Presentation1

CORPORATE FINANCE
(Ref:Introduction to Accounting and Finance-Geoff Black)

Do you think ..
-you know nothing about accounting

Y/N

-accounting needs advanced mathemetical skills

Y/N

-accounting requires an IQ of 200 plus

Y/N

-accounting is boring

Y/N

-accounting is only relevant for some people

Y/N

Why are we here?
To learn from each other, because,

you cannot teach a
person anything
you can only help him find it
within himself
-'Galileo-an italian professor

Negative Slab or Positive Boon
' Mr. Anchovy, our experts describe you as a appallingly dull

fellow, unimaginative, timid, lacking in initiative, spineless, easily
dominated, no sense of humour, tedious company and
irrepressibly drab and awful.'

And , in most professions these would be considerable
drawbacks, in accounting they are a positive boon' Monty Python, 'The Lion Tamer Sketch”

Do you really don't know what's
accounting?

Consider this snippet of conversation:

“Tan, wrote his car off yesterday. He'd gone into
the red to pay for it, but - would you credit it –
the car wasn't insured. There's no accounting for
some people. The bottom line is you need to
protect your assets”

Presenter:
:



This module will be lead-managed by Mr.Masilamani R
He has about 3 decades of working, training & consulting
experience



His basic degree is in statistics & economics



His MBA is in finance and economics



He also has several professional accreditations, including
business performance management & project management

Why accounting Course?
Offered to all incoming Masters students at any School
of Business.
In particular, this lecture is designed for those who have
no previous education or training in accounting.
The intention is for this lecture to teach at the most basic
level.
To teach the “alphabet” of accounting so that students
can learn to speak in “full sentences” in the accounting
(and other) courses.
Students with even minimal background may wish to
skim or skip sections of the lecture.

Food for Thought
With reference to non-business, performance management
occurs in Sun Tzu's The Art of War. Sun Tzu claims that, 'to
succeed in war, one should have full knowledge of one's own
strengths and weaknesses as well as those of one's enemies.
Lack of either set of knowledge might result in defeat'
Parallels between the challenges in business and those of
war include:
* collecting data - both internal and external
* discerning patterns and meaning in the data (analyzing)

* responding to the resultant information

Financial and Management Accounting
Accounting has two main divisions:
Financial accounting
Primarily prepared for users external to the company.
Revenues, earnings, assets, etc.
Management accounting
Primarily for internal purposes
Costing, budgeting, net present value, etc.
This lecture will focus mainly on financial accounting for
business. Thus it is called 'CORPORATE FINANCE'

Corporate Finance
Corporate finance is the area of finance dealing with
monetary decisions that business enterprises make and
the tools and analysis used to make these decisions. The
primary goal of corporate finance is to maximize
shareholder value while managing the firm's financial
risks.
Although it is in principle different from managerial
finance which studies the financial decisions of all firms,
rather than corporations alone, the main concepts in the
study of corporate finance are applicable to the financial
problems of all kinds of firms

Learning Emphasis
In business management program we emphasise
more on application of accounting and finance
concepts, skills and practices.
This course focuses on using student
awareness of accounting and finance to learn
how to apply in practice

Course Aims
The broad aims of this course are to:
1. Introduce the basic principles and underlying concepts of
accounting and finance;
2. Describe profit and loss accounts, balance sheets and cash
flows tatements and generally how they are prepared;
3. Explain in detail how these statements may be read and
interpreted, including points of weakness and their shortcomings;
and
4. Provide basic understanding of how management accounting
can assistmanagers in planning, control and decision.

Course Outcomes
At the completion of this course, it is expected that you will be able to:
1. Explain the effect of decision, transactions and events on financial
performance and construct simple sets of accounts;
2. Interpret published financial statements intelligently and translate

financial information accordingly to match the various needs of business
problems;
3. Identify the main uses and limitations of financial information and
administer them effectively for decision-making, planning and control;
4. Apply cash flow statements, cash forecasts and consolidate data for
capital investments, project appraisals and management budget; and
5. Evaluate company performance, estimate its cost of capital and justify
the processes of budgeting.

