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FINANCE 3403 - 3404: Lecture Notes
Raymond H. Diggle, Jr., CFA
College of Business
University of Central Florida
TEXT:
Keown, Scott, Martin & Petty
Basic Financial Management
8th. edition
This workbook is a compilation of class handouts.
It has been prepared to help you understand concepts
and do well on examinations. Please bring this workbook
to each class with your financial calculator.
E-MAIL ADDRESS IS ON SYLLABUS AND MY WEB SITE
I AM HERE TO HELP. HOME TEL (Ormond Beach) 904- 615-0700
PLEASE CALL BEFORE 9 PM on nights when I am not teaching
OFFICE TEL: DAYTONA BLDG 36 200B 904-254-4412 X 4030
BREVARD ROOM 345
632-1111 X 65576
OFFICE HOURS AND CLASS SCHEDULE ARE POSTED ON OFFICE DOOR
INTRODUCTION
2
This workbook has been designed to consolidate all lecture notes and handouts. It has been prepared to
help you study for exams and to cover key concepts. It amplifies many concepts in the text and summarizes
key formulas and points. It is not a problem workbook. I will provide sample problems from the text
workbook for exam review in the library and by handout. There will be problem assignments from
problems at the end of each chapter. These assignments will be supplemented with class handouts and
overhead slides. Homework assignments are designed to help you do well on examinations. Solutions will
be provided. Homework is checked but not graded. This book will be referred to extensively during the
course so bring it to each class EACH class meeting. It is also designed to help you do well on exams so
be sure and study it carefully. Some exam questions are taken from this book.
TABLE OF CONTENTS
TOPIC
PAGE NUMBER
FIN 3403 AND 3404
Course notes
3-4
Group project notes
5-6
Using Excel and Powerpoint
7
Exam study tips
9
Time value of money concepts
9-11
Use of a financial calculator
12-15
TVM homework problems and solutions
16-22
Financial Ratio analysis and team project tips
23-26 (also see appendix p. 49)
Cost of capital concepts
27-28
Capital budgeting concepts
29-33
Capital Structure and Leverage
34-36
FIN 3404 TOPICS
37
Financial Forecasting and modeling
38-41
Financial markets and instruments
42-43 (INTRODUCED IN FIN 3403)
Valuation of bonds and stocks
44-46(INTRODUCED IN FIN 3403)
Convertible Securities and Warrants
47
Common stock valuation concepts
48
Dividend Discount Model sample
49
Put and Call Options
50-51
Appendix
Tips on taking exams in this course
52
Read the WSJ Like a Pro
53-54
Career opportunities in finance
55-56
Preparing an effective resume
57
Interviewing tips
57
Formulas
58
Financial ratio formulas
59
Business Math -- common exam errors
60
AIMR and the CFA designation
61
© R. H. Diggle, Jr., CFA. All rights reserved. 1998.
SYLLABUS SUMMARY DATA
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FIN 3403
FIN 3404
INSTRUCTOR
OFFICE HOURS
OFFICE NUMBER
TELEPHONE:
E-MAIL
BUSINESS FINANCE
INTERMEDIATE FINANCE
R. H. DIGGLE, JR, CFA
POSTED—CHECK OFFICE DOOR
BLDG 36 200B DAYTONA CAMPUS
TEL: 904-254-4412
ROOM 345
BREVARD CAMPUS
TEL: 904-632-1111 X 65576
HOME
904-615-0700
NOT AFTER 9 PM
CHECK WEB SITE WHICH HAS AN E-MAIL ICON
COURSE DESCRIPTIONS:
FIN 3403 is entitled “Business Finance”and deals with fundamental corporate finance
issues including time value of money, use of a financial calculator, cost of capital, capital
budgeting, financial markets and instruments and valuation issues.
PREREQUISITES ACC 2021, 2071, ECO 2013, 2023
FIN 3404 (Intermediate Finance) is a continuation of the FIN 3403 for finance majors.
Additional topics covered include financial structure and leverage, financial forecasting
and modeling, more advanced valuation and ratio analysis, options and derivatives.
PREREQUISITES FIN 3403 (not to be taken concurrently)
TEXTBOOKS AND INSTRUMENT (BOTH COURSES):
REQUIRED TEXT: Basic Financial Management, 8th edition, 1996, Keown, Scott,
Martin & Petty.
The TI BA II+. Texas Instruments Business Analyst II Plus. The workbook,
lectures, and the text are keyed to this instrument. You will be at an extreme
disadvantage in exams if you attempt to use another financial calculator.
HIGHLY RECOMMENDED
The Wall Street Journal (student subscription sign up will be the second week of class. Students
may share subscriptions. The WSJ is HIGHLY recommended)
PLEASE REFER TO THE COURSE SYLLABUS FOR
1.
2.
3.
4.
Grading, exam, and attendance policy
Office hours. Hours will also be posted on office door.
Assignments
Other current information
The instructor reserves the right to change the order of material and to change class assignments.
Both FIN 3403 and 3404 are quantitative courses. Students who took basic accounting more than 2 terms
ago should brush up on accounting. Knowledge of basic accounting is assumed. This course will use the
personal computer. There are assignments using MS Excel and Powerpoint. I will briefly demonstrate
these tools in class.
GENERAL COURSE NOTES
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4
General knowledge of accounting is assumed. The instructor will be available to assist students before
class. Office hours will be posted. This is a quantitative course. It is important that you do assigned
problems and bring your text and financial calculator to each class.
Accounting Review:
It has been my experience that if you have not had accounting within the past 2
years, you may need to brush up on concepts. I will provide library materials to
help you. Read Chapter 2 of the text and do problems at the end of that chapter.
See instructor early if you are confused. Finance is a cumulative discipline. If
you are unclear on a concept, spend the time to understand it. The best way to
do this is usually by doing problems.
My job is to help you and to simplify text material.
Financial Calculator:
Your first assignment is to become familiar with the assigned financial
calculator. Read the manual. Test the TVM keys which are described later in
these lecture notes. The calculator will be used in both FIN 3403 and 3404 It
will also help you in real life calculate the cost of an auto loan or lease, figure a
mortgage and even price a bond. I have made arrangements with local retailers
to stock this calculator. Cost is typically under $40.
Examinations:
BRING YOUR FINANCIAL CALCULATOR AND SEVERAL PENCILS.
There will be three exams plus a cumulative final exam. You can drop the
lowest exam score. If you do well in Exams 1, 2 and 3, you have the option of
not taking the final.
Coverage: assigned chapters, homework assignments and problems
Lectures will emphasize important topics.
Format: multiple choice, problems and short answer
Time: Maximum of 1 hour 45 minutes
Formula sheets provided with all exams.
There will be a lecture after each of the exams (1 to 3)
Make up exams:
Only granted to students who can provide documentation of illness or personal
emergency. Students must see instructor ASAP regarding a missed exam.
Homework assignments:
Assignments should be turned in after class on the due date. Homework
problems are designed to help you do well on the exams.
.
The two lowest homework grades will be dropped. Assignments marked in
bold type are to be handed in. Other problems will be assigned in class to help
clarify concepts and help you use calculator spreadsheets.
For students who have trouble with quantitative problems, the Study Guide is
recommended for review as are the questions at the end of each chapter.
Attendance policy:
Homework:
Lectures are designed to help you understand concepts and to help you work
problems. STUDENTS WITH MORE THAN 3 UNEXCUSED ABSENCES
WILL NOT PASS THIS COURSE.
Prepare and turn in homework problems on date assigned. Please STAPLE all
homework. ALL HOMEWORK MUST BE MARKED AS FOLLOWS in
UPPER RIGHT corner of p. 1: Your name, date, FIN 3403 and campus,
chapter and problems assigned. Place name on all pages
COURSE NOTES CONTD.
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Computer use:
You should have an active student number at the University Computer Center.
Assignments may be made using software loaded on the server. See instructor
you have questions or problems in accessing assigned software or databases.
Special needs:
See instructor during office hours if you have special needs.
If you have trouble seeing the screen, see me and have your seat changed.
Seating chart:
I will set up a seating chart early in the term. I ask that teams sit together.
Recording lectures:
You may make tape recordings of lectures if it will help you review material. I
will work on making copies of Powerpoint lecture slides available in the
library.
GROUP PROJECT NOTES
Both FIN 3403 and FIN 3404 will be divided into groups to analyze a real company and perform ratio
analysis. This exercise is designed to enhance the learning experience. The FIN 3404 analysis will be more
advanced and will include a sales and earnings forecast. Peer evaluations will be made. Each student will
be asked to complete a form at the end of the term. The purpose of this is to assure that all team members
contribute to the team. How you manage this is up to you. Teams will be given time to get organized in
class. You must attend team meetings. See instructor with any problems.
Most work in companies today is done in teams. It is important that you get experience working in a team
environment. The goal of this exercise is to give you hands on experience in analyzing a real company. It
is likely that you will encounter accounting treatments that may vary from those you have encountered in
textbooks. This is normal. You are asked to meet with instructor as a TEAM either during office hours or
by appointment with any and all questions on this project.
TEAM COMPANY CHECKLIST:
1.
2.
Organize your teams early in the term. You should team meetings at a convenient time for all
members. You will be given some class time to sign up and exchange phone numbers. All team
members should be involved in preparing your company analysis. Your team can function as a study
group as well.
Companies should be selected by the THIRD class meeting (second week in summer). The instructor
will approve all companies to avoid duplication and to make sure data is available on your company.
IT IS IMPORTANT that you do the following in selecting your company:
 See that there is information on your company in the library. You MUST limit your choice to
a PUBLIC INDUSTRIAL company with at least 10 years of operating history. This is so that
information will be easier to find. The company must have sales of at least $500 million.
 The company must be profitable. DO NOT select a company with a loss.
 See if there are current financials available in the library or elsewhere such as the internet
You should call, fax or write your company ASAP requesting copies of the most recent annual
report and 10K. Try and get the most recent proxy, 10Qs (quarterly reports) and recent press
releases. Please try and work with original documents and not EDGAR copies or summaries
from the internet. I cannot over stress the importance of obtaining information on your
company immediately.
TEAM COMPANY ANALYSIS CHECKLIST CONTD.
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3.
Define responsibilities for each team member in the written and oral report. This is PARTICULARLY
important for team 1 & 2 since your presentation is due immediately after exam 2. The oral
presentation on your company should include slides for the overhead projector and/or handouts and
must be TIMED to last 15 minutes. Allow another 5 minutes for questions.
4. A team representative should see the instructor each week with a progress report and questions on
ratios and specific issues relevant to your company. I strongly suggest you let me review as much of
your presentation materials as possible before the due date so I can make suggestions.
5. Begin filling in data on the Excel spreadsheet program. A disk will be provided each team. Make
6. sure that you follow instructions and enter data consistently in $millions (except per share data).
See instructor with questions as a team or send one team member with all team questions.
 Begin by transferring the Excel spreadsheet to a floppy disk and entering names of all team
members, your team number, and the company name in the yellow spaces.
 Look in the Wall Street Journal for current price, annualized dividend per share and P/E ratio.
By dividing price by the P/E you can determine Last 12 month (LTM) E.P.S. or earnings per
share. You may need to update this just prior to your presentation. Also find your company
ticker symbol and where it is traded.
 Enter the month and year of the last published annual report. Use this data since quarterly
data is not audited. You are encouraged to update earnings to the last quarter in your remarks
especially if trends are different but your analysis uses only audited annual data.
 Enter income statement and balance sheet data in spaces indicated. There may be gaps. Do as
much as you can before seeing instructor.
 Using Value Line, Moody’s Handbook or Internat sources, enter the HI and LO stock prices
for the past 5 years.
7. Check comparatives on other firms in the same industry using the S&P Compustat database.
Important: Review this with instructor.
8. Look at your output and check for any input errors. Begin analyzing the ratios and comparing your
company’s performance with its peers. This is called “benchmarking.”
 Look at trends in growth.
 Are ratios of your company better or worse than the competition? Why?
FIN 3404 0NLY
 Complete the Forecast section after the ratio analysis. (SEE P. 39 BELOW)
 Complete the DuPont Model and DDM.
(SEE INSTRUCTOR)
 Read the CEO letter for the past several years. Did the company do what they said they would
do? What are their strategic objectives?
9. Begin developing your presentation outline. Remember time your remarks to last 15 minutes so it is
important that your remarks be scripted. You may organize the presentation in any way you want .
10. Begin developing your Microsoft Powerpoint slides. You will use the LCD system for the overhead
projector to project your powerpoint presentation on the screen. USE LARGE FONTS so slides can be
seen in rear of classroom. Make copies of the spreadsheet, slides and remarks for instructor.
11. ON THE DATE OF YOUR PRESENTATION
 IMPORTANT: Bring multiple copies of your Powerpoint computer disk so if one team
member is delayed or if disk is damaged you can proceed. Arrive early. Load your
presentation on the C drive of the PC before class and test it.
 Team members should be dressed in appropriate business attire

Provide a one page outline for your class mates and instructor to use to take notes.
 Review what each team member will do prior to class. Use a script.

IMPORTANT: Before presentation, please give the instructor a copy of last annual
report, handouts and ratio Excel sheet printout and overheads. Place the names of each
team member, the date, name of the company and course on the cover page.
EXCEL AND POWERPOINT
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EXCEL
One of the important skills that you need to master to increase your marketability is effective use of Excel
or Lotus 1-2-3 to do spreadsheet analysis, MS Word to prepare written text and Powerpoint to prepare
visual presentations. This is a skill that you can and should put on your resume. Knowledge of Excel is
assumed. If you do not know how to use this software, take time to go to the computer lab and learn it.
You do not need to be an expert. One of your team members or a lab administrator can help you. LAB
ADMINISTRATORS ARE NOT responsible for teaching you this software, however.
Financial spreadsheets using Excel are a part of financial modeling and financial decision making today. As
a UCF business school graduate
you will be expected to understand these tools. This course will help
you in understanding spreadsheet analysis through your team project. Each team will also be provided with
a computer disk with several other assignments and (possible) extra credit projects. You will not be
required to use Excel on any exam in this course. That is what the financial calculator is for. It is
recommended that finance majors consider a financial case course to apply concepts learned in this course
using preformatted spreadsheets.
POWERPOINT
Powerpoint is the standard for business graphics today. I will demonstrate this software in class about one
third of the way through the term. Here are some tips in the use of Powerpoint:
1.
2.
3.
4.
5.
6.
7.
8.
We use MS NT in the Business School. Be sure and save all your work in MS NT format on a floppy
disk in the computer lab. Lower versions may not work or will need to be converted to MS NT to
function properly.
Be sure and rehearse your presentation. I encourage as many members of the team as you want to
participate in the remarks but the way you decide to organize your team is completely your call.
On the day of your presentation, I recommend you save your presentation on the hard drive on the
portable PC in the classroom. Plan to get to class early to do this. Some charts and tables may not
work properly from a floppy or may delay your presentation due to slow response.
Powerpoint has a notes capability that allows you to type our the “script” of your presentation. I
recommend that you use a script and that you time your presentation. Consider this a dres rehearsal for
your first presentation in a corporate board room.
Have one member of the team follow the script and work the computer to advance the slides. The
presenter should kep eye contact with the audience.
Powerpoint is fun!!! Experiment with various sound effects and icons. However remember that the
primary job you are to do is to evaluate your company using the financial ratio analysis. Begin with
that. Use the ratios in your spreadsheet.
You may use graphics, charts, and tables. Just be sure that fonts are large enough to be seen at the back
of the room. You may wish to download the corporate logo from the internet. Just remember to be
sure and debug your disk for any viruses BEFORE using the server or loading anything on the
classroom PC.
You are REQUIRED to make a class handout of the key points of your presentation. Limit this to one
page. Make enough copies for each of your classmates.
Plan to use the LCD screen for your presentation. This will enable you to use motion and sound and color
effectively. Be sure and print all slides for the instructor.
STUDY TIPS FOR THIS COURSE
These suggestions are based on working with students over the years.
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SUGGESTION 1: GET INTO A STUDY GROUP NOW. This is particularly
important if you have not had accounting recently, or you have
difficulty with quantitative courses. Your project team is designed
to be a study group. Be sure members of your team live in the
same area so it is easy to set up meetings.
SUGGESTION 2: DO THE HOMEWORK FOR EVERY CLASS. Students who
are not prepared become confused. There is a great deal of
material covered in class. If you have not studied the lecture notes
and text and attempted to do the problems, the odds increase
greatly that you will not do well on exams.
SUGGESTION 3: WRITE OUT QUESTIONS. Ask questions in class. Do not
hesitate to see me if you are Having problems. It is normal to be
confused in the beginning. It takes a while for the "light bulb" to
come on and my experience is that everyone sees the light at a
different schedule.
SUGGESTION 4: TAKE ACCURATE NOTES. Exams focus on lecture material
because I try and highlight things I consider important. The best
way to take notes is to DOWNLOAD the powerpoint lecture slides
in slide show format -- 3 - 4 slides per page with room on the right
for notes.
SUGGESTION 5: IN STUDYING FOR EXAMS DO THE FOLLOWING:
A. Do problems in your study group. If you are unsure about an
area, do more problems such as the ST (self test problems).
These provide the solutions at the end of the chapter.
B. Study lecture notes and PPT slides with class notes. Pay
attention to definitions of terms.
C. Be sure and become thoroughly familiar with your financial
calculator WELL BEFORE the exam.
D. A formula page will be provided. You need to know which
formulas apply to the problem at hand.
E. If you are rusty on accounting be sure and review Ch. 2 and
other material suggested by instructor.
F. Watch out for simple math mistakes. Do you know how to
calculate % change between two points? Check your work.
SUGGESTION 6: DO NOT PANIC.
