Chapters 3 and 5 - Financial Statements and Ratio Analysis and Time Value of Money

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Module 2
Chapters 3 and 5
Financial
Statements and
Ratio Analysis and
Time Value of
Money
Chapter 3
Financial
Statements and
Ratio Analysis
The Stockholders Report

Generally accepted accounting principles
(GAAP) are the practice and procedure guidelines
used to prepare and maintain financial records and
reports; authorized by the Financial Accounting
Standards Board (FASB).
Copyright 2015 Pearson Education, Inc. All rights reserved.
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The Stockholders Report (cont.)

The Sarbanes-Oxley Act of 2002, passed to
eliminate the many disclosure and conflict of
interest problems of corporations, established the
Public Company Accounting Oversight Board
(PCAOB), which is a not-for-profit corporation that
overseas auditors.
The PCAOB is charged with protecting the interests
of investors and furthering the public interest in the
preparation of informative, fair, and independent
audit reports.
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The Stockholders Report (cont.)

Public corporations with more than $5 million in
assets and more than 500 stockholders are
required by the Securities and Exchange
Commission (SEC) to provide their stockholders
with an annual stockholders report, which
summarizes and documents the firms financial
activities during the past year.
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Focus on Ethics
Take Earnings Reports at Face Value
Near the end of each quarter, many companies unveil their
quarterly performance.
Firms that beat analyst estimates often see their share
prices jump, while those that miss estimates by even a
small amount, tend to suffer price declines.
The practice of manipulating earnings in order to mislead
investors is known as earnings management.
Why might financial managers be tempted to

manage earnings?
Is it unethical for managers to manage earnings if
they disclose their activities to investors?
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The Four Key Financial Statements: The

Income Statement
The income statement provides a financial
summary of a companys operating results during a
specified period.
Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
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Table 3.1 Bartlett Company Income

Statements ($000)
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Personal Finance Example
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The Four Key Financial Statements: The

Balance Sheet
The balance sheet presents a summary of
a firms financial position at a given point in
time.
The statement balances the firms assets
(what it owns) against its financing, which
can be either debt (what it owes) or equity
(what was provided by owners).
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Table 3.2a Bartlett Company Balance

Sheets ($000)
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Table 3.2b Bartlett Company Balance

Sheets ($000)
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The Four Key Financial Statements:

Statement of Retained Earnings
The statement of retained earnings reconciles
the net income earned during a given year, and
any cash dividends paid, with the change in
retained earnings between the start and the end of
that year.
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Table 3.3 Bartlett Company Statement of

Retained Earnings ($000) for the Year Ended
December 31, 2015
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The Four Key Financial Statements:

Statement of Cash Flows
The statement of cash flows provides a summary
of the firms operating, investment, and financing
cash flows and reconciles them with changes in its
cash and marketable securities during the period.
This statement not only provides insight into a
companys investment, financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.
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Table 3.4 Bartlett Company Statement of Cash

Flows ($000) for the Year Ended December 31,
2015
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Consolidating International Financial

Statements
FASB 52 mandates that U.S.-based companies
translate their foreign-currency-denominated assets
and liabilities into dollars, for consolidation with the
parent companys financial statements. This is
done by using the current rate (translation) method.
The current rate (translation) method is a
technique used by U.S.-based companies to
translate their foreign-currency-denominated assets
and liabilities into dollars, for consolidation with the
parent companys financial statements, using the
year-end (current) exchange rate.
Income statement items (revenues and expenses)
are usually treated similarly.
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Consolidating International Financial

Statements (cont.)
Equity accounts, on the other hand, are translated
into dollars by using the exchange rate that
prevailed when the parents equity investment was
made (the historical rate).
Retained earnings are adjusted to reflect each
years operating profits (or losses).
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Using Financial Ratios:

