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Financial management

By
Prof. Augustin Amaladas
M. Com., AICWA., PGDFM., B.Ed.

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Welcome To
SCDL
Financial
Management
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*10.CAPITAL mARKET
1.FINANCIAL FUNCTION

*2.FORMS OF BUSS.ORG. *11.CAPITAL BUDGETING

*12.WORKING CAPITAL
*3.FINANCIAL STATEMENTS
MANAGEMENT

*4.RATIOS *13.CASH MANAGEMENT

*14.RECEIVABLE
5.FUND FLOW STATEMENT
MANAGEMENT
*5.CASH FLOW STATEMENTS *15.INVENTORY
MANAGEMENT
*6.CAPITALISATION

*7.SOURCES OF LONG
TERM AND MEDIUM TERM *16.DIVIDEND
POLICY
*8.CAPITAL STRUCTURE
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*9.LEVERAGES
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Welcome by SCDL to AZtecsoft

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MANAGEMENT PROCESSES,
DEFICIENCY FINDING
MANAGEMENT AUDIT
MANAGEMENT PLANNING
MANAGEMENT SERVICES
PLANNING AND CONTROL SYSTEMS
MANAGEMENT ACCOUNTING
TAX PLANNING, TAX ADVICING
TAX ACCOUNTING
GOVERNMENT ACCOUNTING
COST STANDARD, COST REVENUE
ANALYSIS,
COST ANALYSIS, COST AND PRODUCTION
STATISTICS
COST ACCOUNTING
PRINCIPLES OF FINANCIAL REPORTING,
AUDITING STANDARDS,
UNIFORM STATEMENTS,AUDITING OF
RECORDS AND
STATEMENTS

FINANCIAL AUDITING
COMPUTERS, PUNCHED CARD RECORDS,TAX
RECORDS,
INCOME STATEMENT ANALYSIS,
BALANCE SHEET EMPHASIS
BOOK KEEPING(SINGLE ENTRY AND DOUBLE ENTRY )
1775 1800 1825 1850 1875 1900 1925 1950 1975 1985 1990 1995 2005
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• COST MANAGEMENT:
GROWTH• OF ACCOUNTABILITY
KNOWLEDGE:FINANCIAL ACCOUNTING
ACTIVITY
Cost accounting, BASED ACCOUNTING,
Management Accounting LIFE
Tax accounting and CYCLE

Management COSTING,
VALUE
CHAIN
ANALYSIS,
TARGET COSTING,
KAIZEN COSTING

RESPONSIBILITY ACCOUNTING
,CURRENT COST ACCOUNTING,
INFLATIONARY ACCOUNTING

EDP ENVIRONMENTAL AUDIT


HUMAN BEHAVIOUT,
MANPOWER VALUES,
INTER GOVERNMENTAL RELATIONS

SOCIAL ACCOUNTING
TOTALSYSTEMS
PLANNING,
INTER DECIPLINARY APPLICATIONS

TOTAL SYSTEM RECVIEW


EFFECTIVENESS AUDITING

EFFECTIVENESS EVALUATIOn
COMPUTERS CYBERNETICS

INFORMATION SYSTEMS
ORGANISATIONAL MODEL,
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ORGANISATIONAL PLANNING,
information information

FLOW OF CASH/SHORT TERM


AND LONG TERM
Work in progress information
Debtors
Information

Accounts receivable Accounts payable

Labour Overheads RAW mATERIAL


Bad debts
Reserves
Rights issue
CASH Public deposits

Equity Preference GDR


Bonds(281) Leasing/Hr.Pur ADR 7
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FLOW OF CASH - LONG
TERM
Know how goodwill
Patent rights Copy right

building
investments

land

furniture
CASH
Short term

Preference
Equity ADR GDR
Shares Long term loans 8
shares
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information information

FLOW OF CASH-SHORT
TERM
Work in progress information
Debtors
Information

Accounts receivable

Labour Accounts payable


Overheads
Bad debts
Bad debts

Bad debts RAW mATERIAL

cash cash
Commer Sale of fixed assets
Issue of long term fund
Cial papers

Cash credit creditors Discounting billsSale of investments


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Bank overdraft
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Working capital finance(361)
1.Spontaneous 2.Bank guarantee 3.Fund based 4.Security

Trade credit
loan
Outstanding pledge
Expenses
overdraft
Letter of credit
Hypothecation
Inter corpo
Cash credit
Rate deposits
lien
Commercial
Bills discounts
papers
mortgage 10
e-mail: aug_bang@yahoo.com www.augustin.co.nr Packing credit
Users of information and goals
liquidity
tax
banks
government
Dividend/value in the share market
shareholders Good name
Benefactors

Debenture holders
Interest/return of capital Less pollution
organisation public

Loan vendor
Interest/return of capital
customers

Good product
Preference shareholders
creditors debtors
dividend
Timely payment Timely supply
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Page-3
T h e P o s it io n o f C a p it a l B u d g e t in g

F in a n c ia l G o a l o f t h e F ir m :
W e a lt h M a x im is a t io n

I n v e s t m e n t D e c is o n F in a n c in g D e c is io n D iv id e n d D e c is io n

L o n g T e rm A s s e ts S h o r t T e r m A s s e ts D e b t / E q u it y M ix D iv id e n d P a y o u t R a t io

C a p ita l B u d g e tin g
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Scope of Financial Management

Financial Financing
Analysis
Profit Source
planning Dividend identification
Financial policy Determine
Forecasting Financing mix
Financial Method of
Control Raising funds

Management of Capital Management of


Current Assets Budgeting Mergers, reorganisation
Cash
Marketable Inventory Identification
Securities Management Selection
Receivables 13
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Implementation
Implementation
Role of Finance in a Typical
Business Organization-page- 9
Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

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Unit-2 Forms of Business
organisation
● Sole trading
● Partnership
● Companies

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My business!! My family?

What will happen


if this deal does
not materialise?

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Partnership

Should we
build this
plant?
h

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Ulta pultaCompany
Mini computer
Ltd.???

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Nature of Financial
Statements-Page-30
Financial accounting
2. Basic
Accounting
4. BRS
Final accounts
3. Process of
accounting
5. Rectification of
Errors

1. Introduction
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Unit-3 Financial statements

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Chapter-2: Basics of financial
accounting
● 1.Concepts
● 2.system of accounting
● 3.Types of Expenditure
● 4.Terms used in financial accounts
● 5.Double entry / Single entry
● 6. Depreciation methods
● 7. Practical consideration relating to
depreciation
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1.concepts& conventions
● Meaning: Basic assumptions upon which the basic
process of accounting based.
● a] Business entity concept-
● b] Dual aspect concept
● c] Going concern concept
● d] Accounting period concept
● e] Cost concept
● f] Money measurement concept
● g] Matching Concept
• Conventions
Coservativism
Materiality
Consistency

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a] Business entity concept-

● Business is different from the owner


● We pass Journal entry when owner
contributes towards capital.
● When amount / goods withdrawn for personal
use we make an entry in the business
● When Income tax paid by the owner out of
business money we make an entry In the
books of accounts.

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b] Dual aspect concept

● Every debit has equal amount of credit


● Asset =Liability
● Liability creates asset
● If asset>Liability= profit
● If Liability> Assets= loss

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c] Going concern concept

● Business will go for at least for a


reasonable period.
● Depreciation is provided based on this
assumption.
● If this assumption is not made all Fixed
assets will be valued at realised value
like current assets.

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d] Accounting period concept
● Fixing time limit for accounts
● Profit for the period
● It can be one week or two weekor 6
months/one year or 5 years
● But to find profit we normally consider
12 months period
● Financial year for income tax point of
view 1st April-31st March of the following
year
● Calendar year –January to December
● Divali to Divali
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e] Cost concept
● The cost to the organisation (Actual) is

recorded in the books


● Assets are not recorded according to the

market price every year.


● Depreciation is calculated on cost not

based on market price


● Accounting records may not show the

real worth of the business


● Market price may be disclosed with in

bracket in the balance sheet


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Exercise
● Accounting Test Question SV No.1:
Company XYZ uses a perpetual inventory
system. Append below the following transaction
relating to its merchandise inventory during the
month of Nov’06
● Date:Transaction
● Nov 1 inventory on hand - 3,000 units @ $8 each
● Nov 7Bought 5,000 units for $8.40 each
● Nov 13Sold 4,000 units for $14.00 each
● Nov 17Bought 6,000 units for $8.20 each
● Nov 24Sold 7,000 units for $14.00 each
● Nov 30Inventory on hand -3000 units

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● Required: Compute the inventory balance
Company XYZ would report on its November
30 2006 balance sheet and the cost of goods
sold for the period of November 2006 income
statement using each of the following
inventory methodology:
● (1) First-in, first-out (FIFO)
● 2) Last-in, first-out (LIFO)
● (3) Average cost[ Refer Answer ]

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f] Money measurement concept
● Every thing which can be expressed in
terms of Money is recorded in the books
● Beautiful women are working /Handsome
boys working in AZTEC /Efficient
engineers worth Rs.5000 crores –How do
you record?.
● Good working environment?
● Highly motivated employees?

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g] Matching Concept

● Matching Cost with revenue


● It is used to estimate correct profits
● Accrual/ cash basis of accounting
– Even cash paid /received if it belongs to accounting
period we consider them as expenditure /income
– Salary outstanding for the last month?
– Income from Investments yet to be received?
– Rent received in advance for next year?

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Conventions
● Customs and traditions that are
followed by the accountants while
preparing the financial statements.
● Why do we respect elders?
● Why do we shake hands?
● Why do Young Indians hate receiving
dowry?

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Coservativism

● To be on the safer side


● Expect future losses as current year loss
● not future income is treated as current
year income.
● Stock is valued cost price / market price
which ever is lower
● Making provision for bad debts is based
on this assumptions.
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Materiality
● Material impact on profitability are
considered
● Insignificant transactions ignored from
recording
● Pen purchased, pencil purchased?
● Wine purchased regularly?

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Consistency
● Accounting policies and procedures
should be followed consistently
● Method of depreciation should be
followed consistently.
● Stock valuation- cost/market price
whichever is lower is consistently
followed
● If not followed it amount to change in
the policy of the company
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2.system of accounting
(26)

● 1.Cash system:
● unless cash received /paid in

the accounting year can not be


considered as
income/expenses respectively

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2.Mercantile

● Mercantile/Accrual/due concept:
● Even cash received/paid but due for
payment/due for receipt (yet to be
received/payable) if they belong to current
accounting year are considered.
● If last year expenditure paid this year?
● If you receive/paid in advance ?

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Mercantile love!!!!???

● Last year I loved her?


Next year I shall love him
depends on type of bike
model!!!!

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Life Education
● If I do not get married to him I will
not be happy- Girl said
● If I do not get married to her I will not
be happy- Boy said
● If both get married what will happen!!!!

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Structure of Financial
Statement-(Chapter-3)page-34

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6.sales
3.General administration 4.Sales and distribution
5.profit
Total cost Cost of sales
+ =
+

Factory cost/ 1.canteen


works +
cost
2

1.Factory administration +

Facility
Stores ledger 1.Production
department

Prime Cost
1.Godown
Bin card
Danger

Cost calculations/operating activity 41


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Financial Statements
● Balance Sheet
● Income Statement

● Cashflow Statement

● Statement of Retained Earnings

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Review: Major Balance Sheet
Items
Assets Liabilities and Equity
● Current assets: ● Current liabilities:

– Cash & securities – Payables


– Receivables – Short-term debt
– Inventories ● Long-term
● Fixed assets: liabilities
– Tangible assets ● Shareholders'
– Intangible assets equity

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An Example: Dell
Abbreviated Balance Sheet-34
● Assets:
– Current Assets: $7,681.00
– Non-Current Assets: $3,790.00
– Total Assets: $11,471.00
● Liabilities:
– Current Liabilities: $5,192.00
– LT Debt & Other LT Liab.: $971.00
– Equity: $5,308.00
– Total Liab. and Equity:
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$11,471.00 44
An Example: Dell
Abbreviated Income Statement-page-47
Sales $25,265.00
Costs of Goods Sold -$19,891.00
Gross Profit $5,374.00
Cash operating expense -$2,761.00
EBITDA 2,613.00
Depreciation & Amortization -$156.00
Other Income (Net) -$6.00
EBIT $2,451.00
Interest -$0.00
EBT $2,451.00
Income Taxes -$785.00
Special Income/Charges -$194.00
Net Income (EAT) $1,666.00
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Financial Statement Analysis
● External users rely on
publicly-available
information to perform
financial analysis
● Such information is
contained in corporate
annual report

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Life education
● Lady in a seashore

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Chapter Learning Objectives

1. Use the statement of cash flows in


decision making
2. Compute the standard financial ratios
used for decision making
3. Use ratios in decision making
4. Measure economic value added by a
company’s operations
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What do you learn??
● Here's how you'll benefit from this course:
● Understand the contents of the balance sheet,
cashflow, and income statements
● Contribute to better costing and working capital
management
● Review production capacity and investment proposals
● Evaluate long, medium and short term financing
● Review financial statements and analyse them using
ratios to determine your business strengths and
weaknesses
● Apply techniques to make decisions that create
genuine value
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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL 1


STATEMENTS
2

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL 1


STATEMENTS
2
SUMMARY OF ACCOUNTING METHODS
3

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL 1


STATEMENTS
2
SUMMARY OF ACCOUNTING METHODS
3
MANAGEMENT’S DISCUSSION AND 4
ANALYSIS OF FINANCIAL STATEMENTS

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL 1


STATEMENTS
2
SUMMARY OF ACCOUNTING METHODS
3
MANAGEMENT’S DISCUSSION AND 4
ANALYSIS OF FINANCIAL STATEMENTS
5
AUDITOR’S REPORT

