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  1. 1. CORPORATE FINANCE (Ref:Introduction to Accounting and Finance-Geoff Black)
  2. 2. Do you think .. -you know nothing about accounting Y/N -accounting needs advanced mathemetical skills Y/N -accounting requires an IQ of 200 plus Y/N -accounting is boring Y/N -accounting is only relevant for some people Y/N
  3. 3. Why are we here? To learn from each other, because, you cannot teach a person anything you can only help him find it within himself -'Galileo-an italian professor
  4. 4. Negative Slab or Positive Boon ' Mr. Anchovy, our experts describe you as a appallingly dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated, no sense of humour, tedious company and irrepressibly drab and awful.' And , in most professions these would be considerable drawbacks, in accounting they are a positive boon' Monty Python, 'The Lion Tamer Sketch”
  5. 5. Do you really don't know what's accounting? Consider this snippet of conversation: “Tan, wrote his car off yesterday. He'd gone into the red to pay for it, but - would you credit it – the car wasn't insured. There's no accounting for some people. The bottom line is you need to protect your assets”
  6. 6. Presenter: :   This module will be lead-managed by Mr.Masilamani R He has about 3 decades of working, training & consulting experience  His basic degree is in statistics & economics  His MBA is in finance and economics  He also has several professional accreditations, including business performance management & project management
  7. 7. Why accounting Course? Offered to all incoming Masters students at any School of Business. In particular, this lecture is designed for those who have no previous education or training in accounting. The intention is for this lecture to teach at the most basic level. To teach the “alphabet” of accounting so that students can learn to speak in “full sentences” in the accounting (and other) courses. Students with even minimal background may wish to skim or skip sections of the lecture.
  8. 8. Food for Thought With reference to non-business, performance management occurs in Sun Tzu's The Art of War. Sun Tzu claims that, 'to succeed in war, one should have full knowledge of one's own strengths and weaknesses as well as those of one's enemies. Lack of either set of knowledge might result in defeat' Parallels between the challenges in business and those of war include: * collecting data - both internal and external * discerning patterns and meaning in the data (analyzing) * responding to the resultant information
  9. 9. Financial and Management Accounting Accounting has two main divisions: Financial accounting Primarily prepared for users external to the company. Revenues, earnings, assets, etc. Management accounting Primarily for internal purposes Costing, budgeting, net present value, etc. This lecture will focus mainly on financial accounting for business. Thus it is called 'CORPORATE FINANCE'
  10. 10. Corporate Finance Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms
  11. 11. Learning Emphasis In business management program we emphasise more on application of accounting and finance concepts, skills and practices. This course focuses on using student awareness of accounting and finance to learn how to apply in practice
  12. 12. Course Aims The broad aims of this course are to: 1. Introduce the basic principles and underlying concepts of accounting and finance; 2. Describe profit and loss accounts, balance sheets and cash flows tatements and generally how they are prepared; 3. Explain in detail how these statements may be read and interpreted, including points of weakness and their shortcomings; and 4. Provide basic understanding of how management accounting can assistmanagers in planning, control and decision.
  13. 13. Course Outcomes At the completion of this course, it is expected that you will be able to: 1. Explain the effect of decision, transactions and events on financial performance and construct simple sets of accounts; 2. Interpret published financial statements intelligently and translate financial information accordingly to match the various needs of business problems; 3. Identify the main uses and limitations of financial information and administer them effectively for decision-making, planning and control; 4. Apply cash flow statements, cash forecasts and consolidate data for capital investments, project appraisals and management budget; and 5. Evaluate company performance, estimate its cost of capital and justify the processes of budgeting.
