Finance

Dr. Suhaib Anagreh

 AREAS IN FINANCE

• Financial Analysis

• Financial Management
 WHAT IS FINANCIAL
MANAGEMENT ?

FINANCIAL MANAGEMENT IS CONCERNED

WITH THE CREATION AND MAINTANENCE OF
ECONOMIC VALUE OR WEALTH

*Management vs Analysis
 RESPONSIBILITY OF THE
FINANCIAL MANAGER

RESPONSIBLE FOR OBTAINING AND

EFFICIENTLY UTILISING THE FUNDS
NECESSARY FOR EFFICENT
OPERATIONS
FUNCTIONS OF FINANCE

1. INVESTMENT DECISIONS

2. FINANCING DECISIONS

3. DIVIDEND DECISIONS

4. OPERATING DECISIONS
 TYPES OF ASSETS

1) FINANCIAL ASSETS - Examples:

a. EQUITIES (STOCKS)
b. DEBT (BONDS)
c. DERIVATIVE (OPTIONS)

2) PHYSICAL ASSET OR REAL ASSET OR

TANGIBLE ASSET – Examples:
a. LAND
b. BUILDINGS
c. EQUIPMENTS

3) INTANGIBLE ASSET
 TIME VALUE OF MONEY

Determine the attractiveness of different

projects

Take into consideration the effect of inflation

on the future cost of assets

Why Time? Which Value?

 Why TIME?

 When to calculate future value “FV”?

Loan example when FV = zero

When to calculate present value “PV”?

Pension scheme when PV = zero
 Compounding vs. Discounting

 Compounding
PV is the starting known value and for a
series of cash flows, when compound
interest is applied, to compute FV

 Discounting
FV is the starting known value and for a
series of cash flows, when discount interest
is applied, to compute PV
 Process

The Arithmetic process of determining the final value of a cash flow

or series of cash flows when interest is added:
• Once a year Annual compounding

• Twice a year Semiannual Compounding

• Every Three Months Quarterly Compounding

• Every month Monthly Compounding

• Every week Weekly Compounding

• Every Day Daily Compounding

 Interest Rate

 Nominal interest
The contracted, or quoted or stated interest rate

 Real Interest rate

The inflation adjusted interest rate is known as
real interest rate

 Why investors refer directly or indirectly to

interest rates when analyzing their projects ?
 Simple vs. Compounded
Interest

• Simple Interest:
FV = PV + PV(I)(N)
= AED100 + AED100(5%)(3)
= AED100 + 15 = AED115

• Compounded Interest:
FV = PV + PV (1+I)3
= AED100 + AED100(1+0.05)
= AED115.76
 TERMINOLOGIES
 Annuity
A series of payments of an equal amount at fixed intervals for a specified number of periods

 Ordinary ( Deferred ) Annuity

Payments occurring at the end of each period

 Annuity Due
Payments occurring at the beginning of each period

 Perpetuity
Equal payments expected to occur forever

 Payment (PMT)
This term designates equal cash flows coming at regular intervals

 Uneven cash flow stream

Series of cash flows are changing between two consecutive periods

 Amortized loan
A loan that is repaid in equal payments over its life
 Using Financial Calculator

 TVM Calculators:
• PV
• PMT
• FV
• RATE
• Number of Periods

NOTES:

1. Negative and positive signs

2. PMT = 0 (because there are no payments until the security matures)

3. Compounding intervals (annually, semiannually, quarterly, etc…)

4. Mode: ending / Begin

 Phases to practice

• Phase 1:
 Annuities = Zero
 End Mode
• Phase 2:
 Annuities = Zero
 Begin Mode
• Phase 3:
 Annuities ≠ Zero
 ANNUITY

How to draw and use a timeline?

 ORDINARY vs. DUE
Annuities
• ANNUITY means when payments EQUAL and are made at FIXED
INTERVALS

• ORDIANRY (or DEFFERED) ANNUITY: when payments occur at

the end of each period.

DRAW THE TIMELINE

• ANNUITY DUE: when payments are made at the beginning of

each period (ex. Rental lease payments, life insurance premiums)

DRAW THE TIMELINE

 Future Value of an Ordinary
Annuity
 Assume that you deposit AED175,000 at the end
of each year for 5 years and earn 8% per year.

Using Financial calculators:

N =5
I/YR = 8
PV =0
PMT = -175,000
Compounding Mode: Annually
ENDING
Therefore: FV = AED 1,026,655
 Future Value of an Annuity Due

 Assume that you deposit AED175,000 at the end

of each year for 5 years and earn 8% per year.

Using Financial calculators:

N =5
I/YR =8
PV =0
PMT = -175,000
Compounding Mode: Annually
BEGINNING

Therefore: FV = AED 1,108,788

 Now Practice finding PV…

Ordinary Annuity

Vs.

Annuity Due

What can be your interpretation?