Corporate Finance
Day One
A. Fundamentals of
Financial
Management
B. Analysis of Financial
Statements
C. Time Value of
Money
D. Securities Valuation

Day Two
E. Risk & Return
F. Capital Budgeting
G. The Cost of Capital
H. Dividend Policy

Accounting
Accounting can be simply defined as the recording,
summarising and interpretation of financial
information
The key aspects of accounting are therefore,

1. Identifying the key financial components of the
oganisation e.g. assets, liabilities, capital, revenue and
cash flow
2. Measuring the monetary values of key financial
components in a way which represents a true and fair view
of the organisation

3. Communicating the financial information in ways that are
useful to the users of the organisation

Accrual vs Cash accounting
why do some report cash and some accrual?
It really depends on the needs of the users.
In most cases, you can choose which method to
use. Learn how they work and the advantages and
disadvantages of each so you can choose the
.
better one for your business.
In a nutshell, these methods differ only in the
timing of when transactions, including sales and
purchases, are credited or debited to your
accounts

What is accrual accounting?
Revenue and expenses reported for an accounting period
are the revenue earned and expenses matched to or
incurred in generating that income – regardless of whether
the income has actually been received or cash paid for the
expenditure

For Example
Where we have performed some work for a client and invoiced this client, we
would include this revenue in our reporting for the period, regardless of whether
we have actually received payment or not. On the expense side, we would
include expenses such as electricity and gas consumed during the period even
if the bill is not due for payment until the following period

What is Cash Accounting
The cash method is the more commonly used method
of accounting in small business. Under the cash method,
income is not counted until cash (or a check) is actually
received, and expenses are not counted until they are
actually paid.

Example
Your computer installation business finishes a job in November,
and doesn't get paid until three months later in January.Under the
cash method, you would record the payment in January. Under
the accrual method, you would record the income in your
November books

The Accounting Formula
Has 3 Major Components to reflect the
organisation value:

a)Assets-the value of the resources of the
organisation
b)Capital-the value of the owner's interest
in the organisation
c)Liabilities-the value of others' claim on the
organisation
ASSETS - LIABILITIES=CAPITAL

The Basic Accounting Statements
1.The Balance Sheet-A financial summary
showing the assets, liabilities and capital of
the organisation at a particular date
2.The Income statement-A financial
summary showing revenue and expenses
for the financial period
3.The Cash flow Statement is a summary of
cash and bank balances over a defined past
period

A. Fundamentals of Financial Management

1.Definition of Financial Management

 The management of the finances of a business / organization
in order to achieve financial objectives.

1.Key Objectives of Financial Management
 Create wealth for the business.
 Generate cash.

 Provide adequate return on investment

A. Fundamentals of Financial Management
1. Key elements of the process of financial
management
a) Financial Planning
 Ensure enough funding is available at the right
time.
b) Financial Control
 Ensure that the business is meeting its
objectives.
c) Financial Decision Making
 Key aspects – investment, financing and
dividends.

B. Analysis of Financial Statements
Financial Statement Analysis
Comparative
Analysis

Horizontal
Analysis

Ratio
Analysis

Vertical
Analysis

1.
2.
3.
4.
5.

Profitability Ratio
Liquidity Ratio
Activity Ratio
Gearing Ratio
Other Ratios

1. Comparative Analysis
 Comparative Analysis involves the comparison against the
company’s past performance, against another company’s
performance or against the industry average. Comparison
against a benchmark will enable users to make an informed
and better decision.
a) Horizontal Analysis
 Involves the comparison of items in the financial
statements over a two year period or more.
 Comparison can be made against last year’s
performance or against few years.

1. Comparative Analysis
a) Vertical Analysis
 As not all companies are of the same size, and
comparing the absolute results of different businesses
of dissimilar sizes will not provide an adequate
picture.
 By turning the absolute figures into percentage, we
could make a more meaningful interpretation of the
data.
 We will compare percentages rather than the absolute
figure (overcome the problems of companies with
different sizes).

1. Financial Ratio Analysis


Shows the relationship between an item in the income
statement or balance sheet with another item.



Provide a meaningful data and will enable users to understand

the financial statement.
a) Profitability Ratios
 Measure the ability of a business entity to earn profits.
 Used as an indicator of how efficient and effective a
company is in achieving its profit.

28

1) Gross Profit Margin (Ratio)
 Measures the gross profit earned for every
Ringgit sales.
 Higher gross profit ratio indicates strong
performance as the company has more profit to
pay for its sales & administrative expenses.
Gross Profit Ratio = ( Gross Profit / Net Sales) x 100

29

1) Net Profit Margin (Ratio)
 Measures the net profit earned for every Ringgit sales.
 Higher net profit ratio indicates strong performance as
the company has more profit to pay dividends to
shareholders.
Net Profit Ratio = ( Net Profit / Net Sales) x 100

30

1) Earnings Per Share (EPS)
 Measures the earning that is earned by each
ordinary share after paying for tax and preference
shares dividend.
 The higher the earning per share the better it is.
EPS = ( Earning after Tax – Div for PS) / Total OS
PS – Preference Share, OS – Ordinary Share

31

a) Liquidity Ratios
 Liquidity refers to the ability to generate or raise cash.
 Measure the ability of a company to meet short term
obligations or debts that might be unexpectedly
demanded to be paid before its maturity dates.
 If a company fails to pay its debts, it could mean an end
to the business.