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL 1


STATEMENTS
2
SUMMARY OF ACCOUNTING METHODS
3
MANAGEMENT’S DISCUSSION AND 4
ANALYSIS OF FINANCIAL STATEMENTS
5
AUDITOR’S REPORT 6

COMPARATIVE FINANCIAL DATA 56


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Financial Statement Analysis
● Pick the one annual
report component ● Before you jump to
which provides a decision, consider
investors and the following:
creditors with the
most descriptive 1. Financial statements
information about provide data about
the corporation’s what happened
activities and during the
financial condition accounting period
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Financial Statement Analysis

2. Investors and creditors use


information contained in the
annual report to:
● Forecast future income and

cash flows
● Assess risk of investing in or

lending to the corporation

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Financial Statement Analysis

MANAGEMENT’S DISCUSSION AND 4


ANALYSIS OF FINANCIAL STATEMENTS

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Financial Statement Analysis-
page-51

Management’s discussion and analysis


(MD&A) includes:
● Evaluation of current business operations

● Assessment of future operations

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Tools to Evaluate Financial
Information

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Tools to Evaluate Financial
Information

Horizontal Analysis
1

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Tools to Evaluate Financial
Information

Horizontal Analysis
1

2
Vertical Analysis

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Tools to Evaluate Financial
Information

Horizontal Analysis
1

2
Vertical Analysis
3

Ratio Analysis
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Perform a horizontal analysis
of comparative financial
statements

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Tools to Evaluate Financial
Information

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Tools to Evaluate Financial
Information

Horizontal Analysis
1

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Horizontal Analysis
● Examines percentage change in
each item on the financial
statements
● Compares current year’s dollar
amount with prior year’s dollar
amount
● Expresses the change in
– Dollars
– Percentage 68
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Horizontal Analysis
First, calculate dollar
change from base year
(prior year) to current year

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Horizontal Analysis
First, calculate
Rupee/dollar change from
base year (prior year) to
current year

Second, divide Rupee/


dollar change by base-year
dollar amount

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Horizontal Analysis

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

1996 1995 Dollars


%
Receivables (net) $325,384 $272,225

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

2007 2006 Dollars


%
Receivables (net) $325,384 $272,225

Difference

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

1996 1995
Dollars %
Receivables (net) $325,384 $272,225
$53,159

Difference

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Horizontal Analysis
DOLLAR AMOUNT INCREASE (DECREASE)
Amounts in thousands

2007 2006 Dollars %


Receivables (net) $325,384 $272,225 $53,159 19.5%
Leasehold Improv. 314,933 273,015 41,918 15.3
Notes Receivable 54,715 32,528

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Trend Percentages
● Specialized form of
horizontal analysis
● Shows trend of
financial statement
items over longer
time periods such as
5 or 10 years

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Trend Percentages

● Base year (earliest year in the


time series) set at 100%
● All other years expressed as
percentage of base year

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Trend Percentages
● Income statement
amounts for Ray’s
Seafood Shack are
presented in the next
slide
● Compute the trend
percentages for these
items

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

Divide
x 100

Net Sales 206% 160% 145% 137% 130%


100%

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

Divide
x 100

Net Sales 206% 160% 145% 137% 130%


100%

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

Divide
x 100

Net Sales 206% 160% 145% 137% 130%


100%

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

Divide
x 100

Net Sales 206% 160% 145% 137% 130%


100%

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346

Divide
x 100

Net Sales 206% 160% 145% 137% 130%


100%

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346
Cost of Sales 373 265 201 259 280 193

Net Sales 206% 160% 145% 137% 130%


100%
Cost of Sales 193 137 104 134 145 100

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Trend Percentages
(AMOUNTS IN THOUSANDS )

2008 2007 2006 2005 2004 2003


Net Sales $714 $553 $502 $474 $451 $346
Cost of Sales 373 265 201 259 280 193
Gross Profit 341 288 301 215 171 153

Net Sales 206% 160% 145% 137% 130%


100%
Cost of Sales 193 137 104 134 145 100
Gross Profit 223 188 197 140 112 100

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Horizontal Analysis and
Trend Percentages: A Summary

Tools used to
compare financial
results of companies
of different sizes
and/or in different
industries

88
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Vertical Analysis

89
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Vertical Analysis

2
Vertical Analysis

90
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Vertical Analysis
● Compares each item on the financial
statement to a key, or base, item
● Base-item dollar amount always set to
100%
● Income statement
– Net sales = 100%
● Balance sheet
– Total assets = 100%
91
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Vertical Analysis
2007 2006
AMOUNT % AMOUNT
%
Net sales $430,013 100% $362,386 100%
Cost of Goods Sold 336,589 78 284,897 79
Gross Profit 93,424 22 77,489 21
Selling, General & Admin. 72,363 17 65,096 18
Income from Operations 21,061 5 12,393 3
Income Taxes 7,072 2 4,350 2
Net Income $13,989 3% $8,043 2%

92
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Vertical Analysis
● Once financial
statement items are
converted into
percentages of the
base item, users can
compare one
company’s financials
against another’s
● These are called
common-size
statements
93
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Prepare common-size financial
statements for benchmarking against
the industry average and key
competitors

94
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Common-Size Statements
● Show all items as percentages of the key,
or base, amount
– Use no dollar amounts
● Facilitate financial statement comparison
among different sized companies
● Improve user’s ability to assess company
performance against industry averages

95
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Common-Size Statements

● Can also be used to


evaluate company
performance over
time

96
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Benchmarking Against the
Industry Average

Benchmarking is a term used to


describe the process of comparing a
company’s activities to a standard of
excellence achieved by industry
leaders
97
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Benchmarking Against Key
Competitors
● A company also can compare its
common-size financials to those of
its industry’s leaders
● Determine where it differs
● Design and implement business
processes to bring financial results
in line with these benchmark
entities
98
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Benchmarking Against Key
Competitors

99
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Life education

•Chineese tree

100
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Interpretation of Financial
Statements-Ratio Analysis-Unit-4

101
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Interpretation of Financial Statement Analysis(
Ratio Analysis)-page 55- Unit-4
By Prof. Augustin Amaladas

102
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PROCTER & GAMBLE and BRISTOL-
MYERS SQUIBB
● A leading company in
the health-care and
consumer products
industry
● Sales revenues of $14-
billion
● Assets of $13-billion

103
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PROCTER & GAMBLE and
BRISTOL-MYERS SQUIBB
● How would you compare Bristol-Myers
Squibb’s performance against other
industry competitors?
● Companies differ in size, so you can’t
compare absolute dollar amounts
● Need to use ratios - tools to translate
financial data into percentages - which
can be compared across companies
104
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PROCTER & GAMBLE and
BRISTOL-MYERS SQUIBB
PROCTER &
GAMBLE
Sales revenues
$33.4
Net income
2.6
Assets
28.0

105
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Opening Vignette -
Bristol-Myers Squibb
PROCTER & BRISTOL-MYERS
GAMBLE SQUIBB
Sales revenues Sales revenues
$33.4 $13.7
Net income Net income
2.6 1.8
Assets Assets
28.0 13.0

106
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Opening Vignette -
Bristol-Myers Squibb
PROCTER & BRISTOL-MYERS
GAMBLE SQUIBB
Sales revenues Sales revenues
$33.4 $13.7
Net income Net income
2.6 1.8
Assets Assets
28.0 13.0

● Which company was


better
e-mail: in generating
aug_bang@yahoo.com www.augustin.co.nr
107
Opening Vignette -
Bristol-Myers Squibb
PROCTER & BRISTOL-MYERS
GAMBLE SQUIBB
Sales revenues Sales revenues
$33.4 $13.7
Net income Net income
2.6 1.8
Assets Assets
28.0 13.0

● Which company was ● You can use the return


better
e-mail: in generating
aug_bang@yahoo.com www.augustin.co.nr on sales ratio to 108
Opening Vignette -
Bristol-Myers Squibb
PROCTER &
GAMBLE
Sales revenues
$33.4
Net income
2.6

109
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Opening Vignette -
Bristol-Myers Squibb
PROCTER &
GAMBLE
Sales revenues
$33.4
Net income
2.6

$2.6
$33.4

= 7.78% 110
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PROCTER & GAMBLE
Sales revenues $33.4
Net income 2.6
BRISTOL-MYERS
$2.6 SQUIBB
$33.4 Sales revenues
$13.7
= 7.78%
Net income
1.8

111
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Opening Vignette -Bristol-Myers Squibb

BRISTOL-MYERS SQUIBB
Sales revenues $13.7
PROCTER & GAMBLE
Sales revenues $33.4 Net income 1.8
Net income 2.6
$1.8
$2.6 $13.7
$33.4
= 13.13%
= 7.78%

112
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Opening Vignette -
Bristol-Myers Squibb
PROCTER & BRISTOL-MYERS
GAMBLE SQUIBB
Sales revenues Sales revenues
$33.4 $13.7

Although P&G’s sales were higher

113
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PROCTER & BRISTOL-MYERS
GAMBLE SQUIBB
Sales revenues Sales revenues
$33.4 $13.7
Net income Net income
2.6 1.8

$2.6 $1.8
Bristol-Myers’ return on sales was
$33.4
nearly twice that of P&G
$13.7

= 7.78% = 13.13% 114


e-mail: aug_bang@yahoo.com www.augustin.co.nr
Financial Statement Analysis
● External users rely on
publicly-available
information to perform
financial analysis
● Such information is
contained in corporate
annual report

115
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Financial Statement Analysis:
Lecture Outline
● Review of Financial Statements
● Ratios
– Types of Ratios
– Examples
● The DuPont Method
● Ratios and Growth
● Summary
– Strengths
– Weaknesses
– Ratios and Forecasting 116
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Financial Analysis
● Assessment of the firm’s past, present
and future financial conditions
● Done to find firm’s financial strengths
and weaknesses
● Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms

117
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The Main Idea
● Value for the firm comes from
cashflows
● Cashflows can be calculated as:

• (Revt - Costt - Dept)x(1-τ) + Dept


—OR—
• (Revt - Costt)x(1-τ) + τxDept
—OR—
• Revtx(1-τ) - Costtx(1-τ) + τxDept 118
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Review: Major Balance Sheet
Items
Assets Liabilities and Equity
● Current assets: ● Current liabilities:

– Cash & securities – Payables


– Receivables – Short-term debt
– Inventories ● Long-term
● Fixed assets: liabilities
– Tangible assets ● Shareholders'
– Intangible assets equity

119
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An Example: Dell
Abbreviated Balance Sheet
● Assets:
– Current Assets: $7,681.00
– Non-Current Assets: $3,790.00
– Total Assets: $11,471.00
● Liabilities:
– Current Liabilities: $5,192.00
– LT Debt & Other LT Liab.: $971.00
– Equity: $5,308.00
– Total Liab. and Equity:
e-mail: aug_bang@yahoo.com www.augustin.co.nr
$11,471.00 120
Absorption Costing vs. Variable
Costing Income Statements

Absorption Costing Variable Costing:


Sales $60,000 Sales $60,000
Cost of sales 30,000 Variable costs:
Gross profit $30,000 Cost of sales 30,000
Operating expenses: Operating expenses 6,000
Variable $6,000 Total variable costs $36,000
Fixed 20,000 Contribution margin: $24,000
Total operating expenses $26,000 Fixed costs 20,000
Income $4,000 Income $4,000

121
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Absorption Costing
Income Statement
Sales XXX
Cost of Goods Sold:
Beginning inventory XXX
Cost of goods manufactured XXX
Cost of goods available XXX
Ending inventory XXX
Cost of goods sold XXX
Gross Margin XXX
Operating Expenses:
Selling XXX
Administrative XXX XXX
Income before Taxes XXX

122
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ABSORPTION COSTING PRO-
FORMA
££Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx

123
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Variable Costing
Income Statement
Sales XXX
Cost of Goods Sold:
Beginning inventory XXX
Cost of goods manufactured XXX
Cost of goods available XXX
Ending inventory XXX
Variable cost of goods sold XXX
Product Contribution Margin XXX
Variable Selling Expense XXX
Total Contribution Margin XXX
Fixed Expenses:
Factory XXX
Selling XXX
Administrative XXX XXX
Income before Taxes XXX
124
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Marginal costing cost sheet
● ££Sales Revenue xxxxx

● Less Marginal Cost of Sales


● Opening Stock (Valued @ marginal cost) xxxx
● Add Production Cost (Valued @ marginal cost) xxxx
● Total Production Cost xxxx
● Less Closing Stock (Valued @ marginal cost) xxx)
● Marginal Cost of Production xxxx

● Add Selling, Admin & Distribution Cost xxx


● Marginal Cost of Sales (xxxx)

