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Financial Management SCDL
 

Financial Management SCDL

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Financial Management SCDL

Financial Management SCDL

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Financial Management SCDL Financial Management SCDL Presentation Transcript

  • Financial management By Prof. Augustin Amaladas M. Com., AICWA., PGDFM., B.Ed.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Welcome To SCDL
    • Financial Management
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    *11.CAPITAL BUDGETING *9.LEVERAGES *8.CAPITAL STRUCTURE *7.SOURCES OF LONG TERM AND MEDIUM TERM *5.CASH FLOW STATEMENTS 5.FUND FLOW STATEMENT *4.RATIOS *10.CAPITAL mARKET *3.FINANCIAL STATEMENTS *2.FORMS OF BUSS.ORG. 1.FINANCIAL FUNCTION *6.CAPITALISATION *13.CASH MANAGEMENT *14.RECEIVABLE MANAGEMENT *15.INVENTORY MANAGEMENT *16.DIVIDEND POLICY *12.WORKING CAPITAL MANAGEMENT e-mail: aug_bang@yahoo.com www.augustin.co.nr
    L L L L L L Welcome by SCDL to AZtecsoft e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • MANAGEMENT PROCESSES,
    • DEFICIENCY FINDING
    • MANAGEMENT AUDIT
    • MANAGEMENT PLANNING
    • MANAGEMENT SERVICES
    • PLANNING AND CONTROL SYSTEMS
    • MANAGEMENT ACCOUNTING
    • TAX PLANNING, TAX ADVICING
    • TAX ACCOUNTING
    • GOVERNMENT ACCOUNTING
    • COST STANDARD, COST REVENUE ANALYSIS,
    • COST ANALYSIS, COST AND PRODUCTION STATISTICS
    • COST ACCOUNTING
    • PRINCIPLES OF FINANCIAL REPORTING,
    • AUDITING STANDARDS,
    • UNIFORM STATEMENTS,AUDITING OF RECORDS AND STATEMENTS
    • FINANCIAL AUDITING
    • COMPUTERS, PUNCHED CARD RECORDS,TAX RECORDS,
    • INCOME STATEMENT ANALYSIS,
    • BALANCE SHEET EMPHASIS
    • BOOK KEEPING(SINGLE ENTRY AND DOUBLE ENTRY )
    • 1775 1800 1825 1850 1875 1900 1925 1950 1975 1985 1990 1995 2005
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
            • COST MANAGEMENT :
            • ACTIVITY BASED ACCOUNTING, LIFE CYCLE COSTING,
    • VALUE CHAIN ANALYSIS,
    • TARGET COSTING,
    • KAIZEN COSTING
    • RESPONSIBILITY ACCOUNTING
    • ,CURRENT COST ACCOUNTING,
    • INFLATIONARY ACCOUNTING
    • EDP ENVIRONMENTAL AUDIT
    • HUMAN BEHAVIOUT,
    • MANPOWER VALUES,
    • INTER GOVERNMENTAL RELATIONS
    • SOCIAL ACCOUNTING
    • TOTALSYSTEMS PLANNING,
    • INTER DECIPLINARY APPLICATIONS
    • TOTAL SYSTEM RECVIEW
    • EFFECTIVENESS AUDITING
    • EFFECTIVENESS EVALUATIOn COMPUTERS CYBERNETICS
    • INFORMATION SYSTEMS
    • ORGANISATIONAL MODEL, ORGANISATIONAL PLANNING,
    • DECISION THEORY,
    • COST BENEFIT ANALYSIS
    • MANAGEMENT SCIENCES
    • 1775 1800 1825 1850 1875 1900 1925 1950 1975 1985 1990 1995 2005
    GROWTH OF ACCOUNTABILITY KNOWLEDGE:FINANCIAL ACCOUNTING Cost accounting, Management Accounting Tax accounting and Management e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • FLOW OF CASH/SHORT TERM AND LONG TERM
    information Accounts payable RAW mATERIAL ADR Bonds(281) Preference Shares Bad debts Accounts receivable Debtors Work in progress information Overheads Labour Equity shares CASH GDR information Information Rights issue Leasing/Hr.Pur Reserves Public deposits e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • FLOW OF CASH - LONG TERM
    ADR Long term loans Preference Shares Equity shares CASH Short term GDR land furniture investments goodwill building Patent rights Know how Copy right e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • FLOW OF CASH-SHORT TERM
    information Accounts payable RAW mATERIAL Bad debts Accounts receivable Debtors Work in progress information Overheads Labour information Information Discounting bills creditors Cash credit Sale of investments Bad debts Bad debts Issue of long term funds Sale of fixed assets Bank overdraft cash cash Commer Cial papers e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Working capital finance(361)
    Inter corpo Rate deposits Trade credit Bills discounts Outstanding Expenses Cash credit Packing credit overdraft Letter of credit loan Commercial papers pledge Hypothecation lien mortgage 1.Spontaneous 2.Bank guarantee 3.Fund based 4.Security e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Users of information and goals
    organisation shareholders public Benefactors government banks Debenture holders Loan vendor Preference shareholders creditors debtors customers dividend liquidity Dividend/value in the share market Interest/return of capital Interest/return of capital Timely payment Timely supply Good product Less pollution Good name tax e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Page-3 e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Scope of Financial Management
    Capital Budgeting Management of Mergers, reorganisation Financing Financial Analysis Management of Current Assets Method of Raising funds Implementation Determine Financing mix Financial Control Receivables Selection Identification Marketable Securities Cash Financial Forecasting Inventory Management Source identification Profit planning Dividend policy e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Role of Finance in a Typical Business Organization-page- 9
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Board of Directors President VP: Sales VP: Finance VP: Operations Treasurer Controller Credit Manager Inventory Manager Capital Budgeting Director Cost Accounting Financial Accounting Tax Department
  • Unit-2 Forms of Business organisation
    • Sole trading
    • Partnership
    • Companies
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • What will happen if this deal does not materialise?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr My business!! My family?
  • Partnership
    h Should we build this plant? e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Mini computer
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Ulta pulta Company Ltd.???
  • Nature of Financial Statements-Page-30
    Financial accounting 1. Introduction 2. Basic Accounting 3. Process of accounting 4. BRS 5. Rectification of Errors Final accounts e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Unit-3 Financial statements
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Chapter-2: Basics of financial accounting
    • 1.Concepts
    • 2.system of accounting
    • 3.Types of Expenditure
    • 4.Terms used in financial accounts
    • 5.Double entry / Single entry
    • 6. Depreciation methods
    • 7. Practical consideration relating to depreciation
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • 1.concepts& conventions
    • Meaning: Basic assumptions upon which the basic process of accounting based.
    • a] Business entity concept-
    • b] Dual aspect concept
    • c] Going concern concept
    • d] Accounting period concept
    • e] Cost concept
    • f] Money measurement concept
    • g] Matching Concept
            • Conventions
            • Coservativism
            • Materiality
            • Consistency
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • a] Business entity concept-
    • Business is different from the owner
    • We pass Journal entry when owner contributes towards capital.
    • When amount / goods withdrawn for personal use we make an entry in the business
    • When Income tax paid by the owner out of business money we make an entry In the books of accounts.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • b] Dual aspect concept
    • Every debit has equal amount of credit
    • Asset =Liability
    • Liability creates asset
    • If asset>Liability= profit
    • If Liability> Assets= loss
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • c] Going concern concept
    • Business will go for at least for a reasonable period.
    • Depreciation is provided based on this assumption.
    • If this assumption is not made all Fixed assets will be valued at realised value like current assets.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • d] Accounting period concept
    • Fixing time limit for accounts
    • Profit for the period
    • It can be one week or two weekor 6 months/one year or 5 years
    • But to find profit we normally consider 12 months period
    • Financial year for income tax point of view 1 st April-31 st March of the following year
    • Calendar year –January to December
    • Divali to Divali
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • e] Cost concept
    • The cost to the organisation (Actual) is recorded in the books
    • Assets are not recorded according to the market price every year.
    • Depreciation is calculated on cost not based on market price
    • Accounting records may not show the real worth of the business
    • Market price may be disclosed with in bracket in the balance sheet
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Exercise
    • Accounting Test Question SV No.1: Company XYZ uses a perpetual inventory system. Append below the following transaction relating to its merchandise inventory during the month of Nov’06
    • Date:Transaction
    • Nov 1 inventory on hand - 3,000 units @ $8 each
    • Nov 7Bought 5,000 units for $8.40 each
    • Nov 13Sold 4,000 units for $14.00 each
    • Nov 17Bought 6,000 units for $8.20 each
    • Nov 24Sold 7,000 units for $14.00 each
    • Nov 30Inventory on hand -3000 units
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Required: Compute the inventory balance Company XYZ would report on its November 30 2006 balance sheet and the cost of goods sold for the period of November 2006 income statement using each of the following inventory methodology:
    • (1) First-in, first-out (FIFO)
    • 2) Last-in, first-out (LIFO)
    • (3) Average cost[ Refer Answer ]
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • f] Money measurement concept
    • Every thing which can be expressed in terms of Money is recorded in the books
    • Beautiful women are working /Handsome boys working in AZTEC /Efficient engineers worth Rs.5000 crores –How do you record?.
    • Good working environment?
    • Highly motivated employees?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • g] Matching Concept
    • Matching Cost with revenue
    • It is used to estimate correct profits
    • Accrual/ cash basis of accounting
      • Even cash paid /received if it belongs to accounting period we consider them as expenditure /income
      • Salary outstanding for the last month?
      • Income from Investments yet to be received?
      • Rent received in advance for next year?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Conventions
    • Customs and traditions that are followed by the accountants while preparing the financial statements.
    • Why do we respect elders?
    • Why do we shake hands?
    • Why do Young Indians hate receiving dowry?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Coservativism
    • To be on the safer side
    • Expect future losses as current year loss
    • not future income is treated as current year income.
    • Stock is valued cost price / market price which ever is lower
    • Making provision for bad debts is based on this assumptions.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Materiality
    • Material impact on profitability are considered
    • Insignificant transactions ignored from recording
    • Pen purchased, pencil purchased?
    • Wine purchased regularly?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Consistency
    • Accounting policies and procedures should be followed consistently
    • Method of depreciation should be followed consistently.
    • Stock valuation- cost/market price whichever is lower is consistently followed
    • If not followed it amount to change in the policy of the company
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • 2.system of accounting (26)
    • 1.Cash system:
    • unless cash received /paid in the accounting year can not be considered as income/expenses respectively
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • 2.Mercantile
    • Mercantile/Accrual/due concept:
    • Even cash received/paid but due for payment/due for receipt (yet to be received/payable) if they belong to current accounting year are considered.
    • If last year expenditure paid this year?
    • If you receive/paid in advance ?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Mercantile love!!!!???
    • Last year I loved her? Next year I shall love him depends on type of bike model!!!!
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Life Education
    • If I do not get married to him I will not be happy- Girl said
    • If I do not get married to her I will not be happy- Boy said
    • If both get married what will happen!!!!
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Structure of Financial
    • Statement-(Chapter-3)page-34
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    1.Production Prime Cost 1.Godown 1.canteen 2 Cost of sales 6.sales 5.profit 1.Factory administration 4.Sales and distribution 3.General administration Total cost Bin card Stores ledger Cost calculations/operating activity + + = + + Danger Facility department Factory cost/ works cost e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statements
    • Balance Sheet
    • Income Statement
    • Cashflow Statement
    • Statement of Retained Earnings
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Review: Major Balance Sheet Items
    • Assets
    • Current assets:
      • Cash & securities
      • Receivables
      • Inventories
    • Fixed assets:
      • Tangible assets
      • Intangible assets
    • Liabilities and Equity
    • Current liabilities:
      • Payables
      • Short-term debt
    • Long-term liabilities
    • Shareholders' equity
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • An Example: Dell Abbreviated Balance Sheet-34
    • Assets:
      • Current Assets: $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • An Example: Dell Abbreviated Income Statement-page-47
    • Sales $25,265.00
    • Costs of Goods Sold -$19,891.00
    • Gross Profit $5,374.00
    • Cash operating expense -$2,761.00
    • EBITDA 2,613.00
    • Depreciation & Amortization -$156.00
    • Other Income (Net) -$6.00
    • EBIT $2,451.00
    • Interest -$0.00
    • EBT $2,451.00
    • Income Taxes -$785.00
    • Special Income/Charges -$194.00
    • Net Income (EAT) $1,666.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis
    • External users rely on publicly-available information to perform financial analysis
    • Such information is contained in corporate annual report
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Life education
    • Lady in a seashore
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 1. Use the statement of cash flows in decision making
    • 2. Compute the standard financial ratios used for decision making
    • 3. Use ratios in decision making
    • 4. Measure economic value added by a company’s operations
    Chapter Learning Objectives
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • What do you learn??