32

a) Liquidity Ratios
1) Current Ratio
 Measures the ability of a business entity to pay up
current liabilities.
 A current ratio of 2:1 indicates strong ability to
meet short term debts.
 The higher the current ratio, the more liquid the
company is said to be.
Current Ratio = Current Assets / Current Liabilities
33

a) Liquidity Ratios
1) Quick Ratio
 Also known as acid test ratio.
 Measures how many quick assets there are to
cover quick liabilities.
 Comprises of cash, receivables and market
securities and exclude inventory.
Current Ratio = [CA – (Inventory + Prepaid)] / CL
CA – Current Asset, CL – Current Liabilities
34

a) Activity Ratios
 Measure the effectiveness and ability of a company in
its resources.
 It can indicate how effective a company’s inventory is
being used to generate sales or how efficient is the
collection of debts by a company.

35

a) Activity Ratios
1) Accounts Receivable Turnover (ART)
 Measures how fast accounts receivable is
collected.
 Indicates the effectiveness of a business entity
in managing its accounts receivables.
ART = Net Credit Sales / *Ave Account
Receivable
*Ave Acc Rec = (Opening Acc Rec + Closing Acc Rec)/2
36

a) Activity Ratios
1) Inventory Turnover
 Measures the ability of a business entity to sell its
inventory.
 Indicates the number of times inventory is sold.

Inventory Turnover = COGS / *Ave Inventory
COGS – Cost of Good Sold
*Ave Inventory = (Opening Inventory + Closing Inventory)/2

37

a) Activity Ratios
1) Total Assets Turnover (TAT)

 Measure the relationship between sales levels
against the average total sales.
 Measures the effectiveness of total assets which
are used in generating sales.
TAT = Net Sales / Average Total Assets

38

a) Gearing Ratios
 Measure how much the assets of a company is

financed by creditor rather than the owners.
 High proportion of shareholders fund indicates
financial strength.

 Heavy reliance on borrowing indicates the risk to the
investors as debts require repayments of loan
principal amount and the interest expenses.

39

a) Gearing Ratios
1) Equity Ratios

 Measure the financial structure of a company.
 Higher equity ratios indicate stability.

Equity Ratio = (*Total OS Fund / Total Assets) x 100
* Total Ordinary Shareholder Fund include retained earnings
and reserves but exclude preference shares

40

a) Gearing Ratios
1) Debts Ratios

 Measures the financial structure of a company.
 Higher debt ratios indicate that a company face a
higher risk in its ability to settle its debts.
Debt Ratio = *Total Debts / Total Assets) x 100
* Total debts = Total Liabilities + Preference S/holders Fund

41

a) Gearing Ratios
1) Debts to Equity Ratios (DER)

 Measures how much of total debts are covered by
equity.
 The lower the ratio the better it is as it indicates
the amount owned by equity is more than
liabilities.
DER = *Total Debts / Total Shareholder Equity
* Total debts = Total Liabilities + Preference S/holders Fund
42

1.Financial Ratios Analysis – Practical Example
Activity No.

Category

Financial ratios

1

Profitabil
ity

Gross Profit
Margin
Net Profit Margin
Earning Per Share

2

Liquidity

Current Ratio
Quick Ratio

3

Activity

Accounts
receivable
turnover
Inventory
turnover

2005

2004

1.Financial Ratios Analysis – Practical Example
No.

Category

Financial ratios

3

Activity

Total Asset
Turnover

4

Gearing

2005

Equity Ratios
Debt Ratio
Debt to Equity
ratio

5

Other
ratios

Any additional
covering ratios
the above under
the respective
category

e.g. interest cover,
dividend cover,
dividend yeild, debt
collection

2004

C. Time Value of Money
TVM

Interest

Simple

Compound

Future Value

Present Value

Annuity

Amortization

1. The Interest Rate
Which would you prefer -- $10,000 today or
$10,000 in 5 years?
Obviously, $10,000 today.

You already recognize that there is
TIME VALUE TO MONEY!!


Why is TIME such an important element in your
decision?
TIME allows you the opportunity to postpone
consumption and earn INTEREST.

a) Simple Interest
 Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
b) Compound Interest
 Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).


 Simple Interest - Formula
SI

=

Where SI =

P0 =

P0(i)(n)
Simple Interest

Deposit Today (t=0)

i =

Interest Rate Per Period

n =

Number of Time Periods

 Simple Interest - Example
Assume that you deposit RM1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?
SI

P0(i)(n)
RM1,000(.07)(2)
= RM140

=
=

a) Compound Interest
 When interest paid on an investment during
the first period is added to the principal.

