Lecture One: The Goal of the firm and Agency

Problem

FINANCIAL MANAGEMENT
Lecture Objectives
Discuss the goals of the
Corporation and the role of
the finance manager
The types of firms
Ownership versus control of
corporations
Financial Markets

Learning outcomes

Know the basic types of

financial management
decisions and the role of
the financial manager

Know the financial

implications of the
different forms of business
organization
Know the goal of financial
management
Understand the conflicts of
interest that can arise
between owners and
managers
Understand the various
types of financial markets
and financial institutions
Be able to discuss trends in
Financial Markets and
Financial Management

Basic Forms of Business Organization

Financial Management is applicable to economic entities such
as:
Business firms
Non-profitable organizations

We focus on Business firms, organized as three forms of

business organizations
Sole proprietorship
Partnership
Corporation(center of our financial management sessions)

Sole Proprietorship
Business owned and run by one person(in numbers)
Typically has few, if any, employees

Advantages

No former charter required (easy to create)

Less or possibly no regulation
Significant tax savings
Minimal organizational costs
Profits and control not shared with others

Disadvantages

Limited liability to raise large sums of money

Unlimited liability for the owner
Limited to the life of the owner
Usually no tax deductions for employees health, life or disability
insurance

Partnership
This is similar to the sole proprietorship except that the
business has more than one owner.
All partners are personally liable for all of the firms debts.

A lender can require any partner to repay all of the firms outstanding debts.

Advantages
Minimal organizational effort and costs

Disadvantages
Unlimited liability for the individual partners
Limited ability to raise large sums of money
Dissolved upon the death or withdrawal of any of the partners

Limited Partnership
Limited Partnership has two types of owners.
General Partners
Have the same rights and liability as partners in a
(general) partnership
Typically run the firm on a day-to-day basis

Limited Partners
Have limited liability and cannot lose more than their
initial investment
Have no management authority and cannot legally be
involved in the managerial decision making for the business

Corporation
Corporation is a legal entity separate from its owners
better known as stockholders,
Ownership is evidenced by the possesion of shares of stocks
Most important of all the business organizations in terms of
Total sales, Assets ,Profits, Contribution to national income

Has many of the legal powers individuals have such as the

ability to enter into contracts, own assets, and
borrow money
The corporation is solely responsible for its own obligations.
Its owners are not liable for any obligation the corporation
enters into.

Features of a Corporation

Formation:
Corporations must be legally formed.
A legal document is created upon the
formation of the company.
Setting up a corporation is more
costly than setting up a sole
proprietorship .

Tax Implications for Corporate Entities

Tax Implications
Double Taxation (or classical
system)
Imputation system
S corporations the firms
profits are not subject to
corporate income tax, but
instead are allocated directly to
the shareholders
Otherwise , C corporation

Ownership:

Represented by shares of stock

An owner of share is known as a:
Shareholder
Stockholder
Equity Holder
Sum of all ownership value is
called equity.
There is no limit to the number
of shareholders, and thus the
amount of funds a company can
raise by selling shares.
Owner is entitled to dividend
payments.

Problem
Question
You are a shareholder in a
corporation.
The corporation earns GHS 4
per share before taxes.
Once it has paid taxes it will
distribute the rest of its
earnings to you as a dividend.
The corporate tax rate is 34%
and the personal tax rate on
dividend income is 15%.
How much is left for you after
all taxes are paid?

Solution:
First, the corporation pays taxes. It
earned GHS 4 per share, but must
pay 0.34 GHS 4 = GHS 1.36 to
the government in corporate taxes.
That leaves GHS 2.64 to distribute.
However, you must pay
0.15 GHS 2.64 = GHS 0.396 in
income taxes on this amount,
leaving GHS 2.64 GHS 0.396 =
GHS 2.244 per share after all taxes
are paid.
As a shareholder you only end up
with GHS 2.244 of the original GHS
4 in earnings. The remaining GHS
1.36 + GHS 0.396 = GHS 1.756 is
paid as taxes.
Thus, your total effective tax rate is
GHS 1.756 GHS 4 = 43.9%.

Advantages and Disadvantages

Advantages
Unlimited life
Limited liability for its owners, as long as no personal guarantee on a
business-related obligation such as a bank loan or lease
Ease of transfer of ownership through transfer of stock
Ability to raise large sums of capital

Disadvantages
Difficult and costly to establish, as a formal charter is required
Subject to double taxation on its earnings and dividends paid to
stockholders
Bankruptcy, even at the corporate level, does not discharge tax
obligations

Limited Liability Company(LLC)

Limits the owners liability
to their investment.
Two types of limited
liability company:
Private company
Public company

Hybrid of partnership and

coporation.

The aim is operate and be

taxed like partnership but
retain limited liability for
owners.
Avoid double taxing (they
can choose to be taxed
like the regular
corporation or pass it on
to owners)
Members of LLC run the
company or they may hire
an outside management
group.

Ownership versus Control of Corporations

The Corporate Management Team

Ownership and direct control are typically
separate.
Board of Directors
Elected by shareholders
Have ultimate decision-making authority

Chief Executive Officer (CEO)

Board typically delegates day-to-day decision making
to CEO.

Organizational Chart of a typical Corporation

Hired by the BOD

Issues in Corporate Finance

What long term investments should be undertaken
by organization (Business Entity)?
Where will organization (Business Entity) get funds to
pay for long term investments?
How should organization (Business Entity) manage
everyday (Short-term) financial activities?
How much of the organizations profits should be
distributed to owners?

The goal of Financial Management

Stock holder wealth maximization
Profit maximization
Managerial reward maximization
Behavioral goals and
Social responsibility
Modern managerial finance theory operates on the
assumption that the primary aim of the firm is to
maximize the wealth of its stock holders.

How can the financial manager affect stockholders

wealth maximization?
By influencing the
Present and future earnings per share (EPS)
Size, timing and the risk of these earnings
Dividend policy
Manner of financing the firm

The Role of financial manager

Financial analysis and planning.

Investment decisions.
Financing and capital structure decisions.
Management of financial resources (such as working
capital).
Risk management (protecting asset by buying
insurance or hedging)

Financial Managment Decisions

Capital Budjeting: planning and managing a firms long-term
investments.
Evaluate the size, timing and risk of future cash flows

Capital Structure: This is the specific mixture of long-term

debt and equity the firm uses to finance its operations.
How much should the firm borrow
What are the least expensive sources of fund available for the firm

Working capital management: short-term assets and

liabilities management
Day to day receipt and disburstment of cash to ensure that the firm
has enough recources to continue its operation without costly
interruptions.

Ownership versus Control Conti.

Financial Manager
Responsible for:
Investment Decisions
Financing Decisions
Cash for Treasury
Management

The Goal of the firm

Shareholders will agree that they

are better off if management
makes decisions that maximizes
the value of their shares.

The firm and the Society

Often, a corporations decisions
that increase the value of the
firms equity benefit society as
a whole.
As long as nobody else is made
worse off by a corporations
decisions, increasing the value
of the firms equity is good for
society.
It becomes a problem when
increasing the value of the
firms equity comes at the
expense of others.

Ownership versus control conti.

Ethics and Incentives within
Corporations
Agency Problems

Managers may act in their

own interest rather than
in the best interest of the
shareholders.
One potential solution is
to tie managements
compensation to firm
performance.
How should performance
be measured?

The CEOs Performance

If a CEO is performing poorly,
shareholders can express their
dissatisfaction by selling their
shares. This selling pressure will
drive the share price down.
Hostile Takeover
Low share prices may
entice a Corporate Raider
to buy enough shares so
they have enough control
to replace current
management. The share
price will rise after the new
management team fixes
the company.

Agency problem conti.

Agency relationship: when one or more
persons(principals) employ one or more other
persons (agents) to perform some task.
Primary agency relationship exist between
Shareholders and managers
Managers and creditors

These relationships are major source of

agency problems

Causes of Agency Problem

Separation between managers and owners
Managers take decisions which are not in line
with the goal of maximizing stock holders
wealth
Work less eagerly and benefit themselves in terms
of salaries and perks

The cost associated with agency problem is

called agency costs.
e.g. Reduced stock price.

Mechanism to ensure managers act in the best

interest of shareholders
Golden parachutes or
severance contracts
Performance based
stock option plans
The threat of firing
The threat of takeover

Corporate Bankruptcy
Reorganization
Liquidation

Creditors vs. MANAGERS conflict

Managers taking projects which are more
riskier than creditors anticipated.
Raising the debt level higher than expected

Financial Markets and Corporations

What is the role of
financial markets in
corporate finance?
Financial markets are a
mechanism that brings
buyers and sellers
together.
Here debt and equity
securities are bought and
sold.
Cash flows to and from
the firm

The stock market

provides liquidity
to shareholders.
Liquidity
The ability to easily sell an
asset for close to the
price you can currently
buy it for

Financial Market and the Corporation

Conti.
Money vs. Capital Markets
Money market

The market in which shortterm (1 year or less) securities

are bought and sold. It is a
dealer market, i.e., dealers buy
and sell from their inventories.

Capital market

The market for long-term debt

and equity shares. It is
primarily a brokered market,
i.e., brokers match up buyers
and sellers.

Primary Markets
When a corporation itself
issues new shares and sells
them to investors, they do so
on the primary market.
Initial Public offer, Seasoned
Public offer, SEC registration,
underwriters are part of this
market.

Secondary Markets
After the initial transaction in
the primary market, the shares
continue to trade in a
secondary market between
investors.

Cash flows to and from the firm

Summary
Businesses may be organized as:
Proprietorships
Partnerships
Corporations
A corporation is legally distinct from its owners (shareholders).
It shareholders have limited liability.
Ownership and management are usually separate, meaning changes in ownership
may occur with little disruption to operations.
Large firms tend to be organized as corporations for this reason.
A firms financial managers are responsible for:
The Capital Budgeting Decision what operating assets to invest in.
The Financing Decision how to pay for those assets.
The financial managers objective is to make decisions which maximize the value of the
companys shares.
The financial manager raises funds for the firm through financial markets and financial
intermediaries like insurance companies or banks.
Conflicts of interest may arise in large firms between the owners and managers.
These conflicts are known as Agency Problems.
There are a number of ways by which agency problems may be reduced:
Compensation plans which align the success of the manager to the success of the
firm.
Monitoring of management behavior.
Threat of replacement if managers do not perform well.

QUICK QUIZE
What are the three types of financial management
decisions and what questions are they designed to
answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What are agency problems and why do they exist
within a corporation?
What is the difference between a primary market
and a secondary market?

 You should know:

The advantages and disadvantages between a sole
proprietorship, partnership and corporation
The primary goal of the firm
What an agency relationship and cost are
The role of financial markets

Thank You

Time Value of Money

QUICK QUIZE
Sole Proprietorship

Who owns the

Business?
Are managers and
owners separate?
What is the owners
Liability?

Are the owners and

business taxed
separately?

Partnership

Corporation

Time Value of Money

Lecture Objectives
To discuss the Time value of money concept

Learning Outcomes
You will:
Be able to compute the future value of an investment made today
Be able to compute the present value of cash to be received at
some future date
Be able to compute the return on an investment
Be able to compute the number of periods that equates a present
value and a future value given an interest rate
Be able to use a financial calculator and a spreadsheet to solve
time value of money problems

Lecture Outline
Future Value and Compounding
Present Value and Discounting
More on Present and Future Values

Time Value of Money

Time value of money is a critical consideration
on financial and investment decisions.
A dollar at hand today is worth more than a dollar
to be receive tomorrow because of the interest it
could earn from putting it in savings or investment
accounts

Example
Future sums of money resulting from investment.
Evaluate future sum of money associated with
capital budgeting projects.

Future Value: Earlier money on a time line

Suppose you invest GHS 1000 for one year at 5% per year.
What is the future value in one year?
Interest = 1000(.05) = 50
Value in one year
principal + interest = 1000 +1000( 0.05) )= 1050
Future Value (FV) = 1000(1 + 0.05) = 1050

Suppose you leave the money in for another year. How much
will you have two years from now?
FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50

Future Value: General Formula

FV=PV(1+r) t
FV = future value
PV = present value
r = period interest rate, expressed as a decimal
t = number of periods
t
(1+r)
Future Value Interest Factor (FVIF)=

FV=PV FVIF(r,t)

Example 1:
Ofosua placed GHS 1,000 in a savings account earning 8
percent interest compounded annually. How much money
will she have in the account at the end of 4 years?
Solution: identify the parameters
PV=GHS 1000, r=.08, t=4 and FV=?
t
but we know
FV=PV(1+r)
FV=1000(1+.08) 4
therefore
= 1000(1.3605)=
=GHS 1,360.5

Ofosua will have GHS 1,360.5 in his accounts in 4 years

time.

Example 2: Future value as growth formula

Kofi Mensah invested a large sum of money in the stock of TLC
Corporation. The company paid a GHS 3 dividend per share.
The dividend is expected to increase by 20 percent per year
for the next 3 years. He wishes to project the dividends for
years 1 through 3.
Solution : FV=PV(1+r) t
Dividend Projections
6
5

FV1 =GHS 3(1+0.2) =GHS 3(1.2000)=GHS3.60

FV2 =GHS 3(1+0.2) 2 =GHS 3(1.4400)=GHS 4.32
3

FV3 =GHS 3(1+0.2) =GHS 3(1.7280)=GHS 5.18

Diviidend

3
2
1
0
0

2
Periods

Effects of Compounding
Suppose you invest GHS
1000 for one year at 5% per
year. What is the future
value in one year?
Interest = 1000(.05) = 50
Value in one year = principal +
interest = 1000 + 50 = 1050
Future Value (FV) = 1000(1 +
.05) = 1050

Suppose you leave the

money in for another year.
How much will you have
two years from now?
FV = 1000(1.05)(1.05) =
1000(1.05)2 = 1102.50

Simple interest earn

interest on principal only
Compound interest earn
interest on principal and
reinvested interest
Consider the previous
example
FV with simple interest =
1000 + 50 + 50 = 1100
FV with compound interest =
1102.50
The extra 2.50 comes from
the interest of .05(50) = 2.50
earned on the first interest
payment

Intra-year Compounding
Interest can be compounded more often than once
year.
For example Banks compound interest quarterly,
daily and sometime continuously.
If the interest is compounded m times a year then
general formula for solving future value problem is
tm
r

FV=PV 1+
m
NB: m=2 for semiannually , m=4 for quarterly, m=12 for
monthly compounding.

