Docstoc

QUIZ2

Document Sample
QUIZ2 Powered By Docstoc
					Review of
Accounting
         Learning Objectives:

• Use of the balance sheet, the income
    statement, and the statement of cash
    flows by managers.
•   Calculation of depreciation.
•   How depreciation affects cash flow.
•   How taxes affect a firm’s value.
•   Calculation of marginal and average
    tax rates.
  The Firm’s Financial Statements

• Annual report includes:

 Income Statement
  Balance Sheet
  Statement of Cash Flows
  Accompanying Notes
Income Statement
               ACME CORPORATION
    For the Year Ended December 31, 2009

Net Sales                               $15,000,000
Cost of goods sold                        5,000,000
Gross profit                             10,000,000
Depreciation Expense                      2,000,000
S&A Expenses                                800,000
Operating Income (EBIT)                   7,200,000
Interest expense                          1,710,000
Income before taxes                       5,490,000
Income taxes (40%)                        2,306,000
                          Net income     $3,184,000


Earnings per Share (4,000,000 shares)         $0.80

Common Dividends paid                     $400,000
   Increase in Retained Earnings         $2,784,000
The Firm’s Financial Statements

• Annual report includes:
   Balance Sheet
         The Firm’s Financial Statements
      Balance Sheet
                    Assets =   Liabilities +   Owners’ Equity


Current Assets:       Current Liabilities:           Owners’ Equity:
• Cash                 A/P                           Common Stock
• Inventory            Accruals                      Capital in Excess
• A/R                  S-T Debt                        of Par
                                                      Retained Earnings
Fixed Assets:         Long Term Liabilities:
 Land                 Bonds
 Plant                L-T Bank Debt
 Equipment            Mortgages
   Less: Ac. Dep.      Preferred Stock
Balance Sheet

                ACME CORPORATION
              Balance Sheet
                                           ACME CORPORATION
                                                              December 31
                                2009            2010      Change
Assets:

Cash                       $9,000,000    $10,000,000     1,000,000
Accounts receivable           700,000      1,000,000       300,000
Inventory                  17,300,000     10,000,000    -7,300,000
Marketable Securities       9,000,000      8,000,000    -1,000,000
Prepaid Expenses            1,000,000      1,000,000             0
 Total current assets      37,000,000     30,000,000    -7,000,000
Fixed Assets, Gross        14,000,000     28,000,000    14,000,000
  less Accumulated Depr.   (6,000,000)    (8,000,000)   -2,000,000
 Fixed Assets, Net          8,000,000     20,000,000    12,000,000
           Total assets $45,000,000 $50,000,000          5,000,000
 Balance Sheet
                            ACME CORPORATION
                    Assets = Liabilities + Owner’s Equity



                               2009          2010      Change
Assets:                                                               2009              2010      Change
Cash                                     Liabilities 1,000,000
                         $9,000,000 $10,000,000 & Equity:
Accounts receivable         700,000   1,000,000           300,000
                                         Accounts Payable            $7,000,000   $4,000,000    -3,000,000
Inventory                17,300,000 10,000,000         -7,300,000
                                         Notes payable                4,000,000    3,000,000    -1,000,000
Marketable Securities     9,000,000   8,000,000        -1,000,000
                                         Accrued Expenses             3,000,000    2,000,000    -1,000,000
Prepaid Expenses          1,000,000   1,000,000                  0
                                         Total current liabilities   14,000,000    9,000,000    -5,000,000
 Total current assets    37,000,000 30,000,000         -7,000,000
                                         Long-term debt              10,784,000   15,000,000     4,216,000
Fixed Assets, Gross      14,000,000 28,000,000 14,000,000
                                         Total liabilities           24,784,000   24,000,000     -784,000
  less Accumulated Depr. (6,000,000) (8,000,000) -2,000,000
                                         Preferred Stock              2,000,000    1,000,000    -1,000,000
 Fixed Assets, Net        8,000,000 20,000,000 12,000,000
                                         Common stock                 1,000,000    3,000,000     2,000,000
           Total assets $45,000,000 $50,000,000 in Excess of Par
                                         Capital        5,000,000    10,000,000   12,000,000     2,000,000
                                         Retained earnings            7,216,000   10,000,000     2,784,000
                                         Total common equity         18,216,000   25,000,000     6,784,000
                                         Total equity                20,216,000   26,000,000     5,784,000
                                           Total liabilities & equity $45,000,000 $50,000,000   5,000,000
  The Firm’s Financial Statements
            Income Statement:

         Revenues - Expenses = Net Income



Sales                        COGS
Investment Income            Salaries
  Gains                      Depreciation Exp.
  Interest Received          Taxes
  Dividends Received         Other Expenses
                             Interest Paid
  The Firm’s Financial Statements
          Income Statement:

Revenues - Expenses = Net Income




              Dividends       Δ Retained
                               Earnings
The Firm’s Financial Statements

   Annual report includes:


    Statement of Cash Flow
     The Firm’s Financial Statements
          Statement of Cash Flows
         Cash Inflow - Cash Outflow = Change in Cash


From Operations:



     Cash Sales +           Payments to Suppliers -
     Depreciation Exp. +    Salaries -
     Collection of A/R +    Increase A/R -
     Decrease inventory +   Decrease Payables -
                            Decrease Accruals -
           The Firm’s Financial Statements

               Statement of Cash Flows

              Cash Inflow - Cash Outflow = Change in Cash



      From Investing:


Sale of Fixed Assets + Purchase of fixed assets -   Purchase of other firms -



                                                                           14
      Statement of Cash Flows
  Cash Inflow - Cash Outflow = Change in Cash

From Financing:



      Sale of stock +       Buy back stock -
      Issue of LT debt +   Repay LT debt -
      or notes payable +   Pay dividends -
                           Pay interest -


                                                15
Market Value & Book Value can be very different.



Book Value is recorded initially at cost.

Changes in book value (depreciation)
  follow specified accounting rules.


                                                   16
   Factors that determine the disparity
    between market and book:
      Time since acquisition
       More time, more difference
     Inflation: Higher inflation, more difference

     Tangible versus intangible assets
        Intangible assets, more difference
As with assets, the market value of liabilities
   may diverge from the book value, but
   the relationship is less complex.
The main factor that determines the difference
   between market and book values for liabilities
   of a healthy firm is:
  “the time until a liability must be paid off ”

At maturity, the market value will equal the
   book value.
Market vs. Book Value of Equity

 Total Market Value of Equity is the market
 price per share times the number of
 shares outstanding.

 Book Value of equity reflects the changes in other
 asset and liability accounts since it is the
 account that can change to enforce the balance
 sheet identity.


  Stockholders’ Equity = Assets - Liabilities
         DEPRECIATION

 Accounting depreciation is the
    allocation of an asset’s initial cost
    over time.
   Allowable depreciation expense is
    determined by established
    accounting rules.
CALCULATION OF DEPRECIATION
Depreciable basis
   Total amount to be depreciated over the accounting
    life of the asset.
   Equal to cost of the asset plus any setup and delivery
    costs incurred.
Straight line depreciation
   Basis divided by accounting life with equal
    amounts of depreciation allocated to each time
    period (except for half-year convention).
MACRS (Modified Accelerated Cost
 Recovery System)
   Specified percent charged each year.
     Federal Income Taxation
 Marginal and Average Tax Rates
    Marginal = Tax Rate on the next dollar of income.
    Average = Taxes paid divided by taxable income.


Progressive Tax System
    Average tax rate increases with the level of
     taxable income.
    Marginal tax rate is greater than the average tax
     rate. (The current corp. tax rate schedule is not
     strictly progressive.)
            THE TAX SYSTEM EXPLAINED IN COFFEE
• Suppose that every day, ten men go out for COFFEE AND CONVERSATION
   and the bill for all ten comes to $100...
• If they paid their bill the way we pay our taxes, it would go something like this...
     • The first four men (the poorest) would pay nothing.
     • The fifth would pay $1.
     • The sixth would pay $3.
     • The seventh would pay $7.
     • The eighth would pay $12.
     • The ninth would pay $18.
     • The tenth man (the richest) would pay $59.

The ten men drank COFFEE every day and seemed quite happy with the arrangement, until
one day, the owner threw them a curve ball. "Since you are all such good customers," he said,
"I'm going to reduce the cost of your daily coffee bill by $20". Unlimited coffee for the ten
men would now cost just $80.
   The group still wanted to pay their bill the way we pay our taxes. So the first four men
were unaffected. They would still drink for free. But what about the other six men? How
could they divide the $20 windfall so that everyone would get his fair share?
   They realized that $20 divided by six is $3.33. But if they subtracted that from
everybody's share, then the fifth man and the sixth man would each end up being paid to
drink THEIR COFFEE.
         THE TAX SYSTEM EXPLAINED IN COFFEE

So, the owner suggested that it would be fair to reduce each man's bill
by a higher percentage the poorer he was, to follow the principle of the
tax system they had been using, and he proceeded to work out the
amounts he suggested that each should now pay.