 During the second period, interest is earned
on the new sum.

a) Compound Interest - Formula
CI =
Where CI =

P(1 + i)n
Compound Interest

P =

Deposit Today

i =

Interest Rate Per Period

n =

Number of Time Periods

a) Compound Interest – Example
David deposited RM100 into his saving account
in Maybank for 5 years with interest of 5% per
annum. What is the return that he is expected to
receive at the end of 5th year?

a) Frequency of Compounding – Formula (future value)
FVn =
Where n =
i =
FVn,m =
PV0 =

PV0(1 + [i/m])mn
Compounding Period per year
Annual Interest Rate
FV at the end of Year n
PV of the Cash Flow today

a) Frequency of Compounding - Example

Suppose you deposit $1,000 in an account that
pays 12% interest, compounded quarterly. How
much will be in the account after eight years if
there are no withdrawals?

a) Frequency of Compounding - Question

John deposit $1,000 in an account that pays 12%
interest, compounded monthly. How much will be
in the account after one year if there are no
withdrawals?

1. Future Value - Formula
FV = PV (1+i)n
Where FV =

PV =

Future Value

Present Value

i =

Rate of interest per compounding period

n =

Number of Compounding Periods

1. Future Value - Example
If you invested $2,000 today in an account that
pays 6% interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?
0

6%

1

2

$2,000
FV

1. Present Value - Question
John wants to know how large his $5,000 deposit will
become at an annual compound interest rate of 8% at
the end of 5 years.
0

1

2

3

4

5

8%

$5,000
FV5

1. Present Value - Formula
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Where FV =

PV =

Future Value

Present Value

i =

Rate of interest per compounding period

n =

Number of Compounding Periods

1. Present Value - Example
Assume that you need to have exactly $4,000 saved
10 years from now. How much must you deposit
today in an account that pays 6% interest,
compounded annually, so that you reach your goal of
$4,000?
0

5

10

6%
$4,000
PV0

1. Present Value - Question
Joann needs to know how large of a deposit to
make today so that the money will grow to $2,500
in 5 years. Assume today’s deposit will grow at a
compound rate of 4% annually.
0

1

2

3

4

5

4%

$2,500
PV0

1. Annuities
 An Annuity represents a series of equal payments
(or receipts) occurring over a specified number of
equidistant periods.
 Examples of Annuities Include:

- Car Loan Payments
- Insurance Premiums
- Mortgage Payments

1. Annuities
a) Annuities Future Value - Formula
0

Cash flows occur at the end of the period
1
2
n
i%
. . .
R

R

R

R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 +
... + R(1+i)1 + R(1+i)0

FVAn

n+1

1. Annuities
a) Annuities Future Value - Question
If one saves $1,000 a year at the end of every
year for three years in an account earning 7%
interest, compounded annually, how much will
one have at the end of the third year?

1. Annuities
a) Annuities Present Value - Formula
0

Cash flows occur at the end of the period
1
2
n
i%
. . .
R

R

n+1

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n

1. Annuities
a) Annuities Present Value - Question
If one agrees to repay a loan by paying $1,000
a year at the end of every year for three years
and the discount rate is 7%, how much could
one borrow today?

1. Amortization - Example
Julie Miller is borrowing $10,000 at a compound
annual interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774

1. Amortization – Example (Table)
Ending
Balance
$10,000

End of
Year
0

Payment

Interest

Principal

---

---

---

8,426

1

$2,774

$1,200

$1,574

6,663

2

2,774

1,011

1,763

4,689

3

2,774

800

1,974

2,478

4

2,774

563

2,211

0

5

2,775

297

2,478

$13,871

$3,871

10,000

[Last Payment Slightly Higher Due to Rounding]

1. Amortization – Question
Suppose you borrow $6,655 to make repairs to
your house, and the loan is considered a
second mortgage. The terms of the loan
require you to make payments every three
months, i.e. quarterly, for the next two years
and the simple interest rate is 6 percent p.a.
What is the amount that must be paid every
three months?

Securities
Valuation
Stock

Common Stock
Preferred Stock

Bonds
1.
2.
3.
4.

Mortgage Bond
Eurobonds
Zero Coupon Bonds
Junk Bond

Securities Valuation

Stock market

D. Securities Valuation-Investment Appraisal
1. Preferred Stock
 Preferred Stock is often referred to as a hybrid
security because it has many characteristics of
both common stocks and bonds.
 Like common stocks
- No fixed maturity date.
- Failure to pay dividends does not bring on
bankruptcy.
 Like bonds
- Dividends are for a limited time.