For continuous compounding FV=PVert

Example:
Suppose PV=GHS 100, r=12% and t=3 years
then for:
Annual compounding (m=1):
FV=GHS 100(1+012)3 =GHS140.49

Semiannual compounding(m=2):
0.12
FV=GHS 100 1+

32

=GHS 141.85

Quarterly compounding(m=4):
0.12
FV=GHS 100 1+

Monthly compounding(m=12):

34

0.12
FV=GHS 100 1+

12

=GHS 142.57

312

=GHS 143.07

Calculator Keys
Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = period interest rate
P/Y must equal 1 for the I/Y to be the period rate
Interest is entered as a percent, not a decimal
N = number of periods
Remember to clear the registers (CLR TVM) after each
problem
Other calculators are similar in format

Future Value Example

Suppose you invest the GHS 1000 from the previous example
for 5 years. How much would you have?
Formula Approach:
FV = 1000(1.05)5 = 1276.28
Calculator Approach:
5N
5 I/Y
-1000 PV
CPT FV = 1276.28

Future Value
The effect of compounding is small for a small number of
periods, but increases as the number of periods increases.
(Simple interest would have a future value of GHS 1250, for a
difference of GHS 26.28.)

Some trends in future values

Future value of $ 1 at different rates and periods

Future value of GHS 1 at different rates and periods

Future Value Example

Suppose you had a relative who deposits GHS 10 at
5.5% interest 200 years ago. How much would the
investment be worth today?
Formula Approach
FV = 10(1.055)200 = 447,189.84
Calculator Approach
200 N
5.5 I/Y
-10 PV
CPT FV = 447,189.84

Future Value as a General Growth Formula

Suppose your company expects to increase unit sales of watches by
15% per year for the next 5 years. If you currently sell 3 million
watches in one year, how many watches do you expect to sell in 5
years?

Formula Approach
FV = 3,000,000(1.15)5 = 6,034,072 units
Calculator Approach
5N
15 I/Y
3,000,000 PV
CPT FV = -6,034,072 units

Present Value or Discounting

Present value is the present worth of future sums of
money.
The process of calculating present value, or
discounting, is actually the opposite of finding the
compounded future value.
With present value calculations, the interest rate r is
called the discount rate.
How much do I have to invest today to have some
specified amount in the future?

Recall:
FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t

When we talk about discounting, we mean finding

the present value of some future amount.
When we talk about the value of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

Examples
Suppose you need GHS 10,000 in one year for the
down payment on a new car. If you can earn 7%
annually, how much do you need to invest today?
You want to begin saving for your daughters college
education and you estimate that she will need GHS
150,000 in 17 years. If you feel confident that you
can earn 8% per year, how much do you need to
invest today?
Your parents set up a trust fund for you 10 years ago
that is now worth GHS 19,671.51. If the fund earned
7% per year, how much did your parents invest?

Important trend in present value

For a given interest rate the longer the time period, the
lower the present value
What is the present value of GHS 500 to be received in 5
years? 10 years? The discount rate is 10%
For a given time period the higher the interest rate, the
smaller the present value
What is the present value of GHS 500 received in 5 years
if the interest rate is 10%? 15%?

Present value of $ 1

Present value of $1 in Picture

Quiz :
What is the relationship between present value and
future value?
Suppose you need GHS 15,000 in 3 years. If you can
earn 6% annually, how much do you need to invest
today?

If you could invest the money at 8%, would you have

to invest more or less than your answer above? How
much?

Reminder:
PV = FV / (1 + r)t
There are four parts to this equation
PV, FV, r and t
If we know any three, we can solve for the fourth
If you are using a financial calculator, the calculator
views cash inflows as positive numbers and cash
outflows as negative numbers. Be sure and
remember the sign convention or you will receive an
error when solving for r or t

Discount Rate
Often we will want to know what the implied interest
rate is in an investment
Rearrange the basic PV equation and solve for r
o FV = PV(1 + r)t
o r = (FV / PV)1/t 1
If you are using the formula approach, you will want
to make use of both the yx and the 1/x keys on your
calculator

 You are looking at an investment that will pay GHS

1200 in 5 years if you invest GHS 1000 today. What is
the implied rate of interest?
Suppose you are offered an investment that will
allow you to double your money in 6 years. You have
GHS 10,000 to invest. What is the implied rate of
interest?

 Suppose you have a 1-year old son and you want to

provide GHS 75,000 in 17 years towards his college
education. You currently have GHS 5000 to invest.
What interest rate must you earn to have the GHS
75,000 when you need it?

Quiz: Part III

Suppose you are offered the following investment
choices:
You can invest GHS 500 today and receive GHS
600 in 5 years. The investment is considered low
risk.
You can invest the GHS 500 in a bank account
paying 4%.
What is the implied interest rate for the first
choice and which investment should you choose?

Finding the number of periods

Start with basic equation and solve for t (remember
your logs)
o FV = PV(1 + r)t
o t = ln(FV / PV) / ln(1 + r)
You can use the financial keys on the calculator as
well, just remember the sign convention.

Number of Periods
You want to purchase a new car and you are willing
to pay GHS 20,000. If you can invest at 10% per year
and you currently have GHS 15,000, how long will it
be before you have enough money to pay cash for
the car?
Suppose you want to buy a new house. You
currently have GHS 15,000 and you figure you need
to have a 10% down payment. If the type of house
you want costs about GHS 200,000 and you can earn
7.5% per year, how long will it be before you have
enough money for the down payment?

Quiz
Suppose you want to buy some new furniture for
your family room. You currently have GHS 500 and
the furniture you want costs GHS 600. If you can earn
6%, how long will you have to wait if you dont add
any additional money?

Spreadsheet:
How to use the Spreadsheet to find the Future Value(FV), the Present
Value (PV), The Rate(r) and the Number of periods.
Future Value

= FV(rate,nper,pmt,pv)

Note:

Present Value

= PV(rate,nper,pmt,fv)

Skip 'pmt' or replace it with zero

Discount rate

=RATE(nper,pmt,pv,fv)

in all the lump sum calculations.

Number of Periods =NPER(rate,pmt,pv,fv)

NB: PV is always has negative sign as the software packages recognizes it as

cash flowing out of you.

You can also work on the Web

Many financial calculators are available online
Go to Cignas web site and work the following
example:
You need GHS 50,000 in 10 years. If you can earn
6% interest, how much do you need to invest
today?
You should get GHS 27,920

Summary
Future value (FV) is the amount to which an investment will
grow after earning interest.
Find the FV of an investment
by multiplying the investment by the
t
future value factor of (1+r) where t is the time period and r is the
discount rate.
The present value (PV) of a future cash payment is the amount you
would need to invest today to create that future cash payment.
Find the PV of an investment by multiplying the future cash
payment by the discount factor of 1/(1+r)t.

Note: The basics of time value of money have been covered.

You should be able to:

Calculate the future value of an amount given today

Calculate the present value of an amount to be received in the future
Find the interest rate
Find the number of periods

Quick Quiz:
What is the difference between simple interest and
compound interest?
Suppose you have GHS 500 to invest and you believe
that you can earn 8% per year over the next 15 years.
How much would you have at the end of 15 years
using compound interest?
How much would you have using simple interest?

Thank You

Discounted Cash Flow Valuation

QUIZ : Recap
To work out how much you will have in the
future if you invest for t years at an interest
rate of r, multiply the initial investment with

To find the present value of the future

payment, run the process in the reverse form
and divide by .

Discounted Cash Flow Valuation

Lecture Objectives
To discuss and apply the Discounted Cash Flow Valuation
technique

Learning Outcomes
You will:

Be able to compute the future value of multiple cash flows

Be able to compute the present value of multiple cash flows
Be able to compute loan payments
Be able to find the interest rate on a loan
Understand how loans are amortized or paid off
Understand how interest rates are quoted

Lecture Outline
Future and Present Values of Multiple Cash Flows
Valuing Level Cash Flows: Annuities and Perpetuities
Comparing Rates: The Effect of Compounding

Loan Types and Loan Amortization

Multiple Cash Flows

So far, we have considered financial problem
involving single cash flows.
Limiting
Many real world investment involves many cash
flows overtime(streams of cash flows)

Future Value of a Multiple Cash Flows

You currently have GHS 7,000 in a bank account
earning 8% interest. You think you will be able to
deposit an additional GHS 4,000 at the end of each
of the next three years. How much will you have in
three years?
Solution:
Find the value at year 3 of each cash flow and add
them together
0
7000
CashFlows

1
GH7000(1.08)
+GH4000
GH11560

2
GH11560(1.08)
+GH4000
GH16484.8

3
GH16484.8(1.08)
+GH4000
GH21803.58

Two ways for calculating future values for multiple

cash flows:
Compound the accumulated balance forward one
year at a time.
Calculate the future value of each cash flow first and
then add them up.
Both give the same answer.

Example 2
Suppose you invest $2000 at the end of each year of
the next five years. The rate is 10%
Future value calculated by compounding forward one
period at a time

 Future value calculated by compounding each cash

flow separately

Example
Suppose you invest GHS 500 in a mutual fund today
and GHS 600 in one year. If the fund pays 9%
annually, how much will you have in two years?
How much will you have in 5 years if you make no further
deposits?

Suppose you plan to deposit GHS 100 into an

account in one year and GHS 300 into the account in
three years. How much will be in the account in five
years if the interest rate is 8%?

Present value with multiple cash flows

Suppose we had an investment that was going to pay
GHS 1000 at the end of every year for the next five
years.
Present value calculation by discounting each cash flow separately

Present value calculated by discounting back one period at a time

Example
You are offered an investment that will pay you GHS
200 in one year, GHS 400 the next year, GHS 600 the
year after, and GHS 800 at the end of the following
year. You can earn 12% on similar investments. How
much is this investment worth today?
solution

Solutions
1

200
178.57
318.88
427.07

508.41
1432.93

400

600

800

Using the spreadsheet

Rate:
Year
1
2
3
4

0.12
Cash Flow Present Value
$200
$178.57
$400
$318.88
$600
$427.07
$800
$508.41
Total PV:
$1,432.93

=PV($D$3,C6,0,-D6)
=PV($D$3,C7,0,-D7)
=PV($D$3,C8,0,-D8)
=PV($D$3,C9,0,-D9)
=SUM(E6:E9)

Quick Quiz
You are considering an investment that will pay you
GHS 1000 in one year, GHS 2000 in two years and
GHS 3000 in three years. If you want to earn 10% on
your money, how much would you be willing to pay?

Annuities and Perpetuities

Annuity finite series of equal payments that occur
at regular intervals
If the first payment occurs at the end of the
period, it is called an ordinary annuity
If the first payment occurs at the beginning of the
period, it is called an annuity due
Perpetuity infinite series of equal payments

Annuities and Perpetuities

Annuities:

1
(1+r) t
PV=C

(1+r) t -1
FV=C

Perpetuity:

C
PV=
r

The formulas above are the basis of many of the

calculations in Financial Management. It will be
worthwhile to keep them in mind!

Annuities on the Calculator

You can use the PMT key on the calculator for the
equal payment
The sign convention still holds
Ordinary annuity versus annuity due
You can switch your calculator between the two
types by using the 2nd BGN 2nd Set on the TI BA-II
Plus
If you see BGN or Begin in the display of your
calculator, you have it set for an annuity due
Most problems are ordinary annuities

Annuity on the spreadsheet

Note that annuity on the spreadsheet uses the
present values format.
Future values is set to zero and negative is placed on
the recurrent payment.

Annuity Example
After carefully going over your budget, you have determined that you can
afford to pay GHS 632 per month towards a new sports car. Your bank will
lend to you at 1% per month for 48 months. How much can you borrow?
Solution:

You borrow money TODAY so you need to compute the present value.
Formula Approach
1

(1.01) 48
PV 632
23,999.54
.01

Calculator Approach
48 N; 1 I/Y; -632 PMT; CPT PV = 23,999.54 (GHS 24,000)

Example
Suppose you win the Publishers Clearinghouse GHS
10 million sweepstakes. The money is paid in equal
annual installments of GHS 333,333.33 over 30 years.
If the appropriate discount rate is 5%, how much is
the sweepstakes actually worth today?

Finding the Payment

Suppose you want to borrow GHS 20,000 for a new
car. You can borrow at 8% per year, compounded
monthly (8%/12 = 0.66667% per month). If you take
a 4 year loan, what is your monthly payment?

Finding the Number of Payments

You ran a little short on your February
vacation, so you put GHS 1,000 on your credit
card. You can only afford to make the
minimum payment of GHS 20 per month. The
interest rate on the credit card is 1.5% per
month. How long will you need to pay off the
GHS 1,000?

Finding the rate of an annuity

Suppose you borrow GHS 10,000 from your
parents to buy a car. You agree to pay GHS
207.58 per month for 60 months. What is the
monthly interest rate?
Calculator Approach

Sign convention matters!!!

60 N
10,000 PV
-207.58 PMT
CPT I/Y = .75%

Annuity Finding the Rate Without a

Financial Calculator
Trial and Error Process
Choose an interest rate and compute the PV of
the payments based on this rate
Compare the computed PV with the actual loan
amount
If the computed PV > loan amount, then the
interest rate is too low
If the computed PV < loan amount, then the
interest rate is too high
Adjust the rate and repeat the process until the
computed PV and the loan amount are equal

Future Values for Annuities

Suppose you begin saving for your retirement by
depositing GHS 2000 per year into your pension or
SSNIT account. If the interest rate is 7.5%, how much
will you have in 40 years?

