Financial Ratios

Liquidity Ratios: the extent to which a company is able to pay off its short term obligations.

Current Ratio: Current Assets/Current Liabilities

Quick Ratio: Current Assets-Inventory/Current Liabilities
Cash Equivalents Ratio: Cash + Cash Equivalents/Current Liabilities
Net Working Capital: Current Assets Current Liabilities

Solvency Ratios

Debt Ratio: Total Liabilities/Total Assets

If a company has a debt ratio of 0.4. It can be said that 40% of assets are contributed by external
capital
Debt-To-Equity: Total Liabilities/Total Equity
The higher the number, the higher the debt and thus the risk
Equity Multiplier: Total Assets/Total Equity
The extent to which assets are contributed by total equity
Times Interest Earned Ratio: EBIT/Interest Cost
Cash Coverage Ratio: EBIT+Depreciation/Interest Cost

Efficiency Ratios

Inventory Turnover: Costs of Goods Sold/Average Inventory

the amount of times inventory is sold and replaced
Days in Inventory: 365/Inventory Turnover
Receivable Turnover: Net Credit Sales/Average Receivables
The amount of times a company receives its receivables in a year
Total Assets Turnover Ratio: Sales/Total Assets
How much does $1 of assets generate in revenue
Operating Cash Flow: EBIT+Depreciation-Tax

Profitability Ratios

Profit Margin: Net Income/Sales (Revenue)

How much of the revenue is kept as net income
Return on Assets: Net Income/Total Assets
With $1 of assets, how much of net income is generated
Return on Equity: Net Income/Total Equity
With $1 of equity, how much of net income is generated

Market Prospect Ratios

Earnings Per Share: Net Income/Shares Outstanding

Net income generated per share
Price Earnings Ratio: Price per share/Earnings per share
How much investors are willing to pay for $1 of earnings
Price per Share: EPS/r
Future & Present Value

Future Value: how much will $100 be worth in 5 years

Present Value: if you received $100 in 5 years, how much will it be worth at t=0

Simple Interest: FV = CF (1 + rt)

Compound Interest: FV = CF (1 + )

CF
no constant cash flow: PV = (1+r)t

CF
Perpetuity: PV =
r

Growing Perpetuity: PV =

1
1
(1+)
Annuity: PV = CF [
]
1+
1( )
1+
Growing Annuity: PV = CF [ ]

Semi-Annual payments: FV = CF (1 + ) ( one time deposit of $1000)


Effective Annual Rate: periodic investments (annual deposits of $25 000) EAR = [1 + ] 1

(1+) 1
Then, plug the r into: FV = CF [ ]
Continuous Interest Payments: FV = CF

Annual Percentage Rate: PV = Co + =1 (1+) example 4.12

Delayed Annuities
Roberta will receive a 4-year annuity of $500 per year, beginning at year 6. If the r is 0.1, what is the
PV of her annuity?
- Calculate a 4-year annuity
1584.95
- Discount the present value of the annuity back to date 0: PV = 5
1.1

Annuity Due
Mark received $50 000 a year for 20 years. The first payment occurs immediately
Therefore: $50 000 + 19

Infrequent Annuities
Ann receives an annuity of $450 payable once every 2 years. The annuity stretches out over 20 years.
The annual interest rate is 6%. The interest rate over 2 years: (1.06 1.06) 1 = 12.36%
Therefore, do an annuity over 10 period with an interest rate of 12.36%

If there are six $5000 semi-annual payments with a discount rate of 10% compounded monthly
Monthly rate = 0.1/12 = 0.008333
EAR (semi-annual rate) -> (1.008333)^6-1
Then in the annuity formula, use thex semi-annual rate, and t=12 since (6*semi-annual)
Bonds & Stocks
1
1
(1+)
Level-Coupon Bonds: PV = C [ ]+
(1+)
F
Zero-Coupon Bonds: PV = (1+)

Consols: PV =

Dividend Growth Model: Price of share =
g = retention ratio return on retained earnings
o retention ratio: % of the net income that remains in the company
Net Income
o return on retained earnings: Total Assets (ROA)

Cash Cow: all earnings per share are paid out to the shareholders and not any part of the net income
EPS Div
remains in the organisation r = r . In other words, EPS = Dividend

EPS
Share price after growth opportunity: R
+ NPVGO

Sarro expects to earn $1 million per year in perpetuity if it undertakes no new investment
opportunities. There are 100 000 shares, therefore EPS is 10. The firm will have an opportunity at
date 1 to spend $1 million on a new marketing campaign. The new campaign will increase earnings in
each period by $210 000. The firms discount rate is 10%. What is the share price before and after
deciding to accept the market campaign?