    • Here's how you'll benefit from this course: 
    • Understand the contents of the balance sheet, cashflow, and income statements
    • Contribute to better costing and working capital management
    • Review production capacity and investment proposals
    • Evaluate long, medium and short term financing
    • Review financial statements and analyse them using ratios to determine your business strengths and weaknesses
    • Apply techniques to make decisions that create genuine value
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS e-mail: aug_bang@yahoo.com www.augustin.co.nr 1
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS e-mail: aug_bang@yahoo.com www.augustin.co.nr 1 2
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS e-mail: aug_bang@yahoo.com www.augustin.co.nr 1 2 3
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS e-mail: aug_bang@yahoo.com www.augustin.co.nr 1 2 3 4
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS AUDITOR’S REPORT e-mail: aug_bang@yahoo.com www.augustin.co.nr 1 2 3 4 5
  • Annual Report Contents
    FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS AUDITOR’S REPORT COMPARATIVE FINANCIAL DATA FOR A SERIES OF YEARS e-mail: aug_bang@yahoo.com www.augustin.co.nr 1 2 3 4 5 6
  • Financial Statement Analysis
    • Before you jump to a decision, consider the following:
    • 1. Financial statements provide data about what happened during the accounting period
    • Pick the one annual report component which provides investors and creditors with the most descriptive information about the corporation’s activities and financial condition
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis
    • 2. Investors and creditors use information contained in the annual report to:
    • Forecast future income and cash flows
    • Assess risk of investing in or lending to the corporation
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis
    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS 4 e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis-page-51
    • Management’s discussion and analysis (MD&A) includes:
    • Evaluation of current business operations
    • Assessment of future operations
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Tools to Evaluate Financial Information
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Tools to Evaluate Financial Information
    • Horizontal Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 1
  • Tools to Evaluate Financial Information
    • Horizontal Analysis
    • Vertical Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 2 1
  • Tools to Evaluate Financial Information
    • Horizontal Analysis
    • Vertical Analysis
    • Ratio Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 3 2 1
  • Perform a horizontal analysis of comparative financial statements
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Tools to Evaluate Financial Information
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Tools to Evaluate Financial Information
    • Horizontal Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 1
  • Horizontal Analysis
    • Examines percentage change in each item on the financial statements
    • Compares current year’s dollar amount with prior year’s dollar amount
    • Expresses the change in
      • Dollars
      • Percentage
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • First, calculate dollar change from base year (prior year) to current year
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • First, calculate Rupee/dollar change from base year (prior year) to current year
    • Second, divide Rupee/ dollar change by base-year dollar amount
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • DOLLAR AMOUNT INCREASE (DECREASE)
    • Amounts in thousands
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • DOLLAR AMOUNT INCREASE (DECREASE)
    • Amounts in thousands
    • 1996 1995 Dollars %
    • Receivables (net) $325,384 $272,225
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • DOLLAR AMOUNT INCREASE (DECREASE)
    • Amounts in thousands
    • 2007 2006 Dollars %
    • Receivables (net) $325,384 $272,225
    • Difference
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • DOLLAR AMOUNT INCREASE (DECREASE)
    • Amounts in thousands
    • 1996 1995 Dollars %
    • Receivables (net) $325,384 $272,225 $53,159
    • Difference
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis
    • DOLLAR AMOUNT INCREASE (DECREASE)
    • Amounts in thousands
    • 2007 2006 Dollars %
    • Receivables (net) $325,384 $272,225 $53,159 19.5%
    • Leasehold Improv. 314,933 273,015 41,918 15.3
    • Notes Receivable 54,715 32,528
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • Specialized form of horizontal analysis
    • Shows trend of financial statement items over longer time periods such as 5 or 10 years
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • Base year (earliest year in the time series) set at 100%
    • All other years expressed as percentage of base year
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • Income statement amounts for Ray’s Seafood Shack are presented in the next slide
    • Compute the trend percentages for these items
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Divide
    • x 100
    • Net Sales 206% 160% 145% 137% 130% 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Divide
    • x 100
    • Net Sales 206% 160% 145% 137% 130% 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Divide
    • x 100
    • Net Sales 206% 160% 145% 137% 130% 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Divide
    • x 100
    • Net Sales 206% 160% 145% 137% 130% 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Divide
    • x 100
    • Net Sales 206% 160% 145% 137% 130% 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Cost of Sales 373 265 201 259 280 193
    • Net Sales 206% 160% 145% 137% 130% 100%
    • Cost of Sales 193 137 104 134 145 100
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Trend Percentages
    • (AMOUNTS IN THOUSANDS )
    • 2008 2007 2006 2005 2004 2003
    • Net Sales $714 $553 $502 $474 $451 $346
    • Cost of Sales 373 265 201 259 280 193
    • Gross Profit 341 288 301 215 171 153
    • Net Sales 206% 160% 145% 137% 130% 100%
    • Cost of Sales 193 137 104 134 145 100
    • Gross Profit 223 188 197 140 112 100
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Horizontal Analysis and Trend Percentages: A Summary
    • Tools used to compare financial results of companies of different sizes and/or in different industries
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Vertical Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Vertical Analysis
    • Vertical Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 2
  • Vertical Analysis
    • Compares each item on the financial statement to a key, or base, item
    • Base-item dollar amount always set to 100%
    • Income statement
      • Net sales = 100%
    • Balance sheet
      • Total assets = 100%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 2007 2006
    • AMOUNT % AMOUNT %
    • Net sales $430,013 100% $362,386 100%
    • Cost of Goods Sold 336,589 78 284,897 79
    • Gross Profit 93,424 22 77,489 21
    • Selling, General & Admin. 72,363 17 65,096 18
    • Income from Operations 21,061 5 12,393 3
    • Income Taxes 7,072 2 4,350 2
    • Net Income $13,989 3% $8,043 2%
    Vertical Analysis
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Vertical Analysis
    • Once financial statement items are converted into percentages of the base item, users can compare one company’s financials against another’s
    • These are called common-size statements
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  • Prepare common-size financial statements for benchmarking against the industry average and key competitors
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Common-Size Statements
    • Show all items as percentages of the key, or base, amount
      • Use no dollar amounts
    • Facilitate financial statement comparison among different sized companies
    • Improve user’s ability to assess company performance against industry averages
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Common-Size Statements
    • Can also be used to evaluate company performance over time
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Benchmarking Against the Industry Average
    • Benchmarking is a term used to describe the process of comparing a company’s activities to a standard of excellence achieved by industry leaders
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • A company also can compare its common-size financials to those of its industry’s leaders
    • Determine where it differs
    • Design and implement business processes to bring financial results in line with these benchmark entities
    Benchmarking Against Key Competitors
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Benchmarking Against Key Competitors
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Chineese tree
    Life education e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Interpretation of Financial Statements-Ratio Analysis-Unit-4
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Interpretation of Financial Statement Analysis( Ratio Analysis)-page 55- Unit-4 By Prof. Augustin Amaladas
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • A leading company in the health-care and consumer products industry
    • Sales revenues of $14-billion
    • Assets of $13-billion
    PROCTER & GAMBLE and BRISTOL-MYERS SQUIBB
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • How would you compare Bristol-Myers Squibb’s performance against other industry competitors?
    • Companies differ in size, so you can’t compare absolute dollar amounts
    • Need to use ratios - tools to translate financial data into percentages - which can be compared across companies
    PROCTER & GAMBLE and BRISTOL-MYERS SQUIBB
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • Assets 28.0
    PROCTER & GAMBLE and BRISTOL-MYERS SQUIBB
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • Assets 13.0
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • Assets 28.0
    Opening Vignette - Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • Assets 13.0
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • Assets 28.0
    • Which company was better in generating net income from sales revenues earned?
    Opening Vignette - Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • Assets 13.0
    • You can use the return on sales ratio to compare
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • Assets 28.0
    • Which company was better in generating net income from sales revenues earned?
    Opening Vignette - Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    Opening Vignette - Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • $2.6
    • $33.4
    • = 7.78%
    Opening Vignette - Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • $2.6
    • $33.4
    • = 7.78%
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • $1.8
    • $13.7
    • = 13.13%
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • $2.6
    • $33.4
    • = 7.78%
    Opening Vignette -Bristol-Myers Squibb
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    Opening Vignette - Bristol-Myers Squibb
    Although P&G’s sales were higher e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • BRISTOL-MYERS SQUIBB
    • Sales revenues $13.7
    • Net income 1.8
    • $1.8
    • $13.7
    • = 13.13%
    • PROCTER & GAMBLE
    • Sales revenues $33.4
    • Net income 2.6
    • $2.6
    • $33.4
    • = 7.78%
    Bristol-Myers’ return on sales was nearly twice that of P&G e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis
    • External users rely on publicly-available information to perform financial analysis
    • Such information is contained in corporate annual report
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Statement Analysis: Lecture Outline
    • Review of Financial Statements
    • Ratios
      • Types of Ratios
      • Examples
    • The DuPont Method
    • Ratios and Growth
    • Summary
      • Strengths
      • Weaknesses
      • Ratios and Forecasting
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Financial Analysis
    • Assessment of the firm’s past, present and future financial conditions
    • Done to find firm’s financial strengths and weaknesses
    • Primary Tools:
      • Financial Statements
      • Comparison of financial ratios to past, industry, sector and all firms
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • The Main Idea
    • Value for the firm comes from cashflows
    • Cashflows can be calculated as:
      • (Rev t - Cost t - Dep t )x(1-  ) + Dep t —OR—
      • (Rev t - Cost t )x(1-  ) +  xDep t —OR—
      • Rev t x(1-  ) - Cost t x(1-  ) +  xDep t
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Review: Major Balance Sheet Items
    • Assets
    • Current assets:
      • Cash & securities
      • Receivables
      • Inventories
    • Fixed assets:
      • Tangible assets
      • Intangible assets
    • Liabilities and Equity
    • Current liabilities:
      • Payables
      • Short-term debt
    • Long-term liabilities
    • Shareholders' equity
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • An Example: Dell Abbreviated Balance Sheet
    • Assets:
      • Current Assets: $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Absorption Costing vs. Variable Costing Income Statements
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Absorption Costing Income Statement
    Sales XXX Cost of Goods Sold: Beginning inventory XXX Cost of goods manufactured XXX Cost of goods available XXX Ending inventory XXX Cost of goods sold XXX Gross Margin XXX Operating Expenses: Selling XXX Administrative XXX XXX Income before Taxes XXX e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • ABSORPTION COSTING PRO-FORMA
      ££Sales Revenue xxxxx Less Absorption Cost of Sales     Opening Stock (Valued @ absorption cost) xxxx   Add Production Cost (Valued @ absorption cost) xxxx  Total Production Cost xxxx  Less Closing Stock (Valued @ absorption cost) (xxx)   Absorption Cost of Production xxxx Add Selling, Admin & Distribution Cost xxxx Absorption Cost of Sales  (xxxx) Un-Adjusted Profit  xxxxx Fixed Production O/H absorbed xxxx  Fixed Production O/H incurred (xxxx)  (Under)/Over Absorption  xxxxx Adjusted Profit xxxxx e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Variable Costing Income Statement
    Sales XXX Cost of Goods Sold: Beginning inventory XXX Cost of goods manufactured XXX Cost of goods available XXX Ending inventory XXX Variable cost of goods sold XXX Product Contribution Margin XXX Variable Selling Expense XXX Total Contribution Margin XXX Fixed Expenses: Factory XXX Selling XXX Administrative XXX XXX Income before Taxes XXX e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Marginal costing cost sheet
    •   ££Sales Revenue  xxxxx
    • Less Marginal Cost of Sales  
    • Opening Stock (Valued @ marginal cost) xxxx
    • Add Production Cost (Valued @ marginal cost) xxxx 
    • Total Production Cost xxxx 
    • Less Closing Stock (Valued @ marginal cost) xxx) 
    • Marginal Cost of Production xxxx
    •   Add Selling, Admin & Distribution Cost xxx
    •   Marginal Cost of Sales  (xxxx)
    • Contribution  xxxxx
    • Less Fixed Cost  (xxxx)
    • Marginal Costing Profit  xxxxx
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • An Example: Dell Abbreviated Income Statement
    • Sales $25,265.00
    • Costs of Goods Sold -$19,891.00
    • Gross Profit $5,374.00
    • Cash operating expense -$2,761.00
    • EBITDA 2,613.00
    • Depreciation & Amortization -$156.00
    • Other Income (Net) -$6.00
    • EBIT $2,451.00
    • Interest -$0.00
    • EBT $2,451.00
    • Income Taxes -$785.00
    • Special Income/Charges -$194.00
    • Net Income (EAT) $1,666.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Objectives of Ratio Analysis
    • Standardize financial information for comparisons
    • Evaluate current operations
    • Compare performance with past performance
    • Compare performance against other firms or industry standards
    • Study the efficiency of operations
    • Study the risk of operations
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Rationale Behind Ratio Analysis
    • A firm has resources
    • It converts resources into profits through
      • production of goods and services
