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Trends 2011 Back Ground Paper
PDATE Team…trends
2011
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Trends team 2011 prepare this document for sharing the knowledge between all of its users…prepared by Hoda
Mahmoud – Sarah Alhamwy – Mahmoud Alsawi and Islam Alparody
Trends
2011

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Trends 2011 Back Ground Paper
Prepared by
Sarah Alhamawy
Hoda Mahmoud
Mahmoud Rajab Alsawi
Islam Mohamed Alparody

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Investments decision
Table of contents:
1- Introduction------------------------------------- 1
2- Chapter one
- Economic analysis---------------------------------------------------- 2
Part one - politico-economic analysis
Part two - The four stages of an economic cycle
3- Chapter two
- Industry analysis ------------------------------------------------------ 17
a- Industry stages & types
b- Porter model
4- Chapter three
- Company analysis
a-Financial statements
b-Ratios analysis
c- Time value of money
d-Capital budgeting
e-Capital structure
f- Islamic finance

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1- Introduction
At the begging we have to thank Allah for all of favors which given to
us, and so we have to know that we have to share all of our
experiences and knowledge we collect all over our life because
‫زﻛ‬‫ﺎ‬‫ة‬‫اﻟﻣﺎل‬‫ﺑﻌض‬‫اﻟﻣﺎل‬‫ﻟﻛن‬‫ز‬‫ﻛ‬" ‫اﻟﻌﻠم‬ ‫ﻛل‬ ‫اﻟﻌﻠم‬ ‫ﺎة‬ "
Our main target is to facilitate all of information for the investor,
decision maker and even students to recognize the quality of
information and how much is it true then to make the right decision
aiming to reach UPDATE team C.U vision to be the most effective
organization around the world.

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1- Chapter one : Economic analysis
The most important factor in fundamental analysis is information - information about the economy,
the industry and the company itself - any information that can affect the growth and profitability of the
company and it is because of this fundamental analysis is broken into three distinct parts:
1. The economy,
2. The industry within which the company operates, and
3. The company.
Relationship of finance to economics:
Financial management has a close relationship to economics on the one hand and accounting on the
other.
Relationships to Economics: There are two important linkages between economics and
finance. The macroeconomic environment defines the setting within which a firm operates and the
micro-economic theory provides the conceptual underpinning for the tools of financial decision
making.
Key macro-economic factors like the growth rate of the economy, the domestic savings rate, the role
of the government in economic affairs, the tax environment, the nature of external economic
relationships the availability of funds to the corporate sector, the rate of inflation, the real rate of
interests, and the terms on which the firm can raise finances define the environment in which the firm
operates. No finance manager can afford to ignore the key developments in the macro economic
sphere and the impact of the same on the firm.
While an understanding of the macro economic developments sensitizes the finance manager to the
opportunities and threats in the environment, a firm grounding in micro economic principles sharpens
his analysis of decision alternatives. Finance, in essence, is applied micro economics. For example
the principle of marginal analysis – a key principle of micro economics according to with a decision

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should be guided by a comparison of incremental benefits and cost is applicable to a number of
managerial decisions in finance.
To sum up, a basic knowledge of macroeconomics is necessary for understanding the environment in
which the firm operates and a good grasp of micro economic principles is helpful in sharpening the
tools of financial decision making
Finance Sense textbook By Chandra
Economic analysis
Economic analysis is a process whereby strengths and weaknesses of an economy are analyzed.
Economic analysis is important in order to understand exact condition of an economy. It can cover a
number of important economic issues that keep cropping up within a particular economy, which is
being analyzed
Macroeconomics and economic analysis Macroeconomic issues are important
aspects of economic analysis process. However, economic analysis can also be done at a
microeconomic level. Macroeconomic analysis helps in understanding fundamentals of an
economy. Since such a form of analysis operates on a wide scale, it helps one to analyze
strengths and weaknesses of particular economies. Macroeconomic analysis takes into account
growth achieved by a particular economy or rather a particular sector of that economy. It tries to
find out reasons behind a particular economic phenomena like growth or reversal of economy.
http://www.economywatch.com/economic-analysis/
part one: politico-economic analysis
A wise man once said, "No man is an island". No person can work and live in isolation. External
forces are constantly influencing an individual's actions and affecting him. Similarly, no industry or
company can exist in isolation. It may have splendid managers and a tremendous product.
However, its sales and its costs are affected by factors, some of which are beyond its control - the
world economy, price inflation, taxes and a host of others. It is important, therefore, to have an
appreciation of the politico-economic factors that affect an industry and a company. (Source:
which company ''sharekhan'' India's leading online retail broking house)

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Economics can be defined as the system that every society has for organizing the production,
distribution and consumption of goods and services.
Politics is the system that every society has for organizing people’s relationships with one another
everywhere.
In today’s globalized world, Political Economy is not only linked with politics and economics but
also with ecology, anthropology, history, international relations, psychology and human
geography
The political equation
A stable political environment is necessary for steady, balanced growth. If a country is ruled by a
stable government which takes decisions for the long-term development of the country, industry
and companies will prosper. On the other hand, instability causes insecurity, especially if there is
the possibility of a government being ousted and replaced by another that holds diametrically
different political and economic beliefs.
India has gone through a fairly difficult period. There had been terrible political instability after the
ouster of Mr. Narasimha Rao from the Prime Ministership. Successive elections held did not give
any single political party a clear majority and mandate. As a result there were coalitions of unlikes.
These led to considerable jockeying for power and led to the breakup of the governments and
fresh elections.
There has also been much grand standing such as the Mandal recommendations in order to
capture votes. These led to riots. There were other religious and ethnic issues that also led to
violence such as the Babri Masjid/Ram Janmabhoomi issue. All these shook the confidence of the
developed world in the security and stability of India. Tourism fell.
Foreign Direct Investment fell. Investments were held back. These had an adverse impact on the
development of the economy. In recent times this scenario has changed. The Government, even
though a coalition has been stable. Its policies have barren positive and the economy has been
doing well. There are predictions that by
2050, India would be one of the three most powerful nations in the world. This has led to renewed
interest in India and investors are back.

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International events too impact industries and companies. The USSR was one of India's biggest
purchasers. When that enormous country broke up into the Confederation of Independent States,
Indian exports declined and this affected the profitability of companies who had to search for other
markets. Wars have a similar effect. The war in Croatia, in Kosovo, in Africa, the Gulf war and
other wars have had an effect on exports of goods. The tragedy of 9/11 (September 9 when two
planes crashed into the World Trade Center at New York), affected the entire world. Many
industries are yet to fully recover. Similarly the SARS epidemic that affected South East Asia
affected trade and tourism.
The other gnawing political issue that has been a thorn in India's back is the Pakistan issue. The
deterioration in our relationship culminated in 1999 in the war in Kargil. Earlier we have fought
several wars on Kashmir and other issues. In 2005 there has been an improvement in the
relationship. One wonders whether this thorn will cease to be a thorn in time. The deterioration in
our relationship culminated in 1999 in the war in Kargil. Earlier we have fought several wars on
Kashmir and other issues. Wars push up inflation and demand declines. It is estimated that the
Gulf War cost India $1.5 billion on account of higher prices of petroleum products, opportunity
costs and fall in exports. The defence budget is enormous. This money could have been spent
elsewhere for the development of the country. Other examples include Sri Lanka, East Europe
and other troubled countries. These countries were once thriving. No longer. Let us take the
example of Sri Lanka. It is a beautiful island and was considered a paradise for tourists - a pearl
in the ocean. The country is in the grips of a civil war. The northern part of the country, which was
once thriving, is in the hands of Tamil guerillas and there is no industry and little economic
activity. Idi Amin in the seventies by expelling Asians from Uganda did that country's economy
irreparable harm. In 1997-98, due to the elections and then the bombing of the American
embassy, the economy of Kenya tailspinned to negative growth. Then a few years later as the
economy was recovering, the Mombasa bombings again
In conclusion, the political stability of a country is of paramount importance. No industry or
company can grow and prosper in the midst of political turmoil.
Foreign Exchange Reserves

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A country needs foreign exchange reserves to meet its commitments, pay for its imports and
service foreign debts.
Without foreign exchange, a country would not be able to import materials or goods for its
development and there is also a loss of international confidence in such a country. In 1991, India
was forced to devalue the rupee as our foreign exchange reserves were, at $532 million very low,
barely enough for few weeks imports.
The crisis was averted at that time by an IMF loan, the pledging of gold, and the devaluation of
the rupee.
Several North American banks had to write off large loans advanced to South American countries
when these countries were unable to make repayments. Certain African countries too have very
low foreign exchange reserves.
Companies exporting to such countries have to be careful as the importing companies may not be
able to pay for their purchases because the country does not have adequate foreign exchange. I
know of an Indian company which had exported machines to an African company a few years
ago. The importing company paid the money to its bank. It lies there still. The payment could not
be sent to India as the central bank refused the
foreign exchange to make the payment. Following the liberalization moves initiated by the
Narasimha Rao Government and endorsed/supported by successive governments, India had by
31 December 1999 foreign investments in excess of $28 billion. In May 2000, the foreign
exchange reserves had swelled to over $38.4 billion - a far cry from the $500 million of reserves in
1991. In 2003, the reserves are in excess of $100 billion. The problem the Reserve Bank of India
now faces is managing the huge reserves. In order to discourage short term flows, the Reserve
Bank has lowered interest rates and even mandated that the interest paid should not exceed 25
basis points over LIBOR on foreign currency funds and Non- resident deposits.
Foreign Exchange Risk
This is a real risk and one must be cognizant of the effect of a revaluation or devaluation of the
currency either in the home country or in the country the company deals in.
A devaluation in the home country would make the company's products more attractive in other
countries. It would also make imports more expensive and if a company is dependent on imports,