Interested Parties
Ratio analysis involves methods of calculating and
interpreting financial ratios to analyze and monitor
the firms performance.
Interested parties:
Current and prospective shareholders are interested in the
firms current and future level of risk and return, which
directly affect share price.
Creditors are interested in the short-term liquidity of the
company and its ability to make interest and principal
payments.
Management is concerned with all aspects of the firms
financial situation, and it attempts to produce financial
ratios that will be considered favorable by both owners and
creditors.
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Types of Ratio Comparisons
Cross-sectional analysis is the comparison of
different firms financial ratios at the same point in
time; involves comparing the firms ratios to those
of other firms in its industry or to industry averages
Benchmarking is a type of cross-sectional analysis
in which the firms ratio values are compared to
those of a key competitor or group of competitors
that it wishes to emulate.
Comparison to industry averages is also popular, as
in the following example.
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Types of Ratio Comparisons (cont.)
Caldwell Manufacturings calculated inventory
turnover for 2015 and the average inventory turnover
were as follows:
Caldwell Manufacturing
Industry average
Inventory turnover, 2015

14.8
9.7
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Table 3.5 Financial Ratios for Select Firms

and Their Industry Median Values
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Using Financial Ratios: Types of Ratio

Comparisons (cont.)
Time-series analysis is the evaluation of the
firms financial performance over time using
financial ratio analysis
Comparison of current to past performance, using
ratios, enables analysts to assess the firms
progress.
Developing trends can be seen by using multiyear
comparisons.
The most informative approach to ratio analysis
combines cross-sectional and time-series analyses.
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Figure 3.1 Combined Analysis
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Using Financial Ratios: Cautions about

Using Ratio Analysis
1. Ratios that reveal large deviations from the norm
merely indicate the possibility of a problem.
2. A single ratio does not generally provide sufficient
information from which to judge the overall
performance of the firm.
3. The ratios being compared should be calculated
using financial statements dated at the same point
in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have
been developed in the same way.
6. Results can be distorted by inflation.
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Ratio Analysis Example

We will illustrate the use of financial ratios for
analyzing financial statements using the Bartlett
Company Income Statements and Balance Sheets
presented earlier in
Tables 3.1 and 3.2.
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Liquidity Ratios
The current ratio measures the ability of the firm to
meet its short-term obligations.
Current ratio = Current assets Current liabilities
The current ratio for Bartlett Company in 2015 is:
$1,223,000 $620,000 = 1.97
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Matter of Fact
Determinants of Liquidity Needs
Large enterprises generally have well established
relationships with banks that can provide lines of credit and
other short-term loan products in the event that the firm
has a need for liquidity.
Smaller firms may not have the same access to credit, and
therefore they tend to operate with more liquidity.
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The personal liquidity ratio is calculated by dividing
total liquid assets by total current debt. It indicates

the percent of annual debt obligations that an
individual can meet using current liquid assets.
Calculate Jan and Jon Smiths liquidity ratio for
calendar year 2015:
Liquidity ratio = ($2,225/$21,539) = 0.1033, or 10.3%
That ratio indicates that the Smiths can cover only

about 10 percent of their existing 1-year debt
obligations with their current liquid assets.
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Liquidity Ratios (cont.)

The quick (acid-test) ratio excludes inventory, which
is generally the least liquid current asset.
The quick ratio for Bartlett Company in 2015 is:
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Matter of Fact
The importance of inventories:
From Table 3.5:
Company
Current ratio
Quick ratio
Dell
1.3
1.2
Home Depot
1.3
0.4
Lowes
1.3
0.2
All three firms have current ratios of 1.3. However, the

quick ratios for Home Depot and Lowes are dramatically
lower than their current ratios, but for Dell the two ratios
are nearly the same. Why?
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Activity Ratios
Inventory turnover measures the activity, or liquidity,
of a firms inventory.
Inventory turnover = Cost of goods sold Inventory
Applying this relationship to Bartlett Company in 2015
yields:
$2,088,000 $289,000 = 7.2
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Activity Ratios (cont.)

