Financial management notes by m.riaz khan 03139533123 (1)


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Financial management notes by m.riaz khan 03139533123 (1)

  1. 1. Comprehensive Notes For Students of BBA, MBA & Prepared By: Muhammad Riaz Khan Government College of Management Sciences Peshawar Contact: +923139533123 (
  2. 2. Financial Management 2 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 ACKNOWLEDGEMENT I am very grateful to Almighty ALLAH who enabled me to complete notes on FINANCIAL MANAGEMENT. I have taken efforts for completion of these Notes. However, it would not have been possible without the kind support and help of many individuals. I would like to extend my sincere thanks to all of them. I am highly indebted to Sir Mr. Jawad Anwar (Lecturer at PIMS Peshawar) and Sir Imtiaz Ali (Lecturer at GCMS Peshawar) for their guidance and constant supervision as well as for providing necessary information regarding these notes & also for their support in completing it. I would like to express my gratitude towards my Parents & Friends for their kind co-operation and encouragement which help me in completion of these notes. My thanks and appreciations also go to my dearest colleagues Mr. Adnan Khan and Tauseef Ullah in preparing such notes who have willingly helped me out with their abilities. Muhammad Riaz Khan
  3. 3. Comprehensive Notes Financial Management COURSE OUTLINE Part – I 1. An Overview of Financial Management i) Careers in Finance ii) How are Companies Organized iii) Finance in the Organizational Structure of the Firm iv) The Goals of the Corporation v) Business Ethics and Social Responsibility vi) Agency Relationships 2. Financial Statement, Cash Flows and Taxes i) A Brief History of Accounting and Financial Statements ii) Financial Statements and Reports iii) The Balance Sheet iv) The Income Statement v) Statement of Retained Earnings vi) Net Cash Flow vii)Statement of Cash Flows viii) Modifying Accounting Data for Managerial Decisions ix) MVA and EVA x) Depreciation 3. Analysis of Financial Statements i) Ratio Analysis ii) Liquidity Ratios iii) Asset Management Ratios iv) Debt Management Ratios v) Profitability Ratios vi) Market Value Ratios vii)Trend Analysis, Common Size Analysis, and Percent Change Analysis viii) Tying the Ratios Together ix) Comparative Ratios and “Benchmarking” x) Uses and Limitations of Ratio Analysis xi) Problems with ROE xii)Looking Beyond the Numbers 4. Financial Planning and Forecasting Financial Statements i) Strategic Plans ii) Operating Plans iii) The Financial Plan iv) Computerized Financial Planning Models v) Sales Forecasts vi) Financial Statement Forecasting: The Percent of Sales Method vii)The AFN Formula viii) Forecasting Financial Requirements When the Balance Sheet Ratios Are Subject to Change ix) Other Techniques of Forecasting Financial Statements Part – II 5. The Financial Environment i) The Financial Markets ii) Financial Institutions iii) The Stock Market iv) The Cost of Money v) Interest Rate Levels vi) The Determinants of Market Interest Rates vii)The Term Structure of Interest Rates viii) What Determines the Shape of the Yield Curve? ix) Using the Yield Curve to Estimate Future Interest Rates x) Investing Overseas xi) Other Factors That Influence Interest Rate Levels xii)Interest Rates and Business Decisions 6. Risk and Return i) Investment Returns
  4. 4. Financial Management 4 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 ii) Stand-Alone Risk iii) Risk in Portfolio Context iv) Calculating Beta Coefficient v) The Relationship between Risk and Rates of Return vi) Physical Assets versus Securities vii)Some Concerns about Beta and the CPM viii) Volatility versus Risk 7. Portfolio Theory and Asset Pricing Models i) Measuring Portfolio Risk ii) Efficient Portfolios iii) Choosing the Optimal Portfolio iv) The Capital Asset Pricing Model v) The Capital Market Line and Security Market Line vi) Calculating Beta Coefficient vii)Empirical Tests of the CAPM viii) Arbitrage Pricing Theory ix) The Fama-French Three-Factor Model x) An Alternative Theory of Risk and Return: Behavioral Finance Part – III 8. The Cost of Capital i) The Weighted Average Cost of Capital ii) Cost of Debt iii) Cost of Preferred Stock iv) Cost of Common Stock v) The CAPM Approach vi) Dividend-Yield-plus-Growth Rate, or DCF Approach vii)Comparison of the CAPM, DCF, and Bond-Yield-plus-Risk- Premium Methods viii) Composite, or Weighted Average, Cost of Capital, WACC ix) Adjusting the Cost of Capital for Risk x) Estimating Project Risk xi) Using the CAPM to Estimate a Project’s Risk-Adjusted Cost of Capital xii)Techniques for Measuring Beta Risk xiii) Adjusting the Cost of Capital for Flotation Costs xiv) Some Problem Areas in Cost of Capital xv) Four Mistakes to Avoid 9. Corporate Valuation and Value- Based Management i) Overview of Corporate Valuation ii) The Corporate Valuation Model iii) Value-Based Management iv) Corporate Governance and Shareholders Wealth 10. Capital Structure Decisions i) The Target Capital Structure ii) Business and Financial Risk iii) Determining the Optimal Capital Structure iv) Capital Structure Theory v) Checklist for Capital Structure Decisions vi) Variations in Capital Structure 11. Distributions to Shareholders: Dividends and Repurchases i) Dividend versus Capital Gains ii) Dividend Policy Issues iii) Dividend Stability iv) Establishing the Dividend Policy in Practice v) Dividend Reinvestment Plans vi) Summary of Factors Influencing Dividend Policy vii)Overview of the Dividend Policy Decision viii) Stock Dividends and Stock Splits ix) Stock Repurchases Part – IV 12. Initial Public Offerings, Investment Banking, and Financial Restructuring i) The Financial Life Cycle of a Startup Company
  5. 5. Financial Management 5 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 ii) The Decision to Go Public Initial Public Offerings iii) The Process of Going Public iv) Equity Carve-Outs: A Special Type of IPO v) Non-IPO Investment Banking Activities vi) The Decision to Go Private vii)Managing the Maturity Structure of Debt viii) Zero (or Very Low) Coupon Bonds ix) Refunding Operations x) Managing the Risk Structure of Debt 13. Lease Financing i) The Two Parties to Leasing ii) Types of Leases iii) Tax Effects iv) Financial Statement Effects v) Evaluation by the Lessee vi) Evaluation by the Lessor vii)Other Issues in Lease Analysis viii) Other Reasons for Leasing 14. Current Asset Management i) Working Capital Terminology ii) Alternative Current Asset Investment Policies iii) The Cash Conversion Cycle iv) The Concept of Zero Working Capital v) Cash Management vi) The Cash Budget vii)Cash Management Techniques viii) Marketable Securities ix) Inventory x) Inventory Costs xi) Inventory Control Systems xii)Receivable Management xiii) Credit Policy xiv) Setting the Credit Period and Standards xv) Setting the Collection Policy xvi) Cash Discounts xvii) Other Factors Influencing Credit Policy 15. Short-Term Financing i) Alternative Current Asset Financing Policies ii) Advantages and Disadvantages of Short-Term Financing iii) Sources of Short-Term Financing iv) Accruals v) Accounts Payable (Trade Credit) vi) Short-Term Bank Loans vii)The Cost of Bank Loans viii) Choosing a Bank ix) Commercial Paper x) Use of Security in Short-Term Financing Recommended Text: 1. Brigham, E.F. and Ehrhardt, M.C., (2002 ), Financial Management: Theory and Practice (10th Edition), HarCourt College Publishers
  6. 6. Financial Management 6 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter#1 An Overview of Financial Management Meaning of Financial Management Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind. Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Functions of Financial Management Based on the above definition functions of the financial management can be categorized into three major categories, these are (A) Investment Decisions Investment decisions are concerned with assets. Major decisions regarding investment decisions are explained below. 1 What is the optimal firm size? It means to decide what amount of assets should be purchased in order to keep the operations of business going and also not increasing the size of the business. 2 What specific assets should be acquired? The exact asset required to maintain the operations of the business. 3 What assets (if any) should be reduced or eliminated? Any asset not contributing in the profitability of the firm should be disposed off in order to release the excess capital. (B) Financing Decisions Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet). This means to arrange funds for purchasing assets. 1 What is the best type of financing? Means either to use debt or equity. 2 What is the best financing mix? A firm normally uses a mix of debt and equity, financial manager decides the ratio of debt and equity which can increase the profitability and reduce risk. 3 What is the best dividend policy (e.g., dividend-payout ratio)? Refers to the percentage of profit to be distributed among the shareholders. 4 How will the funds be physically acquired? Means either to take loan, issue shares debentures etc.
