1
SKETCHES in FINANCE 14OL
adapted for undergraduate finance online
CONTENTS
PREFACE 1
1. INTRODUCTION to FINANCIAL MGT 1
2. FINANCIAL ANALYSIS 4
3. TAXES6
4. RISK and RETURN 8
5. PORTFOLIO MANAGEMENT 11
6. VALUATION CONCEPTS13
7. VALUATION OF BONDS16
8. VALUATION OF STOCKS18
9. CAPITAL BUDGETING20
10. QUANTIFYING UNCERTAINTY24
11. FINANCIAL PLANNING26
12. COST OF CAPITAL28
13. LEVERAGE MODELS31
14. DIVIDEND POLICY33
15. EXERCISES35
PREFACE
The content for Sketches in Finance was compiled from lecture notes created for various financial courses taught by the author over many years. The content is not intended to break new ground, to promote any particular investment philosophy, to be a complete reference book, or to be the source of high entertainment. The collection is intended to replace the traditional financial textbook by touching the peaks of topics considered essential in an introductory course but with an economy of verbiage and minimal cost to the student. The exercises at the end of the book are designed to be completed in an online course environment.
1. INTRODUCTION to FINANCIAL MANAGEMENT
Introductory undergraduate finance courses are variously known as financial management, corporate finance or managerial finance and the courses are presented on the assumption that many students will eventually be employed by corporations and will own shares in corporations. Some students will become active managers of corporations, some even in the field of finance. And all students will be faced with financial decisions on a personal level. The skills and concepts reviewed in this book are designed to address the challenges of managing finances, be they individual or corporate.
1.1 Firm Advantage: The world of finance is often focused on the firm (i.e. the corporation, the enterprise, the business, the organization) because that’s where leveraged economic activity occurs. Economic activity, the exchange of goods and/or services, certainly takes place at the individual level, too, in which two people engage in an economic transaction. But a firm has an advantage over the individual by virtue of scale (e.g. more people, more capital, larger markets) and is thus able to generate many times more revenue and profit than individuals are able to generate on their own. As a consequence of this “firm advantage”, individuals at the beginning of their productive years look to find employment with corporations, rather than trying to start businesses of their own, because it is with the firms where the quick money is most likely to be found.
1.2 The Individual: Thus, an individual working for a firm has these two objectives: to work hours (days, years, a lifetime) for wages to fulfill his or her self-interests and also, to contribute to the financial well-being of the firm for which he or she works. The first objective can be assumed to be inherent to human nature (the survival instinct) and has been both celebrated and condemned – celebrated as the primary energy of progress and aggregate well-being (think Adam Smith, Ayn Rand) and condemned as destructive and anti-social (think Karl Marx, Vladimir Lenin). The second objective, contributing to the financial well-being of the firm, is the very core reason that the individual is originally hired by the firm. Some individuals quickly realize that their own employment security, and the related rewards, is a function of their ability to significantly contribute to the financial health of the firm. Financial management is the study of the practice of maximizing this financial health.
1.3 Stock Price: Maximizing a firm’s financial health has become a mantra in our capitalistic economy, and, like an individual’s self-interests, the notion is constantly being defended and vilified as well as being refined to a simple normative model. [A normative model is one that defines how the world should work in order to be consistent with other generally accepted assumptions]. This model says that that the objective of the firm should be to maximize the stock price.
1.4 Owners: Why is stock price the ultimate goal? Underlying this model is the assumption that the firm exists for the benefit of the owners of the firm. They are the ones who invested the capital to grow the firm, they are the ones who hired the agents to nurture the firm, and they are the ones who risked their own wealth so that the firm could flourish. And the owners’ wealth, or net worth, is directly proportional to the value of their respective shares in the firm. As the value of those shares fluctuates, so does the wealth of the owners. So the owners’ self-interested objective is to have the stock price, the price per share (pps), be as high as possible.
1.5 Managers: As the primary objective of the firm is to maximize stockholders’ wealth as reflected in the stock price, then the primary function of financial management is also to address that objective. Management accomplishes this through convincing investors that the "quality of future earnings" is strong – that is, that future earnings are both "likely" (have a high probability of coming to pass) and robust (exhibiting healthy growth through time). If management is effectively convincing, then a demand for a share of ownership in the firm will apply the upward pressure on the price, and management will have succeeded in fulfilling their objective - for the time being.
1.6 Agents: The relationship between the individual (the employee, the manager) and the firm is explored in the field of “agency theory”, where it is recognized that the employees (the “agents”)are motivated by both self-interests and the rewards from furthering the firm’s interests. The assumption of the theory is that although the corporation exists primarily for the benefit of the owners, that people who are engaged by the corporation to work to achieve those objectives are less than perfectly committed to those corporate objectives. The rationale underlying this conflict is based on the perceived realities of human nature - the realities are that a person can be paid to work toward someone else's goals, but that the "agent" will not fully suppress their own personal objectives. The agent's personal objectives are assumed to be the same rational economic goals that drive the owners, the maximization of their own personal wealth. The theory suggests that the conflict between the owners and the agents is inherent in the relationship, that the conflict cannot be eliminated, although it can be acknowledged and mitigated.
1.7 Compensation: Various practices are designed to address the agency conflict - the most obvious is for the owners to share their ownership with the agents. The sharing is achieved by the construction of compensation packages that are enhanced with a distribution of stock that, in effect, gives two roles to the employee (agent and owner) with the hope that the employees will more fully embrace the objectives of the other owners. Unfortunately for the "pure" owners (stockholders without any other relationship with the firm other than owning stock), sharing ownership has not proven to be effective in fully suppressing the agents' personal objectives.
1.8 Areas of Financial Management: The agents/managers exercise the tools of financial management to support the objectives of the firm through simultaneous actions in four major areas: 1) Capital Structure, 2) Capital Budgeting, 3) Dividend Policy, and 4) Cash Flow Management. These areas are explained further as follows:
1.9 Capital Structure: A firm is built on a foundation of money, the firm’s “capital structure”, which comes primarily from selling ownership shares (stocks) and by long-term borrowing (bonds). The capital structure decision includes determining when and how much stock to issue to outside investors, and when and how much debt (through bond offerings) to incur. The question is sometimes framed as “what proportion of debt to total assets” should be incurred in order to maximize stock price. Academic models that address this issue are ambiguous, with some models concluding that capital structure should have no direct impact on stock price, and others suggesting that a firm should borrow as much as they can. The question may also be framed as “where should the money come from?”
1.10 Capital Budgeting: A firm’s survival depends on the firm investing in future “projects”, where projects is a general term for any funds consuming activity – e.g. buying another firm, opening a new market, or developing a new product. The essence of a capital budget is a plan of expenditures and rewards related to the project under consideration. Incremental cash flows are estimated and appraised before a final decision is made to undertake a project. Some models used to assess capital budgets are based on traditional time-value of money concepts, are widely used in industry today, and are popular fodder for finance classes. There is also a wide-range of esoteric capital budgeting models that provide thought-provoking perspectives on forecasting future events.
1.11 Dividend Policy: A firm secures funding via capital structure decisions, invests the funding into capital budgeting projects, and distributes the earnings from those investments via dividend payouts to the stockholders. After tax earnings are either distributed as dividends or retained by the firm – the determination of the split between dividends and retained earnings is discretionary according to the will of the board of directors (albeit with some legal constraints).
1.12 Cash Flow Management: The earnings of a firm as shown on the bottom of its income statement are not necessarily representative of the actual cash flows. The art of forecasting real cash flows, tracking actual inflows and outflows, and taking action to control the flows are functions of the financial manager. The objectives are to reduce both the financing costs and the risk of depleting cash, thus ensuring the long term health of the firm and the maintenance of its share price.
2. FINANCIAL ANALYSIS
Financial managers use the techniques of financial analysis to measure the corporation’s financial health, to assist in identifying strengths and weaknesses and to track the effectiveness of management initiatives. A classic approach to financial analysis is through the use of ratios and this technique is used both by internal managers and external investors. Some typical ratios include those listed immediately following. Note that the first eight ratios use data taken solely from the income statement and the balance sheets, whereas the last two ratios use current market data combined with those financial statements.
2.1 Current Ratio shows the liquidity of the firm by comparing the current assets relative to the current liabilities. A healthy firm would want a current ratio (current assets divided by current liabilities) greater than 1.00, and a ratio of 2 or 3 would certainly add a margin of comfort. To calculate, divide current assets by current liabilities.
2.2 Quick Ratio, or “Acid Test”, is a more stringent measure of liquidity, in that it subtracts inventory from the current assets before doing the same calculation as with the Current Ratio. Inventory is not considered to be as liquid as other current assets. To calculate, subtract inventory from current assets before dividing the remaining current assets by current liabilities.
2.3 Inventory Turns is another measure of the firm's asset management prowess. In this case, the skill in managing inventory is measured – having the right stuff on the shelf when needed, not having too much in stock, and moving stuff quickly. Inventory Turns represents the number of times the firm has "filled and emptied" its shelves in a year. More turns are better than fewer turns. There is a wide range of what is a normal number of turns, depending on the nature of the business. Some firms use average inventory in the turns calculation, others use year-end inventory. And some firms divide inventory into sales, and others divide inventory into cost of goods sold. To calculate, use COGS divided by year-end inventory.
2.4 Days Sales Outstanding(DSO) is a measure of the firm's ability to manage one portion of its assets - accounts receivable. Equivalent to "average collection period", DSO is a measure of how quickly receivables can be converted into cash. Fewer days are better than more days, and an average of a month and a half is normal for many industries. DSO is calculated by dividing sales into receivables to get the proportion of sales still outstanding and then multiplying the results by 365, the number of days in a year.
2.5 Debt Ratio measures the proportion of debt (total liabilities) relative to the total capitalization (total assets) of the firm. Somewhat counter-intuitively, more debt is not necessarily a bad condition for a firm (debt is still something to be avoided for the individual). A firm that avoids borrowing, at the expense of foregoing profitable projects, may be losing opportunities that its competitors end up taking advantage of. Debt ratios will usually fall between 0 and 1.00. Over 1.00 is definitely a bad sign. But between 0 and .80, it's difficult to say whether a change is better or worse without further information. To calculate, use total liabilities divided by total assets.
2.6 Times Interest Earned (TIE) indicates a firm's ability to cover its interest payments due on its bonds with the firm’s earnings from operations. Said another way, TIE is the number of times the firm could pay its interest obligations with its earnings before interest and taxes (EBIT). Less than 1.00 would be a bad sign for sure, and multiples like 2, 3 and higher are healthy signs. To calculate, divide the interest payments into the earnings before interest and taxes (EBIT).
2.7 Profit Margin is the percentage of the top line (sales, revenues) that flows down to the bottom line (EAC, net profit, net income) after taking out all the firm’s expenses. A firm that keeps two cents for every dollar of sales is typical, although there are certainly more profitable firms, too. To calculate, divide EAC by Sales.
2.8 Return on Assets (ROA) is pretty self-explanatory. ROA measures the firm's bottom line profits as a percentage of the total assets of the firm. Sometimes called "basic earning power", ROA suggests that a firm should be able to earn a (relatively) fixed percentage of every dollar invested in the firm. A 12% ROA is not unusual. To calculate ROA, divide EAC by Total Assets.
2.9 P/E Ratio is unlike the ratios above in that it is not generated solely from the income statement and balance sheets – it also requires the price per share (pps) from current market data. This ratio measures the price that investors are willing to pay for a dollar of earnings. The earnings are usually historical, trailing twelve months (ttm), although the “P/E (est)” ratio compares current pps to estimated (future) earnings. The P/E ratio is often abbreviated to PE ratio and is sometimes called the firm's "multiple". The reciprocal of the PE is called the "earnings yield", the percentage of net earnings generated each year for a given price per share, and is perhaps a more intuitive way of understanding the relationship between pps and earnings available to common stockholders (EAC). Remember, EAC belongs to the owners of the firm – the shareholders. As of the closing bell on 20 July 2012, the average PE for the S&P500 was 15.6. As PE is a measure of the "pricey-ness" of a stock, a PE of 16 was average, over 20 was getting pricey.
2.10 Market to Book is similar to the PE ratio in that it relies on current pps data. In this ratio, "market" refers to the value that investors have given the firm, the "market capitalization" or MKT CAP (as seen on Yahoo). Market cap is the total current market value of all outstanding stock, or pps times number-of-shares. For example, pretend that you wanted to buy IBM, as in, buying the whole company. How much would it cost? That's market cap. In mkt/book, "book" is how the accountants value the company and is found on the balance sheet as "shareholders equity". Mkt/book is another measure of pricey-ness, and typical ratios run 2.0 to 4.0. To calculate, divide the current market cap by the most recent book value.
3. TAXES
Financial managers are well-aware of the reality of taxes – as taxes are prevalent in most business transactions, they are a significant cost, they are somewhat predictable and manageable, and they vary according to a myriad of rules and exceptions. What follows is a sampling of the issues and vocabulary related to the tax implications of transactions in stocks and bonds at both the corporate and the individual level.
3.1 Corporate tax treatment on bonds:
Interest on bonds is paid by the firm to bondholders before taxes. That is, dollars paid to bondholders are subtracted from the firm's operating profits prior to the calculation of the taxes due on those operating profits. Consequently the taxes that are eventually paid on those reduced profits are less than they would have been had interest not been paid out. From one perspective, this reduction in taxes amounts to a subsidy that the government "pays" to the firm for borrowing money.