*Hint FV = 0
 PERPETUITIES

 Some securities promise to make payments

for ever

 The term STUCK, and now any bond that

promises to pay interest perpetually is also
called a CONSOL or a PERPETUITY

 If the rate is 2.5%, so a CONSOL with a face

value of AED1,000 would pay AED25 per
year in perpetuity
ANNUITIES PLUS ADDITIONAL
FINAL PAYMENT

• PMT = -100
• FV = -1000
• RATE = 12%
• PERIODS =5
• Compounding : Annually – End

Therefore, PV = AED 927.9

 IRREGULAR / UNEVEN
CASH FLOW STREAM

 Financial Calculators “NPV”:

– Discount Rate = 12%
– Series of Cash Flows:
 CF0 =0
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = 300
 CF5 = 500

• Therefore, NPV = AED 1,016.35

 Future Value of An Uneven
Cash Flow Stream
 Sometimes called the terminal, horizon or value

 Finding the NPV from the previous example then

compound the NPV to find the NFV

• NPV = 1,016.15
• PMT =0
• I = 12%
• N =5
• Compounding : Annually – End

– Therefore FV = AED 1,791.16

 Finding Rate with irregular
cash flows
IRR function in Financial calculators:
 CF0 = -1000
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = 300
 CF5 = 500

• Therefore, IRR = 12.547%

 Effective rate vs Stated rate

• If a rate is quoted as 10 percent

compounded semiannually, then what this
means is that the investment actually pays
5 percent every six months. A natural
question then arises:

• Is 5 percent every six months the same

thing as 10 percent per year?
 EFFECTIVE ANNUAL RATE

• If you invest AED1 at 10 percent per year, you

will have AED1.10 at the end of the year.

• If you invest at 5 percent every six months,

then you’ll have the future value of:
AED1 x 1.052 = AED1.1025

This is AED0.0025 more

 EFFECTIVE ANNUAL RATE

• Bank A: 14 percent compounded daily

• Bank B: 14.5 percent compounded quarterly
• Bank C: 15 percent compounded annually

Which of these is the best if you are

thinking of opening a savings account?
Which of these is best if they represent
loan rates?
 EFFECTIVE ANNUAL RATE
• BANK C: there is no compounding during the year, this is the
effective rate 15%. Therefore AED 1 x 1.15 = AED……

• Bank B is actually paying .145/4 = ……… or ……. percent per

quarter.
Therefore AED1 x (………..)4 = AED………
The effective rate is ……..%.

• Bank A the daily interest rate is actually = 0.14/365= ………….

This is ……….% per day.
Therefore AED1 x (……….)365 = AED……..
The effective rate is ………%.

Conclusion: ……………………………………………………………….
 Effective or “Equivalent”
Annual Rate
• Assuming a loan at nominal rate of 12%
compounded quarterly

• Rate on Bank Loan

= (1+ 0.03)4 – 1.0 = 1.125509 – 1.0
= 0.125509 = 12.5509 %

• Credit Card:
= (1+0.01)12 - 1.0 = 12.6825%
ANNUAL PERCENTAGE RATE
(APR)

• If a bank quotes a car loan at 12 %

APR, is the consumer actually paying
12 % interest?

Surprisingly, the answer is NO.

ANNUAL PERCENTAGE RATE

• The APR is simply equal to the

interest rate per period multiplied by
the number of periods in a year.

• If a bank is charging 1.2 % per month

on car loans, then the APR that must
be reported is 1.2% x 12 = 14.4%.
 ANNUAL PERCENTAGE RATE

• An APR of 12 percent on a loan calling for

monthly payments is really 1 % per month.

• The EAR on such a loan is thus:

EAR = [1 + (APR/12)]12 - 1
= 1.0112 - 1 = 12.6825%
 DEBT

LOANS

BONDS
 AMORTIZED LOAN

 A loan that is to be repaid in equal amounts on a monthly,

quarterly, or annual basis is called an amortized loan.

 For example, a company borrows AED8,000,000, with the

loan to be repaid in 7 equal payments at the end of each of
the next 7 years. The lender charges 5% on the balance of
each year.

 HOW YOU CAN WRITE THE EQUATION?

 PV(8,000,000), FV(0), R(5%), P(7); therefore:

PMT = AED………..
 Bond Valuation

• A bond is a certificate showing that a borrower (issuer) owes a

specified sum. In order to repay the money, the borrower has agreed to
pay interest and principal on designated dates to the holder
(subscriber) of the bond.

• The date when the issuer of the bond makes the last payment is called
the maturity date of the bond. The bond is said to mature or expire on
the date of its final payment.

• The Par value, or face value of the bond represents the amount of
money (per each bond) a firm borrows and promises to repay on the
maturity date.

