FM Final Reviewer

Unit 4: Financial Assets
(9 hours)
Introduction
Companies raise capital in two main forms: debt and equity. They may issue
bonds and sell stocks to generate money for business operations. When an
investor purchases company’s bonds, the investor is providing the company
with capital. In addition, when a firm issues bonds, the return that investors
require on the bonds represents the cost of debt capital to the firm. Thus,
financial managers must understand that valuation process, for two basic
reasons. First, the value of financial assets including the firm’s common stock
is determined in the securities markets. The way such values are determined
must be well understood as managers seek to accomplish the fundamental goal
of maximizing the value of the firm’s common stock. Second, as managers go
about managing the real assets of the firm, they must recognize how their
decisions will affect the firm’s common stock value. This chapter brings
together the fundamental concepts of the time value of money as it relates to
return in establishing the value of bonds, preferred stock and common stock.
An understanding of how a firm’s securities are valued its essential to
management as it pursues the value-maximization goal.
Learning Outcomes
At the end of this unit, students will be able to:
 Understand and compares the characteristics of the two main source of

company financing: bonds and stocks;
 Explain and compute the valuation of bonds and stocks
Financial Management Module 1

Premises
VALUATION
 The Concepts of Valuation

 It is the process of determining (or at least estimating) how much an
asset is worth.
 Expected cash flows, their timing & their riskiness will determine the
value of a financial asset.
 Valuation Process
 To value an asset, one must discount the expected future cash flows from
that asset using the present value techniques.
 Other things being equal, the greater the perceived risk, the lower the
asset’s value.
EXAMPLE:
Assume that investments in the assets required producing and market two new
products, sweaters and suspenders are expected to bring annual cash flows of Php
10,000 from each for the next 10 years with no value at the end of the 10-year
period. The risk-free interest rate is 8%; the risk premium for the low-risk
sweaters is 2% and for the high-risk suspenders, 12%.
Calculation of the value of these assets

Asset Expected Discount Rate PVFA Value
(product) Annual (Risk-free +
Cash Flow Risk premium)
Sweaters Php 10,000 0.08+0.02=0.10 6.145 Php 61,450
Suspenders Php 10,000 0.08+0.12=0.20 4.192 Php 41,920
Note that the higher discount rate applied to suspenders, attributable entirely to
the higher risk, accounts for the lower PVFA factor and the resulting lower value
of the riskier asset.
The market value of a financial asset is determined by the forces of supply and
demand for that security at the time. The price of an asset will equal its value
when its market is in equilibrium.
o MARKET EQUILIBIRUM - is achieved when the forces of supply
and demand are equal.
o The EQUILIBRIUM VALUE of any financial asset is equal to the
discounted present value of future cash flows expected by those who
invest in it.
Key Elements in the Valuation Process for Financial Assets

1. Future cash flows expected by investors
2. The anticipated timing of these cash flows
3. The discount rate used by investors in reducing these future cash flows to
present values. (The discount rate, in turn, is the sum of the risk-free rate
of return and the premium for perceived risk.)

Topic 6: Bonds and Their Valuation
Putting Things in Perspective
In previous modules, you learned that companies raise capital in two main
forms: debt and equity. In this module, you will study the characteristics of
bonds and the various factors that influences its price.
This module would reinforce your learnings on our past topic “Time Value of
Money.” Simply to say, in this module we will be using case problems which
will let you apply the concepts of time value of money.
Learning Objectives
After successful completion of this topic, you should be able to:
 Identify the different features of corporate and government bonds.

 Discuss how bond prices are determined in the market, what the
relationship is between interest rates and bond prices, and how a
bond’s price changes over time as it approaches maturity.
 Calculate a bond’s yield to maturity and its yield to call if it is callable
and determine the “true” yield.
 Explain the different types of risk that bond investors and issuers face
and the way a bond’s terms and collateral can be changed to affect its
interest rate.

Presentation of Contents
What is Bond?
A bond is a long-term contract/instrument under which a borrower agrees to

make payments of interest and principal on specific dates to the holders of the
bond.
Bond’s terms and conditions are contained in a legal contract between the
buyer and the seller, known as the indenture.
Bonds are issued by corporations and government agencies that are looking
for long-term debt capital.
Who issues Bonds?

1. Treasury Bonds – Bonds issued by the government, generally
called Treasuries and sometimes referred to as government bonds.
- have no default risk (it is assumed that government will make good
on its promised payments).
2. Corporate Bonds – Issued by corporations.
- exposed to default risk - if the issuing company gets into trouble, it
may be unable to make the promised interest and principal payments
and bondholders may suffer losses.
3. Foreign Bonds – Bonds issued by foreign governments and
corporations.
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The Concepts of Bond
 It is a fixed income instrument that represents a loan made by an investor
to a borrower (typically corporate or governmental).
 It is a long-term contract under which a borrower agrees to make
payments of interest and principal on specific dates to the holders of the
bond.
 When an investor purchases a bond, they are "loaning" that money (called
the principal) to the bond issuer, which is usually raising money for some
project. When the bond matures, the issuer repays the principal to the
investor. In most cases, the investor will receive regular interest payments
from the issuer until the bond matures.
 It is a promise to pay the redemption value at a specified date and interest
rate called the redemption date and redemption rate, respectively and in
the meantime to make periodic payments or coupon payments at regular
intervals.
Example: A Php 20,000, 10% bond with semiannual payments is
redeemed at 105% at the end of 12 years. Find the coupon payment and
the redemption value.
F = 20,000 d = 1.05 b = 0.1 m=2 r = b/m = 0.1/2 = 0.05
a. The coupon payment is equal to the face value times the periodic rate
C = Fr = 20,000 x 0.05 = Php 1,000
b. The redemption value is equal to the face value times the redemption
rate.
S = Fd = 20,000 x 1.05 = Php 21,000
How Bonds Work?

 Many corporate and government bonds are publicly traded; others are
traded only over-the-counter (OTC) or privately between the borrower and
lender.
 When companies or other entities need to raise money to finance new
projects, maintain ongoing operations, or refinance existing debts, they may
issue bonds directly to investors. The borrower (issuer) issues a bond that
includes the terms of the loan, interest payments that will be made, and the
time at which the loaned funds (bond principal) must be paid back
(maturity date). The interest payment (the coupon) is part of the return that
bondholders earn for loaning their funds to the issuer. The interest rate that
determines the payment is called the coupon rate.
 Most bonds can be sold by the initial bondholder to other investors after
they have been issued. In other words, a bond investor does not have to
hold a bond all the way through to its maturity date. It is also common for
bonds to be repurchased by the borrower if interest rates decline, or if the
borrower’s credit has improved, and it can reissue new bonds at a lower
cost.