      • sales of goods and services
    • Ratios
      • Measure relationships between resources and financial flows
      • Show ways in which firm’s situation deviates from
        • Its own past
        • Other firms
        • The industry
        • All firms-
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • financials can be used in benchmarking
    Benchmarking Against Key Competitors
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Using Ratios to Make Business Decisions
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Ratio Analysis
    Using Ratios to Make Business Decisions
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 3
  • Types of Ratios-59
    • Financial Ratios:
      • Liquidity Ratios
        • Assess ability to cover current obligations
      • Leverage Ratios
        • Assess ability to cover long term debt obligations
    • Operational Ratios:
      • Activity (Turnover) Ratios
        • Assess amount of activity relative to amount of resources used
      • Profitability Ratios
        • Assess profits relative to amount of resources used
    • Valuation Ratios:
        • Assess market price relative to assets or earnings
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Using Ratios to Make Business Decisions
    • Ratios - the relationship between two items on financial statements - permit users to calculate a variety of financial comparisons
    • These ratios can be compared to:
    • Prior years’ financial results
    • Industry averages
    • Benchmark entities’ ratios
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Ratios measure an entity’s ability to:
    • Pay current liabilities
    • Sell inventory and collect receivables
    • Pay long-term debt
    • Generate profits from operations
    • Sustain shareholder wealth
    Using Ratios to Make Business Decisions
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring the Company’s Ability to Pay Current Liabilities-Page-59
    • One measure of entity’s ability to pay its current obligations is to look at working capital
    • Current assets - current liabilities
    • 2 ratios help users assess working capital information
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring the Company’s Ability to Pay Current Liabilities
    • One measure of entity’s ability to pay its current obligations is to look at working capital
    • Current assets - current liabilities
    • 2 ratios help users assess working capital information
      • Current ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring the Company’s Ability to Pay Current Liabilities
    • One measure of entity’s ability to pay its current obligations is to look at working capital
    • Current assets - current liabilities
    • 2 ratios help users assess working capital information
      • Current ratio
      • Quick (acid-test) ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Using Ratios to Make Business Decisions
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Ability to Pay Current Liabilities
    • Current ratio
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  • Ability to Pay Current Liabilities
    • Current ratio
    • Current assets
    • Current liabilities
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Ability to Pay Current Liabilities-page-59
    • Current ratio
    • Current assets
    • Current liabilities
    • $7,681.00
    • $5,192.00
    • = 1.48
    • Assets:
      • Current Assets: $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Ability to Pay Current Liabilities-page-60
    • Quick ratio
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  • Ability to Pay Current Liabilities
    • Quick ratio
    • Current assets - inventory - prepaid items
    • Current liabilities
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  • Ability to Pay Current Liabilities
    • Liquid ratio
    • Current assets - inventory - prepaid items
    • Current liabilities
    • $25,240
    • $114,744
    • = .22
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring the Company’s Ability to Sell Inventory and Collect Receivables
    • Entity’s operating cycle
      • Time to go from cash to inventory to receivables to cash
    • is critical to generating cash inflows from operating activities
    • 3 ratios help users assess management’s skill in selling inventory and collecting receivables
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Inventory turnover
    Measuring the Company’s Ability to Sell Inventory and Collect Receivables-page-63
    1 e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Inventory turnover
    • A/R turnover
    Measuring the Company’s Ability to Sell Inventory and Collect Receivables
    1 2 e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Inventory turnover
    • A/R turnover
    • Days’ sales in receivables
    Measuring the Company’s Ability to Sell Inventory and Collect Receivables
    1 2 3 e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Inventory Turnover-page-63
    • Number of times the average level of inventory is sold during the accounting year
    • Measures time required to earn return on company’s investment in inventory
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 2008
  • Inventory Turnover
    • Cost of goods sold
    • Average inventory
    • =$19,891/$4000
    • =4.972 times
    Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 Average inventory $ 4000 Average debtors $5000 e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Inventory Turnover
    • High ratio indicates ability to quickly sell inventory
    • Too high a ratio may indicate inadequate inventory levels
    • Turnover ratio should be compared to historical and industry averages
    • Analyze significant variances
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Accounts Receivable Turnover-page-65
    • Number of times the average level of A/R is collected during the accounting year
    • Measures ability to collect cash from credit customers
    $ e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Accounts Receivable Turnover
    • Net credit sales
    • Average net A/R
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Net credit sales*
    • Average net A/R
    • $25,265.00
    • 5000
    • = 5.053 times
    Accounts Receivable Turnover
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Days’ Sales in Receivables
    • Number of equivalent days’ sales revenue represented by the outstanding A/R balance
    • Measures A/R balance in terms of number of days it would take to generate the equivalent dollar amount of sales
    $ e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Average net A/R
    • (Net sales / 365 days)
    • $5000
    • ($25265 / 365 days)
    • = 72.23 days
    Days’ Sales in Receivables
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring the Company’s Ability to Pay Long-Term Debt-67
    • Bondholders and long-term lenders are concerned about an entity’s ability to repay debt principal and accumulated interest on long-term notes and loans
    • 2 ratios help these users assess the entity’s ability to pay its long-term obligations
    • Debt ratio
    • Times-interest-earned ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio-page-67
    • Relationship between company’s total liabilities and total assets
    • Measures proportion of total assets provided through debt
    • 1 - debt ratio = proportion of assets provided by equity
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio-page 67
    • Total Liabilities
    • Total Equity
    • Assets:
      • Current Assets: $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio
    • Total Liabilities
    • Total Assets
      • $971.00 $5,308.00
      • =.1829
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio
    • Total Liabilities
    • Total Assets
    • 2,00000
    • $323,497
    • = .38
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio
    • If debt ratio = 1.0, company used all debt to finance acquisition of its assets
      • A highly unlikely situation
    • Thus, debt ratio is generally less than 1.0
    LOANS, NOTES, BONDS, ETC. e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Debt Ratio
    • The higher the ratio, the more cash the company must commit toward paying annual interest expense and loan principal
    • As a result, company’s cash flow might be negatively affected
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Lenders and creditors might require company to appropriate portion of retained earnings to ensure sufficient assets to repay interest and loan principal
    Debt Ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Times-Interest-Earned Ratio-page-70
    • Relationship between company’s net income from operations and interest expense
    • Measures ability of company to cover, or pay for, its interest expense out of operating income
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Times-Interest-Earned Ratio
    • Income from operations
    • Interest expense
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Times-Interest-Earned Ratio
    • Income from operations
    • Interest expense
    • 2,613.00
    • 0
    • = &
    Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 Average inventory $ 4000 Average debtors $5000 e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • high ratio indicates ease in meeting debt interest payments
    Times-Interest-Earned Ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • A low ratio would signal possible difficulties in making payments to lenders and bondholders
    Times-Interest-Earned Ratio
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Measuring a Company’s Profitability
    • Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently
    • Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 4 profitability ratios are commonly used in financial statement analysis
    Measuring a Company’s Profitability
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    Measuring a Company’s Profitability
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    • Return on assets
    Measuring a Company’s Profitability
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    • Return on assets
    • Return on equity
    Measuring a Company’s Profitability
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    • Return on assets
    • Return on equity
    • Earnings per share
    Measuring a Company’s Profitability-page-74
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Relationship between a company’s net income and net sales
    • Measures management’s ability to efficiently and effectively manage company operations
    • Shows percentage of each net sales dollar earned as net income
    Return on Sales
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Return on Sales-Net profit ratio-73
    • Net income
    • Net sales revenue
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Return on Sales
    • Net income
    • Net sales revenue
    • $1,666.00
    • $25,265.00
    • =0 .065
    Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 $1,666.00 Average inventory $ 4000 Average debtors $5000 e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Higher rate tells users that more net sales dollars add to a company’s profits
      • And fewer dollars go to cover company expenses
    • Company conducts its business effectively, manages expenses
    Return on Sales
    Net Income e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Ratio of the return to the two groups that provide financing to the company
      • Creditors and investors
    • and average assets owned during the period
    • Measures company’s success in generating income from its available resources
    Return on Assets-74
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    • Net income + interest expense
    • Average total assets
    Return on Assets
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    • Net income + interest expense
    • Average total assets
    • $1,666.00 + 0
    • 9000
    • = .185
    Return on Assets
    Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 Average inventory $ 4000 Average debtors $5000 Average total assets $9000 e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Return on Assets
    • Why do we add back interest expense to net income?
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    • Total assets are financed by 2 sources:
      • Investors (equity)
      • Creditors (debt)
    • Net income is the return attributable to investors in the company’s stock
    • Interest expense is the return paid to creditors for using their funds to acquire assets
    Return on Assets
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    • Relationship between net income available to common stockholders and the equity they provide
    • Measures company’s success in using stockholders’ investments to generate net income
    Return on Equity-75
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  • Return on Equity
    • Net income - preferred dividends
    • Common contributed capital + retained earnings
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  • Return on Equity
    • Net income - preferred dividends
    • Common contributed capital + retained earnings
    • $30,555*
    • ($286,676 + $255,773) / 2
    • = .1126
    • * X ltd. does not have preferred stock
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    • Relationship between net income available to common stockholders and the number of shares of common stock issued
    • Expresses net income in terms of one share of the company’s common stock
    Earnings Per Share-77
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  • Earnings Per Share
    • Net income - preferred dividends
    • # of shares of common stock outstanding
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  • Earnings Per Share
    • Net income - preferred dividends
    • # of shares of common stock outstanding
    • $30,555,000*
    • 40,221,000 shares
    • = $.76
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  • Earnings Per Share
    • In addition to net income, EPS is presented for several other elements on the corporate income statement
    • Discontinued operations
    • Extraordinary items
    • Cumulative effect of accounting change
    • Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory
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  • Analyzing the Company’s Stock as an Investment
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    • Investors expect to receive 2 types of returns on their investments in a corporation’s common stock
    • Gains earned when they sell the corporation’s stock
    • Periodic dividends paid by the corporation to its stockholders
    Analyzing the Company’s Stock as an Investment
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    • Financial analysts use several ratios to assess value of stock investments
    • Price/earnings ratio
    • Dividend yield
    • Book value
    Analyzing the Company’s Stock as an Investment
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  • Price/Earnings Ratio-77
    • Relationship between a stock’s market price and its earnings per share
    • Measures the number of times one share of stock sells above the current period’s reported earnings
    • Assists financial analysts in deciding if a stock is overpriced or underpriced
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    • Calculating the P/E ratio
    Price/Earnings Ratio
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    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
    Price/Earnings Ratio
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
    Price/Earnings Ratio
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • The income statement reports EPS of $.92
    Price/Earnings Ratio
    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • The income statement reports EPS of $.92
    • What is Asian Art’s price/earnings ratio?
    Price/Earnings Ratio
    Calculating the P/E ratio Market value of stock Earnings per share e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Price/Earnings Ratio
    • Market value of stock
    • Earnings per share
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  • Price/Earnings Ratio
    • Market value of stock
    • Earnings per share
    • $15.75
    • $.92
    • = 17.12
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  • P/E ratio
    • If a stock has low P/E ratio say 3/1 it may be considered as an undervalued stock.
