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Mos 2310 Midterm Notes

Chapter 1:
What is corporate finance?
- Every decision that a business makes has financial implications and any decision which
affects the finances of a business is a corporate finance decision
- Defined broadly, everything that a business does fits under the rubric of corporate finance
- What products to launch, How to pay to develop those products, What profits to keep and
how to return profits to investors

Valuation Principle:
- The value of a commodity or an asset to the firm or its investors is determined by its
competitive market price. The benefits and costs of a decision should be evaluated using
those market prices. When the value of the benefits exceeds the value of the costs, the
decision will increase the market value of the firm
- The law of one price: in competitive markets, the same goods must have the same price;

financial securities that produce the same cash flows must have the same price

Profit Maximization is NOT a well defined Corporate Objective:

- 3 Reasons:
- 1. Maximize which year’s profits (increase current profits but damage future years profits)
- 2. Increase future profits by cutting this year’s dividend
- 3. Calculate profits in different ways

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Objective of Financial Management:

- The objective of financial management is to maximize the value of the firm:
- The value of the firm to stockholders is determined by how much someone else is willing
to pay for claims on the firm as reflected in increases in stock prices

Maximizing Stockholder Wealth is Achieved By:

- Maximizing the size of cash inflows
- Speeding up (delaying) the timing of cash inflows (outflows)
- Effectively dealing with the risk of cash flows

Factors Affecting Cashflows and Wealth Maximization:

- Factors affecting firms cash flows and thus, stockholder wealth maximization are:
- Inflation, industrial demand and other environmental factors beyond management control
- Strategic and policy decision controlled by management
- Type of products / services offered
- Marketing & production systems
- Investment policy
- Amount of debt used

Flow of Cash Between Capital Markets and the Firm’s Operation:

1. Raise cash by selling financial assets to investors
2. Cash invested in form (purchase real assets)
3. Cash generated by firm’s operations
4a. Cash reinvested in the firm
4b. Cash returned to investors (dividends, interest, principal repayment)

The Agency Problem:

- The behaviour of the managers may not always be conducive to the health of a corporation
- Managers are hired as the agents of the owners
- When the personal goals of these agents create conflict in their roles in the corporation,
they create Agency Problems
- Manager may overindulge in unnecessary expenses
- They may shy away from attractive projects
- They may engage in empire building
How do corporations ensure that managers & shareholders interests coincide?

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- Conflicts of interest between managers and shareholders can lead to agency problems
- These problems are kept in check by:
- Compensation plans (i.e stock options)
- Monitoring of management by the board of directors, security holders & creditors
- Threat of takeover
- Contracts

Agency Costs:
- the reduction in shareholders' wealth due to the agency problem.
- Indirect agency costs are lost opportunities (When managers reject high risk high return proj)

Tax Implications for Corporate Entities:

- A corporation’s profits are subject to taxation separate from its owner’s tax obligations
- Shareholders of a corporation pay taxes twice
- The corporation pays tax on its profits
- The shareholders pay their own personal income tax on the profit distributed by the
corporation

Canada Revenue Agency (CRA):

- CRA allowed an exemption for double taxation flow-through entities (income trust)
- Business Income Trusts
- Energy Trusts
- Real Estate Investment Trust (REIT)
- REITs continue to have no tax at the business level beyond 2011 but the other forms of
income trusts are now taxed

The Canadian Financial System:

- Financial Market: total market for financial instruments
- Primary Market: the sale of initial issues (new securities) by corporations to buyers
- Secondary Market: trading of previously issued (seasoned) securities traded among
investors
- Fixed-Income market: debt securities
- Capital market: for long-term financing

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- Money market: short term financing < 1 year

Functions of Financial Markets & Intermediaries:

- Transporting cash across time
- Offering liquidity & flexibility
- Creating a payment mechanism
- Reducing (spreading) risk
- Opportunity cost of capital

Information (expertise) provided by Financial Markets:

