Financial Management 1

Question No:1

1. 1 Identify the principal financial policies being debated.

2. 2 considering the perpective of management only, what tendencies do you see
in each of these financial policies?
3. considering the perspective of shareholders only, what tendencies do you see
in each of these financial policies?
4. the Mustafa company creditors are not directly mentioned in the case but
what do you think their preferences would be with regard to each of the
financial policies?
5. use some ideas of your own to indicate how Mustafa company shareholders
might persuade management to move in the direction of shareholders
preferences.

Ans:

The Role of Financial Management

• What is Financial Management?

• The Goal of the Firm
• Corporate Governance
• Organization of the Financial Management Function

What is Financial Management?

Concerns the acquisition, financing, and management of assets with some overall goal in
mind

Most important of the three decisions.

• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or eliminated?

Financing Decisions
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance
sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g., dividend-payout ratio)?
• How will the funds be physically acquired?

Asset Management Decisions

• How do we manage existing assets efficiently?

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Financial Management 2

• Financial Manager has varying degrees of operating responsibility over assets.

• Greater emphasis on current asset management than fixed asset management.

Maximization of Shareholder Wealth!

Value creation occurs when we maximize the share price for current shareholders.
Shortcomings of Alternative Perspectives

Preauthorized Payments

Preauthorized debit
The transfer of funds from a payor’s bank account on a specified date to the payee’s bank
account; the transfer is initiated by the payee with the payor’s advance authorization.

Strengths of Shareholder Wealth Maximization

• Takes account of: current and future profits and EPS; the timing, duration,
and risk of profits and EPS; dividend policy; and all other relevant factors.
• Thus, share price serves as a barometer for business performance

Social Responsibility
• Wealth maximization does not preclude the firm from being socially
responsible.
• Assume we view the firm as producing both private and social goods.
• Then shareholder wealth maximization remains the appropriate goal in
governing the firm

Corporate Governance
• Corporate governance: represents the system by which corporations are managed
and controlled.
o Includes shareholders, board of directors, and senior management.
• Then shareholder wealth maximization remains the appropriate goal in governing
the firm.

Sarbanes-Oxley Act of 2002

• Sarbanes-Oxley Act of 2002 (SOX): addresses corporate governance, auditing
and accounting, executive compensation, and enhanced and timely disclosure of
corporate information

o Imposes new penalties for violations of securities laws

o Established the Public Company Accounting Oversight Board (PCAOB)
to adopt auditing, quality control, ethics, disclosure standards for public
companies and their auditors, and policing authority
o Generally increasing the standards for corporate governance

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Financial Management 3

Financial Planning
• Flow of Funds (Sources and Uses) Statement
• Accounting Statement of Cash Flows
• Cash-Flow Forecasting
• Range of Cash-Flow Estimates
• Forecasting Financial Statements

Flow of Funds Statement

A summary of a firm’s changes in financial position from one period to another; it is also
called a sources and uses of funds statement or a statement of changes in financial
position

Types of Common Stock Value

Market Value (per share) -- The current price at which the stock is currently trading
• This value is usually greater than book value (per share), but can occasionally be
less than book value (per share) for firms that have been, are or expected to be in
financial difficulties. Rarely are the two values identical.
• Market value (per share) may be difficult to obtain from thinly traded securities.
• Typically, the shares of new companies are traded in the over-the-counter (OTC)
market, where dealers maintain an inventory of the stock to provide additional
liquidity.

Rights of Common Shareholders

• Right to Income -- entitled to share in the earnings of the company only if
cash dividends are paid (via approval by the board of directors).
• Right to Purchase New Shares (Maybe) -- the corporate charter of state statute
may provide current shareholders with a preemptive right, which requires that
these shareholders be first offered any new issue of common stock or an issue
that can be converted into common stock.
• Voting Rights -- because the shareholders are owners of the firm, they are
entitled to elect the board of directors

Voting Rights

Shareholders are generally geographically widely dispersed

• Two methods of voting: (1) in person or (2) by proxy
• Proxy -- A legal document giving one person authority to act for another.
• SEC regulates the solicitation of proxies and requires companies to disseminate
information to their shareholders through proxy mailings.
• Most shareholders, if satisfied with company performance, sign proxies in behalf
of management

Profit Maximization

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 Financial Management 4

• Maximizing a firm’s earnings after taxes.