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margins can get reduced. On the other hand, a devaluation in the country to which one exports
would make the company's products more expensive and this can adversely impact sales. A
method by which foreign exchange risks can be hedged is by entering into forward contracts, i.e.
advance purchase or sale of foreign exchange thereby crystallizing the exposure.
In India our currency has been appreciating against the dollar. Thus, the threat investors or
recipients of dollars face is that the rupees that they finally receive is less than that they expected.
This is an about turn from the situation earlier. As a consequence many have begun quoting in
rupees.
Restrictive Practices
Restrictive practices or cartels imposed by countries can affect companies and industries. The
United States of America has restrictions regarding the imports of a variety of articles such as
textiles. Licenses are given and amounts that may be imported from companies and countries are
clearly detailed. Similarly, India has a number of restrictions on what may be imported and at what
rate of duty.
To an extent this determines the prices at which goods can be sold. If the domestic industry is to
be supported, the duties levied may be increased resulting in imports becoming unattractive.
During the last two years Indian customs duties have been reduced drastically. Imports are
consequently much cheaper and this has affected several industries. When viewing a company, it
is important to see how sensitive it is to governmental policies and restrictive practices.
Foreign Debt and the Balance of Trade
Foreign debt, especially if it is very large, can be a tremendous burden on an economy. India
pays around $ 5 billion a year in principal repayments and interest payments. This is no small
sum. This has been the price the country has had to pay due to our imports being far in excess of
exports and an adverse balance of payments.
At the time the country did borrow, it had no alternative. In 1991, at the time of devaluation, India
had only enough foreign exchange to finance the imports of few weeks. It is to reverse this that
the government did borrow from the World Bank and devalue the currency.

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A permanent solution will result only when the inflow of foreign currency exceeds the outflow and
it is on account of this that tourism, exports and exchange earning/saving industries are
encouraged.
Inflation
Inflation has an enormous effect in the economy. Within the country it erodes purchasing power.
As a consequence, demand falls. If the rate of inflation in the country from which a company
imports is high then the cost of production in that country will automatically go up. This might
reduce the cost competitiveness of the product finally manufactured. Conversely, if the rate of
inflation in the country to which one exports is high, the products become more attractive resulting
in increased sales.
The USA and Europe have fairly low inflation rates (below 2%). In India, inflation has been falling
steadily in recent times. It is currently estimated between 3.7% and 4%. In South America, at one
time, it was over 1000%. Money there had no real value. Ironically, South American exports
become attractive on account of galloping inflation and the consequent devaluation of their
currency which makes their products cheaper in the international markets.
Low inflation within a country indicates stability and domestic companies and industries prosper at
such times.
The Threat of Nationalization
The threat of nationalization is a real threat in many countries – the fear that a company may
become nationalized. With very few exceptions, nationalized companies are historically less
efficient than their private sector counterparts. If one is dependent on a company for certain
supplies, nationalization could result in supplies becoming erratic. In addition, the fear of
nationalization chokes private investment and there could be a flight of capital to other countries.
Interest Rates
A low interest rate stimulates investment and industry. Conversely, high interest rates result in
higher cost of production and lower consumption. When the cost of money is high, a company's

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competitiveness decreases. In India, the government, through the Reserve Bank, has been
successful in lowering interest rates. Increasing competition among banks has also helped.
Taxation
The level of taxation in a country has a direct effect on the economy. If tax rates are low, people
have more disposable income. In addition they have an incentive to work harder and earn more.
And an incentive to invest. This is good for the economy.
It is interesting to note that in every economy there is a level between 35% to 55% where tax
collection will be the highest. While the tax rates may go up, collection will decline. This is why
there it has been argued that the rates in India must be lowered.
Government Policy
Government policy has a direct impact on the economy. A government that is perceived to be
preindustrial will attract investment. The liberalization policies of the Narsimha Rao government
excited the developed world and foreign companies grew keen to invest in India and increase
their existing stakes in their Indian ventures. The initiative of the former BJP government in
improving the infrastructure grabbed the attention of foreign investors. The present government
continues to focus on infrastructure as it is realized progress at a decent rate would not be
possible without infrastructure.
Domestic Savings and its Utilization
If utilized productively, domestic savings can accelerate economic growth. India has one of the
largest rate of savings (22%). In USA, it is only 2% whereas in Japan it is as high as 23%. Japan's
growth was on account of its domestic savings invested profitably and efficiently. Although India's
savings are high, these savings have not been invested either wisely or well. Consequently, there
has been little growth. It is to be remembered that all investments are born out of savings.
Borrowed funds invested have to be returned.
Investments from savings leads to greater consumption in the future. This has been recognized
by the Government and it was in order to divert savings to industry the 1992 Finance Act

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stipulated that productive assets of individuals (shares, debentures, etc.) would not be liable for
wealth tax.
The Infrastructure
The development of an economy is dependent on its infrastructure. Industry needs electricity to
manufacture and roads to transport goods. Bad infrastructure leads to inefficiencies, poor
productivity, wastage and delays. This is possibly the reason why the 1993 budget lay so much
emphasis, and offered so many benefits, to infrastructural industries, such as power and
transportation. In recent years there has been greater emphasis. Flyovers have been built,
national highways are being widened and made better and the improvements made in
communications is awesome.
Budgetary Deficit
A budgetary deficit occurs when governmental expenditure exceeds its income. Expenditure
stimulates the economy by creating jobs and stimulating demand. However, this can also lead to
deficit financing and inflation. Both these, if not checked, can result in spiraling prices. To control
and cut deficits governments normally cut governmental expenditure. This would also result in a
fall in money supply and a consequent fall in demand which will check inflation. All developing
economies suffer from budget deficits as governments spend to improve the infrastructure - build
roads, power stations and the like. India is no exception.
Budget deficits have been high. The government has, to reduce inflation consciously cut
expenditure down and it has reduced from a high of around 15% few years ago to a little over 7%
today.
Monsoon
The Indian economy is an agrarian one and it is therefore extremely dependent on the monsoon.
Economic activity often comes to a standstill in late March and early April as people wait to see
whether the monsoon is likely to be good or not.
Employment

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High employment is required to achieve a good growth in national income. As the population
growth is faster than the economic growth unemployment is increasing. This is not good for the
economy
Stagflation
FDI (foreign direct investment)
Floating currency
Shadow economy
Crony capitalism

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Part two: Economic cycle
Countries go through the business or economic cycle and the stage of the cycle at which a country is
in has a direct impact both on industry and individual companies. It affects investment decisions,
employment, demand and the profitability of companies. While some industries such as shipping or
consumer durable goods are greatly affected by the business cycle, others such as the food or health
industry are not affected to the same extent. This is because in regard to certain products consumers
can postpone their purchase decisions, whereas in certain others they cannot.
The four stages of an economic cycle are:
- Depression
- Recovery
- Boom
- Recession

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Depression
At the time of depression, demand is low and falling. Inflation is high and so are interest rates.
Companies, crippled by high borrowing and falling sales, are forced to curtail production, close down
plants built at times of higher demand, and let workers go.
The United States went through a depression in the late seventies. The economy recovered and the
eighties was a period of boom. Another downturn occurred in the late eighties and early nineties,
especially after the Gulf War. The recovery of the US economy and that of the rest of Western Europe
began again in 1993. Later the US again went through a period of depression at the turn of the
millennium. India too went through a difficult period and it began its recovery in 2002.
Recovery
During this phase, the economy begins to recover. Investment begins a new and the demand grows.
Companies begin to post profits. Conspicuous spending begins once again. Once the recovery stage
sets in fully, profits begin to grow at a higher proportionate rate. More and more new companies are
floated to meet the increasing demand in the economy. In India 2003 could be seen as a year of
recovery. All the attributes of a recovery are evident in the economy.
Boom
In the boom phase, demand reaches an all time high. Investment is also high. Interest rates are low.
Gradually as time goes on, supply begins to exceed the demand. Prices that had been rising begin to
stabilize and even fall. There is an increase in demand. Then as the boom period matures prices begin
to rise again.
Recession
The economy slowly begins to downturn. Demand starts falling. Interest rates and inflation Demand
starts falling. Interest rates and inflation are high. Companies start finding it difficult to sell their goods.
The economy slowly begins to downturn. Demand starts falling. Interest rates and inflation begin to
increase. Companies start finding it difficult to sell their goods. India went through a terrible recession
for 4 years from 1996.

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The Investment Decision
Investors should attempt to determine the stage of the economic cycle the country is in. They should
invest at the end of a depression when the economy begins to recover.
Investors should disinvest either just before or during the boom, or, at the worst, just after the boom.
Investment and disinvestments made at these times will earn the investor greater benefits.
It must however be noted that there is no rule or law that states that a recession would last a certain
number of years, or that a boom would be for a definite period of time. Hence the length of previous
cycles should not be used as a measure to forecast the length of an existing cycle. An investor should
also be aware that government policy or other events can reverse a stage and it is therefore imperative
that investors analyze the impact of government and political decisions on the economy before making
the final investment decision. Joseph Schumpeter once said, “Cycles are not, like tonsils, separable
things that might be treated by themselves but are, like the beat of the heart, of the essence of
organism that displays them.”

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Chapter two: Industry analysis
The most important factor in fundamental analysis is information - information about the
economy, the industry and the company itself - any information that can affect the
growth and profitability of the company and it is because of this fundamental analysis is
broken into three distinct parts:
1. The economy,
2. The industry within which the company operates, and
3. The company
The second item of the most important factors of the fundamental analysis …
Industry analysis
The importance of industry analysis is now dawning on the investor as never before.
Previously,
Investors purchased shares of companies without concerning themselves about the
industry it operated in.
But an investor must therefore examine the industry in which a company operates
because this can have a tremendous effect on its results, and even its existence.