  14. 14. Corporate Finance Day One A. Fundamentals of Financial Management B. Analysis of Financial Statements C. Time Value of Money D. Securities Valuation Day Two E. Risk & Return F. Capital Budgeting G. The Cost of Capital H. Dividend Policy
  15. 15. Accounting Accounting can be simply defined as the recording, summarising and interpretation of financial information The key aspects of accounting are therefore, 1. Identifying the key financial components of the oganisation e.g. assets, liabilities, capital, revenue and cash flow 2. Measuring the monetary values of key financial components in a way which represents a true and fair view of the organisation 3. Communicating the financial information in ways that are useful to the users of the organisation
  16. 16. Accrual vs Cash accounting why do some report cash and some accrual? It really depends on the needs of the users. In most cases, you can choose which method to use. Learn how they work and the advantages and disadvantages of each so you can choose the . better one for your business. In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts
  17. 17. What is accrual accounting? Revenue and expenses reported for an accounting period are the revenue earned and expenses matched to or incurred in generating that income – regardless of whether the income has actually been received or cash paid for the expenditure For Example Where we have performed some work for a client and invoiced this client, we would include this revenue in our reporting for the period, regardless of whether we have actually received payment or not. On the expense side, we would include expenses such as electricity and gas consumed during the period even if the bill is not due for payment until the following period
  18. 18. What is Cash Accounting The cash method is the more commonly used method of accounting in small business. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid. Example Your computer installation business finishes a job in November, and doesn't get paid until three months later in January.Under the cash method, you would record the payment in January. Under the accrual method, you would record the income in your November books
  19. 19. The Accounting Formula Has 3 Major Components to reflect the organisation value: a)Assets-the value of the resources of the organisation b)Capital-the value of the owner's interest in the organisation c)Liabilities-the value of others' claim on the organisation ASSETS - LIABILITIES=CAPITAL
  20. 20. The Basic Accounting Statements 1.The Balance Sheet-A financial summary showing the assets, liabilities and capital of the organisation at a particular date 2.The Income statement-A financial summary showing revenue and expenses for the financial period 3.The Cash flow Statement is a summary of cash and bank balances over a defined past period
  21. 21. A. Fundamentals of Financial Management 1.Definition of Financial Management  The management of the finances of a business / organization in order to achieve financial objectives. 1.Key Objectives of Financial Management  Create wealth for the business.  Generate cash.  Provide adequate return on investment
  22. 22. A. Fundamentals of Financial Management 1. Key elements of the process of financial management a) Financial Planning  Ensure enough funding is available at the right time. b) Financial Control  Ensure that the business is meeting its objectives. c) Financial Decision Making  Key aspects – investment, financing and dividends.
  23. 23. B. Analysis of Financial Statements Financial Statement Analysis Comparative Analysis Horizontal Analysis Ratio Analysis Vertical Analysis 1. 2. 3. 4. 5. Profitability Ratio Liquidity Ratio Activity Ratio Gearing Ratio Other Ratios
  24. 24. B. Analysis of Financial Statements 1. Comparative Analysis  Comparative Analysis involves the comparison against the company’s past performance, against another company’s performance or against the industry average. Comparison against a benchmark will enable users to make an informed and better decision. a) Horizontal Analysis  Involves the comparison of items in the financial statements over a two year period or more.  Comparison can be made against last year’s performance or against few years.
  25. 25. B. Analysis of Financial Statements 1. Comparative Analysis a) Vertical Analysis  As not all companies are of the same size, and comparing the absolute results of different businesses of dissimilar sizes will not provide an adequate picture.  By turning the absolute figures into percentage, we could make a more meaningful interpretation of the data.  We will compare percentages rather than the absolute figure (overcome the problems of companies with different sizes).
  26. 26. B. Analysis of Financial Statements 1. Financial Ratio Analysis  Shows the relationship between an item in the income statement or balance sheet with another item.  Provide a meaningful data and will enable users to understand the financial statement. a) Profitability Ratios  Measure the ability of a business entity to earn profits.  Used as an indicator of how efficient and effective a company is in achieving its profit. 28
  27. 27. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Profitability Ratios 1) Gross Profit Margin (Ratio)  Measures the gross profit earned for every Ringgit sales.  Higher gross profit ratio indicates strong performance as the company has more profit to pay for its sales & administrative expenses. Gross Profit Ratio = ( Gross Profit / Net Sales) x 100 29
  28. 28. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Profitability Ratios 1) Net Profit Margin (Ratio)  Measures the net profit earned for every Ringgit sales.  Higher net profit ratio indicates strong performance as the company has more profit to pay dividends to shareholders. Net Profit Ratio = ( Net Profit / Net Sales) x 100 30
  29. 29. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Profitability Ratios 1) Earnings Per Share (EPS)  Measures the earning that is earned by each ordinary share after paying for tax and preference shares dividend.  The higher the earning per share the better it is. EPS = ( Earning after Tax – Div for PS) / Total OS PS – Preference Share, OS – Ordinary Share 31
