Christopher B.

Stone ‘01

Present value of future cash flow

FV
PV 
1  r  n

r = discount rate
n = number of periods

Discounting: calculation of present values

Compounding: calculation of future values
 Christopher B. Stone ‘01

Annuities

n n n n n

In advance PmT PmT PmT PmT PmT

In arrears PmT PmT PmT PmT PmT

CF0 CFt
 Christopher B. Stone ‘01

Internal rate of return

IRR is that unique discount

rate which, when applied to
a series of future cash
flows, yields a net present
value of 0.
 Christopher B. Stone ‘01

Financial management rate of return

Series A Series B Series C Only Series A is a “pure” IRR
CF0 $ (100.00) $ (100.00) $ (50.00)
CF1 $ - $ 7.18 $ (42.82) Series B and Series C have money extracted from the system
CF2 $ - $ 7.18 $ 7.18
CF3 $ - $ 7.18 $ 7.18 Series C has money invested in the system after t 0
CF4 $ - $ 7.18 $ 7.18
CF5 141.42 117.18 $ 107.18
The IRR model assumes
IRR 7.18% 8.86% 8.12%
1) That money invested in the system is held in an account
bearing interest at the IRR before being invested;
2) That money extracted from the system is re-invested in an
account yielding the IRR.

IRR FMRR
Negative cash flow s after t0, before they are
invested, are held in an account that produces IRR Safe rate
interest at
Money extracted from the system is re-
IRR Re-investment rate
invested at

FMRR bifurcates negative and positive cash flows

 Christopher B. Stone ‘01

Financial management rate of return

PV’ed at safe rate

(50) (50)

PV FV
(7.18) (7.18) (7.18) (7.18) (107.18)

Future valued at re-investment rate

FMRR > re-investment rate for worthwhile investments

 Christopher B. Stone ‘01

Hurdle rates

The earnings you forego

by deploying capital in a
different way

The rate you must get on an

investment for the deal to
make sense

If hurdle rate < IRR, NPV is positive

 Christopher B. Stone ‘01

Sensitivity analysis
If HR<IRR,
+ NPV

If you discount your cash flows @ the HR

and get a + NPV, the NPV represents your
profit over the life of the deal.

NPV @ HR is the positive

cushion you have

FV
PV 
1  r  n

Annuitize this figure

(calculate PmT) to get Net Uniform Series (NUS)
 Christopher B. Stone ‘01

Recourse debt

Debt

R e c o urs e N o n -re c o urs e

C r e d it o r c a n s u e d e b t o r if n o t r e - p a id B o r r o w e r h a s n o p e r s o n a l li a b il it y

M ig h t b e s e c u r e d , m ig h t n o t M u s t b e s e c u r e d , o t h e r w is e , it ' s n o t h i n g

M o s t c o r p o r a t e d e b t is r e c o u r s e Y o u c a n s t i ll s u e f o r f r a u d u l e n t c o n v e y a n c e s , e t c .
E x c e p t io n : r e a l e s t a t e
 Christopher B. Stone ‘01

Compounded interest

In te re s t
I b o rro w $ 1 0 0 @ 1 2 %

S im p l e C om pound

At Y R1, I ow e $12 At Y R1, I ow e $12

T h e $ 1 2 d o e s n o t a c c r u e in t e r e s t if u n p a id T h e $ 1 2 in t e r e s t it s e lf a c c r u e s in t e r e s t
 Christopher B. Stone ‘01

Capital asset pricing model

Cost of capital = Risk-free return + compensation for additional risk beyond a USG bond
Cost of capital = Risk free return + (β x market risk premium)
Cost of capital = Risk free return + (β x margin by which stock market exceeds risk-free return

ke  Rf  β(Rm  Rf )

Cost of Co-variance Average rate of return

capital Risk-free of returns against on common stocks
return the portfolio (S&P 500)
USG securities
(departure from the average)
B < 1, security is safer than S&P 500 average
B > 1, security is riskier than S&P 500 average

