Spring 2020 FIN 351 Take-Home Final Exam Instructions Dear Student, The final exam of FIN 351 will be a take-home final exam. The content of the exam is detailed as the following: Deadline: April 25 @11:59PM. (I have to read close to 70 exams, so I need to get the exams early in advance in order to make for the grade submission day.) You can submit the final exam to me by email any time BEFORE the deadline. Filename: FINALEXAM_SPRING2020_FIN351_SECYY_XX_LastName_FirstName x. XX is your number. From 01 to 40. YY is your section number. _ is the underscore (not a space). Please make sure that all letters are capitalized. Email Subject Line: Final Exam FIN 351 SecYY XX LastName FirstName Format: Word file. 30 questions. Please generate a mock-final exam as the sample final exam. And in this same mock-final exam you generate, please provide the answer key to each question, right after each question. 1. All questions are multiple choice questions and should have from A to E choices. 2. Please follow the question distributions of the sample final exam. For example, 2 questions on Chapter 1, 6 questions on Chapter 2, etc. 3. Please provide the answer keys to all questions. a. For the conceptual questions, write the answer key: A, B, C, D or E, AND please tell me the slide numbers and the chapters of the lecture notes of the relevant area. b. For the calculation questions, write the answer key: A, B, C, D or E, AND provide the calculation steps. The step-by-step illustration of your answer key is required, starting with the formula, then inputting the numbers, then calculate the answers. 4. For the conceptual questions, please generate *new* questions using the lecture notes. 5. For the calculation questions, you must change AT LEAST ONE (1) number of each question in the sample final exam, and redo the problems. If you’d like to challenge yourself and change more than one numbers, that is also fine with me. Please mark the number(s) you change by underlying it (them). 6. For Chapter 2’s questions’ answers, you can write the table as in the quizzes and midterm 1. For the other calculation questions, it is fairly easy to type the formula. 7. Both the sample final exam and its answer keys are posted online. You can study the answer key to prepare for your own final exam. Please also keep in mind that for your final exam, I want the answer key to be right after your question, not in a separate file. 8. If you have any question, please feel free to email me. -Yi
1
FIN 351
SAMPLE
FINAL
EXAM
NAME (Last, First)
SIGNATURE
INSTRUCTIONS:
1. Multiple Choices: Choose the best answer. There is only one best
answer. You are solely responsible for the accuracy of the answers
on the Scantron. Only the answers on the Scantron are graded.
2. Write your name, number and format on the Scantron.
3. Sign your exam copy.
4. TURN IN all pages of the exams BEFORE you leave the classroom.
If you take the exams out FOR ANY REASON, you will be graded
ZERO automatically for the final exam.
5. Keep BOTH of your hands on the desk ALL the time.
6. 30 questions, 1 point each.
Section Number
2
1. Which of the following best defines the concept of corporate governance?
A. A system for monitoring managers’ activities, rewarding performance, and disciplining
misbehavior.
B. Corporate values and governance structures that ensure the business is conducted in an ethical,
competent, fair, and professional manner.
C. A system of principles, policies, and procedures used to manage and control the activities of a
corporation so as to overcome conflicts of interest inherent in the corporate form.
D. A system to ensure complete transparency in disclosures regarding operations, performance,
risk, and financial position.
E. A system of fairness and accuracy in identifying inherent conflicts of interest.
2. Which of the following best defines the objectives of an effective system of corporate
governance?
A. ensure that the assets of the company are used efficiently and productively.
B. eliminate or mitigate conflicts of interest among stakeholders.
C. A and B.
D. ensure complete transparency in disclosures regarding operations, performance, risk, and
financial position.
E. A and D.
Question 3 to 8 use the following set-up:
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial
cost of the assets is $90 million, and the company’s working capital would increase by $20 million
during the life of the new product. The new product is estimated to have a useful life of four years,
at which time the assets would be sold for $15 million. Management expects company sales to
increase by $120 million the first year, $160 million the second year, $140 million the third year,
and then trailing to $50 million by the fourth year because competitors have fully launched
competitive products. Operating expenses are expected to be 60% of sales, and depreciation is
based on an asset life of three years under MACRS (modified accelerated cost recovery system).
The MACRS deprecation schedule is Year 1: 33.33%. Year 2: 44.45%. Year 3: 14.81%. Year 4:
7.41%. Assume the required rate of return on the Vitamin-Burger project is 10% and the company’s
tax rate is 35%.
3. What is the investment outlay?
A. -100 million.
B. -110 million.
C. -120 million.
D. -90 million.
E. -70 million.
3
4. What is the cash operating expense for Year 2?
A. 100 million
B. 106 million
C. 96 million
D. 92 million
E. 90 million
5. What is the depreciation for Year 3?
A. 30.68 million
B. 24.12 million
C. 20.56 million
D. 13.33 million
E. 12.08 million
6. What is the after-tax operating cash flow for Year 4?
A. 55.60 million
B. 41.07 million
C. 41.70 million
D. 17.33 million
E. 15.33 million
7.What is the total terminal after-tax non-operating cash flows for Year 4?
A. 45.08 million
B. 41.70 million
C. 41.07 million
D.55.60 million
E.15.33 million
8.What is the NPV value of the project?
A. 30.51 million
B. 35.51 million
C. 37.51 million
D. 39.45 million
E. 41. 23 million
9. Suppose the Widget Company has a capital structure composed of the following, in billions:
Debt $30, Common equity $60, Preferred stock $30. The debt rating is of AA. The yield on AA
debt is 8%. The marginal tax rate is 30%. The preferred annual dividend is $10, current stock
price is $100. If the risk-free rate is 3%, the expected market risk premium is 5%, and the
company’s stock beta is 1.5. What is Widget’s weighted average cost of capital?
A. 0.0725
B. 0.0830
C. 0.0915
D. 0.1018
E. 0.1013
4
10. Suppose the Widget Company has a capital structure composed of the following, in billions:
Debt $40, Common equity $60, Preferred stock $20. The debt rating is of AA. The yield on AA
debt is 10%. The marginal tax rate is 30%. The preferred annual dividend is $10, current stock
price is $120. If the risk-free rate is 3%, the expected market risk premium is 5%, and the
company’s stock beta is 1.25. What is Widget’s weighted average cost of capital?
A. 0.0725
B. 0.0830
C. 0.0915
D. 0.1018
E. 0.1013
Question 11 to 12 use the following set-up:
Number of units produced and sold: 1,000
Sales price per unit: $300
Variable cost per unit: $150
Fixed operating cost: $50,000
Fixed financing expense: $10,000
11.What is the degree of operating leverage?
A. 1.1
B. 1.2
C. 1.4
D. 1.5
E. 1.3
12. What is the degree of total leverage?
A. 1.105
B. 1.125
C. 1.110
D. 1.135
E. 1.66
5
13. Which one of the following statements matches M& M Proposition I without taxes?
A. The cost of equity capital has a positive linear relationship with a firm’s capital structure.
B. The dividends paid by a firm determine the firm’s value.
C. The cost of equity capital varies in response to changes in a firm’s capital structure.
D. The value of a firm is independent of the firm’s capital structure.
E. The value of a firm is dependent on the firm’s capital structure
5
14. Which one of the following states that a firm’s cost of equity capital is a positive linear function
of the firm’ s capital structure?
A. Financial risk of capital structure
B. M& M Proposition I without taxes
C. M& M Proposition II
D. Operating risk of capital structure
E. M& M Proposition I with taxes
15. Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to
this relationship?
A. Theory of interest rates
B. M& M Proposition I
C. Financial risk
D. Interest tax shield
E. Financial leverage
16. Which one of the following is the date on which the board of directors agrees to pay a dividend
and passes a resolution to do so?
A. Date of record
B. Ex-dividend date
C. Payment date
D. Declaration date
E. Public announcement date
17. On which one of the following dates is the determination made as to which shareholders will
receive a dividend payment?
A. Date of record
B. Ex-dividend date
C. Payment date
D. Declaration date
E. Public announcement date
18. The clientele effect states that investors fall into various groups because of differences in their
preferences for which one of the following?
A. Share price levels
B. Risk level
C. Short-term versus long-term investments
D. Rates of return
E. Dividends
6
19. This morning, Structural Steel purchased 3,500 of its outstanding shares in the open market.
What type of transaction was this?
A. Stock payout
B. Stock distribution
C. Stock dividend
D. Stock repurchase
E. Stock reversal
20. Which one of the following increases the number of shares outstanding but does not affect the
dividend yield or dividend payout ratio?
A. Reverse stock split
B. Cash distribution
C. Stock split
D. Liquidation dividend
E. Special dividend
21. UXZ has sales of $683,200, cost of goods sold of $512,900, and inventory of $74,315. What
is the inventory turnover rate?
A. 7.33 times
B. 6.90 times
C. 5.70 times
D. 7.14 times
E. 8.47 times
22. Galaxy Sales has sales of $938,300, cost of goods sold of $764,500, and inventory of $123,600.
How long on average does it take the firm to sell its inventory?
A. 6.40 days
B. 7.23 days
C. 48.68 days
D. 59.01 days
E. 61.10 days
23. Leisure Products has sales of $738,800, cost of goods sold of $598,200, and accounts
receivable of $86,700. How long on average does it take the firm’s customers to pay for their
purchases? Assume a 365-day year.
A. 8.65 days
B. 11.28 days
C. 25.01 days
D. 42.83 days
E. 45.33 days
7
24. Fast Kars has a return on equity of 22.3 percent, a profit margin of 14.2 percent, and total
equity of $467,000. What is the net income?
A. $69,608
B. $113,875
C. $104,141
D. $66,314
E. $109,897
25. Health Centers, Inc., has total equity of $948,300, sales of $1.523 million, and a profit margin
of 4.4 percent. What is the return on equity?
A. 4.21 percent
B. 6.49 percent
C. 7.18 percent
D. 8.68 percent
E. 7.07 percent
Question 26 to 30 use the following set-up:
Suppose that the Big Company has made an offer for the Little Company that consists of the
purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid
was made public was $15 per share. Big Company stock is trading at $40 per share, and there are
10 million shares outstanding. Big Company estimates that it is likely to reduce costs through
economics of scale with this merge of $2 million per year, forever. The appropriate discount rate
for these gains is 10%.
26. What are the synergistic gains from this merger?
A. 20 million
B. 18 million
C. 16 million
D. 14 million
E. 12 million
27. What is the target shareholder’s gain?
A. 4 million
B. 3 million
C. 2 million
D. 1 million
E. 5 million
8
28. What is Acquirer’s gain?
A. 15 million
B. 16 million
C. 17 million
D. 19 million
E. 20 million
29. What do Big shareholders get?
A. 25% of the gain
B. 75% of the gain
C. 15% of the gain
D. 85% of the gain
E. 90% of the gain
30. What is the value of Big Company post-merge?
A. 300 million
B. 350 million
C. 390 million
D. 410 million
E. 417 million
FIN 351 SAMPLE MIDTERM 2
WACC and Measures of Leverage
Last Name, First Name
Name: _____________________________________
1. Suppose the Widget Company has a capital structure composed of the following, in
billions: Debt $40, Common equity $50, Preferred stock $10. The debt rating is of AA.
The yield on AA debt is 8%. The marginal tax rate is 30%. The preferred annual dividend
is $10, current stock price is $100. If the risk-free rate is 3%, the expected market risk
premium is 5%, and the company’s stock beta is 1.25. What is Widget’s weighted average
cost of capital?
2. Calculate DOL, DFL, DTL and Q_BE, Q_OBE of a company:
Number of units produced and sold: 1,000
Sales price per unit: 300
Variable cost per unit: 150
Fixed operating cost: 50,000
Fixed financing expense: 10,000
Section Number
FIN 351 Capital Budgeting Quiz 2
Last Name, First Name
Name: _____________________________________
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial cost of
the assets is $95 million, and the company’s working capital would increase by $13 million during the life
of the new product. The new product is estimated to have a useful life of four years, at which time the assets
would be sold for $16 million. Management expects company sales to increase by $140 million the first
year, $175 million the second year, $155 million the third year, and then trailing to $65 million by the fourth
year because competitors have fully launched competitive products. Operating expenses are expected to be
70% of sales, and depreciation is based on an asset life of three years under MACRS (modified accelerated
cost recovery system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81% and Year 4: 7.41%. If the required
rate of return on the Vitamin-Burger project is 8% and the company’s tax rate is 30%, should the company
invest in this new product?
Section Number
FIN 351 Capital Budgeting Quiz 1
Last Name, First Name
Name: _____________________________________
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial cost of
the assets is $90 million, and the company’s working capital would increase by $12 million during the life
of the new product. The new product is estimated to have a useful life of four years, at which time the assets
would be sold for $16 million. Management expects company sales to increase by $130 million the first
year, $170 million the second year, $150 million the third year, and then trailing to $60 million by the fourth
year because competitors have fully launched competitive products. Operating expenses are expected to be
70% of sales, and depreciation is based on an asset life of three years under MACRS (modified accelerated
cost recovery system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81% and Year 4: 7.41%. If the required
rate of return on the Vitamin-Burger project is 8% and the company’s tax rate is 30%, should the company
invest in this new product?
Section Number
FIN 351 WACC Quiz
Last Name, First Name
Name: _____________________________________
Suppose the Widget Company has a capital structure composed of the following, in
billions: Debt $30, Common equity $60, Preferred stock $30. The debt rating is of
AA. The yield on AA debt is 8%. The marginal tax rate is 30%. The preferred annual
dividend is $10, current stock price is $100. If the risk-free rate is 3%, the expected
market risk premium is 5%, and the company’s stock beta is 1.25. What is Widget’s
weighted average cost of capital?
Section Number
FIN 351 fall 201$ Quiz 10
Name:
WA CC
Section Number
0’ o6(
Suppose the Widget Company has a capital structure composed of the following, in
billions: Debt $30, Common equity $60, Preferred stock $30. The debt rating is of
AA. The yield on AA debt is 8%. The marginal tax rate is 30%. The preferred annual
dividend is $10, current stock price is $100. If the risk-free rate is 3%, the expected
market risk premium is 5% and the company’s stock beta is 1.25. What is Widget’s
weighted average cost of capital?