  30. 30. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Liquidity Ratios  Liquidity refers to the ability to generate or raise cash.  Measure the ability of a company to meet short term obligations or debts that might be unexpectedly demanded to be paid before its maturity dates.  If a company fails to pay its debts, it could mean an end to the business. 32
  31. 31. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Liquidity Ratios 1) Current Ratio  Measures the ability of a business entity to pay up current liabilities.  A current ratio of 2:1 indicates strong ability to meet short term debts.  The higher the current ratio, the more liquid the company is said to be. Current Ratio = Current Assets / Current Liabilities 33
  32. 32. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Liquidity Ratios 1) Quick Ratio  Also known as acid test ratio.  Measures how many quick assets there are to cover quick liabilities.  Comprises of cash, receivables and market securities and exclude inventory. Current Ratio = [CA – (Inventory + Prepaid)] / CL CA – Current Asset, CL – Current Liabilities 34
  33. 33. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Activity Ratios  Measure the effectiveness and ability of a company in its resources.  It can indicate how effective a company’s inventory is being used to generate sales or how efficient is the collection of debts by a company. 35
  34. 34. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Activity Ratios 1) Accounts Receivable Turnover (ART)  Measures how fast accounts receivable is collected.  Indicates the effectiveness of a business entity in managing its accounts receivables. ART = Net Credit Sales / *Ave Account Receivable *Ave Acc Rec = (Opening Acc Rec + Closing Acc Rec)/2 36
  35. 35. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Activity Ratios 1) Inventory Turnover  Measures the ability of a business entity to sell its inventory.  Indicates the number of times inventory is sold. Inventory Turnover = COGS / *Ave Inventory COGS – Cost of Good Sold *Ave Inventory = (Opening Inventory + Closing Inventory)/2 37
  36. 36. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Activity Ratios 1) Total Assets Turnover (TAT)  Measure the relationship between sales levels against the average total sales.  Measures the effectiveness of total assets which are used in generating sales. TAT = Net Sales / Average Total Assets 38
  37. 37. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Gearing Ratios  Measure how much the assets of a company is financed by creditor rather than the owners.  High proportion of shareholders fund indicates financial strength.  Heavy reliance on borrowing indicates the risk to the investors as debts require repayments of loan principal amount and the interest expenses. 39
  38. 38. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Gearing Ratios 1) Equity Ratios  Measure the financial structure of a company.  Higher equity ratios indicate stability. Equity Ratio = (*Total OS Fund / Total Assets) x 100 * Total Ordinary Shareholder Fund include retained earnings and reserves but exclude preference shares 40
  39. 39. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Gearing Ratios 1) Debts Ratios  Measures the financial structure of a company.  Higher debt ratios indicate that a company face a higher risk in its ability to settle its debts. Debt Ratio = *Total Debts / Total Assets) x 100 * Total debts = Total Liabilities + Preference S/holders Fund 41
  40. 40. B. Analysis of Financial Statements 1. Financial Ratio Analysis a) Gearing Ratios 1) Debts to Equity Ratios (DER)  Measures how much of total debts are covered by equity.  The lower the ratio the better it is as it indicates the amount owned by equity is more than liabilities. DER = *Total Debts / Total Shareholder Equity * Total debts = Total Liabilities + Preference S/holders Fund 42
  41. 41. B. Analysis of Financial Statements 1.Financial Ratios Analysis – Practical Example Activity No. Category Financial ratios 1 Profitabil ity Gross Profit Margin Net Profit Margin Earning Per Share 2 Liquidity Current Ratio Quick Ratio 3 Activity Accounts receivable turnover Inventory turnover 2005 2004
  42. 42. B. Analysis of Financial Statements 1.Financial Ratios Analysis – Practical Example No. Category Financial ratios 3 Activity Total Asset Turnover 4 Gearing 2005 Equity Ratios Debt Ratio Debt to Equity ratio 5 Other ratios Any additional covering ratios the above under the respective category e.g. interest cover, dividend cover, dividend yeild, debt collection 2004
  43. 43. C. Time Value of Money TVM Interest Simple Compound Future Value Present Value Annuity Amortization
  44. 44. C. Time Value of Money 1. The Interest Rate Which would you prefer -- $10,000 today or $10,000 in 5 years? Obviously, $10,000 today. You already recognize that there is TIME VALUE TO MONEY!!
  45. 45. C. Time Value of Money 1. The Interest Rate Why is TIME such an important element in your decision? TIME allows you the opportunity to postpone consumption and earn INTEREST.
  46. 46. C. Time Value of Money 1. The Interest Rate a) Simple Interest  Interest paid (earned) on only the original amount, or principal, borrowed (lent). b) Compound Interest  Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).
  47. 47. C. Time Value of Money 1. The Interest Rate  Simple Interest - Formula SI = Where SI = P0 = P0(i)(n) Simple Interest Deposit Today (t=0) i = Interest Rate Per Period n = Number of Time Periods
  48. 48. C. Time Value of Money 1. The Interest Rate  Simple Interest - Example Assume that you deposit RM1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year? SI P0(i)(n) RM1,000(.07)(2) = RM140 = =
  49. 49. C. Time Value of Money 1. The Interest Rate a) Compound Interest  When interest paid on an investment during the first period is added to the principal.  During the second period, interest is earned on the new sum.