- Commodity Prices
- Interest Rates
- Company Value

Chapter 2:
The Statement of Financial
Position or Balance Sheet:
- Snapshot of the firm’s financial position at a given point in time
- L-T assets are depreciated (schedule that depends on the assets useful life)
- Shareholders equity (accounting measure) of the firm’s net worth
- The Balance Sheet Identity (the two sides of the balance sheet must balance)

Shareholders’ Equity:
- Difference between the firm’s assets & liabilities
- Book value (BV) of equity
- Net worth from an accounting perspective
- Assets - Liabilities = Equity

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- True value of assets may be different from the book value

- Book value of a firm’s equity is not a good estimate of its true value as an ongoing firm
(but sometimes used as estimate of the liquidation value = value left after its assets
were sold and liabilities paid)
- Market Capitalization
- Market price per share x number of shares
- Doesn’t depend on historical cost of assets

Market versus Book Value:

- When market value is greater than book value, the company must have sources of value that
do not appear on the balance sheet
- These include:
- Opportunities for growth
- The quality of the management team
- Relationships with suppliers & customers, etc.

Market-to-Book Ratio:
- The ratio of firm’s market capitalization to the book value of stockholders’ equity
- Also called Price-to-Book ratio [P/B] ratio
- Sometime used to classify firms as value (low M/B) or growth (high M/B)
- Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

Enterprise Value (EV):

- Market capitalization measures the market value of the firm’s equity
- Enterprise value is the total market value of a firm’s equity and debt, less the value of its
cash & marketable securities
- It measures the total value of the underlying business assets
- Enterprise Value = Market Value of Equity + Debt - Cash

Earnings per share (EPS):

- Net income reported on a per-share basis
- EPS = Net Income / Shares Outstanding

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- Diluted EPS shows earnings per share if the number of shares increases by:
- Stock options issued to employees
- Shares issued due to conversion of convertible bonds

Cash Flow Statement:

- The statement of cash flows is divided into 3 sections which roughly correspond to three
major jobs of the financial manager:
- Operating activities
- Investment activities
- Financing activities
- Payout ratio = Dividends / Net Income
- Retained Earnings = Net Income - Dividends

How does the statement of cash flow differ from the income statement?
- Income statement measures the profits of the firm, while the statement of cash flows
measures how cash moves in and out of the firm
- These are NOT necessarily the same, as many non-cash flow transactions are included in
the income statement (such as depreciation), while other cash flow transactions are not
included in the income statement (such as investment in working capital and property, plant
& equipment)

The Impact of Depreciation on Cash Flow:

- Non-cash entries on the income statement
- Cash is important because it’s needed to pay bills and maintain operations and is the source
of any return of investment for investors
- The increase in cash balance comes completely from the reduction in taxes

Ratio Analysis:
- Liquidity: a measure of a company’s ability to pay short term debt as it comes due
- Net Working Capital, Current Ratio & Quick Ratio
- Activity: a measure of a company’s effectiveness at managing current accounts & fixed
assets (total assets)
- Average age of inventory, inventory turnover, average collection period, average payment
period
- Leverage: the amount of borrowed money being used in an attempt to maximize shareholder
wealth

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- Debt ratio; costly debt raio, debt to equity ratio

- Profitability: evaluate the firm’s earnings with respect to a given level of sales, a certain level
of assets, the owner’s investment or share value
- ROS, ROA, ROE, ROI, EPS, P/E ratio

Name Formula

Net Income Addition to RE + dividends

EPS NI / Shares outstanding

Dividends per share Dividends / Shares outstanding

Book value per share Total Equity / Shares

Market-to-book Share price / Book value per share

P/E Ratio Share price / EPS

Sales per share Sales / Shares

Price-to-Sales ratio Share price / Sales per share

What does a high debt-equity ratio tell you?