Key Characteristics of Bonds
a) Face Value - The face value (also known as the par value) of a bond is
the price at which the bond is sold to investors when first issued; it is also
the price at which the bond is redeemed at maturity. Usually, the face
value is ₱1,000 or a multiple of ₱1,000.
b) Coupon Payment - A bond’s coupon is the dollar value of the periodic
interest payment promised to bondholders; this equals the coupon rate
times the face value of the bond.
For example, if a bond issuer promises to pay an annual coupon rate of
5% to bond holders and the face value of the bond is ₱1,000, the bond
holders are being promised a coupon payment of (0.05)(₱1,000) = ₱50 per
year.
c) Coupon Interest Rate - The periodic interest payments promised to bond
holders are computed as a fixed percentage of the bond’s face value; this
percentage is known as the coupon rate.
d) Fixed-Rate Bonds - A bond whose interest rate is fixed for its entire life.
e) Floating-Rate Bond - A bond whose interest rate fluctuates with shifts in
the general level of interest rates.
f) Zero Coupon Bond - A bond that pays no annual interest but is sold at a
discount below par, thus compensating investors in the form of capital
appreciation.
g) Original Issue Discount (OID) Bond – Any bond originally offered at a
price below it par value.
h) Maturity Date – A specified date on which the par value of a bond must
be repaid.
i) Original Maturity – The number of years to maturity at the time a bond
is issued.
j) Call Provisions - Many bonds contain a provision that enables the issuer
to buy the bond back from the bondholder at a pre-specified price prior to
maturity. This price is known as the call price. A bond containing a call
provision is said to be callable. This provision enables issuers to reduce
their interest costs if rates fall after a bond is issued, since existing bonds
can then be replaced with lower yielding bonds. Since a call provision is
disadvantageous to the bond holder, the bond will offer a higher yield
than an otherwise identical bond with no call provision.
A call provision is known as an embedded option, since it can’t be bought
or sold separately from the bond.
k) Sinking Fund Provisions - Some bonds are issued with a provision that
requires the issuer to repurchase a fixed percentage of the outstanding
bonds each year, regardless of the level of interest rates. A sinking fund
reduces the possibility of default; default occurs when a bond issuer is
unable to make promised payments in a timely manner. Since a sinking
fund reduces credit risk to bond holders, these bonds can be offered with a
lower yield than an otherwise identical bond with no sinking fund.
l) Put Provisions - Some bonds contain a provision that enables the buyer
to sell the bond back to the issuer at a pre-specified price prior to
maturity. This price is known as the put price. A bond containing such a
provision is said to be putable. This provision enables bond holders to

benefit from rising interest rates since the bond can be sold and the
proceeds reinvested at a higher yield than the original bond. Since a put
provision is advantageous to the bond holder, the bond will offer a lower
yield than an otherwise identical bond with no put provision.
m) Convertible Bonds – a bond that is exchangeable at the option of the
holder for the issuing firm’s common stock.
n) Warrant – A long-term option to buy a stated number of shares of a
common stock at a specified price.
o) Income Bond – A bond that pays interest only if it is earned.
p) Indexed (Purchasing Power) Bond – A bond that has interest payments
based on a inflation index so as to protect the holder from inflation.
Bond Valuation
A bond’s price equals the present value of its expected future cash flows. The
rate of interest used to discount the bond’s cash flows is known as the yield to
maturity (YTM.)
A) Pricing Coupon Bonds
The following general equation can be solved to find the value of any bond:
Where:
rd = the market rate of interest on the bond. This is the discount rate used to
calculate the present value of the cash flows, which is also the bond’s
price.
N = the number of years before the bond matures. N declines over time after
the bond has been issued.
INT = dollars of interest paid each year. Coupon rate x Par value
M = the par, or maturity, value of the bond. This amount must be paid at
maturity.
This formula shows that the price of a bond is the present value of its
promised cash flows.
As an example, suppose that a bond has a face value of $1,000, a coupon rate
of 4% and a maturity of four years. The bond makes annual coupon payments.
If the yield to maturity is 4%, the bond’s price is determined as follows:

These results also demonstrate that there is an inverse relationship between
yields and bond prices:
 when yields rise, bond prices fall
 when yields fall, bond prices rise
B) Adjusting for Semi-Annual Coupons

For a bond that makes semi-annual coupon payments, the following
adjustments must be made to the pricing formula:
 the coupon payment is cut in half
 the yield is cut in half
 the number of periods is doubled
As an example, suppose that a bond has a face value of $1,000, a coupon rate
of 8% and a maturity of two years. The bond makes semi-annual coupon
payments, and the yield to maturity is 6%. The semi-annual coupon is $40,
the semi-annual yield is 3%, and the number of semi-annual periods is four.
The bond’s price is determined as follows:
= 38.83 + 37.70 + 36.61 + 924.03 = $1,037.17
C) Pricing Zero Coupon Bonds
A zero-coupon bond does not make any coupon payments; instead, it is sold to
investors at a discount from face value. The difference between the price paid
for the bond and the face value, known as a capital gain, is the return to the
investor. The pricing formula for a zero coupon bond is:

As an example, suppose that a one-year zero-coupon bond is issued with a
face value of $1,000. The discount rate for this bond is 8%. What is the
market price of this bond? In order to be consistent with coupon-bearing
bonds, where coupons are typically made on a semi-annual basis, the yield
will be divided by 2, and the number of periods will be multiplied by 2:
MORE EXAMPLES:
1. A friend of yours just invested in an outstanding bond with a 5% annual
coupon and a remaining maturity of 10 years. The bond has a par value of
Php 1,000 and the market interest rate is currently 7%. How much did
your friend pay for the bond? Is it a par, premium or discount bond?
SOLUTION:
1−( 1+i )−n
Po = I ⌈ ⌉ + M (1+i)-n
i
1−( 1+ 0.07 )−10
= (1,000 x 0.05) ⌈ ⌉ + (1,000)(1+0.07)-10
0.07
= (50 x 7.0235815414) + (1000 x 0.5083492921)
= 351.17907707 + 508.3492921
= 859.53
 The bond’s value is equal to 859.53
 Since the bond’s coupon rate (5%) is less than the current market
interest rate (7%), the bond is a discount bond – reflecting that interest
rates have increased since this bond was originally issued.
2. A Php 10,000 bond with interest 12% converted quarterly is redeemable

at 115% in 10 years. Find the coupon payment, redemption value,
purchase price and premium that yields the purchaser 10% compounded
quarterly.
SOLUTIONS:
a. Coupon Payment = Face Value x bond rate per interest period
= 10000 x (12%/4)
= 300
b. Redemption Value = Face Value x redemption rate

= 10,000 x 115%
= 11,500
c. i = r/m = 10%/4 = 0.025 n = t(m) = 10 x 4 = 40

−n
1−( 1+i )
Purchase Price =I⌈ ⌉ + M (1+i)-n
i
1−( 1+ 0.025 )−40
= 300 ⌈ ⌉ + 11,500 (1+0.025)-40
0.025
= 7,530.8325156263 + 4,282.9521725248

= 11,813.78
d. Bond Premium = Purchase Price – Redemption Value

= 11,813.78 – 11,500
= 313.78
BOND YIELDS
 To be most useful, the bond’s yield should give an estimate of the rate of
return one would earn if we purchased the bond today and held it over its
remaining life.
 YIELD TO MATURITY (YTM) – the rate of return earned on a bond if

it is held to maturity.
Face Value−Market Price
Coupon+
Number of Periods
YTM =
Face Value + Market Price
2
EXAMPLE: Suppose you were offered a 14-year, 10% annual coupon,

