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Comprehensive Notes
For Students of BBA, MBA & M
...
com)
Financial Management
Financial Management
Chapter#1
An Overview of Financial Management
Meaning of Financial Management
Financial management is concerned with the acquisition, financing, and
management of assets with some overall goal in mind
...
It
means applying general management principles to financial resources of the enterprise
...
Major decisions regarding
investment decisions are explained below
...
2
What specific assets should be acquired? The exact asset required to
maintain the operations of the business
...
3
(B) Financing Decisions
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance
sheet)
...
1
What is the best type of financing? Means either to use debt or equity
...
3 What is the best dividend policy (e
...
, dividend-payout ratio)? Refers to the
percentage of profit to be distributed among the shareholders
...
2
(C) Asset Management Decisions
Financial Management
1
How do we manage existing assets efficiently? Efficiently means to
maximize their productivity and overall contribution to profits
...
Greater emphasis is made on current asset management than fixed asset
management
...
The objectives can be-
1
...
To ensure regular and adequate supply of funds to the concern
...
To ensure optimum funds utilization
...
4
...
e
...
To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital
...
The goals must define a mark that can be specifically measured
over a period of time
...
This refers to the main purpose of a corporation
which is to maximize shareholder value in order for the investors to gain from the
corporation
...
Several examples of corporate goals can be used for inspiration for your own business
...
Improving profitability is a common corporate goal
...
For example, actions might include developing new markets, products or services
...
Stated simply, the goal must be clearly understood by all employees
...
If market conditions change, the goal can be adjusted
...
This includes striving for excellence
...
Successful corporate leaders realize that
they have to be vigilant about reducing product errors, waste and customer
dissatisfaction
...
For
example, to reduce product errors, a business might set a goal of implementing a Six
Sigma initiative, a quality management technique
...
This often involves targeting
new audiences, such as younger customers
...
For example, a small business can
promote its products and services using social media technology
...
Satisfaction
Corporate leaders recognize that employee satisfaction contributes to
productivity
...
Programs may include training courses, events and resources
...
For example,
a common goal strives to create a culture based trust and respect for all
...
Sustainability
Corporate goals usually demonstrate a commitment to the community
...
For example, a company may
aspire to improve the environmental performance of the tools and technology used in its
facilities, by its customers and by its suppliers
...
Business Ethics and Social Responsibility
What is Business Ethics?
The concept has come to mean various things to various people, but
generally it's coming to know what it right or wrong in the workplace and doing
what's right -- this is in regard to effects of products/services and in relationships
with stakeholders
...
The ethics of a particular business can be diverse
...
Many businesses have gained a bad reputation just by being in business
...
It could be called capitalism in its purest form
...
It is the manner in which some businesses conduct themselves
that brings up the question of ethical behavior
...
There are many factors
to consider
...
Many global businesses, including most of the major brands that the
public use, can be seen not to think too highly of good business ethics
...
Money
is the major deciding factor
Social Responsibility:
Social responsibility and business ethics are often regarding as the same
concepts
...
The social responsibility movement arose
particularly during the 1960s with increased public consciousness about the role
of business in helping to cultivate and maintain highly ethical practices in society
and particularly in the natural environment
...
Social responsibility is a duty every
individual has to perform so as to maintain a balance between the economy and the
ecosystems
...
An agent is an individual authorized by another person, called the
principal, to act in the latter’s behalf
...
Principals must provide incentives so that management acts in the
principals’ best interests and then monitor results
...
Shareholders and managers have divergent goals
...
Thus, managers may have the incentive to take actions that are
not in the best interest of the shareholders
...
✓ Performance shares: Management receives a certain number of shares if
the company achieves predefined performance benchmarks
...
Agency Problems: Shareholders (Through Managers) Vs
...
Shareholders
empower managers to manage the firm
...
Though employed by shareholders managers work in the best interest of shareholders,
They deprive creditors in two different ways,
✓ By investing in riskier projects they maximize the profits which on turn is
received by the shareholders and creditors bear only risk for them
✓ By increasing dent the company increases leverage and in turn the risk of
insolvency is increased but creditors get nothing as risk premium
...
In the long-run, a firm that deals unfairly with
creditors may impair the shareholders' interest because the firm may
➢ lose access to the debt markets or
➢ Be saddled with high interest rates and restrictive covenants
...
The three basic are the (1) balance sheet, which shows firm's assets, liabilities, and net
worth on a stated date; (2) income statement (also called profit & loss account), which
shows how the net income of the firm is arrived at over a stated period, and (3) cash flow
statement, which shows the inflows and outflows of cash caused by the
firm's activities during a stated period
...
Each business must keep
financial records
...
This puts everyone on the same level playing field, and
makes it possible to compare different companies with each other, or to evaluate
different year's performance within the same company
...
Together they form a comprehensive
financial picture of the company, the results of its operations, its financial condition, and
the sources and uses of its money
...
Armed with this information they will be able to make necessary business
decisions in a timely manner
There are 5 types of Accounts
...
They are
listed in the order shown above
...
Financial Statements
The Balance Sheet lists the balances in all Assets, Liability and Owners' Equity
accounts
...
The Balance Sheet and Income Statement must accompany each other in order
to comply with GAAP
...
This is necessary so financial statement users get a true and complete financial
picture of the company
...
All accounts
are used once, and only once, in the financial statements
...
The Income Statement shows the accumulation in
the Revenue and Expense accounts, for a given period of time, generally one year
...
It is common for companies to prepare a Statement of Retained Earnings or a
Statement of Owners' Equity, but one of these statements is not required by GAAP
...
They also reconcile the Owners' Equity or Retained Earnings account from the start to
the end of the year
...
The Cash Flow statement shows the inflows and outflows of
Cash over a period of time, usually one year
...
In fact, account balances are not used in the Cash Flow statement
...
There are 3 types of cash flow (CF):
Operating - CF generated by normal business operations
Investing - CF from buying/selling assets: buildings, real estate, investment portfolios,
equipment
...
That doesn't mean companies do what they are
supposed to do
...
Auditors are independent CPAs hired by
companies to determine whether the rules of GAAP and full disclosure are being
followed in their financial statements
...
Retained Earnings
The Retained Earnings (RE) account has a special purpose
...
Let's look at the first part of that for a moment
...
Profits increase RE;
losses will decrease RE
...
The changes in the RE accounts are called "Changes in Retained Earnings" and
are presented in the financial statements
...
Each company can decide how to present the
information, but it must be presented in one of those three places
...
Some
companies prepare a Statement of Stockholders' Equity to give a more comprehensive
picture of their financial events
...
The changes in RE are included in
the Stockholders' Equity statement
...
In the strictest sense, net cash flow refers to the change in a
company's cash balance as detailed on its cash flow statement
...
" It is
very important to note that net cash flow is not the same as net income, free cash flow,
or EBITDA
...
However, the statement of cash flows is a
more insightful place to look
...
Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as
presented by Yahoo! Finance
...
This means that
when the cash flow from operations, cash flow from investing, and cash flow from
financing is added up, Wal-Mart added $632 million to its cash balance in 2010
...