Problems
1. Could increase current profits while harming firm (e.g., defer maintenance, issue
common stock to buy T-bills, etc.).
2. Ignores changes in the risk level of the firm.

Earnings per Share Maximization

• Maximizing earnings after taxes divided by shares outstanding.

Problems
• Does not specify timing or duration of expected returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.

Strengths of Shareholder Wealth Maximization

• Takes account of: current and future profits and EPS; the timing, duration,
and risk of profits and EPS; dividend policy; and all other relevant factors.
• Thus, share price serves as a barometer for business performance

Role of Management
Management acts as an agent for the owners (shareholders) of the firm
An agent is an individual authorized by another person, called the principal, to act in the
latter’s behalf

Organization of the Financial Management Function

VP of Finance

Controller
Treasurer • Cost Accounting
• Capital Budgeting • Cost Management
• Cash Management • Data Processing
• Credit Management • General Ledger
• Dividend Disbursement • Government Reporting
• Fin Analysis/Planning • Internal Control
• Pension Management • Preparing Fin Stmts
• Insurance/Risk Mngmt • Preparing Budgets
• Tax Analysis/Planning • Preparing Forecasts

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Financial Management 5

Question No 2:

a) Critically examine the relationship between ROA and ROA.Give example in

support of your answer.
b) What are the five groups of ratios? give two or three example in of each kind.
c) The most recent income statement of allied chemical Ltd is given below.
prepare a common size income statement based on this information. Give
interpretation to the standardization net income. what percentage of sales
goes to cost of good sold?

Ans (a)

Return on Equity
Indicates the profitability to the shareholders of the firm (after all expenses and taxes).

Net Profit after Taxes

=
Shareholders’ Equity

$ 91
= .08
$ 1139

Profitability Ratio Comparisons

Return on Equity

Year BW Industry
2007 8 .0% 17.9%
2006 9.4 17.2
2005 16.6 20.4

BW has a poor Return on Equity.

Return on Equity and the Du Pont Approach

Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier

Equity Multiplier = total Assets

Shareholder equity

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Financial Management 6

ROE2007 = .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179

Return on Equity -Trend Analysis Comparison

Trend Analysis of Return on Equity

21.0

17.5
Ratio Value (%)

14.0
BW
Industry
10.5

7.0
2005 2006 2007
Analysis Year

Return on Assets

Net Profit after Taxes $ 91

= = .042
Total Assets $ 2160

Indicates the profitability on the assets of the firm (after all expenses and taxes).

Return on Assets
Year BW Industry
2007 4.2% 9.8%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Assets

Ans(b)

Use of Financial Ratios

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Financial Management 7

A Financial Ratio is an index that relates two accounting numbers and is obtained by
dividing one number by the other.
Types of Comparisons
• Internal Comparisons
• External Comparisons

External Comparisons and Sources of Industry Ratios

This involves comparing the ratios of one firm with those of similar firms or with
industry averages.
Similarity is important as one should compare “apples to apples.”

Examples:
• Risk Management Association
• Dun & Bradstreet
• Almanac of Business and Industrial Financial Ratios
• Liquidity Ratios
• Balance Sheet Ratios

Balance Sheet Ratios

Loquidity Ratios

Shows a firm’s ability to cover its current liabilities with its current assets Current

Current Assets
=
Current Liabilities

$1195 =$2.39

$500

Liquidity Ratio Comparisons

Current Ratio

Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01
Ratio is stronger than the industry average.

Liquidity Ratios
Shows a firm’s ability to meet current liabilities with its most liquid assets.
Acid-Test (Quick)

Current Assets - Inv

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Financial Management 8

=
Current Liabilities

$1195-$696 = 1.00

$500

Liquidity Ratio Comparisons

Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25
Ratio is weaker than the industry average.