You are allowed to drop one exam. Take advantage of extra credit
opportunities. If you do poorly on an exam DO NOT get
discouraged. Review what you did wrong and work to understand
the material. Exam material is cumulative.
SUGGESTION 7: See me DURING OFFICE HOURS if you are having problems.
THE TIME VALUE OF MONEY
The saying is “A bird in hand is worth two in the bush.” The value of a dollar received
today is worth more than a dollar received a year from now. Why? Money received now
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can be invested and earn interest, or it could be consumed. Investing is trading dollars
today for dollars in the future. Borrowing is trading future dollars for dollars today.
Key concepts:
Time line YEARS 0
1
2
3 YEARS
_______________________________________
Value
$1
$1.10
$1.21
$1.33 10% Compound return
The time line shows that by compounding $1 today it will grow to $1.21 in 2 years and
$1.33 in 3 years. This is called finding future value.
Discounting is the opposite of compounding. Discounting the future value of $1.33 in
year 3 to period zero of $1 is called finding a present value.
The interest rate r is the rate at which a cash flow grows in the future. Compound interest
is earning interest on interest. In the above example, simple interest of 10% would
provide an investor with a return of 10 cents per period.
The formula to express the concept of compounding and future value is:
FVn = PV (1 + r)n
$1(1.10)3
FV3 = $1 (1.10)(1.10)(1.10) = $1.33 or
where n = 3 years
Your financial calculator will help you solve for any of 4 variables: future value (FV),
present value (PV), time periods (n) and the interest rate r. There is another factor to
consider in addition. This is the number of compounding periods m. The financial
calculator requires you to set the number of periods using the key P/Y. You know that
daily compounding will produce a higher future value than annual compounding for
example.
We will look at the use of a financial calculator in the next section.
CONVENTION
In using a calculator, OUTFLOWS are a negative number and
INFLOWS are positive.
PRESENT VALUE TABLES: Please become familiar with Tables B, C , D, and E in
the back of your text. While exams will use the calculator, we will do problems using the
tables to help you understand what the calculator is doing.
TIME VALUE OF MONEY CONTD.
FV CONCEPTS:
1. The higher the interest rate r the higher the future value
2. The longer the time period n the higher the future value
3. The more frequent the compounding m the higher the FV
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As noted above, Discounting is the process of taking a Future Value (FV) and placing it
in Present Value terms. In finance this concept is used in a variety of applications that we
will study in this course. For example:
 The value of an office building is the discounted present value
of the rents received for n years.
 The value of a common stock (using a dividend discount
model) is the expected future dividends paid for n years into
the future.
PV = FVn
(1 + r)n
We saw above that $1 grew to $1.33 in 3 years at 10% compounded. Conversely, the PV
of $1.33 received 3 years from now is $1
PV CONCEPTS:
1. The higher the interest rate r the lower the present value
2. The longer the time period n the lower the present value
3. The more frequent the compounding the lower the present value
So far we have dealt with a simple example of single (or lump sum) cash flows
What about multiple cash flows?
A constant cash flow over time is called an ANNUITY. This contrasts with a lump sum.
The present value of an annuity (PVA) can be derived from the following formula:
PVA =
FV
( 1 + r)1
+
FV
(1 + r)2
+
FV
( 1 + r)3
Let us say you receive a paycheck of $500 per week. That is an annuity which pays you a
total of $26,000 per year (52 weeks).
The future value of an annuity FVA can be derived using the PMT key on your financial
calculator. The PMT is a recurring cash flow of the same size received over time (n). Let
us say you can save $300 per month. At an interest rate r of 15% per annum
compounded, how much money would you have in 30 years? In 25 years?
n = 30 x 12 = 360 months )With the financial calculator, you will learn how to set the
calculator for monthly compounding by setting P/Y to 12. On the calculator you will set
P/Y to 12 meaning this is a monthly payment (12 times per year).
PMT = $300. THIS IS ENTERED AS A NEGATIVE NUMBER -$300
r (I/Y on your calculator) = 15 (note this number is entered with NO decimal)
TIME VALUE OF MONEY CONTD.
SOLVE FOR FV: =$ 2,102,946 (This is the FV of $300 per month for 30 years at 15%.
SOLVE FOR FV WHERE TIME PERIOD IS 25 YEARS (300 months). SET N = 300
FV
= $985,222. (ALMOST A MILLIONAIRE).
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Notice that the money more than doubled between 25 and 30 years.
As we will learn in applying the “RULE OF 72” at a compound rate of 15%
money doubles every 4.8 years.
Divide the number 72 by the interest rate 15 = 4.8
At 10% money doubles every 7.2 years (72/10)
As we have learned: If r increases the FV increases.
A football player is offered a 3 year contract which will pay $5 today (lump sum) or $ 1
million at the end of year 1, $2 million at the end of year 2, and $3 million at the end of
year 3. Assuming an interest rate r of 5%, which offer should he accept?
The PV of the $5 million lump sum is $5 million since it is received today. What is the
PV of 3 uneven cash flows totaling $6 million over 3 years? The answer is $5,357,952.
SETTING UP A TVM PROBLEM ON AN EXAM
1. Read the question carefully. What are you solving for.
2. Draw a time line neatly. Be careful. IN MOST PROBLEMS YOU NEED TO
MAKE SURE THAT THE SOLUTION IS YEAR 0.
3. List data inputs. Is this an annuity problem or a lump sum or both?
4. What is the number of compounding periods per year (P/Y)?
5. What is the discount rate (I/Y)?
YOU MUST LIST ALL INPUTS NEATLY TO GET PARTIAL CREDIT ON AN EXAM
We will illustrate these simple concepts with a series of problems. This will be done in
class and in problems. I also may provide a video and other library materials to help
you.
First, however, we need to become familiar with a financial calculator.
USING A FINANCIAL CALCULATOR
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The TI BA II plus
1. STARTING OUT
It is important that you read the manual carefully before attempting to use your calculator.
1. Clear all registers using 2nd CPT, 2nd CLEAR TVM and 2nd clear Work keys
2. Check P/Y key. For annual calculations set it for 1 payment per year. For bonds (unless otherwise
specified) it is 2/y since bonds pay semiannually, for bank loans it may typically be set at 12/Y (i.e. one
payment per month (the default setting).
3. How many decimal points do you need? In some calculations you may want 5 digits to the right of the
decimal. ENTER 2ND FORMAT 5 (ENTER) This sets calculator to needed accuracy.
2. TIME VALUE OF MONEY KEYS
(learn this first)
These keys are located the third row from the top. There are 5 keys:
N
NUMBER OF TIME PERIODS (P/Y X N) IF P/Y = 2 AND THE TIME IS 5 YEARS N = 10
I/Y
ANNUAL INTEREST RATE ENTER AS A WHOLE NUMBER (8.75% is entered as 8.75)
PV
NET PRESENT VALUE (lump sum) Enter outflows as a negative number
PMT PAYMENTS (periodic payments – annuity) Enter outflows as a negative number
FV
FUTURE VALUE
In addition to these five keys, you must check P/Y:
P/Y
2nd. and I/Y key ENTER THIS FIRST BEFORE ENTERING DATA ON ANY PROBLEM
P/Y is the number of compounding periods. P/Y = 1 = annual, P/Y = 365 = daily etc.
You can enter data in 3 or 4 keys and solve for the remaining variable. There is no preset order in which
you must enter data. Just be sure to clear registers and check P/Y before entering data.
Any of these keys can be the dependent variable. For example, say you want to determine how many years
it will take for you to accumulate $1,000,000 by saving $500 per month at 10% E. growth per annum.
ENTER
P/Y = 12 ENTER
I/Y= 10
PMT= -500 (FINANCIAL CONVENTION: OUTFLOWS ARE A MINUS NUMBER)
FV = 1000000
ENTER CPT , N
= 345.0922 MONTHS
DIVIDE BY 12
=28.758 YEARS
If you stand to inherit $100,000 in 10 years, what is it worth now at a 10% discount rate?
ENTER
P/Y = 1 ENTER
N = 10
I/Y= 10
FV=100000
ENTER CPT, PV
= 35174.82
3. BOND WORKSHEET
PROBLEM:
(we will use this later in the course)
What is the yield to maturity of a 8.75% bond due in 20 years selling at 105
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ENTER
2nd
BOND
CLR WORK
Enter settlement date (This is the date the bond would be paid for in a trade:
IMPORTANT NOTE: Corporate settlement is 3 business days from trade
date. Settlement on U.S. Treasury issues is next day (trade date + 1)
ENTER SDT (settlement date): Use June 30, 1997
ENTER THIS DATE AS: 6.3097 PRESS ENTER AND DOWN ARROW
CPN: The menu prompts you for coupon in pct 8.75% = 8.75 ENTER
ENTER RDT (redemption date): This is the date the bond matures or is called.
In this problem maturity is 20 years from now (June 30, 2017) = 6.3017 PRESS
ENTER
PRESS DOWN ARROW KEY
RV = ENTER PAR (100)
All bonds mature at $1000. Bonds are
quoted as a percent of par. Enter $1000 as 100% or 100.
ACT
Leave calculator set at ACT which means a 365 day year (actual)
2/Y
Leave calculator set at semiannual interest pay. This is true of all
corporate bonds we will be studying.
PRI: SKIP OVER YLD AND scroll down to PRICE and enter 105.
105=$105% 0f par or a dollar price of $1050.
YLD
Scroll UP ARROW to YLD and enter CPT
SOLUTION IS 8.23% THIS IS THE YIELD TO MATURITY
4. CASH FLOW WORKSHEET
(We will use this in capital budgeting)
This worksheet is used in solving capital budgeting problems. You can also do many problems with TVM
keys and use this to CHECK YOUR ANSWER in an exam.
ENTER
2nd CF
Cf0ENTER DOLLAR OUTFLOW OF INITIAL INVESTMENT
CONVENTION: Outflows are a NEGATIVE number
C01 ENTER CASH INFLOW IN YEAR 1 .. n
FO1 ENTER FREQUENCY (for even cash flow stream enter years of cash flows)
CO2 .. C0n
Enter as above
NPV
computer will ask for I
I=WACC in capital budgeting problems
WACC= weighted average cost of capital
(also called “hurdle rate”)
Enter I (i.e. 10% is entered as 10 with no decimal)
USE DOWN ARROW. NPV APPEARS AGAIN. HIT CPT KEY
This provides the NPV of cash flows discounted at I IRR
IRR is a percentage that equates the cash outflows with the inflows
If IRR were used as the discount rate in a NPV calculation the answer
would be zero.
NPV IS CONCEPTUALLY THE MOST ACCURATE METHOD
5. OTHER WORKSHEETS
We may examine other worksheets on your calculator in an effort to solve specific problems such as
leasing, mortgage amortization or compound rate of return. The calculator manual will explain use.
5. USING YOUR CALCULATOR IN AN EXAM
Exam 1 will primarily focus on your ability to do time value of money calculations.
13
14
AT LEAST 60% of this exam will involve TVM problems using your financial
calculator. In Exam 1 you will use the 3rd row of keys only.
When solving a TVM problem do the following each time:
1. DETERMINE THE TIME LINE.
2. CLEAR ALL REGISTERS
3. ENTER P/Y
P/Y
Payments per year The default setting of your calculator is P/Y = 12.
4. ENTER INDEPENDENT VARIABLES IN ANY ORDER
N
number of time periods. (P/Y) x (years) . 30 years of monthly pmts: N = 360
I/Y
annual interest. Enter as a number with no decimal (10% is entered as 10)
PV
Present value. This is for LUMP SUMS
CONVENTION: Outflows are entered as a negative number
PMT Payments -- An ANNUITY stream of EVEN cash inflows or outflows.
FV
Future value. This could represent the value of a portfolio for example where
you invested a lump sum (PV entered as an outflow) and/or a series of PMTS
(also entered as outflows).
5. SOLVE FOR DEPENDENT VARIABLE
6. CHECK YOUR WORK. DOES IT MAKE LOGICAL SENSE?
STEPS IN DOING TVM PROBLEMS IN AN EXAM
1. Clear registers
2. Draw the time line on the back of the exam page. What are you solving for?
3. Show all inputs on your calculator NEATLY starting with P/Y. IF YOU
WANT PARTIAL CREDIT SHOW YOUR WORK AND BE NEAT.
4. Check your work with rule of 72 or other worksheet register.
The only way to learn the calculator is to do problems.
THE RULE OF 72:
This rule will help you check your work.
Divide I/Y into 72. This will tell you the number of years
it will take for a sum to DOUBLE.
Example:
10% (72/10)
=
7.2 YEARS
15% (72/15)
=
4.8 YEARS
20% (72/20)
=
3.6 YEARS
This approximation helps you solve simple lump sum future value (FV) problems.
It is important to understand CONCEPTUALLY what the calculator is doing to see if
your answer makes sense. For example, if you invest $10,000 at 10% interest for 7 years
you know from the rule of 72 that the answer should approximate $20,000 since money
doubles in 7.2 years at 10% compounded annually.
The tables in the text will not be used in an exam. However, it is important that you
understand what they mean. Let us briefly look at them now in the back of your text:
TABLE B
FUTURE VALUE OF A LUMP SUM OF $1 (COMPOUND SUM)
This table tells you the value of $1 for n periods at interest rates of 1% to 36%
Assume you invest a lump sum $1000 at 15% for 20 years.
Go to 20 year line and over to 15% column. The table value is 16.366
Multiply table value times PV (lump sum outlay): ($1000 x 16.366) = $16,366
This is the value of your lump sum savings at the end of the period (20 years)
USING THE FINANCIAL CALCULATOR CONTD.
TABLE D
FUTURE VALUE OF AN ANNUITY (SUM OF AN ANNUITY)
This table is the future value of an annual payment (PMT). For example, let us
14
15
TABLE C
TABLE E
say you save $1000 per year for 12 years at 9%. Go to the 12 year line and
the 9% column. The table value is 20.140.
Multiple table value times PMT
(1000 x 20.141) =
$20141.
This is the FV (future value) of your savings
PRESENT VALUE OF A LUMP SUM OF $1 RECEIVED IN THE FUTURE
The value of $1 received in 15 years at a 12% discount rate is .1827.
If the value at the end of the period (15 years in this example) is $1000, the
present value is $182.70 discounted at 12%. This means that if you invested
$182.70 for 12% for 15 years it would be worth $1000 at the end of the period.
PRESENT VALUE OF AN ANNUITY OF $1 FOR n PERIODS
Assume you invest $500 per year for 15 years. The table value at a 15%
discount rate is 5.8574. What does this mean?
($500 x 5.8474 = 2923.70.
This is the NPV of $500 per year for 15 years at 15%.
6. CAN YOU BECOME A MILLIONAIRE? YES YOU CAN!!!!
Financial planning is a matter of starting early and sticking to it. For those students who
are interested we will give you an opportunity to do a financial plan on yourself as an
extra credit project to illustrate these principles and, hopefully, to start you on the road to
financial independence.
Can you save $300 per month? Assume a return of 15% compounded annually.
Clear registers.
Set P/Y for 12 PRESS 2ND P/Y ENTER 12 (PRESS ENTER)
ENTER -$300 AND PRESS PMT (this is an outflow so it is negative)
ENTER $1000000
PRESS FV
ENTER 15
PRESS I/Y
(ANNUAL RETURN OF 15%)
SOLVE FOR N
N = 301.16 MONTHS =25.09 YEARS AND
7. USING MICROSOFT EXCEL TO SOLVE TVM PROBLEMS
In financial modeling templates can be developed in MS/Excel to solve TVM problems.
The =NPV function will enable you to solve complex multiple cash flow problems. See the dividend
discount model on p. 33 of this workbook. =NPV (I.Y, cells of cash flow stream). Excel will also do IRR
but it estimates the discount rate using an iterative method starting with 10%.
TVM PROBLEMS
CH 5 HOMEWORK SOLUTIONS
NOTE: TABLES AND CALCULATOR SOLUTIONS WILL VARY SLIGHTLY. CALCULATOR
SOLUTION IS MORE ACCURATE. TABLES CAN ONLY BE USED WHEN P/Y IS 1. OUTFLOWS ARE
NEGATIVE.