  7. 7. Financial Management 7 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 (C) Asset Management Decisions 1 How do we manage existing assets efficiently? Efficiently means to maximize their productivity and overall contribution to profits. 2 Financial Manager has varying degrees of operating responsibility over assets. 3 Greater emphasis is made on current asset management than fixed asset management. Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be- 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders? 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate rate of return can be achieved. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. The Goals of Corporations Corporate goals are defined as those specific ambitions or quantifiable targets that are set by an organization of which it commits to so as to achieve its corporate mission and objectives. The goals must define a mark that can be specifically measured over a period of time. The Goal of Corporations refers to the maximizing of profits while managing the financial risks of the firm. This refers to the main purpose of a corporation which is to maximize shareholder value in order for the investors to gain from the corporation. This applies in capital finance where capital is raised for creating, developing, growing or acquiring businesses. Several examples of corporate goals can be used for inspiration for your own business. Profit maximization Goals reflect general statements about what the business wants to achieve. Improving profitability is a common corporate goal. The goal statement usually includes details about the business and aligns its actions with the company mission and values. For
  8. 8. Financial Management 8 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 example, actions might include developing new markets, products or services. Other examples include reducing unnecessary costs, changing suppliers or raising prices. Stated simply, the goal must be clearly understood by all employees. It must also be flexible enough. If market conditions change, the goal can be adjusted. Efficiency Corporate goals typically reflect a commitment to improve existing operations. This includes striving for excellence. It also involves producing results through effective teamwork and using technology to innovate. Successful corporate leaders realize that they have to be vigilant about reducing product errors, waste and customer dissatisfaction. Corporate goals may also specify planned methods or strategies. For example, to reduce product errors, a business might set a goal of implementing a Six Sigma initiative, a quality management technique. Expansion Increasing market share is common corporate goal. This often involves targeting new audiences, such as younger customers. Reaching out to a new demographic may also involve using new marketing techniques. For example, a small business can promote its products and services using social media technology. A company can expand its market presence by designing, developing and delivering new products. Satisfaction Corporate leaders recognize that employee satisfaction contributes to productivity. Corporate goals related to employees typically demonstrate a commitment to the workforce. Programs may include training courses, events and resources. These allow employees to develop professional skills and enhance collaboration. For example, a common goal strives to create a culture based trust and respect for all. This improves employee retention rates, reduces absenteeism and increases employee morale. Sustainability Corporate goals usually demonstrate a commitment to the community. A business has a responsibility to be an asset, not a liability. For example, a company may aspire to improve the environmental performance of the tools and technology used in its facilities, by its customers and by its suppliers. Short-term goals address today’s problems and long-term goals prepare for the future.
  9. 9. Financial Management 9 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Business Ethics and Social Responsibility What is Business Ethics? The concept has come to mean various things to various people, but generally it's coming to know what it right or wrong in the workplace and doing what's right -- this is in regard to effects of products/services and in relationships with stakeholders. Business ethics is the behavior that a business adheres to in its daily dealings with the world. The ethics of a particular business can be diverse. They apply not only to how the business interacts with the world at large, but also to their one-on-one dealings with a single customer. Many businesses have gained a bad reputation just by being in business. To some people, businesses are interested in making money, and that is the bottom line. It could be called capitalism in its purest form. Making money is not wrong in itself. It is the manner in which some businesses conduct themselves that brings up the question of ethical behavior. Good business ethics should be a part of every business. There are many factors to consider. When a company does business with another that is considered unethical, does this make the first company unethical by association? Some people would say yes, the first business has a responsibility and it is now a link in the chain of unethical businesses. Many global businesses, including most of the major brands that the public use, can be seen not to think too highly of good business ethics. Many major brands have been fined millions for breaking ethical business laws. Money is the major deciding factor Social Responsibility: Social responsibility and business ethics are often regarding as the same concepts. However, the social responsibility movement is but one aspect of the overall discipline of business ethics. The social responsibility movement arose particularly during the 1960s with increased public consciousness about the role of business in helping to cultivate and maintain highly ethical practices in society and particularly in the natural environment. Social responsibility is an ethical theory that an entity, be it an organization or individual, has an obligation to act to benefit society at large. Social responsibility is a duty every individual has to perform so as to maintain a balance between the economy and the ecosystems. Agency Relationships in Financial Management  Management acts as an agent for the owners (shareholders) of the firm.  An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf.
  10. 10. Financial Management 10 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  Agency Theory is a branch of economics relating to the behavior of principals and their agents.  Principals must provide incentives so that management acts in the principals’ best interests and then monitor results.  Incentives include stock options, perquisites, and bonuses. Shareholders and managers have divergent goals. The Shareholders goal is to maximize shareholder value while the manager's goals are Job security, Power, status, and compensation etc. Thus, managers may have the incentive to take actions that are not in the best interest of the shareholders. Because managers usually own only a small interest in most large corporations, potential agency conflicts are significant Managerial compensation: The compensation package should be designed to meet two objectives: one is to attract and retain capable managers; two is to align managers' actions with the interest of shareholders.  Performance shares: Management receives a certain number of shares if the company achieves predefined performance benchmarks.  Executive stock options: Management is granted an option to buy stock at a stated price within a specified time period. Agency Problems: Shareholders (Through Managers) Vs. Creditors: Managers are the agent of both shareholders and creditors. Shareholders empower managers to manage the firm. Creditors empower managers to use the loan. Though employed by shareholders managers work in the best interest of shareholders, They deprive creditors in two different ways,  By investing in riskier projects they maximize the profits which on turn is received by the shareholders and creditors bear only risk for them  By increasing dent the company increases leverage and in turn the risk of insolvency is increased but creditors get nothing as risk premium. To protect themselves against shareholders, creditors often include restrictive covenants in debt agreements. In the long-run, a firm that deals unfairly with creditors may impair the shareholders' interest because the firm may  lose access to the debt markets or  Be saddled with high interest rates and restrictive covenants. *End of Chapter*
  11. 11. Financial Management 11 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter#2 Financial Statements, Cash Flow and Taxes Financial Statements Definition: Summary report that shows how a firm has used the funds entrusted to it by its stockholders (shareholders) and lenders, and what is its current financial position. The three basic are the (1) balance sheet, which shows firm's assets, liabilities, and net worth on a stated date; (2) income statement (also called profit & loss account), which shows how the net income of the firm is arrived at over a stated period, and (3) cash flow statement, which shows the inflows and outflows of cash caused by the firm's activities during a stated period. Basic Financial Statements A business is a financial entity separate from its owners. Each business must keep financial records. Financial statements have generally agreed-upon formats and follow the same rules of disclosure. This puts everyone on the same level playing field, and makes it possible to compare different companies with each other, or to evaluate different year's performance within the same company. There are three main financial statements:  Income Statement  Balance Sheet  Statement of Cash Flows Each financial statement tells its own story. Together they form a comprehensive financial picture of the company, the results of its operations, its financial condition, and the sources and uses of its money. Evaluating past performance helps managers identify successful strategies, eliminate wasteful spending and budget appropriately for the future. Armed with this information they will be able to make necessary business decisions in a timely manner There are 5 types of Accounts.  Assets  Liabilities  Owners' Equity (Stockholders' Equity for a corporation)
  12. 12. Financial Management 12 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  Revenues  Expenses All the accounts in an accounting system are listed in a Chart of Accounts. They are listed in the order shown above. This helps us prepare financial statements, by conveniently organizing accounts in the same order they will be used in the financial statements. Financial Statements The Balance Sheet lists the balances in all Assets, Liability and Owners' Equity accounts. The Income Statement lists the balances in all Revenue and Expense accounts. The Balance Sheet and Income Statement must accompany each other in order to comply with GAAP. Financial statements presented separately do not comply with GAAP. This is necessary so financial statement users get a true and complete financial picture of the company. All accounts are used in one or the other statement, but not both. All accounts are used once, and only once, in the financial statements. The Balance Sheet shows account balances at a particular date. The Income Statement shows the accumulation in the Revenue and Expense accounts, for a given period of time, generally one year. The Income Statement can be prepared for any span of time, and companies often prepare them monthly or quarterly. It is common for companies to prepare a Statement of Retained Earnings or a Statement of Owners' Equity, but one of these statements is not required by GAAP. These statements provide a link between the Income Statement and the Balance Sheet. They also reconcile the Owners' Equity or Retained Earnings account from the start to the end of the year.