Summary of the Liquidity Ratio Comparisons

Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25

• Strong current ratio and weak acid-test ratio indicates a potential problem in
the inventories account.
• Note that this industry has a relatively high level of inventories.
Current Ratio -- Trend Analysis Comparison

Trend Analysis of Current Ratio

2.5
2.3
Ratio Value

2.1
1.9 BW
Industry
1.7
1.5
2005 2006 2007
Analysis Year

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Financial Management 9

Summary of the Liquidity Trend Analyses

• The current ratio for BW has been rising at the same time the acid-test ratio
has been declining.
• The current ratio for the industry has been rising slowly at the same time the
acid-test ratio has been relatively stable.
• This indicates that inventories are a significant problem for BW

Financial Leverage Ratios

Debt-to-Equity

Total Debt
=
Shareholders’ Equity

Shows the extent to which the firm is financed by debt

$1030
= .90
$1139

Financial Leverage Ratio Comparisons

Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89

BW has average debt utilization relative to the industry average.

Financial Leverage Ratios

Debt-to-Total-Assets

Total Debt

Total Assets

Shows the percentage of the firm’s assets that are supported by debt financing

$1130 = .47

$2169

Financial Leverage Ratios Total Capitalization

Long-term Debt

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Financial Management 10

Total Capitalization
Shows the relative importance of long-term debt to the long-term financing of the firm.

$530 = .32

$1669
Coverage Ratios
Interest Coverage
EBIT
=
Interest Charges
Indicates a firm’s ability to cover interest charges.

$ 210 =3.56
$ 59

Summary of the Coverage Trend Analysis

• The interest coverage ratio for BW has been falling since 2005. It has been below
industry averages for the past two years.
• This indicates that low earnings (EBIT) may be a potential problem for BW.
• Note, we know that debt levels are in line with the industry averages.

Activity Ratios
Receivable Turnover

Annual Net Credit Sales Receivables

Indicates quality of receivables and how successful the firm is in its collections.

$ 2211
= 5.61
$ 394

Avg Collection Period

Days in the Year

= 65 days
Receivable Turnover
PT in Days

Days in the Year

Payable Turnover

365

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Financial Management 11

= = 22.1 days
16.5
Profitability Ratios
Gross Profit Margin

Gross Profit 612

= = .277
Net Sales 2211

Net Profit Margin

Net Profit after Taxes $ 91

= .041
Net Sales $ 2211

Indicates the firm’s profitability after taking account of all expenses and income taxes.

Coverage Example
Make an examination of the coverage ratios for Basket Wonders when EBIT=$500,000.
Compare the equity and the debt financing alternatives.

Assume that:
• Interest expenses remain at $100,000
• Principal payments of $100,000 are made yearly for 10 years
Compare the interest coverage and debt burden ratios for equity and debt financing.

Interest Debt-service
Financing Coverage Coverage
Equity Infinite Infinite
Debt 5.00 2.50
The firm actually has greater risk than the interest coverage ratio initially suggests.

Summary of Ratio Analyses

• Inventories are too high.
• May be paying off creditors (accounts payable) too soon.
• COGS may be too high.
• Selling, general, and administrative costs may be too high.

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Financial Management 12

Question No ;5
(a) what is the relationship between the required rate of return on an investment
and the cost of capital associated with that investment?
(b) The earnings dividends and stock price of ehsaan technologies inc, are
expected grow at 7% per year in the future.Eshaan’s common stock sells for
Rs.23 per share, its last dividend was Rs.2.00, and the company will pay a
dividend of Rs.2.14 at the end of the current year.
I. What is company’s cost of equity?
II. If the firm’s beta is 1.6, the risk free rate is 9%, and the expected return
on the market is 13%, what will be the firm’s cost of equality using the
CAPM approach?

Ans:

Defining Return
Income received on an investment plus any change in market price, usually expressed as
a percent of the beginning market price of the investment.

Dt + (P
Pt - Pt-1 )
R =
Pt-1

Return Example
The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading
at $9.50 per share and shareholders just received a $1 dividend. What return was earned
over the past year?
The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading
at $9.50 per share and shareholders just received a $1 dividend. What return was earned
over the past year?