 • At a bill of $80, in order to follow the principle of the tax system they had
 been using, and he proceeded to work out the amounts he suggested that
 each should now pay.

     •   Now, the first four men along with the fifth would pay nothing.
     •   The sixth now paid $2 instead of $3 (33% saving).
     •   The seventh now paid $5 instead of $7 (28% saving).
     •   The eighth now paid $9 instead of $12 (25% saving).
     •   The ninth now paid $14 instead of $18 (22% saving).
     •   The tenth now paid $49 instead of $59 (16% saving).
         THE TAX SYSTEM EXPLAINED IN COFFEE

Each of the six was better off than before. And the first four continued to
drink for free. But, once outside the bar, the men began to compare their
savings. "I only got a dollar out of the $20 saving," declared the sixth
man. He pointed to the tenth man AND SAID, "but he got $10!“ "Yeah,
that's right," exclaimed the fifth man. "I only saved a dollar too. It's unfair
that he got ten times more benefit than me!“ "That's true!" shouted the
seventh man. "Why should he get $10 back, when I got only $2? The
wealthy get all the breaks!“ "Wait a minute," yelled the first four men in
unison, "we didn't get anything at all. This new tax system exploits the
poor!“ The nine men surrounded the tenth and beat him up.
The next night the tenth man didn't show up for COFFEE AND
CONVERSATION so the nine sat down and had their COFFEE without
him. But when it came time to pay the bill, they discovered something
VERY important. They didn't have enough money between all of them for
even half of the bill!
    THE TAX SYSTEM EXPLAINED IN
              COFFEE

And that, my dear students is exactly how our tax
system works. The people who already pay the
highest taxes will naturally get the most benefit
from a tax reduction. Tax them too much, attack
them for being wealthy, and they just may not show
up anymore. In fact, they might start drinking coffee
overseas, where the atmosphere is somewhat
friendlier. For those who understand this, no
explanation is needed. For those who do not
understand, no explanation is possible because
you never will get it.
Income      % of Total Income Tax Paid
Top 1%                         40%
Top 10%                        71%
Top 50%                        97%
          From 2009 IRS Data
    Accounts Receivable Tax
       Building Permit Tax
         CDL License Tax
          Cigarette Tax
      Corporate Income Tax
         Dog License Tax
       Federal Income Tax
Federal Unemployment Tax (FUTA)
       Fishing License Tax
        Food License Tax
         Fuel Permit Tax
          Gasoline Tax
         Hunting License Tax
           Inheritance Tax
             Inventory Tax
IRS Interest Charges (tax on top of tax)
   IRS Penalties (tax on top of tax)
               Liquor Tax
               Luxury Tax
        Marriage License Tax
             Medicare Tax
              Property Tax
            Real Estate Tax
         Service charge taxes
                Social Security Tax
            Road Usage Tax (Truckers)
                    Sales Taxes
              Recreational Vehicle Tax
                    School Tax
                State Income Tax
         State Unemployment Tax (SUTA)
           Telephone Federal Excise Tax
    Telephone Federal Universal Service Fee Tax
 Telephone Federal, State and Local Surcharge Tax
     Telephone Minimum Usage Surcharge Tax
Telephone Recurring and Non-recurring Charges Tax
          Telephone State and Local Tax
           Telephone Usage Charge Tax
                     Utility Tax
         Vehicle License Registration Tax
                 Vehicle Sales Tax
            Watercraft Registration Tax
                  Well Permit Tax
            Workers Compensation Tax
 Not one of these taxes existed 100
             years ago...
   and our nation was the most
      prosperous in the world.

We had absolutely no national debt...
We had the largest middle class in the
world... And there was only one wage-
           earner per family

          What happened?
           Can you spell
         'politicians!'
Differential Tax Treatment
of Interest and Dividends
Interest paid on corporate debt is a tax
   deductible expense.

Dividends paid to common and preferred
   stockholders is not tax deductible.


Dividends received by a corporation
   from another corporation have at
   least a 70% exclusion from taxable
   income.
                                           32
         Differential Tax Treatment
         of Interest and Dividends
                     Dividend Income
                                           Corp “A” pays a
Corp “B” owns 100        Corp “A”          $2/share dividend
shares of Common                           to shareholders.
Stock in Corp “A”

       Corp “B”
                        $200


30% or $60 is Taxable               70% or $140 is Tax Free
         Corp. “B” pays marginal tax rate of 25%
   $60 x .25 = $15    Federal Taxes on dividend income
                                                         33
 Who Pays all the Bills?
The Taxpayer that’s Who
                         Don’t
       (Just Us)
                                          forget
   Income    % of Total Income Tax Paid
                                           Who
  Top 1%                    40%            pays
  Top 10%                  71%
  Top 50%                  97%              the
            From 2008 IRS Data             bills.
    Homework Questions and Problems
1. Explain the difference between debt and equity. Why must the two equal total
assets?

2. Ajax Inc. had profits of $200,000 for the year. Their retained earnings account grew
from $800,000 at the beginning of the year to $950,000 by year end. How much did
the firm pay out in dividends?

3. Calculate earnings per share for the following:
          Net income                               $500,000
          Interest expense:                     $ 50,000
          Common Dividends paid                    $100,000
          Common shares outstanding              100,000

4. Working capital includes both current and non-current assets. Do you agree or
disagree with this statement? Explain.

5. Explain why common stockholders are paid after preferred stockholders.

6. Are retained earnings and cash the same thing?

                                                                                          36
Analysis of Financial
    Statements




                        37
 Learning Objectives
• How financial ratio analysis helps
  managers assess the firm’s health.
• Compute profitability, liquidity, debt,
  asset activity, and market value ratios.
• Compare financial information over
  time and among companies.


                                        38
       Ratio Analysis
 Financial managers use ratios to
  interpret the raw numbers on financial
  statements.
 Relative measures allow comparison
  over time and to other firms.
 Ratios are used by financial managers,
  other business managers, creditors,
  and investors.


                                           39
           Ratio Analysis
Five Categories of Ratios

  •   Profitability ratios
  •   Liquidity ratios
  •   Debt ratios
  •   Asset activity ratios
  •   Market value ratios


                              40
         Ratio Analysis
Profitability Ratios
 • Measure the overall effectiveness of the
   firm’s management.




                                          41
         Ratio Analysis
  Profitability Ratios

                            Gross Profit
Gross Profit Margin =
                              Sales



   How effective is the firm at generating
   revenue in excess of its cost of goods
   sold?

                                             42
                                                 Balance Sheet
                                              Excalibur Corporation

                              Cash                 $175    Accounts Payable        $115
                              Accounts Receivable 430       S-T Notes Payable       115
                              Inventories           625    Current Liabilities     $230
                               Current Assets    $1,230    Bonds                   $600
                              Plant & Equipment $2,500     Owner’s Equity
                               Less:Acc. Depr.   (1,200)   Common Stock            $300
                              Net Fixed Assets   $1,300    Capital in Excess of Par 600
                               Total Assets      $2,530    Retained Earnings        800
         Income Statement                                  Total Owners’ Equity $1,700
      Excalibur Corporation                                Total Liabilities and
Sales                       $1,450                            Owners Equity      $2,530
Cost of Goods Sold             875
Gross Profit                 $575
Operating Expenses              45
Depreciation                   200       Gross
Net Operating Income         $330                            Gross Profit
Interest Expense                60
                                         Profit     =
                                                               Sales
Income Before Taxes          $270        Margin
Taxes (40%)                    108
Net Income                   $162                                   $575
                                     Gross Profit Margin =                     = 39.7%
Common Dividends Paid          100                                 $1,450
Addition to Retained Earnings $62
                                                                                    43
          Ratio Analysis
  Profitability Ratios

                            Operating Income
Operating Profit Margin =
                                 Sales



   How effective is the firm in keeping costs
   of production low?


                                                44
                                                 Balance Sheet
                                              Excalibur Corporation

                              Cash                $175     Accounts Payable        $115
                              Accounts Receivable 430       S-T Notes Payable       115
                              Inventories           625    Current Liabilities     $230
                                Current Assets   $1,230    Long-term Debt          $600
                              Plant & Equipment $2,500     Owner’s Equity
                                Less:Acc. Depr.  (1,200)   Common Stock            $300
                              Net Fixed Assets   $1,300    Capital in Excess of Par 600
                                Total Assets     $2,530    Retained Earnings        800
                                                           Total Owners’ Equity $1,700
      Income Statement
    Excalibur Corporation                                  Total Liabilities and
                                                              Owners Equity      $2,530
Sales                       $1,450
Cost of Goods Sold             875
Gross Profit                  $575
Operating Expenses              45
Depreciation                   200
Operating Income              $330
                                          Operating
                                                     Operating Income
Interest Expense                60        Profit   =
                                                          Sales
Income Before Taxes           $270        Margin
Taxes (40%)                    108
Net Income                    $162                                  $330
Common Dividends Paid          100   Oper. Profit Margin =                     = 22.8%
Addition to Retained Earnings $62
                                                                   $1,450
                                                                                   45
           Ratio Analysis
Profitability Ratios
Note: Net Income equals Earnings Available to CS
when there is no preferred stock.