    • If the ratio is 80/1 it may be viewed as overvalued.
    • This ratio is more popular in the secondary market.
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  • Dividend Yield
    • Ratio of dividends per share of stock to the stock’s market value
    • Indicates the percentage of a stock’s market value “returned” to the stockholder in the form of dividends
    • Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock
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  • Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
    • If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?
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  • Dividend Yield-78
    • Annual dividends per share
    • Stock’s market value per share
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  • Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
    • $1.25
    • $15.75
    • = .079
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  • Book Value
    • Relationship between common stockholders’ equity and number of common shares outstanding
    • Measures the accounting value of one share of the corporation’s common stock
    DEBIT CREDIT e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Book Value
    • Total equity - preferred equity
    • # of shares of common stock outstanding
    • The book value of one share of Lands’ End common stock is:
    • $201,192,000
    • 4,02,21,000 shares
    • = $5.00/share
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  • Review: Major Income Statement Items
    • Gross Profit = Sales - Costs of Goods Sold
    • EBITDA = Gross Profit - Cash Operating Expenses
    • EBIT = EBDIT - Depreciation - Amortization
    • EBT = EBIT - Interest
    • NI or EAT = EBT- Taxes
    • Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares
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  • Life education
    Thomas Cooper –Dictionary e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Accounting Test Question No IFS 4:
    • Effect of Management Decisions On Ratios
    • Require:
    • Put by letter whether each of the actions listed below will immediately
    • -increase (I),
    • -decrease (D) or
    • -have no effect (N) on the ratios shown.
    • Current ratio Acid-test ratio Debt to Equity ratio
    • 1.Company issued ordinary shares for cash
    • 2.Bought raw material on account
    • 3.Received money from accounts receivable
    • 4.Expiration of prepaid rent
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    • 5.Payment of cash dividend
    • 6.Purchase long term investment with cash
    • 7.Sale of fixed assets for cash with no gain or loss
    • 8.Stock write off
    • 9.Refinance on a long term basis currently matured debt
    • 10.Bought fixed asset with a 6 month note
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  • Answer to Accounting Test Question IFS No 4 :
    • Current ratio Acid-test ratio Debt to equity ratio
    • 1.Company issued ordinary shares for cash I I D
    • 2.Bought raw material on accountI D I
    • 3.Received money from accounts receivable N N N
    • 4.Expiration of prepaid rent D N I
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    • 5.Payment of cash dividendDDI
    • 6.Purchase long term investment with cash
          • D D N
    • 7.Sale of fixed assets for cash with no gain or loss I I N
    • 8.Stock write off D N I
    • 9.Refinance on a long term basis currently matured debt I I N
    • 10.Bought fixed asset with a 6 month note D D I
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    • Accounting Test Question No IFS 1:
    • Details of financial performance of Company XYZ
    • For year 2005 Income Statement :
    • Net Sales - $ 7 million,
    • Cost of Goods sold - $ 3 million
      • Net Income - $1.2 million
      • Balance Sheet ($’000):- 2007
    • Assets
    • Cash $2,00,240
    • Accounts Receivable $8,10,620
    • Inventory $8,30,710
    • Property, plant and equipment ( net) $2,59,02,420
    • Total Assets $4,43,03,990 
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    •   Liabilities & Shareholders’ Equity:
    •    Current liabilities710640
    • Notes payable550990
    • Paid-in capital1,5001,500
    • Retained earnings1,670860Total Liabilities & Shareholders’ Equity4,4303,990The average industry for
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    • Company’s line of business are:
    • Inventory Turnover  5 times
    • Average Collection period  45 days
    • Asset Turnover 2 times
    • Required:
    • Evaluate Company XYZ’s asset management relative to its industry.
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  • Accounting Test Question No IFS 2:
    • Append below Company TIM s Income Statement and Balance Sheet:
    • Income Statement (000) 2006-2007
    • Net Sales Rs.7,05,06,200
    • Net Income Rs.3,40,410
    • Balance Sheet (000):-Assets2006-2007
    • Current Assets Rs.1,84,01,570
    • Property, plant and equipment ( net) Rs.2,59,02,420
    • Total Assets Rs.4,43,03,990
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    • Current Liabilities1,15,01,190
    • Long term liabilities RS. 8,10,440
    • Paid-in capital1 RS.50,01,500
    • Retained earnings Rs.9,70,860
    • Required:
    • Determine the following ratios for 2006- 2007:
    • profit margin on sales
    • return on assets (ROA)
    • return on shareholders equity
    • (2) Determine the amount of dividends paid to the shareholders during2006- 2007
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  • Answer to Accounting Test Question IFS No 2 :
    • 1(a) Profit margin on sales
    • = Net Income/ Net Sales
    • = Rs.340,000/Rs.7,050,000
    • = 4.8%
    • 1(b) Return on Assets (ROA)
    • = Net Income/(Average Total Assets)/2
    • =RS.340,000/(Rs.4,430,000+3,990,000)/2
    • = 8.1%
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    • 1(c) Return on Shareholders equity
    • = Net Income/ (Average Total Shareholder fund)/2
    • =Rs.340,000/(Rs.3,170,000+2,360,000)/2
    • = 12.3%
    • Computation of Dividend paid during Year 2005:
    • Retained earnings beginning of year 2005 RS.860,000
    • Add: Net Income Rs.340,000
    • Less: Retained earnings end of year 2005 (Rs.970,000)
    • Dividends paid during 2007 Rs.230,000
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    • Accounting Test Question No IFS 3:
    • Append below Company XYZ’s Income Statement and Balance Sheet:
    • Income Statement ($’000)2005
    • Net Sales 7,100
    • Interest expense 40
    • Income tax expense 150
    • Net Income 210
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    • Balance Sheet ($’000):-
    • Assets2005
    • Cash 200
    • Accounts Receivable 810
    • Inventory 830
    • Property, plant and equipment ( net) 2,590
    • Total Assets 4,430
    • Liabilities & Shareholders’ Equity:
    • Current liabilities 710
    • Long-term liabilities 550
    • Paid-in capital 1,500
    • Retained earnings 1,670
    • Total Liabilities & Shareholders’ Equity4,430
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    • Required:
    • Determine the following ratios for 2005:
    • (a) current ratio
    • (b) acid-test ratio
    • (c) debt to equity ratio
    • (d) times interest earned ratio
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  • Answer:3
    • (a) current ratio=
    • Current asset/current liabilities
    • = ($200,000+$810,000+$830,000)/$710,000)= 2.59
    • (b) acid-test ratio=
    • (Current assets- inventory)/current liabilities
    • =($200,000+$810,000)/$710,000= 1,42
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    • (c) debt to equity ratio
    • =(Total liabilities)/Shareholders fund
    • =($710,000+$550,000)/($1,500,000+
    • $1,670,000)
    • = 0.39
    • (d) times interest earned ratio
    • =(Net Income+ Interest Expense+ Income Tax)/InterestExpense
    • =($210,000+$40,000+$150,000)/$40,000
    • =10 times
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  • Some difficulty in ratios
    • All profitability and expenses ratios Sales in the denominator
    • All turn over ratios, sales in the numerator.
    • Propritory ratio=Total assets/owner’s funds
    • Shareholders’ funds=Equity shares+Reserves and surplus
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  • Exercise problems-103
    • 1.1.NC
    • 1.2 decrease
    • 1.3 NC
    • 1.4 NC
    • 1.5 Increase
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  • Exercise-2.
    • 1.GP ratio=15*100/30=50%
    • 2.NP ratio=5*100/30=16.67%
    • 3.STR=COGS/Average stock=15/2.5=6.0 times
    • 4.CR=8/3=2.67
    • 5.LR=6/3=2
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  • Exercise-3
    • GP 33.33% 35%
    • NP 20% 25%
    • ROCE 15% 20%
    • STR 4 5
    • CR 1.5 2
    • D/E 0.17241 0.24
    • Capital employed=3.4-.2=3.2
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  • Exercise-4
    • 1. current ratio=550/200=2.75
    • 2.Acid test ratio=400/200=2
    • 3.Operating ratio=1480*100/1800=82.22%
    • 4.STR=1150/200=5.75 times
    • 5. DTR=1800/250=7.2 times
    • 6.ROPR=
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  • Prob.13.
    • 1.sales=3,20,000
    • 2.sundry debtors=80,000
    • 3. sundry creditors=80,000
    • 4. closing stock=31,000
    • 5. Opening stock=29,000
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  • Prob.12
    • Balance sheet: General reserve at the beginning=2,00,000
    • Proposed addition=1,00,000
    • Profits and loss appro.=20,000
    • 10% Debentures=1,00,000
    • Current liabilities(Proposed dividend)=2,00,000
    • Fixed assets=7,20,000
    • Stock=2,53,125
    • Sundry debtors=84,375
    • Tranfer to general reserve=1,00,000
    • Balance transferred to balance sheet=20,000
    • Net profit=2,50,000
    • Provision for tax=7500
    • Net profit=2,50,000;gross profit=6,07,500;sales=10,12,500; purchases=1,30,625.
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  • Prob.9
    • Balance sheet.
    • Liabilities Assets
    • Equity shares 2,00,000 Fixed assets 2,25,000
    • R/S 1,00,000 current liabilities 1,75,000
    • Long term liabilities NIL
    • Over draft 60,000
    • Sundry creditors 40,000
    • 4,00,000 4,00,000
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  • Chapter Objective 5 Use ratios in decision making
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  • Limitations of Financial Analysis
    • No one ratio or year’s worth of financial information should be relied upon to provide a complete assessment of a corporation’s financial condition
    • Analysts should:
    • Examine trends over time
    • Benchmark to industry and key competitors
    • Seek answers about why ratios are different
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  • Limitations of Financial Analysis
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  • Limitations of Financial Analysis
    • Grant’s ratios were reasonably good up until several years before its failure
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  • Limitations of Financial Analysis
    • But analysts and the investing public continued to believe the company’s strong history would carry it forward
    • Grant’s ratios were reasonably good up until several years before its failure
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  • Limitations of Financial Analysis
    • But analysts and the investing public continued to believe the company’s strong history would carry it forward
    • Financial statement users didn’t consider the social and economic changes of the early 1970s and how these affected the retailer!
    • Grant’s ratios were reasonably good up until several years before its failure
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  • The Complexity of Business Decisions
    • Business environment is complicated by numerous local, regional, national, and global issues - all must be considered when evaluating current financial condition or forecasting future potential for income
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  • An Example: Dell Abbreviated Balance Sheet
    • Assets:
      • Current Assets  inventories$391 $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
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    • Current Ratio:
    • Quick (Acid Test) Ratio:
    Liquidity Ratio Examples: Dell
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  • Ratio Comparison: Current Ratio
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    • Debt Ratio:
    Leverage Ratio Examples: Dell
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  • Ratio Comparison: Debt Ratio
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    • Return on Assets (ROA):
    • Return on Equity (ROE):
    Profitability Ratio Examples: Dell
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  • Profitability Ratio Examples: Dell
    • Net Profit Margin:
    • Retention Ratio
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  • Ratio Comparison: ROE
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  • Ratio Comparison: ROA
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  • Ratio Comparison: Profit Margin
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    • Total Asset Turnover Ratio:
    • Inventory Turnover Ratio:
    Activity (Turnover) Ratio Examples: Dell
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  • Ratio Comparison: Asset Turnover
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  • The DuPont System
    • Method to breakdown ROE into:
      • ROA and Equity Multiplier
    • ROA is further broken down as:
      • Profit Margin and Asset Turnover
    • Helps to identify sources of strength and weakness in current performance
    • Helps to focus attention on value drivers
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System: Dell
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  • A Note on Sustainable Growth and Stock Returns
    • In the long run
      • Sustainable growth and long run capital gains (g) = ROE x 
    • Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D 1 /P 0 ):
      • r = g + D 1 /P 0 = g + D o (1+g)/P 0
    • Note: r & g must be quarterly if D is quarterly and annual if D is annual
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  • Example: Predicted Sustainable Growth for Dell
    • Based on the most recent numbers:
      • ROE = 31.39% &  = 100%
      • g = 0.3139 x 1 = 31.39%
      • r = 0.3139 + 0/P = 31.39%
    • Based on 5 year averages:
      • ROE = 51.94% &  = 100%
      • g = 0.5194 x 1 = 51.94%
      • r = 0.3139 + 0/P = 51.94%
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  • Summary of Financial Ratios
    • Ratios help to:
      • Evaluate performance
      • Structure analysis
      • Show the connection between activities and performance
    • Benchmark with
      • Past for the company
      • Industry
    • Ratios adjust for size differences
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  • Limitations of Ratio Analysis
    • A firm’s industry category is often difficult to identify
    • Published industry averages are only guidelines
    • Accounting practices differ across firms
    • Sometimes difficult to interpret deviations in ratios
    • Industry ratios may not be desirable targets
    • Seasonality affects ratios
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  • Ratios and Forecasting
    • Common stock valuation based on
      • Expected cashflows to stockholders
      • ROE and  are major determinants of cashflows to stockholders
    • Ratios influence expectations by:
      • Showing where firm is now
      • Providing context for current performance
    • Current information influences expectations by:
      • Showing developments that will alter future performance
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  • How Might Ratios Help Me on the IEM?