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a- Industry life cycle
The first step in industry is to determine the cycle it is in, or the stage of maturity of the
industry. All industries evolve through the following stages:
1. Sunrise stage
2. Expansion or growth stage
3. Stabilization or maturity stage, and
4. Decline or sunset stage
The Entrepreneurial or Nascent
Stage "sunrise stage"
At the first stage, the industry is new and it can take some time for it to properly
establish itself. In the early days, it may actually make losses. At this time there may
also not be many companies in the industry. It must be noted that the first 5 to 10 years
are the most critical period. At this time, companies have the greatest chance of failing.
It takes time to establish companies and new products. There may be losses and the
need for large injections of capital.
If a company or an industry is not nurtured or husbanded at this stage, it can collapse.
A good journalist I know began a business magazine.

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His intention was to start a magazine edited by journalists without interference from
industrial magnates or politicians. It was exceptionally readable magazine.
However, it did not have the finance needed in those critical initial years to keep it afloat
and had to fold up. Had it, at that time, had the finance it needed it may have survived
and thrived?
In short, at this stage investors take a high risk in the hope of great reward should the
product succeed?
The Expansion or Growth
Stage
Once the industry has established itself it enters a growth stage. As the industry grows,
many new companies enter the industry.
At this stage, investors can get high reward at low risk since demand outstrips supply. In
2000, a good example was the Indian software industry.
In 2003, the BPO industry is arguably in the growth stage. The mobile phone industry is
also in the growth stage - with newer models and newer entrants.
The growth stage also witnesses product improvements by companies that have
survived the first stage. In fact, such companies are often able to even lower their
prices.
Investors are keener to invest at this time as companies would have demonstrated their
ability to survive.
The Stabilization or Maturity
Stage
After the halcyon days of growth, an industry matures and stabilizes.
Rewards are low and so too is the risk. Growth is moderate. Though sales may
increase, they do so at a slower rate than before. Products are more standardized and
less innovative and there are several competitors.
The refrigerator industry in
India is a mature industry. Growth is slow. It is for the time seeing safe.

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Investors can invest in these industries for comfort and average returns. They must be
aware though that should there be a downturn in the economy and a fall in consumer
demand, growth and returns can be negative.
The Decline or Sunset Stage
Finally, the industry declines. This occurs when its products are no longer popular. This
may be on account of several factors such as a change in social habits The film and
video industries , for example have suffered on account of cable and satellite television,
changes in laws, and increase in prices. The risk at this time is high but the returns are
low, even negative.
The various stages can be likened to the four stages in the life cycle of a human being -
childhood, adulthood, middle age and old age.
Investors should begin to purchase shares when an industry is at the end of the
entrepreneurial or nascent stage and during its growth stage, and should begin to
disinvest when at its mature stage.
The Industry vis-à-vis the
Economy
Investors must ascertain how an industry reacts to changes in the economy. Some
industries do not perform well during a recession, others exhibit less buoyancy during a
boom. On the other hand, certain industries are unaffected in a depression or a boom.
What are the major classifications?
1. Industries that are generally unaffected during economic changes are the evergreen
industries. These are industries that produce goods individuals need, like the food or
agro based industries (dairy products, etc.).
2. Then there are the volatile cyclical industries which do extremely well when the
economy is doing well and do badly when depression sets in. The prime examples are
durable goods, consumer goods such as textiles and shipping.
During hard times individuals postpone the purchase of consumer goods until better
days.

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3. Interest sensitive industries are those that are affected by interest rates. When
interest rates are high, industries such as real estate and banking fare poorly.
4. Growth industries are those whose growth is higher than other industries and growth
occurs even though the economy
What should Investors do?
Investors should determine how an industry is affected by changes in the economy and
movements in interest rates. If the economy is moving towards a recession, investors
should disinvest their holdings in cyclical industries and switch to growth or evergreen
industries. If interest rates are likely to fall, investors should consider investment in real
estate or construction companies. If, on the other hand, the economy is on the upturn,
investment in consumer and durable goods industries are likely to be profitable.

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B- Porter model
1. BARRIER TO ENTRY "threat of new entrants"
New entrants increase the capacity in an industry and the inflow of funds. The question
that arises is how easy is it to enter an industry?
There are some barriers to entry:
a) Economies of scale: In some industries it may not be economical to set up small
capacities. This is especially true if comparatively large units are already in existence
producing a vast quantity. The products produced by such established giants will be
markedly cheaper.

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c) Product differentiation: A company whose products have product differentiation
has greater staying power. The product differentiation may be because of its name or
because of the quality of its products
- Mercedes Benz cars; National VCRs or Reebok shoes.
People are prepared to pay more for the product and consequently the products are at a
premium. It is safe usually to invest in such companies as there will always be a
demand.
d) Capital requirement: Easy entry industries require little capital and technological
expertise. As a consequence, there are a multitude of competitors, intense competition,
low margins and high costs.
On the other hand, capital intensive industries with a large capital base and high fixed
cost structure have few competitors as entry is difficult.
The automobile industry is a prime example of such an industry.
Its high fixed costs have to be serviced and a fall in sales can result in
a more than proportionate fall in profits. Large investments and a big capital base will be
barriers to entry.
e) Switching costs: Another barrier to entry could be the cost of switching from one
supplier's product to another. This may include employee restraining costs, cost of
equipment and the likes. If the switching costs are high, new entrants have to offer a
tremendous improvement for the buyer to switch.
A prime example is computers.
A company may be using a Honeywell computer. If it wishes to change to an IBM
computer, all the terminals, the unit and even the software would have to be changed.
f) Access to distribution channels:
Difficulty in securing access to distribution channels can be a barrier to entry, especially
if existing firms already have strong and established channels.
g) Cost disadvantages independent of scale: This barrier occurs when established
firms have advantages new entrants cannot replicate.

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These include:
Proprietary product technology
Favorable access to raw materials
Government subsidies Long learning curve.
A prime example is Coca Cola.
The company has proprietary product technology. Similar cold drinks are available but it
is not easy for a competition to compete with it.
h) Government policy: Government policy can limit fresh entrants to an industry,
usually by not issuing licenses. Till about the mid-1980s, the Indian motor car industry
was the monopoly of two companies.
Even though others sought licenses there were not given.
I) Expected retaliation: The expected retaliation by existing competitors can also be a
barrier to potential entrants, especially if existing competitors aggressively try to keep
the new entrants out. i) Cost of capacity additions: If the cost of capacity additions is
high, there will be fewer competitors entering the industry.
j) International cartels: There may be international cartels that make it unprofitable for
new entrants.
2. THE THREAT OF SUBSTITUTION
New inventions are always taking place and new and better products replace existing
ones.
An industry that can be replaced by substitutes or is threatened by substitutes is
normally an industry one must be careful of investing in.
An industry where this occurs constantly is the packaging industry - bottles replaced by
cans, cans replaced by plastic bottles, and the like.
To ward off the threat of substitution, companies often have to spend large sums of
money in advertising and promotion. The industries that have to worry most are those

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where the substitutes are either cheaper or better, or are produced by industries earning
high profits. It should be noted that substitutes limit the potential returns of a company.
3. BARGAINING POWER OF THE BUYERS
In an industry where buyers have control, i.e. in a buyer's market, buyers are constantly
forcing prices down, demanding better services or higher quality and this often erodes
profitability. The factors one should check are whether:
a) A particular buyer buys most of the products (large purchase volumes).
If such buyers withdraw their patronage, they can destroy an industry. They can also
force prices down.
b) Buyers can play one company against another to bring prices down.
One should also be aware that:
if sellers face large switching costs, the buyer's power is enhanced. This is especially
true if the switching costs for buyers are low.
If buyers have achieved partial backward integration, sellers face a threat as they may
become fully integrated.
If buyers are well informed about trends and details they are in a better position vis-à-
vis sellers as they can ensure they do not pay more than they need to.
If a product represents a significant portion of the buyers' cost, buyers would strongly
attempt to reduce prices.
If a product is standard and undifferentiated, the buyer's bargaining power is
enhanced.
If the buyer's profits are low, the buyer will try to reduce prices as much as possible.
In short, an industry that is dictated by buyers is usually weak and its profitability is
under constant threat.
4. BARGAINING POWER FOR THE SUPPLIERS

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An industry unduly controlled by its suppliers is also under threat. This occurs when:
a) The suppliers have a monopoly, or if there are few suppliers.
b) Suppliers control an essential item.
c) Demand for the product exceeds supply.
d) The supplier supplies to various companies.
e) The switching costs are high.
f) The supplier's product does not have a substitute.
g) The supplier's product is an important input for the buyer's business.
h) The buyer is not important to the supplier.
i) The supplier's product is unique.
5. RIVALRY AMONG COMPETITORS
Rivalry among competitors can cause an industry great harm. This occurs mainly by
price cuts, heavy advertising, additional high cost services or offers, and the like. This
rivalry occurs mainly when:
a) There are many competitors and supply exceeds demand. Companies resort to price
cuts and advertise heavily in order to attract customers for their goods.
b) The industry growth is slow and companies are competing with each other for a
greater market share.
c) The economy is in a recession and companies cut the price of their products and
offer better service to stimulate demand.
d) There is lack of differentiation between the product of one company and that of
another.
In such cases, the buyer makes his choice on the basis of price or service.
e) In some industries economies of scale will necessitate large additions to existing
capacities in a company.
The increase in production could result in over capacity & price cutting.

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f) Competitors may have very different strategies in selling their goods and in competing
they may be continuously trying to stay ahead of the other by price cuts or improved
service.
g) Rivalry increases if the stakes (profits) are high.
h) Firms will compete with one another intensely if the costs of exit are great, i.e. the
payment of gratuity, unfunded provident fund, pension liabilities, and such like. In such a
situation, companies would prefer remaining in business even if margins are low and
little or no profits are being made. Companies
also tend to remain in business at low margins if there are strategic interrelationships
between the company and others in the group; due to government restrictions (the
government may not allow a company to close down); or in case the management does
not wish to close down the company out of pride or employee commitment.
If exit barriers are high, excess capacity cannot be shut down and companies lose their
competitive edges; profitability is eroded. If exit barriers are high the return is low but
risky. If exit barriers are low the return is low but stable. On the other hand, if entry
barriers are low the returns are high but stable. High entry barriers have high, risky
returns.