The average age of inventory is the average
number of days sales in inventory.
Average Age of Inventory = 365 Inventory turnover
For Bartlett Company, the average age of inventory in 2015
is:
365 7.2 = 50.7 days
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The average collection period is the average
amount of time needed to collect accounts receivable.
The average collection period for Bartlett Company in 2015

is:
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Matter of Fact
Who Gets Credit?
Notice in Table 3.5 the vast differences across industries in
the average collection periods.
Companies in the building materials, grocery, and
merchandise store industries collect in just a few days,
whereas firms in the computer industry take roughly two
months to collect on their sales.
The difference is primarily due to the fact that these
industries serve very different customers.
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The average payment period is the average
amount of time needed to pay accounts payable.
If we assume that Bartlett Companys purchases equaled 70

percent of its cost of goods sold in 2015, its average
payment period is:
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Total asset turnover indicates the efficiency with
which the firm uses its assets to generate sales.
Total asset turnover = Sales Total assets
The value of Bartlett Companys total asset turnover in 2015
is:
$3,074,000 $3,597,000 = 0.85
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Matter of Fact
Sell It Fast
Observe in Table 3.5 that the grocery business turns over
assets faster than any of the other industries listed.
That makes sense because inventory is among the most
valuable assets held by these firms, and grocery stores
have to sell baked goods, dairy products, and produce
quickly or throw them away when they spoil.
On average, a grocery stores has to replace its entire
inventory in just a few days or weeks, and that contributes
to the rapid turnover of the firms total assets.
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Example 3.5
Patty Akers in incorporating her new business. She
needs an initial investment of $50,000. She is
considering a no-debt plan, under which she would
invest the full amount without borrowing. The
second option, the debt plan, involves investing
$25,000 and balancing the remainder at 12%.
Patty expects $30,000 in sales and $18,000 in
operating expenses and has a tax rate of 40%.
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Table 3.6 Financial Statements Associated

with Pattys Alternatives
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Debt Ratios
The debt ratio measures the proportion of total
assets financed by the firms creditors.
Debt ratio = Total liabilities Total assets
The debt ratio for Bartlett Company in 2015 is
$1,643,000 $3,597,000 = 0.457 = 45.7%
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Debt Ratios (cont.)

The debt-to-equity ratio measures the relative
proportion of total liabilities and common stock equity
used to finance the firms total assets.
Debt to equity = Total liabilities Common stock equity
The debt-to-equity ratio for Bartlett Company in 2015 is
$1,643,000 $1,754,000 = 0.937 = 93.7%
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Debt Ratios (cont.)

The times interest earned ratio measures the
firms ability to make contractual interest payments;
sometimes called the interest coverage ratio.
Times interest earned ratio = EBIT taxes
The figure for earnings before interest and taxes (EBIT) is
the same as that for operating profits shown in the income
statement.
Applying this ratio to Bartlett Company yields the following
2015 value:
$418,000 $93,000 = 4.49
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Debt Ratios (cont.)

The fixed-payment coverage ratio measures the
firms ability to meet all fixed-payment obligations.
Fixed-Payment coverage Ratio (FPCR)
Applying the formula to Bartlett Companys 2015 data

yields:
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Table 3.7 Bartlett Company

Common-Size Income Statements
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Profitability Ratios
Gross profit margin measures the percentage of
each sales dollar remaining after the firm has paid for
its goods.
Bartlett Companys gross profit margin for 2015 is:
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Profitabiity Ratios (cont.)

Operating profit margin measures the percentage
of each sales dollar remaining after all costs and
expenses other than interest, taxes, and preferred
stock dividends are deducted.
Operating profit margin = Operating profits sales
Bartlett Companys operating profit margin for 2015 is:
$418,000 $3,074,000 = 13.6%
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Profitability Ratios (cont.)