    • Analysis of AAPL, IBM and MSFT, and comparisons to the S&P500 companies can help to:
      • Assess the (absolute and relative) financial state of each company
      • Show each company’s strengths and weaknesses
      • Predict sustainable growth rate
    • Combined with current information, this can help to:
      • Assess likely future performance
      • Predict future valuation and earnings growth
      • Predict returns
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  • Financial Statement Analysis: Lecture Outline
    • Review of Financial Statements
    • Ratios
      • Types of Ratios
      • Examples
    • The DuPont Method
    • Ratios and Growth
    • Summary
      • Strengths
      • Weaknesses
      • Ratios and Forecasting
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  • Financial Analysis
    • Assessment of the firm’s past, present and future financial conditions
    • Done to find firm’s financial strengths and weaknesses
    • Primary Tools:
      • Financial Statements
      • Comparison of financial ratios to past, industry, sector and all firms
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  • Sources of Data
    • Annual reports
      • Via mail, SEC or company websites
    • Published collections of data
      • e.g., Dun and Bradstreet or Robert Morris
    • Investment sites on the web
      • Examples
        • http://moneycentral.msn.com/investor
        • http://www.marketguide.com
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  • The Main Idea
    • Value for the firm comes from cashflows
    • Cashflows can be calculated as:
      • (Rev t - Cost t - Dep t )x(1-  ) + Dep t —OR—
      • (Rev t - Cost t )x(1-  ) +  xDep t —OR—
      • Rev t x(1-  ) - Cost t x(1-  ) +  xDep t
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  • An Example: Dell Abbreviated Balance Sheet
    • Assets:
      • Current Assets: $7,681.00
      • Non-Current Assets: $3,790.00
      • Total Assets: $11,471.00
    • Liabilities:
      • Current Liabilities: $5,192.00
      • LT Debt & Other LT Liab.: $971.00
      • Equity: $5,308.00
      • Total Liab. and Equity: $11,471.00
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  • Review: Major Income Statement Items
    • Gross Profit = Sales - Costs of Goods Sold
    • EBITDA = Gross Profit - Cash Operating Expenses
    • EBIT = EBDIT - Depreciation - Amortization
    • EBT = EBIT - Interest
    • NI or EAT = EBT- Taxes
    • Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares
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  • An Example: Dell Abbreviated Income Statement
    • Sales $25,265.00
    • Costs of Goods Sold -$19,891.00
    • Gross Profit $5,374.00
    • Cash operating expense -$2,761.00
    • EBITDA 2,613.00
    • Depreciation & Amortization -$156.00
    • Other Income (Net) -$6.00
    • EBIT $2,451.00
    • Interest -$0.00
    • EBT $2,451.00
    • Income Taxes -$785.00
    • Special Income/Charges -$194.00
    • Net Income (EAT) $1,666.00
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  • Objectives of Ratio Analysis
    • Standardize financial information for comparisons
    • Evaluate current operations
    • Compare performance with past performance
    • Compare performance against other firms or industry standards
    • Study the efficiency of operations
    • Study the risk of operations
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  • Rationale Behind Ratio Analysis
    • A firm has resources
    • It converts resources into profits through
      • production of goods and services
      • sales of goods and services
    • Ratios
      • Measure relationships between resources and financial flows
      • Show ways in which firm’s situation deviates from
        • Its own past
        • Other firms
        • The industry
        • All firms-
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  • Types of Ratios
    • Financial Ratios:
      • Liquidity Ratios
        • Assess ability to cover current obligations
      • Leverage Ratios
        • Assess ability to cover long term debt obligations
    • Operational Ratios:
      • Activity (Turnover) Ratios
        • Assess amount of activity relative to amount of resources used
      • Profitability Ratios
        • Assess profits relative to amount of resources used
    • Valuation Ratios:
        • Assess market price relative to assets or earnings
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    • Current Ratio:
    • Quick (Acid Test) Ratio:
    Liquidity Ratio Examples: Dell
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  • Ratio Comparison: Current Ratio
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    • Debt Ratio:
    Leverage Ratio Examples: Dell
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  • Ratio Comparison: Debt Ratio
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    • Return on Assets (ROA):
    • Return on Equity (ROE):
    Profitability Ratio Examples: Dell
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  • Profitability Ratio Examples: Dell
    • Net Profit Margin:
    • Retention Ratio
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  • Ratio Comparison: ROE
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  • Ratio Comparison: ROA
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  • Ratio Comparison: Profit Margin
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    • Total Asset Turnover Ratio:
    • Inventory Turnover Ratio:
    Activity (Turnover) Ratio Examples: Dell
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  • Ratio Comparison: Asset Turnover
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  • The DuPont System
    • Method to breakdown ROE into:
      • ROA and Equity Multiplier
    • ROA is further broken down as:
      • Profit Margin and Asset Turnover
    • Helps to identify sources of strength and weakness in current performance
    • Helps to focus attention on value drivers
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System
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  • The DuPont System: Dell
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  • A Note on Sustainable Growth and Stock Returns
    • In the long run
      • Sustainable growth and long run capital gains (g) = ROE x 
    • Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D 1 /P 0 ):
      • r = g + D 1 /P 0 = g + D o (1+g)/P 0
    • Note: r & g must be quarterly if D is quarterly and annual if D is annual
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  • Example: Predicted Sustainable Growth for Dell
    • Based on the most recent numbers:
      • ROE = 31.39% &  = 100%
      • g = 0.3139 x 1 = 31.39%
      • r = 0.3139 + 0/P = 31.39%
    • Based on 5 year averages:
      • ROE = 51.94% &  = 100%
      • g = 0.5194 x 1 = 51.94%
      • r = 0.3139 + 0/P = 51.94%
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    • Inventory turnover
    • A/R turnover
    • Days’ sales in receivables
    Measuring the Company’s Ability to Sell Inventory and Collect Receivables
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  • Inventory Turnover
    • Number of times the average level of inventory is sold during the accounting year
    • Measures time required to earn return on company’s investment in inventory
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  • Inventory Turnover
    • Cost of goods sold
    • Average inventory
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  • Inventory Turnover
    • Cost of goods sold
    • Average inventory
    • $588,017
    • ($164,816 + $168,652) / 2
    • = 3.53
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  • Inventory Turnover
    • High ratio indicates ability to quickly sell inventory
    • Too high a ratio may indicate inadequate inventory levels
    • Turnover ratio should be compared to historical and industry averages
    • Analyze significant variances
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  • Accounts Receivable Turnover
    • Number of times the average level of A/R is collected during the accounting year
    • Measures ability to collect cash from credit customers
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  • Measuring a Company’s Profitability
    • Financial analysts pay close attention to ratios which assess a company’s ability to generate profits and operate efficiently
    • Creditors and investors rely on forecasts of a company’s potential to generate net income when they make lending and investing choices
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    • 4 profitability ratios are commonly used in financial statement analysis
    Measuring a Company’s Profitability
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    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    Measuring a Company’s Profitability
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    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    • Return on assets
    Measuring a Company’s Profitability
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    • 4 profitability ratios are commonly used in financial statement analysis
    • Return on sales
    • Return on assets
    • Return on equity
    Measuring a Company’s Profitability
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  • Return on Equity
    • Net income - preferred dividends
    • Common contributed capital + retained earnings
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  • Return on Equity
    • Net income - preferred dividends
    • Common contributed capital + retained earnings
    • $30,555*
    • ($286,676 + $255,773) / 2
    • = .1126
    • * Lands’ End does not have preferred stock
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    • Relationship between net income available to common stockholders and the number of shares of common stock issued
    • Expresses net income in terms of one share of the company’s common stock
    Earnings Per Share
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  • Earnings Per Share
    • Net income - preferred dividends
    • # of shares of common stock outstanding
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  • Earnings Per Share
    • Net income - preferred dividends
    • # of shares of common stock outstanding
    • $30,555,000*
    • 40,221,000 shares
    • = $.76
    • * Lands’ End does not have preferred stock;
    • numbers shown are actual amounts
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  • Earnings Per Share
    • In addition to net income, EPS is presented for several other elements on the corporate income statement
    • Discontinued operations
    • Extraordinary items
    • Cumulative effect of accounting change
    • Earnings per share (EPS) disclosure on the face of the corporate income statement is mandatory
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  • Analyzing the Company’s Stock as an Investment
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    • Investors expect to receive 2 types of returns on their investments in a corporation’s common stock
    • Gains earned when they sell the corporation’s stock
    • Periodic dividends paid by the corporation to its stockholders
    Analyzing the Company’s Stock as an Investment
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    • Financial analysts use several ratios to assess value of stock investments
    • Price/earnings ratio
    • Dividend yield
    • Book value
    Analyzing the Company’s Stock as an Investment
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  • Price/Earnings Ratio
    • Relationship between a stock’s market price and its earnings per share
    • Measures the number of times one share of stock sells above the current period’s reported earnings
    • Assists financial analysts in deciding if a stock is overpriced or underpriced
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    • Calculating the P/E ratio
    Price/Earnings Ratio
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    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
    Price/Earnings Ratio
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
    Price/Earnings Ratio
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • The income statement reports EPS of $.92
    Price/Earnings Ratio
    • Calculating the P/E ratio
    • Market value of stock
    • Earnings per share
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    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • The income statement reports EPS of $.92
    • What is Asian Art’s price/earnings ratio?
    Price/Earnings Ratio
    Calculating the P/E ratio Market value of stock Earnings per share e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Price/Earnings Ratio
    • Market value of stock
    • Earnings per share
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  • Price/Earnings Ratio
    • Market value of stock
    • Earnings per share
    • $15.75
    • $.92
    • = 17.12
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  • Dividend Yield
    • Ratio of dividends per share of stock to the stock’s market value
    • Indicates the percentage of a stock’s market value “returned” to the stockholder in the form of dividends
    • Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock
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  • Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
    • If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?
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  • Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
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  • See you in the next chapter BRS
    • Life education
    • God and Poor man
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    TIME TO REST e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Chapter-8 capital structure& cost of capital
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  • Chapter 16: Capital Structure Decisions: The Basics
    • Overview and preview of capital structure effects
    • Business versus financial risk
    • The impact of debt on returns
    • Capital structure theory
    • Example: Choosing the optimal structure
    • Setting the capital structure in practice
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  • Basic Definitions
    • V = value of firm
    • FCF = free cash flow
    • WACC = weighted average cost of capital
    • r s and r d are costs of stock and debt
    • r e and w d are percentages of the firm that are financed with stock and debt.
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  • How can capital structure affect value?
    (Continued…) WACC = w d (1-T) r d + w e r s e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • A Preview of Capital Structure Effects
    • The impact of capital structure on value depends upon the effect of debt on:
      • WACC
      • FCF
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • The Effect of Additional Debt on WACC
    • Debtholders have a prior claim on cash flows relative to stockholders.
      • Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
      • Cost of stock, r s , goes up.
    • Firm’s can deduct interest expenses.
      • Reduces the taxes paid
      • Frees up more cash for payments to investors
      • Reduces after-tax cost of debt
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • The Effect on WACC (Continued)
    • Debt increases risk of bankruptcy
      • Causes pre-tax cost of debt, r d , to increase
    • Adding debt increase percent of firm financed with low-cost debt (w d ) and decreases percent financed with high-cost equity (w e )
    • Net effect on WACC = uncertain.
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • The Effect of Additional Debt on FCF
    • Additional debt increases the probability of bankruptcy.