1,000 par value bond at a price of 1,494.93. What rate of
interest would you earn on your investment if you bought the
bond, held it to maturity and received the promised interest and
maturity payments?
Face Value−Market Price

Coupon+
Number of Periods
YTM =
Face Value+ Market Price
2
1,000−1,494.93
( 1,000 x 10 % ) +( )
14
=
1,000+1,494.93
( )
2
100 – 35.3521428571
=
1247.465
= 5.18%
 YIELD TO CALL (YTC) – the rate of return earned on a bond when it

is called before its maturity date.
YTC =
Call Price−Market Value
Coupon Interest Payment +
Number of Years until Call
Call Price+ Market Value
2
EXAMPLE: You have just purchase an outstanding 15-year bond with a

par value of 1,000 for 1,145.68. Its annual coupon payment is

75. Assume that this bond is callable in 7 years at a price of
1,075. What is the bond’s YTC?
YTC =
Call Price−Market Value
Coupon Interest Payment +
Number of Years until Call
Call Price+ Market Value
2
1075−1145.68
75+
7
=
1075+1145.68
2
64.9028571429
=
1110.34
= 5.85%
Application
Short Problem
The Washington Corporation issued a new series of bonds on January 1, 2005.

The bonds were sold at par (₱1,000); had a 12% coupon; and mature in 30
years, on December 31, 2034. Coupon payments are made semi-annually (on
June 30 and December 31).
a) What was the YTM on January 1, 2005?
b) What was the price of the bonds on January 1, 2010, 5 years later,
assuming that interest rates had fallen to 10%?
c) Find the current yield, capital gains yield, and total return on January 1,
2010, given the price as determined in Part b.
Feedback
Think about these questions

1. What is bond?
2. What are the key characteristics of bonds?
3. How to compute the value of the bonds?
Now you are ready to take an oral quiz for today’s discussion
Unit 5: Investing in Long-Term Assets: Capital

Budgeting
(6 hours)
Introduction
In the past modules, we explained how risk influences prices and required
rates of return on bonds and stocks. A firm’s primary objective is to maximize
its shareholders’ value. The principal way value is increased is by investing in
projects that earn more than their cost of capital. In the next two modules, we
will see that a project’s future cash flows can be forecasted and that those cash
flows can be discounted to find their present value. Then if the PV of the
future cash flows exceeds the project’s cost, the firm’s value will increase if
the project is accepted. However, we need a discount rate to find the PV of the
future cash flows, and that discount rate is the firm’s cost of capital. Finding
the cost of the capital required to take on new projects is the primary focus of
Module 8.
After learning cost of capital, Module 9 on the other hand will bring you to the
decisions that involved long-lived assets. These decisions involve both
investing and financing choices. When a business makes a capital investment,
it incurs a current cash outlay in the expectation of future benefits. Usually,
these benefits extend beyond one year in the future. Examples include
investment in assets, such as equipment, buildings, and land, as well as the
introduction of a new product, a new distribution system, or a new program
for research and development. In short, the firm’s future success and
profitability depend on long-term decisions currently made.
Learning Outcomes
At the end of this unit, students will be able to:

 Define “capital budgeting” and identify the steps involved in the capital
budgeting process;
 Justify why cash, not income, flows are the most relevant to capital
budgeting decisions.
 Define the terms “sunk cost” and “opportunity cost” and explain why sunk
costs must be ignored, whereas opportunity costs must be included, in
capital budgeting analysis.
Topic 8: The Cost of Capital
Learning Objectives
At the end of this topic, students will be able to:
 Explain how a firm creates value, and identify the key sources of value
creation.
 Define the overall “cost of capital” of the firm.
 Calculate the costs of the individual components of a firm’s overall
cost of capital: cost of debt, cost of preferred stock, and cost of equity.
 Explain and use alternative models to determine the cost of equity,
including the dividend discount approach, the capital-asset pricing
model (CAPM) approach, and the before-tax cost of debt plus risk
premium approach.
 Calculate the firm’s weighted average cost of capital (WACC) and
understand its rationale, use, and limitations.
 Explain how the concept of Economic Value Added (EVA) is related
to value creation and a firm’s cost of capital.
 Understand the capital-asset pricing model’s role in computing project-
specific and group specific required rates of return.
Activating Prior Learning
Situation:
Imagine that you are at lost in the wilderness and there is a substitution cypher
(a method of encrypting message in which the letters of the original text are
systematically replaced by different alphabet) that you need to answer to solve
your dilemma.
A B C D E F G H I J K L MN O P Q R S T U V WX Y Z
S T U V WX Y Z A B C D E F G H I J K L MN O P Q R

Hint: You have to capitalize on it to be successful in business.
Encrypted word: UGEHWLALANW SVNSFLSYW
Answer: __________________________________
COST OF CAPITAL
- Cost of capital is an integral part of investment decision as it is used to
measure the worth of investment proposal provided by the business concern.
- It is used as a discount rate in determining the present value of future cash
flows associated with capital projects. Cost of capital is also called as cut-off
rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager
must take careful decision with regard to the cost of capital; because it is
closely associated with the value of the firm and the earning capacity of the
firm.
VALUE CREATION
- Ones that provide expected returns in excess of what the financial markets
require.
Industry Attractiveness
Growth Barriers to Other

phase of competitive protective
product entry devices – e.g.
patents,
cycle monopoly
Perceive Superior
Cost Marketing and Quality Organizational
Price Capability
Competitive Advantage
2 Major Sources
Industry Attractiveness
- Industry attractiveness has to do with the relative position of an industry
in the spectrum of value-creating investment opportunities. Favorable
industry characteristics include positioning in the growth phase of a
product cycle, barriers to competitive entry, and other protective

devices, such as patents, temporary monopoly power, and/or oligopoly
pricing where nearly all competitors are profitable.
Competitive Advantage
- The avenues to competitive advantage are several: cost advantage,
marketing and price advantage, perceived quality advantage, and
superior organizational capability (corporate culture).
MEANING OF COST OF CAPITAL

- Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds.
- If a firm fails to earn return at the expected rate, the market value of the
shares will fall and it will result in the reduction of overall wealth of the
shareholders.
- Rely on return (yield) calculations to determine cost figures because “cost”

and “return” are essentially two sides of the same coin.
Return
Cost
IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial
management to decide the capital structure of the business concern.
ASSUMPTION OF COST OF CAPITAL

Cost of capital is based on certain assumptions which are closely associated
while calculating and measuring the cost of capital.
It is to be considered that there are three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk
and financial risk.
Cost of capital can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = cost of capital.
rj = the riskless cost of the particular type of finance.
b = the business risk premium.
f = the financial risk premium.
CLASSIFICATION OF COST OF CAPITAL

Cost of capital may be classified into the following types on the basis of nature
and usage:

 Explicit and Implicit Cost.
 Average and Marginal Cost.
 Historical and Future Cost.
 Specific and Combined Cost.
Explicit and Implicit Cost

