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Week 2 Lecture 2

Week 2 Lecture 2. Ross, Westerfield and Jordan 7e Chapter 3 Financial Statements, Taxes and Cash Flows Chapter 5 Introduction to Valuation: The Time Value for Money. Last Week. Main areas of Corporate Finance Capital Budgeting Capital Structure Working Capital Management

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Week 2 Lecture 2

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  1. Week 2Lecture 2 Ross, Westerfield and Jordan 7e Chapter 3 Financial Statements, Taxes and Cash Flows Chapter 5 Introduction to Valuation: The Time Value for Money

  2. Last Week.. • Main areas of Corporate Finance • Capital Budgeting • Capital Structure • Working Capital Management • Financial Management Goal = Maximise shareholder’s value • Market Value vs Book Value • Cash Flows matter in Valuation

  3. Chapter 3 Outline • Cash Flow and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The DuPont Identity • Using Financial Statement Information

  4. Sample Balance Sheet Numbers in millions

  5. Sample Income Statement Numbers in millions, except EPS & DPS

  6. Sources and Uses • Sources • Cash inflow – occurs when we “sell” something • Decrease in asset account (Sample B/S) • Accounts receivable, inventory, and net fixed assets • Increase in liability or equity account • Accounts payable, other current liabilities, and common stock • Uses • Cash outflow – occurs when we “buy” something • Increase in asset account • Accounts receivable, and other current assets • Decrease in liability or equity account • Notes payable and long-term debt

  7. Statement of Cash Flows • Statement that summarizes the sources and uses of cash • Changes divided into three major categories • Operating Activity – includes net income and changes in most current accounts • Investment Activity – includes changes in fixed assets • Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends

  8. Sample Statement of Cash Flows Numbers in millions Sale of FA: 3138-3358+116= -104

  9. Standardized Financial Statements • Common-Size Balance Sheets - Table 3.5 • Compute all accounts as a percent of total assets • Common-Size Income Statements - Table 3.6 • Compute all line items as a percent of sales • Standardized statements make it easier to compare financial information, particularly as the company grows • They are also useful for comparing companies of different sizes, particularly within the same industry

  10. Ratio Analysis • Ratios also allow for better comparison through time or between companies • Ratios are used both internally and externally • Be aware! • There is a large number of possible ratios • Different people compute ratios in different ways

  11. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios

  12. Computing Liquidity Ratios • Current Ratio = CA / CL • 2256 / 1995 = 1.13 times • Quick Ratio = (CA – Inventory) / CL • (2256 – 301) / 1995 = .98 times • Cash Ratio = Cash / CL • 696 / 1995 = .35 times • NWC to Total Assets = NWC / TA • (2256 – 1995) / 5394 = .05 • Interval Measure = CA / average daily operating costs • 2256 / ((2006 + 1740)/365) = 219.8 days

  13. Computing Long-term Solvency Ratios(Financial Leverage Ratios) • Total Debt Ratio = (TA – TE) / TA = TD/TA • (5394 – 2556) / 5394 = 52.61% • Debt/Equity = TD / TE = D/E • (5394 – 2556) / 2556 = 1.11 times • Equity Multiplier = TA / TE = A/E = 1 + D/E • 5394 / 2556 = 2.11 • 1 + 1.11 = 2.11 • Long-term debt ratio = LTD / (LTD + TE) • 843 / (843 + 2556) = 24.80%

  14. Computing Coverage Ratiospart of Long Term Solvency Ratios • Times Interest Earned = EBIT / Interest • 1138 / 7 = 162.57 times • Cash Coverage = (EBIT + Depreciation) / Interest • (1138 + 116) / 7 = 179.14 times

  15. Computing Inventory Ratiospart of Asset Management Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 2006 / 301 = 6.66 times • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 6.66 = 55 days

  16. Computing Receivables Ratiospart of Asset Management Ratios • Receivables Turnover = Sales / Accounts Receivable • 5000 / 956 = 5.23 times • Days’ Sales in Receivables = 365 / Receivables Turnover • 365 / 5.23 = 70 days

  17. Computing Total Asset Turnoverpart of Asset Management Ratios • Total Asset Turnover = Sales / Total Assets • 5000 / 5394 = .9269 • It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • NWC Turnover = Sales / NWC • 5000 / (2256 – 1995) = 19.16 times • Fixed Asset Turnover = Sales / NFA • 5000 / 3138 = 1.59 times