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Selecting an Industry
When choosing an industry, it would be prudent for the investor to bear in mind or
determine the following details:
1. Invest in an industry at the growth stage.
2. The faster the growth of a company or industry, the better. Indian software industry,
for example, was growing at a rate of more than 50 per cent per annum at the dawn of
the new millennium.
3. It is safer to invest in industries that are not subject to governmental controls and are
globally competitive.
4. Cyclical industries should be avoided if possible unless one is investing in them at the
time the industry is prospering.
High Low
Entry Barriers Return high but
risky
Return high but
stable
Exit Barriers Return low but risky Return low and
stable
5. Export oriented industries are presently in a favorable position due to various
incentives and government encouragement. On the other hand, import substitution
companies are presently not doing very well due to relaxations and lower duties on
imports.
6. It is important to check whether an industry is right for investment at a particular time.
There are sunrise and sunset industries. There are capital intensive and labor intensive
industries. Each industry goes through a life cycle. Investments should be at the growth
stage of an industry and disinvestments at the maturity or stagnation stage before
decline sets in.

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Chapter 3: Company analysis
A- Financial statements
The Annual Report is broken down into the following specific parts:
1- The Director's Report,
2- The Auditor's Report,
3- The Financial Statements, and
4- The Schedules and Notes to the Accounts.
1- Director's report
The Director’s Report is a report submitted by the directors of a company to its
shareholders, advising them of the performance of the company under their
stewardship.
2- The auditor's report
The auditor represents the shareholders and it is his duty to report to the
shareholders and the general public on the stewardship of the company by its
directors. Auditors are required to report whether the financial statements
presented do, in fact, present a true and fair view of the state of the company.
3- The Financial Statements
The published financial statements of a company in an Annual Report consist of
its Balance Sheet as at the end of the accounting period detailing the financing
condition of the company at that date, and the Profit and Loss Account or Income
Statement summarizing the activities of the company for the accounting period.

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4- SCHEDULES AND NOTES TO THE ACCOUNTS
The schedules and notes to the accounts are an integral part of the financial
statements of a company and it is important that they be read along with the
financial statements. Most people avoid reading these. They do so at their own
risk as these provide vital clues and information.
And we will discuss the financial statements as a common type of annual
reporting
Financial statements forms
- Balance sheet illustration
UPDATE 31 Dec, 2011
- 20-- 20-1
- Fundamental limited (Balance
sheet as on 31 , 2003)
- SOURCES OF FUNDS
- Shareholder's funds
- (a) Capital 1000 1000
- B) Reserves 800 1650
- 1800 2650
- LOAN FUNDS
- (a) Secured Loans 1350 1050
- (b) Unsecured Loans 650 500
- 2000 1550
- TOTAL 3800 4200

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- APPLICATION OF FUNDS
- Fixed Assets 3200 3640
- Investments 400 400
- Current Assets :
- Trade debtors 600 700
- Prepaid Expenses 80 80
- Cash & Bank balances 50 100
- Other Current Assets 100 150
- 830 1030
Less :
Current Liabilities and provisions
Trade Creditors 480 710
- Accrued Expenses 80 70
Sundry Creditors 70 90
630 870
- Net current assets 200 160
TOTAL 3800 4200
Explanation of balance sheet items…
BALANCE SHEET
The Balance Sheet details the financial position of a company on a particular date; of the company's
assets (that which the company owns), and liabilities (that which the company owes), grouped logically
under specific heads. It must however, be noted that the Balance Sheet details the financial position
on a particular day and that the position can be materially different on the next day or the day after.

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Sources of funds
A company has to source funds to purchase fixed assets, to procure working capital, and to fund its
business. For the company to make a profit the funds have to cost less than the return the company
earns on their deployment.
Where does a company raise funds?
what are the sources?
Companies raise funds from its shareholders and by borrowing.
Shareholders' Funds
A company sources funds from shareholders either by the issue of shares or by plugging back profits.
Shareholder's funds represent the stake they have in the company back profits. Shareholders' funds
represent the stake they have in the company, the investment they have made.
Share Capital
Share capital represents the shares issued to the public. This is issued in following ways:
(i) Private Placement
This is done by offering shares to selected individuals or institutions.
(ii) Public Issue
Shares are offered to public. The details of the offer, including the reasons for raising the money are
detailed in a prospectus and it is important that investors read this.
Till the scam of 1992 public issues were extremely popular as the shares were often issued to
investors at a price much lower than its real value. As a consequence, they were oversubscribed many
times. This is no longer true. As companies are now free to price their issues as they like and the office
of the controller of capital issues has been abolished, companies typically price their shares at what
the market can bear.
As a consequence the investing public is no longer applying blindly for new shares but do so only after
a careful analysis.
(iii) Rights issues
Companies may also issue shares to its shareholders as a matter of right in proportion to their holding.
This was often done at a price lower than its market value and shareholders stood to gain enormously.
With the new-found freedom in respect of pricing of shares, companies have begun pricing them
nearer their intrinsic value. Consequently, these issues have not been particularly attractive to
investors and several have failed to be fully subscribed.
(iv) Bonus shares

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Bonus shares are shares issued free to shareholders by capitalizing reserves. No monies are actually
raised from shareholders. It can be argued, however, that if these shares are issued by capitalizing
distributable reserves, i.e. profits not distributed as dividends, then, in effect, shareholders are
contributing capital.
RESERVES
Reserves are profits or gains which are retained and not distributed.
Companies have two kinds of reserves - capital reserves and revenue reserves:
(i) Capital
Reserves
Capital reserves are gains that have resulted from an increase in the value of assets and they are not
freely distributable to the shareholders.
The most common capital reserves one comes across are the share premium account arising from the
issue of shares at a premium, and the capital revaluation reserve, i.e. unrealized gain on the value of
assets.
(ii) Revenue Reserves
These represent profits from operations ploughed back into the company and not distributed as
dividends to shareholders. It is important that all the profits are not distributed as funds are required by
companies to purchase new assets to replace existing ones for expansion and for working capital.
LOAN FUNDS
The other source of funds a company has access to are borrowings.
Borrowing is often preferred by companies as it is quicker, relatively easier and the rules that need to
be complied with are much less.
The loans taken by companies are either:
(a) Secured loans:
These loans are taken by a company by pledging some of its assets, or by a floating charge on some
or all of its assets. The usual secured loans a company has are debentures and term loans.
(b) Unsecured loans
Companies do not pledge any assets when they take unsecured loans.
The comfort a lender has is usually only the good name and credit worthiness of the company. The
more common unsecured loans of a company are fixed deposits and short term loans. In case a

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company is dissolved, unsecured lenders are usually paid after the secured lenders have been
satisfied.
Borrowings or credits for working capital which fluctuate such as bank overdrafts and trade creditors
are not normally classified as loan funds but as current liabilities.
Fixed Assets
Fixed assets are assets that a company owns for use in its business and to produce goods, typically,
machinery. They are not for resale and comprises of land, buildings, i.e. offices, warehouses and
factories, vehicles, machinery, furniture, equipment and the like.
Every company has some fixed assets though the nature or kind of fixed assets vary from company to
company. A manufacturing company's major fixed assets would be its factory and machinery, whereas
that of a shipping company would be its ships.
Fixed assets are shown in the
Balance Sheet at cost less the accumulated depreciation. Depreciation is based on the very sound
concept that an asset has a useful life and that after years of toil it wears down. Consequently, it
attempts to measure that wear and tear and to reduce the value of the asset accordingly so that at the
end of its useful life, the asset will have no value.
As depreciation is a charge on profits, at the end of its useful life, the company would have set aside
from profits an amount equal to the original cost of the asset and this could be utilized to purchase
another asset. However, in these inflationary times, this is inadequate and some companies create an
additional reserve to ensure that there are sufficient funds to replace the worn out asset. The common
methods of depreciation are:
(a) Straight line method
The cost of the asset is written off equally over its life. Consequently at the end of its useful life, the
cost will equal the accumulated depreciation.
(b) Reducing balance
Under this method depreciation is calculated on the written down value, i.e. cost less depreciation.
Consequently, depreciation is higher in the beginning and lower as the years progress. An asset is
never fully written off as the depreciation is always calculated on a reducing balance.
(c) Others:
There are a few others such as the interest method and the rate of 72 but these are not commonly
used.
Land is the only fixed asset that is never depreciated as it normally appreciates in value. Capital work
in progress - factories being constructed,

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etc. - is not depreciated until it is a fully functional asset.
INVESTMENTS
Many companies purchase investments in the form of shares or debentures to earn income or to utilize
cash surpluses profitably. The normal investments a company has are:
(i) Trade
Trade investments are shares or
debentures of competitors that a company holds to have access to information on their growth,
profitability and other details which may not, otherwise, be easily available.
(ii) Subsidiary and associate companies
These are shares held in subsidiary or associate companies. The large business houses hold
controlling interest in several companies through cross holdings in subsidiary and associate
companies.
(iii) Others
Companies also often hold shares or debentures of other companies for investment or to park surplus
funds. The windfall profits made by many companies in the year to
31 March 1992 was on account of the large profits made by trading in shares.
Investments are also classified as quoted and unquoted investments.
Quoted investments are shares and debentures that are quoted in a recognized stock exchange and
can be freely traded. Unquoted investments are not listed or quoted in a stock exchange.
Consequently, they are not liquid and are difficult to dispose of.
Investments are valued and stated in the balance sheet at either the acquisition cost or market value,
whichever is lower. This is in order to be conservative and to ensure that losses are adequately
accounted for.
Current assets
Current assets are assets owned by a company which are used in the normal course of business or
are generated by the company in the course of business such as debtors or finished stock or cash.
The rule of thumb is that any asset that is turned into cash within twelve months is a current asset.
Current assets can be divided essentially into three categories :
(a) Converting assets
Assets that are produced or generated in the normal course of business, such as finished goods and
debtors.
(b) Constant assets