1. Preferred Stock – Features
a) Multiple series of Preferred Stock
b) Preferred Stock’s claim on asset & income
c) Cumulative dividends
d) Protective provisions

e) Convertibility
f) Retirement features
g) Callable

a) Multiple series of Preferred Stock
 If a company desires, it can issue more than
one series of preferred stock, and each series
can have different characteristics.
- Convertible
- Protective provisions

a) Claims on Assets and Income
 Preferred stock has priority over Common
Stock with regard to claim on assets in the
case of bankruptcy.
 Honored before common stockholders, but
after bonds.
 Must pay dividends to preferred stockholders
before it pays common stockholder dividends.

a) Cumulative Dividends
 Cumulative features requires that all past,
unpaid preferred stock dividends be paid
before any common stock dividends are
declared.
b) Protective Provisions
 Protective provisions generally allow for
voting rights in the event of non payment of
dividends.

a) Convertibility
 Convertible preferred stock can, at the
discretion of the holder, be converted into a
predetermined number of shares of common
stock.
 Almost one third of preferred stock issued
today is convertible.
 Reduces the cost of the preferred stock to the
issue

a) Retirement Features
 Although preferred stock has no set maturity
associated with it, issuing firms generally
provide for some method of retiring the stock.
b) Callable
 A call provision entitles a company to
repurchase its preferred stock from their
holders at stated prices over a given time
period.

1. Preferred Stock
a) Valuing Preferred Stock
D

Vps

=

kps
Where Vps =

D =
kps =

The value of preferred stock

The preferred dividend

The required rate of return

Example : Xerox’s Series C preferred stock pays an annual
dividend of RM6.25 and the investors required rate of return is 5%

1. Common Stock
 Common stock is a certificate that indicates
ownership in a corporation.
 Has no maturity date.
 Dividend payments will normally divided into
Interim & Final Dividend
 In the event of bankruptcy, common stockholders
will not receive any payment until the creditors,
including the bondholders and preferred
stockholders, have been satisfied.

1. Common Stock – Features
a) Claim on income
b) Claim on assets
c) Voting rights
d) Preemptive rights

e) Limited liability

a) Claim on income
 Common shareholders have the right to
residual

income

after

bondholders

and

preferred stockholders have been paid

 Can be in the form of dividends or retained
earnings.

a) Claim on assets
 Common stock has a residual claim on assets
after claims of debt holders and preferred
stockholders.

 If bankruptcy occurs, claims of the common
shareholders generally go unsatisfied.

a) Voting Rights
 Common shareholders are entitled to elect the
board of directors.
 Most often are the only security holders with
a vote.
 A proxy gives a designated party the
temporary power of attorney to vote for the
signee at the corporation’s annual general
meeting.

a) Preemptive Rights
 Preemptive right entitles the common
shareholder to maintain a proportionate share
of ownership in the corporation.
 Rights – certificates issued to the shareholders
giving them an option to purchase a stated
number of shares of stock at a specified price
during a two to ten week period.

a) Limited Liability
 Liability of the shareholder is limited to the
amount of their investment.
 Limited liability feature aids the firm in
raising funds.

1. Common Stock
a) Valuing Common Stock

VCS

D0 1 g
kCS g

Where Vcs = The value of common stock
D0 = The preferred dividend
= Growth rate
g

kcs = The required rate of return

1.Common Stock
a) Valuing Common Stock – Example
Consider the valuation of a common stock that paid

RM2.00 dividend at the end of the last year and is
expected to pay a cash dividend in the future.

Dividends are expected to grow at 10% and the
investors required rate of return is 15%

1. Bond – type of debt or long term promissory note,
issued by a borrower, promising to its holder a
predetermined and fixed amount of interest per
year.
a) Types of Bonds
i. Debentures
 Any unsecured long term debt.
 Viewed as more risky than secured
bonds and provide a higher yield than
secured bonds.

1. Bond
a) Types of Bonds
i. Mortgage Bonds
 A bond secured by a lien on real property.
 Typically, the value of the real property is
greater than that of the bonds issued.
ii. Eurobonds
 Securities (bonds) issued in a country
different from the one in whose currency
the bond is denominated.

1. Bond
a) Types of Bonds
i. Zero Coupon Bonds
 Issued at a substantial discount from the
RM1,000 face value with a zero coupon
rate.
 Return comes from appreciation of the
bonds.
 Advantages – cash outflows don’t occur
with zero coupon bonds.

1. Bond
a) Types of Bonds
i. Junk Bonds (High Yield Bonds)
 High risk debt with ratings of BB or below
by Moody’s and Standard & Poor’s.