- Explicit cost is the rate that the firm pays to procure financing.
- Implicit cost is the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be forgone if the
projects presently under consideration by the firm were accepted.
Average and Marginal Cost

- Average cost of capital is the weighted average cost of each component
of capital employed by the company. It considers weighted average cost
of all kinds of financing such as equity, debt, retained earnings etc.
- Marginal cost is the weighted average cost of new finance raised by the
company. It is the additional cost of capital when the company goes for
further raising of finance.
Historical and Future Cost

- Historical cost is the cost which has already been incurred for financing
a particular project. It is based on the actual cost incurred in the previous
project.
- Future cost is the expected cost of financing in the proposed project.
Expected cost is calculated on the basis of previous experience.
Specific and Combine Cost

- The cost of each sources of capital such as equity, debt, retained
earnings and loans is called as specific cost of capital.
- The composite or combined cost of capital is the combination of all
sources of capital. It is also called as overall cost of capital. It is used to
understand the total cost associated with the total finance of the firm.
Cost of Capital
Cost of capital is the required rate of return on its investments which belongs
to equity, debt and retained earnings. If a firm fails to earn return at the
expected rate, the market value of the shares will fall and it will result in the
reduction of overall wealth of the shareholders.
The overall cost of capital is a weighted average of the individual required

rates of return (costs).
– It is the firm’s required rate of return that will just satisfy all capital
providers
The overall cost of capital of a firm is a proportionate average of the costs of

the various components of the firm’s financing.

1. Cost of equity capital – the required rate of return on investment of the
common shareholders of the company.
2. Cost of debt – The required rate of return on investment of the lenders of
the lenders of a company.
3. Cost of preferred stock – The required rate of return on investment of
the preferred shareholders of the company.
(a) (b) (a x b) (c) (b x c)
Capital Invested % Annual Peso Proportion Weighted
Providers Capital Cost Annual of Total Cost
(Investor Cost (Inv. Financing
Return) Return)
Debt P 2,000 5% P 100 20% 1.0%
P. Stock 3,000 10% 300 30% 3.0%
C. Stock 5,000 15% 750 50% 7.5%
P10,000 P 1,150 100% 11.5%
COST OF DEBT
- Cost of debt is the after tax cost of long-term funds through borrowing. Debt
may be issued at par, at premium or at discount and also it may be perpetual
or redeemable.
Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt. It may be
calculated with the help of the following formula.
Kd = (1 – t) R
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount

If the debt is issued at premium or discount, the cost of debt is calculated with
the help of the following formula.
I
Kd = (1−t)
Np
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate
of interest.
I + ( P−N p ) n
Kdb ¿
( P+ N p ) /2
Where,

Kdb = Cost of debt before tax
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of debenture
n = Number of years to maturity
Cost of debt after tax can be calculated with the help of the following formula:
Kda = Kdb × (1–t)
Where,
Kdb = Cost of debt before tax
Kda = Cost of debt after tax
t = Tax rate p
Hedging (Maturity Matching) Approach

- A method of financing where each asset would be offset with a financing
instrument of the same approximate maturity.
- the firm will finance a capital project, whose benefits extend over a number
of years, with financing that is generally long term in nature.
The explicit cost of debt can be derived by solving for the discount rate, kd,
that equates the market price of the debt issue with the present value of interest
plus principal payments and by then adjusting the explicit cost obtained for the
tax deductibility of interest payments. The discount rate, kd, known as the yield
to maturity, is solved for by making use of the formula
n
I +P
P 0= ∑ t t t
t =1 (1+ K d )
Where:
PO = current market price
∑ = summation for the periods 1 through n (final maturity)
It = Interest payment in period t
Pt = Payment of principal in period t
kd = discount rate
After tax cost of debt Ki
Ki = Kd (1- t)
You should note that the percent after-tax cost represents the marginal, or
incremental, cost of additional debt. It does not represent the cost of debt
funds already employed.
“Because predicting the effect of capital investment decisions on stock prices

is an inexact science (some would call it an art form), estimating the
appropriate required rate of return is inexact as well.”
COST OF PREFERRED STOCK

The cost of preferred stock is a function of its stated dividend.
Dividend is not a contractual obligation of the firm but, rather, is payable at

the discretion of the firm’s board of directors. Consequently, unlike debt, it

does not create a risk of legal bankruptcy. To the holders of common stock,
however, preferred stock is a security that takes priority over their securities
when it comes to the payment of dividends and to the distribution of assets if
the company is dissolved. Most corporations that issue preferred stock fully
intend to pay the stated dividend.
There are two types of preference shares irredeemable and redeemable.
 Cost of redeemable preference share capital
- Because preferred stock has no maturity date, its cost, kp, may be
represented as:
kp = Dp /P0
Where: Dp = stated annual dividend

Po = current market price of the P-stock
Note that cost is not adjusted for taxes because the preferred stock dividend is
already an after-tax figure – preferred stock dividends being paid after taxes.
Thus the explicit cost of preferred stock is greater than that for debt.
 Cost of irredeemable preference share capital
D p +(P−N p )/n
K p=
(P+ N p )/2
Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value
Np = Net proceeds of the preference share
n = Number of maturity period.
COST OF EQUITY CAPITAL

Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will
maintain the present market price of equity shares.
Dividend price approach can be measured with the help of the following
formula:
D
Ke =
Np
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate
per share plus growth in dividend. It can be measured with the help of the
following formula:
D
Ke = +g
Np
Where,
D = Dividend per equity share
g = Growth in expected dividend
Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the
future earnings prospects of the equity. The formula for calculating the cost
of equity according to this approach is as follows.
E
Ke =
Np
Where,
E = Earnings per share
Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this
method, cost of equity is calculated on the basis of return actually realized
by the investor in a company on their equity capital.
Ke = PVf×D
Where,
Ke = Cost of equity capital.
PVƒ = Present value of discount factor.
D = Dividend per share.
The cost of equity capital, ke, can be thought of as the discount rate that
equates the present value of all expected future dividends per share, as
perceived by investors at the margin, with the current market price per share.
D1 D2 D∞
P 0= 1
+ 2
+…+
( 1+ K e ) (1+ K e ) ( 1+ K e )∞
∞
Dt
P 0= ∑
t =1 (1+ K e )t
Where:
P0 is the market price of a share of stock at time 0
Dt is the dividend per share expected to be paid at the end of time period t
ke is the appropriate discount rate
Σ represents the sum of the discounted future dividends from period 1 through
infinity, depicted by the symbol ∞.
Capital-Asset Pricing Model Approach

Rj = Rf + (Rm − Rf)βj

Where,
Rj = Required Rate of Return
Rf = Risk-free rate,
Rm = Expected return for the market portfolio
βj = beta coefficient for stock j
…because of the market’s aversion to systematic risk, the greater the beta of a
stock, the greater its required return
Suppose that the beta for XYZ Company was found to be 1.20, based on
monthly excess return data over the last five years. Assume that a rate of
return of about 13 percent on stocks in general is expected to prevail and that a
risk-free rate of 8 percent is expected.
The cost of equity capital would be

Rj = 0.08 + (0.13 − 0.08)(1.20) = 14%
WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Weighted average cost of capital is the expected average future cost of funds
over the long run found by weighting the cost of each specific type of capital
by its proportion in the firm’s capital structure.
The computation of the overall cost of capital (Ko) involves the following
steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
Thus the firm’s overall cost of capital can be expressed as

Ko = Kd Wd + Kp Wp + Ke We
Where W means percentage of equity to total capital
Weighted average cost of capital is calculated in the following formula also:
Kw =
∑ XW
∑W
Where;
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
Also;
n
Cost of capital=∑ k x (W x )
x=1
Where;
kx = after-tax cost of the xth method of financing
Wx = weight given to that method of financing as a percentage of the firm’s
total financing
Σ = denotes the summation for financing methods 1 through n.