• BOND ISSUERS:
Federal Govt. and its Agencies, Local Municipalities, Corporations
 TYPES OF BONDS

 Pure Discount or Zero-Coupon Bonds

 Pay no coupons prior to maturity.
 Pay the bond’s face value at maturity.
 Coupon Bonds
 Pay a stated coupon at periodic intervals prior to maturity.
 Pay the bond’s face value at maturity.
 Perpetual Bonds (Consols)
 No maturity date.
 Pay a stated coupon at periodic intervals.
 Self-Amortizing Bonds
 Pay a regular fixed amount each payment period over the
life of the bond.
 Principal repaid over time rather than at maturity.
 GOVT. BONDS
 Treasury Bills
 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
 Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
 GOVT. BONDS (Cont’d)
 Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond.
 Treasury Strips
 Zero-coupon bond
 Created by “stripping” the coupons and principal from
Treasury bonds and notes.
 Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially

vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the
future.
Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.

40
Valuing Zero Coupon Bonds

• What is the current market price of a U.S. Treasury

strip that matures in exactly 5 years and has a face
value of $1,000. The yield to maturity is id=7.5%.
use the PV equation
𝐹𝑉
𝑃𝑉 =
(1+𝑖)𝑛

1000
5
= $696.56
1075
.
 C 1  F
Bond = 1  
rd  1  rd   1  rd n
n

Valuing Coupon Bonds

The General Formula

• What is the market price of a U.S. Treasury bond that has a

coupon rate of 9%, a face value of $1,000 and matures
exactly 10 years from today if the required yield to maturity
is 10% compounded semiannually?
using the one of the following general formulas:

C 1  M
Bond = 1   
id  1  id n  1  id n

OR
 EQUITY

What is a share?

Difference between a share and a stock

Shareholder’s Equity
 Terms used in Stock
Valuation Models
Dt = Dividend a stockholder expects to receive at the end of
period t.
D0 is the dividend that has been already been paid
(certainty).
Therefore, D1, D2, …….Dt are expected and may differ
among investors.

P0 = Actual market price of the stock TODAY.

𝑃෠ = Expected price of the stock at the end of the period t,

called intrinsic, or fundamental, value of the stock
today.

෡ could differ among investors whereas P0 is fixed

𝑷
and identical to all investors.
 Terms used in Stock
Valuation Models
Dt / P0 = Expected dividend Yield during the coming period. If
the stock is expected to pay a dividend of
D1=AED2 during the next 12 months and its
current price is P0= AED20, therefore, the
expected dividend yield is 2/20=0.10 = 10%.

𝑃෠ − 𝑃0
= Expected capital gain yield during the coming
𝑃0
period.
If the stock sells for AED20 today and it is expected
to rise to AED21.5 at the end of one year, then the
expected capital gain is:
=20-21 = AED1.5 and the expected capital gain
yield is 1.5/20 = 0.075 = 7.5%.
 Terms used in Stock Valuation
Models

g = Expected Growth rate in dividends.

Dividends may increase at a constant rate

rs = minimum acceptable return, or required rate

of return (taking into consideration other
investments’ risk and return
 LEGAL RIGHTS AND PRIVILEGES
OF COMMON STOCKS
 The common stockholders are the owners of a
corporation.

 Control the firm: elect (and remove) directors in the

annual meeting. Each share of stock has one vote.
This vote can be made personally or transfer such
right to another party via a proxy.

 The preemptive right: means the right to purchase

any additional shares sold by the firm. This will enable
shareholders to maintain control and prevent transfer
of wealth to new stockholders.
 STOCK VALUATION
Terms

 STOCK PRICE: is the current market price, and

can be observed for publicly traded companies

 INTRINSIC VALUE: is known as the true value,

not observed and must be calculated

 GOAL: investors should purchase stocks that are

undervalued and avoid stocks that are overvalued

 Fundamental Analysis vs. Technical Analysis

 STOCK PRICE & CASH FLOWS

D1 + P1
P0 =
(1+ r )

 P0 : the value of a share of stock today

 P1 : the value of a share of stock in period 1

 D1: is the cash dividend paid at the end of the period 1

 r : is the required return in the market on this investment

 STOCK PRICE
“D” shapes
 One Period

 Multiple Period – Constant D (growth Zero)

 Multiple period – Constant growth rate in “D”

 Multiple period – Non-Constant growth rate in “D”

 Stock price – one period

 IF you somehow know that the stock will be

worth AED30 next period. You predict that
the stock will also pay a AED1.5 per share
dividend at the end of the year

 IF you require a 25% return on your
investment, what is the most you would pay
for the stock?

Therefore, PV = (1.5 + 30) ÷ 1.25 = AED…..

