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SENIOR OUTCOMES SEMINAR (BU385) FINANCE

SENIOR OUTCOMES SEMINAR (BU385) FINANCE. MODEL OF THE FIRM. 1. OBTAIN FINANCING. Short term debt Long term debt Stocks. 2. INVEST IN RESOURCES. Current assets Fixed assets. 3. TO RUN OPERATIONS. Revenues Expenses. MODEL OF THE FIRM. 1. OBTAIN FINANCING. Short term debt.

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SENIOR OUTCOMES SEMINAR (BU385) FINANCE

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  1. SENIOR OUTCOMES SEMINAR (BU385) FINANCE

  2. MODEL OF THE FIRM 1. OBTAIN FINANCING • Short term debt • Long term debt • Stocks 2. INVEST IN RESOURCES • Current assets • Fixed assets 3. TO RUN OPERATIONS • Revenues • Expenses

  3. MODEL OF THE FIRM 1. OBTAIN FINANCING • Short term debt • Accounts payable • Notes payable • Accrued expenses • Long term debt • Corporate bonds • Stocks • Common stock • Preferred stock NYSE

  4. MODEL OF THE FIRM 2. INVEST IN RESOURCES • Current assets • Cash • Marketable securities • Accounts receivable • Inventories • Fixed assets • Plant and equipment • Accumulated depreciation

  5. MODEL OF THE FIRM 3. TO RUN OPERATIONS • Operating profits • Total sales • Cost of goods sold • Gross margins • Net profits • Selling and admin • Interest expenses • Taxes • Net profit margin

  6. WHAT the firm does: • MODEL OF THE FIRM • OBTAIN FINANCING • 2.INVEST IN RESOURCES • 3. TO RUN OPERATIONS WHY the firm does it: MAXIMIZE SHAREHOLDER WEALTH HOW the firm does it: MINIMIZE RISK / MAXIMIZE RETURNS

  7. BASIC CONCEPTS • Investment: What assets should the firm acquire and how much money should they spend? • Financing: What securities should the firm issue and how much should be raised issuing stocks and bonds? • Dividends: What portion of the firm’s profits should be paid in dividends (payout ratio)? • Working Capital: Management of current assets and current liabilities.

  8. FINANCIAL RATIOS (using financial statements) • Balance sheet • - Common-sized balance sheet shows assets, • liabilities, and equity as a % of total assets. • Income statement • - Common-sized income statement shows • income and expense items as a % of sales. • Statement of cash flows

  9. INCOME STATEMENT (Common Size) (Each line item as a percent of sales) • ($ amount) (% of sales) • Sales $2,311 100.0% • COGS 1,344 58.2 • Depreciation 27611.9 • EBIT 691 29.9 • Interest paid 141 6.1 • Taxable income 550 23.8 • Taxes (34%) 187 8.1 • Net income 363 15.7% • Dividends $121 5.2% • Addition to RE 242 10.5

  10. BALANCE SHEET (Common Size) (Each item as a percent of total assets) • ($ amt) (% tot. assets) • Current Assets cash $ 84 2.5% AR 165 4.9 • Inventory 39311.7 • Total $ 64219.1 • Fixed Assets • Net P & E $2,73180.9 • Total assets $3,373100.0%

  11. FINANCIAL RATIOS (standardized measures) • Used by managers for planning and evaluation • Used by credit managers to assess risk • Used by investors to assess stocks and bonds • Used to compare with industry and over time

  12. FINANCIAL RATIOSTypes of ratios • Liquidity -ability to meet short term debt • Asset management -efficiency in using resources • Financial leverage management -level of risk due to debt • Profitability -effectiveness in generating profits • Market-based -market’s view of the firm

  13. Liquidity Ratios • Current ratio = Current assets Current liabilities • CR = $50,190 / $25,523 • CR = 1.97 vs. 2.4 Ind. Avg. • Quick ratio = Current assets – inventories Current liabilities • QR = ($50,190 - $27,530) / $25,523 • QR = .89 vs. .92 Ind. Avg.

  14. Asset Management Ratios • Avg collection period = Accounts receivable Annual credit sales/365 • ACP = $18,320 / ($112,760/365) • ACP = 59.3 days vs. 47 days Ind. Avg. • Inventory turnover = Cost of sales Average inventory • Inv. Turn. = $85,300 / ($27,530 + $26,470)/2 • Inv. Turn. = 3.16 vs. 3.9 Ind. Avg.