NUMBER IN BOLD AND ITALICS IS SOLUTION
15
16
CHECK WORK TWO WAYS: TABLE AND CALCULATOR IN PROBLEMS WHERE P/Y = 1
LEARN WHICH TABLE TO USE FOR EACH TYPE OF PROBLEM
PROBLEM
TABLE VALUE
BGN/
END
P/Y
N
I/Y
PV
5-1A
B
2.594
BGN
1
10
10
-5000
12969
5-1B
B
1.714
BGN
1
7
8
-8000
13710
5-1C
B
3.896
BGN
1
12
12
-775
3019
5-1D
B
1.276
BGN
1
5
5
-21000
26801
5-2A
B
1039/500=2.079 BGN
1
15
5
-500
1039.5
5-2B
B
1.539
BGN
1
5
9
-35
53.87
5-2C
B
2.986
BGN
1
6
20
-100
208.60
5-2D
B
1.486
BGN
1
20
2
-53
78.76
5-3A
B
3.896
BGN
1
12
12
-500
1948
5-3B
B
1.407
BGN
1
7
5
-300
422.1
5-3C
B
5.604
BGN
1
20
9
-50
280.2
5-3D
B
2.488
BGN
1
5
20
-200
497.6
5-4A
C
.386
BGN
1
10
10
-308
800
5-4B
C
.784
BGN
1
5
5
-235
300
5-4C
C
..789
BGN
1
8
3
-789
1000
5-4D
C
.233
BGN
1
8
20
-233
1000
5-5A
D
12.568
END
1
10
5
-500
6289
5-5B
D
6.105
END
1
5
10
-100
610.5
5-5C
D
12.568
END
1
7
7
-35
303
5-5D
D
12.568
END
1
3
2
-25
76.5
FV
TVM PROBLEMS
PMT
FV
HOMEWORK SOLUTIONS CONTD
PROBLEM
TABLE VALUE
BGN/
END
P/Y
N
I/Y
PV
PMT
5-6A
E
END
1
10
7
17559
-2500
7.024
16
17
5-6B
E
2.829
END
1
3
3
198
-70
5-6C
E
5.582
END
1
7
6
1563
-280
5-6D
E
6.145
END
1
10
10
3072
-500
5-7A
B
1.338 5 YRS
BGN
1
5
6
-10000
13380
5-7B
B
1.611 5 YRS
BGN
1
5
10
-10000
16110
5-8A
NA
NA LOGAN
BGN
1
12
10
-1000
2593
5-8A
NA
NA ROBINSON BGN
4
8
8
-120000
140599
5-10A
NA
ANNUITY A
1
12
13.13
-50000 8500
5-11A
15000 * (1.2)
5-12A
41 * (1.100
1
45
2
50
ROUND TO NEAREST WHOLE NUMBER
5-13a
LOOK AT THE DIFFERENCE BETWEEN BGN AND END IN THIS PROBLEM
BGN 1
25
9
-60000 5604
END
1
25
9
-60000 6108
END
YR 1 = 18000
5-14a
END
YR 2= 21600
1
15
YR 3= 25920
3
55
6
4
644
60
15000
5-15A
BGN 1
10
8.0
-500
1079.5
USING THE RULE OF 72, YOU KNOW ANSWER IS ABOVE BUT CLOSE TO 7.2%
SINCE 7.2% COMPOUNDED WILL DOUBLE IN 10 YEARS
5-19A
In this kind of problem which we will study in Part II of the course, you will use the
cash flow spreadsheet. We will learn how to use this later
5-20A
This kind of security is called a “zero coupon bond. “ Since there is no coupon,
the price is equal to the NPV of the par value of the bond at maturity ($1000)
END
1
7
10
513.18
1000
5-21A
What is the meaning of a perpetuity
A preferred stock is an example
since there is no maturity.
FORMULA (using calc. Keys): PV = PMT / I/Y
300/.08 = 3750 (use calculator and set N to 100, I/Y = 8 \
AND PMT = 300 to achieve same result
1000/.12 = 8333
FIN 3403
PROF DIGGLE
TVM PROBLEMS
Solve these REAL WORLD problems FOR NEXT CLASS using your TI BAII+ financial calculator. In In
Use the following steps: (NOTE: This is required on the exam so practice doing it NOW)
1. Draw the time line
2. List calculator inputs in the following order:
BGN OR END
P/Y ( default = 12 (MONTHLY)
NOTE: With outflows, enter
N
Number and then enter minus
I/Y
Enter actual pct. 8% = 8
17
18
Sign (lower right key)
3.
4.
5.
PV
FV
PMT
Outflow is entered as a negative number
Clear ALL THREE calculator memory registers
Solve problem by entering inputs listed above. What are you solving for?
Check results. Is it logical? Use tables. Use Rule of 72 where applicable.
PROBLEMS
1.
You want to lease a new Taurus. The sticker is $20,000. Tax and title is $1250. The lease term is 3
years. The loan APR interest rate is 6%. The depreciation is 18% in year 1, 12% in year 2 and 10% in
year 3. The cap cost reduction (increase in cost) is $500. CALCULATE LEASE PAYMENT
NOTE: Depreciation is computed by taking the accumulated % depreciation over the least term (3
years in this case) and multiplying it times net investment (cost + tax & title + dealer prep + freight)
2. Assume you negotiate the price on problem 1 to $19000. Tax and title are $1200. Cap cost is $500.
You get financing at a good rate of 2.9%. CALCULATE NEW PAYMENT.
3. Lease a new Camry. Sticker $20,500. You negotiate price of $19500. Tax and title = $1300.
Depeciation = 15% yr 1, 10% yr. 2 and 8% yr. 3. I/Y = 2.9%. Cap cost reduction is $500.
CALCULATE LEASE PAYMENT.
4. Lease a Camry. Same facts as # 3 except I/Y = 8%. SOLVE FOR PMT.
5. Same as 4. You trade in your old car for $5000. SOLVE FOR PMT.
6. You need retirement income of $2500 per month. You plan to retire at age 55. Your actuarial life
expectancy is 85. HOW MUCH MONEY WILL YOU NEED AT AGE 55 TO FUND THIS
RETIREMENT ANNUITY ASSUMING AN 8% INVESTMENT RETURN DURING
RETIREMENT. SET END.
7. How much will you need to save EACH MONTH in problem 6 above assuming an investment return
BEFORE RETIREMENT from age 25 to age 55 (30 YEARS) ASSUMING A 10% INVESTMENT
RETURN PRIOR TO RETIREMENT. SET END.
8. You have a child age 4. You need to save for college. The cost of college in a public university if
$9000 per year in current dollars. Your estimated investment return is 8%. College costs are rising at
6%. CALCULATE THE TOTAL COST OF A COLLEGE EDUCATION IN A PUBLIC
UNIVERSITY FOR THIS CHILD BEGINNING AT AGE 18 FOR 4 YEARS.
9. You want to buy a home costing $200,000. You plan to put 20% down. The loan cost includes 2
POINTS which ar added to principal at closing. The rate is 7.25% for a 30 year mortgage and 6.85%
for a 15 year mortgage. CALCULATE PAYMENT FOR A 30 AND 15 YEAR LOAN.
10. YUPPIE MORTGAGE. Use the facts of the problem 9 above for a 30 year mortgage. Assume
payments are made every 2 weeks (26 times per year – 52/2 = 26). Solve for N and divide by 26 to
determine the years to pay off this “30 year” mortgage.
11. You want to retire in 15 years. You need an annual income of $75000 in income at retirement and do
not wish to touch principal. You plan to save $500 per month. You currently have a small portfolio
worth $100,000. What annual interest return (I/Y) must you achieve in order to reach this goal?
HINT: FV = $75,000 / .5%.
12. USING BOND SPREADSHEET (covered later in course). You want to buy an A rated bond that
matures in 15 years. The coupon rate is 8%. The yield on A rated bonds in the same maturity range is
7.5%. What price would you pay for this bond?
FIN 3403 DIGGLE: TVM PROBLEMS -- SOLUTIONS
These problems and solutions cover a variety of scenarios. It is vital that you work these
answers out and understand how to get answer. Ask questions if you are unclear on
anything.
1. You have decided to lease a new Taurus. The terms are:
Sticker price: $20,000 Cap cost reduction (add to price): $500
18
19
2.
3.
Tax and title: $1250
Term: 3 years
APR interest: 6%
Deprec = 18% in yr 1, 12% yr 2 and 10% yr 3
Residual value in 3 years: $12000 (sticker less accum. depr)
FINANCIAL CALCULATOR INPUTS:
clear registers!!
set BGN
P/Y = 12
N = 36
I/Y = 6
PV = -$21750 FV = 12000 SOLVE FOR PMT= $354.84
SAME PROBLEM. Many people fail to realize that you
can negotiate the price and interest rate in a lease. Assume
you get the price down to $19000 with tax and title equal to
$1200, $500 cap cost ; FMCC offers 2.9% APR lease.
PV = -$20700 I/Y = 2.9
FV=12000 N=36
SOLVE FOR PMT = $280.94
THIS IS A SAVINGS OF $73.90 OR 20.8%
COMPARISON SHOPPING: New Camry
Sticker = $20,500 your price=$19,500 Tax & title = $1300
Depreciation: 15% yr 1, 10% year 2 and 8% year 3
Residual = $13735
I/Y = 2.9
Cap cost reduction= $500
PV = -$21300 FV = $13735
The Camry costs $500 more but the residual is $1174 higher (Foreign cars do not
depreciate as much as U.S. cars)
PMT = $252.25 (SAVINGS OF 10% even though the Camry cost more up front.)
TVM PROBLEMS CONTD.
4.
5.
Camry without factory financing
SAME FACTS AS # 2 EXCEPT I/Y = 8
PV = -21300 FV = 13735 N = 36
SOLVE FOR PMT = $326.44
Camry without factory financing but you trade in your
old car for $5000
PV = -16300 FV = 13735
N = 36
SOLVE FOR PMT = $170.81
TVM PROBLSMS CONTD.:
INVESTING USING TVM
6. You need retirement income of $2500 per month. You plan to retire at age
55. Your actuarial life expectancy is age 85. How much money will you
need at age 55 to fund this annuity assuming an 8% investment return
SET END – ALL ANNUITIES USE END
P/Y = 12
I/Y = 8
PMT = $2500
N = 30 X 12 = 360
19
20
7.
FV = 0 SOLVE FOR PV = -$344,236
PV is negative since it is considered an outflow
How much must you save each month starting at age
25 (30 years) in order to save the sum above assuming
an investment return of 10%. (NOTE: The return is higher when you are
young and declines to 8% when you are retired.)
P/Y = 12
N = 360
I/Y = 10
FV = $344,236 (do not enter this as negative)
SOLVE FOR PMT = -$151.03 This is negative
TVM PROBLEMS –COLLEGE FUNDING
8.
Saving for a child requires planning. Assume funds are
placed in an “UGMA” account and accumulate at the child’s
tax rate which, for our purposes, is assumed to be zero. Your child is
4 now and will enter college at age 18. You have 14 years to save. College
cost in current dollars is $9000 per year. Costs are rising by 6% per year.
STEP ONE: Calculate annual cost in YEAR 14 AT 6% inflation. SET BGN:
N=14 P/Y = 1
I/Y = 6
PV = -9000
SOLVE FOR FV. This is college cost in year 14.
FV =20348.13
STEP TWO: Calculate annual cost of college (year 14-17)
FRESHMAN
YR 14 $20348.13
SOPHOMORE
YR 15 $21569.02 (YR 1 x 1.06)
JUNIOR
YR 16 $22863.17 (YR 2 x 1.06)
SENIOR
YR 17 $24234.96 (YR 3 x 1.06
TOTAL COST – 4 YEARS $89015.28
STEP THREE: Calculate how much you need to save each month to accumulate
enough funds to meet total dollar need in step two. Use I/Y of 8%.
P/Y = 12
N = 168
I/Y = 8
PV = 0
FV =$ 89015.28
SOLVE FOR PMT
PMT = -$ 287.07
SAVINGS / MONTH --1 CHILD
Save for 14 years (168 months) at assumed return of 8%
9. TVM PROBLEMS: SAVING ON A MORTGAGE
COMPARE 15 AND 30 YEAR MORTGAGE
HOME PRICE=$200,000
[COST = PRICE (1- DN PMT) + POINTS AND
CLOSING COSTS] = MORTGAGE LOAN = $160,000 (this is an outflow)
DOWN PAYMENT = 20%
POINTS = 2 = 2% 0F LOAN
P/Y = 12
( 1 Point is 1% of LOAN) 2 points = $3200.
PV = INITIAL MORTGAGE BALANCE: -$163,200
30 YEAR MORTGAGE
N = 360
I/Y = 7.25%
20
21
15 YEAR MORTGAGE
N = 180
I/Y = 6.85%
SET BGN
solve for PMT: 30 year
$1106.62
15 year
$1444.99 ($338.37 / mo more)
31% higher payment
paid off 50% faster
A simple strategy is to pay an additional $338 per month (applied to principal)
when you can to amortize the loan.
10.
YUPPIE MORTGAGE
USE FACTS ON 30 YEAR LOAN ABOVE EXCEPT
ASSUME PAYMENTS ARE MADE EVERY 2 WEEKS
PMT = 1106.62/2
OR $553.31 BI-WEEKLY
Set P/Y to 26 (52/2)
Most people will not notice the difference especially if they get paid bi-weekly
I/Y = 7.25
PV = -$163200
PMT = $553.31
SOLVE FOR N = 616.2 PMTS
Divide by 26 =23.7 Years
RESULT: A reduction in term of 6.3 years or 21%
IF YOU TAKE OUT A MORTGAGE AT AGE 30 IT WILL BE PAID OFF
WHEN YOU ARE ALMOST 54.
TVM PROBLEMS –INVESTING 1
11.
You have a personal goal of retiring in 15 years. You
need a portfolio that will produce $75,000 per year in
income IN 15 YEARS and you do not want to touch
principal. The portfolio is assumed to yield 5%. You
plan to save $500 per month. You have a small
portfolio now of $100,000. What annual interest return
(simple annual compounding) must you obtain in order
to reach this goal?
STEP 1: We much calculate the size of the portfolio needed to produce the
income.
75000/.05 = $1,500,000 THIS IS FV
TVM - INVESTING CONTD. SOLUTIONS
STEP 2: WE ARE SOLVING FOR I/Y
P/Y =12
NOTE: since you are saving MONTHLY, you must
set P/Y to 12
SET BGN (this will always be given
in exam question)
N = 15 X 12 = 180
PV = -100000
PMT = -500
21
22
12.
FV = 1500000
SOLVE FOR I/Y = 16.20%
NOTE: Use the same steps in solving all TVM
problems in an exam
1. Read the question CAREFULLY
2. Draw a time line on the BACK of the exam page
3. Determine what you are solving for
4. NEATLY list your keystroke inputs. Outflows are
negative numbers.
5. Show your answer NEATLY. Either box or
underline it.
TVM PROBLEMS: CORPORATE BONDS—bond spreadsheet.
SAVE THIS PROBLEM AND SOLUTION FOR LATER IN THE COURSE—NOT ON EXAM 1
Before we solve this problem, it is important to understand a few basic concepts:
 Corporate bonds mature at PAR. Par = $1000
 Corporate bonds pay interest coupons SEMIANNUALLY. P/Y = 2
 The stated interest rate on the bond is fixed for the life of the bond. This is
called the “Coupon rate.”
 All bonds are priced to the market yield on bonds of similar type, quality and
maturity. This yield is always changing and bonds adjust to it by the price
fluctuating. If yields in the market go UP, bond prices go DOWN.
You are thinking of buying a corporate bond that matures in 15 years. The
coupon rate is 8%. Yields on similiar corporate bonds in the 15 year maturity
range is 7.5%. What price would you pay for this bond?
SET BGN SET P/Y = 2
N = 30 (Remember N = P/Y times the number of years)
I/Y = 7.5
In a bond problem I/Y is the yield on other similar
bonds. DO NOT use the coupon rate on the bond.
FV = 1000
All bonds mature at par. Par = 1000
PMT = 40
Bonds pay interest semiannually.
This bond has a coupon rate of 8%.
Annual interest = 8% x $1000 = $80
Each coupon is therefore half the annual
interest of $80 or $40
SOLVE FOR PV
1071.32
FINANCIAL RATIO ANALYSIS--TEAM PROJECT
RATIOS ARE FOR INDUSTRIAL COMPANIES Your presentation should highlight TRENDS
A. BALANCE SHEET RATIOS
(SOME OF THE RATIOS LISTED ARE NOT IN THE TEXT)
LIQUIDITY
CR= CA/CL
ACID TEST or QUICK RATIO= CA-INV/CL or CASH + AR / CL
DSO(days sales outstanding) =AR/ (sales / 360)
A 360 day year is assumed
THIS RATIO IS ALSO CALLED AVG COLLECTION PERIOD
OPERATING
Inventory turnover
=
22
Cost of goods sold / Average
23
PROFITABILITY
Fixed assets turnover
LEVERAGE
+
inventory (BOY + EOY)/2
Sales / Property Plant and equipment
TOTAL DEBT / TOTAL ASSETS = Current liabilities + L.T. debt / assets
LT DEBT / ASSETS = debt > 1 year / total assets
LT DEBT / EQUITY = debt > 1 year / (common stock + surplus + ret earnings)
NOTE: Preferred stock is NOT equity
X INT EARNED= EBIT / interest expense from income statement
EBIT = Earnings before interest and taxes. This may = operating income
X FIXED CHGS EARNED= (EBIT + lease pmts )/ (interest + rent expense +
sinking fund ) / (1-tax rate)
B. INCOME STATEMENT RATIOS
PROFITABILITY
C. VALUATION RATIOS
Gross margin =
(Net Sales - CGS)/ net sales
CGS = cost of goods sold SGA = selling general and admin overhead
Operating margin =
(N. sales - (CGS + SGA) / net sales OR
(Gross income - SGA)/ net sales
Pretax margin=
Pretax income / Net sales
Net margin=
Net income before com divds / Net sales
Cap expense / sales
Capital expenditures as % of revenues
R&D / sales
Important measure for high tech firms
P/E
=
Common stock price / Earnings per share
Historical P/E = avg price in year / EPS in that year
Current P/E = current price / LTM EPS
YIELD =
Common DPS (indicated annual rate)/ cur. Price
BVPS =
SH equity / common shs issued AND outstanding
PRICE/BOOK= current price of common / last qtr BVPS
D. COMBINATION RATIOS
ROA
ROE
E. TRENDS
F.
net income / total assets
net income / SH equity MOST IMPORTANT RATIO
historical ROE = net income for year / avg SH equity
(BOY equity + EOY equity)/2
Are margins increasing or decreasing? Is leverage increasing or decreasing?
Are expenses growing faster than revenues? Why?
DUPONT ROE MODEL
=
=
Each team is provided a simplified DuPont model in MS Excel on
computer disk. This model shows the interplay between financial
leverage, other elements in financial structure and ROE.
TEAM PROJECT TIPS
In preparing your team Excel report, here are some tips:
1. Organize your team early. Get names and phone numbers of team members. Set a
REGULAR MEETING TIME. You need to meet each week. Your team will also
function as a study group.
2. It is vital that ALL team members make team meetings. It is VITAL that you see me
if someone on your team is not pulling their weight.
3. Appoint a team secretary to keep track of all team members and make sure everyone
has work done for all team meetings. Share phone numbers and E-Mail addresses.