Net profit margin measures the percentage of each
sales dollar remaining after all costs and expenses,
including interest, taxes, and preferred stock
dividends, have been deducted.
Net profit margin = Earnings available for common
stockholders Sales
Bartlett Companys net profit margin for 2015 is:
$221,000 $3,074,000 = 0.072 = 7.2%
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Earnings per share represents the number of
dollars earned during the period on the behalf of each
outstanding share of common stock.
Bartlett Companys earnings per share (EPS) in 2015 is:

$221,000 76,262 = $2.90
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The return on total assets measures the overall
effectiveness of management in generating profits
with its available assets.
Return on total assets (ROA) = Earnings available for
common stockholders Total assets
Bartlett Companys return on total assets in 2015 is:
$221,000 $3,597,000 = 0.061 = 6.1%
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The return on equity measures the return earned on
common stockholders investment in the firm.
Return on Equity (ROE) = Earnings available for common
stockholders Common stock equity
This ratio for Bartlett Company in 2015 is:
$221,000 $1,754,000 = 0.126 = 12.6%
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Market Ratios
The price/earnings (P/E) ratio measures the
amount that investors are willing to pay for each
dollar of a firms earnings.
Price Earnings (P/E) Ratio = Market price per share of
common stock Earnings per share
If Bartlett Companys common stock at the end of 2015 was
selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2015 is:
$32.25 $2.90 = 11.12
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Market Ratios (cont.)

The market/book (M/B) ratio provides an
assessment of how investors view the firms
performance.
where,
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Market Ratios (cont.)

Substituting the appropriate values for Bartlett
Company from its 2015 balance sheet, we get:
Substituting Bartlett Companys end of 2015

common stock price of $32.25 and its $23.00 book
value per share of common stock (calculated
above) into the M/B ratio formula, we get:
$32.25 $23.00 = 1.40
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Table 3.8a Summary of Bartlett Company Ratios
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Table 3.8b Summary of Bartlett Company Ratios
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DuPont System of Analysis

The DuPont system of analysis is used to dissect
the firms financial statements and to assess its
financial condition.
It merges the income statement and balance sheet
into two summary measures of profitability.
The Modified DuPont Formula relates the firms
ROA to its ROE using the financial leverage
multiplier (FLM), which is the ratio of total assets to
common stock equity:
ROA and ROE as shown in the series of equations
on the following slide.
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DuPont System of Analysis

The DuPont system first brings together the net
profit margin, which measures the firms
profitability on sales, with its total asset turnover,
which indicates how efficiently the firm has used its
assets to generate sales.
ROA = Net profit margin Total asset turnover
Substituting the appropriate formulas into the
equation and simplifying results in the formula
given earlier,
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DuPont System of Analysis (cont.)

When the 2015 values of the net profit margin and
total asset turnover for Bartlett Company, calculated
earlier, are substituted into the DuPont formula, the
result is:
ROA = 7.2% 0.85 = 6.1%
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DuPont System of Analysis:

Modified DuPont Formula
The modified DuPont Formula relates the firms
return on total assets to its return on common
equity. The latter is calculated by multiplying the
return on total assets (ROA) by the financial
leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
ROE = ROA FLM
Substituting the appropriate formulas into the
equation and simplifying results in the formula
given earlier,
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DuPont System of Analysis:

Modified DuPont Formula (cont.)
Substituting the values for Bartlett Companys ROA of
6.1 percent, calculated earlier, and Bartletts FLM of
2.051 ($3,597,000 total assets $1,754,000
common stock equity) into the modified DuPont
formula yields:
ROE = 6.1% 2.051 = 12.5%
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Figure 3.2
DuPont
System of
Analysis
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Matter of Fact
Dissecting ROA
Return to Table 3.5 and examine the total asset turnover
figures for Dell and Home Depot.
Both firms turn their assets 1.6 times per year.
Dells ROA is 4.3%, but Home Depots is significantly
higher at 6.5%. Why?
The answer lies in the DuPont formula.
Notice that Home Depots net profit margin is 4.0%
compared to Dells 2.7%.
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Chapter 5
Time Value of
Money
Future Value versus Present Value

Suppose a firm has an opportunity to spend $15,000
today on some investment that will produce $17,000
spread out over the next five years as follows:
Year
Cash flow
$3,000
$5,000
$4,000
$3,000
$2,000
Is this a wise investment?
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Future Value versus Present Value (cont.)