 High yield – typically pay 3% ~ 5% more
than AAA grade long term bonds.

1. Bond
a) Terminology
i. Claims on assets and income
 In the case of insolvency, claims of debt,
including bonds are honored before those
of common or preferred stock.
ii. Par Value
 Face value of the bond, returned to the
bondholder at maturity.
 Corporate
bonds
are
issued
at
denomination of RM1,000

1. Bond
a) Terminology
i. Coupon Interest Rate
 The percentage of the par value of the
bond that will be paid out annually in the
form of interest.
ii. Maturity
 The length of time until the bond issuer
returns the par value to the bondholder and
terminates or redeem the bonds.

1. Bond
a) Terminology
i. Convertibility
 May allow the investor to exchange the
bond for a predetermined number of the
firm’s shares of common stock.
ii. Indenture
 The legal agreement between the firm
issuing the bond and the trustee who
represents the bondholders.

1. Bond
a) Terminology
i. Call Provision
 A provision such that if the prevailing
interest rate declines, the firm may want to
pay off the bonds early and reissue at a
more favorable interest rate.
 Issuer must pay the bondholder at
premium.
 There is also call protection period where
the firm can’t call for a specified period.

1. Bond
a) Valuation
 Assigning a value to an asset by calculating
the present value of its expected future cash
flows using the investor’s required rate of
return as the discount rate.
 The value of a bond is combination of:- the amount and timing of cash flows to be
received by investors.
- the time to maturity of the loan.
- the investor’s required rate of return.

1. Bond
a) Valuation - Formula
n

Vb
t 1

I
t
(1 kb )

M
n
(1 kb )

Where Vb = Intrinsic value
I = Interest to be received
n = Number of period to maturity

kb = Required rate of return for bondholder
M = Par value of the bond at maturity

1. Bond
a) Valuation - Formula
Vb = I(PVIFAkb,n) + M(PVIFkb,n)
Where Vb = Intrinsic value
I = Interest to be received
n = Number of period to maturity
kb = Required rate of return for bondholder
M = Par value of the bond at maturity

1. Bond
a) Valuation – Example
Consider a bond issued by Toyota with a maturity
date of 2008 and a stated coupon of 5.5%. In
December 2004, with 4 years left to maturity,
Investors owning the bonds are requiring a 4%
rate of return. Calculate the price of Toyota
Bond.

1. Bond
a) Valuation – 3 important relationships
First Relationships
 The value of a bond is inversely related to
changes in investor’s present required rate of
return (interest rate).
 As interested rate increases (decreases), the
value of the bond decreases (increases).

1. Bond
Second Relationship
 The market value of a bond will be less than
the par value if the investor’s required rate of
return is above the coupon interest rate.
 However, it will be valued above par value if
the investor’s required rate of return is below
the coupon interest rate.

1. Bond
Third Relationship
 Long term bonds have greater interest rate
risk than the short term bonds.

E. Risk & Return
Risk & Return

Risk & Return?

Market Risk

Diversification

Summary

E. Risk & Return
1. Risk & Return
a) What is Risk?
 The possibility that an actual return will differ
from our expected return.
 Uncertainty in the distribution of possible
outcomes.
b) What is Return?




Expected Return - the return that an investor
expects to earn on an asset, given its price,
growth potential, etc.
Required Return - the return that an investor
requires on an asset given its risk.

E. Risk & Return
1. Expected Return - Example
State of
Economy

Probability

Return
Company A

Recession

.20

4%

-10%

Normal

.50

10%

14%

Boom


(P)

.30

14%

30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn



k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%



k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Company B

E. Risk & Return
1. How do we Measure Risk?
 A more scientific approach is to examine the
stock’s STANDARD DEVIATION of returns.

 Standard deviation is a measure of the dispersion
of possible outcomes.
 The greater the standard deviation, the greater
the uncertainty, and therefore , the greater the
RISK.

E. Risk & Return
1. How do we Measure Risk?
a) Formula for Standard Deviation
n

2

(ki

k ) P(ki )

t 1

Where n = The number of possible outcomes
ki = The value of ith possible rate of return
P(ki) = Probability that ith return will occur
k = Expected value of the rate of return

E. Risk & Return
1. How do we Measure Risk? - Example
Company A

Company B

Recession

(4% -10%)2 (.2) = 7.2

(-10% -14%)2(.2) = 115.2

Normal

(10% - 10%)2 (.5) = 0

(14% - 14%)2 (.5) = 0

Boom

(14% -10%)2 (.3) = 4.8 (30% - 14%)2 (.3) = 76.8

Variance

12

192

Std Deviation

3.46%

13.86%

E. Risk & Return
1. How do we Measure Risk? - Summary
Company A

Expected Return
Standard Deviation

Company B

10%

14%

3.46%

13.86%

Which stock would you prefer? How would you
decide?
It depends on your tolerance for risk! Remember
there’s a tradeoff between risk and return.