Cost of equity capital = return expected on firm’s common stock

 Christopher B. Stone ‘01

Lease financing

L e a s e f in a n c in g

O p e r a t in g le a s e C a p i t a l iz e d l e a s e

R u n - o f - t h e - m il l " l e a s e "
L e s s e e in c u r s a t a x - d e d u c t i b l e
p e r io d i c e x p e n s e
L e s s o r e n jo y s t h e t a x s h i e ld
o f d e p r e c i a t io n
L o n g - t e r m f i n a n c in g
I s l ik e l o n g - t e r m d e b t
T i t l e is u s u a l l y t r a n s f e r r e d
t o le s s e e a t t h e e n d o f t h e l e a s e t e r m
f o r a n o m in a l a m o u n t
A r e r e f l e c t e d in c o m p a n y ' s
f in a n c i a l s t a t e m e n t s
 Christopher B. Stone ‘01

Income statement
Total revenues
Less Cost of goods sold
Less Fixed costs / purchases
Less Change in inventory
Beginning inventory
Ending inventory
EBITDA
Less depreciation
EBIT
Less interest
EBT
Less taxes
Earnings for com m on & preferred
Less preferred dividends
Earnings for com m on & preferred
Less sinking fund
Unrestricted earnings
 Christopher B. Stone ‘01

Methods of inventory valuation

E n d in g in v e n t o r y v a l u a t io n m e t h o d s

F IF O L IF O
F ir s t g o o d s in t o in v e n t o r y L a s t g o o d s in t o in v e n t o r y
a r e f ir s t g o o d s o u t a r e f ir s t g o o d s o u t

L o w e r o f c o s t o r m a rk e t C ost C ost O N LY
 Christopher B. Stone ‘01

Benefits of FIFO and LIFO

Method
FIFO LIFO
Value closing inventory Value closing inventory
Technique
at end-of-year (current) prices at beginning of year prices
Increases value of closing inventory Decreases value of closing inventory

Inflationary
LESS change in inventory MORE change in inventory
Econom y

Higher EBITDA Low er EBITDA

Decreases value of closing inventory Increases value of closing inventory

Deflationary
MORE change in inventory LESS change in inventory
Low er EBITDA Higher EBITDA

Must use the same method for financial & tax accounting
 Christopher B. Stone ‘01

FIFO and LIFO calculations

Year 1 Year 2 Year 3
ITEM FIFO LIFO FIFO LIFO FIFO LIFO
Cost LCM Cost Cost LCM Cost Cost LCM Cost
Gross revenues $ 200 $ 200 $ 200 $ 80 $ 80 $ 80 $ 200 $ 200 $ 200
Less COGS $ 100 $ 150 $ 100 $ 100 $ 50 $ 50 $ 50 $ 50 $ 50
Purchases $ 100 $ 100 $ 100 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50
Change in inventory $ - $ 50 $ - $ 50 $ - $ - $ - $ - $ -
Opening inventory $ 100 $ 100 $ 100 $ 100 $ 50 $ 100 $ 50 $ 50 $ 100
Closing inventory $ 100 $ 50 $ 100 $ 50 $ 50 $ 100 $ 50 $ 50 $ 100
Gross incom e $ 100 $ 50 $ 100 $ (20) $ 30 $ 30 $ 150 $ 150 $ 150

Facts
Sales
Qty 10 10 10 10 10 10 10 10 10
Price $ 20 $ 20 $ 20 $ 8 $ 8 $ 8 $ 20 $ 20 $ 20
Purchases
Qty 10 10 10 10 10 10 10 10 10
Price $ 10 $ 10 $ 10 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5
Opening inventory
Qty 10 10 10 10 10 10 10 10 10
Price $ 10 $ 10 $ 10 $ 10 $ 5 $ 10 $ 5 $ 5 $ 10
Closing inventory
Qty 10 10 10 10 10 10 10 10 10
Price $ 10 $ 5 $ 10 $ 5 $ 5 $ 10 $ 5 $ 5 $ 10

Market price @ end of year $ 5 $ 5 $ 10

Under FIFO-LCM, opening inventories in the next year should be valued at COST
 Christopher B. Stone ‘01

Depreciation methods

D e p r e c ia t io n m e t h o d s

S t r a ig h t l in e A c c e le ra te d

S u m o f th e y e a rs D e c l in in g b a l a n c e

= Cost-salvage value
Useful life
1 5 0 % m e th o d D o u b l e d e c l in in g b a l a n c e

= Cost-salvage value * remaining years of useful life

n(n+1)
2

Keyed off the remaining balance in each year AFTER depreciation

Does NOT use salvage value
 Christopher B. Stone ‘01

Straight line & sum of the years depreciation

Year Depreciation Expense
0 Straight-line
1 $ 2,500
2 $ 2,500
3 $ 2,500
4 $ 2,500