 Stock price – multiple periods
Growth Zero

 D1 = D2 = D3= D = constant

𝐷 𝐷 𝐷 𝐷
 P0 = + + + ……… +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛

 P0 = D/R

 P0 = 30 / 0.25 = …….
 Stock price – multiple periods
Constant Growth
• This model assumes that dividends will grow at a constant rate, g. if
dividends grow at a constant rate forever, then we can calculate the
value of that cash flow stream by using the formula for a growing
perpetuity. Denoting next year’s dividend as D1, we can determine the
value today of a stock that pays a drividend growing at a constant rate:
D1
P0 =
𝑟−𝑔
• Assume that MicroDrive just paid a dividend of AED1.15 (that is, D0
AED1.15). Its stock has a required rate of return, rs, of 13.4%, and
investors expect the dividend to grow at a constant 8% rate in the future.
The estimated dividend 1 year hence would be D1 AED1.15 (1.08) =
AED1.24; D2 would be AED1.34; and the estimated dividend 5 years
hence would be AED1.69:
Dt = D0 + (1 + 𝑔)𝑡 = 1.15 + (1.08)5 = AED1.69
D1 1.24
P0 =
𝑟−𝑔
=
0.134−0.08
= ………..
 Stock price – multiple periods
Non-Constant Growth
Valuing the stock requires a variable growth model, one in which
the dividend growth rate can vary. Using the earlier definition of
D as most recent dividend paid, g the initial growth rate of
0 1

dividend, g the subsequent (stable) growth rate of dividends, n

2

the number of year in the initial growth period, we can write the
general equation for the variable growth model as follows:

D (1+g )1 D (1+g )2
0 1 0 1 D (1+g )𝑛 0 1 1 D n+1
P0 = (1+r )1 + (1+r )2 + ….. + (1+r )𝑛 + 𝑥 𝑟 −g
(1+r )n 2

present value of dividends present value of stock

during initial growth period at end of initial growth period
 Stock price – multiple periods Non-Constant Growth
Example

A food company has developed a new fat-free ice cream and, as it became more and
more popular, the firm expected to grow rapidly at as much as 20% per year. Overtime,
as the market share of this new food increases, the firm growth rate will reach a steady
state. At that point, the firm may grow at the same rate as the overall economy, perhaps
5% per year. Assume that the market required rate of return on this stock is 14%.

To value the firm’s stock, we first need to break the future stream of cash flows into two
parts: the first consists of the period of rapid growth, and the second is the constant
growth phase. Suppose the firm’s most recent dividend was AED 2 per share. It is
anticipated that the firm will increase the dividend by 20% per year for the next three
years, after it which time it will grow at 5% per year indefinitely. The expected dividend
steam looks like this:
Stable Growth
Fast Growth Fast Growth
𝒈 1 = 20% 𝒈 2 = 5%
Year Dividend Year Dividend
0 2.00 4 3.63
1 2.40 5 3.81
2 2.88 6 4.00
3 3.46 7 4.20
 Stock price – multiple periods Non-Constant Growth
Example

The value of dividends during rapid growing phase is calculate as follows:

2.40 2.88 3.46
PV of Dividends = + +
(1.14)1 (1.14)2 (1.14)3
= 2.11 + 2.22 + 2.33 = AED 6.66
The final part of the equation is the price of the stock at the end of P3 which indicates the
value of a constant growth stock at time t equals the dividend one year later (t + 1)
divided by the difference between required rate of return and growth rate:
D 3.63
P3 = 𝑟−𝒈4 = 0.14 −0.05 = AED 40.33
2

This is P3 however, P0 = 40.33

(1.14)3
= 27.22. this presents the value today of all dividends
that will occur in year 4 and beyond. Putting all the pieces together yields the following
stock total value:
P0= 6.66 + 27.22 = AED 33.88
This is similar to :
2.40 2.88 3.46+40.33
P0= (1.14)1 + (1.14)2 + = AED 33.88
(1.14)3
 Stock price – multiple periods
Non-Constant Growth

𝐷1 𝐷2 𝐷3 𝑃3
P0 = + + +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)3
 DIVIDEN YIELD &
EXPECTED RATE OF RETURN

 P0 = D1/(r - g)
Therefore:
r-g = D1 / P0.

r = (D1/ P0) + g

r = Dividend yield + Capital gains yield

 What is the Cost of Capital?
“The Capital Structure”

 CC reflects the opportunity cost of ALL sources of long

term funds (Equity + Debt) invested in a project

 CC represents:
 the firm’s cost of financing
 the minimum rate of return that a project must earn
to increase firm value

 Most firms attempt to maintain an optimal mix

of debt and equity financing
 Some Decisions

Project 1 Project 2 Project 3

COST 100,000dhs 100,000dhs 100,000dhs
Life 20 years 20 years 20 years
Expected return 7% 12% 7% 12%

Financing DEBT @ 6% Equity @ 14% 10%*

source (cost) 50% debt + 50%
equity
Decision 7% > 6% 12% < 14% U F
Favorable Unfavorable

*The weighted average cost here would be:

(0.50  6% debt) + (0.50  14% equity) = 10%
 Sources of Long-Term Capital

1. STOCKHOLDERS’ EQUITY:
a. Preferred stock

b. Common stock equity:

b.1. Common stock
b.2. Retained Earnings

2. Long- term debt

 Cost of Long-Term Debt

 The pretax cost of debt is the financing cost

associated with new funds through long-term
borrowing.