To make the right investment decision, managers
need to compare the cash flows at a single point in
time.
Figure 5.1 Time Line
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Future Value versus Present Value (cont.)

When making investment decisions, managers usually
calculate present value.
Figure 5.2 Compounding and

Discounting
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Computational Tools
Financial calculators include preprogrammed financial
routines.
Figure 5.3 Calculator Keys
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Computational Tools (cont.)

Electronic spreadsheets:
Like financial calculators, electronic spreadsheets have
built-in routines that simplify time value calculations.
In this text:
The value for each variable is entered in a cell in the
spreadsheet, and the calculation is programmed using an
equation that links the individual cells.
Changing any of the input variables automatically changes the
solution as a result of the equation linking the cells.
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Computational Tools (cont.)

Cash flow signs:
To provide a correct answer, financial calculators and
electronic spreadsheets require that a calculations relevant
cash flows be entered accurately as cash inflows or cash
outflows.
Cash inflows are indicated by entering positive values.
Cash outflows are indicated by entering negative values.
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Basic Patterns of Cash Flow

The three basic patterns of cash flows include:
A single amount: A lump sum amount either held
currently or expected at some future date.
An annuity: A level periodic stream of cash flow.
A mixed stream: A stream of unequal periodic
cash flows.
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Future Value of a Single Amount

Future value is the value at a given future date of
an amount placed on deposit today and earning
interest at a specified rate. Found by applying
compound interest over a specified period of time.
Compound interest is interest that is earned on a
given deposit and has become part of the principal
at the end of a specified period.
Principal is the amount of money on which interest
is paid.
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If Fred Moreno places $100 in a savings account
paying 8% interest compounded annually, how much
will he have at the end of 1 year?
Future value at end of year 1 = $100 (1 + 0.08) = $108
If Fred were to leave this money in the account for

another year, how much would he have at the end of
the second year?
Future value at end of year 2
= $100 (1 + 0.08) (1 + 0.08)

= $116.64
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Future Value of a Single Amount: The

Equation for Future Value
We use the following notation for the various
inputs:
FVn = future value at the end of period n
PV = initial principal, or present value
r = annual rate of interest paid. (Note: On financial
calculators, I is typically used to represent this rate.)
n = number of periods (typically years) that the money is
left on deposit
The general equation for the future value at the

end of period n is
FVn = PV (1 + r)n
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Future Value of a Single Amount: The

Jane Farber places $800 in a savings account paying 6% interest
compounded annually. She wants to know how much money will
be in the account at the end of five years.
FV5 = $800 (1 + 0.06)5 = $800 (1.33823) = $1,070.58
This analysis can be depicted on a time line as follows:
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Figure 5.4
Future Value Relationship
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Present Value of a Single Amount

Present value is the current dollar value of a
future amountthe amount of money that would
have to be invested today at a given interest rate
over a specified period to equal the future amount.
It is based on the idea that a dollar today is worth
more than a dollar tomorrow.
Discounting cash flows is the process of finding
present values; the inverse of compounding
interest.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required
return, or the cost of capital.
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Paul Shorter has an opportunity to receive $300 one
year from now. If he can earn 6% on his investments,
what is the most he should pay now for this
opportunity?
PV (1 + 0.06) = $300
PV = $300/(1 + 0.06) = $283.02
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Present Value of a Single Amount: The

Equation for Present Value
The present value, PV, of some future amount, FVn,
to be received n periods from now, assuming an
interest rate (or opportunity cost) of r, is calculated
as follows:
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Present Value of a Single Amount: The