  13. 13. Financial Management 13 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 The Statement of Cash Flows is the third financial statement required by GAAP, for full disclosure. The Cash Flow statement shows the inflows and outflows of Cash over a period of time, usually one year. The time period will coincide with the Income Statement. In fact, account balances are not used in the Cash Flow statement. The accounts are analyzed to determine the Sources (inflows) and Uses (outflows) of cash over a period of time. There are 3 types of cash flow (CF): Operating - CF generated by normal business operations Investing - CF from buying/selling assets: buildings, real estate, investment portfolios, equipment. Financing - CF from investors or long-term creditors The SEC (Securities and Exchange Commission) requires companies to follow GAAP in their financial statements. That doesn't mean companies do what they are supposed to do. Enron executives had millions of reasons ($$) to falsify financial information for their own personal gain. Auditors are independent CPAs hired by companies to determine whether the rules of GAAP and full disclosure are being followed in their financial statements. In the case of Enron and Arthur Andersen, auditors sometimes fail to find problems that exist, and in some cases might have also failed in their responsibilities as accounting professionals. Retained Earnings The Retained Earnings (RE) account has a special purpose. It is used to accumulate the company's earnings, and to pay out dividends to the company's stockholders. Let's look at the first part of that for a moment. At the end of the fiscal year, all Revenue and Expense accounts are closed to Income Summary, and that account is closed to Retained Earnings. Profits increase RE; losses will decrease RE. So the RE account might go up or down from year to year, depending on whether the company had a profit or loss that year. The changes in the RE accounts are called "Changes in Retained Earnings" and are presented in the financial statements. This information can be included in the Income Statement, in the Balance Sheet, or in a separate statement called the Statement of Changes in Retained Earnings. Each company can decide how to present the information, but it must be presented in one of those three places. Most financial statements today include a Statement of Retained Earnings. Some companies prepare a Statement of Stockholders' Equity to give a more comprehensive picture of their financial events. This statement includes information about how many
  14. 14. Financial Management 14 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 shares of stock were outstanding over the year, and provides other valuable information for large companies with a complex capital structure. The changes in RE are included in the Stockholders' Equity statement. Net Cash Flow: Net cash flow refers to the difference between a company's cash inflows and outflows in a given period. In the strictest sense, net cash flow refers to the change in a company's cash balance as detailed on its cash flow statement. How it works/Example: Net cash flow is also known as the "change in cash and cash equivalents." It is very important to note that net cash flow is not the same as net income, free cash flow, or EBITDA. You can approximate a company's net cash flow by looking at the period-over- period change in cash on the balance sheet. However, the statement of cash flows is a more insightful place to look. Net cash flow is the sum of cash flow from operations (CFO), cash flow from investing (CFI), and cash flow from financing (CFF). Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as presented by Yahoo! Finance. At the bottom of the cash flow statement, we see that the change in cash and cash equivalents is calculated to be $632 million. This means that when the cash flow from operations, cash flow from investing, and cash flow from financing is added up, Wal-Mart added $632 million to its cash balance in 2010.
  15. 15. Financial Management 15 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Dividends Dividends are payments companies make to their stockholders. These must be made from earnings. Since we record accumulated earnings in the RE account, all dividends must come out of that account. There are several types of dividends, but they all must come from Retained Earnings. In order to pay dividends, the RE account MUST have a positive, or Credit, balance. If the RE account has a Debit balance, we would call that a Deficit, and the company would not be able to pay dividends to its stockholders. Deficits arise from successive years of posting losses in excess of profits. Market Value Added (MVA)  Market value added represents the difference in the total value of the firm and the total capital supplied by the investors.  MVA measures the performance of the managers from the creation of the company till current year, because it compares the par value of share with the current market value means the total increase in the firm share till date.  Share holders wealth is maximized by maximizing the difference in market value of the stock and the amount of wealth supplied by the shareholders. MVA = Market value of stock – Equity capital supplied by shareholders. Or = (Shares outstanding) (Stock Price – Total Common Equity Or MVA = Total Market value – Total investor supplied capital  Greater the market value more efficiency and more profitable the firm is Economic Value Added (EVA)  Economic value added is the difference between after tax profits of the firm and the total dollar cost of capital. EVA is the value created by the management due to profitable operations of the business.  Economic value added measures the firm efficiency in the current year only that how much the firm earned more than its cost of capital EVA = NOPAT – Cost of capital required for operations EVA = (Operating capital) (ROIC – WACC) Where ROIC is Return on invested capital and WACC is the weighted average cost of capital And NOPAT is net operating profit after tax  Positive EVA means firm is generating more profit than its cost and additional investment will increase the value of the firm
  16. 16. Financial Management 16 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  The EVA shows the true economic profit of the business greater the value more profitable the firm is. Free Cash flows  Free cash flow is the amount of cash remaining after the company makes investment in assets that are necessary for the firms operations, or the cash which is left over from the investment in assets.  In other words free cash flow is the amount of cash available for distribution to all investors that is shareholders and debt holders.  So the value of the company is directly related to the amount of free cash flow generated Uses of free cash flow Following are the uses of free cash flows 1. To pay interest to debt holders 2. To repay or redeem bonds 3. Pay dividend to shareholders 4. To repurchase some of its stock 5. Buy short term investments Calculating free cash flows Free cash flows can be calculated using the following equations FCF = NOPAT – Net investment in operating assets Where net investment in operating assets means net increase in both current and fixed assets Or FCF = Operating cash flow – Gross investment in operating capital Where Operating cash flow = NOPAT + Depreciation And Gross investment in operating capital = Net investment in operating assets + Depreciation What Is Depreciation? Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources - such as minerals, timber and oil reserves - its called depletion. End of Chapter
  17. 17. Financial Management 17 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter#3 Financial Statement Analysis Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports. Reasons for Analysis Financial statements analysis may be carried out by either internal or external users. What do internal users use it for? Internal users (Management) analyze financial statements for the following reasons. • Evaluating the financial statements • Planning according to the past performance. • And controlling company operations What do external users use it for? • To check long term solvency for Investment decisions • Creditors to check the liquidity for Credit decisions • Investors for Valuation for investment decisions. • Government for regulations and tax purposes. Advantages of financial statement analysis The different advantages of financial statement analysis are listed below:  The most important benefit if financial statement analysis is that it provides an idea to the investors about deciding on investing their funds in a particular company.  Another advantage of financial statement analysis is that regulatory authorities like IASB can ensure the company following the required accounting standards.  Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm.  Above all, the company is able to analyze its own performance over a specific time period.