      • Direct costs: Legal fees, “fire” sales, etc.
      • Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Impact of indirect costs
      • NOPAT goes down due to lost customers and drop in productivity
      • Investment in capital goes up due to increase in net operating working capital (accounts payable goes up as suppliers tighten credit).
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Additional debt can affect the behavior of managers.
      • Reductions in agency costs: debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.
      • Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects.
    (Continued…) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Asymmetric Information and Signaling
    • Managers know the firm’s future prospects better than investors.
    • Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information).
    • Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
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  • What is business risk?
    • Uncertainty about future pre-tax operating income (EBIT).
    • Note that business risk focuses on operating income, so it ignores financing effects.
    Probability EBIT E(EBIT) 0 Low risk High risk e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Business Risks- Unit-9
    • Uncertainty about demand (unit sales).
    • Uncertainty about output prices .
    • Uncertainty about input costs .
    • Product and other types of liability .
    • Degree of operating leverage (DOL) .
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  • What is operating leverage, and how does it affect a firm’s business risk?-9.3( 252)
    • Operating leverage is the change in EBIT caused by a change in quantity sold.
    • The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage .
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    • Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.
    (More...) e-mail: aug_bang@yahoo.com www.augustin.co.nr Sales $ Rev. TC F Q BE Sales $ Rev. TC F Q BE EBIT }
  • Operating Breakeven
    • Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit.
    • Operating breakeven = Q BE
    • Q BE = F / (P – V)
    • Example: F=$200, P=$15, and V=$10:
    • Q BE = $200 / ($15 – $10) = 40.
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    Probability EBIT L Low operating leverage High operating leverage EBIT H
    • In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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  • Business Risk versus Financial Risk-253
    • Business risk:
      • Uncertainty in future EBIT.
      • Depends on business factors such as competition, operating leverage, etc.
    • Financial risk:
      • Additional business risk concentrated on common stockholders when financial leverage is used.
      • Depends on the amount of debt and preferred stock financing.
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    Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Consider Two Hypothetical Firms Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt . e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Impact of Leverage on Returns EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800 $1,080 ROE 9.0% 10.8% Firm U Firm L e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Why does leveraging increase return?
    • More EBIT goes to investors in Firm L.
      • Total dollars paid to investors:
        • U: NI = $1,800.
        • L: NI + Int = $1,080 + $1,200 = $2,280.
      • Taxes paid:
        • U: $1,200; L: $720.
    • Equity $ proportionally lower than NI.
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    Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L? Continued… e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Firm U: Unleveraged Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400 Economy Bad Avg. Good e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Firm L: Leveraged Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U. Economy Bad Avg. Good e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Firm U Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% TIE n.a. n.a. n.a. Firm L Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 4.8% 10.8% 16.8% TIE 1.7x 2.5x 3.3x e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Profitability Measures: E(BEP) 15.0% 15.0% E(ROIC) 9.0% 9.0% E(ROE) 9.0% 10.8% Risk Measures:  ROIC 2.12% 2.12%  ROE 2.12% 4.24% U L e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Conclusions
    • Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA) are unaffected by financial leverage.
    • L has higher expected ROE: tax savings and smaller equity base.
    • L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk.
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    • In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.
      • U and L:  ROIC = 2.12%.
      • U:  ROE = 2.12%.
      • L:  ROE = 4.24%.
    • L’s financial risk is  ROE -  ROIC = 4.24% - 2.12% = 2.12%. (U’s is zero.)
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    • For leverage to be positive (increase expected ROE), BEP must be > r d .
    • If r d > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE.
    • In the example, E(BEP) = 15% while interest rate = 12%, so leveraging “works.”
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  • Life education
    • Fighting Spirit
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  • Capital Structure Theory-261
    • MM theory
      • Zero taxes
      • Corporate taxes
      • Corporate and personal taxes
    • Trade-off theory
    • Signaling theory
    • Debt financing as a managerial constraint
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  • MM Theory: Zero Taxes
    • MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:
      • V L = V U .
    • Therefore, capital structure is irrelevant.
    • Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk (i.e., r s ), so WACC is constant.
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  • MM Theory: Corporate Taxes
    • Corporate tax laws favor debt financing over equity financing.
    • With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.
    • MM show that: V L = V U + TD .
    • If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
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    Value of Firm, V 0 Debt V L V U MM relationship between value and debt when corporate taxes are considered. Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Cost of Capital (%) 0 20 40 60 80 100 Debt/Value Ratio (%) MM relationship between capital costs and leverage when corporate taxes are considered. r s WACC r d (1 - T) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Miller’s Theory: Corporate and Personal Taxes- Page261(9.4)
    • Personal taxes lessen the advantage of corporate debt:
      • Corporate taxes favor debt financing since corporations can deduct interest expenses.
      • Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
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    Miller’s Model with Corporate and Personal Taxes V L = V U + [ 1 - ] D. T c = corporate tax rate. T d = personal tax rate on debt income. T s = personal tax rate on stock income. (1 - T c )(1 - T s ) (1 - T d ) e-mail: aug_bang@yahoo.com www.augustin.co.nr
    T c = 40%, T d = 30%, and T s = 12%. V L = V U + [ 1 - ] D = V U + (1 - 0.75)D = V U + 0.25D. Value rises with debt; each $1 increase in debt raises L’s value by $0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30) e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Conclusions with Personal Taxes
    • Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.
    • Firms should still use 100% debt.
    • Note: However, Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.
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  • Trade-off Theory
    • MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
    • At low leverage levels, tax benefits outweigh bankruptcy costs.
    • At high levels, bankruptcy costs outweigh tax benefits.
    • An optimal capital structure exists that balances these costs and benefits.
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  • Signaling Theory
    • MM assumed that investors and managers have the same information.
    • But, managers often have better information. Thus, they would:
      • Sell stock if stock is overvalued.
      • Sell bonds if stock is undervalued.
    • Investors understand this, so view new stock sales as a negative signal.
    • Implications for managers?
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  • Debt Financing and Agency Costs
    • One agency problem is that managers can use corporate funds for non-value maximizing purposes.
    • The use of financial leverage:
      • Bonds “free cash flow.”
      • Forces discipline on managers to avoid perks and non-value adding acquisitions.
    (More...) e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • A second agency problem is the potential for “underinvestment”.
      • Debt increases risk of financial distress.
      • Therefore, managers may avoid risky projects even if they have positive NPVs.
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    Choosing the Optimal Capital Structure: Example Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; r s = 12%; P 0 = $25; T = 40%; b = 1.0; r RF = 6%; RP M = 6%. e-mail: aug_bang@yahoo.com www.augustin.co.nr
    Estimates of Cost of Debt Percent financed with debt, w d r d 0% - 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock. e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • The Cost of Equity at Different Levels of Debt: Hamada’s Equation
    • MM theory implies that beta changes with leverage.
    • b U is the beta of a firm when it has no debt (the unlevered beta)
    • b L = b U [1 + (1 - T)(D/S)]
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  • The Cost of Equity for w d = 20%
    • Use Hamada’s equation to find beta:
    • b L = b U [1 + (1 - T)(D/S)]
    • = 1.0 [1 + (1-0.4) (20% / 80%) ]
    • = 1.15
    • Use CAPM to find the cost of equity:
    • r s = r RF + b L (RP M )
    • = 6% + 1.15 (6%) = 12.9%
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  • Cost of Equity vs. Leverage
    • w d D/S b L r s
    • 0% 0.00 1.000 12.00%
    • 20% 0.25 1.150 12.90%
    • 30% 0.43 1.257 13.54%
    • 40% 0.67 1.400 14.40%
    • 50% 1.00 1.600 15.60%
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  • The WACC for w d = 20%
    • WACC = w d (1-T) r d + w e r s
    • WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
    • WACC = 11.28%
    • Repeat this for all capital structures under consideration.
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  • WACC vs. Leverage
    • w d r d r s WACC
    • 0% 0.0% 12.00% 12.00%
    • 20% 8.0% 12.90% 11.28%
    • 30% 8.5% 13.54% 11.01%
    • 40% 10.0% 14.40% 11.04%
    • 50% 12.0% 15.60% 11.40%
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  • Corporate Value for w d = 20%
    • V = FCF / (WACC-g)
    • g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).
    • NOPAT = ($500,000)(1-0.40) = $300,000.
    • V = $300,000 / 0.1128 = $2,659,574.
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  • Corporate Value vs. Leverage
    • w d WACC Corp. Value
    • 0 % 12.00% $2,500,000
    • 20% 11.28% $2,659,574
    • 30% 11.01% $2,724,796
    • 40% 11.04% $2,717,391
    • 50% 11.40% $2,631,579
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  • Debt and Equity for w d = 20%
    • The dollar value of debt is:
    • D = w d V = 0.2 ($2,659,574) = $531,915.
    • S = V – D
    • S = $2,659,574 - $531,915 = $2,127,659.
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  • Debt and Stock Value vs. Leverage
    • w d Debt, D Stock Value, S
    • 0% $0 $2,500,000
    • 20% $531,915 $2,127,660
    • 30% $817,439 $1,907,357
    • 40% $1,086,957 $1,630,435
    • 50% $1,315,789 $1,315,789
    • Note: these are rounded; see Ch 16 Mini Case.xls for full calculations.
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  • Wealth of Shareholders
    • Value of the equity declines as more debt is issued, because debt is used to repurchase stock.
    • But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).
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  • Stock Price for w d = 20%
    • The firm issues debt, which changes its WACC, which changes value.
    • The firm then uses debt proceeds to repurchase stock.
    • Stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible).
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  • Stock Price for w d = 20% (Continued)
    • The stock price after debt is issued but before stock is repurchased reflects shareholder wealth:
      • S, value of stock
      • Cash paid in repurchase.
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  • Stock Price for w d = 20% (Continued)
    • D 0 and n 0 are debt and outstanding shares before recap.
    • D - D 0 is equal to cash that will be used to repurchase stock.
    • S + (D - D 0 ) is wealth of shareholders’ after the debt is issued but immediately before the repurchase.
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  • Stock Price for w d = 20% (Continued)
    • P = S + (D – D 0 )
    • n 0
    • P = $2,127,660 + ($531,915 – 0)
    • 100,000
    • P = $26.596 per share.
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  • Number of Shares Repurchased
    • # Repurchased = (D - D 0 ) / P
    • # Rep. = ($531,915 – 0) / $26.596
    • = 20,000.
    • # Remaining = n = S / P
    • n = $2,127,660 / $26.596
    • = 80,000.
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  • Price per Share vs. Leverage
    • # shares # shares
    • w d P Repurch. Remaining
    • 0% $25.00 0 100,000
    • 20% $26.60 20,000 80,000
    • 30% $27.25 30,000 70,000
    • 40% $27.17 40,000 60,000
    • 50% $26.32 50,000 50,000
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  • Optimal Capital Structure
    • w d = 30% gives:
      • Highest corporate value
      • Lowest WACC
      • Highest stock price per share
    • But w d = 40% is close. Optimal range is pretty flat.
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    • Debt ratios of other firms in the industry.
    • Pro forma coverage ratios at different capital structures under different economic scenarios.
    • Lender and rating agency attitudes (impact on bond ratings).
    What other factors would managers consider when setting the target capital structure? e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Reserve borrowing capacity.
    • Effects on control.
    • Type of assets: Are they tangible, and hence suitable as collateral?
    • Tax rates.
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  • Life Education
    • War prisoner’s wife
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  • Capital Budgeting-Chapter-11(297)
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  •  1999, Prentice Hall, Inc.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Ch. 11: Capital Budgeting Decision Criteria
    • example :
    • Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
    • Will the machine be profitable?
    • Will our firm earn a high rate of return on the investment?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Capital Budgeting : the process of planning for purchases of long-term assets.
    • How do we decide if a capital investment project should be accepted or rejected?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Decision-making Criteria in Capital Budgeting
  • Capital Budgeting
    • Time value of money is a fundamental concept. If the interest rate in the economy is 10%, $1 today is worth $1.10 net year, $1.21 two years from today and $1.331 three years from today etc…
    • So, $1.10 next year $1.21 two years from now, $1.331 three years from now are all worth $1 today.