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Constant assets are those that are purchased and sold without any add ones or conversions, such as
liquor bought by a liquor store from a liquor manufacturers.
(c) Cash equivalents:
They can be used to repay dues or purchase other assets. The most common cash equivalent assets
are cash in hand and at the bank, and loans given.
The current assets a company has are:
A) STOCK OR INVENTORIES
These are arguably the most important current assets that a company has as it is by the sale of its
stocks that a company makes its profits.
Stocks, in turn, consist of:
(i) Raw materials
The primary purchase which is utilized to manufacture the products a company makes.
(ii) Work in progress
Goods that are in the process of manufacture but are yet to be completed.
(iii) Finished goods
The finished products manufactured by the company that are ready for sale.
Valuation of stocks
Stocks are valued at the lower of cost or net realizable value. This is to ensure that there will be no
loss at the time of sale as that would have been accounted for.
The common methods of valuing stocks are:
(i) FIFO or first in first out
It is assumed under this method that stocks that come in first would be sold first and those that come
in last would be sold last.
(ii) LIFO or last in last out
The premise on which this method is based is the opposite of FIFO. It is assumed that the goods that
arrive last will be sold first. The reasoning is that customers prefer newer materials or products.
It is important to ascertain the method of valuation and the accounting principles involved as stock
values can easily be manipulated by changing the method of valuation.
B) TRADE DEBTORS
Most companies do not sell their products for cash but on credit and purchasers are expected to pay
for the goods they have bought within an agreed period of time - 30 days or 60 days. The period of
credit would vary from customer to customer and from the company to company and depends on the
credit worthiness of the customer, market conditions and competition.

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Often customers may not pay within the agreed credit period. This may be due to laxity in credit
administration or the inability of the customers to pay. Consequently, debts are classified as:
those over six months, and
Others
These are further subdivided into;
Debts considered good, and
Debts considered bad and doubtful
If debts are likely to be bad, they must be provided for or written off. If this is not done assets will be
overstated to the extent of the bad debt.
A write off is made only when there is no hope of recovery.
Otherwise, a provision is made.
Provisions may be specific or they may be general.
When amounts are provided on certain identified debts, the provision is termed specific whereas if
provisions amounting to a certain percentage of all debts are made, the provision is termed general.
C) PREPAID EXPENSES
All payments are not made when due. Many payments, such as insurance premiums, rent and service
costs, are made in advance for a period of time which may be 3 months, 6 months, or even a year.
The portion of such expenses that relates to the next accounting period are shown as prepaid
expenses in the Balance Sheet.
D) CASH AND BANK BALANCES
Cash in hand in petty cash boxes, safes and balances in bank accounts are shown under this heading
in the Balance Sheet.
E) LOANS AND ADVANCES
These are loans that have been given to other corporations, individuals and employees and are
repayable within a certain period of time. This also includes amounts paid in advance for the supply of
goods, materials and services.
F) OTHER CURRENT ASSETS
Other current assets are all amounts due that are recoverable within the next twelve months. These
include claims receivable, interest due on investments and the like.
CURRENT LIABILITIES
Current liabilities are amounts due that are payable within the next twelve months. These also include
provisions which are amounts set aside for an expense incurred for which the bill has not been
received as yet or whose cost has not been fully estimated.

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( A ) T R A D E
CREDITORS
Trade creditors are those to whom the company owes monies for raw materials and other articles used
in the manufacture of its products.
Companies usually purchase these on credit - the credit period depending on the demand for the item,
the standing of the company and market practice.
(B) ACCRUED EXPENSES
Certain expenses such as interest on bank overdrafts, telephone costs, electricity and overtime are
paid after they have been incurred. This is because they fluctuate and it is not possible to either prepay
or accurately anticipate these expenses.
However, the expense has been incurred. To recognize this expense incurred is estimated based on
past trends and known expenses incurred and accrued on the date of the Balance Sheet.
(C) PROVISIONS
Provisions are amounts set aside from profits for an estimated expense or loss.
Certain provisions such as depreciation and provisions for bad debts are deducted from the concerned
asset itself.
There are others, such as claims that may be payable, for which provisions are made. Other provisions
normally see on balance sheets are those for dividends and taxation.
(D) SUNDRY CREDITORS
Any other amounts due are usually clubbed under the all-embracing title of sundry creditors. These
include unclaimed dividends and dues payable to third parties.
Income statement
Form
Sample Company
Income Statement
January 1, xxxx to December 31, xxxx
Income
Gross Sales ****
Less returns and allowances (****)
Net Sales ****
Cost of Goods (****)
Merchandise Inventory, January 1 ****
Purchases (****)

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Freight Charges (****)
Total Merchandise Handled ****
Less Inventory, December 31 (****)
Cost of Goods Sold (*****)
Gross Profit *****
Interest Income ****
Total Income *****
Expenses
Salaries (*****)
Utilities (*****)
Rent (*****)
Office Supplies (*****)
Insurance (*****)
Advertising (*****)
Telephone (*****)
Travel and Entertainment (*****)
Dues & Subscriptions (*****)
Interest Paid (*****)
Repairs & Maintenance (*****)
Taxes & Licenses (*****)
Total Expenses *****
Net Income *****
Data Definitions
Revenue
Revenue equals total sales from operations.
Cost of Goods Sold
Cost of Goods Sold includes all expenses directly associated with the production of
goods or services the company sells (such as material, labor, overhead, and
depreciation). It does not include SG&A.
Gross Profit
Gross Profit equals Revenue minus Cost of Goods Sold. It identifies the amount
available to cover other operating expenses.

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Gross Profit Margin
Gross Profit Margin equals Gross Profit divided by Revenue, expressed as a
percentage. The percentage represents the amount of each dollar of Revenue that
results in Gross Profit.
SG&A Expenses
Selling, General, and Administrative Expenses include all salaries, indirect production,
marketing, and general corporate expenses.
Operating Income
Operating Income equals Gross Profit minus SG&A Expenses. It is the income from
current operations.
Operating Margin
Operating Margin equals Operating Income divided by Revenue, expressed as a
results in Operating Income.
Nonoperating Income
Nonoperating Income is a residual category into which miscellaneous Nonoperating
revenues and expenses are netted.
Nonoperating Expenses
Nonoperating Expenses is the combination of "Other Taxes" and "Interest Expense."
"Other Taxes," also known as other operating expenses, for most companies includes
taxes other than income taxes (except excise taxes, which the company does not
actually pay, but only collects on behalf of the government). For financial companies, all
expenses other than interest expense and income taxes are included in Other Taxes.
"Interest Expense" is all fixed interest expenses net of capitalized interest. This category
also includes dividends on preferred stock of unconsolidated subsidiaries.

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Income Before Taxes
Income Before Taxes is the income from total operations (continuing + discontinued
operations).
Income Taxes
Income Taxes include any taxes on income, net of any investment tax credits.
Net Income After Taxes
Net Income After Taxes is the income from total operations (continuing + discontinued)
after taxes have been taken out.
Net Income from Continuing Operations
Net Income from Continuing Operations includes income taken after taxes and before
the following: Preferred Dividends, Extraordinary Gains and Losses, Income from
Accumulative Effects of Accounting Change, Non-Recurring Items, Income from Tax
Loss Carryforward, and Other Gains/Losses.
Net Income from Discontinued Operations
Net Income from Discontinued Operations represents the net (gain or loss) resulting
from the selling or closing of discontinued operations of the company. This excludes
income from extraordinary gains/losses.
Net Income from Total Operations
Net Income from Total Operations is the income from the total operations (continuing +
discontinued operations) after taxes and minority interest and before extraordinary
gains/losses.
Total Net Income
Total Net Income is the income after accounting for all corporate actions: Income from
Continuing Operations + Income from Discontinued Operations + Income from

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Extraordinary Items + Income from Accumulative Effect of Accounting Changes +
Income from Tax Loss Carryforward + Income from Other Gains/Losses.
Net Profit Margin
Net Profit Margin equals the Total Net Income divided by Revenue, expressed as a
results in Total Net Income.
Diluted EPS from Continuing Operations
Diluted EPS from Continuing Operations equals the earnings from continuing operations
divided by the Shares Outstanding, assuming full dilution.
Diluted EPS from Discontinued Operations
Diluted EPS from Discontinued Operations equals the earnings from discontinued
operations divided by Shares Outstanding, assuming full dilution. This excludes income
from extraordinary gains/losses.
Diluted EPS from Total Operations
Diluted EPS from Total Operations equals Diluted EPS from Continuing Operations plus
Diluted EPS from Discontinued Operations.
Diluted EPS from Total Net Income
Diluted EPS from Total Net Income is the Diluted EPS after accounting for all corporate
actions: EPS from Continuing Operations + EPS from Discontinued Operations + EPS
from Extraordinary Items + EPS from Accumulative Effect of Accounting Changes +
EPS from Tax Loss Carry forward + EPS from Other Gains/Losses.
Dividends per Share
The cash payment, per share, made by the company to its shareholders. Payment is
usually made quarterly, but can be paid biannually (ADRs).