  18. 18. Financial Management 18 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Ratio Analysis Quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items in financial statements like the balance sheet, income statement and cash flow statement; the ratios of one item – or a combination of items - to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. Ratio analysis can be made by • Comparing one company to another • Comparing one year with another year of the same company • Comparing one company with the industry Following are the different categories of financial ratios. (A)Liquidity: Can we make required payments as they fall due? (B) Asset management: Do we have the right amount of assets for the level of sales? (C)Debt management: Do we have the right mix of debt and equity? (D)Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? (E) Market value: Do investors like what they see as reflected in P/E and M/B ratios? These ratios are now explained below (A) Liquidity Ratios. • Liquidity ratios measure the ability of the company that whether it can pay its short term obligations or not. • This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities. • In general, the greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations. • Short term creditors and suppliers are more interested in these ratios. Liquidity ratios can be measured using two ratios these are 1 Current ratio 2 Quick/ liquid. Acid test ratio Current Ratio  The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.
  19. 19. Financial Management 19 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes).  In theory, the higher the current ratio, the better. the company liquidity is Formula Shows that the company has 2.6 of current assets to pay off 1 re of current liability. Quick ratio • Quick ratio compares quick assets with current liabilities. • It further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. • The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. • Therefore, a higher ratio means a more liquid current position. Formula Quick Ratio = Quick Asset/ Current Liabilities Or It shows that company have 1.3 of quick assets to pay current liabilities of Re 1 (B) Asset Management Ratios Asset Management Ratios attempt to measure the firm's success in managing its assets to generate sales. These ratios shows that how efficiently a company is using their assets Following are the asset management ratios.
  20. 20. Financial Management 20 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Inventory Turnover Ratio • The Inventory Turnover and Days' Inventory Ratios measure the firm's management of its Inventory. • Inventory turnover means the speed through which old inventory is replaced with new one. • In general, a higher Inventory Turnover Ratio is indicative of better performance since this indicates that the firm's inventories are being sold more quickly. Formula Sales/ inventory 300000/50000 = 6 times Which shows that we the company’s old inventory is replaced 6 times annually Receivable management ratio- The days of sales outstanding Ratio • Days of sales outstanding also called the average collection period refers to the days in which account receivables are collected. • This ratio measures the ability of an organization that how efficiently company is their credit sales and receivables • it shows the days during which money is tied up due to credit sales • More quickly the debts are recovered more fund will be available for the organization and hence will show efficiency Formula DSO (in times) = Sales/receivables DSO (in days) = receivables/ average daily sales Or = receivables * 365/ annual sales = 20000 * 365/ 200000 = 36.5 days Shows that it takes 36.5 days for an average debtor to be collected Fixed assets turnover Ratio • This ratio shows that how efficiently the firm uses their fixed assets. • Greater the fixed assets turnover greater is their efficiency. Formula Sales/Net fixed Assets
  21. 21. Financial Management 21 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Total Assets Turnover ratio • Shows the turnover of total assets with respect of sales. • Shows the efficiency of total assets, that how much of revenue is generated by total assets • Greater turnover shows that assets produce greater sales with respect to their value. Formula Sales/ Total Assets (C) Debt Management Ratio • Debt management ratios show how the firm is financed and how better the firm van pay their long term debt and interest payment. • Investors, creditors and banks are often interested in calculating these ratios • Three important debt management ratios are Total Liabilities to total assets ratio • This ratio compares total liabilities of the firm with total assets • Shows the percentage of assets purchased by taking liabilities • Higher the ratio greater will be the leverage, which shows that most of the assets are financed through debt. • If most assets are financed through debt solvency risk will be high and will be less attractive for investors and long term creditors. Formula Total liabilities/ Total assets = 150,000/250,000 = 0.6 or 60% Which means that 60% of the assets are financed through liabilities? Times Interest earned Ratio • Shows the firm’s ability that whether the firm can pay their fixed interest charges or not? In other words it compares the firm’s profits with fixed interest charges, • Banks and other financial institutes which grant loan to the organization are interested in this ratio. • This ratio shows that what amount of profit is available for payment of one dollar of interest, greater the ratio more profit is available, better is the ability to service debt Formula
  22. 22. Financial Management 22 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 = 200000/10000 =20 Which means that the company has 20 Rs of profit to pay I Re of interest? Earnings before interest tax depreciation and amortization (EBITDA) Ratio  Interest coverage ratio does not fully explain the firm’s ability to service debt because interest is not the only payment which a company makes but it also has to pay some portion of its loan and also lease payment  Similarly EBIT is not the total cash available for all these payments  EBITDA is used to find the amount of free cash flow available for payment of interest, repayment of principle amount and also lease installment.  Greater the ratio means more free cash is available for payment of the above payments. Formula: NPBITDA + Lease payments/Interest expense Principle Payment Lease payment (D) Profitability ratios  These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.  The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders. Profit margin to sales  Profit margin to sales compares net profit available to shareholders for distribution with sales.  Net profit available for shareholders is the absolute profit from which all types of expenses, taxes and preference dividend has been deducted  To a large degree, it is the quality, and growth, of a company's earnings that drive its stock price.  Theatrically greater the profit margin ratio greater will be the performance of the business, or more profitable the business is. Formulas: Net profit margin ratio = Profit available for shareholders/ sales Basic Earning Power Ratio  This ratio shows the basic or raw earning capacity of the assets of the business
  23. 23. Financial Management 23 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  This ratio is calculated by taking EBIT (earnings before interest and tax), which shows that tax effects and interest is not taken into consideration. Formula Basic Earning power = EBIT/ Total Assets Return on Total Assets  Return on total assets is calculated by comparing Net profit available for shareholders with total assets  This ratio shows the final earning power and final earning capacity of the business  Greater the ratio more profitable the business is and more efficiently the business is utilizing its resources Formula Return on Total assets = Net profit available for shareholders/ Total asset Return on Equity:  This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity.  The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company.  The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors. Formula: (E) Market Value Ratios Market Value Ratios relate an observable market value, the stock price, to book values obtained from the firm's financial statements. Price-Earnings Ratio (P/E Ratio)  The Price-Earnings Ratio is calculated by dividing the current market price per share of the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net income by the number of shares outstanding.)  The P/E Ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are willing to pay a high price for a dollar of current earnings obviously expect high earnings in the future.)