                               Net Income
     Net Profit Margin =
                                  Sales


 How much net profit is being generated
 from each dollar of sales?
                                                   46
                                                     Balance Sheet
                                                 Excalibur Corporation
                                          Assets                      Liabilities
                                Cash                  $175 Accounts Payable          $115
                                Accounts Receivable 430 S-T Notes Payable             115
                                Inventories            625 Current Liabilities       $230
                                 Current Assets     $1,230 Long-term Debt            $600
                                Plant & Equipment $2,500 Owner’s Equity
                                 Less:Acc. Depr.    (1,200) Common Stock             $300
                                Net Fixed Assets    $1,300 Capital in Excess of Par 600
                                 Total Assets       $2,530 Retained Earnings          800
          Income Statement                                  Total Owners’ Equity $1,700
       Excalibur Corporation                                Total Liabilities and
                                                              Owners Equity        $2,530
Sales                       $1,450
Cost of Goods Sold             875
Gross Profit                 $575
Operating Expenses              45
Depreciation                   200              Net
Operating Income             $330                                   Net Income
Interest Expense                60              Profit     =
                                                                        Sales
Income Before Taxes          $270               Margin
Taxes (40%)                    108
Net Income                   $162                                    $162
Common Dividends Paid          100
                                        Net Profit Margin =                     = 11.2%
                                                                   $1,450
Addition to Retained Earnings $62
                                                                                     47
     Ratio Analysis

Profitability Ratios


  Return on Assets =    Net Income
                        Total Assets


How effectively is the firm generating net
income from its assets ?


                                             48
                                                   Balance Sheet
                                                Excalibur Corporation
                                         Assets                     Liabilities
                                Cash                 $175    Accounts Payable        $115
                                Accounts Receivable 430       S-T Notes Payable       115
                                Inventories           625    Current Liabilities     $230
                                  Current Assets   $1,230    Long-term debt          $600
                                Plant & Equipment $2,500     Owner’s Equity
                                  Less:Acc. Depr.  (1,200)   Common Stock            $300
                                Net Fixed Assets   $1,300    Capital in Excess of Par 600
                                  Total Assets     $2,530    Retained Earnings        800
                                                             Total Owners’ Equity $1,700
         Income Statement                                    Total Liabilities and
      Excalibur Corporation                                     Owners Equity      $2,530
Sales                       $1,450
Cost of Goods Sold             875
Gross Profit                  $575
Operating Expenses              45
Depreciation                   200           Return on               Net Income
Operating Income              $330
                                                              =      Total Assets
                                             Assets
Interest Expense                60
Income Before Taxes           $270
Taxes (40)                     108
Net Income%                   $162                        $162 = 6.4%
Common Dividends Paid          100          ROA =        $2,530
Addition to Retained Earnings $62                                                     49
        Ratio Analysis
Profitability Ratios


                        Net Income
 Return on Equity =
                       Common Equity


How well is the firm generating return to
its equity providers?



                                            50
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
                             Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
                              Current Assets    $1,230 Long-term Debt            $600
                             Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
Depreciation                     200    Return on Equity =       Net Income
Operating Income                $330                            Common Equity
Interest Expense                  60
Income Before Taxes             $270
Taxes (40%)                      108
Net Income                      $162                   $162
Common Dividends Paid            100     ROE =                     = 9.53%
Addition to Retained Earnings    $62
                                                      $1,700
                                                                                  51
             Ratio Analysis
    Liquidity Ratios

 Measure the ability of the firm to
  meet its short-term financial obligations.

                     Current Assets
    Current Ratio =
                    Current Liabilities


  Are there sufficient current assets to pay off
  current liabilities? What is the cushion of
  safety?
                                                   52
                                          Balance Sheet
                                      Excalibur Corporation
                               Assets                       Liabilities
                    Cash                 $175 Accounts Payable            $115
                    Accounts Receivable 430 S-T Notes Payable              115
                    Inventories           625 Current Liabilities        $230
                      Current Assets   $1,230 Long-term Debt             $600
                    Plant & Equipment $2,500 Owner’s Equity
                      Less:Acc. Depr.  (1,200) Common Stock              $300
                    Net Fixed Assets   $1,300 Capital in Excess of Par 600
                      Total Assets     $2,530 Retained Earnings            800
                                                Total Owners’ Equity $1,700
                                                Total Liabilities and
                                                  Owners Equity         $2,530


Current Ratio =    Current Assets
                  Current Liabilities


Current Ratio = $1,230 = 5.35x
                 $230
                                                                         53
           Ratio Analysis
 Liquidity Ratios
• Measure the ability of the firm to meet
  its short-term financial obligations.


                            Current Assets - Inventory
     Acid-Test Ratio =
                                Current Liabilities

    What happens to the firm’s ability to repay current
    liabilities after what is usually the least liquid of the
    current assets is subtracted?
                                                         54
                                               Balance Sheet
                                            Excalibur Corporation
                                     Assets                      Liabilities
                           Cash                 $175 Accounts Payable          $115
                           Accounts Receivable 430 S-T Notes Payable            115
                           Inventories           625 Current Liabilities       $230
                            Current Assets    $1,230 Long-term Debt            $600
                           Plant & Equipment $2,500 Owner’s Equity
                            Less:Acc. Depr.   (1,200) Common Stock             $300
                           Net Fixed Assets   $1,300 Capital in Excess of Par 600
                            Total Assets      $2,530 Retained Earnings          800
                                                       Total Owners’ Equity $1,700
                                                       Total Liabilities and
                                                         Owners Equity       $2,530



                    Current Assets - Inventory
Acid-Test Ratio =
                        Current Liabilities


                       $1,230 -$625
Acid-Test Ratio =                   = 2.63x
                           $230
                                                                                55
        Ratio Analysis

Debt Ratios
 Measure the relative size of the
  firm’s debt load and the firm’s
  ability to pay off the debt.




                                     56
        Ratio Analysis

Debt Ratios

   Debt Ratio =    Total Debt
                  Total Assets


What proportion of the firm’s assets is
financed with debt?


                                          57
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
                             Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
                              Current Assets    $1,230 Long-term Debt            $600
                             Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
Depreciation                     200
                                           Debt Ratio =        Total Debt
Operating Income                $330
Interest Expense                  60                          Total Assets
Income Before Taxes             $270
Taxes (40%)                      108
Net Income                      $162   Debt Ratio = $230 + $600 = 33%
Common Dividends Paid            100                   $2,530
Addition to Retained Earnings    $62
                                                                                  58
      Ratio Analysis
Debt Ratios


  Debt to      =   Total Debt
  Equity Ratio   Common Equity


 What is the proportion of debt relative to
 equity financing for the firm?



                                              59
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
                             Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
                              Current Assets    $1,230 Long-term Debt            $600
                             Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
Depreciation                     200   Debt to                     Total Debt
Operating Income                $330   Equity Ratio       =
                                                                 Common Equity
Interest Expense                  60
Income Before Taxes             $270
Taxes (40%)                      108
Net Income                      $162     D/E = $230 + $600 = 48.8%
Common Dividends Paid            100
Addition to Retained Earnings    $62
                                                  $1,700
                                                                                  60
          Ratio Analysis

Debt Ratios


                                Operating Income
Times Interest Earned Ratio =
                                Interest Expense


   What is the firm’s ability to repay interest
   payments from its operating income?

                                                   61
                                                   Balance Sheet
                                                Excalibur Corporation
                                         Assets                      Liabilities
                               Cash                 $175 Accounts Payable           $115
                               Accounts Receivable 430 S-T Notes Payable             115
                               Inventories           625 Current Liabilities        $230
                                Current Assets    $1,230 Long-term Debt             $600
                               Plant & Equipment $2,500 Owner’s Equity
                                Less:Acc. Depr.   (1,200) Common Stock              $300
                               Net Fixed Assets   $1,300 Capital in Excess of Par 600
                                Total Assets      $2,530 Retained Earnings           800
         Income Statement                                  Total Owners’ Equity $1,700
      Excalibur Corporation                                Total Liabilities and
Sales                       $1,450                           Owners Equity        $2,530
Cost of Goods Sold             875
Gross Profit                  $575
Operating Expenses              45
Depreciation                   200          Times
Operating Income              $330                               Operating Income
                                            Interest       =
Interest Expense                60                               Interest Expense
Income Before Taxes           $270          Earned Ratio
Taxes (40%)                    108
Net Income                    $162                             $330
Common Dividends Paid          100           TIE Ratio =         $60          = 5.50x
Addition to Retained Earnings $62
                                                                                     62
          Ratio Analysis
Asset Activity Ratios

• Help assess how effectively the firm is
  using assets to generate sales.




                                            63
              Ratio Analysis

 Asset Activity Ratios


                              Accounts Receivable
Average Collection Period =
                              Avg. Daily Credit Sales

    How long does it take for the firm on
    average to collect its credit sales from
    customers?

                                                    64
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
 Additional Info:            Cash                 $175 Accounts Payable          $115
 We assume all               Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
 sales are credit             Current Assets    $1,230 Bonds                     $600
                             Plant & Equipment $2,500 Owner’s Equity
 sales.                       Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45   Average
Depreciation                     200                 Accounts Receivable
                                       Collection =
Operating Income                $330                Avg. Daily Credit Sales
Interest Expense                  60
                                       Period
Income Before Taxes             $270
Taxes (40%)                      108
                                                    $430
                                       ACP =     $1,450/365         = 108.24 days
Net Income                      $162
Common Dividends Paid            100                                Days in a
Addition to Retained Earnings    $62                                  year        65
          Ratio Analysis

Asset Activity Ratios


                                   Sales
   Inventory Turnover Ratio =
                                 Inventory


  Is inventory efficiently translating into
  sales for the firm?

                                              66
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
                             Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
                              Current Assets    $1,230 Long-term Debt            $600
                             Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
Depreciation                     200           Inventory
                                                                   Sales
Operating Income                $330           Turnover =
Interest Expense                  60                             Inventory
                                               Ratio
Income Before Taxes             $270
Taxes (40%)                      108
                                                                   $1450 = 2.3x
Net Income                      $162   Inventory Turnover =
Common Dividends Paid            100                               $625
Addition to Retained Earnings    $62
                                                                                  67
           Ratio Analysis

  Asset Activity Ratios

                                    Sales
Fixed Asset Turnover Ratio = Net Fixed Assets


     How effective is the firm in using its fixed
     assets to help generate sales?


                                                    68
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
                             Accounts Receivable 430 S-T Notes Payable            115
                             Inventories           625 Current Liabilities       $230
                              Current Assets    $1,230 Long-term Debt            $600
                             Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
Depreciation                     200      Fixed Asset              Sales
Operating Income                $330      Turnover          = Net Fixed Assets
Interest Expense                  60
Income Before Taxes             $270      Ratio
Taxes (40%)                      108
                                                                   $1,450
Net Income                      $162   Fixed Asset Turnover =             = 1.12x
Common Dividends Paid            100                               $1,300
Addition to Retained Earnings    $62
                                                                                  69
           Ratio Analysis

Asset Activity Ratios

                                    Sales
 Total Asset Turnover Ratio =     Total Assets

  How effective is the firm in using its
  overall assets to generate sales?



                                                 70
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                     Liabilities
                              Cash                 $175    Accounts Payable        $115
                              Accounts Receivable 430       S-T Notes Payable       115
                              Inventories           625    Current Liabilities     $230
                                Current Assets   $1,230    Long-term Debt          $600
                              Plant & Equipment $2,500     Owner’s Equity
                                Less:Acc. Depr.  (1,200)   Common Stock            $300
                              Net Fixed Assets   $1,300    Capital in Excess of Par 600
                                Total Assets     $2,530    Retained Earnings        800
         Income Statement                                  Total Owners’ Equity $1,700
      Excalibur Corporation                                Total Liabilities and
Sales                       $1,450                            Owners Equity      $2,530
Cost of Goods Sold             875
Gross Profit                  $575
Operating Expenses              45
Depreciation                   200
                                            Total Asset             Sales
Operating Income              $330          Turnover =           Total Assets
Interest Expense                60          Ratio
Income Before Taxes           $270
Taxes (40%)                    108                                   $1,450
Net Income                    $162   Total Asset Turnover =                     = 0.57x
                                                                     $2,530
Common Dividends Paid          100
Addition to Retained Earnings $62
                                                                                    71
           Ratio Analysis
  Market Value Ratios

                             Market Price per Share
Price to Earnings Ratio =
                              Earnings per Share

How much are investors willing to pay per
dollar of earnings of the firm?
(Indicator of investor’s attitudes toward future
prospects of the firm and of the firm’s risk.)

                                                      72
                                                 Balance Sheet
                                              Excalibur Corporation
Additional Info:                       Assets                      Liabilities
                             Cash                 $175 Accounts Payable          $115
100 shares                   Accounts Receivable 430 S-T Notes Payable            115
$20.00 per                   Inventories
                              Current Assets
                                                   625 Current Liabilities
                                                $1,230 Long-term Debt
                                                                                 $230
                                                                                 $600
share                        Plant & Equipment $2,500 Owner’s Equity
                              Less:Acc. Depr.   (1,200) Common Stock             $300
                             Net Fixed Assets   $1,300 Capital in Excess of Par 600
                              Total Assets      $2,530 Retained Earnings          800
        Income Statement                                 Total Owners’ Equity $1,700
      Excalibur Corporation                              Total Liabilities and
Sales                     $1,450                           Owners Equity       $2,530
Cost of Goods Sold               875
Gross Profit                    $575
Operating Expenses                45
                                                P/E
Depreciation                     200
                                                      = Market Price/Share
Operating Income                $330            Ratio          EPS
Interest Expense                  60
 Income Before Taxes            $270
Taxes (40%)                      108
Net Income                      $162    P/E ratio =       $20.00
                                                                  = 12.35x
Common Dividends Paid            100                     $162/100
Addition to Retained Earnings    $62
                                                                                  73
              Ratio Analysis

  Market Value Ratios

                         Market Price per Share
Market to Book Ratio =
                         Book Value per Share


   How much are investors willing to pay per
   dollar of book value?



                                                  74
                                                 Balance Sheet
                                              Excalibur Corporation
                                       Assets                     Liabilities
 Additional Info:             Cash                 $175    Accounts Payable        $115
                              Accounts Receivable 430       S-T Notes Payable       115
  100 shares                  Inventories           625    Current Liabilities     $230
                                Current Assets   $1,230    Long-term Debt          $600
  $20.00 per                  Plant & Equipment $2,500     Owner’s Equity
     share                      Less:Acc. Depr.  (1,200)   Common Stock            $300
                              Net Fixed Assets   $1,300    Capital in Excess of Par 600
                                Total Assets     $2,530    Retained Earnings        800
         Income Statement                                  Total Owners’ Equity $1,700
      Excalibur Corporation                                Total Liabilities and
Sales                       $1,450                            Owners Equity      $2,530
Cost of Goods Sold             875
Gross Profit                 $575
Operating Expenses              45
Depreciation                   200     Market             Price/Share
Operating Income             $330       to    =       Common Equity/ # shares
Interest Expense                60     Book
Income Before Taxes          $270
Taxes (40%)                    108
Net Income                   $162
                                        M/B =       $20.00
Common Dividends Paid          100
                                                                         = 1.18x
                                                   $1,700/100
Addition to Retained Earnings $62
                                                                                    75
            EBITDA
EBITDA stands for Earnings Before
 Interest, Taxes, Depreciation, and
 Amortization.
It is often of great interest to financial
 analysts although FASB does not
 require that this number be reported.
It measures the amount of cash thrown
 off from the operations of the company.

                                         76
Ratio               Industry Excalibur
Profitability
Gross Profit Margin         38%   39.7%
Operating Profit Margin    20%    22.8%
Net Profit Margin          12%    11.2%
Return on Assets           9.0%    6.4%
Return on Equity          13.4%    9.5%


   Excalibur is good at keeping
 operating costs down, but not as
good at total costs. ROA and ROE
are low mainly due to productivity
            problems.

                                          77
Summary of Excalibur Corporation Ratios

      Ratio             Industry   Excalibur
      Liquidity
      Current Ratio      5.00x        5.35x
      Acid-Test Ratio    3.00x        2.63x

       Looking at the current ratio it appears
       that Excalibur is more liquid than the
        industry.... however when looking at
       Acid Test (a better measure) they are
       not as liquid indicating that inventory
            levels are probably too high.


                                                 78
Ratio               Industry Excalibur
Debt
Debt Ratio            35%               33%
Times Interest Earned 7.00x            5.50x
Debt to Equity         49%             48%

 While the debt ratio is close to the industry
   average, Excalibur is not able to cover
interest payments as easily as the industry.
This indicates Excalibur may have too much
 debt relative to what they can realistically
                    afford.


                                                 79
Ratio                 Industry Excalibur
 Asset Activity
 Avg. Collection Period    90 days       108 days
 Inventory Turnover          3.00x          2.32x
 Fixed Asset Turnover        1.00x          1.12x
 Total Asset Turnover        0.75x           .57x
Collection policies need examining, as Excalibur is
    slower than average at collecting receivables.
   Inventories are being sold more slowly than the
 industry average, again indicating inventories that
are too high. Excalibur is very efficient at converting
Fixed Assets to Sales (fixed assets are productive).
      However, overall assets are not productive
 indicating Current Assets (e.g. inventories) are not
          as productive as for the industry.

                                                          80
 Ratio             Industry Excalibur
 Market Value
 Price Earnings       18.0       12.35
 Market to Book        2.5        1.18

 Excalibur’s Investors are not willing to
 pay as much per dollar of earnings or
per dollar of book value as they are for
  shares in other firms in the industry.
This signals that they consider the firm’s
prospects to be worse than the average.
However, the firm is still selling for more
    than its accounting book value.


                                              81
         Relationships Among Ratios:
             The Du Pont System

• Ratio Analysis generally involves an
  examination of related ratios.
• Comparison of these relationships over time
  helps to identify the company’s strengths and
  weaknesses.




                                             82
Relationships Among Ratios:
The Du Pont System

     The Du Pont Equation

     Return        Net           Total
      on    =      Profit x      Asset
     Assets        Margin        Turnover


       Net Inc.   = Net Inc. x    Sales
       Assets        Sales       Assets



                                            83
           Relationships Among Ratios:
               The Du Pont System


  The Modified Du Pont Equation
Return      Net               Total        Equity
 on    =    Profit x          Asset    x
                                           Multiplier
Equity      Margin            Turnover


  Net Inc.     Net Inc.          Sales         Assets
  Equity
           =   Sales
                          x     Assets
                                           x   Equity



                                                    84
  Homework Questions & Problems:

Use the following information to answer the questions.

Elton Corporation
Income Statement
for the year ending 12/31/XX
(in thousands of dollars)

           Net sales                          $ 2,700
           Operating Costs                     (2,350)
           Depreciation                                     ( 150)
           Interest Expense                       (   70)

           EBT                                                130
           Income Tax (40%)                       (   52)

           Net Income                         $       78

           Dividends to Common Stock = $      58




                                                                     85
               Homework Questions & Problems:
                                          Elton Corporation
                                            Balance Sheet
                                              12/31/XX
                                      (in thousands of dollars)

Cash                                 $ 150
                                                 Accounts Payable             $100
Accounts Receivable                     250
                                                 Notes Payable                 250
Inventory                                600     Other Current Liabilities      50
Total Current Assets                  $1,000     Total Current Liabilities    $400

Total Fixed Assets                    1,500      Long Term Debt              1,100
                                                 Common Stock                  800
                                                 Retained Earnings             200
Total Assets                          $2,500     Total Liab. & Equity        $2,500

Number of shares outstanding = 10,000 shares
Price per Share = $100




                                                                                      86
              Homework Questions & Problems:

1. Calculate each of the following ratios. Be sure to give the complete equation as well as the
solution:
            a. Current ratio
            b. Quick ratio
            c. Total Debt/Total Asset Ratio
            d. Inventory Turnover Ratio
            e. ROE
            f. TIE
            g. EPS
            h. Net Profit Margin
            i. Market to Book Ratio
            j. Total Assets Turnover Ratio

2. Show the Modified DuPont Equation for the company.




                                                                                                  87
          Homework Questions & Problems:


3. Given these industry ratios:
            Net Profit Margin                  4.3%
            Debt/Asset                           40%
            Total Asset Turnover               1.1
              ROA                              4.73%

Use the DuPont equation to compare the performance of Elton Corp to the industry
average. What can you say about their(a) profitability, (b) expense control, (c) asset
management, and (d) debt management.

4. A firm expects to have net income of $85,000. If preferred dividends paid are 42,000,
common stock dividends paid are $20,000, and shares of common stock outstanding are
10,000, what is the EPS?




                                                                                           88
                  Homework Questions & Problems:


5. Fill in the missing data based on the information provided for years 2009 and 2010.

                                               ABC CORPORATION
                                      Balance Sheet Changes and Classification
                                      Of Key Accounts between 2009 and 2010

Account                            2009                    2010         Change   Source/Use
Long-term debt                     $960                    $800
Accounts receivable                $640                    $500
Common stock                       $200                    $300
Cash                               $640                    $500
Retained earnings                  $960                    $800
Accruals                            $50                    $200
Inventory                          $840                    $600
Accounts payable                 $1,150                   $1,000
Net fixed assets                 $1,800                   $2,000




                                                                                              89
  Forecasting for
Financial Planning




                     90
          Learning Objectives:

• The importance of forecasting to business
  success.
• The financial forecasting process.
• Preparation of pro forma financial
  statements.
• The importance of analyzing forecasts.



                                              91
Why is forecasting important?

Mistakes are costly:

  – If you produce too much of a product, or a
    product that no one wants to buy, you still
    must pay for materials, labor, and storage.
  – If you produce too little of a product, you will
    lose sales and possibly market share.

                                                       92
   Forecasting Approaches

Financial managers concentrate on
three general approaches to financial
forecasting:
  • Experience
  • Probability
  • Correlation

                                        93
            Experience

• Managers who have been in the business
  for a long time have developed a sense for
  the patterns in sales, expenses, consumer
  demand factors, etc.
  – Example: Editors who work for book
    publishers regularly read submitted
    manuscripts and make judgments about
    whether their company should buy the rights
    to publish the books.

                                              94
             Probability
• Past history often tells us a lot about
  what will happen in the future.
• Managers can use this information to
  estimate the future.
  – Example: In the past, a 7-11 manager has
    found that she will lose 1% of candy
    inventory to shoplifters. She can use this
    information to estimate future losses and
    also to design better controls.

                                                 95
                Correlation
• Correlation is a measure of the relative
  movement of two variables relative to each other.
   – Example: If interest rates go up, a real estate agent
     knows that home sales will tend to fall (because the
     higher cost of financing makes it harder for buyers to
     qualify for mortgages).
   – Example: Sales of umbrellas are higher in rainy
     seasons.




                                                          96
          The Sales Forecasting Process
            Marketing
         (sales estimate)

Top Management
(policy, strategy)                  Finance
                                   Department

     Production
(capacity, schedules)

              Accounting
         (financial statements,     SALES
          depreciation, taxes)    FORECAST
                                             97
Forecast future sales based on past
            sales growth

  Sales


                                           Plot of Past Sales




          00 01   02 03 04   05 06 07 08    09   Time
                                                            98
Forecast future sales based on past
            sales growth
 Sales




                                      Trend Line


                                               Time
         00 01   02 03 04   05 06 07 08   09
                                                      99
Forecast future sales based on past
            sales growth
                   Sales Estimates for
                      next 2 years

   Sales


                                         Growth Rate




                                                       Time
           00 01   02 03 04    05 06 07 08      09
                                                              100
Forecast future sales based on
      past sales growth
 Also include the effects of any events which are
  expected to impact future sales (new products or
  economic conditions)
 Sales




                               New Product
                               Introduced



                                               Time
         00 01   02 03 04   05 06 07 08   09
                                                      101
 Forecast future sales based on past sales
  growth

• Also include the effects of any events which are expected
  to impact future sales (new products or economic
  conditions)

   Sales




                       New Product
                       Introduced

                                                 Time
           00 01   02 03 04   05 06 07 08   09
                                                        102
Sales Growth Imposes Costs on the Firm

  Will require additional resources
    – Current Assets: Inventory, A/R, Cash
    – Fixed Assets: Plant and Equipment




   2009
                                  2010
                                             103
  Pro Forma Financial Statements
• Pro forma financial statements are forecasts of
  the firm’s future financial statements based on
  a certain set of assumptions about sales
  trends and the relationships between sales
  and various financial variables, and between
  other financial statement variables relative to
  each other.


                                               104
     Producing Pro Formas

Example Data for Marginal Product Inc.
 Sales will increase from $5million to $8 million.
 Production is at full capacity (24 hrs. per day).
 Dividend payout will be 70% of NI.
 Spontaneous balance sheet accounts. increase in
  a constant proportion to sales.



                                                105
         Producing Pro Formas

                                                 Step 1:
                                        Determining Sales Growth
                                              $8 - $5
                                                      = 60%
                                                $5
    Income Statement
   Marginal Product Inc.
          figures in 000s
      Current               Projected     Note: The projected sales
Sales $5,000                 $8,000       will be determined after input
COGS 4,133                                from many different units or
EBIT      867
                                          departments of the firm.
Int        200
EBT       667
Tax (.40) 267
NI        400
                                                                    106
         Producing Pro Formas
                                              Step 2:
                                     Calculate projected Net
     Income Statement
    Marginal Product Inc.
            figures in 000s
                                      Income. New COGS =
      Current            Projected   Old COGS x 1.6 = 6,613
Sales $5,000              $8,000
COGS 4,133                 6,613
EBIT      867              1,387     Note: There is no increase yet
Int        200               200
                                      in the interest charges since
EBT       667              1,187
Tax (.40) 267                475     Marginal Product’s managers
NI        400                712     have not yet decided how they
                                         will finance the growth.



                                                               107
        Producing Pro Formas
                                                                 Step 3:
                                                       Forecast increase in
                                                        assets (% of sales)

                              Balance Sheet
                           Marginal Product Inc.
                                 figures in 000,000s
   Assets    Current      Projected      Liabilities        Current     Projected
Current Assets     $2.5                    Accounts Payable      $1.0
Net Fixed Assets    3.0                    Accrued Expenses       0.5
Total              $5.5                    Notes Payable          0.0
                                           Current Liabilities   $1.5
                                           Long Term Debt        $2.0
                                           Common Stock           0.5
                                           Retained Earnings      1.5
                                           Common Equity         $2.0
                                           Total Claims          $5.5
                                                                                    108
        Producing Pro Formas
                                      Step 3:
 Forecast increase in assets (% of sales). If
 sales increase by 60%, so too will any asset
 that remains a constant percent of sales.

                              Balance Sheet
                           Marginal Product Inc.
                                    figures in 000,000s
   Assets    Current      Projected         Liabilities     Current        Projected
Current Assets     $2.5      $4.0             Accounts Payable      $1.0
Net Fixed Assets    3.0                       Accrued Expenses       0.5
Total              $5.5                       Notes Payable          0.0
                                              Current Liabilities   $1.5
                                              Long Term Debt        $2.0
                                              Common Stock           0.5
  $2.5(1+.60) = $4.0                          Retained Earnings      1.5
                                              Common Equity         $2.0
                                              Total Claims          $5.5
                                                                                       109
            Producing Pro Formas
                                                             Step 3:
                                                    Forecast increase in
                                                     assets (% of sales)

                              Balance Sheet
                           Marginal Product Inc.
                                    figures in 000,000s
   Assets    Current      Projected        Liabilities      Current        Projected
Current Assets     $2.5      $4.0             Accounts Payable      $1.0
Net Fixed Assets    3.0       4.8             Accrued Expenses       0.5
Total              $5.5      $8.8             Notes Payable          0.0
                                              Current Liabilities   $1.5
                                              Long Term Debt        $2.0
         +$3.30                               Common Stock           0.5
                                              Retained Earnings      1.5
                                              Common Equity         $2.0
   $3.0(1+.60) = $4.8                         Total Claims          $5.5
                                                                                       110
        Producing Pro Formas
                                                          Step 4:

                                  Forecast increase in
                                 spontaneous liabilities.
                               Balance Sheet
                            Marginal Product Inc.
                                    figures in 000,000s
   Assets    Current      Projected       Liabilities         Current      Projected
Current Assets     $2.5      $4.0    Accounts Payable               $1.0     $1.6
Net Fixed Assets    3.0       4.8    Accrued Expenses                0.5
Total              $5.5      $8.8    Notes Payable                   0.0
                                     Current Liabilities            $1.5
                              $1.0(1+.60) = $1.60
                                     Long Term Debt                 $2.0
                                     Common Stock                    0.5
                                     Retained Earnings               1.5
                                     Common Equity                  $2.0
                                     Total Claims                   $5.5
                                                                                       111
        Producing Pro Formas

                                                          Step 4:
                                     Forecast increase in
                                    spontaneous liabilities.

                              Balance Sheet
                           Marginal Product Inc.
                                    figures in 000,000s
   Assets    Current      Projected        Liabilities        Current     Projected
Current Assets     $2.5      $4.0     Accounts Payable             $1.0     $1.6
Net Fixed Assets    3.0       4.8     Accrued Expenses              0.5       .8
Total              $5.5      $8.8     Notes Payable                 0.0
                                      Current $0.80
                               $0.5(1+.60) = Liabilities           $1.5
                                      Long Term Debt               $2.0
                                      Common Stock                  0.5
                                      Retained Earnings             1.5
                                      Common Equity                $2.0
                                      Total Claims                 $5.5               112
        Producing Pro Formas

                                                    Step 5:
                                   Forecast increase in
                                    retained earnings.
                           Balance Sheet
                        Marginal Product Inc.
                              figures in 000,000s
   Assets    Current   Projected      Liabilities     Current    Projected
              New retained earnings
Current Assets    $2.5   $4.0      Accounts Payable       $1.0     $1.6
                   retained earnings Expenses
              =Old 3.0
Net Fixed Assets          4.8      Accrued                 0.5       .8
Total                               earnings
               + additions to ret.Notes Payable
                  $5.5   $8.8                              0.0
              =1.5 + [NI x (1-div. payout)]
                                   Current Liabilities    $1.5
                                   Long Term
              =1.5 + [.712 x (1-.7)] = 1.7 Debt           $2.0
                                        Common Stock       0.5
                                        Retained Earnings 1.5        1.7
                                        Common Equity     $2.0
                                        Total Claims      $5.5
                                                                             113
        Producing Pro Formas
                                                          Step 6:
                                    Hold other accounts constant
                                     to see how much additional
                                         funds will be needed.
                               Balance Sheet
                            Marginal Product Inc.
                                    figures in 000,000s
   Assets    Current      Projected       Liabilities       Current       Projected
Current Assets     $2.5      $4.0            Accounts Payable      $1.0     $1.6
Net Fixed Assets    3.0       4.8            Accrued Expenses       0.5       .8
Total              $5.5      $8.8            Notes Payable          0.0      0.0
                                             Current Liabilities   $1.5      2.4
                                             Long Term Debt        $2.0      2.0
                                             Common Stock           0.5       .5
                                             Retained Earnings      1.5      1.7
                                             Common Equity         $2.0      2.2
                                             Total Claims          $5.5     $6.6
                                                                                      114
        Producing Pro Formas

                                                   Step 7:
                                  Additional funds needed
                                  (AFN) = projected assets
                                   minus projected claims
                          Balance Sheet
                       Marginal Product Inc.
                             figures in 000,000s
   Assets     Current Projected     Liabilities      Current   Projected
Current Assets     $2.5  $4.0        Accounts Payable $1.0        $1.6
Net Fixed Assets    3.0   4.8        Accrued Expenses 0.5           .8
Total              $5.5  $8.8        Notes Payable         0.0     0.0
                                     Current Liabilities $1.5      2.4
     AFN                             Long Term Debt       $2.0     2.0
     = $8.8 - 6.6                    Common Stock          0.5      .5
     = $2.2 mill.                    Retained Earnings 1.5         1.7
                                     Common Equity        $2.0     2.2
                                     Total Claims         $5.5    $6.6
                                                                           115
        Producing Pro Formas
                                                          Step 7:
                                       Additional funds needed
                                       (AFN) = projected assets
                                       minus projected claims

                              Balance Sheet
                           Marginal Product Inc.
   Assets    Current      Projected                     million Using:
                                            Raise $2.2Current Projected
                                    figures in 000,000s
                                            Liabilities
Current Assets     $2.5      $4.0
                                                  Notes Payable, and/or
                                              Accounts Payable $1.0
                                                                          LT
                                                                       $1.6
Net Fixed Assets    3.0       4.8               Debt, and/or 0.5
                                              Accrued ExpensesCommon Stock
                                                                         .8
Total              $5.5      $8.8             Notes Payable        0.0  0.0
                                              Current Liabilities $1.5  2.4
    AFN                                       Long Term Debt      $2.0  2.0
    = $8.8 - 6.6                              Common Stock         0.5   .5
    = $2.2 mill.                              Retained Earnings 1.5     1.7
                                              Common Equity       $2.0  2.2
                                              Total Claims        $5.5 $6.6
                                                                               116
          Producing Pro Formas
                Summary
• Determine sales growth.
• Calculate projected net income.
• Project assets needed to support the new
  sales level.
• Project increases in spontaneous asset and
  liability accounts.
• Project addition to retained earnings.
• Determine the difference between projected
  assets and projected liabilities & equity.

                                               117
          Financing feedback
 If outside financing is required, the new debt or
  equity may affect your original projections of the
  amount of the addition to retained earnings (due
  to increased interest or dividends on the income
  statement).
 In this case, the pro forma should be recast with
  the new information to make final projections of
  AFN.


                                                   118
        Homework Questions

1. Briefly discuss the three general approaches to
forecasting.

2. Why is forecasting important?

3. Distinguish between the cash budget and the
capital budget.




                                                     119
4.   Given the following data on the Sands Corporation, project the balance sheet for the coming year using
     the percentage of sales technique:

                                   Current Sales: $650,000
                                   Next year’s sales: $925,000
                                   After-tax profits: 6% of Sales
                                   Dividend payout ratio: 40%
                                   Current retained earnings: $200,000
                                   Accounts receivable as a percent of sales: 10%
                                   Cash as a percent of sales: 5%
                                   Inventory as a percent of sales: 32%
                                   Net fixed assets as a percent of sales: 38%
                                   Accounts payable as a percent of sales: 6%
                                   Accruals as a percent of sales: 12%
                                   Next year’s common stock: $200,000

                                                Sands Corporation
                                                 Balance Sheet
                                                December 31, 2005
                       ASSETS                                             LIABILITIES AND EQUITIES
                       Cash                     (a)                       Accounts payable     (f )
                       Accounts receivable      (b)                       Notes payable                 (g)
                       Inventory                (c)                       Accruals                      (h)
                       Net fixed assets         (d)                       Common stock                  (i )
                                                                          Retained earnings             (j )
                       Total                    (e)                       Total                         (k)




                                                                                                      120
Risk and Return




                  121
Learning Objectives

  Define risk, risk aversion, and risk-
   return tradeoff.
  Measure risk.
  Identify different types of risk.
  Explain methods of risk reduction.
  Describe how firms compensate for
   risk.
  Discuss the CAPM.


                                           122
         Expected Return

• Expected return is the mean of the
  probability distribution of possible returns.
• Future returns are not known with
  certainty. The standard deviation is a
  measure of this uncertainty.



                                             123
               Expected Return
   • Expected return is the mean of the probability
     distribution of possible returns.
   • Future returns are not known with certainty
   • To calculate expected return, compute the
     weighted average of possible returns

                   where
                     m
m = S(Vi x Pi)
                         = Expected return
                     Vi = Possible value of return
                           during period i
                     Pi = Probability of V
                           occurring during period i 124
Expected Return Calculation
Example:
You are evaluating Zumwalt Corporation’s
common stock. You estimate the following
returns given different states of the economy

 State of Economy    Probability   Return
 Economic Downturn       .10        –5%      =   – 0.5%
 Zero Growth             .20         5%      =     1.0%
 Moderate Growth         .40        10%      =     4.0%
 High Growth             .30        20%      =     6.0%
                                            k=   10.5%
               Expected rate of return on
                  the stock is 10.5%
                                                   125
     Risk and Rates of Return
• Risk is the potential for unexpected events to
  occur.
• If two financial alternatives are similar except
  for their degree of risk, most people will
  choose the less risky alternative because
  they are risk averse i.e. they don’t like risk.
• Risk averse investors will require higher
  expected rates of return as compensation for
  taking on higher levels of risk.


                                                     126
         Measurement of Investment Risk
         Example:
         You evaluate two investments: Zumwalt
         Corporation’s common stock and a one year
         Gov't Bond paying a guaranteed 2%.
                There is risk in owning Zumwalt
               stock, no risk in owning the T-bills
Probability    T-Bill              Probability      Zumwalt Corp
 of Return                          of Return
    100%

                                        40%
                                        30%
                                        20%
                                        10%
                                                 –5% 5% 10% 20% Return
                2%      Return
                                                                     127
          Measurement of Investment Risk
   • Standard Deviation (s) measures the dispersion of
     returns. It is the square root of the variance.

           s = SQRT( S P(V - m)2)
                                     S= s2 = variance
Example:
                                 s2 = .005725 = 0.5725%
Compute the standard deviation on Zumwaltofcommon
                                 s = SQRT       0.005725
                                              as 10.5%
stock. the mean (m) was previously computed = 7.566%
                                 s = .07566
  State of Economy     Probability     Return
  Economic Downturn       .10          (- 5% -   10.5%)2   = .24025%
  Zero Growth             .20          ( 5% -    10.5%)2   = .0605%
  Moderate Growth         .40          ( 10% -   10.5%)2   = .001%
  High Growth             .30          ( 20% -   10.5%)2   = .27075%

                                           s = 7.566%             128
           Risk and Rates of Return
      Risk of a company's stock can be separated into two
        parts:
       – Firm Specific Risk - Risk due to factors within the firm

       ― Market related Risk fall if a majoroverall market
       Stockprice will most likely - Risk due to
        conditions
       government contract is discontinued unexpectedly.


            Stock price is likely to rise if overall stock
            market is doing well.


 Diversification: If investors hold stock in many companies, the
   firm specific risk will be cancelled out.

 Even if investors hold many stocks, cannot eliminate the market
  related risk
                                                                    129
     Risk and Rates of Return
• Risk and Diversification
   – If an investor holds enough stocks in portfolio
     (about 15-20) company specific (diversifiable)
     risk is virtually eliminated
    Variability
    of Returns




                  b          Market Related
                                 Risk
                  # of stocks in Portfolio
                                                 130
     Risk and Rates of Return
• Risk and Diversification
   – If an investor holds enough stocks in portfolio
     (about 20) company specific (diversifiable) risk
     is virtually eliminated
    Variability
    of Returns
                     Firm Specific Risk




                  # of stocks in Portfolio
                                                  131
     Risk and Rates of Return
• Risk and Diversification
   – If an investor holds enough stocks in portfolio
     (about 20) company specific (diversifiable) risk
     is virtually eliminated
    Variability
    of Returns
                     Total Risk




                  # of stocks in Portfolio
                                                  132
          Risk and Rates of Return
• Market risk is the risk of the overall market, so to
  measure we need to compare individual stock
  returns to the overall market returns.
• A proxy for the market is usually used: An index of
  stocks such as the S&P 500
• Market risk measures how individual stock returns
  are affected by this market
• Regress individual stock returns on the returns of the
  market index


                                                      133
    Risk and Rates of Return
• Regress individual stock returns on Market index

                     PepsiCo       15%
                      Return

                                   10%


                                   5%
                                                    S&P
                                                    Return
       -15%   -10%    -5%               5%   10%   15%

                            -5%


                            -10%


                            -15%
                                                             134
              Risk and Rates of Return
Regress individual stock returns on Market index. Plot ordered pairs every 6
   months for ten years starting in January 1999.

                               PepsiCo       15%
                                Return

                                             10%


                                             5%
                                                              S&P
                                                              Return
                 -15%   -10%    -5%               5%   10%   15%

              Jan 1999                -5%
              PepsiCo-0.37%
              S&P    -1.99%           -10%


                                      -15%
                                                                          135
         Risk and Rates of Return
• Regress individual stock returns on Market index

                      PepsiCo       15%
                       Return

                                    10%


                                    5%
                                                     S&P
                                                     Return
        -15%   -10%    -5%               5%   10%   15%

                             -5%
       Plot
       Remaining
       Points                -10%


                             -15%
                                                              136
  Risk and Rates of Return
Regress individual stock returns on Market
index returns
                  PepsiCo   15%
                   Return

                            10%
   Best Fit
   Regression               5%
   Line                                      S&P
                                             Return
    -15%   -10%    -5%           5%   10%   15%

                     -5%


                     -10%


                     -15%
                                                      137
                 Risk and Rates of Return
  Regress individual stock returns on Market
    index returns
                            PepsiCo   15%
                             Return
                                      10%


                                -5%   5%
                                                       S&P
                                                       Return
              -15%   -10%    -5%           5%   10%   15%

          rise 5.5%             -5%
Slope =       =     = 1.1
          run 5%
                               -10%


                               -15%
                                                                138
   Risk and Rates of Return
Market Risk is measured by Beta
   Beta is the slope of the regression (characteristic)
   line.




                                                  139
     Risk and Rates of Return
• Market Risk is measured by Beta
  – Beta is the slope of the regression (characteristic) line

                 PepsiCo    15%
                  Return
                            10%


                            5%              S&P
                                            Return
         -15% -10%   -5%         5%   10%   15%

                            -5%


                            -10%
                           Slope = 1.1 = Beta (b)
                            -15%
                                                           140
      Risk and Rates of Return
• Interpreting Beta
     Beta = 1
         Market Beta = 1
         Company with a beta of 1 has average risk
     Beta < 1
         Low Risk Company
         Return on stock will be less affected by the market than
           average
     Beta > 1
         High Market Risk Company
         Stock return will be more affected by the market than
           average
                                                            141
  The Capital Asset Pricing Model
    Investors adjust their required rates of
     return to compensate for risk.
    The CAPM measures required rate of return
      for investments, given the degree of market
      risk measured by beta.
                   Security Market Line
                 kj = kRF + bj ( kM – kRF )
where:
 Kj = required rate of return on the jth security
 KRF = risk free rate of return
 KM = required rate of return on the market
 Bj = Beta for the jth security                     142
            CAPM Example
• Suppose that the required return on the market
  is 12% and the risk free rate is 5%.

            Security Market Line

         kj = kRF + bj ( kM – kRF )




                                               143
             CAPM Example
• Suppose that the required return on the market
  is 12% and the risk free rate is 5%.

                      kj = 5% + bj (12% – 5% )

           15%


           10%


           5%
                   Risk Free Rate
                                      Beta
                    .50    1.0      1.5
                                                   144
             CAPM Example
• Suppose that the required return on the market
  is 12% and the risk free rate is 5%.

                      kj = 5% + bj (12% – 5% )

           15%
                                 Risk &
                                 Return on
                                 market
          10%


            5%
                   Risk Free Rate
                                      Beta
                    .50    1.0      1.5
                                                   145
            CAPM Example
• Suppose that the required return on the market
  is 12% and the risk free rate is 5%.


           15%                                 SML
                 Market
          10%


                                Connect Points for
           5%                   Security Market Line
                                                  Beta
                          .50        1.0       1.5
                                                         146
                   CAPM Example
Suppose that the required return on the
  market is 12% and the risk free rate is 5%.
If beta = 1.2
     kj = 13.4                  kj = 5% + bj (12% – 5% )
             15%                             SML
                         Company kj
           13.4%

                 10%   Market


                 5%

                                               Beta
                            .50    1.0 1.2   1.5
                                                       147
                     Homework
1. You hold a diversified portfolio of stocks and are considering
investing in the XYZ Company. The firm’s prospects look good and
you estimate the following probability distribution of possible
returns:

                  Probability                Return
                     70%                       15%
                     20%                        9%
                     10%                       20%

         The return on the market is 13.5% and the risk free rate is
7%. You have calculated XYZ’s beta from past returns as 1.3 and
you believe this will be the future beta.

 a. What is the expected return for XYZ?
 b. What is the required return for XYZ according to the CAPM?

                                                                       148
                     Homework

2. Assume your existing portfolio is valued at $9,000 and its beta is 1.0.
You plan to buy an additional $3,000 of a particular stock that has a
beta of 1.8 (without selling any other stock). What is the beta of the
new portfolio?

3. Distinguish between business risk and financial risk.

4. What is risk aversion? How does the assumption of risk aversion
affect the risk/return tradeoff?

5. Compare diversifiable and nondiversifiable risk. What are some
examples of each type of risk?




                                                                         149
The Time Value
  of Money
        Learning Objectives
• The “time value of money” and its
  importance to business.
• The future value and present value
  of a single amount.
• The future value and present value
  of an annuity.
• The present value of a series of
  uneven cash flows.
     The Time Value of Money
• Money grows over time when it earns
  interest.
• Therefore, money that is to be received at
  some time in the future is worth less than
  the same dollar amount to be received
  today.
• Similarly, a debt of a given amount to be
  paid in the future are less burdensome
  than that debt to be paid now.
1. Future Value of Single Sum


 $                         ?

 PV     i     N     CPT   FV
2. Future Value of an Annuity

                               ?
        $       $   $
Today

  PMT       i   N   CPT   FV
             3. Sinking Fund


             ?       ?   ?      $
Today

        FV       i   N   CPT   PMT



                                     155
     4. Present Value Single
            Payment


?                               $

FV       i      N     CPT      PV



                                    156
5. Present Value of the Annuity


?
            $       $         $

PMT     i       N       CPT   PV



                                   157
         6. Amortized Loans

$
               ?       ?         ?

    PV     i       N       CPT   PMT



                                       158
 Financial Calculator Solution - FV
Example: You invest $200
 at 10%. How much is it
  worth after 5 years?
                              322.10
   1) Calculator Enter:
           N      = 5
           I/YR = 10
           PV     = -200
           CPT FV = ?

  2) Using Formula:

FV = $200 (1.10)5 = $322.10
    Do all these homework problems on your overhead
    homework sheets: use your calculator and show the
       keys you would press and circle your answer:
If you would have bought Berkshire Hathaway stock 20 years ago and spent
$10,000 for your investment, how much would you have today if the average
annual compounded rate of return was 18%?
How long it will take for $2,500 to become $8,865 if it is deposited and earns 5%
per year compounded annually? (Calculate to the closest year).
If you deposit a lump sum of $1,200 today into a savings account offering annual
interest of 5% compounded monthly, how much will you have in the account at
the end of three years?
If you deposit $100 in the bank today at an annual rate of 5.5% compounded
annually, how long will it take to double in value?
Your Aunt Matilda Mae makes you the following offer: $14,000 upon
undergraduate graduation now or $15,200 upon MBA graduation in 2 years.
Which offer should you take if current rates are 4%.
                  Annuities
• An annuity is a series of equal cash flows
  spaced evenly over time.
• For example, you pay your landlord an
  annuity since your rent is the same amount,
  paid on the same day of the month for the
  entire year.


     Jan          Feb          Mar                 Dec


           $500         $500         $500   $500         $500
                                                                161
     Future Value of an Annuity

 0          1           2           3
$0         $100       $100        $100



You deposit $100 each year (end of year)
into a savings account.
How much would this account have in it at
the end of 3 years if interest were earned at
a rate of 2% annually?
                                            162
     Future Value of an Annuity
Using the Calculator:
 Don’t forget to clear your
 calculator of the previous    $212.24
         problem!

    N=3
    I/Y = 2
    PV = -$200
    CPT FV = $212.24
 Do all these homework problems on your overhead
 homework sheets: use your calculator and show the
    keys you would press and circle your answer:

What is the future value of an ordinary annuity of $1,000 each year for 10
years, assuming a 4% compounding rate?

What is the future value of an annuity due of $1,000 each year for 10 years
assuming a 4% compounding rate?

Dan plans to fund his IRA with a contribution of $ 200 per month for the
next 10 years. If Dan can earn 6% per year on his contributions, how much
will he have at the end of the 10th year?

James plans to fund his IRA with a lump-sum today of $10,000 and 20
annual deposits of $2,000 for the next 25 years. If he can earn 5%
compounded annually, how much will he have at the end of 25 years?
          Future Value of an Annuity Due


    0              1               2              3

   $100          $100            $100           FVA=?


You deposit $100 each year (beginning of year) into a savings
account.
How much would this account have in it at the end of 3 years if
interest were earned at a rate of 8% annually?


                                                                165
      Annuity Due:
   Calculator Solution
 Example: You receive $100 per
year for 3 years. How much is it
 worth after 3 years if you can
       earn 4% annually?
      N=3
      I/Y = 4
      PMT = -$100
      CPT FV = $312.16
 Do all these homework problems on your overhead
 homework sheets: use your calculator and show the
    keys you would press and circle your answer:
  *NOW ASSUME ALL PAYMENTS ARE AT THE BEGINNING OF THE PERIOD*

What is the future value of an ordinary annuity of $1,000 each year for 10
years, assuming a 4% compounding rate?
What is the future value of an annuity due of $1,000 each year for 10 years
assuming a 4% compounding rate?
Dan plans to fund his IRA with a contribution of $ 200 per month for the
next 10 years. If Dan can earn 6% per year on his contributions, how much
will he have at the end of the 10th year?
James plans to fund his IRA with a lump-sum today of $10,000 and 20
annual deposits of $2,000 for the next 25 years. If he can earn 5%
compounded annually, how much will he have at the end of 25 years?
    Financial Calculator Solution – PV of a
                  Single Sum

 You Expect to receive $100 in EIGHT years. If
                  can invest at 3%, what is it
                         worth today?
Calculator Enter:
       N =8                             -78.94
       I/YR = 3
       FV = 100
       CPT PV = ? -78.94

                                                 168
           Present Value of an Annuity
                 Calculator Solution
    0            1       2           3


-257.71        $100     $100      $100


    PV=?
    Enter:                          -257.71
    N      =3
    I/YR = 8
    PMT = 100                  N I/Y PV PM FV
    CPT PV = ?-257.71

                                                169
          Present Value of an Annuity Due
  How much would the following cash flows be worth
    to you today if you could earn 8% on your deposits?
    0              1             2              3

   $100         $100            $100


$100.00
 $92.60                                             278.33
 $85.73
$278.33    BGN
           N=3
           PMT = -100
           I/Y = 8
           CPT PV = 278.33
                                                             170
        Amortized Loans
• A loan that is paid off in equal
  amounts that include principal as
  well as interest.

• Solving for loan payments.


                                  171
                      Amortized Loans
You borrow $5,000 from your parents to purchase a used car. You agree to
   make payments at the end of each year for the next 5 years. If the
   interest rate on this loan is 6%, how much is your annual payment?


        0         1         2         3         4          5


    $5,000      $?         $?        $?         $?         $?

        ENTER:
        N    =5                                         –1,186.98
        I/Y = 6
        PV = 5,000                                    N I/Y PV PMT FV
        CPT PMT = ?
                  -1,186.98
                                                                        172
   Do all these homework problems on your overhead
   homework sheets: use your calculator and show the
      keys you would press and circle your answer:
1. Calculate the present value of annual payments of $3,000 per year for ten years at
8%:
          a. Ordinary Annuity
          b. Annuity Due
2. How much will you have at the end of the 6th year if you invest $5,000 annually for
six years at 7% annual rate, if you:
           a. Start one year from today
           b. Start today
3. A bank agrees to give you a loan of $12,000,000 and you have to pay $1,309,908 per
year (end of year) for 26 years. What is your rate of interest? What would the
payments be if this were a monthly payment loan?
4. You have found the perfect burial plot. Of course, you don't plan to need it for 60
years. The plot costs $12,000 today and burial plot prices are increasing at 4% per year.
How much do you need to deposit at the beginning of each of the next 60 years to pay
for the plot if you can earn 11% on your deposit?

				
DOCUMENT INFO
Shared By:
Categories:
Stats:
views:210
posted:2/9/2011
language:English
pages:173