These must be
made from earnings
...
There are several types of dividends, but they
all must come from Retained Earnings
...
If the RE account has a Debit balance, we would call that a Deficit, and the
company would not be able to pay dividends to its stockholders
...
Market Value Added (MVA)
Market value added represents the difference in the total value of the firm
and the total capital supplied by the investors
...
Share holders wealth is maximized by maximizing the difference in market
value of the stock and the amount of wealth supplied by the shareholders
...
Or
= (Shares outstanding) (Stock Price – Total Common Equity
Or
MVA = Total Market value – Total investor supplied capital
Greater the market value more efficiency and more profitable the firm is
Economic Value Added (EVA)
Economic value added is the difference between after tax profits of the
firm and the total dollar cost of capital
...
Economic value added measures the firm efficiency in the current year
only that how much the firm earned more than its cost of capital
EVA = NOPAT – Cost of capital required for operations
EVA = (Operating capital) (ROIC – WACC)
Where ROIC is Return on invested capital and WACC is the weighted average cost
of capital
And NOPAT is net operating profit after tax
•
Positive EVA means firm is generating more profit than its cost and
additional investment will increase the value of the firm
Financial Management
•
The EVA shows the true economic profit of the business greater the
value more profitable the firm is
...
In other words free cash flow is the amount of cash available for
distribution to all investors that is shareholders and debt holders
...
2
...
4
...
To pay interest to debt holders
To repay or redeem bonds
Pay dividend to shareholders
To repurchase some of its stock
Buy short term investments
Calculating free cash flows
Free cash flows can be calculated using the following equations
FCF = NOPAT – Net investment in operating assets
Where net investment in operating assets means net increase in both current and fixed
assets
Or FCF = Operating cash flow – Gross investment in operating capital
Where Operating cash flow = NOPAT + Depreciation
And Gross investment in operating capital = Net investment in operating assets +
Depreciation
What Is Depreciation?
Depreciation is the process by which a company allocates an asset's cost over
the duration of its useful life
...
The purpose of
recording depreciation as an expense is to spread the initial price of the asset over its
useful life
...
For natural resources - such as
minerals, timber and oil reserves - its called depletion
...
Reasons for Analysis
Financial statements analysis may be carried out by either internal or external
users
...
•
•
•
Evaluating the financial statements
Planning according to the past performance
...
Government for regulations and tax purposes
...
Another advantage of financial statement analysis is that regulatory authorities
like IASB can ensure the company following the required accounting standards
...
Financial Management
Above all, the company is able to analyze its own performance over a specific
time period
...
Ratio analysis is based on line items in financial statements like the
balance sheet, income statement and cash flow statement; the ratios of one item – or
a combination of items - to another item or combination are then calculated
...
Ratio analysis can be made by
•
•
•
Comparing one company to another
Comparing one year with another year of the same company
Comparing one company with the industry
Following are the different categories of financial ratios
...
Liquidity ratios measure the ability of the company that whether it can pay
its short term obligations or not
...
In general, the greater the coverage of liquid assets to short-term liabilities
the better as it is a clear signal that a company can pay its debts that are
coming due in the near future and still fund its ongoing operations
...
Liquidity ratios can be measured using two ratios these are
1
2
Current ratio
Quick/ liquid
...
➢ The concept behind this ratio is to ascertain whether a company's
short-term assets (cash, cash equivalents, marketable securities,
receivables and inventory) are readily available to pay off its short-term
liabilities (notes payable, current portion of term debt, payables,
accrued expenses and taxes)
...
the company liquidity
is
Formula
Shows that the company has 2
...
Quick ratio
•
•
•
•
Quick ratio compares quick assets with current liabilities
...
The quick ratio is more conservative than the current ratio because it
excludes inventory and other current assets, which are more difficult to
turn into cash
...
Formula
Quick Ratio = Quick Asset/ Current Liabilities
Or
It shows that company have 1
...
These ratios shows that how efficiently a company is using their
assets
Following are the asset management ratios
...
Inventory turnover means the speed through which old inventory is
replaced with new one
...
Formula
Sales/ inventory
300000/50000 = 6 times
Which shows that we the company’s old inventory is replaced 6 times annually
Receivable management ratio- The days of sales outstanding Ratio
•
•
•
•
Days of sales outstanding also called the average collection period refers
to the days in which account receivables are collected
...
5 days
Financial Management
Shows that it takes 36
...
Greater the fixed assets turnover greater is their efficiency
...
Shows the efficiency of total assets, that how much of revenue is
generated by total assets
Greater turnover shows that assets produce greater sales with respect to
their value
...
Investors, creditors and banks are often interested in calculating these
ratios
Three important debt management ratios are
Total Liabilities to total assets ratio
•
•
•
•
This ratio compares total liabilities of the firm with total assets
Shows the percentage of assets purchased by taking liabilities
Higher the ratio greater will be the leverage, which shows that most of the
assets are financed through debt
...
Formula
Total liabilities/ Total assets
= 150,000/250,000
= 0
...
This ratio shows that what amount of profit is available for payment of one
dollar of interest, greater the ratio more profit is available, better is the
ability to service debt
Formula
=
200000/10000
=20
Which means that the company has 20 Rs of profit to pay I Re of interest?
Earnings before interest tax depreciation and amortization (EBITDA) Ratio
•
•
•
•
Interest coverage ratio does not fully explain the firm’s ability to service
debt because interest is not the only payment which a company makes
but it also has to pay some portion of its loan and also lease payment
Similarly EBIT is not the total cash available for all these payments
EBITDA is used to find the amount of free cash flow available for payment
of interest, repayment of principle amount and also lease installment
...
Formula
NPBITDA + Lease payments/Interest expense Principle Payment Lease payment
(D) Profitability ratios
•
•
These ratios, much like the operational performance ratios, give users a
good understanding of how well the company utilized its resources in
generating profit and shareholder value
...
Profit margin to sales
Financial Management
•
•
•
•
Profit margin to sales compares net profit available to shareholders for
distribution with sales
...
Theatrically greater the profit margin ratio greater will be the performance
of the business, or more profitable the business is
...
Formula
Basic Earning power = EBIT/ Total Assets
Return on Total Assets
•
•
•
Return on total assets is calculated by comparing Net profit available for
shareholders with total assets
This ratio shows the final earning power and final earning capacity of the
business
Greater the ratio more profitable the business is and more efficiently the
business is utilizing its resources
Formula
Return on Total assets = Net profit available for shareholders/ Total asset
Return on Equity:
•
•
•
Formula:
This ratio indicates how profitable a company is by comparing its
net income to its average shareholders' equity
...
The higher the ratio percentage, the more efficient management is
in utilizing its equity base and the better return is to investors
...
Price-Earnings Ratio (P/E Ratio)
•
•
•
The Price-Earnings Ratio is calculated by dividing the current market price per
share of the stock by earnings per share (EPS)
...
)
The P/E Ratio indicates how much investors are willing to pay per dollar of
current earnings
...
(Investors who are willing to pay a high price for a dollar of current earnings
obviously expect high earnings in the future
...