Annuity Due
Annuity due value=
Ordinary annuity value (1+r)
You are saving for a new house and you put GHS
10,000 per year in an account paying 8%
compounded annually. The first payment is made
today. How much will you have at the end of 3
years?

10000

10000

10000

32,464

35,061.12

The Calculator Approach

Formula Approach
FV = 10,000[(1.083 1) / .08](1.08) = 35,061.12

Calculator Approach

2nd BGN 2nd Set (you should see BGN in the display)
3N
-10,000 PMT
8 I/Y
CPT FV = 35,061.12
2nd BGN 2nd Set (be sure to change it back to an
ordinary annuity)

Perpetuity: Example
The Home Bank of Ghana wants to sell preferred
stock at GHS 100 per share. A very similar issue of
preferred stock already outstanding has a price of
GHS 40 per share and offers a dividend of GHS 1
every quarter. What dividend would the Home Bank
have to offer if its preferred stock is going to sell?

Perpetuity example continued

Recall Perpetuity formula: PV = C / r
First, find the required rate for the comparable
issue:
40 = 1 / r
r = .025 or 2.5% per quarter

Then, using the required rate found above, find

the dividend for new preferred issue:
100 = C / .025
C = 2.50 per quarter

Growing Annuity
Growing annuities have a finite number of growing
cash flows
Growing annuity present value formula:
1+g t
1-

1+r
PV=C
r-g

Growing annuity example

Gerald Danso has just been offered a job at GHS
50,000 a year. He anticipates his salary will increase
by 5% a year until his retirement in 40 years. Given
an interest rate of 8%, what is the present value of
his lifetime salary?
40

50, 000
1.05
PV
1
1,126,571
0.08 0.05 1.08

Growing Perpetuity
The perpetuities discussed so far are annuities with
constant payments
Growing perpetuities have cash flows that grow at a
constant rate and continue forever
Growing perpetuity formula:

C1
PV=
r-g

Example
Hoffstein Corporation is expected to pay a dividend
of GHS 3 per share next year. Investors anticipate
that the annual dividend will rise by 6% per year
forever. The required rate of return is 11%. What is
the price of the stock today?

3.00
PV
60.00
0.11 0.06

Quick Quiz
You want to have GHS 1 million to use for retirement
in 35 years. If you can earn 1% per month, how
much do you need to deposit on a monthly basis if
the first payment is made in one month?
What if the first payment is made today?
You are considering preferred stock that pays a
quarterly dividend of GHS 1.50. If your desired return
is 3% per quarter, how much would you be willing to
pay?

Recap

Effective Annual Rate (EAR)

This is the actual rate paid (or received) after
accounting for compounding that occurs during the
year
If you want to compare two alternative investments
with different compounding periods, you need to
compute the EAR for both investments and then
compare the EARs.

Question:
Rate is quoted 10% compounded
semiannually
Implication investment pays 5% every six
months
Is 5% percent every six months the same as 10
percent a year?

GHS 1 invested for 10% is 1.10

GHS 1 invested for 5% semiannual
compounding is 11.052 1.1025

 Anytime we have compounding during the year, we

need to be concerned about what the rate really is.
In the example above 10% is the stated or quoted
interest rate. The 10.25% is actually the rate you will
earn and is called effective annual rate(EAR).
The relationship between quoted rates and EAR
m

Quoted rate
EAR= 1+
-1

Example
What is the effective annual rate of 12%
compounded annually?
A bank is offering 12% compounded quarterly. If you
put GHS 100 in an accounts, how much will you have
at the end of one year? What is EAR? How much will
you have at the end of two years.

Annual Percentage rate (APR)

This is the annual rate that is quoted by law
By definition APR = period rate times the number of
periods per year

Consequently, to get the period rate we rearrange

the APR equation:
Period rate = APR / number of periods per year
You should NEVER divide the effective rate by the
number of periods per year it will NOT give you the
period rate

Computing APR
What is the APR if the monthly rate is .5%?
.5(12) = 6%
What is the APR if the semiannual rate is .5%?
.5(2) = 1%
What is the monthly rate if the APR is 12% with
monthly compounding?
12 / 12 = 1%
Can you divide the above APR by 2 to get the
semiannual rate? NO!!! You need an APR based on
semiannual compounding to find the semiannual
rate.

Recollect
You ALWAYS need to make sure that the interest rate
and the time period match.
If you are looking at annual periods, you need an
annual rate.
If you are looking at monthly periods, you need a
monthly rate.

If you have an APR based on monthly compounding,

you have to use monthly periods for lump sums, or
adjust the interest rate appropriately if you have
payments other than monthly

Examples
Suppose you can earn 1% per month on GHS 1
invested today.
What is the APR? 1(12) = 12%
How much is your effective earnings?
FV = 1(1.01)12 = 1.1268
Rate = (1.1268 1) = .1268 = 12.68%

Suppose if you put it in another account, you earn

3% per quarter.
What is the APR? 3(4) = 12%
How much are you effectively earning?
FV = 1(1.03)4 = 1.1255
Rate = (1.1255 1) = .1255 = 12.55%

Decisions, Decisions, Decisions

You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays 5.3%
with semiannual compounding. Which account
should you use?
Lets verify the choice. Suppose you invest GHS 100
in each account. How much will you have in each
account in one year?

Relationship between APR and EAR

m

APR
EAR= 1+
-1

A typical credit card agreement quotes interest rate

of 18% APR. Monthly payments are required. What is
the actual interest rate you pay on such a credit card.

Mortgages
Usually, financial institutions are required by
law to quote mortgage rates with semi-annual
compounding
Since most people pay their mortgage either
monthly (12 payments per year), semimonthly (24 payments) or bi-weekly (26
payments), you need to remember to convert
the interest rate before calculating the
mortgage payment!

Continuous Compounding
Sometimes investments or loans are calculated
based on continuous compounding
EAR = eq 1
The e is a special function on the calculator
normally denoted by ex
Example: What is the effective annual rate of 7%
compounded continuously?
EAR = e.07 1 = .0725 or 7.25%
Note: e = 2.71825

Pure Discount Loans

Treasury bills are excellent examples of pure discount
loans. The principal amount is repaid at some future
date, without any periodic interest payments.

If a T-bill promises to repay GHS 10,000 in 12

months and the market interest rate is 4 percent,
how much will the bill sell for in the market?
PV = 10,000 / 1.04 = GHS 9,615.38, OR,
1 N; 10,000 FV; 4 I/Y; CPT PV = -9,615.38

Interest Only Loan

The borrower pays interest each period and repays
the entire principal at some point in the future.
Consider a 5-year, interest-only loan with a 7%
interest rate. The principal amount is $10,000.
Interest is paid annually.
What would the stream of cash flows be?
Years 1 4: Interest payments of .07(10,000) = 700
Year 5: Interest + principal = 10,700

This cash flow stream is similar to the cash flows on

corporate bonds, and we will talk about them in
greater detail later.

Amortized Loan with Fixed Payment

Each payment covers the interest expense plus
reduced principal
Consider a 4-year loan with annual payments. The
interest rate is 8% and the principal amount is GHS
5000.
What is the annual payment?
4N
8 I/Y
5000 PV
CPT PMT = -1509.60

Amortized Loan with Fixed Principal

Payment - Example
Consider a $50,000, 10 year loan at 8%
interest. The loan agreement requires the firm
to pay $5,000 in principal each year plus
interest for that year.
Click on the Excel icon to see the amortization
table

6F-129

Amortization on loans
Suppose a Business takes out $5000, five-year loan at
9%. The loan agreement calls for the borrower to pay
the interest on the loan balance each year and to
reduce the loan balance each year by $1000.

Beginning
Balance

Total
Payment

Interest
Paid

Principal
Paid

Ending
Balance

$5,000

$1,450

$450

$1,000

$4,000

4,000

1,360

360

1,000

3,000

3,000

1,270

270

1,000

2,000

2,000

1,180

180

1,000

1,000

1,000

1,090

90

1,000

$6,350

$1,350

$5,000

Year

Totals

Fixed payment.
Loan is an ordinary annuity
1
1

5
1.09
$5000 C

.09

C=GHS 1285

Will it payoff the loan?

Beginning
Balance

Total
Payment

Interest
Paid

Principal
Paid

Ending
Balance

$5,000.00

$1,285.46

$ 450.00

$ 835.46

$4,164.54

4,164.54

1,285.46

374.81

910.65

3,253.88

3,253.88

1,285.46

292.85

992.61

2,261.27

2,261.27

1,285.46

203.51

1,081.95

1,179.32

1,179.32

1,285.46

106.14

1,179.32

0.00

$6,427.30

$1,427.31

$5,000.00

Year

Totals

Take Home
Assume interest rates are 4.3884%. You have just
won a lottery and must choose between the
following two options:
Receive a cheque for GHS 150,000 today.
Receive GHS 10,000 a year for the next 25
years.
Which option gives you the biggest winnings?

Application of annuity to home mortgage

PV of annuity formula could be used to determine mortgage payments.
PV (amt borrowed)=mortgage payments x PV(annuity factor for
r%, t periods)
Example: Assume that a house costs 150,000 and the borrower puts
down 25% deposit and borrows the difference from BMO payable over
25 years. The mortgage rate is 1% a month. Determine the monthly
mortgage payments.
PV = Amount borrowed = .75x150,000 = GHS 112,500,
PV =mortgage payments x 300-month annuity factor
Mortgage payment = 112,500/(1/0.01-1/0.10(1+0.01)300
GHS 112,500/94.9466 = GHS 1184.88
The loan in this case is an amortizing loan
the monthly payments are fixed over the life of the loan
Amortizing means determining what part of the monthly payment is
used to pay interest and part is used to reduce the principal borrowed

Summary:
A level stream of payments which continues forever is called a perpetuity.
One which continues for a limited number of years is called an annuity.
Interest rates for periods of less than one year are often quoted as annual
rates by converting to either an APR or an EAR.
Annual percentage rates (APR) do not recognize the effect of compound
interest, that is, they annualize assuming simple interest.
Effective Annual Rates (EAR) annualize using compound interest.
EAR equals the rate of interest per period compounded for the number of
periods in a year.
You should now know how to:
Calculate PV and FV of multiple cash flows
Calculate payments
Calculate PV and FV of regular annuities, annuities due, growing
annuities, perpetuities, and growing perpetuities
Calculate EARs and effective rates
Calculate mortgage payments
Price pure discount loans and amortized loans

LECTURE FOUR: INTEREST RATES AND BOND

VALUATION

Learning Objectives

Know the important bond features and bond types

Understand bond values and why they fluctuate
Understand bond ratings and what they mean
Understand the impact of inflation on interest rates
Understand the term structure of interest rates and
the determinants of bond yields

Outline

Bonds and Bond Valuation

More about Bond Features
Bond Ratings
Some Different Types of Bonds
Bond Markets
Inflation and Interest Rates
Determinants of Bond Yields

Bond Definitions
Bond: selling debt securities(government or corporation),
a typical interest only loan.
Par value (face value): The amount that will be repaid
after the loan term is called par value( face value)
Coupon payment: Regular promise interest payment.
Coupon rate: The annual coupon divided by the face
value is called the coupon rate.
Maturity date: The number of years until the face value is
paid.
Yield or yield to maturity: The interest rate required on
the market for a bond.

Present Value of Cash Flows as Rates Change

Bond Value = PV of coupons + PV of par

Bond Value = PV of annuity + PV of lump sum
As interest rates increase, present values decrease
So, as interest rates increase, bond prices decrease
and vice versa

Valuing a Discount Bond with Annual Coupons

Consider a bond with a coupon rate of 10% and annual
coupons. The par value is GH1,000, and the bond has 5 years
to maturity. The yield to maturity is 11%. What is the value of
the bond?

Using the formula:

B = PV of annuity + PV of lump sum
B = 100[1 1/(1.11)5] / .11 + 1,000 / (1.11)5
B = 369.59 + 593.45 = 963.04

Using the calculator:

N = 5; I/Y = 11; PMT = 100; FV = 1,000
CPT PV = -963.04

Valuing a Premium Bond with Annual Coupons

Suppose you are reviewing a bond that has a 10% annual
coupon and a face value of GH1000. There are 20 years to
maturity, and the yield to maturity is 8%. What is the price of
this bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20
B = 981.81 + 214.55 = 1196.36

Using the calculator:

N = 20; I/Y = 8; PMT = 100; FV = 1000
CPT PV = -1,196.36

Graphical Relationship Between Price and Yieldto-maturity (YTM)

1500
1400
1300
1200
1100
1000
900
800
700
600
0%

2%

4%

6%

8%

10%

12%

14%

Bond Prices: Relationship Between Coupon and

Yield
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
Why? The discount rate provides yield above coupon rate
Price below par value, called a discount bond

If YTM < coupon rate, then par value < bond price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond

The Bond Pricing Equation

1

1 - (1 r) t
Bond Value C
r

FV

t
(1

r)

Interest Rate Risk

Price Risk: Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon rate
bonds

Reinvestment Rate Risk: Uncertainty concerning rates at which

cash flows can be reinvested
Short-term bonds have more reinvestment rate risk than long-term
bonds
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds

Interest rate risk and time to maturity

Computing Yield to Maturity

Yield to Maturity (YTM) is the rate implied by the
current bond price
Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the
process for finding r with an annuity
If you have a financial calculator, enter N, PV, PMT,
and FV, remembering the sign convention (PMT and
FV need to have the same sign, PV the opposite sign)

YTM with Annual Coupons

Consider a bond with a 10% annual coupon rate, 15
years to maturity and a par value of GH1,000. The
current price is GH928.09.
Will the yield be more or less than 10%?
N = 15; PV = -928.09; FV = 1,000; PMT = 100
CPT I/Y = 11%

YTM with Semiannual Coupons

Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of GH1,000,
20 years to maturity and is selling for GH1,197.93.