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4. Be sure you are all using the same software. UCF computer lab PCs operate on
Windows NT and the latest version of Powerpoint, Word and Excel. If you have an
older version of either Windows or MS Office, you may not be able to open or save
your work. Please use the UCF computer lab whenever possible. Note that the
DBCC and BCC computers are NOT necessarily compatible. Check with the
computer lab manager to be SURE you are using a UCF machine with latest
software.
5. Delegate specific jobs such as:
 Obtaining company reports
 Looking up market data on my web site using Yahoo or Big Charts
 Filling in the Excel spreadsheet. Assign different portions to each team
member.
 Understanding the ratios. See instructor as a team with specific questions.
 Developing PPT slides
6. Make sure you BACK UP all work including the spreadsheet and PPT slides. All
team members should make copies every week so if someone is missing it will not
bring your efforts to a halt.
7. Follow the outline in the Excel program. See instructor regarding the DuPont Model
and the DDM.
8. You will be asked to complete a team peer group evaluation. This is for your benefit.
It is vital that you let instructor know if someone in your group is not pulling their
weight. Most students have jobs, many have families and other responsibilities. This
class is your job. You are expected to work in this group project as a TEAM. Those
who fail to heed this message will receive a zero on the team project.
9. TEAMS WHO WANT TO DO THE SEGMENT ANALYSIS AND PROJECTION-This is an OPTIONAL module for FIN 3303 students. Do NOT attempt to do this on
your own. You MUST see instructor. If you enter any data at all in the worksheet it
will affect the Dividend Discount Model. You may do this for extra credit, but do so
only if you have time and have completed all your slides.
RATIO ANALYSIS:
1.
SAMPLE EXAM QUESTIONS
XYZ Corp. common is selling at $100 / sh. Which represents a P/E of 10X. If the firm has 100
common shares outstanding, a ROE of 20%, and a total debt ratio of 60%, what is the return on assets
ROA?
SOLUTION
P/E = PRICE / EPS =10
THEREFORE E.P.S
= $10 PER SHARE
NET INCOME = $10 X 100 SHES OUT = $1000
ROE = 1000/ SH EQUITY = 20%
THEREFORE SH EQUITY = $5000
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IF DEBT RATIO IS 40% THEN EQUITY IS 60%.
$$5000 = 60% OF TOTAL CAP
THEREFORE: TOTAL LIABILITIES AND SH EQUITY = $12,500
TOTAL ASSETS = TOTAL LIABILITIES + SH EQUITY
ROA = NET INCOME / TOTAL ASSETS
2.
= 1000/12500 = 8%
A firm has total assets of $14 million and a debt/equity ratio of .75. Its sales are $10 million and it has
total fixed assets of $4 million. If the firm’s EBIT is $2 million, its tax rate if 45%, and the interest rate
on all debt is 10%, what is the firm’s ROE?
SOLUTION:
TOTAL DEBT + TOTAL EQUITY = $14 MM
TOTAL DEBT = .75 (TOTAL EQUITY)
$14mm = TOTAL EQUITY +.75
TOTAL EQUITY =
$14MM / 1.75 = $8 MM
THEREFORE TOTAL DEBT = $6 MILLION
DEBT INTEREST = $6MM X 10%
=
$600,000
EBIT = $2 MM
PRETAX= EBIT - I = $1.4MM
NET = PRETAX (1-T)
=
ROE = $770,000/8,000,000
3.
$1.4MM
X .55
=
$770,000
= 9.625%
Given the following information, calculate the market price per share of WAM Inc.
Net income
E.P.S.
S/H equity
Market/book
$200,000
$2.00
$2,000,000
1.5X (150%)
Common shares out =
BVPS
=
market value
=
$200,000 / $2
= 100,000
$2,000,000 / 100,000 shs = $20
1.5X book value per share = $30 per share
RATIO ANALYSIS PROBLEM
Fill in the balance sheet and income statement data below. SHOW YOUR WORK!!!!
Debt ratio: 50%
Days sales outstanding
36 days
Quick ratio 0.8X
`
Gross margin
25%
Total asset turnover 1.5X
Inventory turnover
5X
Cash
$_______________
Accts. Payable
$_______________
Accts. Receivable
$_______________
L. T. Debt
$
Inventories
$_______________
Common stock
$_______________
Fixed assets
$_______________
Retained earnings $
25
60,000
97,500
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Total assets
Sales
$
$_______________
300,000
Total liabilities and
S/H equity
$_______________
Cost of goods sold $_______________
SOLUTION
TOTAL LIABILITIES AND EQUITY
= TOTAL ASSETS
= $300,000
TOTAL DEBT = TOTAL ASSETS X 50%
= $150,000
AP =
TOTAL DEBT - LT DEBT
= $150,000 - $ 60,000 = $90,000
COMMON STOCK =
(TOTAL LIAB + EQUITY) - RET EARNINGS - TOTAL DEBT
=
$300,000
- ($97500 + $90,000 + 50,000) = $52,500
SALES
= 1.5 x TOTAL ASSETS
CGS = sales (1-.25) = 75% OF SALES
=
=
INVENTORIES
$$90,000
= SALES / 5
=
DSO
=
DSO
= 36
THEREFORE
ACCTS REC = 450,000/360
CASH + AR
= QUICK RATIO
= 90,000 X 0.8 =
= $45,000
SINCE AR
ACCTS RECEIVABLE
FIXED ASSETS =
=
/
$450,000
$337,500
(ANNUAL SALES / 360)
X 36
= $45,000
=
80% OF CURRENT LIAB
$72,000
THEREFORE CASH = $72,000 - $45,000 = $27,000
TOTAL ASSETS - CURRENT ASSETS (CASH + AR + INV)
$300,000
- ($27,000 + $45,000 + $90,000)
= $138,000
COST OF CAPITAL CONCEPTS
A.
TECHNIQUE
LONG TERM USES FOR CAPITAL BUDGETING –USE LT SOURCES
In this course we will limit our discussion to long term debt, preferred and common stock.
 These three external long term financing sources should be evaluated on an after tax basis.
Only interest on debt is deductible for Federal income tax purposes.
 Weighted average cost of capital (WACC) evaluation techniques
 At cost (as shown on financial statements which are historical).
In this course we will use historical or book values in computing WACC.
 At market (particularly important for appreciated equity)
It is important to understand, however, that book values can be misleading and that many
analysts attempt to assign current market values in computing WACC.
 Marginal or prospective cost (current rates) vs. embedded costs. Focus on current market
costs (i.e. what would it cost to go public with a debt issue or equity issue now)
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
Floatation costs –usually included but amortized over life of issue. Underwriting cost
of floating debt (particularly private placements) is less than equity
 Difference between “nominal” “effective” costs is usually ignored.
 New issue costs are constantly changing. The measure of a debt issue is the rate of
bonds of similar type, quality (including subordination) and maturity.
Formulas used in computing cost of capital components:
WACC = WdKd(1-T) + WpsKps + WceKs
Kd (1-t) Kps = Dps
K s = D1 + g
K e = D1
+g
(new equity)
Pn
P0
P 0(1-F)
Kd = cost of debt
Kd(1-t) is the after tax cost of debt
Kpf = current yield of all preferreds = Pfd. Dividend / pfd. Price
Ks = cost of equity = D1 (annual D.P.S. (year 1 in the future))/ price + %
growth in dividends g.
g may be estimated using historical compound growth in E.P.S. or D.P.S.
N = number of years
P/Y = 1
PV = first year (negative) FV = last year in time series of EPS or DPS
SOLVE FOR I/Y (this is the compound annual growth)
WACC = WEIGHTED AVERAGE COST OF CAPITAL
STEPS
1. Compute the percentage mix on the balance sheet of debt, preferred and
equity capital. Take each item and divide by the sum of these items which is
called “total capitalization.” One or more items may be excluded. Some
companies do not use preferred stock for example.
2. Compute after tax cost of debt, preferred and equity.
3. Multiply each component after tax cost time the percentage mix.
Weighted cost—expressed as a percent.
4. Add each weighted cost in percent. The sum is WACC.
EXAMPLE:
Please use the balance sheet below to calculate the after tax WACC for ABC Corp.
The corporate tax rate is 40%. The common dividend is $3.00 and expected to grow at 8%. The
stock is selling at $25 which is equal to book value.
ASSETS
LIABILITIES AND EQUITY
Cash
$120
Accts receivable
$240
Inventories
$360
L.T. debt 13% coupon
$1152
Plant & equipment net
$2160 S/H equity
$1728
_________________________________
_________________________________
TOTAL ASSETS
$2880 TOTAL LIAB & EQUITY
$2880
STEP 1: Kd (1-T) = 13% *(1-.4)
7.8% after tax cost of debt
Kpf NOT IN THIS PROBLEM --use Dpf / Price pfd.
Ks = D1/P0 +g
WHERE D1 = is the D.P.S. next year (an estimate)
= D0 * (1+g) = 3.00 *(1+.08)= (3.24/25)+.0812.96% + 8% = 20.96%
STEP 2: Multiply cost of each component times weight in cap structure
WACC = WdKd(1-T) + WpsKps + WceKs
$1152 / $2880 = 40% (LT debt is 40% of total capitalization)
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$1728/2880
= 60% (equity is 60% of capitalization)
7.8% (after tax cost of debt) TIMES 40% weight = 3.12%
20.96% cost of equity
TIMES 60% weight = 12.57%
WACC =
15.69%
CAPM
CAPITAL ASSET PRICING MODEL
This is an alternate method for determining weighted average cost of capital
B.

The Capital Asset Pricing Model is a market driven model. It is based on a “risk free” rate.
For situations with some level of risk, investors demand a “risk premium.” The risk premium
has several components:
 Default or business risk premium. This is based on size of enterprise and
“track record.” Venture capital and IPOs are the most risky. The nature of
the competition and technological change are also important here.
 Liquidity risk premium (increases with term)
 Interest rate risk (premium for uncertainty of macroeconomic conditions)
 Inflation risk premium
 Other: regulatory risk, technological obsolesence, currency risk Important
for multinational companies), labor risk (important when labor contracts are
in renewal), environmental risk (toxic waste dump on the back 40, nuclear
reactors for utilities) etc.
EXAMPLE:
Risk free rate
Use T-note= maturity of new issue 5.15%
+
Business risk
Company well established
1.00%
+
Liquidity risk
Varies with maturity
1.00
+
Interest rate risk Uncertainty
2.00
+
Inflation risk premium
2.00
Total risk premium
6.0% X BETA 1.3
7.80%
TOTAL
12.95%
CAPM is a theoretical model that has drawbacks. Two of these are beta which research has not proven to
be reliable in all cases and the fact that the CAPM model requires an estimate of FUTURE market returns
or interest rates. If we could do that we would all be rich.
.
Most companies hire an outside company such as investment banking firm to evaluate capital costs. The
process of examining the condition of the firm, its competitive environment and risk posture, market
conditions (remember new debt or equity issues can be floated anywhere in the world for multinationals)
and balance sheet components at cost and market (replacement cost) is called “Due Diligence.” A
document summarizing these factors is called a “Fairness Opinion.”
CAPITAL BUDGETING
Capital budgeting is the analysis of projects or investments such as new plant &
equipment. Every enterprise must evaluate capital investments.
FIRST THE GOOD NEWS: Capital budgeting is an application of a technique you have
already mastered: Net Present Value analysis!
We will also use NPV in the valuation of bonds and stocks. It is the most pervasive
concept in finance. You will learn that there are several techniques used in capital
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budgeting. Net present value is considered the best because it directly relates to the key
objective we learned in Chapter 1: maximizing shareholder value.
We will examine three techniques used in capital budgeting:
1.
2.
3.
Payback
Internal Rate of Return (IRR)
Net Present Value (NPV)
TERMINOLOGY:
Net investment = cost + tax + installation + addition to
net working capital
=
Depreciable basis
C0
= Net investment less > in NWC
Net cash flows
=
C1….n
Even Cash flows:
This is where all cash flows are the same
Can use frequency key on calculator
F0 etc.
Uneven cash flows: More normal case. Each cash flow must
be evaluated individually.
DEFINITIONS:
PAYBACK
The number of years where flows C1 ….. Cn =
EVEN CASH FLOWS =
UNEVEN
=
C0
C0 / ANNUAL CASH FLOW
C0 - SUM OF ANNUAL CF UNTIL ANSWER = 0
Payback has the advantage of being conceptually easy
to understand (i.e. I get my money back in say 5 years).
The problems with the payback approach are:
1.
2.
The number of years to recoup the initial investment is
arbitrary and is not compared with any standard measure
or benchmark.
Payback ignores cash flows beyond the payback period.
Payback ignores the time value of money.
CAPITAL BUDGETING CONTD.
IRR
That discount rate where PV(inflows) = PV (outflows)
IRR is the interest rate that sets NPV = 0
C0 +
CF
(1 +
1
IRR)1
+
CF
2
(1+IRR)2
+…+ CF
n
(1+IRR)3
= 0
In order for a project to be accepted, the IRR must usually
be larger than a “hurdle rate.” This is usually defined
as the weighted average cost of capital (WACC).
STEP 1 in IRR analysis is to solve the IRR equation using
your financial calculator.
STEP 2 in IRR analysis is to compare the computed IRR
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with the required rate of return (usually WACC). If the
IRR exceeds the required rate of return, the project should
be accepted. If it is less, the project should be rejected.
NPV
Calculates the net present value of all cash flows
(outflows and inflows) discounted at the WACC.
NPV IS CONCEPTUALLY THE MOST CORRECT
METHOD. IF COMPETING METHODS GIVE
DIFFERENT RESULTS, THE NPV SOLUTION IS
THE ONE TO USE.
NPV
=
PV OF BENEFITS - PV OF COSTS
This difference is the net present value of the project.
If the NPV is positive, benefits exceed costs and project would
be accepted. A negative NPV means costs exceed benefits
and project would be rejected. The disount rate
used is the WACC or Required rate of return.
OTHER TERMS
MUTUALLY EXCLUSIVE PROJECTS
Projects where
acceptance of one project forces rejection of another project.
INDEPENDENT PROJECTS:
Projects where acceptance
of one does not lead to rejection of others.
CAPITAL RATIONING: Typical situation where limited
budget limits number of projects with positive NPVs that
can be accepted. In capital rationing, a firm must rank which
positive NPV projects to accept.
WACC = [% in equity at book x cost of equity after tax] +
[% in debt at book x after tax cost of debt]+
[% in pfd. Stock x after tax cost of pfd]
NOTE: Only interest on debt is tax deductible.
PROBLEMS IN CAPITAL BUDGETING
CASH FLOW = NET INCOME AFTER FIT + DEPREC,
OPERATING CASH FLOW = NET INCOME + TAX SAVINGS ON DEPR.
DEPRECIABLE BASIS (DB)= Direct cost of equipment, taxes and set up but
excluding working capital requirements.
NET INVESTMENT = Equipment or project cost including set up, taxes, delivery and
working capital needs. (NI = DB + CHANGE IN WC)
CORP A
CORP B
PRETAX INCOME
$100
$100
FIT RATE
40%
30%
NET INCOME
$60
$70
DEPRECIATION
$100
$0
CASH FLOW
$160
$70
CF = net income or net savings plus depreciation
DEPRECIATION CONCEPTS:
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What affects depreciation:
1. Depreciable basis = net outlay + shipping, tax, installation
2. Asset life for accounting purposes
3. Depreciation accounting method used
S.L. IS MOST CONSERVATIVE. Depreciation is a NON CASH
charge. Companies prefer accelerated depreciation because it results
in more rapid tax savings.
$1100 INVESTMENT WITH$100 shipping cost
5 YEAR LIFE and $100 salvage value
DEPRECIABLE BASIS = $1200 Basis is NOT adjusted for salvage value
(straignt line) S.L. DEPREC
$240 oer year
CONVENTION: Assume asset is placed in service in middle of year 1
MACRS
Modified accellerated cost recovery system (replaces DDB and
MACRS CLASS
Depreciation schedule as % of Depreciable basis
MACRS TABLE WILL BE GIVEN IN AN EXAM
5 YEAR PROJECT
YEAR 1 20% Half year convention
YEAR 2 32%
YEAR 3 19%
YEAR 4 12
YEAR 5 11
YEAR 6 6
DEFINITIONS
REPLACEMENT = Decision to totally replace an existing asset that is still
productive with a new asset.
SALVAGE VALUE = estimate of value of asset as scrap at end of useful life.
Include DECOMMISSIONING COSTS . Salvage value
may be negative such as in the case of a mining company who must restore land
to former condition.
PROBLEMS IN CAPITAL BUDGETING CONTD.
DEFINITION: Incremental cash flows= those marginal returns that directly
impact decision to accept or reject project
DEFINITION: SUNK COSTS Outlay that has been incurred and cannot
be recovered
How do you compare a project such as a new shopping center where site
plans and surveys have been conducted vs a “greenfield” location?
DEFINITION: Opportunity costs = return on BEST ALTERNATIVE use
of an asset
 EXTERNALITIES: Effects of decision on other parts of the firm.
 INDIRECT COSTS (SHIPPING AND INSTALLATION, TAX, ETC) =
Any cost included in depreciable basis
 INVESTMENT IN NET WORKING CAPITAL WC (CA-CL) = short term
funds needed to support project (inventory, accounts receivable financed
etc). This is a COST ( part of net investment) and may be recovered as a
POSITIVE cash flow at the end of project life.
SOLVING A CAPITAL BUDGTING PROBLEM WHERE CASH FLOWS MUST BE CALCULATED
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STEP ONE:
DETERMINE DEPRECIABLE BASIS
This is basis for depreciation. It includes net cost + installation + tax
STEP TWO: DETERMINE NET INVESTMENT.