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FIN 351 SAMPLE MIDTERM 2
N am e:
WA CC and Measures oJ Leverage
Last Name, First Name
Section Number
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1. Suppose the Widget Company has a capital structure composed of the following, in
billions: Debt $40, Common equity $50, Preferred stock $10. The debt rating is of AA.
The yield on AA debt is 8%. The marginal tax rate is 30%. The preferred annual dividend
is $10, current stock price is $100. If the risk-free rate is 3%, the expected market risk
premium is 5%, and the company’s stock beta is 1 .25. What is Widget’s weighted average
cost of capital?
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Number of units produced and sold: 1,000
Sales price per unit: 300
Variable cost per unit: 1 50
fixed operating cost: 50,000
Fixed financing expense: 10,000
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FIN 351 FALL 201$ Midterm 2
Name:
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Section Number
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1. Suppose the Widget Company has a capital structure composed of the following, in
billions: Debt $40, Common equity $55, Preferred stock $5. The debt rating is of AA. The
yield on AA dis 10%. The marginal tax rate is 35%. The preferred annual dividend is
$10, current stock price is $100. If the risk-free rate is 3 the expected JLtial /VRp
is’. and the company’s stock beta is 1.50. What is Widget’s weighted average
cost of capital?
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L2 Number of units produced and sold: 2,000
P Sales price per unit: 300
V Variable cost per unit: 100
Fixed operating cost: 50,000
C Fixed financing expense: 20,000
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- Email Subject Line: Final Exam FIN 351 SecYY XX LastName FirstName
- Filename: FINALEXAM_SPRING2020_FIN351_SECYY_XX_LastName_FirstName x. XX is your number. From 01 to 40. YY is your section number. _ is the underscore (not a space). Please make sure that all letters are capitalized.
- Measuring and Managing Liquidity
- Managing Cash
- Types and Motives
- Mergers and Acquisitions’ Evaluation
- Herfindahl-Hirschman Index (HHI)
- Who Benefits from Mergers
- Dividends: Cash Distributions
- Dividends: Payment Chronology
- Share Repurchases
- Stock Splits
- Dividend Policy and Company Value: Theory
- Factors Affecting Dividend policy
- Tax System and Dividend Policy
- Motivation
- Cost of Debt
- Cost of Preferred Stock
- Cost of Equity
- Weighted Average Cost of Capital (WACC)
- Leverage
- DOL, DFL and DTL
- The breakeven points, QBE and QOBE
- Modigliani�Miller (MM) Proposition I & II
- Corporate Taxes and Capital Structure
- Optimal Capital Structure
- Bankruptcy Process
- Introduction
- Objectives and Guiding Principles
- Forms of Business Organization
- The Goal of Financial Management
- Net Present Value
- Payback Period
- Internal rate of return (IRR)
- Ranking conflicts: NPV vs. IRR
- Cash flow projections
- Example: Cash Flow analysis
- Scenario Analysis
- Standardized Financial Statements
- Using Financial Statement Information
- Financial Ratios
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fIN 351
Name:
FALL2O1$ Quiz6
Cczpital Budgeting Quiz 1
Section Number
o ob
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Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial
cost of
the assets is $95 million, and the company’s working capital would increase by $13 million during the life
of the new product. The new product is estimated to have a useful life of four years, at which time the assets
would be sold for $16 million. Management expects company sales to increase by $140 milliq the first
year, $ 75 million the second year, jjillipp the third year, and then trailing to $65 million by the
fourth
year because competitors have fully launched competitive products. Operating expenses at-c expected to be
70% of sales, and depreciation is based on an as ife of three years under MACRS (modified accelerated
cost recovery system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.8
10/n and Year 4: 7.41%. If the required
rate of return on the Vitamin-Burger project is 8% and the company’s tax rate is 30%, should the company
invest in this new product?
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FIN 351 FALL 2018 Quiz 7
Name:
Capital Bttdgeting QuL- tindependent)
Section Number
o7
3
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial cost of
the assets is $90 million, and the company’s working apjtj would increase by $12 million during the life
of the new product. The new product is estimatedto have a useful life of four years, at which time the assets
would be sold for $16 million. Management expects companysto increase by $130 million the first
year, $170 million thednd year, $150 million the third year, and then trailing to $60 million by the fourth
year because competitors have fully launched competitive products. Operating expenses are expected to be
70% of sales, and depreciation is based on anjass life of three years under MACRS (modified accelerated
cost recovery system). Year 1: 33.33%, Yearr44.45%, Year 3; 14.81% and Year 4: 7.41%. If the required
rate of return on the Vitamin-Burger project is 8% and the companys tax rate is 30%, should the company
invest in this new product?
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FIN 351 FALL 201$ Midterm 1
Name:
Capital Budgeting Midterm
Section Number
‘ 05
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Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial cost of
the assets is $85 million, and the company’s working capital would increase by $15 million during the life
of the new product. The new product is estimated to have a useful life of four years, at which time the assets
would be sold for $i.5!M1flon. Management expects company sales to increase by $120 million the first
year, $160 million the second year, $130 million the third year, and then trailing to $70 million by the fourth
year because competitors have fully launched competitive products. Operating expenses are expected to be
70% of sales, and depreciation is bae4pnanst)life of three years under MACRS (modified accelerated
cost recover system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81% and Year 4: 7.41%. If the required
rate of return on the Vitamin-Burger project is 10% and the company’s tax rate is 35%, should the company
invest in this new product? –
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FIN 351 Measures of Leverage Quiz
Last Name, First Name
Name: _____________________________________
What are the DOL, DFL, DTL, Q_BE, Q_OBE of each firm?
Section Number
FIN 351 Financial Statements Quiz
Last Name, First Name
Name: _____________________________________
1. Current ratio
2. Cash ratio
3. financial leverage
4. Long-term debt-to-assets ratio
5. Inventory turnover
6. Receivables turnover
7. Total asset turnover
8. Net profit margin
9. Return on assets
10. Return on equity
Section Number
Spring 2020 FIN 351 Take-Home Final Exam Instructions
Dear Student,
The final exam of FIN 351 will be a take-home final exam. The content of the exam is
detailed as the following:
Deadline: April 25 @11:59PM. (I have to read close to 70 exams, so I need to get the exams
early in advance in order to make for the grade submission day.)
You can submit the final exam to me by email any time BEFORE the deadline.
Filename:
FINALEXAM_SPRING2020_FIN351_SECYY_XX_LastName_FirstName x. XX is
your number. From 01 to 40. YY is your section number. _ is the underscore (not a
space). Please make sure that all letters are capitalized.
Format: Word file. 30 questions. Please generate a mock-final exam as the sample final
exam. And in this same mock-final exam you generate, please provide the answer key to
each question, right after each question.
1. All questions are multiple choice questions and should have from A to E choices.
2. Please follow the question distributions of the sample final exam. For example, 2
questions on Chapter 1, 6 questions on Chapter 2, etc.
3. Please provide the answer keys to all questions.
a. For the conceptual questions, write the answer key: A, B, C, D or E, AND
please tell me the slide numbers and the chapters of the lecture notes of the
relevant area.
b. For the calculation questions, write the answer key: A, B, C, D or E, AND
provide the calculation steps. The step-by-step illustration of your answer
key is required, starting with the formula, then inputting the numbers, then
calculate the answers.
4. For the conceptual questions, please generate *new* questions using the lecture
notes.
5. For the calculation questions, you must change AT LEAST ONE (1) number of
each question in the sample final exam, and redo the problems. If you’d like to
challenge yourself and change more than one numbers, that is also fine with me.
Please mark the number(s) you change by underlying it (them).
6. For Chapter 2’s questions’ answers, you can write the table as in the quizzes and
midterm 1. For the other calculation questions, it is fairly easy to type the formula.
7. Both the sample final exam and its answer keys are posted online. You can study
the answer key to prepare for your own final exam. Please also keep in mind that
for your final exam, I want the answer key to be right after your question, not in a
separate file.
8. If you have any question, please feel free to email me. -Yi
Email Subject Line: Final Exam FIN 351 SecYY XX LastName FirstName
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
CHAPTER EIGHT:
WORKING CAPITAL MANAGEMENT
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
INTRODUCTION
MEASURE OF LIQUIDITY
OPERATING AND CASH CONV. CYCLES
COMPANY A
COMPANY B
INTRODUCTION
Liquidity is the ability of the company to satisfy its short-term
obligations using assets that are readily converted into cash.
Liquidity management is the ability of the company to generate cash
when and where needed.
The operating cycle is the length of time it takes a company’s
investment in inventory to be collected in cash from customers.
The net operating cycle (or the cash conversion cycle) is the length of
time it takes for a company’s investment in inventory to generate cash,
considering that some or all of the inventory is purchased using credit.
The length of the company’s operating and cash conversion cycles is a
factor that determines how much liquidity a company needs.
The longer the cycle, the greater the company’s need for liquidity.
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
INTRODUCTION
MEASURE OF LIQUIDITY
OPERATING AND CASH CONV. CYCLES
COMPANY A
COMPANY B
MEASURE OF LIQUIDITY
Liquidity ratios
Current ratio = Current assetsCurrent liabilities : The ability to satisfy current liabilities using current
assets.
Current assets= Cash and equivalents + Short- and long-term investments + Accounts
receivable + Inventories + Prepaid expenses
Current liabilities= Accounts payable + Accrued expenses + Income tax payable +
Short-term notes payable + Portion of long-term debt payable
Quick ratio = Cash+Short-term investments+ReceivablesCurrent liabilities : The ability to satisfy current liabilities
using the most liquid of current assets.
Ratios indicating management of current assets
Receivables turnover = Total revenueAverage receivables : How many times accounts receivable are
created and collected during the period.
Payables turnover = Cost of goods soldAverage payables : How many times accounts payable are created and
collected during the period.
Inventory turnover = Cost of goods soldAverage inventory : How many times inventory is created and sold
during the period.
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
INTRODUCTION
MEASURE OF LIQUIDITY
OPERATING AND CASH CONV. CYCLES
COMPANY A
COMPANY B
OPERATING AND CASH CONV. CYCLES
Number of days of inventory = InventoryAverage day’s cost of goods sold =
365
Inventory turnover :
The average time it takes to create and sell inventory.
Number of days of receivables = ReceivablesAverage day’s revenues =
365
Receivables turnover :
The average time it takes to collect on accounts receivable.
Number of days of payables = Accounts payableAverage day’s purchases =
365
Accounts payables turnover :
The average time it takes to pay its suppliers.
Operating cycle = Number of days of inventory + Number of days of
receivables.
Net operating cycle or Cash conversion cycle = Number of days of inventory
+ Number of days of receivables − Number of days of payables.
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
INTRODUCTION
MEASURE OF LIQUIDITY
OPERATING AND CASH CONV. CYCLES
COMPANY A
COMPANY B
COMPANY A
Cash and cash equivalents: 200, Inventory: 500, Receivables: 600, Accounts payable: 400,
Revenues: 3,000, Cost of goods sold: 2,500.
Current ratio = 200+500+600400 = 3.25
Quick ratio = 200+600400 = 2
Receivables turnover = 3,000600 = 5
Payables turnover = 2,500400 = 6.25
Inventory turnover = 2,500500 = 5
Number of days of receivables = 3655 = 73
Number of days of payables = 3656.25 = 58.4
Number of days of inventory = 3655 = 73
Operating cycle = Number of days of inventory + Number of days of receivables = 146
Cash conversion cycle = Number of days of inventory + Number of days of receivables
− Number of days of payables = 87.6
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH
INTRODUCTION
MEASURE OF LIQUIDITY
OPERATING AND CASH CONV. CYCLES
COMPANY A
COMPANY B
COMPANY B
Cash and cash equivalents: 200, Inventory: 900, Receivables: 1,000, Accounts payable: 600,
Revenues: 6,000, Cost of goods sold: 5,200.
Current ratio = 200+900+1,000600 = 3.5
Quick ratio = 200+1,000600 = 2
Receivables turnover = 6,0001,000 = 6
Payables turnover = 5,200600 = 8.67
Inventory turnover = 5,200900 = 5.78
Number of days of receivables = 3656 = 60.8
Number of days of payables = 3658.67 = 42.1
Number of days of inventory = 3655.78 = 63.15
Operating cycle = Number of days of inventory + Number of days of receivables = 124
Cash conversion cycle = Number of days of inventory + Number of days of receivables
− Number of days of payables = 81.9
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
MEASURING AND MANAGING LIQUIDITY
MANAGING CASH MANAGING CASH
MANAGING CASH
Management of the cash position of a company has a goal of maintaining positive cash balances
throughout the day. Companies tend to maintain a minimum balance of cash (a target cash
balance) to protect against a negative cash balance.
Examples of Cash Inflows
Receipts from operations, broken down by operating unit, departments, etc.
Fund transfers from subsidiaries, joint ventures, third parties
Maturing investments
Debt proceeds (short and long term)
Other income items (interest, etc.)
Tax refunds
Examples of Outflows
Payables and payroll disbursements, broken down by operating unit, departments, etc.
Fund transfers to subsidiaries
Investments made
Debt repayments
Interest and dividend payments
Tax payments
YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT
Introduction
Measure of Liquidity
Operating and Cash Conv. Cycles
Company A
Company B
Managing Cash
TYPES AND
MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
CHAPTER TEN:
MERGERS AND ACQUISITIONS
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
DEFINITIONS
POISON PILL
TYPES
MOTIVES
DEFINITIONS
Consolidation: A + B → C. Acquisition: X + Y → New Firm X.
Target: the company being acquired. Acquirer: the company
acquiring the target.
Friendly takeover: when the target company board of directors
endorses a takeover offer. Offer made through the target’s board
of directors.
Hostile takeover: when the target company board of directors
objects to a takeover offer. Offer made directly to target
shareholders. 1) Bear hug: Informal offer made directly to the
target shareholders. 2) Tender offer: Formal offer made directly
to the target shareholders. 3) Poison pill: Share dilution.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
DEFINITIONS
POISON PILL
TYPES
MOTIVES
POISON PILL
A poison pill is created when a board allows some shareholders
to purchase a great deal of newly–issued stock very cheaply in
the event that anyone buys a block of shares without managers’
prior approval. Once triggered, the bidder’s shares are drastically
diluted
Thus, no acquirer has ever intentionally triggered a poison pill
and, as long as the pill is in place, it is an insurmountable defense
against takeover.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
DEFINITIONS
POISON PILL
TYPES
MOTIVES
TYPES
Horizontal Merger: Companies are in the same line of business
(competitors). Walter Disney Company buys Lucasfilm for $4
billion in October 2012.