 Flotation costs are the total costs of issuing and

selling a security:
 Underwriting costs - compensation earned by investment
bankers for selling the security.

 Administrative costs - issuer expenses such as legal, accounting,

and printing.

 Net proceeds are the funds actually received by the firm from the
sale of a security.
 Cost of Long-Term Debt
Example

 Star Co. is contemplating selling AED10 million worth

of 20-year, 9% coupon bonds with a par value of
AED1,000. Because current market interest rates are
greater than 9%, the firm must sell the bonds at
AED980. Flotation costs are 2% or AED20. The net
proceeds to the firm for each bond is therefore AED960
(980 – 20).

 PV = 960; PMT =-90; FV = -1000; N = 20;

compounding annually mode end……..press Rate

Rate = 9.452%
 Cost of Long-Term Debt:
After-Tax Cost of Debt

ri = rd  (1 – T)
Where:
ri = After-tax cost of debt
rd = Before tax cost of debt (yield to maturity)
T = Tax rate

Assuming a tax rate of 18 % and the same cost of 9.452%, therefore:

ri = 9.452% x (1-0.18) = ………..%

 Cost of preferred stock

• Preferred stock gives preferred stockholders the right to

receive their stated “fixed” dividends before the firm
can distribute any earnings to common stockholders.

𝐷𝑝
rp =
𝑁𝑝
• Where:
rp The cost of preferred stock
Dp The preferred stock dividend
Np The firm’s net proceeds from the sale of
preferred stock.
 Cost of preferred stock
Example

Star Co. is contemplating the issuance of a

14.3% preferred stock that is expected to sell for
its 21-per share value. The cost of issuing and
selling the stock is expected to be AED2 per
share. The dividend is AED3 (14.3%  AED21).
The net proceeds price (Np) is AED19 (21 – 2).

rP = DP/Np = 3/19 = 15.78%

 Cost of Common Stock

The cost of common stock equity, rs, is the

rate at which investors discount the expected
dividends of the firm to determine its share
value.

There are mainly two forms of common stock

financing:
 retained earnings
 new issues of common stock
 Cost of Common Stock
Dividend Model

𝑫𝟏
P0 =
𝒓𝒔 −𝒈
Where:
P0 = value of common stock
D1 = per-share dividend expected at the end of year 1
rs = required return on common stock
g = constant rate of growth in dividends

Therefore:
𝑫𝟏
rs = +𝒈
𝑷𝟎

rs = (3/21) + 0.05 = 0.142 + 0.05 = 0.192, or

19.2%
 Cost of Common Stock
CAPM
rs = RF + [β  (rm – RF)]
where
RF = risk-free rate of return
rm = return on the market portfolio of assets
β = non-diversifiable risk of the firm as measured by the beta coefficient

 rs = ……% + [1.2  (% – %)] = ………%

 rs = ……% + [0.4  (% – %)] = ………%

 Cost of Common Stock
Cost of Retained Earnings

The cost of retained earnings, rr, is the same as

the cost of an equivalent fully subscribed issue of
additional common stock, which is equal to the
cost of common stock equity, rs.
rr = rs

Therefore, rr = 19.452%
 Cost of Common Stock
“New Issues” of Common Stock
To determine its cost of new common stock, rn, Star Co. has
estimated that on average, new shares can be sold for AED19.

The AED2-per-share underpricing is due to the competitive

nature of the market.
A second cost associated with a new issue is flotation costs of
AED1.50 per share that would be paid to issue and sell the new
shares.
The total underpricing and flotation costs per share are
therefore AED3.50

rn = (3.0/15.5) + 0.05 = 0.194 + 0.05 = 0.2435, or 24.35%

 Weighted Average Cost of Capital

The weighted average cost of capital (WACC),

ra can be calculated when weighting the cost of
each type of fund by its proportion in the total
company’s capital structure

ra = (wi  ri) + (wp  rp) + (ws  rr or n)

where
 wi = proportion of long-term debt in capital structure
 wp=proportion of preferred stock in capital structure
 ws=proportion of common stock equity in capital structure
wi + wp + ws=1.0
 Weighted Average Cost of Capital
Example
We found the costs of the various types of capital
for Star Co. to be as follows:
 Cost of debt, ri = 9.452%
 Cost of preferred stock, rp = 15.78%
 Cost of retained earnings, rr = 19.452%
 Cost of new common stock, rn = 24.0%

The company uses the following weights in

calculating its weighted average cost of capital:
 Long-term debt = …………%
 Preferred stock = …………%
 Common stock equity = …………%
 Weighted Average Cost of Capital
Calculation

Source of capital Weight Cost Weighted Cost

(1) (2) (1*2)

Long term Debt …….. 9.452% …….%

Preferred Stock …….. 15.78% …….%

Common Stock …….. 24.0% …….%

TOTAL 1.0 WACC …….%

 Capital Budgeting - Questions

The capital structure question: How a

firm chooses to finance its operations

The working capital question: how a firm

manages its short-term operating activities

The fixed assets (long Term) question:

how the business of the firm will be
defined.
 The Projects

J S Manufacturing has the following two mutually exclusive projects.