  50. 50. C. Time Value of Money 1. The Interest Rate a) Compound Interest - Formula CI = Where CI = P(1 + i)n Compound Interest P = Deposit Today i = Interest Rate Per Period n = Number of Time Periods
  51. 51. C. Time Value of Money 1. The Interest Rate a) Compound Interest – Example David deposited RM100 into his saving account in Maybank for 5 years with interest of 5% per annum. What is the return that he is expected to receive at the end of 5th year?
  52. 52. C. Time Value of Money 1. The Interest Rate a) Frequency of Compounding – Formula (future value) FVn = Where n = i = FVn,m = PV0 = PV0(1 + [i/m])mn Compounding Period per year Annual Interest Rate FV at the end of Year n PV of the Cash Flow today
  53. 53. C. Time Value of Money 1. The Interest Rate a) Frequency of Compounding - Example Suppose you deposit $1,000 in an account that pays 12% interest, compounded quarterly. How much will be in the account after eight years if there are no withdrawals?
  54. 54. C. Time Value of Money 1. The Interest Rate a) Frequency of Compounding - Question John deposit $1,000 in an account that pays 12% interest, compounded monthly. How much will be in the account after one year if there are no withdrawals?
  55. 55. C. Time Value of Money 1. Future Value - Formula FV = PV (1+i)n Where FV = PV = Future Value Present Value i = Rate of interest per compounding period n = Number of Compounding Periods
  56. 56. C. Time Value of Money 1. Future Value - Example If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals? 0 6% 1 2 $2,000 FV
  57. 57. C. Time Value of Money 1. Present Value - Question John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years. 0 1 2 3 4 5 8% $5,000 FV5
  58. 58. C. Time Value of Money 1. Present Value - Formula Since FV = PV(1 + i)n. PV = FV / (1+i)n. Where FV = PV = Future Value Present Value i = Rate of interest per compounding period n = Number of Compounding Periods
  59. 59. C. Time Value of Money 1. Present Value - Example Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000? 0 5 10 6% $4,000 PV0
  60. 60. C. Time Value of Money 1. Present Value - Question Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually. 0 1 2 3 4 5 4% $2,500 PV0
  61. 61. C. Time Value of Money 1. Annuities  An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.  Examples of Annuities Include: - Car Loan Payments - Insurance Premiums - Mortgage Payments
  62. 62. C. Time Value of Money 1. Annuities a) Annuities Future Value - Formula 0 Cash flows occur at the end of the period 1 2 n i% . . . R R R R = Periodic Cash Flow FVAn = R(1+i)n-1 + R(1+i)n-2 + ... + R(1+i)1 + R(1+i)0 FVAn n+1
  63. 63. C. Time Value of Money 1. Annuities a) Annuities Future Value - Question If one saves $1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?
  64. 64. C. Time Value of Money 1. Annuities a) Annuities Present Value - Formula 0 Cash flows occur at the end of the period 1 2 n i% . . . R R n+1 R R = Periodic Cash Flow PVAn PVAn = R/(1+i)1 + R/(1+i)2 + ... + R/(1+i)n
  65. 65. C. Time Value of Money 1. Annuities a) Annuities Present Value - Question If one agrees to repay a loan by paying $1,000 a year at the end of every year for three years and the discount rate is 7%, how much could one borrow today?
  66. 66. C. Time Value of Money 1. Amortization - Example Julie Miller is borrowing $10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years. PV0 = R (PVIFA i%,n) $10,000 = R (PVIFA 12%,5) $10,000 = R (3.605) R = $10,000 / 3.605 = $2,774
  67. 67. C. Time Value of Money 1. Amortization – Example (Table) Ending Balance $10,000 End of Year 0 Payment Interest Principal --- --- --- 8,426 1 $2,774 $1,200 $1,574 6,663 2 2,774 1,011 1,763 4,689 3 2,774 800 1,974 2,478 4 2,774 563 2,211 0 5 2,775 297 2,478 $13,871 $3,871 10,000 [Last Payment Slightly Higher Due to Rounding]
  68. 68. C. Time Value of Money 1. Amortization – Question Suppose you borrow $6,655 to make repairs to your house, and the loan is considered a second mortgage. The terms of the loan require you to make payments every three months, i.e. quarterly, for the next two years and the simple interest rate is 6 percent p.a. What is the amount that must be paid every three months?
  69. 69. D. Securities Valuation Securities Valuation Stock Common Stock Preferred Stock Bonds 1. 2. 3. 4. Mortgage Bond Eurobonds Zero Coupon Bonds Junk Bond
  70. 70. Securities Valuation Stock market
  71. 71. D. Securities Valuation-Investment Appraisal 1. Preferred Stock  Preferred Stock is often referred to as a hybrid security because it has many characteristics of both common stocks and bonds.  Like common stocks - No fixed maturity date. - Failure to pay dividends does not bring on bankruptcy.  Like bonds - Dividends are for a limited time.
