Instructional Material on Financial Management PDF

FINANCIAL MANAGEMENT (FIMA 202) INSTR. R-JHAI T. BALCITA BSBA-FM FACULTY MEMBER...

FINANCIAL MANAGEMENT (FIMA 202) INSTR. R-JHAI T. BALCITA BSBA-FM FACULTY MEMBER PUP SAN JUAN CITY CAMPUS Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Table of Contents Overview Institutional Learning Outcomes Program Outcomes Course Outcomes Classroom Policy Course Materials Midterm Period Lesson 1: Introduction to Financial Management Overview of Financial Management The Firm and Its Financial Manager Organizational Structure of the Finance Department Organization of the Finance Function Lesson 2: Financial Markets, Institutions, and Interest Rates Financial Institutions and Markets Interest Rate Fundamentals Term Structure of Interest Rates Lesson 3: Financial Reporting and Analysis The Stockholders’ Report Four Key Financial Statements Using Financial Ratios Lesson 4: Basic Financial Analysis Horizontal Analysis Vertical Analysis Lesson 5: Risk, Return and Valuation Types of Risks Capital Asset Pricing Model Valuation of Financial Assets – Stocks and Bonds Final Period Lesson 6: Capital Budgeting Overview of Capital Budgeting Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Capital Budgeting Techniques Relevant Cash Flows Finding the Initial Investment, Operating Cash Inflows, and Terminal Cash Flow Lesson 7: Planning the Financial Structure Alternative Methods of Financing Debt versus Equity Operating, Financial, and Total Leverage Breakeven Analysis and Operating Breakeven Point Capital Structure Theory Lesson 8: Managing and Financing Current Assets Cash Accounts Receivable Inventory Lesson 9: Management of Short-term, Intermediate and Long-term Funds Internal Sources External Sources Money Market Capital Market Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Overview This is an introductory course in financial management designed to make students understand the basic finance concepts. It involves studies on decision making utilizing financial resources available to the firm from the perspective of the manager. It covers the whole range of basic finance concepts; financial statement analysis; working capital management and short-term financing; financial asset valuation; risk, return and cost of capital; capital budgeting; capital markets and sources of long-term financing. Institutional Learning Outcomes 1. Creative Thinking and Critical Thinking Graduates use their rational and reflective thinking as well as innovative abilities to life situations in order to push boundaries, realize possibilities, and deepen their interdisciplinary, multidisciplinary, and/or transdisciplinary understanding of the world. 2. Effective Communication Graduates apply the four macro skills in communication (reading, writing, listening, and speaking), through conventional and digital means, and are able to use these skills in solving problems, making decisions, and articulating thoughts when engaging with people in various circumstances. 3. Strong Service Orientation Graduates exemplify strong commitment to service excellence for the people, the clientele, industry and other sectors. 4. Adept and Responsible Use or Development of TechnologY Graduates demonstrate optimized and responsible use of state-of-the-art technologies of their profession. They possess digital learning abilities, including technical, numerical, and/or technopreneurial skills. 5. Passion to Lifelong Learning Graduates perform and function in society by taking responsibility in their quest for further improvement through lifelong learning. 6. Leadership and Organizational Skills Graduates assume leadership roles and become leading professionals in their respective disciplines by equipping them with appropriate organizational skills. 7. Personal and Professional Ethics Graduates manifest integrity and adherence to moral and ethical principles in their personal and professional circumstances. 8. Resilience and Agility Graduates demonstrate flexibility and the growth mindset to adapt and thrive in the volatile, uncertain, complex and ambiguous (VUCA) environment. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  9. National and Global Responsiveness Graduates exhibit a deep sense of nationalism as it complements the need to live as part of the global community where diversity is respected. They promote and fulfill various advocacies for human and social development. Program Outcomes Select the proper decision-making tools to critically, analytically and creatively solve problems. Express oneself clearly and communicate effectively with stakeholders both in oral and written forms. Exhibit positive service mindset and value-driven service approaches. Participate in community-based projects that make a difference in the civic life of communities. Apply information and communication technology skills as required by the business environment. Engage in lifelong learning with a passion to keep current with national and global banking and finance developments. Demonstrate interpersonal, team and leadership skills necessary to promote organizational effectiveness. Exercise high personal moral and ethical standards. Employ national and global perspectives to analyze issue. Course Outcomes Use basic financial management concept. Identify the major sources of short-term and long-term financing available to the firm. Apply techniques for estimating the cost of each component of the cost of capital. Apply time value, risk, and return concepts. Identify relevant cash flows for capital budgeting projects and apply various methods to analyze projects. Analyze financial statements using standard financial ratios of liquidity, activity, debt, profitability, and market value. Explain the role of short-term financial management, and the key strategies and techniques used to manage cash, marketable securities, accounts receivable and inventory. Classroom Policy Course Requirements 1. Students must read this syllabus carefully for proper information and guidance regarding the course content, required materials, course requirements and grading. They should not hesitate to ask questions or clarifications. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  2. Students are expected to attend all lectures regularly. A student may be dropped from the course after accumulating a total of 12 lecture hour unexcused absences. 3. Students are expected to read the assigned readings before lecture to prepare for and to better profit from the lectures and discussions. 4. Students must submit the requirements/assignments/projects on the set deadline. They shall be collected before the start of the session. Late requirements/assignments/projects will not be accepted without prior approval. If approved, this will automatically result in the reduction of the grade earned on the requirement/assignment/project. 5. Students forfeit their opportunity to earn points for the lecture quizzes/exercises that they will miss due to unexcused absences and shall receive 0 point for any missed examination/exercise. Exams are announced in advance and if the student knows that he is going to miss an exam, he must notify the lecturer in advance by email or a phone message. For other major examinations such as midterm and final examinations, the students are allowed to take make-up examinations. 6. Makeup exams will generally only be allowed for family emergencies, verifiable illness, or University/College/Department-sponsored activities. The makeup, if granted, must be completed within one week of returning to class. 7. The University Student Handbook shall be always observed on matters pertaining to academic dishonesty (e.g., cheating, plagiarism, collusion, falsification or fraud in the materials or requirements submitted, etc.) Classroom Behavior 1. Students are expected to observe proper decorum and behavior during classroom instruction. Personal conversations are not allowed while in class. Remember that any disruptive behavior can detract others from maximizing learning experiences. 2. When in session, students are expected to pay attention, take notes, and actively participate in class discussion. They are strongly encouraged to raise inquiries/questions that will encourage critical thinking among members of the class. 3. Mobile phones must be turned off or always put in silence mode while in sessions. Use of mobile phones during emergency may be allowed upon securing permission from the instructor. 4. Students are expected to observe cleanliness and orderliness of the classroom at the start and the end of every session. Consultation Time Consultation may be done 15 minutes before the start of the session or 15 minutes after the end of the session. The student may also set an appointment with the lecturer for consultation/advising pertaining to the course. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 1: Introduction to Financial Management Overview: The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertising campaigns. Because there are important financial dimensions to almost any aspect of business, there are many financially oriented career opportunities for those who understand the principles of finance described in this learning material. Even if you do not see yourself pursuing a career in finance, you’ll find that an understanding of a few key ideas in finance will help make you a smarter consumer and a wiser investor with your own money. Module Objectives: Describe Financial Management in terms of the three major decision areas that confront the financial manager. Identify the goal of the firm and extrapolate why shareholders’ wealth maximization is preferred. Explain the basic responsibilities of financial managers. Describe how the finance function is related to Economics and Accounting. Course Materials: What is Finance? Science and the art of managing money. Concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings. Involves the same types of decisions: how firms raise money from investors, how firms invest money to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. Career Opportunities in Finance Financial Services – the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. It involves a variety of interesting career opportunities within the areas of banking, personal financial planning, investments, real estate, and insurance. Managerial Finance – concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses: private and public, large, and small, profit seeking and not for profit. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 1.1: Career Opportunities in Managerial Finance Legal Forms of Business Organization Sole Proprietorship. A business owned by one person and operated for his or her own profit. o Unlimited Liability – the condition of a sole proprietorship (or general partnership), giving creditors the right to make claims against the owner’s personal assets to recover debts owed by the business. Partnership. A business owned by two or more people and operated for profit. o Articles of Partnership – the written contract used to formally establish a business partnership. Corporation. An entity created by law. o Stockholders. The owners of a corporation, whose ownership, or equity, takes the form of common stock or, less frequently, preferred stock. o Limited Liability. A legal provision that limits stockholders’ liability for a corporation’s debt to the amount they initially invested in the firm by purchasing stock. o Common Stock. The purest and most basic form of corporate ownership. o Dividends. Periodic distributions of cash to the stockholders of a firm. o Board of Directors. Group elected by the firm’s stockholders and typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures. o President or Chief Executive Officer (CEO). Corporate official responsible for managing the firm’s day to day operations and carrying out the policies established by the board of directors. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 1.2: Corporate Organization Cooperative. An autonomous and duly registered association of persons with a common bond of interest, who have voluntarily joined together to achieve a lawful common social or economic end, making equitable contributions to the capital required and accepting the fair share of the risks and benefits of the undertaking in accordance with the universally accepted cooperative principles. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Exhibit 1.3: Strengths and Weaknesses of the Common Legal Forms of Business Organization Goal of the Firm Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners, the stockholders. The simplest and best measure of stockholder wealth is the firm’s share price, so most ideas instruct managers to take actions that increase the firm’s share price. A common misconception is that when firms strive to make their shareholders happy, they do so at the expense of other constituencies such as customers, employees, or suppliers. This line of thinking ignores the fact that in most cases, to enrich shareholders, managers must first satisfy the demands of these other interest groups. Dividends that stockholders receive ultimately come from the firm’s profits. It is unlikely that a firm whose customers are unhappy with its products, whose employees are looking for jobs at other firms, or whose suppliers are reluctant to ship raw materials will make shareholders rich because such a firm will likely be less profitable in the long run than one that better manages its relations with these stakeholder groups. Therefore, we argue that the goal of the firm, and of managers, should be to maximize the wealth of the owners for whom it is being operated, which in most instances is equivalent to maximizing the stock price. This goal translates into a straightforward decision rule for managers: Only take actions that are expected to increase the wealth of shareholders. Although that goal sounds simple, implementing it is not always easy. To determine whether a particular course of action will increase or decrease shareholders’ wealth, managers must assess what return (that is, cash inflows net of cash outflows) the action will bring and how risky that return might be. Exhibit 1.4 depicts this process. In fact, we can say that the key variables that managers must consider when making business decisions are return (cash flows) and risk. Exhibit 1.4: Share Price Maximization Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Earnings per Share (EPS). The amount earned during the period on behalf of each outstanding share of common stock, calculated by dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of common stock outstanding. Risk. The chance that actual outcomes may differ from those expected. Risk Averse. Requiring compensation to bear risk. Stakeholders. Groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. Organization of the Finance Function The size and importance of the managerial finance function depend on the size of the firm. In small firms, the finance function is generally performed by the accounting department. As a firm grows, the finance function typically evolves into a separate department linked directly to the company president or CEO through the chief financial officer (CFO). The lower portion of the organizational chart in Exhibit 1.2 shows the structure of the finance function in a typical medium- to large-size firm. Controller. The firm’s chief accountant is responsible for the firm’s accounting activities, such as corporate accounting, tax management, financial accounting, and cost accounting. Treasurer. The firm’s chief financial manager, who manages the firm’s cash, oversees its pension plans, and manages key risks. o Foreign Exchange Manager. The manager responsible for managing and monitoring the firm’s exposure to loss from currency fluctuations. Relationship to Economics The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operation. Examples include supply-and-demand analysis, profit-maximizing strategies, and price theory. The primary economic principle used in managerial finance is marginal cost–benefit analysis, the principle that financial decisions should be made, and actions taken only when the added benefits exceed the added costs. Nearly all financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs. Example: Jaime Teng is a financial manager for Nord Department Stores, a large chain of upscale department stores operating primarily in the western United States. She is currently trying to decide whether to replace one of the firm’s computer servers with a new, more sophisticated one that would both speed up processing and handle a larger volume of transactions. The new computer would require a cash outlay of $8,000, and the old computer could be sold for a net of $2,000. The total benefits from the new server (measured in today’s Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  dollars) would be $10,000. The benefits over a similar time from the old computer (measured in today’s dollars) would be $3,000. Applying marginal cost–benefit analysis, Jamie organizes the data as follows: Because the marginal (added) benefits of $7,000 exceed the marginal (added) costs of $6,000, Jaime recommends that the firm purchase the new computer to replace the old one. The firm will experience a net benefit of $1,000 because of this action. Relationship to Accounting The firm’s finance and accounting activities are closely related and generally overlap. In small firms, accountants often carry out the finance function; in large firms, financial analysts often help compile accounting information. There are, however, two differences between finance and accounting; one is related to the emphasis on cash flows, and the other is related to decision making. Emphasis on Cash Flows: Accrual Basis. In preparation of financial statements, recognizes revenue at the time of sale and recognizes expenses when they are incurred. Cash Basis. Recognizes revenues and expenses only with respect to actual inflows and outflows of cash. Example: Nassa Corporation, a small yacht dealer, sold one yacht for $100,000 in the calendar year just ended. Nassau originally purchased the yacht for $80,000. Although the firm paid in full for the yacht during the year, at year-end it has yet to collect the $100,000 from the customer. The accounting view and the financial view of the firm’s performance during the year are given by the following income and cash flow statements, respectively. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  In an accounting sense, Nassa Corporation is profitable, but in terms of actual cash flow, it is a financial failure. Its lack of cash flow resulted from the uncollected accounts receivable of $100,000. Without adequate cash inflows to meet its obligations, the firm will not survive, regardless of its level of profits. As the example shows, accrual accounting data do not fully describe the circumstances of a firm. Thus, the financial manager must look beyond financial statements to obtain insight into existing or developing problems. Of course, accountants are aware of the importance of cash flows, and financial managers use and understand accrual-based financial statements. Nevertheless, the financial manager, by concentrating on cash flows, should be able to avoid insolvency and achieve the firm’s financial goals. The second major difference between finance and accounting has to do with decision making. Accountants devote most of their attention to the collection and presentation of financial data. Financial managers evaluate the accounting statements, develop additional data, and make decisions based on their assessment of the associated returns and risks. Of course, it does not mean that accountants never make decisions or that financial managers never gather data but rather that the primary focuses of accounting and finance are distinctly different. Primary Activities of the Financial Manager In addition to ongoing involvement in financial analysis and planning, the financial manager’s primary activities are making investment and financing decisions. Investment decisions determine what types of assets the firm holds. Financing decisions determine how the firm raises money to pay for the assets in which it invests. One way to visualize the difference between a firm’s investment and financing decisions is to refer to the balance sheet shown in Exhibit 1.5. Investment decisions generally refer to the items that appear on the left-hand side of the balance sheet, and financing decisions relate to the items on the right-hand side. Keep in mind, though, that financial managers make these decisions based on their effect on the value of the firm, not on the accounting principles used to construct a balance sheet. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 1.5: Financial Activities Activities: I. Activity No. 1: X and Y went to a business school together 10 years ago. A corporation that wants to bring in new Financial Managers has just hired them. X studied Finance, with an emphasis on financial markets and institutions. Y majored in accounting and became a Certified Public Accountant 5 years ago. Who is more suited to be the Treasurer and who is more suited to be the Controller? II. Answer the following Discussion Questions: 1. What is Finance? Explain how this field affects all the activities in which businesses engage. 2. What is the financial services area of finance? Describe the field of managerial finance. 3. Which legal form of business organization is more common? Which form is dominant in terms of business revenues? 4. Describe the roles and the basic relationships among the major parties in a corporation – stockholders, board of directors, ang manager. How are corporate owners rewarded for the risks they take? 5. Why is the study of financial management important to your professional life regardless of the specific area of responsibility you may have within the business firm? Why is it important to your personal life? Sources: Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Essex, England: Pearson Education Limited. Official Gazette. (2009). Republic Act No. 9520. Retrieved September 19, 2023, from https://www.officialgazette.gov.ph/2009/02/17/republic-act-no-9520/. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 2: Financial Markets, Institutions, and Interest Rates Overview: Most successful firms have ongoing needs for funds. They can obtain funds from external sources in three ways. The first source is through a financial institution that accepts savings and transfers them to those that need funds. A second source is through financial markets, organized forums in which the suppliers and demanders of various types of funds can make transactions. A third source is through private placement. Because of the unstructured nature of private placements, here we focus primarily on the role of financial institutions and financial markets in facilitating business financing. Module Objective: Discuss the term structure of interest rates and their relationship to yield curve. Course Materials: Financial Institutions Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments. Many financial institutions directly or indirectly pay savers interest on deposited funds; others provide services for a fee (for example, checking accounts for which customers pay service charges). Some financial institutions accept customers’ savings deposits and lend this money to other customers or to firms, others invest customers’ savings in earning assets such as real estate or stocks and bonds, and some do both. Financial institutions are required by the government to operate within established regulatory guidelines. Key Customers of Financial Institutions Individuals. The savings that individual consumers place in financial institutions provide these institutions with a large portion of their funds. Individuals not only supply funds to financial institutions but also demand funds from them in the form of loans. However, individuals as a group are the net suppliers for financial institutions: They save more money than they borrow. Businesses. Firms also deposit some of their funds in financial institutions, primarily in checking accounts with various commercial banks. Like individuals, firms borrow funds from these institutions, but firms are net demanders of funds: They borrow more money than they save. Governments. Maintain deposits of temporarily idle funds, certain tax payments, and Social Security payments in commercial banks. They do not borrow funds directly from financial institutions, although by selling their debt securities to various institutions, governments indirectly borrow from them. The government, Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  like business firms, is typically a net demander of funds: It typically borrows more than it saves. We’ve all heard about the federal budget deficit. Commercial Banks, Investment Banks, and the Shadow Banking System Commercial Banks. Institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers. Investment Banks. Institutions that assist companies in raising capital, advise firms on major transactions such as mergers or financial restructurings, and engage in trading and market making activities. Shadow Banking System. A group of institutions that engage in lending activities, much like traditional banks, but do not accept deposits and therefore are not subject to the same regulations as traditional banks. Financial Markets Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans made by financial institutions are granted without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested. The two key financial markets are the money market and the capital market. Transactions in short-term debt instruments, or marketable securities, take place in the money market. Long-term securities—bonds and stocks—are traded in the capital market. Private Placement. The sale of a new security directly to an investor or group of investors. Public Offering. The sale of either bonds or stocks to the public. Primary Market. Financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction. Secondary Market. Financial market in which preowned securities (those that are not new issues) are traded. The Relationship between Institutions and Markets Financial institutions actively participate in the financial markets as both suppliers and demanders of funds. Exhibit 2.1 depicts the general flow of funds through and between financial institutions and financial markets as well as the mechanics of private placement transactions. Domestic or foreign individuals, businesses, and governments may supply and demand funds. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 2.1: Flow of Funds Interest Rate Fundamentals The interest rate or required return represents the cost of money. It is the compensation that a supplier of funds expects, and a demander of funds must pay. Interest Rate. Usually applied to debt instruments such as bank loans or bonds; the compensation paid by the borrower of funds to the lender; from the borrower’s point of view, the cost of borrowing funds. Required Return. Usually applied to equity instruments such as common stock; the cost of funds obtained by selling an ownership interest. Inflation. A rising trend in the prices of most goods and services. Liquidity Preference. A general tendency for investors to prefer short-term (that is, more liquid) securities. Real Rate of Interest. The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where suppliers and demanders of funds have no liquidity preferences and there is no risk. Nominal Rate of Interest. The actual rate of interest charged by the supplier of funds and paid by the demander. Deflation. A general trend of falling prices. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Example: Marilyn Carbs has $10 that she can spend on candy costing $0.25 per piece. She could buy 40 pieces of candy ($10.00 / $0.25) today. The nominal rate of interest on a 1-year investment is currently 7%, and the expected rate of inflation over the coming year is 4%. Instead of buying the 40 pieces of candy today, Marilyn could invest the $10. After 1 year, she would have $10.70 because she would have earned 7% interest—an additional $0.70 (0.07 x $10.00)—on her $10 investment. During that year, inflation would have increased the cost of the candy by 4%—an additional $0.01 (0.04 x $0.25)—to $0.26 per piece. As a result, at the end of the 1-year period Marilyn would be able to buy about 41.2 pieces of candy ($10.70 / $0.26), or roughly 3% more (41.2 / 40.0 = 1.03). The 3% increase in Marilyn’s buying power represents her real rate of return. The nominal rate of return on her investment (7%) is partly eroded by inflation (4%), so her real return during the year is the difference between the nominal rate and the inflation rate (7% - 4% = 3%). Term Structure of Interest Rates The term structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. A graph of this relationship is called the yield curve. A quick glance at the yield curve tells analysts how rates vary between short-, medium-, and long- term bonds, but it may also provide information on where interest rates and the economy in general are headed in the future. Usually, when analysts examine the term structure of interest rates, they focus on Treasury securities because they are generally considered to be free of default risk. Yield to Maturity (YTM). Compound annual rate of return earned on a debt security purchased on a given day and held to maturity. Inverted Yield Curve. A downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates. Normal Yield Curve. An upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates. Flat Yield Curve. A yield curve that indicates that interest rates do not vary much at different maturities. Theories of Term Structure Expectations Theory. The theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve. Liquidity Preference Theory. Theory suggesting that long-term rates are generally higher than short-term rates (hence, the yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities. Market Segmentation Theory. Theory suggesting that the market for loans is segmented based on maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment. Activity: I. Answer the following Discussion Questions: 1. Who are the key participants in the transactions of financial institutions? Who are net suppliers, and who are net demanders? 2. What roles do financial markets play in our economy? What are primary and secondary markets? What relationship exists between financial institutions and financial markets? 3. What is the term structure of interest rates, and how is it related to the yield curve? 4. For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward-sloping; (b) upward-sloping; and (c) flat? What is the normal shape of the yield curve? 5. Briefly describe the following theories of the general shape of the yield curve: (a) Expectations Theory; (b) Liquidity Preference Theory; and (c) Market Segmentation Theory. Source: Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Essex, England: Pearson Education Limited. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 3: Financial Reporting and Analysis Overview: In this lesson, you will learn about some of the basic analytical tools that financial managers use almost every day. Lesson 3 reviews the main financial statements that are the primary means by which firms communicate with investors, analysts, and the rest of the business community. It also illustrates some simple tools that managers use to analyze the information contained in financial statements to identify and diagnose financial problems. Module Objectives: Review the contents of the stockholders’ report. Explain the purpose of basic financial statements and their contents. Define, calculate, and categorize the major financial ratios and comprehend and extrapolate what they can tell us about the firm. Identify the limitations of financial ratio analysis. Course Materials: The Stockholders’ Report “Every corporation has many and varied uses for the standardized records and reports of its financial activities. Periodically, reports must be prepared for regulators, creditors (lenders), owners, and management.” – Gitman & Zutter, 2015 Generally Accepted Accounting Principles (GAAP). The practice and procedure guidelines used to prepare and maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB). Financial Accounting Standards Board (FASB). The accounting profession’s rule- setting body, which authorizes generally accepted accounting principles (GAAP). Public Company Accounting Oversight Board (PCAOB). A not-for-profit corporation established by the Sarbanes-Oxley Act of 2002 to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports. Stockholders’ Report. Annual report that publicly owned corporations must provide to stockholders; it summarizes and documents the firm’s financial activities during the past year. Letter to Stockholders. Typically, the first element of the annual stockholders’ report and the primary communication from management. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch The Four Key Financial Statements Income Statement. Provides a financial summary of the firm’s operating results during a specified period. o Dividends per share (DPS). The amount of cash distributed during the period on behalf of each outstanding share of common stock. Balance Sheet. Summary statement of the firm’s financial position at a given point in time. o Current Assets. Short-term assets expected to be converted into cash within 1 year or less. o Current Liabilities. Short-term liabilities, expected to be paid within 1 year or less. o Long-term Debt. Debt for which payment is not due in the current year. o Paid-in Capital in Excess of Par. The amount of proceeds more than the par value received from the original sale of common stock. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  o Retained Earnings. The cumulative total of all earnings, net of dividends, that have been retained and reinvested in the firm since its inception. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Statement of Stockholders’ Equity. Shows all equity account transactions that occurred during a given year. o Statement of Retained Earnings. Reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year. An abbreviated form of the statement of stockholders’ equity. Statement of Cash Flows. Provides a summary of the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Notes to the Financial Statements Included with published financial statements are explanatory notes keyed to the relevant accounts in the statements. These notes to the financial statements provide detailed information on the accounting policies, procedures, calculations, and transactions underlying entries in the financial statements. Common issues addressed by these notes include revenue recognition, income taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies. Since the passage of Sarbanes-Oxley, notes to the financial statements have also included some details about compliance with that law. Professional securities analysts use the data in the statements and notes to develop estimates of the value of securities that the firm issues, and these estimates influence the actions of investors and therefore the firm’s share value. Using Financial Ratios The information contained in the four basic financial statements is of major significance to a variety of interested parties who regularly need to have relative measures of the company’s performance. Relative is the key word here, because the analysis of financial statements is based on the use of ratios or relative values. Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance. The basic inputs to ratio analysis are the firm’s income statement and balance sheet. Types of Ratio Comparisons Cross-sectional Analysis. Comparison of different firms’ financial ratios at the same point in time involves comparing the firm’s ratios with those of other firms in its industry or with industry averages. o Benchmarking. A type of cross-sectional analysis in which the firm’s ratio values are compared with those of a key competitor or with a group of competitors that it wishes to emulate. Time-series Analysis. Evaluation of the firm’s financial performance over time using financial ratio analysis. Combines Analysis. The most informative approach to ratio analysis combines cross- sectional and time-series analyses. A combined view makes it possible to assess the trend in the behavior of the ratio in relation to the trend for the industry. Exhibit 3.1 depicts this type of approach using the average collection period ratio of Bartlett Company over the years 2012–2015. This ratio reflects the average amount of time (in days) it takes the firm to collect bills, and lower values of this ratio generally are preferred. The figure quickly discloses that (1) Bartlett’s effectiveness in collecting its receivables is poor in comparison to the industry, and (2) Bartlett’s trend is toward longer collection periods. Clearly, Bartlett needs to shorten its collection period. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 3.1: Combined View of Bartlett Company’s ACP, 2012-2015 Cautions About Using Ratio Analysis 1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. Additional analysis is typically needed to determine whether there is a problem and to isolate the causes of the problem. 2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. However, if an analysis is concerned only with certain specific aspects of a firm’s financial position, one or two ratios may suffice. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. If they are not, the effects of seasonality may produce erroneous conclusions and decisions. 4. It is preferable to use audited financial statements for ratio analysis. If they have not been audited, the data in them may not reflect the firm’s true financial condition. 5. The financial data being compared should have been developed in the same way. The use of differing accounting treatments—especially relative to inventory and depreciation— can distort the results of ratio comparisons, regardless of whether cross-sectional or time- series analysis is used. 6. Results can be distorted by inflation, which can cause the book values of inventory and depreciable assets to differ greatly from their replacement values. Additionally, inventory costs and depreciation write-offs can differ from their true values, thereby distorting profits. Without adjustment, inflation tends to cause older firms (older assets) to appear more efficient and profitable than newer firms (newer assets). Clearly, in using ratios, you must be careful when comparing older with newer firms or comparing a firm to itself over a long period of time. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Categories of Financial Ratios Liquidity Ratios Liquidity. A firm’s ability to satisfy its short-term obligations as they come due. Current Ratio. A measure of liquidity calculated by dividing the firm’s current assets by its current liabilities. Quick (Acid-test) Ratio. A measure of liquidity calculated by dividing the firm’s current assets minus inventory by its current liabilities. Activity Ratios Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows. Inventory Turnover. Measures the activity, or liquidity, of a firm’s inventory. Average Age of Inventory. Average number of days’ sales in inventory. For Bartlett Company, the average age of inventory in 2015 is 51 days (365 / 7.2). Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Average Collection Period. The average amount of time needed to collect accounts receivable. Average Payment Period. The average amount of time needed to pay accounts payable. The difficulty in calculating this ratio stems from the need to find annual purchases, a value not available in published financial statements. Ordinarily, purchases are estimated as a given percentage of the cost of goods sold. If we assume that Bartlett Company’s purchases equaled 70 percent of its cost of goods sold in 2015, its average payment period is Total Asset Turnover. Indicates the efficiency with which the firm uses its assets to generate sales. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Debt Ratios The debt position of a firm indicates the amount of other people’s money being used to generate profits. In general, the financial analyst is most concerned with long-term debts because these commit the firm to a stream of contractual payments over the long run. The more debt a firm has, the greater its risk of being unable to meet its contractual debt payments. Because creditors’ claims must be satisfied before the earnings can be distributed to shareholders, current and prospective shareholders pay close attention to the firm’s ability to repay debts. Lenders are also concerned about the firm’s indebtedness. In general, the more debt a firm uses in relation to its total assets, the greater its financial leverage. Financial leverage is the magnification of risk and return using fixed-cost financing, such as debt and preferred stock. The more fixed-cost debt a firm uses, the greater will be its expected risk and return. Debt Ratio. Measures the proportion of total assets financed by the firm’s creditors. Debt-to-Equity Ratio. Measures the relative proportion of total liabilities and common stock equity used to finance the firm’s total assets. Times Interest Earned Ratio. Measures the firm’s ability to make contractual interest payments; sometimes called the interest coverage ratio. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits shown in the income statement. Applying this ratio to Bartlett Company yields the 2015 value of Fixed-Payment Coverage Ratio. Measures the firm’s ability to meet all fixed- payment obligations. where T is the corporate tax rate applicable to the firm’s income. The term 1 / (1 - T) is included to adjust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-tax values of all other terms. Applying the formula to Bartlett Company’s 2015 data yields Profitability Ratios There are many measures of profitability. As a group, these measures enable analysts to evaluate the firm’s profits with respect to a given level of sales, a certain level of assets, or the owners’ investment. Without profits, a firm could not attract outside capital. Owners, creditors, and management pay close attention to boosting profits because of the great importance the marketplaces on earnings. Gross Profit Margin. Measures the percentage of each sales dollar remaining after the firm has paid for its goods. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Operating Profit Margin. Measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted; the “pure profits” earned on each sales dollar. Net Profit Margin. Measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. Earnings per Share. Represents the number of dollars earned during the period on behalf of each outstanding share of common stock. Return on Total Assets (ROA). Measures the overall effectiveness of management in generating profits with its available assets; also called the return on investment (ROI). Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Return on Equity (ROE). Measures the return earned on the common stockholders’ investment in the firm. Market Ratios Market ratios relate the firm’s market value, as measured by its current share price, to certain accounting values. These ratios give insight into how investors in the marketplace believe that the firm is doing in terms of risk and return. They tend to reflect, on a relative basis, the common stockholders’ assessment of all aspects of the firm’s past and expected future performance. Here we consider two widely quoted market ratios, one that focuses on earnings and another that considers book value. Price / Earnings (P/E) Ratio. Measures the amount that investors are willing to pay for each dollar of a firm’s earnings; the higher the P/E ratio, the greater the investor confidence. If Bartlett Company’s common stock at the end of 2015 was selling at $32.25, the P/E ratio, using the EPS of $2.90, at year-end 2015 is $32.25 / $2.90 = 11.12. This figure indicates that investors were paying $11.12 for each $1.00 of earnings. Market / Book (M/B) Ratio. Provides an assessment of how investors view the firm’s performance. Firms expected to earn high returns relative to their risk typically sell at higher M/B multiples. Substituting the appropriate values for Bartlett Company from its 2015 balance sheet, we get The formula for the market/book ratio is Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Substituting Bartlett Company’s end of 2015 common stock price of $32.25 and its $23.00 book value per share of common stock (calculated above) into the M/B ratio formula, we get $32.25 / $23.00 = 1.40 This M/B ratio means that investors are currently paying $1.40 for each $1.00 of book value of Bartlett Company’s stock. A Complete Ratio Analysis Analysts frequently wish to take an overall look at the firm’s financial performance and status. Here we consider two popular approaches to a complete ratio analysis: (1) summarizing all ratios and (2) the DuPont system of analysis. The summary analysis approach tends to view all aspects of the firm’s financial activities to isolate key areas of responsibility. The DuPont system acts as a search technique aimed at finding the key areas responsible for the firm’s financial condition. Activities: I. Activity No. 2: Based on the discussion, state your insights on Bartlett Company’s overall financial performance in 2015 terms of: 1) Liquidity; 2) Activity; 3) Debt; 4) Profitability; 5) Market II. Answer the following Discussion Questions: 1. What roles do the Generally Accepted Accounting Principles (GAAP) and the Financial Accounting Standards Board (FASB) play in the financial activities of public companies? 2. Describe the purpose of each of the four major financial statements. 3. Why are the notes to financial statements important to professional securities analysts? 4. Regarding financial ration analysis, how do the viewpoints held by the firm’s present and prospective shareholders, creditors, and management differ? 5. What is the difference between cross sectional analysis and time-series analysis? What is benchmarking? 6. Why is it preferable to compare ratios calculated using financial statements that are dated at the same point in time during the year? 7. Financial ratio analysis is often divided into five areas: liquidity, activity, debt, profitability, and market ratios. Differentiate each of these areas of analysis from others. Which is of the greatest concern to creditors? Source: Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Essex, England: Pearson Education Limited. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 4: Basic Financial Analysis Overview: Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency. A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan. A long-term creditor, such as a bondholder, looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. Similarly, stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock. Module Objective: Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm’s performance. Course Materials: Need for Comparative Analysis Every item reported in a financial statement has significance. When J.C. Penney Company, Inc. reports cash and cash equivalents of $3 billion on its balance sheet, we know the company had that amount of cash on the balance sheet date. But we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company’s need for cash. To obtain such information, we need to compare the amount of cash with other financial statement data. Comparisons can be made on several different bases. 