Vertical Merger: Companies are in the same line of production
(supplier–customer). Google acquired Motorola Mobility
Holdings for $12.5 billion in June 2012.
Conglomerate Merger: Companies are in unrelated line of
business. Warren Buffett’s Berkshire Hathaway Inc. acquires
Lubrizol (chemical maker) for $9 billion in 2011.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
DEFINITIONS
POISON PILL
TYPES
MOTIVES
MOTIVES
Synergy. Economies of scale.
Growth. External growth.
Increasing market power. Horizontal or vertical integration to
increase strength in the industry.
Acquiring unique capabilities or resources. Resources include
patents, technology, trademarks, or raw materials.
Unlocking hidden value. Improve management, reorganize
structure, breakups, or liquidations.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
METHOD 1: BID EVALUATION
METHOD 2: COMPARABLE COMPANY ANALYSIS
METHOD 1: BID EVALUATION
Suppose that the Big Company has made an offer for the Little Company that consists of the
purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid
was made public was $15 per share. Big Company stock is trading at $40 per share, and there
are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs
through economics of scale with this merger of $2 million per year, forever. The appropriate
discount rate for these gains is 10%. What are the synergistic gains from this merger? What
parties, if any, share in these gains? What is the estimated value of the Big Company
post-merger?
Suppose that the Big Company has made an offer for the Little Company that consists of
the purchase of 1 million shares at $18 per share. Price paid for the Target = $18 million.
The value of Little Company stock before the bid was made public was $15 per share.
Pre-merger value of the Target = $15 million.
Big Company stock is trading at $40 per share, and there are 10 million shares
outstanding. Pre-merger value of the Acquirer = $40 × 10 = $400 million.
Big Company estimates that it is likely to reduce costs through economics of scale with
this merger of $2 million per year, forever. The appropriate discount rate for these gains
is 10%.
Synergistic gains S = $2 million/10% = $20 million.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
METHOD 1: BID EVALUATION
METHOD 2: COMPARABLE COMPANY ANALYSIS
SOLUTIONS
Suppose that the Big Company has made an offer for the Little Company that consists of the
purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid
was made public was $15 per share. Big Company stock is trading at $40 per share, and there
are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs
through economics of scale with this merger of $2 million per year, forever. The appropriate
discount rate for these gains is 10%. What are the synergistic gains from this merger? What
parties, if any, share in these gains? What is the estimated value of the Big Company
post-merger?
Synergistic gains S = $2 million/10% = $20 million.
Target’s gain = Premium = Price paid for the Target − Pre-merger value of the Target =
$18 million − $15 million = $3 million. (3/20 = 15% of the synergistic gains.)
Acquirer’s gain = Synergistic gains − Premium = $20 million − 3 million = $17
million. (17/20 = 85% of the synergistic gains.)
Post-merger value of the Acquirer = Pre-merger value of the Acquirer + Acquirer’s gain
= $400 million + $17 million = $417 million.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
METHOD 1: BID EVALUATION
METHOD 2: COMPARABLE COMPANY ANALYSIS
METHOD 2: COMPARABLE COMPANY ANALYSIS
Using the comparable company analysis, if the takeover premium is 20%,
what is the XYZ Company’s value in a merger?
XYZ Company Average of Comparables
Earnings (E) $10 million P/E of comparables 30 times
Cash flow (CF) $12 million P/CF of comparables 25 times
Book equity (BV) $50 million P/BV of comparables 2 times
Sales (S) $100 million P/S of comparables 2.5 times
Answer : = (E × P/E + CF × P/CF + BV × P/BV + S × P/S)/4 (1)
= (10 × 30 + 12 × 25 + 50 × 2 + 100 × 2.5)/4
= (300 + 300 + 100 + 250)/4
= 237.50
Estimated takeover price: 237.50 × (1 + 20%) = 285.00.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
HHI
HHI
The Herfindalhl–Hirschman Index (HHI) is a measure of concentration within an industry and
is often used by regulators to evaluate the effects of a merger.
Post-Merge HHI Concentration Government Action
Less than 1,000 Not concentrated No action
Between 1,000 and 1,800 Moderately concentrated Possible challenge
More than 1,800 Highly concentrated Challenge
Company Mkt Shr. HHI Before Company Mkt Shr. HHI After
A 15% 225 A 15% 225
B 15% 225 B 15% 225
C 15% 225 C 15% 225
D 15% 225 D+E 30% 900
E 15% 225
1125 1575
The industry would be considered moderately concentrated after the combination of E and F,
which may result in a government challenge.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
TYPES AND MOTIVES
MERGERS AND ACQUISITIONS’ EVALUATION
HERFINDAHL-HIRSCHMAN INDEX (HHI)
WHO BENEFITS FROM MERGERS
WHO BENEFITS FROM MERGERS
WHO BENEFITS FROM MERGERS
Mergers create value for the target company shareholders in the
short run.
Acquirers tend to overpay in merger bids. The transfer of wealth
is from acquirer to target company shareholders. Roll:
Overpayment results from “hubris.”
Acquirers tend to underperform in the long run. They are unable
to fully capture any synergies or other benefit from the merger.
YI ZHOU CHAPTER TEN: MERGERS AND ACQUISITIONS
Definitions
Poison Pill
Types
Motives
Method 1: Bid Evaluation
Method 2: Comparable Company Analysis
HHI
Who Benefits from Mergers
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
CHAPTER SIX:
DIVIDENDS AND SHARE
REPURCHASES: BASICS
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
INTRODUCTION
REGULAR CASH DIVIDENDS
OTHER DIVIDENDS
INTRODUCTION
A dividend is a distribution to shareholders.
A share repurchase is a distribution in the form of the company
buying back its stock from shareholders.
Dividend initiations have a positive effect on share prices.
Dividend increases have a positive effect on share prices.
Share repurchases have a positive effect on share prices.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
INTRODUCTION
REGULAR CASH DIVIDENDS
OTHER DIVIDENDS
REGULAR CASH DIVIDENDS
A regular cash dividend is a cash dividend paid at regular intervals
of time.
The regular intervals may be any frequency, but the most
common are quarterly, semiannually, or annually.
Tendency of companies is to maintain or increase dividends.
Companies prefer not to cut or reduce the dividend.
Often viewed as signals of management’s assessment of the
company’s future, that is, whether the company can maintain the
dividend in the future.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
INTRODUCTION
REGULAR CASH DIVIDENDS
OTHER DIVIDENDS
OTHER DIVIDENDS
An extra dividend (or special dividend) is a dividend that is
either paid by a company that does not pay dividends regularly or
paid by a company in addition to a regular dividend. Pay out in
strong years without investors expecting an increased dividend.
A liquidating dividend is a distribution of cash to shareholders
when
Going out of business, or
Selling a portion of the business, or
Paying a dividend when retained earnings are not positive.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
DIVIDENDS: PAYMENT CHRONOLOGY
DIVIDENDS: PAYMENT
The ex-dividend date is set exactly two business days before the dividend record date.
On and after the ex-dividend date, a buyer of the stock will not receive the dividend
as the seller is entitled to it.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
DIVIDENDS: PAYMENT CHRONOLOGY
DIVIDEND PAYMENT CHRONOLOGY: AN EXAMPLE
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
DIVIDENDS: PAYMENT CHRONOLOGY
PRICE BEHAVIOR AROUND THE EX-DIVIDEND DATE FOR
A $1 CASH DIVIDEND
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
SHARE REPURCHASES
SHARE REPURCHASE VS. CASH DIVIDENDS
SHARE REPURCHASES
A share repurchase is the transaction in which the stock issuer buys
back its shares from investors. –Also known as a share buyback.
Signal that the stock is undervalued.
Flexibility of distributing cash without using cash dividends.
Tax efficiency when the tax rate on capital gains is less than that
of cash dividends.
Offset share increases from executive stock options.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
SHARE REPURCHASES
SHARE REPURCHASE VS. CASH DIVIDENDS
SHARE REPURCHASE VS. CASH DIVIDENDS
If the tax consequences of dividends and capital gains are the same
and the information content of cash dividends and stock repurchases
is the same, then the effects of cash dividends and repurchases on
shareholder value will be the same.
Both cash dividends and stock repurchases:
Reduce assets by the amount of the dividend or repurchase.
Reduce equity by the amount of the dividend or repurchase.
Provide investors with the same cash flow.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
STOCK SPLITS
REVERSE STOCK SPLITS
STOCK SPLITS
A stock split is a proportionate increase in the number of shares
outstanding.
Number of new shares:Number of old shares
2:1 means that for each share held before the split, the shareholder
holds two shares after the split.
Stock splits do not affect the dividend yield or the dividend payout
ratio.
Accounting: Memorandum entry, no change in accounts.
The announcement is generally viewed as a positive signal.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
DIVIDENDS: CASH DISTRIBUTIONS
DIVIDENDS: PAYMENT CHRONOLOGY
SHARE REPURCHASES
STOCK SPLITS
STOCK SPLITS
REVERSE STOCK SPLITS
REVERSE STOCK SPLITS
A reverse stock splits is the proportionate reduction in the number of
shares.
A reverse stock split has the opposite effect of the traditional, or
forward, stock split: –It reduces the number of shares, with the
expectation of increasing the stock price.
A 1:2 reverse stock split results in half the number of shares
outstanding after the split.
The goal may be to increase the share price to make it more attractive
for institutional investors.
Reverse stock splits are most common for companies in financial
distress.
YI ZHOU CHAPTER SIX: DIVIDENDS AND SHARE REPURCHASES: BASICS
Introduction
Regular cash dividends
Other Dividends
Dividends: Payment Chronology
Share Repurchases
Share repurchase vs. Cash Dividends
Stock Splits
Reverse Stock Splits
SAN FRANCISCO STATE UNIVERSITY (SFSU)
FIN
3
5
1
: FINANCIAL MANAGEMENT
SAMPLE FINAL REVIEW by Professor Yi Zhou
1. Which of the following best defines the concept of corporate governance?
A. A system for monitoring managers’ activities, rewarding performance, and
disciplining misbehavior.
B. Corporate values and governance structures that ensure the business is
conducted in an ethical, competent, fair, and professional manner.
C. A system of principles, policies, and procedures used to manage and con-
trol the activities of a corporation so as to overcome conflicts of interest
inherent in the corporate form.
D. A system to ensure complete transparency in disclosures regarding oper-
ations, performance, risk, and financial position.
E. A system of fairness and accuracy in identifying inherent conflicts of in-
terest.
Answer: C. Corporate governance is the system of principles, policies, proce-
dures, and clearly defined responsibilities and accountabilities used by stakehold-
ers to overcome the conflicts of interest inherent in the corporate form. [Directly
from the Lecture Note.]
2
. Which of the following best defines the objectives of an effective system
of corporate governance?
A. ensure that the assets of the company are used efficiently and productively.
B. eliminate or mitigate conflicts of interest among stakeholders.
C. A and B.
D. D. ensure complete transparency in disclosures regarding operations, per-
formance, risk, and financial position.
E. A and D.
Answer: C. OBJECTIVES: To eliminate or mitigate conflicts of interest.
Particularly those between corporate managers and shareholders; and To ensure
that the assets of the company are used efficiently and productively and in the
best interests of its investors and other stakeholders. [Directly from the Lecture
Note.]
1
Question 3 to
8
use the following set-up:
Suppose a company has the opportunity to bring out a new product, the
Vitamin-Burger. The initial cost of the assets is $
9
0 million, and the company’s
working capital would increase by $20 million during the life of the new product.
The new product is estimated to have a useful life of four years, at which time
the assets would be sold for $
15
million. Management expects company sales
to increase by $
12
0 million the first year, $1
6
0 million the second year, $1
4
0
million the third year, and then trailing to $50 million by the fourth year because
competitors have fully launched competitive products. Operating expenses are
expected to be 60% of sales, and depreciation is based on an asset life of three
years under MACRS (modified accelerated cost recovery system). The MACRS
deprecation schedule is Year 1: 33.33%. Year 2: 44.45%. Year 3:
14
.81%. Year
4:
7
.41%. Assume the required rate of return on the Vitamin-Burger project is
10
% and the company’s tax rate is 35%.
Year 0 1 2 3 4
Investment Outlays:
Fixed capital -90.00
Net working capital -20.00
Total –
11
0.00
Annual after-tax operating cash flows:
Sales 120.00
16
0.00 140.00 50.00
− Cash operating expenses 72.00 96.00 84.00 30.00
− Depreciation 30.00 40.01
13
.33 6.67
Operating income before taxes
18
.00 24.00 42.67 13.33
− Taxes on operating income 6.30 8.40 14.93 4.67
Operating income after taxes 11.70 15.60 27.74 8.67
+ Add back: depreciation 30.00 40.01 13.33 6.67
After-tax operating cash flow 41.70 55.60 41.07 15.33
Terminal year after-tax nonoperating cash flows:
Salvage value 15.00
After-tax salvage value 9.75
Return of net working capital 20.00
Total after-tax cash flow -110.00 41.70 55.60 41.07
45.08
Tax Rate 35%
Required Rate of Return 10%
Net Present Value 35.51
−110 + 41.70
(1 + 0.1)
+
55.60
(1 + 0.1)2
+
41.07
(1 + 0.1)3
+
45.08
(1 + 0.1)4
= 35.51
2
3. What is the investment outlay?
A. −100 million.
B. −110 million.
C. −120 million.
D. −90 million.
E. −70 million.
Answer: B.
Outlay = FCInv +NWCInv − (1− T )Sal0 − TB0
• FCInv = Investment in new fixed capital
• NWCInv = Investment in net working capital
• Sal0 = Cash proceeds (salvage value) from sale of old fixed capital.
• T = Tax rate
• B0 = Book value of old fixed capital.