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Note ---
Operating Income Statement
The lender should use this form to determine the amount of operating income that can
be used in evaluating the applicant's credit on applications for conventional mortgages
that are secured by one-family investment properties and all two- to four-family
properties (including those in which the applicant occupies one of the units as a
principal residence).
Printing Instructions
This form must be printed on legal size paper, using portrait format.
Instructions
This form is prepared either by the loan applicant or the appraiser. This form is prepared
either by the loan applicant or the appraiser. If the applicant prepares the form, the
appraiser must also include his or her comments about the reasonableness of the
projected operating income of the property. The lender should retain the original of the
completed form and the appraiser should retain the copy. The lender's underwriter uses
the second page of the form to calculate monthly operating income and net cash flow
for the property, and to explain any adjustments he or she made to the applicant's
figures.
Rent Schedule
The applicant (or appraiser) should complete this schedule by entering the current rents
in effect, as well as market rents. Rental figures should be based on the rent for an
"unfurnished" unit. The applicant should indicate which utility expenses he or she will
provide as part of the rent and which must be paid separately by the tenants.

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Income and Expense Projections
The applicant (or appraiser) should complete all items that apply to the subject property,
and should provide actual year-end operating statements for the past two years.
If the applicant prepares the Operating Income Statement (Form 216), the lender should
send the form and any previous actual operating and expense reports the applicant
provides to the appraiser for review and comment. If the appraiser completes the form,
the lender should make sure the appraiser has the operating statements; any expense
statements related to mortgage insurance premiums, owners' association dues,
leasehold payments, or subordinate financing payments; and any other pertinent
information related to the property.
The lender's underwriter should carefully review the applicant's (or the appraiser's)
projections (and, if the applicant prepared the form, the appraiser's comments
concerning those projections). Based on the appraiser's comments, the lender should
make any necessary final adjustments for inconsistencies or missing data.
Specific instructions for completing the projections for effective gross income follow.
When the applicant will occupy one of the units of a two- to four-family property as a
principal residence, income should not be calculated for the owner-occupied unit.
Effective Gross Income
 Annual Rental at 100% Occupancy
Multiply the total monthly rental shown in the rent schedule by 12. If the lender disagrees with
the applicant's figures, the reasons for the disagreement should be documented in writing.
 Positive Adjustments
Any additional income should be added to the rental income. The source of that income--such
as parking, laundry, etc.--should also be shown.

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 Negative Adjustments
The income should be reduced by the annual dollar amount of rent loss that can be expected as
the result of anticipated vacancies or uncollectible rent from occupied units.
Operating Expenses
Specific instructions for completing the projections of operating expenses follow. Any
operating expenses that relate to an owner-occupied unit in a two- to four-family
property should not be included.
 Heating, Cooking, Hot Water If any of these items are provided by the applicant as part of the
rent for a unit, the projected cost and type of fuel used should be included. When the costs for
heating relate to public areas only, an appropriate notation should be made.
 Electricity This should include only those projected expenses that will be incurred by the
applicant over and above any similar expense for heating, cooking, or hot water already taken
into account. If the expense relates to the cost of electricity for public areas only, an appropriate
notation should be made.
 Water/Sewer These projected expenses should not be included when they are part of the real
estate tax bill or when the units are serviced by an on-site private system.
 Casual Labor This includes the costs for public area cleaning, snow removal, etc., even though
the applicant may not elect to contract for such services.
 Interior Paint/Decorating This includes the costs of contract labor and materials that are
required to maintain the interiors of the living units.
 General Repairs/Maintenance
This includes the costs of contract labor and materials that are required to maintain the public
corridors, stairways, roofs, mechanical systems, grounds, etc.
 Management Expenses
these are the customary expenses that a professional management company would charge to
manage the property.
 Supplies.
This includes the costs of items like light bulbs, janitorial supplies, etc.
 Total Replacement Reserves This represents the total average yearly reserves that were
computed in the "Replacement Reserve Schedule" portion of the form. Generally, all equipment

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that has a remaining life of more than one year--such as refrigerators, stoves, clothes
washers/dryers, trash compactors, etc.--should be expensed on a replacement cost basis--even
if actual reserves are not provided for in the operating statement or are not customary in the
local market.
Income Reconciliation
The first formula in this section is used to determine the monthly operating income for a
two- to four-family property when one unit is occupied by the applicant as his or her
principal residence. The monthly operating income should be applied either as income
or debt in accordance with the instructions on the form.
Both formulas must be used to determine the net cash flow for a single-family
investment property or for a two- to four-family property that the applicant will not
occupy. The net cash flow should be applied as either income or debt in accordance
with the instructions on the form
- Cash flow statement
The cash flow statement reports the cash generated and used during the time interval
specified in its heading. The period of time that the statement covers is chosen by the
company. For example, the heading may state "For the Three Months Ended December
31, 2010" or "The Fiscal Year Ended September 30, 2010".
Form
Sample Business Plan
Sample Cash Flow Statement
Statement For the Month Ended_________.
Cash Flow From Operating Activities
Net Income $***

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Non-cash Expenses and Revenues
Include income
Increase in Accounts Receivable $(***)
Increase in Supplies ***
Increase in Accounts Payable *** (***)
Net Cash Flow from Operating Activities ***
Cash Flows From Investing Activities
Purchase of land $(****)
Purchase of Building (****)
Net Cash Flow used by Investing Activities
Cash Flow Financing Activities
Invested ****
Withdrawals (***)
Net Cash Flow Provided by Financing Activities $****
Net Increase (Decrease) in Cash
What Can The Statement of Cash Flows Tell Us?
Because the income statement is prepared under the accrual basis of accounting, the
revenues reported may not have been collected. Similarly, the expenses reported on
the income statement might not have been paid. You could review the balance sheet
changes to determine the facts, but the cash flow statement already has integrated all
that information. As a result, savvy business people and investors utilize this important
financial statement.
Here are a few ways the statement of cash flows is used.
1. The cash from operating activities is compared to the company's net income. If the cash from
operating activities is consistently greater than the net income, the company's net income or

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earnings are said to be of a "high quality". If the cash from operating activities is less than net
income, a red flag is raised as to why the reported net income is not turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is
flowing in and out of the company. If a company is consistently generating more cash than it is
using, the company will be able to increase its dividend, buy back some of its stock, reduce
debt, or acquire another company. All of these are perceived to be good for stockholder value.
3. Some financial models are based upon cash flow.
Data Definitions
The cash flow statement organizes and reports the cash generated and used in the
following categories:
- Operating activities Cash Flow
converts the items reported on the income statement from the accrual basis of accounting to
cash.
- Investing activities CF
reports the purchase and sale of long-term investments and property, plant and equipment.
- Financing activities CF
reports the issuance and repurchase of the company's own bonds and stock and the payment of
dividends.
Depreciation and Amortization
Depreciation and Amortization is a noncash charge that represents a reduction in the
value of fixed assets due to wear, age, or obsolescence. This figure also includes
amortization of leased property, intangibles, and goodwill, and depletion. This number is
an add-back to the Statement of Cash Flows.

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Capital Expenditures
reports the issuance and repurchase of the company's own bonds and stock and the payment of
dividends.
Cash Dividends paid
the cash payment made by the company to its shareholders. Payment is usually made
quarterly, but can be paid biannually (ADRs).

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B - Financial ratios
Why financial ratios:
It has been said that you must measure what you expect to manage and
accomplish. Without measurement, you have no reference to work with and
thus, you tend to operate in the dark.
One way of establishing references and managing the financial affairs of an
organization is to use ratios.
What are financial ratios:
*Ratios are simply relationships between two financial balances or financial
calculations. These relationships establish our references so we can
understand how well we are performing financially.
*Ratios also extend our traditional way of measuring financial Performance;
i.e. relying on financial statements.
*By applying ratios to a set of financial statements, we can better understand
financial performance.

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I) Liquidity ratios:
Liquidity Ratios help us understand if we can meet our
obligations over the short-run. Higher liquidity levels
indicate that we can easily meet our current obligations
as they come due.
1) Current ratio:
 Current assets include:
Cash, accounts receivable, marketable securities,
inventories, and prepaid items.
 Current liabilities include:
Notes payable, accounts payable, accrued expenses(
salaries payable, taxes payable, current maturities of long-
term obligations and other current accruals),unearned
revenues .
EXAMPLE — Current Assets are $ 200,000 and Current Liabilities are
$80,000.
The Current Ratio is $ 200,000 / $ 80,000 or 2.5.
We have 2.5times more current assets than current
liabilities.
Note:
Low current ratio would imply possible insolvency problems. A very high
current ratio might imply that management is not investing idle assets
productively. Generally, we want to have a current ratio that is proportional to
our operating cycle.

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2) Quick ratio:(The Acid Test Ratio) measures our ability to meet
current obligations based on the most liquid assets
 Since certain current assets (such as inventories, prepaid
expenses) may be difficult to convert into cash, we may want to
modify the Current Ratio. Also, if we use the LIFO (Last In First
Out) Method for inventory accounting, our current ratio will be
understated. Therefore, we will remove certain current assets
from our previous calculation. This new ratio is called the Acid
Test or Quick Ratio; i.e. assets that are quickly converted into
cash will be compared to current liabilities.
 Liquid assets include
Cash, marketable securities, and accounts receivable.
EXAMPLE: Cash is $ 5,000; Marketable Securities are $ 15,000,
Accounts Receivable are $ 40,000, and Current Liabilities are $
80,000. The
Acid Test Ratio is ($ 5,000 + $ 15,000 + $ 40,000) / $ 80,000 or .75.
We have $ .75 in liquid assets for each $ 1.00 in current liabilities
3) Cash ratio: It places emphasis on cash flows to meet fixed
debt obligations.
 Current debt obligations:
Current maturities of long-term debts along with notes payable.
 We can refer to the Statement of Cash Flows for operating
cash flows.