  18. Computing Profitability Measures • Profit Margin = Net Income / Sales • 689 / 5000 = 13.78% • Return on Assets (ROA) = Net Income / Total Assets • 689 / 5394 = 12.77% • Return on Equity (ROE) = Net Income / Total Equity • 689 / 2556 = 26.96%

  19. Computing Market Value Measures • Market Price = $87.65 per share • Shares outstanding = 190.9 million • PE Ratio = Price per share / Earnings per share • 87.65 / 3.61 = 24.28 times • Market-to-book ratio = market value per share / book value per share • 87.65 / (2556 / 190.9) = 6.56 times

  20. Deriving the DuPont Identity • ROE = Net Income/ Total Equity • Multiply top and bottom by Total Assets and then rearrange • ROE = (NI/ TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply ROA by Sales and then rearrange • ROE = (Sales / Sales) (NI / TA) (TA / TE) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM

  21. Using the DuPont Identity • ROE = PM * TAT * EM • PM - Profit margin is a measure of the firm’s operating efficiency – how well does it control costs • TAT - Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets • EM - Equity multiplier is a measure of the firm’s financial leverage

  22. DuPont Example • Calculated previously: • ROE = Net Income/ Total Equity = 26.96% • Using DuPont Identity: • ROE = PM * TAT * EM • ROE = 13.78% * 0.9269 * 2.11 = 26.96%

  23. Why Evaluate Financial Statements? • Internal uses • Performance evaluation – compensation and comparison between divisions • Planning for the future – guide in estimating future cash flows • External uses • Creditors • Suppliers • Customers • Stockholders

  24. Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis • Used to see how the firm’s performance is changing through time • Peer Group Analysis • Compare to similar companies or with the industry

  25. Potential Problems • There is no underlying theory, so there is no way to know which ratios are most relevant • Benchmarking is difficult for diversified firms • Globalization and international competition makes comparison more difficult because of differences in accounting regulations • Varying accounting procedures, i.e. FIFO vs. LIFO • Different fiscal years • Extraordinary events

  26. End of Chapter 3

  27. Week 2Lecture 2 Ross, Westerfield and Jordan 7e Chapter 5 Introduction to Valuation: The Time Value for Money

  28. Chapter 5 Outline • Future Value and Compounding • Present Value and Discounting • More on Present and Future Values • Determine the return on an investment • Calculate the number of periods • Use excel to solve problems

  29. Future Values • Suppose you invest $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 +1000(.05) = 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

  30. Future Values: 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 • Future value interest factor = (1 + r)t • “r” also known as: • Discount rate • Cost of capital • Required return

  31. Simple vs Compound Interest • Simple interest • interest earned each period only on the principal • Compound interest • Interest is reinvested each period – interest on interest • Consider the previous example • FV with simple interest = 1000 + 50 + 50 = 1100 1000+1000(.05)+1000(.05) • FV with compound interest=1000 + 50 + 52.50 = 1102.5 1000+1000(.05)+1050(.05) • The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the first interest payment

  32. Future Values – Example 2 • Suppose you invest the $1000 from the previous example at 5% per year, for 5 years. How much would you have at the end of 5 years? • FV = 1000(1.05)5 = 1276.28 • The effect of compounding is small for a small number of periods, but increases as the number of periods increases. • What would be the future value using simple interest ?

  33. Future Values – Example 3 • Suppose you had a relative deposit $10 at 5.5% pa interest 200 years ago. How much would the investment be worth today? • FV = 10(1.055)200 = 447,189.84 • What is the effect of compounding? • Simple interest = 10 + 200(10)(.055) = 120.00 • Compounding added $447,069.84 to the value of the investment

  34. Quick Quiz – Part I • What is the difference between simple interest and compound interest? • Suppose you have $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?