  24. 24. Financial Management 24 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  In this manner, the P/E Ratio also indicates how expensive a particular stock is. This ratio is not meaningful, however, if the firm has very little or negative earnings. Where Market-to-Book Ratio  The Market-to-Book Ratio relates the firm's market value per share to its book value per share.  This shows the amount of money an investor is willing to pay to get 1 rupee ownership in that company  Since a firm's book value reflects historical cost accounting, this ratio indicates management's success in creating value for its stockholders.  Greater the ratio more interested the investors are in your company and will show greater growth in the shares. Where Book value per share = Total equity/ total outstandding shares, Retention Ratio: The proportion of earnings kept back in the business as retained earnings. The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of earnings paid out to shareholders as dividends. On a per-share basis, the retention ratio can be expressed as (1 – Dividends per share / EPS).
  25. 25. Financial Management 25 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 The retention ratio is 100% for companies that do not pay dividends, and is zero for companies that pay out their entire net income as dividends. Also known as “plowback ratio.” Trend Analysis, Common Size Analysis and Percent Change Analysis Trend Analysis Trend analysis Is one of the tools for the analysis of the company’s monetary statements for the investment purposes. Investors use this analysis tool a lot in order to determine the financial position of the business. In a trend analysis, the financial statements of the company are compared with each other for the several years after converting them in the percentage. In the trend analysis, the sales of each year from the 2008 to 2011 will be converted into percentage form in order to compare them with each other. In order to convert the figures into percentages for the comparison purposes, the percentages are calculated in the following way: Trend analysis percentage = (figure of the previous period – figure of the current period)/total of both figures The percentage can be found this way and if the current-year percentages were greater than previous year percentage, this would mean that current-year result is better than the previous year result. Common‐Size Analysis Common‐size analysis (also called vertical analysis) expresses each line item on a single year's financial statement as a percent of one line item, which is referred to as a base amount. The base amount for the balance sheet is usually total assets (which is the same number as total liabilities plus stockholders' equity), and for the income statement it is usually net sales or revenues. By comparing two or more years of common‐size statements, changes in the mixture of assets, liabilities, and equity become evident. On the income statement, changes in the mix of revenues and in the spending for different types of expenses can be identified. Percentage Change Analysis A percent change analysis shows how two items changed as a percentage from one period to another period. Used on a balance sheet, a percent change analysis shows how a balance sheet account changes from year to year, or quarter to quarter. The balance sheet accounts are assets,
  26. 26. Financial Management 26 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 liabilities and stockholders' equity. Percent change analysis is important for managers and investors to see how a company is growing or retracting from year-to-year. DuPont Analysis: DuPont analysis is an extended analysis of a company's return on equity. It concludes that a company can earn a high return on equity if: 1. It earns a high net profit margin; 2. It uses its assets effectively to generate more sales; and/or 3. It has a high financial leverage Formula According to DuPont analysis: Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage Return on Equity = Net Income × Sales × Total Assets Sales Total Assets Total Equity Analysis DuPont equation provides a broader picture of the return the company is earning on its equity. It tells where a company's strength lies and where there is a room for improvement. DuPont equation could be further extended by breaking up net profit margin into EBIT margin, tax burden and interest burden. This five-factor analysis provides an even deeper insight. ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage Return on Equity = EBIT × EBT × Net Income × Sales × Total Assets Sales EBIT EBT Total Assets Total Equity *End of Chapter*
  27. 27. Financial Management 27 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter#4 Financial Planning and Forecasting Financial Statements Financial Planning - Definition, Objectives and Importance Definition of Financial Planning Financial Planning is the process of estimating the capital required and determining its competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Objectives of Financial Planning Financial Planning has got many objectives to look forward to: a. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements. b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term. c. Framing financial policies with regards to cash control, lending, borrowings, etc. d. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment. Importance of Financial Planning Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as- 1. Adequate funds have to be ensured. 2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. 3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning. 4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company.
  28. 28. Financial Management 28 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. 6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability and profitability in concern. Forecasting Financial Statements Introduction: Financial Forecasting describes the process by which firms think about and prepare for the future. The forecasting process provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assists the firm in identifying the asset requirements and needs for external financing. For example, the principal driver of the forecasting process is generally the sales forecast. Since most Balance Sheet and Income Statement accounts are related to sales, the forecasting process can help the firm assess the increase in Current and Fixed Assets which will be needed to support the forecasted sales level. Similarly, the external financing which will be needed to pay for the forecasted increase in assets can be determined. Strategic Planning: Strategic planning provides the vision, direction and goals for the business. Strategic planning is an organization's process of defining its strategy, or direction, and making decisions about allocating resources to pursue this strategy. In order to determine the direction of the organization, it is necessary to understand its current position and the possible avenues through which it can pursue a particular course of action. A financial forecast is an estimate of future financial outcomes for a company. Using historical internal accounting and sales data, in addition to external market and economic indicators, a financial forecast is an economist's best guess of what will happen to a company in financial terms over a given time period—which is usually one year. Operating Plans: Operational planning is a subset of strategic work planning which describes short- term ways of achieving milestones and explains how. The strategic plan will be put into operation during a given operational period. An operational plan draws directly from agency and program strategic plans to describe agency and program missions and goals, program objectives, and program activities. Like a strategic plan, an operational plan addresses four questions:  Where are we now?  Where do we want to be?
  29. 29. Financial Management 29 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123  How do we get there?  How do we measure our progress? The Financial Plans: Financial planning is the process of meeting your life goals through the proper management of your finances. Life goals can include buying a home, saving for your child’s education or planning for retirement. The financial planning process involves the following steps:  Gathering relevant financial information  Setting life goals  Examining your current financial status  Coming up with a financial strategy or plan for how you can meet your goals  Implementing the financial plan  Monitoring the success of the financial plan, adjusting it if necessary Using these steps, you can determine where you are now and what you may need in the future in order to reach your goals. Financial planning is a systematic approach whereby the financial planner helps the customer to maximize his existing financial resources by utilizing financial tools to achieve his financial goals. Financial planning is simple mathematics. There are 3 major components:  Financial Resources (FR)  Financial Tools (FT)  Financial Goals (FG) When you want to maximize your existing financial resources by using various financial tools to achieve your financial goals, which is financial planning. Financial Planning: FR + FT = FG Computerized Financial Planning Model: The financial plan describes the practice's financial strategy, projects the strategy's future effect on the practice, and establishes goals by which the practice's manager can measure subsequent performance. The act of putting together a financial plan is called the financial planning process. It is a process that consists of analyzing the practice; projecting future outcomes of decisions that have to be made regarding finances, investments, and day to day operations; deciding which alternatives to undertake; and measuring performance against goals that are established in the financial plan. Computer financial planning models can aid the practice manager in projecting future outcomes of various financial, investment, and operational decisions. These models can be created inexpensively by non-computer programmers with the aid of computer software on the market today. The financial planning process for a hypothetical
  30. 30. Financial Management 30 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 practice was summarized, and the financial model used to test out various alternatives available to the practice was described Sales Forecasts: Sales forecasting is estimating what a company's future sales are likely to be based on sales records as well as market research. The information used in them must be well organized and may include information on the competition and statistics that affect the businesses' customer base. Companies try to forecast sales in hopes of identifying patterns so that revenue and cash flow can be maximized. Before the forecasting process begins, marketing, sales, or other managers should determine how far ahead the estimate should be done. Short-term forecasting is a maximum of three months and is often effective for analyzing budgets and markets. Intermediate forecasting is between a period of three months and two years and may be used for schedules, inventory and production. Long-term forecasting is for a minimum of two years and is good for dealing with growth into new markets or new products. Sales forecasts should be conducted regularly and all results need to be measured so that future methods can be adjusted if necessary. Basically, sales forecasting is analyzing all parts of a business from total inventory to the strengths and weaknesses of salespeople. Managers must think about changes in customer sales or other changes that could affect the estimated figures. They must be competitive when assessing the competition and how they can surpass others in the marketplace to better meet the needs of the target market. Financial Statement Forecasting Methods To forecast financial data, corporate leadership and department heads rely on various methods and tools. These include appraisal methodologies, such as vertical and horizontal analyses, as well as financial ratios, such as net profit margin and return on equity. Forecasted financial information is also known as pro forma or projected accounting information. Following are some methods of forecasting Financial Statements Statistical Forecasting  Statistical forecasting enables department heads to project financial statements based on assumptions and internally derived factors. For example, supervisors may review the state of the economy and take government-published GDP metrics to estimate how much the company might grow sales in the future -- say, in one, two or 10 years. Gross domestic product, or GDP, is the total market value of goods and services produced within a nation's borders during a given period.