R= $1.00 + ($9.50 - $10.00 ) = 5%

= $10.00

Determining Expected Return (Discrete Dist.)

R = S ( Ri )( Pi )
• R= is the expected return for the asset,
• Ri= is the return for the ith possibility,
• Pi =is the probability of that return occurring,
• n =is the total number of possibilities.

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Financial Management 13

• S=Determination of the Required Rate of Return Small-firm Effect Price /

Earnings Effect
Required Returns and the Cost of Capital
Creation of Value
Overall Cost of Capital of the Firm
Project-Specific Required Rates
Group-Specific Required Rates
Total Risk Evaluation

Key Sources of Value Creation

Industry Attractiv
Overall Cost of Capital of the Firm
Cost of Capital is the required rate of return on the various types of financing. The
overall cost of capital is a weighted average of the individual required rates of return
(costs). Growth Barriers to
Market Value of Long-Term Financing phase of competitive
product entry
Type of Financing Mkt Val Weight
Long-Term Debt $ 35M 35% cycle
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
$ 100M 100%

Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company.

ki = kd ( 1 - T ) Marketing
and Pe
Cost q
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Financial Management 14

Determination of the Cost of Debt

Assume that Basket Wonders (BW) has $1,000 par value zero-coupon bonds outstanding.
BW bonds are currently trading at $385.54 with 10 years to maturity. BW tax bracket is
40%.
$385.54 = $0+$1000
(1 + kd)10

Determination of the Cost of Debt

(1 + kd)10 = $1,000 / $385.54 = 2.5938 (1 +

kd) = (2.5938) (1/10) = 1.1
kd = .1 or 10%

ki = 10% ( 1 - .40 )
ki = 6%

Cost of Preferred Stock

Cost of Preferred Stock is the required rate of return on investment of the preferred
shareholders of the company.

kP = DP / P0

Determination of the Cost of Preferred Stock

Assume that Basket Wonders (BW) has preferred stock outstanding with par value of
$100, dividend per share of $6.30, and a current market value of $70 per share.

kP = $6.30 / $70
kP = 9%

Cost of Equity Approaches

• Dividend Discount Model
• Capital-Asset Pricing Model
• Before-Tax Cost of Debt plus Risk Premium

Dividend Discount Model

The cost of equity capital, ke, is the discount rate that equates the present value of all
expected future dividends with the current market price of the stock
Constant Growth Model
The constant dividend growth assumption reduces the model to:

ke = ( D1 / P0 ) + g
Assumes that dividends will grow at the constant rate “g” forever.

Determination of the Cost of Equity Capital

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Financial Management 15

Assume that Basket Wonders (BW) has common stock outstanding with a current market
value of $64.80 per share, current dividend of $3 per share, and a dividend growth rate of
8% forever.
ke = ( D1 / P0 ) + g
ke = ($3(1.08) / $64.80) + .08
ke = .05 + .08 = .13 or 13%

Capital Asset Pricing Model

The cost of equity capital, ke, is equated to the required rate of return in market
equilibrium. The risk-return relationship is described by the Security Market Line
(SML).

ke = Rj = Rf + (Rm - Rf)bj

Determination of the Cost of Equity (CAPM)

Assume that Basket Wonders (BW) has a company beta of 1.25. Research by Julie
Miller suggests that the risk-free rate is 4% and the expected return on the market is
11.2%
ke = Rf + (Rm - Rf)bj
= 4% + (11.2% - 4%)1.25
ke = 4% + 9% = 13%

Before-Tax Cost of Debt Plus Risk Premium

The cost of equity capital, ke, is the sum of the before-tax cost of debt and a risk premium
in expected return for common stock over debt.
ke = kd + Risk Premium*

* Risk premium is not the same as CAPM risk premium

Determination of the Cost of Equity (kd + R.P.)

Assume that Basket Wonders (BW) typically adds a 3% premium to the before-tax cost
of debt.
ke = kd + Risk Premium
= 10% + 3%
ke = 13%

Comparison of the Cost of Equity Methods

Constant Growth Model 13%
Capital Asset Pricing Model 13%
Cost of Debt + Risk Premium13%

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