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    • 100(1+.12)=112(1.12)=125.44
    • 100=112
    • 100=125.44
    • 112=100
    • 125.44=100
    • Today’s worth of 112 at the end 1 st year is =100 today
    • 100=112/1.12
    • (1+K)
    • A(1+K)^n=FV
    • PV(1+K)^n=FV
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  • Capital Budgeting
    • Now if I am to get $1.1 next year, $1.21 the year after and $1.331 the third year, what should I be willing to pay for the right to this stream of cash flows assuming that my only other alternative is to put the money in a bank account and get 10% interest?
    • Ans: $3, why?
      • Each year’s cash inflow is worth a dollar today.
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  • Capital Budgeting
    • If someone wants to sell me this investment for $2.90, my NPV (net present value) of the project is _____
    • Ans: 10cents. How computed?
      • The cash inflows are worth $3 in today’s dollars, the outflows are $2.90 in today’s dollars, so the NPV (always in current dollars) is Cash Inflows – Cash Outflows = $0.10.
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  • Capital Budgeting
    • The basic equation of compound interest is shown on p. 96:
      • PV(1+r) n = FV
    • (1+r) n is called the “factor”
    • To get the present value of a stream of cash inflows divide each future inflow amount by the factor for that year (this is called deflating the FV) and add all the deflated inflows … this is the formula on
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  • Capital Budgeting
    • To get the present value of a stream of cash outflows compute the sum of the deflated cash outflows.
    • To compute NPV of a project subtract PV(outflows) from PV(Inflows).
    • To do the computations by hand you can use special formulas for perpetuities and annuities. We will ignore this.
    • For this course, you should know how to do the computations using a financial calculator.
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  • Principles underlying Cash Flows
    • 1. Decision based on cash flows-Non cash charges not considered ie.Depreciation for tax calculation only. We add depreciation after calculating tax with profit after tax
    • 2.The amount of long term funds are used for capital investment purpose are considered.
    • 3.Cash inflow is defined as profit after tax but before depreciation
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  • Principles underlying Cash Flows
    • 4.Interest on long term loan is not considered as it is used for discounting purpose.
    • 5. Incremental cost and incremental benefits are considered.
    • 6.Quantify the detremental impact or benefits are considered.
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  • Principles underlying Cash Flows
    • 7.Sunk cost are irrelevant.
    • 8.Opportunity costs are to be considered.
    • 9. share of existing overheads has no value
    • 10. short term loan –interest on such loan to be deducted from contribution.
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  • Principles underlying Cash Flows
    • 11. salvage value to be determined and tax benefit on short term capital gain to be deducted from salvage value. And tax benefit on short term capital loss to be added to salvage value.
    • 12. while valuing lease/buy tax benefit on interest payment and tax benefit on depreciation have to be deducted from equated annual/monthly instalment.
    • 13. While valuing lease net lease payment after tax has to be considered.
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  • Relevant cost and relevant benefit
    • Required for decision making
    • Costs that are affected by by the decision
    • Costs and benefits that are independent of a decision are not relevant and need not be considered.
    • Future cash inflows and future outflows are relevant.
    • Sunk costs are irrelevant
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  • Relevant cost and relevant benefit
    • Allocated common costs are irrelevant
    • Opportunity costs are relevant (shadow price)
    • Incremental costs are relevant incremental benefits are relevant.
    • Avoidable costs are relevant and unavoidable costs are irrelevant for decision making.
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  • Relevant and irrelevant
    • Five engineers already employed on monthly salary but will not be sent out if not employed in an another project. The salary paid to those engineers are relevant or irrelevant to estimate the price for the project?
    • Two more engineers are selected exclusive to the new project-are the costs relevant to take decision for new project?
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  • Examples:
    • 1.Aztec. Spent Rs.20,00,000 for feasibility study before expansion is dead cost (sunk cost) therefore it is not considered as cash outflow.
    • 2. If feasibility study can be sold to other companies say, for Rs. 5,00,000 is an opportunity cost which should be considered as cash inflow for the project.
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  • Examples:
    • 3. Plant is Rs. 36,00,000, working capital is Rs. 24,00,000 required for a project. The company issues Equity capital Rs.26,00,000 and term loan Rs.16,00,000 then the cash outflow for the project is Rs. 42,00,000 as long term funds such as Equity capital and long term loan equal to Rs.42,00,000. If short term funds are employed for long term purpose we do not consider such funds as out flow.
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  • Depreciation
    • 4. Depreciation should be calculated as per Block assets method. The assets are similar nature having the rate of depreciation the costs are to be clubbed together. If any new asset(s) purchased during the year the amounts incurred on such asset are to be added.
    • Depreciation can not be calculated in the year of sale but the sale value(scrap ) is deducted from the block value.
    • If the some of the assets of the block are not sold and WDV(Balance in the block) exceeds sale value of the assets of the same block we can provide depreciation on the balance.
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    • If Sale value exceeds the block WDV value there is a capital gain which attracts capital gain. In such situation sale minus tax on short term capital gain will be cash inflow.
    • If all assets of the block is sold and the WDV of the block exceeds sale value we get short term capital loss. The real cash inflow is equal to scrap plus tax benefit on short term capital loss .
    • Example:1. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000
    • The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is 25% . How do we calculate depreciation? Life is 3 years
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    • .75*5,00,000= = =2,10,937.5-1,00,000
    • = 1,10,937(loss)
    • 1,00,000+1,10937(.339)
    • =1,37,607(Inflow)
    • Suppose salvage value is 3,00,000
    • Short term capital gain= 3,00,000-2,10,937
    • =89,063
    • Tax on 89,063=89063*.339=30,192
    • Net cash inflow =3,00,000-30,192
    • =2,69,807.This should be discounted to today’s value
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  • Depreciation and their impact in fin.A/c, fin.Mgt.,Income tax etc. By Prof.Augustin Amaladas M.Com.,AICWA.,B.ED.,PGDFM
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  • Meaning
    • Reduction in the value of fixed assets due to wear and tear and due to effluction of time.
    • All assets except land can be depreciated.
    • The underlying principle of depreciation is that cash flows generated by an asset over its life cannot be considered income until provision is made for asset’s replacement.
    • It is an allocation of past cash flows.
    • Depreciation expense appears on the income statement, but has no impact on the statement of cash flows.
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  • Depreciation methods
    • Straight line method
    • Written down value method
    • Sinking fund method
    • Machine Hour rate method
    • Unit cost method
    • Depletion asset method
    • Depreciation Fund method
    • Sum of digits method
    • Accelerated depreciation method
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  • Impact on books
    • Depreciation Expense
    • Net income
    • Asset
    • Equity
    • Return on assets
    • Return on Equity
    • Turnover Ratios
    • Cash flow
    • NPV
    • IRR
    • Pay back
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  • Impact of Tax
    • Block asset method
    • Purchase of Asset
    • Sale of Asset
    • Short term/Long-term Capital asset
    • Asset used less than 180 days during the previous year
    • Asset purchased preceding previous year but put into use less than 180 days during the current previous year
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  • Impact of Tax
    • Rate decided by whom?
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  • Inflation and Depreciation
    • If prices are rising, Incomes and taxes will be over stated / Under stated
    • Replacement?
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  • Accounting Standard
    • AS-06
    • As-10
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  • Tax planning
    • U/S-32 of IT act
    • When own funds used in plant and machinery -18.66% saving
    • When borrowed funds used –Tax savings through depreciation-22.91%
    • Depreciation on intangible assets can be provided at 25% rate. The eligible assets are: Know how, patent right, copy right,
    • Trade mark, licenses, franchises, any other commercial rights
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  • Carry forward and set of depreciation in the subsequent periods
    • Any number of years provided filed returns
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  • Amalgamation, absorption, reconstruction and demerger
    • CAN NEW CO. CARRY FORWAD AND SET OF LOSS AND DEPRECIATION?
    • SEC 72 A TO BE FULFILLED
    • ACCUMULATED LOSSES REMAIN UNABSORBED FOR 3 OR MORE YEARS
    • 75% OF BOOK VALUE TO BE HELD ATLEAST FOR 2 YEARS BEFORE AMALGAMATION
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    • THE AMALGAMATED CO. CONTINUES TO HOLD 3/4 TH OF BOOK VALUE ATLEAST FOR 5 YEARS
    • NEW CO. SHOULD CONTINUE FOR ANOTHER 5 YEARS
    • NEW CO. SHOULD ACHIEVE ATLEAST 50%OF INSTALLED CAPACITY BEFORE END OF 5 YEARS AND SHOULD CONTINUE FOR 5 YEARS
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    e-mail: aug_bang@yahoo.com www.augustin.co.nr A LTD AMALGAMATES WITH B LTD AS ON 2007
  • OTHER TAX BENEFITS
    • Expenditure on amalgamation or de-merger – allowed under sec 35DD both revenue and capital expenditure allowed
    • Expenditure on scientific research can be carried forward
    • Expenditure on acquisition of patent rights copyrights – depreciation can be provided
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  • OTHER TAX BENEFITS
    • Expenditure for obtaining license for tele-communication service can be written off
    • Preliminary expenses
    • Capital expenditure on family planning
    • Bad debts are allowed
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  • Calculation of Depreciation- continues
    • Example:1.
    • Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000
    • The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is 25% . Life is 3 years. Tax rate=30% surcharge 10% and 3% educational cess.
    • How do we calculate Capital loss? Cash Inflow at the end of third year?.
    • Short term capital loss
    • Block value at the end of 2 nd year- scrap at the end of three years
    • =Rs.2,81,750-Rs. 1,00,000
    • =Rs. 1,81,750
    • Cash Inflow at the end of third year
    • =Rs.1,00,000+(*33.90% *1,81,750)
    • = Rs.1,61,613
    • *Tax= 30%+10%(30%)+3%*33=33.99%
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  • Depreciation as per Income tax act
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Year Beginning value Depreciation 25% End value 1 2 3 5,00,000 3,75,000 2,81,750 1,25,000 93,750 No 3,75,000 2,81,750
  • owned funds Vs borrowed funds
    • If owned funds are invested in plant and machinery one can get tax saving on depreciation.
    • If assets are acquired on borrowed funds one can get tax benefit on depreciation and also tax benefit on interest.
    • The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest.
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  • Exercise-2 owned funds Vs borrowed funds
    • An assessee who carries on a business, acquires a plant and machinery costing Rs.10,00,000 in a year one. This plant is used for 5 years and will be discarded at the end of 5th year for Rs. 2,00,000.
    • Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 5 th year. Cost of Capital is 10% and rate of depreciation is 15%.
    • Required:
    • 1. Evaluate when owned funds are invested
    • 2. When 75% cost of plant is financed by deposit taken from public at the rate of 9%pa.
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    e-mail: aug_bang@yahoo.com www.augustin.co.nr year beginning Depreciation End value Tax benefit on depre discount factor present value 1 10,00,000 1,50,000 8,50,000 50,850 0.909 50,799 2 8,50,000 1,27,500 7,22,500 43,223 0.826 35,702 3 7,22,500 1,08,375 6,14,125 36,739 0.751 27,591 4 6,14 112 92119 5,22,006 31,228 0.683 21,328 5 5,22,006 Present value 0.62 1,35,420
    • Present value of scrap =*3,09,158*.620=1,91,678
    • *Scrap value=2,00,000
    • *Calculation of short term capital gain as the asset is depreciated
    • Book value at the end of 4 th year-scrap value=5,22,000-2,00,000
    • =3,22,000
    • Tax savings on STCG=3,22,000*.339
    • =*1,09,158
    • Present value on tax saving on STCG= 1,09,158*0.620=37,004=67,678
    • Net present cash out flow value
    • Initial cash out flow-Present value of tax savings on depreciation-present value of cash inflow on scrap
    • Rs.10,00,000-Rs.1,35,420-Rs.1,91,678=Rs.6,72,902
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  • Lease vs Purchase
    • Purchase with Borrowed Funds:-
    • If assets are acquired on borrowed funds one can get tax benefit on depreciation and also tax benefit on interest.
    • The actual cash out flow will be annual instalment-tax saving on depreciation-tax saving on interest.
    • Lease-
    • Deduction can be claimed in respect of lease rentals and lease management fees.
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  • Exercise-3 Lease vs Purchase
    • An assessee who carries on a business, acquires a plant and machinery costing Rs.10,00,000 in a year one. This plant is used for ten years and will be discarded at the end of ten years for Rs. 2,00,000.