  31. 31. Financial Management 31 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Ratio Method  In ratio analysis, a company uses previously calculated metrics to forecast financial statement data. Financial ratios indicate everything from efficiency and profitability to solvency and liquidity. Examples include net profit margin, asset-turnover ratio and return on equity, or ROE. A company may, for example, forecast income data for each of the next five years by multiplying current-year sales by the current-year ROE. The firm then may adjust the final number by including material cost and labor expense projections. Vertical Method  Vertical analysis means a company sets a financial statement item as a numerical standard and compares other items with the benchmark. For example, a company may set total sales as the benchmark for income statement forecasts. The business then may calculate that material costs amounted to a certain percentage -- say, 50 percent -- of total sales over the last 12 months. Using this proportion, accountants may extrapolate by setting material costs at 50 percent of total sales for the next five years. Horizontal Method  In horizontal analysis, the goal is to review financial data year over year, giving analytical prominence to the study of historical information. For example, a business may analyze its sales data over a five-year period and determine that the average revenue-growth rate is 11 percent. The organization then may use the same number to forecast that sales will grow 11 percent for each of the next five or 10 years. *End of Chapter*
  32. 32. Financial Management 32 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter#5 Financial Environment Introduction: Financial environment is the outcome of a range of functions of the economy on all financial outcomes of an area or a country. It includes forex markets, bond markets, stock markets and commodity markets. Financial Markets  A market is a venue where goods and services are exchanged.  A financial market is a place where individuals and organizations wanting to borrow funds/capital are brought together with those having a surplus of funds. Types of Financial markets: Some Financial markets are as follows 1-Real/tangible/Physical assets Markets and Financial Asset Market Real assets are tangible assets that determine the productive capacity of an economy, that is, the goods and services its members can create. These include land, buildings, machines, and knowledge that can be used to produce goods and services. Other common examples of investments in Real Assets are paintings, antiques, precious metals and stones, classic cars etc. While Financial Asset Market refers to that market where financial assets are dealt. Financial Assets, (Assets in the form of paper) or more commonly known as Securities, include stocks, bonds, unit trusts etc. In essence, financial assets or securities represent legal claim on future financial benefits. 2-Spot Markets and Future Markets: The spot market is where securities (e.g. shares, bonds, funds, warrants and structured products) and goods (e.g. commodities) are traded. In spot market goods are delivered on the same day or within a few days In other words, the transaction takes place immediately or within a short period of time (T+3; transactions are usually settled three working days after they take place). Future market transactions are transactions in which the price, number and delivery date of the traded securities are agreed when the transaction is concluded but
  33. 33. Financial Management 33 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 delivery and payment take place at a future time. Usually, the term "forward transaction" is used if the time period is three days or more. 3-Money Market and Capital Market The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. A capital market is one in which individuals and institutions trade those securities and instruments whose maturity is more than one year. 4-Primary Market and Secondary market The primary market is where securities are created. It's in this market that firms sell new stocks and bonds to the public for the first time. Or the market in which new shares are issued The secondary market is that market in which second hand shares and bonds are traded. Stock exchange is the market in which one investor buys 3nd hand shares from another investor 5-Private and Public Markets: A private market, also known as the private market sector, is the part of a nation's economy that is not controlled by the government. It is operated by individuals and firms with the aim of making profits. It is the complete opposite of a public sector which is operated by the government with the aim of providing goods and services. Financial Institutions Financial institutions are the organizations that are involved in providing various types of financial services to their customers. Examples of financial institutions include; Banks, Credit Unions, Asset Management Firms, Insurance companies and pension funds among others. Following are some financial institutions: 1-Commercial Banks This is a financial institution providing services for businesses, organizations and individuals. Services include offering current, deposit and saving accounts as well as giving out loans to businesses. Commercial banks are defined as a bank whose main business is deposit-taking and making loans. 2-Savings and Loan Associations
  34. 34. Financial Management 34 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 A savings and loan association (S&L) is a financial institution that specializes in savings deposits and mortgage loans, and has become one of the primary sources of mortgage loans for homebuyers today. It offers mortgage services to people from the savings and deposits received from private investors. 3-Mutual Savings Bank: A Mutual Savings Bank is a financial establishment which is licensed through a centralized or state government and provides individuals with a secure place to invest in mortgages, credit, stocks and other securities. It is owned and operated by the depositors. 4-Credit union: This is a mutual financial organization formed and managed by a group of people with a common affiliation, such as employees of a company or a trade union. When you deposit money into a credit union, you become a member and a partial owner. 5-Insurance Companies: These are corporate entities that insure people against loss. The client pays a fee, known as a premium, in exchange for the promise of the company to protect the client financially in the event of certain potential misfortunes. The different t types of insurance include life, Vehicle, health, liability and homeowners. 6-Investment Banks: Unlike commercial banks, investment banks do not take deposits. Their focus is assisting individuals, corporations, and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions. 7-Mutual Fund Companies: Sometimes called investment companies, these are companies that pool money from many investors to purchase securities. Each fund invests in a different group of securities for the investors. They serve the general public. The Stock Exchange or Stock Market “Stock exchanges are privately organized markets which are used to facilitate trading in securities.” Stock Exchange (also called Stock Market or Share Market) is one important constituent of capital market Stock Exchange is an organized market for the purchase and
  35. 35. Financial Management 35 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations. It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country. Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange and bonds and debentures issued by government, public corporations and municipal and port trust bodies. Over-the-counter (OTC) A decentralized market, without a central physical location, where market participants trade with one another through various communication modes such as the telephone, email and proprietary electronic trading systems. An over-the-counter (OTC) market and an exchange market are the two basic ways of organizing financial markets. In an OTC market, dealers act as market makers by quoting prices at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges and are also subject to fewer regulations. What are the Bid-ask spread? The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. For example, if the bid price is $20 and the ask price is $21 then the "bid-ask spread" is $1. The Cost of Money: Concept of the Cost of Money The cost of money refers to the price paid for using the money, whether borrowed or owned. In other words the cost of money is the expectation of investor from investing or lending money every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of
  36. 36. Financial Management 36 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below: Factors Affecting the Cost of Money 1. Production Opportunities Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money. 2. Time Preference for Consumption Time preference for consumption refers to the preference of consumers for current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer to consume in current period or in future period. If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa. 3. Risk Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase. 4. Inflation Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increase in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation. Interest Rate Levels What is interest rate? Interest rate is the rate of interest charged for the amount of money borrowed. Banks or lending institutions usually have general guidelines for the rate they intend to charge. Money borrowed by the bank on short term basis (such as overdraft facility) or long term basis (debentures, mortgages or bank loans) has different interest rate.