Is the YTM more or less than 10%?

What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4%
(Is this the YTM?)
YTM = 4%*2 = 8%

Refresh

Current Yield vs. Yield to Maturity

Current Yield = annual coupon / price
Yield to maturity = current yield + capital gains yield
Example: 10% coupon bond, with semiannual
coupons, face value of 1,000, 20 years to maturity,
GH1,197.93 price
Current yield = 100 / 1,197.93 = .0835 = 8.35%

Price in one year, assuming no change in YTM

= 1,193.68
Capital gain yield = (1,193.68 1,197.93) / 1,197.93 = .0035 = -.35%
YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier

Bond Pricing Theorems

Bonds of similar risk (and maturity) will be priced to
yield about the same return, regardless of the
coupon rate
If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond
This is a useful concept that can be transferred to
valuing assets other than bonds

Bond Prices with a Spreadsheet

There is a specific formula for finding bond prices on
a spreadsheet
PRICE( Settlement, Maturity, Rate,Yld,Redemption,
Frequency, Basis)
YIELD(Settlement, Maturity, Rate, Pr, Redemption,
Frequency, Basis)
Settlement and maturity need to be actual dates
The redemption and Pr need to be input as % of par value

Click on the Excel icon for an example

Differences Between Debt and Equity

Debt
Not an ownership interest
Creditors do not have voting
rights
Interest is considered a cost
of doing business and is tax
deductible
Creditors have legal recourse
if interest or principal
payments are missed
Excess debt can lead to
financial distress and
bankruptcy

Equity
Ownership interest
Common stockholders vote
for the board of directors and
other issues
Dividends are not considered
a cost of doing business and
are not tax deductible
Dividends are not a liability of
the firm, and stockholders
have no legal recourse if
dividends are not paid
An all equity firm can not go
bankrupt merely due to debt
since it has no debt

The Bond Indenture

Contract between the company and the bondholders
that includes

The basic terms of the bonds

The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants

Bond Classifications
Security
Collateral secured by financial securities
Mortgage secured by real property, normally land or
buildings
Debentures unsecured
Notes unsecured debt with original maturity less than 10
years

Seniority

Bond Characteristics and Required Returns

The coupon rate depends on the risk characteristics
of the bond when issued
Which bonds will have the higher coupon, all else
equal?

Secured debt versus a debenture

Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond

Bond Ratings Investment Quality

High Grade
Moodys Aaa and S&P AAA capacity to pay is extremely strong
Moodys Aa and S&P AA capacity to pay is very strong

Medium Grade
Moodys A and S&P A capacity to pay is strong, but more
susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms ability to
pay

Bond Ratings - Speculative

Low Grade
Moodys Ba and B
S&P BB and B
Considered possible that the capacity to pay will
degenerate.
Very Low Grade
Moodys C (and below) and S&P C (and below)
income bonds with no interest being paid, or
in default with principal and interest in arrears

Government Bonds
Treasury Securities
Federal government debt
T-bills pure discount bonds with original maturity of one year or less
T-notes coupon debt with original maturity between one and ten
years
T-bonds coupon debt with original maturity greater than ten years

Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate debt
Interest received is tax-exempt at the federal level

Example
A taxable bond has a yield of 8%, and a municipal
bond has a yield of 6%
If you are in a 40% tax bracket, which bond do you prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%, compared to a
6% return on the municipal

At what tax rate would you be indifferent between the two

bonds?
8%(1 T) = 6%
T = 25%

Zero Coupon Bonds

Make no periodic interest payments (coupon rate
= 0%)
The entire yield-to-maturity comes from the
difference between the purchase price and the
par value
Sometimes called zeroes, deep discount bonds,
or original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips
are good examples of zeroes

Floating-Rate Bonds
Coupon rate floats depending on some index value
Examples adjustable rate mortgages and inflation-linked
Treasuries
There is less price risk with floating rate bonds
The coupon floats, so it is less likely to differ substantially from
the yield-to-maturity

Coupons may have a collar the rate cannot go above a

specified ceiling or below a specified floor

Other Bond Types

Disaster bonds
Income bonds
Convertible bonds
Put bonds
There are many other types of provisions that can be
added to a bond and many bonds have several
provisions it is important to recognize how these
provisions affect required returns

Bond Markets
Primarily over-the-counter transactions with dealers
connected electronically
Extremely large number of bond issues, but generally
low daily volume in single issues
Makes getting up-to-date prices difficult, particularly
on small company or municipal issues
Treasury securities are an exception

Work the Web Example

Bond quotes are available online
One good site is Bonds Online
Click on the web surfer to go to the site
Follow the bond search, corporate links
Choose a company, enter it under Express Search Issue and
see what you can find!

Inflation and Interest Rates

Real rate of interest change in purchasing power
Nominal rate of interest quoted rate of interest,
change in actual number of dollars
The ex ante nominal rate of interest includes our
desired real rate of return plus an adjustment for
expected inflation

The Fisher Effect

The Fisher Effect defines the relationship between
real rates, nominal rates, and inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate

Approximation
R=r+h

Example
If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation are
relatively high, there is significant difference
between the actual Fisher Effect and the
approximation.

Term Structure of Interest Rates

Term structure is the relationship between time to
maturity and yields, all else equal
Yield curve graphical representation of the term
structure
Normal upward-sloping; long-term yields are higher than
short-term yields
Inverted downward-sloping; long-term yields are lower
than short-term yields

Upward-Sloping Yield Curve

Downward-Sloping Yield Curve

Factors Affecting Bond Yields

Default risk premium remember bond ratings
Taxability premium remember municipal versus
taxable
Liquidity premium bonds that have more frequent
trading will generally have lower required returns
Anything else that affects the risk of the cash flows to
the bondholders will affect the required returns

Quick Quiz
How do you find the value of a bond, and why do
bond prices change?
What is a bond indenture, and what are some of the
important features?
What are bond ratings, and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on
bonds?

Ethics Issues
In 1996, allegations were made against Moodys that
it was issuing ratings on bonds it had not been hired
to rate, in order to pressure issuers to pay for their
service. The government conducted an inquiry, but
charges of antitrust violations were dropped. Even
though no legal action was taken, does an ethical
issue exist?

Thank You

Valuation of stock

Learning Objectives

Understand how stock prices depend on

future dividends and dividend growth
Be able to compute stock prices using the
dividend growth model
Understand how corporate directors are
elected
Understand how stock markets work
Understand how stock prices are quoted

Outline
Common Stock Valuation
Some Features of Common and Preferred Stocks
The Stock Markets

Cash Flows for Stockholders

If you buy a share of stock, you can receive
cash in two ways
The company pays dividends
You sell your shares, either to another investor in
the market or back to the company

As with bonds, the price of the stock is the

present value of these expected cash flows

One-Period Example
Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. You expect it to pay a GH2 dividend
in one year, and you believe that you can sell the
stock for GH14 at that time. If you require a return
of 20% on investments of this risk, what is the
maximum you would be willing to pay?
Compute the PV of the expected cash flows
Price = (14 + 2) / (1.2) = GH13.33
Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

Two-Period Example
Now, what if you decide to hold the stock for two
years? In addition to the dividend in one year, you
expect a dividend of GH2.10 in two years and a
stock price of GH14.70 at the end of year 2. Now
how much would you be willing to pay?
PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

Three-Period Example
Finally, what if you decide to hold the stock for three
years? In addition to the dividends at the end of
years 1 and 2, you expect to receive a dividend of
GH2.205 at the end of year 3 and the stock price is
expected to be GH15.435. Now how much would
you be willing to pay?
PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 =
13.33

Developing The Model

You could continue to push back the year in
which you will sell the stock
You would find that the price of the stock is
really just the present value of all expected
future dividends
So, how can we estimate all future dividend
payments?

Estimating Dividends: Special Cases

Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula

Constant dividend growth

The firm will increase the dividend by a constant percent every
period
The price is computed using the growing perpetuity model

Supernormal growth
Dividend growth is not consistent initially, but settles down to
constant growth eventually
The price is computed using a multistage model

Zero Growth
If dividends are expected at regular intervals forever, then this
is a perpetuity and the present value of expected future
dividends can be found using the perpetuity formula
P0 = D / R

Suppose stock is expected to pay a GH0.50 dividend every

quarter and the required return is 10% with quarterly
compounding. What is the price?
P0 = .50 / (.1 / 4) = GH20

Dividend Growth Model (DGM)

Dividends are expected to grow at a constant percent
per period.
P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 +
P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 +

With a little algebra and some series work, this

reduces to:

D 0 (1 g)
D1
P0

R -g
R -g

DGM Example 1
Suppose Big D, Inc., just paid a dividend of GH0.50
per share. It is expected to increase its dividend by
2% per year. If the market requires a return of 15%
on assets of this risk, how much should the stock be
selling for?
P0 = .50(1+.02) / (.15 - .02) = GH3.92

DGM Example 2
Suppose TB Pirates, Inc., is expected to pay a
GH2 dividend in one year. If the dividend is
expected to grow at 5% per year and the
required return is 20%, what is the price?
P0 = 2 / (.2 - .05) = GH13.33
Why isnt the GH2 in the numerator multiplied by (1.05)
in this example?

Stock Price Sensitivity to Dividend Growth,

g
250

D1 = GH2; R = 20%

Stock Price

200
150
100
50
0
0

0.05

0.1
Growth Rate

0.15

0.2

Stock Price Sensitivity to Required Return, R

250

D1 = GH2; g = 5%

Stock Price

200
150
100
50
0
0

0.05

0.1

0.15
Growth Rate

0.2

0.25

0.3

Example 3: Gordon Growth Company

Gordon Growth Company is expected to pay a
dividend of GH4 next period, and dividends are
expected to grow at 6% per year. The required return
is 16%.
What is the current price?
P0 = 4 / (.16 - .06) = GH40
Remember that we already have the dividend expected
next year, so we dont multiply the dividend by 1+g

Example 4 Gordon Growth Company

What is the price expected to be in year 4?
P4 = D4(1 + g) / (R g) = D5 / (R g)
P4 = 4(1+.06)4 / (.16 - .06) = 50.50
What is the implied return given the change in price during the four
year period?
50.50 = 40(1+return)4; return = 6%
PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
The price is assumed to grow at the same rate as the dividends

Non-constant growth problem statement

Suppose a firm is expected to increase

dividends by 20% in one year and by 15% in
two years. After that, dividends will increase
at a rate of 5% per year indefinitely. If the last
dividend was GH1 and the required return is
20%, what is the price of the stock?
Remember that we have to find the PV of all
expected future dividends.

Non-constant Growth Example Solution

Compute the dividends until growth levels off
D1 = 1(1.2) = GH1.20
D2 = 1.20(1.15) = GH1.38
D3 = 1.38(1.05) = GH1.449

Find the expected future price

P2 = D3 / (R g) = 1.449 / (.2 - .05) = 9.66

Find the present value of the expected future cash flows

P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

Quick Quiz
What is the value of a stock that is expected to pay a
constant dividend of GH2 per year if the required
return is 15%?
What if the company starts increasing dividends by
3% per year, beginning with the next dividend? The
required return stays at 15%.

Using the DGM to Find R

Start with the DGM:

D 0 (1 g)
D1
P0

R -g
R -g
D 0 (1 g)
D1
R
g
g
P0
P0
Dividend yield

Capital gains
yield(capital
appreciation)

Finding the Required Return

Suppose a firms stock is selling for GH10.50. It just
paid a GH1 dividend, and dividends are expected to
grow at 5% per year. What is the required return?
R = [1(1.05)/10.50] + .05 = 15%

What is the dividend yield?

1(1.05) / 10.50 = 10%

What is the capital gains yield?

g =5%

Refresh:

Features of Common Stock

Voting Rights
Proxy voting
Classes of stock
Other Rights

Share proportionally in declared dividends

Share proportionally in remaining assets during liquidation
The right to vote on important matters like merging
Preemptive right first shot at new stock issue to maintain
proportional ownership if desired

Dividend Characteristics
Dividends are not a liability of the firm until a dividend has
been declared by the Board
Consequently, a firm cannot go bankrupt for not declaring
dividends
Dividends and Taxes
Dividend payments are not considered a business expense;
therefore, they are not tax deductible
The taxation of dividends received by individuals depends on
the holding period
Dividends received by corporations have a minimum 70%
exclusion from taxable income

Features of Preferred Stock

Dividends
Stated dividend that must be paid before dividends can be
paid to common stockholders
Dividends are not a liability of the firm, and preferred
dividends can be deferred indefinitely
Most preferred dividends are cumulative any missed
preferred dividends have to be paid before common
dividends can be paid

Preferred stock generally does not carry voting rights

Stock Market
Ghana Stock Exchange(GSE)
Dealers vs. Brokers

New York Stock Exchange (NYSE)

Largest stock market in the world
License holders (1,366)

Commission brokers
Specialists(market makers)
Floor brokers
Floor traders

NASDAQ
AMEX

Work the Web Example

Electronic Communications Networks provide trading
in NASDAQ securities
Click on the web surfer and visit Instinet

Reading Stock Quotes on the GSE

This week in
Focus
Shares

Bonds
Market
Capitalizatio
n GH
million

Value of
Coporate
Bonds
Traded US$

Value of
Government
Bonds
Traded GH
million

Date

Volume

GSE
Composite
Index(GSECI)

Monday

29-Jul-13

585,561

1,921.06

55,785.89

Tuesday

30-Jul-13

2,123,464

1,931.22

55,832.24

Wednesday

31-Jul-13

497,272

1,936.29

55,778.54

Thursday

01-Aug-13

1,303,885

1,942.20

55,810.78

Friday

02-Aug-13

658,884

1,944.92

55,825.63

0
Note: The base date for the
GSE-CI is December 31, 2010
and the base index value is
1000

Reading Stock Quotes (USA)

Sample Quote

What information is provided in the stock quote?