  35. Present Values • How much do I have to invest today to have some amount in the future? • FV = PV(1 + r)t • Rearrange to solve for PV = FV / (1 + r)t • PVIF = 1/(1+r)t • When we talk about discounting, we mean finding the present value of some future amount. • PV = the current value of future cash flows discounted at the appropriate discount rate

  36. Present Value – Examples • Suppose you need $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? • PV = 10,000 / (1.07)1 = 9345.79 • You want to begin saving for your child’s education and you estimate that the cost will be $150,000 in 17 years. You feel confident that you can earn 8% per year, how much do you need to invest today? • PV = 150,000 / (1.08)17 = 40,540.34

  37. Present Value – Important Relationships • For a given interest rate – the longer the time period, the lower the present value • What is the present value of $500 to be received in 5 years? 10 years? The discount rate is 10% • 5 years: PV = 500 / (1.1)5 = 310.46 • 10 years: PV = 500 / (1.1)10 = 192.77 • For a given time period – the higher the interest rate, the smaller the present value • What is the present value of $500 received in 5 years if the interest rate is 10%? 15%? • Rate = 10%: PV = 500 / (1.1)5 = 310.46 • Rate = 15%; PV = 500 / (1.15)5 = 248.59

  38. Quick Quiz – Part II • What is the mathematical relationship between present value and future value? • Suppose you need $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 at 6%? How much?

  39. FV = PV (1+r)t PV = FV / (1 + r)t = FV(1+r)-t There are four parts to these equations PV, FV, r and t If we know any three, we can solve for the fourth To find r FV = PV(1 + r)t (FV/PV) = (1+r)t 1+r = (FV/PV)1/t r = (FV/PV)1/t – 1 To find t FV = PV(1 + r)t (FV/PV) = (1 + r)t LN(FV/PV) = t x LN(1+r) t = LN(FV/PV)/LN(1 + r) Future and Present Values

  40. Finding the Rate r – Example 1 • You are looking at an investment that will pay $1200 in 5 years if you invest $1000 today. What is the implied rate of interest? • FV = PV(1+r)t • 1200 = 1000(1+r)5 • 1200/1000 = (1+r)5 • (1200/1000)1/5 = 1+r • r = (1200 / 1000)1/5 – 1 = (1.2)1/5 – 1= 1.03714 -1 = .03714 = 3.714%

  41. Finding r – More Examples • Suppose you are offered an investment that will allow you to double your money in 6 years. You have $10,000 to invest. What is the implied rate of interest? • r = (20,000 / 10,000)1/6 – 1 = .122462 = 12.25% • Suppose you have a 1-year old son and you want to provide $75,000 in 17 years towards his college education. You currently have $5000 to invest. What interest rate must you earn to have the $75,000 when you need it? • r = (75,000 / 5,000)1/17 – 1 = .172688 = 17.27%

  42. Finding the Number of Periods t – Example 1 • You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car? • FV = PV(1 + r)t • 20000 = 15000(1+.1)t • 20000/15000 = (1.1)t • LN(20,000 / 15,000) = t x LN(1.1) • t = LN(20,000 / 15,000) / LN(1.1) • t = LN(1.3333)/ LN(1.1) = 0.2876 / 0.0953 = 3.02 years

  43. Number of Periods – Example 2 • Suppose you want to buy a new house. You currently have $15,000 and you figure you need to have a 10% deposit plus an additional 5% of the loan amount for loan fees. Assume the type of house you want will cost about $150,000 and you can earn 7.5% per year, how long will it be before you have enough money for the deposit and fees?

  44. Number of Periods – Example 2 Continued • How much do you need to have in the future? • Deposit = .1(150,000) = 15,000 • Loan becomes = 150000-15000 = 135000 • Fees = .05(135000) = 6,750 • Total needed = 15,000 + 6,750 = 21,750 • Compute the number of periods • PV = 15,000 21,750 = 15,000(1+0.075)t • FV = 21,750 21,750/15,000 = (1.075)t • r = 7.5% • Solving for the number of periods: • t = LN(21,750 / 15,000) / LN(1.075) = 5.14 years

  45. Spreadsheet Example • Use the following formulas for calculations • FV(rate,nper,pmt,pv) • PV(rate,nper,pmt,fv) • RATE(nper,pmt,pv,fv) • NPER(rate,pmt,pv,fv)

  46. Work the Web Example • Many financial calculators are available online • Go to Investopedia’s web site and work the following example: • You need $50,000 in 10 years. If you can earn 6% interest, how much do you need to invest today? • You should get $27,919.74 www.investopedia.com/calculator

  47. Table 5.4

  48. End of Lecture 2

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