1. Intracompany Basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of J.C. Penney’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a comparison of J.C. Penney’s year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash. 2. Industry Averages. Comparisons with industry averages provide information about a company’s relative position within the industry. For example, financial statement Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  readers can compare J.C. Penney’s financial data with the averages for its industry compiled by financial rating organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by organizations such as Yahoo! on its financial site. 3. Intercompany Basis. Comparisons with other companies provide insight into a company’s competitive position. For example, investors can compare J.C. Penney’s total sales for the year with the total sales of its competitors in retail, such as Sears. Tools of Analysis We use various tools to evaluate the significance of financial statement data. Three commonly used tools are these: Horizontal Analysis evaluates a series of financial statement data over a period. Vertical Analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount. Ratio Analysis expresses the relationship among selected items of financial statement data. Horizontal analysis is used primarily in intracompany comparisons. Two features in published financial statements facilitate this type of comparison: First, each of the basic financial statements presents comparative financial data for a minimum of two years. Second, a summary of selected financial data is presented for a series of five to ten years or more. Vertical analysis Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch is used in both intra- and intercompany comparisons. Ratio analysis is used in all three types of comparisons. Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period. Its purpose is to determine the increase or decrease that has taken place. This change may be expressed as either an amount or a percentage. If we assume that 2007 is the base year, we can measure all percentage increases or decreases from this base period amount as follows. For example, we can determine that net sales for J.C. Penney decreased from 2007 to 2008 by approximately 6.9% [($18,486 - $19,860) / $19,860]. Similarly, we can determine that net sales decreased from 2007 to 2009 approximately 11.6% [($17,556 - $19,860) / $19,860]. Alternatively, we can express current year sales as a percentage of the base period. We do this by dividing the current year amount by the base year amount, as shown below. The illustration below presents this analysis for J.C. Penney for a three-year period using 2007 as the base period. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Balance Sheet To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store Inc., a fictional retailer. Exhibit 4.1 presents a horizontal analysis of its two-year condensed balance sheets, showing dollar and percentage changes. Exhibit 4.1: Horizontal Analysis of Balance Sheets The comparative balance sheets in Exhibit 4.1 show that several significant changes have occurred in Quality Department Store’s financial structure from 2008 to 2009: In the assets section, plant assets (net) increased $167,500, or 26.5%. In the liabilities section, current liabilities increased $41,500, or 13.7%. In the stockholders’ equity section, retained earnings increased $202,600, or 38.6%. These changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Income Statement Exhibit 4.2 presents a horizontal analysis of the two-year condensed income statements of Quality Department Store Inc. for the years 2009 and 2008. Horizontal analysis of the income statements shows the following changes: Net sales increased $260,000, or 14.2% ($260,000 / $1,837,000). Cost of goods sold increased $141,000, or 12.4% ($141,000 / $1,140,000). Total operating expenses increased $37,000, or 11.6% ($37,000 / $320,000). Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable. Exhibit 4.2: Horizontal Analysis of Income Statements Retained Earnings Statement Exhibit 4.3 presents a horizontal analysis of Quality Department Store’s comparative retained earnings statements. Analyzed horizontally, net income increased $55,300, or 26.5%, whereas dividends on the common stock increased only $1,200, or 2%. We saw in the horizontal analysis of the balance sheet that ending retained earnings Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. Exhibit 4.3: Horizontal Analysis of Retained Earnings Statements Horizontal analysis of changes from period to period is relatively straightforward and is quite useful. But complications can occur in making the computations. If an item has no value in a base year or preceding year but does have a value in the next year, we cannot compute a percentage change. Similarly, if a negative amount appears in the base or preceding period and a positive amount exists the following year (or vice versa), no percentage change can be computed. Vertical Analysis Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. On a balance sheet we might say that current assets are 22% of total assets—total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount. Balance Sheet Exhibit 4.4 presents the vertical analysis of Quality Department Store Inc.’s comparative balance sheets. The base for the asset items is total assets. The base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity. Vertical analysis shows the relative size of each category in the balance sheet. It also can show the percentage change in the individual asset, liability, and stockholders’ equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2008 to 55.6% in 2009 (even though the absolute dollar amount increased $75,000 in that time). Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total liabilities and stockholders’ equity. These results reinforce the earlier Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Exhibit 4.4: Vertical Analysis of Balance Sheets Income Statement Exhibit 4.5 shows vertical analysis of Quality’s income statements. Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising to see net income as a percentage of net sales increase from 11.4% to 12.6%. Quality appears to be a profitable business that is becoming even more successful. An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality’s main competitor is the JC Penney store in a nearby town. Using vertical analysis, we can compare the condensed income statements of Quality Department Store Inc. (a small retail company) with J.C. Penney Company, Inc. (a giant international retailer), as shown in Exhibit 4.6. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Exhibit 4.5: Vertical Analysis of Income Statements Exhibit 4.6: Intercompany Income Statement Comparison Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  J.C. Penney’s net sales are 8,372 times greater than the net sales of the relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality’s and J.C. Penney’s gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.7%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%) which is much lower than J.C. Penney’s (35.7%). Although J.C. Penney earned a net income more than 951 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (1.4%) is only 11% of Quality’s (12.6%). Activity: Answer the following Discussion Questions: 1. Discuss the need for comparative analysis. 2. Identify the tools of financial statement analysis. 3. Explain horizontal analysis. 4. Describe vertical analysis. Sources: Weygandt, J.J., Kimmel, P. D., & Keiso, D. E., (2012). Accounting Principles. United States of America, United States of America: John Wiley & Sons, Inc. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 5: Risk, Return and Valuation Overview: In most important business decisions, there are two key financial considerations: risk and return. Each financial decision presents certain risk and return characteristics, and the combination of these characteristics can increase or decrease a firm’s share price. Module Objectives: Define risk and return and their relationship. Differentiate types of risks and how to mitigate them. Measure/Calculate risk and return. Calculate the required rate of return using the capital-asset pricing model (CAPM). Value bonds, preferred stocks, and common stock. Calculate the rates of return (or yields) of different types of long-term securities. Course Materials: Risk and Return Fundamentals Analysts use different methods to quantify risk, depending on whether they are looking at a single asset or a portfolio— a collection or group of assets. We will look at both, beginning with the risk of a single asset. First, though, it is important to introduce some fundamental ideas about risk, return, and risk preferences. Risk is a measure of the uncertainty surrounding the return that an investment will earn. Investments whose returns are more uncertain are generally riskier. More formally, the term risk is used interchangeably with uncertainty to refer to the variability of returns associated with a given asset. A $1,000 government bond that guarantees its holder $5 interest after 30 days has no risk because there is no variability associated with the return. A $1,000 investment in a firm’s common stock is very risky because the value of that stock may move up or down substantially over the same 30 days. The total rate of return is the total gain or loss experienced on an investment over a given period. Mathematically, an investment’s total return is the sum of any cash distributions (for example, dividends or interest payments) plus the change in the investment’s value, divided by the beginning-of-period value. The expression for calculating the total rate of return earned on any asset over period t, rt, is commonly defined as Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  The return, rt, reflects the combined effect of cash flow, Ct, and changes in value, Pt - Pt-1, over the period. The equation is used to determine the rate of return over a period as short as 1 day or as long as 10 years or more. However, in most cases, t is 1 year, and r therefore represents an annual rate of return. Example: Robinhood wishes to determine the return on two stocks that she owned during 2012, Apple Inc., and Wal-Mart. At the beginning of the year, Apple stock traded for $411.23 per share, and Wal-Mart was valued at $60.33. During the year, Apple paid $5.30 in dividends, and Wal-Mart shareholders received dividends of $1.59 per share. At the end of the year, Apple stock was worth $532.17, and Wal-Mart sold for $68.23. Substituting into equation, we can calculate the annual rate of return, r, for each stock: Apple: ($5.30 + $532.17 - $411.23) / $411.23 = 30.7% Wal-Mart: ($1.59 + $68.23 - $60.33) / $60.33 = 15.7% Robinhood made money on both stocks in 2012, and her return was higher on Apple both in dollars and on a percentage basis. Risk Preferences Risk Averse. The attitude toward risk in which investors require an increased return as compensation for an increase in risk. Risk Neutral. The attitude toward risk in which investors choose the investment with the higher return regardless of its risk. Risk Seeking. The attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns. Risk of a Single Asset Risk Assessment Scenario Analysis. An approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  o Range. A measure of an asset’s risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome. Probability Distribution. A model that relates probabilities to the associated outcomes. o Probability. The chance that a given outcome will occur. o Bar Chart. The simplest type of probability distribution shows only a limited number of outcomes and associated probabilities for a given event. o Continuous Probability Distribution. A probability distribution showing all the possible outcomes and associated probabilities for a given event. Risk Measurement Standard Deviation. The most common statistical indicator of an asset’s risk; it measures the dispersion around the expected value. o Expected Value of a Return. The average return that an investment is expected to produce over time. Example: Norman Company’s past estimates indicate that the probabilities of the pessimistic, most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note that the sum of these probabilities must equal 100%; that is, they must be based on all the alternatives considered. Expected Values of Returns and Standard Deviation for Assets A and B Possible Outcomes Probability Return Weighted Value Deviations (1) (2) [(1) x (2)] = (3) [(2) – (r)]2 x (1) ASSET A Pessimistic 0.25 13% 3.25% 4 x 0.25 = 1% Most Likely 0.50 15% 7.50% 0 x 0.50 = 0% Optimistic 0.25 17% 4.25% 4 x 0.25 = 1% Total 1.00 15% 2% Standard Deviation = √2 = 1.41% ASSET B Pessimistic 0.25 7% 1.75% 64 x 0.25 = 16% Most Likely 0.50 15% 7.50% 0 x 0.50 = 0% Optimistic 0.25 23% 5.75% 64 x 0.25 = 16% Total 1.00 15% 32% Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Standard Deviation = √32 = 5.66% Coefficient of Variation. A measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. Example: When the standard deviations and the expected returns for assets A and B are substituted into the equation, the coefficients of variation for A and B are 0.094 (1.41% / 15%) and 0.377 (5.66% / 15%), respectively. Asset B has the higher coefficient of variation and is therefore riskier than asset A—which we already know from the standard deviation. Capital Asset Pricing Model (CAPM) The basic theory that links risk and return for all assets. Types of Risk: Total Risk. The combination of a security’s non diversifiable risk and diversifiable risk. Diversifiable Risk. The portion of an asset’s risk that is attributable to firm specific, random causes can be eliminated through diversification. Also called unsystematic risk. Non diversifiable Risk. The relevant portion of an asset’s risk attributable to market factors that affect all firms cannot be eliminated through diversification. Also called systematic risk. The Model: CAPM Beta Coefficient. A relative measure of non-diversifiable risk. An index of the degree of movement of an asset’s return in response to a change in the market return. o The return on the market portfolio of all traded securities. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Portfolio Beta. The beta of a portfolio can be easily estimated by using the betas of the individual assets it includes. Letting wj represent the proportion of the portfolio’s total dollar value represented by asset j and letting bj equal the beta of asset j, we can use the below equation to find the portfolio beta, bp: Example: Mario Austino, an individual investor, wishes to assess the risk of two small portfolios he is considering, V and W. Both portfolios contain five assets, with the proportions and betas shown below: The betas for the two portfolios, bV and bW, can be calculated by substituting data from the table into the above equation: Portfolio V’s beta is about 1.20, and portfolio W’s is 0.91. These values make sense because portfolio V contains relatively high-beta assets, and portfolio W contains relatively low-beta assets. Mario’s calculations show that portfolio V’s returns are more responsive to changes in market returns and are therefore riskier than portfolio W’s. He must now decide which, if either, portfolio he feels comfortable adding to his existing investments. Using the beta coefficient to measure non diversifiable risk, the capital asset pricing model (CAPM) is given by: Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Example: Benjamin Corporation, a growing computer software developer, wishes to determine the required return on an asset Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%, and rm = 11% into the capital asset pricing model given in Equation 8.8 yields a required return of rZ = 7% + [1.5 x (11% - 7%)] = 7% + 6% = 13% The market risk premium of 4% (11% - 7%), when adjusted for the asset’s index of risk (beta) of 1.5, results in a risk premium of 6% (1.5 x 4%). That risk premium, when added to the 7% risk-free rate, results in a 13% required return. Corporate Bonds A corporate bond is a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. Most bonds are issued with maturities of 10 to 30 years and with a par value, or face value, of $1,000. The coupon interest rate on a bond represents the percentage of the bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest. The bondholders, who are the lenders, are promised semiannual interest payments and, at maturity, repayment of the principal amount. Legal Aspects of Corporate Bonds: Coupon Interest Rate. The percentage of a bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest. Bond Indenture. A legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. Standard Debt Provisions. Provisions in a bond indenture specifying certain recordkeeping and general business practices that the bond issuer must follow; normally, they do not place a burden on a financially sound business. Restrictive Covenants. Provisions in a bond indenture that place operating and financial constraints on the borrower. Subordination. In a bond indenture, the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Sinking fund Requirement. A restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity. Trustee. A paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated. Basic Bond Valuation The value of a bond is the present value of the payments its issuer is contractually obligated to make from the current time until it matures. The basic model for the value, B0, of a bond is given by: Example: Tim Sanchez wishes to determine the current value of the Mills Company bond. Assuming that interest on the Mills Company bond issue is paid annually and that the required return is equal to the bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000, and n = 10 years. B0 = $100 x {1 – [1 / (1 + 0.10)10] / 0.10} + $1,000 x [1 / (1 + 0.10)10] = ($100 x 6.1446) + ($1,000 x 0.38554) = $614.46 + $385.54 B0 = $1,000.00 The computations involved in finding the bond value are depicted graphically on the following timeline. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Bond Value Behavior Discount. The amount by which a bond sells below its par value. Example: When the required return is 12% B0 = $100 x {1 – [1 / (1 + 0.12)10] / 0.12} + $1,000 x [1 / (1 + 0.12)10] = ($100 x 5.6502) + ($1,000 x 0.32197) = $565.02 + $321.97 B0 = $886.99 Premium. The amount by which a bond sells above its par value. Example: When the required return is 8% B0 = $100 x {1 – [1 / (1 + 0.08)10] / 0.08} + $1,000 x [1 / (1 + 0.08)10] = ($100 x 6.7101) + ($1,000 x 0.46319) = $671.01 + $463.19 B0 = $1,134.20 Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Semiannual Interest and Bond Values The procedure used to value bonds paying interest semiannually involves: 1. Converting annual interest, I, to semiannual interest by dividing I by 2. 2. Converting the number of years to maturity, n, to the number of 6-month periods to maturity by multiplying n by 2. 3. Converting the required stated (rather than effective) annual return for similar- risk bonds that also pay semiannual interest from an annual rate, rd, to a semiannual rate by dividing rd by 2. Example: If Mills Company bond pays interest semiannually and that the required stated annual return is 12% for similar-risk bonds that also pay semiannual interest: B0 = ($100 / 2) x {1 – [1 / (1 + 0.06)20] / 0.06} + $1,000 x [1 / (1 + 0.06)20] = ($50 x 11.470) + ($1,000 x 0.31180) = $573.50 + $311.80 B0 = $885.30 Common and Preferred Stock Common Stock The true owners of a corporate business are the common stockholders. Common stockholders are sometimes referred to as residual owners because they receive what is left— the residual—after all other claims on the firm’s income and assets have been satisfied. They are assured of only one thing: that they cannot lose any more than they have invested in the firm. As a result of this generally uncertain position, common stockholders expect to earn relatively high returns. Those returns may come in the form of dividends, capital gains, or both. Preferred Stock Most corporations do not issue preferred stock, but preferred shares are common in some industries. Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount. How the dividend is specified depends on whether the preferred stock has a par value. Par-value preferred stock has a stated face value, and its annual dividend is specified as a percentage of this value. No-par preferred stock has no stated face value, but its annual dividend is stated in dollars. Preferred stock is most often issued by public utilities, by financial institutions Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch such as banks and insurance companies, by acquiring firms in merger transactions, and by young firms receiving investment funds from venture capital firms. Like the dividends on common stock, preferred dividends are not tax deductible for the firm that pays them. Basic Common Stock Valuation Zero-Growth Model. An approach to dividend valuation that assumes a constant, nongrowing dividend stream. Example: Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock’s value is $20 ($3 / 0.15) per share. Constant-Growth (Gordon Growth) Model. A widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return. Example: Lamar Company, a small cosmetics company, from 2010 through 2015 paid the following per-share dividends: The company estimates that its dividend in 2016, D1, will equal $1.50 (about 7% more than the last dividend). The required return, rs, is 15%. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Variable-Growth Model. A dividend valuation approach that allows for a change in the dividend growth rate. To determine the value of a share of stock in the case of variable growth, we use a four-step procedure: 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 through N. This step may require adjusting the most recent dividend, D0, using the initial growth rate, g1, to calculate the dividend amount for each year. Therefore, for the first N years, 2. Find the present value of the dividends expected during the initial growth period. Using the notation presented earlier, we can give this value as 3. Find the value of the stock at the end of the initial growth period, PN = (DN+1) / (rs - g2), which is the present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth rate, g2. This value is found by applying the constant-growth model to the dividends expected from year N + 1 to infinity. The present value of PN would represent the value today of all dividends that are expected to be received from year N + 1 to infinity. This value can be represented by 4. Add the present value components found in Steps 2 and 3 to find the value of the stock, P0, given in the below equation. Example: Victoria Robb is considering purchasing the common stock of Warren Industries, a rapidly growing boat manufacturer. She finds that the firm’s most recent (2015) annual dividend payment was $1.50 per share. Victoria estimates that these dividends will increase at a 10% annual rate, g1, over the next 3 years (2016, 2017, and 2018) because of the introduction of a hot new boat. At the end of the 3 years (the end of 2018), she expects the firm’s mature product line to result in a slowing of the dividend growth rate to 5% per year, g2, for the foreseeable future. Victoria’s required return, rs, is 15%. To estimate the current (end- of-2015) value of Warren’s common stock, P0 = P2015, she applies the four-step procedure to these data. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Step 1. The 2016, 2017, and 2018 dividends are $1.65, $1.82, and $2.00, respectively. Step 2. The sum of the present values of the three dividends is $4.12. Step 3. The value of the stock at the end of the initial growth period (N = 2018) can be found by first calculating DN+1 = D2019: D2019 = D2018 x (1 + 0.05) = $2.00 x (1.05) = $2.10 By using D2019 = $2.10, a 15% required return, and a 5% dividend growth rate, the value of the stock at the end of 2018 is calculated as Finally, in Step 3, the share value of $21 at the end of 2018 must be converted into a present (end-of-2015) value. Using the 15% required return, we get: Step 4. Adding the present value of the initial dividend stream (found in Step 2) to the present value of the stock at the end of the initial growth period (found in Step 3), the current (end-of- 2015) value of Warren Industries stock is: P2015 = $4.12 + $13.81 = $17.93 per share Victoria’s calculations indicate that the stock is currently worth $17.93 per share. Free Cash Flow Valuation Model. A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firm’s weighted average cost of capital, which is its expected average future cost of funds over the long run. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch Example: Dewhurst, Inc. wishes to determine the value of its stock by using the free cash flow valuation model. To apply the model, the firm’s CFO developed the data given in the table below. Application of the model can be performed in four steps. Step 1. Calculate the present value of the free cash flow occurring from the end of 2021 to infinity, measured at the beginning of 2021 (that is, at the end of 2020). Because a constant rate of growth in FCF is forecast beyond 2020, we can use the constant-growth dividend valuation model to calculate the value of the free cash flows from the end of 2021 to infinity: Step 2. Add the present value of the FCF from 2021 to infinity, which is measured at the end of 2020, to the 2020 FCF value to get the total FCF in 2020: Total FCF2020 = $600,000 + $10,300,000 = $10,900,000 Step 3. Find the sum of the present values of the FCFs for 2016 through 2020 to determine the value of the entire company, VC. This calculation is shown in the table below. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Step 4. Calculate the value of the common stock using the equation VS = VC - VD - VP. Substituting into the equation the value of the entire company, VC, calculated in Step 3, and the market values of debt, VD, and preferred stock, VP, given, yields the value of the common stock, VS: VS = $8,626,426 - $3,100,000 - $800,000 = $4,726,426 The value of Dewhurst’s common stock is therefore estimated to be $4,726,426. By dividing this total by the 300,000 shares of common stock that the firm has outstanding, we get a common stock value of $15.75 per share ($4,726,426 / 300,000). Other Approaches to Common Valuation Book Value per Share. The amount per share of common stock that would be received if all the firm’s assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. Example: At year-end 2015, Lamar Company’s balance sheet shows total assets of $6 million, total liabilities and preferred stock of $4.5 million, and 100,000 shares of common stock outstanding. Its book value per share would therefore be: Liquidation Value per Share. The actual amount per share of common stock that would be received if all the firm’s assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money was divided among the common stockholders. Lamar Company found on investigation that it could obtain only $5.25 million if it sold its assets today. The firm’s liquidation value per share would therefore be: Price / Earnings Multiple Approach. A popular technique used to estimate the firm’s share value; calculated by multiplying the firm’s expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. Example: Ann Perrier plans to use the price/earnings multiple approach to estimate the value of Lamar Company’s stock, which she currently holds in her retirement account. She Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  estimates that Lamar Company will earn $2.60 per share next year (2016). This expectation is based on an analysis of the firm’s historical earnings trend and of expected economic and industry conditions. She finds the price/earnings (P/E) ratio for firms in the same industry to average 7. Multiplying Lamar’s expected earnings per share (EPS) of $2.60 by this ratio gives her a value for the firm’s shares of $18.20, if investors will continue to value the average firm at 7 times its earnings. Activity: Answer the following Discussion Questions: 1. Why is it important for financial managers to understand the valuation process? 2. What are the three key inputs to the valuation process? 3. What are the key differences between debt and equity? 4. Explain the linkages among financial decisions, return, risk, and stock valuation. Source: Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Essex, England: Pearson Education Limited. Instructional Material on Financial Management Compiled by Mr. R-Jhai T. Balcita of PUP San Juan Branch  Lesson 6: Capital Budgeting Overview: Long-term investments represent sizable outlays of funds that commit a firm to some course of action. Consequently, the firm needs procedures to analyze and select its long-term investments. Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owners’ wealth. Firms typically make a variety of long-term investments, but the most common is in fixed assets, which include property (land), plant, and equipment. These assets, often referred to as earning assets, generally provide the basis for the firm’s earning power and value. Module Objectives: Understand the key elements of the capital budgeting process. Calculate, interpret, and evaluate the payback period, the net present value (NPV), and the internal rate of return (IRR). Discuss the three major cash flow components. Discuss relevant cash flows, and sunk costs and opportunity costs.