  37. 37. Financial Management 37 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 These are factors that influence the level of market interest rates: Expected levels of inflation: Over time, as the cost of products and services increase, the value of money decreases. Consumer will therefore have to spend more money for the same products or services which had cost less in the previous year. As for finance lending sector, borrowers may find it is attractive to borrow now but less attractive for lender. The value of money now has fallen as compared to the time when they lent their money. In order to compensate this loss, lenders have to increase the interest rate. Demand and supply of money: Demand and supply of money can affect interest rates. In United States, The Federal Reserve Bank has taken a step to manipulate money supply through an open market operation, by purchasing large volumes of government security to increase money supply, thus reduce the interest rates, or sell large volumes of government security to reduce money supply which will subsequently increase interest rates. On the other hand, liquidity preference theory is linked to demand of money. Developed by John Keynes, this theory explains how demand and supply for money influence interest rates. It states that demand for liquidity is determined by transaction, precaution and speculation motives. Monetary policy and intervention by the government: One of the government’s strategies to control the flow of money within its consumers is by monetary policy. People will avoid borrowing money when the interest rates are high. This in turn will reduce the money outflow and affect the country’s revenue as consumers will not be spending unless it is necessary. In order to stimulate growth, government may offer lower interest rates on borrowing which subsequently attracts consumer to spend more borrowing. As a result, when the growth rate increases rapidly to the extent that economy may face overheat problem, the government then have to curb this by imposing higher interest rates. General economic conditions: Economic condition may face series its booms and slumps. The world economy has been on the slump side since the past five years with many business closures. Banks are unable to provide loan at lower rate as they have to cover their cost. Apart from the above, other factors such as political and financial stability and investors’ demand for debt securities also affect interest rates. While increase in interest rates helps consumer to save more, it is not good news for lenders and business as they lose their revenue. Globally, this also adversely affects the world economy.
  38. 38. Financial Management 38 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Determinants of market interest rates The explanation of these determinants of interest rates is given as under: Risk Free Interest Rate (kRF=k*+IP) Risk free rate is one of the determinants of the interest rate. Risk free rate means the rate of interest received if no risk is taken. Factually speaking, there is no such thing as a risk-free rate of return because no investment can be entirely risk-free. All the investments and securities include a certain amount of risk. A company may go bankrupt or close down. However, if we talk about the relevant risk involved in different securities, the government-issued securities are considered as risk-free, since the chances of default of a government are minimal. These government issued securities provide a benchmark for the determination of interest rates. Internationally the US T-Bills are considered as risk free rate of return. In Pakistan, Government of Pakistan T-Bills can be used as a proxy for risk free rate of return, however, since Pakistan faces some sovereign risk, the T-bills would not be considered entirely risk-free in the true sense. Inflation (g): The expected average inflation over the life of the investment or security is usually inculcated in the nominal interest rate by the issuer of security to cover the inflation risk. For instance, consider a bond with a maturity of 5 years. If the inflation rate in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the investors would not be willing to invest in the bond since the gains from the interest rate would be exactly offset by the inflate ion rate which is actually eroding the wealth of the investor. To secure the investor against inflation the issuers, while quoting nominal interest rates, add the rate of inflation to the real interest rate. Default Risk Premium (DR): Default risk refers to the risk that the company might go bankrupt or close down & bonds, or shares issued by the company may collapse. Default Risk Premium is charged by the investor, as compensation, against the risk that the company might goes bankrupt. Companies may also default on interest payments, something not very unusual in the corporate world. In USA, rating agencies like Moody’s and S&P grade securities (debt and equity instruments) according to their financial health and thus identify those companies which have a good ability to pay off their principal lending and interest charges and those which might default on the payments.
  39. 39. Financial Management 39 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Maturity Risk Premium (MRP): The maturity risk premium is linked to the life of that security. For example, if you purchase the long term Federal Investment Bonds issued by the government of Pakistan, you are assuming certain risk, because changes in the rates of inflation or interest rates would depreciate the value of your investment. These changes are more likely in the long term and less likely in the short term. Maturity risk Premium is linked to life of the investment. The longer the maturity period, the higher the maturity risk premium. Sovereign Risk Premium (SR): Sovereign Risk refers to the risk of government default on debt because of political or economic turmoil, war, prolonged budget and trade deficits. This risk is also linked to foreign exchange (F/x), depreciation, and devaluation. Now-a-days the individuals as well as institutions are investing billions of rupees globally. If a bank wants to invest in Pakistan, it will have to take view of Pakistan’s political, economic, and financial environment. If the bank sees some risk involved it would be willing to lend at a higher interest rate. The interest rate would be high since the bank would add sovereign risk premium to the interest rate. Here it may be clarified that Pakistan is not considered as risky as many other countries of Africa and South America. Liquidity Preference (LP): Investor psychology is such that they prefer easily encashable securities. Moreover, they charge the borrower for forgoing their liquidity. A higher liquidity preference would always push the interest rates upwards. So summing up Quoted interest rate=k=k*+IP+DRP+LP+MRP The above relation includes all the above factors. The Term Structure of Interest Rates The relationship between interest rates or bond yields and different terms or maturities. The term structure of interest rates is also known as a yield curve and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.
  40. 40. Financial Management 40 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 In general terms, yields increase in line with maturity, giving rise to an upward sloping yield curve or a "normal yield curve." One basic explanation for this phenomenon is that lenders demand higher interest rates for longer-term loans as compensation for the greater risk associated with them, in comparison to short-term loans. Occasionally, long- term yields may fall below short-term yields, creating an "inverted yield curve" that is generally regarded as a harbinger of recession. What determines the shape of the yield curve? The yield curve, also known as the "term structure of interest rates," is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. (Note that the chart does not plot coupon rates against a range of maturities -- that's called a spot curve.) How it works/Example: The yield curve shows the various yields that are currently being offered on bonds of different maturities. It enables investors at a quick glance to compare the yields offered by short-term, medium-term and long-term bonds. The yield curve can take three primary shapes. If short-term yields are lower than long- term yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve. Below you'll find an example of a normal yield curve: If short-term yields are higher than long-term yields (the line is sloping downwards), then the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an example of an inverted yield curve:
  41. 41. Financial Management 41 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Finally, a flat yield curve exists when there is little or no difference between short- and long-term yields. Below you'll find an example of a flat yield curve: It is important that only bonds of similar risk are plotted on the same yield curve. The most common type of yield curve plots Treasury securities because they are considered risk-free and are thus a benchmark for determining the yield on other types of debt. The shape of the yield curve changes over time. Investors who are able to predict how the yield curve will change can invest accordingly and take advantage of the corresponding change in bond prices. Yield curves are calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions. *End of Chapter*
  42. 42. Financial Management 42 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Chapter # 06 Risk and Return What is Risk? The probability or threat of quantifiable damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action. In Finance: The probability that an actual return on an investment will be lower than the expected return. Financial risk can be divided into the following categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk, Political risk, Refinancing risk, risk, Settlement, Sovereign risk, and Underwriting risk. What Are the Different Types of Risk? *Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk. *Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect you from unsystematic risk. Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds. Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign- exchange risk applies to all financial instruments that are in a currency other than your domestic currency.