  72. 72. D. Securities Valuation 1. Preferred Stock – Features a) Multiple series of Preferred Stock b) Preferred Stock’s claim on asset & income c) Cumulative dividends d) Protective provisions e) Convertibility f) Retirement features g) Callable
  73. 73. D. Securities Valuation 1. Preferred Stock – Features a) Multiple series of Preferred Stock  If a company desires, it can issue more than one series of preferred stock, and each series can have different characteristics. - Convertible - Protective provisions
  74. 74. D. Securities Valuation 1. Preferred Stock – Features a) Claims on Assets and Income  Preferred stock has priority over Common Stock with regard to claim on assets in the case of bankruptcy.  Honored before common stockholders, but after bonds.  Must pay dividends to preferred stockholders before it pays common stockholder dividends.
  75. 75. D. Securities Valuation 1. Preferred Stock – Features a) Cumulative Dividends  Cumulative features requires that all past, unpaid preferred stock dividends be paid before any common stock dividends are declared. b) Protective Provisions  Protective provisions generally allow for voting rights in the event of non payment of dividends.
  76. 76. D. Securities Valuation 1. Preferred Stock – Features a) Convertibility  Convertible preferred stock can, at the discretion of the holder, be converted into a predetermined number of shares of common stock.  Almost one third of preferred stock issued today is convertible.  Reduces the cost of the preferred stock to the issue
  77. 77. D. Securities Valuation 1. Preferred Stock – Features a) Retirement Features  Although preferred stock has no set maturity associated with it, issuing firms generally provide for some method of retiring the stock. b) Callable  A call provision entitles a company to repurchase its preferred stock from their holders at stated prices over a given time period.
  78. 78. D. Securities Valuation 1. Preferred Stock a) Valuing Preferred Stock D Vps = kps Where Vps = D = kps = The value of preferred stock The preferred dividend The required rate of return Example : Xerox’s Series C preferred stock pays an annual dividend of RM6.25 and the investors required rate of return is 5%
  79. 79. D. Securities Valuation 1. Common Stock  Common stock is a certificate that indicates ownership in a corporation.  Has no maturity date.  Dividend payments will normally divided into Interim & Final Dividend  In the event of bankruptcy, common stockholders will not receive any payment until the creditors, including the bondholders and preferred stockholders, have been satisfied.
  80. 80. D. Securities Valuation 1. Common Stock – Features a) Claim on income b) Claim on assets c) Voting rights d) Preemptive rights e) Limited liability
  81. 81. D. Securities Valuation 1. Common Stock – Features a) Claim on income  Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid  Can be in the form of dividends or retained earnings.
  82. 82. D. Securities Valuation 1. Common Stock – Features a) Claim on assets  Common stock has a residual claim on assets after claims of debt holders and preferred stockholders.  If bankruptcy occurs, claims of the common shareholders generally go unsatisfied.
  83. 83. D. Securities Valuation 1. Common Stock – Features a) Voting Rights  Common shareholders are entitled to elect the board of directors.  Most often are the only security holders with a vote.  A proxy gives a designated party the temporary power of attorney to vote for the signee at the corporation’s annual general meeting.
  84. 84. D. Securities Valuation 1. Common Stock – Features a) Preemptive Rights  Preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the corporation.  Rights – certificates issued to the shareholders giving them an option to purchase a stated number of shares of stock at a specified price during a two to ten week period.
  85. 85. D. Securities Valuation 1. Common Stock – Features a) Limited Liability  Liability of the shareholder is limited to the amount of their investment.  Limited liability feature aids the firm in raising funds.
  86. 86. D. Securities Valuation 1. Common Stock a) Valuing Common Stock VCS D0 1 g kCS g Where Vcs = The value of common stock D0 = The preferred dividend = Growth rate g kcs = The required rate of return
  87. 87. D. Securities Valuation 1.Common Stock a) Valuing Common Stock – Example Consider the valuation of a common stock that paid RM2.00 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 10% and the investors required rate of return is 15%
  88. 88. D. Securities Valuation 1. Bond – type of debt or long term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year. a) Types of Bonds i. Debentures  Any unsecured long term debt.  Viewed as more risky than secured bonds and provide a higher yield than secured bonds.
  89. 89. D. Securities Valuation 1. Bond a) Types of Bonds i. Mortgage Bonds  A bond secured by a lien on real property.  Typically, the value of the real property is greater than that of the bonds issued. ii. Eurobonds  Securities (bonds) issued in a country different from the one in whose currency the bond is denominated.
  90. 90. D. Securities Valuation 1. Bond a) Types of Bonds i. Zero Coupon Bonds  Issued at a substantial discount from the RM1,000 face value with a zero coupon rate.  Return comes from appreciation of the bonds.  Advantages – cash outflows don’t occur with zero coupon bonds.
  91. 91. D. Securities Valuation 1. Bond a) Types of Bonds i. Junk Bonds (High Yield Bonds)  High risk debt with ratings of BB or below by Moody’s and Standard & Poor’s.  High yield – typically pay 3% ~ 5% more than AAA grade long term bonds.
  92. 92. D. Securities Valuation 1. Bond a) Terminology i. Claims on assets and income  In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock. ii. Par Value  Face value of the bond, returned to the bondholder at maturity.  Corporate bonds are issued at denomination of RM1,000
  93. 93. D. Securities Valuation 1. Bond a) Terminology i. Coupon Interest Rate  The percentage of the par value of the bond that will be paid out annually in the form of interest. ii. Maturity  The length of time until the bond issuer returns the par value to the bondholder and terminates or redeem the bonds.
  94. 94. D. Securities Valuation 1. Bond a) Terminology i. Convertibility  May allow the investor to exchange the bond for a predetermined number of the firm’s shares of common stock. ii. Indenture  The legal agreement between the firm issuing the bond and the trustee who represents the bondholders.
  95. 95. D. Securities Valuation 1. Bond a) Terminology i. Call Provision  A provision such that if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.  Issuer must pay the bondholder at premium.  There is also call protection period where the firm can’t call for a specified period.
  96. 96. D. Securities Valuation 1. Bond a) Valuation  Assigning a value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate.  The value of a bond is combination of:- the amount and timing of cash flows to be received by investors. - the time to maturity of the loan. - the investor’s required rate of return.
  97. 97. D. Securities Valuation 1. Bond a) Valuation - Formula n Vb t 1 I t (1 kb ) M n (1 kb ) Where Vb = Intrinsic value I = Interest to be received n = Number of period to maturity kb = Required rate of return for bondholder M = Par value of the bond at maturity
  98. 98. D. Securities Valuation 1. Bond a) Valuation - Formula Vb = I(PVIFAkb,n) + M(PVIFkb,n) Where Vb = Intrinsic value I = Interest to be received n = Number of period to maturity kb = Required rate of return for bondholder M = Par value of the bond at maturity
  99. 99. D. Securities Valuation 1. Bond a) Valuation – Example Consider a bond issued by Toyota with a maturity date of 2008 and a stated coupon of 5.5%. In December 2004, with 4 years left to maturity, Investors owning the bonds are requiring a 4% rate of return. Calculate the price of Toyota Bond.
  100. 100. D. Securities Valuation 1. Bond a) Valuation – 3 important relationships First Relationships  The value of a bond is inversely related to changes in investor’s present required rate of return (interest rate).  As interested rate increases (decreases), the value of the bond decreases (increases).
  101. 101. D. Securities Valuation 1. Bond a) Valuation – 3 important relationships Second Relationship  The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate.  However, it will be valued above par value if the investor’s required rate of return is below the coupon interest rate.
  102. 102. D. Securities Valuation 1. Bond a) Valuation – 3 important relationships Third Relationship  Long term bonds have greater interest rate risk than the short term bonds.
  103. 103. E. Risk & Return Risk & Return Risk & Return? Market Risk Diversification Summary
  104. 104. E. Risk & Return 1. Risk & Return a) What is Risk?  The possibility that an actual return will differ from our expected return.  Uncertainty in the distribution of possible outcomes. b) What is Return?   Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. Required Return - the return that an investor requires on an asset given its risk.
  105. 105. E. Risk & Return 1. Expected Return - Example State of Economy Probability Return Company A Recession .20 4% -10% Normal .50 10% 14% Boom  (P) .30 14% 30% k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn  k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%  k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14% Company B
  106. 106. E. Risk & Return 1. How do we Measure Risk?  A more scientific approach is to examine the stock’s STANDARD DEVIATION of returns.  Standard deviation is a measure of the dispersion of possible outcomes.  The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK.
  107. 107. E. Risk & Return 1. How do we Measure Risk? a) Formula for Standard Deviation n 2 (ki k ) P(ki ) t 1 Where n = The number of possible outcomes ki = The value of ith possible rate of return P(ki) = Probability that ith return will occur k = Expected value of the rate of return
  108. 108. E. Risk & Return 1. How do we Measure Risk? - Example Company A Company B Recession (4% -10%)2 (.2) = 7.2 (-10% -14%)2(.2) = 115.2 Normal (10% - 10%)2 (.5) = 0 (14% - 14%)2 (.5) = 0 Boom (14% -10%)2 (.3) = 4.8 (30% - 14%)2 (.3) = 76.8 Variance 12 192 Std Deviation 3.46% 13.86%
  109. 109. E. Risk & Return 1. How do we Measure Risk? - Summary Company A Expected Return Standard Deviation Company B 10% 14% 3.46% 13.86% Which stock would you prefer? How would you decide? It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return.
  110. 110. E. Risk & Return 1. Diversification  Investing in more than one security to reduce risk.  If two stocks are perfectly positively correlated, diversification has no effect on risk.  If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.  If you owned a share of every stock traded on the BSKL and Mesdaq, would you be diversified? YES!  Would you have eliminated all of your risk? NO! Common Stock portfolios still have risk.
  111. 111. E. Risk & Return 1. Diversification  Some risk can be diversified away and some can not. a) Market Risk is also called Non - diversifiable risk. This type of risk can not be diversified away.  Unexpected changes in interest rates.  Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.
  112. 112. E. Risk & Return 1. Diversification a) Firm-Specific risk is also called diversifiable risk. This type of risk can be reduced through diversification.  A company’s labor force goes on strike.  A company’s top management dies in a plane crash.  A huge oil tank bursts and floods a company’s production area.
  113. 113. E. Risk & Return 1. Market Risk  As we know, the market compensates investors for accepting risk - but only for market risk. Firmspecific risk can and should be diversified away. So we need to be able to measure market risk.  Beta: a measure of market risk.  Specifically, it is a measure of how an individual stock’s returns vary with market returns.  It’s a measure of the “sensitivity” of an individual stock’s returns to changes in the market.
  114. 114. E. Risk & Return 1. Market Risk  A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.  A firm with a beta > 1 is more volatile than the market (ex: computer firms).  A firm with a beta < 1 is less volatile than the market (ex: utilities).
  115. 115. E. Risk & Return 1. Summary of Risk & Return  We know how to measure risk, using standard deviation for overall risk and beta for market risk.  We know how to reduce overall risk through diversification.  We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
  116. 116. F. Capital Budgeting Methodology Payback Period Net Present Value Internal Rate Of Return
  117. 117. F. Capital Budgeting 1. Importance of Capital Budgeting  Capital budgeting is the process of evaluating proposed large, long-term investment projects.  capital budgeting ensures that proposed investment will add value to the firm.  Effective capital budgeting can improve both the timing of asset acquisitions and the quality of assets purchased.
  118. 118. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Payback Period (PBP)  PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflows.  Formula for PBP :Unrecovered cost at start of yr PBP = Year b4 full recovery + Cash flow during year
  119. 119. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Net Present Value (NPV)  The present value of an investment project’s net cash flows minus the project’s initial cash outflow.  Formula for NPV :n NPV t 0 CFt t (1 k )
  120. 120. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Net Present Value (NPV)  NPV’s values: NPV = 0, the firm’s overall value will not change if the new project is adopted.  NPV > 0, the firm’s overall value will increase.  NPV < 0, the firm’s overall value will be decrease.
  121. 121. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Net Present Value (NPV)  NPV’s Decision Rules: For independent projects : accept all independent projects having NPVs greater than or equal to 0.  For mutually exclusive projects : projects having highest positive NPV will be ranked first.
  122. 122. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Internal Rate of Return (IRR)  IRR is the estimated rate of return for a proposed project, given the project’s incremental cash flows.  Formula for IRR :n 0 t 0 CFt t (1 IRR )
  123. 123. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Internal Rate of Return (IRR)  IRR Decision Rules: For independent project – accept projects having IRRs greater than the hurdle rate.  For mutually exclusive projects – projects are ranked from highest to lowest IRR.
  124. 124. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Conflicting ranking between NPV & IRR  For Independent Projects  Both the NPV and IRR methods will produce the same accept / reject indication.  Accept projects having NPV > 0, IRR > the hurdle rate.  For mutually exclusive projects  Project having a higher NPV should be chosen instead of a higher IRR.
  125. 125. F. Capital Budgeting 1. Capital Budgeting Decision Method a) Conflicting ranking between NPV & IRR  For mutually exclusive projects  Reason for higher choosing higher NPV i. NPV method makes maximizing the firm value. ii. NPV method assumes that a project’s cash flows can be reinvested at the cost of capital. iii. Whereas, IRR method’s assumption on cash flows reinvestment is the IRR.
  126. 126. G. The Cost of Capital WACC Cost of PS Cost of Debt Cost of Equity
  127. 127. G. The Cost of Capital When we say a firm has a “cost of capital” of, for example, 12%, we are saying: The firm can only have a positive NPV on a project if return exceeds 12%.  The firm must earn 12% just to compensate investors for the use of their capital in a project.  The use of capital in a project must earn 12% or more, not that it will necessarily cost 12% to borrow funds for the project.
  128. 128. G. The Cost of Capital 1. Cost of Debt (Kd)  We use the after tax cost of debt because interest payments are tax deductible for the firm.  Formula for Cost of Debt Kd after taxes = Kd (1 – tax rate)  Example : If the cost of debt for ABC Sdn Bhd is 10% and its tax rate is 40% then :- Cost of debt is?
  129. 129. G. The Cost of Capital 1. Cost of Preferred Stock (Kps)  Preferred Stock has a higher return bonds, but is less costly than common stock. WHY?  In case of default, preferred stockholders get paid before common stockholders.  However, in case of bankruptcy, the holders of preferred stock get paid only after short and long term debt holder claims are satisfied.  Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s affairs.
  130. 130. G. The Cost of Capital 1. Cost of Preferred Stock (Kps)  Formula for Cost of Preferred Stock D kps = Vps Example : If ABC Sdn Bhd is issuing preferred stock at $100 per share, with a stated dividend of $12, then the cost of preferred stock :-
  131. 131. G. The Cost of Capital 1. Cost of Equity (Kcs)  The cost of equity is the rate of return that investors require to make an equity investment in a firm.  CAPM (Capital Asset Pricing Model) - The CAPM is one of the most commonly used ways to determine the cost of common stock.
  132. 132. G. The Cost of Capital 1. Cost of Equity (Kcs)  Formula for Cost of Equity kcs = krf + ß (km – krf) Where krf = The risk free rate ß = The firm’s beta km = The return on the market Example : ABC Sdn Bhd has a ß = 1.6. The risk free on T-bills is currently 4% and the market return has averaged 15%:-
  133. 133. G. The Cost of Capital 1. Weighted Average Cost of Capital (WACC)  Formula for WACC WACC = wd (Cost of Debt) + wcs (Cost of Equity) + wps (Cost of PS) Example : ABC Sdn Bhd maintains a mix of 40% debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is :-
  134. 134. H. Dividend Policy Dividend Policy Types Chronology Impact Alternatives
  135. 135. H. Dividend Policy 1. Types of Dividend Policy a) Constant Payout Ratio b) Constant Nominal Dividend (Regular) c) Special Dividend Payout d) Cash Dividend Payment 2. Chronology of Date of Dividend Payment a) Declaration Date b) Ex Dividend Date c) Record Date d) Payment Date
  136. 136. H. Dividend Policy 1. Impact of Dividend Policy – Firm Value a) Arguments for Irrelevancy Theory  Signaling Effect  Clientele Effect b) Arguments against Irrelevancy Theory  Bird in the Hand Theory  Taxes  Floatation Costs
  137. 137. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Dividend  Firms sometimes tend to distribute additional shares in the form of dividends to a firm’s shareholders rather than giving cash dividends, which are kept in the firm for investment.
  138. 138. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Dividend – Example A firm has 10 million shares outstanding. Currently the market value of the firm is RM20 million. Therefore, price per share is to be RM2.00. Assume that the firm is to issue another 1 million shares as a stock dividend. The total number of shares outstanding will be 11 million. Hence, given the market value of the firm, the new price per share will be?
  139. 139. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Split  Stock Split involve issuing of additional shares to firm’s stockholders.  The investors’ percentage ownership in the firm remain unchanged.  The investor is neither better nor worse off before the stock split.
  140. 140. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Split – Example YTM Bhd. Is planning a two for one stock split. You own 5,000 shares of YTM Bhd’s stock that is currently selling for RM12.00 per share. What is the value of your YTM Bhd. Stock now, and what will it be after the split?
  141. 141. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Repurchase  It is a common practice for developed and developing markets for a firm to buy back stock from its shareholders.  Reasons for repurchase :- an effective substitute for dividends. - the price of stocks are undervalued. - Provide internal investment opportunity.
  142. 142. H. Dividend Policy 1. Alternative Dividend Policy a) Stock Repurchase – Example UEB Bhd. Has RM0.8 million in cash for its next dividend. However, it is considering a repurchase of its own shares instead of paying dividends. The firm has 10 million shares outstanding, currently selling at RM2.00 per share. The P/E is 10 times and the firm’s EPS is RM0.20. What will be the firm’s dividend per share? If stock is repurchased, how many shares will be remain outstanding and what will the new EPS be?

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