Click on the web surfer to go to Bloomberg for current stock
quotes.

Quick Quiz Part II

You observe a stock price of GH18.75. You expect a
dividend growth rate of 5%, and the most recent
dividend was GH1.50. What is the required return?
What are some of the major characteristics of
common stock?
What are some of the major characteristics of
preferred stock?

Comprehensive Problem
XYZ stock currently sells for GH50 per share. The
next expected annual dividend is GH2, and the
growth rate is 6%. What is the expected rate of
return on this stock?
If the required rate of return on this stock were 12%,
what would the stock price be, and what would the
dividend yield be?

Thank You

Net present value and other investment

criteria

Good Decision Criteria

We need to ask ourselves the following questions when
evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are
creating value for the firm?

Lecture OUTLINE

Net Present Value (NPV)

The Payback Rule
The Discounted Payback
The Average Accounting Return(AAR)
The Internal Rate of Return(IRR)
The Profitability Index(PI)
The Practice of Capital Budgeting

Objectives
Be able to compute the NPV and understand the strength and
their shortcomings
Be able to compute payback and discounted payback and
understand their shortcomings
Understand accounting rates of return and their shortcomings
Be able to compute internal rates of return (standard and
modified) and understand their strengths and weaknesses
Be able to compute the net present value and understand why it
is the best decision criterion
Be able to compute the profitability index and understand its
relation to net present value

Net Present Value -NPV

The difference between the market value of a project
and its cost
How much value is created from undertaking an
investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects
of this risk level.
The third step is to find the present value of the cash flows
and subtract the initial investment.

NPV Decision Rule

If the NPV is positive, accept the project

A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal.

Illustration of NPV

Assume you have the following information on

Project X:
Initial outlay -$1,100 Required return = 10%
Annual cash revenues and expenses are as
follows:
Year
Revenues
Expenses
1
$1,000
$500
2
2,000
1,000

Draw a time line and compute the NPV of

project X

0
Initial outlay
($1,100)

Revenues
Expenses

$1,000
500

Revenues
Expenses

$2,000
1,000

Cash flow

$500

Cash flow

$1,000

$1,100.00

$500 x
+454.55

1
1.10
$1,000 x

+826.45
+$181.00 NPV

1
1.10 2

Project Example Information

You are reviewing a new project and have estimated the
following cash flows:

Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000

Your required return for assets of this risk level is 12%.

Computing NPV for the Project

Using the formulas:
NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41

Do we accept or reject the project?

Decision Criteria Test - NPV

Does the NPV rule account for the time value of money?
Does the NPV rule account for the risk of the cash
flows?
Does the NPV rule provide an indication about the
increase in value?
Should we consider the NPV rule for our primary
decision rule?

 Why does the NPV rule work? And what does work mean? Look
at it this way:
A firm is created when security holders supply the funds to
acquire assets that will be used to produce and sell a good or a
service;
The market value of the firm is based on the present value of the
cash flows it is expected to generate;
Additional investments are good if the present value of the
incremental expected cash flows exceeds their cost;
Thus, good projects are those which increase firm value - or, put
another way, good projects are those projects that have positive
NPVs!
Moral of the story: Invest only in projects with positive NPVs.

Payback Period
How long does it take to get the initial cost back in a
nominal sense?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until the
initial investment has been recovered

Decision Rule Accept if the payback period is less than

some preset limit

Illustration of the PayBACK period

Initial outlay -$1,000
Year
1
2
3
Year
1
2
3

Cash flow
$200
400
600
Accumulated
Cash flow
$200
600
1,200

Payback period = 2 2/3 years

Computing Payback for the Project

Assume we will accept the project if it pays back within
two years.
Year 1: 165,000 63,120 = 101,880 still to recover
Year 2: 101,880 70,800 = 31,080 still to recover
Year 3: 31,080 91,080 = -60,000 project pays back in year 3

Do we accept or reject the project?

Decision Criteria Test - Payback

Does the payback rule account for the time value of

money?
Does the payback rule account for the risk of the
cash flows?
Does the payback rule provide an indication about
the increase in value?
Should we consider the payback rule for our primary
decision rule?

Advantages and Disadvantages of Payback

Advantages
Easy to understand
Adjusts for uncertainty
of later cash flows
Biased toward liquidity

Disadvantages
Ignores the time value of
money
Requires an arbitrary cutoff
point
Ignores cash flows beyond
the cutoff date
Biased against long-term
projects, such as research
and development, and new
projects

Discounted Payback Period

Compute the present value of each cash flow and then
determine how long it takes to pay back on a discounted
basis
Compare to a specified required period
Decision Rule - Accept the project if it pays back on a
discounted basis within the specified time

Illustration
Year
1
2
3
4

Year
1
2
3
4

Initial outlay -$1,000

R = 10%
PV of
Cash flow
Cash flow
$ 200
400
700
300

$ 182
331
526
205
Accumulated
discounted cash flow
$ 182
513
1,039
1,244

Discounted payback period is just under 3 years

Computing Discounted Payback for the

Project

Assume we will accept the project if it pays back on a discounted

basis in 2 years.
Compute the PV for each cash flow and determine the payback
period using discounted cash flows
Year 1: 165,000 63,120/1.121 = 108,643
Year 2: 108,643 70,800/1.122 = 52,202
Year 3: 52,202 91,080/1.123 = -12,627 project pays back in year 3

Do we accept or reject the project?

Ordinary and discounted payback

We have an investment that cost $300 and cash flows of $100 per year for five
years. The required rate is 12%
Cash Flow

Year

Accumulated Cash Flow

Undiscounted Discounted

Undiscounted

Discounted

$100

$89

$100

$89

100

79

200

168

100

70

300

238

100

62

400

300

100

55

500

355

Decision Criteria Test Discounted Payback

Does the discounted payback rule account for the
time value of money?
Does the discounted payback rule account for the
risk of the cash flows?
Does the discounted payback rule provide an
indication about the increase in value?
Should we consider the discounted payback rule for
our primary decision rule?

Advantages and Disadvantages of

Discounted Payback
Advantages

Includes time value of

money
Easy to understand
Does not accept
negative estimated NPV
investments when all
future cash flows are
positive
Biased towards liquidity

Disadvantages
May reject positive NPV
investments
Requires an arbitrary
cutoff point
Ignores cash flows
beyond the cutoff point
Biased against long-term
projects, such as R&D
and new products

Average Accounting Return (AAR)

There are many different definitions for average
accounting return
The one used in this lecture is:
Average net income / average book value
Note that the average book value depends on how the
asset is depreciated.

Need to have a target cutoff rate

Decision Rule: Accept the project if the AAR is
greater than a preset rate

Illustration of - aar
Suppose the investment requires $240
Average net income:

Year

Sales

$440

$240

$160

Costs

220

120

80

Gross profit

220

120

80

Depreciation

80

80

80

140

40

35

10

$105

$30

$0

Earnings before taxes

Taxes (25%)
Net income

Average net income = ($105 + 30 + 0)/3 = $45

 Average book value:

Initial investment = $240
Average investment = ($240 + 0)/2 = $120
Average net income 45
AAR=

37.5%
Average book value 120

Computing AAR for THE Project

Assume we require an average accounting

return of 25%
Average Net Income(NI):
(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

Decision Criteria Test - AAR

Does the AAR rule account for the time value

of money?
Does the AAR rule account for the risk of the
cash flows?
Does the AAR rule provide an indication about
the increase in value?
Should we consider the AAR rule for our
primary decision rule?

Advantages and Disadvantages of AAR

Advantages

Easy to calculate
Needed information will
usually be available

Disadvantages

Not a true rate of return;

time value of money is
ignored
Uses an arbitrary
benchmark cutoff rate
Based on accounting net
income and book values,
not cash flows and
market values

Internal Rate of Return-IRR

This is the most important alternative to NPV

It is often used in practice and is intuitively
appealing
It is based entirely on the estimated cash flows
and is independent of interest rates found
elsewhere

IRR Definition and Decision Rule

Definition: IRR is the return that makes the NPV =
0
Decision Rule: Accept the project if the IRR is
greater than the required return

Illustration of IRR
Initial outlay = -$200
Year

Cash flow

1
2
3

$ 50
100
150

Find the IRR such that NPV = 0

50

0 = -200 +

100

(1+IRR)1

50

200 =

(1+IRR)1

(1+IRR)2

100

150

(1+IRR)2

(1+IRR)3

150

(1+IRR)3

 Trial and Error

Discount rates

NPV

0%

$100

5%

68

10%

41

15%

18

20%

-2

IRR is just under 20% -- about 19.44%

NET PRESENT VALUE PROFILE

Net present value
120
100
80
60
40
20
0
20
Discount rate

40
2%

6%

10%

14%

18%

IRR

22%

Computing IRR for the Project

If you do not have a financial calculator, then this
becomes a trial and error process
Calculator
Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return

Do we accept or reject the project?

70,000
60,000
50,000

NPV

40,000
30,000
20,000
10,000
0
-10,000 0

0.02 0.04 0.06 0.08

0.1

0.12 0.14 0.16 0.18

-20,000
Discount Rate

0.2

0.22

Decision Criteria Test - IRR

Does the IRR rule account for the time value of money?
Does the IRR rule account for the risk of the cash flows?
Does the IRR rule provide an indication about the
increase in value?
Should we consider the IRR rule for our primary decision
criteria?

Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate the value of
a project to someone who doesnt know all
the estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task

Summary of Decisions for the Project

Summary
Net Present Value

Accept

Payback Period

Reject

Discounted Payback Period

Reject

Average Accounting Return

Reject

Internal Rate of Return

Accept

NPV vs. IRR

NPV and IRR will generally give us the same

decision
Exceptions
Nonconventional cash flows cash flow signs
change more than once
Mutually exclusive projects
Initial investments are substantially different (issue of
scale)
Timing of cash flows is substantially different

IRR and Nonconventional

Cash Flows

When the cash flows change sign more than once, there
is more than one IRR
When you solve for IRR you are solving for the root of an
equation, and when you cross the x-axis more than
once, there will be more than one return that solves the
equation
If you have more than one IRR, which one do you use to
make your decision?

Another Example Nonconventional

Cash Flows
Suppose an investment will cost $90,000 initially and
will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

NPV Profile
$4,000.00
$2,000.00

NPV

$0.00
($2,000.00)

0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

($4,000.00)
($6,000.00)
($8,000.00)

IRR = 10.11% and 42.66%

($10,000.00)
Discount Rate

Summary of Decision Rules

The NPV is positive at a required return of

15%, so you should Accept
If you use the financial calculator, you would
get an IRR of 10.11% which would tell you to
Reject
You need to recognize that there are nonconventional cash flows and look at the NPV
profile

IRR and Mutually Exclusive Projects

Mutually exclusive projects
If you choose one, you cant choose the other
Example: You can choose to attend graduate school at either
GIMPA or UGBS, but not both

Intuitively, you would use the following decision rules:

NPV choose the project with the higher NPV
IRR choose the project with the higher IRR

Example With Mutually Exclusive Projects

Period Project Project
A
B
0
-500
-400
1

325

325

325

200

IRR

19.43
%
64.05

22.17
%
60.74

NPV

The required return

for both projects is
10%.

Which project
should you accept
and why?

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm
Whenever there is a conflict between NPV and another
decision rule, you should always use NPV
IRR is unreliable in the following situations
Nonconventional cash flows
Mutually exclusive projects

Modified IRR (MIRR)

Calculate the net present value of all cash
outflows using the borrowing rate.
Calculate the net future value of all cash inflows
using the investing rate.
Find the rate of return that equates these
values.
Benefits: single answer and specific rates for
borrowing and reinvestment

Profitability Index (PI)

Measures the benefit per unit cost, based on the
time value of money
A profitability index of 1.1 implies that for every
$1 of investment, we create an additional $0.10
in value
This measure can be very useful in situations in
which we have limited capital

Advantages and Disadvantages of Profitability Index

Advantages
Closely related to NPV,
generally leading to
identical decisions
Easy to understand and
communicate
May be useful when
available investment
funds are limited

Disadvantages
May lead to incorrect
decisions in comparisons
of mutually exclusive
investments

Capital Budgeting In Practice

We should consider several investment criteria when
making decisions
NPV and IRR are the most commonly used primary
investment criteria
Payback is a commonly used secondary investment
criteria

Summary
Net present value

Difference between market value and cost

Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with nonconventional cash flows or mutually exclusive projects

Profitability Index

Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing

 Payback period
Length of time until initial investment is recovered
Take the project if it pays back within some specified period
Doesnt account for time value of money, and there is an arbitrary
cutoff period

Discounted payback period

Length of time until initial investment is recovered on a discounted
basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period

 Average Accounting Return

Measure of accounting profit relative to book
value
Similar to return on assets measure
Take the investment if the AAR exceeds some
specified return level
Serious problems and should not be used

Quick quiz
Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
required return is 9%, and required payback is 4
years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What decision rule should be the primary decision
method?
When is the IRR rule unreliable?

CAPITAL MARKET HISTORY

Learning Objectives
Know how to calculate the return on an investment
Understand the historical returns on various types of
investments
Understand the historical risks on various types of
investments
Understand the implications of market efficiency

Outline

Returns
The Historical Record
Average Returns: The First Lesson
The Variability of Returns: The Second Lesson
More about Average Returns
Capital Market Efficiency

Risk, Return and Financial Markets

We can examine returns in the financial markets to help
us determine the appropriate returns on non-financial
assets
Lessons from capital market history
There is a reward for bearing risk
The greater the potential reward, the greater the risk
This is called the risk-return trade-off

Dollar Returns
Total dollar return = income from investment + capital
gain (loss) due to change in price
Example:
You bought a bond for GH950 one year ago. You have
received two coupons of GH30 each. You can sell the bond
for GH975 today. What is your total dollar return?
Income = 30 + 30 = 60
Capital gain = 975 950 = 25
Total dollar return = 60 + 25 = GH85

Percentage Returns
It is generally more intuitive to think in terms of
percentage, rather than dollar, returns
Dividend yield = income / beginning price
Capital gains yield = (ending price beginning price) /
beginning price
Total percentage return = dividend yield + capital gains
yield

Example Calculating Returns

You bought a stock for GH35, and you

received dividends of GH1.25. The stock is
now selling for GH40.
What is your dollar return?
Dollar return = 1.25 + (40 35) = GH6.25

What is your percentage return?