In this question
• FCInv = −$90 million (The initial cost of the assets is $90 million.)
• NWCInv = −$20 million (The company’s working capital would increase by
$20 million during the life of the new product.)
• Sal0 = $0 million (No information).
• T = 35% (The company’s tax rate is 35%.)
• B0 = $0 million (No information).
Outlay = FCInv +NWCInv = −90− 20 = −110.
4. What is the cash operating expense for Year 2?
A. 100 million
B. 106 million
C. 96 million
D. 92 million
E. 90 million
Answer: C. “Operating expenses are expected to be 60% of sales”, and “Man-
agement expects company sales to increase by $120 million the first year, $160
million the second year,”… Thus Cash operating expense for Year 2 is 60%×$160
= 96.
3
5. What is the depreciation for Year 3?
A. 30.68 million
B. 24.12 million
C. 20.56 million
D. 13.33 million
E. 12.08 million
Answer: D. The MACRS deprecation schedule is Year 1: 33.33%. Year 2:
44.45%. Year 3: 14.81%. Year 4: 7.41%. Deprecation is of the initial cost of
assets. Thus the depreciation for Year 3 is 14.81%×90=13.33.
6. What is the after-tax operating cash flow for Year 4?
A. 55.60 million
B. 41.07 million
C. 41.70 million
D.
17
.33 million
E. 15.33 million
Answer: E. After-tax operating cash flow = Operating cash flow (OCF)
OCF = (S − C −D)(1 − T ) +
D
S4 = 50, C4 = 60% × 50 = 30, D4 = 7.41% × 90 = 6.67, T = 35%
OCF4 = (S4−C4−D4)(1−T4)+D4 = (50−30−6.67)×(1−35%)+6.67 = 15.33
7. What is the total terminal after-tax non-operating cash flows for Year 4?
A. 45.08 million
B. 41.70 million
C. 41.07 million
D. 55.60 million
E. 15.33 million
Answer: A. The Total terminal after-tax non-operating cash flows = After-tax
operating cash flow + TNOCF
where
TNOCF = SalT (1 − T ) +NWCInv + TBT
4
• SalT = Cash proceeds (salvage value) from sale of fixed capital on termi-
nation date.
• NWCInv = Investment in working capital.
• BT = Book value of fixed capital on termination date.
In this question:
• SalT = $15 million (At which time the assets would be sold for $15 mil-
lion.)
• T = 35% (The company’s tax rate is 35%.)
• NWCInv = $20 million (The company’s working capital would increase
by $20 million during the life of the new product.)
• BT = $0 million (No information).
TNOCF = SalT (1−T )+NWCInv+TBT = 15×(1−0.35)+20 = 9.75+20 = 29.75
The Total terminal after-tax non-operating cash flows = OCF4 + TNOCF
= 15.33 + 29.75 = 45.08.
8. What is the NPV value of the project?
A. 30.51 million
B. 35.51 million
C. 37.51 million
D. 39.45 million
E. 41. 23 million
Answer: B. Management expects company sales to increase by $120 million
the first year, $160 million the second year, $140 million the third year, and
then trailing to $50 million by the fourth year because competitors have fully
launched competitive products. S1 = 120, S2 = 160, S3 = 140, S4 = 50.
Operating expenses are expected to be 60% of sales, C1 = 120 × 60% =
72, C2 = 160 × 60% = 96, C3 = 140 × 60% = 84, C4 = 50 × 60% = 30.
and depreciation is based on an asset life of three years under MACRS
(modified accelerated cost recovery system). The MACRS deprecation sched-
ule is Year 1: 33.33%. Year 2: 44.45%. Year 3: 14.81%. Year 4: 7.41%.
D1 = 90 × 33.33% = 30, D2 = 90 × 44.45% = 40.01, D3 = 90 × 14.81% =
13.33, D4 = 90 × 7.41% = 6.67.
Outlay = FCInv +NWCInv = −90 − 20 = −110.
5
Total after-tax cash flow1 = OCF1 = (S1 − C1 −D1)(1 − T1) +D1 (1)
= (120 − 72 − 30) × (1 − 35%) + 30 = 41.70
Total after-tax cash flow2 = OCF2 = (S2 − C2 −D2)(1 − T2) +D2
= (160 − 96 − 40.01) × (1 − 35%) + 40.01 = 55.60
Total after-tax cash flow3 = OCF3 = (S3 − C3 −D3)(1 − T3) +D3
= (140 − 84 − 13.33) × (1 − 35%) + 13.33 = 41.07
Total after-tax cash flow4 = OCF4 + TNOCF
= (S4 − C4 −D4)(1 − T4) +D4 + TNOCF
= (50 − 30 − 6.67) × (1 − 35%) + 6.67 + 29.75 = 45.08
The required rate of return on the Vitamin-Burger project is 10%, r = 10% =
0.1.
NPV = Outlay +
Total after-tax cash flow1
(1 + r)
+
Total after-tax cash flow2
(1 + r)2
(2)
+
Total after-tax cash flow3
(1 + r)3
+
Total after-tax cash flow4
(1 + r)4
= −110 + 41.70
(1 + 0.1)
+
55.60
(1 + 0.1)2
+
41.07
(1 + 0.1)3
+
45.08
(1 + 0.1)4
= 35.51
9. Suppose the Widget Company has a capital structure composed of the
following, in billions: Debt $30, Common equity $60, Preferred stock $30. The
debt rating is of AA. The yield on AA debt is 8%. The marginal tax rate is 30%.
The preferred annual dividend is $10, current stock price is $100. If the risk-free
rate is 3%, the expected market risk premium is 5%, and the company’s stock
beta is 1.5. What is Widget’s weighted average cost of capital?
A. 0.0725
B. 0.0830
C. 0.0915
D. 0.1018
E. 0.1013
Answer: C. Weighted Average Cost of Capital (WACC)
WACC = wdrd(1 − t) + wprp + were
• wd is the proportion of debt.
• rd is the before-tax marginal cost of debt.
6
• t is the company’s marginal tax rate.
• wp is the proportion of preferred
stock.
• rp is the marginal cost of preferred stock.
• we is the proportion of equity.
• re is the marginal cost of equity.
Total Value of the Firm = Debt + Preferred Stock + Common Equity = 30 +
30 + 60 = 120.
• wd = DebtTotalV alueoftheFirm =
30
120 = 0.25 is the proportion of debt.
• rd is the before-tax marginal cost of debt 8%. (The debt rating is of AA.
The yield on AA debt is 8%)
• t = 30% is the company’s marginal tax rate.
• wp = PreferredDividendTotalV alueoftheFirm =
30
120 = 0.25 is the proportion of preferred stock.
• rp = PreferredDividendStockPrice =
10
100 = 0.1 is the marginal cost of preferred stock.
• we = CommonEquityTotalV alueoftheFirm =
60
120 = 0.5 is the proportion of equity.
• re is the marginal cost of equity.
Using CAPM
re = rf + β × (rM − rf ) = rf + β ×MRP
The market risk premium MRP = rM − rf = 5%, the company’s stock
beta β is 1.5, the risk-free rate rf is 3%, thus re = rf + β × MRP =
0.03 + 1.5 × 0.05 = 0.03 + 0.075 = 0.105
WACC = wdrd(1 − t) + wprp + were (3)
= 0.25 × 0.08 × (1 − 0.3) + 0.25 × 0.1 + 0.5 × 0.105
= 0.014 + 0.025 + 0.0525 = 0.0915
10. Suppose the Widget Company has a capital structure composed of the
following, in billions: Debt $40, Common equity $60, Preferred stock $20. The
debt rating is of AA. The yield on AA debt is 10%. The marginal tax rate is
30%. The preferred annual dividend is $10, current stock price is $120. If the
risk-free rate is 3%, the expected market risk premium is 5%, and the company’s
stock beta is 1.25. What is Widget’s weighted average cost of capital?
A. 0.0725
B. 0.0830
7
C. 0.0915
D. 0.1018
E. 0.1013
Answer: B. Weighted Average Cost of Capital (WACC)
WACC = wdrd(1 − t) + wprp + were
• wd is the proportion of debt.
• rd is the before-tax marginal cost of debt.
• t is the company’s marginal tax rate.
• wp is the proportion of preferred stock.
• rp is the marginal cost of preferred stock.
• we is the proportion of equity.
• re is the marginal cost of equity.
Total Value of the Firm = Debt + Preferred Stock + Common Equity = 40 +
20 + 60 = 120.
• wd = DebtTotalV alueoftheFirm =
40
120 = 0.333 is the proportion of debt.
• rd is the before-tax marginal cost of debt 10%. (The debt rating is of AA.
The yield on AA debt is 10%)
• t = 30% is the company’s marginal tax rate.
• wp = PreferredDividendTotalV alueoftheFirm =
20
120 = 0.167 is the proportion of preferred
stock.
• rp = PreferredDividendStockPrice =
10
120 = 0.0833 is the marginal cost of preferred
stock.
• we = CommonEquityTotalV alueoftheFirm =
60
120 = 0.5 is the proportion of equity.
• re is the marginal cost of equity.
Using CAPM
re = rf + β × (rM − rf ) = rf + β ×MRP
The market risk premium MRP = rM − rf = 5%, the company’s stock
beta β is 1.25, the risk-free rate rf is 3%, thus re = rf + β ×MRP =
0.03 + 1.25 × 0.05 = 0.03 + 0.0625 = 0.0925
WACC = wdrd(1 − t) + wprp + were (4)
= 0.333 × 0.10 × (1 − 0.3) + 0.167 × 0.0833 + 0.5 × 0.0925
= 0.0231 + 0.167 × 0.0833 + 0.5 × 0.0925 = 0.0830
8
Question 11 to 12 use the following set-up:
Number of units produced and sold: 1,000 Sales price per unit: $300 Variable
cost per unit: $150 Fixed operating cost: $50,000 Fixed financing expense:
$10,000
11.What is the degree of operating leverage?
A. 1.1
B. 1.2
C. 1.4
D. 1.5
E. 1.3
Answer: D.
• The degree of operating leverage (DOL): DOL = Q(P−V )Q(P−V )−F
• The degree of financial leverage (DFL): DFL = Q(P−V )−FQ(P−V )−F−C
• The degree of total leverage (DTL): DTL = DOL×DFL.
• Q: Number of units sold.
• P : Price per unit.
• V : Variable operating cost per unit.
• F : Fixed operating cost.
• C: Fixed financing expense.
In this question:
• Q = 1, 000: Number of units sold.
• P = $300: Price per unit.
• V = $150: Variable operating cost per unit.
• F = $50, 000: Fixed operating cost.
• C = $10, 000: Fixed financing expense.
• DOL = Q(P−V )Q(P−V )−F =
1,000×(300−150)
1,000×(300−150)−50,000 =
150,000
100,000 = 1.5
• DFL = Q(P−V )−FQ(P−V )−F−C
1,000×(300−150)−50,000
1,000×(300−150)−50,000−10,000 =
100,000
90,000 = 1.11
• DTL = DOL×DFL = 1.5 × 1.11 = 1.665.
9
12. What is the degree of total leverage?
A. 1.105
B. 1.125
C. 1.110
D. 1.135
E. 1.665
Answer: E. Please see the previous question’s answer.
13. Which one of the following statements matches M&M Proposition I
without taxes?
A. The cost of equity capital has a positive linear relationship with a firm’s
capital structure.
B. The dividends paid by a firm determine the firm’s value.
C. The cost of equity capital varies in response to changes in a firm’s capital
structure.
D. The value of a firm is independent of the firm’s capital structure.
E. The value of a firm is dependent on the firm’s capital structure
Answer: D.
• ModiglianiMiller (MM) Proposition I (No tax):
The market value of a company is independent of its capital structure.
• ModiglianiMiller (MM) Proposition II (No tax):
The cost of equity is a linear function of the company’s capital structure
(debt/equity ratio).
RA = WACC =
E
V
×RE +
D
V
×RD
RE = RA + (RA −RD) ×
D
E
14. Which one of the following states that a firm’s cost of equity capital is
a positive linear function of the firm’ s capital structure?
A. Financial risk of capital structure
B. M&M Proposition I without taxes
C. M&M Proposition II
10
D. Operating risk of capital structure
E. M&M Proposition I with taxes
Answer: C.
• ModiglianiMiller (MM) Proposition I (No tax):
The market value of a company is independent of its capital structure.
• ModiglianiMiller (MM) Proposition II (No tax):
The cost of equity is a linear function of the company’s capital structure
(debt/equity ratio).
RA = WACC =
E
V
×RE +
D
V
×RD
RE = RA + (RA −RD) ×
D
E
15. Paying interest reduces the taxes owed by a firm. Which one of the
following terms applies to this relationship?
A. Theory of interest rates
B. M&M Proposition I
C. Financial risk
D. Interest tax shield
E. Financial leverage
Answer: D.
11
• The tax shield lowers the cost of debt.
• The tax shield lowers the WACC as more debt is used.
• The tax shield increases the value of the firm by tD.
16. Which one of the following is the date on which the board of directors
agrees to pay a dividend and passes a resolution to do so?
A. Date of record
B. Ex-dividend date
C. Payment date
D. Declaration date
E. Public announcement date
Answer: D.
17. On which one of the following dates is the determination made as to
which shareholders will receive a dividend payment?
A. Date of record
B. Ex-dividend date
12
C. Payment date
D. Declaration date
E. Public announcement date
Answer: A.
The ex-dividend date is set exactly two business days before the dividend record
date. On and after the ex-dividend date, a buyer of the stock will not receive the
dividend as the seller is entitled to it.
18. The clientele effect states that investors fall into various groups because
of differences in their preferences for which one of the following?
A. Share price levels
B. Risk level
C. Short-term versus long-term investments
D. Rates of return
E. Dividends
Answer: E.
• The clientele effect is the influence of groups of investors attracted to
companies with specific dividend policies. Clientele are simply a group of
investors who have the same preference.
• Types of clientele:
–If an investor has a marginal tax on capital gains lower than the marginal
tax on dividends, the investor prefers a return in the form of capital gains.
–Investors who are tax exempt (e.g., pension funds) are indifferent about
dividends and capital gains.
–Some investors, by policy or restrictions, only invest in stocks that pay
dividends.
13
• The importance of the existence of clientele is that investors will have a
preference for stocks with a specific dividend policy.
The clientele effect does not necessarily imply that dividends affect value.
19. This morning, Structural Steel purchased 3,500 of its outstanding shares
in the open market. What type of transaction was this?
A. Stock payout
B. Stock distribution
C. Stock dividend
D. Stock repurchase
E. Stock reversal
Answer: D. A share repurchase is the transaction in which the stock issuer
buys back its shares from investors. –Also known as a share buyback.
20. Which one of the following increases the number of shares outstanding
but does not affect the dividend yield or dividend payout ratio?
A. Reverse stock split
B. Cash distribution
C. Stock split
D. Liquidation dividend
E. Special dividend
Answer: C. A stock split is a proportionate increase in the number of shares
outstanding.
• Stated in the following form: Number of new shares:Number of old shares
• So, 2:1 means that for each share held before the split, the shareholder
holds two shares after the split.
• Stock splits do not affect the dividend yield or the dividend payout ratio.
• The announcement is generally viewed as a positive signal.
21. UXZ has sales of $683,200, cost of goods sold of $512,900, and inventory
of $74,315. What is the inventory turnover rate?
A. 7.33 times
14
B. 6.90 times
C. 5.70 times
D. 7.14 times
E. 8.47 times
Answer: B.
Inventory turnover =
Cost of goods sold
Inventory
=
$512, 900
$74, 315
= 6.90.
22. Galaxy Sales has sales of $938,300, cost of goods sold of $764,500, and
inventory of $123,600. How long on average does it take the firm to sell its
inventory?
A. 6.40 days
B. 7.23 days
C. 48.68 days
D. 59.01 days
E. 61.10 days
Answer: D.
Inventory turnover =
Cost of goods sold
Inventory
=
$764, 500
$123, 600
= 6.185.
Number of days of inventory =
365
Inventory turnover
=
365
6.185
= 59.01
23. Leisure Products has sales of $738,800, cost of goods sold of $598,200,
and accounts receivable of $86,700. How long on average does it take the firm’s
customers to pay for their purchases? Assume a 365-day year.
A. 8.65 days
B. 11.28 days
C. 25.01 days
D. 42.83 days
E. 45.33 days
15
Answer: D.
Receivables turnover =
Total revenue
Accounts receivable
=
$738, 800
$86, 700
= 8.521
Number of days of receivables =
365
Receivables turnover
=
365
8.521
= 42.83
24. Fast Kars has a return on equity of 22.3 percent, a profit margin of 14.2
percent, and total equity of $467,000. What is the net income?
A. $69,608
B. $113,875
C. $104,141
D. $66,314
E. $109,897
Answer: C.
Return on equity =
Net income
Total equity
Net income = Return on equity × Total equity =22.3%× 467, 000 = 104, 141.
25. Health Centers, Inc., has total equity of $948,300, sales of $1.523 million,
and a profit margin of 4.4 percent. What is the return on equity?
A. 4.21 percent
B. 6.49 percent
C. 7.18 percent
D. 8.68 percent
E. 7.07 percent
Answer: E.
Return on equity =
Net income
Total equity
Profit margin = Net profit margin =
Net income
Total revenue
Net income = Profit margin × Total revenue
Return on equity =
Profit margin × Total revenue
Total equity
Return on equity =
0.044 × 1, 523, 000
948, 300
= 7.07%.
16
Question 26 to 30 use the following set-up:
Suppose that the Big Company has made an offer for the Little Company
that consists of the purchase of 1 million shares at $18 per share. The value
of Little Company stock before the bid was made public was $15 per share.
Big Company stock is trading at $40 per share, and there are 10 million shares
outstanding. Big Company estimates that it is likely to reduce costs through
economics of scale with this merge of $2 million per year, forever. The appro-
priate discount rate for these gains is 10%.
• Suppose that the Big Company has made an offer for the Little Company
that consists of the purchase of 1 million shares at $18 per share. Price
paid for the Target = $18 million.
• The value of Little Company stock before the bid was made public was $15
per share. Pre-merger value of the Target = $15 million.
• Big Company stock is trading at $40 per share, and there are 10 million
shares outstanding. Pre-merger value of the Acquirer = $40 × 10 = $400
million.
• Big Company estimates that it is likely to reduce costs through economics
of scale with this merger of $2 million per year, forever. The appropriate
discount rate for these gains is 10%. Synergistic gains S = $2 million/10%
= $20 million.
• Synergistic gains S = $2 million/10% = $20 million.
• Target’s gain = Premium = Price paid for the Target − Pre-merger value
of the Target = $18 million − $15 million = $3 million. (3/20 = 15% of
the synergistic gains.)
• Acquirer’s gain = Synergistic gains − Premium = $20 million − 3 million
= $17 million. (17/20 = 85% of the synergistic gains.)
• Post-merger value of the Acquirer = Pre-merger value of the Acquirer +
Acquirer’s gain = $400 million + $17 million = $417 million.
26. What are the synergistic gains from this merger?
A. 20 million
B. 18 million
C. 16 million
D. 14 million
E. 12 million
17
Answer: A.
27. What is the target shareholder’s gain?
A. 4 million
B. 3 million
C. 2 million
D. 1 million
E. 5 million
Answer: B.
28. What is Acquirer’s gain?
A. 15 million
B. 16 million
C. 17 million
D. 19 million
E. 20 million
Answer: C.
29. What do Big shareholders get?
A. 25% of the gain
B. 75% of the gain
C. 15% of the gain
D. 85% of the gain
E. 90% of the gain
Answer: D.
30. What is the value of Big Company post-merge?
A. 300 million
B. 350 million
C. 390 million
D. 410 million
E. 417 million
Answer: E.
18
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
CHAPTER SEVEN:
DIVIDEND POLICY
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
DIVIDENDS ARE IRRELEVANT
In Miller and Modigliani’s (MM) world with no taxes, no transaction
costs, and homogeneous information, dividend policy does not affect
the value of the company.
The decision of how a company finances its business is separate
from the decision of what and how much to invest in capital
projects.
If an investor wants cash flow, he/she could sell some shares.
If an investor wants more risk, he/she could borrow to invest.
An investor is indifferent about a share repurchase or a dividend.
Dividend policy does not affect a firm’s value.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
THE BIRD-IN-THE-HAND ARGUMENT
Investors prefer a cash dividend to uncertain capital gains.
Investors prefer the “bird in the hand”.
If this explanation holds, a company that pays a cash dividend
will have a higher value than a similar company that does not
pay a cash dividend.
Dividend policy affects the value of the firm.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
THE TAX ARGUMENT
If dividends are taxed at a rate higher than capital gains, investors
prefer capital gains.
When dividends are taxed at a rate higher than that of capital
gains, this advocates a zero dividend payout.
Dividend policy affects the value of the firm.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
THE CLIENTELE EFFECT
The clientele effect is the influence of groups of investors attracted to
companies with specific dividend policies. Clientele are simply a
group of investors who have the same preference.
If an investor has a marginal tax on capital gains lower than the
marginal tax on dividends, the investor prefers capital gains.
Investors who are tax exempt are indifferent about dividends and
capital gains.
The importance of the existence of clientele is that investors will have a
preference for stocks with a specific dividend policy.
The clientele effect does not necessarily imply that dividends affect
value.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
DIVIDENDS AND SIGNALING
Under MM’s theory, everyone has the same information.
When there is asymmetric information, dividend changes may
convey information.
Positive Information: Dividend initiations and increases.
Negative Information: Dividend omissions and reductions.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
DIVIDENDS ARE IRRELEVANT
THE BIRD-IN-THE-HAND ARGUMENT
THE TAX ARGUMENT
THE CLIENTELE EFFECT
DIVIDENDS AND SIGNALING
AGENCY COSTS AND DIVIDEND POLICY
AGENCY COSTS AND DIVIDEND POLICY
The separation of ownership and management in a corporation may
lead to suboptimal investment. Management may invest in negative
NPV projects to enhance the company’s size or management’s control.
Jensen’s free cash flow hypothesis is that having free cash flow tempts
management to make investments that are not positive NPV. Paying
dividends or interest on debt uses this free cash flow and averts an
agency issue.
Dividends may reduce agency costs and, therefore, increase the value
of the firm.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
FACTORS AFFECTING DIVIDEND POLICY
FACTORS AFFECTING DIVIDEND POLICY
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
FACTORS AFFECTING DIVIDEND POLICY
FACTORS AFFECTING DIVIDEND POLICY
More investment opportunities, less dividends.
More expected volatility of future earnings, less dividends.
For firms seeking financial flexibility, less dividends.
Tax considerations: the tax rate on dividends and how dividends are taxed
relative to capital gains affect investors’ preferences.
Flotation costs: the costs which make it more expensive to use newly issued
stock instead of internally generated funds. Smaller companies face higher
flotation costs.
Contractual and legal restrictions: –Impairment of capital rule: a legal
restriction on paying dividends if there is not a minimum amount of equity
capital. –Requirement of preferred shares.
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
DIVIDEND POLICY AND COMPANY VALUE: THEORY
FACTORS AFFECTING DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
TAX SYSTEM AND DIVIDEND POLICY
Consider a company whose tax rate is 35%, and individual
shareholders have a marginal tax rate of 25%.
Double taxation (U.S.): Earnings are taxed at corporate level;
dividends are taxed at shareholder level.
Tax rate = tcorporate + tshareholder − (tcorporate × tshareholder) =
35% + 25% − 35% × 25% = 35% + 25% − 8.75% = 51.25%
YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY
Dividend Policy and Company Value: Theory
Dividends are irrelevant
The Bird-in-the-Hand Argument
The Tax Argument
The Clientele Effect
Dividends and Signaling
Agency costs and Dividend policy
Factors Affecting Dividend policy
Tax System and Dividend Policy
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
CHAPTER THREE:
COST OF CAPITAL
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
MOTIVATION
MOTIVATION
Suppose you have just become the president of a large company and
the first decision you face is whether to go ahead with a plan to
renovate the company’s warehouse distribution system. The plan will
cost the company $50 million, and it is expected to save $12 million
per year after taxes over the next six years. To address it, you would
determine the relevant cash flows, discount them, and, if the net present
value is positive, take on the project; if the NPV is negative, you would
scrap it. So far, so good; but what should you use as the discount rate?
The new project will have a positive NPV only if its return exceeds
what the financial markets offer on investments of similar risk. We
called this minimum required return the cost of capital associated with
the project. We use the terms required return, discount rate, and cost of
capital interchangeably.
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
YIELD-TO-MATURITY APPROACH
DEBT-RATING APPROACH
YIELD-TO-MATURITY APPROACH
Consider a company whose yield-to-maturity is 5.26%. What is the
after-tax cost of debt if the marginal tax rate is 40%?
The after-tax cost of debt is rd(1 − t) = 5.26% × (1 − 40%) = 3.16%.
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
YIELD-TO-MATURITY APPROACH
DEBT-RATING APPROACH
DEBT-RATING APPROACH
Use yields on comparably rated bonds with maturities similar to what
the company has outstanding.
Example: Consider a company whose debt rating is AA. The yield on
AA debt is currently 6.2%. What is the after-tax cost of debt if the
marginal tax rate is 40%?
The after-tax cost of debt is rd(1 − t) = 6.2% × (1 − 40%) = 3.72%
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
COST OF PREFERRED STOCK
The cost of preferred stock that is noncallable and nonconvertible:
rpreferred =
Dpreferred
P
Suppose a company has a preferred stock outstanding that has a
dividend of $1.25 per share and a price of $ 20. What is the
company’s cost of preferred equity?
rpreferred =
1.25
20
= 0.0625 = 6.25%
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
CAPITAL ASSET PRICING MODEL (CAPM)
DIVIDEND GROWTH MODEL (DGM)
BOND YIELD PLUS RISK PREMIUM
CAPITAL ASSET PRICING MODEL (CAPM)
Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 8 percent, and the risk-free rate is 6 percent. What is
Alpha’s cost of equity capital?
re = rf + βe × (rM − rf ) = 6% + 1.2 × 8% = 15.6%
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
CAPITAL ASSET PRICING MODEL (CAPM)
DIVIDEND GROWTH MODEL (DGM)
BOND YIELD PLUS RISK PREMIUM
DIVIDEND GROWTH MODEL (DGM)
Alpha’s last dividend was $2 per share, and the dividend is expected
to grow at 8 percent indefinitely. The stock currently sells for $30.
What is Alpha’s cost of equity capital?
re =
D1
P0
+ g =
D0(1 + g)
P0
+ g =
2 × (1 + 0.08)
30
+ 0.08 = 15.2%
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
CAPITAL ASSET PRICING MODEL (CAPM)
DIVIDEND GROWTH MODEL (DGM)
BOND YIELD PLUS RISK PREMIUM
BOND YIELD PLUS RISK PREMIUM
The bond yield plus risk premium approach requires adding a premium to
a company’s yield on its debt:
re = rd + risk premium
Citigroup, as of early January 2006, the yield to maturity of the Citigroup
bonds maturing in 2016 was approximately 4.95%. Adding an arbitrary risk
premium of 3.5% produces an estimate of the cost of equity of
4.95 + 3.5 = 8.45%.
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC = wd rd(1 − t) + wprp + were
wd is the proportion of debt.
rd is the before-tax marginal cost of debt.
t is the company’s marginal tax rate.
wp is the proportion of preferred stock.
rp is the marginal cost of preferred stock.
we is the proportion of equity.
re is the marginal cost of equity.
wd + wp + we = 1
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC EXAMPLE 1
Assume that ABC Corporation has the following capital structure: 30
percent debt, 10 percent preferred stock, and 60 percent equity. ABC
Corporation wishes to maintain these proportions as it raises new funds. Its
before-tax cost of debt is 8 percent, its cost of preferred stock is 10 percent,
and its cost of equity is 15 percent. If the company’s marginal tax rate is 40
percent, what is ABC’s weighted average cost of capital?
wd = 0.3, wp = 0.1, we = 0.6, rd = 0.08, rp = 0.10, re = 0.15, t = 0.40
WACC = 0.3 × 0.08 × (1 − 0.40) + 0.1 × 0.1 + 0.6 × 0.15 = 11.44%
YI ZHOU CHAPTER THREE: COST OF CAPITAL
MOTIVATION
COST OF DEBT
COST OF PREFERRED STOCK
COST OF EQUITY
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC EXAMPLE 2
Suppose the Widget Company has a capital structure composed of the
following, in billions: Debt $10, Common equity $40. If the before-tax cost
of debt is 9%, the required rate of return on equity is 15%, and the marginal
tax rate is 30%, what is Widget’s weighted average cost of capital?