Pam Valenti wishes to find the present value of
$1,700 that will be received 8 years from now. Pams
opportunity cost is 8%.
PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
This analysis can be depicted on a time line as

follows:
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Figure 5.5
Present Value Relationship
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Annuities
An annuity is a stream of equal periodic cash flows,
over a specified time period. These cash flows can be
inflows of returns earned on investments or outflows
of funds invested to earn future returns.
An ordinary (deferred) annuity is an annuity for which
the cash flow occurs at the end of each period
An annuity due is an annuity for which the cash flow
occurs at the beginning of each period.
An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound
for an additional period.
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Fran Abrams is choosing which of two annuities to
receive. Both are 5-year $1,000 annuities; annuity A is
an ordinary annuity, and annuity B is an annuity due.
Fran has listed the cash flows for both annuities as
shown in Table 5.1 on the following slide.
Note that the amount of both annuities total

$5,000.
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Table 5.1 Comparison of Ordinary Annuity

and Annuity Due Cash Flows ($1,000, 5
Years)
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Finding the Future Value of an Ordinary

Annuity
You can calculate the future value of an ordinary
annuity that pays an annual cash flow equal to CF
by using the following equation:
As before, in this equation r represents the interest

rate and n represents the number of payments in
the annuity (or equivalently, the number of years
over which the annuity is spread).
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Fran Abrams wishes to determine how much money she
will have at the end of 5 years if he chooses annuity A, the
ordinary annuity and it earns 7% annually. Annuity A is
depicted graphically below:
This analysis can be depicted on a time line as follows:
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Personal Finance Example (cont.)
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Finding the Present Value of an Ordinary

Annuity
You can calculate the present value of an ordinary

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Annuity (cont.)
Braden Company, a small producer of plastic toys, wants
to determine the most it should pay to purchase a
particular annuity. The annuity consists of cash flows of
$700 at the end of each year for 5 years. The firm requires
the annuity to provide a minimum return of 8%.
This situation can be depicted on a time line as follows:
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Table 5.2 Long Method for Finding the

Present Value of an Ordinary Annuity
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Annuity (cont.)
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Finding the Future Value of an Annuity

Due
You can calculate the present value of an annuity
due that pays an annual cash flow equal to CF by
using the following equation:

3-95

Fran Abrams now wishes to choose between an ordinary annuity
and an annuity due, both offering similar terms except the timing
of cash flows. We have already calculated the value of the
ordinary annuity, but need to calculate the value of an annuity
due.
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Note: Before using your calculator to
find the future value of an annuity
due, depending on the specific
calculator, you must either switch it
to BEGIN mode or use the DUE key.
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3-98
Future value of ordinary

annuity
Future value of annuity

due
$5,705.74
$6,153.29
The future value of an annuity due is always higher

than the future value of an ordinary annuity.
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Finding the Present Value of an Annuity

Due
You can calculate the present value of an ordinary

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Finding the Present Value of an Annuity

Due (cont.)
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Matter of Fact
Kansas truck driver, Donald Damon, got the surprise
of his life when he learned he held the winning ticket
for the Powerball lottery drawing held November 11,
2009. The advertised lottery jackpot was $96.6
million. Damon could have chosen to collect his prize
in 30 annual payments of $3,220,000 (30 $3.22
million = $96.6 million), but instead he elected to
accept a lump sum payment of $48,367,329.08,
roughly half the stated jackpot total.
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Finding the Present Value of a Perpetuity

A perpetuity is an annuity with an infinite
life, providing continual annual cash flow.
If a perpetuity pays an annual cash flow of
CF, starting one year from now, the present
value of the cash flow stream is
PV = CF r
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Ross Clark wishes to endow a chair in finance at his
alma mater. The university indicated that it requires
$200,000 per year to support the chair, and the
endowment would earn 10% per year. To determine
the amount Ross must give the university to fund the
chair, we must determine the present value of a
$200,000 perpetuity discounted at 10%.
PV = $200,000 0.10 = $2,000,000
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Future Value of a Mixed Stream

Shrell Industries, a cabinet manufacturer, expects to
receive the following mixed stream of cash flows over
the next 5 years from one of its small customers.
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Future Value of a Mixed Stream

If the firm expects to earn at least 8% on its
investments, how much will it accumulate by the end
of year 5 if it immediately invests these cash flows
when they are received?
This situation is depicted on the following time line.
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Future Value of a Mixed Stream (cont.)
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Present Value of a Mixed Stream