The required rate of return is 12 % .The cash flows from the projects
are given below:
Year Project Y ( AED ) Project Z ( AED )
0 ( 45000) ( 75000)
1 18000 26000
2 17000 24000
3 16000 22000
4 15000 22000
5 5000 10000
Scrap value 0 2000

Calculate:
1) Payback period
2) Average Rate of Return
3) Net Present Value

Based on the above capital budgeting technique, advice the management

 Payback – Expected Time

The payback is the length of time it

takes to recover our initial investment

 An investment is acceptable if its calculated

payback period is less than some pre-specified
number of years
 Payback period

Year Project Y ( AED ) Project Z ( AED )

0 ( 45000) ( 75000)
1 18000 26000
2 17000 24000
3 16000 22000
4 15000 22000
5 5000 10000
Scrap value 0 2000

 Payback period (Y): Cumulative

1st year: 18,000 18,000
nd
2 year: 17,000 35,000

Remains (45,000 – 35,000) = 10,000

Therefore; Payback Period Y = 2 years + (10,000 / 16,000) = 2.625 years

 Payback Period (Z) Cumulative

1st year: 26,000 26,000
2nd year: 24,000 50,000
3rd year: 22,000 72,000

Remains (75,000 – 72,000) = 3,000

Therefore; Payback period Z = 3 years + (3,000 / 22,000) = 3.14 years
 Average Rate of Return (ARR)

 Project Y:
Compute Deprec. = 45,000 / 5 = 9,000
Compute Net Profit = ARR – Deprec.
ARR(Y) (-) Deprec. Net Profit
1 18,000 9,000 9,000
2 17,000 9,000 8,000
3 16,000 9,000 7,000
4 15,000 9,000 6,000
5 5,000 9,000 (4,000)

Compute the average “mean” of net profit = total / number of years

= (26,000 / 5) = 5,200.

Compute average investment = [Opening investment + closing

investment] / 2
= (45,000+0] / 2 = 22,500

ARR = [Average Profit / Average investment] x 100

= [5,200 / 22,500] x 100 = 23.11%
 Average Rate of Return (ARR)

 Project Z:
Compute Deprec. = (75,000 – 2,000) / 5 = 14,600
Compute Net Profit = ARR – Deprec.
ARR(Y) (-) Deprec. Net Profit
1 26,000 14,600 11,400
2 24,000 14,600 9,400
3 22,000 14,600 7,400
4 22,000 14,600 7,400
5 12,000 14,600 (2,600)

Compute the average “mean” of net profit = total / number of years

= (33,000 / 5) = 6,600.

Compute average investment =

[Opening investment + closing investment] / 2
= (75,000+2,000] / 2 = 38,500

ARR = [Average Profit / Average investment] x 100

= [6,600 / 38,500] x100 = 17.14%
 NPV – Creating Value

 The net present value of the investment NPV,

is equal to:
 The investment’s market value
(minus)
 The investment’s cost

 An investment should be accepted if NPV is

positive and rejected if NPV is negative
 NPV (cont.)
PV (x) PV (Z)
1 18,000 16,071 26,000 23,214
2 17,000 13,552 24,000 19,133
3 16,000 11,389 22,000 15,659
4 15,000 9,533 22,000 13,981
5 5,000 2,837 12,000 6,809
Total 53,382 78,796
PV (X) Calculation:
PV (x) : PMT = 0 ; FV = 18,000 ; Rate = 12 ; P = 1 ===== PV = 16,071
PV (x) : PMT = 0 ; FV = 17,000 ; Rate = 12 ; P = 2 ===== PV = 13,552
PV (x) : PMT = 0 ; FV = 16,000 ; Rate = 12 ; P = 3 ===== PV = 11,389
PV (x) : PMT = 0 ; FV = 15,000 ; Rate = 12 ; P = 4 ===== PV = 9,533
PV (x) : PMT = 0 ; FV = 5,000 ; Rate = 12 ; P = 5 ===== PV = 2,837

PV (Z) Calculation:
PV (x) : PMT = 0 ; FV = 26,000 ; Rate = 12 ; P = 1 ===== PV = 23,214
PV (x) : PMT = 0 ; FV = 24,000 ; Rate = 12 ; P = 2 ===== PV = 19,133
PV (x) : PMT = 0 ; FV = 22,000 ; Rate = 12 ; P = 3 ===== PV = 15,659
PV (x) : PMT = 0 ; FV = 22,000 ; Rate = 12 ; P = 4 ===== PV = 13,981
PV (x) : PMT = 0 ; FV = 12,000 ; Rate = 12 ; P = 5 ===== PV = 6,809

THEREFORE:
NPV(X) = 53,382 – 45,000 = 8,382
NPV(Z) = 78,796 – 75,000 = 3,796
STATEMENT SHOWING CAPITAL
BUDGETING TECHNIQUES
PROJECT PROJECT F = Favorable