NI on TIBA2+ cash flow worksheet is CF0
SOME PROBLEMS WILL CONSIDER TANGIBLE AND INTANGIBLE CAPITAL OUTLAY COSTS
(if quantifiable). SOME OF THESE COSTS ARE ESTIMATES.
FOR AN EXPANSION PROJECT – there are 3 elements in net outlay
FOR A REPLACEMENT PROJECT THERE ARE 4 elements
STEP THREE: REVENUE OR SAVINGS FORECAST (usually given in problem)
Use a spreadsheet to estimate SALES for life of project
Revenues = price times estimated volume
An exam question may give you SAVINGS from a project or machine.
STEP THREE
COMPLETE A PRO-FORMA P&L
1. From sales or savings SUBTRACT
2. costs
3. depreciation (NOTE: Use MACRS table if needed to compute depr.)
4. Determine pretax income and compute taxes
Net income = net income after taxes and all expenses including depreciation
Estimate OPERATING CASH FLOW for estimated life of project
OCF = NET INCOME + TAX SAVINGS ON DEPRECIATION
STEP FOUR: Determine additional cash flow in last year from sale of machine (Salvage Value)
1. From salvage value (given in problem) SUBTRACT any remaining basis
(% undepreciated amount on MACRS table times depr. Basis)
2. Compute tax on net recovery (SV - remaining basis) X FIT rate
3. Subtract tax from SV. THIS IS ADDITIONAL CF IN LAST YEAR
4. Add additional cash flow from salvage to OCF in last year
STEP 5:
DRAW TIME LINE AND CALCULATE NPV AND IRR FOR PROJECT
Use cash flow worksheet on TIBA2+. Include ALL cash flows including net salvage
CAPITAL BUDGETING PROBLEM
The CEO of your firm has asked you to evaluate the acquisition of a new computer. The price is
$30,000 and it falls into the MACRS 3 year class. Tax and installation costs are $10,000 and
estimated increase in new working capital (NWC) is $2000. You estimate the computer would
increase revenues by $20,000 per year but would also increase operating costs by $5,000 per year.
The computer will be used for 3 years and sold for $25,000. The firm’s tax rate is 40% and its
WACC is 14%
Calculate the net investment and depreciable basis in year t = 0:
What is the operating cash flow in year 2?
SOLUTION:
COST OF EQUIPMENT
TAX + INSTALLATION
DEPRECIABLE BASIS
+ NET INCREASE IN NWC
NET INVESTMENT
$30,000
$10,000
$40,000
2,000
$42,000
THIS IS CF0
MACRS DEPRECIATION (TABLE WILL BE GIVEN IN AN EXAM) PP. 35-37 Appendix 1A
YEAR
% of dep. Basis DEPRECIATION
TAX SAVINGS (40%)
1
33%
$13,200
$5,280
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2
3
4
45
15
7
$18,000
$ 6,000
$ 2,800
$7,200
$2,400
USED IN SALVAGE VAL BELOW
PRO-FORMA INCOME STATEMENT
YEAR
1
2
REVENUES
$20,000
$20,000
LESS DIRECT EXPENSES
$ 5,000
$ 5,000
EBDIT
LESS DEPRECIATION
$13,200
$18,000
PRETAX
$ 1,800
$(3,000)
LESS FIT 40%
$ 720
$ 1,200 CR
$ 3,600
NET
$ 1,080
$(1,800)
3
$20,000
$ 5,000
$ 6,000
$ 9,000
$ 5,400
you were asked to calculate operating cash flow which was defined on formula page as net income plus tax
savings on depreciation: YEAR 1
YEAR 2
YEAR 3
NET PLUS SAVINGS ON
DEPR (DEF IN FORMULAS)
SALVAGE (3rd year cash flow)
LESS: TAX ON S.V. (40%)
PLUS: Increase in NWC
CASH FLOW IN YEAR 3
CASH FLOWS
net investment
CO1
C02
C03
SOLVE FOR NPV
$ 6,360
$ 5,400
SALV VALUE
$ 7,800
$25,000
( 8,800) **
2,000
($25,000-$2,800) x 40%
$18,120
CF0
-$42,000 (THIS IS A NEGATIVE NUMBER) WHY?
FO1 = 1 6,360
FO2 = 1 5,400
FO3 = 1 25,920 (OCF + salvage and NWC >)
(I = 14) Enter as 14, not .14
=
$(14,771)
CAPITAL STRUCTURE AND LEVERAGE
Capital structure looks at ways to OPTIMIZE capital structure (debt vs equity)
SIX IMPORTANT TERMS:
1..EBIT
2. OPERATING LEVERAGE
3. FINANCIAL LEVERAGE
Earnings before interest and taxes
Pretax income + interest expense on debt
high fixed costs
DOL = % CHG IN EBIT / % CHG IN SALES
The degree to which the use of debt and pfd places additional
financial risks on common shareholders.
% CHG IN EPS / % CHG IN EBIT
Concept: USE OF DEBT MAGNIFYIES CHANGES IN SALES
IT CAN MAGNIFY E.P.S.. AND ROE IN GOOD TIMES
IT CAN HAVE VERY NEGATIVE CONSEQUENCES
If interest is reduced or eliminated this goes to the bottom line
4. TOTAL LEVERAGE
DTL = DOL * DFL
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How much increase in EPS will result from a % increase in Sales
HIGHLY LEVERAGED FIRMS SELL AT LOWER P/E RATIOS
THAN LOWER LEVERAGED FIRMS. WHY?
5. BUSINESS RISK
Variability, cyclicality, price sensitivity
FACTORS VARY BY INDUSTRY
1. DEMAND VARIABILITY
2. RAW MATERIAL COST VARIABILITY
3. PRICING FLEXIBILITY
Ability to maintain margins in face of > costs
4. LEVEL OF FIXED COSTS & OPERATING LEVERAGE
Utilities have steady demand and fuel adjustment clauses.
Even though they have high fixed costs—business risk is low
Steel mills have very high operating leverage and business risk
A pharmaceutical manufacturer tends to have low business risk
6. OPTIMAL CAPITAL STRUCTURE
operating leverage
That mix of debt and equity that maximizes price of stock
OR MAXIMIZES SHAREHOLDER VALUE
^
financial leverage
Operating leverage is a term in finance that refers to the cost structure of the firm. Typically, firms with
high operating leverage have heavy fixed costs such as electric utilities. The rule of thumb is that firms with
high operating leverage MUST have low financial leverage.
FINANCIAL STRUCTURE AND LEVERAGE contd.
Please see Ch 13 and accompaning handout. Learn formulas on p. 493. Formulas can be at one
point of output or between two points.
BEP (breakeven point) is that level of output (in dollars or units) where zero profit or loss is reached
Financial leverage is the use of debt in the financial or capitalization structure.
Operating leverage is the effect of high fixed costs. High fixed costs result in a high breakeven point.
DCL (Degree of Combined leverage) = Financial Leverage X Operating leverage
FORMULAS FOR OPERATING AND FINANCIAL LEVERAGE
Operating and financial leverage MAGNIFY the impact of a change in sales or EBIT. This expressed as a
multiple or percentage.
FORMULAS see text P. 493 FORMULAS GIVEN ON EXAM. You must know which one to use.
BETWEEN 2 POINTS
AT ONE POINT OF OUTPUT Q
BEP (in units)
Qb = F / (P - V)
DOL (degree of operating leverage)
% change in EBIT
% change in Sales
34
RBFC
EBIT
35
DFL (degree of financial leverage)
% change in E.P.S.
% change in EBIT
EBIT
EBT
DCL (degree of combined leverage)
% change in E.P.S.
% change in Sales
RBFC
EBT
In solving any leverage problems the FIRST STEP is to construct an income statement similar to that given
on 489 of your text and on the next page of these lecture notes (p. 36) below.
RATIOS DEALING WITH LEVERAGE:
TIE RATIO (margin of safety)
EBIT / I
I = INTEREST COSTS ON INC STATEMENT
X FIXED CHARGES
EBIT + LEASE PMTS
I + LEASE PMTS + SF PMTS AFTER TAX SEE P. 85
LOOK AT CAPITAL STRUCTURES FOR DIFFERENT INDUSTRIES
DRUGS
LOW DEBT
HIGH ROE
ELECTRONICS
HIGHER DEBT
AVG ROE
RETAILING
HIGH DEBT
AVG ROE
UTILITIES
VERY HIGH DEBT
LOW ROE
WHICH INDUSTRY WOULD YOU LIKE TO OWN AS AN INVESTOR?
CONCEPT OF FINANCIAL FLEXIBILITY
1. Rating agencies S&P and Moody’s rate corporate debt (AAA to C)
Banks and other money market lenders also evaluate risk and price loans accordingly.
I.E. HIGHER RISK = HIGHER INTEREST RATE ON LOANS
2. High ratings mean lower Kd (cost of debt) and lower WACC
FIN 3403
LEVERAGE PROBLEM
Facts: FIT rate
TOTAL DEBT
AVG DEBT COST
FIXED COSTS
VARIABLE COSTS
PRICE
COMMON SHARES OUT
50%
$20 MILLION
7.5%
$4 MILLION
$ 2 PER UNIT
$4 PER UNIT
1,000,000
PREPARE A PRO FORMA P&L AT 4 MILLION UNITS OF OUTPUT
SALES (units x price per unit = $4 x 4MM) $16,000,000
Less VARIABLE COSTS
8,000,000 $2 x 4 MM units
=
RBFC (revenue before fixed costs)
8,000,000 CONTRIB MARGIN = 50%
FIXED COSTS
4,000,000
=
EBIT (earnings before int and taxes)
4,000,000
INTEREST EXPENSE
1,500,000 7.5% of $20 MM
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=
=
Pretax income (EBT)
FIT PAID (NOTE 1)
NET INCOME
NI
Earnings / share (E.P.S.) NI / shs out
2,500,000
1,150,000 50% FIT rate
1,250,000
$1.25
NOTE 1: If EBT is negative (a loss) the convention we use in this course is that taxes are
a CREDIT (tax rate times EBT). In the real world, companies can apply tax loss
carryforwards. Please see Text p. 11.
A. DOL = rev bef fixed costs / EBIT
=$8MM / $4MM
= 2X
B. DFL = EBIT / (EBIT – I)
= $4MM / $2.5MM = 1.6X
NOTE: EBIT – I = PRETAX OR EBT
C. DCL AT $16MM OUTPUT = (2) (1.6) = 3.2 X
D. 20% INCREASE IN SALES X 3.2 = 64% INCREASE IN E.P.S. = $2.05 PER
SHARE
E. S*= BEP IN DOLLARS = F / CONTRIB MARGIN = $4 MM / .5 = $8 MM
CONTRIBUTION MARGIN IS RBFC / SALES
FIN 3404 TOPICS
Material in this section is primarily covered in the FIN 3404 course.
Fin 3404 will review the following material:
 Time Value of Money concepts
 Use of the TIBAII+ Financial Calculator.
You may have used another calcualtor in FIN 3403
I am sorry but you will need to get a TIBAII+ calculator for this course
since all lectures, this workbook and the text are keyed to it.
 Capital budgeting
 Cost of Capital
 Financial statement analysis
FIN 3403 will cover some of the elements included below on an introductory basis:



Stock and Bond Valuation
Financial Markets and Instruments
Options and Futures (time permitting)
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FIN 3404 will explore the following new material:






Financial forecasting using spreadsheet models
Cash, receivables and inventory management and budgeting
Merger and Acquisition analysis
International finance issues
Convertible securities
Additional material in use of derivatives. NOTE: Students interested in
exploring derivatives in more depth should consider taking the Speculative
Markets course
We will seek to introduce current events on the above topics into class discussion.
Both courses will utilize a team Excel Spreadsheet Analysis of a
company of your choice --(must be approved by instructor).
FINANCIAL FORECASTING
One of the major differences between accounting and finance is that accounting tends to look in the rear
view mirror and prepare historical statements from past results whereas finance is constantly engaged in
doing what is called “pro forma analysis” or “what if scenarios.”
Forecasting and planning is covered in Chapter 4 of your text.
Financial modeling is an exciting area of finance. Using tools ranging from Excel Spreadsheets such as that
you will work on in your company report to sophisticated super computers using artificial intelligence,
financial modeling seeks to evaulate markets, make projections and assist the manager, trader or analyst in
decision making.
On Wall Street, much of the former drudgery in the form of number crunching is now eliminated through
sophisticated models. Highly paid securities analysts build industry models to help them keep track of the
impact of variables on their companies. A simple example would be a crude oil price model that would be
keyed into individual oil stock income statement projections. Since oil demand is relatively inelastic,
decreases in price do not translate into a meaningful volume gain. Crude is a volatile commodity. Price
changes impact the income statement almost immediately depending on the type of inventory accounting.
Most U.S. firms use LIFO, so the impact is felt right away.
If you are rusty on accounting, you need to brush up on ratios (see Text p. 106 and appendix to this
workbook), the difference between a cash flow statement and an income statement and fundamentals
covered in Chapter 3. It is important that all students carefully review and understand the DuPont Model
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on p. 107. This model shows the impact of various balance sheet and income statement elements on Return
on Equity which is the most important financial ratio since it measures how well management is maximizing
shareholder value.
It is important to understand that Earnings Per Share can be influenced by a variety of forces. Some of
these are under the direct control of the financial manager. Others are independent of the firm such as the
economic environment, foreign currency translation impact, government taxes and regulation etc. Let us
examine some of the ways EPS can increase.
1.
2.
3.
4.
5.
6.
7.
8.
9.
Revenue increases. Two elements influence revenue increases:
 Prices are hiked
 Unit volume is increased
Profit margins widen (gross margin, operating margin, pretax and net margin are influenced by
different forces.)
The Tax rate is cut either by the Government or by planning, tax incentives, etc..
Financial leverage is used to magnify small changes in revenues to the bottom line.
The product mix changes with a greater emphasis on higher margin products or services.
A common share repurchase is effected. Reducing the share count increases E.P.S.
Costs are reduced. The process of “Downsizing” is a major recent trend. Cost cutting falls into many
categories some examples include:
 Reducing personnel through reduction in force (RIF)
 Cutting specific internal component costs such as inventory through better management such
as “just in time” techniques, or new technology such as robotics.
 Cutting costs from outside suppliers
 Tax strategies such as building a plant in an enterprise zone or tax haven
 Sale - leasebacks of assets to increase return on assets and ROI
Poor performing subsidiaries are sold which reduces costs and improves margins.
A non-dilutive acquisition is made. We will discuss what dilution is later. Basically it refers to the
return earned on an acquisition is vs. the cost of funds.
FORECASTING USING AN EXCEL SPREADSHEET
In your company Excel spreadsheet after the ratio page, the computer provides for a simply P&L
forecasting model to project E.P.S. for the next 5 years. Enter data only where indicated.
NOTE: In this model, enter data in yellow cells only. All yellow cells must be filled in for the model to
work. If you only have 4 segments but the model asks for 5, enter 0s on row five in the yellow cells.
You are required to enter segment data for sales, margins and growth rates. Most companies provide sales
breakdown data by product line or in geographic segments. Some provide margin data. Virtually none
provide estimated growth rates by segment and you will have to estimate this.
Financial forecasting is an educated guess. It is not rocket science. The elements in your forecast are:
1.
2.
3.
4.
Developing a sales mix by product line, division, or geographic mix. This may be provided in the 10K
or you may need to make some assumptions and engage in educated guesswork.
Estimating the operating or gross margin by product line or division.
Estimating the revenue growth rate (units X price change) for each segment in percent.
Making sure that the bottom lines for historical data agree with actual results. For example, the total of
segment sales MUST equal actual corporate sales for the preceeding fiscal year. The total gross or
operating income MUST equal actual data. The growth rate should be based on past trends. Be
conservative. The model forecasts EPS. This should be close to recent results from 10Q data.
The computer will make a projection based on these elements. As a manager, you need to INTERPRET
this output. Does is make sense? Here is how you do that:
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1.
2.
3.
Look at the current year forecast. How much did sales and EPS increase? Did EPS increase more than
sales? Why? (See all the elements listed on the previous page that can magnify EPS relative to sales)
 Are your margins roughly the same as last year or did they increase materially. Can you
justify the increase. If not, go back to the top of the model and reduce your margin estimates
by division or growth rates for higher margin divisions.
 Check the tax rate. Has it changed? Does this make sense?
If you are near the end of the fiscal year, how does your number compare with actual quarterly data. If
you took a trend line forecast of the remaining quarters in the year would your projection be close?
Compare your numbers with a forecast of a professional analyst or Value Line (if available)
Each team should hand in your model. Try different assumptions. This is called “sensitivity analysis.”
What are your conclusions.
FORECASTING USING HISTORICAL RATIOS
Please refer to problem 4-5 B in your text. Compute the balance sheet.
Please refer to page 17 (above) in this workbook. We will work this in class.
These kind of problems are typical exam questions.
M&A (MERGER AND ACQUISITION) ANALYSIS (TEXT CH. 21)
Restructuring and M&A is a special subset of the forecasting model. This is covered in Ch. 21 of your text.
As head of the Capital Markets Group at a brokerage firm, I supervised research and “Corporate Finance”
activities. Corporate Finance analysts were engaged in M&A and new issues (IPOs or initial public
M&A (MERGER AND ACQUISITION) ANALYSIS (TEXT CH. 21)
offerings and secondaries). Their job (for which they are extremely highly compensated, is to develop proforma projections and “what if” scenarios.
In Chapter 4 and in your project, the main method of forecasting is called the “percentage of sales” method.
It is simply a trend line projection. MS Excel has built in functions that will do least squares trend line
projections. This works well for companies and industries which are non-cyclical and where growth is
based on demographic factors rather than R&D or new product development. This method does NOT work
for cyclical enterprises, companies engaged in acquisition or divertiture or firms such as high tech
enterprises dependent on new products.
M&A analysis is an MBA level analytical project. It is beyond the scope of this course. M&A can be a
relatively simple matter however. If Company A buys Company B using purchase and not pooling of
interest accounting, in general the combined balance sheet and income statements will be the sum of the two
independent balance sheets plus Goodwill. Computer software is available that will combine the
statements into a simple pro-forma.
In the late Sixties and early Seventies, a prominent school of thought in M&A was dubbed the
“Conglomerate” merger. This merger combined entities that were seemingly unrelated. This was in stark
contrast to the mergers driven by vertical integration seeking to control the entire distribution channel from
raw material to the customer or the horizontal deal seeking to dominate a given segment or market across
product lines. The buzzword for the conglomerate deal was:
2 + 2 =5
This is called “Synergy.”
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Does it work? The results are mixed.
The Eighties focused on the LBO or leveraged buyout using massive amounts of debt. This was M&A
using financial leverage to the max. It worked until interest rates rose and forced many firms into Ch. 11.
The Nineties concentrated on undoing the excesses of the Eighties. The Nineties have focused on
divestitures of acquisitions made during the conglomerate era. The objective now is to return the company
to its “core” business or competency. This has seen GM sell off its Hughes Electronics and EDS divisions
for example. Perhaps the Nineties should be labelled 4 - 2 = 3. Conglomerates posed a problem.
Managers did not understand the key product or service. There were so many divisions in large companies
that top management often did not know what business they were in. The era of “downsizing” now seeks to
return to a company’s roots.
WHAT IS A FIRM WORTH?
We have studied valuation of stocks and bonds. You understand terms like BVPS (book value per share),
Price to book and P/E (price / earnings per share).
How do you value a firm? See Text p. 817-830
Consider Weyerhauser or Georgia Pacific. These are timber companies where the assets are right there
growing before your eyes. The balance sheet reflects historical cost. George Weyerhaeuser purchased
prime Pacific Northwest hardwood forest land for a song. This is true for companies like British Petroleum
which purchased Standard Oil of Ohio’s (the original Standard Oil) Alaskan North Slope oil fields. Clearly
balance sheet value for many fixed assets is not useful in determining market value. Normally current assets
are marked to market so their values are OK.
WHAT IS A FIRM WORTH? contd.
Ch 21 looks at some ways to develop a fair market value for an enterprise:
1. Book Value (stated shareholder’s equity per share). This works for some enterprises like banks.
2. Appraisal. This would work for a real estate firm or even Weyerhaeuser. Obviously if the forest
burns, this appraisal would be adjusted. If prices for timber decline this would also affect valuation.
3. Stock Market Value. Theoretically, in a perfectly efficient market where all information is known,
the market capitalization of a company reflects its value. Why then are other companies willing to pay
big remiums in an acquisition? The answer can include that old concept: synergy (economies of
scale), assumptions about future earnings etc. Nevertheless, a market where assets are freely traded is
the best arbiter of value since it represents fair market transactions between willing buyers and sellers.
4. Segment or chop shop value. The parts may be worth more than the whole. The parts in a used car
are worth 3 times the value of the car itself. This is why car thieves usually avoid new cars and
concentrate on 2-5 year old cars. The same is true of companies.
5. Cash flow value. What is cash flow? It is NOT the same as accounting profit. In Japan, ALL
companies are managed based on cash flow. A company with substantial depreciation, depletion or
amortization expense pays less taxes. This can be valuable to an acquiring company paying the
maximum corporate tax bracket. Companies with large loss carryforwards may command premium
prices in an acquisition for similar reasons.
CHALLENGES AND LIMITATIONS IN FINANCIAL FORECASTING
My Wall Street analysts believed everything could be simulated in a model. If computers could accurately
forecast our complex environment we would not need educated, thinking managers like you. Models are
valuable tools. However they have their limitations:
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1.
2.
3.
4.
5.
The world is a complex place and it is constantly changing. Events in Asia can affect your business.
Government regulations can impact you in unexpected ways. Models simply cannot be large enough to
anticipate all these variables. However as we build more and more sophisticated financial and
econometric models we do get better at understanding key interrelationships.
In a corporation managers are expert model builders. Most financial executives I have known are
expert at designing models to make themselves look good. Let us assume you are the Chief Financial
Officer at a large company and you have 5 vice presidents reporting to you. Each V.P. presents capital
budgeting projects to you for consideration. Each has a vested interest in getting his/her project
approved since it means money, prestige and promotions. Your challenge is to dig through the
assumptions in the model to sort out hype, fuzzy thinking and forecasts and to standardize key
assumptions so all of your 5 V.P.s are on a level playing field. This is a difficult task.
My experience is that some managers become such slaves to their models that they fail to exercise good
judgment. A good battlefield military commander such as Patton or Rommel knows when to say
“enough” and make a key decision based on limited information. If you wait for all the data to fill up
the model, the competition will beat you to the punch. Entrepreneurs (dubbed “gunslingers” in the
investment arena) tend to be good in this area. Unfortunately they often manage by the famous maxim”
“Ready, Fire, Aim.”
Models need to be easy to use or they will be ignored. A good example is the new Morgan Stanley
trading system for foreign currency which shows a matrix on the CRT. Each swap is colored RED,
GREEN or YELLOW. The Green swap is a GO. The Red swap provides unaccaptable risk / reward
tradeoffs and should be avoided and the Yellow swap is a judgment call. It is simple. It allows for the
kind of instantaneous decisions that typify a trading desk.
Forecasts need to be flexible. A simple example of this concept is what is called A, B, C budgeting.
The A budget is the best guess. The B budget is often more conservative version and the C is the worst
case scenario. In event of a Recession or other external event, management can instantly switch to the
B or C budget which includes cost reduction strategies, reduced revenue goals etc. Being a slave to a
fixed budget has spelled doom for many companies (and careers).
FINANCIAL MARKETS AND FINANCIAL INSTRUMENTS
A. FINANCIAL INSTRUMENTS
MONEY MARKET
T-BILLS
FEDERAL FUNDS
COMMERCIAL PAPER
< 1 YEAR IN DURATION
Short term debt of the Federal Govt.
Issued in 90, 180 and 360 day maturities
Sold at a DISCOUNT
T-bills are “risk free” and form the basis for
all other money market rates
Interbank overnight loans secured by deposits at the Fed.
Short term debt instrument of a large corporation or its
finance subsidiary such as FMCC sold through brokers.
Quality of paper is “Rated” by firms such as S&P, Moody’s.
Fitch, or Duff and Phelps.
BANKER ACCEPTANCES
Letter of credit (a bank’s promise to pay) that has been
stamped “guaranteed” by another bank. Like a post dated check.
Used widely in international finance.
NEGOTIABLE CDs
Debt instruments issued by banks paying a stated interest.
No penalty for early withdrawal – Can be resold in secondary
mkt (unlike consumer CDs) may or may not be FDIC insured
Issued in denominations of $100,000 minimum
MMM FUNDS
A portfolio of other MM instruments (i.e.: bills and commercial
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paper, etc). Portfolio Net Asset Value (NAV) is kept at $1.00
so theoretically there is no principal fluctuation.
EURODOLLARS
U.S. dollar denominated deposits of U.S. commercial banks with
banks in foreign countries. These IOUs are actively traded in all
international exchanges based on current exchange rates.
CONSUMER CREDIT PAPER
Packaged groups of loans that are traded in major exchanges at a
discount based on risk level of “portfolio.”
CAPITAL MARKET
TREASURY NOTES
TREASURY BONDS
MORTGAGES
> 1 YEAR IN DURATION
U.S. government direct obligations (usually 2-10 years in duration)
NOTE: Interest on ALL U.S. treasury paper is exempt from state and
local income tax.
U.S. government direct obligations (10-30years in duration)
A bank loan secured by real property (land, commercial, residential or
industrial). If the buyer defaults, lender forecloses and receives title.
Many varieties: Adustable rate or ARM (reset annually at 90 day
bill rate or other benchmark + a set risk premium
Fixed rate-rate fixed for life of loan ( 15-30 yrs)
Active secondary market caused by SECURITIZATION
FINANCIAL MARKETS AND FINANCIAL INSTRUMENTS CONTD.
MUNICIPAL BONDS
“MUNYS”
Muny issuers may be
a state, city, county,
agency, University etc.
$1000 par semi-annual pay
CORPORATE BONDS
$1000 par
Interest paid semi-annually
normally.
corporations
Bonds or notes issued by a state of local government.
General obligation (GO) Backed by taxes (”Full faith and credit”)
Revenue:
Backed by tolls or other revenue
IDR:
Issued by a municipality for a corporation
Exempt from Federal income tax. Some issues may also be
exempt from state and/or local income tax (“Triple tax free”)
Long term debt instruments of large corporations.
Mortgage bonds:
1st., 2nd., etc secured by real property
Equipment Trust Certificates secured by chattels like airplanes
Debentures –unsecured except by earning power of corporation
Interest on corporate debt is tax deductible to U.S.
PAR= $1000
COUPON= stated interest rate (8% = $80) Paid SEMIANNUALLY
MATURITY = stated redemption date
SINKING FUND= prepayment of issue prior to maturity
LEASES
Debt obligation of individuals or corporations. May be bundled
into a portfolio and securitized such as a package of leases issued
by GMAC under standardized terms.
PREFERRED STOCKS
Par variable
Dividend fixed.
A unlimited maturity quasi-debt instrument with a fixed dividend
At present 70% of dividend income on preferred stocks owned by
other U.S. corporations is free of income tax (This is called the
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No maturity
Pfds are “quasi debt”
COMMON STOCK
common shareholders
Own the Corporation
and vote for directors
intercorporate. Dividend exclusion)
Preferred dividend payments are NOT deductible to the issuer
Dividends are fixed. Most issues are CUMULATIVE.
“Residual Equity” or ownership capital of a corporation.
Dividends are declared by the board and vary with profitability
(earnings per common share).
Excess profits after payment of all expenses and dividends go to
Retained earnings which is part of shareholder’s equity capital.
PRIMARY VS. SECONDARY MARKETS
A primary market is new capital such as a new stock or bond issue.
A secondary market (such as the New York Stock Exchange—NYSE or “Big Board”) merely trades
existing securities and does not raise new capital.
Markets today are global. An issue of a large corporation like Exxon may trade on the NYSE, Tokyo, Hong
Kong or other exchanges.
There are many “Derivatives” of these financial instruments such as traded option contacts or commodity
futures that also trade actively. These are beyond the scope of this course but are covered in FIN 407.
VALUATION OF BONDS AND STOCKS
BOND VALUATION
The value of a bond is the net present value of the cash flow stream: interest coupons
+ redemption value discounted at the market rate of interest for bonds of similar type,
quality, and maturity. Coupon income is an annuity paid semiannually. The
redemption value is a lump sum ($1000 or par in most cases) and is paid at maturity.
BOND VALUE = NPV OF INTEREST COUPONS (an annuity) + NPV OF PAR VALUE AT
MATURITY Discounted at yield of bonds of similar type, quality and maturity
NOTE:
ALL CORPORATE BONDS MATURE AT PAR = $1000. FOR OUR PURPOSES ALL BONDS
ARE ASSUMED TO BE SEMIANNUAL PAY WITH COUPONS EVERY 6 MONTHS.
Bond time line
YEAR 0
COUPONS EVERY 6 MOS
YEAR N (MATURITY)
FINAL COUPON plus
PAR ($1000 PER BOND)
BOND TERMINOLOGY



INDENTURE A contract between a U.S. corporation and bondholders specifying terms of a
new bond issue. This document is required by the SEC. The indenture specifies coupon,
trustee, call provisions, maturity, and other terms such as convertibility.
TRUSTEE Institution (usually a bank) charged with enforcing terms of indenture. The
trustee would initiate bankruptcy proceedings is coupon interest is not paid on time.
COUPON The stated interest rate on a bond. Coupon is stated in percentage terms.
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An 8% coupon is equal to $80 per year (8% times $1000 par). THE COUPON IS FIXED
FOR THE LIFE OF THE BOND. ALL CORPORATE BONDS WE WILL STUDY PAY
INTEREST SEMIANNUALLY. Each coupon in this example would be $40. All problems
will use semiannual coupons. Set bond spreadsheet for 2/Y
 COUPON IN DOLLARS
8% = $80 paid semiannually ($40 and $40)
 PAR Face value. $1000 FOR CORPORATE BONDS. ALL BONDS MATURE AT PAR.
NOTE: IF A BOND IS CALLED BEFORE MATURITY THERE IS USUALLY A
CALL PREMIU (i.e. 103 call price means firm refunds issue at $1030 per bond.)
 PRICES OF BONDS ARE QUOTED IN % OF PAR -- 80% = $800. Your BOND
WORKSHEET is in % of par. If you solve a problem and the NPV is 92 this MUST be
converted to dollars (i.e. $920)
 CURRENT YIELD Current percantage return :
$ COUPON / PRICE OF BOND
 YIELD TO MATURITY (YTM)
This is the TOTAL RETURN on the bond:
Current yield + capital gain (or loss)
 ACCRUED INCOME Interest due the SELLER of the bond based on the number of days
since the last coupon date. This is the last entry on your bond calculator (AI). The calculator
uses a 365 day year for all corporate bonds (ACT). In U.S. Government bonds, the calculator
is set for 360 day year by pressing ACT and ENTER. Calc should read 360.
NOTE: Since this is a corporate finance course, leave your calculator set for ACT (365 day year)
 DURATION A measure of sensitivity of a bond price to changing interest rates. Duration is
a mix of MATURITY and COUPON INCOME. Long maturity bonds generally have longer
duration. Higher COUPON bonds of the same maturity as a lower coupon issue will have
shorter duration since the NPV of the coupon income is greater.
BOND CONCEPTS







At par Coupon rate = current yield = yield to maturity (YTM)
If a bond is selling ABOVE PAR , current yield will be > YTM. WHY?
Because if a
bond is above par (over $1000) and matures at $1000 you will incur a CAPITAL LOSS at
maturity. This loss is incorporated in YTM calculations.
If a bond is selling BELOW PAR you will have a gain upon maturity and YTM > current
yield.
If interest rates DECLINE, bond PRICES INCREASE
A bonds YIELD TO MATURITY is ALWAYS EQUAL to interest rates on bonds of similar
TYPE, QUALITY AND MATURITY in the marketplace. In order for the YTM to equal the
market rate, the bond price adjusts to reflect current rates.
The NPV key on your calculator is the sum of two elements: the NPV of all semiannual
interest coupons (AN ANNUITY) and the NPV of the price at maturity or call. At maturity
the bond will be worth $1000. If the bond is called prior to maturity, the corporation may
have to pay a call premium (say 103). This will be disclosed in the indenture.
If you know a bond COUPON, MATURITY DATE, and the MARKET RATE on bonds of
similar type, maturity and quality, you can solve for NPV. This is how Wall Street Bond
traders determine the price of a bond (excluding accrued income and commission)
FINANCIAL CALCULATOR INPUTS IN A BOND VALUATION PROBLEM USING TVM KEYS:
P/Y = 2
SET P/Y TO 2 FOR ALL BOND PROBLEMS AND EXAM
N
= YEARS TO MATURITY
I
= INTEREST ON BONDS OF SIMILAR TYPE AND QUALITY (NOT COUPON)
PV
= CURRENT PRICE (NEGATIVE NUMBER)---WE SOLVE FOR THIS
PMT = DOLLAR VALUE OF SEMI ANNUAL COUPONS
FV
= $1000 OR REDEMPTION CALL PRICE (DISCUSSED LATER IN LECTURE)
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EXAMPLE
SOLUTION USING TVM KEYS
WHAT IS ITS THEORETICAL VALUE? IT IS THE NPV OF ALL
CASH FLOWS DISCOUNTED AT THE MARKET PREVAILING \
INTEREST RATE FOR BONDS OF SIMILAR TYPE AND QUALITY
THIS INTEREST RATE IS 7.5%
SET P/Y = 2 AND CLEAR ALL REGISTERS
MATURITY IS 25 YEARS
N=50 (25*2)
COUPON
= 8% THEREFORE PMT = $40 ($80/2 NO MINUS SIGN)
FV
= $1000 (par) FV may be CALL PRICE if bond is called.
I/Y
= 7.5 IMPORTANT: I/Y = market rate NOT coupon on bond
SOLVE FOR PV = $1064.17
BOND IS SELLING AT A PREMIUM TO PAR.
WHY?
On the next page we will look at the Bond Spreadsheet. It is recommended that in an exam if you are
asked to compute the theoretical price of a bond (NPV) use BOTH methods to check yourself.
In any exam question where you are asked to compute YIELD TO MATURITY or ACCRUED
INCOME you MUST use the Bond Spreadsheet. Be sure and clear all registers after pressing the CF
key. REMEMBER That PV in your solution will be a negative number since it is a cash outflow.
BOND VALUATION CONTD.
semiannual DOLLAR COUPON = INTEREST COUPON TIMES PAR ($1000) / 2
8%
= $80 PER YEAR
coupon + $40
SOLVING FOR YTM USING THE BOND WORKSHEET see sec. 5-2 IN TI BA2 MANUAL
Problem: Compute yield to maturity and accrued income for a 8% debenture with a
trade date of 6-30-97 and a maturity of 30 years from trade date. The purchase price on this bond
is 106.53
NOTE; ALL INPUTS IN SPREADSHEET ARE AS A % OF PAR
This is a step-by-step solution using your TI BAII + calculator:
ENTER: 2ND BOND to enter the bond worksheet
SDT
= SETTLEMENT DATE (3 days from TRADE DATE for corporate issues)
July 3, 1997 is entered as: 7.0397. This is when you BUY the bond.