WACC =
10
10 + 40
× 0.09 × (1 − 0.30) + 0 +
40
10 + 40
× 0.15 (1)
= 0.0126 + 0.120 = 0.1326
YI ZHOU CHAPTER THREE: COST OF CAPITAL
Motivation
Yield-to-maturity Approach
Debt-rating Approach
Capital Asset Pricing Model (CAPM)
Dividend Growth Model (DGM)
Bond yield plus risk premium
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
CHAPTER FOUR:
MEASURES OF LEVERAGE
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
LEVERAGE
BUSINESS RISK & FINANCIAL RISK
DEFINITIONS
LEVERAGE
is the use of fixed costs in a company’s cost structure. A
company’s use of leverage affects its risk and return.
Operating leverage relates to the company’s operating cost structure.
Financial leverage relates to the company’s capital structure.
Leverage helps us understand a company’s future cash flows and the
risk associated with those cash flows and, hence, its valuation.
Leverage increases the volatility of earnings and cash flows. Hence, it
increases risk to suppliers of capital (creditors and owners).
Total leverage is the combined effect of operating leverage and
financial leverage.
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
LEVERAGE
BUSINESS RISK & FINANCIAL RISK
DEFINITIONS
BUSINESS RISK & FINANCIAL RISK
Business risk is the risk associated with operating earnings and reflects
both sales risk (uncertainty with respect to the price and quantity of
sales) and operating risk (the risk related to the use of fixed costs in
operations). It is affected by demand uncertainty, output price
uncertainty, and cost uncertainty.
Financial risk is the risk associated with how a company finances its
operations (i.e., the split between equity and debt financing of the
business).
In the event that creditor claims cannot be satisfied, there may be legal
statuses that help sort out the claims:
–Reorganization is the restructuring of claims, with the expectation
that the company will be able to continue, in some form, as a going
concern.
–Liquidation is the situation in which assets are sold and then the
proceeds distributed to claimants.
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
LEVERAGE
BUSINESS RISK & FINANCIAL RISK
DEFINITIONS
DEFINITIONS
The degree of operating leverage (DOL) is the sensitivity of operating
earnings to changes in units produced and sold. It is the ratio of the
percentage change in operating income to the percentage change in
units sold.
The degree of financial leverage (DFL) is the sensitivity of cash flows
to owners to changes in operating earnings. It is the ratio of the
percentage change in net income to the percentage change in operating
income.
The degree of total leverage (DTL) is the sensitivity of the cash flows
to owners to changes in unit sales.
The breakeven point, QBE , is the number of units produced and sold at
which the company’s net income is zero.
The operating breakeven point, QOBE , is the number of units produced
and sold at which the company’s operating income is zero.
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
DOL, DFL AND DTL
EXAMPLE OF DOL, DFL AND DTL
DOL, DFL AND DTL
The degree of operating leverage (DOL) (operating income):
DOL = Q(P−V)Q(P−V)−F
The degree of financial leverage (DFL) (net income):
DFL = Q(P−V)−FQ(P−V)−F−C
The degree of total leverage (DTL) (cash flow):
DTL = DOL × DFL.
Q: Number of units sold.
P: Price per unit.
V : Variable operating cost per unit.
F: Fixed operating cost.
C: Fixed financing expense.
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
DOL, DFL AND DTL
EXAMPLE OF DOL, DFL AND DTL
EXAMPLE OF DOL, DFL AND DTL
DOL1 =
Q(P − V)
Q(P − V) − F
=
1, 000(250 − 125)
1, 000(250 − 125) − 50, 000
= 1.67 (1)
DOL2 =
Q(P − V)
Q(P − V) − F
=
1, 000(250 − 25)
1, 000(250 − 25) − 100, 000
= 1.80
DFL1 =
Q(P − V) − F
Q(P − V) − F − C
=
1, 000(250 − 125) − 50, 000
1, 000(250 − 125) − 50, 000 − 5, 000
= 1.07
DFL2 =
Q(P − V) − F
Q(P − V) − F − C
=
1, 000(250 − 25) − 100, 000
1, 000(250 − 25) − 100, 000 − 55, 000
= 1.79
DTL1 = DOL1 × DFL1 = 1.67 × 1.07 = 1.79
DTL2 = DOL1 × DFL1 = 1.80 × 1.79 = 3.22
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
THE BREAKEVEN POINTS, QBE AND QOBE
EXAMPLE OF QBE AND QOBE
THE BREAKEVEN POINTS, QBE AND QOBE
The financial breakeven point, QBE, is the number of units
produced and sold at which the company’s net income is zero,
QBE =
F+C
P−V .
The operating breakeven point, QOBE, is the number of units
produced and sold at which the company’s operating income is
zero, QOBE =
F
P−V .
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
LEVERAGE
DOL, DFL AND DTL
THE BREAKEVEN POINTS, QBE AND QOBE
THE BREAKEVEN POINTS, QBE AND QOBE
EXAMPLE OF QBE AND QOBE
EXAMPLE OF QBE AND QOBE
QBE,1 =
F + C
P − V
=
50, 000 + 5, 000
250 − 125
= 440 (2)
QOBE,1 =
F
P − V
=
50, 000
250 − 125
= 400
QBE,2 =
F + C
P − V
=
100, 000 + 55, 000
250 − 25
= 689
QOBE,2 =
F
P − V
=
100, 000
250 − 25
= 444
YI ZHOU CHAPTER FOUR: MEASURES OF LEVERAGE
- Leverage
Leverage
Business Risk & Financial Risk
Definitions
DOL, DFL and DTL
Example of DOL, DFL and DTL
The breakeven points, QBE and QOBE
Example of QBE and QOBE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
CHAPTER FIVE:
CAPITAL STRUCTURE
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
MODIGLIANI–MILLER’S (MM) ASSUMPTIONS
MODIGLIANI–MILLER PROPOSITION I & II
MODIGLIANI–MILLER’S (MM) ASSUMPTIONS
Modigliani–Miller’s (MM) assumptions are unrealistic, but they help
us work through the effects of the capital structure decision:
1 Investors have homogeneous expectations about future cash
flows.
2 Bonds and stocks trade in perfect markets.
3 Investors can borrow and lend at the same rate.
4 There are no agency costs.
5 Investment and financing decisions are independent of one
another.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
MODIGLIANI–MILLER’S (MM) ASSUMPTIONS
MODIGLIANI–MILLER PROPOSITION I & II
MODIGLIANI–MILLER PROPOSITION I & II
Modigliani–Miller (MM) Proposition I (No tax):
The market value of a company is independent of its capital
structure.
Modigliani–Miller (MM) Proposition II (No tax):
The cost of equity is a linear function of the company’s capital
structure (debt/equity ratio).
RA = WACC =
E
V
× RE +
D
V
× RD
RE = RA + (RA − RD) ×
D
E
RA is the business risk, (RA − RD) × DE is the financial risk.
Here, for simplicity, we don’t consider preferred stocks.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
M&M PROPOSITION I WITH
TAXES
MODIGLIANI AND MILLER SUMMARY
M&M PROPOSITION I WITH TAXES
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
M&M PROPOSITION I WITH TAXES
MODIGLIANI AND MILLER SUMMARY
TAXES
The tax shield lowers the cost of debt.
The tax shield lowers the WACC as more debt is used.
The tax shield increases the value of the firm by tD.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
M&M PROPOSITION I WITH TAXES
MODIGLIANI AND MILLER SUMMARY
MODIGLIANI AND MILLER SUMMARY
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
FINANCIAL DISTRESS COST
THE STATIC THEORY OF CAPITAL STRUCTURE
OBSERVED CAPITAL STRUCTURES
BANKRUPTCY COSTS
Direct bankruptcy cost: the costs that are directly associated with
bankruptcy, such as the legal and administrative expenses
associated with the bankruptcy proceeding.
Indirect bankruptcy cost: the costs of avoiding a bankruptcy
filing incurred by a financially distressed firm.
Financial distress cost: the direct and indirect costs associated
with going bankrupt and/or avoiding a bankruptcy filing.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
FINANCIAL DISTRESS COST
THE STATIC THEORY OF CAPITAL STRUCTURE
OBSERVED CAPITAL STRUCTURES
FINANCIAL DISTRESS COST
The stockholders and the bondholders are different groups. Until the firm is
legally bankrupt, the stockholders control it. They, of course, will take actions
in their own economic interests. Because the stockholders can be wiped out in a
legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing.
The bondholders, on the other hand, are primarily concerned with protecting
the value of the firm’s assets and will try to take control away from the
stockholders. They have a strong incentive to seek bankruptcy to protect their
interests and keep stockholders from further dissipating the assets of the firm.
The net effect of all this fighting is that a long, drawn-out, and potentially quite
expensive legal battle gets started.
Meanwhile, the assets of the firm lose value because management is busy
trying to avoid bankruptcy instead of running the business. Normal operations
are disrupted, and sales are lost. Valuable employees leave, potentially fruitful
programs are dropped to preserve cash, and otherwise profitable investments
are not taken.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
FINANCIAL DISTRESS COST
THE STATIC THEORY OF CAPITAL STRUCTURE
OBSERVED CAPITAL STRUCTURES
THE STATIC THEORY OF CAPITAL STRUCTURE
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
FINANCIAL DISTRESS COST
THE STATIC THEORY OF CAPITAL STRUCTURE
OBSERVED CAPITAL STRUCTURES
OBSERVED CAPITAL STRUCTURES
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
LIQUIDATION
REORGANIZATION
LIQUIDATION
The situation in which assets are sold and then the proceeds distributed to
claimants. Chapter 7 of the Federal Bankruptcy Reform Act of 1978 deals
with “straight” liquidation. The following sequence of events is typical:
A petition is filed in a federal court. A corporation may file a voluntary
petition, or involuntary petitions may be filed against the corporation
by several of its creditors.
A trustee-in-bankruptcy is elected by the creditors to take over the
assets of the debtor corporation. The trustee will attempt to liquidate
the assets.
When the assets are liquidated, after payment of the bankruptcy
administration costs, the proceeds are distributed among the creditors.
If any proceeds remain, after expenses and payments to creditors, they
are distributed to the shareholders.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
LIQUIDATION
REORGANIZATION
THE DISTRIBUTION OF THE PROCEEDS
The distribution of the proceeds of the liquidation occurs according to the
following priority list:
Administrative expenses associated with the bankruptcy.
Other expenses arising after the filing of an involuntary bankruptcy
petition but before the appointment of a trustee.
Wages, salaries, and commissions.
Contributions to employee benefit plans.
Consumer claims.
Government tax claims.
Payment to unsecured creditors.
Payment to preferred stockholders.
Payment to common stockholders.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
MODIGLIANI–MILLER (MM) PROPOSITION I & II
CORPORATE TAXES AND CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE
BANKRUPTCY PROCESS
LIQUIDATION
REORGANIZATION
REORGANIZATION
The restructuring of claims, with the expectation that the company will be able to continue, in
some form, as a going concern. Corporate reorganization takes place under Chapter 11 of the
Federal Bankruptcy Reform Act of 1978. The general objective of a proceeding under Chapter
11 is to plan to restructure the corporation with some provision for repayment of creditors.
A voluntary petition can be filed by the corporation, or an involuntary petition can be
filed by creditors.
A federal judge either approves or denies the petition. If the petition is approved, a time
for filing proofs of claims is set.
In most cases, the corporation (the “debtor in possession”) continues to run the business.
The corporation (and, in certain cases, the creditors) submits a reorganization plan.
Creditors and shareholders are divided into classes. A class of creditors accepts the plan
if a majority of the class agrees to the plan.
After its acceptance by creditors, the plan is confirmed by the court.
Payments in cash, property, and securities are made to creditors and shareholders. The
plan may provide for the issuance of new securities.
For some fixed length of time, the firm operates according to the provisions of the
reorganization plan.
YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE
Modigliani�Miller’s (MM) Assumptions
Modigliani�Miller Proposition I & II
M&M Proposition I with Taxes
Modigliani and Miller Summary
Financial Distress Cost
The Static Theory of Capital Structure
Observed Capital Structures
Liquidation
Reorganization
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
CHAPTER ONE:
CORPORATE GOVERNANCE
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
INTRODUCTION
Corporate governance is the system of principles, policies, procedures, and
clearly defined responsibilities and accountabilities used by stakeholders to
overcome the conflicts of interest inherent in the corporate form.
The quality of a corporation’s corporate of governance affects the risks and
value of the corporation. Effective, strong corporate governance is essential for
the efficient functioning of markets.
There are inherent conflicts of interest in corporations in which the ownership
and management are separate. The separation of ownership and management is
the basis for the agency relationship between managers (agents) and owners
(principals).
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
OBJECTIVES
CORE ATTRIBUTES
OBJECTIVES
To eliminate or mitigate conflicts of interest, particularly those
between corporate managers and shareholders; and
To ensure that the assets of the company are used efficiently and
productively and in the best interests of its investors and other
stakeholders.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
OBJECTIVES
CORE ATTRIBUTES
CORE ATTRIBUTES
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
SUMMARY OF FORMS OF BUSINESS
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
SOLE PROPRIETORSHIP
A sole proprietorship is a business owned by one person.
The simplest type of business. The least regulated form of organization. The
most numerous in terms of number of businesses.
Little separation between the owner and the manager(s) of the business.
Virtually no conflict of interest between the owner and manager(s).
The owner keeps all the profits and has unlimited liability for business debts.
−→ Creditors can look to the proprietor’s personal assets for payment.
There is no distinction between personal and business income, so all business
income is taxed as personal income.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
GENERAL PARTNERSHIP
All the partners share gains or losses, and all have unlimited liability
for all partnership debts. The way partnership gains (and losses) are
divided is described in the partnership agreement.