(Y) (Z) U = Unfavorable

1 PAYBACK 2.625 YEARS 3.14 YEARS PROJECT Y (F)

2 ARR 23.11% 17.14% PROJECT Y (F)

3 NPV 8,382 3,796 PROJECT Y (F)

CONCLUSION:
…………………………………………
 Internal Rate of Return - IRR

An investment is acceptable if:

IRR > required return

 SOLVING IRR

 A project has a total up-front cost of AED2,500,000

The cash flows are:
 First Year : AED 875,000
 Second Year : AED 920,000
 Third Year : AED 1,280,000

Using Financial Calculator: (IRR / NPV)

To find the break-even discount rate, we set NPV equal to zero and solve
for R.

NPV is equal to zero when the expected rate of return is equal to

10.372%
 SOLVING IRR
Management of Al Khaleej Co. Ltd. is considering
purchasing a new machine. With the new $100,000
machine, the company will be able to take on a new order
that will pay $20,000, $30,000, $40,000, and $40,000 in
revenue. The management must determine whether the
machine is a better use of the company’s funds than an
alternative project which earns the company a 12% rate of
return. Calculate the company’s IRR for this project
assuming a discount rate of 8%.
The General formula for 𝑁𝑃𝑉 𝑎𝑛𝑑 𝐼𝑅𝑅
 Dividend Policy

WHY SHAREHOLDERS EXPECTS SOME

REMUNERATION?
 Distribution Policy

The level of distributions

The form of distributions:

 Cash dividends
 Stock repurchases

The stability of distributions

 Dividends and Value

 Is there an optimal distribution policy that

maximizes a company’s intrinsic value?

– Dividend yields

– capital gains

– target distribution ratio (the percentage of net

income distributed to shareholders through
cash dividends or stock repurchases)

– target payout ratio (the percentage of net

income paid as a cash dividend)
 CASH DISTRIBUTIONS

 A company must have cash before it can

make a cash distribution to shareholders.

 The Free Cash Flow (FCF) is defined as the

amount of cash flow available for distribution
to investors after expenses, taxes, and the
necessary investments in operating capital:
– Sales Revenues – Operating costs and taxes.
– Required investments in operating capital (effect
on negative FCF).
 How to use FCF

 Paying the following obligations:

 Pay interest expenses,

 Pay down the principal on debt,
 Pay dividends,

 Repurchase stock,

 Buy non-operating assets such as Treasury bills or other

marketable securities.

Terminologies:
Outstanding shares – Current liabilities – Retained Earnings

DATES: Declaration – Holder-of record – Ex-Dividend – Payment

 Stock Repurchase Procedures
“BUYBACK”
 The repurchased stock is called “treasury stock”.

 Three Situations:
– Increasing leverage(1) by issuing debt and using the proceeds to
repurchase stock (recapitalizations). Leverage shows effects that fixed
costs have on the returns that shareholders earn. Generally, leverage magnifies
both returns and risks.

– Giving employees stock options(2), so companies often

repurchase their own stock to sell to employees when employees
exercise the options. the number of outstanding shares reverts
to its pre-repurchase level after the options are exercised.

– Having excess cash.

(1) Definition: http://www.businessdictionary.com/definition/financial-leverage.html ; Video: http://www.investopedia.com/terms/l/leverage.asp

(2) http://www.investopedia.com/university/employee-stock-options-eso/
Theories of investor preferences for
dividend yield versus capital gains
1. The dividend irrelevance theory

2. The dividend preference theory (also called

the “bird in the hand” theory),

3. Tax Effect Theory: Capital Gains are

Preferred
 Dividend Irrelevance Theory

 Franco Modigliani and Merton Miller.

 Under some assumptions (brokerage costs and taxes), the

value of the firm (stock), described by its’ price and risk
(and therefore the required rate of return), depends only on
the income produced by its assets, not on how this income
is split between dividends and retained earnings letting
every shareholder construct his own dividend policy

 Relation between paying undesired dividend and buying

stocks

 Relation between non-payment of dividend and selling

stocks
 Dividend Preference “Bird-in-the-
Hand” Theory
 Myron Gordon and John Lintner

 A bird in the hand is worth more than two in the bush

 A stock’s risk declines as dividends increase: A return

in the form of dividends is a sure thing, but a return in
the form of capital gains is risky

 Relation between Payouts and Agency (Theory)

costs

 Relation between Risk and Required Rate of Return

 Tax Effect Theory: Capital Gains
Are Preferred
 Eli Talmor and Sheridan Titman

 Tax rates on dividend income and long-term

capital gains.

 Investors may prefer that companies

minimize dividends if the latter are taxed
higher than capital gains.
 THE RESIDUAL DISTRIBUTION
MODEL
 The optimal distribution ratio is a function of four
factors:
1. investors’ preferences for dividends versus
capital gains.