Frey Company, a shoe manufacturer, has been
offered an opportunity to receive the following mixed
stream of cash flows over the next 5 years.
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Present Value of a Mixed Stream

If the firm must earn at least 9% on its investments,
what is the most it should pay for this opportunity?
This situation is depicted on the following time line.
3-109
Present Value of a Mixed Stream (cont.)
3-110
Compounding Interest More Frequently

Than Annually
Compounding more frequently than once a year
results in a higher effective interest rate because
you are earning on interest on interest more
frequently.
As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
Furthermore, the effective rate of interest will
increase the more frequently interest is
compounded.
3-111
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Than Annually
Compounding more frequently than once a year
results in a higher effective interest rate because
you are earning on interest on interest more
frequently.
As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
Furthermore, the effective rate of interest will
increase the more frequently interest is
compounded.
3-112
Table 5.3 Future Value from Investing $100 at

8% Interest Compounded Semiannually over 24
Months (2 Years)
3-113
Table 5.4 Future Value from Investing $100 at

8% Interest Compounded Quarterly over 24
Months (2 Years)
3-114
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Table 5.5 Future Value at the End of Years 1 and

2 from Investing $100 at 8% Interest, Given
Various Compounding Periods
3-115

Than Annually (cont.)
A general equation for compounding more frequently
than annually
Recalculate the example for the Fred Moreno

example assuming (1) semiannual compounding and
(2) quarterly compounding.
3-116

3-117
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3-118
Continuous Compounding
Continuous compounding involves the
compounding of interest an infinite number of times
per year at intervals of microseconds.
A general equation for continuous compounding
where e is the exponential function.
3-119

Find the value at the end of 2 years (n = 2) of Fred
Morenos $100 deposit (PV = $100) in an account
paying 8% annual interest (r = 0.08) compounded
continuously.
FV2 (continuous compounding) = $100 e0.08 2
= $100 2.71830.16
= $100 1.1735 = $117.35
3-120
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3-121
Nominal and Effective Annual Rates of

Interest
The nominal (stated) annual rate is the
contractual annual rate of interest charged by a
lender or promised by a borrower.
The effective (true) annual rate (EAR) is the
annual rate of interest actually paid or earned.
In general, the effective rate > nominal rate
whenever compounding occurs more than once per
year
3-122

Fred Moreno wishes to find the effective annual rate
associated with an 8% nominal annual rate (r = 0.08)
when interest is compounded (1) annually (m = 1);
(2) semiannually (m = 2); and (3) quarterly (m = 4).
3-123
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Special Applications of Time Value: Deposits

Needed to Accumulate a Future Sum
The following equation calculates the annual cash payment (CF)
that wed have to save to achieve a future value (FVn):
Suppose you want to buy a house 5 years from now, and you
estimate that an initial down payment of $30,000 will be
required at that time. To accumulate the $30,000, you will wish
to make equal annual end-of-year deposits into an account
paying annual interest of 6 percent.
3-124
3-125
Special Applications of Time Value: Loan

Amortization
Loan amortization is the determination of the
equal periodic loan payments necessary to provide
a lender with a specified interest return and to
repay the loan principal over a specified period.
The loan amortization process involves finding the
future payments, over the term of the loan, whose
present value at the loan interest rate equals the
amount of initial principal borrowed.
A loan amortization schedule is a schedule of
equal payments to repay a loan. It shows the
allocation of each loan payment to interest and
principal.
3-126
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Special Applications of Time Value: Loan

Amortization (cont.)
The following equation calculates the equal periodic loan
payments (CF) necessary to provide a lender with a
specified interest return and to repay the loan principal (PV)
over a specified period:
Say you borrow $6,000 at 10 percent and agree to make

equal annual end-of-year payments over 4 years. To find
the size of the payments, the lender determines the amount
of a 4-year annuity discounted at 10 percent that has a
present value of $6,000.
3-127
3-128
Table 5.6 Loan Amortization Schedule