Dividend yield = 1.25 / 35 = 3.57%
Capital gains yield = (40 35) / 35 = 14.29%
Total percentage return = 3.57 + 14.29 = 17.86%

The Importance of Financial Markets

Financial markets allow companies, governments and
individuals to increase their utility
Savers have the ability to invest in financial assets so that they can
defer consumption and earn a return to compensate them for
doing so
Borrowers have better access to the capital that is available so that
they can invest in productive assets

Financial markets also provide us with information about

the returns that are required for various levels of risk

0
Oct

Jul-

Apr

Jan-

Oct

Jul-

Apr

Jan-

Oct

Jul-

Apr

Jan-

Oct

Jul-

Apr

Jan-

14

Evolution of GH1 invested

12

10

8
All

6
Non-Fin

4
Fin

T-bill

Year-to-Year Total Returns

Large-Company Stock Returns
Long-Term Government Bond Returns

U.S. Treasury Bill Returns

Average Returns
Investment

Average Return

Large Stocks

12.3%

Small Stocks

17.1%

Long-term Corporate
Bonds
Long-term Government
Bonds
U.S. Treasury Bills

6.2%

Inflation

3.1%

5.8%
3.8%

Risk Premiums
The extra return earned for taking on risk
Treasury bills are considered to be relatively riskfree

The risk premium is the return over and above

the risk-free rate

Average Annual Returns and Risk Premiums

Investment

Average Return

Risk Premium

Large Stocks

12.3%

8.5%

Small Stocks

17.1%

13.3%

Long-term Corporate
Bonds

6.2%

2.4%

Long-term Government
Bonds

5.8%

2.0%

U.S. Treasury Bills

3.8%

0.0%

Figure

Variance and Standard Deviation

Variance and standard deviation measure the volatility
of asset returns

The greater the volatility, the greater the uncertainty

Historical variance = sum of squared deviations from the
mean / (number of observations 1)

Standard deviation = square root of the variance

Example Variance and Standard Deviation

Year

Actual
Return

Average
Return

Deviation from
the Mean

Squared
Deviation

.15

.105

.045

.002025

.09

.105

-.015

.000225

.06

.105

-.045

.002025

.12

.105

.015

.000225

Totals

.42

.00

.0045

Variance = .0045 / (4-1) = .0015

Standard Deviation = .03873

Work the Web Example

Click on the web surfer to go to the Morningstar site
Pick a fund, such as the AIM European Development fund
(AEDCX)
Enter the ticker, press go and then click Risk Measures

How volatile are mutual funds?

Morningstar provides information on mutual funds,
including volatility

Arithmetic vs. Geometric Mean

Arithmetic average return earned in an average period over
multiple periods
Geometric average average compound return per period over
multiple periods
The geometric average will be less than the arithmetic average
unless all the returns are equal
Which is better?
The arithmetic average is overly optimistic for long horizons
The geometric average is overly pessimistic for short horizons
So, the answer depends on the planning period under consideration
15 20 years or less: use the arithmetic
20 40 years or so: split the difference between them
40 + years: use the geometric

Computing Averages
What is the arithmetic and geometric average for the
following returns?

Year 1
5%
Year 2
-3%
Year 3
12%
Arithmetic average = (5 + (3) + 12)/3 = 4.67%
Geometric average =
[(1+.05)*(1-.03)*(1+.12)]1/3 1 = .0449 = 4.49%

Efficient Capital Markets

Stock prices are in equilibrium or are fairly

priced
If this is true, then you should not be able to
earn abnormal or excess returns
Efficient markets DO NOT imply that investors
cannot earn a positive return in the stock market

What Makes Markets Efficient?

There are many investors out there doing
research
As new information comes to market, this
information is analyzed and trades are made based
on this information
Therefore, prices should reflect all available public
information

If investors stop researching stocks, then the

market will not be efficient

Common Misconceptions about EMH

Efficient markets do not mean that you cant make
money
They do mean that, on average, you will earn a return
that is appropriate for the risk undertaken and there is
not a bias in prices that can be exploited to earn excess
returns
Market efficiency will not protect you from wrong
choices if you do not diversify you still dont want to
put all your eggs in one basket

Strong Form Efficiency

Prices reflect all information, including public and
private
If the market is strong form efficient, then investors
could not earn abnormal returns regardless of the
information they possessed
Empirical evidence indicates that markets are NOT
strong form efficient and that insiders could earn
abnormal returns

Semistrong Form Efficiency

Prices reflect all publicly available information including
trading information, annual reports, press releases, etc.
If the market is semistrong form efficient, then investors
cannot earn abnormal returns by trading on public
information
Implies that fundamental analysis will not lead to
abnormal returns

Weak Form Efficiency

Prices reflect all past market information such as price
and volume
If the market is weak form efficient, then investors
cannot earn abnormal returns by trading on market
information
Implies that technical analysis will not lead to abnormal
returns
Empirical evidence indicates that markets are generally
weak form efficient

Quiz
Which of the investments discussed have had the
highest average return and risk premium?
Which of the investments discussed have had the
highest standard deviation?
What is capital market efficiency?
What are the three forms of market efficiency?

Comprehensive Problem
Your stock investments return 8%, 12%, and -4% in
consecutive years. What is the geometric return?
What is the sample standard deviation of the above
returns?
Using the standard deviation and mean that you just
calculated, and assuming a normal probability
distribution, what is the probability of losing 3% or
more?

Lecture 8
Return, Risk and the security market line

Lecture objectives

Know how to calculate expected returns

Understand the impact of diversification
Understand the systematic risk principle
Understand the security market line
Understand the risk-return trade-off
Be able to use the Capital Asset Pricing Model

OUTLINE

Expected Returns and Variances

Portfolios
Announcements, Surprises, and Expected Returns
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital: A Preview

Expected Returns
Expected returns are based on the probabilities of
possible outcomes
In this context, expected means average if the process
is repeated many times
The expected return does not even have to be a
possible return
n

E ( R ) pi Ri
i 1

Example: Expected Returns

Suppose you have predicted the following returns for
stocks C and T in three possible states of the
economy. What are the expected returns?
State
Boom
Normal
Recession

Probability
0.3
0.5
??

RC = .3(15) + .5(10) + .2(2) = 9.9%

RT = .3(25) + .5(20) + .2(1) = 17.7%

C
15
10
2

T
25
20
1

Variance and Standard Deviation

Variance and standard deviation measure the
volatility of returns
Using unequal probabilities for the entire range of
possibilities
Weighted average of squared deviations
n

pi ( Ri E ( R))
2

i 1

Example: Variance and Standard Deviation

Consider the previous example. What are the variance and
standard deviation for each stock?
Stock C
2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29
= 4.50%

Stock T
2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 = 74.41
= 8.63%

Another Example
Consider the following information:
State
Boom
Normal
Slowdown
Recession

Probability
.25
.50
.15
.10

ABC, Inc. (%)

15
8
4
-3

What is the expected return?

What is the variance?
What is the standard deviation?

Portfolios
A portfolio is a collection of assets
An assets risk and return are important in how they
affect the risk and return of the portfolio
The risk-return trade-off for a portfolio is measured by
the portfolio expected return and standard deviation,
just as with individual assets

Portfolio Weights
Suppose you have GH15,000 to invest and you have
purchased securities in the following amounts. What are
your portfolio weights in each security?

GH2000 of DCLK
GH3000 of KO
GH4000 of INTC
GH6000 of KEI

DCLK: 2/15 = .133

KO: 3/15 = .2
INTC: 4/15 = .267
KEI: 6/15 = .4

Portfolio Expected Returns

The expected return of a portfolio is the weighted
average of the expected returns of the respective
assets in the portfolio
m

E ( RP ) w j E ( R j )
j 1

You can also find the expected return by finding

the portfolio return in each possible state and
computing the expected value as we did with
individual securities

Example: Expected Portfolio Returns

Consider the portfolio weights computed previously. If the
individual stocks have the following expected returns, what is
the expected return for the portfolio?

DCLK: 19.69%
KO: 5.25%
INTC: 16.65%
KEI: 18.24%

E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24) =

15.41%

Portfolio Variance
Compute the portfolio return for each state:
RP = w1R1 + w2R2 + + wmRm
Compute the expected portfolio return using the same
formula as for an individual asset
Compute the portfolio variance and standard deviation
using the same formulas as for an individual asset

Example: Portfolio Variance

Consider the following information
Invest 50% of your money in Asset A
Portfolio
State Probability
A
B
Boom .4
30%
-5% 12.5%
Bust
.6
-10%
25% 7.5%

What are the expected return and standard deviation

for each asset?
What are the expected return and standard deviation
for the portfolio?

Solution:

If A and B are your only choices, what percent are you investing in Asset B? 50%
Asset A: E(RA) = .4(30) + .6(-10) = 6%
Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384
Std. Dev.(A) = 19.6%
Asset B: E(RB) = .4(-5) + .6(25) = 13%
Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216
Std. Dev.(B) = 14.7%

Portfolio (solutions to portfolio return in each state appear with mouse click after
last question)
Portfolio return in boom = .5(30) + .5(-5) = 12.5
Portfolio return in bust = .5(-10) + .5(25) = 7.5
Expected return = .4(12.5) + .6(7.5) = 9.5

OR
Expected return = .5(6) + .5(13) = 9.5
Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
Standard deviation = 2.45%

Another Example
Consider the following information
State
Boom
Normal
Recession

Probability
.25
.60
.15

X
15%
10%
5%

Z
10%
9%
10%

What are the expected return and standard deviation

for a portfolio with an investment of GH6,000 in asset
X and GH4,000 in asset Z?

Solution:
Portfolio return in Boom: .6(15) + .4(10) = 13%
Portfolio return in Normal: .6(10) + .4(9) = 9.6%
Portfolio return in Recession: .6(5) + .4(10) = 7%
Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%
Variance = .25(13-10.06)2 + .6(9.6-10.06)2 + .15(7-10.06)2 = 3.6924
Standard deviation = 1.92%
Compare to return on X of 10.5% and standard deviation of 3.12%
And return on Z of 9.4% and standard deviation of .49%

Expected vs. Unexpected Returns

Realized returns are generally not equal to expected
returns
There is the expected component and the unexpected
component
At any point in time, the unexpected return can be either
positive or negative
Over time, the average of the unexpected component is zero

Announcements and News

Announcements and news contain both an expected
component and a surprise component
It is the surprise component that affects a stocks price
and therefore its return
This is very obvious when we watch how stock prices
move when an unexpected announcement is made or
earnings are different than anticipated

Efficient Markets
Efficient markets are a result of investors trading on the
unexpected portion of announcements
The easier it is to trade on surprises, the more efficient
markets should be
Efficient markets involve random price changes because
we cannot predict surprises

Systematic Risk
Risk factors that affect a large number of assets
Also known as non-diversifiable risk or market risk
Includes such things as changes in GDP, inflation,
interest rates, etc.

Unsystematic Risk
Risk factors that affect a limited number of assets
Also known as unique risk and asset-specific risk
Includes such things as labor strikes, part shortages, etc.

Returns
Total Return = expected return + unexpected return
Unexpected return = systematic portion + unsystematic
portion
Therefore, total return can be expressed as follows:
Total Return = expected return + systematic portion +
unsystematic portion

Diversification
Portfolio diversification is the investment in several
different asset classes or sectors
Diversification is not just holding a lot of assets
For example, if you own 50 Internet stocks, you are not
diversified
However, if you own 50 stocks that span 20 different
industries, then you are diversified

The Principle of Diversification

Diversification can substantially reduce the variability of
returns without an equivalent reduction in expected
returns
This reduction in risk arises because worse than
expected returns from one asset are offset by expected
returns from another
However, there is a minimum level of risk that cannot be
diversified away and that is the systematic portion

Diversifiable Risk
The risk that can be eliminated by combining assets into
a portfolio
Often considered the same as unsystematic, unique or
asset(firm)-specific risk
If we hold only one asset, or assets in the same industry,
then we are exposing ourselves to risk that we could
diversify away

Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total
risk
For well-diversified portfolios, unsystematic risk is very
small
Consequently, the total risk for a diversified portfolio is
essentially equivalent to the systematic risk

Systematic Risk Principle

There is a reward for bearing risk
There is no a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on
that assets systematic risk since unsystematic risk can
be diversified away

Measuring Systematic Risk

How do we measure systematic risk?
We use the beta coefficient

What does beta tell us?

A beta of 1 implies the asset has the same systematic risk
as the overall market
A beta < 1 implies the asset has less systematic risk than
the overall market
A beta > 1 implies the asset has more systematic risk than
the overall market

Total vs. Systematic Risk

Consider the following information:
Security C
Security K

Standard Deviation

Beta

20%
30%

1.25
0.95

Which security has more total risk?

Which security has more systematic risk?
Which security should have the higher expected
return?

Work the Web Example

Many sites provide betas for companies
Yahoo Finance provides beta, plus a lot of other
information under its Key Statistics link
Click on the web surfer to go to Yahoo Finance
Enter a ticker symbol and get a basic quote
Click on Key Statistics

Example: Portfolio Betas

Consider the previous example with the following four securities
Security
DCLK
KO
INTC
KEI

Weight
.133
.2
.267
.4

Beta
2.685
0.195
2.161
2.434

What is the portfolio beta?

.133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947

Beta and the Risk Premium

Remember that the risk premium = expected return
risk-free rate
The higher the beta, the greater the risk premium
should be
Can we define the relationship between the risk
premium and beta so that we can estimate the
expected return?
YES!