THE RESIDUAL DISTRINUTION MODEL

2. the firm’s investment opportunities.
3. the firm’s target capital structure.
4. the availability and cost of external capital.
THE RESIDUAL DISTRIBUTION MODEL
EXAMPLE
 Assuming Star Co. company has AED80 million in net income and a
target capital structure of 55% equity and 45% debt.

 In case of future poor investment opportunities, the capital budget is

revised to AED60 million (AED 33 million by Equity and AED27
million by debt).

 Under the residual policy, Star Co. must retain AED33 million from
the AED60 million earnings to help finance new investments and
distribute the remaining AED47 million to its shareholders.
 Distribution = Net Income – (target equity ratio)(Total capital
Budget)
= AED80 – (55%)(AED60)
= AED80 – AED33 = AED47

THEREFORE; the distribution ratio is equal to AED47/AED80 = 0.59 =

59%
THE RESIDUAL DISTRIBUTION MODEL
EXAMPLE (cont.)
INVESTMENT OPPORTUNITIES

POOR AVERAGE GOOD

Capital budget 60 90 160

Net income 80 80 80

Required equity (0.55 33 49.5 88

× Capital budget)

Distributions paid 47 30.5 - 8*

(NI − Required equity)

Distribution ratio 58.75% 38.13% 0%

(Dividend/NI)

* Star Co. should must retain all its earnings and issue AED8 million of new stocks
 Advantages of Repurchases

 Positive signals by investors viewing shares prices as

under evaluated

 Gives the choice to shareholders to sell (who need

cash) or retain their stock. With a cash dividend, on the
other hand, stockholders must accept a dividend
payment

 Management may prefer making the distribution in the

form of a stock repurchase to declaring an increased
cash dividend that cannot be maintained

 Using the residual model, the dividend component once

fixed can lead indirectly to repurchase component
 Advantages of repurchases (cont.)

 Repurchases can be used to produce large-

scale changes in capital structures

 Companies that use stock options as an

important component of employee
compensation usually repurchase shares in
the secondary market and then use those
shares when employees exercise their
options.
Disadvantages of Repurchases

 Non-justified increase in the price of the stock in

case of large demand that can fell after the
repurchase operation

 Potential stockholder suits

 OTHER FORMS OF DIVIDENDS

 Stock dividend is the payment, to existing

owners, of a dividend in the form of
additional shares with no cash payment to be
made.

Preferred Stock 200,000 200,000

Common stock (500,000 shares@AED1 par) 500,000 520,000

Paid-in Capital in excess of par 700,000 740,000

Retained earnings 1,000,000 940,000

Total Shareholders’ equity 2,400,000 2,400,000

4% stock dividend @ AED3 stock price

 Benchmarking

 Analyzing the financial statements will give the analyst a deeper

opinion on the performance of a firm

 Statement of Income: recording revenue and expenses between two dates

 Statement of Financial Position: providing a snap shot of the firm’s assets,

liabilities and owner’s equity from establishment until a determined date

 Audited vs. Non-Audited reports

 The importance of “NOTES” attached to the auditors reports

 Statements reports values in different comparable periods for

comparison purposes
 Benchmarking (cont.)

 Now let’s extract Audited Financial

Statements for listed companies in the UAE

 Calculate variation between two

comparable dates for the both statements

 Detect Trends
 Ratios Analysis
Definition
 It is expressed where accounting item (or group
of items) is divided by another (or group) to
have an interpretation with regard to financial
position and performance

 The absolute accounting data cannot provide a

meaningful understanding and interpretation

 Personal example: total income vs total salary

to petrol, rent costs
 Ratios Analysis
Forms
Ratio can be expressed in any of the
following forms:
 Pure Ratio (1 : 2)

 In the form of rate (2 times)

 Percentage (%)
 Ratios Analysis
Interested Parties
 Current and prospective shareholders are interested
in the share price determined by the firm’s current and
future level of risk and return

 Creditors are interested in the short-term liquidity of the

company

 Management is concerned with all aspects of the firm’s

financial situation
 Ratios Analysis
Uses
 Index of efficiency

 Instrument of management control

 Evaluating performance

 Measuring financial solvency

 Forecasting future events

 Effective decisions to management

 Comparability

 Communication
 Ratios Analysis
Precautions
 Accuracy of financial statements

 Selection of Ratios (to match the purpose)

 Competence of the Analyst

 A start to be completed by additional

information and events

 Use of standards
 Financial Ratios

• ABU DHABI SECURITIES

EXCHANGE (ADX):
Reports and Publications : Daily
Financial Ratios
https://www.adx.ae/English/publication/Pages/PublicationsViewer.aspx?
CategoryName=31
 Ratios
Types of comparison

• Cross-sectional analysis.

• Time-series analysis.
 Ratios Analysis
Classification
 Profitability Ratios

 Activity Ratios

 Liquidity Ratios

 Leverage (Debt) Ratios

Handouts for this chapter will be distributed in class