- The debt-equity ratio is a common ratio used to assess a firm’s leverage
- Because of the difficulty of interpreting the book value of equity, the book debt-equity ratio
is not especially useful

What do you use the P/E ratio to gauge the market value of a firm?
- Analysts and investors use a number of ratios to gauge the market value of the firm
- The P/E ratio is a simple measure that’s used to assess whether a stock is over or under-
valued based on the idea that the value of a stock should be proportional to the level of
earnings it can generate for its shareholders
- The P/E ratio is not useful when the firm’s earnings are negative
- PEG ratio: firms P/E to its expected earnings growth rate

DuPont Model:
- ROE = Profit Margin * Total Asset Turnover * Equity Multiplier
- ROE = (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Total Equity)

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- Profit margin (PM) is a measure of the firm’s operating efficiency; how well does it control
costs
- Total asset turnover (TAT) is a measure of the firm’s asset use efficiency, how well does it
manage its assets
- Equity multiplier (EM) is a measure of the firm’s financial leverage

Chapter 3:
What makes an investment decision a good one?
- A decision is a good one when the present value of the benefits is greater than the present
value of the costs. Benefits & costs can be measured in $. We call this idea the cost-benefit
analysis

Why are market prices useful to a financial manager?

- Market prices are useful b/c it is the market price that determines that value of a good
- When market prices are not available, it becomes more difficult to value an investment
- We normally value the effects (cost & benefits) in the same terms - cash today
- The best decision makes the firm and its investors wealthier, because the value of its
benefits exceeds the value of its costs. We call this tea the Valuation Principle (Ch. 1)

What is the relation between the Law of One Price and the Principle of No Arbitrage?
- If the Law of One Price is violated that is the same goods are priced differently on different
markets, then arbitrage opportunity exists
- The supply and demand forces will cause the price difference to disappear as astute
investors try to take advantage of the profitable opportunity
- In a normal competitive market, arbitrage opportunities quickly disappear. Hence, in a
normal competitive market, the supply and demand forces cause prices to equalize so that
arbitrage opportunities are eliminated

Time Value of Money:

- Results from the concept of interest
- A dollar on hand today is worth more that a dollar to be received in the future because the
dollar on hand today can be invested to earn interest to yield more than a dollar in the future
- It’s possible to compare or combine values ONLY at the same point in time
- Having money now is more valuable than having the same amount of money in the future; if
you have money today you can invest it and earn interest on it

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- To calculate a cash flow’s future value, you must compound it

- Interest Rate Factor (1 + r)

Compounding:
- Accumulating interest in an investment over time to earn more interest
- Interest on interest
- Compound interest is earned on both the initial principal and the interest received from prior
periods
- Simple interest is earned only on the original principal amount invested

Future Value:
FV = PV (1+r)n

Present Value (PV)

PV = FV / (1+r)^n

How do you compare costs at different points in time?

- In general, a dollar today is worth more than a dollar in one year
- To compare costs at different points in time, we either need to find the future value
(compounding) of all the cash flows at the same point in time in the future or find the present
value (discounting) of all the future cash flows today
- To compute a cash flow’s present or future value we must know the number of periods, the
discounting rate for present value, compounding rate for future and cash flows

Rule of 72:
- To find the number of years required to double your money at a given interest rate, divided
the compound return into 72
- Years to double = 72/r%
- This rule is fairly accurate for discount rates b/n 5-20 percent range

Chapter 4:
Valuing Cash Flows at Different Points in Time:
- Rule 1: Only values at the same point in time can be compared or combined
- Rule 2: To calculate a cash flow’s future value, we must compound it.
- Rule 3: To calculate the present value of a future cash flow, we must discount it

Steps to Solve Time Value of Money Problems:

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1. Read problem thoroughly

2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF, annuity streams or mixed flow
6. Solve

Present Value of an Uneven Series:

- Since the payments are uneven, PV’s must be used instead of PVA’s
- Each cash flow must be discounted separately; unless some can be treated as an annuity
- What is the present value of an uneven series of cash flows of 100 at y1, 120 at y2 and 140

at y3 if the discount rate is 10%?

Present Value of an Annuity (PVA):

- A stream of equal cash flows arriving at a regular interval over a specified time period
- First payment takes place at date 1
- i.e You just won the lottery, it will pay you 75k per year for 45 years. How much is it worth
now if the interest rate is 8%?