The partnership terminates when a general partner wishes to sell out or
dies. Ownership by a general partner is not easily transferred because a
new partnership must be formed.
All income is taxed as personal income to the partners, and the amount
of equity that can be raised is limited to the partners’ combined wealth.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
LIMITED PARTNERSHIP
One or more general partners will run the business and have unlimited
liability.
One or more limited partners will not actively participate in the
business and have limited liability to the amount that partner
contributes to the partnership.
If you are a limited partner, you must not become deeply involved in
business decisions unless you are willing to assume the obligations of a
general partner.
A limited partner’s interest can be sold without dissolving the
partnership, but finding a buyer may be difficult.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
CORPORATION
A corporation is a business created as a distinct legal entity owned by one or
more individuals or entities, with major decisions made by the board of
directors.
The members of the board of directors are elected by shareholders. The board
of directors monitor the company’s management on behalf of the shareholders.
Potential conflicts between the agents (the management and the members of
the board of directors) and the owners (the shareholders).
The corporation is the most important form (in terms of size) of business
organization in the United States.
A corporation is a legal “person” separate and distinct from its owners, and it
has many of the rights, duties, and privileges of an actual person. It can borrow
money and own property, can sue and be sued, and can enter into contracts. It
can even be a general partner or a limited partner in a partnership, and a
corporation can own stock in another corporation.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
THE ADVANTAGES
Owners not managers. The stockholders and the managers are usually
separate groups. The stockholders elect the board of directors, who then select
the managers. Management is responsible of running the corporation’s affairs
in the stockholders’ interests. In principle, stockholders control the corporation
because they elect the directors.
Transferable ownership interests. Ownership (represented by shares of
stock) can be readily transferred, and the life of the corporation is not limited.
The corporation borrows money in its own name. As a result, the stockholders
in a corporation have limited liability for corporate debts. The most they can
lose is what they have invested.
Easy to raise capital. If a corporation needs new equity, it can sell new shares
of stock and attract new investors.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
SUMMARY OF FORMS OF BUSINESS
SOLE PROPRIETORSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
CORPORATION
THE DISADVANTAGES
Double taxation. Because a corporation is a legal person, it
must pay taxes. Moreover, money paid out to stockholders in the
form of dividends is taxed again as income to those stockholders.
−→ Corporate profits are taxed twice: at the corporate level
when they are earned and again at the personal level when they
are paid out.
More highly regulated. For example, in the U.S. there are State
laws pertaining to corporations and the Securities and Exchange
Commission requires specific disclosures.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
THE GOAL OF FINANCIAL MANAGEMENT
SARBANES-OXLEY ACT
THE AGENCY PROBLEM
MANAGING MANAGERS
THE GOAL OF FINANCIAL MANAGEMENT
Maximize shareholder wealth: The goal of financial management
in a corporation is to maximize the current value per share of the
existing stock.
It doesn’t matter whether the business is a proprietorship, a
partnership, or a corporation. For each of these, good financial
decisions increase the market value of the owners’ equity and poor
financial decisions decrease it.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
THE GOAL OF FINANCIAL MANAGEMENT
SARBANES-OXLEY ACT
THE AGENCY PROBLEM
MANAGING MANAGERS
SARBANES-OXLEY ACT
In response to corporate scandals involving companies such as Enron,
WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in
2002. The act, which is better known as “Sarbox,” is intended to strengthen
protection against corporate accounting fraud and financial malpractice. Key
elements of Sarbox took effect on November 15, 2004.
Sarbox contains a number of requirements designed to ensure that companies
tell the truth in their financial statements. For example, the officers of a public
corporation must review and sign the annual report. They must attest that the
annual report does not contain false statements or material omissions and also
that the financial statements fairly represent the company’s financial results. In
essence, Sarbox makes management personally responsible for the accuracy of
a company’s financial statements.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
THE GOAL OF FINANCIAL MANAGEMENT
SARBANES-OXLEY ACT
THE AGENCY PROBLEM
MANAGING MANAGERS
THE AGENCY PROBLEM
Managerial goals may be different from shareholder goals. Imagine that a
corporation is considering a new investment. The new investment is expected to
favorably affect the stock price, but it is also a relatively risky venture. The owners of the
firm will wish to take the investment (because the share value will rise), but management
may not because there is the possibility that things will turn out badly and management
jobs will be lost. If management does not take the investment, then the stockholders may
lose a valuable opportunity.
Increased growth and size are not necessarily equivalent to increased shareholder
wealth. If left to themselves, managers would tend to maximize the amount of resources
over which they have control, or, more generally, business power or wealth. This goal
could lead to an overemphasis on business size or growth. For example, management
overpays to buy another company just to increase the size of the business or to
demonstrate corporate power.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
INTRODUCTION
OBJECTIVES AND GUIDING PRINCIPLES
FORMS OF BUSINESS ORGANIZATION
THE GOAL OF FINANCIAL MANAGEMENT
THE GOAL OF FINANCIAL MANAGEMENT
SARBANES-OXLEY ACT
THE AGENCY PROBLEM
MANAGING MANAGERS
MANAGING MANAGERS
Incentives can be used to align management and stockholder interests
First, managerial compensation, particularly at the top, is usually tied
to financial performance in general and oftentimes to share value in
particular. For example, managers are frequently given the option to
buy stock at a fixed price. The more the stock is worth, the more
valuable is this option.
Second, job prospects. Better performers within the firm will tend to
get promoted. More generally, those managers who are successful in
pursuing stockholder goals will be in greater demand in the labor
market and thus command higher salaries.
YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE
Objectives
Core Attributes
Summary of Forms of Business
Sole Proprietorship
General partnership
Limited partnership
Corporation
The Goal of Financial Management
Sarbanes-Oxley Act
The Agency Problem
Managing Managers
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
CHAPTER TWO:
CAPITAL BUDGETING
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
NET PRESENT VALUE
NPV EXAMPLES
NPV’S ADVANTAGES & DISADVANTAGES
NET PRESENT VALUE
Net present value (NPV ): the difference between an investment’s
market value and its cost.
NPV is a measure of how much value is created or added today by
undertaking an investment, and how well the project will meet the goal
of increasing shareholder wealth.
The capital budgeting process can be viewed as a search for
investments with positive net present values.
NPV > 0: Project is expected to add value to the firm will increase the
wealth of the owners. NPV = 0: Project’s inflows are exactly sufficient
to repay the invested capital.
We estimate NPV by using discounted cash flow, or DCF, valuation.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
NET PRESENT VALUE
NPV EXAMPLES
NPV’S ADVANTAGES & DISADVANTAGES
NPV EXAMPLE 1
Suppose we are asked to decide whether or not a new consumer product
should be launched. Based on projected sales and costs, we expect that the
cash flows over the five-year life of the project will be $2,000 in the first two
years, $4,000 in the next two, and $5,000 in the last year. It will cost about
$10,000 to begin production. We use a 10 percent discount rate to evaluate
new products. What should we do here?
NPV = −10, 000 +
2, 000
1.10
+
2, 000
1.102
+
4, 000
1.103
+
4, 000
1.104
+
5, 000
1.105
(1)
= −10, 000 + 1, 818 + 1, 653 + 3, 005 + 2, 732 + 3, 105 (2)
= 2, 313 (3)
This is positive; we should take on the project.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
NET PRESENT VALUE
NPV EXAMPLES
NPV’S ADVANTAGES & DISADVANTAGES
NPV EXAMPLE 2
Assume that Gerhardt Corporation is considering an investment of
$50 million in a capital project that will return after-tax cash flows of
$16 million per year for the next four years plus another $20 million
in year five. The required rate of return is 10 percent.
NPV = −50
+
16
1.101
+
16
1.102
+
16
1.103
+
16
1.104
+
20
1.105
(4)
= −50 + 14.545 + 13.223 + 12.021 + 10.928 + 12.418 (5)
= 13.136 (6)
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
NET PRESENT VALUE
NPV EXAMPLES
NPV’S ADVANTAGES & DISADVANTAGES
NPV EXAMPLE 3
Consider the Hoofdstad Project, which requires an investment of $1
billion initially, with subsequent cash flows of $200 million, $300
million, $400 million, and $500 million. What is the net present value
of the Hoofdstad Project if the required rate of return of this project is
5%?
NPV = −1, 000 +
200
1.051
+
300
1.052
+
400
1.053
+
500
1.054
(7)
= −1, 000 + 190.48 + 272.11 + 345.54 + 411.35 (8)
= 219.46 (9)
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
NET PRESENT VALUE
NPV EXAMPLES
NPV’S ADVANTAGES & DISADVANTAGES
NPV’S ADVANTAGES & DISADVANTAGES
Advantages
Easy to understand (i.e., value added).
Considers the time value of money.
Considers all project cash flows.
Disadvantages
Result is a monetary amount, not a return.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
PAYBACK PERIOD
PAYBACK PERIOD
The payback period is the length of time it takes to recover the initial
cash outlay of a project from future incremental cash flows.
In the following example, the payback occurs in the last year, Year 4:
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
PAYBACK PERIOD
PAYBACK PERIOD: IGNORING CASH FLOWS
The payback period for both Project X and Y is three years, even
through Project X provides more value through its Year 4 cash flow:
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INTERNAL RATE OF RETURN (IRR)
IRR’S ADVANTAGES & DISADVANTAGES
INTERNAL RATE OF RETURN (IRR)
Consider the following Project, which requires an investment of $1
billion initially, with subsequent cash flows of $200 million, $300
million, $400 million, and $500 million. What is the IRR?
0 = −1, 000 +
200
(1 + IRR)1
+
300
(1 + IRR)2
+
400
(1 + IRR)3
+
500
(1 + IRR)4
(10)
After several rounds of trials and errors
IRR = 12.826%
You will NOT be tested on how to calculate IRR in the final exam of
FIN 351.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INTERNAL RATE OF RETURN (IRR)
IRR’S ADVANTAGES & DISADVANTAGES
IRR’S ADVANTAGES & DISADVANTAGES
Solved iteratively. The problem is that we cannot solve directly
for IRR, but rather must either iterate (trying different values of
IRR until the NPV is zero) or use a financial calculator or
spreadsheet program to solve for IRR.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
When evaluating more than one project at a time, it is important to identify
whether the projects are independent or mutually exclusive. This makes a
difference when selecting the tools to evaluate the projects.
Independent projects are projects in which the acceptance of one project does
not preclude the acceptance of the other(s). Example: A large conglomerate is
introducing a new soup and a new peanut butter substitute.
Mutually exclusive projects are projects in which the acceptance of one
project precludes the acceptance of another or others. Example: An airline
requires a single jet for a new route. The airline can buy a jet from Boeing or
Airbus, but cannot buy one from each.
If projects are independent, accept if NPV > 0 produces the same result as
when IRR > r. If projects are mutually exclusive, accept if NPV > 0 may
produce a different result than when IRR > r.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
EXAMPLE: RANKING CONFLICTS
Consider two mutually exclusive projects, Project P and Project Q:
Which project is preferred and why?
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
EXAMPLE: PROJECT P AND PROJECT Q
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
NPV PROFILES: PROJECT P AND PROJECT Q
From IRR only, Project Q is preferred. However, from NPV, the choice is more
complicated.
For required rates of return less than 4.89%, Project P is preferred (that is, higher NPV).
For required rates of return between 4.89% and 12.11%, Project Q is preferred.
For required rates of return above 12.11%, both projects are rejected.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
THE MULTIPLE IRR PROBLEM
If cash flows change sign more than once during the life of the
project, there may be more than one rate that can force the
present value of the cash flows to be equal to zero. This scenario
is called the “multiple IRR problem.”
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
EXAMPLE: RANKING CONFLICTS
THE MULTIPLE IRR PROBLEM
EXAMPLE: THE MULTIPLE IRR PROBLEM
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
BEGINNING: INVESTMENT OUTLAY
AFTER-TAX OPERATING CASH FLOW (OCF)
TERMINAL YEAR
MACRS SCHEDULE
CASH FLOW PROJECTIONS
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
BEGINNING: INVESTMENT OUTLAY
AFTER-TAX OPERATING CASH FLOW (OCF)
TERMINAL YEAR
MACRS SCHEDULE
BEGINNING: INVESTMENT OUTLAY
Investment Outlay = FCInv + NWCInv − (1 − T)Sal0 − TB0
FCInv = Investment in new fixed capital
NWCInv = Investment in net working capital
Sal0(1 − T) = After-tax salvage value from sale of old fixed capital if
applicable.
T = Tax rate
B0 = Book value of old fixed capital if applicable.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
BEGINNING: INVESTMENT OUTLAY
AFTER-TAX OPERATING CASH FLOW (OCF)
TERMINAL YEAR
MACRS SCHEDULE
AFTER-TAX OPERATING CASH FLOW (OCF)
After-tax Operating Cash Flow =
OCF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + TD.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
BEGINNING: INVESTMENT OUTLAY
AFTER-TAX OPERATING CASH FLOW (OCF)
TERMINAL YEAR
MACRS SCHEDULE
TERMINAL YEAR
Terminal Year OCF = OCFT + SalT (1 − T) + NWCInv + TBT
SalT (1 − T) = After-tax salvage value.
NWCInv = Investment in working capital.
BT = Book value of fixed capital on termination date if applicable.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
BEGINNING: INVESTMENT OUTLAY
AFTER-TAX OPERATING CASH FLOW (OCF)
TERMINAL YEAR
MACRS SCHEDULE
MACRS SCHEDULE
Will be Provided at All Tests.
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
EXAMPLE: CASH FLOW ANALYSIS
EXAMPLE: CASH FLOW ANALYSIS
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The
initial cost of the assets is $95 million, and the company’s working capital would increase by
$13 million during the life of the new product. The new product is estimated to have a useful
life of four years, at which time the assets would be sold for $16 million. Management expects
company sales to increase by $140 million the first year, $175 million the second year, $155
million the third year, and then trailing to $65 million by the fourth year because competitors
have fully launched competitive products. Operating expenses are expected to be 70% of sales,
and depreciation is based on an asset life of three years under MACRS (modified accelerated
cost recovery system). Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81% and Year 4: 7.41%.If
the required rate of return on the Vitamin-Burger project is 8% and the company’s tax rate is
30%, should the company invest in this new product?