  43. 43. Financial Management 43 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment. Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the day-to-day fluctuation in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Investment Return: A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio. The rate of return on an investment can be calculated as follows: In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken. Return on investment, or ROI, is the most common profitability ratio. There are several ways to determine ROI, but the most frequently used method is to divide net profit by total assets. So if your net profit is $100,000 and your total assets are $300,000, your ROI would be .33 or 33 percent. Return on investment isn't necessarily the same as profit. ROI deals with the money you invest in the company and the return you realize on that money based on the net profit of the business. Profit, on the other hand, measures the performance of the business. Don't confuse ROI with the return on the owner's equity. This is an entirely different item as well. Only in sole proprietorships does equity equal the total investment or assets of the business. Stand Alone Risk Standalone risk describes the danger associated with investing in a particular instrument or investing in a particular division of a company. A typical investment portfolio contains a wide array of instruments in which case investors are exposed to a
  44. 44. Financial Management 44 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 large number of risks and potential rewards. In contrast, a standalone risk is one that can easily be distinguished from these other types of risk. When an investor only invests in one type of stock, then his or her entire investment returns depend on the performance of that security. If the company that issued the stock performs well then the stock will grow in value but if the firm becomes insolvent then the stock may become worthless. Therefore, such an investor is exposed to standalone risk because that individual's entire investment could be lost due to the poor performance of a single asset. Additionally, someone who invests in a wide array of securities is also exposed to standalone risk if that individual holds each type of instrument in a separate brokerage account. In such situations, the investor would not lose everything if one asset dropped in value, but each holding account would expose the investor to a different standalone risk since each account would only hold one type of security. Probability Distribution A statistical function that describes all the possible values and likelihoods that a random variable can take within a given range. This range will be between the minimum and maximum statistically possible values, but where the possible value is likely to be plotted on the probability distribution depends on a number of factors, including the distributions mean, standard deviation, skewness and kurtosis. Academics and fund managers alike may determine a particular stock's probability distribution to determine the possible returns that the stock may yield in the future. The stock's history of returns, which can be measured on any time interval, will likely be comprised of only a fraction of the stock's returns, which will subject the analysis to sampling error. By increasing the sample size, this error can be dramatically reduced. There are many different classifications of probability distributions, including the chi square and normal and binomial distributions. Expected Rate of Return: Expected return is calculated as the weighted average of the likely profits of the assets in the portfolio, weighted by the likely profits of each asset class. Expected return is calculated by using the following formula:
  45. 45. Financial Management 45 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnRn Example: Expected Return For a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect the stock fund to return 10% and the bond fund to return 6% and our allocation is 50% to each asset class, we have the following: Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8% Expected return is by no means a guaranteed rate of return. However, it can be used to forecast the future value of a portfolio, and it also provides a guide from which to measure actual returns. Standard Deviation Standard deviation can be defined in two ways: 1. A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. 2. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as volatility and is used by investors as a gauge for the amount of expected volatility. Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while a stable blue chip stock will have a lower standard deviation. A large dispersion tells us how much the fund's return is deviating from the expected normal returns. Example: Standard Deviation Standard deviation (σ) is found by taking the square root of variance: (165)1/2 = 12.85%. We used a two-asset portfolio to illustrate this principle, but most portfolios contain far more than two assets. The formula for variance becomes more complicated for multi- asset portfolios. All terms in a covariance matrix need to be added to the calculation. Risk aversion Risk aversion is a concept in economics and finance, based on the behavior of humans (especially consumers and investors) while exposed to uncertainty to attempt to reduce that uncertainty.
  46. 46. Financial Management 46 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value. Example: A person is given the choice between two scenarios, one with a guaranteed payoff and one without. In the guaranteed scenario, the person receives $50. In the uncertain scenario, a coin is flipped to decide whether the person receives $100 or nothing. The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble. However, individuals may have different risk attitudes. Risk in a Portfolio Context Portfolio A collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices. A group of investments such as stocks, bonds and cash equivalents, mutual funds, exchange-traded funds, and closed-end funds that are selected on the basis of an investor's short-term or long-term investment goals. Portfolios are held directly by investors and/or managed by financial professionals. Portfolio Return The monetary return experienced by a holder of a portfolio. Portfolio returns can be calculated on a daily or long-term basis to serve as a method of assessing a particular investment strategy. Dividends and capital appreciation are the main components of portfolio returns. Portfolio returns can be calculated through various methodologies such as a time- weighted and money-weighted return. However, the overall return must be compared to the required benchmarks and risk of the portfolio as well. Calculation Portfolio Return: To determine the expected return on a portfolio, the weighted average expected return of the assets that comprise the portfolio is taken. Formula 17.4 E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn Example: Assume an investment manager has created a portfolio with the Stock A and Stock B.
  47. 47. Financial Management 47 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the portfolio? Answer: E(R) = (0.30) (20%) + (0.70) (15%) = 6% + 10.5% = 16.5% The expected return of the portfolio is 16.5% Portfolio Risk Portfolio risk is the possibility that an investment portfolio may not achieve its objectives. There are a number of factors that contribute to portfolio risk, and while you are able to minimize them, you will never be able to fully eliminate them. Portfolio risk refers to the combined risk attached to all of the securities within the investment portfolio of an individual. This risk is generally unavoidable because there is a modicum of risk involved in any type of investment, even if it is extremely small. Investors often try to minimize portfolio risk through diversification, which involves purchasing many securities with different characteristics in terms of potential risk and reward. There are some risks which cannot be solved through diversification, and these risks, known as market risks, can only be lessened by hedging with contrasting investments. Calculating Beta Coefficient A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Also known as "beta coefficient." Beta coefficient is a measure of sensitivity of a share price to movement in the market price. It measures systematic risk which is the risk inherent in the whole financial system. Beta coefficient is an important input in capital asset pricing model to calculate required rate of return on a stock. It is the slope of the security market line. Formula Beta coefficient is calculated as covariance of a stock's return with market returns divided by variance of market return. A slight modification helps in building another key relationship which tells that beta coefficient equals correlation coefficient multiplied by standard deviation of stock returns divided by standard deviation of market returns. Beta coefficient is given by the following formulas: β = Covariance of Market Return with Stock Return Variance of Market Return β = Correlation Coefficient × Standard Deviation of Stock Returns Between Market and Stock Standard Deviation of Market Returns
  48. 48. Financial Management 48 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 The Relationship between Risk and Rate of Return There are two primary concerns for all investors: the rate of return they can expect on their investments and the risk involved with that investment. While investors would love to have an investment that is both low risk and high return, the general rule is that there is a more or less direct trade-off between financial risk and financial return. This does not suggest that there is some perfect linear relationship between risk and return, but merely that the investments that promise the greatest returns are generally the riskiest. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return. A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses. Physical assets verses securities An item of economic, commercial or exchange value that has a tangible or material existence. For most businesses, physical assets usually refer to cash, equipment, inventory and properties owned by the business. Physical assets are the opposite of intangible assets, which are non-physical assets such as leases, computer programs or agreements. A financial instrument that represents: an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer. Securities are typically divided into debt securities and equities. A debt security is a type of security that represents money that is borrowed that must be repaid, with terms that define the amount borrowed, interest rate and maturity/renewal date. Debt securities
  49. 49. Financial Management 49 Prepared By: Muhammad Riaz Khan ( GCMS Peshawar) Mob#+923139533123 include government and corporate bonds, certificates of deposit (CDs), preferred stock and collateralized securities (such as CDOs and CMOs). Capital Asset Pricing Model (CAPM) A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk- free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Risk and the Capital Asset Pricing Model Formula The formula for CAPM is as follows: In this formula, Ri represents the return on a risky security i, Rf represents the risk free rate, βi represents the beta of security i, and Rm represents the market return. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. For example, if Security A has an expected return of 5%, but based on the CAPM the expected return should be 6%, then you should not buy Security A because for the same level of risk you can find other investments with an expected return of 6%. Using the CAPM model and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock