FINANCIAL MANAGEMENT SEMESTER 2 NOTES

Dupont analysis (Chapter 3) ( 3 pont and 5 pont analysis)

DCF technique of Evaluation (chapter 3)

Chapter 7

Divident model – Constant growth model, Dcf model of valuation

Valuation model – Non constant growth model

Chapter 12 and 13, have to read fully.

Chapter 9,10 and 11(only theory)

Chapter 15 – Gordon, walter and MM model( Dividend policy)

Chapter 8 – CAPM

Chapter 16 – Working capital

NUMERICALS:

WC

Dividend model of valuation

(FCFF) DCF model of valuation

Walter model

Gordon model

Capm model

WACC

Concept of Retained earnings

Yield to maturity
 Dupont analysis:
A financial analysis assists in identifying the major strengths and weaknesses of
a business enterprise. It indicates whether a firm has enough cash to meet
obligations; a reasonable accounts receivable collection period; an efficient
inventory management policy; sufficient property, plant, and equipment; an
efficient cost structure; sufficient profits; and an adequate capital structure—all
of which are necessary if a firm is to achieve the goal of maximizing shareholder
wealth. Financial analysis can also be used to assess a firm’s viability as an
ongoing enterprise and to determine whether a satisfactory return is being
earned for the risks taken. Financial analysis helps a firm’s management to
discover specific problem areas in time for remedial action. For example, the
analysis may show that a firm is carrying an excessive accounts receivable
balance, which if not looked into may lead to liquidity problems in the future. The
results of a financial analysis may indicate facts and trends that can aid the
financial manager in planning and implementing a course of action consistent
with the goal of maximizing shareholder wealth.

A financial ratio is a relationship that indicates something about a company’s

activities, such as the ratio between current assets and current liabilities or
between its accounts receivable and its annual sales. Financial ratios enable an
analyst to make a comparison of a company’s financial condition over time or in
relation to other firms.

Basic Classifications of Financial Ratios:

 Liquidity ratios indicate a firm’s ability to meet short-term financial obligations.
 Asset management ratios indicate how efficiently a firm is using its assets to
generate sales.
 Financial leverage management ratios indicate a firm’s capacity to meet short-
and long-term debt obligations.
 Profitability ratios measure how effectively a firm’s management generates
profits on sales, assets, and stockholders’ investments.
 Market-based ratios measure the financial market’s evaluation of a company’s
performance.
 Dividend policy ratios indicate the dividend practices of a firm.
Key Financial Statements
The Balance Sheet
The Income Statement
Common-Size Financial Statements
The Statement of Cash Flows

Liquidity Ratios
Liquidity ratios are quick measures of a firm’s ability to provide sufficient cash
to conduct business over the next few months.

Current Ratio
The current ratio is defined as follows:

Current assets include the cash a firm already has on hand and
in the bank plus any assets that can be converted into cash
within a “normal” operating period of 12 months, such as
marketable securities (also known as cash equivalents) held as
short-term investments, accounts receivable, inventories, and
prepayments. Current liabilities include any financial
obligations expected to fall due within the next year, such as
accounts payable, notes payable, the current portion of long-
term debt due, other payables, and various accruals such as
taxes and wages due.
Quick Ratio
The quick ratio is defined as follows:

This ratio, sometimes called the “acid test,” is a more stringent

measure of liquidity than the current ratio. By subtracting
inventories from current assets, this ratio recognizes that a
firm’s inventories are often one of its least-liquid current assets.
This is, of course, more applicable to some industries than to
others. For example, if you are an apparel manufacturer, the
ability to liquidate your inventory at fair value is highly
doubtful. On the other hand, if you manufacture a commodity
product such as newsprint, you may have greater confidence in
the value of the inventory, especially if the prices are stable. 

Asset Management Ratios

Asset management ratios indicate how much a firm has
invested in a particular type of asset (or group of assets)
relative to the revenue the asset is producing. By comparing
asset management ratios for the various asset accounts of a firm
with established industry norms, the analyst can determine how
efficiently the firm is allocating its resources.
Financial Leverage Management
Ratios:
Profitability Ratios
Market-Based Ratios

Dividend Policy Ratios:

A trend analysis indicates a firm’s performance over

time and reveals whether its position is improving or
deteriorating relative to other companies in the industry.

A trend analysis requires that a number of different ratios be

calculated over several years and plotted to yield a graphic
representation of the company’s performance.
Analysis of Profitability: Return on
Investment
DuPont Equation: Watch video
Sources of Comparative Financial Data
Dun & Bradstreet.

Risk Management Association

Quarterly Financial Report for Manufacturing, Mining, Trade, and Selected

Trade Industries

Earnings and Balance Sheet Quality and Financial Analysis

When performing a financial analysis of a firm, an analyst must be

mindful of the quality of the earnings reported by a firm, as well as
the quality of the firm’s balance sheet. These two dimensions of financial
analysis can have a critical impact on the final assessment of the firm’s
financial condition.
Chapter 7:  Common Stock: Characteristics, Valuation, and Issuance

Introduction

Unlike long-term debt and preferred stock, which are normally

fixed-income securities, common stock is a variable-income
security. Common stockholders are said to participate in a
firm’s earnings because they may receive a larger dividend if
earnings increase in the future or their dividends may be cut if
earnings drop. For example, in 1974, Tucson Electric Power
Company sold new common stock when annual dividends were
$0.84 per share. By 1989, the annual rate was $3.90 per share,
having been raised several times during the intervening years.
However, during 1990, the company suffered substantial losses
and cut its dividend to zero. Its common stock price dropped
from about $65 a share in 1986 and 1987 to  a share by early
1994. In 1996, the stock had a 1 for 5 reverse stock split and the
company changed its name to UniSource Energy. At the end of
2000, its stock was trading at $19 per share. After a 10-year
period of no dividend payments, the company resumed paying
common stock dividends in 2000 ($0.32 per share). Since then,
the company (now known as UNS Energy) has raised its
dividend rate each year, paying $1.72 in 2013. Late in 2013,
Fortis (Canada’s largest gas and electric distributor) agreed to
purchase UNS Energy for $60.25 per share, a 31 percent
premium of UNS’s closing share price.
Common stock also differs from long-term debt and preferred
stock in that the market price tends to fluctuate more than the
price of bonds and preferred stock, thus causing returns on
common stock investments to vary more widely over time than
returns on long-term debt or preferred stock.

Characteristics of Common Stock

A firm’s common stockholders are its true owners. Common
stock is a residual form of ownership in that the claims of
common stockholders on the firm’s earnings and assets are
considered only after the claims of governments, debt holders,
and preferred stockholders have been met. Common stock is
considered a permanent form of long-term financing because,
unlike debt and some preferred stock, common stock has no
maturity date.

Advantages and
Disadvantages of Common
Stock Financing
One of the major advantages of common stock financing is that
no fixed-dividend obligation exists, at least in principle. In
practice, however, dividend cuts are relatively uncommon for
companies paying a “regular” dividend, a fact that implies that
corporate management generally views a firm’s current level of
dividends as a minimum for the future.  Nevertheless, common
stock financing does allow firms a greater degree of flexibility in
their financing plans than fixed-income securities. Thus,
common stock is less risky to the firm than fixed-income
securities. Limits on additional debt and the maintenance of
working capital levels are only two of the constraints imposed
on a firm when fixed-income security financing is employed.

In addition, common stock financing can be advantageous for a

firm whose capital structure contains more than an optimal
amount of debt. Under these circumstances, common stock
financing can lower the firm’s weighted cost of capital.

From the investors’ perspective, however, common stock is a

riskier investment than debt securities or preferred stock.
Because of this, investors in common stock require relatively
high rates of return, and this means that the firm’s cost for
common stock financing is high compared with fixed-income
securities.

From another perspective, external common stock financing

frequently results in an initial dilution of per-share earnings,
particularly if the assets acquired with the proceeds of the
financing do not produce earnings immediately. Table 7.2,
which contains figures for Desert Electric Power Company for
2014 and 2015, illustrates this point.

Valuation of Common Stock

In principle, the valuation of common stock is no different from
the valuation of other types of securities, such as bonds and
preferred stock. The basic procedure involves capitalizing (that
is, discounting) the expected stream of cash flows to be received
from holding the common stock. This is complicated by several
factors, however.
First, the expected cash flows from holding a common stock
take two forms: the cash dividend payments made during the
holding period, and/or changes in the price of the stock (capital
gains or losses) over the holding period. All the cash flows
received by the common stockholder are derived from the
firm’s earnings and can be either paid to shareholders in the
current period as cash dividends or reinvested in the firm to (it
is hoped) provide higher future dividends and a higher stock
price.

Second, because common stock dividends are normally

expected to grow rather than remain constant, the relatively
simple annuity and perpetuity formulas used in the valuation of
bonds and preferred stock are generally not applicable, and
more complicated models must be used.

Finally, the expected cash flows from common stock are more
uncertain than the cash flows from bonds and preferred stock.
Common stock dividend payments are related to the firm’s
earnings in some manner, and it can be difficult to forecast
future long-term earnings and dividend payments with a high
degree of accuracy.