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
EXAMPLE: CASH FLOW ANALYSIS
EXAMPLE: CASH FLOW ANALYSIS
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS
PESSIMISTIC SCENARIO
MOST LIKELY SCENARIO
OPTIMISTIC SCENARIO
INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS
PESSIMISTIC SCENARIO
MOST LIKELY SCENARIO
OPTIMISTIC SCENARIO
PESSIMISTIC SCENARIO
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS
PESSIMISTIC SCENARIO
MOST LIKELY SCENARIO
OPTIMISTIC SCENARIO
MOST LIKELY SCENARIO
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
NET PRESENT VALUE
PAYBACK PERIOD
INTERNAL RATE OF RETURN (IRR)
RANKING CONFLICTS: NPV VS. IRR
CASH FLOW PROJECTIONS
EXAMPLE: CASH FLOW ANALYSIS
SCENARIO ANALYSIS
INPUT VARIABLES AND NPV FOR SCENARIO ANALYSIS
PESSIMISTIC SCENARIO
MOST LIKELY SCENARIO
OPTIMISTIC SCENARIO
OPTIMISTIC SCENARIO
YI ZHOU CHAPTER TWO: CAPITAL BUDGETING
Net Present Value
NPV Examples
NPV’s Advantages & Disadvantages
Payback Period
Internal rate of return (IRR)
IRR’s Advantages & Disadvantages
Independent vs. mutually Exclusive projects
Example: Ranking conflicts
The multiple IRR problem
Beginning: Investment Outlay
After-tax Operating Cash Flow (OCF)
Terminal year
MACRS Schedule
Example: Cash Flow analysis
Input Variables and NPV for Scenario Analysis
Pessimistic Scenario
Most Likely Scenario
Optimistic Scenario
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
CHAPTER NINE:
FINANCIAL STATEMENT ANALYSIS
Yi Zhou
Associate Professor
Department of Finance
College of Business
San Francisco State University
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
STANDARDIZED FINANCIAL STATEMENTS
BALANCE SHEETS EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
STANDARDIZED FINANCIAL STATEMENTS
Common-Size Balance Sheets
All accounts = percent of total assets (%TA)
Common-Size Income Statements
All line items = percent of sales or revenue (%SLS)
Standardized statements are useful for:
Comparing financial information year-to-year
Comparing companies of different sizes, particularly within the
same industry
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
STANDARDIZED FINANCIAL STATEMENTS
BALANCE SHEETS EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
BALANCE SHEETS EXAMPLE
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
STANDARDIZED FINANCIAL STATEMENTS
BALANCE SHEETS EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
STANDARDIZED FINANCIAL STATEMENTS
BALANCE SHEETS EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
INCOME STATEMENT EXAMPLE
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
STANDARDIZED FINANCIAL STATEMENTS
BALANCE SHEETS EXAMPLE
COMMON-SIZE BALANCE SHEETS EXAMPLE
INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
COMMON-SIZE INCOME STATEMENT EXAMPLE
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
BENCHMARKING
PROBLEMS WITH FINANCIAL ANALYSIS
CATEGORIES OF FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
Internal uses
Performance evaluation – compensation and comparison between
divisions
Planning for the future – guide in estimating future cash flows
External uses
Creditors
Suppliers
Customers
Stockholders
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
BENCHMARKING
PROBLEMS WITH FINANCIAL ANALYSIS
CATEGORIES OF FINANCIAL RATIOS
BENCHMARKING
Allow for better comparison through time or between companies
Used both internally and externally
Time-Trend Analysis
How the firm’s performance is changing through time
Internal and external uses
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
BENCHMARKING
PROBLEMS WITH FINANCIAL ANALYSIS
CATEGORIES OF FINANCIAL RATIOS
SELECTED TWO-DIGIT SIC CODES
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
BENCHMARKING
PROBLEMS WITH FINANCIAL ANALYSIS
CATEGORIES OF FINANCIAL RATIOS
PROBLEMS WITH FINANCIAL ANALYSIS
Conglomerates–No readily available comparables
Global competitors–Different accounting procedures
Different fiscal year ends
Seasonal variations and one-time events: For firms in seasonal
businesses (such as a retailer with a large Christmas season), this
can lead to difficulties in comparing balance sheets because of
fluctuations in accounts during the year.
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
WHY EVALUATE FINANCIAL STATEMENTS?
BENCHMARKING
PROBLEMS WITH FINANCIAL ANALYSIS
CATEGORIES OF FINANCIAL RATIOS
CATEGORIES OF FINANCIAL RATIOS
Liquidity ratios or Short-term solvency
Financial leverage ratios or Long-term solvency ratios
Asset management or Turnover ratios
Profitability ratios
Market value ratios
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
INCOME STATEMENT
Revenues 51,407
Cost of goods sold 25,076
Gross profit 26,331
Selling, general, and administrative expenses 16,504
Operating income/Earnings before interest and taxes (EBIT) 9,827
Interest expense 629
Other nonoperating income, net 152
Earnings before income taxes/Taxable Income 9,350
Income tax 2,869
Net income 6,481
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
BALANCE SHEET–ASSETS
Cash, cash equiv., and marketable securities 5,469
Investment securities 423
Accounts receivable 4,062
Inventories 4,400
Deferred income taxes 958
Prepaid expenses and other receivables 1,803
Total current assets 17,115
Net property, plant, and equipment 14,108
Intangible assets 23,900
Other assets 1,925
Total assets 57,048
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
BS–LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable 3,617
Accrued and other liabilities 7,689
Taxes payable 2,554
Debt due in one year 8,287
Total current liabilities 22,147
Long-term debt 12,554
Deferred income taxes 2,261
Other noncurrent liabilities 2,808
Total liabilities 39,770
Convertible Class A preferred stock 1,526
Common shareholders’ equity 15,752
Total shareholders’ equity 17,278
Total liabilities and shareholders’ equity 57,048
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
LIQUIDITY RATIOS
The primary concern is the firm’s ability to pay its bills over the short run without undue stress.
The ability to meet its short-term, immediate obligations.
Current ratio =
Current assets
Current liabilities
=
17, 115
22, 147
= 0.77
Quick ratio =
Cash+Short-term marketable investments+Receivables
Current liabilities
(1)
=
5, 469 + 423 +
4, 062
22, 147
= 0.45
Cash ratio =
Cash+Short-term marketable investments
Current liabilities
=
5, 469 + 423
22, 147
= 0.27
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
LIQUIDITY RATIOS’ MEANING
Current Ratio: One of the best-known and most widely used ratios.
Quick (or Acid-Test) Ratio: (1) Inventory is often the least liquid
current asset. Some of the inventory may later turn out to be damaged,
obsolete, or lost. (2) Relatively large inventories are often a sign of
short-term trouble. The firm may have overestimated sales and
overbought or overproduced as a result. In this case, the firm may have
a substantial portion of its liquidity tied up in slow-moving inventory.
Thus we use Quick (or Acid-Test) Ratio.
Cash Ratio: A very short-term creditor might be interested in the cash
ratio.
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
SOLVENCY/FINANCIAL LEVERAGE RATIOS
Solvency/Financial Leverage Ratios–ability to meets its debt obligations or financial leverage.
Total debt = Debt due in one year + Long-term debt + Deferred income taxes + Other noncurrent liabilities (2)
= 8, 287 + 12, 554 + 2, 261 + 2, 808 = 25, 910.
Total debt ratio = Debt-to-assets ratio =
Total debt
Total assets
=
25, 910
57, 048
= 0.45
Total equity = Total shareholders’ equity
Debt-to-equity ratio =
Total debt
Total equity
=
25, 910
17, 278
= 1.50
Financial leverage = Equity Multiplier =
Total assets
Total equity
=
57, 048
17, 278
= 3.30
Long-term debt-to-assets ratio =
Long-term debt
Total assets
=
12, 554
57, 048
= 0.22
Times interest earned ratio = Interest coverage ratio =
Earnings before interest and taxes (EBIT)
Interest payments
=
9, 827
629
= 15.62
Suppose the Cash flow from operations is 9,362.
Cash flow coverage ratio =
Cash flow from operations + Interest payments + Income Tax
Interest payments
=
9, 362 + 629 + 2, 869
629
= 20.45
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
ACTIVITY/ASSET MANAGEMENT RATIOS (I)
Activity/Asset Management Ratios–effectiveness in putting its asset
investment to good use.
Inventory turnover =
Cost of goods sold
(Average) inventory
=
25, 076
4, 400
= 5.70
Receivables turnover =
Total revenue
(Average)
Accounts receivable
=
51, 407
4, 062
= 12.66
Total asset turnover =
Total revenue
(Average) total assets
=
51, 407
57, 048
= 0.90
Capital Intensity =
(Average) total assets
Total revenue
=
57, 048
51, 407
= 1.11
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
ACTIVITY/ASSET MANAGEMENT RATIOS (II)
Number of days of inventory =
365
Inventory turnover
=
Inventory
Cost of goods sold/365
=
4, 400
25, 076/365
= 64.05
Number of days of receivables =
365
Receivables turnover
=
Accounts receivable
Revenue/365
=
4, 062
51, 407/365
= 28.84
Number of days of payables =
365
Payables turnover
=
Accounts payable
Purchases*/365
=
3, 617
25, 836/365
= 51.10
*NOTE: Purchases=COGS+Ending inventory−Beginning inventory. Suppose the Inventory of 2003 is 3,640. Then
Purchases= 25, 076 + 4, 400 − 3, 640 = 25, 836
Operating cycle = Number of days of inventory + Number of days of receivables = 64.05 + 28.84 = 92.89
Net operating cycle = Number of days of inventory + Number of days of receivables − Number of days of payables (3)
= 64.05 + 28.84 − 51.10 = 41.79
Note that sometimes, we also use this formula
Payables turnover =
COGS
Accounts payable
=
25, 076
3, 617
= 6.93
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
ACTIVITY/ASSET MANAGEMENT RATIOS’ MEANING
Inventory Ratios: the higher this ratio is, the more efficiently we are managing inventory.
It will take about Number of days of inventory to work off our current inventory. For
example, in 2014, General Motors had a 94-day supply. It would have taken General
Motors 94 days to deplete the available supply, or, equivalently, that General Motors had
94 days of vehicle sales in inventory. Mitsubishi had a 75-day supply of cars, while Ford
had a mere 25-day supply. Historically, a 60-day supply of inventory has been considered
normal in the automobile industry. This type of information is useful to auto
manufacturers in planning future marketing and production decisions.
It might make more sense to use the average inventory in calculating turnover. It depends
on the purpose of the calculation. If we are interested in how long it will take us to sell
our current inventory, then using the ending figure is probably better.
If the total asset turnover is 0.64 times, this means for every dollar in assets, we
generated $0.64 in sales. The capital intensity ratio, is simply the reciprocal of (that is, 1
divided by) total asset turnover. It can be interpreted as the dollar investment in assets
needed to generate $1 in sales. High values correspond to capital-intensive industries
(such as public utilities). The capital intensity is $l/0.64 = $1.56. That is, it takes $1.56 in
assets to create $1 in sales.
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
PROFITABILITY RATIOS
Profitability Ratios–ability to manage its expenses to generate profits from its sales.
Gross profit margin =
Gross profit
Total revenue
=
26, 331
51, 407
= 0.51
Operating profit margin =
Operating income
Total revenue
=
9, 827
51, 407
= 0.19
Profit margin = Net profit margin =
Net income
Total revenue
=
6, 481
51, 407
= 0.13
Pretax profit margin =
Earnings before taxes
Total revenue
=
9, 350
51, 407
= 0.18
Operating return on assets =
Operating income
Total assets
=
9, 827
57, 048
= 0.17
Return on assets =
Net income
Total assets
=
6, 481
57, 048
= 0.11
Return on equity =
Net income
Total equity
=
6, 481
17, 278
= 0.38
ROA and ROE should properly be called return on book assets and return on book equity.
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
DUPONT ANALYSIS
Return on equity =
Net income
Total equity
(4)
=
Total assets
Total equity
× Return on assets
= Financial leverage × Return on assets
=
Total assets
Total equity
×
Net income
Total assets
=
Total assets
Total equity
×
Revenues
Total assets
×
Net income
Revenues
= Financial leverage × Total asset turnover × Net profit margin
=
Total assets
Total equity
×
Revenues
Total assets
×
Operating income
Revenues
×
Pre-tax Income
Operating income
× (1 − TaxRate)
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
MARKET VALUE MEASURES
b= Retention ratio = (Earnings − Cash dividends)/Net income.
Dividend payout ratio = 1 − b = Cash dividends/Net income.
Price–earning (PE) ratio =
Price per share
Earnings per share (EPS)
Price–sales ratio =
Price per share
Sales per share
Market-to-book ratio =
Market value per share
Book value per share
EBITDA ratio =
Enterprise value
EBITDA
Enterprise value = Total market value of the stock (5)
+ Book value of all liabilities − Cash
EBITDA = EBIT + Depreciation & Amortization
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
STANDARDIZED FINANCIAL STATEMENTS
USING FINANCIAL STATEMENT INFORMATION
FINANCIAL RATIOS
EXAMPLES
LIQUIDITY RATIOS
SOLVENCY/FINANCIAL LEVERAGE RATIOS
ACTIVITY/ASSET MANAGEMENT RATIOS
PROFITABILITY RATIOS
DUPONT ANALYSIS
MARKET VALUE MEASURES
SUM. OF INTERNAL AND SUSTAINABLE GROWTH RATES
YI ZHOU CHAPTER NINE: FINANCIAL STATEMENT ANALYSIS
Standardized Financial Statements
Balance Sheets Example
Common-Size Balance Sheets Example
Income Statement Example
Common-Size Income Statement Example
Why Evaluate Financial Statements?
Benchmarking
Problems with Financial Analysis
Categories of
Financial Ratios
Examples
Liquidity Ratios
Solvency/Financial Leverage Ratios
Activity/Asset Management Ratios
Profitability Ratios
DuPont Analysis
Market Value Measures