($6,000 Principal, 10% Interest, 4-Year
Repayment Period)
3-129
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3-130
Focus on Practice
New Century Brings Trouble for Subprime Mortgages
In 2006, some $300 billion worth of adjustable ARMs were
reset to higher rates.
In a market with rising home values, a borrower has the
option to refinance their mortgage, using some of the equity
created by the homes increasing value to reduce the
mortgage payment.
But after 2006, home prices started a three-year slide, so
refinancing was not an option for many subprime borrowers.
As a reaction to problems in the subprime area, lenders
tightened lending standards. What effect do you think this had
on the housing market?
3-131
Special Applications of Time Value:

Finding Interest or Growth Rates
It is often necessary to calculate the compound
annual interest or growth rate (that is, the annual
rate of change in values) of a series of cash flows.
The following equation is used to find the interest
rate (or growth rate) representing the increase in
value of some investment between two time
periods.
3-132
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Ray Noble purchased an investment four years ago
for $1,250. Now it is worth $1,520. What compound
annual rate of return has Ray earned on this
investment? Plugging the appropriate values into
Equation 5.20, we have:
r = ($1,520 $1,250)(1/4) 1 = 0.0501 = 5.01% per year
3-133
3-134

Jan Jacobs can borrow
$2,000 to be repaid in equal
annual end-of-year amounts
of $514.14 for the next 5
years. She wants to find the
interest rate on this loan.
3-135
45
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3-136
Special Applications of Time Value:

Finding an Unknown Number of Periods
Sometimes it is necessary to calculate the number
of time periods needed to generate a given
amount of cash flow from an initial amount.
This simplest case is when a person wishes to
determine the number of periods, n, it will take for
an initial deposit, PV, to grow to a specified future
amount, FVn, given a stated interest rate, r.
3-137

Ann Bates wishes to
determine the number of
years it will take for her
initial $1,000 deposit,
earning 8% annual
interest, to grow to equal
$2,500. Simply stated, at
an 8% annual rate of
interest, how many years,
n, will it take for Anns
$1,000, PV, to grow to
$2,500, FVn?
3-138
46
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3-139

Bill Smart can borrow $25,000 at
an 11% annual interest rate;
equal, annual, end-of-year
payments of $4,800 are
required. He wishes to determine
how long it will take to fully
repay the loan. In other words,
he wishes to determine how
many years, n, it will take to
repay the $25,000, 11% loan,
PVn, if the payments of $4,800
are made at the end of each
year.
3-140
3-141
47

Chapters 3 and 5 - Financial Statements and Ratio Analysis and Time Value of Money

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Chapters 3 and 5 - Financial Statements and Ratio Analysis and Time Value of Money

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The Stockholders Report

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The Stockholders Report (cont.)

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The Stockholders Report (cont.)

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Why might financial managers be tempted to

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The Four Key Financial Statements: The

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Table 3.1 Bartlett Company Income

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Personal Finance Example

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The Four Key Financial Statements: The

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Table 3.2a Bartlett Company Balance

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Table 3.2b Bartlett Company Balance

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Personal Finance Example

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The Four Key Financial Statements:

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Table 3.3 Bartlett Company Statement of

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The Four Key Financial Statements:

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Table 3.4 Bartlett Company Statement of Cash

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Consolidating International Financial

Consolidating International Financial

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Using Financial Ratios:

Using Financial Ratios:

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Using Financial Ratios:

Inventory turnover, 2015

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Table 3.5 Financial Ratios for Select Firms

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Using Financial Ratios: Types of Ratio

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Figure 3.1 Combined Analysis

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Using Financial Ratios: Cautions about

Ratio Analysis Example

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Personal Finance Example

The personal liquidity ratio is calculated by dividing

total liquid assets by total current debt. It indicates

That ratio indicates that the Smiths can cover only

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Liquidity Ratios (cont.)

The quick ratio for Bartlett Company in 2015 is:

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All three firms have current ratios of 1.3. However, the

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Activity Ratios (cont.)

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