To illustrate the calculations involved, suppose that a firm had the following
financing at the latest balance sheet statement date, where the amounts
shown in the table below represent market values.
Amt. of Proportion After-tax Weighted
Financing Cost Cost
Debt P 30M 30% 6.6% 1.98%
Preferred 10M 10% 10.2% 1.02%
Stock
Common 60M 60% 14.0% 8.40%
Stock
P 100M 100% 11.40%
Economic Value Added (EVA)

A measure of business performance. It is a type of economic profit, which is
equal to a company’s after-tax net operating profit minus a cost of capital
charge (and possibly including some adjustments).
EVA is the trademarked name for a specific approach to calculating economic

profit developed by the consulting firm of Stern Stewart & Co.
Net operating profit after tax (NOPAT)

A company’s potential after-tax net profit if it was all-equity-financed
or “unlevered.”
EVA is the economic profit a company earns after all capital costs are
deducted. More specifically, it is a firm’s net operating profit after tax
(NOPAT) minus a dollar-amount cost of capital charge for the capital
employed.
Illustration:
Net (adjusted) operating profit after taxes 34,910,000
Less: Average capital employed × Cost of capital
P94,170,000 × 14.97% 14,097,249
Economic value added 20,812,751

Application
Answer the following questions below (5 points each).

Essay
1. Assume that the risk-free rate increases. What impact would this have on
the cost of debt? What impact would it have on the cost of equity?
2. How should the capital structure weights used to calculate the WACC be
determined?
3. Suppose a firm estimates its WACC to be 10%. Should the WACC be
used to evaluate all of its potential projects, even if they vary in risk? If
not, what might be “reasonable” costs of capital for average-, high-, and
low-risk projects?
4. The WACC is a weighted average of the costs of debt, preferred stock,
and common equity. Would the WACC be different if the equity for the
coming year came solely in the form of retained earnings versus some
equity from the sale of new common stock? Would the calculated WACC
depend in any way on the size of the capital budget? How might dividend
policy affect the WACC?
Problem Solving. Show your solutions in good form.

5. The Honoromo Rigodon Company’s currently outstanding bonds have a
10% coupon and a 12% yield to maturity. Honoromo Rigodon believes it
could issue new bonds at par that would provide a similar yield to
maturity. If its marginal tax rate is 35%, what is Honoromo Rigodon after-
tax cost of debt?
6. Mulan Industries can issue perpetual preferred stock at a price of $47.50 a
share. The stock would pay a constant annual dividend of $3.80 a share.
What is the company’s cost of preferred stock, rp?
7. Covid Bryant Motors has a target capital structure of 40% debt and 60%
common equity, with no preferred stock. The yield to maturity on the
company’s outstanding bonds is 9%, and its tax rate is 40%. Percy’s CFO
estimates that the company’s WACC is 9.96%. What is Covid Bryant’s
cost of common equity?
8. Aika Deimic Fris & Sons’ common stock currently trades at $30.00 a
share. It is expected to pay an annual dividend of $3.00 a share at the end
of the year (D1 = $3.00), and the constant growth rate is 5% a year.
a. What is the company’s cost of common equity if all of its equity
comes from retained earnings?
b. If the company issued new stock, it would incur a 10% flotation cost.
What would be the cost of equity from new stock?

Feedback
How would each of the following scenarios affect a firm’s cost of debt,
rd(1 – T); its cost of equity, rs; and its WACC? Indicate with a plus (+), a
minus (–), or a zero (0) if the factor would raise, would lower, or would have
an indeterminate effect on the item in question. Assume for each answer that
other things are held constant even though in some instances this would
probably not be true. Be prepared to justify your answer but recognize that
several of the parts have no single correct answer. These questions are
designed to stimulate thought and discussion.
Topic 9: Capital Budgeting

Learning Objectives

 Discuss capital budgeting;
 Calculate and use the major capital budgeting decision criteria,
which are NPV, IRR, MIRR, and payback.
 Explain why NPV is the best criterion and how it overcomes
problems inherent in the other methods
Activating Prior Knowledge
Think- Pair- Share
Capital Budgeting
Look at the two words “Capital Budgeting”. With your partner, breakdown
the meaning of the two words.
Capital
means___________________________________________________
Budgeting
means________________________________________________
Now, combine the two words and try to come up with your own definition
of capital budgeting:
Capital budgeting means

___________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
_____________________________________________________________
________
CAPITAL BUDGETING
The process of identifying, evaluating, planning, and financing capital
investment projects of an organization.
Investment Decision – judgment about which assets to acquire to achieve

the company’s stated objectives
Financing Decision – judgment regarding the method of raising capital to

fund an investment
Characteristics of Capital Investment Decisions
1. Capital investment decisions usually require large commitments of
resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short term
decisions.
4. Capital investment decisions involve so much risk and uncertainty.
Stages in the Capital Budgeting Process

1. Identification and definition
2. Search for potential investment projects
3. Information gathering – both quantitative and qualitative information
4. Selection – choosing the investment projects after evaluating their
projected costs and benefits
5. Financing
6. Implementation and monitoring
Types of Capital Investment Projects

1. Replacement
2. Improvement
3. Expansion
Capital Investment Factors

1. Net Investment
2. Cost of capital
3. Net returns
Net investment – cost or cash outflows less cash inflows or savings

incidental to the acquisition of the investment projects
Cost or Cash Outflows:

1. The initial cash outlay covering all expenditures on the project up to the
time when it is ready for use or operation:
Ex. Purchase price of the asset
Incidental project-related cost such as freight, insurance, taxes,
handling, installation, test-runs, etc.
2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be
transferred to or utilized in the operations of the proposed capital
investment project.
Savings or Cash Inflows:

1. Trade-in value of old assets (in case of replacement)
2. Proceeds from sale of old asset to be disposed due to the acquisition of
new project (less applicable tax, in case there is gain on sale, or add tax
savings, in case there is loss on sale)
3. Avoidable cost of immediate repairs on old asset to be replaced, net of
tax.