  15. Asset Management Ratios • Fixed-asset turnover = Sales Net fixed assets • FAT = $112,760 / $31,700 • FAT = 3.56 vs. 4.6 Ind. Avg. • Total asset turnover = Sales Total assets • TAT = $112,760 / $81,890 • TAT = 1.38 vs. 1.82 Ind. Avg.

  16. Financial Leverage Management • Debt ratio = Total debt Total assets • DR = $47,523 / $81,890 • DR = 58% vs. 47% Ind. Avg. • Debt-to-equity ratio = Total debt Total equity • D/E = $47,253 / $34,367 • D/E = 138.3% vs. 88.7% Ind. Avg.

  17. Financial Leverage Management • Times interest earned = EBIT Interest charge • Coverage Ratio = $11,520 / $3,160 • Coverage Ratio = 3.65 vs. 6.7 Ind. Avg. • Equity multiplier = Total assets Total equity • EM = $81,890 / $34,367 • EM = 2.38 vs. 1.89 Ind. Avg.

  18. Profitability Ratios • Gross profit margin = Sales - Cost of sales Sales • GPM = ($112,760 - $85,300) / $112,760 • GPM = 24.4% vs. 25.6% Ind. Avg. • Net profit margin = EAT Sales • NPM = $5,016 / $112,760 • NPM = 4.45% vs. 5.1% Ind. Avg.

  19. Profitability Ratios • ROI = EAT Total Assets • ROI = $5,016 / $81,890 • ROI = 6.13% vs. 9.28% Ind. Avg. • ROE = EAT Stockholders equity • ROE = $5,016 / $34,367 • ROE = 14.6% vs. 17.54% Ind. Avg.

  20. Market-Based Ratios • P/E ratio = Market price per share Current earnings per share • Market to book ratio= Market price per share Book value per share

  21. Dividend Policy Ratios • Payout ratio = Dividends per share EPS • Dividend yield = Expected dividends per share Stock price

  22. Trend analysis20000102 XYZ current ratio 1.9 2.2 2.3 Cross-sectional analysis2002 XYZ current ratio 2.3 Industry averages 2.5 Both simultaneously200001 02 XYZ current ratio 1.9 2.2 2.3 Industry averages 2.5 2.4 2.5 Financial Ratio Analysis

  23. Relationships Among Ratios This is the Dupont formula: • ROE = Net profit  Total Assets  Equity margin turnover multiplier or • ROE = NPM  TAT  EM

  24. Dupont Formula Example of the Dupont formula: • ROE = NPM  TAT  EM Company: • 14.6% = 4.45%  1.38  2.38 Industry average: • 17.5% = 5.10%  1.82  1.89

  25. TIME VALUE OF MONEY (PV-present value, FV-future value) • Rate of return (interest/discount rate) • B. Single Amount – PV / FV (PV Princ. #1) • C. Annuities: • FV: Sinking Fund (saving for college) • PV: Capital Recovery (car payment) • D. Cash Flows (PV Principle #2) • E. Bond valuation/Stock valuation • F. Perpetuities

  26. Interest Rates • Simple Interest • Interest paid on the principal sum only • Compound Interest • Interest paid on the principal and on prior interest that has not been paid or withdrawn. Note: this is referred to as a discount rate when computing the PV of a FV sum of money. • Real Interest Rate • Real rate = nominal rate – inflation

  27. PV/FV Single Amount What’s the FV of an initial $100 after 3 years if i = 10%? 0 1 2 3 10% PV 100 FV = ? $133.10 Finding FVs (moving to the right on a time line) is called compounding.