This ratio is not meaningful, however, if the firm has very little or negative
earnings
...
This shows the amount of money an investor is willing to pay to get 1
rupee ownership in that company
Since a firm's book value reflects historical cost accounting, this ratio
indicates management's success in creating value for its stockholders
...
Where
Book value per share = Total equity/ total outstandding shares,
Financial Management
Trend Analysis, Common Size Analysis and Percent Change Analysis
Trend Analysis
An aspect of technical analysis that tries to predict the future movement of a
stock based on past data
...
Trend analysis
Trend analysis Is one of the tools for the analysis of the company’s monetary statements
for the investment purposes
...
In a trend analysis, the financial statements of the
company are compared with each other for the several years after converting them in
the percentage
...
In order to
convert the figures into percentages for the comparison purposes, the percentages are
calculated in the following way:
Trend analysis percentage = (figure of the previous period – figure of the current
period)/total of both figures
The percentage can be found this way and if the current-year percentages were greater
than previous year percentage, this would mean that current-year result is better than
the previous year result
...
The base amount for the balance sheet is usually total assets (which is
the same number as total liabilities plus stockholders' equity), and for the income
statement it is usually net sales or revenues
...
On the income statement, changes in the mix of revenues and in the
spending for different types of expenses can be identified
...
Used on a balance sheet, a percent change analysis shows
how a balance sheet account changes from year to year, or quarter to quarter
...
Percent change
analysis is important for managers and investors to see how a company is growing or
retracting from year-to-year
...
It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise
...
Determining capital requirements- This will depend upon factors like cost of
current and fixed assets, promotional expenses and long- range planning
...
b
...
e
...
This
includes decisions of debt- equity ratio- both short-term and long- term
...
Framing financial policies with regards to cash control, lending, borrowings, etc
...
A finance manager ensures that the scarce financial resources are maximally
utilized in the best possible manner at least cost in order to get maximum returns
on investment
...
This ensures effective and
adequate financial and investment policies
...
Adequate funds have to be ensured
...
Financial Planning helps in ensuring a reasonable balance between outflow and
inflow of funds so that stability is maintained
...
Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning
...
Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company
...
Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds
...
Financial Planning helps in reducing the uncertainties which can be a hindrance
to growth of the company
...
Forecasting Financial Statements
Introduction:
Financial Forecasting describes the process by which firms think about and
prepare for the future
...
It also assists the
firm in identifying the asset requirements and needs for external financing
...
Since most Balance Sheet and Income Statement accounts are related to
sales, the forecasting process can help the firm assess the increase in Current and
Fixed Assets which will be needed to support the forecasted sales level
...
Strategic Planning:
Strategic planning provides the vision, direction and goals for the business
...
In order to
determine the direction of the organization, it is necessary to understand its current
position and the possible avenues through which it can pursue a particular course of
action
...
Using historical internal accounting and sales data, in addition to external market and
economic indicators, a financial forecast is an economist's best guess of what will
happen to a company in financial terms over a given time period—which is usually one
year
...
The strategic plan will be put
into operation during a given operational period
...
Like a strategic plan, an operational plan addresses four questions:
•
•
•
Where are we now?
Where do we want to be?
How do we get there?
Financial Management
•
How do we measure our progress?
The Financial Plans:
Financial planning is the process of meeting your life goals through the proper
management of your finances
...
The financial planning process involves the
following steps:
•
•
•
•
•
•
Gathering relevant financial information
Setting life goals
Examining your current financial status
Coming up with a financial strategy or plan for how you can meet your goals
Implementing the financial plan
Monitoring the success of the financial plan, adjusting it if necessary
Using these steps, you can determine where you are now and what you may need in the
future in order to reach your goals
...
Financial planning is simple mathematics
...
Financial Planning: FR + FT = FG
Computerized Financial Planning Model:
The financial plan describes the practice's financial strategy, projects the
strategy's future effect on the practice, and establishes goals by which the practice's
manager can measure subsequent performance
...
It is a process that consists of analyzing the
practice; projecting future outcomes of decisions that have to be made regarding
finances, investments, and day to day operations; deciding which alternatives to
undertake; and measuring performance against goals that are established in the
financial plan
...
These
models can be created inexpensively by non-computer programmers with the aid of
computer software on the market today
...
The information used in them must
be well organized and may include information on the competition and statistics that
affect the businesses' customer base
...
Before the forecasting process begins, marketing, sales, or other managers
should determine how far ahead the estimate should be done
...
Intermediate forecasting is between a period of three months and two years and may be
used for schedules, inventory and production
...
Sales
forecasts should be conducted regularly and all results need to be measured so that
future methods can be adjusted if necessary
...
Managers must think about
changes in customer sales or other changes that could affect the estimated figures
...
Financial Statement Forecasting Methods
To forecast financial data, corporate leadership and department heads rely on various
methods and tools
...
Forecasted financial information is also known as pro forma or projected
accounting information
...
For example, supervisors may review the
state of the economy and take government-published GDP metrics to estimate how
much the company might grow sales in the future -- say, in one, two or 10 years
...
Ratio Method
•
In ratio analysis, a company uses previously calculated metrics to forecast financial
statement data
...
Examples include net profit margin, asset-turnover ratio and
Financial Management
return on equity, or ROE
...
The firm
then may adjust the final number by including material cost and labor expense
projections
...
For example, a company may
set total sales as the benchmark for income statement forecasts
...
Using this proportion, accountants may extrapolate
by setting material costs at 50 percent of total sales for the next five years
...
For example, a business may analyze
its sales data over a five-year period and determine that the average revenue-growth
rate is 11 percent
...
*End of Chapter*
Chapter#5
Financial Environment
Introduction:
Financial environment is the outcome of a range of functions of the economy
on all financial outcomes of an area or a country
...
Financial Markets
•
•
A market is a venue where goods and services are exchanged
...
Types of Financial markets:
Some Financial markets are as follows
1- Real/tangible/Physical assets Markets and Financial Asset Market
Real assets are tangible assets that determine the productive capacity of an
economy, that is, the goods and services its members can create
...
Other common examples of investments in Real Assets are paintings, antiques, precious
metals and stones, classic cars etc
...
Financial Assets, (Assets in the form of paper) or more commonly known
as Securities, include stocks, bonds, unit trusts etc
...
2- Spot Markets and Future Markets:
The spot market is where securities (e
...
shares, bonds, funds, warrants and
structured products) and goods (e
...
commodities) are traded
...
Future market transactions are transactions in which the price, number and
delivery date of the traded securities are agreed when the transaction is concluded but
delivery and payment take place at a future time
...
3- Money Market and Capital Market
The money market is a segment of the financial market in which financial
instruments with high liquidity and very short maturities are traded
...
A capital market is one in which individuals and institutions trade those securities and
instruments whose maturity is more than one year
...
It's in this market that firms
sell new stocks and bonds to the public for the first time
...
Stock exchange is the market in which one investor buys 3nd hand shares
from another investor
5- Private and Public Markets:
A private market, also known as the private market sector, is the part of a
nation's economy that is not controlled by the government
...
It is the complete opposite of a public sector
which is operated by the government with the aim of providing goods and services
...
Examples of financial institutions include;
Banks, Credit Unions, Asset Management Firms, Insurance companies and pension
funds among others
...
Services include offering current, deposit and saving accounts as well as
giving out loans to businesses
...
2- Savings and Loan Associations
A savings and loan association (S&L) is a financial institution that specializes
in savings deposits and mortgage loans, and has become one of the
primary sources of mortgage loans for homebuyers today
...
3- Mutual Savings Bank:
A Mutual Savings Bank is a financial establishment which is licensed through a
centralized or state government and provides individuals with a secure place to invest in
mortgages, credit, stocks and other securities
...
4- Credit union:
This is a mutual financial organization formed and managed by a group of people
with a common affiliation, such as employees of a company or a trade union
...
5- Insurance Companies:
These are corporate entities that insure people against loss
...
The different t types of
insurance include life, Vehicle, health, liability and homeowners
...
Their focus is
assisting individuals, corporations, and governments in raising capital by underwriting
and/or acting as the client's agent in the issuance of securities
...
7- Mutual Fund Companies:
Financial Management
Sometimes called investment companies, these are companies that pool money
from many investors to purchase securities
...
They serve the general public
...
”
Stock Exchange (also called Stock Market or Share Market) is one important
constituent of capital market Stock Exchange is an organized market for the purchase
and sale of industrial and financial security
...
e
...
It performs various functions and offers useful services to investors and
borrowing companies
...
Stock exchange is an organized market for buying
and selling corporate and other securities
...
It provides a convenient and secured
mechanism or platform for transactions in different securities
...
Over-the-counter (OTC)
A decentralized market, without a central physical location, where market
participants trade with one another through various communication modes such as the
telephone, email and proprietary electronic trading systems
...
In an OTC market, dealers act as market makers by quoting prices at which they will buy
and sell a security or currency
...
In general, OTC markets are therefore less transparent than exchanges and
are also subject to fewer regulations
...
This is essentially the
difference in price between the highest price that a buyer is willing to pay for an asset
and the lowest price for which a seller is willing to sell it
...
Financial Management
The Cost of Money:
Concept of the Cost of Money
The cost of money refers to the price paid for using the money, whether
borrowed or owned
...
The
interest paid on debt capital and the dividends paid on ownership capital are examples
of the cost of money
...
In addition, the cost of money is affected by the following factors as
below:
Factors Affecting the Cost of Money
1
...
Increase in production opportunities in an economy increases the
cost of money
...
2
...
The cost of money also
depends on whether the consumers prefer to consume in current period or in future
period
...
It leads to the lower saving
...
Therefore, as much
as the consumers give high preference to current consumption, the cost of money will
increase and vice versa
...
Risk
Risk refers to the chance of loss
...
The degree of risk
perceived by investors and the cost of money has positive relationship
...
4
...
The expected
future rate of inflation also affects the cost of money, because, it affects the purchasing
power of investors
...
The investors will demand higher rate of return to commensurate against
decline in purchasing power because of inflation
...
Banks or lending institutions usually have general guidelines for the rate they intend to
charge
...
These are factors that influence the level of market interest rates:
Expected levels of inflation:
Over time, as the cost of products and services increase, the value of money
decreases
...
As for finance lending sector,
borrowers may find it is attractive to borrow now but less attractive for lender
...
In order to
compensate this loss, lenders have to increase the interest rate
...
In United States, The
Federal Reserve Bank has taken a step to manipulate money supply through an open
market operation, by purchasing large volumes of government security to increase
money supply, thus reduce the interest rates, or sell large volumes of government
security to reduce money supply which will subsequently increase interest rates
...
Developed by John Keynes, this theory explains how demand and supply for money
influence interest rates
...
Monetary policy and intervention by the government:
One of the government’s strategies to control the flow of money within its
consumers is by monetary policy
...
This in turn will reduce the money outflow and affect the country’s
revenue as consumers will not be spending unless it is necessary
...
As a result, when the growth rate increases
rapidly to the extent that economy may face overheat problem, the government then
have to curb this by imposing higher interest rates
...
The world economy
has been on the slump side since the past five years with many business closures
...
Apart from the above, other factors such as political and financial stability and investors’
demand for debt securities also affect interest rates
...
Globally, this also adversely affects the world economy
...
Risk free rate means
the rate of interest received if no risk is taken
...
All the
investments and securities include a certain amount of risk
...
However, if we talk about the relevant risk involved in different securities,
the government-issued securities are considered as risk-free, since the chances of
default of a government are minimal
...
Internationally the US T-Bills are
considered as risk free rate of return
...
Inflation (g):
The expected average inflation over the life of the investment or security is
usually inculcated in the nominal interest rate by the issuer of security to cover the
inflation risk
...
If the inflation rate
in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the investors
would not be willing to invest in the bond since the gains from the interest rate would be
exactly offset by the inflate ion rate which is actually eroding the wealth of the investor
...
Default Risk Premium (DR):
Default risk refers to the risk that the company might go bankrupt or close down
& bonds, or shares issued by the company may collapse
...
Companies may also default on interest payments, something not very
unusual in the corporate world
...
Maturity Risk Premium (MRP):
Financial Management
The maturity risk premium is linked to the life of that security
...
These changes are more
likely in the long term and less likely in the short term
...
The longer the maturity period, the higher the maturity risk
premium
...
This risk is also
linked to foreign exchange (F/x), depreciation, and devaluation
...
If a bank wants
to invest in Pakistan, it will have to take view of Pakistan’s political, economic, and
financial environment
...
The interest rate would be high since the bank would add sovereign
risk premium to the interest rate
...
Liquidity Preference (LP):
Investor psychology is such that they prefer easily encashable securities
...
A higher liquidity
preference would always push the interest rates upwards
...
The Term Structure of Interest Rates
The relationship between interest rates or bond yields and different terms or
maturities
...
The term structure reflects expectations of market
participants about
future
changes in interest
rates and
their assessment of
monetary
policy conditions
...
" One basic explanation for this phenomenon
is that lenders demand higher interest rates for longer-term loans as compensation for
the greater risk associated with them, in comparison to short-term loans
...
What determines the shape of the yield curve?
The yield curve, also known as the "term structure of interest rates," is a graph
that plots the yields of similar-quality bonds against their maturities, ranging from
shortest to longest
...
)
How it works/Example:
The yield curve shows the various yields that are currently being offered
on bonds of different maturities
...
The yield curve can take three primary shapes
...
Below you'll find an example of a normal yield curve:
If short-term yields are higher than long-term yields (the line is sloping downwards), then
the curve is referred to as an inverted (or "negative") yield curve
...
Below you'll find an example of a flat yield curve:
It is important that only bonds of similar risk are plotted on the same yield curve
...
The shape of the yield curve changes over time
...
Yield curves are calculated and published by The Wall Street Journal, the Federal
Reserve, and a variety of other financial institutions
...
In Finance: The probability that an actual return on an investment will be
lower than the expected return
...
What Are the Different Types of Risk?
*Systematic Risk - Systematic risk influences a large number of assets
...
It is virtually impossible to protect yourself against this type of risk
...
This kind of risk affects a very small number of assets
...
Diversification is the only way to protect you from unsystematic risk
...
Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations
...
Country Risk - Country risk refers to the risk that a country won't be able to
honor its financial commitments
...
Country risk applies to stocks, bonds,
mutual funds, options and futures that are issued within a particular country
...
Foreign-exchange risk applies to all financial instruments that are in a
currency other than your domestic currency
...
This risk affects the value of
bonds more directly than stocks
...
This is a major reason why
developing countries lack foreign investment
...
Also referred to as volatility,
market risk is the day-to-day fluctuation in a stock's price
...
As a whole, stocks tend to perform well during a
bull market and poorly during a bear market - volatility is not so much a cause but
an effect of certain market forces
...
To calculate
ROI, the benefit (return) of an investment is divided by the cost of the investment;
the result is expressed as a percentage or a ratio
...
Return on investment is a very
popular metric because of its versatility and simplicity
...
Return on investment, or ROI, is the most common profitability ratio
...
So if your net profit is $100,000 and your total assets
are $300,000, your ROI would be
...
Return on investment isn't necessarily the same as profit
...
Profit, on the other hand, measures the
performance of the business
...
This is an entirely different item as well
...
Stand Alone Risk
Financial Management
Standalone risk describes the danger associated with investing in a
particular instrument or investing in a particular division of a company
...
In contrast, a
standalone risk is one that can easily be distinguished from these other types of
risk
...
If the company
that issued the stock performs well then the stock will grow in value but if the firm
becomes insolvent then the stock may become worthless
...
Additionally, someone who invests in a wide array of securities is also
exposed to standalone risk if that individual holds each type of instrument in a
separate brokerage account
...
Probability Distribution
A statistical function that describes all the possible values and likelihoods
that a random variable can take within a given range
...
Academics and fund managers alike may determine a particular stock's
probability distribution to determine the possible returns that the stock may yield
in the future
...
By increasing the sample size, this error
can be dramatically reduced
...
Financial Management
Expected Rate of Return:
Expected return is calculated as the weighted average of the likely profits
of the assets in the portfolio, weighted by the likely profits of each asset class
...
+
wnRn
Example: Expected Return
For a simple portfolio of two mutual funds, one investing in stocks and the other
in bonds, if we expect the stock fund to return 10% and the bond fund to return
6% and our allocation is 50% to each asset class, we have the following:
Expected return (portfolio) = (0
...
5) + (0
...
5) = 0
...
However, it can be
used to forecast the future value of a portfolio, and it also provides a guide from
which to measure actual returns
...
A measure of the dispersion of a set of data from its mean
...
Standard deviation is calculated as the
square root of variance
...
In finance, standard deviation is applied to the annual rate of return of an
Financial Management
investment to measure the investment's volatility
...
Standard deviation is a statistical measurement that sheds light on historical
volatility
...
A large dispersion
tells us how much the fund's return is deviating from the expected normal returns
...
85%
...
The formula for variance becomes more
complicated for multi-asset portfolios
...
Risk aversion
Risk aversion is a concept in economics and finance, based on the
behavior of humans (especially consumers and investors) while exposed
to uncertainty to attempt to reduce that uncertainty
...
For example, a risk-averse investor might choose to put
his or her money into a bank account with a low but guaranteed interest rate,
rather than into a stock that may have high expected returns, but also involves a
chance of losing value
...
In the guaranteed scenario, the person
receives $50
...
The expected payoff for both scenarios is $50,
meaning that an individual who was insensitive to risk would not care whether
they took the guaranteed payment or the gamble
...
Risk in a Portfolio Context
Portfolio
A collection of investments all owned by the same individual
or organization
...
Financial Management
A group of investments such as stocks, bonds and cash equivalents,
mutual funds, exchange-traded funds, and closed-end funds that are selected on
the basis of an investor's short-term or long-term investment goals
...
Portfolio Return
The monetary return experienced by a holder of a portfolio
...
Dividends and capital appreciation
are the main components of portfolio returns
...
However, the overall return must be
compared to the required benchmarks and risk of the portfolio as well
...
Formula 17
...
+ wnRn
Example:
Assume an investment manager has created a portfolio with the Stock A and
Stock B
...
Stock B has an expected return of 15% and a weight of 70%
...
30) (20%) + (0
...
5% = 16
...
5%
Portfolio Risk
Portfolio risk is the possibility that an investment portfolio may not achieve
its objectives
...
Portfolio risk refers to the combined risk attached to all of the securities
within the investment portfolio of an individual
...
Investors often try to minimize portfolio risk through
diversification, which involves purchasing many securities with different
characteristics in terms of potential risk and reward
...
Calculating Beta Coefficient
A measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole
...
Also known as "beta coefficient
...
It measures systematic risk which is the risk inherent in the
whole financial system
...
It is the slope of the
security market line
...
A slight modification helps in
building another key relationship which tells that beta coefficient equals
correlation coefficient multiplied by standard deviation of stock returns divided by
standard deviation of market returns
...
While
investors would love to have an investment that is both low risk and high return,
the general rule is that there is a more or less direct trade-off between financial
risk and financial return
...
Low levels of uncertainty (low risk) are associated with low potential
returns
...
The risk/return tradeoff is the balance between the desire for the lowest
possible risk and the highest possible return
...
A higher standard deviation means a higher risk and higher
possible return
...
The risk/return
tradeoff tells us that the higher risk gives us the possibility of higher returns
...
Just as risk means higher potential returns, it also
means higher potential losses
...
For most businesses, physical assets usually refer to cash,
equipment, inventory and properties owned by the business
...
A financial instrument that represents: an ownership position in a publiclytraded corporation (stock), a creditor relationship with governmental body or a
corporation (bond), or rights to ownership as represented by an option
...
The company or entity that issues the security is known as the
issuer
...
A debt
security is a type of security that represents money that is borrowed that must be
repaid, with terms that define the amount borrowed, interest rate and
maturity/renewal date
...
Capital Asset Pricing Model (CAPM)
The capital asset pricing model provides a formula that calculates the
expected return on a security based on its level of risk
...
Financial Management
Risk and the Capital Asset Pricing Model Formula
To understand the capital asset pricing model, there must be an
understanding of the risk on an investment
...
Some securities have
more risk than others and with additional risk; an investor expects to realize a
higher return on their investment
...
The obvious choice would be to lend to the individual who is more likely to
pay, i
...
, carries less risk of default
...
What is Beta?
In finance, the beta (β) of an investment is a measure of the risk arising
from exposure to general market movements as opposed to idiosyncratic factors
...
A beta below
1 can indicate either an investment with lower volatility than the market, or a
volatile investment whose price movements are not highly correlated with the
market
...
An example of the second is gold
...
A measure of a security's or portfolio's volatility
...
A beta of more than 1 indicates greater volatility and a beta of less than 1
indicates less
...
The degree of probability of such loss
...
Financial Management
-Risk is based on the actual fundamentals of a company or country
Volatility:
Tending to fluctuate sharply and regularly
...
-The more volatile stock goes up and down much more violently
...
-If the less volatile stock has never made a profit, has declining sales and will be
forced to take on more debt to pay its short term liabilities, is it really “Less risky”
as the volatility implies?
-Volatility simply refers to the price action
...
Conclusion
-There is an important difference between an investment’s volatility and its risk
...
But just because an investment is more volatile
does not necessarily mean it is more risky in the long term
...
-The stock market as a whole is much more volatile than a bank CD, but that
does not mean savers should bypass any investment in the stock market
altogether
...
End of Chapter
Financial Management
Chapter #08
COST OF CAPITAL
Introduction
Assets of the firm re financed by three major fixed sources of funds, these fixed
sources of finance are called capital of the firm
...
Debt
2
...
Common stock
The investors who have provided these funds demand some return on these
funds
...
This return
depends on the riskiness of the security
...
Cost of Debt
Debt is the major source of finance for a company
...
The first step for
calculating the cost of debt is to determine what rate of return bond holders demand (rd),
which is basically the interest rate on that bond
...
For example market rate of interest is 12%
...
But this
interest paid on debt is a deductable expense from profits so this interest reduces the
profits and hence reduces the tax liability as well
...
So the actual
cost of debt is the interest rate less tax savings
...
4)
= 7
...
2%
Cost of Preferred stock
Preferred stock is that which are preferred in payment of dividend
...
It should be noted that preferred stock dividend is not a deductible
expense and hence the issuer bears the full cost of dividend without any tax adjustment
...
For proffered stock having stated maturity the method used is
same as used for bonds, but without considering the effect of taxes
...
Floatation cost is recorded in percentage of the amount realized on issue of preference
shares and it is basically the cost incurred on issuing these preference shares
...
By putting the values in the above equation we find that
...
4
=13
...
For issuing new shares the company
must incur floatation cost in shape of brokerage and commission etc
...
The cost of capital is the expectation of share holders from the investment they
have made in a specific company
...
In which the most important is the amount of risk they are taking in
investing in that company
...
Overall market situation etc
There are three different methods for calculating the cost of capital
...
The Capital Asset Pricing Model Approach
The Capital Asset Pricing Model (CAPM) is a model which describes the
relationship between risk and required rates of return
...
The overall model of CAPM is as under
...
Risk
free rate is that rate of return which is earned on such type of securities which have
relatively zero risk
...
But here we will take the rate of treasury securities s the risk free rate
...
So the risk free rate
will be the rate of interest on T-bonds
...
It is calculated by subtracting
the risk free return from the market return
...
Market return
can be calculated using the average return of the historical data, or can also be
calculated by forward looking approach using the discounted cash flow model
...
Beta measures the
relevant risk of an individual security compared to the market portfolio
...
The above discussion can be summarized that the cost of equity (rs) under the CAPM
approach depends on three main factors, risk free rate, market risk premium and beta
...
Dividend Yield Plus Growth Rate, or Discounted Cash Flow
approach
Cost of equity can also be calculated using the dividend yield plus growth
approach
...
Equation is derived by rearranging the equation of calculating the price per
share
...
Dividend per share and price per share are simple and normally they are known
...
There are three methods for calculating
growth on shares these are discussed below
...
The future growth for an individual security can be
calculated by finding the growth pattern of the previous years
...
Normally if a
company retains their profits it increases the book value of the shares of the firm, which
causes the market value of shares to rise and hence a company earns capital
...
Mathematically
g = (Retention rate) (ROE)
g = (1 - payout rate) (ROE)
g = (1 – 0
...
25%
...
Financial Management
Bond Yield plus Risk Premium Approach
Some analyst estimates the cost of equity by subjective procedure
...
This interest premium ranges from 3 to 5 percent based on judgment of the analyst
...
These costs may
be brokerage commission taxes etc
...
But if we issue new shares floatation cost
must be taken into consideration
...
Which include debt, preferred stock and common stock it is the
weighted average of all the costs of individual capitals? Weight is the percentage
proportion of any component of the capital
...
These percentage proportions
of capital (weights) are based on the target or optimal capital of the management
...
WACC = (Cost of debt) (Weight of debt) + (Cost of of preferred stock)(Weight of
preferred stock) + (Cost of equity)(weight of equity)
WACC = wdrd(1 - T) + wpsrps + wcers
Suppose the stock price is $150 million of common stock, $25 million of preferred stock,
and $75 million of debt
...
6
wps = $25/$250 = 0
...
3
Then calculate the individual cost of capital and put them in the equation of WACC
WACC = 0
...
6) + 0
...
6(14%)
WACC = 1
...
9% + 8
...
1%
...
Financial Management
Factors the firm cannot control
Three most important factors which are beyond the control of the firm re
The level of interest rates affects the overall cost of capital directly
...
It affects cost of debt directly as a
company must issue new bonds at higher rate if there is increase in market rate of
interest
...
Market risk premium higher market risk premium rises the cost of equity, and hence
the overall WACC
Tax rate If tax rates increases it will decrease the cost of debt
...
So there is an inverse relationship
between tax rates and WACC
...
And hence
WACC will change
*End Of Chapter*
Financial Management
Chapter #09
Corporate Valuation and value based
Management
Corporate Valuation an Overview:
Valuation means the process of determining the value of
an asset or company
...
In order to evaluate new projects, consider mergers and
acquisitions, or make strategic decisions, the financial analyst must understand
the factors that drive corporate value
...
Business Valuation:
The process of determining the economic value of a business or company
...
Often times, owners will turn to professional business
valuators for an objective estimate of the business value
...
Items that are usually valued are a financial asset or liability
...
g
...
Valuations are
needed for many reasons such as investment analysis, capital budgeting, merger
and acquisition transactions, financial reporting, taxable events to determine the
proper tax liability, and in litigation
...
This is an objective view of a business
...
Income Based approaches
Financial Management
The income approach identifies the fair market value of a business by
measuring the current value of projected future cash flows generated by the
business in question
...
In contrast the asset based approaches, which are
very objective; the income based approaches require the valuator to make
subjective decisions about discount rates or capitalization
...
This method, which comes in several
approaches, is useful as it identifies fundamental factors driving the value of a
business
...
Financial attributes of these
comparable companies and the prices at which they have transferred can serve
as strong indicators of fair market value of the subject company
Value Based Management
Value based management is a structured approach to measure the
performance of a firm's section managers or products in terms of the total
advantage they provide to shareholders
...
Value based management focusing on creating wealth for shareholders
...
Managers
need to have an understanding of their key value drivers, which can be intangible
assets, the financial structure, asset turns and working capital
...
SAS software can be used to enhance the effectiveness of a VBM
implementation by providing better analysis and predictive capabilities and aiding
communication within the company and with external parties
...
Alignment: ensure the goals cascaded throughout the organization are in line
with the overall corporate objectives, and that there is top to bottom alignment of
activities
...
Performance reporting can be
updated automatically and delivered to the desktop
...
Appropriate VBM drivers can be linked to each metric
...
Top level views can
give management an overall view of VBM performance
...
Corporate Governance and shareholders wealth
Corporate Governance is "the system by which an organization is directed
and controlled
...
The main objective of the firm is always to
maximize shareholders wealth
...
This study was carried out to clearly show the extent to which
corporate governance contributes to shareholder wealth maximization
...
The researcher looked at the various variables of
corporate governance i
...
the Board composition, Number of Board meetings,
attributes of board members and directors' remuneration strategy and showed
the extent to which they contribute towards shareholder wealth maximization
...
The capital structure is how a firm finances its overall
operations and growth by using different sources of funds
...
Short-
Financial Management
term debt such as working capital requirements is also considered to be part of
the capital structure
...
As a company raises new capital it will focus on maintaining this target (optimal)
capital structure
...
Putting it simple, the optimal capital structure for a
company is the one which proffers a balance between the idyllic debt-to-equity
ranges thus minimizing the firm’s cost of capital
...
However, it is seldom the optimal structure for as debt increases, it increases the
company’s risk
...
The most commonly used ones are:
Method 1
One method of estimating a company’s optimal capital structure is utilizing the
average or median capital structure of the principle companies engaged in the
market approach
...
However, this method features a limitation that
fluctuations in market prices and the spread out nature of debt offerings and
retirements might cause the actual capital structure of a principle company to be
significantly different from the target capital structure
...
The main objective of this method is
determining the debt level at which the benefits of increased debt does not
overshadow the increased risks and potential costs associated with an
economically distressed company
...
Business risk is the risk inherent in the company's operations
...
Some of those factors are as follows:
Sales risk - Sales risk is affected by demand for the company's product as well
as the price per unit of the product
...
As an example, let's compare a utility company with a retail apparel
company
...
The
company has less risk in its business given its stable revenue stream
...
Since the sales of a retail apparel company are driven primarily by trends in the
fashion industry, the business risk of a retail apparel company is much higher
...
2- Financial Risk:
A company's financial risk, however, takes into account a company's leverage
...
Capital Structure Theory-The Modigliani-Miller Models
The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is a
theorem on capital structure, debatably forming the basis for modern thinking
on capital structure
...
[1] It does not matter if the firm's capital
is raised by issuing stock or selling debt
...
Therefore, the Modigliani–Miller theorem is also often
called the capital structure irrelevance principle
...
Control aspects of shares ignored
...
Shareholders can lend and borrow at the same interest rate as Örms
...
No bankruptcy
...
Tax ignored
Checklist for Capital Structure Decisions:
•
•
•
•
•
•
Debt ratios of other firms in the industry
...
Reserve borrowing capacity
...
Type of assets: Are they tangible and hence suitable as collateral?
Tax rates
...
Capital Gain
Capital gains and dividends are both financial gains available to investors
of stock
...
Dividends, however, are only
obtained by investing in stock and are paid to shareholders at different intervals
depending on the amount of revenue generated and the types of shares held by
shareholders
...
Dividends Versus Capital Gains: What Do Investors Prefer?
When deciding how much cash to distribute to stockholders, financial
managers must keep in mind that the firm’s objective is to maximize shareholder
value
...
This increase in the
numerator, taken alone, would cause the stock price to rise
...
Thus any change in payout policy will have two opposing effects
...
Dividends are irrelevant
In Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and
homogeneous information, dividend policy does not affect the value of the
company
...
- If an investor wants cash flow, he/she could sell some shares
...
- An investor is indifferent about a share repurchase or a dividend
...
Investors preferring to avoid taxes will be drawn to
firms with lower payout ratios
...
e
...
Therefore, firms should avoid making drastic
changes in their dividend policy
...
A dividend increase may signal
good future earnings
...
Dividend Stability:
According to this policy, the percentage of earnings paid out as dividends remain
constant irrespective of the level of earnings
...
The following figure
shows the behavior of dividends in case this policy is adopted–
Most of the firms follow stable dividends or gradually increasing dividends due to
following reasons –
•
Many investors consider dividends as a part of regular income to meet
their expenses
...
A fall in the dividend income may lead to sale of
some shares, on the other hand when the dividend income increases, an
investor may invest some of the proceeds as reinvestment in shares
...
They
prefer regular dividends
...
Increasing
dividends mean better prospects of the company
...
In addition,
stable dividends are signs of stable earnings of the company
...
Certain investors mainly institutional consider the stability of dividends as
an important criterion before they decide on the investment in that
particular firm
...
It assists the board of directors in establishing how
much should be paid to shareholders in dividends
...
Dividend policy must also be aligned with the main
objective of the firm which is to maximize shareholders’ wealth
...
Factors which affect dividend policy
There are number of external and internal factors which affect dividend policy
...
Legal constraints - this type of constraints depends on the location of the firm
...
Market reactions – a firm needs to consider how markets will react to its dividend
decisions
...
This will decrease
shareholders’ wealth
...
This will increase shareholders’ wealth
...
Internal factors which affect dividend policy
Financing needs of the firm – Mature firms usually have better access to
external financing
...
If a company is young and rapidly growing than it will likely
be unable to pay a large portion of earnings in dividends as it will require retained
earnings to finance acceptable projects and its access to external financing is
likely to be limited
...
For
example, if shareholders will be able to earn higher returns by investing
individually then what firm can earn by reinvesting funds than a higher dividend
payment should be considered
...
Earnings requirement – this constraint is imposed by the firm
...
However, the firm still can pay out
dividends even if it incurred losses in the current financial period
...
The compounding
interest of DRIPs allows investors to purchase additional shares of stock at no
cost -- simply reinvest the dividends, and when enough money is accrued,
additional shares are automatically purchased
...
Instead, those dividends will be used to purchase additional shares of stock in
the company that paid the dividend
...
Cash dividends paid by the company are
automatically reinvested into additional shares
...
Many dividend reinvestment plans are often part of a direct stock
purchase plan
...
The Fee to purchase through dividend reinvestment programs is normally
small, if any
...
Over decades, this can result in significantly more wealth in the
investor's hands
...
Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a
company pays out stock
...
For example, suppose
New
...
Each current stockholder will thus
have 10% more shares after the dividend is issued
...
Stock splits are usually done to increase the liquidity of the stock (more
shares outstanding) and to make it more affordable for investors to buy regular
lots (a regular lot = 100 shares)
...
Stock splits increase the number of shares outstanding and reduce the par
or stated value per share of the company's stock
...
Share repurchase is
usually an indication that the company's management thinks the shares are
undervalued
...
Because a share repurchase reduces the number of shares outstanding
(i
...
supply), it increases earnings per share and tends to elevate the market
value of the remaining shares
...
"
End of Chapter
Financial Management
Chapter #12
Initial Public Offering, Investment
Banking and Financial Restructuring
What is Initial Public Offering – IPO?
The first sale of stock by a private company to the public
...
In an IPO, the issuer obtains the assistance of an underwriting firm, which
helps it determine what type of security to issue (common or preferred), the best
offering price and the time to bring it to market
...
For the individual investor, it is tough to
predict what the stock will do on its initial day of trading and in the near future
because there is often little historical data with which to analyze the company
...
Financing Life Cycle of a Startup Company
Financial Life Cycle A life cycle is a series of stages in which an individual
passes during his or her lifetime
...
They are
usually financed through debt, but may find investors who are willing to take
on risk if projected growth is high
...
It can be financed through venture capital or
issuing equity
...
These firms can
be financed by equity or debt
...
The firm may go into decline as their product becomes obsolete or a
competitor outperforms them
...
Financial Management
The decision to Go Public
The decision to take a company public is one of the most important that a
CFO is involved in
...
It is important to ensure that the decision to go
public is made after full consideration of the challenges involved
...
It is therefore vital that the CFO, in consultation with the
CEO, the board, and other major stakeholders such as owners and investors,
has addressed the following questions when making the decision to go public:
• What factors must be considered in making the decision to go public?
• What must the company have in place prior to going public?
• What will life be like as a public company?
Advantages of Going Public:
Going public and offering stock in an initial public offering represents a milestone
for most privately owned companies
...
Furthermore, taking a company public reduces the overall cost of capital and
gives the company a more solid standing when negotiating interest rates with
banks
...
The main reason companies decide to go public, however, is to raise money — a
lot of money — and spread the risk of ownership among a large group of
shareholders
...
• Being able to raise additional funds through the issuance of more stock
• Companies can offer securities in the acquisition of other companies
• Stock and stock options programs can be offered to potential employees,
making the company attractive to top talent
• Companies have additional leverage when obtaining loans from financial
institutions
• Market exposure – having a company’s stock listed on an exchange could
attract the attention of mutual and hedge funds, market makers and
institutional traders
• Indirect advertising – the filing and registration fee for most major
exchanges includes a form of complimentary advertising
...
Financial Management
Disadvantages of Going Public:
While going public allows the corporation to raise large amounts of money from
stock market investors, it also involves a number of disadvantages that makes
the decision one of the most important choices a private corporation can make
...
A corporation must put
its affairs in order and prepare reports and disclosures to comply with Securities
and Exchange Commission
...
Equity Dilution
Going public is the process of selling ownership of a part of your company to
strangers
...
It is not always possible to raise the amount of money that you
may need to operate a public corporation and still keep at least 51 percent of the
company's ownership in your own hands
...
You can no longer make decisions autonomously
...
Also, you will no longer have total control over the composition of the
board of directors, as federal law places restrictions on board composition to
ensure the independence of the board from insider influence
...
By law, a public corporation has an
obligation to its shareholders to maximize shareholder profits and disclose
operational information
...
This increase in regulatory
oversight significantly changes the way you can manage the business
...
A public
corporation, however, must make extensive quarterly and annual disclosures
about business operations, financial condition, compensation of directors and
officers and other internal matters
...
Financial Management
The Process of Going Public
Taking a company public, also called an initial public offering (IPO), is the
sale of stock that allows the general buying public to own equity in a company
...
It also requires filing extensive paperwork with
the Securities and Exchange Commission (SEC) to make the transition from
private to public legal
...
Decide if going public is right for your company
...
Going public can
help your company raise funding and improve your brand and visibility
...
Taking
a company public requires that you report to shareholders, which can slow
down the pace of decision-making in your business
...
Private companies can keep innovative and proprietary information
private
...
• An investment bank serves as an underwriter for a company that is going
public
...
The underwriter will work with you to
negotiate how the funds you need to raise to go public will be
accumulated
...
In other agreements a primary underwriter will bring in
other banks or firms (called syndicates) to distribute the risk involved with
raising funds by selling your company's stock
...
• The SEC requires a company that's going public to complete an extensive
registration process
...
The
registration process includes submitting a prospectus and a registration
form
...
File the registration statement with the SEC
...
The next
step is to begin selling your company's stock
...
Your company should
respond to the SEC's comments in writing with amendments to your
registration that explain or otherwise address these comments
...
• Distribute your prospectus with information about the amount of stock to
be released and the preliminary price in meetings with potential investors
...
A road show typically lasts around 2 weeks
and it involves managers having multiple meetings in many cities
...
Make the initial public offering of your company's stock on the stock
market at the end of your road show
...
• Complete the application and accompanying documents for listing your
stock
...
• Pay the listing and annual fees
...
• On the 4th day after the initial offering, underwriters are allowed to
purchase their agreed upon number of shares at a discounted rate as
"payment" for their service in taking your company public
...
A lease guarantees the lessee (the renter) use of an
asset and guarantees the lessor (the property owner) regular payments from the
lessee for a specified number of months or years
...
Leases are the contracts that lay out the details of rental agreements in
the real estate market
...
The landlord will require you to sign
the lease before you can occupy the property as a tenant
...
The relationship
between the tenant and the landlord is called a tenancy, and can be for a fixed or
an indefinite period of time (called the term of the lease)
...
Types of Leases:
The most common types of leases are as Follows:
Operating Lease:
Operating leases, also called service leases, are agreements between two
parties in which one provides rent to the other for using an asset
...
The
owner of the asset is responsible for all maintenance costs and other operating
costs associated with the leased asset
...
Financial Management
Sale and Leaseback Arrangement:
A sale and leaseback arrangement is a type of lease in which one party
purchases property, equipment or land from another party and immediately
leases it to the selling party under specific terms
...
A sale and leaseback arrangement
is a type of capital lease, with the only difference being that a buyer purchases a
used asset instead of a brand new one (as is common in capital leases)
...
An example of a combination lease is a capital lease that incorporates a
cancellation clause, typically associated with an operating lease
...
Depreciation expenses
Depreciation is a major consideration for companies when deciding
between buying and leasing
...
In business,
there exists a basic rule of thumb: "If it appreciates, buy it
...
“Leasing could permit the use of the equipment while it is new
...
In
case of a purchase, however, an individual may be "stuck" with an obsolete asset
with no means of recouping the cost of its acquisition
...
This is because in the case of a lease the ultimate ownership is
retained by the lessor; and, it is in their best interest to maintain the asset in its
best working order
...
Other related costs
Financial Management
The costs of leases on the income statement depend on the duration and
type of lease
...
In the event of a lease, however, only a portion of the full value is
assessed, typically around 50%; the figure varies depending on the duration and
type of lease
...
In many instances, this can
better serve the lessee that an outright purchase would
...
EBITDA
Leases will also influence the ratios on income statement
...
The EBITDA
coverage ratio shows if earnings are able to satisfy all financial obligations
including leases and principal payments
...
)
Impact of Leasing on the Balance Sheet:
Capitalized leases have significant effects on the balance sheet, while
operating leases don't show up there at all
...
Say you're leasing a truck for three years
...
Adjustment
The leased asset gets depreciated just like any asset the company
actually owns
...
The book value of the asset thus declines
over time
...
Effect:
A capitalized lease increases the total value of the assets on your balance
sheet
...
It will reduce
your company's return on assets (essentially, the profit it generates for each $1
worth of assets) and its asset turnover (the sales generated for every $1 worth of
assets)
...
In short, a capitalized
lease can make your company's performance look worse, so businesses often
structure leases in such a way so they can report them as operating leases