Cost of Capital – the cost of using funds; it is also called the hurdle rate of
return the company must pay to its long term creditors and shareholders for
the use of their funds.
Net Returns
1. Accounting net income
2. Net cash inflows
Economic life – the period of time during which the asset can provide
economic benefits or positive cash inflows
Depreciable life – the period used for accounting and tax purposes over
which the depreciable asset’s cost is systematically and rationally
allocated.
Terminal Value (End-of-life Recovery Value) – net cash proceeds
expected to be realized at the end of the project’s life.
Commonly Used Methods of Evaluating Capital Investment Projects

1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow
methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return
METHODS THAT DO NOT CONSIDER TIME VALUE OF MONEY

Payback Method
Payback Period = Net cost of initial investment
Annual net cash inflows
*Payback period is the length of time required by the project to return the
initial cost of investment
Advantages:
1. Payback is simple to compute and easy to understand. There is no need
to compute or consider any interest rate. One just has to answer the
question: “How soon will the investment cost be recovered”?
2. Payback gives information about the project’s liquidity.
3. It is good surrogate for risk. A quick payback period indicates a less
risky project.
Disadvantages:
1. Payback does not consider the time value of money. All cash receive
during the payback period is assumed to be equal value in analyzing the
project.
2. It gives more emphasis on liquidity rather than on profitability of the
project. In other words, more emphasis is given on return of investment
than the return on investment.
3. It ignores the cash flows that may occur after the payback period.
Bail-out Period

Cash recoveries include not only the operating net cash inflows but also the
estimated salvage value or proceeds from sale at the end of each year of the
life of the project.
Accounting Rate of Return
Also called book value rate of return, financial accounting rate of return,
average return on investment and unadjusted rate of return.
Accounting Rate of Return = Average annual net income

Investment
Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and records.
2. It facilitates re-evaluation of projects due to the ready availability of data
from the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the projects profitability.
Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not
consider the time value of money.
2. With the computation of income and book value based on the historical
cost accounting data the effect of inflation is ignored.
METHODS THAT CONSIDER TIME VALUE OF MONEY

Present Value (PV) of an amount is the value now on some future cash
flow.
PV of P1 or PV Factor (PVF) = 1 where: i = discount rate

(1+i)n n = number of periods
PV of future cash flows = Future cash flows x PVF
Future Value (FV) of an amount available at a specified future time based

on a single investment (or deposit now)
FV of P1 or FV Factor = (1+i)n
FV of Present Cash Flows = Present cash flows x FVF
Annuities – a series of equal payments at equal intervals of time

 Ordinary Annuity (Annuity in Arrears) – cash flows occur at the end of
the periods involved.
 Annuity Due (Annuity in advance) – cash flows occur at the beginning
of the periods involved.
Net Present Value

1. Present value of cash inflows
 Present value of cash outflows
Net Present Value

 Present value of cost of investment
Net Present Value

 Cost of investment
Net Present Value
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.
Disadvantages
1. It requires predetermination of the cost of capital or the discount rate to
be used.
2. The net present values of different competing projects may not be
comparable because of different magnitudes or sizes of the projects.
Profitability Index
Profitability Index = Total present value of cash inflows

Total present value of cash outflows
If the cost of investment is the only cash outflow:
Profitability Index = Total present value of cash inflows

Cost of investment
Net Present Value Index = Net present value

Investment
Internal Rate of Return

 The rate of return which equates the present value (PV) of cash inflows
to PV of cash outflows.
It is the rate of return where NPV = 0.
When the cash flows are uniform, the IRR can be determined as follows:
1. Determine the present value factor (PVF) for the internal rate of return
(IRR) with the use of the following formula:
PVF for IRR = Net cost of investment

Net cash inflows
2. Using the present value annuity table, find on line n (economic life) the
PVF obtained in step 1. The corresponding rate is the IRR.
When the cash flows are not uniform, the IRR is determined using trial-and-
error method.

Advantage:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes the true return of the project
Disadvantages:
1. Assumes that IRR is the reinvestment rate.
2. When project includes negative earnings during their economic life,
different rates of return may result.
Payback Reciprocal
A reasonable estimate of the internal rate of return,
Provided that the following conditions are met:

1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of
the project.
Payback reciprocal = Net cash inflows
Investment
Or
Payback reciprocal = 1_____

Payback period
Discounted Payback or Break-even Time

The period required for the discounted cumulative cash inflows on a project
to equal the discounted cumulative cash outflows (usually the initial cost).
Application
Answer the following questions:

1. How are project classifications used in the capital budgeting process?
2. What are three potential flaws with the regular payback method? Does
the discounted payback method correct all three flaws? Explain.
3. Why is the NPV of a relatively long-term project (one for which a high
percentage of its cash flows occurs in the distant future) more sensitive
to changes in the WACC than that of a short-term project?
4. What is a mutually exclusive project? How should managers rank
mutually exclusive projects?
5. If two mutually exclusive projects were being compared, would a high
cost of capital favor the longer-term or the shorter-term project? Why?
If the cost of capital declined, would that lead firms to invest more in
longer-term projects or shorter-term projects? Would a decline (or an
increase) in the WACC cause changes in the IRR ranking of mutually
exclusive projects?
6. Discuss the following statement: If a firm has only independent
projects, a constant WACC, and projects with normal cash flows, the

NPV and IRR methods will always lead to identical capital budgeting
decisions. What does this imply about the choice between IRR and
NPV? If each of the assumptions were changed (one by one), how
would your answer change?
7. Why might it be rational for a small firm that does not have access to
the capital markets to use the payback method rather than the NPV
method?
8. Project X is very risky and has an NPV of $3 million. Project Y is very
safe and has an NPV of $2.5 million. They are mutually exclusive, and
project risk has been properly considered in the NPV analyses. Which
project should be chosen? Explain.
9. What reinvestment rate assumptions are built into the NPV, IRR, and
MIRR methods? Give an explanation (other than “because the text says
so”) for your answer.
10. A firm has a $100 million capital budget. It is considering two projects,
each costing $100 million. Project A has an IRR of 20%; has an NPV of
$9 million; and will be terminated after 1 year at a profit of $20 million,
resulting in an immediate increase in EPS. Project B, which cannot be
postponed, has an IRR of 30% and an NPV of $50 million. However,
the firm’s short-run EPS will be reduced if it accepts Project B because
no revenues will be generated for several years.
a. Should the short-run effects on EPS influence the choice between
the two projects?
b. How might situations like this influence a firm’s decision to use
payback?
Feedback
A firm with a 14% WACC is evaluating two projects for this year’s capital
budget. After-tax cash flows, including depreciation, are as follows:
a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each
project.
b. Assuming the projects are independent, which one(s) would you
recommend?
c. If the projects are mutually exclusive, which would you recommend?
d. Notice that the projects have the same cash flow timing pattern. Why is
there a conflict between NPV and IRR?

Topic 10: Working Capital Management
Learning Objectives
 Explain how different amounts of current assets and current liabilities

affect firms’ profitability and thus their stock prices.
 Discuss how the cash conversion cycle is determined, how the cash
budget is constructed, and how each is used in working capital
management.
 Explain how companies decide on the proper amount of each current
asset—cash, marketable securities, accounts receivable, and inventory.
 Discuss how companies set their credit policies and explain the effect of
credit policy on sales and profits.
 Describe how the costs of trade credit, bank loans, and commercial
paper are determined and how that information impacts decisions for
financing working capital.
 Explain how companies use security to lower their costs of short-term
credit.
Working Capital
The capital of a business which is used in its day-by-day trading operations,
calculated as the current assets minus the current liabilities. Working capital
is also called operating assets or net current assets.
WC = CA – CL
Working Capital Management

Working capital management refers to a company’s managerial accounting
strategy designed to monitor and utilize the two components of working
capital, current assets and current liabilities, to ensure the most financially
efficient operation of the company.