DOWN ARROW
CPN
= COUPON RATE IN PERCENT = 8%
ENTER 8
DOWN ARROW
RDT
= REDEMPTION DATE
MATURITY OR CALL DATE
30 YEARS FROM 6-30-97
=
6-30-27
ENTER as: 6.3027
This is when bond matures or is called.
TI CALCULATOR HANDLES THE MILLENIUM PROBLEM
DOWN ARROW
RV
= REDEMPTION VALUE
AT MATURITY THIS IS ALWAYS 100
AS A PERCENT OF PAR
100 = 100% OF PAR
DO NOT enter 1000 here.
IF BOND IS CALLED PRIOR TO
MATURITY THIS IS CALLED A
“CALLABLE” BOND
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REDEMPTION CALL IS ALWAYS
ABOVE PAR --SAY 103
SET ACT and forget
CORP BONDS USE ACT (ACTUAL 365 DAY YEAR) ALL
EXAM PROBLEMS WILL USE ACT
MAKE SURE CALCULATOR IS SET FOR SEMIANNUAL COUPON
= 2/Y
SKIP SOWN TO PRI (PRI)
= 106.53
IMPORTANT: BE SURE AND CONVERT ANSWER FROM PERCENT OR PAR TO DOLLAR
PRICE: BOND PRICE IN DOLLAR TERMS IS $1065.30
AI
= ACCRUED INCOME
= .0652
Accrued income is the interest payable to the seller reflecting accrued interest from the last
coupon to settlement date.
If you buy a bond with coupons on January 1 and June 30 on March 30 you (THE BUYER)
owe the seller half your next coupon payment. This is called accrued income and is added to
your cost when you buy the bond. The sales commission is also added.
YOU SETTLED ON THE BOND 3 DAYS AFTER THE COUPON PAYMENT
Therefore accrued income is 3 days. Your calculator will automatically calculate AI.
MULTIPLY THE ANSWER IN AI BY TEN TO GET THE DOLLAR VALUE OF AI.
80/365.25
21.9 CENTS PER DAY X 3 DAYS =
66 CENTs
CONVERTIBLE BONDS PREFERREDS & WARRANTS
(FIN 3404)
Converts are a special case. SEE TEXT PP. 800-808
Convertible securities are covered in FIN 3404.
All the concepts that apply to fixed coupon bonds apply to converts. The big difference is that a convert is
quasi equity. At some point the bond will self liquidate (disappear) and become common stock.
CONVERTIBLE TERMINOLOGY:
PAR
BONDS: Assume par is always $1000
PFD:
In any problem par must be stated.
CONVERSION RATIO
Number of shares of stock per bond or convertible preferred.
EXAMPLE: Bond is convertible into 20 shares of stock.
CONVERSION PRICE
Par / conversion ratio
EXAMPLE: Bond par is always $1000 for our purposes.
Therefore if the Cv. Ratio is 20, the conv. Price = $50 ($1000/ 20)
CONVERSION VALUE
ALSO CALLED
THEORETICAL VALUE
A key concept in understanding that a convertible bond only has value
as quasi equity when the stock price exceeds conversion price.
EXAMPLE: A convertible bond has a conversion ratio. The bond is
issued at par ($1000). At time of issue the stock is trading at $40.
The bond will not begin to trade as quasi equity (in tandem with
common stock) until the common price rises above $50
EXAMPLE 2: Assume the common is trading at $60 / share.
Theoretical value of the bond is $1200 ($60 x the conv ratio of 20)
46
47
Since each bond is worth 20 common shares, theoretical value
measures the equity value of the bond when the stock is “in the
monay.” (above conversion price).
PREMIUM TO
CONVERSION
VALUE
A convertible bond that is in the money is a unique instrument. It has
safety and priority of claim associated with a bond as well as a yield
that is usually higher than the common dividend yield. However, as
the common increases in value, the bond will also go up. It is obviously
a desirable investment possessing similar returns but lower risk than the
common. As a result, investors tend to bid convertible price up above
theoretical or conversion value.
PREMIUM = (MARKET PRICE OF BOND - CONVERSION VALUE) /
( GREATER OF CONVERSION VALUE OR BOND PRICE)
Premium is expressed as a percentage above conversion or value.
EXAMPLE: In the above example, we compute conversion value at
$1200. Assume the market price of the bond is $1500. Conversion
premium is (300)/ 1500 = 20%
FORCED CONVERSION
When a corporation CALLS a convert that is in the money
this will force conversion to common. The bond will self liquidate.
BOND AND STOCK VALUATION CONTD.
INTEREST RATES
k
KRF
=
=
KRF + DRP + LP + MRP
Risk free rate = K* + IP
CONCEPTS:
1.
2.
3.
4.
5.
6.
7.
The yield curve is normally upward sloping to the right reflecting the time value of money (i.e. we
expect to be paid more for longer maturities).
Money market = < 1 year in duration (Treasury bills for example are MM instruments and mature in
one year or less. Bills are DISCOUNT instruments.
Capital market = > 1 year. Notes are bonds due in 1-10 years
Bonds normally mature in 10 to 30 years
KRF can now be determined by new U.S. Treasury bonds (See UST listings in WSJ)
U.S. Treasury bonds, notes and bills are considered the HIGHEST QUALITY instruments because
there is no default risk. All other bonds have HIGHER yields than treasuries due to the DRP.
If inflation > interest rates FOR ALL INSTRUMENTS > due to the IP. Longer maturity instruments
would be more affected than short maturity instruments.
An illiquid instrument like a CD has a higher K than a liquid investment of similar type, quality and
maturity. This is due to the LP.
Stock prices tend to < when interest rates K >. As we will see, the value of stocks is the NPV of
the future dividend stream discounted at some rate. I recommend using the 10 year U. S. Treasury
bond yield.
STOCK VALUATION
47
48
The value of a share of common stock is the net present value of a stream of dividend income estimated into
the future. This dividend stream in most dividend discount models is projected for 30 years. In my model
on the next page, this cash flow stream is discounted at the 10 year U.S. Treasury yield and if there are no
dividends or the payout is small, the payout is assumed to be 20% (PAYOUT = DPS/EPS or DIVIDENDS
/ NET INCOME)
The formula for valuation of a constant growth stock (see p. 298)
P0
=
D1
Kcs- g
Where P0 = price, D1 = dividend NEXT year, g = analyst estimate of DPS growth or EPS growth if there
are no dividends. Kcs is the investors required rate of return.
DIVIDEND DISCOUNT MODELS
The model on the next page is an example of a DDM. You have this model in your team Excel computer
disk. The model computes the NPV of dividends over a 30 year period discounted at the 10 year Treasury
yield. INPUTS TO THE MODEL ARE:
Current EPS estimate, dividend payout ratio, an estimated EPS
growth rate over the next year and the 10 year Treasury yield and the current stock price. The model will
determine a NPV at current interest rates +/- 100 basis points (+ or - 1%) at the bottom of the model.
E. growth
Year
30.0%
21.0%
14.7%
1-5
6-10
11-20
10.3%
21-30
STOCK PRICE
$ 10.00
NPV OF DPS STREAM
NPV(H7:H36)
$15.37
10 YEAR TREAS
YIELD
6.4%
THIS IS I/Y
NEOGEN CORP (NEOG)
Neogen is a small diagnostic test kit firm located in Lansing,MI
DIVIDEND DISCOUNT MODEL
FISCAL YEAR
1
12/31/98
2
12/31/99
3
12/30/00
4
12/30/01
5
12/31/02
6
12/31/03
7
12/30/04
8
12/30/05
9
12/31/06
10
12/31/07
11
12/30/08
12
12/30/09
13
12/31/10
14
12/31/11
15
12/30/12
16
12/30/13
17
12/31/14
18
12/31/15
19
12/30/16
20
12/30/17
21
12/31/18
22
12/31/19
23
12/30/20
24
12/30/21
48
E.P.S.
$ 0.40
$ 0.52
$ 0.68
$ 0.88
$ 1.14
$ 1.38
$ 1.67
$ 2.02
$ 2.45
$ 2.96
$ 3.40
$ 3.90
$ 4.47
$ 5.13
$ 5.88
$ 6.75
$ 7.74
$ 8.88
$ 10.18
$ 11.68
$ 13.40
$ 14.77
$ 16.29
$ 17.97
GROWTH
30.0%
30.0%
30.0%
30.0%
21.0%
21.0%
21.0%
21.0%
21.0%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
14.7%
10.3%
10.3%
10.3%
E PAYOUT
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
20%
E. D.P.S
$
0.08
$
0.10
$
0.14
$
0.18
$
0.23
$
0.28
$
0.33
$
0.40
$
0.49
$
0.59
$
0.68
$
0.78
$
0.89
$
1.03
$
1.18
$
1.35
$
1.55
$
1.78
$
2.04
$
2.34
$
2.68
$
2.95
$
3.26
$
3.59
49
25
26
27
28
29
30
12/31/22
12/31/23
12/30/24
12/30/25
12/31/26
12/31/27
$
$
$
$
$
$
19.82
21.86
24.11
26.59
29.33
32.34
10.3%
10.3%
10.3%
10.3%
10.3%
10.3%
20%
20%
20%
20%
20%
20%
$
$
$
$
$
$
3.96
4.37
4.82
5.32
5.87
6.47
THIS IS AN EXCEL SPREADSHEET. A DDM NODEL IS A REAL WORLD TVM PROBLEM.
N=30
P/Y =1
I/Y=
6.40
PMT= E. DPS COLUMN--30 CELLS
WE PROJECT EARNINGS AT A DECLINING GROWTH RATE AND HAVE 30 CASH FLOWS
WE PROJECT DIVIDENDS AT A CONSTANT 20% ASSUMED PAYOUT (Payout = DPS/EPS)
SOLUTION:
WE USE THE NPV FUNCTION IN EXCEL:
NPV (I/Y, cells of cash flow stream [h8:h37])
BP= basis point
CURRENT STOCK PRICE:
E VALUE / PRICE
$
$15.37
10.00
154%
Sensitivity analysis: Estimating NPV at different interest rate forecasts
- 100 b.p. - 50 b.p. BASELINE
+ 50 b.p.
+ 100 b.p.
5.4%
5.9%
6.4%
6.9%
7.4%
As rates
E. rate
$18.68
$16.93
$15.37
$13.98
$12.73
rise, NPV
E. NPV
21.5%
10.2%
0.0%
-9.1%
-17.2%
declines
chg
= 1/100 of 1%
I/Y
NPV
PUT AND CALL OPTIONS
PUT = OPTION TO SELL
CALL=OPTION TO BUY
STRIKE
PRICE
PREMIUM
MATURITY
=
=
=
=
CONTRACT
=
Standardized options are money market instruments (expire in < 1 yr)
OPTION EXERCISE PRICE. FIXED FOR LIFE OF CONTRACT
Previous day CLOSING price. Fluctuates daily.
Cost to buy or amount received to sell. All amounts are per share.
Contracts expire on the THIRD Friday of each month. Stock put and call
options are usually 1-3 months in duration.
For common stock 1 contract = 100 shares (round lot)
3 THINGS CAN HAPPEN TO AN OPTION CONTRACT:
1. You can exercise it
2. You can sell it prior to expiration
3. You can let it expire worthless
All options are worthless on expiration
The price of the option is NOT the same as the price of the underlying stock. The option price is the
premium you would pay (in a purchase situation) for 1 share. The minimum purchase is 1 contract or 100
shares. The strike price and the price of the stock must be compared to see if contract is “in the money.”
IF A PUT STRIKE > PRICE OF STOCK it is IN THE MONEY
IF A PUT STRIKE < PRICE OF STOCK it is OUT OF THE MONEY
IF A CALL STRIKE > PRICE OF STOCK it is OUT OF THE MONEY
IF A CALL STRIKE < PRICE OF STOCK it is IN THE MONEY
DIAGRAM IT: PUT OR CALL STOCK PRICE
OPTION PRICE X 100 SHS = PREMIUM
OPTION STRIKE
DETERMINE IS OPTION IS IN THE MONEY OR OUT OF MONEY
PROFIT OR LOSS EQUALS
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50
1.
2.
PREMIUM PAID FOR OPTION CONTRACT (in case of a purchase) PLUS
PROFIT OR LOSS AT EXPIRATION. This is only the case if the option is IN THE MONEY
Otherwise, it expires worthless
OR
1. PREMIUM RECEIVED FOR OPTION CONTRACT (in case of a sale of an option) PLUS
2. PROFIT OR LOSS AT EXPIRATION This is only the case if the option is IN THE MONEY
Otherwise, it expires worthless
A COVERED CONTRACT is an option that is backed by stock you own. If you own 100 shares, you can
write 10 covered contracts (puts or calls). Why would you do this.
IN THIS COURSE OUR FOCUS IS ON OPTIONS PRIMARILY TO HEDGE RISK
 A put is a form is a form of “portfolio insurance” since it limits loss to a specific level
 Selling a call gives seller premium income. Most sales are “out of the money” Seller is betting that the
stock will not appreciate to strike before expiration. If it is in the money, seller will have his stock
purchased away at strike price.
INDEX OPTIONS are options based on an index such as the OEX (S&P 500) –500 stocks or the OEX
(S&P 100)-100 stocks or the DJIA (30 stocks)
LEAPS ARE LONG TERM OPTION CONTRACTS (1-2 years usually)
READING PUT AND CALL OPTION QUOTES
A. Index options
-- Index close must be checked in box usually on upper left of page or section in WSJ
Quote is checked by looking up date and strike price under appropriate index option
Two quotes are given on separate lines C=call
P=put
B. Individual stock options -- Price in LEFT COLUMN is close on underlying stock
Quote is checked by looking for date and strike for the stock
Quotes for puts and calls are given in two adjacent columns
C. The first thing you must do is determine cost of purchasing one contract (100 shares) which is quoted
price x 100.
D. The second thing is to determine if contract is in the money or out of the money. This depends on
whether it is a PUT or CALL (see page 1)
E.
The profit on a contract is equal to profit or loss LESS cost of the contract or multiple contracts.
EXAMPLE:
You buy 5 puts with a $60 strike at a price of $4.50 per share
In the left column you read the closing price of the stock. $62
In the appropriate column you read the premium for one share
This contract is OUT OF THE MONEY. A PUT IS IN THE MONEY
WHEN PRICE < STRIKE
If price is unchanged at expiration, you have no profit. The option
expires worthless. Your loss is $4.50 x 500 = $2250. This is the
premium you paid.
If stock is worth $55 on date of expiration you MUST EITHER
A. Sell the option or
B. Exercise it
If you exercise it by selling the stock at $60 (the strike) for a $5
GROSS profit of $2500 LESS YOUR Premium of $2250 for a
NET PROFIT OF $250 for the 5 contracts
OPTION PROBLEMS
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1.
2.
3.
4.
Read the question
Diagram it.
Show your work NEATLY
IN TVM problems, show your keystrokes:
P/Y= number of compounding periods / yr
N= years * P/Y
I/Y = stated interest or coupon
PV, FV or PMT
What are you solving for?
4. Think. It this answer logical?
I should not have to search all over the page (or the back) to see your mistake or calculations. I
will make every effort to give partial credit must you must SHOW YOUR WORK.
Many exam problems will not be multiple choice. You should show your work neatly and circle
or underline the answer clearly. The only way to study for TVM, options, bond problems and
currency translation problems, is to do practice problems. Ask questions if
you are unclear on any concept.
APPENDIX
A. STUDY TIPS FOR FIN 3403, 3404 EXAMS
Each term students make CORRECTIBLE errors using their financial calculator. These
errors fall into 4 main categories:




Simple addition or multiplication mistakes. Check your work.
Lack of complete understanding of TVM keys and worksheets.
There is only one way to effectively study: Do problems. Work with classmates.
Review lecture notes. Be sure you fully understand all examples given in class.
Not erasing all registers including worksheet registers. It is critical that you erase all
registers before doing each problem
Failure to ask the question: “Does this answer make sense?”
Use TVM keys and a worksheet to cross check your work.
Use the “Rule of 72” to estimate the answer.
Lack of logic. Do a time line. List all inputs (keystrokes) NEATLY on the exam.
Finance is a language. You must study definitions of terms. Precision is important.
Use the lecture notes and glossary in the back of the text. WRITE OUT definitions.
Another problem I see is fuzzy understanding of basic accounting. If it has been a while
since you had accounting, it is strongly suggested that you brush up on terms and
concepts. This is important in ratio analysis, understanding concepts such as “cash flow”
in capital budgeting, and bond and stock valuation. Do all the problems in the text and
workbook dealing with accounting. If you are unclear, ask questions in class.
In your exam you are encouraged to:
 Use pencil. Do calculations on the back of the page. Think before you begin writing.
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





Be neat. I will give partial credit if I can discern your logic. SHOW YOUR WORK
INCLUDING KEYSTROKES.
Read the question carefully.
Be concise and precise in your answers. Be sure and answer all parts of the question.
Budget your time. Do the problems you can solve easily first.
Use the back of the exam for scratch. Please answer problem in SPACE PROVIDED.
Become familiar with the formula pages in these notes. They will be provided with
exams.
When you get the exam back it is important for you to:
 Review any mistakes. Make sure you know what you did wrong.
 See instructor with any questions IMMEDIATELY.
B. TIPS ON READING THE WSJ LIKE A PRO
The Wall Street Journal is published in 3 sections. Section C is the key section containing stock and bond
quotes, options and futures data, international activity, interest rates and other timely data. Most pros read
the Journal backwards starting with Section C.
1.
STOCK QUOTES FOR YOUR COMPANY ANALYSIS
NYSE “BIG BOARD” The NYSE is a 200+ year old “auction” market. There is a trading floor and
specialists offer to buy or sell stock at fixed posts or stations shaped
like horseshoes. NYSE stocks tend to be older so-called “blue chips.”