Annuity versus Annuity Due:

- In an Annuity the annuity payments are made at the end of each period

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- In an Annuity due, the annuity payments are made at the beginning of each period

Future Value of an Ordinary Annuity:

- An annuity is a series of fixed dollar
payments for each of a number of periods

FV (annuity)

Perpetuities:
- A perpetuity is an annuity which continues forever, like preferred stock or a console
(perpetual bond that promises its owners a fixed cash flow every year forever)

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- I.e In order to create an endowment, which pays 100k per year, forever, how much money
must be set aside today if the IR is 10%?

Present Value of a Growing Perpetuity:

- A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a
constant rate (g) forever
- R is greater than g
- i.e You will receive 100 per year and this amount will grow at the rate of 5% per year,
assuming an IR of 10%, what is the
present value of this growing
perpetuity?

Present Value of a Growing Annuity:

- A finite number of growing annual cash flows
- C1 is the payment to occur at the end of the first period, r is the interest rate, g is the rate of
growth per period,
expressed at a
percentage, and n is the
number of periods for the
annuity

Future Value of a Growing Annuity:

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- FV of a growing annuity is used to calculate the future amount of a series of cash flows, or
payments, that grow at a proportionate rate

- Sometimes referred to as an increasing annuity

- r is IR, g is rate of growth per period
Finding the Number of Periods:
- Use the basic equation and solve for n
- FV = PV (1+r)^n
- T = ln (FV/PV) / ln(1+r)
- Can also use rule of 72 for amounts that double

Calculating the Interest Rate:

- We can use either FV or PV equation because they are the inverse of each other
- For individual cash flows: r = (FV/PV)1/n - 1

Chapter 5: Interest Rates

What are Interest Rates?
- Interest rates are the prices paid when an individual, firm, or government borrows money
- Interest rates are costs or benefits depending on whether you are a borrower or lender
- Interest rates are almost always stated on an annual basis
- Interest rates are set by market forces, in particular the supply and demand of loanable
funds and fluctuates over time

Interest Rate Quotes & Adjustments:

- Adjusting the discount rate to different time periods
- In general, by raising the interest rate factor (1+r) to the appropriate power, we can
compute an equivalent interest rate for a longer (or shorter) time period

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- An effective discount rate of r for one period can be converted to an equivalent effective
discount rate for n periods:
- Equivalent n-period discount rate = (1+r)n - 1
- When computing present or future values, you should adjust the discount rate to match
the time period of the cash flows

Kinds of Interest Rates:

- Nominal: means “in name only” this is sometimes the quoted rate
- Periodic rate: the amount of interest you are changed each period (i.e day, month, quarter)
- Annual Percentage Rates (APRs): quoted rate dictated by the Bank Act. APRs do not
recognize the effect of compound interest. Posted rates = rate per period x the # of periods
- i.e 1% per month (1x12) = 12% per year

Annual Percentage Rates (APR):

- Because the APR doesn’t reflect the true amount you will earn over one year, the APR itself
cannot be used as a discount rate
- Instead, the APR is a way of quoting the actual interest earned each compounding period:
- Interest Rate per Compounding period = APR / m
- (m = # of compounding periods per year)

Effective Annual Rate:

- The rate that you actually get charged on an annual basis. Remember you are paying
interest on interest
(annualized using

compound interest)
Determining Interest Rates:
- Determining time periods will tell you the number of compounding
periods between the PV point and the FV point, or vice versa
- The number of compounding periods is a derivative of the compounding frequency of the
interest rate
- If the compounding frequency is monthly, then the number of compounding periods will be
in months
- Each calculation may have a different time period (years, quarters, months, days, etc.)

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Canadian Mortgage Payments:

- A mortgage is a man for which the borrower offers property as security for the lender
- Canadian mortgages are typically quoted in the form of an APR with semi-annual
compounding even though the mortgage has monthly payments
- Need to convert the APR w/ semi-annual compounding into equivalent effective rate
- (1+r)1/6 = % per month
- The monthly payment
can be computed:

Real Rates:
- Interest rate or rates of return that have been adjusted for inflation
- Fisher Effect: A theory describing the long-run relationship between inflation and interest
rates
- Real Rate = Nominal Rate - Inflation Rate / 1 + Inflation Rate
= Nominal Rate - Inflation Rate

Nominal versus Real:

- We will always forecast cash flows including any growth due to inflation, and discount using
nominal interest rates
- When you discount real cash flows with nominal interest rates, you are accounting for
inflation twice. Real cash flows are stripped of any inflation components, but nominal interest
rates include an inflation component. Thus, you end up double-discounting for inflation.
- The real interest rate is the rate of growth of purchasing power after adjusting for inflation.