Need of Working Capital Management
Cash Receivable Inventory

Management Management Management
Factors Affecting Working Capital

1. Nature of business 8. Business
2. Production policy 9. Taxation policy
3. Credit policy 10. Dividend policy
4. Inventory policy 11. Operating efficiency
5. Abnormal factor 12. Price level changes
6. Market conditions 13. Depreciation policy
7. Conditions of supply 14. Availability of raw material
How much Working Capital is Needed?

It depends on the following factors
1. Size of the firm
2. Activities of the firm
3. Availability of credits
4. Attitude towards profit
5. Attitude toward risk
Importance of Adequate Working Capital (Optimum WC)

1. Smooth running of business
2. Profitability with manage risk
3. Growth and development possibility
4. Smooth payment
5. Increase in Goodwill
6. Better trade relationship
Business Cycle

2 P rocesses in M anaging
W o rkin g Capital
Forecasting Fund
Requirement
Arrangement of Fund
Some Important Issues

A. Monetary level of cash, receivable and inventory
i. Current asset / Current Liability
ii. Current asset / Total Liability
iii. (Current asset – inventory) / Liability
iv. (Cash + marketable securities) / Current assets
B. To have understanding of percentage of fund in current account
C. Recording time spent in managing current account
Current Asset Investment Policies

Relaxed Current Asset Investment Policy - Relatively large amounts of
cash, marketable securities, and inventories are carried; and a liberal credit
policy results in a high level of receivables.
Moderate Current Asset Investment Policy - Between the relaxed and

restricted policies.
Restricted Current Asset Investment Policy - Holdings of cash,

marketable securities, inventories, and receivables are constrained.
A restricted (lean-and-mean) policy means a low level of assets (hence, a

high total assets turnover ratio), which results in a high ROE, other things
held constant. However, this policy also exposes the firm to risks because
shortages can lead to work stoppages, unhappy customers, and serious long-
run problems. The relaxed policy minimizes such operating problems; but it
results in a low turnover, which in turn lowers ROE. The moderate policy
falls between the two extremes. The optimal strategy is the one that
maximizes the firm’s long-run earnings and the stock’s intrinsic value.
DuPont Equation
Current Assets Financing Policies

Investments in current assets must be financed; and the primary sources of
funds include bank loans, credit from suppliers (accounts payable), accrued
liabilities, long-term debt, and common equity. Each of those sources has
advantages and disadvantages, so each firm must decide which sources are
best for it.
 Current Assets Financing Policy - The way current assets are

financed.
 Permanent Current Assets - Current assets that a firm must carry
even at the trough of its cycles.
 Temporary Current Assets - Current assets that fluctuate with
seasonal or cyclical variations in sales.
 Maturity Matching, or “Self-Liquidating,” Approach - A financing
policy that matches asset and liability maturities. This is a moderate
policy.
Working Capital Cycle

The duration of working capital cycle may vary depending upon the nature
of business. The duration of operating cycle (working capital cycle) is equal
to the sum of duration of each of above events less the credit period allowed
by the supplier.

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All firms follow a “working capital cycle” in which they purchase or

produce inventory, hold it for a time, and then sell it and receive cash.
 Cash Conversion Cycle - The length of time funds are tied up in
working capital or the length of time between paying for working
capital and collecting cash from the sale of the working capital.
1) Inventory Conversion Period - The average time required to convert
raw materials into finished goods and then to sell them.
2) Average Collection Period (ACP) - The average length of time
required to convert the firm’s receivables into cash, that is, to collect
cash following a sale.
3) Payables Deferral Period - The average length of time between the
purchase of materials and labor and the payment of cash for them.
Example:
On Day 1, Abu Sado buys merchandise and expects to sell the goods and
thus convert them to accounts receivable in 60 days. It should take another
60 days to collect the receivables, making a total of 120 days between
receiving merchandise and collecting cash. However, Abu Sado is able to
defer its own payments for 40 days.
Illustration:
Although GFI must pay $100,000 to its suppliers after 40 days, it will not
receive any cash until 60 + 60 = 120 days into the cycle. Therefore, it will
have to borrow the $100,000 cost of the merchandise from its bank on Day
40, and it will not be able to repay the loan until it collects on Day 120.
Thus, for 120 – 40 = 80 days—which is the cash conversion cycle (CCC)—
it will owe the bank $100,000 and will be paying interest on this debt. The
shorter the cash conversion cycle, the better because that will lower interest
charges.
Note that if Abu Sado could sell goods faster, collect receivables faster, or

defer its payables longer without hurting sales or increasing operating costs,
its CCC would decline, its interest charges would be reduced, and its profits
and stock price would be improved.
Cash Conversion Cycle
Calculating the Cash Conversion Cycle

Sample Financial Statement
Annual sales $1,216,666
Cost of goods sold 1,013,889
Inventory 250,000
Accounts receivable 300,000
Accounts payable 150,000
Cash Budget - A table that shows cash receipts, disbursements, and

balances over some period.
Target Cash Balance - The desired cash balance that a firm plans to
maintain in order to conduct business.

Cash and Marketable Securities
 Also called “cash and cash equivalents”
 currency and demand deposits in addition to very safe, highly liquid
marketable securities that can be sold quickly at a predictable price
and thus be converted to bank deposits
Demand Deposits - are used for transactions—paying for labor and raw
materials, purchasing fixed assets, paying taxes, servicing debt, paying
dividends, and so forth.
The following techniques are used to optimize demand deposit holdings:
1. Hold marketable securities rather than demand deposits to provide
liquidity.
2. Borrow on short notice.
3. Forecast payments and receipts better.
4. Speed up payments.
Ex. Lockbox - A post office box operated by a bank to which payments
are sent. Used to speed up effective receipt of cash.
5. Use credit cards, debit cards, wire transfers, and direct deposits.
6. Synchronize cash flows.
Inventories
Inventories, which can include (1) supplies, (2) raw materials, (3) work in
process, and (4) finished goods, are an essential part of virtually all
business operations. Optimal inventory levels depend on sales, so sales
must be forecasted before target inventories can be established. Moreover,
because errors in setting inventory levels lead to lost sales or excessive
carrying costs, inventory management is quite important. Therefore, firms
use sophisticated computer systems to monitor their inventory holdings.
Accounts Receivable
 Funds due from a customer
Today the vast majority of sales are on credit. Thus, in the typical situation,
goods are shipped, inventories are reduced, and an account receivable is
created. Eventually, the customer pays, the firm receives cash, and its
receivables decline. The firm’s credit policy is the primary determinant of
accounts receivable, and it is under the administrative control of the CFO.
Moreover, credit policy is a key determinant of sales, so sales and marketing
executives are concerned with this policy.
Credit Policy
A set of rules that includes the firm’s credit period, discounts, credit
standards, and collection procedures offered.
1. Credit Period - The length of time customers have to pay for purchases.
2. Discounts - Price reductions given for early payment.
3. Credit Standards - The financial strength customers must exhibit to
qualify for credit.
4. Collection Policy - refers to the procedures used to collect past due
accounts, including the toughness or laxity used in the process.

Credit Terms - a statement of the credit period and discount policy.
Monitoring Accounts Receivable

The total amount of accounts receivable outstanding at any given time is
determined by the volume of credit sales and the average length of time
between sales and collections.
Example:
Boston Lumber Company (BLC), a wholesale distributor of lumber
products, has sales of $1,000 per day (all on credit) and it requires
payment after 10 days. BLC has no bad debts or slow-paying
customers. Under those conditions, it must have the capital to carry
$10,000 of receivables:
Accounts Payable (Trade Credit)

Firms generally make purchases from other firms on credit and record the
debt as an account payable. Accounts payable, or trade credit, is the largest
single category of short-term debt, representing about 40% of the average
corporation’s current liabilities.
Trade Credit - Debt arising from credit sales and recorded as an account
receivable by the seller and as an account payable by the buyer.
Illustration:
Antokers Inc. buys 20 microchips each day with a list price of $100 per chip
on terms of 2/10, net 30. Under those terms, the “true” price of the chips is
0.98($100) = $98 because the chips can be purchased for only $98 by
paying within 10 days. Thus, the $100 list price has two components:
List price = $98 “true” price + $2 finance charge
If Antokers decides to take the discount, it will pay at the end of Day 10 and
show $19,600 of accounts payables:
Accounts payable (Take discounts) = (10 days)(20 chips) ($98 per chip)
= $19,600
If it decides to delay payment until the 30th day, its trade credit will be
$58,800:
Accounts payable (No discounts) = (30 days)(20 chips)($98 per chip)

= $58,800
Promissory Note
A document specifying the terms and conditions of a loan, including the
amount, interest rate, and repayment schedule.
Key Features of Promissory Notes

1. Amount
2. Maturity
3. Interest Rate
4. Interest only versus amortized
5. Frequency of interest payments
6. Discount interest
7. Add-on loans
8. Collateral
9. Restrictive covenants
10. Loan guarantees
Line of Credit - An arrangement in which a bank agrees to lend up to a

specified maximum amount of funds during a designated period.
Revolving Credit Agreement - A formal, committed line of credit

extended by a bank or another lending institution.
Cost of Bank Loans

The costs of bank loans vary for different types of borrowers at any given
point in time and for all borrowers over time. Interest rates are higher for
riskier borrowers, and rates are higher on smaller loans because of the fixed
costs involved in making and servicing loans
 Prime Rate - A published interest rate charged by commercial
banks to large, strong borrowers.
Calculating Banks’ Interest Charges: Regular (or Simple) Interest

 Regular, or Simple, Interest - The situation when only interest is paid
monthly.
Assuming a loan of $10,000 at the prime rate (currently 5.25%) with a
360-day year. Interest must be paid monthly, and the principal is
payable “on demand” if and when the bank wants to end the loan.
To find the monthly interest payment, the daily rate is multiplied by the
amount of the loan, then by the number of days during the payment
period. For our illustrative loan, the daily interest charge would be
$1.458333333 and the total for a 30-day month would be $43.75:
The effective interest rate on a loan depends on how frequently interest

must be paid—the more frequently interest is paid, the higher the
effective rate. If interest is paid once a year, the nominal rate also will

be the effective rate. However, if interest must be paid monthly, the
effective rate will be (1 + 0.0525/12)12 – 1 = 5.3782%.
Add-On Interest - Interest that is calculated and added to funds received to

determine the face amount of an instalment loan.
Commercial Paper - Unsecured, short-term promissory notes of large

firms, usually issued in denominations of $100,000 or more with an interest
rate somewhat below the prime rate.
Accruals - Continually recurring hort-term liabilities, especially accrued

wages and accrued taxes.
Spontaneous Funds - Funds that are generated spontaneously as the firm

expands.
Secured Loan - A loan backed by collateral, often inventories or accounts

receivable.
Summary
This module discussed the management of current assets, including cash,
marketable securities, inventory, and receivables. Current assets are
essential, but there are costs associated with holding them. So if a company
can reduce its current assets without hurting sales, this will increase its
profitability. The investment in current assets must be financed; and this
financing can be in the form of long-term debt, common equity, and/or
short-term credit. Firms typically use trade credit and accruals; they also
may use bank debt or commercial paper.


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Unit 4: Financial Assets

At the end of this unit, students will be able to:

 Understand and compares the characteristics of the two main source of

Financial Management Module 1

 The Concepts of Valuation

Calculation of the value of these assets

Key Elements in the Valuation Process for Financial Assets

Financial Management Module 2

Putting Things in Perspective

After successful completion of this topic, you should be able to:

 Identify the different features of corporate and government bonds.

Financial Management Module 3

A bond is a long-term contract/instrument under which a borrower agrees to

Who issues Bonds?

Source: https://www.google.com/search? Source: https://www.google.com/search?

Financial Management Module 4

How Bonds Work?

Financial Management Module 5

Financial Management Module 6

A) Pricing Coupon Bonds

Financial Management Module 7

B) Adjusting for Semi-Annual Coupons

= 38.83 + 37.70 + 36.61 + 924.03 = $1,037.17

C) Pricing Zero Coupon Bonds

Financial Management Module 8

2. A Php 10,000 bond with interest 12% converted quarterly is redeemable

b. Redemption Value = Face Value x redemption rate

c. i = r/m = 10%/4 = 0.025 n = t(m) = 10 x 4 = 40

Financial Management Module 9

d. Bond Premium = Purchase Price – Redemption Value

 YIELD TO MATURITY (YTM) – the rate of return earned on a bond if

EXAMPLE: Suppose you were offered a 14-year, 10% annual coupon,

Face Value−Market Price

 YIELD TO CALL (YTC) – the rate of return earned on a bond when it

EXAMPLE: You have just purchase an outstanding 15-year bond with a

Financial Management Module 10

The Washington Corporation issued a new series of bonds on January 1, 2005.

Think about these questions

Financial Management Module 11

Unit 5: Investing in Long-Term Assets: Capital

At the end of this unit, students will be able to:

Financial Management Module 12

Topic 8: The Cost of Capital

Activating Prior Learning

Financial Management Module 13

Growth Barriers to Other

Financial Management Module 14

MEANING OF COST OF CAPITAL

- Rely on return (yield) calculations to determine cost figures because “cost”

IMPORTANCE OF COST OF CAPITAL

ASSUMPTION OF COST OF CAPITAL

It is to be considered that there are three basic concepts:

CLASSIFICATION OF COST OF CAPITAL

Financial Management Module 15

Explicit and Implicit Cost

Average and Marginal Cost

Historical and Future Cost

Specific and Combine Cost

The overall cost of capital is a weighted average of the individual required

The overall cost of capital of a firm is a proportionate average of the costs of

Financial Management Module 16

Debt Issued at Par

Debt Issued at Premium or Discount