E. Risk & Return
1. Diversification
 Investing in more than one security to reduce risk.
 If two stocks are perfectly positively correlated,

diversification has no effect on risk.
 If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.

 If you owned a share of every stock traded on the
BSKL and Mesdaq, would you be diversified? YES!
 Would you have eliminated all of your risk? NO!

Common Stock portfolios still have risk.

E. Risk & Return
1. Diversification
 Some risk can be diversified away and some can
not.
a) Market Risk is also called Non - diversifiable
risk. This type of risk can not be diversified
away.
 Unexpected changes in interest rates.
 Unexpected changes in cash flows due to
tax rate changes, foreign competition, and
the overall business cycle.

E. Risk & Return
1. Diversification
a) Firm-Specific risk is also called diversifiable
risk. This type of risk can be reduced through
diversification.
 A company’s labor force goes on strike.
 A company’s top management dies in a
plane crash.
 A huge oil tank bursts and floods a
company’s production area.

E. Risk & Return
1. Market Risk
 As we know, the market compensates investors for
accepting risk - but only for market risk. Firmspecific risk can and should be diversified away. So we need to be able to measure market risk.
 Beta: a measure of market risk.
 Specifically, it is a measure of how an individual
stock’s returns vary with market returns.
 It’s a measure of the “sensitivity” of an individual
stock’s returns to changes in the market.

E. Risk & Return
1. Market Risk
 A firm that has a beta = 1 has average market
risk. The stock is no more or less volatile than
the market.
 A firm with a beta > 1 is more volatile than the
market (ex: computer firms).
 A firm with a beta < 1 is less volatile than the
market (ex: utilities).

E. Risk & Return
1. Summary of Risk & Return
 We know how to measure risk, using standard
deviation for overall risk and beta for market
risk.
 We know how to reduce overall risk through
diversification.

 We need to know how to price risk so we will
know how much extra return we should require
for accepting extra risk.

Methodology
Payback Period

Net Present Value
Internal Rate Of Return

1. Importance of Capital Budgeting
 Capital budgeting is the process of evaluating
proposed large, long-term investment projects.
 capital

budgeting

ensures

that

proposed

investment will add value to the firm.

 Effective capital budgeting can improve both the
timing of asset acquisitions and the quality of
assets purchased.

1. Capital Budgeting Decision Method
a) Payback Period (PBP)
 PBP is the period of time required for the
cumulative expected cash flows from an
investment project to equal the initial cash
outflows.
 Formula for PBP :Unrecovered cost at start of yr
PBP = Year b4 full recovery +
Cash flow during year

a) Net Present Value (NPV)
 The present value of an investment project’s
net cash flows minus the project’s initial cash
outflow.

 Formula for NPV :n

NPV
t 0

CFt
t
(1 k )

 NPV’s values: NPV = 0, the firm’s overall value will not
change if the new project is adopted.

 NPV > 0, the firm’s overall value will
increase.
 NPV < 0, the firm’s overall value will be
decrease.

 NPV’s Decision Rules: For independent projects : accept all
independent projects having NPVs greater
than or equal to 0.
 For mutually exclusive projects : projects
having highest positive NPV will be
ranked first.

a) Internal Rate of Return (IRR)

 IRR is the estimated rate of return for a
proposed project, given the project’s
incremental cash flows.
 Formula for IRR :n

0
t 0

CFt
t
(1 IRR )

a) Internal Rate of Return (IRR)

 IRR Decision Rules: For independent project – accept projects
having IRRs greater than the hurdle rate.
 For mutually exclusive projects – projects
are ranked from highest to lowest IRR.

a) Conflicting ranking between NPV & IRR
 For Independent Projects
 Both the NPV and IRR methods will
produce the same accept / reject indication.
 Accept projects having NPV > 0, IRR >
the hurdle rate.
 For mutually exclusive projects
 Project having a higher NPV should be
chosen instead of a higher IRR.

a) Conflicting ranking between NPV & IRR
 For mutually exclusive projects
 Reason for higher choosing higher NPV
i. NPV method makes maximizing the
firm value.
ii. NPV method assumes that a project’s
cash flows can be reinvested at the cost
of capital.
iii. Whereas, IRR method’s assumption on
cash flows reinvestment is the IRR.

WACC

Cost of PS

Cost of Debt

Cost of Equity

When we say a firm has a “cost of capital” of, for
example, 12%, we are saying: The firm can only have a positive NPV on a

project if return exceeds 12%.
 The firm must earn 12% just to compensate
investors for the use of their capital in a project.
 The use of capital in a project must earn 12% or
more, not that it will necessarily cost 12% to
borrow funds for the project.