● Contribution xxxxx
● Less Fixed Cost (xxxx)
● Marginal Costing Profit xxxxx
125
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An Example: Dell
Abbreviated Income Statement
Sales $25,265.00
Costs of Goods Sold -$19,891.00
Gross Profit $5,374.00
Cash operating expense -$2,761.00
EBITDA 2,613.00
Depreciation & Amortization -$156.00
Other Income (Net) -$6.00
EBIT $2,451.00
Interest -$0.00
EBT $2,451.00
Income Taxes -$785.00
Special Income/Charges -$194.00
Net Income (EAT) $1,666.00
126
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Objectives of Ratio Analysis
● Standardize financial information
for comparisons
● Evaluate current operations
● Compare performance with past
performance
● Compare performance against other
firms or industry standards
● Study the efficiency of operations
● Study the risk of operations 127
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Rationale Behind Ratio
Analysis
● A firm has resources
● It converts resources into profits through
– production of goods and services
– sales of goods and services
● Ratios
– Measure relationships between resources and
financial flows
– Show ways in which firm’s situation deviates from
● Its own past
● Other firms
● The industry
● All firms-
128
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Benchmarking Against Key
Competitors

financials can be
used in
benchmarking

129
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Using Ratios to Make
Business Decisions

130
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Using Ratios to Make
Business Decisions

Ratio Analysis
131
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Types of Ratios-59
● Financial Ratios:
– Liquidity Ratios
● Assess ability to cover current obligations
– Leverage Ratios
● Assess ability to cover long term debt obligations
● Operational Ratios:
– Activity (Turnover) Ratios
● Assess amount of activity relative to amount of
resources used
– Profitability Ratios
● Assess profits relative to amount of resources used
● Valuation Ratios:
● Assess market price relative to assets or earnings
132
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Using Ratios to Make
Business Decisions
● Ratios - the relationship between two
items on financial statements - permit
users to calculate a variety of financial
comparisons
● These ratios can be compared to:
● Prior years’ financial results
● Industry averages
● Benchmark entities’ ratios
133
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Using Ratios to Make
Business Decisions
Ratios measure an entity’s ability to:
● Pay current liabilities

● Sell inventory and collect receivables

● Pay long-term debt

● Generate profits from operations

● Sustain shareholder wealth

134
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Measuring the Company’s Ability to Pay Current
Liabilities-Page-59
● One measure of entity’s ability to pay its
current obligations is to look at working
capital
Current assets - current liabilities
● 2 ratios help users assess working capital
information

135
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Measuring the Company’s Ability to Pay Current
Liabilities
● One measure of entity’s ability to pay its
current obligations is to look at working
capital
Current assets - current liabilities
● 2 ratios help users assess working capital
information
– Current ratio

136
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Measuring the Company’s
Ability to Pay Current
Liabilities
● One measure of entity’s ability to pay its
current obligations is to look at working
capital
Current assets - current liabilities
● 2 ratios help users assess working capital
information
– Current ratio
– Quick (acid-test) ratio
137
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Using Ratios to Make
Business Decisions

138
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Ability to Pay Current
Liabilities
● Current ratio

139
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Ability to Pay Current
Liabilities
● Current ratio
Current assets
Current liabilities

140
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Ability to Pay Current Assets:

Liabilities-page-59
Current Assets:
$7,681.00
Non-Current Assets:
$3,790.00
Total Assets:
$11,471.00

● Current ratio Liabilities:


Current Liabilities:
$5,192.00

Current assets LT Debt & Other LT


Liab.: $971.00
Equity:

Current liabilities $5,308.00


Total Liab. and Equity:
$11,471.00

$7,681.00
$5,192.00

= 1.48
141
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Ability to Pay Current
Liabilities-page-60
● Quick ratio

142
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Ability to Pay Current
Liabilities
● Quick ratio
Current assets - inventory - prepaid items
Current liabilities

143
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Ability to Pay Current
Liabilities
● Liquid ratio
Current assets - inventory - prepaid items
Current liabilities

$25,240
$114,744

= .22

144
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Measuring the Company’s Ability to Sell
Inventory and Collect Receivables

● Entity’s operating cycle


– Time to go from cash to inventory to
receivables to cash
is critical to generating cash inflows
from operating activities
● 3 ratios help users assess
management’s skill in selling inventory
and collecting receivables
145
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Sell Inventory and Collect
Receivables-page-63

Inventory turnover 1

146
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Measuring the Company’s Ability to Sell Inventory
and Collect Receivables

Inventory turnover
1
A/R turnover
2

147
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Sell Inventory and Collect
Receivables

Inventory turnover
1
A/R turnover
2
Days’ sales in
receivables 3
148
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Inventory Turnover-page-63
● Number of times the
average level of
2008
inventory is sold during
the accounting year
● Measures time required
to earn return on
company’s investment
in inventory

149
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Inventory Turnover
Sales $25,265.00
Costs of Goods Sold -$19,891.00
Gross Profit $5,374.00
Cash operating expense
EBITDA
-$2,761.00
2,613.00
Cost of goods sold
Depreciation & Amortization
Other Income (Net)
-$156.00
-$6.00 Average inventory
EBIT $2,451.00
Interest -$0.00 =$19,891/$4000
EBT $2,451.00
Income Taxes
Special Income/Charges
-$785.00
-$194.00
=4.972 times
Net Income (EAT) $1,666.00
Average inventory $ 4000
Average debtors $5000

150
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Inventory Turnover
● High ratio indicates ability
to quickly sell inventory
● Too high a ratio may
indicate inadequate
inventory levels
● Turnover ratio should be
compared to historical and
industry averages
● Analyze significant
variances

151
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Accounts Receivable
Turnover-page-65
● Number of times
the average level $
of A/R is
collected during
the accounting
year
● Measures ability
to collect cash
from credit
customers 152
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Accounts Receivable
Turnover
Net credit sales
Average net A/R

153
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Accounts Receivable
Turnover
Net credit sales*
Average net A/R

$25,265.00
5000

= 5.053 times

154
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Days’ Sales in Receivables
● Number of equivalent
days’ sales revenue
$ represented by the
outstanding A/R
balance
● Measures A/R balance
in terms of number of
days it would take to
generate the
equivalent dollar
amount of sales 155
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Days’ Sales in Receivables
Average net A/R
(Net sales / 365 days)

$5000
($25265 / 365 days)

= 72.23 days

156
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Measuring the Company’s Ability to Pay
Long-Term Debt-67
● Bondholders and long-term lenders are
concerned about an entity’s ability to
repay debt principal and accumulated
interest on long-term notes and loans
● 2 ratios help these users assess the
entity’s ability to pay its long-term
obligations
● Debt ratio
● Times-interest-earned ratio
157
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Debt Ratio-page-67

● Relationship between company’s


total liabilities and total assets
● Measures proportion of total assets
provided through debt
● 1 - debt ratio = proportion of
assets provided by equity

158
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Assets:

Debt Ratio-page 67
Current Assets:
$7,681.00
Non-Current Assets:
$3,790.00
Total Assets:
$11,471.00
Total Liabilities Liabilities:
Current Liabilities:
$5,192.00
Total Equity LT Debt & Other LT
Liab.: $971.00
Equity:
$5,308.00
Total Liab. and Equity:
$11,471.00

159
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Debt Ratio
Total Liabilities
Total Assets

$971.00
$5,308.00

=.1829

160
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Debt Ratio

Total Liabilities
Total Assets

2,00000
$323,497

= .38

161
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Debt Ratio
● If debt ratio = 1.0,
company used all LOANS,
debt to finance NOTES,
acquisition of its BONDS,
assets ETC.
– A highly unlikely
situation
● Thus, debt ratio is
generally less than
1.0
162
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Debt Ratio
● The higher the ratio, the
more cash the company
must commit toward paying
annual interest expense and
loan principal
● As a result, company’s cash
flow might be negatively
affected
163
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Debt Ratio
● Lenders and
creditors might
require company to
appropriate portion
of retained earnings
to ensure sufficient
assets to repay
interest and loan
principal
164
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Times-Interest-Earned Ratio-
page-70
● Relationship between
company’s net income
from operations and
interest expense
● Measures ability of
company to cover, or
pay for, its interest
expense out of
operating income

165
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Times-Interest-Earned Ratio
Income from operations
Interest expense

166
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Times-Interest-Earned Ratio
es $25,265.00
sts of Goods Sold -$19,891.00
oss Profit
sh operating expense
$5,374.00
-$2,761.00 Income from operations
ITDA 2,613.00
preciation & Amortization -$156.00 Interest expense
her Income (Net) -$6.00
T $2,451.00

T
rest -$0.00
$2,451.00 2,613.00
ome Taxes -$785.00
ecial Income/Charges -$194.00 0
Income (EAT) $1,666.00
verage inventory $ 4000
verage debtors $5000 = &

167
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Times-Interest-Earned Ratio

● high ratio indicates


ease in meeting debt
interest payments

168
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Times-Interest-Earned Ratio

● A low ratio would


signal possible
difficulties in making
payments to lenders
and bondholders

169
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Measuring a Company’s
Profitability
● Financial analysts pay close attention to
ratios which assess a company’s ability to
generate profits and operate efficiently
● Creditors and investors rely on forecasts
of a company’s potential to generate net
income when they make lending and
investing choices

170
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

171
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales

172
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales
Return on assets

173
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales
Return on assets
Return on equity

174
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Measuring a Company’s
Profitability-page-74
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales
Return on assets
Return on equity
Earnings per share
175
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Return on Sales
● Relationship between a company’s net
income and net sales
● Measures management’s ability to
efficiently and effectively manage
company operations
● Shows percentage of each net sales dollar
earned as net income

176
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Return on Sales-Net profit ratio-
73
Net income
Net sales revenue

177
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Return on Sales
Sales
Costs of Goods Sold
$25,265.00
-$19,891.00
Net income
Gross Profit
Cash operating expense
$5,374.00
-$2,761.00
Net sales revenue
EBITDA 2,613.00
Depreciation & Amortization -$156.00
Other Income (Net) -$6.00 $1,666.00
EBIT $2,451.00
Interest -$0.00 $25,265.00
EBT $2,451.00
Income Taxes -$785.00 =0 .065
Special Income/Charges -$194.00
Net Income (EAT) $1,666.00
$1,666.00
Average inventory $ 4000
Average debtors $5000

178
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Return on Sales
● Higher rate tells users
Net Income that more net sales
dollars add to a
company’s profits
– And fewer dollars go to
cover company
expenses
● Company conducts its
business effectively,
manages expenses

179
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Return on Assets-74
● Ratio of the return to the two
groups that provide financing to the
company
– Creditors and investors
and average assets owned during
the period
● Measures company’s success in
generating income from its
available resources 180
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Return on Assets

Net income + interest expense


Average total assets

181
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Return on Assets
Net income + interest expense
Sales $25,265.00
Average total assets
Costs of Goods Sold -$19,891.00
Gross Profit $5,374.00
Cash operating expense -$2,761.00
EBITDA
Depreciation & Amortization
2,613.00
-$156.00
$1,666.00 + 0
Other Income (Net)
EBIT
-$6.00
$2,451.00
9000
Interest -$0.00
EBT $2,451.00
Income Taxes -$785.00
Special Income/Charges -$194.00 = .185
Net Income (EAT) $1,666.00
Average inventory $ 4000
Average debtors $5000
Average total assets $9000 182
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Return on Assets
Why do we add back
interest expense to
net income?

183
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Return on Assets
Total assets are financed by 2
sources:
– Investors (equity)
– Creditors (debt)
● Net income is the return
attributable to investors in the
company’s stock
● Interest expense is the return paid

to creditors for using their funds to 184

acquire assets
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Return on Equity-75

● Relationship between net income


available to common stockholders
and the equity they provide
● Measures company’s success in
using stockholders’ investments to
generate net income

185
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Return on Equity
Net income - preferred dividends
Common contributed capital + retained
earnings

186
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Return on Equity
Net income - preferred dividends
Common contributed capital +
retained earnings

$30,555*
($286,676 + $255,773) / 2

= .1126
187
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X ltd. does not have preferred stock
www.augustin.co.nr
Earnings Per Share-77

● Relationship between net income


available to common stockholders
and the number of shares of
common stock issued
● Expresses net income in terms of
one share of the company’s
common stock
188
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Earnings Per Share
Net income - preferred dividends
# of shares of common stock
outstanding

189
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Earnings Per Share
Net income - preferred dividends
# of shares of common stock outstanding

$30,555,000*
40,221,000 shares
= $.76

190
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Earnings Per Share
● Earnings per share ● In addition to net
(EPS) disclosure on income, EPS is
the face of the presented for several
corporate income other elements on the
statement is corporate income
mandatory statement
● Discontinued
operations
● Extraordinary items
● Cumulative effect of
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accounting change 191
Analyzing the Company’s
Stock as an Investment

192
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Analyzing the Company’s
Stock as an Investment
● Investors expect to receive 2 types of
returns on their investments in a
corporation’s common stock
● Gains earned when they sell the
corporation’s stock
● Periodic dividends paid by the
corporation to its stockholders

193
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Analyzing the Company’s
Stock as an Investment

● Financial analysts
use several ratios to
assess value of stock
investments
● Price/earnings ratio
● Dividend yield
● Book value
194
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Price/Earnings Ratio-77
● Relationship between a stock’s
market price and its earnings per
share
● Measures the number of times one
share of stock sells above the
current period’s reported earnings
● Assists financial analysts in
deciding if a stock is overpriced or
underpriced 195
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Price/Earnings Ratio
Calculating the P/E ratio

196
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Price/Earnings Ratio
Calculating the P/E ratio

Market value of stock


Earnings per share

197
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
$15.75 on the last day
Earnings per share of its fiscal year

198
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
$15.75 on the last day
Earnings per share of its fiscal year
● The income statement
reports EPS of $.92

199
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
Earnings per share
$15.75 on the last day
of its fiscal year
● The income statement
reports EPS of $.92
● What is Asian Art’s
price/earnings ratio?

