose
New.co decides to issue a 10% stock dividend. Each current stockholder will thus
have 10% more shares after the dividend is issued.
Stock Splits
Stock splits occur when a company perceives that its stock price may be
too high. Stock splits are usually done to increase the liquidity of the stock (more
shares outstanding) and to make it more affordable for investors to buy regular
lots (a regular lot = 100 shares). Companies tend to want to keep their stock
price within an optimal trading range.
Stock splits increase the number of shares outstanding and reduce the par
or stated value per share of the company's stock.
Stock Repurchase:
A program by which a company buys back its own shares from the
marketplace, reducing the number of outstanding shares. Share repurchase is
usually an indication that the company's management thinks the shares are
undervalued. The company can buy shares directly from the market or offer its
shareholder the option to tender their shares directly to the company at a fixed
price.
Because a share repurchase reduces the number of shares outstanding
(i.e. supply), it increases earnings per share and tends to elevate the market
value of the remaining shares. When a company does repurchase shares, it will
61
usually say something along the lines of, "We find no better investment than our
own company."
End of Chapter
62
Chapter #12
Initial Public Offering, Investment
Banking and Financial Restructuring
What is Initial Public Offering IPO?
The first sale of stock by a private company to the public. IPOs are often
issued by smaller, younger companies seeking the capital to expand, but can
also be done by large privately owned companies looking to become publicly
traded.
In an IPO, the issuer obtains the assistance of an underwriting firm, which
helps it determine what type of security to issue (common or preferred), the best
offering price and the time to bring it to market.
IPOs can be a risky investment. For the individual investor, it is tough to
predict what the stock will do on its initial day of trading and in the near future
because there is often little historical data with which to analyze the company.
Also, most IPOs are of companies going through a transitory growth period,
which are subject to additional uncertainty regarding their future values.
Financing Life Cycle of a Startup Company
Financial Life Cycle A life cycle is a series of stages in which an individual
passes during his or her lifetime.
In the first stage, a new company's external financing needs (EFN) are high,
since it needs money to develop its idea but lacks retained earnings. They are
usually financed through debt, but may find investors who are willing to take
on risk if projected growth is high.
In the growth stage, a firm's initial EFN is high relative to its current value; it
needs significant funds for growth. It can be financed through venture capital or
issuing equity.
Growth eventually slows and the firm enters the mature stage. These firms can
be financed by equity or debt. If they have no new projects, EFN is relatively
low.
The firm may go into decline as their product becomes obsolete or a
competitor outperforms them. In this case, they have very low external
financing needs.
63
The decision to Go Public

The decision to take a company public is one of the most important that a
CFO is involved in. Some companies are founded on the assumption that they
will go public as soon as possible. It is important to ensure that the decision to go
public is made after full consideration of the challenges involved. The more
consideration that goes into the decision, the better prepared the company will be
to deal with the rigors of the going public process itself and the responsibilities of
life as a public company. It is therefore vital that the CFO, in consultation with the
CEO, the board, and other major stakeholders such as owners and investors,
has addressed the following questions when making the decision to go public:
What factors must be considered in making the decision to go public?
What must the company have in place prior to going public?
What will life be like as a public company?
Advantages of Going Public:

Going public and offering stock in an initial public offering represents a milestone
for most privately owned companies. A large number of reasons exist for a
company to decide to go public, such as obtaining financing outside of the
banking system or reducing debt.
Furthermore, taking a company public reduces the overall cost of capital and
gives the company a more solid standing when negotiating interest rates with
banks. This would reduce interest costs on existing debt the company might
have.
The main reason companies decide to go public, however, is to raise money a
lot of money and spread the risk of ownership among a large group of
shareholders. Spreading the risk of ownership is especially important when a
company grows, with the original shareholders wanting to cash in some of their
profits while still retaining a percentage of the company.
Being able to raise additional funds through the issuance of more stock
Companies can offer securities in the acquisition of other companies
Stock and stock options programs can be offered to potential employees,
making the company attractive to top talent
Companies have additional leverage when obtaining loans from financial
institutions
Market exposure having a companys stock listed on an exchange could
attract the attention of mutual and hedge funds, market makers and
institutional traders
Indirect advertising the filing and registration fee for most major
exchanges includes a form of complimentary advertising. The companys
stock will be associated with the exchange their stock is traded on
Brand equity having a listing on a stock exchange also affords the
company increased credibility with the public, having the company
indirectly endorsed through having their stock traded on the exchange.
64
Disadvantages of Going Public:

While going public allows the corporation to raise large amounts of money from
stock market investors, it also involves a number of disadvantages that makes
the decision one of the most important choices a private corporation can make.
Expense
Going public is an expensive, time-consuming process. A corporation must put
its affairs in order and prepare reports and disclosures to comply with Securities
and Exchange Commission. You will have to hire specialists to take the company
through the process, including attorneys, accountants and underwriters.
Equity Dilution
Going public is the process of selling ownership of a part of your company to
strangers. Every bit of ownership that you sell comes out of a current owner's
equity position. It is not always possible to raise the amount of money that you
may need to operate a public corporation and still keep at least 51 percent of the
company's ownership in your own hands.
Loss of Management Control
Once your corporation goes public, management becomes more complicated.
You can no longer make decisions autonomously. Even if you are a majority
shareholder, the minority shareholders have a say in how the company is
managed. Also, you will no longer have total control over the composition of the
board of directors, as federal law places restrictions on board composition to
ensure the independence of the board from insider influence.
Increased Liability
Taking your company public increases the potential liability of the company and
its officers and directors for mismanagement. By law, a public corporation has an
obligation to its shareholders to maximize shareholder profits and disclose
operational information.
Increased Regulatory Oversight
Going public places your company under the supervision of the SEC or state
regulatory agencies that regulate public corporations, as well as the stock
exchange that has agreed to list the company's stock. This increase in regulatory
oversight significantly changes the way you can manage the business.
Enhanced Reporting Requirements
A private corporation can keep its internal business information private. A public
corporation, however, must make extensive quarterly and annual disclosures
about business operations, financial condition, compensation of directors and
officers and other internal matters. It loses most privacy rights as a consequence
of allowing the public to invest in its stock.
65
The Process of Going Public

Taking a company public, also called an initial public offering (IPO), is the
sale of stock that allows the general buying public to own equity in a company.
The decision to take a company public involves more than the agreement of the
board members of a corporation. It also requires filing extensive paperwork with
the Securities and Exchange Commission (SEC) to make the transition from
private to public legal. The decision to take a company public has its pros and
cons and involves taking on new responsibilities.
Decide if going public is right for your company.
Consider the benefits to your company's overall health. Going public can
help your company raise funding and improve your brand and visibility.
If raising funding is the primary motivation for taking your company public,
consider alternative funds such as loans or seeking out investors. Taking
a company public requires that you report to shareholders, which can slow
down the pace of decision-making in your business. Public companies
also have more financial reporting requirements than private companies.
Private companies can keep innovative and proprietary information
private.
Hire an underwriter.
An investment bank serves as an underwriter for a company that is going
public. An underwriter is the link between your company and the public to
whom you will be offering your stock. The underwriter will work with you to
negotiate how the funds you need to raise to go public will be
accumulated. Some underwriting agreements involve the investment bank
guaranteeing a price for your shares, purchasing them and then reselling
them to the public. In other agreements a primary underwriter will bring in
other banks or firms (called syndicates) to distribute the risk involved with
raising funds by selling your company's stock.
Begin the registration process.
The SEC requires a company that's going public to complete an extensive
registration process. The underwriter will work with members of your
company on compiling materials for the registration process. The
registration process includes submitting a prospectus and a registration
form. A prospectus is a compilation of pertinent information about your
company, often presented in book form, that includes operations,
finances, your competitors, board of directors and their annual pay, any
legal issues the company is involved in, and how the company will
distribute the stock as well as how the company plans to use the profits
from the sale of the stock.
File the registration statement with the SEC.
66
If the SEC determines that your registration materials are complete and
accurate, approval of your application will be provided in writing. The next
step is to begin selling your company's stock. If the SEC does not approve
your application, you will receive a letter with comments on the incomplete
or inaccurate information in your prospectus. Your company should
respond to the SEC's comments in writing with amendments to your
registration that explain or otherwise address these comments.
Begin your road show.