To better understand the application of the capitalization of

cash flow valuation method to common stock, it is best to
begin by considering a one-period dividend valuation model and
then move on to consider multiple-period valuation models.
capitalization of cash flow valuation method A method of
determining the present value of an asset that is expected to produce a
stream of future cash flows. This involves discounting the stream of
expected cash flows at an appropriate rate.
Constant Growth Dividend
Valuation Model
Chapter 9
Capital budgeting is the process of planning for purchases of assets whose returns
are expected to continue beyond one year. A capital expenditure is a cash outlay
that is expected to generate a flow of future cash benefits lasting longer than one
year. It is distinguished from a normal operating expenditure, which is expected to
result in cash benefits during the coming one-year period.

A firm’s capital expenditures affect its future profitability and, when taken together,
essentially plot the company’s future direction by determining which products will be
produced, which markets will be entered, where production facilities will be located,
and what type of technology will be used. Capital expenditure decision making is
important for another reason as well. Specifically, it is often difficult, if not
impossible, to reverse a major capital expenditure without incurring considerable
additional expense. For example, if a firm acquires highly specialized production
facilities and equipment, it must recognize that there may be no ready used-
equipment market in which to dispose of them if they do not generate the desired
future cash flows. The losses incurred by Ford on its Volvo investments illustrate this
point well. For these reasons, a firm’s management should establish a number of
definite procedures to follow when analyzing capital expenditure projects. Choosing
from among such projects is the objective of capital budgeting models.

Cost of Capital
A firm’s cost of capital is defined as the cost of the funds (debt, preferred
and common equity) supplied to it and used to finance investments made
by a company. It is also termed the required rate of return because it
specifies the minimum necessary rate of return required by the firm’s
investors on new investments. If a firm earns returns on its new
investments that exceed the cost of capital, shareholder wealth will

increase.
How Projects Are Classified
Independent Projects
An independent project is one whose acceptance or rejection does not
directly eliminate other projects from consideration. For example, a firm
may want to install a new telephone communications system in its
headquarters and replace a drill press during approximately the same
time. In the absence of a constraint on the availability of funds, both
projects could be adopted if they meet minimum investment criteria.

Mutually Exclusive Projects

A mutually exclusive project is one whose acceptance precludes the
acceptance of one or more alternative proposals. Because two mutually
exclusive projects have the capacity to perform the same function for a
firm, only one should be chosen. For example, BMW was faced with
deciding whether it should expand its U.S. manufacturing complex in
Spartanburg, South Carolina, or continue new model production in
Germany. It ultimately chose the Spartanburg site; this precluded other
alternatives.

Contingent Projects
A contingent project is one whose acceptance is dependent on the
adoption of one or more other projects. For example, a decision by Nucor
to build a new steel plant in North Carolina is contingent upon Nucor
investing in suitable air and water pollution control equipment. When a
firm is considering contingent projects, it is best to consider together all
projects that are dependent on one another and treat them as a single
project for purposes of evaluation.

READ CHAPTER 10 from book

Chapter 11
Sensitivity analysis is a procedure that calculates the change in net
present value given a change in one of the cash flow elements, such as
product price. In other words, a decision maker can determine how
sensitive a project’s return is to changes in a particular variable.

Scenario analysis is another technique that has been used to assess the
risk of an investment project. Sensitivity analysis considers the impact of
changes in key variables, one at a time, on the desirability of an
investment project. In contrast, scenario analysis considers the impact of
simultaneous changes in key variables on the desirability of an investment
project.

Capital Asset Pricing Model

(CAPM) Approach:
Many firms use the Capital Asset Pricing Model (CAPM), discussed in
Chapter 8, to compute their cost of common equity. The CAPM formally
describes the risk–required return trade-off for securities. The rate of
return required by investors consists of a risk-free return, , plus a
premium compensating the investor for bearing the risk. This risk
premium varies from stock to stock.
Chapter 15:

Dividend Policy and Firm Value

There are two major schools of thought among finance scholars regarding the effect
dividend policy has on a firm’s value. Although Miller and Modigliani argue that
dividend policy does not have a significant effect on a firm’s value, Myron Gordon,
David Durand, and John Lintner have argued that it does. Each viewpoint is
discussed in this section.

MM’s argument depends on a number of key assumptions, including the following:

 No taxes. Under this assumption, investors are indifferent about whether they
receive either dividend income or capital gains income.
  No transaction costs. This assumption implies that investors in the securities
of firms paying small or no dividends can sell at no cost any number of shares
they wish in order to convert capital gains into current income.
 No issuance costs. If firms did not have to pay issuance costs on the issue of
new securities, they could acquire needed equity capital by issuing new
common stock at the same cost as equity capital generated internally through
retention of earnings. Holding all else constant, firms that pay dividends will
need to issue new common stock to meet equity capital requirements for
their investments.
 Existence of a fixed investment policy. According to MM, the firm’s
investment policy is not affected by its dividend policy. Furthermore, MM
claim that investment policy, not dividend policy, really determines a firm’s
value.