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EXAMPLE : We have operating cash flow of $ 100,000, notes payable of $
20,000 and we have $ 5,000 in current obligations related to our long-term
debt.
The Operating Cash Flow to Current Debt Obligations Ratio is
$100,000 / ($ 20,000 + $ 5,000) or 4.
We have 4 times the cash flow to cover our current debt obligations
II) Activity ratios:
 They measure the ability of assets to generate
revenues or earnings.
 Measures the speed with which various
accounts are converted into sales or cash
inflows or outflows
1) Accounts receivable turnover:
It measures the number of times we were able to convert our
receivables over into cash. Higher turnover ratios are desirable.
EXAMPLE: Sales are $ 480,000, the average receivable balance during the
year was $ 40,000 and we have a $ 20,000 allowance for sales returns.
Accounts Receivable Turnover is ($ 480,000 - $ 20,000) / $ 40,000 or 11.5.
We were able to turn our receivables over 11.5 times during the year.
NOTE: We are assuming that all of our sales are credit sales; i.e. we do
not have any significant cash sales
2) Days in A/R:
It measures the average length of time required to collect our
receivables.
A low number of days is desirable.

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Example: if we base our calculation on the full calendar year, we would
require 32 days on average to collect our receivables.( 365 / 11.5) = 32 days.
3) Inventory turnover:
We are measuring how many times we turned our inventory over
during the year. Higher turnover rates are desirable. A high turnover
rate implies that management does not hold onto excess inventories
and our inventories are highly marketable.
EXAMPLE: Cost of Sales were $ 192,000 and the average inventory
balance during the year was $ 120,000. The Inventory Turnover Rate
is 1.6
Or we were able to turn our inventory over 1.6 times during the year.
Days in Inventory
4) Days in Inventory:
Is the average number of days we held our inventory before a sale. A
low number of inventory days is desirable. A high number of days
implies that management is unable to sell existing inventory stocks.
EXAMPLE: If we refer back to the previous example and we use the entire
calendar year for measuring inventory, then on average we are holding our
inventories 228 days before a sale. (365 / 1.6) = 228 days.

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Note: Cycle
 Now that we have calculated the number of days for receivables and the
number of days for inventory, we can estimate our operating cycle.
Operating Cycle = Number of Days in Receivables + Number of Days in
Inventory.
In our previous examples, this would be 32 + 228 = 260 days.
So on average, it takes us 260 days to generate cash from our current assets.
 If we look back at our Current Ratio, we found that we had 2.5 times more
current assets than current liabilities. We now want to compare our Current
Ratio to our Operating Cycle.
Our turnover within the Operating Cycle is 365 / 260 or 1.40. This is lower than our
Current Ratio of 2.5. This indicates that we have additional assets to cover the
turnover of current assets into cash. If our current ratio were below that of the Operating
Cycle Turnover Rate, this would imply that we do not have sufficient current assets to
cover current liabilities within the Operating Cycle.
We may have to borrow short-term to pay our expenses.
Capital Turnover
III) Profitability Ratios:
 They measure the level of earnings in comparison to a base, such as assets,
sales, or capital.
 Enable analysts to evaluate the firm`s profits with respect to a given
level of sales, certain level of assets, or the owner`s investment.
 A company's long-run solvency depends on the success of its
operations, its ability to raise capital for expansion, and its ability to
make principal and interest payments. And the company's ability to
achieve those goals is heavily dependent on its profitability
1) Gross profit margin
Compares gross profit to sales.

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Example: Gross profit (sales- cost of goods sold)$39845 and net
sales$143086
This gives us a gross profit margin of 27.85%
This means that for every $1:00 of sale, we generated $.2785 in gross profit
2) Operating Income to Sales (Return On
SalesOperating Profit Margin):
Compares Earnings Before Interest and Taxes (EBIT) to Sales.
By using EBIT, we place more emphasis on operating results and we more
closely follow cash flow concepts.
EXAMPLE: Net Sales are $ 460,000 and Earnings Before Interest and
Taxes is $ 100,000.
This gives us a return of 22% on sales, $ 100,000 / $ 460,000 = .22.
For every $ 1.00 of sales, we generated $ .22 in Operating Income.
3) Profit margin:
Profit Margin measures the percent of profits you generate for each dollar of
sales. Profit
Margin reflects your ability to control costs and make a return on your sales.
Management is interested in having high profit margins.
EXAMPLE: Net Income for the year was $ 60,000 and Sales were $480,000.
Profit Margin is $ 60,000 / $ 480,000 or 12.5%. For each dollar of sales, we
generated $ .125 of profits.
Return on A
4) Return on Assets (ROA):

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It measures the net income returned on each dollar of assets. This ratio
measures overall profitability from our investment in assets. Higher rates of
return are desirable.
EXAMPLE : operating Income is $ 60,000 and average total assets for the
year are $ 500,000.
This gives us a 12% return on assets, $ 60,000 / $ 500.000= .12.
 Return on Assets is often modified to ensure accurate measurement
of returns. For example, we may want to deduct out preferred
dividends from Net Income or maybe we should include operating
assets only and exclude intangibles, investments, and other assets
not managed for an overall rate of return.
5) Return on Equity (ROE):
 For publicly traded companies, the relationship of earnings to equity
or Return on Equity is of prime importance since management must
provide a return for the money invested by shareholders.
 Return on Equity is a measure of how well management has used
the capital invested by shareholders. Return on Equity tells us the
percent returned for each dollar (or other monetary unit) invested by
shareholders.
EXAMPLE: operating Income for the year was $ 60,000, total shareholder
equity at the beginning of the year was $ 315,000 and ending shareholder
equity for the year was $ 285,000.
Return on Equity is calculated by dividing$ 60,000 by $ 300,000 (average
shareholders’ equity which is $ 31 5,000 + $ 285,000 / 2). This gives us a
Return on Equity of 20%.

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For each dollar invested by shareholders, 20% was returned in the form of
earnings.
6) Earnings per share:
The EPS expresses the earnings of a company on a "per share"
basis. Growth in earnings is often monitored with Earnings per Share
(EPS). A high EPS in comparison to other competing firms is
desirable.
EXAMPLE: Earnings are $ 100,000 and preferred stock dividends of $
20,000 need to be paid. There are a total of 80,000 common shares
outstanding.
Earnings per Share (EPS) is ($ 100,000 - $ 20,000) / 80,000 shares
outstanding or $ 1.00 per share.
IV) Leverage (debt) Ratios:
Leverage Ratios measure the use of debt and equity
for financing of assets.
Debt to Equity
1) Debt to Equity:
 It is the ratio of Total Debt to Total Equity. It compares the funds
provided by creditors to the funds provided by shareholders. As
more debt is used, the Debt to Equity Ratio will increase.
 Since we incur more fixed interest obligations with debt, risk increases.

Trends 2011 Page 60
On the other hand, the use of debt can help improve earnings since we
get to deduct interest expense on the tax return. So we want to balance
the use of debt and equity such that we maximize our profits, but at the
same time manage our risk
.
EXAMPLE: We have total liabilities of $ 75,000 and total shareholders’
equity of $ 200,000. The Debt to Equity Ratio is 37.5%, $ 75,000 / $200,000
= .375.
When compared to our equity resources, 37.5% of our resources are in the
form of debt.
KEY POINT: as a general rule, it is advantageous to increase our use of
debt (trading on the equity) if earnings from borrowed funds exceeds
the costs of borrowing
2) The Debt Ratio:
It measures the level of debt in relation to our investment in assets. The
Debt
Ratio tells us the percent of funds provided by creditors and to what extent
our assets protect us from creditors. A low Debt Ratio would indicate that we
have sufficient assets to cover our debt load. Creditors and management
favor a low Debt Ratio.
EXAMPLE: Total Liabilities are $ 75,000 and Total Assets are $ 500,000.
The Debt Ratio is 15%, $ 75,000 / $ 500,000 = .15. 15% of our funds for
assets come from debt.

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3) Times Interest Earned:
It is the number of times our earnings (before interest and taxes) covers
our interest expense.
It represents our margin of safety in making fixed interest payments. A
high ratio is desirable from both creditors and management.
EXAMPLE: Earnings Before Interest Taxes is $ 100,000 and we have $
10,000 in Interest Expense. Times Interest Earned is 10 times, $ 100,000 / $
10,000.
We are able to cover our interest expense 10 times with operating income.
V) Market Value Ratios:
These ratios attempt to measure the economic status of
the organization within the marketplace.
Investors use these ratios to evaluate and monitor the
progress of their investments.
1) Price Earnings (P/E) Ratio:
The relationship of the price of the stock in relation to EPS is
expressed as the Price to Earnings Ratio or P / E Ratio. Investors
often refer to the P / E Ratio as a rough indicator of value for a
company. A high P / E Ratio would imply that investors are very
optimistic (bullish) about the future of the company since the price

Trends 2011 Page 62
(which reflects market value) is selling for well above current
earnings.
A low P / E Ratio would imply that investors view the company's
future as poor and thus, the price the company sells for is relatively
low when compared to its earnings.
EXAMPLE: Earnings per share is $ 3.00 and the stock is selling for $
36.00 per share.
The P / E Ratio is $ 36 / $ 3 or 12. The company is selling for 12 times
earnings
2) Book Value per share:
 Book value per Share expresses the total net assets of a business on a
per share basis. This allows us to compare the book values of a
business to the stock price and measure differences in valuations.
 Indicates the recorded value of net assets underlying each share of
common stock.
 Net Assets available to shareholders can be calculated as Total Equity
less Preferred Equity.
* Calculated as Total Equity less Preferred Equity.