Example: Portfolio Expected Returns and Betas

30%
E RA

Expected Return

25%
20%
15%
10%

5%
0%
0

0.5

1.5
Beta

2.5

Reward-to-Risk Ratio: Definition and Example

The reward-to-risk ratio is the slope of the line illustrated in
the previous example
Slope = (E(RA) Rf) / (A 0)
Reward-to-risk ratio for previous example =
(20 8) / (1.6 0) = 7.5

What if an asset has a reward-to-risk ratio of 8 (implying that

the asset plots above the line)?
What if an asset has a reward-to-risk ratio of 7 (implying that
the asset plots below the line)?

Market Equilibrium

In equilibrium, all assets and portfolios must

have the same reward-to-risk ratio, and they
all must equal the reward-to-risk ratio for the
market

E ( RA ) R f

E ( RM R f )

Security Market Line

The security market line (SML) is the representation of
market equilibrium
The slope of the SML is the reward-to-risk ratio: (E(RM)
R f ) / M
But since the beta for the market is ALWAYS equal to
one, the slope can be rewritten
Slope = E(RM) Rf = market risk premium

The Capital Asset Pricing Model (CAPM)

The capital asset pricing model defines the relationship
between risk and return
E(RA) = Rf + A(E(RM) Rf)
If we know an assets systematic risk, we can use the
CAPM to determine its expected return
This is true whether we are talking about financial
assets or physical assets

Factors Affecting Expected Return

Pure time value of money: measured by the risk-free
rate
Reward for bearing systematic risk: measured by the
market risk premium
Amount of systematic risk: measured by beta

Example - CAPM
Consider the betas for each of the assets given earlier. If
the risk-free rate is 4.15% and the market risk premium
is 8.5%, what is the expected return for each?
Security

Beta

Expected Return

DCLK

2.685

4.15 + 2.685(8.5) = 26.97%

KO

0.195

4.15 + 0.195(8.5) = 5.81%

INTC

2.161

4.15 + 2.161(8.5) = 22.52%

KEI

2.434

4.15 + 2.434(8.5) = 24.84%

Quiz
How do you compute the expected return and standard deviation
for an individual asset? For a portfolio?
What is the difference between systematic and unsystematic risk?
What type of risk is relevant for determining the expected return?
Consider an asset with a beta of 1.2, a risk-free rate of 5%, and a
market return of 13%.
What is the reward-to-risk ratio in equilibrium?
What is the expected return on the asset?

Comprehensive Problem
The risk free rate is 4%, and the required return on the
market is 12%. What is the required return on an asset
with a beta of 1.5?
What is the reward/risk ratio?
What is the required return on a portfolio consisting of
40% of the asset above and the rest in an asset with an
average amount of systematic risk?

Long-Term Financial
Planning and Growth

Lecture objectives
Understand the financial planning process and
how decisions are interrelated
Be able to develop a financial plan using the
percentage of sales approach
Be able to compute external financing needed
and identify the determinants of a firms
growth
Understand the four major decision areas
involved in long-term financial planning
Understand how capital structure policy and
dividend policy affect a firms ability to grow
4-344

Outline

What Is Financial Planning?

Financial Planning Models: A First Look
The Percentage of Sales Approach
External Financing and Growth
Some Caveats Regarding Financial Planning
Models

4-345

Elements of Financial Planning

Investment in new assets determined by capital
budgeting decisions
Degree of financial leverage determined by capital
structure decisions
Cash paid to shareholders determined by dividend
policy decisions
Liquidity requirements determined by net working
capital decisions

4-346

Financial Planning Process

Planning Horizon - divide decisions into short-run
decisions (usually next 12 months) and long-run
decisions (usually 2 5 years)
Aggregation - combine capital budgeting decisions into
one large project
Assumptions and Scenarios
Make realistic assumptions about important variables
Run several scenarios where you vary the assumptions by
reasonable amounts
Determine, at a minimum, worst case, normal case, and best
case scenarios

4-347

Role of Financial Planning

Examine interactions help management see the
interactions between decisions
Explore options give management a systematic
framework for exploring its opportunities
Avoid surprises help management identify possible
outcomes and plan accordingly
Ensure feasibility and internal consistency help
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the
firm are consistent with one another
Overall: Committing a plan to paper forces managers
to think seriously about the future
4-348

Financial Planning Model Ingredients

Sales Forecast
many cash flows depend directly on the level of sales (often
estimated using sales growth rate)

Pro Forma Statements

setting up the plan using projected financial statements allows
for consistency and ease of interpretation

Asset Requirements
the additional assets that will be required to meet sales
projections

Financial Requirements
the amount of financing needed to pay for the required assets

4-349

Financial Planning Model Ingredients

Plug Variable
determined by management deciding what type
of financing will be used to make the balance
sheet balance

Economic Assumptions
explicit assumptions about the coming economic
environment

Example: Historical Financial

Statements
Mensah tea Inc.

Mensah tea Inc.

Balance Sheet
December 31, 2009

Income Statement
For Year Ended December 31,
2009

Assets

1000 Debt

400

Revenues
Equity
Total

1000 Total

600

2000

Less: costs

(1600)

1000 Net Income

400

4-351

Example: Pro Forma Income

Statement
Initial Assumptions

Revenues will grow

at 15% (2,000*1.15)
All items are tied
directly to sales, and
the current
relationships are
optimal
Consequently, all
other items will also
grow at 15%

Mensah tea Inc.

Pro Forma Income Statement
For Year Ended 2010

Revenues

2,300

Less: costs

(1,840)

Net Income

460

4-352

Example: Pro Forma Balance Sheet

Mensah tea Inc.

Case I
Dividends are the plug
variable, so equity
increases at 15%

Pro Forma Balance Sheet

Case 1

Assets

Case II
Debt is the plug variable
and no dividends are
paid

1,150 Debt
Equity

Total

1,150 Total

460
690
1,150

Mensah tea Inc.

Pro Forma Balance Sheet
Case 2
Assets
1,150 Debt
Equity

Total

1,150 Total

90
1,060

1,150
4-353

Percentage of Sales Approach

Some items vary directly with sales, while others do not
Income Statement
Costs may vary directly with sales - if this is the case, then the profit
margin is constant
Depreciation and interest expense may not vary directly with sales if
this is the case, then the profit margin is not constant
Dividends are a management decision and generally do not vary
directly with sales this influences additions to retained earnings

Balance Sheet
Initially assume all assets, including fixed, vary directly with sales
Accounts payable will also normally vary directly with sales
Notes payable, long-term debt and equity generally do not vary
directly with sales because they depend on management decisions
about capital structure
The change in the retained earnings portion of equity will come from
the dividend decision
4-354

Example: Income Statement

Keishass Toy Emporium
Income Statement, 2009
% of
Sales
Sales
Less: costs

5,000

10%

(3,000)

60%

EBT

2,000

40%

Less: taxes
(40% of
EBT)

(800)

16%

Net Income

1,200

Dividends

600

Add. To RE

600

24%

Keishas Toy Emporium

Pro Forma Income Statement,
2010
Sales
5,500
Less: costs

(3,300)

EBT

2,200

Less: taxes

(880)

Net Income

1,320

Dividends

660

Add. To RE

660

Assume Sales grow at 10%

Dividend Payout Rate = 50%
4-355

Example: Balance Sheet

Keishas Toy Emporium Balance Sheet
Current

% of
Sales

Pro
Form
a

Current

% of
Sales

Pro
Forma

Liabilities & Owners Equity

ASSETS
Current Assets

Current Liabilities

Cash

500

10%

550 A/P

900 18%

990

A/R

2,000

40

2,200 N/P

2,500

n/a

2,500

Inventory

3,000

60

3,300

Total

3,400

n/a

3,490

5,500

110

6,050 LT Debt

2,000

n/a

2,000

Total

Owners Equity

Fixed Assets
Net PP&E

4,000

80

4,400

CS

2,000

n/a

2,000

Total Assets

9,500

190

10,450

RE

2,100

n/a

2,760

4,100

n/a

4,760

Total
Total L & OE

9,500

10,250
4-356

Example: External Financing Needed

The firm needs to come up with an additional
200 in debt or equity to make the balance
sheet balance
TA TL&OE = 10,450 10,250 = 200

Choose plug variable (200 EFN)

Borrow more short-term (Notes Payable)

Borrow more long-term (LT Debt)
Sell more common stock (CS )
Decrease dividend payout, which increases the
Additions To Retained Earnings
4-357

Example: Operating at Less than Full

Capacity

Suppose that the company is currently operating at 80% capacity.

Full Capacity sales = 5000 / .8 = 6,250
Estimated sales = 5,500, so we would still only be operating at
88%
Therefore, no additional fixed assets would be required.
Pro forma Total Assets = 6,050 + 4,000 = 10,050
Total Liabilities and Owners Equity = 10,250
Choose plug variable (for 200 EXCESS financing)
Repay some short-term debt (decrease Notes Payable)
Repay some long-term debt (decrease LT Debt)
Buy back stock (decrease CS)
Pay more in dividends (reduce Additions To Retained Earnings)
Increase cash account

4-358

Work the Web Example

Looking for estimates of company growth
rates?
What do the analysts have to say?
Check out Yahoo Finance click the web
surfer, enter a company ticker and follow the
Analyst Estimates link

4-359

Growth and External Financing

At low growth levels, internal financing
(retained earnings) may exceed the required
investment in assets
As the growth rate increases, the internal
financing will not be enough, and the firm will
have to go to the capital markets for money
Examining the relationship between growth and
external financing required is a useful tool in
long-range planning

4-360

The Internal Growth Rate

The internal growth rate tells us how much the firm can
grow assets using retained earnings as the only source
of financing.
Using the information from Keishas Toy Emporium
ROA = NI/TA=1200 / 9500 = .1263
b = .5

ROA b
Internal Growth Rate
1 - ROA b
.1263 .5

.0674
1 .1263 .5
6.74%
4-361

The Sustainable Growth Rate

The sustainable growth rate tells us how much the firm can
grow by using internally generated funds and issuing debt to
maintain a constant debt ratio.
Using Keishas Toy Emporium
ROE = NI/TE= 1200 / 4100 = .2927
b = .5

ROE b
Sustainabl e Growth Rate
1 - ROE b
.2927 .5

.1714
1 .2927 .5
17.14%

4-362

Determinants of Growth
ROE=Profit Margin x Total
Asset turn over+Equity
multiplier (Du Pont
Identity)

Profit margin operating

efficiency
Total asset turnover
asset use efficiency
Financial leverage choice
of optimal debt ratio
Dividend policy choice of
how much to pay to
shareholders versus
reinvesting in the firm
4-364

Important Questions
It is important to remember that we are working
with accounting numbers; therefore, we must ask
ourselves some important questions as we go
through the planning process:
How does our plan affect the timing and risk of our cash
flows?
Does the plan point out inconsistencies in our goals?
If we follow this plan, will we maximize owners wealth?

4-365

Quick Quiz
What is the purpose of long-range planning?
What are the major decision areas involved in
developing a plan?
What is the percentage of sales approach?
How do you adjust the model when operating at
less than full capacity?
What is the internal growth rate?
What is the sustainable growth rate?
What are the major determinants of growth?

4-366

Ethics Issues
Should managers overstate budget requests (or
growth projections) if they know that central
headquarters is going to cut funds across the
board?

4-367

Comprehensive Problem

XYZ has the following financial information for 2009:

Sales = 2M, Net Inc. = 0.4M, Div. = 0.1M
C.A. = 0.4M, F.A. = 3.6M
C.L. = 0.2M, LTD = 1M, C.S. = 2M, R.E. = 0.8M
What is the sustainable growth rate?
If 2010 sales are projected to be 2.4M, what is the amount of
external financing needed, assuming XYZ is operating at full
capacity, and profit margin and payout ratio remain constant?

4-368

Thank You

4-369

Cash and Liquidity Management

Lecture objectives
Understand the importance of float and how it
affects cash balance
Understand how to accelerate collections and
manage disbursements
Understand the advantages and disadvantages of
holding cash and some of the ways to invest idle cash
Be able to use the BAT and Miller-Orr models

19-371

Outline

Reasons for Holding Cash

Understanding Float
Cash Collection and Concentration
Managing Cash Disbursements
Investing Idle Cash
Determining the target Cash Balance

The Basic Idea

The BAT Model ( Baumol-Allais-Tobin (BAT)
The Miller-Orr Model: A More General Approach
Implications of the BAT and Miller-Orr Models
Other Factors Influencing the Target Cash Balance

19-372

Reasons for Holding Cash

Speculative motive hold cash to take advantage of
unexpected opportunities
Precautionary motive hold cash in case of
emergencies
Transaction motive hold cash to pay the day-to-day
bills
Trade-off between opportunity cost of holding cash
relative to the transaction cost of converting
marketable securities to cash for transactions
Compensating Balance
19-373

Understanding Float
Float difference between cash balance recorded in the cash
account and the cash balance recorded at the bank
Disbursement float
Generated when a firm writes checks
Available balance at bank book balance > 0

Collection float
Checks received increase book balance before the bank credits
the account
Available balance at bank book balance < 0

Net float = disbursement float - collection float

19-374

Example: Types of Float

You have GHS 3,000 in your checking
account. You just deposited GHS 2,000 and
wrote a check for GHS 2,500.
What is the disbursement float?
What is the collection float?
What is the net float?
What is your book balance?
What is your available balance?