Advantages and Disadvantages

Let us summarize the advantages and disadvantages of share repurchases as an
addition to, or as a substitute for, cash dividends.

Advantages
Share repurchases effectively convert dividend income into capital gains income.
Shareholders in high (marginal) income tax brackets may prefer capital gains income
because of the ability to defer taxes into the future (when the stock is sold). Also,
share repurchases provide the firm with greater financial flexibility in timing the
payment of returns to shareholders. Finally, share repurchases can represent a signal
to investors that the company expects to have higher earnings and cash flows in the
future.

Disadvantages
A company may overpay for the stock that it repurchases. If the stock price declines,
the share repurchase represents an unprofitable use of the company’s resources.
Also, a share repurchase may trigger IRS scrutiny (and possible tax penalties) if the
buyback is viewed as a way for shareholders to avoid taxes on cash dividends. Finally,
some current shareholders may be unaware of the share repurchase program and
may sell their shares before the expected benefits (that is, price appreciation) occur.

Chapter 16:
Working capital is used by firms to maintain liquidity, that is, the ability to meet their
cash obligations as they come due. Otherwise, it may incur the costs associated with
a deteriorating credit rating, a potential forced liquidation of assets, and possible
bankruptcy.

Working capital management is a continuing process that involves a number of day-

to-day operations and decisions that determine the following:

 The firm’s level of current assets

 The proportions of short-term and long-term debt the firm will use to finance
its assets
 The level of investment in each type of current asset
 The specific sources and mix of short-term credit (current liabilities) the firm
should employ

Working capital differs from fixed capital in terms of the time required to recover the
investment in a given asset. In the case of fixed capital or long-term assets (such as
land, buildings, and equipment), a company usually needs several years or more to
recover the initial investment. In contrast, working capital is turned over, or
circulated, at a relatively rapid rate. Investments in inventories and accounts
receivable are usually recovered during a firm’s normal operating cycle, when
inventories are sold and receivables are collected.

Working capital is used by firms to maintain liquidity, that is, the ability to meet their
cash obligations as they come due. Otherwise, it may incur the costs associated with
a deteriorating credit rating, a potential forced liquidation of assets, and possible
bankruptcy.

Working capital management is a continuing process that involves a number of day-

to-day operations and decisions that determine the following:

 The firm’s level of current assets

 The proportions of short-term and long-term debt the firm will use to finance
its assets
 The level of investment in each type of current asset
 The specific sources and mix of short-term credit (current liabilities) the firm
should employ

Working capital differs from fixed capital in terms of the time required to recover the
investment in a given asset. In the case of fixed capital or long-term assets (such as
land, buildings, and equipment), a company usually needs several years or more to
recover the initial investment. In contrast, working capital is turned over, or
circulated, at a relatively rapid rate. Investments in inventories and accounts
receivable are usually recovered during a firm’s normal operating cycle, when
inventories are sold and receivables are collected.
Risk of Long-Term versus Short-
Term Debt
Borrowing companies have different attitudes toward the relative risk of long-term
versus short-term debt than do lenders. Whereas lenders normally feel that risk
increases with maturity, borrowers feel that there is more risk associated with short-
term debt. The reasons for this are twofold.
First, there is always the chance that a firm will not be able to refinance its short-
term debt. When a firm’s debt matures, it either pays off the debt as part of a debt
reduction program or arranges new financing. At the time of maturity, however, the
firm could be faced with financial problems resulting from such events as strikes,
natural disasters, or recessions that cause sales and cash inflows to decline. Under
these circumstances the firm may find it very difficult or even impossible to obtain
the needed funds. This could lead to operating and financial difficulties. The more
frequently a firm must refinance debt, the greater is the risk of its not being able to
obtain the necessary financing.

Second, short-term interest rates tend to fluctuate more over time than long-term
interest rates. As a result, a firm’s interest expenses and expected earnings after
interest and taxes are subject to greater variation over time with short-term debt
than with long-term debt.

Commercial paper consists of short-term unsecured promissory notes issued by

major corporations. Only companies with good credit ratings are able to borrow
funds through the sale of commercial paper. Purchasers of commercial paper include
corporations with excess funds to invest, banks, insurance companies, pension funds,
money market mutual funds, and other types of financial institutions.