1. Cost of Debt (Kd)
 We use the after tax cost of debt because interest
payments are tax deductible for the firm.
 Formula for Cost of Debt
Kd after taxes = Kd (1 – tax rate)
 Example : If the cost of debt for ABC Sdn Bhd is
10% and its tax rate is 40% then :- Cost of debt
is?

1. Cost of Preferred Stock (Kps)
 Preferred Stock has a higher return bonds, but is
less costly than common stock. WHY?
 In case of default, preferred stockholders get paid
before common stockholders.
 However, in case of bankruptcy, the holders of
preferred stock get paid only after short and long
term debt holder claims are satisfied.
 Preferred stock holders receive a fixed dividend
and usually cannot vote on the firm’s affairs.

1. Cost of Preferred Stock (Kps)
 Formula for Cost of Preferred Stock
D
kps

=
Vps

Example : If ABC Sdn Bhd is issuing preferred
stock at $100 per share, with a stated dividend of
$12, then the cost of preferred stock :-

1. Cost of Equity (Kcs)
 The cost of equity is the rate of return that
investors require to make an equity investment in
a firm.
 CAPM (Capital Asset Pricing Model)
- The CAPM is one of the most commonly used
ways to determine the cost of common stock.

1. Cost of Equity (Kcs)
 Formula for Cost of Equity
kcs = krf + ß (km – krf)
Where krf = The risk free rate

ß = The firm’s beta
km = The return on the market
Example : ABC Sdn Bhd has a ß = 1.6. The risk free on T-bills
is currently 4% and the market return has averaged 15%:-

1. Weighted Average Cost of Capital (WACC)
 Formula for WACC

WACC = wd (Cost of Debt) + wcs (Cost
of Equity) + wps (Cost of PS)

Example : ABC Sdn Bhd maintains a mix of 40%
debt, 10% preferred stock, and 50% common stock
in its capital structure. The WACC is :-

H. Dividend Policy
Dividend Policy

Types
Chronology
Impact

Alternatives

H. Dividend Policy
1. Types of Dividend Policy
a) Constant Payout Ratio
b) Constant Nominal Dividend (Regular)
c) Special Dividend Payout
d) Cash Dividend Payment
2. Chronology of Date of Dividend Payment
a) Declaration Date
b) Ex Dividend Date
c) Record Date
d) Payment Date

H. Dividend Policy
1. Impact of Dividend Policy – Firm Value
a) Arguments for Irrelevancy Theory
 Signaling Effect
 Clientele Effect
b) Arguments against Irrelevancy Theory

 Bird in the Hand Theory
 Taxes
 Floatation Costs

H. Dividend Policy
1. Alternative Dividend Policy
a) Stock Dividend
 Firms sometimes tend to distribute additional
shares in the form of dividends to a firm’s
shareholders

rather

than

giving

cash

dividends, which are kept in the firm for
investment.

H. Dividend Policy
a) Stock Dividend – Example
A firm has 10 million shares outstanding.
Currently the market value of the firm is RM20
million.
Therefore, price per share is to be
RM2.00.
Assume that the firm is to issue
another 1 million shares as a stock dividend. The
total number of shares outstanding will be 11
million. Hence, given the market value of the
firm, the new price per share will be?

H. Dividend Policy
a) Stock Split
 Stock Split involve issuing of additional
shares to firm’s stockholders.
 The investors’ percentage ownership in the
firm remain unchanged.
 The investor is neither better nor worse off
before the stock split.

H. Dividend Policy
a) Stock Split – Example
YTM Bhd. Is planning a two for one stock split.
You own 5,000 shares of YTM Bhd’s stock that
is currently selling for RM12.00 per share. What
is the value of your YTM Bhd. Stock now, and
what will it be after the split?

H. Dividend Policy
a) Stock Repurchase
 It is a common practice for developed and

developing markets for a firm to buy back
stock from its shareholders.

 Reasons for repurchase :- an effective substitute for dividends.
- the price of stocks are undervalued.

- Provide internal investment opportunity.

H. Dividend Policy
a) Stock Repurchase – Example
UEB Bhd. Has RM0.8 million in cash for its next
dividend. However, it is considering a repurchase of
its own shares instead of paying dividends. The firm
has 10 million shares outstanding, currently selling
at RM2.00 per share. The P/E is 10 times and the
firm’s EPS is RM0.20. What will be the firm’s
dividend per share? If stock is repurchased, how
many shares will be remain outstanding and what
will the new EPS be?

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