19-375

Solution:

Disbursement float = GHS 2500

Collection float = -GHS 2000
Net float = 2500 2000 = GHS 500
Book balance = GHS 3000 + 2000 2500 =
GHS 2500
Available balance = GHS 3000

Example: Measuring Float

Size of float depends on the dollar amount and the time delay
Delay = mailing time + processing delay + availability delay
Suppose you mail a check each month for GHS 1,000 and it
takes 3 days to reach its destination, 1 day to process, and 1
day before the bank makes the cash available
What is the average daily float (assuming 30-day months)?
Method 1: (3+1+1)(1,000)/30 = 166.67
Method 2: (5/30)(1,000) + (25/30)(0) = 166.67

19-377

Example: Cost of Float

Cost of float : opportunity cost of not being able to use the
money
Suppose the average daily float is GHS 3 million with a
weighted average delay of 5 days.
What is the total amount unavailable to earn interest?
5*3 million = 15 million

What is the NPV of a project that could reduce the delay by 3 days if
the cost is GHS 8 million?
Immediate cash inflow = 3*3 million = 9 million
NPV = 9 8 = GHS 1 million

19-378

Cash Collection
Payment
Mailed

Payment
Received

Mailing Time

Payment
Deposited

Processing Delay

Cash
Available

Availability Delay

Collection Delay

One of the goals of float management is to try to reduce the

collection delay. There are several techniques that can reduce
various parts of the delay.

19-379

Example: Accelerating Collections Part I

Your company does business nationally, and currently, all
checks are sent to the headquarters in Accra. You are
considering a lock-box system that will have checks
processed in Kumasi and Tamale. The Accra office will
continue to process the checks it receives in house.

Collection time will be reduced by 2 days on average

Daily interest rate on T-bills = .01%
Average number of daily payments to each lockbox is 5,000
Average size of payment is GHS 500
The processing fee is GHS .10 per check plus GHS 10 to wire
funds to a centralized bank at the end of each day.

19-380

Example: Accelerating Collections Part II

Benefits
Average daily collections = 3(5,000)(500) = 7,500,000
Increased bank balance = 2(7,500,000) = 15,000,000

Costs
Daily cost = .1(15,000) + 3*10 = 1,530
Present value of daily cost = 1,530/.0001 = 15,300,000

NPV = 15,000,000 15,300,000 = -300,000

The company should not accept this lock-box proposal

19-381

Cash Disbursements
Slowing down payments can increase
disbursement float but it may not be ethical
or optimal to do this
Controlling disbursements
Zero-balance account
Controlled disbursement account

19-382

Investing Cash
Money market financial instruments with an
original maturity of one year or less
Temporary Cash Surpluses
Seasonal or cyclical activities : buy marketable
securities with seasonal surpluses, convert
securities back to cash when deficits occur
Planned or possible expenditures accumulate
marketable securities in anticipation of upcoming
expenses

19-383

19-384

Characteristics of Short-Term Securities

Maturity firms often limit the maturity of
short-term investments to 90 days to avoid
loss of principal due to changing interest rates
Default risk avoid investing in marketable
securities with significant default risk
Marketability ease of converting to cash
Taxability consider different tax
characteristics when making a decision

19-385

Costs of Holding Cash

Trading costs increase when the firm
must sell securities to meet cash needs.

Costs in dollars of
holding cash

Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.
Trading costs
C*

Size of cash balance

19A-386

The BAT Model

F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
R = The opportunity cost of holding cash, i.e., the
interest rate

C
C
2

If we start with GHS C, spend

at a constant rate each period
and replace our cash with
GHS C when we run out of
C
cash, our average cash
2
balance will be
The opportunity cost
C is C R
of holding

2
2
Time
19A-387

The BAT Model

As we transfer GHS C
each period we incur a
trading cost of F.

If we need GHS T in
total over the planning
T
period we will pay
C
GHS F times.

C2
1

Time

T F
The trading cost is
C
19A-388

The BAT Model

C
T
Total cost R F
2
C

Opportunity C R
Costs
2

T
Trading costs F
C
C*
2T
C
F
R

Size of cash balance

19A-389

The BAT Model

The optimal cash balance is found where the
opportunity costs equals the trading costs.

Opportunity Costs = Trading Costs

C
T
R F
2
C
Multiply both sides by C

C2
R T F
2

T F
C 2
R

2TF
C
R

19A-390

Example:
Akua and Co. has cash outflows of GHS 500 per day,
the interest rate is 10% and the fixed transfer cost is
GHS 25.
Solution:
T = 365*500 = 182,500
F = 25
R = .1
C* = GHS 9,552.49

The Miller-Orr Model

The firm allows its cash balance to wander
randomly between upper and lower control limits.

Cash
(GHS)

When the cash balance reaches the upper control limit U, cash
is invested elsewhere to get us to the target cash balance
C*.

U*

C*
L
X

Time

When the cash balance

reaches the lower
control limit, L,
investments are sold to
raise cash to get us up
to the target cash
balance.
19A-392

The Miller-Orr Model Math

Given L, which is set by the firm, the
Miller-Orr model solves for C* and U
2
3
F
C* 3
L
4R

U * 3C * 2 L

where 2 is the variance of net daily cash flows.

The average cash balance in the Miller-Orr model
is:
4C * L
Average cash balance
3
19A-393

Example:
Suppose F = GHS 25, R = 1% per month, and the
variance of monthly cash flows is GHS 25,000,000
per month. Assume a minimum cash balance of
GHS 10,000.
Solution:
C* = 10,000 + ( (25)(25,000,000)/.01)1/3 = GHS
13,605.62
U* = 3(13,605.62) 2(10,000) = GHS 20,816.86

Implications of the Miller-Orr Model

To use the Miller-Orr model, the
manager must do four things:
1. Set the lower control limit for the cash
balance.
2. Estimate the standard deviation of
daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying
and selling securities.
19A-395

Implications of the Miller-Orr Model

The model clarifies the issues of
cash management:
The optimal cash position, C*, is
positively related to trading costs, F,
and negatively related to the interest
rate R.
C* and the average cash balance are
positively related to the variability of
cash flows.
19A-396

Other Factors Influencing the Target

Cash Balance
Borrowing
Borrowing is likely to be more expensive
than selling marketable securities.
The need to borrow will depend on
managements desire to hold low cash
balances.

19A-397

Quick Quiz
What are the major reasons for holding cash?
What is the difference between disbursement
float and collection float?
How does a lockbox system work?
What are the major characteristics of shortterm securities?

19-398

Ethics Issues
Some corporations routinely pay late or take
discounts that they do not qualify for.
How does this impact the supplier?
Does this action have any negative impact on the
company itself?

19-399

Comprehensive Problem
A proposed single lockbox system will reduce collection
time 2 days on average
Daily interest rate on T-bills = .01%
Average number of daily payments to the lockbox is 3,000
Average size of payment is GHS 500
The processing fee is GHS .08 per check plus GHS 10 to
wire funds each day.
What is the maximum investment that would make this
lockbox system acceptable?

19-400

THANK YOU

19-401

Credit and Inventory Management

Lecture Objectives

Understand the key issues related to credit management

Understand the impact of cash discounts
Be able to evaluate a proposed credit policy
Understand the components of credit analysis
Understand the major components of inventory
management
Be able to use the EOQ model to determine optimal
inventory ordering

20-403

Outline

Credit and Receivables

Terms of the Sale
Analyzing Credit Policy
Optimal Credit Policy
Credit Analysis
Collection Policy
Inventory Management
Inventory Management Techniques

20-404

Credit Management: Key Issues

Granting credit generally increases sales
Costs of granting credit
Chance that customers will not pay
Financing receivables

Credit management examines the trade-off

between increased sales and the costs of
granting credit

20-405

Components of Credit Policy

Terms of sale
Credit period
Cash discount and discount period
Type of credit instrument

Credit analysis distinguishing between good

customers that will pay and bad customers that will
default
Collection policy effort expended on collecting
receivables
20-406

The Cash Flows from

Granting Credit
Credit Sale

Check Mailed

Check Deposited

Cash Available

Cash Collection
Accounts Receivable

20-407

Determinants of the Length of the Credit Period

Several factors influence the length of the
credit cycle. Among these factors are:

Perishability and collateral value

Consumer demand for the product
Cost, profitability and standardization
Credit risk of the buyer
The size of the account
Competition in the product market
Customer type

Terms of Sale
Basic Form: 2/10 net 45
2% discount if paid in 10 days
Total amount due in 45 days if discount not taken

Buy GHS 500 worth of merchandise with the credit

terms given above
Pay GHS 500(1 - .02) = GHS 490 if you pay in 10 days
Pay GHS 500 if you pay in 45 days

20-409

Example: Cash Discounts

Finding the implied interest rate when customers do
not take the discount, suppose the order is GHS 100
Credit terms of 2/10 net 45
Period rate = 2 / 98 = 2.0408%
Period = (45 10) = 35 days
365 / 35 = 10.4286 periods per year

EAR = (1.020408)10.4286 1 = 23.45%

The company benefits when customers choose to
forgo discounts

20-410

Credit Policy Effects

Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales

Cost Effects
Cost of the sale is still incurred even though the cash from the sale has
not been received
Cost of debt must finance receivables
Probability of nonpayment some percentage of customers will not
pay for products purchased
Cash discount some customers will pay early and pay less than the
full sales price

20-411

Evaluating a Proposed Credit Policy

P =
v =
Q =
Q =
R =

price per unit

variable cost per unit
current quantity sold per period
new quantity expected to be sold
periodic required return

The benefit of switching is the change in cash

flow:
New cash flow - old cash flow
[(P - v) Q+ - [(P - v) Q]
rearranging,
(P - v) (Q - Q)

Evaluating a Proposed Credit Policy

(concluded)
The present value of switching is:
PV = [(P - v) (Q - Q)]/R

The cost of switching is the amount uncollected for the

period + the additional variable costs of production:
Cost = PQ + v(Q - Q)

And the NPV of the switch is:

NPV = -*PQ + v(Q - Q)] + [(P - v)(Q - Q)]/R

Example: Evaluating a Proposed Policy Part I

Your company is evaluating a switch from a cash only

policy to a net 30 policy. The price per unit is GHS
100, and the variable cost per unit is GHS 40. The
company currently sells 1,000 units per month.
Under the proposed policy, the company expects to
sell 1,050 units per month. The required monthly
return is 1.5%.
What is the NPV of the switch?
Should the company offer credit terms of net 30?

20-414

Example: Evaluating a Proposed Policy Part II

Incremental cash inflow
(100 40)(1,050 1,000) = 3,000

Present value of incremental cash inflow

3,000/.015 = 200,000

Cost of switching
100(1,000) + 40(1,050 1,000) = 102,000

NPV of switching
200,000 102,000 = 98,000

Yes, the company should switch

20-415

Total Cost of Granting Credit

Carrying costs
Required return on receivables
Losses from bad debts
Costs of managing credit and collections

Shortage costs
Lost sales due to a restrictive credit policy

Total cost curve

Sum of carrying costs and shortage costs
Optimal credit policy is where the total cost curve is
minimized

20-416

20-417

Credit Analysis
Process of deciding which customers receive credit
Gathering information

Financial statements
Credit reports
Banks
Payment history with the firm

Determining Creditworthiness
5 Cs of Credit
Credit Scoring

20-418

Five Cs of Credit
Character willingness to meet financial obligations
Capacity ability to meet financial obligations out of
operating cash flows
Capital financial reserves
Collateral assets pledged as security
Conditions general economic conditions related to
customers business

20-419

Collection Policy
Monitoring receivables
Keep an eye on average collection period relative to your
credit terms
Use an aging schedule to determine percentage of
payments that are being made late

Collection policy
Delinquency letter
Telephone call
Collection agency
Legal action

20-420

Inventory Management
Inventory can be a large percentage of a firms assets
There can be significant costs associated with carrying
too much inventory
There can also be significant costs associated with not
carrying enough inventory
Inventory management tries to find the optimal
trade-off between carrying too much inventory versus
not enough

20-421

Types of Inventory
Manufacturing firm
Raw material starting point in production process
Work-in-progress
Finished goods products ready to ship or sell

Remember that one firms raw material may

be another firms finished goods
Different types of inventory can vary
dramatically in terms of liquidity

20-422

Inventory Costs
Carrying costs range from 20 40% of inventory value
per year

Storage and tracking

Insurance and taxes
Losses due to obsolescence, deterioration, or theft
Opportunity cost of capital

Shortage costs
Restocking costs
Lost sales or lost customers

Consider both types of costs, and minimize the total

cost

20-423

EOQ: Inventory Holdings

EOQ Model
The EOQ model minimizes the total inventory
cost
Total carrying cost = (average inventory) x
(carrying cost per unit) = (Q/2)(CC)
Total restocking cost = (fixed cost per order) x
(number of orders) = F(T/Q)
Total Cost = Total carrying cost + total restocking
cost = (Q/2)(CC) + F(T/Q)
Q
*

2TF
CC
20-425

20-426

Example: EOQ
Consider an inventory item that has
carrying cost = GHS 1.50 per unit. The
fixed order cost is GHS 50 per order, and
the firm sells 100,000 units per year.
What is the economic order quantity?

2(100,000)(50)
Q
2,582
1.50
*

20-427

Extensions
Safety stocks
Minimum level of inventory kept on hand
Increases carrying costs

Reorder points
At what inventory level should you place an order?
Need to account for delivery time

Derived-Demand Inventories
Materials Requirements Planning (MRP)
Just-in-Time Inventory

20-428

Safety Stocks
Inventory

A. Safety Stocks

Minimum inventory level

Safety Stocks
Time

Reorder Points
Inventory

B. Reorder points

Reorder Point

Time

Delivery
time

Delivery
time

Safety Stocks and Reorder Points

Inventory

B. Reorder points

Reorder Point

Delivery
Delivery
Safety
Stocks
time
time

Minimum inventory
level

Time

Ethics Issues
It is illegal for companies to use credit scoring models that
apply inputs based on such factors as race, gender, or
geographic location.
Why do you think such inputs are deemed illegal?
Beyond legal issues, what are the ethical and business reasons for
excluding (or including) such factors?

20-432

Comprehensive Problem
What is the effective annual rate for credit
terms of 2/10 net 30?
What is the EOQ for an inventory item with a
carrying cost of GHS 2.00 per unit, a fixed
order cost of GHS 100 per order, and annual
sales of 80,000 units?

20-433

Big Thank You

20-434