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Corporate finance is the study of planning, evaluating and drawing decisions in the course of business.

(1) SWOT analysis is also very helpful in capital budgeting process.

SWOT stands for: Strengths Weaknesses Opportunities Threats

Broadly speaking there are two potential sources for making investments The first sources emerge from the contributions of sponsors or directors who commence the business. This portion of investment is called Capital or Equity contribution.

(2)

The other source of investment is from loans and various financial instruments and markets. Banks provide long term and short loans to the business world and this has been the most important source of business finance and is being used widely. Other source of external financing is issuance of bonds and securities in primary and secondary markets. This process is known as Capital Structure

(3)

There are basically three financial statements that every business entity runs periodically. It includes: Balance Sheet Income Statement Cash Flow

Balance Sheet

This is a statement of resources controlled by and obligations to settle by an entity as on a specified date. The format of Financial Statements is governed by International Financial Reporting Standard in Pakistan. Assets (both fixed and current) are placed in balance sheet in the order of less liquid or illiquid to liquid. This means that current assets are more liquid than fixed assets. What is a liquid asset? Answer: An asset that can be converted to cash quickly and without loss of value is liquid asset Example Prize bond or gold highly liquid asset

Current Assets and Current Liabilities when clubbed together, give birth to another concept known as working capital. Current assets are those that form part of the circulating capital of a business. The most common current assets are stocks, trade debtors, and cash.

Current liabilities are those short-term liabilities which are intended to be constantly replaced in the normal course of trading activity. Current liabilities typically comprise: trade creditors, accruals and bank overdrafts. There is another concept of Cash

capital Example

You were still able to use money for 5 days before paying to creditors. This means the operating cycle is positive.

Types of analysis (1) vertical analysis (2) horizontal analysis

Horizontal Analysis Base year analysis is another tool of comparing performance and is also known as Horizontal Analysis.

Ratio analysis

Ratio analysis is another widely acknowledged and used comparison tool for financial managers

Question : A ratio is a relationship between ------------- or more line items expressed in ---------------------------- of times? Five, %age or numbers Two, %age or numbers Three, %age or number One, %age or number Question : Financial ratios are useful indicators of a firms performance and --------------------? Financial changes Financial situation Financial requirement Financial needs

Financial ratios can be used to analyze trends and to compare the firms financials to those of other firms.

Different ratios

Current ratio = current assets / current liabilities Note: current ratio is a measure of short term liquidity. This is short term solvency or liquidity measurement Current assets inventory Quick (or acid test) ratio = ____________________________ Current liabilities Note: using cash to buy inventory does not affect the current ratio, but It reduces the quick ratio. This is short term solvency or liquidity measurement

Total assets Note: Total debt equity ratio take into all debts of all maturities to all creditors. This is long term solvency measurement.

Total debt Debt-equity ratio= ----------------Total equity Note: This is long term solvency measurement.

EBT ------------Interest

Interest coverage ratio = EBIT / interest Note: This is long term solvency measurement. Cost of goods sold Inventory turnover ratio = ---------------------------------Avg. Inventory Days sale in inventory = 365 days / inventory turnover

Note: They are intended to describe is how efficiently, or intensively, a firm uses its assets to generate sales. This is assets management or turnover measure.

Average collection period or days sales in receivables= 365 days / receivables turnover

Cost of goods sold Payable turnover = ----------------------------------Trade credits Average payment period = 365 days / payable turnover

Note: All other things being equal, a relatively high profit margin is obviously. This situation corresponds to low expense ratio relative to sales. How ever, we hasten to add that other things are often not equal.

Net income Return on equity = ------------------ * 100 Total equity Note: ROE is a measure how the shareholder fared during the year. Since befitting shareholder our goal, ROE in accounting sense, the true bottom-line measure of performance.

Short Term Solvency Or Working Capital Ratios (1) (2) CURRENT RATIO QUICK RATIO

(3)

CASH RATIO

Long Term Solvency Or Financial Leverage Ratios (1) (2) (3) (4) (5) TOTAL DEBT RATIO DEBT EQUITY RATIO EQUITY MULTIPLIER TIME INTEREST EARNED RATIO CASH COVERAGE RATIO

(1) INVENTORY TURNOVER AND INV. DAYS (2) RECEIVABLE TURNOVER AND AVERAGE COLLECTON PERIOD (3) PAYALE TURNOVER AND AVERAGE PAYMENT PERIOD (4) TOTAL ASSETS TURNOVER (5) CAPITAL INTENSITY

PROFITABILITY RATIOS (1) NET PROFIT OR PROFIT MARGIN (2) RETURN ON ASSETS (3) RETURN ON EQUITY

Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.