Facts
Cost $ 12,000
Salvage Value $ 2,000
Useful Life 4

Calculation (sum of the years) Depreciation

Year Sum of the years
Rem aining years Denom inator Coefficient Base Expense
1 4 10 0.4 $ 10,000 $ 4,000
2 3 10 0.3 $ 10,000 $ 3,000
3 2 10 0.2 $ 10,000 $ 2,000
4 1 10 0.1 $ 10,000 $ 1,000

Facts
Cost $ 12,000
Salvage Value $ 2,000
Useful Life 4
 Christopher B. Stone ‘01

Declining balance depreciation

150% m ethod Double declining balance m ethod

Coefficient Calculations Coefficient Calculations
Year
Useful Depreciation Rem aining Useful Depreciation Rem aining
% Coefficient % Coefficient
life (yrs) expense balance life (yrs) expense balance
0 $ 12,000.00 $ 12,000
1 150% 4 0.375 $ 4,500.00 $ 7,500.00 200% 4 0.5 $ 6,000 $ 6,000
2 150% 4 0.375 $ 2,812.50 $ 4,687.50 200% 4 0.5 $ 3,000 $ 3,000
3 150% 4 0.375 $ 1,757.81 $ 2,929.69 200% 4 0.5 $ 1,000 $ 2,000
4 150% 4 0.375 $ 929.69 $ 2,000.00 200% 4 0.5 $ - $ 2,000

Facts
Useful life (yrs) 4
Cost $ 12,000
Salvage value $ 2,000

$12,000 x .375 = $4,500

 Christopher B. Stone ‘01

Depreciation graphs

Methods of depreciation

$14,000
$12,000
Value of asset

$10,000 Straight line

$8,000 Sum of the years
$6,000 Declining balance @ 150%
$4,000 Double declining balance
$2,000
$-
0 1 2 3 4
Year
 Christopher B. Stone ‘01

Capitalization vs. expenses

E x p e n d it u r e s

E xp e nse s C a p i t a li z a t io n

R e p a ir s
C re a te a n a s s e t th a t R e p a ir + u p g r a d e
U p g r a d e is c a p it a li z e d
R e c u r r in g e v e n t s p ro d uc e s re ve nue
th a t p ro d u c e beyond 1 year
lo n g - liv e d a s s e t s

E x c e p t io n : r e c u r r in g e v e n t s
ca n b e e xp e nse d
 Christopher B. Stone ‘01

Merger accounting

M e t h o d s o f a c c o u n t in g f o r b u s in e s s c o m b in a t io n s

P o o l in g P u rc h a s e

B a s e d o n B O O K ( h is t o r ic a l ) v a l u e s B a s e d o n f a ir m a r k e t v a l u e ( F M V )

R e s u l t s in h ig h e r n e t in c o m e
o n fu tu re b a la n c e s h e e ts
1 ) B o o k v a lu e < F M V
2 ) G o o d w ill m u s t b e a m o r t i z e d

M U S T b e u s e d if a n d o n l y if
a l l 1 2 c o n d it io n s a r e m e t

Defeat hostile takeovers by ensuring the combination doesn’t qualify for pooling
 Christopher B. Stone ‘01

Pooling method
X Corp Y Corp
Assets Liabiliites Assets Liabiliites
Cash $ 300,000 Debt $ 250,000 Inventory $ 50,000 Debt $ -
Plant $ 400,000 Plant $ 150,000
Equity Equity
Common $ 300,000 Common $ 100,000
R/E $ 150,000 R/E $ 100,000

Total $ 700,000 Total $ 700,000 Total $ 200,000 Total $ 200,000

Facts
FMV of Y's
Inventory $ 60,000 (Notice that FMV's are irrelevant to the pooling method)
Plant $ 180,000

Earnings
X $ 15,000
Y $ 20,000

Consideration for X's acquisition of Y

X common $ 250,000

X Corp (after acquisition) or X Corp (after acquisition) X Corp (consolidated)

Assets Liabiliites Assets Liabiliites Assets Liabiliites
Cash $ 300,000 Debt $ 250,000 Cash $ 300,000 Debt $ 250,000 Cash $ 300,000 Debt $ 250,000
Investment $ 200,000 Inventory $ 50,000 Inventory $ 50,000
Plant $ 400,000 Equity Plant (Y) $ 150,000 Equity Plant $ 550,000 Equity
Common $ 400,000 Plant $ 400,000 Common $ 400,000 Common $ 400,000
R/E $ 250,000 R/E $ 250,000 R/E $ 250,000