  28. PV/FV Single Amount What’s the PV of $100 due in 3 years if i = 10%? Finding PVs is discounting, and it’s the reverse of compounding. 0 1 2 3 10% FV 100 PV = ? $75.13

  29. PV/FV Single Amount • PV Principle # 1 • There is an inverse relationship between interest rate and PV (present value). • How much is $1000 received one year from now worth today-using 5% and 15% discount rate? • FVRatePV (n = 1) • $1,000 5% $952 • $1,000 15% $870

  30. FV: Sinking Fund (saving for college) What’s the FV of a 3-year ordinary annuity of $100 at 10%? 0 1 2 3 10% 100 100 PMT=100 110 121 FV = 331

  31. PV: Capital Recovery (car payment) What’s the PV of this ordinary annuity? 0 1 2 3 10% 100 100 PMT=100 90.91 82.64 75.13 248.69 = PV

  32. TIME VALUE OF MONEY (PV-present value, FV-future value) Cash Flows (PV Principle #2): Cash flows closer in time have more value than cash flows received later (“bird in the hand” principle). year CF1CF2 1 $100 $300 2 300 300 3 300 100 4 50 50 total $750 $750 PV $598 $630

  33. Cash Flows (PV Principle #2) What is the PV of this uneven cashflow stream? 4 0 1 2 3 10% 50 100 300 300 90.91 247.93 225.39 34.15 598.38 = PV Option #1: total cash=$750

  34. Cash Flows (PV Principle #2) What is the PV of this uneven cashflow stream? 4 0 1 2 3 10% 50 300 300 100 272.73 247.93 75.13 34.15 629.94 = PV Option #2: total cash = $750

  35. Bonds and Their Valuation • Key features of bonds • Bond valuation • Measuring yield • Assessing risk

  36. Key Features of a Bond 1. Par value: Face amount; paid at maturity. Assume $1,000. 2. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. Generally fixed. (More…)

  37. 3. Maturity: Years until bond must be repaid. Declines. 4. Issue date: Date when bond was issued. 5. Default risk: Risk that issuer will not make interest or principal payments.

  38. How does adding a call provision affect a bond? • Issuer can refund if rates decline. That helps the issuer but hurts the investor. • Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds. • Most bonds have a deferred call and a declining call premium. (Note: convertible bonds would have lower yields.)

  39. What’s a sinking fund? • Provision to pay off a loan over its life rather than all at maturity. • Similar to amortization on a term loan. • Reduces risk to investor, shortens average maturity. • But not good for investors if rates decline after issuance.

  40. Sinking funds are generally handledin 2 ways 1. Call x% at par per year for sinking fund purposes. 2. Buy bonds on open market. Company would call if rd is below the coupon rate and bond sells at a premium. Use open market purchase if rd is above coupon rate and bond sells at a discount.

  41. 0 1 2 10 What’s the value of a 10-year, 10% coupon bond if rd = 10%? 10% ... 100 + 1,000 V = ? 100 100 $100 $100 $1 , 000 V  . . . + + + B 1 10 10       1 r 1 r + + 1 + r d d d = $90.91 + . . . + $38.55 + $385.54 = $1,000.

  42. What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 0 1 9 10 rd=? ... 90 90 90 1,000 PV1 . . . PV10 PVM Find rd that “works”! r = 10.91% 887

  43. What’s interest rate (or price) risk? Does a 1-year or 10-year 10% bond have more risk? Interest rate risk: Rising rd causes bond’s price to fall. rd 1-year Change 10-year Change 5% $1,048 $1,386 4.8% 38.6% 10% 1,000 1,000 4.4% 25.1% 15% 956 749

  44. What is reinvestment rate risk? The risk that CFs will have to be reinvested in the future at lower rates, reducing income. Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

  45. Year 1 income = $50,000. At year-end get back $500,000 to reinvest. If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

  46. Bond Risk • Long-term bonds: High interest rate risk, low reinvestment rate risk. • Short-term bonds: Low interest rate risk, high reinvestment rate risk. • Nothing is riskless!

  47. What factors affect default risk and bond ratings? • Financial performance • Debt ratio • Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio • Current ratios (More…)

  48. What factors affect default risk and bond ratings? • Provisions in the bond contract • Secured versus unsecured debt • Senior versus subordinated debt • Sinking fund provisions • Debt maturity • Other factors • Earnings stability • Regulatory environment • Potential product liability • Accounting policies

  49. Stocks and Their Valuation • Features of common stock • Determining common stock values • Efficient markets • Preferred stock

  50. Common Stock: Owners, Directors, and Managers • Represents ownership. • Ownership implies control. • Stockholders elect directors. • Directors hire management. • Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

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