Time Value of Money is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future.

Time value of money divided into following topics (1) present value

Present value

The present value of a future cash flow is the nominal amount of money to change hands at some future date, discounted to account for the time value of money

Future value measures what money is worth at a specified time in the future assuming a certain interest rate.

n

Annuities

Equal annual series of cash flow Annuities may be (1) equal annual deposit (2) equal annual withdrawal (3) equal annual payments (4) equal annual receipts Annuities is key of equal annual cash flow Present value of annuity = c [1/r-1/r (1+r) t] = c {1-[1/ (1+r) t] / r}

Annuity A level stream of cash flows for a fixed period of time. Ordinary annuity Cash flow that occurs at the end of each period for some fixed number of period is called an ordinary annuity. Annuity due Cash flow occurs at the beginning of each period.

Perpetuity

An annuity in which the cash flow continue forever. Or

Perpetuity is a cash flow without a fixed time horizon.

Consol Also called perpetuity and type of perpetuity Present value of perpetuity = C/r

Lesson 4

Discounting cash flow & Effective annual interest

Effective Annual Rate EAR Interest rate that is annualized using compound interest Formula EAR = [1 + i/n) n 1

BOND VALUATION

A bond is a financial instrument or a debt security issued by a company to raise money. It is offered to general public or to institutions. Equity & Debt (Bonds) Equity represents ownership and is a residual claim

Lesson 5 Bond

Bond

Contract between investor and issuer It is debt instrument. Use to raise capital and return pay interest to investor Bonds are redeemable

Interest payment stated is annualized term Or The rate at which issuer pays interest to investor is know as coupon rate Current yield = annual coupon payment / bond price Maturity date The date on which company return the principle amount back to investor Discount bond Bond sells less than the face or par value so the return on a bond is greater than the current yield, in this case capital gain at maturity. Premium bond Bond sells more than the face or par value so return on a bond less than the current yield. In this case capital loss at maturity. Interest rate risk & bond

The risk arising from fluctuating interest rate is known as interest rate risk. Two things to change sensitivity to change interest rate

(1) time to maturity (2) coupon rate Small changes in interest rate will have greater impact on yield to maturity and bond.

Bond valuation

Bond valuation is the process of determining the fair price of a bond. The fair value of a bond is the present value of the stream of cash flows it is expected to generate. (1) general relationship (2) bond pricing

General Relationships o Present value relationship Coupon yield Current yield Yield to maturity Present value relationship C F Po = ----------- + -----------(1+r) t (1+r) T There is inverse relationship between price and discount rate. The higher the interest rate the lower the price of a bond Coupon yield Coupon yield are called nominal yield Coupon yield = C/F C: is coupon payment F: is percentage of face value Current yield Current yield = coupon payment / bond price

YTM

If YTM increases, the rate of return will be less than yield. If the YTM decreases, the rate of return will be greater than yield.

Bond pricing Relative price approach Arbitrage free price approach Arbitrage free price approach C F Po = ------------ + -----------(1+r t) t (1+rT) T

Relationship between long term &short term rates (1) When long term rate is greater than short term rate than the term structure is upward sloping (2) when short term rate is greater than long term rate then term structure will be downward sloping Q: the term structure of interest rate, also know as ----------? Coupon rate Coupon yield Yield curve Current yield

Q: there are ----------- main patterns created by the term structure of interest rate? Two Three Five Eight Market interest rate In market interest rate ultimately includes money market, bond market, stock market, and currency market as well as retail financial institutions like bank. Risk free cost of capital Real interest on risk free loan, while no loan is ever entirely risk-free

Rate of incorporates the deferred consumption and alternative investment is element of interest. Inflationary expectations In = ir+pe In: nominal interest rate Ir: real interest rate Pe: inflationary expectations

Risk The level of risk in investment is taken into consideration. Risk premium

The extra interest charged on risky investment is called risk premium Longer-term investment carries a maturity risk premium, because long term loan are more exposed to more risk of default during this duration.