Total $ 900,000 Total $ 900,000 Total $ 900,000 Total $ 900,000 Total $ 900,000 Total $ 900,000

Pooling: Uses book value, A inherits T’s retained earnings

 Christopher B. Stone ‘01

Purchase method
X Corp Y Corp
Assets Liabiliites Assets Liabiliites
Cash $ 300,000 Debt $ 250,000 Inventory $ 50,000 Debt $ -
Plant $ 400,000 Plant $ 150,000
Equity Equity
Common $ 300,000 Common $ 100,000
R/E $ 150,000 R/E $ 100,000

Total $ 700,000 Total $ 700,000 Total $ 200,000 Total $ 200,000

Facts
FMV of Y's
Inventory $ 60,000 (Purchase method uses FMV)
Plant $ 180,000

Earnings
X $ 15,000
Y $ 20,000

Consideration for X's acquisition of Y

X common $ 250,000

X Corp (after acquisition) or X Corp (after acquisition) X Corp (consolidated)

Assets Liabiliites Assets Liabiliites Assets Liabiliites
Cash $ 300,000 Debt $ 250,000 Cash $ 300,000 Debt $ 250,000 Cash $ 300,000 Debt $ 250,000
Investment $ 250,000 Inventory $ 60,000 Inventory $ 60,000
Plant $ 400,000 Equity Plant (Y) $ 180,000 Equity Plant $ 580,000 Equity
Common $ 550,000 Plant $ 400,000 Common $ 550,000 Goodw ill $ 10,000 Common $ 550,000
R/E $ 150,000 Goodw ill $ 10,000 R/E $ 150,000 R/E $ 150,000

Total $ 950,000 Total $ 950,000 Total $ 950,000 Total $ 950,000 Total $ 950,000 Total $ 950,000

Purchase: Uses FMV, A doesn’t inherit T’s retained earnings

 Christopher B. Stone ‘01

Goodwill
G o o d w ill

R e p u t a t io n , t a le n t e d m g m t . , g o o d r e la t io n s h ip s w it h s u p p lie r s , e t c .
C a n n o t b e s o ld a p a r t fr o m id e n t ifia b le a s s e t s

E n t e r p r is e c a n r e c o r d g o o d w ill O N L Y w h e n it p u r c h a s e s a n e n t ir e b u s in e s s

A m o r t iz a b le u n d e r a 4 0 - y r p e r io d ( u s u a lly - s h o r t e r in h ig h - t e c h )

V a lu in g g o o d w ill

R e s id u a l m e t h o d E x c e s s e a r n in g s m e t h o d

Item Am ount
P u r c h a s e p r ic e Average earnings over X years $ 150,000
Less expected return on identifiable assets $ 100,000
L e s s F M V o f a s s e ts Excess earnings $ 50,000
Amount @ 10% interest that w ill produce
$50,000 in excess earnings each year $ 500,000
(I.e., goodw ill)

Facts
Identifiable assets (book value? FMV?) $ 1,000,000
Return on assets 10%
 Christopher B. Stone ‘01

Stock and dividend issuance

Scenario 1 (par stock issued) Scenario 2 (no-par stock issued)
Assets Liabiliites Assets Liabiliites
Cash $ 10,000 Cash $ 10,000

Equity Equity
c/s $ 100 c/s $ 10,000
Paid-in capital $ 9,900

Total $ 10,000 Total $ 10,000 Total $ 10,000 Total $ 10,000

Facts
1) Board authorizes and issues 100 shares at @1 par value, selling for $100 per share
2) Board authorizes and issues 100 shares of "no-par stock" for $100/share
3) As in #1; earnings for the year are $5,000
4) As in #3; Board declares dividend of $1,000
5) As in #4; Board buys a Van Gogh for $2,000
6) Painting is distributed as dividend ("deemed sale")
7) Covertible debt to stock

Scenario 3 (earnings of $5,000 reported) Scenario 4 (div of $1,000)

Assets Liabiliites Assets Liabiliites
Cash $ 10,000 Cash $ 10,000
Cash $ 5,000 Cash $ 4,000
Equity Equity
c/s $ 100 c/s $ 100
Paid-in capital $ 9,900 Paid-in capital $ 9,900
Retained earnings $ 5,000 Retained earnings $ 4,000