NYSE STOCKS HAVE 1 TO 3 LETTERS IN TICKER
LOOK UP U.S. STEEL
TICKER IS X
Older companies have Tickers of one or two letters
LOOK UP IBM Company name is International Busienss Machines
NOTE that IBM is NOT listed at beginning of I listings
Kodak Name is Eastman Kodak –listed under E for founder George
Eastman
Stock Daily Listings: LEFT TO RIGHT
52 WK HI LO NAME ABBREV TICKER ANN DIV
YLD
LTM P/E VOL HI LO
CLOSE FOR THAT DAY OF TRADING AND CHANGE FOR DAY
Stocks may have footnotes next to the ticker. A list of these footnotes is in a box near the
beginning of the stock quotes.
TO GET LAST 12 MONTH EARNINGS DIVIDE PRICE BY LTM P/E
TERMS:
NET INCOME =BOTTOM LINE AFTER ALL EXPENSES BUT BEFORE COM DIVDS
E.P.S. (LTM) =NET INCOME / COM SHARES ISSUED AND OUTSTANDING
D.P.S.
=PART OF E.P.S. PAID TO SH IN CASH. NORMALLY PAID QTRLY.
DPS as reported in the WSJ is the last quarter annualized (multiplied by 4)
EXAMPLE
D.P.S.
Q1
Q2
Q3
Q4
52
$1.00
$1.00
$1.10
$1.10
Board increases DPS by 10 cents
53
DIVD FOR LAST 12 MONTHS
(abbreviated LTM)
=
$4.20
WSJ AFTER Q 3 WILL LIST DIVD RATE AT ANNUAL RATE OF $4.40
THIS IS WHAT YOU ENTER FOR YOUR COMPANY
P/E
= PRICE / LTM EARNINGS PER SHARE
EXAMPLE
STOCK CLOSED AT $50
P/E
=
25x
WHAT IS LTM E.P.S.
50/25 = $2.00
ENTER THIS FOR YOUR COMPANY
FOR CALENDAR YEAR FIRMS WE ARE IN WHAT QTR NOW?
TIPS ON READING THE WSJ LIKE A PRO contd.
MARKET CAP
=MARKET CAP OR capitalization = price times shares
outstanding. A company will a billion dollar market cap
may have 100 million shares trading at $10 per share.
EARNINGS REPORTS
Check the fiscal year end on your company.
Each quarter will fall 3 months from that date.
Quarterly earnings (SEC form 10Q) are usually reported 2-3
weeks from the end of the calendar quarter The annual report
(10K) takes longer since it is fully audited.
NASDAQ
National Assn. Of Securities Dealers Automated Quotation System
The Nasdaq stock market is an ELECTRONIC network market. There is no
trading floor and no specialist.
4 or 5 letters in Ticker
LOOK UP MICROSOFT MSFT
$120.375
There is really not a “close” for NASDAQ as there is for listed stocks.
COMPOSITE
MARKET DATA:
A. STOCKS
U.S. STOCKS MEASURED SEVERAL WAYS
TURN TO PAGE C-1 OF THE WSJ
The Markets Diary in the left column summarizes key U.S.
and International Stock Indices, Bond price and interest rate
data and key commodities.
DJIA
30 STOCKS
SEE P. C-3 for component stocks
The Dow is the oldest index and was invented by the
first publisher of the WSJ - Charles Dow. Older
stocks in this index are called “blue chips.” It is
important to understand that an old “blue chip” like
U.S. Steel may NOT be as good an investment as a
newer company like Microsoft.
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54
S&P 500
NASDAQ
B. BONDS
500 STOCKS BY MARKET CAP
Smaller cap stocks. In terms of trading
volume the NASDAQ is slightly larger now
than the NYSE. The NASDAQ Composite
is an unweighted index of all stocks trading
on the NASDAQ.
Page C-1 highlights the “Bellwether” 30
year Treasury recent yield trend in a table.
To get the actual Treasury “Yield Curve”
you will need to find the Treasury Bonds Notes
and Bills section. The location moves around
but is at the back of Section C
C. CAREER OPPORTUNITIES IN FINANCE
Some of you may already be employed in finance or accounting and want to learn what other opportunities
exist. I have spent over 30 years as a financial manager. I have been a bank trust officer, served as CEO of
a money management company, managed a growth “Go-Go” mutual fund, and been the Director of
Research of two regional brokerage firms. In my experience, the most exciting aspects of this field are:




It is dynamic. Every day is different.
You are pitting your skills against the best brains in the World. Finance is a
highly paid profession. As such, it tends to attract highly qualified and
motivated people such as yourself.
Finance is the heart of any enterprise. Can you imagine any business,
governmental entity, or not-for-profit group without a cash or capital budget
for example?
You will use concepts in this course in every day life. The financial
calculator will help you evaluate the APR on a mortgage, determine the true
cost of an auto lease, and compute how much you need to save to have a
comfortable retirement.
Here are some areas for you to consider in your interviewing. Even if you are currently employed, it is
suggested that you take advantage of the UMD placement office to gain experience in interviewing, and to
learn more about career options. An internship is an option available to you to see a business or industry
from the inside and see if it is for you.
A. CORPORATE TREASURY
Large corporations hire financial analysts and accountants to staff their large treasury functions who engage
in credit analysis, cash management, capital budgeting, and risk management activities. This is an excellent
place to gain experience. Larger corporations tend to use more sophisticated analytical techniques. Many
students start there or in public accounting and then move to a CFO role in a larger enterprise.
You will probably have more campus interview opportunities in this area than in any other. Take advantage
of it.
B. COMMERCIAL BANKING
Commercial Banks are the “Department Stores of Finance.” Opportunities for a career are in various
departments including:
Credit
Commercial lending
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55

B.
INSURANCE
Trust and investment management
Leasing
Mortgage lending and administration
Branch administration
Banking is consolidating. This creates opportunity. Banks are entering
insurance and financial planning. There are about 8500 banks in
the U.S. today. Many of the larger banks are overseas.
There are 3 primary types of insurers. They are:
 Life insurers including credit life
 Fire and Casualty (also called property and casualty)
 Multi-line (a combination of the two above forms)
CAREER OPPORTUNITIES CONTD.
Insurance companies are state regulated and may be of mutual or
stock form. Life companies tend to invest in longer term instruments like real
estate and stocks. They tend to do many “private placements” in which an
entire corporate bond or preferred issue is placed with the insurer.
P&C companies are focused on shorter term instruments because they are
impacted by unforseen events like a flood or fire. They still do invest in
common stock and have large portfolios. P&C companies make use of
derivatives for hedging.
Career opportunities for finance students include financial planning, portfolio
management, actuarial analysis, and sales management. Insurance companies
tend to be stable and have excellent benefits.
C.
INVESTMENT BROKERAGE AND INVESTMENT BANKING
These firms are usually categorized two ways:
 Wire houses. These are large national firms like Merrill Lynch.
 Regionals like A. G. Edwards.
 Discount brokers like Charles Schwab
The larger wire houses are typically located in New York. There is
consolidation going on in this industry among regionals in particular.
Commercial banks are attempting to enter the investment banking industry with
the demise of Glass-Steagall restrictions in the U.S.
Investment banking is the activity associated with raising new funds in the form
of an initial public offering (IPO) or secondary. Investment banking tends to be
cyclical since activity varies with the level of the stock and bond markets.
Merger and Acquisition (M&A activity) tends to be the bread and butter revenue
source when deal flow is light.
Research is another activity for regionals and wire houses. Analysts tend to
specialize in one or two industries and publish reports with specific
recommendations. An MBA is generally considered necessary to land a
corporate finance or research job.
D.
MONEY MANAGEMENT
Money managers handle individual portfolios and employee benefit
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56
funds for corporations, churches, and other organizations. These organizations
tend to hire experienced traders, analysts, and bank trust officers. An exception
is mutual funds which will hire analysts from top business schools like UCF.
Again an MBA is necessary.
E. OTHER (Thrifts, credit unions, non-profit organizations, government).
Governmental entities need finance managers. So do many church
organizations, private pension funds, unions, casinos, airports,
sports teams, hotels and resorts, etc. Be creative. Use your
contacts. As in any profession, specialization usually is the key to higher pay.
C. PREPARING YOUR RESUME
I will be happy to review your resume. There are many books on the subject of effective resume writing.
The fact is that many corporations are simply inundated with resumes. Getting yours read in a major
challenge. Remember that a resume is a fact sheet marketing YOU. It should be concise, professional, free
of spelling errors or typos, and seek to grab the reader’s attention like a good ad. Here are a few tips:

State your career objective at the top of the resume. This statement can be modified to fit your
interview on your PC but it must have one characteristic: it should state what you can contribute to the
company. Do not say you want to learn to be a financial manager.
 Print your resume on quality bond paper with matching envelope
 State skills including expertise in MS Word, Excel, Powerpoint, and other skills employers are
seeking. This will set you apart.
 Do not attach references to the resume but line up references before you interview.
 If you plan to mail resumes, DO NOT send them to Human Resources. Try and hand deliver one to a
contact in senior management. Network and use family contacts. Failing that, try sending the resume
to the CEO via FedEx. Companies receive hundreds of resumes each day. Personal contact is the best
way to get noticed.
D. INTERVIEWING TIPS
1. Use the UCF recruiting office.
2. Who is your interviewer? Seek to determine what they are looking for. In
3.
4.
5.
6.
7.
8.
the initial interview you primary mission is to get invited back for a second
interview. Be friendly but avoid rambling. Use time well. Look the
interviewer in the eye.
Do a financial statement analysis on a corporation before you go to the
interview on the company and read the annual report. Prepare a list of
questions. Prepared candidates will get invited for a second interview.
Dress professionally.
Do a few “trial” interviews before you interview with your top choice.
Experience makes you more relaxed.
Take copies of your resume and copies of your work that you can leave with
the interviewer.
Seek out top executives through networking. This is much more productive
than going through the Human Resources funnel.
Be sure and send a thank you letter after every interview and after you
accept a position. Courtesy goes a long way. You will probably want to
change jobs sometime in your career so don’t burn any bridges.
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9. Keep a list of contacts as you move upward in your career. Help people.
10.
This includes people who work for you. Networking is a two way street.
Do a personal assessment or review annually. This assessment should
evaluate not just money but personal satisfaction and happiness.
I will be happy to provide a reference and help you with your resume.
You are strongly encouraged to take advantage of internship opportunities.
FORMULAS
Formulas will always be provided on your exam. In studying for the exam you should
concentrate on how to use each formula in different kinds of problems.
Future Value (FV) of a lump sum
FVn = PV (1 + r)n
Present value (PV) of a lump sum
PV =
Present Value PV of an annuity
FVa
(1 + r)n
PVA =
Table A-2
Table A-3
Table A-1
FV + FV + …+ FV
(1 + r)1 (1 + r)2
(1 = r)n
K = Krf + DRP + LP + MRP
WACC = WdKd(1-T) + WpsKps + WceKs
Kps = Dps
Pn
NOTE:
K s = D1 + g
P0
D0 = current dividend
K e = D1
P 0(1-F)
D1 = (D0 X (1 + g)
DOL = % chg EBIT
DOLq =Q (P - V)
% chg Sales
Q (P - V) - F
DFL = % CHG EPS
% CHG EBIT
DTL = (DOL)(DFL)
Q (P - V)
Q(P - V) - F - I
Class of investment
3 year
1
2
33%
45
5 year
7 year
20%
32
14%
25
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g
(new equity)
Be sure you know use of both DOL formulas
MACRS ALLOWANCE PERCENTAGES
Year
+
58
3
4
5
6
7
8
15
7
19
12
11
6
17
13
9
9
9
4
FINANCIAL RATIOS
THIS WILL BE PROVIDED WITH EXAMS ALSO
A. BALANCE SHEET RATIOS
LIQUIDITY
CR= CA/CL
QUICK= CA-INV/CL or
DSO = AR/ (sales / 360)
CASH + AR / CL
A 360 day year is assumed unless indicated
Inventory turnover
= Sales (from income statement)/ Inventory
LEVERAGE
Debt Ratio
= Short and long term debt / total
assets or total liabilities and SH equity capital
LT DEBT / ASSETS = debt > 1 year / total assets
LT DEBT / EQUITY = debt > 1 year / (common stock + surplus + ret earnings)
NOTE: Preferred stock is NOT equity
X INT EARNED= EBIT / interest expense from income statement
X FIXED CHGS EARNED= (EBIT + lease pmts )/ (interest + rent expense +
sinking fund ) / (1-tax rate)
B. INCOME STATEMENT RATIOS
PROFITABILITY
Gross margin =
Operating margin =
Pretax margin=
Net margin=
Cap expense / sales
R&D / sales
C. VALUATION RATIOS
P/E
(Net Sales - CGS)/ net sales
(N. sales - (CGS + SGA) / net sales OR
(Gross income - SGA)/ net sales
Pretax income / Net sales
Net income before com divds / Net sales
Capital expenditures as % of revenues
Important measure for high tech firms
=
Common stock price / Earnings per share
Historical P/E = avg price in year / EPS in that year
Current P/E = current price / LTM EPS
YIELD =
Common DPS (indicated ann rate)/ cur. Price
BVPS =
SH equity / common shs issued AND outstanding
PRICE/BOOK= current price of common / last qtr BVPS
D. COMBINATION RATIOS
ROA
ROE
E. BONDS
=
=
net income / total assets
net income / SH equity
Current yield:
YTM
dollar coupon income / bond price
Use bond spreadsheet on fin calculator
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59
F. COMMON
G. PREFERRED
YTC
“ “
“
BOND PRICE
EXPRESSED AS A PERCENT
Conversion ratio = par / conversion price
cost of debt
Kd (1-T)
Divd yield
Annual divd / stock price
ks =
D1 + g
P0
Current yield
Kps
D/P (perpetuity –no maturity)
MATHEMATICS IN FINANCE
A. DEALING WITH NEGATIVE NUMBERS
In Finance we encounter negative numbers often. As managers we hope that there are not too many
negative numbers on the bottom line. You may encounter negative numbers in your company analysis. It is
important to be know how to properly handle negative numbers when preparing a presentation.
1.
2.
Do not multiply or divide by a negative number or by zero.
Do not attempt to do a percentage change analysis between positive and negative numbers. It is
meaningless.
3. Most ratios do not compute with a negative number. For example consider the case of a stock selling at
$20 per share with E.P.S. of (-$2.00). The P/E is NOT -10x. This does not mean anything. It is like a
TIE of 0 when it should be infinite.
 An exception is margin analysis. It is possible to have a negative net margin and a
negative ROE. The problem with ROE is that we normally compute an average
between two years. IF one year is positive and the other is negative, the average is
meaningless.
4. As with all other work we have done, ask yourself the question: “Does this make sense?” The acid test
of any number in finance is whether it can serve as a predictor or decision making tool.
Consider this time series:
E.P.S
1995
$2.00
1996
$2.20
1997
$1.80
1998
-$0.50
1999
$1.00
% chg.
+10%
-18%
INDETERMINATE
“
The only way to analyze trends using this data is to develop an index number. Usually the lowest number
(in this case -.50) is set to zero.
1995
1996
1997
1998
1999
E.P.S
1998 = 0
250
270
230
0
150
THESE ARE INDEX NUMBERS
YOU CAN PREPARE A BAR CHART USING THEM
B. DEALING WITH PERCENTAGES
If a number DOUBLES that is a 100% increase. A TWO FOLD change is a 100% increase.
If a number triples that is a 200% increase NOT a 300% change.
A 5 fold increase is not 500%. It is a 400% increase. THIS IS A COMMON EXAM MISTAKE.
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In business we use percentages a great deal. In the Financial Leverage segment of the course some
formulas deal with % change. For example DOL between two points = % change in EBIT / % change in
sales. Assume sales 1 = $150,000 and sales 2 = $1,000,000. Assume EBIT 1 = $30,000 and EBIT 2 =
$250000. Compute DOL
% change in EBIT
% change in SALES
DOL = 1.358X
=
=
(250,000 - 30000) / 30000
= 7.33X
(1,000,000 - 150,000) / 150000 = 5.66X
= 633%
= 466%
THE ASSOCIATION OF INVESTMENT
MANAGEMENT AND RESEARCH (AIMR)
THE CHARTERED FINANCIAL ANALYSTCFA DESIGNATION
AIMR is a nonprofit professional society for practitioners within the investment management
profession. Members include securities analysts, portfolio managers, strategists, consultants,
investment counsellors and academics.
AIMR was founded in 1990 through the merger of the Financial Analyst Federation (FAF) and
the Institute of Chartered Financial Analysts. AIMR currently represents investment
professionals in 69 countries. This past year, over 50,000 candidates sat for one of three parts of
the CFA examination. About a third of these candidates were outside North America.
There are a limited number of AIMR scholarships available each year though your instructor.
These scholarships provide the course materials for CFA EXAM 1. If you think this may be of
interest see me about this opportunity.
AIMR is headquartered in Charlottesville, Virginia and publishes many professional publications
including the Financial Analyst’s Journal. It also sponsors conferences and seminars around the
world. There are constituent local societies in over 105 cities worldwide. Local chapters in
Florida are in Orlando, Miami, Tampa Bay and Jacksonville.
I received my CFA designation in 1971 and have been active in the society since 1966. I am
involved in grading the CFA exams. I will be most happy to discuss this professional association
with anyone. If you are contemplating a career in the investment field, you should consider
looking into the CFA. The CFA consists of 3 examinations spaced over 3 years. Each exam is 6
hours in duration. The curriculum is rigorous and consists of advanced reading in accounting,
financial and industry analysis, portfolio management, regulation and ethics.
My experience as Director of Research for a major brokerage firm is that CFA charterholders
earn 10-50% more than their contemporaries without the designation.
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