Liquidity preference

Cash is on hand to be spent immediately if the need arises, but some investments require time or effort to transfer into spending able form. This is known as liquidity preference

Lesson # 7

DIVIDEND DISCOUNT MODEL Dividend discount model states that todays price is equal to the present value of all future dividends. After One year

P0 = Div + P1 / (1 + r) After 2 years the value of stock is: =div1/ (1+r) + div2+P2/ (1+r) 2 After 3 years the value of stock is: =div1/(1+r) + div2/(1+r)2 + div3+P3/(1+r)3 PV of stock depends only on future dividends . DIVIDEND GROWTH MODELS: If the value of stock is the PV of all future dividend then PV = DIV / r When company pay out everything as dividend then earnings and dividend will be equal and PV can be calculated as: PV = EPS / r CONSTANT GROWHT MODEL: P0 = D1 x (1+g) / (r g) This is known as Constant-growth Dividend Discount Model or Gordon Growth Model Gordon model is valid as long as g < r

Lesson 8

Fundamental Analysis

In large organizations fundamental analysis is usually performed in three steps: Analysis of the macroeconomic situation, usually including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. Industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Individual firm analysis of unit sales, prices, new products, earnings, and the possibilities of new debt or equity issues Often the procedure stresses the effects of the overall economic situation on industry and firm analysis and is known as top down analysis. If instead the procedure stresses firm analysis and uses it to build its industry analysis, which it uses to build its macroeconomic analysis, it is known as bottom up analysis.

Capital budgeting Capital Budgeting is the planning process used to determine a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects. Capital budgeting process is carried out for projects involving heavy initial upfront cost.

BY PROJECT SIZE

BY TYPE OF BENEFIT TO THE FIRM BY DEGREE OF DEPENDANCE BY DEGREE OF STATISTICAL DEPENDANCE BY TYPE OF CASH FLOW

Relevant Costs: These are costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs. Every decision involves a choice between at least two alternatives. To identify which costs are relevant in a particular situation, take this three step approach: 1. Eliminate sunk costs and committed costs 2. Eliminate costs and benefits that do not differ between alternatives 3. Compare the remaining costs and benefits that do differ between alternatives to make the proper decision. 4. Take care of opportunity cost

Lesson 9

Net present value (NPV) Two aspects of NPV method of project evaluation

(1) initial investment or upfront cost (2) benefit (cash flow) emerging from the project

The present value of future cash flow is calculated using a discount rate. And if this PV of future cash flow is greater than the initial investment, the NPV is stated as positive. If the PV of future cash flow is less than initial investment, then it is better to scrap the project. NPV = PV required investment Formula net present value NPV = Co +C1 / 1+r Co = the cash flow at time o or investment and therefore cash outflow r = the discount rate/the required minimum rate of return on investment The discount factor r can be calculated using: Q (t, i) = 1/ (1+i) t

Weighted Average Cost of Capital All capital sources - common stock, preferred stock, bonds and any other longterm debt - are included in a WACC calculation. Multiply the cost of each capital component by its proportional weight and the summing

Formula WACC = E / V * Re + D / V * Rd * ( 1 Tc )

Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt

V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Opportunity Cost The cost of an alternative that must be forgone in order to pursue a certain action is called opportunity cost.

Lesson 10

The Internal Rate of Return (IRR) The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. (1)The IRR is the break-even discount rate. (2)The IRR is found by trial and error.

Q (n, r) is the discount factor Io is the initial outlay C is the uniform annual receipt (C1 = C2 =....= Cn).

Net present value vs. Internal rate of return NPV and IRR methods are closely related because: i) Both are time-adjusted measures of profitability, and ii) Their mathematical formulas are almost identical.

NPV vs. IRR: Independent projects Independent project: Selecting one project does not preclude the choosing of the other. With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRR lead to the same accept/reject decisions. NPV vs. IRR: Dependent projects NPV clashes with IRR where mutually exclusive projects exist.

Advantage of NPV: It ensures that the firm reaches an optimal scale of investment

Lesson 11

THE PAYBACK PERIOD (PP) The time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years'. When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. Payback is often used as a "first screening method".

PP = Io / Ct

DISADVANTAGES OF PAYBACK (1) It Ignore The Timing Of Cash Flow Within The Payback Period, The Cash Flow After The End Of Payback Period And Therefore The Total Project Return (2) It ignore the time value of money (3) Unable to distinguish between projects within the same payback period. (4) It may lead to excessive investment in short-term projects

Advantages of the payback method Payback can be important: long payback means capital tied up and high investment risk. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept

DISCOUNTED PAYBACK PERIOD Length of time required to recover the initial cash outflow from the discounted future cash inflows. This is the approach where the present values of cash inflows are cumulated until they equal the initial investment.

THE ACCOUNTING RATE OF RETURN ARR method also called return on capital employed (ROCE) or return on investment (ROI)

Formula

ARR on total investment = net annual profit / investment outlay Or = [Rt+ c-d / Io]

Profitability index

This is also known as benefit-cost ratio. It is a relationship between the PV of all the future cash flows and the initial investment. This is a variant of the NPV method

PI= PV / Io

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