Total $ 15,000 Total $ 15,000 Total $ 14,000 Total $ 14,000

Scenario 5 (Board buys a Van Gogh) Scenario 6a (Van Gogh distributed as div - "deem ed sale")
Assets Liabiliites Assets Liabiliites
Cash $ 10,000 Cash $ 10,000
Cash $ 2,000 Cash $ 2,000
Painting $ 2,000 Equity Deemed cash $ 4,000 Equity
c/s $ 100 c/s $ 100
Paid-in capital $ 9,900 Paid-in capital $ 9,900
Retained earnings $ 4,000 Retained earnings $ 6,000

Total $ 14,000 Total $ 14,000 Total $ 16,000 Total $ 16,000

Scenario 6b (Van Gogh distributed as div - "deem ed sale")

Assets Liabiliites
Cash $ 10,000
Cash $ 2,000
Equity
c/s $ 100
Paid-in capital $ 9,900
Retained earnings $ 2,000

Total $ 12,000 Total $ 12,000

Scenario 8: convertible debt (before) Scenario 8: convertible debt (after)

Assets Liabiliites Assets Liabiliites
Cash $ 100,000 Debt $ 50,000 Cash $ 100,000 Debt $ -
Cash Cash
Equity Equity
c/s $ 50,000 c/s $ 100,000

Total $ 100,000 Total $ 100,000 Total $ 100,000 Total $ 100,000

Com pany has 100 outstanding shares of $5 par value com m on Buys back treasury shares for $150
Assets Liabiliites Assets Liabiliites
Cash $ 900 Debt $ 300 Cash $ 750 Debt $ 300

Equity Equity
c/s $ 100 c/s $ 100
Paid-in capital $ 200 Paid-in capital $ 200
Retained earnings $ 300 Retained earnings $ 300
Treasury shares $ (150)

Total $ 900 Total $ 600 Total $ 750 Total $ 750

Initial condition Com pany declares a stock dividend of 10 shares @ $6/share

Assets Liabiliites Assets Liabiliites
Cash $ 1,200 Debt $ - Cash $ 1,200 Debt $ -
 Christopher B. Stone ‘01

Liquidity ratios

Current Current assets

=
ratio Current liabilities

Quick
= Current assets - inventory
ratio Current liabilities

Cash flow
Cash flow from operations*
liquidity =
Current liabilities
ratio
*From the cash flow statement
 Christopher B. Stone ‘01

Leverage ratios

Debt Liabilities
=
ratio Assets

Debt/equity Liabilities
=
ratio Net worth
 Christopher B. Stone ‘01

Financial leverage index

Is a company trading positively on its leverage?
I.e., is it bringing in capital at less than the return?

Financial Return on equity

leverage =
Adjusted return on assets
index

= Net earnings* / equity**

[Earnings + interest (1-tax rate)] / assets

* Note this does not include pfd div

**Or market cap
 Christopher B. Stone ‘01

Activity ratios

Accounts
Net sales*
receivable =
Accounts receivable
turnover

Accounts
Total expenses*
payable =
Accounts payable
turnover

Inventory COGS*
=
turnover Inventory
*From the income statement
 Christopher B. Stone ‘01

Operating cycle
Capital
infusion
$

Accounts Inventory
receivable

Sale

Avg. amount of time inventory is outstanding

Operating
= +
cycle
Avg. amount of time receivables are outstanding
 Christopher B. Stone ‘01

Cash conversion cycle

Capital
infusion
$
Accounts
payable
Accounts Inventory
receivable (Payment)

Sale

Avg. amount of time inventory is outstanding

Cash +
conversion = Avg. amount of time receivables are outstanding
cycle -
(Avg. amount of time payables are outstanding)
 Christopher B. Stone ‘01

Profitability ratios

Gross profit Gross profit

=
margin Gross sales

This is very much driven by variable costs / cost of goods sold. Overhead is NOT included.

Measures profitability

A business can be profitable and still trade negatively on its leverage

 Christopher B. Stone ‘01

P/E ratio
Stock price per share
P/E ratio =
Earnings per share

G ro w th s to c k V a lu e s to c k
H ig h P / E r a t io L o w P / E r a t io

Return on Earnings + interest

=
total assets Assets