    • Tax rate is 30%, surcharge is 10% and educational cess is 3%.Assume the plant is sold at the end of the 10 th year. Discounting rate is 10% and rate of depreciation is 15%.
    • Required:
    • 1. Evaluate when plant taken on lease by paying lease rental of Rs. 3,50,000 for the first five years in the beginning and 50,000 thereafter for the remaining years.
    • 2. When 75% cost of plant is financed by deposit taken from public at the rate of 9%p.a.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Purchase by instalment vs Hire
    • Purchase by instalment vs Hire
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
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    • Apologies to the ---------
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Life education
    • shoes
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Short cut techniques by using ordinary calculator.
    • Future value at 10%
    • year 1. 1.1
    • Year 2. 1.1*=
    • Year 3. 1.1*= =
    • Year 5. 1.1*= = = =
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Scientific calculator
    • Amount*1.1= for the first year
    • Amount *1.1*1.1= for the second year
    • Amount *1.1*1.1= = = = 6 th year value
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Present value by ordinary calculator
    • 1 st year 1.1/=
    • 2 nd year 1.1/= =
    • 6 rd year 1.1/= = = = = =
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • WDV value
    • 15% depreciation as per WDV
    • value at the end of 1 st year= 0.85*asset value=
    • Value at the end of 2 nd year =0 .85*asset value= =
    • Value at the end of 6 th year=0.85*asset value= = = = = =
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • The Ideal Evaluation Method should:
    • a) include all cash flows that occur during the life of the project,
    • b) consider the time value of money ,
    • c) incorporate the required rate of return on the project.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Decision-making Criteria in Capital Budgeting
    • The number of years needed to recover the initial cash outlay.
    • How long will it take for the project to generate enough cash to pay for itself?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Payback Period
    • How long will it take for the project to generate enough cash to pay for itself?
    (500) 150 150 150 150 150 150 150 150
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Payback Period 0 1 2 3 4 5 8 6 7
    • How long will it take for the project to generate enough cash to pay for itself?
    Payback period = 3.33 years.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Payback Period 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
    • Is a 3.33 year payback period good?
    • Is it acceptable?
    • Firms that use this method will compare the payback calculation to some standard set by the firm.
    • If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?
    • Accept the project .
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • Firm cutoffs are subjective .
    • Does not consider time value of money .
    • Does not consider any required rate of return .
    • Does not consider all of the project’s cash flows .
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Drawbacks of Payback Period:
    • Does not consider all of the project’s cash flows.
    (500) 150 150 150 150 150 (300) 0 0 Consider this cash flow stream!
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7
    • Does not consider all of the project’s cash flows.
    (500) 150 150 150 150 150 (300) 0 0 This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7
    • Discounts the cash flows at the firm’s required rate of return.
    • Payback period is calculated using these discounted net cash flows.
    • Problems :
    • Cutoffs are still subjective.
    • Still does not examine all cash flows.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    • 2 250 192.38
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    • 2 250 192.38 2 years
    • 88.32
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    • 2 250 192.38 2 years
    • 88.32
    • 3 250 168.75
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    • 2 250 192.38 2 years
    • 88.32
    • 3 250 168.75 .52 years
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250
    • Discounted
    • Year Cash Flow CF (14%)
    • 0 -500 -500.00
    • 1 250 219.30 1 year
    • 280.70
    • 2 250 192.38 2 years
    • 88.32
    • 3 250 168.75 .52 years
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years
    • 1) Net Present Value (NPV)
    • 2) Profitability Index (PI)
    • 3) Internal Rate of Return (IRR)
    • Each of these decision-making criteria:
    • Examines all net cash flows,
    • Considers the time value of money, and
    • Considers the required rate of return.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Other Methods
    • NPV = the total PV of the annual net cash flows - the initial outlay.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Net Present Value NPV = - IO ACF t (1 + k) t n t=1 
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Net Present Value
    • Decision Rule :
    • If NPV is positive, ACCEPT .
    • If NPV is negative, REJECT .
    • Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV Example
    • Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV Example 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
    • -276,400 CFj
    • 83,000 CFj
    • 4 shift Nj
    • 116,000 CFj
    • 15 I/YR
    • shift NPV
    • You should get NPV = 18,235.71.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the HP10B:
    • Select CFLO mode.
    • FLOW(0)=? -276,400 INPUT
    • FLOW(1)=? 83,000 INPUT
    • #TIMES(1)=1 4 INPUT
    • FLOW(2)=? 116,000 INPUT
    • #TIMES(2)=1 INPUT EXIT
    • CALC 15 I% NPV
    • You should get NPV = 18,235.71
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the HP17BII:
    • Select CF mode.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    • F01= 1 4 ENTER
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    • F01= 1 4 ENTER
    • C02=? 116,000 ENTER
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    • F01= 1 4 ENTER
    • C02=? 116,000 ENTER
    • F02= 1 ENTER
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    • F01= 1 4 ENTER
    • C02=? 116,000 ENTER
    • F02= 1 ENTER
    • NPV I= 15 ENTER CPT
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    • Select CF mode.
    • CFo=? -276,400 ENTER
    • C01=? 83,000 ENTER
    • F01= 1 4 ENTER
    • C02=? 116,000 ENTER
    • F02= 1 ENTER
    • NPV I= 15 ENTER CPT
    • You should get NPV = 18,235.71
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV with the TI BAII Plus:
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Profitability Index NPV = - IO ACF t (1 + k) t n t=1 
  • t
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Profitability Index NPV = - IO ACF t (1 + k) t n t=1  PI = IO ACF t (1 + k) n t=1 
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Profitability Index
    • Decision Rule :
    • If PI is greater than or equal to 1, ACCEPT .
    • If PI is less than 1, REJECT .
    • -276,400 CFj
    • 83,000 CFj
    • 4 shift Nj
    • 116,000 CFj
    • 15 I/YR
    • shift NPV
    • You should get NPV = 18,235.71.
    • Add back IO: + 276,400
    • Divide by IO: / 276,400 =
    • You should get PI = 1.066
    e-mail: aug_bang@yahoo.com www.augustin.co.nr PI with the HP10B:
    • IRR : the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Internal Rate of Return (IRR)
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    • Toss a coin
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Internal Rate of Return (IRR) NPV = - IO ACF t (1 + k) t n t=1 
  • n t=1 
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Internal Rate of Return (IRR) IRR: = IO ACF t (1 + IRR) t NPV = - IO ACF t (1 + k) t n t=1 
    • IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay.
    • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Internal Rate of Return (IRR) n t=1  IRR: = IO ACF t (1 + IRR) t
    • Looking again at our problem:
    • The IRR is the discount rate that makes the PV of the projected cash flows equal to the present value of outlay.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Calculating IRR 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
    • This is what we are actually doing:
    • 83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR )
    • = 276,400
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
    • This is what we are actually doing:
    • 83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR )
    • = 276,400
    • This way, we have to solve for IRR by trial and error.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000
    • IRR is easy to find with your financial calculator.
    • Just enter the cash flows as you did with the NPV problem and solve for IRR.
    • You should get IRR = 17.63%!
    e-mail: aug_bang@yahoo.com www.augustin.co.nr IRR with your Calculator
    e-mail: aug_bang@yahoo.com www.augustin.co.nr IRR
    • Decision Rule :
    • If IRR is greater than or equal to the required rate of return, ACCEPT .
    • If IRR is less than the required rate of return, REJECT .
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    (500) 200 100 (200) 400 300
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 0 1 2 3 4 5
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    (500) 200 100 (200) 400 300
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 0 1 2 3 4 5
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    • We could find 3 different IRRs!
    (500) 200 100 (200) 400 300
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 0 1 2 3 4 5 1 2 3
    • Enter the cash flows only once.
    • Find the IRR .
    • Using a discount rate of 15%, find NPV .
    • Add back IO and divide by IO to get PI .
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600
    • IRR = 34.37%.
    • Using a discount rate of 15%,
    • NPV = $510.52.
    • PI = 1.57.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600
  • NPV Profiles
    • A graphical representation of project NPVs at various different costs of capital.
    • k NPV L NPV S
    • 0 $50 $40
    • 5 33 29
    • 10 19 20
    • 15 7 12
    • 20 (4) 5
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Drawing NPV profiles
    -10 0 10 20 30 40 50 60 5 10 15 20 23.6 NPV ($) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% S L . . . . . . . . . . . e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Comparing the NPV and IRR methods
    • If projects are independent, the two methods always lead to the same accept/reject decisions.
    • If projects are mutually exclusive …
      • If k > crossover point, the two methods lead to the same decision and there is no conflict.
      • If k < crossover point, the two methods lead to different accept/reject decisions.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Finding the crossover point
    • Find cash flow differences between the projects for each year.
    • Enter these differences in CFLO register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%.
    • Can subtract S from L or vice versa, but better to have first CF negative.
    • If profiles don’t cross, one project dominates the other.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Reasons why NPV profiles cross
    • Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high k favors small projects.
    • Timing differences – the project with faster payback provides more CF in early years for reinvestment. If k is high, early CF especially good, NPV S > NPV L .
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Reinvestment rate assumptions
    • NPV method assumes CFs are reinvested at k, the opportunity cost of capital.
    • IRR method assumes CFs are reinvested at IRR.
    • Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.
    • Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Since managers prefer the IRR to the NPV method, is there a better IRR measure?
    • Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.
    • MIRR assumes cash flows are reinvested at the WACC.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Calculating MIRR
    e-mail: aug_bang@yahoo.com www.augustin.co.nr 66.0 12.1 10% 10% -100.0 10.0 60.0 80.0 0 1 2 3 10% PV outflows -100.0 $100 MIRR = 16.5% 158.1 TV inflows MIRR L = 16.5% $158.1 (1 + MIRR L ) 3 =
  • Why use MIRR versus IRR?
    • MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.
    • Managers like rate of return comparisons, and MIRR is better for this than IRR.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Project P has cash flows (in 000s): CF 0 = -$800, CF 1 = $5,000, and CF 2 = -$5,000. Find Project P’s NPV and IRR.
    • Enter CFs into calculator CFLO register.
    • Enter I/YR = 10.
    • NPV = -$386.78.
    • IRR = ERROR Why?
    e-mail: aug_bang@yahoo.com www.augustin.co.nr -800 5,000 -5,000 0 1 2 k = 10%
  • Multiple IRRs
    e-mail: aug_bang@yahoo.com www.augustin.co.nr NPV Profile 450 -800 0 400 100 IRR 2 = 400% IRR 1 = 25% k NPV
  • Why are there multiple IRRs?
    • At very low discount rates, the PV of CF 2 is large & negative, so NPV < 0.
    • At very high discount rates, the PV of both CF 1 and CF 2 are low, so CF 0 dominates and again NPV < 0.
    • In between, the discount rate hits CF 2 harder than CF 1 , so NPV > 0.
    • Result: 2 IRRs.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Solving the multiple IRR problem
    • Using a calculator
      • Enter CFs as before.
      • Store a “guess” for the IRR (try 10%)
      • 10 ■ STO
      • ■ IRR = 25% (the lower IRR)
      • Now guess a larger IRR (try 200%)
      • 200 ■ STO
      • ■ IRR = 400% (the higher IRR)
      • When there are nonnormal CFs and more than one IRR, use the MIRR.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • When to use the MIRR instead of the IRR? Accept Project P?
    • When there are nonnormal CFs and more than one IRR, use MIRR.
      • PV of outflows @ 10% = -$4,932.2314.
      • TV of inflows @ 10% = $5,500.
      • MIRR = 5.6%.
    • Do not accept Project P.
      • NPV = -$386.78 < 0.
      • MIRR = 5.6% < k = 10%.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Capital Budgeting
    • Moral:
      • Use NPV as the first step in evaluating projects.
      • If capital is in short supply, try and find the best mix of projects to take using simulation rather than use some arbitrary short-cuts (IRR etc.).
      • Look at payback period as a second step, especially if the projects are otherwise comparable (in magnitude of investment, life of cash flows). If strategic flexibility in the firm’s investment base matters, payback period is a healthy tool in spite of serious theoretical deficiencies.
      • In other words, be careful of using only NPV because cash flows in the far future are hard to predict.
    e-mail: aug_bang@yahoo.com www.augustin.co.nr
  • Life education
    • Bringing rain inside
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  • Thank You
    e-mail: aug_bang@yahoo.com www.augustin.co.nr