10 EPS
Share price of Sarro when firm acts as a cash cow: = 100 =
0.1 R
210 000
The value of marketing campaign at date 1: 1 000 000 + 0,1 = 1 100 000
1 100 000
Value of marketing campaign at date 0: 1.1 = 1 000 000
Thus, NPVGO per share is $10 (1 000 000/100 000 shares)
The share price is: 100+10=$110
NPV & Other Investment Rules
Capital Budgeting the decision-making process for accepting or rejecting projects

Net Present Value: + =1 (1+)
accept if NPV > 0
reject if NPV < 0
NPV uses cash flows rather than accounting profits. It is also based on all cash flows of a project.
However, it does not take into account the duration of the project.

Any adjustments in the future are called real options:

1. The project can be extended
2. The project can be terminated
3. Cash flows may increase with time

Other Investment Rules:

Payback Period: the time needed to earn back the initial investment
o does not take into account the time value of money
o cash flows after the payback period are not taken into account
o arbitrary
Discounted Period: slight better, in a way that it does take into account the time value of
money
Average Profit
Average Accounting Return:
Average Investment
o Av. Profit = sum of net incomes/number of operating years
o Av. Investment = investment/2
o If AAR > r, accept
o If AAR < r, reject
Internal Rate of Return
o Investment project: if IRR > r, accept
o Financing project: if IRR > r, reject
o IRR should not be used for mutually exclusive projects, but only to decide whether a
single project is worth investing
o When cash flows of a project change sign more than once, there will be multiple
IRRs.

When determining incremental cash flows from a new project, several problems arise:
- Sunk costs: costs made before the moment of decision
- Opportunity costs: costs someone sacrifices by choosing or something over something else
- Side effects: the addition to Newco's plant is for the purpose of producing a new product. It
must be considered whether the new product may actually take away or add to sales of the
existing product.
- Allocated costs: the new project takes sales away from the existing product

1+nominal interest rate

Inflation: 1
1+inflation percentage

Question 3 of the exam

Risk and Returns
+1 +1
Return: the amount an investor earns on its investment: + 1 = +

Arithmetic mean
Geometric mean: [(1 + = 1) (1 + = 2) (1 + = )]1/ 1
Holding Period Return: [(1 + = 1) (1 + = 2) (1 + = )] 1

Risk: the more volatile the stock, the more risk

Calculate the arithmetic mean
((=12 )+((=22 )+((=2 )
Calculate the variance:
1
Calculate the standard deviation: = Variance

If an investor owns several stocks, then it is called a portfolio

The extent to which shares are related to each other could be determined with covariance and
correlation

Covariance: 1(Ra, t = 1 Ra) (Rb, t = 1 Rb) + n(Ra, t = n Ra) (Rb, t = n Rb)

Cov(RaRb)
Correlation: (Ra)(Rb)

The diversification effect only occurs when the correlation between two securities is below 1.

Variance of portfolio: 2 2 + 2 2 + 2()

Capital Asset Pricing Model: takes into account the risk while calculating the returns

= + ( )

R = expected return on a share or portfolio

Rf = the risk-free rate
= Measure of risk
Rm return on the market portfolio

R = Rf+SlopeCML(a)
SlopeCML = (Rm-Rf)/m

Beta: is a measure of risk of a stock or portfolio. It is a number that indicated the volatility of a share
compared to the market. If a specific share price increases at the same rate as the market, then the
share has a beta of 1.

=
2

Systematic Risk: type of risk that concerns the entire financial market. Eg: recessions
Unsystematic Risk: type of risk specific to an investment
Chapter 10 graphs

Security Market Line

Capital Market Line