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EXAMPLE: Total Equity is $ 5,000,000 including $ 400,000 of preferred
equity. The total number of common shares outstanding is 80,000 shares.
Book Value per Share is ($ 5,000,000 - $ 400,000) / 80,000 or $ 57.50
This means that each share of common stock is financed by $3.75 of the
total shareholders' equity
3) Dividend yield:
The percentage of dividends paid to shareholders in relation to the price of
the stock is called the Dividend Yield. For investors interested in a source of
income, the dividend yield is important since it gives the investor an
indication of how much dividends are paid by the company.
EXAMPLE: Dividends per share are $ 2.10 and the price of the stock is
$30.00 per share.
The Dividend Yield is $ 2.10 / $ 30.00 or 7%

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Uses and Limitations of Financial Ratios
Benchmarking Financial Ratios
Financial ratios are not very useful on a stand-alone basis; they must be
benchmarked against something. Analysts compare ratios against the
following:
1. The Industry norm - This is the most common type of comparison.
Analysts will typically look for companies within the same industry and
develop an industry average, which they will compare to the company they
are evaluating. Ratios per industry are also provided by Bloomberg and the
S&P. These are good sources of general industry information. Unfortunately,
there are several companies included in an index that can distort certain
ratios. If we look at the food and beverage ratio index, it will include
companies that make prepared foods and some that are distributors. The
ratios in this case would be distorted because one is a capital-intensive
business and the other is not. As a result, it is better to use a cross-sectional
analysis, i.e. individually select the companies that best fit the company
being analyzed.
2. Aggregate economy - It is sometimes important to analyze a
company's ratio over a full economic cycle. This will help the analyst
understand and estimate a company's performance in changing economic
conditions, such as a recession.
3. The company's past performance - This is a very common
analysis. It is similar to a time-series analysis, which looks mostly for trends
in ratios.
Limitations of Financial Ratios
There are some important limitations of financial ratios that analysts should
be conscious of:

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 Many large firms operate different divisions in different industries.
For these companies it is difficult to find a meaningful set of industry-
average ratios.
 Inflation may have badly distorted a company's balance sheet. In this
case, profits will also be affected. Thus a ratio analysis of one company
over time or a comparative analysis of companies of different ages must
be interpreted with judgment.
 Seasonal factors can also distort ratio analysis. Understanding
seasonal factors that affect a business can reduce the chance of
misinterpretation. For example, a retailer's inventory may be high in the
summer in preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.
 Different accounting practices can distort comparisons even within
the same company (leasing versus buying equipment, LIFO versus
FIFO, etc.).
 It is difficult to generalize about whether a ratio is good or not. A high
cash ratio in a historically classified growth company may be interpreted
as a good sign, but could also be seen as a sign that the company is no
longer a growth company and should command lower valuations.
 A company may have some good and some bad ratios, making it
difficult to tell if it's a good or weak company.
*In general, ratio analysis conducted in a
mechanical, unthinking manner is dangerous.
On the other hand, if used intelligently, ratio
analysis can provide insightful information.

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c- The Time value of Money
Introduction:
Time Value of Money problems refer to situations involving the exchange of
something of value (money) at different points in time. In a basic sense, all
investments involve the exchange of money at one point in time for the rights
to the future cash flows associated with that investment.
Expressing all of the values that are exchanged in terms of a common
medium of exchange, or money, allows different
sets of products or services to be compared in terms of a single standard of
value (e.g., dollars).
However, the passage of time between the outflows and inflows in a typical
investment situation results in different current values associated with cash
flows that occur at different points in time.
Thus, it is not possible to assess an investment simply by adding up the
total cash inflows and outflows and determining if they are positive or
negative without first considering when the cash flows occur.
Interest rates represent the price paid to use money for some period of time.
Interest rates are positive to compensate lenders (savers) for foregoing the
use of money for some interval of time.
What is the time value of money?
The time value of money is one of the most fundamental concepts in finance,
it is based on the notion that receiving a sum of money in the future is less
valuable than receiving that sum today.
This is because a sum received today can be invested and earn interest.
The four basic time value of
Money concepts are:
 Future value of a sum
 Present value of a sum

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 Future value of an annuity
 Present value of an annuity
FUTURE VALUE OF A SUM:
If a sum is invested today, it will earn interest and increase in value over
time. The value that the sum grows to is known as its future value.
Computing the future value of a sum is known as compounding.
The future value of a sum depends on the interest rate earned and the time horizon
over which the sum is invested. This is shown with the following formula:
FVN = PV (1+I) N
Where:
FVN = future value of a sum invested for N periods
I = periodic rate of interest
PV = the present or current value of the sum invested
EXAMPLE:
Suppose that a sum of $1,000 is invested for four years at an annual rate of
interest of 3%. What is the future value of this sum?
In this case,
N = 4
I = 3
PV = $1,000

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Using the future value formula,
FVN = PV(1+I)N
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.125509)
FV4 = $1,125.51
PRESENT VALUE OF A SUM:
The present value of a sum is the amount that would need to be invested
today in order to be worth that sum in the future. Computing the present
value of a sum is known as discounting.
The formula for computing the Present value of a sum is:
PV = (1+ )
EXAMPLE:
How much must be deposited in a bank account that pays 5% interest per
year in order to be worth $1,000 in three years?
In this case,
N = 3
I = 5
FV3 = $1,000
PV= (1+ )
= = $863.84
ANNUITIES:
An annuity is a periodic stream of equally-sized payments.
The two basic types of annuities are:
ordinary annuity
annuity due

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With an ordinary annuity, the first payment takes place one period in the
future.
With an annuity due, the first payment takes place immediately.
COMPUTING THE FUTURE AND PRESENT VALUES OF AN
ANNUITY :
The formulas used to compute the future value and present value of a sum
can be easily extended to the
Case of an annuity.
Future value of an ordinary annuity:
The formula for computing the future
Value of an ordinary annuity is:
FVAN= PMT [1+ −1 ]
Where:
FVAN = future value of an N-period ordinary annuity
PMT = the value of the periodic payment
EXAMPLE:
Suppose that a sum of $1,000 is invested at the end of each of the next four
years at an annual rate of interest of 3%. What is the future value of this
ordinary annuity?
In this case,
N = 4
I = 3
PMT = $1,000
Using the formula:
FVAN = PMT [
FVA4 = 1,000 [(1+3%)4−13%] = $4,183.63
The future value of the annuity can also be obtained by computing the future
value of each term and then
Combining the results:
1,000(1.03)3
+ 1,000(1.03)2
+

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1,000(1.03)1
+ 1,000(1.03)0
= 1,092.73 + 1,060.90 +
1,030.00 + 1,000.00
= $4,183.63
FUTURE VALUE OF AN ANNUITY DUE :
The future value of an annuity due is computed as follows:
FVAdue = FVAordinary(1+I)
Referring to the previous example, the future value of an annuity
due would be:
4,183.63(1+.03) = $4,309.14
PRESENT VALUE OF AN ORDINARY ANNUITY:
The formula for computing the present value of an ordinary annuity is:
PVAN= PMT [1−1(1+ ) ]
Where:
PVAN = future value of an N-period ordinary annuity
PMT = the value of the periodic payment
EXAMPLE:
How much must be invested today in a bank account that pays 5% interest
per year in order to generate a stream of payments of $1,000 at the end of
each of the next three years?
In this case,
N = 3
I = 5
PMT = $1,000
Using the formula,
PVAN= PMT [1−1(1+ ) ]

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PVA3= 1,000 [1−1(1+5%)35%] = $2, 723.25
The present value of the annuity can also be obtained by computing the
present value of each term and then combining the results:
1,000(1.05)-3
+ 1,000(1.05)-2
+ 1,000(1.05)-1
= 863.84 + 907.03 + 952.38
= $2723.25
PRESENT VALUE OF AN ANNUITY DUE:
The present value of an annuity due is computed as follows:
PVAdue = PVAordinary(1+I)
Referring to the previous example, the
present value of an annuity due would be:
2,723.25(1+.05) = $2,859.41
OTHER APPLICATIONS:
The time value of money formulas can be used to solve for the appropriate
rate of interest or time horizon given the present and future value of a sum.
SOLVING FOR THE INTEREST RATE:
The present and future value Formulas can be used to solve for the rate of
interest.
EXAMPLE:
Suppose that an investor deposits $10,000 in a bank account.
The investor plans to keep these funds in the bank for ten years, with a goal
of having $20,000 at the end of that time. What rate
Of interest would he have to earn to double His money in ten years?
This can be determined
algebraically as follows:
FVN = PV (1 + I) N
= (1+I)N
= (1+I)

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- 1 =I
In this example,
1020,00010,000 -1= 10.07177 = 7.177%
SOLVING FOR THE TIME HORIZON:
The present and future value formulas can also be used to solve for the time
horizon.
EXAMPLE:
Suppose that an investor deposits $5,000 in a bank account that pays 6%
interest per year. The investor wants to know how long it will take for these
funds to be worth $10,000.
This can be determined algebraically as follows:
FVN = PV (1 + I) N
= (1+I)N
In ( )= N In (1+I)
N= (1+ )
In this example,
N= = 11.896

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D- Capital budgeting
Capital budgeting: the process of evaluating and selecting
long term investments those are consistent with the firm's goals of
maximizing owner's wealth
Capital expenditure: the outlay of funds by the firm that is
expected to produce benefits over a period of time greater than one
year
*Whenever we make an expenditure that generates a cash flow benefit for more
than one year, this is a capital expenditure. Examples include the purchase of new
equipment, expansion of production facilities, buying another company, acquiring new
technologies, launching a research & development program, etc., etc., etc. Capital
expenditures often involve large cash outlays with major implications on the future
values of the company.
Additionally, once we commit to making a capital expenditure it is sometimes difficult to
back out. Therefore, we need to carefully analyze and evaluate proposed capital
expenditures
Three stages of capital budgeting:
Capital Budgeting Analysis is a process of evaluating how we invest in capital assets;
i.e. assets that provide cash flow benefits for more than one year. We are trying to
answer the following question:
Will the future benefits of this project be large enough to justify the investment
given the risk involved?
It has been said that how we spend our money today determines what our value will be
tomorrow. Therefore, we will focus much of our attention on present values so that we
can understand how expenditures today influence values in the future. A very popular
approach to looking at present values of projects is discounted cash flows or DCF.
However, we will learn that this approach is too narrow for properly evaluating a project.
We will include three stages within Capital Budgeting Analysis:
Decision Analysis for Knowledge Building
Option pricing to Establish Position

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