200
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Price/Earnings Ratio
Market value of stock
Earnings per share

201
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Price/Earnings Ratio
Market value of stock
Earnings per share

$15.75
$.92

= 17.12

202
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P/E ratio
● If a stock has low P/E ratio say 3/1 it
may be considered as an undervalued
stock.
● If the ratio is 80/1 it may be viewed as
overvalued.
● This ratio is more popular in the
secondary market.

203
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Dividend Yield
● Ratio of dividends per share of stock to
the stock’s market value
● Indicates the percentage of a stock’s
market value “returned” to the
stockholder in the form of dividends
● Assists investors who desire a steady flow
of dividend revenue in their decisions to
invest in a particular stock

204
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Dividend Yield
Annual dividends per share
Stock’s market value per share

● If Asian Art paid a total of $1.25 in dividends per


share, what would be its dividend yield, assuming
the same market value for its stock ($15.75)?

205
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Dividend Yield-78
Annual dividends per share
Stock’s market value per share

206
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Dividend Yield
Annual dividends per share
Stock’s market value per share
$1.25

$15.75

= .079

207
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Book Value
● Relationship between
common stockholders’
equity and number of
common shares

DEBIT CREDIT
outstanding
● Measures the
accounting value of
one share of the
corporation’s common
stock
208
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Book Value
Total equity - preferred equity
# of shares of common stock outstanding

The book value of one share of Lands’ End


common stock is:

$201,192,000
4,02,21,000 shares

= $5.00/share
209
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Review: Major Income
Statement Items
● Gross Profit = Sales - Costs of Goods Sold
● EBITDA
= Gross Profit - Cash Operating Expenses
● EBIT = EBDIT - Depreciation - Amortization
● EBT = EBIT - Interest
● NI or EAT = EBT- Taxes
● Net Income is a primary determinant of the
firm’s cashflows and, thus, the value of the
firm’s shares
210
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Life education

Thomas
Cooper –
Dictionary

211
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Accounting Test Question No IFS 4:
● Effect of Management Decisions On Ratios
● Require:
● Put by letter whether each of the actions listed
below will immediately
● -increase (I),
● -decrease (D) or
● -have no effect (N) on the ratios shown.
● Current ratio Acid-test ratio Debt to Equity
ratio
● 1.Company issued ordinary shares for cash
● 2.Bought raw material on account
● 3.Received money from accounts receivable
● 4.Expiration of prepaid rent

212
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● 5.Payment of cash dividend
● 6.Purchase long term investment with
cash
● 7.Sale of fixed assets for cash with no
gain or loss
● 8.Stock write off
● 9.Refinance on a long term basis
currently matured debt
● 10.Bought fixed asset with a 6 month
note

213
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Answer to Accounting
Test Question IFS No 4:

● Current ratio Acid-test ratio Debt to


equity ratio
● 1.Company issued ordinary shares for
cash I I D
● 2.Bought raw material on accountI D I
● 3.Received money from accounts
receivable N N N
● 4.Expiration of prepaid rent D N I
214
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● 5.Payment of cash dividendDDI
● 6.Purchase long term investment with cash
– D D N
● 7.Sale of fixed assets for cash with no gain or
loss I I N
● 8.Stock write off D N I
● 9.Refinance on a long term basis currently
matured debt I I N
● 10.Bought fixed asset with a 6 month note
D D I

215
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● Accounting Test Question No IFS 1:
● Details of financial performance of Company XYZ
● For year 2005 Income Statement:
● Net Sales - $ 7 million,
● Cost of Goods sold - $ 3 million
– Net Income - $1.2 million
– Balance Sheet ($’000):-2007
● Assets
● Cash $2,00,240
● Accounts Receivable $8,10,620
● Inventory $8,30,710
● Property, plant and equipment ( net)
$2,59,02,420
● Total Assets $4,43,03,990
216
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● Liabilities & Shareholders’ Equity:
● Current liabilities710640
● Notes payable550990
● Paid-in capital1,5001,500
● Retained earnings1,670860Total
Liabilities & Shareholders’
Equity4,4303,990The average industry
for
217
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● Company’s line of business are:
● Inventory Turnover 5 times
● Average Collection period 45 days
● Asset Turnover 2 times
● Required:
● Evaluate Company XYZ’s asset
management relative to its industry.

218
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Accounting Test Question No IFS 2:
● Append below Company TIM s Income
Statement and Balance Sheet:
● Income Statement (000) 2006-2007
● Net Sales Rs.7,05,06,200
● Net Income Rs.3,40,410
● Balance Sheet (000):-Assets2006-2007
● Current Assets Rs.1,84,01,570
● Property, plant and equipment ( net)
Rs.2,59,02,420
● Total Assets
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Rs.4,43,03,990 219
● Current Liabilities1,15,01,190
● Long term liabilities RS. 8,10,440
● Paid-in capital1 RS.50,01,500
● Retained earnings Rs.9,70,860
● Required:
● Determine the following ratios for 2006- 2007:
● profit margin on sales
● return on assets (ROA)
● return on shareholders equity
● (2) Determine the amount of dividends paid to
the shareholders during2006- 2007

220
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Answer to Accounting
Test Question IFS No 2:
● 1(a) Profit margin on sales

● = Net Income/ Net Sales

● = Rs.340,000/Rs.7,050,000

● = 4.8%

● 1(b) Return on Assets (ROA)

● = Net Income/(Average Total Assets)/2

● =RS.340,000/(Rs.4,430,000+3,990,000)/2

● = 8.1%

221
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● 1(c) Return on Shareholders equity
● = Net Income/ (Average Total Shareholder fund)/2
● =Rs.340,000/(Rs.3,170,000+2,360,000)/2
● =12.3%

● Computation of Dividend paid during Year 2005:


● Retained earnings beginning of year 2005
RS.860,000
● Add: Net Income Rs.340,000
● Less: Retained earnings end of year 2005
(Rs.970,000)
● Dividends paid during 2007 Rs.230,000

222
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● Accounting Test Question No IFS 3:
● Append below Company XYZ’s Income
Statement and Balance Sheet:
● Income Statement ($’000)2005
● Net Sales 7,100
● Interest expense 40
● Income tax expense 150
● Net Income 210

223
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● Balance Sheet ($’000):-
● Assets2005
● Cash 200
● Accounts Receivable 810
● Inventory 830
● Property, plant and equipment ( net) 2,590
● Total Assets 4,430
● Liabilities & Shareholders’ Equity:
● Current liabilities 710
● Long-term liabilities 550
● Paid-in capital 1,500
● Retained earnings 1,670
● Total Liabilities & Shareholders’ Equity4,430 224
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● Required:
● Determine the following ratios for 2005:
● (a) current ratio
● (b) acid-test ratio
● (c) debt to equity ratio
● (d) times interest earned ratio

225
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Answer:3
● (a) current ratio=
● Current asset/current liabilities
● = ($200,000+$810,000+$830,000)/$710,000)=
2.59

● (b) acid-test ratio=


● (Current assets- inventory)/current liabilities
● =($200,000+$810,000)/$710,000= 1,42

226
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● (c) debt to equity ratio
● =(Total liabilities)/Shareholders fund
● =($710,000+$550,000)/($1,500,000+
● $1,670,000)
● =0.39

● (d) times interest earned ratio


● =(Net Income+ Interest Expense+ Income
Tax)/InterestExpense
● =($210,000+$40,000+$150,000)/$40,000
● =10 times
227
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Some difficulty in ratios
● All profitability and expenses ratios
Sales in the denominator
● All turn over ratios, sales in the
numerator.
● Propritory ratio=Total assets/owner’s
funds
● Shareholders’ funds=Equity
shares+Reserves and surplus
228
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Exercise problems-103
● 1.1.NC
● 1.2 decrease
● 1.3 NC
● 1.4 NC
● 1.5 Increase

229
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Exercise-2.
● 1.GP ratio=15*100/30=50%
● 2.NP ratio=5*100/30=16.67%
● 3.STR=COGS/Average stock=15/2.5=6.0
times
● 4.CR=8/3=2.67
● 5.LR=6/3=2

230
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Exercise-3
● GP 33.33% 35%
● NP 20% 25%
● ROCE 15% 20%
● STR 4 5
● CR 1.5 2
● D/E 0.17241 0.24
● Capital employed=3.4-.2=3.2

231
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Exercise-4
● 1. current ratio=550/200=2.75
● 2.Acid test ratio=400/200=2
● 3.Operating
ratio=1480*100/1800=82.22%
● 4.STR=1150/200=5.75 times
● 5. DTR=1800/250=7.2 times
● 6.ROPR=

232
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Prob.13.
● 1.sales=3,20,000
● 2.sundry debtors=80,000
● 3. sundry creditors=80,000
● 4. closing stock=31,000
● 5. Opening stock=29,000

233
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Prob.12
● Balance sheet: General reserve at the beginning=2,00,000
● Proposed addition=1,00,000
● Profits and loss appro.=20,000
● 10% Debentures=1,00,000
● Current liabilities(Proposed dividend)=2,00,000
● Fixed assets=7,20,000
● Stock=2,53,125
● Sundry debtors=84,375
● Tranfer to general reserve=1,00,000
● Balance transferred to balance sheet=20,000
● Net profit=2,50,000
● Provision for tax=7500
● Net profit=2,50,000;gross profit=6,07,500;sales=10,12,500;
purchases=1,30,625.

234
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Prob.9
● Balance sheet.
Liabilities Assets
Equity shares 2,00,000 Fixed assets
2,25,000
R/S 1,00,000 current liabilities
1,75,000
Long term liabilities NIL
Over draft 60,000
Sundry creditors 40,000
4,00,000
4,00,000

235
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236
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Chapter Objective 5
Use ratios in decision making

237
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Limitations of Financial
Analysis
● No one ratio or year’s worth of financial
information should be relied upon to
provide a complete assessment of a
corporation’s financial condition
Analysts should:
● Examine trends over time

● Benchmark to industry and key

competitors
● Seek answers about why ratios are
238
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Limitations of Financial
Analysis

239
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Limitations of Financial
Analysis
● Grant’s ratios were
reasonably good up
until several years
before its failure

240
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Limitations of Financial
Analysis
● Grant’s ratios were ● But analysts and the
reasonably good up investing public continued
until several years to believe the company’s
before its failure strong history would carry
it forward

241
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Limitations of Financial
Analysis
● Grant’s ratios were ● But analysts and the
reasonably good up investing public continued
until several years to believe the company’s
before its failure strong history would carry
it forward
● Financial statement users
didn’t consider the social
and economic changes of
the early 1970s and how
these affected the retailer!

242
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The Complexity of Business
Decisions
Business environment
is complicated by
numerous local,
regional, national,
and global issues - all
must be considered
when evaluating
current financial
condition or
forecasting future
potential for income 243
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An Example: Dell
Abbreviated Balance Sheet
● Assets:
– Current Assetsinventories$391 $7,681.00
– Non-Current Assets: $3,790.00
– Total Assets: $11,471.00
● Liabilities:
– Current Liabilities: $5,192.00
– LT Debt & Other LT Liab.: $971.00
– Equity: $5,308.00
– Total Liab. and Equity:
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$11,471.00 244
Liquidity Ratio Examples: Dell
● Current Ratio:

● Quick (Acid Test) Ratio:

245
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Ratio Comparison: Current Ratio
2.5

2
Current Ratio

1.5

0.5

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 2.08 1.66 1.45 1.72 1.48
Industry 1.80 1.80 1.90 1.60

246
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Leverage Ratio Examples:
Dell
● Debt Ratio:

247
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Ratio Comparison: Debt Ratio
0.8
0.7
0.6
Debt Ratio

0.5
0.4
0.3
0.2
0.1
0

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 54.70% 73.07% 69.70% 66.25% 53.73%
Industry 62.96% 60.00% 52.38% 62.96%

248
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Profitability Ratio Examples:
Dell
● Return on Assets (ROA):

● Return on Equity (ROE):

249
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Profitability Ratio Examples:
Dell
● Net Profit Margin:

● Retention Ratio

250
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Ratio Comparison: ROE
80%
70%
60%
50%
ROE

40%
30%
20%
10%
0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 28.13% 64.27% 73.01% 62.90% 31.39%
Industry 22.30% 30.60% 25.50% 18.00%

251
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Ratio Comparison: ROA
25%

20%

15%
ROA

10%

5%

0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 12.66% 17.31% 22.12% 21.23% 14.52%
Industry 6.80% 10.90% 7.20% 5.70%

252
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Ratio Comparison: Profit Margin
9%
8%
7%
Profit Margin

6%
5%
4%
3%
2%
1%
0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 5.14% 6.68% 7.66% 8.00% 6.59%
Industry 3.40% 4.74% 3.79% 2.85%

253
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Activity (Turnover) Ratio
Examples: Dell
● Total Asset Turnover Ratio:

● Inventory Turnover Ratio:

254
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Ratio Comparison: Asset Turnover
350%

300%
Asset Turnover

250%

200%

150%

100%

50%

0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 2.47 2.59 2.89 2.65 2.20
Industry 2.00 2.30 1.90 2.00

255
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The DuPont System
● Method to breakdown ROE into:
– ROA and Equity Multiplier
● ROA is further broken down as:
– Profit Margin and Asset Turnover
● Helps to identify sources of strength and
weakness in current performance
● Helps to focus attention on value drivers

256
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

257
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier


Net Income Total Assets
= ×
Total Assets Common Equity
258
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover


Net Income Sales
= ×
Sales Total Assets
259
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier


Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity

260
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The DuPont System: Dell
Net Income Sales Total Assets
ROE = × ×
Sales Total Assets Common Equity
= Profit Margin × Total Asset Turnover × Equity Multiplier
= ROA × Equity Multiplier

$1,666.00 $25,265.00 $11,471.00


ROE = × ×
$25,265.00 $11,471.00 $5,308.00
= 0.0659 × 2.2025 × 2.1611
= 0.1452 × 2.1611
= 31.39%
261
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A Note on Sustainable Growth
and Stock Returns
● In the long run
– Sustainable growth and long run capital
gains (g) = ROE x ρ
● Recall the relationship between stock
returns (r), capital gains (g) and
forward dividend yields (D1/P0):
– r = g + D1/P0 = g + Do(1+g)/P0
● Note: r & g must be quarterly if D is
quarterly and annual if D is annual 262
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Example: Predicted
Sustainable Growth for Dell
● Based on the most ● Based on 5 year
recent numbers: averages:
– ROE = 31.39% & – ROE = 51.94% &
ρ = 100% ρ = 100%
– g = 0.3139 x 1 = – g = 0.5194 x 1 =
31.39% 51.94%
– r = 0.3139 + 0/P = – r = 0.3139 + 0/P =
31.39% 51.94%

263
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Summary of Financial Ratios
● Ratios help to:
– Evaluate performance
– Structure analysis
– Show the connection between activities and
performance
● Benchmark with
– Past for the company
– Industry
● Ratios adjust for size differences
264
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Limitations of Ratio Analysis
● A firm’s industry category is often
difficult to identify
● Published industry averages are only
guidelines
● Accounting practices differ across firms
● Sometimes difficult to interpret
deviations in ratios
● Industry ratios may not be desirable
targets
● Seasonality affects ratios 265
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Ratios and Forecasting
● Common stock valuation based on
– Expected cashflows to stockholders
– ROE and ρ are major determinants of cashflows
to stockholders
● Ratios influence expectations by:
– Showing where firm is now
– Providing context for current performance
● Current information influences expectations
by:
– Showing developments that will alter future
performance
266
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How Might Ratios Help Me on
the IEM?
● Analysis of AAPL, IBM and MSFT, and
comparisons to the S&P500 companies can
help to:
– Assess the (absolute and relative) financial state of
each company
– Show each company’s strengths and weaknesses
– Predict sustainable growth rate
● Combined with current information, this can
help to:
– Assess likely future performance
– Predict future valuation and earnings growth
– Predict returns
267
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Financial Statement Analysis:
Lecture Outline
● Review of Financial Statements
● Ratios
– Types of Ratios
– Examples
● The DuPont Method
● Ratios and Growth
● Summary
– Strengths
– Weaknesses
– Ratios and Forecasting 268
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Financial Analysis
● Assessment of the firm’s past, present
and future financial conditions
● Done to find firm’s financial strengths
and weaknesses
● Primary Tools:
– Financial Statements
– Comparison of financial ratios to past,
industry, sector and all firms
269
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Sources of Data
● Annual reports
– Via mail, SEC or company websites
● Published collections of data
– e.g., Dun and Bradstreet or Robert Morris
● Investment sites on the web
– Examples
● http://moneycentral.msn.com/investor
● http://www.marketguide.com
270
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The Main Idea
● Value for the firm comes from
cashflows
● Cashflows can be calculated as:

• (Revt - Costt - Dept)x(1-τ) + Dept


—OR—
• (Revt - Costt)x(1-τ) + τxDept
—OR—
• Revtx(1-τ) - Costtx(1-τ) + τxDept 271
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An Example: Dell
Abbreviated Balance Sheet
● Assets:
– Current Assets: $7,681.00
– Non-Current Assets: $3,790.00
– Total Assets: $11,471.00
● Liabilities:
– Current Liabilities: $5,192.00
– LT Debt & Other LT Liab.: $971.00
– Equity: $5,308.00
– Total Liab. and Equity:
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$11,471.00 272
Review: Major Income
Statement Items
● Gross Profit = Sales - Costs of Goods Sold
● EBITDA
= Gross Profit - Cash Operating Expenses
● EBIT = EBDIT - Depreciation - Amortization
● EBT = EBIT - Interest
● NI or EAT = EBT- Taxes
● Net Income is a primary determinant of the
firm’s cashflows and, thus, the value of the
firm’s shares
273
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An Example: Dell
Abbreviated Income Statement
Sales $25,265.00
Costs of Goods Sold -$19,891.00
Gross Profit $5,374.00
Cash operating expense -$2,761.00
EBITDA 2,613.00
Depreciation & Amortization -$156.00
Other Income (Net) -$6.00
EBIT $2,451.00
Interest -$0.00
EBT $2,451.00
Income Taxes -$785.00
Special Income/Charges -$194.00
Net Income (EAT) $1,666.00
274
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Objectives of Ratio Analysis
● Standardize financial information
for comparisons
● Evaluate current operations
● Compare performance with past
performance
● Compare performance against other
firms or industry standards
● Study the efficiency of operations
● Study the risk of operations 275
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Rationale Behind Ratio
Analysis
● A firm has resources
● It converts resources into profits through
– production of goods and services
– sales of goods and services
● Ratios
– Measure relationships between resources and
financial flows
– Show ways in which firm’s situation deviates from
● Its own past
● Other firms
● The industry
● All firms-
276
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Types of Ratios
● Financial Ratios:
– Liquidity Ratios
● Assess ability to cover current obligations
– Leverage Ratios
● Assess ability to cover long term debt obligations
● Operational Ratios:
– Activity (Turnover) Ratios
● Assess amount of activity relative to amount of
resources used
– Profitability Ratios
● Assess profits relative to amount of resources used
● Valuation Ratios:
● Assess market price relative to assets or earnings
277
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Liquidity Ratio Examples: Dell
● Current Ratio:

● Quick (Acid Test) Ratio:

278
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Ratio Comparison: Current Ratio
2.5

2
Current Ratio

1.5

0.5

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 2.08 1.66 1.45 1.72 1.48
Industry 1.80 1.80 1.90 1.60

279
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Leverage Ratio Examples:
Dell
● Debt Ratio:

280
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Ratio Comparison: Debt Ratio
0.8
0.7
0.6
Debt Ratio

0.5
0.4
0.3
0.2
0.1
0

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 54.70% 73.07% 69.70% 66.25% 53.73%
Industry 62.96% 60.00% 52.38% 62.96%

281
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Profitability Ratio Examples:
Dell
● Return on Assets (ROA):

● Return on Equity (ROE):

282
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Profitability Ratio Examples:
Dell
● Net Profit Margin:

● Retention Ratio

283
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Ratio Comparison: ROE
80%
70%
60%
50%
ROE

40%
30%
20%
10%
0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 28.13% 64.27% 73.01% 62.90% 31.39%
Industry 22.30% 30.60% 25.50% 18.00%

284
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Ratio Comparison: ROA
25%

20%

15%
ROA

10%

5%

0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 12.66% 17.31% 22.12% 21.23% 14.52%
Industry 6.80% 10.90% 7.20% 5.70%

285
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Ratio Comparison: Profit Margin
9%
8%
7%
Profit Margin

6%
5%
4%
3%
2%
1%
0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 5.14% 6.68% 7.66% 8.00% 6.59%
Industry 3.40% 4.74% 3.79% 2.85%

286
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Activity (Turnover) Ratio
Examples: Dell
● Total Asset Turnover Ratio:

● Inventory Turnover Ratio:

287
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Ratio Comparison: Asset Turnover
350%

300%
Asset Turnover

250%

200%

150%

100%

50%

0%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00


Dell 2.47 2.59 2.89 2.65 2.20
Industry 2.00 2.30 1.90 2.00

288
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The DuPont System
● Method to breakdown ROE into:
– ROA and Equity Multiplier
● ROA is further broken down as:
– Profit Margin and Asset Turnover
● Helps to identify sources of strength and
weakness in current performance
● Helps to focus attention on value drivers

289
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

290
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = ROA × Equity Multiplier


Net Income Total Assets
= ×
Total Assets Common Equity
291
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROA = Profit Margin × Total Asset Turnover


Net Income Sales
= ×
Sales Total Assets
292
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The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier


Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity

293
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The DuPont System: Dell
Net Income Sales Total Assets
ROE = × ×
Sales Total Assets Common Equity
= Profit Margin × Total Asset Turnover × Equity Multiplier
= ROA × Equity Multiplier

$1,666.00 $25,265.00 $11,471.00


ROE = × ×
$25,265.00 $11,471.00 $5,308.00
= 0.0659 × 2.2025 × 2.1611
= 0.1452 × 2.1611
= 31.39%
294
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A Note on Sustainable Growth
and Stock Returns
● In the long run
– Sustainable growth and long run capital
gains (g) = ROE x ρ
● Recall the relationship between stock
returns (r), capital gains (g) and
forward dividend yields (D1/P0):
– r = g + D1/P0 = g + Do(1+g)/P0
● Note: r & g must be quarterly if D is
quarterly and annual if D is annual 295
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Example: Predicted
Sustainable Growth for Dell
● Based on the most ● Based on 5 year
recent numbers: averages:
– ROE = 31.39% & – ROE = 51.94% &
ρ = 100% ρ = 100%
– g = 0.3139 x 1 = – g = 0.5194 x 1 =
31.39% 51.94%
– r = 0.3139 + 0/P = – r = 0.3139 + 0/P =
31.39% 51.94%

296
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Sell Inventory and Collect
Receivables

Inventory turnover 1
A/R turnover 2
Days’ sales in
receivables
3
297
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Inventory Turnover
● Number of times the
average level of
1998
inventory is sold during
the accounting year
● Measures time required
to earn return on
company’s investment
in inventory

298
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Inventory Turnover
Cost of goods sold
Average inventory

299
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Inventory Turnover
Cost of goods sold
Average inventory

$588,017
($164,816 + $168,652) / 2

= 3.53

300
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Inventory Turnover
● High ratio indicates ability
to quickly sell inventory
● Too high a ratio may
indicate inadequate
inventory levels
● Turnover ratio should be
compared to historical and
industry averages
● Analyze significant
variances

301
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Accounts Receivable
Turnover
● Number of times
the average level $
of A/R is
collected during
the accounting
year
● Measures ability
to collect cash
from credit
customers 302
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Measuring a Company’s
Profitability
● Financial analysts pay close attention to
ratios which assess a company’s ability to
generate profits and operate efficiently
● Creditors and investors rely on forecasts
of a company’s potential to generate net
income when they make lending and
investing choices

303
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

304
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales

305
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales
Return on assets

306
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Measuring a Company’s
Profitability
● 4 profitability ratios are commonly used
in financial statement analysis

Return on sales
Return on assets
Return on equity

307
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Return on Equity
Net income - preferred dividends
Common contributed capital +
retained earnings

308
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Return on Equity
Net income - preferred dividends
Common contributed capital + retained
earnings

$30,555*
($286,676 + $255,773) / 2

= .1126
309
* Lands’
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aug_bang@yahoo.com have preferred stock
Earnings Per Share

● Relationship between net income


available to common stockholders
and the number of shares of
common stock issued
● Expresses net income in terms of
one share of the company’s
common stock
310
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Earnings Per Share
Net income - preferred dividends
# of shares of common stock
outstanding

311
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Earnings Per Share
Net income - preferred dividends
# of shares of common stock
outstanding

$30,555,000*
40,221,000 shares
= $.76
* Lands’ End does not have preferred stock; 312
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numbers shown are actual amounts
Earnings Per Share
● Earnings per share ● In addition to net
(EPS) disclosure on income, EPS is
the face of the presented for several
corporate income other elements on the
statement is corporate income
mandatory statement
● Discontinued
operations
● Extraordinary items
● Cumulative effect of
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accounting change 313
Analyzing the Company’s
Stock as an Investment

314
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Analyzing the Company’s
Stock as an Investment
● Investors expect to receive 2 types of
returns on their investments in a
corporation’s common stock
● Gains earned when they sell the
corporation’s stock
● Periodic dividends paid by the
corporation to its stockholders

315
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Analyzing the Company’s
Stock as an Investment

● Financial analysts
use several ratios to
assess value of stock
investments
● Price/earnings ratio
● Dividend yield
● Book value
316
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Price/Earnings Ratio
● Relationship between a stock’s
market price and its earnings per
share
● Measures the number of times one
share of stock sells above the
current period’s reported earnings
● Assists financial analysts in
deciding if a stock is overpriced or
underpriced 317
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Price/Earnings Ratio
Calculating the P/E ratio

318
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Price/Earnings Ratio
Calculating the P/E ratio

Market value of stock


Earnings per share

319
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
$15.75 on the last day
Earnings per share of its fiscal year

320
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
$15.75 on the last day
Earnings per share of its fiscal year
● The income statement
reports EPS of $.92

321
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Price/Earnings Ratio
Calculating the P/E ratio ● Suppose the market
value of Asian Art,
Market value of stock Inc., common stock is
Earnings per share
$15.75 on the last day
of its fiscal year
● The income statement
reports EPS of $.92
● What is Asian Art’s
price/earnings ratio?

322
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Price/Earnings Ratio
Market value of stock
Earnings per share

323
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Price/Earnings Ratio
Market value of stock
Earnings per share

$15.75
$.92

= 17.12

324
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Dividend Yield
● Ratio of dividends per share of stock to
the stock’s market value
● Indicates the percentage of a stock’s
market value “returned” to the
stockholder in the form of dividends
● Assists investors who desire a steady flow
of dividend revenue in their decisions to
invest in a particular stock

325
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Dividend Yield
Annual dividends per share
Stock’s market value per share

● If Asian Art paid a total of $1.25 in dividends per


share, what would be its dividend yield, assuming
the same market value for its stock ($15.75)?

326
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Dividend Yield
Annual dividends per share
Stock’s market value per share

327
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See you in the next chapter
BRS

● Life education

God and Poor man

328
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TIME TO
REST

329
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Chapter-8 capital structure& cost
of capital

330
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Chapter 16: Capital Structure
Decisions: The Basics
● Overview and preview of capital structure effects
● Business versus financial risk
● The impact of debt on returns
● Capital structure theory
● Example: Choosing the optimal structure
● Setting the capital structure in practice

331
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Basic Definitions
● V = value of firm
● FCF = free cash flow
● WACC = weighted average cost of
capital
● rs and rd are costs of stock and debt
● re and wd are percentages of the firm
that are financed with stock and debt.

332
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How can capital structure affect
value?

FCFt
V = ∑t =1 (1 + WACC) t

WACC = wd (1-T) rd + we rs

(Continued…)
333
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A Preview of Capital Structure
Effects
● The impact of capital structure on value
depends upon the effect of debt on:
– WACC
– FCF

(Continued…)
334
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The Effect of Additional Debt
onDebtholders

WACC have a prior claim on cash
flows relative to stockholders.
– Debtholders’ “fixed” claim increases risk of
stockholders’ “residual” claim.
– Cost of stock, rs, goes up.
● Firm’s can deduct interest expenses.
– Reduces the taxes paid
– Frees up more cash for payments to
investors
– Reduces after-tax cost of debt
(Continued…)
335
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The Effect on WACC
(Continued)
Debt increases risk of bankruptcy

– Causes pre-tax cost of debt, rd, to increase


● Adding debt increase percent of firm
financed with low-cost debt (wd) and
decreases percent financed with high-
cost equity (we)
● Net effect on WACC = uncertain.
(Continued…)
336
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The Effect of Additional Debt
on FCF
● Additional debt increases the
probability of bankruptcy.
– Direct costs: Legal fees, “fire” sales, etc.
– Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable)
offered by suppliers

(Continued…)
337
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● Impact of indirect costs
– NOPAT goes down due to lost customers
and drop in productivity
– Investment in capital goes up due to
increase in net operating working capital
(accounts payable goes up as suppliers
tighten credit).

(Continued…)
338
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● Additional debt can affect the behavior
of managers.
– Reductions in agency costs: debt “pre-
commits,” or “bonds,” free cash flow for
use in making interest payments. Thus,
managers are less likely to waste FCF on
perquisites or non-value adding
acquisitions.
– Increases in agency costs: debt can make
managers too risk-averse, causing
“underinvestment” in risky but positive
NPV projects.

(Continued…)
339
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Asymmetric Information and
Signaling
● Managers know the firm’s future
prospects better than investors.
● Managers would not issue additional
equity if they thought the current stock
price was less than the true value of the
stock (given their inside information).
● Hence, investors often perceive an
additional issuance of stock as a
negative signal, and the stock price falls.

340
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What is business risk?
Uncertainty about future pre-tax operating
income (EBIT).
Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
341
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● Business Risks- Unit-9

● Uncertainty about demand (unit sales).


● Uncertainty about output prices.
● Uncertainty about input costs.
● Product and other types of liability.
● Degree of operating leverage (DOL).

342
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What is operating leverage, and how does
it affect a firm’s business risk?-9.3( 252)

● Operating leverage is the change in EBIT


caused by a change in quantity sold.
● The higher the proportion of fixed costs
within a firm’s overall cost structure, the
greater the operating leverage.

(More...)
343
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● Higher operating leverage leads to more
business risk, because a small sales
decline causes a larger EBIT decline.

$ Rev. $ Rev.
TC } EBIT
TC
F
F

QBE Sales QBE Sales

(More...)
344
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Operating Breakeven
● Q is quantity sold, F is fixed cost, V is
variable cost, TC is total cost, and P is
price per unit.
● Operating breakeven = QBE
QBE = F / (P – V)
● Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
(More...) 345
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Probability Low operating leverage

High operating leverage

EBITL EBITH

 In the typical situation, higher


operating leverage leads to higher
expected EBIT, but also increases risk.
346
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Business Risk versus Financial Risk-253

● Business risk:
– Uncertainty in future EBIT.
– Depends on business factors such as competition,
operating leverage, etc.
● Financial risk:
– Additional business risk concentrated on
common stockholders when financial leverage is
used.
– Depends on the amount of debt and preferred
stock financing.

347
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Consider Two Hypothetical Firms

Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

Both firms have same operating


leverage, business risk, and EBIT of
$3,000. They differ only with respect to
use of debt. 348
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Impact of Leverage on Returns

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080

ROE 9.0% 10.8%


349
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Why does leveraging increase
return?
● More EBIT goes to investors in Firm L.
– Total dollars paid to investors:
● U: NI = $1,800.
● L: NI + Int = $1,080 + $1,200 = $2,280.

– Taxes paid:
● U: $1,200; L: $720.
● Equity $ proportionally lower than NI.

350
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Now consider the fact that EBIT is not
known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
Firm L?

Continued…
351
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Firm U: Unleveraged

Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
352
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Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
353
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Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
354
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Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%

Risk Measures:
σ ROIC 2.12% 2.12%
σ ROE 2.12% 4.24%

355
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Conclusions
● Basic earning power (EBIT/TA) and
ROIC (NOPAT/Capital = EBIT(1-T)/TA)
are unaffected by financial leverage.
● L has higher expected ROE: tax savings
and smaller equity base.
● L has much wider ROE swings because
of fixed interest charges. Higher
expected return is accompanied by
higher risk. (More...)
356
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● In a stand-alone risk sense, Firm L’s
stockholders see much more risk than
Firm U’s.
– U and L: σ ROIC = 2.12%.
– U: σ ROE = 2.12%.
– L: σ ROE = 4.24%.
● L’s financial risk is σ ROE - σ ROIC = 4.24%
- 2.12% = 2.12%. (U’s is zero.)
(More...)
357
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 For leverage to be positive (increase
expected ROE), BEP must be > rd.
 If rd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
 In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
“works.”
358
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Life education

Fighting Spirit

359
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Capital Structure Theory-261
● MM theory
– Zero taxes
– Corporate taxes
– Corporate and personal taxes
● Trade-off theory
● Signaling theory
● Debt financing as a managerial
constraint
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360
MM Theory: Zero Taxes
● MM prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected by
its financing mix:
– VL = VU.
● Therefore, capital structure is irrelevant.
● Any increase in ROE resulting from financial
leverage is exactly offset by the increase in risk
(i.e., rs), so WACC is constant.

361
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MM Theory: Corporate Taxes
● Corporate tax laws favor debt financing over
equity financing.
● With corporate taxes, the benefits of financial
leverage exceed the risks: More EBIT goes to
investors and less to taxes when leverage is
used.
● MM show that: VL = VU + TD.
● If T=40%, then every dollar of debt adds 40
cents of extra value to firm.
362
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MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value


increases continuously as more and more debt is used.
363
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MM relationship between capital costs
and leverage when corporate taxes are
considered.
Cost of
Capital (%)
rs

WACC
rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
364
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Miller’s Theory: Corporate and
Personal Taxes- Page261(9.4)
● Personal taxes lessen the advantage of
corporate debt:
– Corporate taxes favor debt financing since
corporations can deduct interest expenses.
– Personal taxes favor equity financing, since
no gain is reported until stock is sold, and
long-term gains are taxed at a lower rate.

365
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Miller’s Model with Corporate and
Personal Taxes

VL = VU + 1 - [
(1 - Tc)(1 - Ts)
(1 - Td) D. ]
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
366
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Tc = 40%, Td = 30%, and Ts = 12%.

(1 - 0.40)(1 - 0.12)
VL = V U + 1 - [
(1 - 0.30) D ]
= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $1 increase in


debt raises L’s value by $0.25. 367
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Conclusions with Personal
Taxes
● Use of debt financing remains
advantageous, but benefits are less than
under only corporate taxes.
● Firms should still use 100% debt.
● Note: However, Miller argued that in
equilibrium, the tax rates of marginal
investors would adjust until there was no
advantage to debt.
368
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Trade-off Theory

● MM theory ignores bankruptcy (financial


distress) costs, which increase as more
leverage is used.
● At low leverage levels, tax benefits outweigh
bankruptcy costs.
● At high levels, bankruptcy costs outweigh tax
benefits.
● An optimal capital structure exists that
balances these costs and benefits.
369
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Signaling Theory
● MM assumed that investors and managers
have the same information.
● But, managers often have better information.
Thus, they would:
– Sell stock if stock is overvalued.
– Sell bonds if stock is undervalued.
● Investors understand this, so view new stock
sales as a negative signal.
● Implications for managers?
370
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Debt Financing and Agency
Costs
● One agency problem is that managers
can use corporate funds for non-value
maximizing purposes.
● The use of financial leverage:
– Bonds “free cash flow.”
– Forces discipline on managers to avoid perks
and non-value adding acquisitions.
(More...)
371
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● A second agency problem is the potential
for “underinvestment”.
– Debt increases risk of financial distress.
– Therefore, managers may avoid risky
projects even if they have positive NPVs.

372
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Choosing the Optimal Capital
Structure: Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;

P0 = $25; T = 40%; b = 1.0; rRF = 6%;

RPM = 6%.
373
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Estimates of Cost of Debt

Percent financed
with debt, wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
If company recapitalizes, debt would be
issued to repurchase stock.
374
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The Cost of Equity at Different
Levels of Debt: Hamada’s
Equation
● MM theory implies that beta changes
with leverage.
● bU is the beta of a firm when it has no
debt (the unlevered beta)
● bL = bU [1 + (1 - T)(D/S)]

375
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The Cost of Equity for wd =
20%
● Use Hamada’s equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
● Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
376
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Cost of Equity vs. Leverage
wd D/S bL rs
0% 0.00 1.000 12.00%
20% 0.25 1.150 12.90%
30% 0.43 1.257 13.54%
40% 0.67 1.400 14.40%
50% 1.00 1.600 15.60%
377
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The WACC for wd = 20%

● WACC = wd (1-T) rd + we rs
● WACC = 0.2 (1 – 0.4) (8%) + 0.8
(12.9%)
● WACC = 11.28%

● Repeat this for all capital structures


378
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WACC vs. Leverage
wd rd rs WACC
0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%
379
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Corporate Value for wd = 20%

● V = FCF / (WACC-g)
● g=0, so investment in capital is zero; so
FCF = NOPAT = EBIT (1-T).
● NOPAT = ($500,000)(1-0.40) =
$300,000.

380
V = $300,000 / 0.1128 = $2,659,574.
e-mail:
● aug_bang@yahoo.com www.augustin.co.nr
Corporate Value vs. Leverage
wd WACC Corp. Value
0% 12.00% $2,500,000
20% 11.28% $2,659,574
30% 11.01% $2,724,796
40% 11.04% $2,717,391
50% 11.40% $2,631,579
381
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Debt and Equity for wd = 20%

● The dollar value of debt is:


D = wd V = 0.2 ($2,659,574) = $531,915.
● S=V–D
S = $2,659,574 - $531,915 = $2,127,659.

382
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Debt and Stock Value vs.
Leverage
wd Debt, D Stock Value,
S
0% $0 $2,500,000
20% $531,915 $2,127,660
30% $817,439 $1,907,357
40% $1,086,957 $1,630,435
50% $1,315,789 $1,315,789 383
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Note: these are rounded; see Ch 16 Mini Case.xls for
Wealth of Shareholders
● Value of the equity declines as more
debt is issued, because debt is used to
repurchase stock.
● But total wealth of shareholders is value
of stock after the recap plus the cash
received in repurchase, and this total
goes up (It is equal to Corporate Value
on earlier slide).

384
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Stock Price for wd = 20%
● The firm issues debt, which changes its
WACC, which changes value.
● The firm then uses debt proceeds to
repurchase stock.
● Stock price changes after debt is issued, but
does not change during actual repurchase (or
arbitrage is possible).
(More…) 385
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Stock Price for wd = 20%
(Continued)
● The stock price after debt is issued
but before stock is repurchased
reflects shareholder wealth:
– S, value of stock
– Cash paid in repurchase.

(More…)
386
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Stock Price for wd = 20%
(Continued)
● D0 and n0 are debt and outstanding
shares before recap.
● D - D0 is equal to cash that will be used
to repurchase stock.
● S + (D - D0) is wealth of shareholders’
after the debt is issued but immediately
(More…)
before the repurchase.
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387
Stock Price for wd = 20%
(Continued)
● P = S + (D – D0)
n0
P = $2,127,660 + ($531,915 – 0)
100,000
P = $26.596 per share.
388
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Number of Shares
Repurchased
● # Repurchased = (D - D0) / P
# Rep. = ($531,915 – 0) / $26.596
= 20,000.
● # Remaining = n = S / P
n = $2,127,660 / $26.596
= 80,000.
389
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Price per Share vs. Leverage
# shares # shares
wd P Repurch. Remaining
0% $25.00 0 100,000
20% $26.60 20,000 80,000
30% $27.25 30,000 70,000
40% $27.17 40,000 60,000
50% $26.32 50,000 50,000 390
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Optimal Capital Structure

● wd = 30% gives:
– Highest corporate value
– Lowest WACC
– Highest stock price per share
● But wd = 40% is close. Optimal
range is pretty flat.
391
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What other factors would managers
consider when setting the target
capital structure?
● Debt ratios of other firms in the
industry.
● Pro forma coverage ratios at different
capital structures under different
economic scenarios.
● Lender and rating agency attitudes
(impact on bond ratings).
392
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● Reserve borrowing capacity.
● Effects on control.
● Type of assets: Are they tangible,
and hence suitable as collateral?
● Tax rates.

393
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Life Education

War prisoner’s
wife
394
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Capital Budgeting-Chapter-
11(297)

395
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Ch. 11:
Capital Budgeting
Decision Criteria

396
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 1999, Prentice Hall, Inc.
Capital Budgeting: the process of
planning for purchases of long-
term assets.
● example:
Suppose our firm must decide whether
to purchase a new plastic molding
machine for $125,000. How do we
decide?
● Will the machine be profitable?

● Will our firm earn a high rate of return

on the investment? 397


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Decision-making Criteria in
Capital Budgeting

How do we decide
if a capital
investment
project should be
accepted or
rejected?

398
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Capital Budgeting
● Time value of money is a fundamental
concept. If the interest rate in the
economy is 10%, $1 today is worth $1.10
net year, $1.21 two years from today
and $1.331 three years from today etc…
● So, $1.10 next year $1.21 two years from
now, $1.331 three years from now are
all worth $1 today.

399
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● 100(1+.12)=112(1.12)=125.44
● 100=112
● 100=125.44
● 112=100
● 125.44=100
● Today’s worth of 112 at the end 1st year is =100 today
● 100=112/1.12
● (1+K)
● A(1+K)^n=FV
● PV(1+K)^n=FV

400
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Capital Budgeting
● Now if I am to get $1.1 next year, $1.21
the year after and $1.331 the third year,
what should I be willing to pay for the
right to this stream of cash flows
assuming that my only other alternative
is to put the money in a bank account
and get 10% interest?
● Ans: $3, why?
– Each year’s cash inflow is worth a dollar
today.
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401
Capital Budgeting
● If someone wants to sell me this
investment for $2.90, my NPV (net
present value) of the project is _____
● Ans: 10cents. How computed?
– The cash inflows are worth $3 in today’s
dollars, the outflows are $2.90 in today’s
dollars, so the NPV (always in current
dollars) is Cash Inflows – Cash Outflows =
$0.10.
402
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Capital Budgeting
● The basic equation of compound interest is
shown on p. 96:
PV(1+r)n = FV
● (1+r)n is called the “factor”
● To get the present value of a stream of cash
inflows divide each future inflow amount by
the factor for that year (this is called deflating
the FV) and add all the deflated inflows …
this is the formula on

403
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Capital Budgeting
● To get the present value of a stream of cash
outflows compute the sum of the deflated cash
outflows.
● To compute NPV of a project subtract
PV(outflows) from PV(Inflows).
● To do the computations by hand you can use
special formulas for perpetuities and
annuities. We will ignore this.
● For this course, you should know how to do
the computations using a financial calculator.
404
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Principles underlying Cash Flows
● 1. Decision based on cash flows-Non cash
charges not considered ie.Depreciation for tax
calculation only. We add depreciation after
calculating tax with profit after tax
● 2.The amount of long term funds are used for
capital investment purpose are considered.
● 3.Cash inflow is defined as profit after tax but
before depreciation

405
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Principles underlying Cash Flows
● 4.Interest on long term loan is not
considered as it is used for discounting
purpose.
● 5. Incremental cost and incremental
benefits are considered.
● 6.Quantify the detremental impact or
benefits are considered.

406
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Principles underlying Cash Flows
● 7.Sunk cost are irrelevant.
● 8.Opportunity costs are to be
considered.
● 9. share of existing overheads has no
value
● 10. short term loan –interest on such
loan to be deducted from contribution.

407
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Principles underlying Cash Flows
● 11. salvage value to be determined and tax
benefit on short term capital gain to be
deducted from salvage value. And tax benefit
on short term capital loss to be added to
salvage value.
● 12. while valuing lease/buy tax benefit on
interest payment and tax benefit on
depreciation have to be deducted from
equated annual/monthly instalment.
● 13. While valuing lease net lease payment
after tax has to be considered.
408
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Relevant cost and relevant
benefit
● Required for decision making
● Costs that are affected by by the decision
● Costs and benefits that are independent of
a decision are not relevant and need not be
considered.
● Future cash inflows and future outflows
are relevant.
● Sunk costs are irrelevant
409
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Relevant cost and relevant
benefit
● Allocated common costs are irrelevant
● Opportunity costs are relevant (shadow
price)
● Incremental costs are relevant
incremental benefits are relevant.
● Avoidable costs are relevant and
unavoidable costs are irrelevant for
decision making.
410
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Relevant and irrelevant
● Five engineers already employed on
monthly salary but will not be sent out if
not employed in an another project. The
salary paid to those engineers are
relevant or irrelevant to estimate the
price for the project?
● Two more engineers are selected
exclusive to the new project-are the
costs relevant to take decision for new
project?
411
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● Examples:
1.Aztec. Spent Rs.20,00,000 for feasibility study before
expansion is dead cost (sunk cost) therefore it is not
considered as cash outflow.
● 2. If feasibility study can be sold to other companies say, for
Rs. 5,00,000 is an opportunity cost which should be
considered as cash inflow for the project.

412
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Examples:
● 3. Plant is Rs. 36,00,000, working capital
is Rs. 24,00,000 required for a project.
The company issues Equity capital
Rs.26,00,000 and term loan Rs.16,00,000
then the cash outflow for the project is
Rs. 42,00,000 as long term funds such as
Equity capital and long term loan equal
to Rs.42,00,000. If short term funds are
employed for long term purpose we do
not consider such funds as out flow.
413
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Depreciation
● 4. Depreciation should be calculated as per
Block assets method. The assets are similar
nature having the rate of depreciation the
costs are to be clubbed together. If any new
asset(s) purchased during the year the
amounts incurred on such asset are to be
added.
Depreciation can not be calculated in the year of
sale but the sale value(scrap ) is deducted from
the block value.
If the some of the assets of the block are not sold
and WDV(Balance in the block) exceeds sale
value of the assets of the same block we can
provide depreciation on the balance.

414
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If Sale value exceeds the block WDV value there is a
capital gain which attracts capital gain. In such
situation sale minus tax on short term capital gain will
be cash inflow.
If all assets of the block is sold and the WDV of the block
exceeds sale value we get short term capital loss. The
real cash inflow is equal to scrap plus tax benefit on
short term capital loss .
Example:1. Plant and machinery costs Rs.5,00,000
salvage value is Rs. 1,00,000
The rate of depreciation as per Companies Act is
20% whereas income tax rate of depreciation is 25% .
How do we calculate depreciation? Life is 3 years

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● .75*5,00,000= = =2,10,937.5-1,00,000
● = 1,10,937(loss)

● 1,00,000+1,10937(.339)

● =1,37,607(Inflow)

● Suppose salvage value is 3,00,000

Short term capital gain= 3,00,000-2,10,937


=89,063
Tax on 89,063=89063*.339=30,192
Net cash inflow =3,00,000-30,192
=2,69,807.This should be discounted to today’s value

416
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Depreciation and their impact
in fin.A/c, fin.Mgt.,Income tax
By Prof.Augustin
etc. Amaladas
M.Com.,AICWA.,B.
ED.,PGDFM

417
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Meaning

● Reduction in the value of fixed assets due to


wear and tear and due to effluction of time.
● All assets except land can be depreciated.
● The underlying principle of depreciation is
that cash flows generated by an asset over its
life cannot be considered income until
provision is made for asset’s replacement.
● It is an allocation of past cash flows.
● Depreciation expense appears on the income
statement, but has no impact on the statement
of cash flows.
418
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Depreciation methods
● Straight line method
● Written down value method
● Sinking fund method
● Machine Hour rate method
● Unit cost method
● Depletion asset method
● Depreciation Fund method
● Sum of digits method
● Accelerated depreciation method
419
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Impact on books

● Depreciation Expense
● Net income
● Asset
● Equity
● Return on assets
● Return on Equity
● Turnover Ratios
● Cash flow
● NPV
● IRR
● Pay back 420
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Impact of Tax

● Block asset method


● Purchase of Asset
● Sale of Asset
● Short term/Long-term Capital asset
● Asset used less than 180 days during the
previous year
● Asset purchased preceding previous
year but put into use less than 180 days
during the current previous year 421
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Impact of Tax

● Rate decided by whom?

422
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Inflation and
Depreciation
● If prices are rising, Incomes and taxes
will be over stated / Under stated
● Replacement?

423
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Accounting Standard

● AS-06
● As-10

424
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Tax planning

● U/S-32 of IT act
● When own funds used in plant and machinery
-18.66% saving
● When borrowed funds used –Tax savings
through depreciation-22.91%
● Depreciation on intangible assets can be
provided at 25% rate. The eligible assets are:
Know how, patent right, copy right,
● Trade mark, licenses, franchises, any other
commercial rights
425
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Carry forward and set of depreciation in
the subsequent periods

● Any number of years provided filed


returns

426
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Amalgamation, absorption,
reconstruction and demerger
CAN NEW CO. CARRY FORWAD AND SET OF
LOSS AND DEPRECIATION?
SEC 72 A TO BE FULFILLED
3. ACCUMULATED LOSSES REMAIN
UNABSORBED FOR 3 OR MORE YEARS
4. 75% OF BOOK VALUE TO BE HELD ATLEAST
FOR 2 YEARS BEFORE AMALGAMATION

427
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l THE AMALGAMATED CO. CONTINUES
TO HOLD 3/4TH OF BOOK VALUE
ATLEAST FOR 5 YEARS
l NEW CO. SHOULD CONTINUE FOR
ANOTHER 5 YEARS
l NEW CO. SHOULD ACHIEVE ATLEAST
50%OF INSTALLED CAPACITY
BEFORE END OF 5 YEARS AND
SHOULD CONTINUE FOR 5 YEARS

428
e-mail: aug_bang@yahoo.com www.augustin.co.nr
A LTD AMALGAMATES WITH B LTD AS ON 2007

429
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OTHER TAX
BENEFITS
1. Expenditure on amalgamation or de-merger –
allowed under sec 35DD both revenue and capital
expenditure allowed
2. Expenditure on scientific research can be carried
forward
3. Expenditure on acquisition of patent rights
copyrights – depreciation can be provided

430
e-mail: aug_bang@yahoo.com www.augustin.co.nr
OTHER TAX BENEFITS
1. Expenditure for obtaining license for
tele-communication service can be
written off
2. Preliminary expenses
3. Capital expenditure on family
planning
4. Bad debts are allowed

431
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Calculation of Depreciation-
continues
● Example:1.
Plant and machinery costs Rs.5,00,000 salvage value is Rs.
1,00,000
The rate of depreciation as per Companies Act is 20% whereas
income tax rate of depreciation is 25% . Life is 3 years. Tax
rate=30% surcharge 10% and 3% educational cess.
How do we calculate Capital loss? Cash Inflow at the end of
third year?.
Short term capital loss
Block value at the end of 2nd year- scrap at the end of three years
=Rs.2,81,750-Rs. 1,00,000
=Rs. 1,81,750
Cash Inflow at the end of third year
=Rs.1,00,000+(*33.90% *1,81,750)
= Rs.1,61,613

*Tax= 30%+10%(30%)+3%*33=33.99%
432
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Depreciation as per Income tax
act
Year Beginning Depreciation End value
value 25%
1 5,00,000 1,25,000 3,75,000
2 3,75,000 93,750 2,81,750
3 2,81,750 No

433
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owned funds Vs borrowed funds
● If owned funds are invested in plant and
machinery one can get tax saving on
depreciation.
● If assets are acquired on borrowed funds one
can get tax benefit on depreciation and also
tax benefit on interest.
● The actual cash out flow will be annual
instalment-tax saving on depreciation-tax
saving on interest.

434
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Exercise-2 owned funds Vs
borrowed funds
● An assessee who carries on a business, acquires a
plant and machinery costing Rs.10,00,000 in a year
one. This plant is used for 5 years and will be
discarded at the end of 5th year for Rs. 2,00,000.
● Tax rate is 30%, surcharge is 10% and educational
cess is 3%.Assume the plant is sold at the end of the
5th year. Cost of Capital is 10% and rate of
depreciation is 15%.
● Required:
● 1. Evaluate when owned funds are invested
● 2. When 75% cost of plant is financed by deposit
taken from public at the rate of 9%pa.

435
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discount
Depreciati Tax benefit facto present
year beginning on End value on depre r value

1 10,00,000 1,50,000 8,50,000 50,850 0.909 50,799

2 8,50,000 1,27,500 7,22,500 43,223 0.826 35,702

3 7,22,500 1,08,375 6,14,125 36,739 0.751 27,591

4 6,14 112 92119 5,22,006 31,228 0.683 21,328


5,22,006
5 0.62
Present 1,35,420
value

436
e-mail: aug_bang@yahoo.com www.augustin.co.nr
● Present value of scrap =*3,09,158*.620=1,91,678
● *Scrap value=2,00,000
● *Calculation of short term capital gain as the asset is depreciated
Book value at the end of 4th year-scrap value=5,22,000-2,00,000
=3,22,000
Tax savings on STCG=3,22,000*.339
=*1,09,158
Present value on tax saving on STCG= 1,09,158*0.620=37,004=67,678
Net present cash out flow value
Initial cash out flow-Present value of tax savings on depreciation-
present value of cash inflow on scrap
Rs.10,00,000-Rs.1,35,420-Rs.1,91,678=Rs.6,72,902

437
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Lease vs Purchase
● Purchase with Borrowed Funds:-
● If assets are acquired on borrowed funds one can get
tax benefit on depreciation and also tax benefit on
interest.
● The actual cash out flow will be annual instalment-tax
saving on depreciation-tax saving on interest.
● Lease-
● Deduction can be claimed in respect of lease rentals
and lease management fees.

438
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Exercise-3 Lease vs Purchase
● An assessee who carries on a business, acquires a plant and
machinery costing Rs.10,00,000 in a year one. This plant is used
for ten years and will be discarded at the end of ten years for Rs.
2,00,000.
● Tax rate is 30%, surcharge is 10% and educational cess is
3%.Assume the plant is sold at the end of the 10th year.
Discounting rate is 10% and rate of depreciation is 15%.
● Required:
● 1. Evaluate when plant taken on lease by paying lease rental of
Rs. 3,50,000 for the first five years in the beginning and 50,000
thereafter for the remaining years.
● 2. When 75% cost of plant is financed by deposit taken from
public at the rate of 9%p.a.

439
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● Purchase by instalment vs Hire
● Purchase by instalment vs Hire

440
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Life education

Apologies to the
---------

441
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Life education

● shoes

442
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Short cut techniques by using
ordinary calculator.
● Future value at 10%
year 1. 1.1
Year 2. 1.1*=
Year 3. 1.1*= =
Year 5. 1.1*= = = =

443
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Scientific calculator
● Amount*1.1= for the first year
● Amount *1.1*1.1= for the second year
● Amount *1.1*1.1= = = = 6th year value

444
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Present value by ordinary
calculator
● 1st year 1.1/=
● 2nd year 1.1/= =
● 6rd year 1.1/= = = = = =

445
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WDV value
● 15% depreciation as per WDV
value at the end of 1st year= 0.85*asset value=
Value at the end of 2nd year =0 .85*asset value= =
Value at the end of 6th year=0.85*asset value= = = = = =

446
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Decision-making Criteria in
Capital Budgeting

● The Ideal Evaluation Method should:

a) include all cash flows that occur


during the life of the project,
b) consider the time value of money,
c) incorporate the required rate of return
on the project.
447
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Payback Period
● The number of years needed to
recover the initial cash outlay.
● How long will it take for the project to
generate enough cash to pay for itself?

448
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Payback Period
● How long will it take for the project to
generate enough cash to pay for itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

449
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Payback Period
● How long will it take for the project to
generate enough cash to pay for itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years.


450
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● Is a 3.33 year payback period good?
● Is it acceptable?
● Firms that use this method will
compare the payback calculation to
some standard set by the firm.
● If our senior management had set a
cut-off of 5 years for projects like
ours, what would be our decision?
● Accept the project.

451
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Drawbacks of Payback Period:
● Firm cutoffs are subjective.
● Does not consider time value of money.
● Does not consider any required rate of
return.
● Does not consider all of the project’s cash
flows.

452
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Drawbacks of Payback Period:
● Does not consider all of the project’s cash
flows.

(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8

Consider this cash flow stream!


453
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Drawbacks of Payback Period:
● Does not consider all of the project’s cash
flows.

(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
e-mail: aug_bang@yahoo.com www.augustin.co.nr
454
Discounted Payback

● Discounts the cash flows at the


firm’s required rate of return.
● Payback period is calculated using
these discounted net cash flows.
● Problems:
● Cutoffs are still subjective.
● Still does not examine all cash flows.
455
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30

456
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Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70

457
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38

458
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Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
459
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75
460
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
461
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 The
-500 Discounted
-500.00
1 250Payback 219.30 1 year
is 2.52 years
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
462
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Other Methods

1) Net Present Value (NPV)


2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Each of these decision-making criteria:


● Examines all net cash flows,

● Considers the time value of money, and

● Considers the required rate of return.

463
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Net Present Value

• NPV = the total PV of the annual net


cash flows - the initial outlay.

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

464
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Net Present Value

• Decision Rule:

• If NPV is positive, ACCEPT.


• If NPV is negative, REJECT.
465
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NPV Example
● Suppose we are considering a capital investment
that costs $276,400 and provides annual net cash
flows of $83,000 for four years and $116,000 at
the end of the fifth year. The firm’s required rate
of return is 15%.

466
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NPV Example
● Suppose we are considering a capital investment
that costs $276,400 and provides annual net cash
flows of $83,000 for four years and $116,000 at
the end of the fifth year. The firm’s required rate
of return is 15%.

83,000 83,000 83,000 83,000 116,000


(276,400)

0 1 2 3 4 5
467
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the HP10B:
● -276,400 CFj
● 83,000 CFj
● 4 shift Nj
● 116,000 CFj
● 15 I/YR
● shift NPV
● You should get NPV = 18,235.71.

468
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the HP17BII:
● Select CFLO mode.
● FLOW(0)=? -276,400 INPUT
● FLOW(1)=? 83,000 INPUT
● #TIMES(1)=1 4 INPUT
● FLOW(2)=? 116,000 INPUT
● #TIMES(2)=1 INPUT EXIT
● CALC 15 I% NPV
● You should get NPV = 18,235.71
469
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.

470
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER

471
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER

472
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NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER
● F01= 1 4 ENTER

473
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER
● F01= 1 4 ENTER
● C02=? 116,000 ENTER

474
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER
● F01= 1 4 ENTER
● C02=? 116,000 ENTER
● F02= 1 ENTER

475
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER
● F01= 1 4 ENTER
● C02=? 116,000 ENTER
● F02= 1 ENTER
● NPV I= 15 ENTER CPT

476
e-mail: aug_bang@yahoo.com www.augustin.co.nr
NPV with the TI BAII Plus:
● Select CF mode.
● CFo=? -276,400 ENTER
● C01=? 83,000 ENTER
● F01= 1 4 ENTER
● C02=? 116,000 ENTER
● F02= 1 ENTER
● NPV I= 15 ENTER CPT
● You should get NPV = 18,235.71
477
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1

478
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Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1

Σ
ACFt
PI = IO
(1 + k) t
t=1 479
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Profitability Index

• Decision Rule:

• If PI is greater than or equal


to 1, ACCEPT.
• If PI is less than 1, REJECT.
480
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● -276,400 CFj PI with
● 83,000 CFj the
● 4 shift Nj HP10B:
● 116,000 CFj
● 15 I/YR
● shift NPV
● You should get NPV = 18,235.71.
● Add back IO: + 276,400
● Divide by IO: / 276,400 =
● You should get PI = 1.066
481
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Internal Rate of Return (IRR)

● IRR: the return on the firm’s


invested capital. IRR is simply
the rate of return that the firm
earns on its capital budgeting
projects.

482
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Life education

● Toss a coin

483
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Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

484
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

n
ACFt
IRR:
Σ t=1
(1 + IRR) t = IO

485
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Internal Rate of Return (IRR)
n
ACFt
IRR:
Σ t=1
(1 + IRR) t = IO

● IRR is the rate of return that makes the PV of


the cash flows equal to the initial outlay.
● This looks very similar to our Yield to
Maturity formula for bonds. In fact, YTM is
the IRR of a bond.
486
e-mail: aug_bang@yahoo.com www.augustin.co.nr
Calculating IRR
● Looking again at our problem:
● The IRR is the discount rate that
makes the PV of the projected cash
flows equal to the present value of
outlay.
83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
487
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83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
● This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)


= 276,400

488
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83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
● This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)


= 276,400

● This way, we have to solve for IRR by trial


and error.
489
e-mail: aug_bang@yahoo.com www.augustin.co.nr
IRR with your Calculator

● IRR is easy to find with your financial


calculator.
● Just enter the cash flows as you did
with the NPV problem and solve for
IRR.
● You should get IRR = 17.63%!

490
e-mail: aug_bang@yahoo.com www.augustin.co.nr
IRR
• Decision Rule:

• If IRR is greater than or equal


to the required rate of return,
ACCEPT.
• If IRR is less than the required
rate of return, REJECT.
491
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● IRR is a good decision-making
tool as long as cash flows are
conventional. (- + + + + +)
● Problem: If there are multiple

sign changes in the cash flow


stream, we could get multiple
IRRs. (- + + - + +)

492
e-mail: aug_bang@yahoo.com www.augustin.co.nr
● IRR is a good decision-making
tool as long as cash flows are
conventional. (- + + + + +)
● Problem: If there are multiple

sign changes in the cash flow


stream, we could get multiple
IRRs. (- + + - + +)

(500) 200 100 (200) 400 300

0 1 2
e-mail: aug_bang@yahoo.com www.augustin.co.nr 3 4 5 493
● IRR is a good decision-making
tool as long as cash flows are
conventional. (- + + + + +)
● Problem: If there are multiple

sign changes in the cash flow


stream, we could get multiple
IRRs. (- + + - + +)

(500) 200 100 (200) 400 300

0 1 2
e-mail: aug_bang@yahoo.com www.augustin.co.nr 3 4 5 494
● Problem: If there are multiple sign
changes in the cash flow stream, we
could get multiple IRRs. (- + + - +
+)
● We could find 3 different IRRs!

1 2 3
(500) 200 100 (200) 400 300

0 1 2
e-mail: aug_bang@yahoo.com www.augustin.co.nr 3 4 5 495
Summary Problem:
● Enter the cash flows only once.
● Find the IRR.
● Using a discount rate of 15%, find NPV.
● Add back IO and divide by IO to get PI.

(900) 300 400 400 500 600

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Summary Problem:
● IRR = 34.37%.
● Using a discount rate of 15%,
NPV = $510.52.
● PI = 1.57.

(900) 300 400 400 500 600

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NPV Profiles
● A graphical representation of project NPVs at
various different costs of capital.

k NPVL NPVS
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

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Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

.. S IRRS = 23.6%
10
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10 499
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Comparing the NPV and IRR
methods
● If projects are independent, the two
methods always lead to the same
accept/reject decisions.
● If projects are mutually exclusive …
– If k > crossover point, the two methods
lead to the same decision and there is no
conflict.
– If k < crossover point, the two methods
lead to different accept/reject decisions.

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Finding the crossover point
1. Find cash flow differences between the
projects for each year.
2. Enter these differences in CFLO register,
then press IRR. Crossover rate = 8.68%,
rounded to 8.7%.
3. Can subtract S from L or vice versa, but
better to have first CF negative.
4. If profiles don’t cross, one project dominates
the other.

501
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Reasons why NPV profiles cross
● Size (scale) differences – the smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more
valuable these funds, so high k favors small
projects.
● Timing differences – the project with faster
payback provides more CF in early years
for reinvestment. If k is high, early CF
especially good, NPVS > NPVL.

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Reinvestment rate assumptions
● NPV method assumes CFs are reinvested
at k, the opportunity cost of capital.
● IRR method assumes CFs are reinvested at
IRR.
● Assuming CFs are reinvested at the
opportunity cost of capital is more
realistic, so NPV method is the best. NPV
method should be used to choose between
mutually exclusive projects.
● Perhaps a hybrid of the IRR that assumes
cost of capital reinvestment is needed.
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Since managers prefer the IRR to the
NPV method, is there a better IRR
measure?
● Yes, MIRR is the discount rate that

causes the PV of a project’s terminal


value (TV) to equal the PV of costs. TV
is found by compounding inflows at
WACC.
● MIRR assumes cash flows are

reinvested at the WACC.

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Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0


10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 $158.1 TV inflows
$100 =
PV outflows
(1 + MIRRL)3
MIRRL = 16.5%
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Why use MIRR versus IRR?
● MIRR correctly assumes reinvestment
at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
● Managers like rate of return
comparisons, and MIRR is better for
this than IRR.

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Project P has cash flows (in 000s): CF0 =
-$800, CF1 = $5,000, and CF2 = -$5,000.
Find Project P’s NPV and IRR.
0 1 2
k = 10%

-800 5,000 -5,000

● Enter CFs into calculator CFLO


register.
● Enter I/YR = 10.
● NPV = -$386.78.
● IRR = ERROR Why?
507
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Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
508
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Why are there multiple IRRs?
● At very low discount rates, the PV of CF2 is
large & negative, so NPV < 0.
● At very high discount rates, the PV of both
CF1 and CF2 are low, so CF0 dominates and
again NPV < 0.
● In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
● Result: 2 IRRs.

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Solving the multiple IRR problem
● Using a calculator
– Enter CFs as before.
– Store a “guess” for the IRR (try 10%)
10 ■ STO
■ IRR = 25% (the lower IRR)
– Now guess a larger IRR (try 200%)
200 ■ STO
■ IRR = 400% (the higher IRR)
– When there are nonnormal CFs and more than
one IRR, use the MIRR.
510
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When to use the MIRR instead of
the IRR? Accept Project P?
● When there are nonnormal CFs and
more than one IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314.
– TV of inflows @ 10% = $5,500.
– MIRR = 5.6%.
● Do not accept Project P.
– NPV = -$386.78 < 0.
– MIRR = 5.6% < k = 10%.
511
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Capital Budgeting
● Moral:
– Use NPV as the first step in evaluating projects.
– If capital is in short supply, try and find the
best mix of projects to take using simulation
rather than use some arbitrary short-cuts (IRR
etc.).
– Look at payback period as a second step,
especially if the projects are otherwise
comparable (in magnitude of investment, life of
cash flows). If strategic flexibility in the firm’s
investment base matters, payback period is a
healthy tool in spite of serious theoretical
512
deficiencies.
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Life education


Bringing rain
inside

513
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Thank You

514
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