How do changes in inflation expectations affect interest rates?

- An interest rate is the price of using money today rather than in the future. Alternatively, an
interest rate is the reward for saving money for the future
- However, if inflation is expected to increase, the purchasing power of the money in the
future is less. This makes the reward of saving less attractive

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- Normally, when inflation expectations increase, so do interest rates, as borrowers offer

greater incentives to lenders to counteract the additional burden of higher inflation

Can the nominal interest rate available to an investor be negative?

- Nominal interest rates cannot be negative
- An investor would rather save money under the mattress at home than pay a bank to hold it
- But real interest rates can be negative if inflation is higher than nominal interest rates.
(Japan in 1990s)

The Determinants of Interest Rates:

- The yield curve and discount rates
- Term Structure: the relationship b/n the investment term and the interest rate
- Yield Curve: A plot of bond yields as a function of the bonds maturity date
- Risk-Free Interest Rate: the interest rate at which money can be borrowed or lent without
risk over a given period

Term Structure of Interest Rates:

- A yield curve shows the relationship b/n yield to maturity and term to maturity for securities
with the same level of default risk
- Yield curves shift up and down, depending on the general supply and demand for funds
- The shape of the yield curve changes as investors expectations of future rates of inflation
change
- Yield curves for firms will be above that for governments due to higher risk

The Determinants of Interest Rates:

- Interest Rate Determination
- The Bank of Canada determines very short-term interest rates through its influence on the
overnight rate
- Overnight rate: the rate at which banks can borrow cash reserves on an overnight basis
from the BOC

Slope of the Yield Curve:

- Normal (upward sloping) yield curve indicates generally cheaper short-term borrowing cots
than long-term borrowing costs

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- Inverted (downward sloping) yield curve indicates generally cheaper long-term borrowing
costs than short-term borrowing costs
- Flat yield curve reflects relatively similar borrowing costs for both short and long-term loans

The Determinants of Interest Rates:

- The Yield Curve and Discount Rates
- Present Value of a Cash Flow
Stream Using a Term Structure
of Discount Rates

Opportunity Cost of Capital:

- The opportunity cost of capital is the best available alternative to the investment that you are
looking at, given the same level of risk and investment horizon
- The term (opportunity) cost of capital comes from—investors in your firm are giving up the
opportunity to invest their funds elsewhere
- This is an opportunity cost to them, and to overcome it you must offer them a return equal to
or utter than their opportunity cost of capital

Chapter 6: Bonds

Valuation Fundamentals:
- Key inputs to the valuation process include cash flows, timing and the required return,
periods. The value of any asset is equal to the present value of all future can flows it is
expected to provide over its useful life

Bond Terminology:
- Bond Indenture: A statement of the terms of a bond, as well as the amounts and dates of all
payments to be made
- Maturity Date: The final repayment date of a bond
- Term: The time remaining until the final repayment date of a bond
- Face Value (aka par value of principal amount)
- Notional amount used to compute interest payments
- Usually standard increments, 1,000

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- Typically repaid at maturity

Coupons:
- Coupons: The promised interest payments of a bond, paid periodically until the maturity date
of the bond
- Coupon Rate: set by
the issuer of the bond
certificate. Expressed
as an APR

Coupon Rate & Required Return:

- How does a bond issuer decide on the appropriate coupon rate to set on its bonds?
- Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such
bonds are used to establish the coupon rate necessary for a particular issue to initially sell
them
- Explain the difference b/n the coupon rate and the required return on a bond
- The coupon rate is fixed & simply determines what the bond’s coupon payments will be

Bond Valuation:
The Bond-Pricing Equation:

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