Distribute your prospectus with information about the amount of stock to
be released and the preliminary price in meetings with potential investors.
This is called a road show. A road show typically lasts around 2 weeks
and it involves managers having multiple meetings in many cities.
Decide on the final price for your stock on the last day of your road show.
Make the initial public offering of your company's stock on the stock
market at the end of your road show.
To list your stock with the New York Stock Exchange (NYSE) your
company must meet the basic criteria for listing your stock: earnings of
$40 million or greater; shares priced at a minimum of $4.
Complete the application and accompanying documents for listing your
stock. You can download these forms from the NYSE website.
Pay the listing and annual fees. Information on the NYSE website offers
details about how to calculate fees.
On the 4th day after the initial offering, underwriters are allowed to
purchase their agreed upon number of shares at a discounted rate as
"payment" for their service in taking your company public.
67
Chapter #13
LEASE FINANCING
Definition of Lease:
A legal document outlining the terms under which one party agrees to rent
property from another party. A lease guarantees the lessee (the renter) use of an
asset and guarantees the lessor (the property owner) regular payments from the
lessee for a specified number of months or years. Both the lessee and the lessor
must uphold the terms of the contract for the lease to remain valid.
Leases are the contracts that lay out the details of rental agreements in
the real estate market. For example, if you want to rent an apartment, the lease
will describe how much the monthly rent is, when it is due, what will happen if
you don't pay, how much of a security deposit is required, the duration of the
lease, whether you are allowed to have pets, how many occupants may live in
the unit and any other essential information. The landlord will require you to sign
the lease before you can occupy the property as a tenant.
The Two Parties to Leasing:

The lessee is the receiver of the services or the assets under
the lease contract and the lessor is the owner of the assets. The relationship
between the tenant and the landlord is called a tenancy, and can be for a fixed or
an indefinite period of time (called the term of the lease). The consideration for
the lease is called rent.
Types of Leases:
The most common types of leases are as Follows:
Operating Lease:
Operating leases, also called service leases, are agreements between two
parties in which one provides rent to the other for using an asset. In an operating
lease, the borrower uses an asset for only a fixed portion of the assets life. The
owner of the asset is responsible for all maintenance costs and other operating
costs associated with the leased asset.
Finance or Capital Lease:
Capital leases, also called finance leases, are those in which the borrower
has full control over the use of the asset(s) during its lease period, is responsible
for all maintenance and other associated costs and is directly affected by its
associated advantages and disadvantages.
68
Sale and Leaseback Arrangement:

A sale and leaseback arrangement is a type of lease in which one party
purchases property, equipment or land from another party and immediately
leases it to the selling party under specific terms. The seller could be an
individual investor, a limited partnership, an industrial firm, a leasing company, a
commercial bank or an insurance company. A sale and leaseback arrangement
is a type of capital lease, with the only difference being that a buyer purchases a
used asset instead of a brand new one (as is common in capital leases).
Combination Lease:
Combination leases combine aspects of both capital and operating leases.
An example of a combination lease is a capital lease that incorporates a
cancellation clause, typically associated with an operating lease.
Financial statement Effect

Impact of Leasing on the Income Statement
Through leasing, companies can avoid expenses that decrease their bottom line.
Depreciation expenses
Depreciation is a major consideration for companies when deciding
between buying and leasing. For assets that suffer from significant depreciation,
either as a result of regular wear and tear or through becoming obsolete upon the
release of newer versions of the same materials (particularly applicable in the
case of technology) leasing can prevent a significant loss of value. In business,
there exists a basic rule of thumb: "If it appreciates, buy it. If it depreciates, lease
it. Leasing could permit the use of the equipment while it is new. Upon the
completion of the lease, it can be easy to upgrade by virtue of a new lease. In
case of a purchase, however, an individual may be "stuck" with an obsolete asset
with no means of recouping the cost of its acquisition.
Maintenance expenses
There are no maintenance expenses on the income statement as a result
of leasing. This is because in the case of a lease the ultimate ownership is
retained by the lessor; and, it is in their best interest to maintain the asset in its
best working order. Therefore, lessees can often benefit from comprehensive
maintenance programs offered by lessors while still paying a
discounted premium due to the fact that the asset is being leased, not
purchased.
Other related costs
69
The costs of leases on the income statement depend on the duration and
type of lease. In the event of a purchase, the full value of the asset must be paid
to the seller. In the event of a lease, however, only a portion of the full value is
assessed, typically around 50%; the figure varies depending on the duration and
type of lease. As a consequence, a lessor can gain the use of a much needed
asset for a fraction of the full price of ownership. In many instances, this can
better serve the lessee that an outright purchase would. As a corollary, a lessor
could be granted the use of an asset that could otherwise be cost prohibitive.
EBITDA
Leases will also influence the ratios on income statement. For instance,
the EBITDA coverage ratio will improve if using operating leases. The EBITDA
coverage ratio shows if earnings are able to satisfy all financial obligations
including leases and principal payments. (EBITDA is short for earnings before
interest, taxes, depreciation, and amortization.)
Impact of Leasing on the Balance Sheet:

Capitalized leases have significant effects on the balance sheet, while
operating leases don't show up there at all.
Entries
When you capitalize a lease, the asset appears on your balance sheet the
same as if you had bought it. Say you're leasing a truck for three years. The truck
goes on the balance sheet as a fixed asset -- property, plant and equipment.
Adjustment
The leased asset gets depreciated just like any asset the company
actually owns. If your company uses straight-line depreciation for assets, then
you would use it for the truck, as well. The book value of the asset thus declines
over time. On the liabilities side, you treat the lease obligation like debt, reducing
it over time as you pay off the lease.
Effect:
A capitalized lease increases the total value of the assets on your balance
sheet. That affects a number of ratios that creditors, potential investors and
others use to evaluate your company's profitability and efficiency. It will reduce
your company's return on assets (essentially, the profit it generates for each $1
worth of assets) and its asset turnover (the sales generated for every $1 worth of
assets). And since the lease also appears as a liability, it affects measures of
financial leverage, such as your liabilities-to-equity ratio. In short, a capitalized
lease can make your company's performance look worse, so businesses often
structure leases in such a way so they can report them as operating leases.
70

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Comprehensive Notes

For Students of BBA, MBA & M.com

I am very grateful to Almighty ALLAH who enabled me to

Muhammad Riaz Khan

(A) Investment Decisions

What is the optimal firm size? It means to decide what amount of

What specific assets should be acquired? The exact asset required to

(B) Financing Decisions

(C) Asset Management Decisions

How do we manage existing assets efficiently? Efficiently means to

Financial Manager has varying degrees of operating responsibility over

Objectives of Financial Management

To ensure regular and adequate supply of funds to the concern.

The Goals of Corporations

Business Ethics and Social Responsibility

Business ethics is the behavior that a business adheres to in its daily

Agency Relationships in Financial Management

Management acts as an agent for the owners (shareholders) of the firm.

Shareholders and managers have divergent goals. The Shareholders goal is to

Performance shares: Management receives a certain number of shares if

By investing in riskier projects they maximize the profits which on turn is

lose access to the debt markets or

Basic Financial Statements

The Statement of Cash Flows is the third financial statement required by

MVA = Total Market value Total investor supplied capital

Economic Value Added (EVA)

EVA = NOPAT Cost of capital required for operations

Free Cash flows

Uses of free cash flow

To pay interest to debt holders

Calculating free cash flows

Reasons for Analysis

Evaluating the financial statements

What do external users use it for?

To check long term solvency for Investment decisions

Advantages of financial statement analysis

The most important benefit if financial statement analysis is that it provides an

Another advantage of financial statement analysis is that regulatory authorities

Financial statement analysis is helpful to the government agencies in analyzing

Comparing one company to another

Following are the different categories of financial ratios.

(A) Liquidity: Can we make required payments as they fall due?

Liquidity ratios can be measured using two ratios these are

The current ratio is a popular financial ratio used to test a

capital position) by deriving the proportion of current assets available

Quick ratio compares quick assets with current liabilities.

Quick Ratio = Quick Asset/ Current Liabilities

(B) Asset Management Ratios

Inventory Turnover Ratio

DSO (in days)

= receivables/ average daily sales

= receivables * 365/ annual sales

Shows the turnover of total assets with respect of sales.

Total Liabilities to total assets ratio

Which means that the company has 20 Rs of profit to pay I Re of interest?

Earnings before interest tax depreciation and amortization (EBITDA) Ratio

Profit margin to sales

Profit margin to sales compares net profit available to shareholders for

Net profit margin ratio = Profit available for shareholders/ sales

Return on Total Assets

Return on total assets is calculated by comparing Net profit available for

This ratio indicates how profitable a company is by comparing its

(E) Market Value Ratios